So, when the history books describing this time are written will they really look back at yesterday’s decision by Congress as the pivotal moment? Will the decisions of those 228 Law makers really send the global economy into a 1930s style depression? Was this really a one off opportunity to fix the problem?
Last night, EU Commissioner Peter Mandelson was interviewed on BBC2 Newsnight. He said “I feel they’ve taken leave of their senses and I hope that in Europe we will not see politicians and parliamentarians replicating the sort of irresponsibility and political partisanship that we have seen in Washington.”
And yet, consider this. The Paulson plan had many flaws. There are strong arguments to suggest it was the wrong plan. Some say, well, at least it was a plan. Any plan is better than no plan.
But is that right ?
Most successful business people will tell you it is a mistake to make split second decisions. If you enter into a hire purchase agreement to buy a new TV, you are given a seven days cool off period. If you are buying a house, the lawyers seem to do their best to slow the whole process down, with their due diligence. In business, it sometimes feels as if lawyers call the shots – their “moreovers” and ”whereupons” can be irritating, they can slow transactions down, but most would agree they are essential.
Sometimes you may find yourself under pressure. We are usually suspicious of take it or leave it deals. Here is some advice for a would be buyer subjected to a high pressured sales techniques: walk away. Anyone who tries to persuade you the deal won’t be available tomorrow is usually bluffing.
Now we are told we face financial Armageddon. That it is 1929 all over again, that yesterday’s no vote by the House of Representatives spells the end of prosperity. That the US is a third world economy in the making. And markets do their headless chicken impersonation. Paulson wanted $700bn, yesterday the US stocks markets had more than $1trillion knocked off their value, therefore goes the argument, Congress’s reticence has already cost more than the money Paulson wanted to spend.
Yet, you know that’s not true. Markets rise and fall, even the US government has only limited opportunities to spend $700bn.
Right now, what is really called for is thought, a considered response to the financial crisis. Those who can keep their head while others panic, should be the ones who set the pace.
Yesterday’s decisions by Congress does not spell disaster. And this is why.
The first thing you need to bear in mind is this. Congress acted the way it did, yesterday because that is what the electorate wanted. Your average US American was not impressed by the Paulson plan. Bankers have lost the confidence of US citizens, well they have lost the confidence of most citizens everywhere, and this was a plan hatched by an ex banker. Bankers failed to see this crisis coming, and former chairmen of Goldman Sachs turned Treasury Secretary are no exception to this.
George Dubya’s loss of credibility in the US is almost as bad as the loss of credibility he suffered from in Europe a few years ago. If George likes the plan, it must be bad, went the reasoning. This point is perfectly illustrated by the comments from one US politician, comparing the argument that the Paulson plan will save the economy with claims that there were weapons of mass destruction in Iraq.
But, set aside the emotive response, there were major flaws with the Paulson plan.
Nouriel Roubini, high profile Professor of economics at New York university pointed out that in an IMF study of 42 systemic banking crises, only seven, Mexico, Japan, Bolivia, Czech Republic, Jamaica, Malaysia, and Paraguay, saw the government purchase bad assets, in the style of the proposed Paulson plan. None of these seven Paulsonesque plans were especially successful.
By contrast, the banking rescue that seems to have been the most successful – if you like the model rescue, was seen in Scandinavia. This saw no buyout of bad debts, instead, the governments in Sweden, Norway, and Finland, injected capital into the banks, and in return the governments acquired substantial equity.
Yesterday, when it was assumed the plan would go through, Capital Economics said “The root of this crisis is not the lack of liquidity in that market, it is the lack of capital in the banking system. As it stands, the Treasury’s plan to buy the illiquid assets on banks’ balance sheets will do almost nothing to prevent the destruction of bank capital and the resulting reduction in lending and economic activity. We still expect the economy to endure a torrid recession over the next year, forcing the Fed to slash interest rates to only 1.0 per cent.
“In using the government’s money to buy assets, the Treasury will be working against the leverage on banks’ balance sheets. What the Treasury should be doing is working with the leverage, using its money to inject capital directly into the banking system.”
Mr Roubinu, perhaps one of the biggest critics of the Paulson plan said “the claim by the Fed and Treasury that spending $700 billion of public money is the best way to recapitalize banks has absolutely no factual basis or justification. This way of recapitalizing financial institutions is a total rip-off that will mostly benefit – at a huge expense for the US taxpayer - the common and preferred shareholders and even unsecured creditors of the banks.”
The big snag with the Paulson plan, of course, as was pointed out here yesterday, is that it is based on the assumption that mortgage debt is undervalued. The Treasury was in effect supposed to second guess the market, buy assets on the cheap and sell them at the market price down the line.
But supposing Paulson estimate of the true value of debt was wrong. His plan mounted to little more than asking tax payers to fund speculation.
This is what we know. The global finance sector is in crisis. The last few days has seen two of the largest US banks go down – Washington Mutual and Wachovia, (Wachovia did not go bust as such, it was bought by Citigroup at a rock bottom price.) In Belgium, within hours of the nationalisation of Fortis, news broke that the Belgium bank Dexia SA, the world’s largest lender to local authorities was on the verge of collapse. In Iceland, Glitnir, the islands third largest bank has been nationalised.
But the underlying problem behind all of this is the collapse in house prices - around the world. The house prices crash was not caused by the credit crunch, the relationship is the other way round. Implicit to the Paulson plan is assumption that house prices will stop falling – then go up, which in turn will get the US tax payers off the hook.
But this may not be the right thing for the long-term.
The best possible solution is for all governments, US, UK, and Eurozone, to inject banks with capital - and in return acquire substantial equity. When things recover, maybe in several years time, government shares should then be sold. The rejection of the Paulson plan was the right thing, because a better plan was needed, and if that takes a bit more time, then so be it.
With regard to your observation on the Scandinavian cuurency crisis it was not just an injection of capital but in the case of the Swedish banks the failing assets - largely comprising commercial property investment stock bought at the peak of the UK and European markets - were hived off into 5 parallel banks euphemistically known as the bad banks. These organisations were capitalised with institional funds as well.
The stock was released to the market once values had recovered sufficiently to cover the debt. In the intevening period which was the best part of the 1990’s the stock was actively manged on the same footing as any property company would handle its assets.