"The government has to do something to keep markets from falling and the economy from getting worse." How many times have you heard that mantra this past week from President Bush, Treasury Secretary Hank Paulson, Democrat leaders, the news media, and even some ostensibly conservative periodicals?
But what if the bailout, as originally proposed and in its latest incarnation, would spend $700 billion of taxpayers' money and actually make the economy worse? Believe it or not, there is good evidence this may happen. The inflationary prospects of the bailout price tag may lead to spikes in oil and crop prices that could hit ordinary Americans in their cars and on their kitchen tables. And government purchases of financial assets could ironically further constrain credit through causing write-downs on even the balance sheets of financial firms not participating in the bailout by worsening the effects of mark-to-market accounting rules.
All last week, the stock market's plunging downward was pointed to as a sign that Washington must step up to the plate -- as quickly as possible. Yet ironically last Friday -- the day after the bailout talks broke down at the wild White House meeting with the presidential candidates -- the Dow Jones industrial average actually went up by 120 points! This doesn't mean that the market is opposed to the bailout, but it does show that the market volatility is probably as much due to the potential effects of a bailout as it is to a lack of one.
One of the things the market seems to fear about a bailout is inflation due to the staggering price tag. Even if the government recoups some of its purchases when the market stabilizes, as bailout proponents argue, the spending outlays will be done immediately, requiring a huge increase in the debt limit that's in the current plan. The market expects (probably rightly) that the government will monetize much of the new debt through a looser monetary policy.
So a substantial indirect effect of the bailout will be higher prices for food and gasoline, and this will probably hit ordinary households sooner than many politicians expect. When speculators expect the dollar to fall or be volatile, they immediately try to hedge an unstable currency through buying commodity futures. Thus, last week saw a big spike in oil prices, which had been steadily declining over the last few months. Other commodities, notably gold, also shot up. Corn and wheat prices, already boosted because of ethanol mandates, will also likely shoot up in response to a falling dollar. An article in Stocks, Futures and Options Magazine entitled "New Rules in the Commodity Game" notes that the dollar is now a stronger day-to-day factor in corn futures trading than even weather conditions.
On top of this inflation, the bill might even worsen the very credit contraction it is trying to stop. This is because of its effects on financial firms that have to follow mark-to-market accounting rules. As I wrote earlier this month in the Wall Street Journal, the credit "contagion" has been spread in large part by these rules, adopted by the Securities and Exchange Commission and bank regulators in the last few years, and subject to a big expansion last November with Financial Accounting Standard 157.
Because the mark-to-market rules require writedowns of even performing loans based on the last sale of similar assets, good banks holding mortgages that haven't been impaired often have to adjust their books based on another bank's sale -- even if they plan to hold their loans to maturity. And because the rules are tied to solvency requirements from the government's bank regulators, banks lose "regulatory capital," even if the loss is only on paper. Thus, in the scramble to conserve capital, financial firms have less money to lend.
But the bailout -- in addition to putting taxpayers on the hook and massively increasing government's role in the economy -- would likely make mark-to-market and hence the credit crisis worse, according to experts who have reviewed Paulson's plan. Paulson proposes a "reverse auction" approach by which government would choose a selling price to buy a financial firm's mortgage-backed securities. But unless mark-to-market rules were changed, this sale would force other firms to write down their assets to this price, which could further constrain the amount of money they can lend.
An Associated Press story paraphrases American Enterprise Institute scholar Vincent Reinhart, a former Federal Reserve monetary affairs director, as saying that "if the auctions set too low a price for mortgage-related assets, other institutions with bad debt may be forced to take the distressed valuation onto their books under mark-to-market accounting rules." Similarly a Washington Post story by financial reporter Neil Irwin says that the purchase could force more regional banks to write their assets down. Thus, regional banks as well as big banks will be subject to credit constraints.
As of today, some accounts say the bills will include authority for the SEC to suspend mark-to-market. But the SEC and the banking agencies already have the authority to suspend it and use any accounting rules they wish. Since they have been resistant to doing so thus far, even in the midst of this crisis, putting in what amounts to at best Congressional "wishes" will likely not move these agencies. The only way Congress could make a meaningful change would be to require this suspension of rules, and lawmakers do not seem willing to do that yet.
The stock and credit markets go up and down for a variety of reasons. Right now, much of the paralysis is due to the uncertainty about what Washington will do. Several people have told me that no one wants to sell mortgages for 10 cents on the dollar, if Washington is about to pay 50 cents. If Congress were to say no action until next year, we may very well see the Dow go up the next day and the credit market slightly improve. Markets may move to resolve bad assets knowing that for at least three months, Washington won't bail them out. If mark-to-market rules aren't repealed, the best strategy for the economy would be to just "hurry up and wait."