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Thursday, September 25, 2008

Do We Need to Act Now?

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Anne Krueger says we need "swift action" on a bailout plan:

Why We Need to Act Now, by Anne O. Krueger, Commentary, Washington Post: It is imperative that the United States act quickly to restore confidence and the flow of credit. The longer action is delayed, the more costly rescue is likely to be. Rescuing the financial system is in the interests of all Americans: Failure to do so would result in rising unemployment and falling output... A financial system incapable of appropriately assessing the trade-offs between risk and reward cannot support economic growth.

Fortunately, the reduction in U.S. construction activity has, to date, been offset by increases in net exports, and there has been no recession. But as uncertainty about the value of assets underlying various credit instruments has spread, the risks that credit will shrink, and thus lead to declining economic activity, have increased. There must be a rescue before that happens; sustaining credit availability to creditworthy borrowers is crucial for the economy as a whole. Simultaneously, viable banks must be recapitalized. ...

Japan's experience holds lessons. The real estate boom in Japan ended around 1990, and it was assumed that the banks could handle the nonperforming loans on their books. The result of that assumption was more than a decade of stagnation, until measures were taken to reduce the nonperforming loans on the banks' books, recapitalize the banks and restore the flow of credit. The costs of acting a decade or more earlier would have been substantially smaller. The choice Japan faced was not whether to act but whether to act now or later. That is almost certainly the decision United States faces now.

Any rescue should not reward shareholders and those who made the risky decisions. If a fund is established to buy up some of the banks' questionable assets, accurately pricing those assets will be critical. It will also be crucial to purchase assets only from financial institutions that are healthy enough to survive. The more transparent the rules for purchasing loans from banks, the more effective the system will be. ...

Enough resources must be provided to ensure the success of the operation: If "too much" is allocated, the funds will not need to be spent. Ironically, a larger pool of resources may ultimately cost less than a smaller one. If the allocation is "too small," it will not instill the confidence necessary to ensure that capital markets function. In that case, the inevitable next rescue effort will probably cost even more.

But the focus today should be on swift action. ...

Not everyone agrees:

A Bailout We Don't Need, by James K. Galbraith, Commentary, Washington Post: Now that all five big investment banks -- Bear Stearns, Merrill Lynch, Lehman Brothers, Goldman Sachs and Morgan Stanley -- have disappeared or morphed into regular banks, a question arises.

Is this bailout still necessary?

The point of the bailout is to buy assets that are illiquid but not worthless. But regular banks hold assets like that all the time. ...

And, back on the it's urgent side:

The Paulson Plan: a useful first step but nowhere near enough, Willem Buiter: Given the extreme urgency of the situation, the response of the US Congress has been truly astonishing.

The House and the Senate are acting as if this is politics as usual. Some grandstanding here. The threat of delays or even a filibuster. Amendments and modifications that range from the revoltingly populist to the terminally stupid with the disgustingly opportunistic and self-serving in between.

Admittedly, Secretary Paulson laid an egg by including the following phrase in his proposal: “Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law of any administrative agency”. This reads as though it was personally written by Dick Cheney, the prince of absolute executive authority, no checks and balances, no accountability, no recourse. No administration that brought us WMD in Iraq and the torture camps of Guantanamo Bay and should expect anything but hysterical giggles in response to such a request. Not smart.

So, let’s put in accountability and oversight and make sure than Paulson cannot donate $700bn to Nature Conservancy. But then let’s pass the plan.

She said - He said - He said - He said. Back to the no bailout side:

Why I am opposed to the bailout, by Morris A. Davis: First, I've decided it is bad economics. Suppose the bailout costs 500 billion. Suppose the bailout is effective in avoiding a recession -- The bailout itself costs 3-1/2 percent of GDP. I think you have to go back to 1982, maybe further, to get that kind of contraction in GDP during a recession.

Second, Paulson and Bernanke have proven, repeatedly, they have no idea what is going on. ... The reason I have no faith in Bernanke or Paulson is that they have no simple theory to explain what is going on. ...

Third, what assets should be bought in a bailout? Mortgages? ... Forget the adverse selection problem for the moment. Just ask: Why would the government know which class of assets to buy and why?

Fourth and Fifth, the precedent this sets is terrible. This bailout means we have lost faith in free markets to allocate scarce capital to its most productive use. It also tells punishes responsible investors (who did not underwrite or hold high yield junk mortgages) and rewards ex-post the participants in financial markets who took the riskiest bets.

I think a bailout is needed, but is it urgent? What's important for financial markets is not so much how long the agreement takes, though pressures are building so we can't waste time, the important thing is that it appears Congress is working toward a solution. So long as markets have confidence in the potential outcomes, and so long as it is evident that a solution will be forthcoming before too long, then there is time to get the details right. But as we saw today (here too), markets are fragile and any clear sign of a breakdown in negotiations or a long, drawn out process could start a chain reaction that causes credit to evaporate quickly. Maybe we'd get through it okay, but except in an academic sense, it's not an experiment I want to run. I expect we'll have an agreement before too long.

    Posted by on Thursday, September 25, 2008 at 02:25 AM in Economics, Financial System | Permalink  TrackBack (0)  Comments (107)


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