The Bumpy Ride Ahead

Dealbreaker has a most germane chart of what happened when Pakistan banned short selling: a brief and large rally, followed by a slow and devastating collapse.

Could the same thing happen with the US stock market? Absolutely, yes. Banning short-selling is a way of buying time -- but if the mooted RTC II isn't up and running very quickly, the stocks which went up today are liable to go straight back down to where they were -- and, probably, further, given that each successive stock-market low is lower than the last.

It's surely no coincidence that the short-selling ban was unveiled at exactly the same time as politicians started talking in public about a huge government bailout fund. The problem with the fund is that it will require time-consuming legislation to set up, and time was the one thing which Morgan Stanley, in particular, didn't have.

And so the short-selling ban is a stopgap measure, designed to artificially boost stock prices until Congress can get its act together and throw a few hundred billion dollars at the market in a more substantive attempt to stop it from imploding.

Those kind of measures actually can work: I'm thinking here of when the Hong Kong government started simply buying all the stocks on the Hang Seng index during the Asian financial crisis, and ended up making a fortune.

Whether it's the government's job to intervene in the markets, however, is another question entirely. If it were just stocks falling, no one would ever suggest the Treasury should start propping up the equity markets, but somehow if those stocks are financial then that seems to change the moral calculus substantially.

It's certainly hard to imagine a Treasury secretary more well-disposed towards Wall Street than Hank Paulson, who was CEO of Goldman Sachs up until the minute he moved to Washington. Paulson, in turn, gave Morgan Stanley the mandate of advising on the Frannie bailout. You can look at Morgan Stanley's payment for that job in one of two ways: either it was very, very small (the headline figure), or else it was very, very large (tens of billions of dollars of Federal money being used to take toxic assets off Morgan Stanley's balance sheet).

What's more, if Morgan Stanley imploded, Goldman Sachs would surely have been next in the firing line -- Goldman needs Morgan to survive, there's safety in numbers, there can't be only one. Does Hank Paulson overestimate the systemic importance of Goldman Sachs to the US economy? Almost certainly, yes -- he could hardly have been CEO of Goldman if he didn't.

On the other hand, he's a decisive dealmaker who understands finance, knows what he's doing, and still retains the confidence of the market. His attempts to stop the financial system from collapsing might not be working very well, but he's certainly no laughingstock in the way that, say, John Snow might have been if he'd attempted something similar.

The upshot is that it's still far too early to tell whether any of Paulson's decisions will actually work. But even the best-case scenario is unattractive at this point: financial disaster averted, but a massive increase in government debt, the moral hazard associated with a brand-new Treasury put, and a discredited SEC which looks like it's taking policy advice from Pakistan.

As for the worst-case scenario, well, for that, I'll send you over to Nouriel. Credit losses of $2 trillion, half the US banking system nationalized, municipal defaults, house price declines accelerating, a sudden stop in consumer spending, global contagion, stagflation, you name it. Nouriel concludes:

At this point the perfect financial storm of the century cannot be contained. The only light at the end of the tunnel is the one of the coming financial and economic train wreck.

So brace yourselves: whatever happens, it's going to be a bumpy ride for a while yet.