10 September 2008

The Political/Economic Debacle

From Tyler Cowen at Marginal Revolution regarding the Fannie Mae and Freddie Mac bailouts...

In essence we already agreed to the bail out some time ago.  Have you ever spent $17,000 on a car and asked the dealer what the warranty for the car "really meant"?  Well, the Chinese spent $340 billion on agency debt and probably asked the same question at least once or twice.  They live in a world of secret agreements with leaders, not transparent democratic arrangements.  So when it comes to the U.S government decision, we're not just starting from scratch here.  How many phone calls do you think Hank Paulson has received from the Chinese central bank since August 2007?

"Are you *sure* that paper is safe enough for us to keep on buying?"

We'll never know exactly what kind of verbal dance Paulson concocted in response, but just look at the resulting flow of purchases and the relatively slight mark-up over Treasuries over that period of time.  The Chinese (among others) thought we were standing behind the securities, at least in any world-state short of federal government quasi-bankruptcy.  (In fact Paulson is in a total bind once that phone call comes in.  He doesn't have much incentive to just say "tough luck" and precipitate a crisis when otherwise no crisis is on the horizon.)

So should we try this: "Oh, is that what you thought?  Guaranteed?  Did we use that word? Sorry, try reading our signals better next time.  We love you.  Great job with those Olympics.  And when it comes to those Treasury Bills, we really do still mean it.  And don't forget to support us on Iran and North Korea."

I think Mr. Cowen has brought up an important point that I haven't heard many (if any) people talking about, and that is the political implications of this credit crisis.  The global economic implications have been pondered.  But the political have yet to be speculated upon.

There's no shortage of people arguing against the bailouts, but they seem to fail to understand that we cannot just tell all the foreign institutions that bought Fannie and Freddie debt to eat crap.  We still have to maintain relations with them.  The common (and even preferred) shareholders are more ambiguous entities that are easy to forget, and we can wipe them out without fear of significant negative repurcussions; but foreign countries that bought hundreds of billions of dollars in debt from these companies can't be disregarded.  Take the Chinese for example, as Mr. Cowen has.  They've been buying American debt (both private and public) for probably the past decade (I'm not sure how long exactly and haven't looked up the figures).  Their investment has fueled American economic growth from the late 90's on.  If we crap out on them now by refusing to guarantee the debt they've bought then we won't be seeing much capital coming from them for the next decade or so, severely limiting our government's ability to borrow money and our national economy to grow.

The political implications are mentioned in Mr. Cowen's hypothetical situation.  Where do foreign relations end up if we screw them over on this?  They probably won't be likely to back us in foreign disputes and could potentially become hostile regarding trade.

I was skeptical at first about the bailouts, even a bit weary.  But as more light is shed on the situation, it's becoming more and more clear that this is a necessary action, even though it's putting taxpayers on the hook for potentially hundreds of billions of dollars.

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