The Wall Street Journal reported yesterday on the government’s latest improvisation for propping up the banking system, called “loss-sharing”. Essentially, what it boils down to is that the FDIC encourages healthy banks to acquire failing banks by guaranteeing that it will cover 80% of any losses arising from the acquisitions. The Journal and others have correctly observed that this amounts to a taxpayer-funded giveaway to the acquiring banks. While it is certainly true that loss-sharing is yet another federal giveaway to banks, I believe that focusing on this part of the picture overlooks the most important aspect of the program.
It is said that people living in war zones become so acclimated to horror and destruction that they hardly even notice it after a while. While a car bomb in Manhattan would bring the entire city to a standstill, one in Baghdad probably goes unnoticed by everyone except those immediately affected by it. Unfortunately, much the same can be said about the American economy these days. Disasters have become so commonplace that they hardly even register in the average American’s consciousness anymore.
One of the most peculiar aspects of the economic crisis is also one of the least remarked upon. Never in recent memory have so many economic experts warned of the prospect of inflation while an equally large group warned of impending deflation. In all but the most unusual cases, inflation and deflation are mutually exclusive. Either one or the other might be a threat, but not both at the same time. The current bizarre situation is as if a group of doctors examined a patient and half of the doctors warned that the patient was freezing to death while the other half diagnosed the patient with heat stroke.
Inflation is the phenomenon of too much money chasing too few goods, thereby causing rising prices, whereas deflation is the opposite – i.e. a glut of goods and services with not enough demand, thereby causing prices to fall. So, how is it possible that both could threaten us simultaneously?
Mainstream media and government officials confidently tell us that the worst of the economic crisis is behind us. Undoubtedly, the current environment seems calmer than the free-fall that characterized the early part of this year. However, I would argue that, far from being finished with the crisis, the present situation is akin to the calm at the center of a storm. We have experienced the violence of the first wave of the tempest, but anyone who mistakes this temporary lull for an indication of smooth sailing will soon suffer a rude awakening.
Real estate is nowhere near a bottom, our nation’s largest banks are insolvent, gas prices are heading back up in a hurry, and two of the “Big Three” are in bankruptcy. Twelve percent of all mortgages (not just subprime) are either in foreclosure or behind on payments. Commercial real estate is just beginning to crumble. Forget about what the talking heads tell you, just look around. Does this look like the beginning of a recovery?
by Josh Sidman
April 26, 2009
There were many things that were deeply disturbing about the Bush Administration, but perhaps nothing was more so than its willingness to make blatantly false statements in the face of obvious evidence to the contrary. When a government commits itself to upholding obviously false positions, all rational discourse and debate is short-circuited. Once that happens, there is no limit to the atrocities that the government can commit in the name of protecting the public interest. Continue reading
The “almost” is due to my firm belief that electing John McCain would have led to World War III. That being said, in terms of the economy, I don’t believe McCain could possibly have done worse than Obama is doing.
Those who read my blog regularly may have noticed that despite supporting Obama in the election, I quickly became critical of him when he took office. I felt somewhat bad about doing so – as if he deserved some kind of “grace period”. So, although I made a number of criticisms, I felt conflicted – like maybe I was being a little too hard on the guy. As of now though, I am convinced that Obama is either a) incompetent, or b) a bought-and-paid-for stooge of the banking industry.
There’s a lot that doesn’t make sense about the economy these days. The situation is so mind-numbing that an increasing number of Americans seem to be opting to simply ignore it all in the hopes that it just goes away. Most people I know have stopped looking at their account statements, and “bailout fatigue” is nearly universal.
Part of the reason for our collective denial is that we don’t want to come to terms with our diminished circumstances. When the average American’s life-savings has been cut in half, its understandable that people would be reluctant to face the new realities. However, I would argue that there’s something deeper going on. Not only does a clear-eyed appraisal of the situation require people to come to terms with painful facts, but it is also threatening to their basic sanity. How are we to make sense of the idea that the way to solve a crisis caused by excessive debt is by taking on even more debt? Faced with such counterintuitive notions, the rational mind simply turns away.
