Behind the Bailout: Ten days in the fall


September 24-October 3, 2008

In late September, 2008, what administration officials were accustomed to discounting as a bother in the financial markets developed like a hurricane over hot water. President Bush, sporting a glassy prostate exam stare, broke the news on prime time television, warning that, “without immediate action by Congress, America could slip into a financial panic."

The signal that scared him, Wall Street, and global financial markets was a blaring siren from the credit markets. It was directly, but not wholly, attributable to the sub-prime housing bubble and how it was financed.

Mortgages transformed
Until recently, mortgage loans were a kind of cottage industry. Borrowers went to a lending institution—commercial bank, credit union, or S&L—filled out reams of forms to establish credit-worthiness, and received their loans. The lending institution held the mortgage and collected the payments.

Deregulation, a process gaining traction since the Reagan administration, changed all that. By the 1990s, deregulation was also championed by free market Democrats, including then president Clinton and some of his economic advisors. But the name that repeatedly popped up in the deregulation record was Phil Gramm, at that time a US senator (R TX).

Gramm was lead sponsor of 1999 legislation repealing a portion of the Depression-era Glass-Steagall Act. Along with creating the FDIC, Glass-Steagall prohibited CitiGroup, Bank of America, and other bank holding companies from owning other financial service businesses. In effect, regular lending institutions were unable to invest on Wall St.

In a climate rife with deregulation, securities traders jumped with both feet into all sorts of unregulated territory. The Enron example gives a flavor of how innovative it all became. (On the eve of the George W. Bush administration, Gramm codified the deregulation of energy trading by slipping the “Enron loophole” into law.) Enron, an energy producer, worked the change to establish legally distinct but obscure divisions under the corporate umbrella to trade energy futures. The left hand controlled electricity supplies; the right hand bet on supply futures. Gramm and his wife also did well. He went on to become a vice chairman of Swiss uberbank UBS.  His wife, Wendy, took a seat on the Enron board.

In the mortgage biz, developments were more far-flung and Byzantine. In the wake of the .com bubble, with low interest rates and big capital looking for a place to go, people took advantage of loosening mortgage requirements to maximize their housing. The front end of the process seemed familiar. Borrowers approached a traditional financial institution or new lending startup, such as Countrywide or DiTech. But the lenders now had no intention of holding the mortgages. The paper was sold to Fannie Mae, Freddie Mac, or the so-called shadow banking system of investment banks, hedge funds, money market mutual funds, and other entities springing up beyond the regulatory pale.

The new mortgages lost much of their individual identities by virtue of “securitization.” They were grouped and repackaged into new breeds of tradable instruments known by acronyms like MBS (Mortgage-Backed Securities) and ABS (Asset-Backed Securities). The acronymed boxes of bundled debt could then be further consolidated in virtual banks called Special Investment Vehicles (SIVs).

In effect, lending institutions had become sellers of mortgage contracts with no ongoing financial stake in the loans they made. Who cared whether a borrower had good credit? Thus were born the infamous Alt-A liar loans, sub-prime NINJA (No Income, No Job, No Asset) loans, and Option-ARM mortgages that allowed borrowers to foregoe any payment on borrowed principal for some period of time.

The brave new unregulated markets couldn’t call on the Federal Reserve, FDIC, or other traditional insurers for safety net protection. This fact, and too many greedy kids with sharp pencils, spawned another alphabet soup of tradable “credit derivatives,” among which were exotic families of products including Credit Default Swaps (CDS) that allowed traders to bet on defaults of paper they might not even own. Nobody kept track of the underlying worth of the derivatives. Because they were called "swaps" instead of "insurance," regulators were excluded from ensuring that swap sellers had the means to pay claims. One division of an investment bank or insurance company could hold risky loan instruments; another could write the CDS to protect against default.

Across the spectrum of participants, from homeowners to Wall St. tycoons, everybody made money as the housing bubble inflated. Foreign investment, necessary to finance the US national debt, flowed in. For an illuminating explanation of the whys and wherefores—and a prediction of the current crisis—see the Harpers account by Eric Janszen in February, 2008.

