Understanding the US bailout plan

The last two weeks have been tsunami like for financial markets across the globe. The failure of the US bail out plan to pass Congress on Monday made things seem worse, as markets reacted to the decision of the Congress . And unlike what we have become accustomed to in Jamaica, the members of the lower house listened to the people who put them there, for better or worse.

I am one who believes that the bailout plan, as was being proposed on Monday, would not have made any fundamental difference to the crisis being faced. What happened in equities on Monday was more a reaction to disappointed expectations more than any fundamental changes in market conditions. If you look at it what significant changes happened to markets between Friday and Monday last. The only difference was that there was an expectation that the bail out plan would pass and it didn't.

Disappointed expectations
As I have always said, we must remember that economics is a social science and so it is about market behaviour. The reason why it became necessary to pass the bill on Monday was that it was clear that expectations were that if it didn't pass there would be a significant fall out of equity markets. Consequently the market priced in the expectation that the Congress would pass the bill, and when it didn't the market became jittery amongst the gloom and doom predicted and sold off the purchases they had made, as they expected that markets would plummet. So said so done, as the DJIA had its largest point drop ever and the highest percentage drop since 9/11.

My view is that because of market expectation and reaction the bill will pass today, as fear sets in based on what happened on Monday. And although I agree it is important to be passed it is even more critical that careful thought is given to the details of its implementation, as just merely pumping in US$700 billion in the market will not make any long term difference if it does not address the underlying problem, as we found out with our own bailout plan. Even though we cauterized the fallout of the financial system, in the 1990s, we did it at the expense of negatively affecting long term economic prospects, thus resulting in an economy based on credit just as the US is today.

In order to understand whether or not the bailout plan will work it is not enough to look at the size of money involved or whether it will stop the slide of the stock market but rather will it address the underlying problem. What the initial plan failed to do was to address the underlying problem, and the fact that it was designed by Paulson and Bernanke, and supported by Bush, makes no difference to its credibility. Paulson and Bernanke have been incorrect about the economy for the past two years, and if they were more aware could have prevented the extent of global turmoil we see today. Bush we all know has been totally off base on the Iraq war, which is one of the reasons for the decline in the US economy today, as it is costing the US billions. So anything they support should be closely scrutinized as a prolonged financial crisis would be just as devastating as any world war.

The fact is that any reaction on the equity markets is just a symptom of what the underlying problem is, and any bailout plan should be addressed at dealing with the underlying issues rather than catering to the cry of a few overpaid persons, who were the ones that created the financial crisis in the first place by their irresponsible risk management practices. Just a note, these are the same people that we revered as financial geniuses, even while the soundness of our financial system was secured by locally designed legislation. Big up our own Jamaicans, who have always been underestimated, unless of course accepted internationally first, while we continue the export of capital and expertise by preferring the foreigners over our own.

Address the underlying cause
The underlying issue to be addressed in the US, is not to be found on the asset side of the balance sheet, but rather on the liability side. The problem is not that assets are losing value, and are making balance sheets look bad. The problem is that there is a very high degree of uncertainty in asset values and this has resulted in no one wanting to lend to anyone else as they are not certain about balance sheet exposures for fear of the companies they lend to having to liquidate as Lehman did. Note that when the Fed showed its willingness to save bear Stearns markets responded positively. The uncertainty got heightened only after the Fed allowed Lehman to fail, and at that point the risk of lending in such an uncertain environment increased significantly.
This means that any bailout package needs to address the uncertainty surrounding the lending of money. Everyone who has money to lend would want to protect their own balance sheets from any unknown risk, hence the moves to Treasury Bills and Gold. The revised plan passed by the senate seeks to do that by increasing the insurance limit at the FDIC. What this does is guarantee to those who lend money, through deposits or other facilities, that the US government is backing those funds and so they can sleep at nights. This way people will feel confident about lending monies to the system again.

If on the other hand the government pumps US$700 billion into these companies, by buying bad assets, and the uncertainty about balance sheet values and exposure still exists then this will not free up credit markets. After all before we knew the real effect of the mortgage backed securities we did believe that the balance sheets were sound, so the details surrounding how the government identifies and values bad assets is going to be important, and even itself is uncertain. And this is why the liability side of the balance sheet ( liabilities to customers and counter parties) is more important than the asset side, which is the original bill's focus. I think it may have been a blessing in disguise that the bill didn't pass on Monday, as a false impression may have been created, from the equity market response, that the problem was fixed when uncertainty remained.

The revised bail out plan includes (I) tax breaks for some home owners; (II) restrictions on compensation to executives; and (III) an increase in insurance on liabilities, and makes a lot more sense but will not be enough to prevent the slowing down of the economy. It will only prevent a ceasing up of credit in the markets. There have been calls also for the suspension of the mark to market accounting rules, and as many of the analysts have said, this is really ignoring the problem. The fact is that people already know there is uncertainty around values and any removal of transparency will heighten uncertainty.

The details of the bailout plan will be important for the world in, as any further tightening of credit in the world's largest economy could have devastating consequences. Even with a proper plan in place the global economy will still slow, and we have not seen the full effect on other developed economies such as Europe and the UK and the emerging economies of China, India, Asia and Russia. It is going to be a wild ride but the powers that be need to be careful not to make the mistake we did in the 1990s of so much intervention that it prevented markets from working efficiently thus causing long term economic stagnation, as where in our case it affects Jamaica only, in the US it will have a global impact.