I remain adamantly opposed to the "Emergency Economic Stabilization Act of 2008". And I'm astonished that so many who opposed the bare-bones Paulson Plan have, however begrudgingly, risen to support this proposal. Yves Smith is right that "turning Hank Paulson's three pager into a 110 page draft made for a nice fig leaf but made virtually no substantive difference." There is a bit more accountability and transparency. But, there are also huge new powers for the Federal Reserve and the SEC that weren't in the original, and were inserted with no public debate. All the rest, the equity sharing, the "installment plan", the compensation limitations are weak, and the act specifically authorizes the Treasury to overpay for assets (that is, "at the lowest price that the Secretary determines to be consistent with the purposes of this Act").

There has been so much talk of catastrophic consequences if we do not support this bail-out. What happens if we do pass the act — over the clear objections of the vast majority of Americans — and the depression still comes?

I think people are severely underestimating the depths of the crisis we are in. This is not a financial crisis about banks and commercial paper. It is not about the housing market. We are in an economic crisis, because America's productive capacity is deeply out of kilter with our habits of consumption. No amount of financial legerdemain can fix that. We have to actually produce the goods and services we want to consume, or else produce current goods and services that we can trade for what we consume. Relying on the mysteries of finance to square the circle has brought us low. At best, the proposed bail-out might buy us some time to fix the underlying economics before the pain kicks in. At worst, the pain will kick in anyway, but we'll have even less flexibility than we have now to address the real problems.

Suppose we pass the "Emergency Economic Stabilization Act of 2008", and a depression comes anyway, and we cannot raise taxes (blood, turnips, all of that), and we cannot borrow from abroad (because our paymasters have tired of us). Sure, the Federal Reserve will print money, because the debt must be paid and the government must continue, and in a depression many prices will fall regardless, but commodities and imports will grow dear. We will know then that we want to build factories, for all the televisions and computers that used to be cheap from Asia, but that can no longer be bought with debauched greenbacks. But we won't have the capital.

What will we say, in those dark days, when someone comes along and blames the bankers? It was the bankers, after all, who "intermediated" our vast current account deficit, who found ways of accepting goods and producing debt despite our incapacity to repay, and who enriched themselves by doing so. And then these self-same bankers threatened us with armageddon unless we paid them hundreds of billions of dollars, back when dollars could still buy steel and cement and machinery. We paid the ransom, but the hostage died anyway. How will Secretary Paulson answer their charge?

Suddenly we will realize the cost of putting expedience before even the thinnest veneer of justice. Because in the end, Secretary Paulson will answer these charges with a locked gate and an exception to the Posse Comitatus Act. An economic depression will bring temptations to violence and radicalism. And a lot of people will look back on this decade, right up to and through the "Emergency Economic Stabilization Act of 2008", and feel with some justice that they were royally screwed.

Now, in a deep downturn, scapegoats will be found no matter what. Maybe we really have nothing to lose by passing this badly flawed proposal, since it might prevent a depression and if not we're all toast anyway. But, you know what? While we still can borrow valuable dollars, we could use that 700B to build infrastructure that might make the economic facts of a depression less severe. And, if we insisted that the mighty bankers actually fall now, actually take the hit that their own ideology demands of them, that just might blunt the sense that we are "us" and "them", rather than a nation with a common struggle, when it all hits the fan. Maybe the choice we are really making here is not about financial and monetary arcana, but a choice between civic peace and civil war.

Obviously this is speculative, and alarmist, while the crises in the credit markets are acute, real, and tangible. But we really could nationalize failing banks before they take down the credit markets, while bailing out senior creditors. It has been done. The Federal Reserve or the Treasury could buy high quality commercial paper if the money markets go on strike. (That's much less risky than buying frozen mortgage assets.) We really could invest in productive infrastructure, rather than in claims on already built subdivisions. We do have other choices, besides starting the depression tomorrow or giving Secretary Paulson what he wants.

The Paulson Plan is now the easy out. It has a lot of momentum behind it. It feels safe. But it is not guaranteed to work even in the short run, and does not address the substance of our economic problems at all. Much of the public perceives the plan as at best a kind of ransom and at worst a kind of theft. The plan might buy us enough time to put our economic house in order, in which case it would have been well worth the cost. But if it doesn't work out that way, if the public is forced to swallow a bail-out that seems flamboyantly unjust and everything falls to pieces anyway, we will have painted ourselves into a very dark corner. In a genuine catastrophe, social cohesion matters more than anything. Surely, by now, we should have learned not to underestimate tail risk.

