Boom, Bust, Bailout. Repeat?

In a nearby thread, Dave Fitzgerald has pointed reasonable minds to some informed opinion about the bailout bill currently being urged upon us with such, um, urgency.  In the interest of equal time, I thought I should offer some uninformed opinion.

My commentary on the plan is probably longer than the plan itself, but that’s not as unusual as it may seem:  When it comes to grants of power, short and general is almost always much stronger than long and specific.  Indeed, my main problem with the bailout plan is that it vests almost limitless discretion in the Treasury Secretary while giving him almost no guidance whatsoever on what policies we want him to implement.  Placing an oversight board above the whole process may help eliminate arbitrariness or favoritism, but it does little to answer the underlying question of policy — and that, it seems to me is the most important question to answer if we really want to restore confidence in financial markets.  People have to understand what our fundamental attitude is toward markets and risk.

Section 3 of the draft bill pretends to attempt an answer, directing the Secretary to stabilize the banking system and protect the taxpayer.  But that’s not a policy, it’s a petitionary prayer.  It’s also a cop-out by our elected officials.  The crux of the problem is that people who say they know what it takes for us to stabilize the banking system also say that it requires us to spend $700 billion or more to do it.  If even a tenth of that gets spent, it’s hard to say the taxpayer has been in any sense protected.  And even if all $700 billion of it gets spent, there is no guarantee that the banking system will have been stabilized.  After all, the previous market interventions were supposed to stabilize the banking system.  We were told that they would.  They didn’t.  Why should we believe it now?

This might concern me less if the general direction of our national economic policy could be discerned from past market interventions.  But alas, the current Treasury Secretary has vacillated wildly.  First we bailed out Bear Stearns, at least long enough to sell it off.  To be as charitable as possible, this was probably a genuine hardship for many Bear Stearns shareholders, and Treasury might have thought the other players would take it as a wake-up call.  But a few weeks ago, we essentially nationalized Fannie & Freddie, apparently because the Russians and the Chinese were starting to get nervous about whether they would ever be paid for the debt instruments they were holding.  In retrospect, maybe we should have been more alarmed when we concluded that the Russians and the Chinese had a better grasp on our predicament than Wall Street did.

After Fannie and Freddie, though, it was tough love.  The feds told Lehman Brothers to go to Hell, and it did.  Merrill Lynch got itself married off in a shotgun wedding.  Then the government zigged again, essentially nationalizing AIG.  It looks to me like the current legislation is intended to authorize a $700 billion zag to the “cash for trash” approach.  What pattern are we supposed to see here?  The only reliable rule seems to be that nothing bad is supposed to happen to Goldman Sachs.  (No wonder Buffett’s putting $5 billion there — it’s a flight to safety!)

If there has to be an intervention, I can live with the AIG model, which as I understand it counsels action only when a widespread undervaluing of specific assets makes it genuinely possible to stabilize banking and turn a profit — for taxpayers — in the bargain.  But I’d prefer to see some anti-socialism principles, like mandating that the government fund that’s doing the buying must get 50% of its capital from private investment.  If the fund buys too much trash, capital dries up and the bleeding stops for the taxpayers.  But we’re not doing anything like that.  Instead, it’s to be all government, all the way, spending other people’s money.  When the next credit scare pops up, I don’t expect any Treasury Secretary to turn a deaf ear to predictions that pension funds and retirees will lose their savings on the ground that he doesn’t see any way to turn a profit by buying up the assets.  And no, I’m not comforted by the fact that both Democrats and Republicans will be represented on the oversight board.

Which brings us to my second major concern, namely that I don’t see what’s to stop the whole thing from happening again.  Somehow, the risks have to be borne by the people who decide whether to take them, or else capitalism doesn’t work either in theory or in practice.  How is this bailout supposed to reconnect the risk with the risk-taker?  After the bad securities are off the books, won’t the CEOs still prefer double-digit growth to single-digit growth?  Won’t they re-leverage themselves to do it?  And indeed, won’t they be more confident than ever that when they take their largest risks, they are working above a federal safety net?  Many financial types insist that the federal government had a solemn obligation to bail out Fannie and Freddie because Congress chartered them and the feds implicitly subsidized them and thus implicitly guaranteed them.  Under this bailout plan, is there any major financial institution that is not implicitly guaranteed against failure by the federal government?

