Thursday, October 2, 2008

Global Economy is Why Bailout Is Needed

I received a note from a financial educator colleague opposing the bailout. However much I agree with her about the causes, I reach the opposite conclusion about the bill. Here is my take.

Unlike all of the other financial debacles you cite, this one is global and its attendant risks are unprecedented. At least 10 other countries have intervened to prop up illiquid banks. This one is more like the run-up to the 1930s Depression that only ended because of WWII. In other words, it got so bad that no one could put the economy back together again. Symbolic and real action by the US is essential to limit the scope of the current crisis and prevent it from getting into that zone where a functioning financial system can't be put back together.

I find George Soros' concept of reflexivity, and his analysis of the generic features of booms and busts, very instructive and very compatible with you comments about risk. The flaw in the system is a human one, in which higher and higher levels of risk become socialized as normal. It's not just the CRA of the's the young homebuyers who felt it was normal to get a interest only mortgage! Or to flip a house for $100K in two years! This is much as it was in the 1920s....income and equity became a lower and lower share of one's financial story, because everyone thought everything would go up and up forever. I would add to Soros's analysis that the risk models are linear and institition-specific, whereas in a globally interconnected economy, the risk issues don;t just sit there on your spreadsheet -- they interact with each other in new ways. Risk doesn;t just increasse in a linear fashion -- it rises and them falls off the cliff into breakdown. That is where we are now.

And on the mortgage side, many banks sold off those sub-prime loans as mortgage-backed securities in tranches reflecting risk. That is the move that has made this a global crisis. Pension funds in Finland bought securities backed by interest only and CRA mandated mortgages! Can you imagine the long-term damage to our nation in foreign affairs, to our global leadership, and to our future economic prospects if we stiffed those countries left and right?

In other words, we can cast blame and rightly so, but everyday Americans will pay a much higher price if there is no action to stabilize the economy.

The idea I favored (see a previous e-mail) would have acquired assets from troubled institutions by issuing preferred stock in a government owned "stabilization corporation." That corporation would be seeded with $100B of taxpayer money (not $700B). The net effect is that the banks would have owned the bailout, not the government owning the banks. If asset sales went well, the stockholders would make money....if not, the would not make money. The bad loans were off their books, crisis solved, but not on the taxpayers nickel.

Unfortunately, that excellent idea never got the time of day on the Hill. The bailout is what it is, and I am glad it appears to move forward, however flawed.

I am blogging on this subject at the address below. Like you, Colleen, something in me has changed deeply over this crisis. I grew up in the Rust Belt and know how horrendous it is to have no opportunity because the fundamentals of the economy turn against you. I don't want to see that happen in this country, which has been the source of much that is good in this world -- including economic growth and financial strength.

That is why I hold my nose and support the bailout as the best of two lousy choices.


Chanakya said...

All of us have to be financially healthy. We have to earn, work, and grow. No doubt.

But what are the causes of this crisis? Does the bailout plan help in removing the causes of the crisis?

I don’t think so. We somehow believe that this bailout plan is good because it prevents us from falling into a deeper crisis. I am sure I will be benefited by the plan too. But I have a feeling that with the bailout, we will merely be postponing the problem because those causes will recur. If I were to truly wish good for all of us, I would expect, along with the temporary bailout plan, concrete action to improve the institutional oversight to take corrective action *prior* to such issues snowballing into such crises.

-- Susan Kuhn said...

I agree with your recommendation of strong oversight. Now that we have the plan, the oversight begins.