A toe in the water...

No, I would not recommend getting back into the stock market (the reference in the blog post title - dipping a toe in the water meaning getting some small percentage of your cash back into stocks).

I am just posting a brief comment on the current Geithner Plan to save our financial system. Hopefully more posts will follow...

I do not want to give the impression that I think any 'solutions' have worked, nor that any recent proposals will work, since I stopped posting to this blog in November. On the contrary, I think things have played out pretty much as I pessimistically expected - I just haven't had time to blog about it.

People are outraged at the AIG bonuses, the Merrill Lynch bonuses, the corporate jets, the lack of shame on the part of Wall Street, but the amount of money we're talking about with these stories is peanuts compared to the looting of taxpayer monies that has already occurred with AIG payouts (that's billions of dollars, slightly more than the $100s of millions we're demanding payback for) and what the new Geithner Plan entails.

Here's Jamie Galbraith on the Geithner Plan:

If Geithner's plan to fix the banks would also fix the economy, this would be tolerable. But no smart economist we know of thinks that it will.

We think Geithner is suffering from five fundamental misconceptions about what is wrong with the economy. Here they are:

The trouble with the economy is that the banks aren't lending. The reality: The economy is in trouble because American consumers and businesses took on way too much debt and are now collapsing under the weight of it. As consumers retrench, companies that sell to them are retrenching, thus exacerbating the problem. The banks, meanwhile, are lending. They just aren't lending as much as they used to. Also the shadow banking system (securitization markets), which actually provided more funding to the economy than the banks, has collapsed.

The banks aren't lending because their balance sheets are loaded with "bad assets" that the market has temporarily mispriced. The reality: The banks aren't lending (much) because they have decided to stop making loans to people and companies who can't pay them back. And because the banks are scared that future writedowns on their old loans will lead to future losses that will wipe out their equity.

...

Click on that link to catch the video clip or read the full transcript.

I've been saying all along that the fundamental problem here is that our economy has been built up over the past couple of decades on a foundation of debt. Economic growth based upon ever greater amounts of leverage over time is unsustainable and trying to get the economy back on track (back to the 90s or even the less attractive early 00s) is a fool's mission. One last quote from Galbraith:

In Geithner's plan, this debt won't disappear. It will just be passed from banks to taxpayers, where it will sit until the government finally admits that a major portion of it will never be paid back.

On the surface, Barack Obama does not appear to be effecting change. Larry Summers, Robert Rubin and Timothy Geithner represent the philosophy and are at the core of the policy decision-making that got this country into the mess that we are in right now. These are the same people that are currently in charge of policy.

I can only hope that this is part of some grand plan of Obama's to eventually do what is necessary to move the economy forward again.

"Light" Blogging...

To say the least, the blog has been put on the back-burner.

I started the blog to try to help people understand what was going on with the financial crisis. At this point I don't know what's in store for the blog. Frankly it's mostly because web traffic was so low that I stopped posting last month, but I'll probably come back when the next round of the financial crisis flares up.

I confidently predict several more rounds of this crisis will unfold in the next 12-18 months. It is highly unlikely that Obama's team will be able to solve our problems, though I do think that we are better off (from an economist's perspective) than we would be under a McCain administration.

I may also change the tone of the blog and start posting on some unorthodox economic theories that seem to be much more relevant today than the overwhelmingly accepted standard neoclassical theory.

As always, feel free to post questions in the comment section.

What is going on here?

Okay, if you caught me on Garland's show the other day then you heard me say that we have partially nationalized our banking industry, and many people aren't even aware of it. So I thought I'd take a couple of minutes to explain in case I was correct.

So last Monday, Secretary Paulson took the extreme step of forcing the nine largest banks in the U.S. to participate in the latest version of the bailout. As I remarked on Thursday, this never would have gotten through Congress due to all of the conservative's that are up for re-election this fall, as it is effectively nationalizing (partially) the banking system. You may have heard that the banks got good terms (this means the U.S. taxpayers got bad terms), that is indisputably correct. [By the way, that link is to an article written by extreme right-wing pseudoeconomist, Don Luskin - the irony is that he is typically screaming (literally) about limited government, laissez-faire, free market capitalism, etc... - here he tips his cap to Hank for stepping up big.]

Regardless, I think I got around to saying that it won't work, but I'm not sure if I actually said those words. I did say that Paulson's approach is flawed because he is doing nothing to separate the good banks from the bad banks. This is not about punishment (though I'm all for punishing those bankers that got us here), but about getting us in a position where our economy is able to move forward.

