Wednesday, October 15, 2008

Economics 101 -2: Before the Debate

So much for the Monday evening prognosticators who saw last Monday’s 936 point rebound in the Dow Jones average as the signal that the market had bottomed out. Yesterday’s 77 point loss has been eclipsed by today’s 733 point nosedive.

The Treasury Department has announced it will distribute the initial $250 billion of the $700 billion Congress voted to make available to the Secretary of the Treasury to stave off complete collapse of the credit markets. The nine largest banks in the country will receive the bulk of the funds on condition that the funds be used to maintain liquidity in the credit markets and not simply be “locked” away in the vaults of those receiving the monies.

For their part, the banks receiving the Treasury largess will have to issue non-voting preferred stock in the banks that will pay 5% interest annually to the Treasury for the first three years. Should the stock remain unredeemed at the end of the three years, the interest rate will jump to 9%. Bank executives would have to accept some ceiling on their annual compensation, and dividends could not be paid without first notifying the government. Financial pundits in both major parties and on both wings are already arguing whether this “semi-nationalization” of the financial sector will mark the tipping point of post World War II capitalism.

Interestingly, many of the regional banks that Treasury Secretary Henry Paulson is trying to bring on board in the effort to spread “liquidity” more quickly and smoothly (like butter on hot toast) are resisting. The chief objection goes quite far in explaining how the financial meltdown managed to get as far as it did before any action was initiated. Simply put, those who were charged with oversight of the operations of the financial sector and of oversight of the regulatory apparatus simply failed to do their jobs.

As detailed in the Washington Post (October 15, 2008), an economic Rubicon was crossed in April 1998 when three of the economic gurus in the Clinton administration – the head of the Securities and Exchange Commission, the Chairman of the Federal Reserve Board, and the Treasury Secretary (all from Wall Street) rejected a suggestion by their peer from the Commodity Futures Trading Commission to look into a new financial instrument called a “derivative” to find out what effects it was having on the markets.

Given the rampant opposition in the Republican Party to any regulation that even remotely hinders the “free market,” when the GOP took the White House in 2000 the outlook for any restraint or discipline disappeared. More alarming today – in addition to the actual free-fall in the market, is that two of the chief advisors to the Democratic contenders are familiar from the 1998 meeting.

Not to worry, however, for both now confess to believe in some regulation to prevent irrational exuberance.

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