Rescue no cure-all for underlying flaws
Bailouts such as the $700 billion plan for Wall Street firms can help stabilize an economy, but history shows they don't cure the deep economic problems that created a crisis in the first place.
Even after the federal government starts buying mortgage-related assets in an effort to get credit flowing again, the fundamental weaknesses of the US economy will remain, including distressed housing markets, deteriorating labor markets, and faltering consumer spending as families struggle under heavy debt, high prices for food and energy, and uncertainty about their jobs.
The bailout will limit damage and prevent a catastrophic collapse of the global financial system, which would mean an extended and far more costly downturn, economists say. But the ultimate cure to what ails the economy would require time, wrenching systemic change, and a good deal of pain.
The last major government bailout, undertaken to clean up the savings and loan crisis of the late 1980s, is widely viewed as a success. Congress created the Resolution Trust Corp. in 1989 to take over and sell the assets of failed banks that had made risky real estate loans during that era's housing boom. The potential cost to taxpayers, more than $500 billion, was reduced to about $125 billion by the Resolution Trust Corp. and the remedy left behind a stronger banking system, one that has largely weathered the current crisis, analysts said.
But the repair took the better part of a decade, and the price included the disappearance of several hundred savings banks and an economic rebound so slow that economists coined a new term to describe it: "jobless recovery." In New England, particularly hard hit by the real estate bust, the Resolution Trust Corp. shutdown of troubled banks worsened a credit crunch, contributing to the region's deepest recession in the post-World War II period.
In Massachusetts, it took nine years for employment and eight years for home prices to return to their prerecession levels.
"Then, as now, we had a lending crisis that necessitated large-scale transformation of the financial system, which was painful for both Wall Street and Main Street," said Peter Ireland, a Boston College economics professor. "Unfortunately, though, we failed to learn another lesson; namely, that aggressive lending practices that go unchecked by a lax regulatory system nearly always end with pain."
Many economists are forecasting more pain for the US economy, even with the bailout. They expect the unemployment rate to rise to 7 percent before the excesses of the recent housing and credit bubbles are squeezed from the economy. They don't expect a significant recovery until 2010.
The jobless rate hasn't hit 7 percent since 1993. National unemployment, which has jumped more than a point in the past year, rose to 6.1 percent in August.
The goal of the new bailout is to restore sagging confidence, which has undermined financial and credit markets. Banks and other financial firms have stopped lending to each other, worried that their counterparts might have large holdings of troubled mortgage-backed securities and related assets, and follow firms such as Lehman Brothers Holdings Inc. into bankruptcy.
The reluctance to lend has brought the global financial system nearly to a halt, forcing the Federal Reserve and other central banks to pump hundreds of billions of dollars into the banking system. In turn, this reluctance to lend is filtering through the financial system, drying up credit for consumers and businesses, and worsening the downturn.
Without credit, businesses can't expand and hire, families can't buy homes, cars, and other goods, and students can't get college loans. The result: The economy shrinks.
The bailout aims to rebuild trust among financial firms and get credit markets operating normally again. Right now, firms can't sell their mortgage-related assets, even at deeply discounted prices. Under the bailout plan, the government would buy these assets, allowing the firms to get them off their books. Then, once markets start operating normally again, the government would resell the assets to recoup taxpayers' money.
William Wheaton, an economics professor at MIT, said the government could get out of the securities business much faster than it got out of the real estate business during the savings and loan crisis, when the problem was too much real estate on the market following the overbuilding of the 1980s.
The Resolution Trust Corp. had to hold onto property for years as it waited for real estate inventories to decline. Not until then could the market recover and the agency get better prices to reduce taxpayer losses, Wheaton said. This time, it's not a matter of an oversupply of mortgage-backed securities, but fear that has caused the market for them to freeze up.
If the bailout can calm those fears and jump-start this market, the government can quickly sell its holdings and even make a profit, since it's likely to buy the assets at very low prices, Wheaton said.
"I don't think we'll have to wait five, 10, 20 years," Wheaton said. "At the end of a year or two, we might have more than $700 billion."
But confidence is not easily restored, said Gary Richardson, an economics professor at the University of California at Irvine. Richardson, a Great Depression scholar, observed that the current bailout has many similarities to a Depression-era program, the Reconstruction Finance Corp., that pumped today's equivalent of about $300 billion into loans to banks and other companies.
Taxpayers eventually got their money back, but the economy struggled for another decade. After the Hoover administration launched the program in early 1932, the nation suffered the worst year of the Great Depression, culminating with a nationwide run on banks that became known as the Banking Panic.
It took until the end of World War II for banks to extend credit as they had in the 1920s, Richardson said.
In the end, money alone was not enough to restore confidence, Richardson said. It required the administration of President Franklin D. Roosevelt to shut down and audit every bank; create several independent regulatory agencies; and adopt regulations that drew distinct lines between traditional banking and securities.
"The Reconstruction Finance Corporation did something, but it didn't solve the problem," Richardson said. "Confidence in they system was destroyed, and it took a massive transformation of the financial system to restore it."
Robert Gavin can be reached at rgavin@globe.com. 