Wall Street Crisis to Main Street Crisis: Are We Witnessing a Paradigm Shift in Free Market Economy?

By Ajay Pradhan | October 4, 2008

Is America witnessing a paradigm shift unfolding in its economic system? America is the bastion of free market economy. Those who profess and bet their life that market can do no wrong are squirming today. The notion that market can do no wrong has turned out to be a myth. The myth has been shattered into 700 billion pieces by the financial crisis in Wall Street. The Wall Street crisis has spawned crisis in stock markets and crisis in credit markets. The crisis has the potential to melt down the capitalist society of the United States.

America has mostly trusted an unfettered market economy largely free of government regulations. Those who believed in Milton Friedman's Chicago School of free-market economic thought labeled attempts to impose any regulation on market a meddling attempt of the socialists. The idea professed that market itself rectifies any failure it faces. In the political sphere, it was mostly the conservatives, the Republicans, that didn't want to tolerate market regulation.

The current financial crisis in the U.S. has shaken up the presidential campaign. The Republicans have been hammered in the polls. Two months ago, on August 2nd, I wrote a blog on U.S. election-year energy politics in the U.S., in which I referred to "shagging economy, recession-like situation and a real estate mortgage crisis of astronomical proportion."

The point I made was that if Barack Obama wanted to win the presidential election, he must not let John McCain let the American electorate dwell on McCain's pet and strongest vault of weapons against the Democrats--national security, and that the Democrats must make the American voters turn their attention to issues that McCain is weak at--economy flirting with recession and the Main Street America struggling with the real estate mortgage crisis that is of an astronomical proportion. As presidential candidate Bill Clinton's star campaign staff in 1992, James Carville, Paul Begala, Rahm Emanuel, George Stephenopolos, and Dee Dee Myers would say: It's economy, stupid! Well, this election season, it is economy, again. George Bush and his treasury secretary, Henry Paulson, put a figure on that astronomic proportion: $700 billion.

Two Saturdays ago, President Bush sent a proposed Bill to U.S. Congress, asking for an astronomical $700 billion to buy illiquid (read: bad) financial assets from financial institutions, mostly related to housing mortgage. The logic behind this astronomical funding request is deceptively simple. The $700 billion dollars that Bush asked from the Congress will be used by the Treasury Department to buy bad mortgage-related securities and then Treasury will hold on to the securities and sell them at an undetermined time later at a profit. Hopefully.

Well, on the surface, the logic does not seem to have any problem. But the problem is that nobody, even Secretary Paulson, whose brainchild this proposal seems to be, knows if this logic will work. Illiquid assets can't be converted into cash. Paulson himself admitted two Sundays ago with NBC's Meet the Press with Tom Brokaw and ABC's This Week with George Stephenapoulos, that there is risk to the tax payers in the proposal.

Just so we understand the magnitude of the requested fund to bail out financial institutions, let me just put the number in perspective. One billion is 1,000 million. $700 billion is $700,000 million. That's $700,000,000,000. And that's all taxpayer's money. The 2007 United States population estimate is 301 million (301,139,947, to be precise). This means each American (man, woman and child) will be on the hook for approximately $2,325 for the "rescue" of Wall Street firms. An American family of four will be on the hook for almost $9,300. In 2006, 20 percent of Americans earned less than $19,178 per year before tax. For someone who earns less than that amount of money a year, $2,325 used by the Federal government to rescue financial institutions is a huge burden.

It is more of a burden because the intended results of investing $700 billion to rescue the failing investment banks are not guaranteed. Two Sundays ago, Secretary Paulson admitted to Tom Brokaw and George Stephanapoulos on Meet the Press and This Week Sunday morning television shows, respectively, that he cannot guarantee that the investment of $700 billion will work. He said there is risk involved. In other words, if the $700 billion rescue package doesn't work, American people will be bearing a colossal financial burden for years, perhaps even decades, to come.

When Secretary Paulson began to lobby for $700 billion of taxpayer money to bailout Wall Steet investment banks and other consumer banks in credit market, the Bush Administration started the lobbying in an overtly imperious manner. As a result, Secretary Paulson ended up irking the U.S. Congress and outraging the American taxpayers. He made it sound as though the Administration was asking for a mere $7 million or even $700 million. The lobbying was laced with outrageous logic and and yielded no ground for reasoning.

First, he said the Congress has to dole out the $700 billion funding within a matter of days; otherwise, he warned, the financial market would collapse and the American economy would slide into deep recession. He never gave any explanation how that would happen and when it is too late to do something.

Second, Paulson wanted the Congress to have no oversight power over his authority. Bush Administration's bailout bill explicitly stated that treasury secretary's decisions would not be open to challenge in any court of law or a Congressional oversight review. Was the Bush Administration for real? They wanted a mind-boggling amount of money from the Congress and they wanted the Congress to have no power to ask any questions?

