Archive for the ‘Federal Reserve’ Category
According to Bob Higgs we may as well call the so-called stimulus bill “swimming-pool economics.” It’s based on the idea that if you take water from the deep end and pour it into the shallow end, the water level will rise.
Over the next few years, the February 4 report of the Congressional Budget Office (CBO) assures us, the stimulus is all sunshine and lollipops. The CBO concedes that by 2019 the stimulus will have depressed GDP by somewhere between 0.1 and 0.3 percent, but almost no Washington politician has a time horizon that long. (And even if those arbitrary figures were correct, they reflect only the palest shadow of the real consequences of the stimulus, as I explain in my new book Meltdown.)
The Keynesian idea behind the so-called stimulus is that prosperity can be restored if the government is allowed to seize enough resources from the private sector and spend them on just about anything.
Well, to be fair, not quite anything: according to Section 1109 of the bill, “None of the funds appropriated or otherwise made available in this Act may be used for any casino or other gaming establishment, aquarium, zoo, golf course, or swimming pool.”
The CBO provides us with the usual arbitrary estimates of the number of jobs the stimulus will create: between 1.3 million and 3.9 million. Wherever they pulled those figures from (and I have my suspicions), what kind of jobs are these? Are they jobs the economy would have produced in response to genuine consumer demand, or are they jobs the economy would have to be, um, “stimulated” into creating? If “creating jobs” is all we want, we should hand out teaspoons and tell people to start digging trenches. Government, since it acts in isolation from the market, can’t possibly know what kind of jobs actually yield value rather than simply squandering resources and wealth.
Section 3(a)(4) of the stimulus bill describes one of its goals as stabilizing “state and local government budgets, in order to minimize and avoid reductions in essential services and counterproductive state and local tax increases.” Isn’t that nice? Instead of having to raise taxes or (perish the thought!) cut spending, the states can simply get free money! Why didn’t we think of this before?
Now if you’re a saboteur who hates America, which is how President Obama characterizes critics of the stimulus, you might be inclined to ask where the tooth fairy is getting the money she’s giving to the states.
Also, Young Americans for Liberty has launched a campaign to help get Woods on TV so that more people can be exposed to real cause of our current economic mess. Join up here.
[Incidentally, this will be the second book titled Meltdown that I'll be reading. Patrick Michael's book on the distortions and lies that surround global warming alarmism is also worth a read.]
Oops. Turns out the GOP was right on the bailout before they flip-flopped:
Not that anyone pays attention to party platforms, least of all McCain, but a reader spots this rather unambiguous section of the platform just passed by the GOP:
We do not support government bailouts of private institutions. Government interference in the markets exacerbates problems in the marketplace and causes the free market to take longer to correct itself.
[University of Chicago economics professor Luigi Zingales on why Paulson is wrong.]
When a profitable company is hit by a very large liability, as was the case in 1985 when Texaco lost a $12 billion court case against Pennzoil, the solution is not to have the government buy its assets at inflated prices – the solution is Chapter 11. In Chapter 11, companies with a solid underlying business generally swap debt for equity. The old equity holders are wiped out and the old debt claims are transformed into equity claims in the new entity which continues operating with a new capital structure. Alternatively, the debt holders can agree to trim the face value of debt in exchange for some warrants.
Even before Chapter 11, these procedures were the solutions adopted to deal with the large railroad bankruptcies at the turn of the twentieth century. So why is this well-established approach not used to solve the financial sectors current problems?
The obvious answer is that we do not have time.
Chapter 11 procedures are generally long and complex, and the crisis has reached a point where time is of the essence. The negotiations would take months, and we do not have this luxury. However, we are in extraordinary times, and the government has taken and is prepared to take unprecedented measures. As if rescuing AIG and prohibiting all short-selling of financial stocks was not enough, now Treasury Secretary Paulson proposes a sort of Resolution Trust Corporation (RTC) that will buy out (with taxpayers’ money) the distressed assets of the financial sector.
But at what price?
If banks and financial institutions find it difficult to recapitalise (i.e., issue new equity), it is because the private sector is uncertain about the value of the assets they have in their portfolio and does not want to overpay.
Would the government be better in valuing those assets? No. In a negotiation between a government official and banker with a bonus at risk, who will have more clout in determining the price?
The Paulson RTC will buy toxic assets at inflated prices thereby creating a charitable institution that provides welfare to the rich – at the taxpayers’ expense. If this subsidy is large enough, it will succeed in stopping the crisis.
But, again, at what price?
The answer: billions of dollars in taxpayer money and, even worse, the violation of the fundamental capitalist principle that she who reaps the gains also bears the losses. Remember that in the Savings and Loan crisis, the government had to bail out those institutions because the deposits were federally insured. But in this case the government does not have do bail out the debtholders of Bear Sterns, AIG, or any of the other financial institutions that will benefit from the Paulson RTC.
Since we do not have time for a Chapter 11 and we do not want to bail out all the creditors, the lesser evil is to do what judges do in contentious and overextended bankruptcy processes. They force a restructuring plan on creditors, where part of the debt is forgiven in exchange for some equity or some warrants. And there is a precedent for such a bold move.
