One of my favorite Cleveland sports columnists often does a column of brief observations and insights after a game or big event. I don’t scribble, and I lack a notebook, but watching the AIG bailout has me thinking about a few things:
Wow, that’s a lot of money. To put this in perspective, recall the 2004 Presidential Election, when Kerry was rolled for being for the $87 billion before he was against it. That was a yearly supplemental appropriation to fund the war in Iraq and Afghanistan. Paulson spent about the same to bail out AIG in one day.
This may have avoided an imminent financial crisis, but (and I’m not the first to say this, but its so important as to bear repeating) this 1) did nothing to address the roots of this crisis that got us to this point in the first place and 2) did nothing to address the fact that another shoe dropping seems imminent. Shouldn’t there be hearings on emergency financial sector reform or something?
If Paulson’s gamble pays off, it could affect the character of globalization. For the past two decades or so, international finance has developed largely on U.S. terms and in the U.S. image. The Federal Reserve has stood behind the dollar, which is the world’s dominant reserve currency, and the world’s faith in the dollar has allowed the Fed to cut interest rates in response to global shocks such as Russia’s default in 1998 without risking a run on the currency. Meanwhile, U.S. banks have dreamed up funky new financial instruments that have been marketed all over the world. To a considerable extent, the globalization of finance has meant its Americanization.
The first 12 months of this crisis scrambled that equation. The Fed cut interest rates, as it often does in response to trouble. But this time the world lost confidence in the dollar, which failed to play its traditional role as a safe store of value in tough times and instead seesawed wildly. The innovative U.S. banks lost billions of dollars and were forced to turn for help to the new masters of finance — foreign sovereign wealth funds. And U.S.-style financial innovation suffered a massive reputational blow. No less a commentator than Paul Volcker, the former Fed chairman, has emerged to denounce it.
The longer the financial turbulence goes on, the greater the likely backlash against U.S.-style financial globalization. But Paulson’s gamble — if it succeeds — could limit the damage. By refusing to use the Fed’s balance sheet to bail out Lehman, he may have saved the Fed from becoming further bogged down in its crisis-management role, freeing it to focus more on preserving the value of the dollar. And by repealing the too-entangled doctrine, Paulson may have strengthened market penalties for banks that mismanage modern financial instruments — thereby increasing the chances that sophisticated, market-based finance can flourish safely.
I don’ think folks yet understand how profound this crisis might become. The Dollar as Global Reserve currency allows the US to do all kinds of things that no other country can get away with. The US budget looks more like Argentina in a bad year than the IMF recommended Washington Consensus, but the US can get away with it and Argentina can’t because the US can always sell debt, and there remains a market for dollar-denominated debt. If the dollar loses this preeminent position, the US is in for major major economic turbulence.
In less than a week, the Dow lost nearly 1000 points reacting to the AIG bailout. But, this is a highly skewed indicator, because AID is one of the 30 stocks that make up the Dow. AIG’s loss in value has a direct impact on the Dow–the decline is not a great indicator of the degree of investor mood. Better would be the Dow without AIG or some other indicator. But, the Dow, S&P 500, and NASDAQ are all down about 4-5% today (AIG is part of the S&P also).
Lots of people are making a comparison to the bailout of Chrysler back in the early 80’s. I wonder if the bailout of Mexico in 1994 might be more appropriate–the Treasury and Fed acting on their own to bail out a bad and highly interconnected position in the global economy.
One really hopes that Krugman is right about this: Bernanke is a leading expert on the Great Depression, so he might be able to keep it from happening again.