Congress decides it is worth risking depression

By Martin Wolf

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It is just over three score years and ten since the Great Depression. Judged by its rejection of the plan put forward by Hank Paulson, US Treasury secretary, Congress believes it is time to risk another one. That slump was, arguably, the greatest catastrophe of the 20th century: it was, among other things, responsible for the events that led to the second world war – not least Hitler’s rise. One can only imagine what horrors a depression might bring now?

Such forebodings must seem exaggerated. So, I expect, they will be. But that dire outcome is no longer impossible, not because a slump is inevitable, far from it, but because action is needed to prevent one.

We are watching the disintegration of the financial system. Finance is the web of intermediation binding economic agents to one another, across both space and time. Without it, no modern economy can survive. Yet that is now threatened, with the ongoing collapse in trust and flight to safety. We can indeed run this experiment. But why should we?

Even before Congress rejected the plan, the spread in dollars between the London interbank offered rate and expected official rates (as shown in overnight indexed swaps) had reached more than 200 basis points, for a period as short as three months. Prior to the start of the crisis in August 2007, the spread was negligible. (See chart.) Nor is this all: on Monday short-term yields on Treasury bills were below 1 per cent; credit default swap spreads on financial institutions reached exceptional levels and credit spreads on riskier bonds were widening rapidly. In the aftermath of the plan’s rejection, all this was likely to worsen. The S&P 500 also fell by 8.8 per cent on Monday, its worst day since October 19 1987. Nothing can better demonstrate how absurd it is to believe one can punish Wall Street without hurting Main Street. The two streets meet. That is what streets do.

If the financial system ceases to function properly and a range of financial institutions collapses, everybody will be hurt, as businesses and households are starved of credit. What is occurring now is a downward spiral of panic in which liquidity-starved financial institutions dump assets, weakening themselves and others, particularly now that their balance sheets are marked to market. This reduces their ability to lend and so undermines asset prices and the economy still more, thereby further damaging asset quality.

This, then, is “revulsion” – the final stage of a bubble when, as the late Hyman Minsky argued, investors are so scarred that they can no longer bring themselves to participate in the market. Unfortunately, among today’s panic-stricken investors are banks. These even wish to avoid lending to one another. As I noted last week (“Paulson’s plan was not a true solution to the crisis”, September 23), the gross liabilities of the US financial sector have soared from just 21 per cent of gross domestic product in 1980 to 116 per cent in 2007. A huge part of these massive liabilities must be from one financial firm to another. If credit is not extended, collapse will follow. This is why the investment-banking industry disappeared within weeks.

Against this dire background, what is one to make of the failure of Congress to ratify the plan? It is both understandable and a gross error.

It is understandable because the use of taxpayer money to buy so-called “toxic” mortgage-backed securities from the greedy fools who created the crisis is hard to tolerate. It is also understandable – even creditable – that those Republicans hostile to “socialism” do not want to bail out the undeserving rich, at least before an election. It is understandable, too, because, for reasons I put forward last week, the plan is not convincing. It is designed to deal with a problem of illiquidity in what seems certain to be a growing crisis of insolvency, particularly as house prices fall and the economy continues to weaken.

Yet the rejection is grossly mistaken because the resulting ruin will hurt the weak and destroy the legitimacy of the market economy. The plan is indeed flawed. But failure to ratify it is unlikely to convince anybody that something better will be forthcoming. It will convince them, instead, that the US is choosing to be impotent. At a time of such fragility, when the insurance offered by government is most indispensable, this is the worst possible message. It is a pity Mr Paulson did not choose another plan. It is a pity, too, that a former titan of high finance was charged with bailing out Wall Street. Yet it was still a mistake to reject the plan. It was necessary, instead, to build upon it.

What now? The first effort must be to find a plan that Congress can pass. It is quite possible to find one that protects the taxpayers’ interest better, by insisting on full reimbursement, after assisted companies return to health. Buying preference shares, as Warren Buffett did in Goldman Sachs, would be a good way to do this.

Second, it seems likely that a number of significant financial institutions will find it hard to fund themselves in coming days, as their share prices weaken and interbank lending is frozen. Central banks must make every imaginable effort – and a few unimaginable ones – to make sure liquidity needs are fully met during this period. The Federal Reserve may find itself having to rescue additional institutions. So, alas, be it.

Third, Europeans (among whom I include the British) must recognise they are in the same boat. In times of such peril, even a small cut in interest rates by the European Central Bank and the Bank of England would send a helpful signal. It is now most unlikely to prove inflationary.

None of what is happening is easily palatable. The need for a rescue is hard to swallow. The emergence of bigger and even more complex financial behemoths – all too big to fail – is a harbinger of crises to come. Yet, while one must consider the long-run implications of how a crisis is resolved, one must resolve it first.

Franklin Delano Roosevelt famously said that “the only thing we have to fear is fear itself”. In truth, the economic processes unleashed by the bursting of the housing and credit bubbles are real. But fear is also a danger. When confidence collapses, a market economy cannot function. It must now be restored.

The problem is not lack of knowledge of how to do this: we know how to recapitalise and restructure damaged financial systems. The problem is lack of will. Government must start to show it is in control of events. In the twilight of a failed US administration, that may seem far too much to ask. Winston Churchill, Roosevelt’s partner, said: “The United States invariably does the right thing, after having exhausted every other alternative.” The alternatives are now exhausted. It is time for politicians to do the right thing.

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