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John Quiggin

Much rests on rescue plan

John Quiggin Australian Financial Review

26 March 2008

The reaction of markets and economists to the bank rescue plan announced by US Treasury Secretary Tim Geithner has been revealing. Stock markets loved both the Geithner plan and the announcement, a few days earlier that the US Federal Reserve would create a $1 trillion loan facility to assist in the purchase of dubious asset-backed security.

By contrast, the US dollar fell sharply against other currencies, including the Australian dollar. Oil prices, denominated in US dollars, rose accordingly, although more accurate measures, based on a basket of currencies showed much less change.

This divergence is not so surprising. The plan is, to put it mildly a high-risk option. If it succeeds, the benefits will largely accrue to holders of stocks in general, and even if it fails, it will certainly benefit banks and their shares, which make up a substantial part of the major market indexes.

If the plan fails, on the other hand, it will be bad for holders of US dollars and US government debt, which is being issued at an alarming rate.

A similar divergence can be seen in the quoted reactions of economists. The views of ‘market economists’, representatives of financial businesses on whom the press commonly relies for instant reaction on such matters, were overwhelmingly favorable. By contrast, the responses from economists who actually undertake research into how the economy works ranged from outright rejection to the most tepid of endorsements.

In many ways, the endorsements are more damning than the criticism. Berkeley economist Brad DeLong, who has been among the most prominent supporters of the plan sees it as the best that can be done without new legislation, which would almost certainly fail in the wake of the outrage over massive bonuses paid to the executives of failed banks. And, he says, it might lay the groundwork to convincing doubters of the inevitability of bank nationalisation. Writing in the New York Times, he says ‘“We tried alternatives like the Geithner Plan and they did not work” might well be an effective argument several months down the road.’

Joseph Stiglitz and Paul Krugman are among the many who disagrees. Krugman points out that the design of the plan gives private investors in dubious assets an effective put option. If the assets rise in value, they get much of the gain, but if they fall, the loss can be put back to the US taxpayer. And, against DeLong, Krugman argues that the financial and political resources used up in a plan that has little hope of success will not be available to support nationalisation.

Supporters and critics agree that the Geithner plan depends critically on the assumption that the ‘toxic’ assets on bank balance sheets, such as securities backed by home mortgages, are actually worth substantially more than the market is willing to pay for them at present.

There is an even more fundamental assumption underlying the Geithner Plan. Geithner, like Larry Summers, Robert Rubin and Henry Paulson, is deeply committed to Wall Street and its economic model. Their plans are based on the assumption that, when the crisis is over, everything will return to ‘normal’ as this term has been defined for the past thirty years, with a global financial system dominated by financial institutions like Citigroup, Bank of America and Goldman Sachs.

The resort to yet another publicly provided put option reflects this thinking. Just as with the ‘Greenspan put’ and the ‘Bernanke put’ that created the crisis, the assumption is that governments must support the financial sector at all costs.

On the Geithner is view, some new regulations may be needed, but contrary to the rhetoric of the Obama campaign, real change is neither possible nor desirable. By contrast, Kevin Rudd has recognised that the financial crisis signals a ‘seismic’ change in the economic organisation of capitalism, even if not all his government’s policies reflect this.

What does the Geithner plan mean for Australia? On the whole, it is probably a positive. The fact that it is a bad deal for US taxpayers is less important to us than the magnitude of the stimulus involved. And the decline of confidence in the US dollar, while not helpful to exporters competing with US suppliers, will probably make allow the Australian government, and Australian banks, to borrow on more favorable terms.

The biggest risk is that the failure of the plan could discredit the Obama Administration and produce a leadership vacuum. That would be a disaster for the entire world. The US led us into this mess, and, like it or not, the US must lead us out.

John Quiggin is an ARC Federation Fellow in Economics and Political Science at the University of Queensland.

John Quiggin is an Australian Research Council Federation Fellow in Economics and Political Science at the University of Queensland.

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