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Who's Afraid of a Big, Bad Bailout?, Part 2


Why we need the bailout.


The Transmission Mechanism

The transmission in a car takes energy from the engine and transfers it to the wheels. Let's talk about the economy's transmission mechanism.

Let's start with our friend Dave Moritz down the street. He needs financing to be able to sell a car. To get those loans at good prices, an auto maker has to be able to borrow money and make the loans to Dave's customers. But if something does not stop the bleeding, it's going to get very expensive for General Motors (GM) to get money to make loans. That will make his cars more expensive to Minyanville's Why Wall Street Will Never Be the Sameconsumers. Cheap loans with small down payments are the life blood of the auto selling business. That's going to change dramatically unless something is done to stabilize the markets.

Credit card debt is typically packaged and sold to investors like pension funds and insurance companies. But in today's environment, that credit card debt is going to have to pay a much higher price to find a buyer. That means higher interest rates. Further, because most of the large issuers of credit cards are struggling with leverage, they're reducing the amount of credit card debt they'll give their card holders. If they continue to write down mortgages on their books because of mark-to-market rules that price assets at the last fire-sale price, it will mean even more shrinkage in available credit.

Try to sell a home above the loan limits of Fannie (FNM) and Freddie (FRE) today with a nonconforming jumbo loan. Try to find one that doesn't have very high rates. And a subprime mortgage? Forget about it.

We're in a recession. Unemployment is going to rise well over 6%. Consumer spending is going to slow. This is an environment that normally means it's tougher for small businesses and consumers to get financing. Congress or the Fed cannot repeal the business cycle.

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There are always going to be recessions. And we always get through them, because we have a dynamic economy that figures out how to get things moving again.
Recessions are part of the normal business cycle. But it takes a major policy mistake by Congress or the Fed to create a depression. Allowing the credit markets to freeze would count as a major policy mistake.

I've said for some time that the economy will go through a normal recession and a slow recovery--what I call a Muddle Through Economy. This week I met with executives of one of the larger hedge funds in the world. They challenged me on my Muddle Through stance. And I had to admit: My Muddle Through scenario is at risk if Congress doesn't act to stabilize the credit markets.

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No positions in stocks mentioned.

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