The latest insanity announced by the government is a plan whereby the Fed will buy over $1 trillion of government bonds and mortgage backed securities. In other words, the government is going to print money and then loan it to itself.
Sad to say, but with each passing day President Obama looks less like an agent of change and more like the latest installment in a never-ending series of Washington powerbrokers. This is doubly disappointing, since if there is a silver lining to the current crisis, it is that we have a once-in-a-generation opportunity to fundamentally change the way things are done. So far, all indications are that the Obama Administration lacks the courage and integrity to deliver upon the hopes they raised during the course of the campaign.
Case in point is the omnibus spending bill that the President signed last week. Despite promising repeatedly to veto any budget with earmarks, Obama signed this spending bill containing over 8,000 earmarks. Granted, it would be much more difficult to cobble together a congressional majority without the sweeteners that these earmarks represent, but this is precisely the kind of situation that tests the mettle of a leader. Does he have the strength to hold the line, or will he cave in to the status quo when push comes to shove? Obama could have stood up to the corrupt leaders of his own party (Pelosi, Reid, Frank, etc.) and refused to sign the bill, but he didn’t.
Another example of failing to lead is this week’s populist pandering over AIG bonuses. Yes, it is infuriating for the American public to see executives being rewarded after the enormous amounts of public money that have been pumped into their companies. That being said, the bonuses in question are microscopic in comparison with the real story. In the context of the trillions of dollars the government has already used to prop up the financial system, $165 million is completely insignificant. By turning it into a public firestorm, our leaders are cynically exploiting the public’s inability to comprehend the magnitude of the amounts of money currently being thrown around. $165 million, $20 billion, $1.5 trillion, what’s the difference? They’re all staggeringly large numbers. That being said, there’s a very big difference between a hundred million and a hundred billion, and our leaders are counting on our inability to tell the difference.
Of the money that has been pumped into AIG, over $12 billion has gone to Goldman, Sachs, the company once led by former Treasury Secretary Hank Paulson. The President and the leaders in Congress have nothing to say about this, while they make an enormous stink about bonuses that represent less than 2% of that amount. This is a deliberate and cynical error of omission and emphasis. By making a spectacle out of a relatively insignificant issue, our leaders are hoping we’ll be distracted enough that we won’t notice the hundreds of billions that are being allocated according to a process that is both opaque and riddled with conflicts of interest. In other words, pay no attention to the man behind the curtain…
I was recently asked by the administrator of Dandelion Salad, a news and politics website that I contribute to regularly, to review a book written by another contributor to the site. The book is entitled We Hold These Truths: The Hope of Monetary Reform and deals with a subject that I have written about at great length. While the author and I disagree about what should be done, we both agree that there is a fundamental flaw in our monetary system and that any attempts to repair our financial system that ignore the nature of money itself are bound to fail.
Anyone wishing to order a copy of the book can do so here.
“Credit should really be viewed as a publicly-regulated utility like water, clean air, or electricity.” For this thought alone, Mr. Cook’s book is worth reading.
The main thesis of the book is that by improperly ceding control of credit creation to private financial institutions, the government has abdicated its responsibility to govern this all-important tool for the benefit of society at large. The private institutions which enjoy an unfair monopoly on credit creation use it to siphon off a portion of our national productivity, thereby leaving us with a perpetually unbalanced financial situation which necessarily results in an ever-increasing debt burden hanging over the real economy.