We might be better equipped to prevent this from happening again if we could agree on why it’s happening now, but we don’t.  Republicans tend to blame liberal do-gooder laws like the Community Reinvestment Act.  Democrats tend to blame Republican de-regulatory initiatives.  I’m deeply skeptical of all explanations focused on only one of the two major parties.  People on Wall Street seem happy not to talk much about the cause, almost as if this was some kind of natural disaster that is just bound to happen now and then.  But a whole school of economics holds that this sort of bubble-bursting is the inevitable result of sustained credit expansion, and that the only long-term solution is to let asset values deflate.  If these folks are right, then even if we manage not to reap the disastrous consequences now, we only succeed in postponing the pain until even more disastrous consequences occur next time.  It is important to have some intelligent discussion about this, because a considerable number of people are willing to commit $700 billion to avert financial catastrophe and get ourselves back on the right course, but my guess is that far fewer of us are willing to commit $700 billion so that we can postpone catastrophe another three years at which time we can commit a trillion or two.  Disaster relief is one thing, but only an insane person would spend money on hurricane relief that generates more hurricanes.  I’m afraid that’s exactly what we’re doing.

My third major criticism of the bailout bill is the way the administration is trying to ram it through Congress, which I’m pleased to say has been marginally less supine and compliant than usual.  We know that the most effective way to grab power is to grab it in an emergency.  We also know that if you paint a dark enough picture of what will happen under Plan B, people can be made to prefer Plan A even if they don’t really think your dark picture is very likely to become a reality.  So when I hear about a global financial meltdown, about pension funds going broke and senior citizens living on dog food, and I’m told that swift action is necessary, without the usual legislative compromises, it gives me pause.  I can’t help but think of the $40 billion airline bailout after 9/11, the Patriot Act, the invade-first-inspect later approach to Iraq, the defense legislation that made it easier to declare martial law, etc.  I even find myself a little surprised that I’m not being told that short-sellers hate us for our freedom.  One knowledgeable friend told me that, until the AIG bailout was announced, we were within hours of a complete financial meltdown.  Maybe so.  Maybe this time the situation really is as serious as the administration says, but I just don’t believe it any more.  I can’t believe it any more.  Such are the wages of crying wolf.

Some would say that, whatever the merit of these concerns for an actual expenditure of $700 billion, my concerns are exaggerated here because in fact nothing like that expenditure will be necessary.  According to these folks, it is not necessary for the Treasury to buy up all the trash; only to threaten to buy the trash.  At that point the “market failure” we’re currently experiencing (note again the importance of settling the question of what caused this) will end, and financial markets will be fine and dandy.  All they need is a little time.

I’ve heard arguments like this before.  I think the most recent occasion was July.  I was in Lake Tahoe, and I was at a craps table where everyone was losing.  But our luck was bound to change; we just needed time.  The casino staff seemed oddly unmoved.

Less recently, and more analogously, I heard this sort of argument from telecom execs back in 2001-2002.  Sure, bandwidth had been way over built, and network capacity was dirt cheap, and retail prices were falling like rocks, but in time those infrastructure investments were bound to pay off.  After all, everyone was still using the Internet, right?  The market values didn’t reflect the true values.  The companies just needed time.  Where was the Treasury then?  Was the problem that Goldman Sachs was untouched?  I lost my shirt on some of those stocks.  In fact, my monthly IRA statement continues to list the shares, along with a notation of the exact month in which they officially became worthless.  Will the Treasury buy my trash?  Where do I go for my check?