Houses of paper
Rising interest rates and the 2007 sub-prime mortgage crisis—also precipitated by the end of teaser rates, balloon payments, and the like—rocked the shadow banking system. Mortgage-based and other acronym securities including CDSs were now significant components of institutional asset portfolios. AIG, the insurance giant, depended on them too. But a smell of default emanated from the warehouses of black box instruments. Securitization made it hard to tell which particular issues were stinking and how badly. The illusory protection of swaps was exposed. Nobody wanted to buy the stuff anymore, except perhaps at ruinous discount.

Mark-to-market" accounting rules were blamed by many, particularly conservatives, for transforming unsalability into institutional insolvency. Mark-to-market required banks to periodically revalue their investment portfolios at present market value rather than some theorized eventual worth. When sub-prime and related instruments tanked and became unsaleable, their mark-to-market value could drop as far as zero.

Bear Stearns was the first investment bank to be caught short. Merrill Lynch and Lehman Bros. were next. The remaining two US investment banks, Goldman Sachs and Morgan Stanley, reinvented themselves as bank holding companies. By returning to the regulated sector they could accept customer deposits of actual money and have FDIC protection for those investments.

Bad balance sheets at Fannie and Freddie, through which half of all US mortgages flowed, forced nationalization of both these quasi-private companies. Without them, it was said, there’d be no new mortgages. The Federal Reserve bailed out AIG because “it was too big to fail.”

None of this activity, however, addressed the contents of black box securities and the garbage therein. These questionable instruments remained in the financial system and continued to wreak havoc. The trigger for Treasury Secretary Paulson’s “Come to Jesus” meeting with congressional leaders on September 18th was the threatened collapse of money market mutual funds.

Money market funds—common in retirement accounts and other conservative portfolios—provide a sort of Federal Reserve function for the shadow system. Institutional borrowers go there for short-term cash. Investors have an unspoken guarantee that a dollar deposited in a money market mutual fund will always be worth at least a dollar.

But, in the days before Paulson’s meeting, that assumption was violated. Three funds “broke the buck,” trading at below $1. A run on the funds ensued, though we didn’t hear about it until after the feds stepped in with an offer to provide a variation on FDIC insurance to protect investors. Before then, the US banking system briefly froze. Banks couldn’t borrow from each other. Companies from Main St. to McDonalds couldn’t obtain cash for short-term needs, etc.

Had the freeze persisted, we’re told, our economy was in imminent danger of collapse. No credit cards, big layoffs, the whole nine yards. If this was so, the global economy was also endangered. Foreign investment floated our national debt. Everybody had a hand, or worse, trapped in the US cookie jar.

The mother of all bailouts
The $700 billion Wall St. bailout Treasury Secretary Henry Paulson proposed over the weekend of September 20-21 was an attempt to gain control of and neutralize the black box acronym instruments causing the credit crunch. Paulson, Federal Reserve Chairman Ben Bernanke, and others told lawmakers that such a move was necessary to avert a potentially catastrophic loss of confidence in US markets.

Paulson’s plan was breathtaking. A man who’d profited massively from the deregulated markets now asked for $700 billion taxpayer dollars and carte blanche in the US banking sector. Apparently innocent of constitutional principles and with a tin ear for public opinion, Paulson proposed the equivalent of financial martial law with himself cast in the role of absolute dictator. Forget golden parachutes. His plan provided golden Get Out of Jail Free cards for Treasury’s cadre of bailout agents. After a hundred years of abetting them in Central and South America, the banana republic would finally come home to Wall St.

Congress suspended its acrimonious near-paralysis long enough to balk. Both Democrats and Republicans agreed that meaningful oversight must be part of the package. Since nobody knew the underlying value of the troubled paper Paulson proposed to purchase, members asked what a taxpayer investment of $700 billion dollars would actually achieve. Could Paulson guarantee success? Oh, he couldn’t?

Nor was it reassuring that both Paulson and Bernanke claimed to have been surprised by the consequences of a housing market deflation long predicted outside the Beltway. What made their current opinions more reliable? Why the last minute bum’s rush to Bananaland? Hadn’t Americans seen this show before?

There are also qualms about nationalizing financial institutions, the advisability of punishing the bad guys, helping homeowners with mortgages, reregulation, etc.