Note: Josh added this to Obama’s website, please vote it up there.
by Josh Sidman
January 14, 2009
Most people had probably never heard this phrase a year ago. It refers to the monetary phenomenon whereby the financial authorities find themselves powerless to stimulate the economy via the normal expedient of cutting interest rates. Ordinarily, interest-rate policy is a viable tool for speeding up or slowing down the business cycle. If the economy is sluggish, interest rates are lowered, and economic activity picks up. If the economy is too active and inflation looms, interest rates are increased, and the economy slows down. Continue reading
The late Senator Everett Dirksen famously quipped, “A billion here, a billion there, pretty soon you’re talking real money.” Times have changed. Nowadays a billion is a mere rounding error, ten billion elicits little more than yawns, a hundred billion might start to raise a few eyebrows.
In the latest of a never-ending series of public bailouts, today the government injected $20 billion into Citigroup (on top of a previous infusion of $25 billion). In response, the stock price of the company surged 60%, representing an increase in shareholder wealth of approximately $13 billion. In other words, while increasing numbers of Americans are crushed by a financial crisis caused in large part by companies like Citigroup, the government saw fit to take another $20 billion of taxpayer money and give it to the very people who caused the problem in the first place.
Now, I agree with the notion that a company like Citigroup may be “too big to fail”. The consequences of letting an institution like Citi go under would be dramatic and far-reaching, but this is no argument for rewarding shareholders. Those who profited from the excesses of the lending bubble ought to bear the full brunt of the crisis they helped to create, and if that means that the stock price goes to zero, so be it.
Let’s think about what we could do with $20 billion if we decided not to use it to reward the very people who caused the problem in the first place.
We could open the phone book and select 20,000 people at random and give each of them a million dollars. I bet that would stimulate the economy. Or we could select 400,000 high school seniors and give them each $50,000 to put toward a college education. Or we could identify 20 companies that are likely to play a leading role in the “green economy” of the 21st Century and give each of them a billion dollars to invest in research and development.
And that’s just one bailout. Imagine what we could have done with all of the money that has been plowed into AIG, Fannie, Freddie, etc., etc. I guess all of this should come as no surprise given that the man in charge is the former CEO of Goldman Sachs. And, hopeful as I am that President Obama will deliver on his promises of change, his appointments of such establishment figures as Timothy Geithner, Larry Summers, Hillary Clinton, Bill Richardson, and Tom Daschle doesn’t instill a great deal of confidence that his administration will represent a true changing-of-the-guard.
Aw hell, if you can’t beat ’em, join ’em. I think I’m just gonna try to figure out which will be the next mega-corporation to receive a $20 billion bailout and buy their stock. Heck, I might even see if I can put it on my credit card.
Since the beginning of the financial crisis, one of the things that has been most striking is the unanimity of opinion that large financial institutions cannot be allowed to fail. The conventional wisdom is so one-sided in this regard that nobody (that I’m aware of) has actually gone through the exercise of asking what exactly would be the result if we simply did nothing and allowed the banks to fail. Given the enormous costs we are incurring to prevent this outcome, we have to at least consider the alternative. Would it not be more economical to simply let any bank fail that can’t stand on its own and let the government print money to pay off all the claims of the FDIC?
In broad terms, the banking industry uses three primary inputs in order to fulfill its functions. These inputs are capital, information, and human resources. Obviously much of the first category has been destroyed, but capital can always be rebuilt in time. The other two categories of inputs are largely unaffected by the current crisis. The informational infrastructure of the banking industry is completely intact (and will almost certainly be improved upon as a result of the hard lessons we are currently learning), and the available human capital is undiminished. So, even if the greater part of the banking industry were to cease to exist, new institutions would spring up (and would employ many of the same people – hopefully a little older and wiser now – who staffed the old ones). What would be so terrible about that?
Treasury Secretary Hank Paulson announced today that the government will not be purchasing troubled assets from banks, as they had previously planned to do. This is a startling reversal, given that this was the centerpiece of the original bailout package. Such an abrupt about-face is hardly encouraging as it begs the question of what exactly the government has been doing all this time and calls into question whether those in charge really have any idea how to solve our problems.
