Monday, September 29, 2008

Losses from the Bailout Vote and How to Ease Main Street's Credit Crunch

A hot populist wind blew a prairie fire into Washington today and burned up the Bush Administration's $700 billion proposal to bail out Wall Street. The President, Treasury Secretary Paulson, and Fed Chairman Bernanke wound up with major egg on their faces. So did the Democratic leadership in Congress. Wall Street was also a big loser, with expectations of a $700 billion windfall dashed.

The biggest loss, however, was of the electorate's trust in their government. Although prominent political leaders, including the two Presidential candidates, and financial experts of almost every political persuasion testified to the need for the bailout, the people just didn't buy it. Constituent calls to members of Congress ran heavily against the bailout. Americans didn't accept the idea that their hard-earned tax dollars should be used to save smart, highly-paid financiers who sometimes could hardly deign to acknowledge the existence of flyover country.

Political leaders and regulatory officials have focused on the need for confidence in the financial system. Without confidence, there is no credit, and without credit, the economy is at serious risk. They should have focused more on the need for confidence in the government, which remains the key player in propping up the world financial system. The Wall Street of the 21st Century is a black box to most Americans. Just at the level of managing one's 401(k), the financial markets are often impenetrably complex, even for well-educated and highly competent professionals. The need for a bailout of Wall Street isn't obvious--Wall Street's intertwined and interlocking layers of liabilities are difficult even for the government to grasp. It's understandable why 98% of the electorate had trouble getting the picture, and the proponents of the bailout failed to educate them properly. Too much attention was given to warning of the horrors of not bailing, and not enough was paid to explaining why all this spending was necessary. For $700 billion, the electorate deserved a better explanation than they got.

The proponents of the bailout were driven by their perceptions of the exigencies of the credit crunch to try to push the bailout package through in a week or two. They, in effect, asked the voters to trust them, the government, on the need for the bailout. The problem is that this is about their fifth trip to the plate in the financial crisis. They're 0-4 for the previous four trips. Expanded Federal Reserve lending policies, bailing out Bear Stearns, nationalizing Fannie Mae and Freddie Mac, and lending $85 billion to AIG, were failures because they did not restore financial market confidence. After all this, why would the American people again believe Paulson, Bernanke, et al.? Those guys may be right about the need for further governmental support for the financial markets, but their batting average calls into question whether they can develop the right program.

It is unclear whether the bailout proposal will be reconfigured and resubmitted for another Congressional vote. The Bush Administration has lost all its political capital, and the Democratic leadership in Congress may not want to take the lead on spending hundreds of billions of taxpayer dollars five weeks before an election. The electorate's loss of confidence in the government may be the greatest loss today, because it could preclude any possibility of a bailout package until there is a new President.

The world won't come to an immediate halt without a bailout package. The Federal Reserve and U.S. Treasury will continue to fund Wall Street, and take over distressed banks. The cost of these measures may be more or less than $700 billion. Only time will tell.

In the meantime, federal bank regulators should pay more attention to the spread of the credit crunch to Main Street, where loans are becoming harder to get. The economy outside lower Manhattan isn't vibrant, but it's still got a decent pulse. Non-financial companies are mostly operating at a decent clip and consumers are still buying, albeit not exuberantly. Small businesses may be cutting back, but the doors mostly still open every morning. Credit for many smaller businesses and individuals comes from local financial institutions, like community banks, credit unions, and savings and loans associations. Federal regulators should make sure that the funding needs of these institutions are met. The largest banks have become bottlenecks in the financial system. They will be hunkering down and operating in survival mode for a while. The federal government should use central banking facilities and regulatory policies to promote the flow of funds to the smaller institutions that can still lend to the larger economy. The voters and Congress clearly said today that they want a financial system of the people, by the people and for the people. That would be a good idea.

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