Has the US Treasury gone mad?

US government actions over the weekend will be extremely negative for the world economy.
In the course of one tumultuous weekend, US treasury secretary Hank Paulson and Federal Reserve chairman Ben Bernanke have permitted one bank to go under and another bank to be quite unexpectedly sold.

For some observers, the news is almost enough to bring on a 'Jim Cramer moment' û a meltdown broadcast on TV in August last year when the CNBC pundit Cramer wondered whether the US government had any concept of the trouble brewing in the US housing market.

Orchestrating a sale and a bankruptcy in such a short period of time has certainly led to an acute sense of crisis both in the US and internationally. For a start, no one believed the sale of Merrill Lynch was so imminent; there had been very little discussion of a sale prior to this weekend.

But the act of allowing Lehman Brothers to go bankrupt is especially high risk. The fire sale price of the mortgage-related assets that Lehman will now have to unload will depress prices across the board û including similar asset classes held by all the other major financial institutions.

The fact that Washington Mutual and AIG û a deposit-taking bank and a major insurer even more important to the financial system than two broker-dealers û and also struggling suggests that the timing of LehmanÆs demise could not have been worse. It may even provoke the dreaded 'domino effect', when investors panic and dump all financial shares, or in WaMu's case pull out their deposits, because there is no clear commitment from the government in the event of a crisis.

The risk now is that sagging stockmarkets (inevitable after the failure to bailout Lehman) and a weakening dollar (equally inevitable) will affect the capital adequacy ratios of even the healthy commercial banks in the US. This will force them to reduce lending, worsening the credit squeeze, and condemning the US economy to further pain.

Effects on emerging markets will also be severe. Russia's stockmarket has lost 50% of its value since its May peak, at least partly due to foreign investors having moved their capital to safer havens. About $1 billion has left Russian private equities since July, according to the FT. Sharp reductions in the price of gold and oil over the past few days also suggests a serious flagging in global demand which blow-ups in the financial system will aggravate.

Ideologues in the ruling Republican Party, with an election less than two months away, may be delighted that the ævisible handÆ of the government has been withdrawn, especially after being extended to help Bear Stearns and Fannie Mae/Freddie Mac. Indeed, it may be in response to powerful pro-free market pressures that the government is allowing Lehman to fail, and for Merrill to be sold. But neutral observers canÆt but be filled with foreboding at the governmentÆs stance. The crisis calls for restoring confidence and economic activity by showing a willingness to mobilise the country's financial resources. It does not call for ideological moralising about free markets, similar to the importance attached to avoiding government deficits which so harmed the US during the Great Depression.

Lehman is a case in point. It may well have deserved to fail. But in the current environment, it is too dangerous to permit it to fail. Given the uncertainty in the markets, and the drama at Merrill Lynch, it would have made more sense to fire CEO Dick Fuld for his incompetence, and keep Lehman going, either by injecting a slug of equity or some form of government guarantee, or both. Even a heavily subsidised sale would have been better than the confidence shattering effect of no sale at all. What kind of toxic garbage really is on those bank balance sheets, investors will be asking.

ItÆs incorrect to say that the US canÆt cover the cost of a bailout, especially in light of the huge, but orderly and effective, disbursements by Japan during its economic crises. US gross debt to GDP is just 60%, compared to almost 215% in Japan, according to research firm Japaninvest. However, the US could avoid a great deal of that crippling debt load by bailing out the banks immediately. After a bank bailout failed in 1992 because of popular disgust, Japan had to wait until 1997 and 1998. By that time, the problem was much worse and was more expensive to fix, involving an extensive programme of public works as well as bank capital injections.

And yes, it is unfair that, as is often pointed out, bankers bring home huge bonuses in good times, while the taxpayer picks up the bill in bad times. But taxpayers will eventually be the greatest losers if credit concerns slow down the whole economy. Consumers and businesses will get the message that debt is no longer a good thing. As happened in Japan in the 1990s, that could result in a sustained deleveraging and retrenchment by companies and consumers, and with that comes the threat of a deflationary death spiral.

But the crucial point is that concerns about 'socialising losses' need to be acted on before a financial crisis. It's absurd to invoke them while a crisis is actually unfolding. Paulson's current opposition to a Wall Street 'bailout culture' developing rings hollow compared to his and Congress's inability to properly regulate the banks in the first place. Bailing out the banks now is the price to be paid for former mistakes. Not bailing out the banks compounds former mistakes.

Ultimately, this is a heavy blow to the US model of capitalism. Very few countries around the world will now be tempted to open up their capital markets to turbo-charge growth. The USÆs own transition from manufacturing to financial services has suffered a huge setback, even as China takes over its mantle as the world's biggest manufacturer. The UK is next in line, with its even more 'manufacturing light' model û mortgage-lender HBOS is already being shredded. But while Asian countries may be feeling smug, they are in trouble as well, with suddenly much fewer outlets for their manufactured goods. The world suddenly looks a much more dangerous place.
¬ Haymarket Media Limited. All rights reserved.
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