Paulson Fashions `Powell Doctrine’ for Markets: Caroline Baum

Commentary by Caroline Baum

Oct. 1 (Bloomberg) — Yesterday, the sun rose in the east. It was something of a miracle because on Monday the end of the world seemed nigh.

That was the day the U.S. House of Representatives dared to defy the warnings of Treasury Secretary Hank Paulson, Federal Reserve Chairman Ben Bernanke and President George W. Bush (echoing Paulson and Bernanke) and defeated the $700 billion bill to buy troubled assets from financial institutions. The vote was 228 to 205.

Stocks plummeted. Interbank lending rates soared. The dollar rocketed higher. (How did something positive sneak in?)

Central banks around the globe pumped in tens of billions of dollars to calm jittery money markets. The Fed made an additional $630 billion available through its various lending facilities, following a $500 billion increase in the previous two weeks.

Taken together, the expansion of liquidity is greater than the size of the Fed’s balance sheet just two weeks ago, according to Tom Gallagher and Andy Laperriere of the ISI Group in Washington.

Several European banks were nationalized or required a government cash infusion. Citigroup Inc. acquired the banking operations of Wachovia Corp. The Irish government guaranteed all bank deposits.

It seemed to go unnoticed that U.S. stocks were already down in Asian and European trading Monday at a time when Paulson and congressional leaders were touting the rescue package as a done deal.

The `People’s Business’

For once, members of Congress seemed to be doing the people’s business. They voted the bill down, in part because they didn’t want to go back to their home districts to campaign and face the wrath of their constituents, who were overwhelmingly opposed to throwing money at those who had squandered it.

While it’s true that a functioning banking system is as vital to Main Street as it is to Wall Street, Paulson never closed the sale.

Instead, he and Bernanke told Congress and the American people that a failure to pass the government’s Troubled Asset Relief Program (TARP) would result in dire consequences for the financial system and the economy. Congressional leaders repeated the warnings. President Bush, never one for extraneous words, cut right to the chase: “If money isn’t loosened up, this sucker could go down.”

Failure to Explain

Fear isn’t an effective communications strategy.

“They didn’t explain how it’s going to work or why it’s going to work,” said Allan Meltzer, professor of political economy at Carnegie Mellon University in Pittsburgh and author of a two-volume history of the Fed. “They put out scare statements — you’re going to lose your job, lose your money-market account. They know this isn’t true. They used fear instead of explanation.”

Some of the fear is irrational. The Federal Deposit Insurance Corp. guarantees deposits up to $100,000. To reduce the odds of a run on the banks, raise the limits on insured deposits, which is what Ireland did yesterday.

Last month, the Treasury announced a temporary program to guarantee money-market funds after the Reserve Primary Fund “broke the buck,” triggering a massive outflow from other money-market funds.

These are all sound responses, designed to instill confidence in the midst of the worst financial crisis since the Great Depression.

`Paulson Doctrine’

It seems that Paulson is looking to implement the financial equivalent of the “Powell Doctrine,” named after former chairman of the Joint Chiefs of Staff, Colin Powell. The doctrine holds that the U.S. should take military action only as a last resort and then only with overwhelming force.

There are lots of folks who say overwhelming force is called for.

“This is a big package because it was a big problem,” Bush said on Sept. 21.

While the administration works with Congress to redraft a rescue package that can garner adequate votes, the mission of TARP seems to be proceeding apace. In facilitating Citigroup’s acquisition of Wachovia, the FDIC entered into a loss-sharing agreement, under which Citigroup absorbs as much as $42 billion of losses on a $312 billion pool of loans. The FDIC absorbs the rest in return for $12 billion of preferred stock and warrants. No congressional action was required.

`Preferred Plan’

Critics of legislation to buy troubled assets say it fails to recapitalize the banking system. Instead of crafting a “Paulson Doctrine,” the Treasury secretary could use his political capital to encourage banks to dump their “troubled assets” at whatever price they will fetch in the market. The government can then inject capital into those institutions in exchange for senior preferred stock, as outlined in a Sept. 26 Wall Street Journal op-ed by John Paulson (no relation to Hank), president of Paulson & Co., an investment management company in New York.

Paulson (John) calls this the “Preferred Plan,” which Treasury has already implemented with Fannie Mae and Freddie Mac.

It might be preferable as well.

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