Flaws In The $700 Billion Bailout

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[Election 2008]

The emergency legislation before Congress was ill-conceived - or, more accurately, not conceived at all.

As Congress tried to improve what Treasury requested, an amalgam plan has emerged that consists of Treasury's original troubled asset relief program and a quite different capital infusion program in which the government invests in and stabilizes weakened banks and profits from the economy's eventual improvement.

The capital infusion approach will cost taxpayers less in future years and may even make money for them.

Two weeks ago the Treasury did not have a plan ready - that is why it had to ask for total discretion in spending the money. But the general idea was to bring relief to the banking system by relieving banks of their toxic securities and parking them in a government-owned fund so that they would not be dumped on the market at distressed prices.

With the value of their investments stabilized, banks would then be able to raise equity capital. The idea was fraught with difficulties. The toxic securities in question are not homogenous and in any auction process the sellers are liable to dump the dregs on to the government fund.

Moreover, the scheme addresses only one half of the underlying problem - the lack of credit availability. It does very little to enable house owners to meet their mortgage obligations and it does not address the foreclosure problem.

With house prices not yet at the bottom, if the government bids up the price of mortgage-backed securities, the taxpayers are liable to loose; but if the government does not pay up, the banking system does not experience much relief and cannot attract equity capital from the private sector.

A scheme so heavily favoring Wall Street over Main Street was politically unacceptable. It was tweaked by the Democrats, who hold the upper hand, so that it penalizes the financial institutions that seek to take advantage of it.

The Republicans did not want to be left behind and imposed a requirement that the tendered securities should be insured against loss at the expense of the tendering institution.

The rescue package as it is now constituted is an amalgam of multiple approaches. There is now a real danger that the asset purchase program will not be fully utilized because of the onerous conditions attached to it.

Nevertheless, a rescue package was desperately needed and, in spite of its shortcomings, would change the course of events. As late as September 22, Treasury secretary Hank Paulson hoped to avoid using taxpayers' money; that is why he allowed Lehman Brothers to fail.

Tarp establishes the principle that public funds are needed and, if the present program does not work, other programs will be instituted. We will have crossed the Rubicon.

Since Tarp was ill-conceived, it is liable to arouse a negative response from America's creditors. They would see it as an attempt to inflate away the debt. The dollar is liable to come under renewed pressure and the government will have to pay more for its debt, especially at the long end. These adverse consequences could be mitigated by using taxpayers' funds more effectively.

Instead of just purchasing troubled assets the bulk of the funds ought to be used to recapitalize the banking system.

Funds injected at the equity level are more high-powered than funds used at the balance sheet level by a minimal factor of 12 - effectively giving the government $8,400 billion to re-ignite the flow of credit.

In practice, the effect would be even greater because the injection of government funds would also attract private capital. The result would be more economic recovery and the chance for taxpayers to profit from the recovery.


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