Recession Politics Will Push Massive Bailout Plan

With Fed rates cuts seemingly ineffective and the dollar plunging, all signs point to an expensive government fix for the housing crisis.

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"Look, if we have a recession, it's not the end of the world," is how one well-known economy bear succinctly summed up things in a recent chat with me. A simple point but one worth keeping in mind these days. Superinvestor Warren Buffett, who does think the economy is in recession, is also keeping any downturn in perspective: "Over time, my children are going to live better than I do, although they don't believe it."

Indeed, recessions are hardly an indictment of capitalism or free markets. We'll always have downturns from time to time as long as workers, owners, consumers, and investors are imperfect humans rather than superintelligent machines. That said, I think we have four possible economic paths in front of us right now:

1) Keep cutting rates. This seems to be what the Fed is going to do in order to contain the spreading credit crunch and avert a really nasty, 1982-style downturn. Of course, that strategy—which the European Union is not buying into—is absolutely killing the dollar and fueling further speculation in commodities. That, in turn, is actually boosting U.S. inflation, hurting the purchasing power of consumers. (Inflation is a tax of sorts.)

And while lower short-term rates will help homeowners with adjustable-rate mortgages and home equity lines of credit, it doesn't seem to be helping fixed mortgages rates, which are at a three-month high. Now the Fed hopes that the softening labor market will help bring down inflation and that commodity prices will stabilize. But, to use the Fed's new favorite phrase, "adverse feedback" effects seem to be sapping its rate-cutting strategy of its effectiveness.

2) Do nothing. That is the preferred path of many Capital Commerce readers. Let the market correct and provide a stark warning to future real estate speculators on Main Street and financial engineers on Wall Street. But listen, folks, this is America. We don't do pain, especially in an election season. I think this strategy is a nonstarter.

3) Go for growth. One way people deal with weak real income growth is by borrowing against or selling assets, like stocks and homes. But as JPMorgan economists Bruce Kasman notes, "At a time when both stock prices and housing wealth have been declining, households may be reluctant to sell assets. This is another way of saying that wealth effects on consumer spending are turning negative."

We could turn that around by slashing the capital-gains tax to, say, 5 percent for people making over $250,000 and zero for everybody else. That would increase the after-tax return on housing and stocks and boost prices. Such a bold move might well reignite the economic expansion, which would also alleviate the housing crisis. Consider this: An analysis of the economy from 2001 to 2006 by Allen Sinai, chief economist of Decisions Economics, found that if neither of the 2001 and 2003 tax cuts had been enacted, U.S. economic growth would have been 0.7 percent less each year and the unemployment rate would have been 1.2 percentage points higher over 2001 to 2006 than it actually was. But the economy really didn't take off until the 2003 capital-gains cut. Unfortunately, this option is about as unlikely as the do-nothing option because of election-year politics and the Democratic congressional majority.

4) Settle for a bailout. All signs seem to be pointing in this direction. Alan Blinder, former Fed vice chair, has proposed a $300 billion plan for Uncle Sam to refinance 1 million to 2 million mortgages to stem the deluge in home foreclosures and prop up home prices. Now I know Hank Paulson has scowled at the idea of a game-ending bailout, but Federal Deposit Insurance Corp. chief Sheila Bair says the White House has not ruled it out. I think Team Bush is giving Bernanke and his rate cuts, as well as the fiscal stimulus package, a bit more time to bite before embracing a return to the New Deal. Still, Alex Pollock, former chief executive officer of the Federal Home Loan Bank of Chicago, recently told U.S. News that it is "virtually certain" that lawmakers will act.