Administration and Congress Reach Broad Agreement on $700-Billion Troubled Asset Repurchase Plan (TARP)

The modified TARP program represents a reasonable compromise that more aggressively protects the interests of the American taxpayer.

The expected passage of the legislation in the upcoming week will provide some critical life support for the U.S. financial system, which has been hit by a dangerous escalation in volatility in turmoil since early July, leading to some spectacular failures of major players and a significant ramping up of direct government intervention in the sector.

The success of the TARP program in steadying the financial system over the next several weeks will be measured in the first instance by some normalization of interbank funding conditions—more specifically a reduction in LIBOR borrowing spreads, which spiked to critical levels in the second week of September.

In a separate fiscal 2009 spending bill passed by the Senate, the government is proposing to provide $25 billion in loan subsidies to the auto industry to support industry retooling to produce smaller, more fuel-efficient vehicles, as well as about $23 billion in disaster relief related to hurricanes Gustav and Ike, and a 6% increase in military spending.

With the imminent passage of the TARP legislation, attention will be re-focused on the cyclical weakness in the economy, which deteriorated sharply over the past several weeks.

Congress is also debating an additional $50-billion fiscal stimulus package, and that will rapidly come up on the radar screen after the expected passage of the TARP program. However, Congress is becoming increasingly hemmed in on fiscal options, with significant upward pressure on the forecasted fiscal deficit for 2009.

For the TARP program ultimately to be successful, with limited fallout for the taxpayer, the domestic economy's extreme cyclical weakness needs to be turned around, or at least we need to see some light at the end of the tunnel. With top-level inflationary pressures easing, and virtually no evidence of an inflation problem in domestic product prices, there is room for the Federal Reserve to lower interest rates further in order to lay the groundwork for a cyclical upturn in 2009.

While the TARP program will relieve some of the extreme pressure on the financial system in the short term, the economic patient is in critical condition and needs an increased flow of oxygen from the Federal Reserve immediately.