Dr. Paulson's Magic Potion
This article was updated on October 16 to reflect events on Wall Street.
American capitalism is having a nervous breakdown, losing confidence and acting out in self-destructive ways. Let's try talk therapy. No, wait, it's more serious--a case for high-powered drugs. No response? Maybe high finance has a brain tumor. Time for surgery! Cut out the bad parts and things will stabilize. Hold on. The patient is swooning now, gasping for air and trembling with seizures. Oxygen! Blood! We need a massive transfusion to rid the body of toxins. Doctor, the patient is flat-lining. What's next? Shock therapy?
My mordant medical metaphor sounds a trifle cruel, given the massive losses people are suffering, but it roughly describes the stages of diagnosis and cures with which the government has hesitantly attempted to heal the collapsing financial system. Each new cure revives hope that the worst is over--at least until the symptoms start darkening again. The doctors in Washington changed their diagnosis once more when Treasury Secretary Henry Paulson announced his latest magical medicinal potion--a $250 billion relief package to be invested directly in stock shares of the nine largest banks and spread more thinly among hundreds of smaller banks. The stock market cheered wildly with a 900-point rally in the Dow, as well it might have. Wall Street had just secured a fabulously well-heeled investor. Oops. Two days later, the magic wore off and share prices plunged again disastrously.
This time Paulson is much closer to a genuine solution, but hold the celebration and keep your eye on the patient. The government's new outline is deliberately vague about how exactly the Treasury and Federal Reserve intend to execute the details. The proposal implies but does not say that the government is taking charge of the banking system and will use its emergency powers to compel bankers to restart lending to restore the real economy of producers and consumers. Maybe that's what Paulson has in mind, but he made no promises. The public money gives a comforting tonic to the bad boys of Wall Street, but it's still packaged as a voluntary approach--not to be confused with the genuine nationalization that Britain and other governments have undertaken.
Nationalization is the "shock therapy." We may yet see it before this turmoil is ended. Naturally, it is ideologically offensive to the Bush administration, and especially to Paulson's old colleagues and rivals on Wall Street. Taking control would impose on the government the daunting challenge of reshaping these large and overbearing institutions, winnowing out banks that deserve to die and instilling in the survivors formal obligations to serve the national interest they have willfully betrayed for a generation. That task will probably be left to Paulson's successors.
Without taking explicit control, the government is simply betting the bankers will cooperate in exchange for rescue. Maybe they will start lending again, but maybe not: banks are in a deep hole of their own making, having lost more than a trillion. Typically, they apply tightfisted lending tactics to heal balance sheets--the opposite of what the country needs from them now. The $125 billion or so targeted for the nine biggest banks will not be enough to heal them all. Institutional Risk Analytics, a bank monitoring firm, says $250 billion in capital injections "will be just the down payment to get through the wave of loan losses headed for some of the larger players in the US banking sector."
Meanwhile, the money provides a feel-good tonic for the club--the relatively small congregation of financial institutions that exert such oppressive influence over business and society, not to mention politics. Paulson is handing them cheap money (ours) that will initially earn only 5 percent, even as Warren Buffett gets 10 percent dividends on the capital he provided Goldman Sachs. Nor does the public get a controlling interest, or even seats on the board, for its generosity. The choices Paulson makes as he hands out the public money will effectively design the future--making the big boys even bigger and more arrogant, since they know the government will not let them fail. Informed financiers already see the nine largest banks consolidating into four behemoths. The next president and treasury secretary (if they have the nerve) will have to confront this question of scale and cut the big banks down to size--small enough to fail without damaging society.
Dr. Paulson's latest cure has once again left out something important--American society at large. There's a lot of cheap talk about Main Street, but nothing in this plan helps the folks who are taking it in the neck through bankruptcy or unemployment. When Paulson met privately with the CEOs from the nine leading banks, he presumably asked them to be kind to the debtors. He ought to have commanded the bankers, one by one, to stop foreclosures, roll over debts and give people time to work their way out of their predicament, or else government would shut its lending window and dump the banks' stock.
Fortunately, Bush and Paulson are lame ducks. They will be replaced soon (we fervently hope) by Barack Obama, who is addressing the side of the crisis that Republicans always ignore--what's happening to the people. Obama has revised and expanded his agenda, and he does not intend to wait until January. Many of his proposals can be undertaken right now by Treasury and the Fed. Others can be swiftly enacted by Congress in a lame-duck session right after the election. If bitter Republicans wish to filibuster or Bush wants to veto, that will simply deepen their party's shame.
John McCain responds to the crisis with grandly irrelevant ideas like cutting the capital gains tax in half, but also useful ones like reducing the tax rate on withdrawals from IRAs and a mortgage plan similar to the New Deal-era Home Owners' Loan Corporation that Hillary Clinton has led many Dems in proposing. Obama proposes smaller but concrete measures like a ninety-day moratorium on home foreclosures. Banks that receive government aid would be told not to act against families trying to make payments, even if they are behind. Bankruptcy judges would be authorized to modify mortgage terms. Families could withdraw money from retirement accounts to pay bills without being penalized. Obama would extend unemployment benefits and suspend taxes on that income. He would give small businesses a $3,000 tax credit for each new job they create, and distribute $50 billion to states and localities to finance roads and bridges and to make schools energy efficient. He would double the capital loan to the auto industry, to $50 billion.
These and other proposals are of course excellent fodder for the closing days of the campaign. But they also suggest the Democratic candidate is moving rapidly to adapt to the crisis that awaits the next president. Economic turmoil has instilled a dynamic process in politics, driving everyone, including voters, to new ground. We are likely to see even larger changes in the coming months. The treasury secretary seems out of breath. Obama appears to be getting his second wind.