Congress will, of course, pass the bailout legislation.  We don’t have the national stomach for any other course of action.  And then the federal government’s balance sheet will be used for other bailouts of non-financial sectors in the future.  Meanwhile our national debt — remember our national debt? — will continue to rise; the bailout legislation raises the debt ceiling to $11.3 trillion.  Anyone care to talk about what happens when the nation is as highly leveraged as the investment banks on Wall Street?  Will our friends the Chinese bail us out?


12 Responses to “Boom, Bust, Bailout. Repeat?”

  1. Timothy Peach Says:

    When the meteor is headed directly for Earth, and the only people who can stop it are Bruce Willis and his friends from the drilling platform, and they demand in exchange that they never have to pay taxes again, I think you agree to their terms and worry about the moral hazard you’ve created later. Because it’s really hard to stand your ground when that ground is floating around the cosmos in chunks.

    Don’t you get it? Don’t you understand what we were hours away from last Thursday? The entire short-term funding market was collapsing! A total run on the money market system! If Paulson hadn’t announced a comprehensive bailout effort Thursday night, we are talking a complete seize-up and breakdown of the global financial system. Equity markets open limit down Friday, close for an hour, limit down again, close for two hours, limit down again, close for the day.

    Mass panic, runs on banks, impossible collateral calls everywhere, mass overnight bankruptcy filings, Fed balance sheet emptied, markets shut down indefinitely, payrolls missed, credit cards shut off, cash-only for everything, riots in the streets, martial law. Don’t you get that? Or is your lawyer brain that compartmentalized?

    If you don’t get it, I’d be happy, at the appropriate time, to introduce you to some people who understand how the financial system actually works.

    They asked Paulson this. Paulson ran Goldman. He understands the workings of the financial markets better than anyone in Washington. When they asked him what would happen if they didn’t pass something, he said, “If this doesn’t happen, Heaven help us all.” That wasn’t hyperbole. He understands how the dominoes are set up.

    This plan won’t fix everything. The market is going to have starts and fits for years now. We will have other pressures to deal with. But we cannot have a meteor strike the Earth. There is no glue to put it back together.

    The plan obviously doesn’t need to be precisely what Paulson wants. It just needs to be big, and it needs to start soon. Because another wave of panic is ready to hit us, and there’s no guarantee that it can be talked down again. Individual actors don’t understand the consequences of their panic — they run for cover, the outcome be damned. When everyone does that, it’s over.

    An immense amout of regulatory overhaul will be needed. The system needs to be permanently less levered. Fair value accounting needs to be intensely rethought. Sarbanes-Oxley needs to be revised so that efforts at interim communication can’t be reconstrued later as felonies.

    But last week was the Titanic, man. Next month, we can work on deck chair arrangement. Right now, we need to miss that iceberg.

    I’m curious to hear what David thinks about this.

  2. Steve Grannis Says:

    “Invade-first-inspect-later approach” in Iraq?! Sorry to respond off the main topic but that comment hit my memory like a meteor.

  3. Mark Grannis Says:

    A fair point, Steve — that phrase is too compact to be entirely fair. Perhaps I should have referred to the “grave and gathering danger” in Iraq. From Sept. 12, 2002:

    “We know that Saddam Hussein pursued weapons of mass murder even when inspectors were in his country. Are we to assume that he stopped when they left? The history, the logic, and the facts lead to one conclusion: Saddam Hussein’s regime is a grave and gathering danger. To suggest otherwise is to hope against the evidence. To assume this regime’s good faith is to bet the lives of millions and the peace of the world in a reckless gamble. And this is a risk we must not take.”

  4. David Fitzgerald Says:

    I think a lot of things.

    I think that last Wednesday and Thursday were very scary days indeed in NY. It was like 9/11 without the tragedy.

    I think that no one in the government has adequately explained to the American people that unless we get institutions lending to each other again they will not be able to get a mortgage, an auto loan, a student loan, their home equity lines will be pulled, their businesses will have to implement hiring freezes and all capital projects, both public and private will stop.

    I think someone needs to explain the basics of the way credit markets work so that they will understand why this is so. Americans maybe slow, but they are not stupid.

