5 Minute Tute – The US Bailout

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WHAT HAPPENED THIS WEEK?

The US Congress passed the Emergency Economic Stabilization Act. The $700 billion (£394 billion) government plan to rescue the US financial sector had been rejected in a previous form by the House of Representatives on September 29th. This defeat led to the Dow Jones industrial average dropping 777.68 points in a day, losing $1.2 trillion in market value. A new version was drafted, which increased the value of bank deposits protected by the Federal Deposit Insurance Corporation to $250,000. This passed the Senate by 74-25 on October 1, then being approved by the House in a 263-171 vote two days later. It was then signed into law by President Bush. The law’s passing calmed the financial markets, but its long-term consequences remain uncertain.

WHAT IS THE CURRENT DEBT SITUATION?

On September 30, the US national debt hit the landmark figure of $10 trillion. President Bush signed legislation in July raising the debt ceiling to $10.615 trillion, and the bailout plan raises it further to $11.315 trillion. The gross national debt as a percentage of GDP has, under the Bush Administration, hit a 50-year high at around 70%, with the FY2009 budget recording a near-record deficit of $407 billion (excluding $700 billion spent on the bailout and $900 billion already spent on rescues of financial institutions).

HOW DID THIS PROBLEM EMERGE?

Professor John Cochrane of the University of Chicago explains the problem to be as follows: Many banks hold a lot of mortgages and mortgage-backed securities, the values of which have fallen below the value of money that the banks have borrowed. Credit market problems are a symptom of this underlying problem. Nobody really knows which banks are in trouble or how badly, nor when these troubles will lead to a sudden failure. As a result these banks do not want to lend more money. It is a problem that many believe can only be solved by recapitalizing banks that are in trouble, or even allowing orderly failures, whilst providing liquidity to short-term credit markets.

HAS THIS HAPPENED BEFORE?

In Sweden, mid-1980s deregulation sparked a great deal of risky lending and led to an overheated real estate market. The bubble burst in 1991, and Sweden’s GDP fell by 4.4% over two years, with abuot 600,000 companies filing for bankruptcy. Housing prices fell by 19%. The government spent $10 billion on blanket guarantees for credits and depositors, whilst buying two failing banks and setting up an asset management firm to assume bad loans and the collateral behind them. The plan’s swift action, bipartisan cooperation and transparency won public support. Much of the government’s costs were recouped when assets were sold. In Japan, financial institutions bet that real estate prices would continue to rise in the 1990s. But when values plunged, borrowers were unable to repay loans, which then became harder to obtain. Inaction and deceit in the financial system exacerbated the problem as institutions hid bad debts. In 1999, the government set up the Resolution and Collection Corp to handle the disposal of nonperforming loans at a cost of $168 billion. This has now been largely recouped by reselling collateral, although the stock market still has not returned to its pre-crash peak. The government was blamed for waiting too long to act to resolve the crisis.

WHAT EXACTLY IS A ‘CREDIT CRUNCH’?

A ‘credit crunch’ is the danger to the economy brought about by this situation. Banks need capital to operate. In order to borrow another dollar and make a new loan, a bank needs an extra, say, 10 cents of its own money (capital) – so that if the loan declines in value by 10 cents, the bank can still pay back the dollar it borrowed. If a bank does not have enough capital – due to declines in asset values which wiped out the 10 cents from the last loan – it cannot make new loans, even to credit-worthy customers. When all banks are in this position, we have a credit crunch. People want to save and earn interest; other people want to borrow to finance houses and businesses; but the banking system is no longer able to do its match-making job.

SO CAN THE US GOVERNMENT AFFORD THIS?

Former Treasury Secretary Lawrence Summers stated in the Financial Times that the US does not necessarily need to cut back spending on other areas such as healthcare, energy, education and tax relief. He claimed that the $700 billion should be viewed as an investment in purchasing assets, buying equity or making loans and not a give-away. Secondly, the budget deficit will not crowd out other more productive investments or force greater foreign dependence with an increased issuance of government debt. Professor Summers argued further that government intervention in the form of a fiscal stimulus is necessary due to the ineffectiveness of monetary policy. The key is to preserve fiscal sustainability.

 

 

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