Consequences of no bail-out

The US banking system is like Schrödinger’s unfortunate cat. Until the US Congress decides to back the bail-out package or not, it is caught in a curious state between death and undeath. What are the consequences of either result?

Life, with a variant of the Paulson plan, should be calmer. If the Treasury can create prices for mortgage backed paper by acting as a buyer, it will have two positive effects. Capital that is now useless will re-enter the system. And reasonable valuations will help banks to come clean about their exposure. Bank failures lie ahead – the credit party hangover must still be faced – but some trust should return. The Federal Deposit Insurance Corporation should then be able to deal clinically with stricken institutions as it has done so far, without paralysing the system.

However, if the plan is blown away by political winds, bank funding will continue to dry up as cash is hoarded. Commercial paper markets will remain dysfunctional. Absent such short term funding, companies will be forced to draw more heavily on pre-arranged revolving credit lines. Money market funds, the arteries of the economy, could again seize up. Bankruptcies, both financial and otherwise, will follow.

A great depression, however, will not. It will be unpleasant, but banks have suffered bouts of distrust before. The eurodollar Ted spread – which measures the difference between the risk-free rate of US T-Billls and interbank lending rates – was above current levels for prolonged periods in 1973-74, and in the early 1980s. Merrill Lynch, using IMF data on the 124 banking crises of the past 27 years, points out that the cost to the taxpayer averages 13 per cent of GDP. The greater the spending, it seems, the smaller the hit to growth in the following years. The longer it takes the authorities to start cleaning up, the greater the eventual bill.

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