No Rescue? Economists Explore What's Next

The House of Representatives' defeat Monday of a $700 billion financial rescue package may have come as a surprise to President Bush and top administration officials. But economists who have been watching the process say the package had some shortcomings and these became hurdles to its passage.

As political leaders ponder what to do next, here's a look at what some economists think lies ahead.

Dean Baker
Co-director, Center for Economic and Policy Research

Baker says the rationale for the rescue package — to prevent a "meltdown" in the financial system — remains a viable concern: "We're at risk of that. There's clearly a lot of stress," he says. "I'm sure we will see more upheavals, most likely following bank failures."

His primary concern is not the ups and downs of the stock market but what's happening in the credit markets and financial firms' access to credit. Baker says he wasn't a fan of the proposed legislation because it was a "very indirect way" of addressing problems in this arena — namely, that firms lack the capital they need to support their operations. "It would have made much more sense just to inject capital directly into the financial system," he says.

And the underlying issue, Baker says, is that the U.S. has lost close to $4 trillion in housing equity. The toxic assets at the heart of the financial meltdown are mortgage-backed securities. But with house values plummeting, it's impossible to gauge how much these securities are worth.

"This is the story of the downturn and of course, the bailout does almost nothing to counter this drop in demand," Baker writes in an article published Monday on the Talking Points Memo blog.

Baker says the government should have taken an approach akin to what it did with the insurance giant American International Group, infusing capital in exchange for a large share of the institution. Instead, the bailout package advocated an indirect approach focused on buying troubled assets, he says.

Baker says he would like to see a "qualitatively different proposal" but thinks there will be intense lobbying to get the additional votes needed for the passage of the current bill.

Simon Johnson
Senior fellow, Peterson Institute for International Economics

Johnson, who is a professor at MIT's Sloan School of Management and served as the economic counselor for the International Monetary Fund, says the rescue package wasn't "ideal," but it would have bought time and "stabilized the markets." He expects some form of the legislation to pass later this week.

Like Baker, Johnson says the crux of the problem is declining house prices. Regardless of whether the rescue legislation goes through, Johnson says the two key issues that need to be addressed by any follow-up plan are mortgages and banks' lack of capital.

Johnson also remains concerned about what's on the horizon in Europe. He warns that the "cracks in the financial system" extend beyond the U.S., but European lawmakers have been reluctant to acknowledge that. "In fact, they're saying, 'We don't have a problem. It's an American problem.' ... That is known as sticking your head in the sand."

Michele Gambera
Chief economist, Ibbotson Associates

Given that all 435 House seats are up for re-election, Gambera says he was surprised that House members felt they could afford not to act in favor of a financial rescue plan. "I don't know how they will be able to go back to their electoral district with their hands empty," he says.

The bailout plan proposed by Treasury and modified by Congress was "clearly imperfect," Gambera says, and he acknowledges that voter anger was high over what many saw as "free money" for Wall Street. Still, he says lawmakers failed to make it clear that under the plan, the government would actually be acting like an investment bank or a "bottom feeder," swooping in to buy troubled assets on the cheap, with the potential of making a profit when — and if — prices recover.

Gambera agrees that the priority for banks remains capital — not a path for selling assets. Once banks have capital, they can write off bad assets and "come clean," he says.

The big problem for banks is that they "don't know who will be in business next week," Gambera says. As a result, they are not lending to each other — or to households or small and medium-sized businesses. Instead, they're keeping a lot of cash on their balance sheet to show that they remain solvent.

Ultimately, Gambera thinks the U.S. economy might be stuck in "second gear" for a while. The outlook for the U.S., compared with Europe and Japan, is worrisome, he says, because Americans have low rates of savings and their salaries, on average, have not increased; they've just grown enough to cover inflation. "American households have very little flexibility — they have no elasticity to take any hits."

International spillover is already a factor. Gambera says banks across the world have tightened their lending standards. Because the U.S. remains a huge importer, if the economy here continues to slow down, it will have an adverse effect on companies overseas.

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