Preventing banking system nationalization but not economic catastrophe.
by Dan Lieberman
The $700 billion plus purchase of financial instruments, which essentially trades cash for trash, even if necessary, is an insufficient measure for resolving the "once in a hundred years," economic crisis. There must be more to the crisis than meets the eye.
Usually when someone requests a huge loan, the person arrives at the loan office with a detailed plan, which is backed up by considerable analysis, a legal framework and relevant financial documents. During the Senate and House hearings of the Paulson plan to rescue the banking system, neither Secretary of the Treasury Henry Paulson nor Federal Reserve Chairman Ben Bernanke submitted an analysis, a prepared ledger or specific reasons to authenticate their demands for a federal purchase of troubled securities from the banking system. The two government officials didn't even seem to have a pencil and pad on the table for their use. Questions for details of the "plan" or recommendations for alternative measures always received a monotonous response: "There is no alternative to prevent a catastrophe and time is short to prevent a financial meltdown." The participants then proceeded to contradict their propositions.
In response to limiting compensation for executives of enterprises that will participate in the rescue plan, Secretary Paulson originally claimed that the suggestion would inhibit many companies from agreeing to the bailout. Since the Treasury Secretary intimated that inability to sell the downgraded assets would prove disastrous to financial institutions, can anyone believe that a CEO would prefer to permit an enterprise to spin into nowhere rather than accept a lower salary? Would the U.S. government allow a CEO in desperate need to dictate to those who are leading the cavalry charge? Although reports have Paulson compromising with the compensation proposal, the initial response damaged his credibility.
Paulson's sense of urgency stifled debate. Won't it take several months to assemble the funds, examine the books of the institutions, and prepare a mechanism for sale of the troubled assets? How could a few days of intensive debate and disclosure of facts delay the rescue mission? If that wasn't sufficiently puzzling, Paulson's lack of activity after the acceptance vote of his plan was incomprehensible. He had no mechanism in place to move his plan into action. Considering his constant rhetoric of immediacy, why wasn't some form of administration in place, prepared to immediately perform required responsibilities with detailed assignments?
Most curious was the covert manner of the government's financial managers. Both of them replied to relevant and meaningful questions with one consistent and simple answer: "Our way is the only way and delay can bring economic catastrophe." The covert manner leads to questions: "What is the referenced economic catastrophe and why the breathless urgency?" Are Paulson and Bernanke referring to a complete breakdown of the financial system in which hundreds of banks will fail and the Federal Deposit Insurance Corporation (FDIC) will exhaust funds that insure deposits?
If so, why not slowly give the $700 billion directly to the FDIC by replying to each of the insurance agency demands for funds as it rescues financial institutions? The obvious reason is that the massive number of bank failures will overwhelm the system's ability to assist the banks, and the FDIC will be forced to retain the banking operations. Similar to government operation of the mortgage industry by seizure of Fannie Mae and Freddie Mac and government operation of the insurance industry by control of AIG, the government will be forced to operate the banking industry by its seizure of troubled banks. In effect, the U.S. banking system will be nationalized.
Has a possible complete breakdown of the financial system forced Paulson and his associates to maintain silence on the extent of then catastrophe? Loose lips not only sink ships; they can force bank runs and turn a manageable turndown into an unmanageable financial disaster. If the conjecture has a basis, and Paulson's objective is to preserve an effective private banking system, then the Paulson plan has merit. Nevertheless, unless it is backed up by unusually clever policies, the plan will only be a temporary expedient for delaying the sorrowful inevitable – an economic breakdown of gigantic proportions.
Injecting cash into an almost defunct banking system and removing illiquid assets from its balance sheets will enable financial institutions to be re-capitalized and conform to FDIC requirements. The banks will remain solvent – a worthwhile endeavor. Nevertheless, a danger exists that the financial obligations of the United States will have passed a point of no return. The enormous increase in the national government deficit, forecasted at $700B, could lower the value of the dollar and increase interest rates. This awkward combination could then increase prices and unemployment. The latter combination will decrease tax revenues and escalate the already increasing deficit and interest rates. The rescue plan can become an uncontrolled feedback mechanism that soon tears itself apart; the U.S. government could go bankrupt. Unless those preparing the $700B bailout are able to show that a government bankruptcy is definitely impossible, then what seems to be a remote possibility can become a valid prediction. The dire consequence is sufficiently frightening. Any indication that the bailout is only an expedient measure that buys time and does not address the actual problem is shocking.
The credit crunch, failures of sub-prime loans, and bank bailouts are manifestations of the real problem. And what is the major problem? It is the trade deficit, which siphoned money out of the country and dictated an uncontrolled credit expansion to finance domestic spending. The trade deficit continues, but the credit expansion has reached its end. Two graphs tell the story.
The first graph
describes the trade balance of payments and shows the resulting deficit, which has grown steadily since the mid-1980s (except during the 1991 and 2002 recessions) and rapidly since the late 1990s. The present $900B trade deficit is still rising and cannot be easily contained. With manufacture of basic goods, such as clothing, electronics and plastics having been shifted to developing nations, the U.S. consumer presently has no alternative and must purchase these imported goods from external suppliers. Add a dependence upon imports for crude petroleum, steel mill products and refinery products and also the excessive consumption of imported raw materials and automobiles and we learn that the totality of reliance upon imports severely limits the domestic income and funds that are available for spending on domestic production.
To compensate for the lack of domestic savings, the U.S. economy opened its gates to foreign savings. Foreign investment and purchase of U.S. Treasuries served to recirculate dollars, which relieved the pressure on the dollar, and financed purchases of imports and domestic production. These mechanisms are only partial solutions to low domestic savings and cannot continue forever. The investments and their profits must be repaid and this is now happening. The Balance Of Payments Account can no longer be supported by foreign savings and investment, which means the U.S. has no supports for the flight of its jobs and capital.
The shift of capital and manufacturing to the low wage nations has shifted purchasing power to the workers of these nations and decreased the purchasing potential of American workers. Maintainability of this shift is possible if the U.S. runs a positive balance of trade and foreigners purchase more U.S. goods and services. This has not been the case. Instead a continuous credit expansion has been used to finance an unsustainable trade deficit and the sales of domestic production. The next figure
describes the credit expansion.
The Credit Outstanding curve shows steady growth since 1970 and accelerates rapidly after 1998, coincident with the time the trade deficit increased rapidly. Debt has obviously been used to finance imports and domestic consumption by substituting credit for the lack of internal purchasing power. The total debt, which consists of government, consumer, corporate and all other financial debt instruments reached $40T in 2004 and is now about $50T.
Federal government deficits, which have become unwieldy, financed a part of U.S. growth. Credit did the rest; fueling the seemingly perpetual motion economy of continuous growth. Theory predicted, as for all perpetual motion machines, it would soon grind to a halt. Adhering to the principle that "a rolling loan gathers no loss," and utilizing artificially maintained low interest rates, creative financing, credit card expansion and finally sub-prime mortgages for the last batch of available spenders, system financiers increased the money supply and enabled purchasing power, especially for the home construction industry. Free money, rather than free enterprise, more accurately characterized the U.S. economic system, which has been hit by a four times whammy: (1) Credit markets have reached their limit, (2) foreign investment can no longer finance the trade deficit, (3) the federal debt seems too high to support adequate fiscal stimulus plans, and (4) a sizeable number of debtors cannot repay loans.
Lower the trade deficit by limiting consumption of superfluous imported goods, diminishing energy needs, withdrawing from foreign adventures and decreasing foreign assistance.