Economists see financial bailout as necessary - Yahoo! News

Economists in the US are calling this week’s bailout of numerous US companies a necessary step in ensuring that no permanent harm is caused to the financial system and that we do not head into a deep recession.

The Treasury Department under the leadership of Henry Paulson is currently asking congress to move quickly on a bill that would provide $700 billion to the Department to buy up much of the bad debt that many financial institutions have incurred over the past years. Where’s this money going to come from? Since it doesnt look like the Bush Administration will be pushing for increased taxes anythime soon, Congress will have to borrow the money. 

Though most economists are agreeing that this is a necessary step in ensuring the integrity of the economy, I believe that it is important to look at how this additional debt may effect our government and economy in the future. So lets start with some numbers. The following statisitics are taken from the above article.

The deficit for this budget year, which ends on Sept. 30, is expected to rise to $407 billion, a figure that is more than double the $161.5 billion imbalance for 2007, reflecting what the economic slowdown and this year’s $168 billion economic stimulus program are already doing to the government’s books.

The Bush administration is estimating that the deficit for the budget year that begins Oct. 1, which will cover the new president’s first year in office, will hit $482 billion, a record in dollar terms.

And that forecast doesn’t include the $200 billion the administration committed to spending two weeks ago when it took over the nation’s two biggest mortgage companies, Fannie Mae and Freddie Mac.

And it doesn’t have any of the $700 billion the administration is seeking to soak up the bad mortgage-backed securities that have been at the heart of the severe credit crisis the country has been struggling with since August 2007.

The legislation the administration is now seeking to authorize the financial system bailout, according to a draft obtained by The Associated Press, would boost that debt limit to $11.3 trillion, up another $700 billion.

It is the rapidly rising debt that is cause for concern. The government is already spending more than $400 billion a year just to pay interest on the national debt. The higher that debt goes, the higher the government’s borrowing costs and the less it has to spend on other programs.

Discussion Questions:

1. What impact does the knoweldge that the government will bailout struggling financial firms have on investors willingness to take risks?
2. Should the government intervene in these finacial markets or leave the “invisble hand” to its own devices?
3. What are the opportunity costs associated with this decision?
4. What are some short term and long term implications of this bailout?

Judging by today’s headlines, things aren’t looking too hot for the US economy:

• Job losses, unemployment both worse than forecast - Apr. 4, 2008
• Dollar slips against euro, yen on jobs - Apr. 4, 2008
• BBC NEWS | Business | Oil price edges up on Opec stance
• FT.com / Asia-Pacific / China - US economy is ‘down sharply’, Paulson says
• Bernanke Nods at Possibility of a Recession - New York Times

From the last article:

In his bleakest economic assessment to date, the Federal Reserve chairman, Ben S. Bernanke, said Wednesday that the American economy could contract in the first half of 2008, meeting the technical definition of a recession, and he encouraged Congress to help homeowners caught up in the mortgage crisis.

For the first time during his three years in the job, Bernanke has admitted we could be in a recession, defined as two consecutive quarters of negative GDP growth. By June, we could very well have experienced just such a decline in output; every central banker’s nightmare!

The source of America’s economic woes? Weak housing market. In fact, house prices have fallen around 10% nationwide over the last 12 months. To understand why, we need to recall the basic microeconomic principles of supply and demand. Quite simply, too many homes were built over the last decade, as low interest rates and optimism about the continued strenght of the housing market (rooted, of course, in the irrational exuberance about the economy as a whole) led builders to expand the suburban sprawl like never before, anticipating growing demand forever into the future. Problem was, demand couldn’t keep up with supply, and now the price is starting to reflect this basic economic principle.

To make things more complicated, many home buyers over the last seven years should never have been given loans based on their credit histories and household incomes. Many of these buyers were thus given “sup-prime” loans, many with adjustable interest rates, which means that today people who were too poor to get a normal loan four years ago are seeing their monthly payments increase just as the economy is slowing down. Rising unemployment puts downward pressure on wages, and inflation (caused by rising energy and commodity prices) forces poor homeowners to allocate more of their wages towards food and electricity, making it doubly hard to make their monthly mortgage payments.

The outcome is predictable: foreclosures. Banks that made loans to uncreditworthy buyers are now taking the houses back and putting them on the market for really low prices, putting even more downward pressure on all home prices. Since their homes make up the majority of Americans’ wealth, and since wealth and disposable income are the main determinants of consumption, inflation and falling home prices both lead to huge decreases in consumption.

The cycle continues: declines in household consupmtion signals to firms that it’s a bad time to invest, so investment spending declines. As consumption and investment fall, aggregate demand shifts in, causing output and employment to fall, hence our current recession.

“It now appears likely that real gross domestic product, or G.D.P., will not grow much, if at all, over the first half of 2008 and could even contract slightly,” he said. “We expect economic activity to strengthen in the second half of the year, in part as the result of stimulative monetary and fiscal policies.”

For now, however, judging by today’s headlines, conditions will continue to worsen for the American worker, homeowner, consumer and firm.

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Promotional Fax Mistaken for Bomb Threat - washingtonpost.com

I don’t know, but I would say the American people are a little on edge these days. What does it say about our society when a paranoid bank employee receives a fax and calls in the bomb squad? The arrival of the threatening fax coincided with the arrival of a “suspicious” package, escalating the fears of the terrified bank staff. Turns out the fax was from the corporate office, and the package contained some paper files, but by the time police figured it out 15 local businesses and a nearby day care’s 30 children had been evacuated from the area!

Okay, so this story may not appear to have much to do with our Econ course… or does it?

Discussion questions*:

1. What impact might mass paranoia about terrorism have on the macro economy? Explain.
2. Would the free market provide the security and protection needed to ensure a healthy and safe environment for investment? Why or why not?
3. What is the term for a service or product that provides spillover benefits for society but which is under-provided by the free market (such as a police force)?
4. Do you think the bank employees were right to be frightened by the threatening fax? Is their fear rational or irrational given the political and social climate in America today?

*From now on, most of the posts on this blog will include discussion questions. These are meant to help students start their own discussion about the issues raised in the posts and how they connect to our economics course. Posts like this one are tagged with a category, and next year when we get to a particular topic in our Econ course, students will be asked to find a past post from that category on the blog, read it and post their comments. This will become a part of students’ grades. To see how the blog will graded, click here.

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