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Sep 30, 2008 | 01:56 GMT

5 mins read

Geopolitical Diary: Crises from Washington to Wall Street

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.
The financial crisis appeared to be in the process of being contained on Monday morning, when something wholly unexpected — certainly by us — happened. The U.S. House of Representatives voted against the package that the administration had negotiated with the Democratic and Republican Congressional leadership. The immediate result was a dramatic fall in the equity markets, with the S&P 500 falling almost 8 percent in a few hours. We are now in an intense political crisis that will determine the outcome of the financial and economic crises. STRATFOR has been arguing that the financial crisis would be contained as previous crises had been through government intervention. Whether that intervention came through guaranteed loans or direct acquisition of assets made little difference. The resources the government could bring to bear might create long-term inefficiencies in the markets, but would prevent more immediate disasters. A revolt of this magnitude by the House rank and file against the leadership of both parties is unprecedented, but then we are truly wandering off the map. The objection to the plan seemed to divide into three parts. The first was a moral argument that taxpayer money should not be used to bail out Wall Street. The second was political, in that the plan made the secretary of the Treasury enormously powerful in allocating funds, and that given the administration's lame duck status, there were no real checks on his action. The final argument was that there were cheaper and more effective methods that hadn't been used, with everyone opting for the most expansive and dramatic solution, and that there was no certainty that this plan would work anyway. There was a fourth, unstated reason: Sentiment against bailing out Wall Street was high, and all Congress was up for re-election in a month. They did not want to be blamed for the bailout at home. It is not clear that Congress expected to be running on a market meltdown either. The market had been operating with the general assumption that there would be a bailout Monday and had been fairly stolid on that assumption. When it became clear that no solution was coming, a complete panic set in as the market realized that the dam between the financial markets and the economy was going to break. The inability to inject liquidity into the financial markets would affect non-financial businesses, whose access to credit for operating purposes would contract if not disappear. This would lead to a major downturn in the economy. In anticipation of that, the equity markets would break, contracting the net worth of individuals at the same time as housing prices were falling. A financial problem is thus transformed into an impending economic disaster — a depression. It is not clear that Congress expected the equity markets to react as they did or that it understood the other consequences. Having made the point that taxpayers ought not bail out Wall Street — an estimable concept — their constituents are now facing the practical consequences of this very good point. Therefore the problem lawmakers face now is that they are going to have to run for re-election either after having voted for the bailout package or potentially in the midst of a major economic crisis. Either way, they will not be in good shape. It remains difficult for us to imagine a scenario in which the federal government will not inject liquidity into the system on a massive scale. The precise method of how this is done is really not that important. It will be messy and inefficient, and it will have many critics. But the alternative is pretty grave. It is all the more grave because time is now increasingly a factor. A few more days of these kinds of declines, should they occur, will wipe out vast amounts of value in the markets, while contractions in credit in the broad economy will quickly bring results that cannot be reversed in a short period of time. The window for containing this crisis is not very big. It would seem to us that between the pressure emanating from the White House and the Congressional leadership, and the pain constituents will be feeling very soon from inaction, Congress will start looking for an exit strategy. Having made the point of prudence by voting against the solution for the first time, congress will approve a new and different solution, which will reassure the markets that the federal government is prepared to guarantee the liquidity of the financial markets in order to protect the economy. This solution may well be unfair in some moral sense, but the alternative is rather stark. This is a political problem and not an economic one — a point we have consistently argued. If Congress can't make a decisive move and leaves the Fed and administration to try to cope with the situation with available tools, the consequences will be disastrous. Since this is a politically unacceptable outcome, we have to assume that Congress, facing the decline in equity markets and understanding what that will look like in a month, will find a solution. Given Monday's decline and the possibility of it continuing in the absence of a solution, they really don't have much time to act.
Geopolitical Diary: Crises from Washington to Wall Street

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