In another fateful day in what have become dramatic times, the US Congress rejected the Paulson bail-out plan. Republicans joined with Democrats to vote down the bill 228-205.
Global financial markets took it badly. More banks failed in America, Belgium and even in Iceland. The Australian stock market was trading 7 per cent down in futures before trading, and when markets opened at 10am immediately plunged hundreds of points. As I write, they were rallying briefly, indicating they will finish somewhere shy of the 8 and 9 per cent drops experienced by the S&P 500 and Nasdaq indices.
Writing in The Guardian over the weekend, respected commentator and author Will Hutton wrote "I’ve watched the economy for 30 years. Now I’m truly scared." Hutton points out the credit crunch has been unlike traditional bank runs in the sense that it wasn’t small deposit holders who were pulling out their funds – though that too is happening. "Rather," he writes, "it was an escalating and terrifying run on the banks in effect by themselves."
And it’s not over yet. Overnight Citibank took over the 6th-largest bank in the US, the troubled Wachovia, in a deal which will give the US Federal Deposit Insurance Corporation – the federal bank insurer – a US$12 billion stake in Citi.
In Germany, the shares of massive financial conglomerate Hypo Real Estate dropped more than 70 per cent after it announced it secured a new 35 billion euro line of credit from a consortium of local lenders.
In Europe, two big banks have got into trouble. The Netherlands, Belgium and Luxembourg have injected 11.2 billion euros to keep huge Belgian bank Fortis afloat, which has implications for Australia as the Belgian bank had significant operations in this country.
In the UK, troubled savings bank Bradfield and Bingley was nationalised ] and in Iceland the Icelandic Government took over that country’s third biggest bank, Glitnir.
Stocks in another big Belgian bank, Dexia, dropped nearly 30 per cent after reports it was seeking an emergency capital raising and there were big falls in other financial stocks across he continent.
What caused it? A devastating one-two combination of the spread of the contagion to the European banking sector plus the voting down of the Paulson bill in the US House of Representatives. Despite the urgings of the Democratic House and Senate leaders, many Democrat representatives voted against the bill, as well as a majority of Republicans.
Wall Street then panicked as traders and investors realised that maybe the US public didn’t particularly like the idea of bailing out massive bank losses.
In a very real sense, the defeat of the US$700 billion bail-out is a win for democracy. The plan was deeply unpopular with voters and ordinary citizens, who could not understand why taxpayer money should be extended to the very institutions that have caused the current crisis through lax lending standards. It’s also, as Slate‘s Dan Gross points out, a stunningly hypocritical decision by House Republicans who approved countless spending bills for two wars. The combination of a weak leader and a dysfunctional Republican party has resulted in a situation where, to quote Paul Krugman, the US has become "a banana republic with nukes".
The real culprit – apart from that shadow of a man, President George W. Bush – is US Treasurer Henry Paulson, himself a mega-rich former investment banker. Paulson’s hastily concocted proposal was a remarkable exercise in panic and naivety: panic at the sea of red ink engulfing Wall Street, and politically naive in the extreme. The original plan, a flimsy two-and-a-half pages long, was broad, vague, and arguably unconstitutional. Despite a week of wrangling on Washington’s Capitol Hill that introduced many new provisions, including significant oversight clauses, many US lawmakers could clearly not bring themselves to vote for it.
Paulson’s position now looks untenable. But with President George W. Bush’s administration only weeks away from lame duck status, there is little chance he will resign. It hasn’t been a good week for Senator John McCain either.
What now? Paulson says he will go back to Congress to try and get an amended bill passed. With events moving this quickly, it’s almost impossible to predict what will happen. One thing seems almost certain: the US and Europe are headed for a sustained economic contraction. A depression? No. But a recession? Ireland, Spain, the US and the UK may already be in one. If these prove severe, Asia, which exports much of the world’s industrial output to these economies, will suffer accordingly. Australia, which exports much of the world’s raw materials to Asia, will then feel the pain too.
The only good news for Wayne Swan is that, through the good luck and occasional good judgment of his predecessor, Australia has the most benign macro-economic conditions in the western world. Our banking system is sound: as Alan Kohler points out, Australia has four of the 18 remaining AAA-rated banks left in the world. And with interest rates above 7 per cent and basically no Government debt, Australia has the ammunition to spend our way out of almost any downturn.
We may need it.
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