Wednesday, October 15, 2008

It’s not the time for fiscal gradualism

Yesterday I appeared on TV Tokyo (and Bloomberg Asia) to respond about the $250 billion re-capitalization effort. They asked me the typical economic questions, but what they really wanted to know, is whether or not $250 billion is enough? I side-stepped the question by telling them that the Treasury still has $450 billion of fire power left to load its gun, but in the end, I believe that it will not be enough. Paulson should have throw the whole $700 billion at the banking sector. This $250 billion re-capitalization plan is just a tease; the Treasury’s gradual policy response is unlikely to put out the fire in the banking system.

I do agree that a direct capital injection is a more prudent way to deal with the banking crisis; it improves the bank’s ability to lend, rather than just sloshing around liquidity across balance sheets. However, the jury’s still out on whether or not the $250 billion injection will work. Signs of relief are emerging, but that will be short-lived if banks don’t actually lend the new capital to consumers and firms. Even though the Treasury is assuming ownership in the firms in exchange for the capital injection, they assume no voting rights, and Paulson cannot force banks to lend!


Gradualism usually refers to the Fed’s small and incremental rate cuts (or hikes) that eventually bottom out (peak) at the ultimate target. Alan Greenspan was famous for his gradual rate cuts; spanning 2001-2003, he cut the federal funds rate 5.5% to 1% over 13 different meetings. Why not just cut in a third of those meetings? Or in 1 meeting? The Fed could cut the whole kit’n caboodle, the whole shebang, one clean sweep – 5.5% in one meeting: the big bang.

Economic research supports gradualism; incremental rate cuts are appropriate in a world of uncertainty. However, if the economy is in dire need of liquidity, a more severe rate cut may be is the smarter policy response. Can you imagine what the market response would have been if Greenspan cut the federal funds rate target by 5.5%?

In 2004 Ben Bernanke said,
“In my own view, economic developments over the next year are reasonably likely to be consistent with a gradual adjustment of policy.”
Gradualism – relating to standard open market operations and not the newly created liquidity measures (TAF, TSLF, PDCF) - is still very relevant to modern monetary policy. But what about fiscal policy?

It's not the time for fiscal gradualism

There is a fire in the banking sector, and the government response should include re-capitalizing with a fire hose – throwing the whole $700 billion at the banking sector in one shot – rather than with a bucket of water - $250 billion. Even Europe is taking the big bang route with a joint $2.3 trillion response to the banking crisis. I am certainly not a fan of the TARP program, but if they are going to do it, why not make it work?

Paulson was forced into a gradual response because Congress restricted the funds. The stipulations of the $700 billion approved in the TARP program are: the Treasury Secretary has access to $250 billion upon enactment of the bill, plus another $100 billion with Presidential approval, and finally, $350 billion with Congress’ approval after a 2-week deliberation. Congress, which is full of politicians rather than policy experts, gave Paulson a bucket of water when he should have received a firehose. Pauslon is not without blame here – why wasn’t he pushing a re-capitalization plan all along?

The market response has been slightly positive, and going forward, further relief is expected to emerge incrementally as banks purge the bad assets through further writedowns. According to some, the banking sector still has an estimated $600-$800 billion in write-downs left to go, so a $700 billion capital injection may be just what the doctor ordered!

The Treasury’s gradual capital injection creates more uncertainty for banks and investors. How is the Treasury going to spend the final $450 billion? Further re-capitalization efforts? Or back to the initial liquidity program where the Treasury buys toxic assets from the banks? Will the Treasury even get the $350 billion after Congress deliberates for two weeks? Too much uncertainty resonates to make the $250 billion gradual response effective.

It’s too bad

The outlook of the U.S. economy remains clouded until the banking crisis takes a decided turn – up or down. Recently, the economic news – although dwarfed by news related to the banking crisis – has taken a turn for the worse. Here are a few headlines over the last two days:

U.S. September Retail Sales Probably Fell, Led by Automobiles
Job security worries nearly half U.S. workers: survey
U.S. budget deficit swells to record $455 billion
NYC may lose 165,000 jobs, double July's estimate
Yellen Says U.S. in a Recession, Interest Rates Will Stay Low

The U.S. economy is sick and expansionary policy is designed nurse it back to health, and another $300 billion stimulus plan is in the works. Hopefully, the government will form an actual spending or tax plan, rather than a silly rebate program. But potential stimulus plans aside, one thing is for certain: the economy will not heal until the banking crisis has either run its course (without intervention) or investor confidence re-emerges to stabilize the crisis. Too bad Congress and Paulson took such a gradual fiscal stance.

Rebecca Wilder

1 comment:

  1. With Obama talking about a 3 month lull in foreclosures, TARP will not help much either. Wouldn't it be better to foster the solvent institutions and let the mismanaged ones fail? So far, Pelosi is talking about unemployment extension but not rebates for this next stimulus package. You are so right about the bucket/fire hose. I've heard it is wise to watch the NASDAQ for clues on where the market is headed. The bucket is not going to help them a bit.


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