What Comes Next?

The Economic and Budgetary Consequences of the Financial Bailout

On Wednesday, October 8th, experts from private industry, think tanks and government came together on two panels to discuss the recent financial crisis and its effect on future policy. The first panel discussed the economic conditions surrounding the bailout and possible government responses, and featured Mark Zandi of Moody's Economy.com, Martin Baily of the Brookings Institution, Rob Dugger of the Tudor Investment Corporation, Dean Baker of the Center for Economic and Policy Research, and Tim Adams of The Lindsey Group. The second panel covered the likely policy ramifications of the crisis and how the next administration should respond, and included Leon Panetta, former Head of the Office of Management and Budget and Former Chief of Staff for President Clinton, Bill Frenzel, former Minnesota representative and ranking minority member on the House Budget Committee, Rudolph Penner, Senior Fellow at The Urban Institute, Alice Rivlin, former director of the Congressional Budget Office, and David Walker, President and CEO of the Peterson Foundation.
Martin Bailey kicked off the first panel, explaining that we had arrived at this crisis because housing prices went out of line with market fundamentals, and people no longer had a clear understanding of the risks involved in buying a home or purchasing certain mortgage-backed securities. A variety of causes contributed to this "housing bubble:" the easy availability of credit, interest rate cuts by the Federal Reserve, and money flowing to the U.S. from around the world. Other systemic problems abounded: many of the companies issuing mortgages had no financial stake in the credit-worthiness of people to whom they sold mortgages, and rating and regulatory agencies failed to provide a controlling influence. The economy is already showing signs of recession, a pattern that would likely continue through at least 2009.
Bailey said he "reluctantly" supported the bailout. As an additional measure, Bailey recommended that the Treasury buy non-voting equity in banks to provide them with much-needed capital. In the long term, he said it was clear that a new "regulatory regime" for finance would be necessary, and that some system would have to be devised so that all economic parties could better understand the risk they undertook.
Dean Baker thought the bailout was necessary, but noted that the government, by buying up $700 billion worth of toxic mortgage securities, has made it more difficult to pursue other options. He believed that the Fed and Treasury have enough "duct tape" measures to prevent the crisis from becoming too severe, but called attention to other worrying economic indicators (e.g., industrial production, auto sales) that have received less attention recently because of the turmoil in Congress and on Wall Street. Baker suggested that another economic stimulus package might be necessary. He also proposed the imposition of a small tax on financial transactions as a mechanism against speculation and an additional government revenue-generator.
Mark Zandi believed that the financial panic of the past month virtually ensured that there would be a worldwide recession, and thought that the U.S. unemployment rate would probably rise to 7.5-8% before the crisis abated. Saying that "we will be worth less for a long time to come," Zandi speculated that the country's decreased wealth, and loss of consumer confidence that accompanied it, would negatively affect the GDP by at least one percentage point. Zandi predicted that the cumulative budget deficit would be at least a half-trillion dollars larger for the next president.
On the upside, he said that governmental interventions will be successful, citing especially the recent decision to buy commercial paper and coordinated rate cuts by the Fed and other national banks. Zandi believed the $700 billion rescue plan would work, and said the prices that arose through a reverse auction of "toxic" securities would serve as a signal indicating which banks needed additional capital. He also expressed hope that the nationalization of the housing market would "help insulate the mortgage from the vagaries of the financial system."
Rob Dugger said that the housing bubble was only part of the problem with the US economy. He declared that "the US has relied on savings from the rest of the world" for some time, and that housing was just the first part of the economy to be affected because it is the "most interest-rate sensitive market." Dugger said the underlying problem is an inability by the US to finance itself in any sector, and that a "debt-financed, consumption-led growth strategy" was no longer sustainable.
He called attention to the problems of energy and food prices, saying that most buildings were obsolete and profoundly energy inefficient, and rising food prices are hampering the ability of families to create a workable budget. Dugger lamented that spending was growing far faster than revenue, citing a 6-7% drop per year in discretionary spending. Dugger predicted that we would only see long-term economic recovery and stability when foreign confidence was restored in US assets, the population accepts a tax burden in line with its spending priorities, and government starts operating at a sustainable spending level.
