Sep 29, 2008 | 01:59 GMT

5 mins read

Geopolitical Diary: Congress' Plan for the U.S. Financial Sector

It can be difficult to separate the important from unimportant on any given day. Reflections mean to do exactly that — by thinking about what happened today, we can consider what might happen tomorrow.
An agreement has apparently been reached in Congress on the government plan to return liquidity to the economy. Rather than giving U.S. Treasury Secretary Henry Paulson immediate access to all $700 billion, the plan gives him immediate access to $250 billion, and the administration will give him another $100 billion when he asks for it. The last $350 billion will be available when he requests it unless Congress rejects the request (the legislature does not have to approve it). Institutions selling assets to the government will have to provide some form of equity to the government as well. Companies bound by contract to provide failed executives with termination packages will not be able to deduct more than $500,000 of those expenses. All of this makes it more palatable politically, but the bottom line is the federal government is going to acquire control of a lot of paper backed by a lot of homes, and as a result liquidity will wash back into the system. The government will obviously have to create some sort of system for managing the massive administrative load, but it has some experience in this. This is not the first time the government has bailed out an entire sector of the financial community; that was the savings and loans failure brought on by bad commercial lending practices in the 1980s. Resolution Trust Corporation was created and became the largest realtor in the world for a time. These panics are built into American capitalism going back into the 19th century. They originated at the same source. At the height of a business cycle, everyone is looking for a way to make more money without risk. This time, the story was that conservative investors looking for a higher return on fixed investments could buy into the mortgage pool (what is safer than that?) and get safety, liquidity, higher interest rates and undoubtedly a cure for athlete's foot. Like characters in a Mark Twain story, the creators of this "product" believed their own hype and starting holding the paper and borrowing against it. In due course, they all choked on it. The government is teaching a very bad lesson, according to some. We assume that a total financial meltdown would be regarded as a learning experience. Regardless, in the real world, it isn't going to happen. The federal government cannot let the financial system spasm just to make MBAs smarter. Besides, one generation's lesson will be lost on the next generation. Or more precisely, everyone will remember that the smart ones pulled the scam early and retired to be sober elder statesman. There is a question of whether $700 billion is enough, but that really isn't the critical issue, since there is more where that came from. Neither is the future of Wall Street icons. What really matters now is what happens to the economy. The danger has been that the liquidity crisis will turn into a major recession, as everything from the financing of inventories to auto loans dries up, forcing the economy to collapse. Second-quarter gross domestic product (GDP) growth figures were revised downward but remained well above 2 percent. So the economy was growing as late as June. We do not have numbers yet for the third quarter, and they get revised anyway, but that will be the first indication of whether or not a recession is under way. It has been seven years since the last one, so we suspect that with or without the drama of the last months, we would be heading toward a recession. If so, the question is how long and deep it will be. Months ago we said that this wasn't the big one — the crisis that drives the economy to a 1929-style economic crisis. That seems to us clearer than ever. It has been devastating for the financial community, but then other crises have been devastating for other economic areas. That's the way it goes. It has been frightening for the financial markets, but it was always our expectation that the savings and loan model would repeat itself. As we said, this is not the first time a whole segment of the financial community destroyed itself, and it is not the first time the Feds have stepped in. We continue to expect a recession on the order of 2000-2001. Life goes on. Only on Wall Street it will not go on the same way for the same people. But in 20 years we will all be shaking our heads at how anyone could have permitted the financial community to come up with whatever scheme they come up with then. The point is that this isn't going to trigger a great depression in which GDP contracts by almost half in a few years. We should point out that many have written to us saying that we do not understand the magnitude of the crisis or economics. Perhaps not. But we do understand the magnitude of the U.S. economy and the federal government's abilities. And that is what those who felt that the entire system was going to collapse simply didn't get: The sheer size of the economy and the sheer power of the Federal government trump the financial markets every time.

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