Page last updated at 18:56 GMT, Tuesday, 16 September 2008 19:56 UK

Crisis challenges McCain and Obama

By Steve Schifferes
BBC News, Washington DC

The state of the economy was the central issue in the US election campaign even before this week's financial crisis - now it's beginning to eclipse all others.

Consternation at the NYSE
It's unclear how much the crisis will affect the real economy
Many politicians refrained from comment in the hours after the collapse of Lehman Brothers for fear of unsettling markets further, but the two presidential campaigns leapt straight in.

For Barack Obama it provides a chance to move on from the excitement over the nomination of Sarah Palin as Republican vice-presidential candidate and push on a key campaign message - that the Republicans have wrecked the economy.

Michael Dimock, associate director of the Pew Research Center, told BBC News the story could be beneficial for Mr Obama in two ways - it would reinforce the overwhelming public view that the US was "going in the wrong direction" and would make it more difficult for Republican John McCain to distance himself from the current administration.

Polls have consistently shown the Democrats are trusted more than Republicans to handle the economy.

Mr Dimock said Senator McCain's recent improvement in the opinion polls stemmed from the fact that people like his character and believe he has the experience to be president - not from their support for his policies.

No new policies

Mr McCain's dilemma was illustrated by his uncertain response to the crisis on Monday, when he started off by praising the government for not wasting taxpayers' money by rescuing Lehman, and echoed Mr Bush's remarks that the economy was fundamentally sound.

The market has gotten into such a terrible state that specific interventions haven't helped
Barney Frank, Democratic chairman of the House of Representatives financial services committee
By the afternoon, speaking in Orlando, Florida, Senator McCain had reversed himself, saying the economy was in crisis. Meanwhile his running mate, Sarah Palin, pledged to clean up "mismanagement and abuses" in Washington and Wall Street, attacking those who "have been asleep at the switch and ineffective."

Mr Obama seized the opportunity, describing Mr McCain's remarks "disturbingly out of touch".

The most serious financial crisis since the Great Depression had been brought on by "eight years of policies that have shredded consumer protections, loosened oversight and regulation, and encouraged outsized bonuses to CEOs while ignoring middle-class Americans," he said.

But he did not repudiate the measures taken by US Treasury Secretary Henry Paulson and Federal Reserve boss Ben Bernanke, nor did he offer any new policies.

Internal divisions

Behind the scenes, there are divisions within both Republican and Democratic camps about the future level of government intervention in the economy.

Barney Frank, the influential Democratic chairman of the House financial services committee, has been one of the few politicians to speak out, saying that further federal intervention might be needed as "the market has gotten into such a terrible state that specific interventions haven't helped".

He believes that the next president will have to consider setting up the equivalent to a Resolution Trust Corporation, the $500bn entity that took over all the failed savings and loan institutions in the l980s - the last big banking crisis - and eventually sold them.

People who touch a hot stove have to learn that it hurts
Dean Mitchell, Cato Institute
However, Doug Elmendorf, the director of the Hamilton Project at the centre-left Brookings Institution (where he recently replaced Jason Furman, Mr Obama's economic advisor) praised Mr Paulson and Mr Bernanke for making exactly the right moves to rescue the markets while not enmeshing the government too deeply.

In a similar way, they represent two different lines of Democratic thinking on the ultimate fate of Freddie Mac and Fannie Mae, the giant mortgage institutions temporarily taken into state ownership last week.

Congressman Frank sees them being restored to operate as government-sponsored enterprises ensuring extra support for low-income home ownership. Mr Elmendorf argues they should be eventually sold off and privatized.


There are similar divisions on the Republican side.

Dean Mitchell of the libertarian Cato Institute argues that governments are wrong to subsidise housing at the expense of the rest of the economy.

He says that "people who touch a hot stove have to learn that it hurts" and that both investors and borrowers should pay the price of their imprudence - a view Mr McCain once shared.

But for former Bush administration official J D Foster, now at the Heritage Foundation, the rescue was a "necessary evil". The public effectively "had eaten its lunch" (by benefiting from the cheap loans provided by these companies) and now had to "pay the bill".

Letting the institutions fail would have been a disaster, he says - but argues that they were flawed from the beginning and can now be wound up in an orderly fashion.

Government enmeshed

Beneath these debates lurks another - just how seriously the real economy will be damaged by the financial crisis.

Mr Foster argues that the bloodletting on Wall Street will actually be good for economic growth, as it will end the uncertainty in financial markets and allow them to get on with the business of lending money again.

He expects the economy to recover strongly next year, reducing the burgeoning budget deficit, and does not believe the rescue plans will eventually cost the government that much.

Mr Elmendorf argues that on most measures, the US economy is already in recession, and that a collapse in the financial markets would make matters much worse. Further intervention, if needed, would cost much less than the loss of tax revenue caused by a deeper economic slowdown, he says.

Although no taxpayer money was offered as two large Wall Street firms teetered on the brink of collapse, the events of this week have enmeshed the government more deeply than ever before in shoring up the financial markets.

The Treasury has doubled the national debt by taking over the $5.5 trillion obligations of the two giant government-sponsored mortgage lenders, with a $200bn down payment to recapitalize them.

And the Federal Reserve has been forced to agree to take the "toxic" sub-prime loans as collateral from banks, giving them short-term loans in return, in order to prevent a further meltdown on Wall Street - with another potentially large liability for the taxpayer.

The consequence is likely to that the next president may well spend much of his first year in office sorting out the financial mess.

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