As I am writing this, the Congress is about to vote on the legislation to facilitate the US bailout of American financial institutions.  It will in essence take much of their bad debt and place it in a “box” and from that box eventually the government will sell off those bad assets.  Permit me seven observations about this crisis and the proposed solution by Treasury Secretary Paulson.

1. How much will this cost?  At this point, this is impossible to say.  As the US Treasury begins to buy these distressed mortgage-backed securities, it will not pay the “face value” of these securities.  It might pay 40 or 50% of their value and then hold them.  Consider this example:  Suppose the Treasury buys securities valued at $100 million paying 6% interest.  If the government buys these securities at say $50 million with money it borrowed at 4% and those securities pay a 6% profit, it has earned a nice profit.  Further, if it holds these securities until the remaining homeowners repay their mortgages, the Treasury would again come out ahead.  What we do not know is how much the Treasury will pay for these securities.  And we do not know how an economy that is growing weaker by the day will affect these future mortgage-backed securities in terms of their value.  How many of these mortgages will actually foreclose?  The foreclosure rate in the US is growing each month.  At the end of June, 2.75% of home mortgages were in foreclosure.  That figure will certainly grow.  So, the more foreclosures there are on homes that are bundled in these securities, the more the government will lose.  So, at this point in time, we really have no idea how much this will cost.  But another way to look at this is to ask, what would be the cost if the government did nothing?  See Robert Samuelson in the Washington Post (25 September 2008) and Breakpoint (26 September 2008).

2. Now, contrast this plan with the fact that the US is currently sending $400 billion each year to foreign countries for the purchase of oil.  That is an enormous annual transfer of wealth.  The US Treasury will be purchasing these mortgage-based assets at depressed prices—of that there is no question.  These assets are now clogging the pipe called the US credit system.  Until and unless these are pushed out of the pipeline, credit will continue to dry up and business will grind to a halt.  Further, when the housing market stabilizes—and history tells us it will—these assets will increase in value.  As I mentioned in #1, no one knows when this will occur and how much the value will increase.  But, there is little doubt that these assets will increase in value.  There is the strong possibility that the Treasury will actually realize a profit on these assets.

3. Economist Robert Samuelson makes an important comparison of this crisis with another one in the 1970s.  He writes:  “Contrary to much commentary, Paulson’s plan would not be the largest government intervention in the private economy since World War II.  That distinction still belongs to Richard Nixon’s imposition of wage and price controls in August 1971.  True, Paulson would socialize unprecedented amounts of private debt, but Nixon asserted control over the entire economy.  What’s fascinating are the possible parallels between the two episodes, starting with a shared irony:  Both came from administrations committed to ‘free markets.’”  He goes on that generally people welcomed this decisive action.  But “inflationary pressures built up the artificial lid of the controls.  Moreover, the faulty economic doctrines that produced inflation—easy-money policies aimed at maintaining ‘full employment’ of 4% joblessness—remained.  When controls ended in 1974, inflation exploded to 12%.  It averaged almost 9% from 1975 to 1981.  Only the brutal 1981-82 recession, imposed by Paul Volcker’s Fed and raising unemployment to 10.8%, ended the wage-price spiral.”  So, Samuelson concludes:  “Like wage-price controls, Paulson’s plan is no panacea.  Banks, hedge-funds, private equity funds and others are trying to reduce risk by ‘deleveraging’—selling stocks and bonds to raise cash, increase capital and cut their own debt.  The rush to cash is a hallmark of financial crisis.  But what makes sense for one may be ruinous for all.  Heavy selling depresses prices; lower prices then increase losses, deplete capital, prompt more selling and heighten fear.  At best, Paulson’s plan might preempt this spiral by allowing investors to unload their least attractive securities.”  See Samuelson’s essay in the Washington Post (24 September 2008).

4. George Will makes an important and critical observation:  “The essence of this crisis is lack of knowledge, including the inability to know who owes what to whom and where risk resides.”  Further, the US Constitution states categorically that the allocation of public funds is totally and exclusively in the hands of the legislative branch of government—i.e., the Congress (see Article I, Section 1).  The truth of history, however, is that in the 20th century the Congress routinely gave those powers over to the executive branch of government and especially to the alphabet soup of regulatory agencies.  Particularly these regulatory agencies wield enormous power, much of it unchecked and rarely understood even by the Congress.  This is the price, presumably, we pay for a highly regulated economy.  So, as I understand the legislation that Congress is voting on as I write this Perspective, a staggering number of judgments will need to be made, not by the elected representatives of this democratic-republic, but by bureaucrats in the US Treasury department and in the new agency this legislation will create.  To whom will this money be directed?  How will these assets be valued?  How long will the Treasury hold them?  Etc.  However, as George Will points out, how these questions are answered pale in significance when one considers the following:  “This crisis has arrived during the ninth month of a vast demographic deluge—the retirement of 78 million baby boomers.  As the population ages, the welfare state—primarily, a transfer-payments pump providing pensions and medical care for the elderly—requires more rapid economic growth to generate increasing revenue.  To the extent that today’s crisis results in large amounts of capital being allocated by considerations other than those of economic efficiency, the nation will be consigned to less-than-optimal economic growth.”  The next administration will need to deal with this harsh reality.  The state will play an increasingly powerful and necessary role in the allocation of this nation’s financial resources.  But that is the price we will pay for entitlement programs.  See Will’s essay in the Washington Post (24 September 2008).

5. It is for this reason that I must echo something that Chuck Colson has advocated—namely, an idea constructed by Congressman Frank Wolf of Virginia called the SAFE Commission.  The need for something like this is so obvious.  The size of entitlements already committed by the US government for Social Security and Medicare (as well as Medicaid) is now estimated at $53 trillion!!  Entitlement spending is now the largest portion of the federal budget, having grown from one-third of spending in 1965 to nearly two-thirds in 2007.  This will continue until it consumes virtually all taxpayer spending.  However, obviously, this trend cannot continue.  There would be no money left for defense, homeland security, education, etc.  Some financial analysts are already saying that by 2012 the US will lose its triple-A bond rating because of its staggering debt.  Its rating could achieve junk bond status soon after that if nothing is done.  But something must be done.  For that reason, Congressman Wolf has introduced legislation (HR 3654) to do the following: