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Bailout will avert long, deep economic downturn, U. of I. economist says

10/3/2008

Jan Dennis, Business & Law Editor
217-333-0568; jdennis@illinois.edu

Villamil
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Photo by L. Brian Stauffer
Economist Anne Villamil says the $700 billion rescue plan approved today in a second House vote is essential to undo a mounting credit crunch that could trigger a long, costly economic downturn if left unchecked.

CHAMPAIGN, Ill. — A massive Wall Street bailout won’t stave off a recession, but will ease a creeping economic meltdown that threatened to slice into jobs, retirement savings and access to credit across the country, a University of Illinois economist says.

Anne Villamil says the $700 billion rescue plan approved today in a second House vote is essential to undo a mounting credit crunch that could trigger a long, costly economic downturn if left unchecked.

“We currently have an internationally spreading credit crisis among large financial institutions,” she said. “Yet this is not just a Wall Street problem. It is coming to a Main Street near you, and soon.”

Villamil says the rescue plan will wipe out bad debt on financial institutions’ balance sheets that has paralyzed credit markets, making even financially healthy operations unwilling to do business with others due to fears of toxic assets.

Signs have already surfaced that the crisis is seeping into the overall economy, she said. On Thursday, Wachovia Bank limited access to $9.3 billion it holds for nearly 1,000 colleges in a short-term investment fund.

“This is but one example of the types of things that would occur without a bailout – people would be unable to access funds immediately or get loans,” Villamil said. “This could affect large institutions, small businesses and consumers.”

History shows the bailout, while costly, will be cheaper in the long run than letting the credit crisis linger, she said. A government bailout of the U.S. savings and loan industry cost less than 4 percent of gross domestic product to clean up, compared to 24 percent for a Japanese banking crisis a decade ago that was met with a slow, unfocused response.

“Unfortunately, banking problems occur in most countries at some point in time,” Villamil said. “The good news is that the problem can be fixed, but the question is how costly will it be to clean it up. The answer depends on our policy response. Will it be timely and appropriate?”

 Villamil says government officials are at fault for the public outcry against the bailout that held up a deal, including a failed House vote earlier this week.

“Policymakers and politicians have done an exceptionally poor job of communicating what is at stake here,” she said. “In their haste to solve the problem and prevent panic, which is important, they failed to understand the anger on Main Street.”

“But left unchecked, the crisis is coming to Main Street,” she said. “We need to get past the anger and down to the economic nuts and bolts. There will be plenty of time for investigations and regulatory reform. However, a timely and appropriate policy response is essential to limit the damage now.”
Even with the bailout, Villamil says a recession is inevitable.

“Recessions occur periodically and, while painful, they are not cause for undue alarm if they are mild and short,” she said. “What is worrisome about the current crisis is that recessions that follow financial crises can be severe due to linkages in the economy that are not apparent.”

Villamil studies financial contracts and the impact of inflation on public finance. She is co-editor of the Annals of Finance and an associate editor of Economic Theory, the European Economic Review, and the Quarterly Review of Economics and Finance.

Editor’s note: To contact Anne Villamil, e-mail avillami@illinois.edu