Friday, February 27, 2009
Gordy Ringoen - Stimulus, Bailouts and Such
Brief History: First there came the sub-prime mortgages losses for financial institutions beginning in early 2008. It resulted in more than $500 billion in bank losses. This translated into more than $3 trillion contraction in loan capacity.
The losses and shrinking loan capacity led to illiquidity in the financial markets. Secretary Paulson asked for “standby” authority which was to give the markets “confidence.” No such luck, the markets began freezing out Fanny and Freddy. To stop their collapse, the government guaranteed $10 trillion of their paper (an amount equal to the total US debt at the time). Next was Bear Stearns which was forced into a shotgun marriage. The Treasury decided it couldn’t save Merrill and Lehman simultaneously. Bye, bye Lehman. Enter AIG, WAMU, Wachovia, Citi, and Bof A- the blackest of holes with more to come.
Paulson got on his knees and begged Nancy Pelosie to save the Union by giving him a discretionary account of $700 billion to buy toxic mortgage loans from failing institutions. He got the first installment of $350 billion. After a couple of weeks he realized this was a nonstarter. He then determined that putting the money into capital of the financial institutions would be more efficient. It could possibly be leveraged up to 10 times in loans by the banks. Nice hypothecation, but the banks merely used the capital to improve their capital structure while continuing to restrict credit.
Meanwhile, the world was also suffering a huge $US liquidity crisis. The LIBOR market, the international lending of $US, became illiquid for a number weeks in the fall of 2008. The Fed opened up its balance sheet for the world's Central Bankers to avert the crisis. The Fed expanded its balance sheet by $2.3 trillion. We don’t know where this money has actually gone because they won’t tell us. They say that if we knew, we might think someone was in trouble. You think?
Meanwhile, the rest of the economy began to catch up with the financial markets by falling off the cliff. More than1.5 million jobs were lost during the last three months of the year while foreclosures exploded. The Government went on holiday for three months waiting for a new administration.
Enter Obama. After haggling with Congress, he will have affected a nearly $800 billion stimulus program to get the economy moving and create 4 million jobs, or so we hope. There is about $600 billion in actual spending stimulus which amounts to less than 1/3 of the economic contraction expected in 2009. It is not nearly enough to jump start the economy, but it is a start. There will be more to come.
Meanwhile, Tim Geithner unveiled the Treasury program which would put $100 billion of capital into financial institutions which might generate $1 trillion in loans. Also, it would purchase $1 trillion of bad loans. Essentially, it is a “Paulson 2” plan, albeit with promised better record keeping and oversight. In any event, what it actually means is still a mystery since so little of the details have been disclosed. We assume that there are details.
The Fed, not to be left out, will increase credit for business and consumers from $200 billion to $1 trillion.
So, now we are caught up. Make sense? Of course not. All we can say for sure is that there is a big problem and we are throwing tons of money at it.
Political Response: There are four basic responses available to the government:
Spending to increase demand in the economy.
Tax cuts to stimulate demand.
Government purchase of bad loans.
Government injection of capital directly into business or guarantee of their debts.
Unfortunately, the responses thus far have been jumbled with only partial disclosure and shockingly little oversight. But, perhaps the most alarming aspect is a lack of coherent objectives and plan.
The fundamental requirements of a sound economic stimulus program would be that the spending of taxpayer money, or cutting taxes, which is financially equivalent, has sound objectives in one of the following ways:
1. Spending would ideally be an investment in our economy. An investment where the principle and a fair return is expected. Investment in education, health care, infrastructure, technology, environment, R&D, and energy independence could all qualify as sound investments.
2. Spending for consumption is more problematical. It may be justified on a social basis. Unemployment insurance, food stamps, and medical care can constitute money well spent. Increases in defense spending and wars may be justified for protection or political reasons but not as an efficient stimulus.
3. Tax cuts are hard to justify on a stimulus basis. Tax cuts for corporations would tend to be the least rewarding. Although it can be argued that our corporate tax rates are higher than most competing countries, the argument is misleading. The net taxes paid by corporations as a percent of government revenues has been declining for decades because of loopholes in the tax system. Though stated rates are high, actual tax payments are low. Further, corporate tax cuts would tend to benefit the largest, established companies which tend to be poor engines for economic growth. For the past 30 years, the Fortune 500 companies have had a net decline in jobs. They have had net capital investment loss when comparing stock buy backs and dividends vs. capital raised. They have traded higher stock prices for shrinking their capital base. Nearly 18% of job creation is from start up companies that make up only about .2% of our total economy. They have minimal tax bills.
