While It's Big, Bad and Ugly, The Bailout Is the Only Answer

By Jane Bryant Quinn
Sunday, October 12, 2008

There's a lot of sloganeering around the Treasury's $700 billion financial rescue package, the Federal Reserve's $900 billion-plus lending authority, plus whatever else happens in the days ahead. Taxpayers need some clarification, so they don't hate the rescue anymore than is, well, reasonable.

Q Is the U.S. taxpayer losing $700 billion?

ANo. We're bailing Wall Street out of bad mortgage-related loans and other assets that no one else wants to buy. The Treasury will buy them at something more than their current, depressed market value. That adds capital to struggling banks, which they sorely need. At some point, the government will resell the assets to private investors.

The ultimate cost to the taxpayer depends on when the bleeding in home values stops and these assets rise in price. Peter Orszag, director of the Congressional Budget Office, expects the cost to be "substantially less than $700 billion but more likely than not to be greater than zero."

Will taxpayers make money by taking debt or equity stakes in the banks that sell the distressed assets to the government?

Orszag pours cold water on this idea. That's because the Treasury would have to pay more for assets that include a stake in the company than it would for the assets alone.

Where is the Treasury getting $700 billion?

It will borrow worldwide, by selling Treasury securities. Right now, there's a strong demand for them, so it's selling into a welcoming market. "It is remarkable how much capital the U.S. has been able to attract to finance its borrowing needs," says Brian Sack, Washington-based senior economist at Macroeconomic Advisers. That might change, he says, "but there are no clear signs, yet."

Are we adding $700 billion to the budget deficit while waiting to resell those impaired assets?

No. The money laid out to buy bad assets won't be counted as "spending" in the usual manner, as if the government put down money in exchange for goods. Instead, asset purchases will be scored on a "subsidy" basis. The Office of Management and Budget and the Congressional Budget Office will project how much the government might lose or gain over time by buying and selling assets and only the net amount gets added to the deficit.

That's the way the direct student-loan program is handled. The government lends money to students and parents who repay with interest. There's a net cost but not a large one.

Isn't any increase in the deficit a bad idea?

Not when the country stands on the brink of a financial disaster. Besides, the deficit -- although large in dollars -- isn't a problem at the moment, says economist Irwin Kellner of Dowling College in Oakdale, N.Y. It amounts to about 2 percent of the economy, well below the 6 percent deficits of the early Reagan years or 4.5 percent in the early Clinton years. The deficit will rise as the recession advances but not primarily because of the rescue activities.

Is the bailout inflationary?

No. When the Treasury sells securities to the public, it's neither inflationary nor deflationary. You are simply using money that otherwise might be invested elsewhere and investing it in government securities instead.

The Federal Reserve, which manages inflation, is making short-term loans to financial institutions that cannot borrow elsewhere. It can lend without limit. The institutions put up various types of collateral and the loans are expected to be paid in full.

The Fed earns interest on these loans, typically 2.25 percent but sometimes higher -- so it's making money. It will also buy short-term commercial paper from corporations. That earns interest, too, which will help cover losses if any of the paper goes bad.

The Fed isn't raising inflation by "printing money," as some critics charge. It's adding to bank reserves (that's the "printing") so banks will have more money to lend. But it's also removing money from the system, to hold the overnight lending rate at a level believed to be noninflationary.

At the moment, "credit creation in the economy has decelerated to recessionary levels," says Brian Bethune, chief U.S. financial economist for Global Insight, an economics forecasting firm based in Lexington, Mass. He calls the printing-money claim "a complete red herring."

Inflation might rise in the future, but that will depend on Fed policy at the time.

Are the bankers getting a free pass?

No. "Most of the cost of the whole mortgage mess will be borne by the banking system," Bethune says.

What about the cost of raising deposit insurance to $250,000, from $100,000 previously?

There will be larger losses to the FDIC insurance fund, which stands at $45.2 billion, down from $52.8 at the end of the first quarter. The taxpayer doesn't support the FDIC. It's maintained by assessments on banks. To cover recent losses, the FDIC announced a doubling in bank assessments this week.

In theory, the $250,000 insurance ceiling expires Dec. 31, 2009. The rescue legislation decrees that, during this time, the banks won't have to be assessed for the extra risk. If the FDIC's fund runs down and it has to turn to the Treasury for a loan, a special assessment on the banks will be allowed.

Will the rescue -- or rather, multiple, daily rescues -- work?

They won't stop the recession that's upon us, but the floods of money will put a floor under the financial system, eventually. At this point, government isn't the problem, it's the solution -- the only one.

Jane Bryant Quinn, author of "Smart and Simple Financial Strategies for Busy People," is a Bloomberg News columnist. Alexis Leondis contributed to this column.

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