A Bailout Is Just a Start
Congressional negotiators have completed action on a $700 billion authorization for the bailout of the financial sector. This step was as necessary as the need for it was regrettable. In the coming weeks, the authorities will need to consider hugely important tactical issues regarding the deployment of these funds if the chance of containing the damage is to be maximized.
Right now, what must be considered are the conditions necessitating the bailout and its impact on federal budget policy. The idea seems to have taken hold that the nation will have to scale back its aspirations in areas such as health care, energy, education and tax relief. This is more wrong than right. We have here the unusual case where economic analysis suggests that dismal conclusions are unwarranted and recent events suggest that in the near term, government should do more, not less.
First, note that there is a major difference between a $700 billion program to support the financial sector and $700 billion in new outlays. No one is contemplating that $700 billion will simply be given away. All of its proposed uses involve purchasing assets, buying equity in financial institutions or making loans that earn interest. Just as a family that goes on a $500,000 vacation is $500,000 poorer but a family that buys a $500,000 home is only poorer if it overpays, the impact of the $700 billion depends on how it is deployed and how the economy performs.
The American experience with financial support programs is somewhat encouraging. The Chrysler bailout, President Bill Clinton's emergency loans to Mexico and the Depression-era support programs for the housing and financial sectors all ultimately made profits for taxpayers. While the savings and loan bailout through the Resolution Trust Corp. was costly, this reflected enormous losses exceeding the capacity of federal deposit insurance. The head of the FDIC has offered assurances that nothing similar will be necessary this time.
It is impossible to predict the ultimate cost to the Treasury of the bailout and the other commitments that financial authorities have made -- this will depend primarily on the economy as well as the quality of execution and oversight. But it is very unlikely to approach $700 billion and will be spread over a number of years.
Second, the usual concern about budget deficits is that the need for government bonds to be held by investors will crowd out other, more productive, investments or force greater dependence on foreign suppliers of capital. To the extent that the government purchases assets such as mortgage-backed securities with increased issuance of government debt, there is no such effect.
Third, since Keynes we have recognized that it is appropriate to allow government deficits to rise as the economy turns down if there is also a commitment to reduce deficits in good times. After using the economic expansion of the 1990s to bring down government indebtedness, the United States made a serious error in allowing deficits to rise over the past eight years. But it would compound this error to override what economists call "automatic stabilizers" by seeking to reduce deficits in the near term.
Indeed, in the current circumstances the case for fiscal stimulus -- policy actions that increase short-term deficits -- is stronger than ever before in my professional lifetime. Unemployment is almost certain to increase -- probably to the highest levels in a generation. Monetary policy has little scope to stimulate the economy given how low interest rates already are and the problems in the financial system. Global experience with economic downturns caused by financial distress suggests that while they are of uncertain depth, they are almost always of long duration.
The economic point here can be made straightforwardly: The more people who are unemployed, the more desirable it is that government takes steps to put them back to work by investing in infrastructure or energy or simply by providing tax cuts that allow families to avoid cutting back on their spending.
Fourth, it must be emphasized that nothing in the short-run case for fiscal stimulus vitiates the argument that action is necessary to ensure the United States is financially viable in the long run. We still must address issues of entitlements and fiscal sustainability.
From this perspective the worst possible actions would be steps that have relatively modest budget impacts in the short run but that cut taxes or increase spending by growing amounts over time. Examples would include new entitlement programs or exploding tax measures. The best measures would be short-run investments that will pay back to the government over time or those that are packaged with longer-term actions to improve the budget, such as investments in health-care restructuring or steps to enable states and localities to accelerate, or at least not slow, their investments.
A time when confidence is lagging in the consumer, financial and business sectors is not a time for government to step back.
Well-designed policies are essential to support the economy and, given the seriousness of health-care, energy, education and inequality issues, can make a longer-term contribution as well.
The writer, who served as Treasury secretary from 1999 to 2001, is a managing director of D.E. Shaw & Co. He writes a monthly column for the Financial Times, where this article also appears today.