A tax cut for individuals from a stimulas standpoint are at best marginal and at worst highly inefficient. Tax cuts for individuals will likely be used to pay down debt or increase consumption. There is nothing in current behavior that suggests that individual tax cuts would be invested for long term economic benefits. A recent report says there has been no net savings since 2000. The loss of revenue would increase long term government debt but would not provide long term economic benefits.
Middle class tax cuts can be argued on a social basis. The working class has been effectively saddled with a 14% social security sur tax and do not benefit from the 15% capital gains taxes. Social justice it may be, but not an efficient stimulus.
In summary, an economic spending stimulus program is pretty straight forward. A prudent program will provide near term economic gains. It will be paid for by increased debt, but will bear economic fruits in the future which will allow for an increase in future taxes.
There is a contingent that thinks that all government spending is bad and all tax cuts are good. As Jon Stewart says, “20% of all dentists say that sugar gum is good for your teeth.”
Bailouts are much more problematic. Bailouts socialize overvalued debt, provide government funded equity for private firms, or simply nationalize businesses.
The reason that bailouts are needed is that the financial claims are not supported by assets or income generating power. In other words, the debt is overvalued. And, there is insufficient confidence in the private sector to make investment. The fundamental question is under what circumstances is a government bailout justified?
It is important to understand the circumstances that created the problem in the first place so that any program will not merely aggravate the situation. There are essentially three fundamental causes;
1. Mal- Investment: There has been excess construction of houses in marginal locations at prices that can not be afforded by the working populace. Probably too much has been invested in such things as leisure industries including resort development, casinos, cruise ships, and sports stadiums. Insufficient or ill-conceived investment in the automobile industry that produces only marginally competitive autos. And, perhaps the greatest distortion of all exists in the finance industry. This industry, before the recent market declines, had profits and market value of more than 20% of the Fortune 500 companies. This is a head scratching tariff to our producing economy for only moving money and credit from A to B.
2. Over Consumption: We essentially consume more than we produce. That is to say that we have no savings and consequentially no domestically generated investment. The net investment we do have has come from abroad. It is economically impossible to consume your way to long term prosperity.
3. Excessive Credit: Before the recent problems, public and private debt totaled more than 360% of our GDP. This compares to 160% in 1929 before the Great Depression. This is an amount that can not be sustained and will not be paid in kind because of a lack of economic capacity and unwillingness to service the debts on the part of the borrowers. This credit explosion triggered the mal-investment and over-consumption as previously mentioned. It also inflated the prices of real estate and financial assets above their economic value.
So, how big is the problem? Nouriel Roubini, of Stern School at NYU, who has been prescient regarding recent economic events, has recently estimated that the losses to financial institutions will be $3.6 trillion. The previous forecast was $1- 2 trillion. Approximately half the loss will be in banks which have only $1.4 trillion in equity leaving them with a negative net worth of $400 billion if he is correct.
To reduce the debt to GDP ratio to 1929 levels would require more than $25 trillion destruction in financial assets. This would result in a horrendous blow to the balance sheets of the 20% of the families with the vast majority of financial assets, but it would be even worse for the workers with no financial back up.
Oh, and lest we forget, there are $55 trillion Credit Default Swaps as part of the $550 trillion derivative market. The derivative market is 10x the total world’s GDP. Alan Greenspan told us in the past that derivatives reduced risk. It would be helpful for him to step forward now and explain how that is so. We could use some risk reduction.
The potential derivative losses may simply crush the financial system if the winners are allowed to pursue their gains. AIG might provide systemic risk to the financial system by itself. The debacle is a direct result of deregulation of financial institutions and non-regulation of the derivative markets.
And, the problems are not only a domestic issue. The Director of National Intelligence recently warned Congress that the world financial collapse poses the greatest risk to US security - replacing terrorism as the primary threat. It is forecast that 50 million jobs will be lost worldwide in 2009 causing much social unrest.
Government Guidelines: The following are things the government must do to improve their programs to alleviate the crisis.
