The Morning After: Can the bailout be saved?

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The recovery of the U.S. stock market on Tuesday sent mixed signals to Washington: either market participants believe that the president will be able to persuade reluctant congressmen to pull the Paulson plan back from the brink, or they understand the Treasury and Federal Reserve will simply continue the bank-by-bank and loan-by-loan bailout that has been underway for months if it fails.

Of course, there is another possibility: maybe the market’s recovery is simply what traders call a dead cat bounce. If so, it was a pretty big dead cat.

What is clear is how we got to this point: the White House and congressional leadership miscounted when they scheduled Monday’s ill-fated vote. They were completely surprised when about a dozen conservative Republicans voted against the bill, which in turn led some Democrats to run for cover.

Essentially two-thirds of the Democrats voted for and two-thirds of the Republicans voted against the bill. The “no” votes fit broadly into four bunches:

•    Republicans and Democrats from states hardest hit by the housing crisis—California, Florida, Arizona—who want more taxpayer relief, in particular modification of the bankruptcy law to exempt first homes;
•    very liberal Democrats who want more oversight and who want to see “Wall Street” excesses somehow punished;
•    very conservative Republicans who want less of everything that is in the proposal (at the extreme, they want to reduce taxes to encourage new bank capital formation);
•    Republicans and Democrats in competitive races who just don't want to vote for an unpopular bill.

The far left and the far right agree on one thing: anything that could be good for bankers is bad for the country.

Which leaves the open question: can this bailout be bailed out?

The problem is that the changes to Paulson’s initial my-way-or-the-highway proposal were crafted to try to meet the needs of just enough congressmen and senators to squeeze through the process. Meeting the demands of legislators in any of the first three categories above would lose too many other votes. Moreover, any legislation still has to pass the Senate where a big conservative Republican defection would horribly embarrass Sen. McCain, who has no choice but to vote for the bill.

The only practical possibility is to make some minor changes and then bring pressure on those who voted against the legislation because they thought it might cost them at the polls in five weeks.

With any new vote delayed until Thursday at the earliest because of the Jewish holidays, most congressmen are undoubtedly hearing about how unpopular this bill has become. And conservative commentators are being brutal in their commentary, adding to the pressure.

For example, Lou Dobbs is almost as hysterical about the bailout as he usually is about illegal immigrants: “It's absolutely obscenely irresponsible of House Speaker [Nancy] Pelosi, Treasury Secretary [Henry] Paulson, President Bush, Sen. Harry Reid, the leader of the Senate; for these people to be clucking about like hysterical—so hysterically. It really must stop...These Congress people are all at home in their home districts—nearly every one of them—and they're hearing an earful. The American people don't want to hear this nonsense about $700 billion to bail out financial institutions."

That kind of noise will make the next vote even tougher. Moreover, the bailout is hostage to the fact that its chief architect, Secretary Paulson, is more a symbol of the problem than a likely crusader for a fair solution.

In fact, if President Bush really wanted to change the game, he would fire Paulson and bring in someone with wide political and economic credibility and, in turn, ask the Congress to suspend its own political bickering. But this highly partisan and highly unpopular president lacks the moral authority—and certainly the inclination—to do either.

If Washington remains in its business-as-usual mindset, the odds the Paulson plan passes are barely better than 50/50—and dropping with every point the Dow rises.

What happens if the legislation fails?

The short answer is, probably nothing much different than has been happening: more bank interventions and consolidations, more need for the Fed to pump out liquidity, more incentive for investors to trade stock for cash and less new credit.

However, all of this will happen even if the bailout passes through Congress.

At its core, the Paulson plan is a framework to soften the hard landing that is inevitable as the markets and economy recover from years of financial recklessness. If the plan passes, we would have a more formal, more predictable and more technically legal process in the short run. If it fails, the Federal Reserve will continue doing what it has been doing: taking bad loans from the banks in the hopes that they can eventually start functioning like banks again.

Thus, the passage or failure of Paulson’s bailout plan has more to do with confidence than with reality. It would be a symbol that someone is in control of what appears to be a situation that is fundamentally out of control.

At best, it would slow—but not stop—the pace at which the U.S. economy is contracting. American consumers are retrenching, overseas markets are weakening, state and local governments are cutting spending and increasing taxes, and even well-capitalized businesses are delaying most new investments.

Admittedly, there is a big difference between a recession and a depression, and between a one- or two-year slowdown and the kind of stagnation that gripped Japan for a decade after their own financial meltdown. Clearly, Washington should be focused on avoiding the worst and not suggesting that it can prevent the inevitable.

This is where the election comes in. Only a new president and Congress with new mandates can build a credible solution. Just as Hoover’s efforts to cope with financial collapse had to be reshaped by Roosevelt, whatever Bush engineers—particularly in the weeks before an election—will have to be redone by his successor.

– Alan Stoga