It is common knowledge by now that the root cause of our financial difficulties is excessive debt. Across the whole economic landscape – from individual homeowners to corporations to the government – everyone dug themselves into financial holes that they are now unable to climb out of. This being the case, doesn’t it seem odd that the government’s solution to the crisis is to borrow even more money to shower upon the financial sector in hopes that they will start lending again? This is like treating a patient suffering from alcohol poisoning by force-feeding him another drink.
Yes, functioning credit markets are an essential part of a modern industrial economy, but we seem to have lost sight of the fact that the ultimate health of an economy is based on individuals and corporations creating, buying, and selling valuable goods and services. Yet virtually all of the money the government is spending on its rescue efforts are aimed at Wall Street rather than Main Street. The credit markets ought to be the servant of the real economy, rather than the other way around.
Does nobody find it strange that, while hardly anyone bats an eyelash at the latest hundred-billion-dollar bailout of a bank or insurance company, we hear nothing of plans for increased public spending on infrastructure, technology, or education? Is it really better use of taxpayer money to pour countless billions into a financial black hole like AIG rather than investing in technology and education which will improve the long-term ability of American workers and corporations to compete in the global economy? What if, instead of spending a trillion dollars to help banks avoid the consequences of their own foolishness, we spent that money on building bridges and roads, developing alternative energy, and retraining American workers with outdated skills?
Forgetting for a moment the question of fairness, let’s consider from a purely practical point of view which approach to rescuing the economy is most likely to work.
All of the measures aimed at repairing the credit markets are based on the presupposition that once banks stop the financial bleeding they will resume “normal lending”, thereby rescuing the economy. The rationale underlying this argument is based on a very questionable assumption. Even if banks are willing to lend, borrowers need to perceive attractive uses for capital or they will have no incentive to utilize the available credit. After all, if someone offered you a zero interest loan to purchase real estate right now, would you do it? Two years ago virtually everyone would have answered this question in the affirmative, but things have changed since then.
In the absence of solid investment opportunities, the government can print all of the money it wants, but it may still be incapable of stimulating the real economy. I would argue that the trauma of the last several months has fundamentally changed public attitudes to debt and that a return to “normal lending” is neither possible nor desirable. Do we really want to go back to a state in which people borrow as much as they possibly can in order to buy bigger TVs and homes they can’t really afford?
If, on the other hand, the government announced that it was going to spend a trillion dollars to repair roads and bridges, build wind farms, and retrain American workers, the stimulative effects would be far more certain. Millions of jobs would be created and those millions of employees would have an increased ability to spend and invest. This seems like a far more effective way of battling the current crisis than pouring money into banks and insurance companies in the hopes that they will return to business as usual.
In 1994 I had the opportunity to have dinner one-on-one with the current CEO of Citigroup, Vikram Pandit. At the time I was employed as a trader in the Japanese equity derivatives department at Morgan Stanley, which Mr. Pandit oversaw. He struck me as a decent, thoughtful, ego-free person. Given that he is now a central player in crafting the changes that are occurring in the financial markets, I wanted to share my thoughts with him on the proposed reforms. It is my belief that all of the measures currently under consideration miss the most important aspect of the overall picture — i.e. the role of money. It is my hope that someone in a position like Mr. Pandit’s might promote the argument that the reforms currently under consideration are inadequate and that if we fail to address the fundamental problems with money itself we will at best accomplish a temporary fix for our problems.
Following is the text of the letter:
Oct. 29, 2008
I know that your time these days is subject to intense demands, so I don’t expect that you will necessarily have the time to read (much less respond to) this letter. That being said, I have spent a good deal of time over the past several years thinking about issues of monetary economics, and I have some thoughts which are relevant to the current crisis.
