It's Not Hank's Mess, but He's Doing Well on Cleanup

By Steven Pearlstein
Friday, November 21, 2008

Poor Hank Paulson doesn't deserve the drubbing he's been getting.

I'm sure the Treasury secretary had no idea what he was in for when he signed on after the 2006 election, and as my colleague David Cho reported in a pair of splendid articles this week, Paulson has been pragmatic and aggressive in responding to the mess he inherited. He set aside long-held views, changed course when he felt necessary, and provided badly needed leadership to a politically weakened administration. And even if he has been unwilling to use some of his bailout money to finance an auto rescue or a foreclosure prevention program, he's acknowledged that action is needed.

Sure, he's made some missteps -- the handling of Fannie Mae and Freddie Mac since the takeover, for example, has been ham-handed. But much of the criticism is based on a misunderstanding of the nature of the problem, what government can accomplish and how much money will be required. So far, we've probably done as well as any country in containing the crisis, and because ours is without precedent in so many ways, some trial and error was inevitable. So let's cut the guy some slack.

One reason it has been so hard to get this crisis under control is that the front-burner problem keeps changing, with each problem requiring a different response.

Sometimes the immediate challenge has been a lack of liquidity in the financial system, with banks, corporations and hedge funds unwilling to lend even to each other. The usual response to such a liquidity crisis is for the Federal Reserve to step in as lender of last resort, which it has done aggressively since the Bear Stearns rescue in March. Not only has the Fed pumped out tens of billions of dollars through its discount window and special new facilities to banks, financial institutions and major corporations, but it has swapped dollars for other currencies to allow other central banks to do the same with their financial institutions.

At other times, however, it's not liquidity but solvency that has been the issue -- a bank or a big company or large number of households borrowed or invested unwisely and now doesn't have the assets to cover its liabilities. Making short-term loans won't solve such a problem. What's required is an outright government investment in exchange for ownership and control, or the creation of a bankruptcy-like process to restructure things without actually going through bankruptcy.

That's basically what was done with AIG, Fannie Mae and Freddie Mac, and is the rationale behind the recapitalization of the major banks. It's also what is likely to happen with the Detroit auto companies. In a slightly different form, a government-sponsored workout is at the heart of the proposal from Sheila Bair, the head of the Federal Deposit Insurance Corp., to prevent a large number of home foreclosures through a refinancing scheme with modest government subsidies. With the support of the new president, some version of Bair's proposal is likely to be enacted by the new Congress early next year.

Beyond liquidity and solvency is the broader economic crisis, which requires a different government response in the form of monetary and fiscal stimulus.

The Federal Reserve has delivered plenty of monetary medicine by cutting the federal funds rate to 1 percent, and given the recent sharp rise in unemployment, could well bring that down to zero over the next few months. At this point, the impact of these cuts may be more psychological than real, since the normal channels through which Fed rate cuts work back into the system have been badly damaged by the financial crisis.

On fiscal policy, the federal deficit is well on its way to $1 trillion, which in any normal recession would be considered more than enough stimulus. But now there is serious talk of going beyond that with a $300 billion-plus package that could include $1,000 rebates for households (a bad idea, in my opinion), grants to cash-strapped state and local governments (urgently needed) and a big increase in public investment (worth doing, particularly if the spending moves beyond roads and bridges to projects with bigger payoffs, such as mass transit and computerizing medical records).

Each of these three problems is still with us. Although the liquidity crisis has eased as a result of the Fed's massive interventions, wide swaths of the "shadow" banking system -- the markets for securities backed by car loans, student loans, commercial real estate loans and home equity loans -- are still shut tight. Until they revive, the credit crunch will continue. Paulson has abandoned the idea of trying to revive these markets by having the government buy some of these unwanted securities. His latest plan is to ask the Fed to create new facilities to lend money against these assets, with the Treasury providing the financial backstop for any losses.

The insolvency crisis, meanwhile, is now beginning to kick into high gear, with a wave of new defaults expected from commercial real estate developers and builders, along with the regional banks and insurance companies that traditionally provide them with financing. Ratings agencies are also warning of a big spike in defaults on corporate bonds, including those used to finance the orgy of overpriced corporate takeovers of recent years. Most of these won't rise to the level of posing "systemic risk" and warranting federal intervention. But Paulson has been wisely holding some of his remaining bailout money in reserve for the few that do.

As for the economic crisis, don't be surprised if the economy begins losing jobs at the rate of 500,000 in each of the next few months in response to the sudden collapse in consumer spending and corporate investment. Other than the federal government and possibly health care, no sector is immune.

While the stock market is an imperfect barometer, the 2,000-point drop in the Dow Jones industrial average since Election Day, and the dramatic plunge in yields on Treasury bonds, are unmistakable signs of another big leg down in this financial and economic crisis. As we muddle through it, remember that Hank Paulson didn't cause it, had no power to prevent it and has managed the government's response about as well as could be expected.

Steven Pearlstein can be reached at

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