Congress resolved to rise above partisan wrangling and hoped to have some sort of deal by the end of the week. It appeared that the major complaints about the Paulson plan could be addressed within its framework.

But hopes for a bipartisan agreement faded on the afternoon of Sept. 25th, when Senator Richard Shelby (R-Cool Hand Luke) and House Republicans rebelled. They proposed to start over and craft a bailout said to be based on private investment, government-backed mortgage insurance, further financial deregulation, and reduced capital gains taxes.

Chagrined Democratic leaders also blamed the arrival of Republican presidential candidate Senator John McCain who had "suspended" his campaign to go to Washington to assist with reaching a deal.

Outside the halls of Congress, the natives were restless. Members of Congress were flooded by messages from constituents opposed to the bailout. An email message from Indypendent journalist Arun Gupta to his friends went viral and led to protest actions on Wall St. and elsewhere.

Some political observers detected sinister motives in the Paulson plan. Influential progressive corporate watcher and journalist Naomi Klein described the proposal as another example of “disaster capitalism” in action. The libertarian Cato Institute saw the bailout as a prime example of the failure of the socialist nanny state. The Club for Growth also condemned massive government intervention. McCain economic advisor Donald Luskin cautioned “principled conservatives” to wait and see on the final deal before supporting or opposing passage.

Meanwhile, the crumbling continued on Wall. St. As the House Republicans were rebelling on September 25, Washington Mutual became the largest bank failure in American history. Immediately after federal regulators seized the company, JPMorgan Chase, the firm that had earlier absorbed Bear Stearns, bought the best bits at fire-sale prices. Credit showed new signs of freezing. On September 26th, Wachovia stock dropped 27%. Suitors with sharpened knives gathered at the bedside. By the 29th, Citigroup had an FDIC go-ahead to carve out Wachovia’s banking business. Four days later, Wells Fargo trumped Citi’s move by agreeing to purchase Wachovia lock stock and barrel. Citi cried foul, and the fight was on.

Bailout nuts and bolts
Public and congressional recognition of the egregious provisions in the original Paulson plan doomed it. Subsequent discussions, whether offered as modifications to that proposal or independent from it, focused on a number of specific issues.

Oversight—There is solid bipartisan agreement that no government official should have free rein to spend taxpayer money or act outside the framework of court and regulatory purview.

Main St. v Wall St.—Much of the “illiquidity” or unsaleability of the black box securities that threatens to choke off credit in the United States stems from questionable mortgage loans. Bad loans must be removed from the system. Three strategies for accomplishing this were on the table.

  • The Paulson plan took a Wall St. approach. The government would buy smelly paper, hold it, clean it, and resell it later, perhaps at a profit.
  • Democrats and some Republicans accepted the necessity of Wall St. investment but wanted it to run in tandem with a rescue of Main St. Bankruptcy judges should have the option of rewriting mortgage provisions, thereby converting some bad paper to good paper.
  • Wildcat Republicans proposed to coax private money into buying the problem securities through a combination of government-backed insurance, lower capital gains taxes, and reduced government regulation.

Laissez unfair?—Among the calamities resulting in the Great Depression, bank failures rank high. The Glass-Steagall Act separation of commercial banks and the stock market was enacted as a direct result of bank losses incurred by Wall St. speculation. The 1999 repeal of the Act seemed to have resulted in a recurrence of risky bank behavior.

  • Democrats didn't call for reregulation of the financial system as part of an emergency bailout. However, they favored of some sort of reregulation at a later date.
  • Rebellious congressional Republicans abetted by the Cato Institute and other “small government” free marketers, saw the crisis as a threat to capitalism and an opportunity to further their long-standing deregulation agenda.

Golden parachutes—In testimony before the Senate Banking Committee, Secretary Paulson opposed controls on executive compensation and other “punitive” bailout provisions, saying these would limit cooperation with the plan. He found little or no support on either side of the aisle for rewarding, or appearing to reward, corporate executives whose risky decisions were blamed for causing the crisis.

How much money?—Under the Paulson plan, taxpayers could be on the hook for $700 billion at any given time.

