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US bails out Wall Street « Previous | |Next »
September 23, 2008

Some institutions find themselves with too little capital to support lending. Some are also unable to raise the money they need to finance the securities. By selling assets, to raise money, they have depressed prices further. This has weakened balance sheets, forcing them to dump yet more. The plan of Hank Paulson, the US Treasury secretary, is to buy up $700bn of these toxic securities and to put a floor under the price.The aim is to end the spiral and the de-leveraging convulsion.

This cash for trash effectively bails out Wall Street. The libertarians in this financial crisis are hiding in the foxholes since government isn’t seen as the problem in Washington these days, as it’s the solution.

The spiral highlights a real problem. As finance shrinks, credit is being sucked out of the economy and without credit, people cannot buy houses, run businesses or as easily invest in the future.The financial sector needs capital, because assets like houses and promises to pay debts are worth less than most people thought. Even if some gain from falling asset prices, lenders and insurers have to book losses, which leaves them needing money. Governments are the only buyers around.

If bailing out Wall Street's shadow banking system increases the huge US national debt, then it also puts another nail into the body of the US model of free-market capitalism. Morgan Stanley has turned to Asia for a capital lifeline of $9 billion. Morgan Stanley and Goldman Sachs have converted into banks and so will now be regulated as banks. So the shadow banking system continues to unravel.

A question: isn't it it better to boost the banking system by increasing its capital than by reducing its loans?As Paul Krugman points out even if the vicious circle is limited, the financial system will still be crippled by inadequate capital. The financial system needs more capital is the core argument. You can’t socialize the losses if you don’t also socialize some of the gains.

And if the government is going to provide capital to financial firms, it should get what people who provide capital are entitled to – a share in ownership, so that all the gains if the rescue plan works don’t go to the people who made the mess in the first place.

| Posted by Gary Sauer-Thompson at 7:56 AM | | Comments (6)
Comments

Comments

Krugman has a good line:

Basically, after having spent a year and a half telling everyone that things were under control, the Bush administration says that the sky is falling, and that to save the world we have to do exactly what it says now now now.

Love it.

Krugman's article is very helpful, especially his four fold step of the financial crisis.

1. The bursting of the housing bubble has led to a surge in defaults and foreclosures, which in turn has led to a plunge in the prices of mortgage-backed securities — assets whose value ultimately comes from mortgage payments.

2. These financial losses have left many financial institutions with too little capital — too few assets compared with their debt. This problem is especially severe because everyone took on so much debt during the bubble years.

3. Because financial institutions have too little capital relative to their debt, they haven’t been able or willing to provide the credit the economy needs.

4. Financial institutions have been trying to pay down their debt by selling assets, including those mortgage-backed securities, but this drives asset prices down and makes their financial position even worse. This vicious circle is what some call the “paradox of deleveraging.”

That is the clearest account I've read. As Krugman points out, the Paulson plan might break the vicious circle of deleveraging, step 4 in the above description. Krugman points to the 2nd step.

Things are not looking good. Unemployment in America rose to 6.1% in August and is likely to climb further. Industrial production fell by 1.1% last month; and the annual change in retail sales is at its weakest since the aftermath of the 2001 recession. Output is shrinking in Japan, Germany, Spain and Britain, and is barely positive in many other countries.

"This problem is especially severe because everyone took on so much debt during the bubble years."

Not quite empirical evidence of the 'rationality' that pure free-market economists assume drives the actions of unregulated market participants! Gotta love Utopia.

"irrational exuberance disrupts the self-regulation for rational market"-- I read that somewhere.

Peter,
the US is taking a battering from this crisis. And the US has been weakened and humbled.