When the going gets tough, the government gets going. That seems to be the key message from the recent extraordinary events in the US. Many people there seem to be surprised at the nationalization of mortgage agencies Fannie Mae and Freddie Mac and newspapers are full of articles with headlines such as Is this the beginning of the end of capitalism?, We’re all socialists now, or the more flippant Welcome to USSA, the United Socialist States of America.
This is all a bit weird, perhaps because most of us are quite used to the notion that it’s the government’s duty to ensure financial stability. It also seems rather obvious to most of us that companies and government are often hand-in-glove. For some reason, many in the US seem to believe the propaganda about a kind of pristine free market, unsullied by any links between the government and the corporate world. And, this is in spite of Enron and Dick Cheney and the revolving door between Wall Street and the US treasury.
All the heavy-duty corporate public relations seems to have worked wonders. Nevertheless, it is certainly true that the view of the state as “the executive committee of the ruling class” does seem to have been borne out by recent events.
Ideological purity is the least of the US government’s worries. The Chinese government had become very concerned about the fate of the bonds issued by the mortgage finance agencies, as it had invested heavily in them. According to The Wall Street Journal, senator Charles Schumer from New York said he was told by government officials that foreign investors were threatening to bail out and that there was a real fear that foreign governments would start dumping these bonds. And since the US depends on the kindness of the Chinese and other foreign central banks to continue to recycle their surpluses into US bonds — helping to keep liquidity high and interest rates down — the authorities had to do something to reassure these powerful investors.
In short, if the government didn’t want an unravelling of Bretton Woods 2, the informal international system that has propped up the global economy since the 1990s, it had no option but to bail out the mortgage agencies.
In fact, socialization of housing losses already has a precedent in the US. In the late 1980s, a housing bust bankrupted a large number of regional banks and special institutions for savings and mortgages, known as the savings and loans, or S&L, institutions.
According to Wikipedia, “the ultimate cost of the crisis is estimated to have totalled around $160.1 billion (Rs7.19 trillion now), about $124.6 billion of which was directly paid for by the US government... which contributed to the large budget deficits of the early 1990s.”
By all accounts, the problem this time is far more severe, with some calling it the greatest housing bust since the Great Depression of the 1930s. William Poole, former president of the US Federal Reserve Bank of St Louis, is reported to have said on Monday that the treasury may need to cough up $300 billion in losses.
What was the experience of the stock markets to the bailout of the US mortgage institutions in the 1980s? Resolution Trust Corp., which took over the assets of the insolvent mortgage institutions and disposed of them, was formed in August 1989 and the Standard and Poor’s (S&P) 500 index closed that month at 351. Twelve months later, at the end of August 1990, the index was at 322. The first Gulf War then intervened and it wasn’t until the middle of 1991 that the S&P 500 decisively moved up from the range it was stuck in. US gross domestic product (GDP) growth slowed from 3.5% in 1989 to 1.8% in 1990 in real terms, before turning negative in 1991. The bottom line — a government bailout of the housing sector, even if it works, takes time to work through both the stock market and the economy.
What about the rest of the world? The word “globalization” hadn’t even been coined in the 1980s. Yet GDP growth for the world as a whole slowed from 3.7% in 1989 to 2.9% the next year and slumped to 1.4% in 1991. For the developing Asia, GDP growth fell from 9.1% in 1988 to 6.1% in 1989 and then to 5.5% in 1990. Most interestingly, private portfolio flows to the developing Asia, at $1.1 billion in 1988, turned negative for the three years 1988, 1989 and 1990 before recovering to $1.9 billion in 1991.
In short, if the US is down and out, you can’t count on any kind of decoupling — but equity markets recover before the economy does. Also, direct investment to the developing Asia wasn’t affected at all during the slowdown, and in fact, went from strength to strength. The prices of both crude oil and industrial commodities fell during the downturn. As a result, inflation in the developing Asia region went down from a high of 14.9% in 1988 to 7.1% by 1990. To cut a long story short, even after the socialization of a housing bust, the recovery takes years.
Also, 2008 is not 1990. The US housing bust in the 1980s was not accompanied by either securitized loan tranches or exotic credit derivatives. The boom in housing, too, had not been so impressive.
At the moment, nobody knows how much the bailout is going to ultimately cost the US government. All that can be said is that, just as the bubble this time has been gigantic, the bailout too has to be equally colossal. The US government has embarked on a gamble of truly heroic proportions.
To read all of Manas Chakravarty’s earlier columns, go to www.livemint.com/capitalaccount
Manas Chakravarty looks at trends and issues in the financial markets. Your comments are welcome at firstname.lastname@example.org