At this moment on Friday morning, Congress looks set to do… well, there’s simply no information to answer the question. Members of both parties appear to be just as frozen in place as the credit markets, deeply fearful of being tarred and feathered by angry voters if they pass the Paulson bailout plan.
I’m going to leave aside the very interesting but not definitively-answered question of whether the Paulson plan will actually fix the economy.
I am going to address the question of what happens next if Congress fails to act. Or to put it another way: Congress believes that they land in the fry-pan if they pass the plan. But if they don’t, they’ll land in the fire. How hot is the fire?
Yet another way to ask this question is: what happens if we let Mr. Market handle the problem all by himself?
At this point, credit markets are largely frozen in place, waiting on Congress to excrete or get off the pot. Financial institutions are extremely reluctant to lend any money to each other, even overnight, for fear of trading with someone who will declare bankruptcy tomorrow.
That means the normal ebb and flow of ordinary commerce around the world is severely impacted. Every day we wait is forgone economic activity that will never come back, and over time that will make the economy smaller than it would have been. That means job losses and smaller retirement savings accounts.
Now what if Congress pulls the plug and adjourns without doing anything?
The credit crunch will then resolve itself with a large wave of bankruptcies by banks and financial firms, large and small, around the world. This will most likely happen with breathtaking speed, far faster than any similar financial re-alignment in history. The Fannie/Freddie/Lehman/AIG/WaMu failures will be the tip of the iceberg.
Now, lost in this maelstrom will be a great many financial institutions that are basically solvent and could hold on otherwise. There will be a lot of wreckage out there, and a lot of damage to stock-market and commodities prices, which in turn will hurt the retirement savings of ordinary people.
Where will it end? That’s a good question. My guess is that it will work like a defibrillator applied to a stopped heart. It will take months to sort out, but new credit structures will arise quickly to replace the old ones.
And the Federal Reserve will step in to provide the additional liquidity needed to get over the hump. They may take steps like reducing interest rates to zero, and opening their discount window facilities even wider.
And significant co-operation will be required with foreign central banks, because this will be a global problem.
The Paulson/Bernanke plan, in its basic essence, is a way of executing this crash in slow motion rather than all at once.
The big hole in the financial system is the capital losses that resulted from the collapse in housing values. These losses need to be realized one way or another. If we get a crash, they will be realized all at once. Dozens, maybe hundreds, of institutions will fail, and many will be bailed out by the Fed on an individual basis. (Assuming they have time.) We’ll clean up the wreckage and move on from there.
The Paulson plan, on the other hand, would create a channel through which global investors (significantly, including foreign central banks) can shoulder the financial burden of covering the capital losses. By purchasing up to $700 billion in new Treasury debt, they will in effect be assuming the investment risk on the bad assets, although it will look to them like dollar risk.
If it all works out according to plan (or hope, if you will), then we’ll get the time to recover from the housing-asset deflation, without having to reconstruct the financial system.
Anyway, there’s your scorecard. We’ll see what happens and hope for the best.