11/03/2008 05:12 am ET Updated May 25, 2011

Why We Must Move a Financial Rescue Package Forward

Congress must take action to rescue the financial system from its current crisis, even if it is impossible to remove or modify the provisions I object to.

Look, I understand why everyone is upset about the financial system rescue plan. The version presented to the Congress is, according to my most trusted source (Nouriel Roubini) wrongheaded; a disgrace. And we all would love to punish someone for the fact that we now have to deal with the effects of more than a quarter century of deregulation of the financial system. Even Bill Clinton participated in the dismantling of the protections put in place after the great crash of 1929; it is very hard to find everyone who needs to be punished, herd them into a single corral, and decide which to shoot and which to use the electric prods and stun guns on.

And I understand why each of us, and each liberal and progressive interest and pressure group, might think this is the time to press for advantage - to bring forward the major social and political changes we have long advocated which may have some relevance to the present crisis, and use this occasion, when the old system is in shock and distress, to achieve our worthy goals.

But I think that we must consider the consequences of letting these impulses of self interest and self justification determine our actions and our advocacy at this time of crisis. For I do believe that the crisis is real, that the present financial system world wide is threatened, and that if it were to shut down for any length of time the consequences for our nation and the world, in our time and our children's could be severe - perhaps irreparable.

I remember Naomi Klein's admonition that the Right invented the Shock Doctrine, not liberals. The Right holds values that are congenial to the application of the Shock Doctrine to social change at times of social stress, not progressives. The Right has decades of experience in turning times of confusion and discontent into newly repressive policies which deprive the disadvantaged and advantage the privileged, suppress the oppressed and exalt the powerful - we have decades of experience in watching that happen. Yet we let ourselves believe that encouraging chaos and social stress through a disorderly, chaotic, process of protest can further our desires for a better, more just, more tolerant, and more compassionate world.

I approach my 70th year. Perhaps I am hearing noises in the night that are not really there. But I do not, cannot, believe that protest against a rescue of a financial system which is on the verge of collapse can bring anything but evil. Such a collapse will advantage and further the values and goals of the Right, not of civilization. The retrograde consciousness which believes "cosmopolitan" is an nasty word will advance its narrowness and intolerance further into the public mind, and into public policy. This is the way humans deal with sudden onslaughts of fear, uncertainty, and doubt. We turn inward, suspect the outside world, demand conformity within our own, and reject the values of the apparently too open and generous social arrangements which seem to have failed us. It takes decades, sometimes centuries, of peace, prosperity, comity, and stability before openness again becomes tolerable within such a closed social order. In truth it is this squalling, foot stamping, fist throwing reaction to deprivation, to the onset of hard times, that destroys civilizations and creates holocausts.

For this reason I will not permit myself to be a part of any action or advocacy which has a substantial risk of bringing the effective operation of even the present, dysfunctional world financial system to a halt. There is a better way to do it. There are better ways in which to conduct ourselves.

What is really going on here, anyway?

Our people, and our representatives think the financial system rescue plan is about protecting financial institutions from failure resulting from bad judgement about mortgage backed securities.

It is actually about protecting the worldwide supply of money and credit from collapse. This collapse would follow financial "deleveraging" which results from the vanishing value of highly leveraged collateralized debt obligations (CDO) and credit default swaps (CDS) built up out of mortgages and other debt instruments.

These have become, under the market fundamentalist mandated financial deregulation regime, the source and underpinning of the world's money supply. If they collapse in value the money supply will collapse along with them. The money supply will then have to be re-created by central banks and governments. Doing that will require addressing enormously difficult political and distributional issues.

Delay in restoring the money supply will kill economic activity, and throw the world economy back 20 to 30 years, I suspect. People will become homeless, illness will go untreated, starvation will become common, and civil unrest and warfare even more common.

Absent an effective "rescue" package,  the sooner the (money) printing presses roll, the better.

Don't get me wrong: Even if we get a rescue package passed, and avoid a collapse of the world economy and money supply, it will not fix everything...

Our current credit crisis is likely to deepen and spread, but in a more "regulated" and less damaging way. Many more (between 200 and 300) major banks will fail, according to more than one student of the banking system. The economy will sink into a severe recession, lasting 12 to 18 months, possibly more. But we have to compare this to the possible multiple year contraction that might result from collapse of the money supply.

For many years the market has valued stocks well above their 'natural" price/earnings ration of 16:1. Vulnerable investments will suffer some of the greatest losses in modern times and average returns on stocks will likely retreat toward the historical norm.

Housing prices will likely decrease, and rentals increase, until the ratio of the two returns to its 400 year average, 100:1 (one month's rent x 100 = property value; eg. $4300/month x 100 months = $430,000 property value). That's one quarter the value of the property, or four times the rental cost, in the ratio which has held in some markets in recent years.

But avoiding these unpleasant realities is not what the rescue is about. It is about avoiding a much worse scenario, resulting from a collapse of the world's money supply and a dramatic shrinking of worldwide trade and economic activity.

And yes, of course the financial deregulation was absurd, the central banks should never have let the money supply become dependant upon debt instruments instead of real production and economic activity, and the system has for too many years rewarded impetuous, reckless, and irresponsible risk takers instead of hard working laborers and farmers and business owners. Many Americans are tired of watching the money earned from agricuture and industry run, like water in rivers, from the center of the country to financial centers on the coasts.

But that's not really the point, just now, is it? We are trying to avoid a disaster just now, and have to deal with the "financial genius" crazies later.

Even Critics Agree: The crisis is real; so is the need for action

Some have argued that there is no crisis. Some have used a letter signed by a whole bunch of econ professors, which criticizes the Paulson plan for financial system rescue to argue that the crisis is an imaginary thing, ginned up to support "bailing out" rich evildoers.

That "letter was sent to Congress on Wed Sept 24 2008 regarding the Treasury plan as outlined on that date. It does not reflect all signatories views on subesquent plans or modifications of the bill".

My own favorite student of this topic opposes the Paulson debt purchase plan. But he goes on to say, very clearly:

"Whenever there is a systemic banking crisis there is a need to recapitalize the banking/financial system to avoid an excessive and destructive credit contraction."

I agree with Dr. Nouriel Roubini in that.

Yes, action does need to be taken. Two essential actions described by Dr. Roubini:

  1. ". . .address the need to recapitalize those financial institutions that are badly undercapitalized: this could have been achieved by using some of the $700 billion to inject public funds in ways other and more effective than a purchase of toxic assets: via public injections of preferred shares into these firms; via required matching injections of Tier 1 capital by current shareholders to make sure that such shareholders take first tier loss in the presence of public recapitalization; via suspension of dividends payments; via a conversion of some of the unsecured debt into equity (a debt for equity swap)."
  2. ". . .explicitly include an HOLC-style program to reduce across the board the debt burden of the distressed household sector; without such a component the debt overhang of the household sector will continue to depress consumption spending and will exacerbate the current economic recession.
Another measure, which should be taken by central banks, apart from the rescue plan, is a coordinated 100 basis point reduction in policy rates in all the major economies in the world, as recommended by Dr. Roubini on September 29.

Yes, the Paulson proposal is wrongheaded and would be ineffective, even after the Congressional improvements - though not as ineffective as doing nothing.

I do not believe, as many apparently do, that the need to recapitalize ought be delayed or neglected in favor of "progressive" interest group building actions, or appeals to substitute political agitation for effective legislative action to rescue the financial system.

Action I Support

I support moving forward with a financial system rescue package
- once the Obama campaign, and the Democratic leadership in the House and Senate have clearly and forthrightly considered and addressed the criticisms put forth by economists who are specialists in financial economics. Not one that is perfect, not one that is punitive, not one that presses advantage to gain political objectives other than the rescue of the financial system, but one that will pass, be signed by the President, and halt our slide into generalized panic in credit markets and toward a systemic meltdown of the entire financial system.

On Tuesday, September 30, I called the offices of Senator Obama's campaign, the Democratic National Commitee, Senator Harry Reid, Speaker Nancy Pelosi, Senator Chris Dodd, and Representative Barney Frank. In these calls I expressed my understanding of the need to promptly pass an effective financial system rescue package, and described how I have been working with friends and relatives who have opposed that action to secure their support for it. They listened.

And they were concerned that I, a strong supporter of the Democratic party and of Barack Obama, am dissatisfied the poposal currently before us and want full consideration of alternatives to it;  that I believe that it is absolutely essential that the weakesses of the Paulson proposal be reexamined. I believe it is essential that the inclusion of purchase of distressed debt instruments using a $700 billion taxpayer funded program be reviewed in the light of criticisms by experts in this specific area of financial economics, including Dr. Roubini of RGE Economics, and Brad Setser, at the Center for Geoeconomic Studies at the Council on Foreign Relations.

I explained that the cautionary judgements of such critics needed to be explicitly and visibly discussed by the House and Senate leadership, and by the economic policy team of the Obama campaign. And that this should be done publicly, with the results publicly discussed and announced, so that those of us concerned about the suitability and adequacy of the Paulson proposal would know what action they were taking as a result of having considered criticisms of the Paulson plan, and why they were taking that action in the light of those criticisms and alternative proposals. And that my further financial support of the Party and the candidate would be dependent on their response to this need for visibility and transparency.

The Naysayers

In working to secure support for action on a rescue package I have been asked by friends who do not support it to explain myself. I've answered some of those questions in this way:
  • This bailout is BS and not necessary. It is only a give away to greedy, selfish Wall Street millionaires. I think they're lying/manipulating once again to get what they want. There is no real systemic crisis in the global financial economy, and if there were that would be a good thing. They've hollered "wolf" too many times. Anyway, since big money so believes in letting the "free" market do its thing, maybe it should be proved once and for all that they're wrong.  The $700 billion dollars should be used to (followed by a laundry list of sometimes worthy social and political reform programs).

A. Your pie in the sky, castle in the air, nihilist revolt against taking effective action to rescue the financial system is worthy of a Kieth Olberman award.

  • Oh looky, I have a NEW bill, written by three ultra [Righty] [Progressive] legislators; the "No Bailout" bill! That proves the Bush Bailout is not our only option. This alternative is congenial to "our" values; help us stop action by the House on the Bush/Paulson giveaway!

A. See first answer, above. It is ridiculous to think that a few members - rightist, leftist, or moderate - or the combined leadership of the House and Senate can create in a few days a bill that makes economic sense. What economist, or group of economists who specialize in financial economics have vetted and recommended this bill? Pitiful.Give me an alternative vetted and supported by Nouriel Roubini, Brad Setser, and Bill Gross, and I will support it!

  • Well who do you think made the bad judgements? And why? Maybe we need new representatives, not owned by 'fat cats'.

A. The "bad judgements" were made by many people, starting with the Reagan administration, continuing through Clinton's support of repeal of the Glass-Steagle act, down to people who let bad mortgage brokers sell them bad adjustable rate home equity mortgages and the financial advisors who encouraged them to take those mortgages, and finally to the financiers who packaged the bad mortgages and wrapped them into highly leveraged securities - whose value is now in doubt.

  • Perhaps we need new financial systems! (call them nfs!) seems to me we've just created another version of the feudal system that we left england to escape (how about what is past is prologue..And if we don't learn from our mistakes, we're destined to repeat them)

A. The existing system is bad news, it permitted the system to get to the point it is at. We do need new systems. We also badly need to keep the one we have running until that can be devised and the transition made to it without stopping the worlds economies dead in their tracks for an indefinite period.

  • Okay well addressing these difficult political and distributional isssues is way overdue so the time is now

A. Decisions made under the kind of stress this will create are always bad, and always disadvantageous, negative, retrograde - not progressive. Remember Naomi Klein's "Shock Doctrine"? That is what you'd get. No improvement, only fascism and fear. Besides, it will take lots of time to resolve - unless resolved by a "strong man" dictator who imposes it, as in Germany the last time a major currency melted down - and in the meantime people will suffer, turn inward, become crippled and fearful emotionally, with all the personal, social, and political consequences of those conditions.

  • We'll get it right this time, and wake up to the need to share wealth, cooperate, and have food and shelter and gardens for everyone on the planet

A. Decisions, especially social/political decisions made under this kind of stress are negatively conditioned, there will be no such positive outcome to a crash in the world economy.