  • Paulson justified this by saying he needed the flexibility to spend what is necessary and assured congressional leaders that, in the long run, taxpayers would get most of the money back. There might even be a profit if he was able to strike favorable purchase deals. Paulson proposed “reverse auctions” in which financial institutions could bid against each other in offering questionable securities to the government at discounted prices. When pressed on how he’d know how much to pay, Paulson offered vague answers.
  • Congress didn't like the idea of authorizing the expenditure of $700 billion at a time. It would be doled out in tranches (French for portions). The first tranche might be in the range of $150-350 billion.

Show me the money—Paulson opposed establishing “equity positions” for taxpayers in rescued companies. He said this would make participation in the program less attractive to the executives of the affected companies.

  • Many in Congress wanted provisions to reward taxpayers for money invested in the bailout.
  • Some conservative Republicans objected to a taxpayer stake on ideological grounds. Government shouldn't mix with private industry.

The House proposal
Early Sunday morning, September 28th, House and Senate negotiators reached agreement on a revised bailout package. Provisions of the draft Emergency Economic Stabilization Act included:

  • Multiple levels of oversight. The Secretary of the Treasury and the Office of Financial Stability implementing the Troubled Asset Relief Plan (TARP) would consult with a Financial Stability Oversight Board. This would be composed of several high government financial officials. There’d also be a Congressional Oversight Panel, supervision from the General Accounting Office, a Special Inspector General, and some judicial review.
  • Money available to the Secretary would initially be limited to $250 billion. A higher limit requires Congressional review. $700 billion remained the absolute maximum that could be on the line at any given time.
  • The Secretary was empowered to coordinate with foreign authorities and central banks, and “to the extent that such foreign financial authorities or banks hold troubled assets as a result of extending financing to financial institutions that have failed or defaulted on such financing, such troubled assets qualify for purchase.”
  • "Free market" modifications. The Secretary of the Treasury might offer financial institutions insurance on troubled assets including mortgage-backed securities issued prior to March 18, 2008. Premiums would reflect the risk involved. Private investors would be encouraged to purchase troubled securities to conserve taxpayer money.
  • Main St. modifications. The government could redraw the terms of purchased mortgages but Democrats didn’t insist on expanded power for bankruptcy judges to change mortgage terms. Existing relief from tax liability on mortgage foreclosures would be extended. Government purchases could extend beyond mortgage-backed securities to include assistance to small community banks, local governments, and troubled assets in pension plans.
  • Golden parachutes and executive compensation. Weak provisions were included as a nod to popular revulsion. The government could also recover past executive bonus payments “based on statements of earnings, gains, or other criteria that are later proven to be materially inaccurate.”
  • Taxpayer reimbursement for securities bought with taxpayer money might include nonvoting stock or another ownership stake in participating institutions. If necessary, after 5 years, taxpayers were guaranteed repayment in full for their investment. The money would come from participating companies.
  • The Securities and Exchange Commission (SEC) was given authority to suspend mark-to-market accounting rules if the Commission determines “that is necessary or appropriate in the public interest and is consistent with the protection of investors.” The SEC would also study the wisdom of mark-to-market accounting.
  • The Secretary of the Treasury would study the state of federal financial regulations and report to Congress no later than April 30, 2009.

Response to the bill
Democratic and Republican leaders in Congress felt they had a viable bill and encouraged its enactment. Presidential candidates John McCain and Barack Obama made positive noises but didn’t take a lead in selling the package. Public opposition on the left and right remained high.

The Republican rank and file continued to grumble, particularly in the House, despite pleading from their leaders and President Bush. Politico reported that House Minority Leader John Boehner described the deal as a “crap sandwich” but said he’d vote for it. So apparently will House Republican negotiator, Minority Whip Rep. Roy Blunt (R-MO), chief Deputy Whip Eric Cantor, and Paul Ryan, (R-WI), a hard-core conservative who allegedly added, “This sucks.”

Early market reactions weren’t encouraging. Asian and European stock markets sold off on Monday morning as the House of Representatives debated the bill. Belgium, the Netherlands, and Luxembourg injected money into their domestic systems. Great Britain took a second bank “under its wing” as a result of the mess in the United States. The Dow spent the morning down 250-300 points.

