The Meltdown (Part II)

The easy answer to why the bailout hasn’t worked is it hasn’t been implemented yet. But its purpose was largely psychological – to boost confidence that the government is doing something big to clear out bad debts that have been clogging the system. That psychological boost should have happened as soon as the bailout was enacted.

Yet no one seems to believe that 700 billion dollars will make much difference. And today’s interest-rate cut, coordinated with the European Central Bank and Bank of England, may not, either. This isn’t a liquidity crisis. It’s a crisis of trust. Lenders don’t trust that borrowers will be able to repay, because they don’t think borrowers will be able to collect on what’s owed to them. Every major player is moving to safer ground – holding money, hoarding it, putting it under a giant global mattress.

Bad mortgage loans from the era of anything-goes credit standards started it. But now that America is tipping into deeper recession and unemployment is mounting, more bad loans are cropping up because more people can’t pay their bills. And as consumers pull in their belts, more businesses can’t pay their bills. Which means more layoffs, and more bad loans, and a global sell-off.

The Fed and other central banks can pour endless money into the system but the problem is no longer just on the supply side. It’s now also on the demand side. Which means the federal government, as spender of last resort, has to jump start the economy, as do other governments. Now’s the time to start rebuilding our crumbling infrastructure – roads, bridges, levees, public transit. And help cash-starved state and local governments invest in their schools.

It does make sense to help homeowners directly, as Barack Obama has said. But John McCain last night came up with the stupidist plan I’ve heard yet for doing so. He wants the government to buy mortgages from the banks at face value and then write down the principal for homeowners. This would be the biggest handout yet to the financial industry. Taxpayers would take all the losses, including the downside risks of additional defaults if houses drop further in value, while the banks would get off scott free.

Originally published at Robert Reich’s Blog on Oct 9, 2008 and reproduced here with the author’s permission.