03 October 2008

Casting some doubts

I shall most likely respond to Andre's piece next week. I am currently undecided when it comes to the bailout, but I would like to raise some doubts. The bailout bill passed, so the question is not if it should be implemented, but whether it is a correct policy.

Firstly, although Wall Street firms are in turmoil, this is not the case for Main Street commercial banks. As Alan Reyonold from Cato Institute writes in Forbes:

Contrary to many comments, consumer and industrial loans actually increased in the latest week. Troubled giant banks have cut back on lending, but smaller banks have picked up the slack. Consumer and real estate loans dipped insignificantly through Sept. 17, remaining much higher than they were a year earlier.

Reynolds proceeds with presenting FED data. The question, however, is for how long that is possible. What will happen when commercial banks are hit by current deleveraging in financial markets? Some of commercial banks may have some ties to financial markets and if they lose due to deleveraging, they may seek more cash and limit their credit supply. As the Economist writes:

What hurts finance affects the rest of the economy in spades. Tim Bond, of Barclays Capital, reckons that, thanks to the gearing effect, a shortfall of bank capital of around $170 billion may reduce the potential supply of credit by $1.7 trillion.

Secondly, Professor Eichengreen points out that dollar going down together with fast-growing BRICs will put the American economy on the right track soon. This is self-explaining - decreasing dollar makes exports more profitable. As Eichengreen writes:

And what the contraction of the financial services industry taketh, the expansion of exports can give back, what with the continuing growth of the BRICs, no analog for which existed in the 1930s. The ongoing decline of the dollar will be the mechanism bringing about this reallocation of resources. But the U.S. economy, notwithstanding the admirable flexibility of its labor markets, is not going to be able to move unemployed investment bankers onto industrial assembly lines overnight. I suspect that I am now less likely to be regarded as a lunatic when I ask whether unemployment could reach 10 per cent.

Here understanding Professor Eichengreen is a bit difficult: we can't say if the crisis will touch the economy at large or just the financial sector. My intuition tells me that a 5% increase in unemployment cannot be caused just by layoffs in financial sector, so the latter is most likely true. Nevertheless, the question remains how fast the effect of dollar going down will be, relatively to problems in financial markets affecting other industries.

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