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Sweetening the Trillion Dollar Bailout

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It's been said so many times this week, it hardly needs restating, but I'll restate it anyway: the financial collapse we're in the middle of, and the trillion dollar federal bailout now planned, is a once in a century event. We're living through the collapse of an entire economic - and by extension political - model, and the improvised emergence of an entirely new system for managing money, distributing wealth and risk, and keeping the wheels of modern, consumption-based societies turning.

It's too early to say how this will shake out, but two things are already clear. Firstly, Americans are going to be saddled with a historically unprecedented bill for three decades of greed-is-good, regulation-is-bad governance; that will mean higher taxes, more stresses on the U.S. dollar, higher inflation, probably higher interest rates and rising unemployment for the next many years. Secondly, the American government is assuming entirely new, and uncharted, obligations and responsibilities. It is, to all intents and purposes, nationalizing large parts of the international finance system, assuming ownership over millions of mortgages, and becoming an insurer of last resort for the global banking, credit, insurance, and investment systems.

However you look at it, we're in a whole heap of trouble here. The question is can the bail out package be crafted so that some good comes along with the bad?

Done badly, the bail-out is quite capable of crashing the U.S. economy. Something on this scale could all-too-easily signal the end of American hegemony. After all, the money has to come from somewhere - either from borrowing from the Chinese (the only country in the world with cash reserves on a scale capable of tackling this crisis) on increasingly unfavorable terms; from a crushing reduction in social services and payments to America's poor and elderly populations; or from expanding the money system to a point at which high inflation makes the bailout affordable but dangerously corrodes the savings, education accounts, and IRAs of the country's large middle class.

Done well, however, and it's possible some of the worst side effects could be mitigated.

Here's a suggestion. Since the 1930s, the federal government has been in the business of building housing for some of America's poor and subsidizing housing costs for millions of low-income families. But it's always done it in a somewhat halfhearted way, one that has left millions without access to affordable housing and has concentrated poverty in increasingly dilapidated inner-cities. Over the last twenty years, with "small government" rhetoric holding sway in Washington, few new federal housing units have been built and waiting lists have grown. In 2008, the Department of Housing and Urban Development's entire annual budget is only $35 billion, a fraction the amount spent on, say, the war in Iraq, and on about a par with the dollars released to rescue Bears Stearns investment bank earlier this year.

But now the era of "small government" is over, if not rhetorically then at least on the ground. Over the course of the last month, with virtually no debate, the federal government has spent, or announced that it plans to spend, somewhere in the region of $1.5 trillion to bail out banks, insurance companies, mortgage companies, and, now... well, the entire world's interconnected financial system.

So, here's a suggestion. If we have no choice but to take over $700 billion worth of "toxic debt," much of it tied to dodgy mortgages to under-qualified borrowers, loans that should never have been issued in the first place, let's at least get some bang for our bucks here.

If the Feds simply assume responsibility for millions of shaky mortgages, a whole lot of homeowners will just walk away from their debts, and the government - which means the American population - will have to foot the bill. The number of foreclosed homes will continue to rise, which means there will be a glut of cheap houses on the market. Since the number of qualified buyers has vastly declined during the past year of credit tightening, that means deflated housing prices for years to come, with too few buyers for too many houses. It also means a growing number of dispossessed and homeless Americans.

On the other hand, there's an opportunity here for a progressive social policy to be implemented. Let me sketch out an idea - on the hope that economists amongst my readers might want to flesh it out some more. How about the government implementing a carrot-and-stick system for these mortgages?

The carrot first: the government (which is about to become the lien holder on an awful lot of properties) will set in place reasonable fixed rate mortgages and give defaulters a grace period, say a few months to a year, to get their finances in order and begin to make payments again. If they do, their mortgage will function just as if it were still a private sector arrangement. The homeowner gains by getting a second chance - a low interest fixed rate mortgage with no penalties, no points, no hidden fees; and the feds gain because that's one less "toxic loan" to have to absorb.

Now for the stick. There's a real risk here that in socializing risk to such an unprecedented extent, the government is giving two thumbs up to an extreme version of moral hazard. Not only do billion-dollar corporations get to have the government clean up their mess, but millions of individual borrowers, some of whom made horrendous financial decisions over a period of many years, also get out of the debacle relatively cost-free, leaving their more fiscally responsible peers to foot the bill.

So, a gentle version of the stick is also needed: the government won't foreclose on delinquent homeowners, because to do so would, as I mentioned above, further depress the housing market. Instead, it will nationalize their properties, paying back the homeowners' principal to them and then claiming the house for the state.

In other words, delinquent homeowners who don't make a good-faith effort to make their new mortgage payments, will be converted into renters from the state. They will get to stay in their homes - which is a whole lot better than what would have happened to them under the private mortgage system -- but they will lose their property rights. When they die, their children will not inherit. Instead, the property will be added to the stock of the nation's public housing, available to low-income families at below-market rates.

In taking these houses out of the private market, and in also taking their owners-cum-tenants out of the real estate market, the size of the private housing market would be allowed to shrink back to a level at which privately held housing stock could again start to appreciate.

Over the course of decades, a large number of well-built homes, in mixed-income areas not blighted by concentrated poverty, would thus become the property of the state. And an increasing number of low-income Americans would have access to subsidized housing. Had they had such access in the first place, many of them would not have been tempted into a housing market they couldn't afford to participate in, and this mess might never have gotten so out of hand.

Yes, this would mean the end of the "ownership society," the end of the dream that everyone can, and should, buy their own homes. But let's be honest, that dream has pretty comprehensively collapsed on its own these past two years.

A new country is being crafted in the halls of power this week, one in which the government assumes a role in our markets it has never occupied before. My hope is that out of this catastrophe comes at least some good. Creating a long-term state-funded system for housing those priced out of the private market would be a good place to start.