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Economists see financial bailout as necessary

The economy could suffer a massive hangover from the government's efforts to rescue the financial system in the form of a soaring debt burden. But the alternatives look infinitely worse.
/ Source: The Associated Press

The economy could suffer a massive hangover from the government's efforts to rescue the financial system in the form of a soaring debt burden. But the alternatives look infinitely worse.

The $700 billion the administration is seeking from Congress as the upper bounds of what it will need to take a mountain of bad loans off the books of financial firms is certainly an eye-popping figure.

To get the funds to buy up the bad mortgage loans that have threatened to bring the financial system to its knees, the government will have to borrow. And that borrowing will come at a time when the federal budget deficit is already soaring.

The deficit for this budget year, which ends on Sept. 30, is expected to rise to $407 billion, a figure that is more than double the $161.5 billion imbalance for 2007, reflecting what the economic slowdown and this year's $168 billion economic stimulus program are already doing to the government's books.

The Bush administration is estimating that the deficit for the budget year that begins Oct. 1, which will cover the new president's first year in office, will hit $482 billion, a record in dollar terms.

And that forecast doesn't include the $200 billion the administration committed to spending two weeks ago when it took over the nation's two biggest mortgage companies, Fannie Mae and Freddie Mac.

And it doesn't have any of the $700 billion the administration is seeking to soak up the bad mortgage-backed securities that have been at the heart of the severe credit crisis the country has been struggling with since August 2007.

The legislation Congress passed this summer that gave the authority to rescue Fannie and Freddie boosted the limit on the national debt by $800 billion to $10.6 trillion.

The legislation the administration is now seeking to authorize the financial system bailout, according to a draft obtained by The Associated Press, would boost that debt limit to $11.3 trillion, up another $700 billion.

Cause for concern
It is the rapidly rising debt that is cause for concern. The government is already spending more than $400 billion a year just to pay interest on the national debt. The higher that debt goes, the higher the government's borrowing costs and the less it has to spend on other programs.

Republican John McCain and Democrat Barack Obama are both running for president, making campaign promises about what new programs they will implement once in office, promises that could be severely constrained by the costs of a financial bailout.

The escalating borrowing also means that the government is competing with the private sector for loans, driving up interest rates. And then there is the matter of the country's large trade imbalances which mean the United States has to borrow $2 billion a day from foreigners.

Will foreigners still want to lend as much to the U.S. if there are concerns that all the borrowing could weaken the dollar's value against other currencies.

But even with all these threats, economists said the government has to take decisive action because the alternative of letting the financial system slide into even deeper problems which could jeopardize the routine loans that businesses and consumers need was simply not an option.

"It was critical to arrest the downward slide in financial markets," said Sung Won Sohn, an economist at California State University, Channel Islands.

The dire situation was dramatically demonstrated this past week when the Federal Reserve, working with the central banks of other nations, poured billions of dollars into the financial system without any significant impact because of the fear keeping banks from lending.

The financial system has already been staggered with $500 billion in losses from the mortgage mess and the International Monetary Fund has estimated the ultimate price could be $1 trillion.

What the administration's plan would do is at least establish a price for the mortgage-backed securities, which at the moment no one wants to own.

Officials who have briefed Congress on Treasury Secretary Henry Paulson's plan have suggested that one approach would be for the government to buy the toxic debt through a reverse auction process in which companies wanting to unload their mortgage-backed securities would propose a price to the government — say 50 cents on the dollar — and those offering the lowest price would win the bid.

By establishing a price for assets no one currently wants to buy, it could allow a market to develop and allow financial firms to get on with the effort of taking their losses and getting the damaged assets off their books.

"This could go a long way toward solving these problems," said Mark Zandi, chief economist at Moody's, who has written a book on the mortgage meltdown.

Government's final cost?
No one knows for sure, but Zandi said if the experience with cleaning up all the assets left over from the savings and loan mess is any guide, it should be less than the $700 billion that the administration is seeking.

In the S&L crisis, the government was able to recoup about two-thirds of its initial costs when it sold the assets it had obtained from the failed S&Ls.

"Obviously there is a big upfront cost to taxpayers," Zandi said, "but the ultimate cost may be measurably lower."