1. Congress needs to take a crash course in economics and address the issues instead of ideology.
2. It must initiate actions that will avert systemic liquidity collapses and bankruptcies that would precipitate a chain reaction throughout the economy.
3. It must provide the necessary finance to ensure that the economy can function while nudging it into more productive ways. Meanwhile, it must protect families from catastrophic hardship for those caught in the maelstrom.
4. It must resist pressures from asset owners to monetize their overvalued financial assets. It has been said that “in a bull markets everyone is a capitalist and everyone becomes a socialist in bear markets.” Former free market advocates in finance have elbowed their way to the front of the bailout line.
Major Government Alternatives
1. Continue the patchwork programs to meet the immediate crisis, while ignoring the fundamental problems in hopes that we can muddle our way through. The first problem with this approach is that it may not work. Circumstances, delayed, or ineffective programs may simply be overwhelmed and the entire financial system collapses. We have been perilously close to this condition since September, 2008 and the overall situation continues to deteriorate. Secondly, without a plan and controls, the largess of spending and guarantees could lead to catastrophic hyper inflation. Thirdly, even if we were to avoid the extremes, it would likely provide a drag on the economy that could last for decades. Japan’s “lost decade,” which is now going on 20 years provides a lesson on muddling through without taking the necessary financial hits to let the economy reset.
2. An even more ominous approach would be for the government to inflate its way out of the problems by simply monetizing the bad debts and spending until the economy restarts. This would undoubtedly destroy the $US and could set off a chain reaction leading to hyperinflation which could threaten our very political system. Though no one would suggest this approach, if government would bailout everyone screaming for help, it could happen in any event. As we remember, Napoleon, Lenin, Hitler, and Mao all sprung from the ashes of hyperinflation.
3. A more thoughtful approach would be to have an objective of deflating the bloated financial claims through the markets while providing the stimulus, guarantees, and restructuring necessary to avoid collapse. This would be a tricky, politically difficult task requiring many and varying measures as required as events unfold. This would require a series of better alternative decisions and not some grand, overriding program. Perhaps, we have the economic minds in Obama, Tim Geithner, Ben Bernanke, Larry Lindsay, and Paul Volker to work us through the problems. And, we hope Obama has the leadership, political skills, and will to put the programs in place. It is encouraging to see that there are initial steps in analyzing the problems of the banking and auto industries rather than simply showing thumbs up or thumbs down on throwing more money at them. At first look, the mortgage rescue program seems well thought out.
4. Recently, there are thoughtful people coming forward with specific approach recommendations. George Soros has made specific recommendations regarding the mortgage system, recapitalization of banks, energy policy, and international financial reform http://www.huffingtonpost.com/george-soros/a-plan-for-economic-recov_b_166518.html . Nouriel Roubini proposes nationalizing the banking system. Paul Krugman continually suggests dramatic, far reaching economic programs including significantly expanding spending stimulus. All of these plans have a high cost and will inflict much economic pain.
According to the Federal Reserve, nearly 23% of “financial wealth” has already disappeared. Much more is to be lost. There will be many more bankruptcies and many more job losses. Much of these losses are necessary to reset the economy. The forecast of economic turnaround later this year is a pipe dream.
Further, we will have large dislocations. Many jobs will never return. There will likely be huge reductions in finance, some manufacturing, and service industries. But, most importantly, it will reset our economy to more productive pursuits and reset the financial system so that it is a support system for the real economy rather than its driver. It will encourage thrift and tend to reverse the unhealthy distribution of wealth which is a requirement in a democracy.
No one knows how this economic situation is going to play out. We are still in the early stages, and things are still very unstable. Unforcastable future events will likely surprise on the downside for a while yet.
From an individual standpoint, it is a time for extreme caution. The safest investment is to pay down outstanding debt. It is the only riskless investment and it will reduce an interest cost that is higher than can be earned from other low risk investments. The volatility and potential downside for stocks and bonds qualify them as high risk at this time. Hedges against the devaluation of the $US are volatile and may be difficult to execute, but should be considered. Or, so I say, which may be wrong.
The economic problems are perhaps the biggest in our history, but we have had greater problems as a nation in the past and have not only survived, but have improved our circumstance through creative destruction. It will be accomplished this time by clear thinking on all of our parts and demanding the same of our leaders.
gordy ringoen 2/19/09