During the Great Depression, many debt contracts were indexed to gold. So when the dollar convertibility into gold was suspended, the value of that debt soared, threatening the survival of many institutions. The Roosevelt Administration declared the clause invalid, de facto forcing debt forgiveness. Furthermore, the Supreme Court maintained this decision.
My colleague and current Fed Governor Randall Koszner studied this episode and showed that not only stock prices but bond prices as well soared after the Supreme Court upheld the decision. How is that possible? As corporate finance experts have been saying for the last thirty years, there are real costs from having too much debt and too little equity in the capital structure, and a reduction in the face value of debt can benefit not only the equity holders, but also the debt holders.
If debt forgiveness benefits both equity and debt holders, why do debt holders not voluntarily agree to it?
· First of all, there is a coordination problem.
Even if each individual debtholder benefits from a reduction in the face value of debt, she will benefit even more if everybody else cuts the face value of their debt and she does not. Hence, everybody waits for the other to move first, creating obvious delay.
· Second, from a debt holder point of view, a government bail-out is better.
Thus, any talk of a government bail-out reduces the debt-holders’ incentives to act, making the government bail-out more necessary.
As during the Great Depression and in many debt restructurings, it makes sense in the current contingency to mandate a partial debt forgiveness or a debt-for-equity swap in the financial sector. It has the benefit of being a well-tested strategy in the private sector and it leaves the taxpayers out of the picture.
But if it is so simple, why has no expert mentioned it?
The major players in the financial sector do not like it. It is much more appealing for the financial industry to be bailed out at taxpayers’ expense than to bear their share of pain. Forcing a debt-for-equity swap or a debt-forgiveness would be no greater a violation of private property rights than a massive bailout, but it faces much stronger political opposition. The appeal of the Paulson solution is that it taxes the many and benefits the few. Since the many (we, the taxpayers) are dispersed, we cannot put up a good fight in Capitol Hill. The financial industry is well represented at all the levels. It is enough to say that for 6 of the last 13 years, the Secretary of Treasury was a Goldman Sachs alumnus. But, as financial experts, this silence is also our responsibility. Just as it is difficult to find a doctor willing to testify against another doctor in a malpractice suit, no matter how egregious the case, finance experts in both political parties are too friendly to the industry they study and work in.
The decisions that will be made this weekend matter not just to the prospects of the US economy in the year to come. They will shape the type of capitalism we will live in for the next fifty years. Do we want to live in a system where profits are private, but losses are socialised? Where taxpayer money is used to prop up failed firms? Or do we want to live in a system where people are held responsible for their decisions, where imprudent behavior is penalised and prudent behavior rewarded?
For somebody like me who believes strongly in the free market system, the most serious risk of the current situation is that the interest of few financiers will undermine the fundamental workings of the capitalist system. The time has come to save capitalism from the capitalists.
Of course we already do that through inflation, however Gerald P. O’Discoll, former adviser to the Fed, writes in the Wall Street Journal that we’re at a tipping point:
As Milton Friedman long ago taught us, government spending is the ultimate tax on the economy: It extracts real resources from productive, private use and puts them to unproductive, public use. And there is the rub.
Not even a President Obama and a Congress controlled by House Speaker Pelosi and Senate Majority Leader Reid is going to hike taxes enough to pay for all their spending. Indeed, they have shown themselves quite unwilling to engage in honest budgeting. The best example is saddling Fannie Mae and Freddie Mac with $500 million of new (off-budget) obligations to fund cheap housing at a time when the two companies were already on the ropes. Is it any wonder the stock prices of these two companies are imploding?
The markets have long assessed the debt of Fannie and Freddie at AAA because of the Treasury’s guarantee, now explicit. But no one has ever seriously assessed the Treasury’s creditworthiness with Fannie and Freddie on its books. The public guarantee is entirely open-ended and unbounded. The appetite of the two companies to balloon their balance sheets and take on risk has not been curtailed. Meanwhile, Congress spends apace with new programs for constituents in an election year.
We are at a Smithian moment, in which the temptation for the Fed to spend its last dime of credibility may prove irresistible. Investors are already being taxed by inflation and can rationally expect that tax rate (the inflation rate) to be raised going forward. Wages are not keeping up. Main Street is being taxed to fund Wall Street excess. Anyone who works, saves and invests is exposed to confiscation of his capital and earnings through inflation.
If the Fed maintained its independence of action and said no to the inflationary finance of Congress’s profligacy, we wouldn’t have reached this point. But the Fed has forsaken that independence amid an absence of leadership.
By the way, as recently as February McCain said he wanted more inflation.
I can’t find the link now, but I also recently read a article comparing commodities that have futures markets to those that don’t. Not surprisingly, those with futures markets were less volatile since hedging allows for consumers (particularly large consumers) to stockpile when prices are low, decreasing demand when prices are high.
It is striking to me how the issue of inflation is ignored when it comes to the soaring fuel prices. When the price of oil is measured in gold, it has remained incredibly stable, as shown by the chart at right (where the price of oil in gold is in purple, the price in Dollars is blue and the price in Euros is red).
Turns out that constantly devaluing the dollar does matter. And as oil producers move away from the petrodollar, it will likely become worse.
A great spot with Ron Paul on Fox Business news. He makes it clear that the Federal Reserve is responsible for the massive malinvestment that has caused the recent recession, and that real capitalism would create real growth, instead of the current and predicable, bubble and bust cycle: