Does the economy need a government bailout?

September 5, 2008


In short, the answer is yes. As previously noted in another post on this website, and as yesterday opined by Bill Gross at PIMCO’s website, the danger of a negative feedback loop is very real and after the excesses of the past ten years, if not more, the financial system now appears ill-equipped to deal with the arising complications. As days pass, instead of healing and giving hopes of recovery, the situation of the US economy is giving more and more signs of getting worse. So the economy needs all the remedy it can be afforded; the question is about the price of the medicine.

To see the severity of the crisis, one must be more farsighted than just basing one’s assessment on high frequency economic data, such as the PMI’s, factory orders, etc., which are boosted by the temporary strength of the export sector, or the illusory strength of the world economy. It’s more fitting to look at the underlying causes and dynamics that are driving the developments in markets and the real economy, and a brief analysis of these easily demonstrates how difficult and dangerous the situation is.

We have been through a global real estate bubble of unprecedented size in the history of the world. Bubbles are bursting across the world: in Hong Kong, France, Italy, Ireland, Spain, Turkey, US, Norway, Denmark, UK, China, Balkans, Baltics, real estate activity has either begun contracting, decelerating, or prices are already falling.

Most of the developed world is in a recession, and it’s only logical, that in an era of ever increasing correlation between economies, we see the trend continued in emerging economies fairly soon. Indeed,  the whole world is slowing, and this cannot be explained by seasonal factors. Falling commodity prices are likely to dampen activity in commodity producing nations, and increasing risk premiums should see a reduction in money flows to all emerging economies.

So what will be achieved if the US government, for example, buys all the subprime mortgage in the US, and nationalises the GSE’s?

First of all, that the US will stand behind agency debt is common knowledge now; there’s almost no one who doesn’t expect the Treasury to assume the debt of these organisations if they somehow have difficulty meeting their obligations. While it’s necessary that they be nationalised at some point, it’s absurd to expect that this will provide the end of the crisis, as it will merely confirm what is already assumed in the financial markets.

Secondly, provided that the government buys and nationalises the subprime mortgage paper, and in a way “levels” excess housing, by taking it out of the market, will there be a change to the fundamental issues facing the US consumer?

If he spends the way he spends, and if the Chinese keep overinvesting, commodities keep rising, and the triple bubble in the world, in manufacturing, consumption and real estate is allowed to keep building momentum, what kind of a benefit will be derived from this, apart from moving the problems from one pocket to the other?

Yes, government intervention may succeed if done properly. But the failure of unilateral action by the Fed in easing the lending constraints in the US demonstrates in an unmistakable fashion that the global nature of this crisis allows only a global, concerted effort by central banks any chance of success. It’s foolhardy to expect that an independent bailout of the US mortgage market by the government can somehow defuse and resolve all the global excesses that have been building up almost ten years now.

Besides, why would we expect that placing the consumers’ and corporations’ debt in the government’s pocket will necessarily improve our the financial situation? 

Like any other entity, the government must pay back its debt. It’s not too much to say that today, rightly or wrongly, the only financial institution with strong credibility in the US is the US government. By burdening its already patchy balance sheet by trillions of worthless mortgage paper, there’s a chance that we’ll risk perpetuating the crisis, instead of defusing it.

We will have to live through this period of lesser consumption, and lesser economic activity. There doesn’t exist a way of evaporating the problems, however much we desire that they would.


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