October 20, 2007
Dean Baker
The Guardian Unlimited, October 17, 2007
See this article on the original website
Twenty years ago the stock market experienced its largest single-day dive in history, with the Dow falling by 22.6%. The next day, Alan Greenspan, newly appointed as Federal Reserve chairman, ensured his everlasting status as a Wall Street icon by engineering a rescue of the market. Greenspan coordinated arrangements with the major banks who stood behind the specialty brokers that make the market. This restored liquidity to the market and brought Wall Street back to life.
This history is noteworthy now, not just because of the 20th anniversary, but also because we seem to have a new bailout in the works. According to press accounts, Treasury secretary Henry Paulson has made arrangements for several major banks to form a bailout fund. This fund will buy up debt instruments that are now illiquid as a result of the fallout from the subprime crisis. Investors are shying away from these debt instruments out of fear of incurring large losses. Paulson hopes that a fund backed by several large banks will restore confidence to the market and thereby encourage investors to hold bonds and other assets backed in whole or in part by subprime mortgages.
This deal raises several important questions. First, there is an immediate question about an implicit guarantee of taxpayer dollars. Paulson has issued assurances that there is no such guarantee. This seems hard to believe. If these banks lose tens of billions of dollars because the losses on these mortgages are greater than expected, will Paulson just say “sorry folks”? That doesn’t seem likely.
To make his assertion more credible perhaps Paulson should write up an explicit statement that says that no public money in any form (either funds authorized by Congress or loans from the Fed) will go to these institutions to offset potential losses on this bailout fund.
The second question is what message this bailout is sending investors. The principle under which such a bailout would be reasonable policy is if the price of these bonds are temporarily depressed because of unfounded fear. Let’s assume that this is in fact the case (as opposed to their price being depressed because they really have lost much of their value). The question then is under what circumstances does the government move in to protect investors from unfounded fears.
My home may plunge in price because people wrongly believe that it is in a bad neighborhood. Paulson will not organize a consortium of major banks to support the price of my home in the face of this irrational fear. When and why does the Treasury/Fed step in? Whenever the big boys get in trouble? It would be nice to have a statement of policy on this issue. And how about some payment from the financial institutions for the insurance that they now get free of charge? The selective and one-sided protection policy that appears to be in place will simply encourage more irresponsible speculation in the future.
This raises the final and most important point. If the government has an interest in protecting against an irrational run pushing down the price of bonds or other assets, it follows that it also has an interest in protecting against an irrational run-up in the price of assets. In other words, shouldn’t the Fed and Treasury take responsibility for preventing the sort of bubbles that we have recently witnessed in the stock and housing markets?
Irrational price declines are no more harmful than irrational asset bubbles. An over-valued stock or housing market sends the wrong signals to consumers and investors. For example, tens of millions of homeowners will find themselves less well prepared for retirement than they expected because they thought house prices would continue to rise. By allowing the housing bubble to grow unchecked, the Fed and Treasury undermined the public’s ability to plan for the future. Similarly, the unsustainable stock prices of the tech bubble caused many corporations and governments to contribute too little to pension funds, leading to huge underfunding problems following the crash.
It’s nice that Treasury is quick to help its friends on Wall Street, but we need a real policy, not just ad hoc bailouts
Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of The Conservative Nanny State: How the Wealthy Use the Government to Stay Rich and Get Richer (www.conservativenannystate.org). He also has a blog, “Beat the Press,” where he discusses the media’s coverage of economic issues. You can find it at the American Prospect’s web site.