The House voted early in the afternoon. Although the vote was kept open for an unusually long period, the measure was defeated on a vote of 205 yes and 228 no. Leaders of both parties left the House floor to point fingers and strategize about reviving the measure before adjourning for the election recess. Later in the day, CNN reported frozen credit and a stampede into short term Treasury Bills paying less than 1% interest. The Dow ended the day down 777 points.

Tuesday saw House, Senate, and administration officials promising that a bill would pass within the week. Senators Obama and McCain voiced stronger support and urged their voters to do likewise. Both urged the FDIC to temporarily raise the ceiling on insured savings to $250,000. The Dow recovered 485 points. Credit continued to tighten. California governor Arnold Schwarzenegger warned that his state was being locked out of the credit market and, absent some resolution, California “may be forced to turn to the Federal Treasury for short-term financing” to pay salaries.

Ireland moved to quell banking unease in that country by providing blanket insurance for Irish banks. Six European governments banded together to pony up $150 billion for the protection of threatened institutions in Iceland, Great Britain, Germany, and Belgium. Criticism, even derision, of the US financial disorder flowed in from around the globe.

The Senate steps in
With the failure of a bill deemed neither fish nor fowl, lawmakers were faced with moving the bill left or right in search of votes.

Progressives favored a focus on mortgage foreclosures. Neighborhood Assistance Corporation of America CEO Bruce Marks proclaimed, “It’s the foreclosures, stupid.” Marks proposed a three-point intervention; “do a moratorium on foreclosures, stop the interest-rate increases, and restructure loans to make them affordable. That’s it, without one dollar of taxpayer money.” Respected progressive commentator William Greider offered an additional suggestion: temporary nationalization of the entire US banking system.

Democratic members of the House weren’t prepared to go that far, but Rep. Peter DeFazio (D-OR) and others proposed a “No Bailouts Act” which wouldn’t require an injection of taxpayer money. His alternative was said to focus on banking and financial market reforms. FDIC insurance would cover larger accounts. Mark-to-market accounting requirements would be set aside. There’d be permanent alteration of market rules on short-selling and something like the Reagan-era “Net Worth Certificate Program” would be instituted as a mechanism for the FDIC to exert greater oversight of some banks.

But the Senate had other ideas. It rendered the DeFazio plan moot and pressured the House by voting on October 1st, before the lower chamber could act again. Rather than make the bill more appealing to progressives, the Senate moved right and got personal. Its 451-page revision of the House bill included the widely popular increase in FDIC deposit insurance and a variety of tax relief ornaments for business and individuals, worth an estimated $110 billion, not offset by spending cuts or increased revenues.  Perhaps as sops to the left, there were also tax incentives for alternative energy and provisions for mental health parity in health insurance.

Other “sweeteners” were aimed at specific House members who voted “no” the first time around. Rep. Earl Blumenauer (D-Ore.) might be impressed with the tax benefit for bicycle commuting. Tax breaks for Hollywood studios filming in the United States might win the support of reluctant Southern California Democrats. Rep. Steve King (R-Iowa) said the insertion of his pet project, new biodiesel tax credits, didn’t change his mind; he’d still vote no. The rationale for better tax treatment of Puerto Rican rum, washing machines, and “certain wooden arrows designed for use by children” remained obscure.

The porky Senate plan passed on a vote of 74 to 25. Senators McCain, Obama, and Biden voted in favor. North Carolina Senator Burr also voted yes. Senator Dole, up for re-election, voted no.

The end of the beginning
The House debated the revised measure on Oct. 3rd. Minority leader Boehner again pled for affirmative Republican votes, ending with a plaintive invocation of the House motto, “In God We Trust.” Speaker Pelosi, who’d been accused of poisoning the earlier vote by blasting Republican deregulation, held her tongue and closed debate with a cheery bipartisan address. The final vote was 263-171 in favor. (Western North Carolina Representative, Democrat Heath Shuler, again voted no.)