As I watch the unfolding drama of the attempt to save the financial system, I can’t help but despair that all of the proposed reforms ignore the most fundamental cause of our problems. We can (and should) update our regulatory framework, improve transparency, etc., but unless we address the heart of the matter – i.e. the nature of money itself – we will only be instituting a temporary fix for a perpetual problem. It will always be the case that in the aftermath of a crisis there is outcry for reform and regulation, but as the memory of a crisis recedes, the pursuit of profit inevitably overwhelms the abilities and resources of the regulators. New abuses arise which eventually lead to the next crisis.
The other day I received an e-mail from my uncle asking for my thoughts on the economic crisis and the proposed bailout. Below is his e-mail followed by my response.
Maybe you can help me. I am trying to apply an aging physicist brain to the current economic situation and I could use some help.
Admitted bias upfront, I tend to see things more positively by reflex.
Inflation is caused by an increase in the “money supply” without a corresponding increase in goods and services causing more money to chase the unchanged supply of goods thereby increasing the price.
The value of “bad” mortgages was part of the “money supply” when the mortgages were good
and therefore marketable. Now that the mortgages are “bad” and unsellable they are no longer
part of the “money supply”, or have radically decreased in value, thus the “money supply” has decreased as a result.
If the government prints money to e. g. buy the illiquid mortgages, (for less than 100 cents on the $)is it not just replacing the money which the illiquidity of the mortgages removed, and thus is “neutral” effect on the “money supply”?
The root of the problem is the decline in housing prices which “removes” wealth from the system,
and is thus “deflationary”.
Does not the effect of Premise 3 give the treasury room to “print money” to balance it without
increasing the overall money supply and thus being neutral on the inflation front.
Sincerely wanting to understand,
P.S. Henry Paulson is: A. a socialist B. an idiot C. Someone whose career evidences a solid understanding of the system, and who is a believer in “capitalism”. D. Other (Please specify)
I’ve had a chance to think about your questions, and while I don’t have any conclusive answers, I do have some thoughts that might help flesh out the picture a bit.
For starters, I will observe that your premises/conclusions are based on an oversimplification that is typical of most mainstream discussion of economics – i.e. considering economic phenomena in terms of broad homogeneous categories rather than as aggregations of an infinitude of discrete and varied elements. For example, when the government measures GDP, no distinction is made between a dollar spent on a TV-set and a dollar spent on education, although obviously their effects on the economy are very different. Of course, we have to lump together many disparate things in order to measure them, but the fact remains that according to this type of analysis, we could redirect every dollar currently spent on education to providing children with cigarettes, and the economy would be just as “healthy” in terms of GDP.
The point is not to argue against using the standard tools of macroeconomic analysis. Obviously it would be impossible to quantify the consequences of every individual transaction in an economy, and we must resort to abstract techniques if we want to be able to measure anything at all, but we must also avoid falling into the trap of mistaking man-made concepts like “GDP” and “money supply” for the actual economy.
So, when we talk about the “money supply”, what we are really talking about is an infinitely varied collection of instruments which have potential purchasing power. A dollar hidden under the mattress of a miser does not impact the economy in the same way as a dollar in the hands of a drunk at a blackjack table, but from the point of view of a monolithic concept like “money supply”, the two are indistinguishable. And, while we are all familiar with the big-picture monetary hazards called “inflation” and “deflation”, in actuality what is harmful is monetary instability in general. In fact, the very worst monetary scenario is “stagflation” in which aspects of inflation and deflation occur simultaneously. [For a more detailed discussion of money and the consequences of monetary instability, see my article entitled “American Economy: The Veil of Money”.]
So, while it is conceivable that the government could exactly offset the amount of money that has been wiped out by the credit crunch and thereby leave the “money supply” unchanged, this doesn’t mean that the result wouldn’t still be catastrophic. For example, the fact that the government is creating money by buying bad debts from banks is of little consolation to the family that is losing its home.
