TARP: Issues and implications

Abstract

Fiscal policies have been used by governments all over the world to influence the economy primarily with the help of two tools – government spending and taxation1 . Government spending and taxation influence the aggregate demand, distribution of income and pattern of resource allocation in the economy. Fiscal policies are contrasted with monetary policies which also stabilize the economy by controlling the interest rates and money supply in the economy. The current economic crisis is the outcome of devaluation of mortgage based securities backed by falling house prices in the US housing market. The declining prices in real estate market made refinancing of housing loans very difficult. The housing mortgages were adjustable rate mortgages. As they began to reset at higher rates, mortgage delinquencies soared and securities backed with subprime mortgages, widely held by financial firms, lost most of their value. The result has been a large decline in the asset base of many banks and US government sponsored enterprises, tightening credit around the world. In response to this crisis caused by the asset liability mismatch on the balance sheets of major financial institutions in the US, the US government utilized the fiscal tool of capital infusion and monetary tool of quantitative easing 2 i.e. by printing more money when interest rates touch near zero values. To stabilize the economy using fiscal methods, the United States government introduced the Troubled Assets Relief Program (TARP) to purchase assets and equity from financial institutions in order to strengthen its financial sector. TARP allows the Treasury to purchase illiquid, difficult-to-value assets from banks and other financial institutions and is the largest component of the government's measures in 2008 to address the subprime mortgage crisis3 . TARP is intended to improve the liquidity of these assets by purchasing them using secondary market mechanisms, thus allowing participating institutions to stabilize their balance sheets and avoid further losses.