President Bush emerged from the White House to praise the bill. House Democrats patted themselves on the back for showing leadership in the crisis and promised to investigate the state of financial sector regulations during the next congressional term.  Boehner’s office issued a statement saying the bill was no cause for celebration. “The financial crisis is not a failure of the free-market system.  It is a failure of a broken Washington, and a government culture that allowed executives at Fannie Mae and Freddie Mac and other firms to run amok . . .”

Within ninety minutes of the positive vote, the first 527 attack ad appeared on CNN, lauding McCain as a reformer and blaming the Democrats, Fannie Mae, and Freddie Mac for creating the debacle.

The applause from Wall St. was tepid at best. The Dow finished at 10,325, a loss of 157 points on the day and more than 800 points on the week. Effects on the credit crunch were expected to develop over several weeks, perhaps not being fully evident until some time next year.

Send in the clowns
If nothing else, the occasion of the credit crisis provided the American people with an unusually candid view of their federal government in action. To compare it to sausage-making demeaned sausage. Regardless of who and what deserved blame for the housing bubble, two things were abundantly clear. We are as addicted to credit as we are to oil. And Washington had fiddled around until the credit quit flowing.

The freeze set off an orgy of self-parody, obliterating the line between governance and performance art. President Bush, lamest of lame ducks, foe of big government, opened the show by allowing his Treasury Secretary to propose the largest government bailout in history.

Paulson rose to the occasion, drafting a bill of such stunning ineptitude that Congress stopped its fighting in the back seat. It couldn't decide which was worse, the return of the Grapes of Wrath or Paulson's bill.

Despite the plan’s faults, dumping money into the system without asking too many questions had political appeal. The Paulson framework was sufficiently value-free to garner bipartisan support even as it achieved the rare trifecta of inflaming libertarians, progressives and the general public alike. A compromise measure, remedying some of Paulson’s excesses, began to emerge.

Meanwhile, John McCain saw an opportunity to spite his Democratic presidential rival by mounting an exhibition of iron-willed military leadership. The nominee charged Capitol Hill, inadvertently precipitating the fray he’d come to alleviate. Finding himself as popular as Custer in Indian country, he proclaimed success and retreated with all deliberate speed.

A long night of negotiation put the bill back on track for what was assumed to be a close House vote in favor. But Speaker Pelosi couldn’t resist needling the administration's regulatory record one more time. The bill failed, House Republicans said, because she'd gone partisan. Barney Frank (D-MA) retorted with a mocking zinger, “Somebody hurt my feelings, so I’ll punish the country.”

The Senate, alarmed by the rapidity with which the legislative branch was covering itself in glory, elbowed the House aside to break out pork lifejackets for members fearful of an Election Day drowning. McCain, stalwart opponent of earmarks, forgot about the veto pen he’d been rhetorically waving on the campaign trail and voted in favor of tax advantages for certain toy arrows.

Then it was back to the House, where a sweet and sour sauce of unfunded tax breaks and fear of the market gods won enough additional votes to speed the bill over to the White House. Laura hollered out back for George, who suspended his horseshoe game long enough to come inside and sign.


Apart from unparalleled entertainment value and the commitment of enough money to fund the German government for two years, the benefits of the bailout package remain uncertain.

Maybe next year, when we know, we'll have serious debates about the merits of laissez faire capitalism and how we use credit in this country. Or maybe not. The already portentous General Election of 2008 just became even more critical.

—Michael Hopping
copyright © 2008 all rights reserved

Addendum: Living on Credit
What I began to realize in the course of my layman's progress through the acronyms and analysis as the credit crisis developed, was that the United States suffers from a more fundamental problem than the media have so far explained. We—government, industry, and people—are as addicted to credit as we are to oil.

We owe vastly more than our underlying assets and cash flow can cover. Though we’re happy to blame the federal government for deficit spending, we expect, even demand, that it continue. Ironically, the Reagan and George W. Bush administrations that promised to get government off our backs have been the worst debt offenders. We love lower taxes so long as they don't interfere with the social programs those taxes supported. Wars and burgeoning national security industries also cost money.

And, as the unlikely duo of George Will and Robert Reich recently observed, deficit spending isn't confined to Washington. It trickled down to the living room of the average family. A friend, Russell McCrimmon, shared a piece of his father-in-law’s Depression-informed advice with me. “Use credit for investment. For fun, use cash.” By investment, he meant things expected to increase in value over time. This included housing, education, starting a business. Everything else, even cars, fell into the fun category.

