GSI: What is your opinion on the US$ 700 billion bailout of U.S. financial institutions passed earlier this month by the U.S. Congress?

D.B.: It is a very poor and inefficient use of public money, and at the same time, it really is not clear how it will help.  The basic argument in favour of the bailout is that the banks hold so much bad debt that they can't trust each other to repay loans, creating a situation in which the system of payments breaks down.

Ultimately, that could mean that we cannot use our ATMs or credit cards or cash checks, which is a very frightening scenario. But this is not where things end. The Federal Reserve Board would surely step in and take over the major money-center banks so that the system of payments would begin to functioning again. The Federal Reserve was prepared to take over the major banks back in the 1980s when bad debt to developing countries threatened to make them insolvent. It is inconceivable that it has not made similar preparations in the current crisis.

In other words, the worst-case scenario is that we have an extremely scary day in which the markets freeze for a few hours. Then the Federal Reserve steps in and takes over the major banks. The system of payments continues to operate exactly as before, but the bank executives are out of their jobs and the bank shareholders have likely lost most of their money. In other words, the banks have a gun pointed to their heads and are threatening to pull the trigger unless we hand them US$ 700 billion.

In fact, the bailout could make things worse. We are facing a serious recession because of the collapse of the housing bubble, and we will need effective stimulus measures to boost the economy and keep the recession from getting worse. However, the US$ 700 billion outlay on the bailout is likely to be used as an argument against an effective stimulus response. We have already seen voices like the Washington Post and the Wall Street funded Peterson Foundation arguing that the government will have to make serious cutbacks because of the bailout. These are powerful voices in national debates. If the bailout proves to be an obstacle to effective stimulus in future months and years, then it could lead to exactly the sort of prolonged economic downturn that its proponents claim it is intended to prevent.

GSI: Some have argued that the market showed what it thought of the bailout by dropping almost 800 points when it was first rejected by the House. Given this fact, is a bailout of the sort not needed to restore confidence in the market?

D.B.: The conventional wisdom in the media was that the economy would collapse in the absence of the bailout. But we cannot look at the markets as an independent gauge of the impact of Congress not passing the bailout, because stock markets are reflecting the conventional wisdom in the media. They do not provide an independent assessment of the economy. Furthermore, while the sharp one-day drop is in fact scary, it actually has relatively little direct impact on the economy. As former Treasury Secretary Robert Rubin often said, "markets go up, markets go down." Lower stock prices do not cause firms to cut back investment or layoff workers. Such decisions will be made based on their assessment of the state of the economy and their specific market.

People who warn about the system collapsing don’t have a clue about what that means. Those are scare tactics.  I mean, the stock market will go down, banks will go under, but that is just part of the system. There is no plausible scenario under which no bailout gives us a Great Depression type scenario. With people touting a credit crisis, you would never know that a typical 30-year mortgage is going for around 6.0 percent these days. The New York Times recently told its readers that “early on Tuesday (Sept. 30), banks were charging one another the highest overnight borrowing costs ever recorded, as measured by an important rate known as Libor.” That sounds really bad —the highest overnight borrowing cost in history. It would have been helpful to tell readers that this data has only been compiled since 2001, a period of unusually low interest rates. If we want a longer time frame, we can look at the history for the three-month interbank rate. Bloomberg reports that the three-month London Interbank rate (LIBOR) closed at 4.05 percent on Tuesday (Sept. 30). In the same chart, we can find that it was 5.23 percent a year ago.

Those interested in a little more history will discover that the LIBOR rate was over 8.0 percent for most of 1990 and actually topped 9.0 percent on some days in September of 1989. So how scared should we be about interest rates being almost half as large as the three month LIBOR back in 1989? It would be hard to explain how a 4.05 percent LIBOR can shut down the economy, when the interest rate has been more than twice as high in the not-too-distant past. But, that won't fit the New York Times’ credit crisis story, so you won't see the historical data mentioned.

GSI: What would be a better approach for the government to respond?

D.B.: A better way for the government to intervene would be to buy equity in troubled companies it feels need to be saved. That way you provide them with some capital to allow them to keep operating and at the same time insert liquidity into the system. It would be helpful to have a one-time intervention that resulted in some institutions being allowed to fail and others rescued with an injection of capital. That way the markets would know that the surviving institutions are sound. 

GSI: How is the government to choose which institutions can fail and which cannot?  Was the government right to let Lehman fail but then loaning US$ 85 billion to AIG?

D.B.: There is no clear answer to that: a judgment needs to be made on a case–by-case basis. There are two issues. First, how close is an institution to solvency?  If they would require huge injections of capital relative to their size, it generally makes more sense to shut them down. The exception is if they are so tied into the financial system that a failure would create a morass of legal claims (as was the case with Bear Stearns and AIG). In that case, it is better to use whatever money is necessary to keep them afloat. I don’t know whether Lehman and AIG were good calls. It is difficult to determine without looking at their books.

GSI: Some commentators point out that the final cost of the proposed bailout will not be close to the full US$ 700 billion. Realizing that this is hard to answer, how much could this plan ultimately cost, and is the whole amount at risk?

D.B.: It is hard to say how much of that money could be lost. It probably won’t be the whole amount though the whole amount is at risk. The US$ 700 billion will be put in a revolving loan fund to purchase bad debt. What this means is that when a loan is repaid, the money can then be lent out again. In principle the $700 billion can be used to purchase several trillion dollars of assets, but only US$ 700 billion at a point in time. Supposing you lose something like 35% in each round the money is lent out, eventually you can lose quite a bit of money.

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, DC. He previously worked as a senior economist at the Economic Policy Institute and an assistant professor at Bucknell University. His blog, Beat the Press, features commentary on economic reporting. He received his Ph.D in economics from the University of Michigan.