When taxpayers end up holding the baby

Business Times - 21 Mar 2008

When taxpayers end up holding the baby

Greater oversight and transparency of financial industry needed to regain market trust


FOR a while, officials, lawmakers and pundits in Washington were debating whether the American economy was - or soon would be - in a recession. The key historical analogy applied in their discussions was the mild recession in late 1990, during the presidency of George Bush the elder that lasted for only six months.

The message then was that the economy was facing a cyclical downturn that could be managed through appropriate monetary and fiscal policies.

So it is intriguing - or scary, some would argue - when the same officials, lawmakers and pundits are now starting to refer more frequently in recent days to the Great Depression of the 1930s and to the various 'New Deal' programmes initiated by then president Franklin Delano Roosevelt.

Under his leadership, the US federal government succeeded in rescuing the American capitalist system by using the government's power and resources to refinance homes, bail out banks and create the American welfare state.

No one called any of that 'socialism', but it was certainly a form of huge intervention by the federal government in the economy - which runs very much contrary to the free market philosophy shared by President George Bush the younger and his economic advisers.

It's certainly too early to describe the current signs of economic downturn and financial meltdown as the beginning of a depression - great or small. But when one considers some of the recent moves taken by the US central bank, and in particular, the decision to negotiate a bailout for the insolvent investment bank, Bear Stearns, and to supply emergency credit to other financial firms, it becomes clear that the current administration - whose cheerleaders in the media and think-tanks have for years been celebrating the 'magic of the market' - has decided that there were no magicians on Wall Street. It's the much reviled government that is going to have to fix the economic problems now.

Say good-bye to Adam Smith, and say hello, once again, to John Maynard Keynes.

Optimists hope that the Fed's rescue of Bear Stearns and the opening of its lending window to investment banks would prove to be limited in nature, not unlike the move by the administration of President Bill Clinton and Alan Greenspan's Fed to negotiate a bailout of the troubled hedge fund, the Long-Term Capital Management (LTCM) firm in 1998.

But it's quite possible that what we saw last weekend revealed the shape of things to come in the form of more government-backed bailouts of other highly leveraged financial institutions whose possible collapse could devastate the entire economy by producing a financial meltdown.

Indeed, the federal government, through its central bank, has decided to put in a lot of taxpayers' money in order to save a firm whose top executives had made a lot of easy money in recent years - advancing their own private interests, as opposed to the public good. This has been justified - by the administration and Congress - on the basis of the potential risk that the collapse of Bear Stearns could pose to the public interest in the shape of a national and perhaps even global economic calamity.

In fact, even Democrats, including presidential candidates Hillary Clinton and Barack Obama, and the states they represent - New York and Illinois, which contain key centres for America's financial industry - have backed the latest moves by the Fed.

Washington is wishing and hoping that these dramatic steps - the term 'historic' has also been used by the media - coupled with Tuesday's decision by the policymaking arms of the Fed to cut the federal funds rate by a three-quarter percentage point will be a shot in the arm for the financial sector and will finally make credit available to help stimulate new business activity.

Whether all this will indeed bring about a long-term uptrend or whether Washington is just postponing the big day of reckoning on Wall Street remains to be seen.

Indeed, there are few signs that the financial institutions are regaining the sense of confidence that the crisis is over. In a way, no one seems to fully understand what exactly are the causes and the magnitude of this catastrophe that looks more and more like a huge black hole.

If anything, the frantic response by the Fed suggests to some investment bankers that Ben Bernanke and his colleagues are as confused as they are.

Moreover, while the Fed's announcement on Tuesday suggested that the central bank continues to be more concerned over a possible recession than about the risk of inflation, for most American consumers facing higher energy and food prices it certainly feels like inflationary times and it's doubtful they are about to spend extra hours and extra dollars - assuming these dollars will be available - in the shopping mall and help energise business activity.

It looks, therefore, that in order to create the conditions for ending the credit squeeze, the US federal government will need to intervene in a more systematic and direct way in the economy. In addition to more bailouts of financial institutions, plans could include providing more government-backed loans to homeowners facing foreclosures and guaranteeing failing mortgages in order to prevent such foreclosures.

And it is not inconceivable that, at some point, one or two of the failed financial institutions will have to go into receivership like Northern Rock did in England. That's the 'N' (for 'nationalisation') word.

Indeed, as the federal government becomes more directly involved in rescuing irresponsible investors and consumers, the public through Congress could end up demanding that Washington acquires more regulatory power over those sectors of the markets whose reckless decisions have brought about the current crisis.

Demanding more oversight and transparency when it comes to the financial industry will almost certainly be part of the necessary process of renewing a sense of trust among investors and consumers. After all, it was the lack of oversight and transparency that created the conditions for the current mess.

Copyright © 2007 Singapore Press Holdings Ltd. All rights reserved.


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