(TALKZIMBABWE) US$700 billion bailout plan; correct prescription or not?

US$700 billion bailout plan; correct prescription or not?
Itayi GARANDE
Tue, 30 Sep 2008 00:44:00 +0000

THE United States economy is in turmoil. In fact, Western financial institutions are in turmoil. They are tittering on the edge of abyss, if they haven’t already reached the abyss.

The Dow Jones plunged a record 778 points in the US yesterday. Madame President in the House of Representatives (HOR) in the US, Nancy Pelosi, said “action is now needed to protect the economy” from collapse. This was an interesting call by a country that believes in “non-interference” in markets. President GW Bush called it an “Economic Rescue Plan”, but HOR thought otherwise. It saw it as interference, and a call by the Government to tax the not so rich and not so reckless to “rescue” the rich – the rich on Wall Street.

The US Government argued that it was not a bailout of Wall Street but of the “main street” – and the main street will be put on dire straits if the “rescue” is not pushed through. The main street representing the taxpayers, the voters. How then can you tax the taxpayer, to save them?

Like the esoteric doctrines of Pythagoras, the financial crisis – at least in the US – was disguised in a number of terms in the media, until the US$700 billion bail out was flatly rejected by the HOR.

GW Bush played down the crash, saying that the “Minsky moment” had not been reached. US Treasury Secretary, Henry Paulson allayed people’s fears and the lack of optimism in the market saying he had a plan to “rescue” the market. Nobel Peace Prize winning economist and former World Bank chief, Joseph Stiglitz, told us a fortnight ago that there are shock absorbers in the current crisis – he meant the “bail out package”, so did Paulson.

A 'bail out package' will not resolve the fundamental "dis ease" in the economy. Where’s the practicality and the morality? How do you explain to your electorate that they have to pay for bailing out a huge financial institution, when their own debts led to foreclosures?

In 1998 the Long Term Capital Management (LTCM) crisis did not have profound impact because the US and Western banks merely injected large amounts of liquidity into the financial system. But LTCM is not comparable to today’s credit crunch.

In 1998 the US economy was strong averaging a 4% growth rate. Today the war effort has crippled the US economy, and there’s an insolvency/debt crisis as borrowers overborrowed excessively during the boom phase.

The issue is being downplayed as a subprime problem. It is not! It started as a subprime mortgage problem, but has transformed. The recklessness in the mortgage business cuased the crunch: no downpayment, no verification of income and assets, interest rate only loans, negative amortization, teaser rates – were used for near prime, home equity loans, piggyback loans, etc. These led to an insolvency/debt crisis.

We have already started seeing signs of insolvent mortgage lenders, not just sub prime, but prime ones too. We will soon have insolvent home builders and a slump in the home-building sector and insolvent hedge funds and other funds exposed to subprime and other mortgages will suffer. Hedge funds at Bear Stearns, in Australia, in Germany, in France – have already gone bankrupt or are near bankrupt.

The fundamental problem is not of liquidity but insolvency. So how could pumping liquidity help a problem that is not of liquidity? How will central banks ensure future profitability of bailed out institutions without “taking from the poor and bailing out the rich"? Providing liquidity during an insolvency crisis causes a moral hazard as it creates expectations of investors’ bailout – and a domino effect in future as markets are meddled with.

The US Government should realise that liquidity injections cannot necessarily resolve the deep insolvency problems of many overstretched borrowers: households, financial institutions, corporates. “Insolvency/credit crises lead to financial and economic distress – hard landing of economies – and cannot be resolved with liquidity injections by a lender of last resort,” said one commentator.

itayi@talkzimbabwe.com