The vote on Monday, September 29 in the House of Representatives to reject the
$700 billion Paulson troubled asset relief plan (TARP) was regrettable—not because the design of the TARP is flawless but rather because a failure of the US administration and the Congress to agree on an effective systemic approach to managing this increasingly worrisome financial crisis can only depress confidence further. The historic decline in US equity markets following that negative vote—the difficulties at Wachovia Bank notwithstanding—was hardly a coincidence.

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The following essay traces the origins of the current crisis, assesses the actions of recent weeks, and suggests ways to implement the Troubled Asset Rescue plan before Congress. The Troubled Asset Rescue plan, this piece says, “may be enough to settle markets” but that “it would be a mistake to assume that the worst is behind us.” Because of the risk of failure, the authors urge that a Plan B be prepared now. They outline possible elements, including establishment by the Treasury of a “preferred equity injection program” for major financial institutions.

In order to figure out how to combat the current economic crisis, it is important to understand what kind of crisis we are dealing with. The conventional wisdom is that we are dealing with a housing crisis (falling housing prices) magnified by excessive leverage. But this puts the emphasis in the wrong place, and fails to grasp the key dynamics of the crisis.

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The global credit crisis is entering its fifteenth month. This crisis is different in its origins, but its contours are familiar to anyone who was watched such crises over the past several decades or to anyone who has studied the history of earlier crises. Those regularities include the replacement of greed by fear and the slow adjustment by policy makers as they gradually recognize that rules have to be broken.

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Should the United States be concerned about ending up like Japan in the 1990s? There are signs that American policymakers are worried about just such a development. By this they and other economists mean the threat of an extended recessionary period of sub-par growth, and an inability to sustain a recovery, apparently because of bad assets weighing down the economy’s financial system. Last week’s lock-up in the US commercial paper and short-term lending markets for solid non-financial corporations, reminiscent of what preceded the real economy nose-diving in Japan in 1997-98, made the prospect all the more real.

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The continued danger levels on a leading indicator of bank stress suggest it is time to complete the Troubled Asset Relief deal rather than delaying for additional Monday morning quarterbacking.

The “Ted Spread” between the interest rate paid on short-term US Treasury paper and the London Inter-bank Offer Rate (LIBOR) is one barometer of financial sector stress. A flight to quality depresses the return on short-term government paper, while a reluctance of banks to lend to each other causes the LIBOR rate to rise.

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We can now confirm a major outbreak of democratic accountability in Washington this week. When I wrote my first op-ed of the week, which appeared in the Washington Post on Tuesday, my fear was that the Treasury would get exactly what it asked for in its, let’s say, rather succinct proposal to establish a government-owned and Wall Street-managed $700 billion hedge fund.

Instead, there has been a great deal of debate and some pretty serious pushback from Capitol Hill, but also from a wide range of others—I’ve been amazed at some of the supportive conversations I’ve had in the past 24 hours with people across the political spectrum. In retrospect, a social movement, no doubt short-lived, but pretty energized and well focused, sprung into being sometime over the weekend. But it wasn’t until we all opened the papers on Tuesday morning that it was clear what was going on. A lot of people said: hold on, we’re in a hurry but there is no need to stampede, so let’s take a bit more time and argue out some of the key alternatives.

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The financial crisis has been raging for 15 months. One shoe that has yet to drop has been the dollar. Against major currencies the greenback has declined on balance only 4 percent since June 2007 though it dipped 11 percent through April before coming back until recently. The risk is that if the US authorities are not perceived to have their act together, a renewed rapid decline in the dollar will open up a new front in the crisis. At a minimum, it is more than likely that the Bush administration will be defending the dollar before it leaves office on January 20, 2009, and it should be open to doing so.

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Treasury Secretary Paulson made many important decisions last week in response to the national financial emergency. One of them however—the decision to use the Exchange Stabilization Fund (ESF) to guarantee the assets of money market mutual funds—was a mistake. The size of the ESF, the need to preserve it for other contingencies, and problems with Treasury’s existing authority, make its use for this purpose a risky tactic, a stop-gap measure grabbed hastily in the midst of a crisis. There are better ways to maintain confidence in money-market mutual funds. As they design legislation for what has been called the “new Resolution Trust Corporation,” Secretary Paulson and the US Congress should shift support for money market assets from the ESF to the new entity.

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The Bernanke-Paulson proposal to spend $700 billion to shore up the financial system can be helpful if done wisely. That will require only purchasing assets at prices reflecting their medium-term value. Doing so would provide much needed liquidity while promising minimal costs to taxpayers.

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