How a tsunami of debt saved the rescue plan

Misnamed a bailout, the Treasury secretary Henry Paulson's rescue bid represents a buying opportunity for taxpayers

Customers make purchases at a Home Depot in Chicago. Home Depot is the nation's largest home improvement retailer.

It took four days for a plurality of US lawmakers who rejected the Bush administration's US$700 billion (Dh2.57 trillion) economic rescue plan to understand a basic fact of the global economy: Wall Street is Main Street. In an economy where mutual funds and retirement accounts are exposed to foreign stock and bond markets, ripples from the trading floors of lower Manhattan and Chicago can swamp small businesses as well as major corporations. So on Friday, their epiphany delivered, legislators passed a last-ditch effort by the Bush administration to replenish the nation's dangerously illiquid credit sector.

Tragically misnamed a bailout, the Treasury secretary Henry Paulson's rescue bid represents more of a buying opportunity for taxpayers than an indulgence of Wall Street speculators. While economists are split on how effective the plan will be, the cost of doing nothing asserted itself rudely last week after it was rejected by a dissident cadre of fiscal conservatives. Monthly data issued by the government confirmed worries that the economy was contracting. New factory orders, demand for durable goods and a key manufacturing index had all declined to historic lows. The jobless rate, announced on Friday, recorded 150,000 slashed payrolls last month, the highest number in five years. Most economists say the US economy is in recession and will remain so until at least the first quarter of next year.

Prior to Friday's vote, the Standard & Poor's 500 Index had shed eight per cent of its value in four days, the worst decline since the attacks on the US on September 11. But what Congress and a growing share of their constituents now realise, finally, is that this is not an equity crisis like the Oct 1987 stock market crash, or even the collapse of the dot-com bubble in the late 1990s, which caused only minor macroeconomic damage. This is a crisis of overleverage. The short-term credit market, the very boiler room of the US economy that covers everything from an order for power tools and building supplies to a meal for two at the corner bistro, has seized up. The spreads on credit default swaps, a $43tn market in which bond owners buy protection against the prospect of default, have spiked dramatically. Since April, there has been zero growth in new lending and the credit freeze is migrating to Europe.

The ocean of debt that kept America's demand-driven economy afloat has become a tsunami. At the household level, the rate of indebtedness is astronomical. The value of mortgages and consumer credit is estimated at 134 per cent of disposable income and 101 per cent of gross domestic product (GDP). In the financial sector, gross liabilities have risen from 21 per cent of GDP in 1980 to 116 per cent last year. Economists estimate corporations must shed some $1tn in dodgy debt to right their balance sheets. To do this they need fresh capital, but the markets are not forthcoming. They can auction off assets but most buyers are still lingering on the sidelines. They can hope earnings will increase, although that's unlikely at a time when equity prices are most certainly facing a secular downturn. And in fact - as if the current crop of bad news wasn't bad enough - there are signs that analysts have yet to price a recession into the market. According to John Greenwood, the chief economist at Invesco, based in London, analysts are projecting next year's multiples for S&P's listed companies at 22 times earnings, an extremely low figure given such a grim economic outlook.

The good news is that deleveraging has already begun, albeit slowly. Corporations have written off $500bn in bad debt over the last year and household debt has declined about five percentage points as a ratio of disposable income since the first quarter of this year. The billionaire US investor Warren Buffet has reaffirmed the first principal of the market - buy low - following up his $5bn stake in Goldman Sachs with a $3bn share in General Electric. Once the spectre of a dithering Congress finally exhausts itself, investors may align themselves with what Mr Buffet clearly perceives: once the Treasury Department starts buying distressed mortgages and converting them into marketable assets, foreclosure rates should ease along with the pressure on home prices. The long, laborious process of unwinding American indebtedness will help steady credit markets and stabilise the dollar, which should lure foreign investors into the marketplace.

That's the optimistic scenario. It isn't much, given how much we still don't know, but it's the only one we've got. [e-mail]