  • Time to think outside the box.

A. It's a good idea, that thinking outside the box. But the doctrinaire oppositionalists on the left and right don't seem to be able to, or want to do it.

  • Do you have confidence in any of those who will be designing the 'rescue package'? and in those who may be executing it?

A. The people I trust most have a high but not unconditional regard for them. I have felt Paulson was doing a good job at Treasury since he got there, but dislike the specifics of his proposal.

I very much like Bernanke, trust him, and have been reading his writings carefully for 4 years or more - he gave a superb speech in Richmond, VA back then.

Treasury policy is one area that Cheney seems to have not screwed over, and the staff has been pretty much left to the Secretary. I suspect that O'Neill did a good job protecting Treasury staff - which may have gotten him fired, but held the place together.

Their recommendations and writings fit with my understanding of how these things work, and I've been studying that for 6 years or so, in some depth; and have written quite a bit about it - not that anyone pays attention.

The experts I like best - Gross, Setser, Roubini - quarrel with some of the details (and with one another), but all agree something along these lines has to be done. Roubini, Gross, and I think Setser have recommended action of some kind a long time ago; Gross recommended action of this kind explicitly a few weeks ago, months ago Roubini recommend a HOLC, which was not included, and should be.

I think a lot of economists who have criticised the program did so not realizing that their criticism could give cover to those seeking to derail the whole thing - and would wish that had not happened.

Of course the radical Right Wing is happy as hell about this. A real disaster will give them ample opportunity to apply "Shock Doctrine" solutions.

  • Why should those of us who didn't borrow more than we could pay back and lived BELOW our means (old school) be penalized for those stupid bastards who bought way more home than they could afford and have maxed out all of their credit cards?

I understand the feeling, but that problem has been overstated, greatly. Most of the bad paper originated was because the mortgage brokers "sold" it to people who did not know better - I know this first hand from experience in California, where a broker almost trapped a friend into an ARM, and dropped it only when I called her on her lies.

And the problem that needs to be addressed is only superficially the result of overextension of this kind of credit - if those were the only mortgages going bad, it would have been easily dealt with. In housing there is a mismatch of high cost supply and low cost demand that was being disguised by crazy and illegal financing practices. When those practices are halted, it depresses the value of houses people had hoped to refinance, or sell. Those go on the market as distress sales, further decreasing the market value of all housing.

While this would fix the mismatch between supply and demand price, it also leaves a huge volume of "bad mortgages" in the hands of the institutions who bought them from the fakers brokers who originated them.
This process made developers, flippers, brokers, and mortgage backed security originaters rich. Everybody else goes underwater.

That puts people with straight 30 year mortgages "underwater" - they can make their payments, but their net worth has gone down, and they cannot sell with any hope of getting what they have in out. If they have medical expenses, or retire, or lose a job, then they are in the same position as the rest - facing foreclosure or simply walking away from what was once a good mortgage and a good house.

So the housing crash has at least three cycles - the first is "liar loans", where the broker inflated values and incomes to get approval of loans which should never have been approved. These failed first. That was a small set, but is the one the less informed "moral hazard" people so love to flog.

The next group - currently in play - are 5 year fixed "option" loans. These people could make only principal payments, added interest to the principal, and expected that they would be able to refi at as good or better rate, on a property of greatly increased value, and having a higher income, at the end of the 5 years. That group, except for John and Joanie Flipper, was not so much stupid as ignorant - young couples with high hopes who had never seen a business cycle and believed their mortgage broker's BS. Now they are underwater in a sinking economy, and being foreclosed in droves.

The group coming up, and this is the one which will really kill the housing market and the economy if there is no mortgage relief, is the holders of traditional mortgages who suffer illness, or job loss or transfer, or retirement and find they cannot sell and cover the balance due on the mortgage. I don't know the stats, but the people who study this seem to think it's a very serious problem and will worsen if the economy falls into extended recession.

But housing is only the scab on the wound.

