Doing Something

"The government has to do something to keep markets from falling
and the economy from getting worse." How many times have you heard
that mantra this past week from President Bush, Treasury Secretary
Hank Paulson, Democrat leaders, the news media, and even some
ostensibly conservative periodicals?

But what if the bailout, as originally proposed and in its
latest incarnation, would spend $700 billion of
taxpayers’ money and actually make the economy worse? Believe it or
not, there is good evidence this may happen. The inflationary
prospects of the bailout price tag may lead to spikes in oil and
crop prices that could hit ordinary Americans in their cars and on
their kitchen tables. And government purchases of financial assets
could ironically further constrain credit through causing
write-downs on even the balance sheets of financial firms not
participating in the bailout by worsening the effects of
mark-to-market accounting rules.

All last week, the stock market’s plunging downward was pointed
to as a sign that Washington must step up to the plate — as
quickly as possible. Yet ironically last Friday — the day after
the bailout talks broke down at the wild White House meeting with
the presidential candidates — the Dow Jones industrial average
actually went up by 120 points! This doesn’t mean that the
market is opposed to the bailout, but it does show that the market
volatility is probably as much due to the potential effects of a
bailout as it is to a lack of one.

One of the things the market seems to fear about a bailout is
inflation due to the staggering price tag. Even if the government
recoups some of its purchases when the market stabilizes, as
bailout proponents argue, the spending outlays will be done
immediately, requiring a huge increase in the debt limit that’s in
the current plan. The market expects (probably rightly) that the
government will monetize much of the new debt through a looser
monetary policy.

So a substantial indirect effect of the bailout will be higher
prices for food and gasoline, and this will probably hit ordinary
households sooner than many politicians expect. When speculators
expect the dollar to fall or be volatile, they immediately try to
hedge an unstable currency through buying commodity futures. Thus,
last week saw a big spike in oil prices, which had been steadily
declining over the last few months. Other commodities, notably
gold, also shot up. Corn and wheat prices, already boosted because
of ethanol mandates, will also likely shoot up in response to a
falling dollar. An article in Stocks, Futures and Options
Magazine entitled "New Rules in the Commodity Game" notes that
the dollar is now a stronger day-to-day factor in corn futures
trading than even weather conditions.

On top of this inflation, the bill might even worsen the very
credit contraction it is trying to stop. This is because of its
effects on financial firms that have to follow mark-to-market
accounting rules. As I wrote earlier this month in the Wall Street
Journal, the credit "contagion" has been spread in large part
by these rules, adopted by the Securities and Exchange Commission
and bank regulators in the last few years, and subject to a big
expansion last November with Financial Accounting Standard 157.

Because the mark-to-market rules require writedowns of even
performing loans based on the last sale of similar assets, good
banks holding mortgages that haven’t been impaired often have to
adjust their books based on another bank’s sale — even if they
plan to hold their loans to maturity. And because the rules are
tied to solvency requirements from the government’s bank
regulators, banks lose "regulatory capital," even if the loss is
only on paper. Thus, in the scramble to conserve capital, financial
firms have less money to lend.

But the bailout — in addition to putting taxpayers on the hook
and massively increasing government’s role in the economy — would
likely make mark-to-market and hence the credit crisis worse,
according to experts who have reviewed Paulson’s plan. Paulson
proposes a "reverse auction" approach by which government would
choose a selling price to buy a financial firm’s mortgage-backed
securities. But unless mark-to-market rules were changed, this sale
would force other firms to write down their assets to this price,
which could further constrain the amount of money they can

An Associated Press story paraphrases American Enterprise Institute
scholar Vincent Reinhart, a former Federal Reserve monetary affairs
director, as saying that "if the auctions set too low a price for
mortgage-related assets, other institutions with bad debt may be
forced to take the distressed valuation onto their books under
mark-to-market accounting rules." Similarly a Washington
Post story by financial reporter Neil Irwin says that
the purchase could force more regional banks to write their assets
down. Thus, regional banks as well as big banks will be subject to
credit constraints.

As of today, some accounts say the bills will include authority
for the SEC to suspend mark-to-market. But the SEC and the banking
agencies already have the authority to suspend it and use any
accounting rules they wish. Since they have been resistant to doing
so thus far, even in the midst of this crisis, putting in what
amounts to at best Congressional "wishes" will likely not move
these agencies. The only way Congress could make a meaningful
change would be to require this suspension of rules, and lawmakers
do not seem willing to do that yet.

The stock and credit markets go up and down for a variety of
reasons. Right now, much of the paralysis is due to the uncertainty
about what Washington will do. Several people have told me that no
one wants to sell mortgages for 10 cents on the dollar, if
Washington is about to pay 50 cents. If Congress were to say no
action until next year, we may very well see the Dow go up the next
day and the credit market slightly improve. Markets may move to
resolve bad assets knowing that for at least three months,
Washington won’t bail them out. If mark-to-market rules aren’t
repealed, the best strategy for the economy would be to just "hurry
up and wait."