Santa Claus has come to Wall Street three months before Christmas. The US government has said it will put in place a massive plan to bail out that country’s troubled financial sector. There is still too little information about the details of this plan — how big the eventual bill will be and who will pay it. But its very announcement last week has buoyed stock market sentiments, also helped by the ban on short sales imposed by securities regulators in many countries.
Illustration: Malay Karmakar / Mint
Traders are clutching at straws. While it is becoming increasingly clear that public money is being used to clean up the mess left behind by private indulgence in the US financial system, the actual bailout plan will have to be cleared by American legislators. That is when the issue of the size of the bill is likely to come to the fore.
One of the trickiest questions will be how to value the toxic debt that has choked the US financial system. Valuing it liberally will add to the bill. Valuing it very low will make the whole exercise pointless. Already, numbers between $700 billion and $1 trillion are being bandied about. In comparison, the savings and loans bailout of the early 1990s cost $160 billion.
The money will have to be rustled up over the years from ordinary US families and companies — through higher taxes or higher inflation. Either way, there will be second-level effects on the US budget gap, economic growth, the value of the dollar and US interest rates. All these will hurt stock values in the medium term.
Few seem to realize we are in the middle of an asset deflation that was long overdue. A combination of low interest rates, financial innovation run riot and perverse incentives in trading rooms conspired to create a bubble that has been pricked. Even as public authorities in the West use public money to clean up the mess, it is time to ask whether the era of financial capitalism that began in the late 1990s is now over.
It is very likely that the US financial sector will shrink in size over the next few years. In fact, International Monetary Fund managing director Dominique Strauss-Kahn said in Cairo last week that “the financial sector not only in the US but in the rest of the world at the end of the crisis is going to be smaller than the financial sector today”. We doubt this prophecy will apply to countries such as India that still need financial deepening, but there is ample reason to agree with him on the broader forecast. These will be hard times for the financial sector and the real economy in the US — even if close to a trillion dollars are thrown at them.
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