Humpty Dumpty Economics by Josh Sidman

Josh

by Josh Sidman
Dandelion Salad
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Josh’s Blog Post

Dec. 12, 2007

Lately, it seems that every passing week provides new examples of “emergency medicine” by governments, central banks, and corporations to fix the problems of the financial system. Whether it be interest rate cuts, mortgage bailout schemes, or creative juggling of corporate balance sheets, a pattern is becoming increasingly clear – namely, there is no avoiding the law of cause-and-effect, and any attempts to do so inevitably create larger problems than they are intended to fix.

We must, in one way or another, pay the costs of the excesses we have indulged in over the past decades, and any form of “emergency medicine” aimed to avoid this harsh reality will simply delay (and magnify) the eventual reckoning. If we were smart, we would have learned a lesson from Japan, which experienced a spectacular crash of real estate and financial assets beginning in the early-90s. By failing to acknowledge the extent of their problems and trying to prop up the eroded foundations of their financial system, the Japanese authorities only managed to prolong the suffering, producing a period of economic stagnation that stretched out for over a decade. And, we now face the same daunting choice – i.e. come to terms with the realities of a dangerously overextended financial system and tolerate a period of economic hardship, or continue to administer emergency measures which will solve nothing and will only prolong and magnify the problems. Unfortunately, it seems we are opting for the latter.

The most recent batch of emergency measures includes a three-pronged attack – i.e. rate cuts by central banks, a mortgage bailout scheme, and emergency injections of liquidity into the financial system. None of these measures are likely to have a significant impact in terms of long-term healing of the financial system, and all three present significant risks of causing even bigger problems.

Let’s consider the recent proposal by the US Treasury to freeze rates on adjustable-rate mortgages. As we all know, millions of Americans face the prospect of losing their homes as a result of “exploding mortgages”. It seems to make sense that one way of solving the problem is to defuse the ticking bomb by preventing upward adjustments in mortgage interest rates. However, this logic is superficial and fundamentally flawed. The fact is that many of the millions of jeopardized home-owners never should have bought their homes in the first place. If it wasn’t for the newfangled mortgages introduced in the past decade, these people never would have been able to buy their homes to begin with. Only by means of teaser-rates and negative-amortization were they convinced that they could “afford” to buy their homes. The truth is that they never could afford the homes they bought.

To attempt to paper over this problem by freezing interest rates is another instance of treating the symptom rather than the disease, and, as with all such attempts, the medicine is likely to prove worse than the disease. The long-term effects of such an unprecedented governmental interference with the market could be tremendous and long-lasting. Our whole financial super-structure is based on the rule of law and the stability of the purchasing power of money. Without either of these ingredients, holders of wealth will not feel secure enough to commit large amounts of capital to productive uses and will therefore refrain from long-term investment. When governments step in and simultaneously undermine both of these pillars of the global economy, the likely result is a reduced sense of security and a consequent fall in overall productive investment. So, even if we succeed in preventing some people from losing their homes (homes, keep in mind, that they never should have owned in the first place), the cost in terms of long-term economic prosperity is likely to be far greater than the short-term economic benefit.

Especially at a time when the functioning of the global economy is predicated upon the ongoing ability of the US government to borrow enormous sums of money to service its growing debt, such a measure could send a message to investors that contracts are not inviolable and the US government is willing to change the rules whenever it suits its aims. If the commitment of the US government to honor its obligations were ever to come into serious question, the likely effects would dwarf our current problems.

Likewise with the attempts of central banks to solve our problems by flooding the market with liquidity. I don’t remember where I first heard the distinction made between illiquidity and insolvency, but this is a key point for understanding the nature of the current economic crisis. Illiquidity is when a fundamentally sound economic entity finds itself endangered by a short-term shortage of funds. For example, if a company will be paid for its products a month from now but needs to pay its employees today, this is a liquidity problem, and it can be addressed by means of a short-term financial infusion. Insolvency, on the other hand, is when an entity is built on a fundamentally flawed economic foundation – e.g. when a person earning $30,000 per year buys a $400,000 home by means of a high-risk mortgage. In this case, no amount of additional short-term liquidity is capable of bringing the long-term imbalances back into equilibrium. And, this is exactly what is happening in the realm of central bank policy these days. Entities across the board – from governments, to banks, to private citizens – have built upon flawed economic foundations, and no amount of short-term liquidity can solve these fundamental problems. Additionally, the negative effects of unrestrained liquidity pose an even larger risk to the financial system than the problems it is supposed to fix.

The proof, as they say, is in the pudding. All of the emergency measures employed by governments and banks have thus far failed to solve the systemic problems we face. The problems remain, while the dollar collapses and central bankers deplete their diminishing supplies of ammunition. A perfect case-in-point is provided by the announcement today that the Fed and the European Central Bank will jointly act to inject $40 billion in emergency funds into the financial system. An Associated Press article describing the measures states, “The European Central Bank said Wednesday it would make as much as $20 billion available to European banks, in part to fill their demand for scarce dollars, as part of coordinated action with the U.S. Federal Reserve and other central banks.” But, if “scarce dollars” are really the problem, why has the dollar plummeted against other world currencies? The answer is that the problem isn’t illiquidity, it is insolvency, and no amount of additional short-term liquidity can help. The only likely consequence of this move is a further erosion of the value of the dollar.

America is sick right now – everybody knows this. Everybody also knows that long-term health is achieved not by ever-increasing medication, but by treating the causes of disease and restoring the health of the organism. Our current economic sickness may not be fatal, but the medicine may very well be.

4 thoughts on “Humpty Dumpty Economics by Josh Sidman

  1. Thanks, Josh.

    I don’t understand how a family could afford to pay their property taxes and home owners insurance on homes that they really can’t afford.

    I have more of a problem with our govt bailing out the mortgage companies than I do the home owners.

  2. Good question — and there is no easy answer. However, I think it would make much more sense to spend money helping people who lose homes find more economical housing. The mortgage bailout aims to leave people in homes that they shouldn’t be in in the first place. Yes, many people were duped by unscrupulous mortgage brokers into buying homes that they couldn’t possibly keep up payments on, and I believe it is the right thing to use public funds to help these people out, but that doesn’t mean the money should be used to perpetuate an economically unsound situation. The reality in many cases is that someone who could really afford, say, a $200,000 house using a traditional mortgage was convinced to buy a $400,000 house using a high-risk mortgage. If the government bails this person out, it basically amounts to a gift of $200,000 at the expense of the taxpayer.

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