"We've planned for various contingencies" is how one economic adviser to Barack Obama recently described to U.S. News—while declining to go into the messy details—how a future Obama administration would respond to a worsening of Wall Street's credit crisis.
This cautiously cryptic statement was made pre-Lehman bankruptcy and before insurer AIG went into its death spiral, forcing the Federal Reserve to extend an $85 billion loan and take an 80 percent ownership stake. Yet now the candidate may be hinting at just what the Wall Street endgame might look like. Obama was asked about an idea gaining momentum in Congress whereby Uncle Sam—aka the American taxpayer—would cowboy up and actually buy distressed debt and mortgages. (It would be sort of an updated version of the Resolution Trust Corp. from the savings and loan crisis of the 1980s.) After first begging off, Obama later seemed to indicate that it was a 2009 possibility.
After the voting. Surely, one option for the next president, Obama or John McCain, will be for the government to take bad debt off the hands of the banks. Former Treasury Secretary Larry Summers has written recently that "consideration should be given to whether the government should establish a mechanism for purchasing assets from stressed banks in return for warrants or other consideration." International economist and blogger Brad Setser sees a similar outcome: "After the U.S. election, I suspect the debate will shift toward the need for such a systemic solution."
"Systemic solution" is econ-geek talk for the mother of all bailouts. And in the end, banking bailouts are kind of like what Tolstoy said about happy families: They are "all alike." One way or another, the government steps in. Big time. It's just a matter of how soon the action is taken and how dramatic it is. One of the most frequently cited examples is the so-called Stockholm solution, undertaken by Sweden's government after a real estate boom led to a banking crisis in the early 1990s. In fairly short order, the government extended massive loan guarantees and nationalized faltering institutions. In the end, nearly a quarter of all banking assets fell under state control at a cost equal to around 4 percent of that nation's gross domestic product.
Economists consider that government's actions a big success, crediting, in particular, its rapid response to the crisis. (By comparison, Japan took nearly a decade to come to the same policy conclusion during its 1990s banking crisis.) A complete financial collapse and depression were averted. Economist Edward Harrison, coauthor of the Credit Writedowns blog, thinks the United States will eventually follow Sweden's example but, like Japan, is moving way too slowly. "I still don't think the politicians get it," he says.
But maybe not. Maybe last week's AIG rescue shows that policymakers are now shifting into rapid response mode. Yet even if that's so, it may not be enough to avoid tough times ahead. Note the conclusion of a Federal Reserve analysis of the Stockholm solution: "In the early 1970s, Sweden had one of the highest income levels in Europe; today, its lead has all but disappeared.... So, even well-managed financial crises don't really have happy endings."