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Is US response to financial crisis strong enough?

Government action to save major financial firms has yet to show clear, positive results.

By Staff writer / March 1, 2009

President Barack Obama met with the Senate Banking and House Financial Services committees last week. Here, he made an announcement flanked by Treasury Secretary Timothy Geithner, White House Economic Council Chairman Larry Summers, and leaders from both committees.

Jim Young/Reuters

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In the history of financial crises, one lesson stands out: It’s important to match the scale of the remedy to the scale of the problem – and to do so quickly.

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That doesn’t mean every corporate bailout is a good idea. But what’s needed is a forceful approach, whether the costs fall on investors or taxpayers. Governments that try to cut corners or take a wait-and-see approach often end up making recessions deeper and taxpayer costs higher, say financial historians.

The Obama administration is well aware of that trap, yet many economists see a high risk that the United States will go down that path in 2009.

Some signs that efforts to date haven’t been adequate to the task:

• Insurance giant AIG, now largely government-owned and supported, is expected to report the largest quarterly loss in corporate history Monday – plus a newly restructured bailout that will amount to the third rescue of a company that has already tapped $150 billion in federal funding.

• The Treasury on Friday announced its third rescue in six months of the bank Citigroup, which has received $45 billion in capital infusions plus billions more to insure against losses.

• The overall economy has declined more sharply than economists expected, with gross domestic product shrinking at a 6.2 percent annual pace in the final quarter of 2008.

“As long as they don’t fix the banking system, the economy is going to get worse,” says Pete Kyle, a professor of finance at the University of Maryland. “Death by a thousand cuts is not going to work.”

He notes that the Treasury has just taken its “cut No. 3” at Citigroup, and that it’s possible more rescues will be needed at that company alone.

As the woes of AIG suggest, the financial crisis goes well beyond the borders of the banking industry itself. The Obama administration and the Federal Reserve are working on several fronts to break a downward spiral in which consumer spending, jobs, and the value of financial assets have been declining in tandem. Their programs are designed to restore health to banks, to repair damage to the economy’s nonbank channels of credit, and to stimulate economic activity.

But the costs keep rising, and a key question is whether tax dollars are being used in the most effective way to meet the challenge.

In his new budget for next year, President Obama allocates $750 billion for corporate rescues. That amount is just a best estimate of what the administration may seek after it runs through the second half of the government’s current $700 billion rescue fund.

For policymakers, choosing a course of action hinges on a couple of questions: How bad are the financial-system losses, and who should bear them?

On the first question, uncertainty reigns, but the estimates of losses have been trending up. Where the International Monetary Fund was estimating $1 trillion a year ago, it has more recently put a $2 trillion estimate on US credit losses in the current crisis.

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