Larry Summers is certainly right in asserting that the impact of Hank Paulson’s US$700 billion plan on the US fiscal position need not be very large and it will depend very much on how it is deployed and how the economy performs. He is also right in arguing that, in the present difficult economic circumstances, the automatic fiscal policy stabilizers should be allowed to work and that serious thought should be given to a second fiscal stimulus package. However, he would seem to be very wide of the mark in intimating that the damage to the public finances that will result from the present financial and housing market crises will not require the scaling back of aspirations in other areas of fiscal policy such as health care, energy, education, and tax relief.
Much as was the case in Japan and Sweden in the aftermath of their asset price busts in the 1990s, major public expenditure will be required in the United States to address the “once in a century” US financial market crisis and the worst US housing market bust since the Great Depression. As is already apparent in the estimated US$300 billion cost of bailing out Fannie Mae and Freddie Mac and the US$500 billion of mortgage-backed securities on the Federal Reserve’s balance sheet, further large-scale public expenditure will be involved in addressing the acute solvency and capital shortage problems of the US financial sector. And if the downward spiral in housing prices and the associated alarming rise in foreclosures are to be arrested, further large scale public expenditures will be required along the lines of the Home Owners’ Loan Corporation of the 1930s.
A key point that Larry Summers seems to be overlooking is the fact that if the Paulson Plan were to involve the purchase of the banks’ bad assets at fair market rather than at inflated prices, it will have done very little to solve the banks’ acute capital shortage problem, which is the root cause of the very vicious de-leveraging process that is presently underway. Put differently, it is more than likely that the Paulson Plan will soon have to be supplemented by further major fiscal policy initiatives when it is seen that the Paulson Plan at most only partially repaired the banks’ very damaged balances sheet position. Those new initiatives will need to actually address the banks’ solvency problem rather than simply providing liquidity assistance to the banks in their de-leveraging process, which will necessarily be at a considerable budgetary cost.
The fiscal cost of addressing the banks’ solvency problem and of stabilizing the US housing market will add meaningfully to the US net public indebtedness position, as is already anticipated by the rise to record levels in the cost of credit default protection of US government debt. One must also expect that the public debt will be further bloated by allowing the fiscal stabilizers to work and by engaging in additional fiscal stimulus packages as needed, particularly when one considers the poor budget deficit position from which we will be starting.
One would think that, further down the road, the long-run cost of servicing a very much larger US public debt than is the case today will limit US fiscal policy options in much the same way as Japan’s bloated public debt run-up in the 1990s limits Japan’s fiscal policy options to this day. That would seem to be especially the case when one considers the future very negative impact of existing entitlement programs on the US public finances.
Originally published at AEI and reproduced here with the author’s permission.