    I think that both presidential candidates need to announce that, whomever wins, federal resources will be available to help people stabilize their mortgage situation and to explain why that program and the MBS buyback program are related, because they are, and that this will have a cost, but the cost is worth it.

    I think that we are now reaping the effects of a governing philosophy that for a generation has basically promoted more and more inequality in the system. A guy making 65K a year in Ohio, struggling to make his mortgage payments, save for his kids’ college and keep his health insurance is having a real hard time understanding why he should bail out a bunch of investment bankers who make 200x’s what he makes. Frankly, as one who works in the financial services industry and whose livelihood is riding on the outcome of this, even I’m having a hard time blaming him. Sarah Palin, and the diametrical reactions she inspires, is symptomatic of the fact that more and more, we are becoming two nations, separate and unequal, based on education, income and, largely, geography. We are facing a big problem right now and we need to face it as one people and where everyone feels they have a stake in a beneficial outcome. We need both leaders and policies that inspire that kind of confidence. Sixteen years of “triangulation” and Rovian governing for the base needs to stop and it needs to stop now.

    I think fiscal discipline needs to be imposed on the government, firms and individuals. We need a strong dollar policy, more tax incentives to save and tight limits on credit. If the markets won’t impose that type of discipline, regulation should. If that means we all drive Toyotas and live in 1500 sq ft houses, so be it. The loose credit party is over.

    Well, you asked what I thought.

  5. Timothy Peach Says:

    David, can you take over this blog now?

    Granulous has spun off the deep end and I’m afraid of where he’s trying to taking us. I think he probably just needs a break.

    Let’s go for a Granulous bailout with “tranches” like the proposed mortgage bailout. You take over for 3 months, and then we’ll have an independent oversight committee evaluate him. If he’s “dried out” from an intellectual standpoint, he can resume command.

  6. David Fitzgerald Says:

    I am not fit to unloose Grannis’ sandals.

  7. Timothy Peach Says:

    And you’d be well-advised not to, because if you tried to and startled him, he’d most likely shoot you, or hit you over the head with a bar of gold.

  8. Mark Grannis Says:

    You guys are both funny. Let me just say that I support free enterprise, and this blog is definitely for sale. Last quarter, the blog generated slightly negative earnings, but they were still nearly $4 billion higher than Lehman’s.

  9. Mark Grannis Says:

    I’m not the only one who found the current “hard sell” from the administration reminiscent of hard sells past. Jon Stewart teased it out brilliantly.

  10. Tim Naughton Says:

    I’m enjoying (wince) the spector of fed officials trying to step in to run the mortgage GSEs. Will they actually figure out how to encourage a secondary market in mortgages, while insisting that the primary sources of that liquidity earn a profit for shareholders? The goals sometimes are consistent, but sometimes not. When not, one must yield to the other. This was a grand policy failure, and a time bomb. Econ 101, folks.

    The democratization of that role (as investment banks diced up Fannie / Freddie functions through private sector entities of all sort, to try and siphon off some of the profit), and then the morphing of that market as exotic mortgages sprang off the shelves), were an enormous distraction from that original, impossible dual role the GSE’s were chartered to perform. Fix that (imho, by dropping the liquidity mandate), and the crisis will be cleaned up by the marketplace. (Yes, it means that sometimes, mortgage loans will be mush more expensive, and that lenders will not reach as deep as they did before.)

    Leave it broken, and under the proposed bailout, the chase for short term profits will commence, and as MAG first suggests, the ticket for the future fix will dwarf today’s $700B pricetag. The current bailout proposal would merely try to liquify the market, and it will work short term. The Chinese banks’ decision to cease new U.S. investment ough to remind us that they have read our Economics texts, even if we have not.

  11. Timothy Peach Says:

    Hey Granulous, the bar may be going up.

    If they pass one of the Republican suggestions — three-month rolling average on fair value accounting — then Lehman actually MADE $4bn last quarter.

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