October 8, 2008 (Housing Market Monitor)

Housing Market Monitor

United Kingdom Does Bailout the Right Way

October 8, 2008

By Dean Baker

"President Bush's 'Great Depression' talk may have sent consumption plunging."

The United Kingdom announced this morning that it would undertake an $87 billion bailout of its banks. This is approximately the same size as the bailout approved by Congress last week. (Britain’s economy is just under one-fifth of the size of the U.S. economy, making this equivalent to $500 billion in the U.S. economy.)

There are important differences between the structure of the bailout in the UK and the United States. While the Paulson plan centers on paying too much for the bad assets of banks, the UK plan involves the direct infusion of capital through the purchase of preferred bank shares. The British Treasury announced the immediate suspension of bank dividends and cuts in executive compensation. It also announced that it would return banks to their core business of issuing loans and underwriting security and bond issues. It will be interesting to see how well the two plans perform in the coming year.

The economic data already looked very bleak before the credit markets really began to freeze up in the last few weeks. For example, the 1.0 percent drop in industrial production in August (before the crisis really exploded) would have been big news in calmer economic times. Similarly, the fact that non-residential construction is now falling, after booming the last years, would also get attention in normal times. Consumption was also dropping in real terms in July and August.

However, the situation is likely to get much worse in the months ahead. The September data will not be available until the end of the month, but the sharp plunge in auto sales reported last week indicates that consumption almost certainly fell even more rapidly in September. The jump in unemployment claims to levels near their post-September 11th peak in the last couple of weeks also suggests a marked worsening of the economy.

In short, it seems clear that the economy is in a recession with the labor market likely worsening rapidly in the months ahead. President Bush’s warning of a Great Depression in order to get his bailout through Congress may have shocked households into cutting back their consumption. While a reduction in consumption was necessary and desirable in the wake of the housing crash (the near zero savings rate was not sustainable), it is not good to see this collapse occur all at once.

Ideally the fall in consumption would happen gradually over a couple of years, allowing for the expansion of other demand components (e.g. net exports) to make up the gap. In the current environment, there is no demand component that can plausibly make up for the drop in consumption. This means that unless the government steps in with an aggressive fiscal stimulus package (@$300 billion to $400 billion), there is likely to be a sharp downturn over the next year.

The Fed’s move to buy up commercial paper issued by non-financial corporations should go a long way to reducing the immediate squeeze in credit markets. In addition to the direct effect of the Fed’s purchases, the presence of a large buyer in the market should reassure other potential lenders. It is interesting that this move was not discussed prior to the bailout, since it addresses the credit squeeze that was the most pressing motivation for the bailout. Perhaps Congress would have voted differently on the bailout package if the Fed had begun buying this commercial paper last week.

As bad as the financial situation appears at present, there is almost certainly more bad news yet to come. The losses on mortgage debt thus far have been disproportionately in the subprime and Alt-A markets. With millions of homeowners with prime mortgages far underwater, there will be a large wave of losses on these loans as well. Some portion will be due to defaults, but perhaps an even larger volume of losses will result from short sales in which sellers must accept a price insufficient to pay off the mortgage and lack the resources to make up the shortfall. In other words, the Paulson bailout is almost certainly just the beginning.

Dean Baker is Co-Director of the Center for Economic and Policy Research, in Washington, D.C. CEPR's Housing Market Monitor is published weekly and provides an incisive breakdown of the latest indicators and developments in the housing sector.