Right, So...Now What

So, the bailout has been passed and signed, and suddenly the media is struggling to figure out what else to talk about. I mean, it's not so much that the economy has magically been fixed by the bailout's passage (although, more in a minute on that score), but the bailout was good theatre, and now, the show's over.

We're also not the only nation on Earth who just bailed our financial sector out. Germany, Denmark and France all moved over the weekend to find ways to rescue or shore up banks that were sliding into the pit of despair. Germany, for example, pledged billions of Euros to bail a bank called Hypo Real Estate, and announced unlimited depositor insurance, the latter matching a move by Denmark. France had to move to save Fortis. Even tiny Iceland has had to move to save a bank this last week.

Some of these moves are real bailouts, designed to fix broken banks. But some of them, and to some degree our own bailout and the politics surrounding it, are about psychology.

Market economic theories mostly rely on the notion that participants in the market are cool and collected, making rational, informed decisions about what to do with their money. As long as this remains true, markets should work.

As soon as emotion gets injected into a market, however, it begins to malfunction. You see, on the one hand, what Greenspan liked to call "irrational exuberance", like the dot-com bubble or for that matter the housing bubble; or on the other hand an irrational, excessive exodus as people get skittish about parting with their money. Emotion leads to such foolishness as believing, because you want optimistically to believe, that the housing market can only ever go up, or that the dot-com boom can go on forever despite a lack of earnings by so many of the companies involved.

Rationality, and even a cursory glance at history, tells us plainly that there's never been a market that went up that didn't eventually come down. The overall trend might continue upward--I doubt, for example that the bottom of the housing market will bring us back to house prices comparable to what they were when I moved to Minnesota in 1995. But there will always come a moment of peak, rather than an everlasting asymptotic rise.

What is remarkable about our current circumstances is how ill prepared many financial institutions, both commercial depository banks and investment banks, were to weather the day when the peak hit and the downward slide began. Large numbers of very intelligent people, all versed in the history of their chosen field, somehow convinced themselves that it couldn't happen to them.

Not everyone was fooled. There was an interview on NPR the other day--I don't remember the fellow's name, but he was a just-retired executive or board member of Washington Mutual, who felt that, now that the company had filed Chapter 11 and functionally no longer existed, his non-disclosure agreement was void and he could speak freely. He'd been telling WaMu's management for years that it was overexposed to bad mortgages and that it was going to suffer for it. Indeed, WaMu had already started to shed some of the bad loans, finally beginning to believe that he may be right.

But it was much too late, and there was much more crap on their books than they imagined. Nobody was willing to believe that the housing market could fall apart, or that it would become a self-fueling trend as foreclosure suppressed neighbourhod value and led to more foreclosure.

Of course, we're in the same sort of denial about so many potential peaks. Peak oil is one that gets talked about a lot. The possibility of reaching a tipping point in the climate, where it will change dramatically and not just gradually, is one that even many who recognize that climate change is happening prefer not to talk about much. We've already passed the peak of America's post-WWII influence over the world, although really, after nearly 60 years, perhaps we were overdue anyway.

We don't really seem to want to think about the troughs, much, either. The housing market has not yet hit bottom. Many people with perfectly ordinary mortgages are believed to be on the brink of default. If you think there's a borrowing crisis now, when sub-prime lending has turned out to be a mistake, wait 'til you see what happens when prime lending starts to fall apart.

And then, there's the really big one: how much debt can the US government rack up before people stop taking our markers? The Iraqi war is a leveraged operation, floated on bonds that are reputed to be held largely by China. I'm sure some doomsayers worry about what happens if China calls those markers in all at once, but I have a much more realistic worry, given all this bailout spending we have in mind: what happens if China stops buying our bonds? What happens when the credit freeze starts to apply to the US Government's own desire to fund its operations on credit?

I think this moment may be coming. I might be entirely wrong--I have yet to see any more educated pundit talking about it seriously--but I don't see any theoretical reason why, if individuals can't get credit on favourable terms, and corporations can't get credit on favourable terms, and cities and states can't get credit on favourable terms, there won't come a moment, very soon, when the US Treasury will find itself unable to float bonds and get money for them.