There are serious questions about both the capability and the motives of the economic team that is presently in charge. But, for the purposes of argument, let us give them the benefit of the doubt while I describe what I believe to be their understanding of the situation and offer my critique of it. Then, in next month’s issue, I shall propose some alternative prescriptions.
Their formula has been a combination of early action to stimulate the economy— a stimulus package, the Recovery Act, that was the first legislative achievement of the Administration— and a bank bailout whose stated objective is to get credit flowing again. In the Administration’s view, or in the view of the economic team, these two measures are intended to work together to provide, on the one hand, some impetus toward activity to thwart the massive loss of jobs that the economy is experiencing and the consequences thereof, and on the other, to resurrect the banking system by cleansing its books of the so-called toxic assets. The latter measure is based on the theory that it is a kind of congestion or clogging of said books that is the principal reason why bank lending and borrowing has dried up so thoroughly.
With these two steps the Administration envisages— and its economic forecasts reflect— an expectation of a fairly rapid return to normal, where normal is defined as the conditions, say, of the middle 1990s or the middle 2000s; i.e. an economy operating at a fairly high level of employment driven forward by an active financial sector extending credit and making possible profitable private enterprise.
If you assess the stimulus package as it was developed and enacted, the most obvious features of the situation all lead to the conclusion that it was smaller than it should have been and not as ambitious in its timeframe as it should have been.
In the first place, there were political constraints. In spite of the fact that the Administration came in with massive public support, that support did not extend to Congress; neither to complete control of the Senate, nor to the self-styled centrists within the Democratic Party (in both the House and the Senate) who remain deeply preoccupied with fiscal questions— that is to say with the size of deficits and public debt. In Congress, a trillion dollars is a very large number.
Second, there was the technical question of the economic forecasting within which the stimulus package was constructed. The economic forecasts, for example, of the Congressional Budget Office or the Office of Management and Budget are built around the presumption that the economy has certain normal values to which it will return in a reasonable period of time.
In the case of the CBO there is an expectation that an unemployment rate of 4.8 percent— the so-called natural rate— is the normal value and that the economy will get back there over a four- or five-year period, even if nothing is done. That being so, estimates of the effect of a stimulus package are in the context of a recovery that will begin in the early part of next year whatever policy steps are taken.
That context— professional expectation— reduced the urgency associated with the stimulus package and made it very hard to argue for a package that should have been dramatically larger than the one that was enacted; the reality of the situation leaves us no reason to believe that the underlying forecast was correct.
There is also an expectation that the economy will recover— a certain short-term-ism— which caused the Administration to place an enormous emphasis on measures that could be put in place quickly. The buzz-phrase was “shovel-ready”: projects that municipal and state governments were already planning to undertake but were being held up for lack of funding. The result was— and is— that measures that would rebuild the economy over the long run did not get high priority in the design of the recovery package; the underlying belief was that after two years things could be wrapped up.
Let us now turn to the banking question. It took a long time to get to the Geithner Plan— the program advanced by the Treasury Secretary in February/March, and now delayed, perhaps indefinitely— so we should ask what was it supposed to do? It is, obviously, a complicated structure involving the creation of public/private partnerships that would purchase banks’ securities (i.e. the debt from the toxic assets of defaulted/defaulting mortgages) and remove them from the books of the banks, thereby permitting the banks to deleverage and recapitalize (i.e. reduce their debt-to-asset ratios and increase their liquidity.)
These purchases were to be funded, to the tune of eighty-five percent, by loans from the Federal Deposit Insurance Corporation— which is to say from the taxpayer— that would be non-recourse in nature. This means that if the assets turn out in the end to be non-paying, they would default to the FDIC and the losses would be absorbed in the first instance by the public/private partnership and then, secondarily, by the taxpayer.
The mortgages that underlie these assets— the securities— appear intrinsically unmarketable. They represent a set of financial instruments that exist only because of the abandonment of state responsibility in the regulation of finance in the Bush Administration. They are intrinsically unsafe. They came to market only because of the pervasive climate of openness, and permissiveness with respect to financial fraud, including by the ratings agencies, whose credibility in these matters is now wrecked. Therefore it seems to be very likely that no matter what happens to the economy, these mortgages will not recover value. They are, in effect, permanently impaired. If there is a market for them in the first place, it is very possibly a market that the banks will have thoughtfully created for themselves by bidding up the price of these assets in order to get them off their books at a high price.
The presumption behind this program is, once again, that the world will return to normal and that, as the economy recovers, those bad mortgage assets will become good again. They will pay off over time, they will retain and regain value, the investors— including the Treasury which will have a seven and a half percent ownership equity share in the partnerships— will make money. There are people who thought that is a reasonable proposition. I am not one of them. The recently-announced delay in the implementation of the Geithner Plan suggests that market participants largely agreed with me. This leaves the assets on the books of the banks and the question of their capital adequacy substantially, and perhaps deliberately, unresolved.