Tim Adams also believed that the government would create another stimulus package, and would try to keep foreclosures at a minimum. Adams wondered if "there would be any mortgage infrastructure left" once the economy recovers. He worried that the global nature of the current financial crisis might tempt some nations or regions to "turn inward" to create a protectionist buffer from future financial shocks. Before the crisis is over, Adams believed that the world might see a few "failed states," and called attention to some formerly emerging markets which are now in shambles. Lastly, Adams saw a potential positive in the crisis, saying that "for thirty years we have been spending more than we earned," and that recent events may finally force us to re-examine these patterns and decide on a more limited set of important fiscal priorities.
After Adams finished, moderator Maya MacGuineas asked the panelists to expand upon their earlier points by discussing the US long-term financial outlook, and what other options government officials might have at their disposal. Most of the panelists noted that, despite a growing national debt, they were pleasantly surprised by the continual interest of investors in buying more US Treasury bonds. Martin Bailey warned that the US may be "running out of ideas" to jump-start the economy, pointing to a stimulus package as one of regulators' favorite tools. Dean Baker suggested that the government implement a "green stimulus" that would subsidize buildings to retrofit their facilities into greater energy efficiency. Mark Zandi thought that a tax incentive to buy a home in 2009 might help clear out excess home inventories and help jump-start the economy. On the question of the long-term health of the economy, panelists were mixed. Mark Zandi pointed to the fact much of the population has spend within its means and has a "basically sound balance sheet," and this population accounts for over three-quarters of consumer spending. Rob Dugger said that we have seen the most visible portion of the credit contraction already, and predicted that we would soon see a drying up of credit begin to ravage the "real" economy, which would reveal the fragility of household finances.
Time for questions from the audience was short, but one questioner asked whether the US ought to create a "sovereign wealth fund" similar to the model set up by some other nations. Another asked whether the federal government should begin providing additional assistance to states. Panelists seemed unenthusiastic about the creation of a sovereign wealth fund. Most thought that any future stimulus package would need to provide some aid for the states.
Leon Panetta started the second panel by commenting that "balanced-budget hawks are an endangered species," and noted how past presidents from both parties, like Reagan and Clinton, both had to make difficult spending decisions to achieve a fiscally responsible budget. Panetta said that the next president would face a more difficult task than either of these past presidents: a $700+ billion deficit and an economy in recession. Panetta also cautioned that by involving itself so heavily in the private market, the government was opening the door to ever-growing new calls for a "bailout" in other areas. Panetta recommended that the next president limit his new initiatives severely, and called on the next administration to devise a 5-year strategy for returning to fiscal discipline. PAYGO rules would have to be enforced, and some type of entitlement reform would have to happen.
Bill Frenzel opened by saying that the next president's campaign promises would have to go "out the window," predicting a possible $1 trillion deficit in the next budget. He was pessimistic that a new administration would see through serious spending cuts to improve the US fiscal position. He feared that the next president and future congressional sessions would fail to adopt a strong, decisive plan to deal with the crisis, and would instead opt to “just move forward as usual."
Rudy Penner said "the world had changed" since the presidential campaigns started, and that next year would "be like a cold shower" to whoever enters the White House and tries to see through his campaign promises. Penner joked that "debt has been our most successful export," and wondered whether foreign investors would continue to buy US debt for much longer. He expressed hope that the current crisis could serve as a "golden opportunity" for various parts of government and the public to come together and re-define its fiscal priorities. Penner said that public education must be a part of this effort, because the public "won't accept higher taxes," as long as it holds the perception, as it currently does, that the tax system is unfairly preferential to the rich and inefficient.