If you weren't aware, Japan has been dealing with similar issues for the past 15 years or so. One of the key criticisms of the Japanese policy decisions over this time has been that they have left too many bad loans on the books of the banks (it is also generally thought that they did not move quickly enough, nor with large enough fiscal (tax cuts and increased government spending) or monetary (lowering interest rates) stimulus).

Banks that made reckless investments in Mortgage Backed Securities (MBSs) and other financial innovations should be forced to bring them onto their balance sheets and shut down if that means that they are insolvent (meaning they don't have enough assets to pay off all of their liabilities). Paulson didn't even require them to stop paying dividends!

Let's list the reasons why this plan will not work (as outlined this past week, subject to change on a whim):

• Bad banks are still operating - none of the other banks really knows who is a bad bank and who is a good bank. This is a trust issue. Banks want to hold on to as much cash and other safe assets as they can, scared to lend even overnight to other banks because they may not pay them back.
  
• Paulson can force the banks to take the government's money (you may wonder why they wouldn't want the money, I'll discuss below), but he cannot force them to lend. There is some incentive for the banks to do something with the taxpayers money, they are paying 5% on it, but they are far better off paying down higher interest rate debt, or even worse if they are insolvent, "doubling down" on some other very risky assets (they either win big or lose big if they do this, but they are pretty much guaranteed to lose big if they don't).
• Businesses and consumers are rightfully bracing for a recession, possibly a long, dragged out Japanese style recession. Banks may finally come around and be willing to lend, but there needs to be sufficient demand for loans in order for any of this to get the economy going again.
• There is still nothing being done to affect the direction of home prices. Unlike many economists, I do not think that we should encourage government interference in housing markets. Any program that is designed to help people stay in their homes will only extend the pain that our economy is going to go through. It is very simple: you need first-time homebuyers in order to get the housing cycle started again. Anything that keeps housing prices too high, relative to incomes or rents will continue to price out those first-time buyers. Without that core demographic, the rest of us will have trouble finding buyers when we decide to move into a bigger house, or a smaller house (for those entering retirement), or making a geographic move. Anyway, just because I don't agree with it doesn't mean it won't happen, but it's not happening right now. So what? Well, as long as home prices continue to fall (broadly, obviously not everywhere around the country), the value of those MBSs continues to fall and the worse off the banks are that hold those bad assets.

Anyway, I can probably come up with a couple more problems with the plan, but we can sum it up with the idea that even if it works by some miracle, we are still enriching the same Wall St. criminals (at least morally bankrupt, if not outright criminal) that got us into this mess.

And to answer the question I posed above: why would banks not want "cheap" money from the Treasury? Well, good banks (seemingly like Wells Fargo, but I base that upon their response to the idea, not having any inside knowledge of their actual balance sheet) know they are good and don't really need this bailout. They are being forced to participate because Paulson doesn't want to only help the bad banks. Just helping the bad banks would guarantee that they would go bankrupt because there wouldn't be any more uncertainty about who to lend to, no more trust problems. That would be great for the economy (even if there was some short term pain - spike in unemployment, hiccups in the payments system, etc.) because we could focus on how to best move forward, rather than just continuing to put band-aids on the problem.

Very good explanation of "Everything you need to know about the financial crisis"

Posted at the Freakonomics blog. It is a guest post, and they really do cover a lot, if not quite everything - stock markets, the initial plan, the new plan, the problems underlying the market turmoil, and are we heading for a depression?

Shameless self-promotion

I'll be on Garland Robinette's show tomorrow at noon with my colleague, Dr. Jose Bautista.

That's 870 AM, http://www.wwl.com/ if you want to stream on the web.

Fundamental problem with the bailout.

You may have read or heard about the idea of moral hazard in the past few weeks (maybe even right here on this blog).

Moral hazard is the tendency for those that are insured to take on more risk. Big banks were "too big to fail" so they destroyed the financial system by taking on too much risk, knowing that the government (or the Fed) would bail them out if things went bad. Those with a long term perspective won't get caught up in this game, but the short run profits are so huge that many did.

Fannie and Freddie were "implicitly" guaranteed by the government. This allowed them to raise a lot of cheap money to buy up a lot of mortgages and mortgage-backed securities (MBSs). That is how they became so large and it was basically a self-fulfilling prophecy as they were taken over last month. Again, they made a lot of bad decisions - bad for the taxpayer, bad for the long term prospects for themselves, bad for stockholders - because they could get away with it, earning many millions in compensation even while doing their part to destroy the financial system.

