In the latest episode of the financial drama “Credit Crunch,” the President, the Presidential candidates, and congressional leaders from both parties gather in the White House to agree on a seven-hundred-billion-dollar bailout for the very financial firms whose greed and recklessness created the crisis. George W. Bush, perched between Senate Majority Leader Harry Reid and House Speaker Nancy Pelosi, is wearing a grim expression. Barack Obama also looks grave, but John McCain, who pretended to “suspend” his campaign before rushing back to Washington to help “solve” the crisis, is grinning broadly. Off camera, House Republican Leader John Boehner is threatening to sink the deal.
As political theatre (“If money isn’t loosened up, this sucker could go down,” Bush declared at one point in the White House meeting, according to the Times), the wrangling over the Wall Street rescue package is engrossing. As an exercise in crisis management, it is potentially disastrous—and, to the rest of the world, dumbfounding. Willem Buiter, an economist at the London School of Economics, who has served on the Bank of England’s policymaking committee, said in a blog entry last Thursday that unless Congress acts now “the freeze of the financial wholesale markets will intensify and the attacks on financial institutions will resume, first in the U.S., then in the U.K., then in the rest of Europe and soon after everywhere in the financially connected world. . . . Instead of a mere recession, there will be a long and deep depression.”
Some experts dispute the Bush-Buiter analysis. One school argues that the financial system is a mere “veil” wrapped around the rest of the economy. Strip it away and other business activities—the development and marketing of new products; families buying clothes and going out for meals—will go on unabated. If a bank that was performing a valuable function fails, another will spring up in its place.
Boehner and his Republican colleagues, to judge from their attempts to block the bailout—which coincided with the failure of Washington Mutual, the biggest banking collapse in U.S. history—were apparently intent on organizing a natural experiment to test the veil theory. But they neglected to point out that their get-tough approach has been tried twice before: in the period from 1929-32, when Treasury Secretary Andrew Mellon’s advice to bankers burdened with bad loans was “liquidate, liquidate”; and just a few weeks ago, when Mellon’s successor Henry Paulson and Federal Reserve chairman Ben Bernanke chose to let Lehman Brothers go bankrupt.
In the first instance, what followed was the Great Depression. In the second, it was outright panic in the markets. The cost of overnight borrowing jumped sharply, and the stocks of other financial firms, including Paulson’s former employer, Goldman Sachs, plummeted. Worried that the entire financial system was about to break down, Paulson and Bernanke embarked on an embarrassing reversal, first agreeing to lend eighty-five billion dollars to A.I.G., the giant insurance company, then launching their controversial mortgage-purchase plan.
They had little choice. The big banks are so interconnected, and so important to the economy, that they can hold it ransom. A responsible government has to shore up a system in crisis using public money. The only question is on what terms this should be done. Paulson’s first proposal was suspiciously vague and scandalously arrogant. In addition to requesting authority from Congress for the Treasury to spend seven hundred billion dollars—about five per cent of the value of all home loans outstanding—on “mortgage-related assets,” the draft legislation he circulated said that the Treasury Secretary’s actions “may not be reviewed by any court of law or any administrative agency.” After protests from all sides, negotiators from both parties in Congress and from the Treasury put together a much improved plan, under which the Treasury would be granted access to three hundred and fifty billion dollars, but with a strong oversight board and an independent Inspector General monitoring its actions, and with the Government Accountability Office reviewing them. Access to the remaining three hundred and fifty billion would be contingent on a vote in Congress.
The revised plan almost certainly wouldn’t turn the economy around by itself, but it could help, and some of the objections that have been raised to it are misleading. Ultimately, it is likely to cost a lot less than seven hundred billion dollars. The government, in return for its outlays, will obtain ownership of securities tied to the mortgages of millions of American homeowners. Some, perhaps most, of these lenders will end up defaulting, but that is already figured into the depressed price of the securities. As long as the Treasury Department refuses to pay more than fair value, it should recoup most of its investment. Of course, nobody knows exactly what the securities are worth. But, in return for the Treasury Department’s stepping in and taking on risk, the revised plan requires that the government get “equity sharing”—i.e., the right to buy stocks at a fixed price in the seller bank. If the credit crisis is eventually resolved and investors bid the stocks up again, taxpayers will benefit.
Some economists believe that the government should rescue troubled banks directly, by buying special issues of preference shares. Others propose making the banks fix themselves, by suspending dividend payments and issuing new stock—or even forcing them into bankruptcy courts, where they would have to swap debt for equity. If things don’t improve, Paulson and Bernanke will probably end up adopting some or all of these policies in addition to the asset purchase. Paulson is a practical Midwesterner; Bernanke is a leading expert on the Great Depression. Both men rightly believe that the middle of a financial crisis is no time for ideological inflexibility.
Or for political posturing. On the afternoon of the White House meeting, three Republican congressmen with links to John McCain—Eric Cantor, of Virginia; Jeb Hensarling, of Texas; and Paul Ryan, of Wisconsin—presented a list of conditions that they wanted to be considered in any bipartisan deal, including a privately funded insurance plan for mortgage securities. Such plans would, at best, have a marginal impact on the bank-insolvency problem. (They already exist; A.I.G. was one of their big marketers.) McCain reportedly spoke with House Republican lawmakers before the meeting. When Boehner presented the new proposal, the negotiations collapsed. Did this mean that the G.O.P. had split into two factions on the biggest economic crisis in decades? Or was it, as some Democrats suspect, a mere ruse, designed to give McCain an opportunity to emerge as the savior of an eventual deal?
All we know for sure is that McCain refused to commit either way on the revised plan, or on the House Republicans’ plan, and, according to reports, said next to nothing during the White House meeting. On Friday, despite his earlier proclamations that he wouldn’t leave town until an agreement was struck, he flew to Mississippi for the first Presidential debate, in which he expressed sympathy for the House Republicans, said that he hoped he would be able to vote for a bailout, and repeatedly vowed to “cut spending.” If this is any indication of how a potential McCain Administration would handle a banking crisis, now may be the time to start buying gold and stashing cash under the mattress.