Diary

The Other Bailout

A bounce in the markets yesterday was not unexpected after the day we had Tuesday, but many people were surprised to see the Dow jump 400 points. Many people chalked this up to the idea that the markets were already recovering from the plunge after the bailout was rejected, but this is because the majority of people didn’t realize fundamentally why the increases happened.

As Bloomberg reported yesterday, while Congress was politicking Paulson’s rescue plan to death, Ben Bernanke & Co at the Fed had a different appointment yesterday afternoon. As Greg Mankiw puts it , Bernanke’s “Plan B” involved the Fed pumping $630 billion into the financial markets yesterday, just as the Congress rejected the $700 billion bailout. These funds, which came from a variety of sources and were implemented through different channels, acted as a liquidity injection to our markets’ bottom line. The market drops yesterday were a responds to the failed bailout, but the market increases today were a response to the new liquidity that was available.

Now, take a step back here and let’s look at the overall situation … the price tag of the proposed bailout was $700 billion; however, when the package wasn’t approved, the market dropped 7% and more than $1 trillion of value was lost in our markets (for instance, Apple’s market cap decreased in value by $20 billion in approximately one hour). On the other hand, through an injection of $630 billion from various facilities the Fed has access to as a lender of last resort, the market responded with a jump of almost 5%, which equates to roughly another 3/4 of a trillion dollars worth of value in the markets.

So, just think of the direction we could have been going today if we would have approved the bailout package, which will inevitably be approved in one form or another in the near future. Now, when the bailout is approved, we will still be down considerably, but it’s almost sickening to think of where we could be already.

Finally, I should point out that the response from those who fought this package have said the relative declines in percentage points yesterday is not significant compared to other market plunges. This is not totally accurate, because you can’t look at the markets in a vaccume, or from the perspective of a sound bite, like we do in politics. They are much too complex for that.

For instance, in order to determine how the declines compare, one must look at the entire picture, which includes not only the percentage drop in the Dow, but what about the aggregate market declines, which include the basis point drops in the credit markets. These declines were larger than any other market decline in history, with the exception of the crash that spawned the Great Depression in 1929. Also, the percentage drop itself was only about 5% off from that of 1929, which considering the volatility today, 5% is not that far off. Further, one must consider the adjusted value declines, which were much closer to that of 1987, compared to the percentage drop.

Thank goodness the markets didn’t crash yesterday and thank goodness the markets regained today. But, I’m still concerned many people out there still don’t understand what the impact was and still potentially is on the financial markets. Speaking from an economist’s viewpoint, the worst thing for our financial markets is uncertainty, and anyone acquainted with our financial markets would agree that uncertainty is higher than it has ever been in the past. This makes the volatility incredibly high, so that a swing of 5-7% is not surprising, but it is extremely detrimental to the long-term stability of the financial landscape. All of this makes the probability of a Black Swan event much higher, to the point where yesterday’s systemic event was barely a blip on the radar.

NOTE: This article was originally published on my blog at www.marktomarket.typepad.com on September 30, 2008.