Yesterday, the Dow dropped 777 points in reaction to the failure of Congress to pass the Troubled Assets Relief Program (TARP) — that is, the Bush-Paulson plan reworked by Chris Dodd and Barney Frank. Today, the Dow recovered almost 500 points in expectation of some deal in Capitol Hill.
Of course the financial system needs to be propped up somehow, at taxpayers expense, or risk a deeper and longer recession. If there’s no deal in Congress in the next few weeks, several financial institutions are very likely to collapse due to short term but hard to solve liquidity problems. Interbank and all types of credit will freeze further. The stock market could sink — Dow 5,000 anyone? And the effects on that part of the economy that produces actual wealth (rather than financial claims over such wealth) can be huge.
Even without this financial mess, the “real” economy is already in trouble. The statistics on output and employment are not yet terrifying, but they show clearly that the economy is sliding into a recession. That has to do with the usual cycle, with the effect intensified by the bursting of the real estate bubble. So, there’s a wealth effect already hitting the “real” economy. The portion of it that comes from shrinking values of real estate assets. As people get poorer because their real estate equity stopped functioning as — to use the expression coined by Doug Henwood — an ATM machine, they are likely to shrink their consumption spending, which is by far the largest (and typically most stable) component of the economy’s overall demand.
With the financial mess, those problems in the “real” economy compound. We have a double whammy: 1) the credit freeze slowing down further the “real” economy and 2) the wealth effect in steroids that results from the seriously shrinking values of financial assets across the board, including corporate stocks. The latter effect is particularly worrying because, so far, “real”-economy corporations have had, on average, rather robust balance sheets. With 1) and 2) working in tandem, we have a whole new game. If equity shrinks significantly, then all corporate balance sheets will suddenly appear more leveraged, right at a time when rolling over corporate debt is become more difficult.
I’m going over the risks of the no deal just to convince myself that, all said and done, the choices may not be as stark as they appear. I mean, no deal now doesn’t have to mean no deal at all. It is just no deal for now. I mean, as of today, Obama is expected to win the election. As we know, expectations can change, as they depend on the information we have now, and the information gets updated as time elapses. But if there’s no deal, the economy is not likely to improve and probable voters are not likely to blame Obama and the Democrats for it.
So, here’s the thing: In principle, yes, it’s better to face now these risks and try to preempt a deeper and longer recession by passing the TARP deal as is, or almost as is. However, in the long run, this “better” may turn out to be only “marginally better.” Why? Because it’s likely that, in November, Obama and the Democrats running for Congress will prevail, which will drastically alter the political landscape.
Come January (or even November) the Democrats will be in a completely different position, thus having more clout to shape up expectations in the economy and, more importantly, to shape the actual bank rescue deal. It seems to me that the Democrats in power would be more willing, especially under active popular pressure, to undertake the (partial) nationalization of troubled banks, a much better approach than buying off toxic assets at some above-market arbitrary price in the hope that 1) the banks are thus re-capitalized and 2) the Treasury is at some point able to dump them in the market at a decent premium.
Krugman, DeLong, Galbraith, et alia have aptly argued in favor of the Sweedish approach to rescuing the banks and there’s no reason to belabor that point here. I could add (a bit vaguely, I admit) that Mexico’s own experience is consistent with their argument. In 1982, Mexico nationalized the banking system. Then, during the Salinas administration, the banks were sold back to private capitalists. Even though the process was corrupt to the core, it seems that Mexico’s treasury didn’t do too bad on the deal. (I’ll sound like Palin vis Couric, but I should get back to ya on this. Need to look for references to this, as I’m sure there are studies that show it. My 3 readers: please help.)
Then, in 1995, as a result of the Tequila crisis, Mexico’s private banks got again in deep trouble. This time, the government of Ernesto Zedillo used the National Fund for Savings’ Protection (FOBAPROA), an institution created by Carlos Salinos in the spirit of the FDIC, to assume the banks’ liabilities that resulted from the insolvencies and bankruptcies following the peso plunge. Altogether, the FOBAPROA assumed about 50 billion USD of banks’ bad debt, and that debt was later (in 1998) formalized as part of Mexico’s public debt. Aside from the outright fraud and corruption involved in FOBAPROA’s operations, duly documented by the political opposition in Mexico, the deal was not nearly as good from the viewpoint of Mexico’s treasury as the 1982 nationalization.
I wish I could be more specific about the reasons why one approach worked and the other didn’t, but at some point one has to be humble and admit that ignorance is no valid argument.
Anyway, the main point I wanted to make today is this: Sometimes it’s better to have a good fight than a bad settlement.