The atmosphere in Washington is all too redolent of 2001. Swept up in the turbulent aftermath of 9-11, legislators were easily stampeded into passing the Patriot Act. Few, as it turned out, had even read the Act, much less thought carefully about its implications.
Today, it’s the Professor and the Banker (as Bernanke and Paulson were dubbed over the weekend) who’ve pressed the panic button. According to Senator Dodd, they told congressional leaders on Thursday evening “that we’re literally maybe days away from a complete meltdown of our financial system, with all the implications here at home and globally”. It's tough for anyone, much less politicians up for re-election in November, to stand firm against such pressure. Nor, in fairness, can anyone reasonably claim the whole crisis is overblown; it’s only too real and has for quite some time had all the relentlessness of a slow motion train wreck.
What is truly remarkable is the proposed solution and the apparent haste with which it’s been cobbled together. It’s not, after all, as if they’ve been blindsided by the escalating crisis. Consider Paulson’s comment on Friday:
“Going back a long time, maybe a year ago, Ben, as a world-class economist, said to me, ‘When you look at the housing bubble and the correction, if the price decline was significant enough,’ the only solution might be a large-scale government intervention,” Mr Paulson said. “He talked about what had happened when there had been other situations historically.”
Indeed the study of past financial crises (in particular, the Great Depression) and potential official responses to them has been Bernanke’s enduring academic passion. He has, in fact, been prepping for this moment his whole adult life.
Under his leadership, the Fed has certainly been creative. As the crisis intensified, he unveiled a wide range of new facilities to bolster liquidity and prevent a systemic meltdown. The amounts involved have been large (in the many hundreds of billions) but until now, the basis of all these actions was to provide credit against pledged assets, albeit ones of steadily declining quality. For all the noise and fury, before last week the monetary base had grown a mere 3 per cent over the last 12 months. (Mind you, without the seemingly unending foreign purchases of US dollar assets the Fed could not have adopted such a comparatively low key stance.)
Now, though, all is about to change. One can only assume the failure of the markets to heave a sigh of relief after the sudden $85 billion bailout (and effective takeover) of AIG must have crystallised Bernanke’s worst fears. The intemperate language, the sense of urgency and the radical nature of the proposal they took to Congress suggests Bernanke & Co could see the whole financial system being sucked into a black hole. Unfortunately, given the degree of leverage, the opacity of many of its assets and the pervasive and growing sense of uncertainty, this is not an entirely unreasonable fear.
What, then, of the proposal itself, granted that political horsetrading may change it substantially in the days to come? Or maybe even sink it entirely, although given how the debate has been framed this really would be a shock. The full initial proposal can be found here. A few snippets will give a sense of how much it packs into its crisp 870 words:
Sec. 2. Purchases of Mortgage-Related Assets.
(a) Authority to Purchase. The Secretary is authorized to purchase, and to make and fund commitments to purchase, on such terms and conditions as determined by the Secretary, mortgage-related assets from any financial institution having its headquarters in the United States. [Overseas institutions: This is apparently going to be expanded to allow purchases from overseas institutions.]
Sec. 6. Maximum Amount of Authorized Purchases.
The Secretary’s authority to purchase mortgage-related assets under this Act shall be limited to $700,000,000,000 outstanding at any one time.
Sec. 8. Review.
Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.
It isn’t difficult to see why eyebrows have been raised, not all of them unfriendly. Indeed, some have wondered aloud about its constitutionality. If passed, it would be a remarkable expansion of executive power, even by the standards of this administration. Still, our intent here is to consider only its likely economic effectiveness.
In order to make any sense of the proposal, or the events which prompted it, we must look a little more closely how things came to such a pretty pass.
A market based economy is a complex, self organising system. In order to adapt and prosper, such systems must have constant real world feedback. In the case of the financial system in the US (and, to varying degrees, elsewhere), that loop has for decades been clogged and distorted. Implicit or explicit central bank guarantees together with various government support schemes over time fundamentally altered the perception of risk. Combined with central bank accommodation, this encouraged credit growth to far exceed all historical parameters.