Sunday, September 28, 2008

The Bailout Explained by the CBO

Peter Orszag, Ph. D., Director of the CBO

The Director of the Congressional Budget Office (CBO), economist Peter Orszag, publishes a blog with detailed information about the issues shaping current legislation. In his role as the leader of the non-partisan research office of the U.S. Congress, Dr. Orszag is the ultimate insider--a primary source of impartial information to which Members of Congress often turn when seeking deeper insight.

Of course Dr. Orszag has posted a number of comments over the past few weeks on the current liquidity crisis. For example, the article posted 26-Sept-08, entitled Net Budget Cost of Treasury Proposal, begins:

A Wall Street Journal blog posting mischaracterizes CBO’s testimony earlier this week on the net budget impact of the Treasury proposal to buy troubled assets. The Wall Street Journal blog states that the plan “likely won’t have any effect on the 2009 budget deficit.” That is incorrect.
Orszag goes on to discuss how the plan would impact the 2009 budget deficit with the kind of specificity and understanding typically lacking in media coverage.

In his remarks of 25-Sept-08, Troubled Asset Relief Act and Insolvencies, Director Orszag focuses attention on the distinction between competing goals: increasing liquidity for the financial system as a whole and avoiding insolvency at particular financial institutions.
A company holding an overvalued asset would have to write down the value of that asset not only if it actually sold that asset to the government at a price beneath its current book value, but also if other companies sold comparable assets to the government at a price beneath that book value. This is the essence of mark-to-market accounting.

...Even if this process revealed more financial institutions to be insolvent, the result would not necessarily worsen the financial crisis. As I stated in my testimony yesterday before the House Budget Committee, the current crisis is fundamentally one of collapsing confidence in the financial markets and “providing more transparency about the lack of solvency at specific institutions may be necessary to restore trust in the financial system.”

...Financial markets face two distinct, but related, problems. One problem is that the markets for some types of assets and transactions have essentially stopped functioning. To address that problem, the government could conceivably intervene as a “market maker,” by offering to purchase assets through a competitive process and thereby provide a price signal to other market participants. That type of intervention, if designed carefully to keep the government from overpaying, might not involve any significant subsidy from the government to financial institutions. The second problem involves the potential insolvency of specific financial institutions. Restoring solvency to insolvent institutions requires additional capital injections, and one possible source of such capital is the federal government. Although the problems of illiquidity and insolvency are interrelated, they are at least conceptually distinct. Indeed, some policy proposals appear to be aimed primarily at the illiquidity of particular asset markets, and others appear to be aimed primarily at the potential insolvency of specific financial institutions. The Treasury proposal appears to be motivated primarily by concerns about illiquid markets. The more the government overpays for assets purchased under that act, however, the more the proposed program would instead provide a subsidy to specific financial institutions, in a manner that seems unlikely to be an efficient approach to addressing concerns about insolvency.

We expect to learn more about how well policymakers have actually performed when the revised proposal is published, which is expected to happen later today. It is difficult for this consultant to remember an economic episode that played out more dramatically or with greater consequences.

Update: Review of the Emergency Economic Stabilization Act of 2008, signed 3-Oct-08.

The Senate passed a modified version of the bill, now called HR1424, the night of 1-October-08. A letter of summary and analysis of that version was prepared by Director Orszag for Sen. Dodd. That bill is expected to be put up for a vote by the House 3-October-08. If passed without amendment, it will go to the President, who will then have 10 days to sign it into law.

A collection of our posts about the US Economy is maintained here. See also The Case Against the Paulson Plan and Can the Banking System Hold Water?

A permanent link to the CBO Director's Blog has been added to Reference Websites.

See Key Provisions of the Bailout Plan as summarized by Reuters 28-Sept-08. For the complete text of the 28-Sept-08 version of HR 3997 The Emergency Economic Stabilization Act of 2008, click here.

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