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Wall Street in Crisis September 24, 2008, 5:04PM EST

The Trouble with Paulson's Bailout

(page 2 of 2)

Matt Mahurin

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"A Sense of Fairness"

Even aside from efficiency grounds, there's a fairness argument for not showering money indiscriminately on firms that got in trouble. Jeffrey Sachs, director of the Earth Institute at Columbia University, advised Russia on its transition from Communism before resigning in disgust over the rise of the oligarchs. Speaking from that experience, Sachs says: "There has to be a sense of fairness about anything that's done. Right now there is a profound and justifiable skepticism about the Treasury Dept. It seems like it's Wall Street bailing out Wall Street."

If history is any guide, it's likely the Paulson plan will gradually evolve into one that minimizes the cost to taxpayers by giving government a strong hand to rebuild the healthier firms and kill or merge the weak ones. Government is likely to grow more powerful in other respects as well. To counteract the deflationary impact of massive debt repayment, the government is likely to step up spending on things like public works projects, even though that will swell the federal budget deficit. Japan's massive spending on marginally useful roads and bridges is often ridiculed, but it's what kept the nation's unemployment rate low and prevented economic output from ever falling below its 1990 level, when the stock market peaked, argues Richard Koo, chief economist of Nomura Research Institute. Says Koo: "If you don't put this [government spending] in, the deficit will be larger and larger because the economy will be collapsing."

One often-mentioned option for the U.S. is a "Green Deal"—a modern-day successor to the employment and public works programs of the Depression-era New Deal, which would create a mix of high- and low-skilled jobs. Massachusetts Institute of Technology President Susan Hockfield isn't calling for a jobs program, but says that achieving an "energy revolution" would help the economy at the same time it eased global warming and reduced dependence on imported oil.

How things shape up will depend in part, of course, on whether Republican John McCain or Democrat Barack Obama wins the White House. But in coping with a financial crisis of epic proportions, either Administration is likely to be forced into a more interventionist stance than the U.S. has seen in years. Paulson's free-market bailout may seem in retrospect like the last gasp of a failed Wall Street culture.

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The Swedish Solution

Property prices soar, banks lend recklessly, private debt shoots up. Sound familiar? It happened in Sweden, too, in the early 1990s. Threatened with the collapse of its banking sector, Swedish authorities responded quickly. Urban Bäckström, who headed Sweden's central bank during those years, recalls that a decision was made to extend blanket loan guarantees to all banks--no collateral required. A special agency was set up to comb through banks' books and assign a realistic value to real estate and other assets. The government then nationalized some banks, merged others, and took the weakest off life support. Total cost of the bailout: about 4% of gross domestic product. In a 1997 speech to officials of the U.S. Federal Reserve, Bäckström, boasted that Sweden escaped a prolonged and debilitating credit crunch(à la Japan).

To read Bäckström's speech, go to http://bx.businessweek.com/credit-crunch.

With Michael Mandel in New York, Ariane Sains in Stockholm, and John Carey in Washington. Coy is BusinessWeek's Economics editor.

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