Paulson's Panic

By Robert J. Samuelson
Wednesday, September 24, 2008

Call it Paulson's Panic. That's both unfair and accurate. It's unfair because Treasury Secretary Hank Paulson didn't create the underlying conditions that led to today's financial turmoil, and the failure for not quelling it is shared by Federal Reserve Chairman Ben Bernanke. But it's also accurate, because as world financial markets verged on panic, Paulson himself panicked. He saw no remedy except a massive bailout: having the government buy up to $700 billion worth of risky bonds.

Historians will judge whether his outsized proposal was necessary, but the notion that its congressional enactment -- assuming that happens -- would magically end the crisis seems like wishful thinking. Americans often delude themselves that all problems can be "solved" if only government would act "boldly." This may be another example.

Contrary to much commentary, Paulson's plan would not be the largest government intervention in the private economy since World War II. That distinction still belongs to Richard Nixon's imposition of wage and price controls in August 1971. True, Paulson would socialize unprecedented amounts of private debt, but Nixon asserted control over the entire economy. What's fascinating are the possible parallels between the two episodes, starting with a shared irony: Both came from administrations committed to "free markets."

When Nixon declared the wage-price freeze -- a complete surprise because he had consistently opposed controls -- the decision proved "wildly popular," Rice University historian Allen Matusow writes in his book "Nixon's Economy." By one survey, 75 percent of Americans supported it.

"There was widespread public rejoicing that at last the government was protecting the people," Herbert Stein, a Nixon economist, later observed. Consumer price inflation, which had been rising at a 4 percent annual rate, dropped toward 1 percent. People believed that by acting decisively government could outlaw inflationary psychology. It couldn't.

Inflationary pressures built up under the artificial lid of the controls. Moreover, the faulty economic doctrines that produced inflation -- easy-money policies aimed at maintaining "full employment" of 4 percent joblessness -- remained. When controls ended in 1974, inflation exploded to 12 percent. It averaged almost 9 percent from 1975 to 1981. Only the brutal 1981-82 recession, imposed by Paul Volcker's Fed and raising unemployment to 10.8 percent, ended the wage-price spiral.

Paulson argues that relieving banks of dubious mortgage-backed securities will "unclog" the financial system and encourage essential business and consumer lending. Maybe. It's true that these securities, because they cannot easily be valued, have created immense uncertainty. Banks and other financial institutions reduced routine lending to each other; everyone worried that the other bank might be in trouble. Having the Treasury buy these mortgage securities, on which losses have already been booked, might minimize these fears.

The trouble is that fears extend beyond mortgage securities. It wasn't just home mortgages that were bundled up into bonds and sold to institutional investors (pension funds, insurance companies, college endowments). Auto loans, credit card debt and commercial real estate loans have been similarly packaged, $900 billion worth in 2007. Naturally, doubts about the value of these securities have also increased. "Securitization" may survive, but this lending is already down (80 percent in 2008), reports Thomson Reuters. Credit is tightening across the board; issuance of high-quality corporate bonds is down 22 percent, while riskier "high yield" bonds are down 65 percent.

What we are discovering is that all the complex securities, combined with ever-greater international investment flows, have created a global financial system "so arcane that few people can understand its workings," David Smick writes in "The World Is Curved: Hidden Dangers to the Global Economy." The difference between now and two years ago is that financial managers then thought they understood the system; now they know they don't. Ignorance breeds risk-aversion and fear.

Like wage-price controls, Paulson's plan is no panacea. Banks, hedge funds, private equity funds and others are trying to reduce risk by "deleveraging" -- selling stocks and bonds to raise cash, increase capital and cut their own debt. The rush to cash is a hallmark of financial crises. But what makes sense for one may be ruinous for all. Heavy selling depresses prices; lower prices then increase losses, deplete capital, prompt more selling and heighten fear. At best, Paulson's plan might preempt this spiral by allowing investors to unload their least attractive securities.

But it wouldn't automatically stimulate new lending, revitalize "securitization" or prevent more "deleveraging." Time is needed. The rescue is being constructed so hastily that it may include all manner of flawed provisions: too much power for the Treasury secretary; authority for bankruptcy judges to modify mortgages. Congress faces a wrenching dilemma, imposed on it by financial markets and Paulson. If it dawdles, it may invite the panic that Paulson has brazenly predicted. But if it acts quickly, it may create a monster whose full implications emerge only with time.

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