Another way of thinking about the economy is by way of metaphor. I like to think of the role of money in an economy as analogous to that of blood in a physical organism. Blood flows in different ways throughout all parts of an organism, and the overall health of the organism is dependent not only on the quantity of blood but also on it flowing properly. Maladies occur whenever the flow is too fast or too slow or impeded or misdirected. This metaphor is useful for addressing your question about why the government can’t just print an equivalent amount of money to the amount that has been destroyed in order to achieve a neutral effect on the economy. It would be as if we took a trauma patient who has lost a lot of blood and gave him a massive transfusion without knowing his blood type (although, whereas a random blood transfusion might end up working just based on blind luck, in the case of the economy, since there is an infinite number of “blood types”, a random transfusion cannot possibly work).
Another metaphor that I like to use when thinking about the role of money in an economy is to visualize a fertile river valley in the middle of a desert. The volume of water in the river determines how far in either direction crops will grow. So, for example, while in a drought year crops might only grow right next to the river, in a year with abundant rainfall the margin of cultivation will lie at a greater distance from the river. Now, let’s imagine that the flow of water is suddenly increased by artificial means. This will allow crops to be grown over a larger area of land than usual for as long as the artificially large flow is continued, but as soon as the unsustainable flow is interrupted, all of the crops that ordinarily would never have sprung up in the first place will wither and die.
I would liken the monetary policies of Alan Greenspan to the artificially high river. Rather than allow the boom & bust of the dot.com bubble to run its course, Greenspan turned the spigots wide open and let the river flow at an abnormally high rate that averted short-term pain but assured much greater destruction later on. All you have to do to see this with your own eyes is to take an airplane flight into Las Vegas (or Phoenix, or Miami, or Los Angeles…) and look at the massive number of housing developments in various stages of completion around the margins of the city. These developments are the equivalent of the crops that under normal circumstances never would have sprung up in the first place. As a result of artificially abundant money all of this excess housing stock has come into existence and must now be reckoned with before we can get the economy back on a sound footing. And simply printing money will not remedy the fact that the economic organism developed along unsustainable lines.
All of that being said, I am not arguing against the use of fiscal and monetary policy to deal with the current crisis. I am just not optimistic about our chances of success. I believe we will be unable to avert a crisis for two reasons.
First, to use yet another metaphor, imagine that the job of the financial authorities is to steer a ship through a winding channel. One side of the channel represents unemployment and economic stagnation, while the other side represents inflation and “irrational exuberance” (to borrow a Greenspan-ism). Under ordinary circumstances it is a difficult but manageable task to keep the ship safely within the channel and not to err too badly in either direction. However, the steering mechanism of the ship is highly imprecise and cumbersome. Much like steering an actual ship, you must always be thinking ahead and compensating before your errors become evident. If you fail to stay ahead of the curve, you have to resort to increasingly risky maneuvers in order to avoid harmful divergences, and each of these risky measures makes the next maneuver that much more difficult to execute safely until a point is reached at which there is no way to avoid a painful crack-up.
I would argue that this is the position that Bernanke and Paulson find themselves in right now. They are steering a ship that is careening wildly in an ever narrower channel. The truth is that most of the blame for the current situation lies not with Bernanke or Paulson but with their predecessors. Bernanke and Paulson could be the most intelligent, upright people in the world and still fail to avoid a collapse. Personally I don’t have a strong opinion one way or the other as to the abilities or integrity of either one, although I think it is worrisome that Paulson is one of the people who profited most from the abuses which caused the crisis in the first place. Putting Paulson in charge of the bailout is like a bank hiring the best safe-cracker to run its security department. He might in fact be the best guy for the job, but you have to question his motives, and with the kind of absolute, non-reviewable power the current plan seeks to give him, I wouldn’t take it for granted that he’ll do what is in the best interests of the average American.
Add to all of this the fact that we are in the middle of a presidential election (which means that most parties in Washington are just as concerned with their own political futures as they are with the state of the economy), and I just don’t see much cause to be hopeful that they will be able to thread the needle and come up with just the right set of solutions to avoid a painful and protracted crisis.