HISTORY SUGGESTS that the US government's proposal to buy mortgage-linked investments on a massive scale represents a necessary response to avert a global financial meltdown.
A series of ad hoc rescue measures taken by the US authorities, involving four separate bailouts of major financial institutions, has failed to restore investor and public confidence. And against a background of a rapidly worsening situation, a larger and bolder intervention was required.
This the US treasury has proposed in the shape of a $700 billion bailout fund which is the subject of negotiations between the Bush administration and Congress. The so-called "troubled asset relief programme" would involve the US government spending billions of dollars in buying distressed assets, defaulted mortgages, and non-performing loans from financial institutions. The hope is that the sale of those toxic assets would ease the strain on the balance sheets of banks and encourage them to recapitalise and to resume lending. That should help, in turn, to provide reassurance about the stability of the financial system.
In the circumstances, the proposal represents an appropriate response. The lessons from the Great Depression, where state intervention was delayed too long, as well as from Japan's prolonged financial crisis in the 1990s, are clear. Both events illustrated the need for aggressive state interventions during unprecedented market crises whatever the prevailing financial dogma.
In more normal times, where the regulatory system is working and the financial system is properly supervised, the invisible hand of the market provides an adequate mechanism of control. But where - as we have seen in the US - regulators fail to enforce the rules and credit rating agencies fail to fulfil their function; where banks engage in risky lending practices that culminate in the subprime mortgage debacle and where the massive derivatives market remains wholly unregulated, the end result is a financial catastrophe waiting to happen.
The hazards attached to the mortgage rescue plan are obvious, but unavoidable, given the greater threat posed by inaction. For without a large-scale intervention by government the stability of the financial system would be placed in question, carrying a threat of impoverishment for millions and hitting the poorest hardest. American taxpayers, however, now find themselves being asked to pay for the financial mess that Wall Street has created. They will be hoping the bailout works and that distressed mortgages bought by the proposed fund can be resold in future, at a profit, when the property market stabilises and recovers, thereby minimising the cost to the taxpayer. Few would estimate how long this adjustment process will take and how much it may cost.
Negotiations over the bailout are focused on a US Senate Democrat proposal that would give the government a stake in firms unloading troubled assets, limit the pay of corporate executives involved and provide for more oversight of the treasury's actions. Whatever the details, however, this unprecedented plan would represent a major step towards restoring financial stability.