Under that is the fact that the entire world money supply has been built on top of "derivitaves" or financial instruments derived from and built on these mortgages and other credit instruments. "I've an AAA rated bond I'd like to sell you that is secured by a 1951 grain elevator in Almena, KS." (And slices of which underpin various Credit Default Swaps, some between institutions in Hong Kong and Melbourne.)

After financial "deregulation" the central banks found that the money supply increased pretty much in synch with measured output. That was convenient because it limited the need for central bank intervention to manage the supply of money and limit (measured) inflation. But that synchronization occured primarilybecause the money supply was being increased by of the growth of these financial derivitaves, and the derivitaves were the source of the measured growth. (A self referential system.)

The engine of money growth and much economic growth was not increased productivity and production, but inflation of the values of assets, based primarily on an increasing money supply - inflation that did not show up in consumer goods or the CPI. It was reflected, though, in the cost of homes, real estate, and high end amenities in the developed world, in cities like Moscow and in prinipalities on the Gulf.

When the weakness of that "asset value" base is exposed, and it is known that paper assets are not supported by the value of real assets, then the money supply based on the paper assets simply vanishes - and the entire financial system crashes.

No problem. Except that the real economy does need money to operate, and that money is no longer there. So it stops too.

So, when we pay for a financial system rescue we are not paying to help other people out. We are paying to save the system we all depend upon. And we are not paying all that much.

Despite fears to the contrary, even under the Paulson plan Treasury would probably get the assets it picks up for 65% of nominal value. It should be able to "clear" about 1.5 trillion in bad paper from the market with an operating fund of 700 billion; and even skeptics like Nouriel Roubini have said the net cost to taxpayers would probably not exceed 250 Billion - a pittance compared to what a deep recession would cost in tax reciepts, and plain trivial in comparison to the cost of systemic failure of the system.

Of course the loss to private income resulting from a recession which might be avoided by spending this money would be much, much greater. (The simple announcement of the House failure to pass the TARP on Monday resulted in a temporary loss in stock markets of more than a trillion dollars! There are a lot of ways to lose that kind of money, but not to lose the kind of money that a systemic failure would take from us.)

  • We must not permit this $700 billion bailout to increase the Treasury's debt, it will weaken the dollar!

Demand for U.S. T-bills and other safe-haven instruments have helped underpin the dollar, despite the fact the United States is the epicenter of the financial crisis.

The fear of a full blown destruction of the money supply and world economy strengthens the dollar, since holders of other currencies engage in a "flight to safety" by buying US Treasury debt instruments; this also forces the interest rates the US Treasury pays down, so our own debt is cheaper -- at least until the entire pond freezes over, after which we can all do subsistence agriculture to feed ourselves.

This strength is based on fear, uncertainty and doubt (FUD). When that fades, the dollar may well lose strength. A general sense that the markets world wide have hit rock bottom would reduce FUD, and may weaken the dollar. Passage of a rescue package may:

    * weaken the dollar by reducing FUD

    * weaken it by increasing the need for Treasury to borrow dollars

    * strengthen it by improving the outlook for the US economy against others

    * strengthen it by making it less necessary to lower interest rates as an alternative credit enhancement strategy

    * be neutral as a consequence of increasing other central banks' willingness to assist in managing the flow of deposits and among national Treasuries to reduce exchange rate swings. Dr. Roubini has proposed a coordinated 100 basis point reduction in policy rates by the central banks of all the major countries, which would help to guarantee a neutral effect for the reduction. (Non central bank flows have been reduced by private holders' fear of credit and exchange fluctuation risk.)

Beyond that, remember that, as Mark Weisbrot writes "for the vast majority of the country, a "strong dollar" is more like a "strong influenza virus" - something to be avoided whenever possible." The supposed strength of the dollar has, for the last 25 years, underwritten the hollowing out of the United States economy by raising the relative cost of our labor and the goods we produce. It has subsidized our purchase of foreign goods, and raised our annual trade and balance of payments to unsustainable levels. It is a mistake to desire a strong dollar, and a mistake to fear a weak dollar, so long as we are exporting to little and importing too much.

