Failout

The bailout has failed for now. Of course they will try again after Rosh Hashanah, so this is by no means over. But let’s think about what will happen if nothing gets passed. Not that I know what I’m talking about.

What pushed Paulson and Bernanke to seek the bailout was the freezing up of the credit markets. Banks started to refuse to lend short-term money to each other or to anybody else. The TED spread, which essentially measures the risks of lending to commercial banks, went over 3%. This is a huge number, and means that the people with money have little faith that the banks are going to survive. With the failure of the bailout, the TED spread is now over 3.5%.

In a nice piece of timing, a hedge fund redemption date has arrived—one of the four times a year when people can withdraw money from most hedge funds. Most hedge funds are still doing OK during this crisis—at least, as far as we know, given the limited amount of information which hedge funds supply to the public. But you have to think that a lot of people are going to be sufficiently nervous to want to transfer at least some of their money into U.S. Treasury bonds or under their mattress. If a run on hedge funds forces them to start selling assets into this market, the bottom is going to fall even farther.

So, anyhow, what happens? The cost of short term money goes up enormously. The cost of long-term money—mortgages—may or may not change significantly, though certainly only people with strong credit records will be able to borrow. When the cost of short term money goes up, businesses can not afford to get loans, which means that they can not afford to expand. Some businesses finance their day-to-day operations with short-term paper; those businesses are in huge trouble. It’s hard to raise prices significantly in today’s environment, so they lay people off. Those people have less money to spend, so they stop buying things. The economy goes into a recession. With the economy in a recession, people are unwilling to make large purchases, and housing prices continue to fall. Foreclosure numbers increase.

Obama gets elected president—there’s no way McCain can win under these conditions. Pragmatic center left politician that he is, he starts a New New Deal for the economy. He appoints Robert Rubin as Treasury Secretary. He increases the deficit to pay for infrastructure and cleaner energy, putting the construction workers back to work. The government creates its own temporary commercial paper market.

After a year, the economy starts to grow again. Housing prices remain depressed compared to their peak for many years, and many people lose money on their houses. The unemployment rate remains high for several more years.

One interesting question is: does China continue to buy U.S. Treasury bonds and thus finance the deficit spending which Obama will put in place? Or does the U.S. have to pay higher interest rates and thus sink even deeper into a long-term hole?

Regardless of all this, my guess is that they will manage to pass some sort of bailout this week.