Alice Rivlin drew attention to the previous night's presidential debate, saying that neither candidate did particularly well on fiscal issues, and that both men, if elected president, would have to prove their leadership capabilities on economic and budget issues. Her biggest economic concern in the short term was the need to re-start the flow of credit, and she believed that the Paulson bailout plan was a good step towards this goal, though it might take a while to succeed. Above all, she said, inaction would be extraordinarily costly. Rivlin also laid out two possible criteria for any new spending: that it be "clearly temporary," or that it go towards a project, like infrastructure rebuilding, which we needed to do anyway. Finally, Rivlin pointed to the long-run challenges of entitlement reform, and was hopeful that either candidate, if elected, would be able to create the political will to tackle these problems.
David Walker set a strong tone from the beginning, saying that we live in a "dysfunctional democracy" with a grave lack of leadership. Leaders in government were "reacting" to problems, rather than staying "ahead of the curve,' and some of the actions the government had taken were "perhaps unconstitutional." Walker said this state of affairs was "morally reprehensible," and would in effect be "taxation without representation" of coming generations. He called on the next president to create a budgetary panel that would make recommendations for statutory budget controls, Social Security reform, tax reform, and healthcare reform. Walker also thought the press had been lax in its duty to "hold government accountable" for fiscal irresponsibility.
The first question came from the moderator, Maya MacGuineas, who asked how the next president can best "do the right thing" to restore fiscal accountability. Leon Panetta answered that the next president "must be honest with the American people," and if he does so, "the American people are not stupid" and will realize the need for difficult spending and tax decisions. He said the president has to "hit the ground running" and try to push through reform during his first "honeymoon" days in office. Alice Rivlin said that while many observers have compared the next president's situation to Bill Clinton's in 1993, the next president will face far greater difficulties. If Obama were to win, she believed that his biggest resistance would come from members of his own party. Bill Frenzel answered that Obama's choice of competent cabinet members was crucial, and that he should institute a commission for budget reform whose recommendations are given an up-or-down vote. Rudy Penner expressed worry that the next president would "just muddle through" without creating a definite plan of action.
The second questioner asked if the president-elect would have to work with Bush in any way to deal with the crisis, and if additional civic education about government fiscal policy might be necessary. Most panelists thought that Bush was too unpopular at this point to figure into the next administration in any major way, although most agreed that more civic education would be appropriate.
A third questioner asked if healthcare represented another "bubble" like housing. The panelists didn't seem to think that this comparison applied well to healthcare, as the continual rise in healthcare costs came largely from increased complexity of treatment options, a trend that was unlikely to reverse itself.
The last questioner wondered when the benefits of another stimulus or rescue package might be counteracted by damage done through erosion of US fiscal position as it goes deeper into deficit and debt. David Walker answered that "all stimuli aren't equal," and the merits of any stimulus package were mostly dependent upon the content of the stimulus itself. Leon Panetta was skeptical of any future stimulus package, declaring that "the benefits are more political than economic." Bill Frenzel said that the next president must restrain Congress from creating another "obscene" rescue package.
The National Press Club
529 14th Street NW Conference Rooms
Washington, DC, 20045
Welcome Remarks 9:00 a.m.
Maya MacGuineas
President, Committee for a Responsible Federal Budget
Director, New America Fiscal Policy Program
Panel 1: Dissecting the Package - How Will the Markets and the Economy Respond?

Mark Zandi
Chief Economist, Moody's Economy.com
Martin Baily
Former Chairman, Council of Economic Advisers
Senior Fellow, The Brookings Institute
Rob Dugger
Director, Tudor Investment Corporation
Dean Baker
Co-Director, Center for Economic and Policy Research
Tim Adams
Managing Director, The Lindsey Group
Panel 2: US Budget Watch - How Does this Affect the Campaign?

Leon Panetta
Former Chief of Staff for President Clinton and Director Office of Management and Budget
Co-Chair, Committee for a Responsible Federal Budget
William Frenzel
Former Representative from Minnesota
Co-Chair, Committee for a Responsible Federal Budget

Alice Rivlin
Former Director, Congressional Budget Office and Office of Management and Budget
Senior Fellow, The Brookings Institute
Rudolph Penner
Former Director, Congressional Budget Office
Senior Fellow, The Urban Institute
David Walker
President and CEO, Peter G. Peterson Foundation
Former Comptroller General