Those whom the gods would destroy, they first make mad, Willem Buiter

September 29, 2008

The US House of Representatives has voted to reject the Emergency Economic Stabilization Act - the $700bn Treasury-funded facility for purchasing and managing toxic assets held by the US banking system.

Opposition to the proposal came from two different sources. A few remaining libertarians and believers in unfettered free enterprise voted against. Even when they recognise the risk that a calamitous collapse in economic activity may result, they view this as a form of creative destruction that is an integral part of a Darwinian market economy. I don’t know anything about Gresham Barrett, a Republican congressman from South Carolina but his statement fits the bill: “My fear is the government will be forever changing the face of the American free market. Because I believe so strongly in the principles of the free market and the belief in freedom, I will be opposing this bill.” Those who genuinely hold these views are mad, but honest and principled. I wish them a good depression.

A larger body of nay-voters consists of populist rabble-rousers or, worse, politicians who know better but follow the whims, fancies and passions of their constituents, even when this means that before long the real economy risks falling off a cliff. The following statement by Ted Poe, a Texan Republican member of Congress is a nice example: “New York City fatcats expect Joe Sixpack to buck up and pay for all of this nonsense,”… “Putting a financial gun to the head of every American is not the answer.”

The dedicated followers of constituency fashion reckon that the date of the election is likely to be before the full impact of the financial collapse made likely by this vote will hit their constituents’ jobs and businesses. They put re-election before the economic health of the nation and the interests of their constituents. Opportunism guides them rather than principle. I wish them a rather nasty depression.

What is likely to happen next? With a bit of luck, the House will be frightened by its own audacity and will reverse itself. If a substantively similar bill (or a better bill that addresses not just the problem of valuing toxic assets and getting them off the banks’ books, but also the problem of recapitalising the US banking sector) is passed in the next day or so, the damage can remain limited. If the markets fear that the nays have thrown their toys out of the pram for the long term, the following scenario is quite likely:

* The US stock market tanks. Bank shares collapse, as do the valuations of all highly leveraged financial institutions. Weaker versions of this occur in Europe, in Japan and in the emerging markets.
* CDS spreads for banks explode, as will those of all highly leveraged financial institutions. Credits spreads generally take on loan-shark proportions, even for reputable borrowers. Again the rest of the world will experience a slightly milder version of this.
* No US bank will lend to any other US bank or any other highly leveraged institution. The same will happen elsewhere. Remaining sources of external finance for banks, other than the facilities created by the central banks and the Treasuries, will dry up.
* Banks and other highly leveraged institutions will try to unload assets at fire-sale prices in illiquid markets. Even assets not viewed as toxic before will become unsaleable at any price.
* The interaction of a growing lack of funding liquidity and increasing market illiquidity will destroy the banks’ business models.
* Banks will stop providing credit to households and to non-financial enterprises.
* Banks will collapse, both through balance sheet insolvency and through liquidity insolvency. No bank will be safe, not even the household names for whom the crisis has thus far brought more opportunities than disasters.
* Other highly leveraged financial institutions collapse on a large scale.
* Households and non-financial businesses revert to financial autarky, among wide-spread defaults and insolvencies.
* Consumer demand and investment demand collapse. Unemployment shoots up.
* The government suspends all trading in financial stocks until further notice.
* The government nationalises all US banks and other highly leveraged financial institutions. The shareholders get nothing up front and have to wait for an eventual re-privatisation or liquididation to find out whether they are left with anything at all. Holders of bank debt get a sizeable haircut ‘up front’ on the face value of the debt and have part of the remainder converted into equity that shares the fate of the old equity.
* We have the Great Depression of the 2010s.

None of this is unavoidable, provided the US Congress grows up and adopts forthwith something close to the Emergency Economic Stabilization Act as a first, modest but necessary step towards re-establishing functioning securitisation markets and restoring financial health to the banking sector. Cutting off your nose to spite your face is not a sensible alternative.

PS My remaining financial wealth is now kept in a (small) old sock in an undisclosed location.

PPS The conduct of both US Presidential candidates in this matter makes them unfit for purpose.
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Willem Buiter: Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC;

September 29th, 2008 in Economics, Ethics, Financial Markets, Monetary Policy, Politics | Permalink