By the time you read this, the US Congress will probably have approved a $700 billion bailout plan for America?s ailing financial system. First things first: is the bailout necessary?
The blunt answer is yes. Financial institutions in the US continue to be weak, and continue to collapse with an eerie regularity. It may not be long before there is a run on a commercial bank, which will deepen the crisis further. In any case, banks are already running on each other?no one is lending to anyone else in the absence of confidence in the other?s solvency?the complete opacity of toxic assets on balance sheets will not inspire confidence any time soon. The wholesale money market has thus dried up, and before long, the real economy?consumers and industry?may be choked for credit. If the real economy begins taking a hit, growth will become negative and unemployment, which is already at recent high of 6.1%, may rise further, confirming a recession and perhaps even a depression if both the financial and real economy go down together. The worst case scenario is, of course, The Great Depression when many banks failed, the real economy collapsed, and unemployment rose to 25% largely because rescue came too late?Andrew Mellon, the Treasury Secretary at the time preferred a ??liquidate, liquidate, liquidate, until the system is purged of bad debt? strategy and look what happened. The US and world economy would rather not risk emulating that episode in history. Closer in time, there is the example of the Japanese recession through the 1990s on account of its moribund and unreformed banking system, which was belatedly?with a huge cost to the economy as a whole in the 1990s?rescued by the government in 2002.
Japan hasn?t been the role model for anything economic since 1990 but the government backed rescue of financial institutions in 2002 is a ?model? successful bailout. In a programme, not dissimilar to what the US is planning now, the Japanese government committed $100 billion (admittedly much less than $700 billion) to shore up banks on the verge of insolvency. Japanese banks were horribly exposed to bad loans, many of which were in the housing and construction sector?again, like in the US banks lent a huge amount to a once booming real estate industry that eventually collapsed, leading to toxic loans on the bank books. The government offered financial support to stricken banks on two conditions: full disclosure on the part of banks on exactly how many non-performing loans they were holding; and a purchase of equity by the government in banks opting for government money to purge bad debt. By 2006, most banks were back in profit and free of bad debt. Taxpayers made a neat profit when the government sold its shares in banks at a higher price than they were bought.
Critics will, of course, point to an imminent recession in Japan and the exposure of Japan?s financial institutions to US subprime debt. These will be a challenge, but the rescue effort should not be discounted. After all, some Japanese banks are now cash rich enough to consider buying out their sickly American counterparts?Mitsubishi UFJ has bought a 20% stake in Morgan Stanley and Nomura is buying out Lehman?s Asia, Europe and Middle East divisions. Earlier this year, Mizuho and Sumitomo invested $1 billion in Merrill Lynch and Barclays respectively.
Apart from extreme fringes on the Left (who don?t want taxpayers money to bailout Wall Street fat cats) and the Right (who don?t want extensive government involvement in the economy, whatever the cost), most other opinion agrees on the necessity of the bailout. For all the criticism of the US political system, it has done a remarkable job of coming up with a bailout plan which is likely to be backed by significant bi-partisan consensus. The division of government between executive and legislature, of course, meant lengthy and painful wrangling over a number of sticking points?amongst other things this led to Hank Paulson?s original three page rescue plan being converted into a 110 page booklet.
Still, looking at the package as it stands now, one has to say it?s the best outcome possible, better than the three page original. What remains the same in both versions, however, is the final aim of bailing out a collapsing financial sector with lots of government money, primarily by buying out toxic securities. What have changed are the conditionalities attached with the rescue (a la Japan 2002). Congress will now have substantial oversight over the Treasury?s implementation of the rescue?so no blank cheque for Paulson. Accountability when such a large sum of money (6% of US GDP) is involved sounds like a good idea. There will be a cap on executive pay (and restrictions on golden parachutes for fat cats) at firms signing up for the rescue plan?this is necessary as managements must bear the brunt of their imprudence to avoid any future problem of moral hazard. Shareholders will also have to face some losses, as they should, again to avoid moral hazard?the government will, in effect, be buying into the equity of stricken firms at fairly cheap prices. This is also a way to ensure that shareholders recover some (if not all) of their money. Presumably, the banks unburdened from their bad debt will eventually return to profit, which will enable the government to sell the acquired shares for a profit. At any rate, the financial sector is bound to share the burden?if necessary through additional taxes and fees?if the taxpayers make a loss on the rescue.
The bailout plan thus seems right on the ball?as did the earlier decisions on Fannie, Freddie, Lehman and AIG. Congress should pass it with unanimity. The US government?s action in this financial crisis will then perhaps be remembered as the plan which rescued the US and global economy from a deep depression, while punishing imprudent financiers for their mistakes. Seems like a fair deal.
?dhiraj.nayyar@expressindia.com
