Bailout Plan Is Only One Step on a Long Road
Bailout Plan Is Only One Step on a Long Road
By STEVE LOHR
Published: September 28, 2008
The government’s planned financial bailout is a significant if costly step intended to avert economic calamity, but it may not be the last one, according to economists and finance experts.
The rescue plan would use taxpayer money — $350 billion initially, and up to $700 billion with Congressional approval — to buy mostly soured mortgage-backed securities from Wall Street firms and banks.
These arcane investment instruments, linked to home mortgages, have combined with falling housing prices to ignite the credit crisis, which in turn has dire potential for an economic contagion that threatens even sound businesses and secure jobs in industry after industry.
By taking these securities off the banks’ hands, the bailout plan seeks to restore confidence in the financial system and ensure that banks can still carry on their fundamental role of handling payments and offering credit to the masses.
“Maybe they can restore confidence with the program,” said Simon Johnson, an economist at the Sloan School of Management at the Massachusetts Institute of Technology. “It may work, and it could get us through the election in November,” he said.
But Mr. Johnson, a former senior researcher at the International Monetary Fund, said further steps might well be needed, with much work remaining for the next administration.
The list, he said, includes overseeing the workings of the rescue plan, helping to guide the contraction and recapitalization of the banking industry, assisting homeowners who face mortgage defaults, and in general shaping policy for a nation that will be less accustomed to easy credit and overspending.
“Managing this issue is going to dominate the agenda of the next president for two years,” Mr. Johnson said.
Besides buying troubled mortgage securities, the main features of the bailout package include restraints on executive pay for companies that sell off weak assets; a shareholder stake for the government in firms that sell large amounts of distressed securities to the government; and a requirement that the government take more aggressive steps to prevent home foreclosures.
The eventual price tag for the bailout is uncertain. It all depends on the price that the government pays for the troubled securities it buys from banks, and the price the government receives when it eventually sells them, years later.
To many, the weekend agreement on a plan is cause for a qualified sense of relief, even for many conservative policy makers and economists, despite qualms that it may be too generous to Wall Street bankers, too weak for struggling homeowners and too costly for taxpayers.
“By far, the most important way to help homeowners and taxpayers is avoid a serious economic recession,” said Robert E. Hall, an economist and senior fellow at the Hoover Institution, a conservative research group at Stanford.
An abrupt downturn, Mr. Hall estimated, would reduce economic activity and opportunity in the United States by 5 percent to 10 percent in terms of production of goods and services, job creation and personal income. That total cost, he noted, would certainly exceed $1 trillion. “A recession costs way more than $700 billion,” Mr. Hall said.
There was no assurance that the bailout plan would work as intended to ease financial turmoil and economic uncertainty.
Indeed, the reckoning in the finance industry has a long way to go, said Nouriel Roubini, an economist at the Stern School of Business at New York University.
The $350 billion to $400 billion in bad credit reported by the banks so far could eventually exceed $1.5 trillion, he estimated, as banks are forced to write off more bad loans, not only on more housing-related debt, but also for corporate lending, consumer loans, credit cards and student loans.
The rescue package, if successful, would make the recognition of losses and the inevitable winnowing of the banking system more an orderly retreat than a collapse. Yet that pruning of the banking industry must take place, economists say, and it is the government’s role to move it along instead of coddling the banks if the financial system is going to return to health.
Japan’s experience in the 1990s is a cautionary example of the peril of propping up banks after a real estate boom ends. The Japanese government helped keep many troubled banks afloat, hoping to avoid the pain of bank failures, only to extend the economic downturn as consumer spending and job growth fell.
The Japanese slump continued for many years, ending only a few years ago, a stretch of economic stagnation known as Japan’s lost decade.
“The lesson from Japan is that tough love for the banks is what’s needed,” said Kenneth Rogoff, an economist at Harvard. “In the current crisis, you do want to get rid of the bad assets from the banks, to get markets working again. But the key is going to be in the details of how the bailout works. You don’t want it to be a subsidy in disguise that keeps insolvent banks alive. That would just prolong the economic pain.”
History’s most sobering example, though, is the Great Depression. In that case, the government waited too long to do anything to aid the battered banks, and the economy cracked.
The Federal Reserve chairman, Ben S. Bernanke, a former professor at Princeton, has studied Japan’s policy missteps and is also an expert on the Depression. “The lesson of the Depression, failing to act soon enough, very much underlies the urgency behind the government’s proposal,” Mr. Rogoff said.
Sweden in the early 1990s took a middle path, swiftly taking over many of its troubled banks. The American bailout plan, economists say, takes a page from the Swedish example by making the government a shareholder in banks participating in the program. But, they add, the American banking system is so much larger and diverse than Sweden’s that the parallels are limited.
The curbs on executive pay were an essential ingredient to gain political support for the United States rescue plan, blunting the criticism that a bailout would protect the suspect gains of wealthy Wall Street executives. For companies making substantial use of the program, the government would limit the tax deductibility of executive pay to $500,000, prohibit “golden parachute” payments to departing executives, and allow the recovery by the financial institution of bonuses from gains that later prove to have been based on false or inaccurate information.
Earlier legislative efforts to curb executive pay have had little lasting effect, corporate governance experts say. In the early 1990s, curbs on the tax deductibility of executive salaries, they say, were sidestepped and even contributed to the generous grants of stock options, which helped drive executive pay to new heights.
The provision to recover hefty bonus payments is problematic, the experts say. To make a recovery, they say, the government would have to show an executive had engaged in misconduct, not just poor judgment.
Yet by taking such action, combined with the provision to become a big shareholder in companies that take part in the bailout, the government moves could well have an impact on executive pay.
“Even if these steps prove to be largely symbolic, it will influence practices,” said Charles Elson, a corporate governance expert at the University of Delaware. “The government has made a clear statement, and the boards of these financial companies will be under pressure to rein in compensation.”
The bailout effort, economists say, underlines the pivotal role of the financial industry in the economy and the need for proportionate regulation.
When the Internet dot-com bubble burst at the start of the decade, investors suffered, employment dropped, companies went out of business and America slipp
ed into a brief recession. But there were no calls, or need, for government rescue plans for the technology industry.
“Finance is so central and peculiar, so essential, and yet it carries a death threat for the economy,” said Jagdish Bhagwati, a professor of economics at Columbia. “What we’ve seen, once again, is that finance is a very powerful instrument, but one that needs to be intensively watched.”