It is, to be honest, more than a little disturbing to me to see people who write about the need to restore the United States economy, rebuild our manufactures, and increase the wages of non-financial workers, who do not understand the part that overvaluation of the dollar has played in destroying those values. And how our appetite for foreign goods and oil is fed by that same overvaluation.

  • If what you say is true, that the Treasury will reap billions from the turn around after your "rescue" why aren't the Warren Buffett's buying the debt up?

Buffet's Berkshire-Hathaway is buying shares in companies that might have difficulties without his personal intervention, but would not be directly assisted by the Treasury rescue package - he just possibly saved GE's "at risk" finance arm by injecting $3 billion on Oct. 1st, and put $5 billion into Goldman on Sept. 23rd. He will reap millions if not billions from that. But he won't, for years, if the system crashes; he is trying to help prevent that crash and make money at the same time. These investments may do more good, in terms of preventing human privation and misery, than all the philanthropy he has done or ever will do.

The same principle should have been applied to the financial system rescue - use Treasury money to inject liquidity into the system through purchase of preferred stock - rather than buying bad mortgage deb- the Paulson approach considered by Congress. The bad mortgage problem should have been dealt with through a HOLC. Once the system had settled, than the preferred stock could be redeemed - at a profit, as Buffet hopes to do.

Unfortunately the TARP bill would have Treasury buy bad debt from these institutions, instead of buying preferred stock in them. That relieves the institutions, and increases thier value. To recoup the cost of the purchase of the bad debt, the Treasury must clean it up and sell it at a profit. Estimating the net profit or loss to the taxpayer/Treasury is difficult, but based on the information available to him Dr Roubini has suggested a possible net loss of over $200 Billion - less than $700 Billion, but still not pleasant. A provision for securing warrants for common stock from the companies whose debt is purchased could offset much of the potential loss, or produce a profit.

  • What about this Senate bill? Have you taken a look at the "PORK" attached to the bail out bill? Why do the tax payers want to give 192 Mill. To the rum producers of PR, 128 Mil. To some race tracks, 6 Mil for the producer of wooden arrows, 33 Mil for some Corp. in American Samoa? Does the Senate think we're stupid?

In the Senate the Treasury TARP proposal was grafted onto a pre-existing finance bill. That seems (based on what you say) to have already had the things you describe in it; those tax benefit items have nothing at all to do with the TARP proposal. This is (and everyone is very straightforward about this) an effort to move the proposal rapidly through the Senate by making it part of a bill already under consideraton; and to get support for the TARP proposal by attaching it to a bill extending tax benefits, including new "alternative minimum tax" limits. The tax benefit costs of that Senate bill are not new but were grafted onto the TARP package.

Summing up

I support moving forward with a financial system rescue package
- once the Obama campaign, and the Democratic leadership in the House and Senate have clearly and forthrightly considered and addressed the criticisms put forth by economists who are specialists in financial economics. Not one that is perfect, not one that is punitive, not one that presses advantage to gain political objectives other than the rescue of the financial system, but one that will pass, be signed by the President, and halt our slide into generalized panic in credit markets and toward a systemic meltdown of the entire financial system.

  • A rescue of the financial system is absolutely essential, and it must be done soon.

  • Economists who are credible experts in the world financial system are almost universally in agreement with the need for effective action, but have substantive and well founded doubts about the effectiveness and appropriatness of the debt purchase plan proposed by Secretary of the Treasury Paulson.

  • Virtually all who are serious students of the subject are persuaded by daily events that, in the absence of action, there is a very serious and increasing chance that the world financial system will cease to perform its essential functions.  These are functions which the entire world economy needs to continue producing goods and moving them to markets and consumers, and their failure would result in significant and long lasting human privation and tragedy.

  • After full and transparent consideration of criticisms of the plan presented by Secretary Paulson, in particular the proposal for debt purchase and the omission of the HOLC, the leadership of the Democratic Party should, if at all possible, adopt modifications to it which will meet the most significant of those criticisms and are consonant with Democratic values.

  • I will support the action that is taken, provided that there has been full consideration of alternatives, and the reason these modifications cannot be adopted have been communicated to the public.

  • Congress must take action to rescue the financial system from its current crisis, even if it is impossible to remove or modify the provisions I object to.