Thursday, December 13, 2007

Interventionist solution to the Subprime Crisis?

Some time ago you might have come across a news peice that the president of the US, George W Bush announced a major plan to help those house owners in the US now in serious debt due to the sub-prime lending problem.

The plan entails significant tax exemptions and aid packages to be offered by the Bush government to these afflicted house owners. Now, this was, to put it in a subtle way, a 'radical' move. Firstly, because this was a major shift in the Republican Party policy, which is a mainly conservative. Moving away from a policy leaning towars the free market, laissez faire approach; to a more government intervention based Keynesian policy. Typically, the Democrats are more Keynesian in their approach. Secondly, on further analysis of the new plan, it becomes clear that this tends to constitute what we learn in a Basic Economics course, called as a 'Moral Hazard'. Think about it, by giving tax cuts and aid to those sub prime borrowers (those who have a poor credit rating) and bailing out those sub prime lenders (banks and money instruments which did not sufficiently investigate the credit worthiness of their borrowers) what the plan intends to do is reward the people who made the mistake once by allowing them to wipe their slate clean. This might even encourage them to think that such a bail out might happen in the future too, thus constituting a moral hazard. This is counterintuitive to the 'let there be a market solution to the issue' approach of laissez faire capitalism.

Exactly 100 years ago in 1907, the famous and wealthy banker, J Pierpont Morgan bailed out the US government during a credit crunch by committing his personal finances to save an economy slipping into recession. What happened soon after in the early 1920s when JP Morgan was not around anymore is for you to guess! Similar speculation ensued, but the US Federal Reserve did not support the banks this time around and issue more currency to help against the bank runs, leading up to the Great Depression! Now this new plan to resolve the sub prime crisis is being touted as the 'Paulson Plan' after the current US treasury secretary Henry Paulson. I recently had a chance to attended a guest lecture by Dr. Shailesh Jha, Director, Credit Suisse. He predicted that a global recession was looming large in the near future mainly due to the slowing down of the globalization pace. I feel that the Paulson plan will act as a catalyst to that end! 2008 is election year in the US and politicians need to be forgiven for pre election jitters which cause them to take up such policies.

But then it is a chicken and an egg story. If the politicians did not have to govern masses of people who find it difficult to believe in the mechanics of the free market, they will have to yield to such interventionist policies to assuage the 'vote banks'! 'Vote Bank Politics', does this word sound familiar? This is again a similar situation in our own India but the contexts are defined differently. I think it is imperative on us educated Indians at least to get our Economics right! If you think that a market economy is a better option and need more 'understanding' I suggest you browse the various clips on and by 'Milton Friedman' on YouTube. Its good learning! I particularly like the lucidity of his explanations.

I also found this interesting article on the 'Paulson Plan' which is sceptical about the new policy, but gives it a much more credit! But a balanced view may not always be the right one!

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