We just learned today that the House of Representatives voted in favor of the TARP plan and President Bush signed it into law. This makes $700B available to the Treasury to buy “toxic” assets from the banks.

OK great, so now what??

If you’ve been reading my blog, you know that I supported the proposal (in principle). For me, the key was taxpayer protection – that taxpayers would receive an equity stake in exchange for putting their capital at risk, and that there would be ample oversight of the Treasury in implementing the plan (see A Letter to Main Street and Letter to My Senators for background). I believe that we received a decent deal with respect to the former (the equity part), but it’s unclear that the taxpayers received sufficient concessions with respect to the latter (the oversight part).

Nevertheless, it was my position that something needed to be done to stave off an imminent financial calamity, and that the consequences of inaction would be far greater than the consequences of imperfect action. So although the plan, as signed into law today, leaves much to be desired, to me, it is better than none at all.

Even so, I suggested that this plan might not be enough to solve our economic ills. In a recent post, A Letter to Main Street, I hinted that it was unclear if the plan would work and promised to explain why. I’m trying to make good on that promise now.

There are several issues with the plan that suggest that it might be a difficult one to make work. These are some of the considerations that I feel are important. Feel free to add others that I may have overlooked:

1. The plan is too small relative to the overall problem. The main issue here is that in the end $700B is not nearly enough to tackle the problem. By some accounts, in order to properly address capitalization and credit problems, an amount in the order of $2-4 Trillion is closer to reality. In this respect then, the $700 Billion may just represent a drop in the ocean. Many experts have suggested that in addition to the purchase of assets, banks will need to be further recapitalized, and it is unclear that private investors are willing to do that, even with the Treasury taking $700B of assets off bank books. What is clear to me however is that the TARP is just one of many additional measures that the Fed/Treasury/U.S. Gov’t will have to take to restore confidence.
2. You can give banks money, but you cannot force them to lend. Forget for a moment that this plan is structured as a purchase of assets. Even if this were simply a cash giveaway, you can’t force the banks to lend. Giving them money will not suddenly restore their faith in counterparties and solve the confidence problem.
3. Borrowers may be scarce. Just because banks may be suddenly flush with cash (and it is unclear that the TARP will accomplish that), and assuming banks are willing to lend, this does not mean that there will be demand from prospective borrowers. Borrowers of all kinds are sufficiently scared that they’ve already tightened their belts – deciding not to consume and/or invest. In this sense then, credit will contract irrespective of how much capital the banks have on hand.
4. Buyers of paper backed by assets against which the banks lend are on strike. If we give the banks capital and they lend, who will buy the paper? The reputation of these institutions may have been tarnished to the point that buyers might not be willing to come back into the market and buy the asset-backed paper issued by the banks. After having been burned by the banks the last time, they may lack trust in these institutions. And banks depend not only on the ability to make money lending, but also to make money selling paper and re-lending the proceeds. If buyers are not willing to buy the paper so that the banks are able to re-lend, then really all that has been created is the equivalent of the economic stimulus plan. The money gets spent once, and then the banks are stuck sitting on paper again (only hopefully better paper this time).

The approach of the TARP then, as I see it, is to attack the problem by addressing the supply side (supplying capital to the banks). Overall, it’s unclear to me that anything has been (or even can be) done to address the demand side. This is where the rubber meets the road.

While I hope for the best, my fear is that even if the TARP addresses the interbank credit problems (which it does not entirely), confidence among both borrowers and buyers will take a long time to return. The end result is still long and protracted recession. I am just hoping the plan is enough to avoid a depression.

For greater detail (in flowchart format) about the costs associated with the TARP plan, see Steve Keen’s excellent, and funny, post (Why it Can’t Work) at RGE Monitor.

This entry was posted on Friday, October 3rd, 2008 at 5:19 pm and is filed under Economy. You can follow any responses to this entry through the RSS 2.0 feed. You can skip to the end and leave a response. Pinging is currently not allowed.