From the September 28, 2008 Sunday Times (London)
September 30, 2008
by Irwin Stelzer
Let’s try to look beyond last week’s political scrap over repeated bailouts of the banking system, and consider some of the longer-term consequences of the billions that the American government has already thrown — and in the near-term will continue to throw — at America’s financial institutions. Start by giving a wide berth to stories about a possible default by the government, the end of the dollar’s reign as the world’s reserve currency, and runaway inflation.
The huge sums the government has already shelled out, and will in the future pay to buy dud loans from the banks, are not “spending” as that term is generally understood. These billions are not being ploughed into some welfare programme. In return for its cash the government is getting assets — not the world’s best assets, but assets that are far from valueless.
The best analogies are the Home Owners’ Loan Corporation of the 1930s, and the Resolution Trust Corporation that took over the properties of failed savings and loan banks in the 1980s. In both cases, the assets acquired were eventually sold at a small profit.
Nobody is quite sure what the government will eventually realise when it sells off the paper it is acquiring in return for its billions. But if there is a loss it will not be large enough to cause a dangerous increase in the ratio of debt to the nation’s GDP. And there is a real possibility that the government will turn a small profit if it holds these assets until a recovery is under way.
So massive losses are not likely. Nor is it likely that inflation will be triggered by the bailouts already engineered by Ben Bernanke and his colleagues at the Federal Reserve System, which some estimate to have involved close to $300 billion. The net effect of the Fed’s moves has not been to increase the money supply at a dangerous rate. Experts estimate that the increase in the money supply — which, if substantial, would trigger inflation — has been lower during this “crisis” than in recent years.
Throw in another fact: the economic slowdown that is hitting America, euroland and other parts of the world will ease pressures on commodity prices, and keep labour costs from rising. That’s why economists at Goldman Sachs are confident that once the cyclical downturn is behind us, the dollar will appreciate in value.
They are guessing that in the next three to six months the dollar will hold its value against the euro at about $1.45- $1.50 to the euro. Then, assuming that financial markets return to some semblance of normality, they are looking at euros costing $1.40. In the longer term, rising productivity and lower domestic inflation, should enable Americans to stomp across the pleasure spots of Europe, paying only $1.25 for each euro. Not as wonderful as when the eurozone currency could be had for less than a single greenback, but a big improvement over recent times when the euro cost $1.60.
Currency traders tell me that forecasts such as these are useless, that events drive the markets, and events are unpredictable. They are right about that — who would have imagined a few weeks ago that the buccaneering masters of the universe at Goldman Sachs and Morgan Stanley would trade their relative freedom from regulation for the ability to tap the Fed for cash should the need arise.
But the world of policymakers is different from the world of currency traders. The Fed’s monetary-policy gurus know that about 18 months elapse before a change in interest rates fully works through to spending and investment decisions. So forecast they must, and right now they are guessing that inflation is not a threat, or at least not as great a threat as a collapse of the banking system and a recession.
The unanswered question, of course, is whether a bailout will have its intended effect of enabling the banks to start lending again. And, more important, if they can lend, whether they will indeed lend, or continue to hoard their cash. It is possible that handing over cash to the banks won’t induce them to lend it. We just don’t know what these increasingly skittish institutions will do.
But it is a good guess that a $700 billion rescue will buy a lot — some think all — of the delinquent mortgages on the banks’ books. If that doesn’t make much of a difference, we are probably in even more trouble than we now know.
The political consequences of the economic problems have been of more interest to the political classes in Washington than the economic-policy questions. Washington is a town that specialises in redistributing wealth, rather than in creating it. Lobbyists are buzzing around Hank Paulson’s new honey pot to make certain that their clients are not forgotten. Lawmakers are under pressure from their constituents to tell the bankers to take their begging bowls elsewhere — to the Middle East, or their existing shareholders — anywhere but Washington. And as the crisis unfolds, both John McCain and Barack Obama want to make sure that voters know that they share their pain.
Which is why McCain dropped his argument that America’s economy is in good shape, and that all would be well if only the president would fire the chairman of the Securities and Exchange Commission. His problem is that the more he expresses a willingness to drive up the federal deficit, the more difficult it is for him to defend his plan to cut corporate taxes.
Obama has a similar problem. He is willing to bail out banks, but also wants to spend billions to help troubled homeowners avoid repossession. That leaves no money to fund his promises to cut taxes for middle-class families, rebuild the nation’s infrastructure, and develop alternatives to oil.
Meanwhile, Washington Mutual bank has gone under — the largest bank failure in America’s history — a signal to the squabbling politicians that they had better come together to see America through the next year or so.
Irwin Stelzer is a Senior Fellow and Director of Economic Policy Studies for the Hudson Institute. He is also the U.S. economist and political columnist for The Sunday Times (London) and The Courier Mail (Australia), a columnist for The New York Post, and an honorary fellow of the Centre for Socio-Legal Studies for Wolfson College at Oxford University. He is the founder and former president of National Economic Research Associates and a consultant to several U.S. and United Kingdom industries on a variety of commercial and policy issues. He has a doctorate in economics from Cornell University and has taught at institutions such as Cornell, the University of Connecticut, New York University, and Nuffield College, Oxford.
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