Third, Paulson didn't want to limit compensation for Wall Street executives who'd participate in the Federal government bailout program. When he was interviewed by Tom Brokaw and George Stephenopolous two Sundays ago, Paulson said something that'd defy any sense of logic and propriety. He more or less said that the government should not impose a punitive action against the Wall Street CEOs. That's incredible. Paulson wants to give $700 billion to failing financial institutions and he's okay if the CEOs of those institutions make millions of dollars in compensation out of hardworking taxpayers' money? What could one expect from a treasury secretary who was in Wall Street before he came to the government and will most likely go back to Wall Street? He was merely protecting his turf at the cost of average taxpayers. He wanted to protect the interest of those greedy CEOs who created this gigantic mess in the first place.

Paulson said the $700 billion package should be swift, clean and should not have punitive provision (i.e., compensation limits for Wall Street executives). Taxpayers are paying this $700 billion and the government should have no oversight authority? What does he want, privatize profits and socialize loss? That's incredible.

This mess is a little too complex for most people to understand. Paul Krugman, a Princeton University economics professor and New York Times op-ed columnist, wrote one of the most lucid articles, "Cash for Trash" in the New York Times on September 21st, explaining the situation. How did the problem come about and what is the implication of the Wall Street meltdown?

The Wall Street meltdown is largely due to overissuanceof mortgage-backed securities by the government-backed mortgage behemoths, Fannie Mae and Freddie Mac. First-time home-buyers got easy credit from banks at sub-prime rate. Banks offered mortgage at sub-prime rates because they wanted to increase credit flow. In the process, the simple verification step to check the ability of the first-time home-buyers to pay back the mortgage loan got bypassed. This all happened even when the housing prices skyrocketed abnormally. The housing prices went up so high the high prices became unsustainable.

Then the housing prices plunged approximately two years ago. People who bought expensive houses were suddenly left with houses worth two-thirds as much. And when sub-prime rates no longer remained sub-prime, the mortgage payments exceeded the ability of the homeowners to meet their monthly payment obligations. They couldn't sell the house because it would mean a drastic loss. Foreclosures then began to sweep across America, leaving people at the mercy of the vicious circle of economy. Their income didn't go up because the economy dwindled into recession-like situation, with economic activity declining significantly across the economy over a significant period of time. When the number of foreclosures began to soar through the roof, the lenders were left with worthless mortgage-backed securities. These are the bad, illiquid assets.

As long as the banks were saddled with these bad assets, they'd have little capital to loan credits to businesses and individuals. Then the credit market froze and businesses began to run into trouble to get credit to do their normal day-to-day businesses and meet short-term financial needs. This threatened the economy, as it had the potential to wipe off employment, productivity, and other economic activities.

For some big, venerable Wall Street financial institutions like Bear Sterns, Lehman Brothers, Merryl Lynch, AIG Assurance, the only recourse left was to file for bankruptcy. The 158-year-old Lehman Brothers and Bear Sterns went down. Merryl Lynch got bought over by Bank of America. AIG Assurance got bailed out by the federal government, as were the mortgage giants Fannie Mae and Freddie Mac.

The government thought these companies were too large let down. The government stepped in to infuse the credit market with cash and so Bush approached the Congress for that cash. As Arianna Huffington of the Huffington Post said, if those companies are too large to let down, then maybe they are too large to exist.

I think cash infusion is necessary, but the way it was planned and the provisions stitched into the original bailout bill were almost bogus.

What political implication this financial meltdown has for America? This has changed the color of the presidential race in the United States. As I wrote in August, John McCain's best chance at winning the election is by fear-mongering and putting topmost priority to national security. That's his trump card.

I wrote in August that if Barack Obama wanted to trump up McCain, Obama would have to turn the page away from McCain's pet subject of national security and turn the focus on economy. The Wall Street meltdown did that for Obama, although, I'm sure, he wasn't hoping for it to happen that way. Regardless of how it happened, McCain became the loser, as is now evident in polls across the country.

Perhaps the most compelling lesson of this mess is that it put the Republicans at a tough spot. First, the Republicans had an ideological stance against government intervention of the market. They said the market is able to rectify its own problems. Mostly yes, but not always. That has now turned out to be a myth. The Republicans themselves are now biting their own tongue and accept some level of government intervention and regulation.

Second, the Republicans never got tired of giving speeches against "big" government and accused the Democrats of spawning a big government. With $700 billion dollar under one person, the treasury secretary, the Bush Administration has created a government juggernaut. Who would administer this whopping pile of money? Will the Treasury Department hire private firms to manage this money, giving sweetheart deals to favored companies? Time will tell.

For now, it is quite apparent that there is no such thing as pure free market. "Free" markets function well and in the interest of the public, if the people's representatives have a power to keep an eye on them. Is this the end of capitalism? I don't think so, but the days of unbridled greed in Wall Street may be over. Also likely gone are the days of easy mortgage loan.

America is not turning away from capitalism, but it surely won't be able to let the markets run amok with little or no regulation to keep them under control. Is this a paradigm shift in free market economy of the United States? You tell me.