Yesterday, the US Senate backed the financial bail-out bill amounting to $700bn (£380bn). The essence of the plan is to buy up bad debts in order to try and stabilise financial markets through restoring confidence that no other institutions will collapse as the result of existing debts. The ultimate objective is to to keep banks lending – so that the global credit crunch does not take an even stronger hold and completely paralyze the economy.

In order to become effective, the Houe of Representatives have to approve the bill as well. Earlier, this bill failed to pass the House of Representatives vote. Since this first failure, extra modifications were added to make it more palatable to the public, such as additional guarantees of the amount of savings US will guarantee, and tax breaks for smaller businesses to encourage the economy.

At the next hurdle, the bill might still be rejected. There is of course pressure (or strong encouragement) from President Bush and both presidential candidates for it to be passed, which might sway the vote to some extent. But what could the outcomes be of the bill being (a) passed – or (b) rejected – on the markets in the longer term?

Bill passed: The US government will effectively become the owner of devalued assets of the financial firms, rescuing the latter from the mess they were responsible for in the first place. 2 side effects might occur:

  • Whilst the bailout might create greater confidence in the markets of no more imminent banking failures, the US state will be saddled with a huge amount of non-performing (but not completely worthless) assets and hence some degree of increase in its budget deficit. This increase will be particularly large if the US housing market slumps further, making these assets even less valuable. The increase in budget deficit will filter through into the real ecomony and might trigger interest rate rises, deterioration of the economic climate and a deepening of the recession which is already starting to take hold in the US. The recession can be quite protracted and painful as the government might resort to helping banks further, even the technically bankrupt ones (kind of like keeping a dead patient on a life support machine for the sake of preserving appearances). This brings to mind a parallel with the protracted recession in Japan in the nineties where (to the best of my knowledge) the government’s continuous intervention to prop up firms just prolonged the economy’s problems.
  • The bailout reinforces the perception that banks can behave totally irresponsibly and take any unjustified risks, since they will be rescued nevertheless. So the problem will occur again in future – because no-one ever learns! And we will pay for it again.

Damned if you do?…

Bill not passed: The crisis of confidence will resume but magnified many-fold. There will almost certainly be more high profile bankruptcies. The impact and the shock of it will be severe and harsh with wide ranging negative ecomonic implications for the US and the world alike, and it is bound to be very challenging on the people living through it, with an increase in unemployment just for starters. The global credit crunch will squeeze everyone even more strongly.

A part of me keeps coming back to this thought though – in this case, although the resulting downturn will undoubtedly be very severe, maybe it will not be as prolonged? Maybe with careful macroeconomic management after all the bankruptcies have happened, the US economy will actually have solid foundations on which to build long term recovery?

The collapse of the financial system might be a price too high to pay for this though.

Damned if you don’t, then.

 

I welcome people’s feedback and comments on the above.

Copyright 2008 by CuriouslyInspired

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