I watched in awe today as members in the US House of Representatives failed to pass the 700 billion dollar bailout package. How could this possibly be? All the signals from President Bush, Treasury Secretary Hank Paulson, and Federal Reserve Chairman Ben Bernanke indicated that if something was not done soon, we would all be doomed. McCain even “suspended” his campaign because this impending crisis was so urgent. Yet, 95 Democrats and 133 Republicans voted against this bill. To make matters worse, it seemed as though the impending doom was correctly predicted. As the votes were tallied on the floor, Wall Street watched and the Dow Jones dropped 788 points, its lowest point drop in history.
After taking a moment to calm down (and contemplating whether I should convert my dollars to pesos- Mike’s suggestion), I realized this all this drama may not be as dire as some would want the American public to believe. The Republican Party may be making this crisis seem worse for strategic purposes, which I will explain more about below. However, I want to talk about why this crisis may not be as bad as it seems.
More after the jump...
The stock market is in decline, that is a fact. However, while the Dow Jones dropped 788 points today, its largest drop in history, it is still not among the top ten highest percentage drops in history. Its 7% drop even rates below the 8.04% drop on October 19, 1987 (yes, I was old enough to remember this). So, depending on how you look at the problem, it is not as dire as it may seem.
Further, it is unclear even to economists how bad this crisis will get and what the full effects will be. This is partially because this crisis deals with financial markets, not the “real economy” of production. According to Robert J. Samuelson of Newsweek,
“What's been so unsettling about the present crisis is that it has not conformed to the standard model of business cycles and has not submitted to familiar textbook solutions...
Economists of this tradition [mainstream "macroeconomics"] watch consumer and business behavior. Are car sales soft? How much are companies raising prices? What about profits? The $152 billion "stimulus" program earlier this year was a classic exercise in "demand management." It didn't work well mainly because this crisis originated in frightened financial markets. Massive losses on mortgage-related securities caused some financial institutions to fail. As fear spread, financial institutions grew wary of dealing with each other because no one knew who was solvent and who wasn't.”
Some, like Paulson and Bernanke, believe that the breakdown of financial markets would have serious consequences on the rest of the economy. Why? Because businesses depend on bank borrowings to conduct everyday business (for example, buying supplies or paying workers). If the financial market failed, these businesses would not get the resources they needed and would also fail.
Others economists disagree with Paulson and Bernanke. They say that, in response to not having access to financial resources from banks, businesses will just try to cut down on other costs (for example, by firing employees or reducing spending), and this will help them stay afloat until the crisis is over. (Samuelson 2008) (I guess individuals from this tradition do not think a rise in unemployment, or a reduction in purchases of raw materials is such a bad thing?)
Regardless, it appears as though it is unclear to many what exact effect this crisis will have on the economy. So why all the panic….?
From a right wing, free market perspective, dumping 700 billion dollars into the economy to save businesses does not seem kosher. Yet, the Republicans seem pretty supportive of this plan and want to pass the measure quickly. Why? Because (1) the election in November, and (2) if they drag out the process, the final bailout package will be more to the left than they want.
The Republican Party knows that the financial market is in a mess. If they let the financial market fail, they fail in November. So it is important to them to do something to mitigate the effects of the crisis, even if it means dumping money into the economy in the short run.
But why all the panic and urgency? A simple one-dimensional spatial model can answer that question (assuming all the assumptions apply). Even though the Republicans want to dump some money into the economy, they do not want to the measure to become too liberal. So by making it appear like the legislative process is a one shot game (we have to do this now or doom), Democrats are forced to accept whatever the Republican administration proposes to them (and it will propose something close to its own ideal point). If not, then a financial crisis will occur, and the Democrats will possibly not have another opportunity to move the very right status quo more to the left. See the figure below.
Here’s the problem for Republicans. First, they do not control the institutionally recognized ex ante veto gates, as in Congress- the Democrats do. Second, by sending a signal that a measure has to be passed quickly, they are allowing Democrats to propose a solution closer to their own ideal point knowing that the Republicans are unlikely to vote against it. Unfortunately for Democrats, they cannot propose anything they want. Since the status quo is very far right, the closest passable proposal they can get to their own ideal point is where the Republicans are indifferent, or almost indifferent, to the SQ. See below.
Alternatively, if this continues to be a repeatable game, as it beginning to appear to be as some wanted this bill to be voted on last week, the result will be similar to the one in Figure 2. The Democrats will continue to reject anything until it gets to point X, the closest possible proposal they can get to their own ideal point.
Thus, in conclusion, it appears as though the current financial crisis is not only an economic one, it is a political one as well. It is a political one for realistic reasons (the Republicans can lose in the November), but also manufactured ones (making the need for a solution seem urgent changes exactly where the final proposal will end up on the left-right spectrum).