There's plenty more on this issue (people that bought too much house, mortgage brokers that profited by selling these horrible mortgage products to people that couldn't possibly understand how they worked, banks that originated and sold the mortgages, etc. - all basically expecting someone else to bail them out when the tide turns), but let me just say that the fundamental problem is not moral hazard. This is part of the explanation of why some people behaved the way they did, but it is not the fundamental issue.

Many alternative plans have been proposed, some sound pretty good, but virtually all are fundamentally flawed because they are just creative (in most cases anyway) ways of reflating the economy (meaning, getting people/companies back to the lending trough). Lending/borrowing just for the sake of increasing consumption cannot be the solution to the problem. That is the problem.

Economists have referred to the past twenty-eight year time period as the great moderation. That is, a time when the economy was generally strong and inflation was generally not a problem. Many feel that we have basically conquered the business cycle, particularly with adept use of monetary policy to control inflation and limit downturns in the economy. This is an illusion built on the expansion of money and credit over this time period.

Everything produced in the United States (overall output, GDP) is categorized into one of the following: Consumption (C), Investment (I), Government spending (G) or Exports (NX - Net exports). Consumption in the U.S. has grown from around 62% of GDP to around 70% of GDP. Think about how much of that consumption growth was driven by access to easy, cheap credit. Consumers are tapped out and the tide is slowly turning. Unfortunately, the economy has to go through a hard recession in order to effect the changes in attitudes that will lead to a stronger economy with some real long-term potential ahead of it. This would have been much easier on everyone if we'd just dealt with the problem 10 or 15 years ago, and that should be the primary lesson coming out of this economic crisis.

I'm going to spend a lot of time refining this line of thinking over the next couple of years. Whether or not you agree with me, your comments on this will be greatly appreciated.

President Bush famously declared that this country was addicted to oil just a couple of years ago. There may be some truth to that assertion, but I contend that this country has a much bigger monkey on it's back with its addiction to credit.

Why didn't they just do this?

Here's something that should actually help.

The Paulson Plan doesn't actually tackle the problem of banks unwilling to lend to one another and/or the related problem of banks hoarding cash. This crisis was supposed to be affecting "Main St." via companies having problems getting financing and having problems paying suppliers, employees, and their creditors. Because credit was getting to be so difficult to get, companies were going to have to make some tough decisions - probably leading to a lot of layoffs.

The Fed is now lending directly to corporations in what is called the commercial paper market. I'll try to post more later. I don't know the answer to the question posed above, but I'll try to give it some more thought.

If you are on the West Bank, I'll be participating in a forum this evening at 6 PM @ The Suite, 3580 Holiday Drive in Algiers (right off Gen. De Gaulle).

Well, let's hope this works

I can't say that I have any confidence in the plan (obviously), but let's hope I've been wrong all this time...

Meet one of the five members of the oversight board on this plan. Two of the others: Ben Bernanke & Hank Paulson. Should be interesting to see how this plays out.

Developing Consensus

I'll try to get some links up on this today, but there's seems to be a developing consensus amongst economists that this bailout won't do what it is intended to do (surprise!) and that we are in for a pretty severe recession regardless of the what happens with the vote today.

The plan ignores (and complicates in some ways) the biggest problem in the credit markets, that is that banks and other financial institutions do not know how much exposure other banks have to the bad assets (MBSs, CDOs, CDSs, etc.) and therefore are not willing to lend to them. Any liquidity (cash/reserves) that they get (by selling assets, from the Federal Reserve, increased deposits) is being hoarded, and this just makes things worse for the entire financial system.

This plan cannot work because part of the current plan is to continue to allow banks to "mark-to-model" - that is keep assets on their books at made-up valuations. This is not going to encourage lending in the short-term credit markets.

A better plan would address this particular issue, because without guaranteeing short-term credit (or providing it directly from the Fed), there will be continuing problems with businesses securing the short-term debt they need to make payroll, pay their suppliers, pay their rent/lease/mortgages or to pay their long-term debtholders. This is how the crisis will impact the rest of the economy.

Very helpful perspective

I say very because it matches my thoughts pretty closely, is easy to follow and is written much better than I can write. Please read this post at Economist's View, linking to an article written by Harvard economist, Ken Rogoff if you are having trouble understanding why I am so opposed to this plan.

It is unlikely to actually solve the problem, and will result in a transfer of wealth to the very same people responsible for this mess.

As an aside, I'll be part of a panel discussion of this crisis at 6pm next Tuesday, Oct. 7 at the Savvy Gourmet (4519 Magazine St. - Upstairs, I think @ Vintage) for those that are local and interested. I have no idea who else will be there, but I think it will be slightly more "mainstream" than my recent appearance on "Our Story." Thanks also for those that have commented and/or sent emails.