Steve Randy Waldman — Monday September 29, 2008 at 7:04am permalink
I agree the plan completely ignores the tail risk of insolvency. Roubini had an interesting come-back in the form of a compromise between asset purchases and capital injections, and between public and private sector participation:

"Indeed, the plan also does not address the need to recapitalize those financial institutions that are badly undercapitalized: this could have been achieved by using some of the $700 billion to inject public funds in ways other and more effective than a purchase of toxic assets: via public injections of preferred shares into these firms; via required matching injections of Tier 1 capital by current shareholders to make sure that such shareholders take first tier loss in the presence of public recapitalization; via suspension of dividends payments; via a conversion of some of the unsecured debt into equity (a debt for equity swap). All these actions would have implied a much lower fiscal costs for the government as they would have forced the shareholders and creditors of the banks to contribute to the recapitalization of the banks. So less than $700 billion of public money could have been spent if the private shareholders and creditors had been forced to contribute to the recapitalization; and whatever the size of the public contribution were to be its distribution between purchases of bad assets and more efficient and fair forms of recapitalization (preferred shares, common shares, sub debt) should have been different. For example if the private sector had done its fair matching share only $350 billion of public money could have been used; and of this $350 billion half could have taken the form of purchase of bad assets and the other half should have taken the form of injection of public capital in these financial institutions. So instead of purchasing – most likely at an excessive price - $700 billion of toxic assets the government could have achieved the same result – or a better result of recapitalizing the banks – by spending only $175 billion in the direct purchase of toxic assets. And even after the government will waste $700 billion buying toxic assets many banks that have not yet provisioned for such losses/writedowns will be even more undercapitalized than before. So this plan does not even achieve the basic objective of recapitalizing undercapitalized banks."
9.29.2008 7:40am

Of the several things that I'm dumbfounded about, the at least tacit trust in people who have repeatedly proven they do not deserve such trust nor any confidence at all in their ability ranks highest now.

You bring up a neglected issue. With all of the fear mongering going on, what does it say about our power elite that they are utterly unafraid of the wrath of the populace.

While we can denigrate voters all we want, I think it's important to keep in mind the deep implicit trust that many people have in their government, inculcated practically since we're in diapers. This notwithstanding widespread cynicism. There is danger when such trust is betrayed.

Much as I am a staunch believer in free enterprise and property rights, I, for one, would support a constitutional amendment for a one time disgorgement of wealth. It's much preferable to mindless venting of anger. Still our fearless leaders (heh!) would laugh at the prospect that the comatose electorate would do _anything_, let alone something radical. We'll see.

On a more substantive note, one thing I'd like to add to, or at least amplify in your assessment is that continued extraordinary forebearance by our creditors is highly likely and can serve to mitigate much suffering during the inevitable adjustment you cite. If our leaders to continue to squander that until it's exhausted, we will be in much deeper trouble for much longer.

Thanks for yet another fine and thought provoking post.
9.29.2008 12:39pm
There's a simple way to solve the money market crisis: Admit that the market is collapsing and deal with that fact rather than trying to stop a force of nature. Let the money markets go. Recognize that the commercial paper ends up as a bank liability -- financial paper for obvious reasons and non-financial paper because of bank backstops.

All Congress needs to do is extend FDIC insurance to all bank deposits that are in the bank as of close of business on Friday October 3. Support for money market funds should be withdrawn. The flow of money to the banks will avert the current crisis. Either the Fed, the Treasury or the banks will have to provide 3 months of collateralized loans to the money market funds to assist them in closing down.

In short, the government should be accelerating the movement of the money market funds into bank accounts to solve the crisis. This huge flow of liquidity will reopen interbank markets. After this process is completed, the FDIC can handle bank failures by shafting shareholders and bondholders, before taking losses.
9.29.2008 1:49pm
Anonymous (mail):
Couldn't have said it better
9.29.2008 3:03pm
Richard H. Serlin (mail) (www):
Steve, I have a question for you: So far the executive and legislative branch have done nothing, and with so many Republicans, as usual, they certainly aren't going to do the smartest thing (see for example 1,2,3,4,5); purchasing (taking over) the troubled companies, then buying the bad debt, injecting a healthy amount of money, and then selling the newly rejuvenated companies back to the private sector for a large capital gain that goes to the government rather than the existing management and stockholders.

So, given that the congress and president won't do this, can the Fed just do it? They've already done it on a small scale with for example AIG just two weeks ago. I know this is a fuzzy legal issue (and there are political pressures too), but do you think Bernanke can just start a program of taking over all, or almost all, of the troubled companies, restoring them, and then selling them back to the private sector?
9.29.2008 5:16pm
I've been appalled that basic monetary policy has been neglected in the debate over the crisis -- prior to the last two week's injections, the Fed had done nothing since April 30ths FF cut to add liquidity to the system -- all the monetary benefits of the TAF/TSLFs were immediately sterilized away . . .
9.29.2008 8:41pm
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