This week: the failure of the bailout.
Possibly. If I had to bet at even odds, I’d bet against near-total seizure of global credit markets, but it’d be a closer call than I think I want to admit to myself.
If it does fail, however, it’s likely to do so sooner rather than later, and it will do so because the bailout wasn’t extensive enough– it didn’t give enough probably-unconstitutional authority to Henry Paulson (or, as was never seriously discussed, someone else, a point to which I will return later). My great concern is that the crisis hits Europe with full force, bringing down a major European bank or two– not banks on the scale of Fortis, but larger ones that couldn’t be easily bailed out by their home countries’ banks. This scenario that keeps me up at night starts with the TED (Treasury-Eurodollar) spread, which is the interest rate spread between the inter-bank borrowing rate (as represented by the three-month LIBOR, or London Inter-Bank Offer Rate), and the cost of “riskless” lending (as represented by three-month T-bill interest rates). The TED spread is an indicator of risk in credit markets: as the risk of borrowers defaulting on their debt rises, lenders require a higher rate of return to justify taking the risk of lending to those borrowers. At the moment, it is quite high. This increases the risk that firms that rely on short-term borrowing to cover debts won’t be able to meet their obligations, and will go bankrupt as a result, creating chain reactions that ripple through the economy as their creditors are unable to meet their obligations. Obviously, this has already occurred with the highly-leveraged investment banking firms in the US, but it could spread to other sectors of the U.S. economy, which is what the bailout plan is supposed to avert. Unfortunately, to the extent that the crisis spreads to related sectors of foreign economies, the bailout plan won’t do a thing to help. Given the difficulty of passing the plan through the House the first time, what are the chances that the Treasury secretary is going to be able to get the second $350 billion if he spends the first half rescuing foreign banks? I consider this a real threat; the fact that every student learns the lesson of Smoot-Hawley, that passing protectionist tariffs in the face of a massive downturn in the economy will only make things worse, does not mean that politicians will not make slightly-different-but-equally-crippling populist mistakes.
It’s for this reason that I’d like to give Mr. Paulson the benefit of the doubt. It’s entirely likely that some of the very smart people over at the Treasury considered the possibility of foreign bank failure and a populist backlash against using U.S. taxpayer funds for a bailout and added the language to the “Paulson Plan” that stated:
“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.”
Of course, such language would also provide certainty to the markets– a government bailout in limbo, awaiting a decision on a motion for summary judgment on an appeal, etc., etc., would be worse than none at all. What the Treasury clearly didn’t anticipate, however, was that there would be such a powerful backlash to their brazen grab for power. Were the administration more credible, the Treasury’s proposal might have had a chance. As things are, any talk of a crisis from the administration sounds an awful lot like “The Boy Who Cried Wolf”, and it would clearly have been a wiser move to give much of the authority sought by Mr. Paulson to an explicitly bipartisan oversight board constituted in such a way as to be insulated from political pressures.
So– back to my nightmare– we’re in a situation where major global banks could fail, and the U.S. would be unable to do anything. It’s natural to ask, why wouldn’t other countries be able to step in to save their own banks? The answer is twofold: first, when dealing with very large global banks, like RBS or Deutsche Bank, they’re so large relative to their home countries’ economies that the fiscal constraint would be crippling, as there’s simply a lack of necessary capitalization; second, it’s not clear that the European Central Bank or its member nations have the authority or competence necessary to take coordinated action on the necessary scale. Thus, we face the possibility this week that major European banks will fail, seizing up credit markets and causing a global economic contraction, as the only bailout plan that can pass is one that is too weak to actually help.
And that is why the quality of governance in relatively stable times matters more than the hot-button social issues used to manipulate the populace– it sets the constraints of governance in times of crisis.