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The Real Impact of the Plan

We now know the first version of the big bailout plan. It gives Paulson virtually unlimited authority to buy and sell up to $700 billion in residential and commercial mortgages, and related securities. Right now the proposal is focused on U.S.-headquartered financial institutions, but that could expand.

So the question now is: Who wins? Who loses? What is the real impact of the plan?

Here’s my analysis. Over the past ten years, Americans overspent by roughly $3 trillion. Which Americans? It’s hard to say. In some cases people borrowed against their homes and spent more than their incomes justified on SUVs and big screen televisions. Part of the overspending came in the form of too many big homes, built in too many suburbs. Part of it came from excess spending on health care, both by families and by the government.

The truth is, we can’t really figure out who overspent. We just know that it happened.

So we have all this excess debt that we can’t afford to pay back, or at least not easily. So somebody is left holding the bag. Financial institutions have absorbed big losses, but they (or their investors)have reached their limit.

So who bears the rest of the losses? Keep in mind that ultimately that $3 trillion in excess debt is owed to the rest of the world, who lent it to Americans, who in turn used it to buy imported goods and services.

So if the debt is going bad, either Americans will bear the losses, or foreign lenders (including many central banks). That is, either Americans dramatically reduce their consumption (and imports!) in order to pay back the loans, or foreign lenders accept that the loans that they made are worth a lot less.

Neither alternative is palatable. The first one would mean a very sharp recession. The second would probably mean a flight away from dollars, a sharp increase in interest rates, and a recession as well. Both alternatives would lead to a sharp drop in imports, and probably global recession.

So what does the plan do? The plan effectively turns mortgage securities into treasury securities, fully backed by the U.S. government, at some discount. It inflicts pain on foreign lenders, but it says: “We are responsible. We will guarantee the rest of the debt.”

So the real impact of the plan is that it maintains the flow of capital from overseas, and allows Americans to keep borrowing to pay for imports, backed up now by the full weight of the U.S. government and its ability to levy taxes.

In effect, the Paulson-Bernanke plan maintains the current structure of the global economy, where U.S. borrowing helps pay for consumption in the U.S. and investment elsewhere.


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