With the passage of the economic rescue plan, the federal government has mobilized more than $700 billion to quell the parallel crises in housing and finance. While this massive allocation may mitigate the turmoil in the credit markets, there are broader economic ramifications to consider.
The necessity of this action was born of consecutive, multiplebilliondollar writedowns from some of the U.S.s largest financial institutions and the following seizure of the credit markets. With this injection of $700 billion, Wall Street firms responsible for offering credit will have enough money to continue business ventures, such as offering loans to qualified borrowers.
Inaccessibility of capital affects the entire market (hence the governments eagerness to offer transfusions as our financial institutions hemorrhage red ink). Startup funds for businesses would be more difficult to obtain. Companies would pursue fewer new ventures, leading to a reduction in hiring, and would likely slash payrolls to reduce costs. Unemployment would rise. If the contraction of the money supply were severe enough, we might have even seen deflation, which would trigger a general drop in the pricing of goods and services (a good thing for individuals who have a lot of cash on hand).
However, as I wrote in a recent blog post, inaction may have been the healthier option.Government manipulation of interest rates (specifically, the federal funds rate) near the turn of the millennium led investors to gorge themselves on housing. Artificially low rates meant inexpensive credit and increased ability to finance large purchases.
While this put the dream of home ownership within the reach of many for whom that dream had been previously unattainable, there was consequently an artificial increase in demand for new homes. Thus, the housing boom was born.
Home values spiraled out of control amid speculation and absurdly easily accessible credit. Unfortunately, the resulting glut in the supply of housing far surpassed the actual demand, particularly when interest rates began to return to sane levels and the payments on peoples adjustablerate mortgages ballooned beyond their ability to cover them. The correction in the housing market left people saddled with debt that exceeded the actual value of their homes, leading them to abandon both their house and mortgage.
The government is impeding the markets return to equilibrium, via the taxpayers purchase of illiquid paper (for example, mortgages and the assets attached to them). In a desire to prevent the value of firms assets (particularly real estate) from eroding, the government is inflating the value of these assets, which would otherwise have to be sold at market value. Propping up the prices of affected securities by misrepresenting the value of their holdings creates the potential for a painfully protracted return to equilibrium.
Additionally, the government is financing this venture by leveraging an everincreasing amount of debt. The dollar has already suffered as the good faith and credit of the United States government is being increasingly called into question. Skepticism of the governments ability to repay its massive obligations is already being reflected in the credit default swap market, where the cost of insuring the governments debt has surged drastically in recent months. Whats more, the liberal application of porkbarrel legislation politically motivated appropriations further bloated an already expensive proposition, as the bill was greased through Congress.
While the threat to health of the economy was and remains grave, the side effects of this intervention could prove equally severe. This action may prove to be a timely application of liquidity to a sezing market or a reckless misallocation of funds that we dont have.