The Bailout Is Just the Beginning

NECESSARY, BUT NOT sufficient. That best describes the $700 billion financial-markets rescue package that made its tortured way through Congress last week, finally earning the House of Representatives' OK Friday, along with $152 billion of ancillary goodies for Main Street thrown in to attract the necessary votes.

It is doubtful that passage of legislation establishing the Troubled Asset Relief Program, or TARP, will cure the key ill crippling the capital markets and the U.S. economy: the inability of borrowers to obtain credit from lenders unwilling to extend it. The stock market indicated as much in Friday's session, with the Dow Jones Industrial Average surrendering an earlier gain of 300 points even as President Bush signed the bill in mid-afternoon. Stocks ended the day with a 157-point loss.

The TARP effectively uses the U.S. Treasury's balance sheet to take on impaired mortgage assets from banks and other financial institutions that can't find buyers for such instruments- at least not at anything but giveaway prices. In theory, the TARP would purchase those assets at prices above fire-sale levels, but not so far above that the government — that is, taxpayers — couldn't profit down the road, even if that road is long and bumpy.

The Treasury could fund the TARP by issuing securities that, because of the strong demand for government paper, pay less than 2% for shorter maturities. At the same time, it could earn double-digit returns on the assets as they are resold. Think of it as the mother of all "carry trades" — trader lingo for borrowing at low cost to invest in higher-yielding assets.

The idea behind the TARP is that sellers of impaired assets would use the cash received from the program to make new loans or investments, thus reliquefying the financial system. But there is no assurance either that holders of such assets could be induced to sell at a loss, or that they'd lend out their newfound cash instead of sitting on it. Depression, after all, is a state of mind as well as a state of the economy.

That's why further action needs to be taken to get credit flowing again, and prevent the current constriction from turning today's economic downturn into something worse.

The quickest and easiest first step would be an internationally coordinated cut in interest rates carried out by the Big Three central banks — the Federal Reserve, the European Central Bank, the Bank of Japan — with the Bank of England, the Swiss National Bank, the Bank of Canada and the Reserve Bank of Australia all joining in.

Until recently, the Fed has had to go it just about alone by slashing its key federal-funds target rate by 325 basis points, or 3.25 percentage points, to 2% from 5.25%. The ECB most notably has stood its ground against rising inflation readings.

In the past few weeks, however, both the economic and financial risks have morphed into a deepening crisis, which has jumped borders and begun to grip Europe. Fortis, the giant Dutch-Belgian bank, was partially nationalized last week; Hypo Real Estate in Germany received a 35-billion-euro ($49 billion) bailout, and U.K. lender Bradford & Bingley was taken over by the British government. The Irish government said it would insure all liabilities to shore up confidence in its financial institutions.

Meanwhile, the Fed has been furiously pumping liquidity into the global banking system, extending massive amounts of credit to U.S. institutions and sharply increasing the so-called swap lines with foreign central banks to $630 billion. These provide dollars to foreign banks that desperately need them.

These measures have succeeded in preventing the pressures in the global money markets only from becoming more dire. Libor, the London interbank offered rate, has crept steadily higher, to 4.33% from under 4%. And Libor is no esoteric foreign interest rate; it is the benchmark for many business loans and many Americans' adjustable-rate mortgages, so its impact is considerable on this side of the pond.

A Fed rate cut is already priced into the financial-futures market, and could provide actual relief to U.S. consumers. Robert Kessler, head of Kessler Cos., a Denver-based manager of fixed-income portfolios, says a cut in the Fed's target rate would translate into a drop in the prime rate, currently 5%. That would lower the cost for loans pegged to the prime, such as many home-equity lines of credit, and help put money in the pockets of consumers, the lack of which is at the core of the economy's woes.

Fed-funds futures fully discount a half-point reduction in the target rate by the time the Federal Open Market Committee holds its next regularly scheduled meeting Oct. 29. Indeed, a sharp drop in employment and a marked weakening in the ISM purchasing managers' index in September would argue for rate cuts even in the absence of a credit crunch.

Jean-Claude Trichet, the head of the ECB, said last week that the topic of rate cuts came up at the European Central Bank's most recent meeting. Japan's economy is contracting, too, so its central bank shouldn't be averse to at least a symbolic cut, even though its key policy rate is just 0.5%.

But, as the Japanese experience of the 1990s demonstrated, low interest rates alone will not spur lending. Other steps are necessary.