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Main Street's Rescue


(CREDIT: TWP; SOURCE: Paul Swartz, Council on Foreign Relations)

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By Sebastian Mallaby
Friday, October 10, 2008

The most stunning graphic of the past few days shows the stock market's reaction to government attempts to rescue the financial system. Between Monday and Wednesday, the Federal Reserve unveiled five initiatives to unfreeze credit, and stocks slumped after each announcement. Meanwhile, in Europe, the story is the same: The series of deposit guarantees, bank rescues, partial bank nationalizations and interest rate cuts has yet to calm investors. To the contrary, market panic and apparent government panic have fed on each other. In Washington, the Treasury went from ad hoc bailouts to demanding $700 billion without saying how it would be spent. In Europe, rival governments tripped over themselves as they rolled out uncoordinated measures.

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There is a silver lining, and a cautionary message, to this terrible week. The silver lining is that market panic has now overshot so much that there's at least a chance that it will subside. We have gone from grappling with genuine financial challenges -- that mortgage loans are tumbling in value; that shrinking the excess borrowing in the financial system is bound to force asset prices down -- to grappling with the exaggerated terror that nobody is to be trusted. Banks won't lend to each other or to healthy companies even for short periods. Companies that have pre-negotiated rights to borrow are calling in the money, not because they need the cash but because everyone else is hoarding it.

Central banks, which face fewer political constraints than finance ministries, have rapidly come up with a plan to calm everybody's nerves, though the patient has not yet responded. The Fed's version of the policy comes down to this: If Bank A won't lend to Bank B, let's have Bank A lend to us and then we'll lend to Bank B; and if Banks A and B won't lend to companies C, D and E, then we'll get between them also. In this way, the full faith and credit of the U.S. government can be made to substitute for the lack of faith in private players.

The Fed's plan is already driving extraordinary growth in its borrowing and lending. This is the most sudden expansion in the state's role in the economy at least since the Depression. But the plan is sound. It does not involve printing money or igniting inflation. It shouldn't cost taxpayers much, if anything. Once investors see that the Fed's approach works in practice as well as in theory, there will be at least some reason for the markets to settle down.

Here is the cautionary message: If financial professionals are confused by government actions, the voting public is doubly bewildered. As far as most people can see, government is spraying money at the Wall Street fat cats who created the chaos. Federal policy needs to pay more attention to ordinary families, and with the economy tanking and unemployment set to soar, this change had better happen quickly. Otherwise, voters will respond to government in the same way that markets have reacted over the past week -- with contemptuous cynicism.

How should government demonstrate concern for regular people? John McCain's plan to refinance mortgages shows that he has the right impulse, but this is not the best approach. Rearranging home loans one by one would be a slow process when what's needed is quick action. It would be almost impossible to rearrange the loans fairly: Prudent home buyers who have kept up with their payments might lose out to imprudent ones who stretched too far; folks who rented while saving for a home would get nothing. Besides, McCain's plan could exacerbate the financial crisis in a perverse way. Help for families who are behind in their mortgage payments could encourage others to stop paying, too, in which case loans that are now good would quickly turn rotten.

The fastest and fairest way to help ordinary people is via a budget stimulus package. Part of the extra spending should be distributed to state governments, which are having trouble maintaining Medicaid and other programs as recession eats into their tax revenue. Part of the extra spending could go to infrastructure projects, though this tends to be a slow way of getting cash into the economy. But much of the stimulus should be in checks made out directly to citizens. Wall Street is getting its bailout. Main Street deserves one also.

This is not just about politics and fairness. The next stage of this crisis, if financial markets do calm down, will be trouble in the real economy. A new Wall Street Journal poll of economists predicts that U.S. gross domestic product is three months into a contraction that will last until spring -- which implies that the economy is headed for the longest period of shrinkage in more than half a century. There is only so much the Fed can do to fight this recession, especially since banks are too bruised to transmit the tonic of low interest rates rapidly through the economy. For reasons both political and economic, therefore, it is time for a budget stimulus.

smallaby@cfr.org

Read more from Sebastian Mallaby on washingtonpost.com's political opinion blog, PostPartisan.


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