Bailout Bill: Just the Beginning

Few are talking about it. Among the professional economists, however, a broad consensus seems to be emerging that the Paulson-Bush bailout plan -- which likely goes to the House floor today for final passage -- just won't work.

At best, in the words of Pulitzer Prize winning economist Joseph Stiglitz ("Why We Aren't Done Yet"), "it’s neither the most efficient nor the fairest way of addressing the problem." It is essentially a feel-good tickle for Wall Street's feet, not a serious solution to the nation's very serious economic emergency.

There are three critical flaws in the proposal. The first is that it relies—once again—on trickle down economics: somehow, throwing enough money at Wall Street will trickle down to the benefit of Main Street, helping ordinary workers and homeowners. (The irony is that Wall Street was itself destroyed in an act of trickle up economics — in its rush to make sure that the money it had discovered at the bottom of the pyramid was moved to the top.) Trickle down economics almost never works, and it is no more likely to work at this time than at any other.
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The second is that it sees the fundamental problem as a crisis of confidence. That no doubt is part of the problem; but the failure of confidence is because the financial markets made some very bad loans. That’s not just a matter of imagination or perception. It’s reality.
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The third is that real contractionary dynamics are already in play, and this proposal does nothing about that. Even if the proposal were implemented quickly, there would be some credit contraction. But beyond that, states and localities are hurting, and are cutting back expenditures. Household balance sheets are weaker, and we can expect consumers to contract expenditure — or at least not expand it at a pace to sustain growth. The U.S. economy has been sustained by a consumption boom fueled by excessive borrowing, and that will be curtailed. But an economic slowdown will exacerbate all our financial problems.

Ironically, just as the academic journal with Stiglitz' warnings was hitting the desks of his fellow economists, the Terminator was telling Treasury Secretary Paulson that the State of California "might need an emergency loan of as much as $7 billion from the federal government within weeks."

The warning comes as California is close to running out of cash to fund day-to-day government operations and is unable to access routine short-term loans that it typically relies on to remain solvent.

The state of California is the biggest of several governments nationwide that are being locked out of the bond market by the global credit crunch. If the state is unable to access the cash, administration officials say, payments to schools and other government entities could quickly be suspended and state employees could be laid off.

If California is begging for money, can other state and local governments be far behind?

Is there, even at this last moment, a better or cheaper alternative for solving the financial crisis? Stiglitz, as we have noted so many of his colleagues are saying, urges that we learn from Sweden's credit crisis experience of nearly two decades ago:

What should have been done is simple. The hole in the balance sheet of financial institutions should be filled in a transparent way. The Scandinavian countries showed the way, almost two decades ago. Warren Buffett showed another way, in providing equity to Goldman Sachs. By issuing preferred shares with warrants (options), one reduces the public’s downside risk, and insures that they participate in some of the up-side potential. This approach is not only proven, it provides both the incentives and wherewithal to resume lending. It also avoids the hopeless task of trying to value millions of complex mortgages and even more complex products in which they are embedded, and it deals with the “lemons” problem—the government getting stuck with the worst or most overpriced assets. Finally, it can be done far more quickly.

As for the root problem of escalating home foreclosures, what Stiglitz effectively says is that we should learn from our own experience, too. In this case, FDR's New Deal:

Let’s be clear about one thing: the Administration’s view that the $700 billion bail-out will ensure that the mortgages the market views as bad aren’t really so bad is a fantasy. The fact is that loans were made on the basis of inflated prices, and real estate prices are falling. No amount of talking up the market is going to change that. But direct aid to homeowners can make a difference.
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There are three things we could do easily and quickly, and for a fraction of the price of the Wall Street bail-out. First, we can make housing more affordable for poor and middle income Americans, by converting our mortgage deduction into a cashable tax credit. The government pays in effect [through current tax laws] 50% of mortgage interest and real estate taxes for upper income Americans, yet for poor Americans it does nothing. This reform is, in any case, long overdue.

Secondly, we need bankruptcy reform allowing for homeowners to write down the value of their homes and stay in their houses, in addition to the help that the current legislation proposes.

Thirdly, government could assume part of the mortgage, taking advantage of the lower interest rate at which it has access to funds and its greater ability to demand repayment. In return for the lower interest rate — which would make housing more affordable — it could demand from the homeowner the conversion of the loan into a recourse loan (reducing the likelihood of default), and from the original holders of the mortgage, a write down of the value of the mortgage to say 90% of the current market price.

If Stiglitz is right -- and it seems the greater weight of economic thinking is on his side -- then even if the House of Representatives passes the Paulson-Bush plan, at best it's only the beginning of the financial crisis -- not the end. We are likely to look back on these days of a $700 billion bailout as "the good old days."

Start thinking in multiple trillions of dollars.