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.

Contrary to common perception, the American government is full of some very clever people indeed. A simpleton might think that it’s a bad idea for the Federal Reserve to lend billions of dollars that don’t exist, encourage banks to do the same and ask the government to insure the resulting financial system with money it doesn’t have. A dullard might tell you that if the Federal Government spends far more money than it receives year on year there will be long term consequences. A true Neanderthal will point out that if you encourage banks to give loans to people to who can’t afford to pay them back, it might blow up in your face when they, umm, don’t pay them back.

Clever people, though, know better. Their answers are, in order, the Fractional Reserve, Deficit Spending and the Community Re-investment Act.

The re-establishment of sound money and public finances are essential to America’s long term future, but I will, here, only deal with the last item. Everyone knows that the current financial crisis originated in the American ‘sub-prime’ market. A lot of journalistic ink has been spilt discussing the practices of predatory lenders, but that wasn’t the talk a few years ago. Then it was tight-fisted bankers who were alleged to be engaged in “redlining”, a practice in which people from poor and minority communities are refused mortgages. To combat this The Community-Re-Investment Act was passed in 1977, criminalising those who did not give a certain proportion of loans to the subprime market; it was subsequently expanded in 1995.

Their final two pieces of the puzzle were the Housing and Community Development Acts of 1992, which got Fannie Mae and Freddie Mac on board to underwrite and give these subprime mortgages and the establishment of myriad taxpayer funded NGOs, such as ACORN, that would use legal measures to intimidate alleged redliners. The consequence was a massive injection of money into the housing market, generating a housing boom as well as increased home ownership among the desired groups. The loans were parcelled up into little packages and re-sold throughout the financial system. A lot of people with political connections, especially those in the pseudo-private GSEs, Fannie Mae and Freddie Mac, made a lot of money.

Of course, eventually house prices stopped rising, oil and food prices started to do so and millions of Americans decided they either couldn’t or wouldn’t keep up with their monthly payments. Fast forward to now and we have Congress scrapping over a bailout to sort out the resulting mess.

I don’t want to make a partisan point. Washington Democrats are up to their necks in this debacle, but so are many, many Republicans. The Bush administration did try to reform the regulation of Freddie Mac and Fannie Mae in 2005, but it certainly didn’t try hard enough. At some point almost everyone from either party was prepared to cash in, either electorally or financially, from what amounts to the Subprime Pyramid Scam.

So, why is Palin important? When she became Governor of Alaska she promised to sort out two problems. First, a cartel of energy companies that paid almost nothing in tax, received grotesque subsidies and bribed officials to block all competitors; secondly, a corrupt Republican establishment responsible for this and other problems. Palin told the cartel, who were requesting billions of dollars to build a new pipeline, to get lost, introduced competition, taxed the companies at equitable rates and got the new pipeline completed anyway. In so doing she contributed more to meeting America’s energy challenges than literally any other politician alive. She also demonstrated practically the difference between being pro-market and pro-business. As for corrupt Alaska’s Republicans: well, ask them how they feel about her.

Washington is a disgrace. It has spent decades encouraging the poor decisions that caused this crisis and is now proving woefully incapable of even ameliorating it. The Republic has the chance to bring to the White House someone not in the pocket of special interests – be they party, financial, industrial, union or whatever – whose political career is characterised by opposition to the politics of corrupt, crony capitalism that has brought it to this impasse. In all likelihood it will pass up this chance for a smooth talker who rose through Chicago politics by associating with slumlords and machine-politicians and just so happened to be the third largest recipient of bribes (sorry, donations) by Freddie Mac and Fannie Mae last year. When the next, even bigger, bailout comes in 15 years, I hope Americans are glad their President, whoever he or she may be, gives a good interview.