The rejection of the Paulson plan by the US House of Representatives was an irresponsible exercise in political brinkmanship. The consequences go well beyond the panic in the stock markets. In the West, inter-bank lending has become almost non-existent and banks are collapsing like dominoes. Confidence in the system has evaporated. And thanks to America’s place in the global economy and because the dollar is the global currency, what affects the US affects the whole world.

Illustration: Jayachandran / Mint

Of course, the US authorities could step in and try to mitigate the damage with the tools that they already have. They could, for instance, continue to prop up banks and distressed financial institutions on a case-by-case basis, as they have been doing in the past. They could continue to pump in ever increasing doses of liquidity, including supplying dollars under swap agreements with other central banks to help money markets in other countries. But the problem with this approach is that they really have nothing new to throw at the markets and what they have done earlier hasn’t really worked. Solvency, not liquidity, is in question. As a matter of fact, on Monday morning when the Paulson plan was expected to be passed, the stock markets continued to plunge and the credit markets were dysfunctional.

But if American lawmakers can be prevailed upon to stop their political posturing, the crisis could in fact be converted into an opportunity. That’s because the Paulson plan, too, was in many respects a hastily cobbled programme, with several glaring loopholes. Importantly, it did nothing to recapitalize the banking system, nor did it do anything to address the problem of housing prices falling even lower in the US. These uncertainties would have continued to plague the markets even if the bailout package had been passed.

The task ahead is to restore confidence in the system. For that to happen, two things need to be done. One, it is essential to have a comprehensive, well-thought-out plan to stabilize the system. Two, it must be done expeditiously. There are several attractive options, perhaps the best being the example of the recapitalization of the Swedish banks in the early 1990s. The approach taken was to allow the worst affected among them to go under, forcing other banks to write down their losses and then issuing cheques for recapitalizing the system in exchange for equity. At the other extreme, Japan is an example where the state dithered for too long before stepping in to rescue the system, with the result that the crisis has dragged on and on. Unlike Japan, however, the US runs a huge current account deficit. Further dithering by US lawmakers could well result in a complete loss of faith in the US financial system.

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