Another friend, Linda Brown, cast the issue in terms of “surplus value.” If you have money left over after paying your bills, it is available to grow an economy. When people and businesses must borrow just to get by, wallets should snap shut. However, greed and easy credit lulled too many of us into seeing our patriotic duty in continued consumption. We did as our president asked after 9/11; we went shopping. We took that trip to Disney World.

In a way, and for a while, the president's advice made sense. Without robust consumer spending the US economy was in trouble. When the value of real assets doesn't justify the value of a currency, cash flow must make up the difference.

During the Nixon years, we abandoned the last vestige of a dollar redeemable in gold. The greenback's value would henceforth depend on the worth of our physical assets, the cash flow they generated, and international agreement. We were an exporting titan, so why not? But then our international balance of payments turned consistently negative. We became net importers. What would now back up the buck? consumer spending and cash flow from the financial, insurance, and real estate sectors.

The bursting of the sub-prime housing bubble undercut that rationale. The dollar fell big-time against international currencies. We began to reap the inevitable consequences in higher prices for imported products.

Modestly negative governmental balance sheets can be dealt with by delaying repayment until underlying asset values and cash-flow catch up with the money owed. It’s the “credit for investment purposes” idea. But we’re long past any reasonable prospect of growing out of the multi-tiered collective debt we've accumulated.

Janszen’s article in Harpers suggests that serial economic bubbles have become our default mechanism for postponing the inevitable day of reckoning. Inflation, artificial value, confined to a particular economic sector, papers over the debt imbalance and rolls it forward into the future. We had a .com bubble succeeded by a housing bubble. Janszen speculates that a green economy bubble may be next. Others think the next bubble might be less sexy, related to repairing our aging infrastructure.

If we get that far without an economic collapse. If we don't, we'll probably do what other debtor nations have done. We could overturn the economic card table with war. We could resort to printing money. This pays bills at the cost of devaluing the currency. The result of an overactive printing press is inflation. If the presses go into overdrive, inflation does too. During a bout of hyperinflation, paper money can drop in value by a factor of a thousand or more in a single month.

Beginning in the 1980s, free market followers of Milton Friedman added a third option for failing economies. In return for a World Bank or International Monetary Fund bailout, countries were forced to impose “shock therapy” on themselves. Public services were slashed and government assets privatized. While a few at the top of the local heap got rich, the broader effects were higher rates of poverty and social unrest. The resurgence of leftist governments in Latin America has been attributed to popular rejection of shock therapy.

The panic in Washington that produced the Emergency Economic Stabilization Act (EESA) amounted to an effort to buy time for an economy on the brink of a cold turkey withdrawal from credit. Industries and states relying on credit for operating expenses could go belly up, resulting in mass layoffs. At the consumer level, retirement accounts could lose major value. Not only would car or education loans be tough to get, credit cards might become problematic. The interaction of unavailable domestic credit and reduced infusions of foreign capital could set off an irreversible downward economic spiral of Depression proportions.

Without the EESA would this actually have happened? Nobody knows. But given the degree of our economic imbalance—and an attractive smorgasbord of additional unfunded tax cuts—Congress wasn't willing to take the chance of sitting on its hands. Of course, nobody was willing to guarantee the success of the EESA either.

I reluctantly supported the bill, recognizing that it didn’t begin to touch the issue of deficit spending. The EESA had the further liability of concentrating on the top end of the problem rather than on homeowners at risk for default. At my pay grade, it seemed that a bottom up approach could have reduced the volume of bad paper in the system by converting it to good.

Be that as it may, if the EESA works and if we’re all smart enough to extricate ourselves from debtor positions as expeditiously as possible, we might get by next year with only a nasty recession. We may also have the option of rolling the problem forward again—nudge, nudge, wink, wink—in a new economic bubble.

One way or another, however brutal and tragic it may be, the real long-term solution to our problem is producing more than we spend. If we do that, we can claw our way back to the position of surplus value that once made the American economy strong.

—Michael Hopping
copyright © 2008 all rights reserved



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