Danger - Ben and Henry at work
By Hossein Askari and Noureddine Krichene
The US House of Representatives' 228 to 205 rejection of the financial bailout plan put forward by US Treasury Secretary Henry Paulson and Federal Reserve chairman Ben Bernanke may usher the end of inflationary policies and a readiness to address more orderly financial and economic adjustment. But for now one thing is for sure. The bailout is dead. Long live the bailout!
After so much hype about the absolute need for the bailout and with so much political capital on the line, there may be little choice but to pass some form of a financial rescue, albeit drastically modified and reduced in size. Financial markets around the world had expected the bill to pass and its rejection may now fuel more financial turmoil than might have been previously expected, something that US politicians may not be able to stomach. So where did Paulson and Bernanke go wrong and where might we go from here?
If, before the Paulson-Bernanke plan was submitted to Congress, you had heard that the Fed chairman and secretary of the Treasury planned to request US$700 billion from Congress based on a three-page document, you would have laughed about the plausibility of such a rumor.
If you had been told that the three pages allowed for no congressional oversight and no controls on how the secretary of the Treasury used these funds, you would have been incredulous and further dismissed the rumor as absurd and utter nonsense. Were these gentlemen on to something when they chose this modus operandi? Are they so arrogant as to think that their record merits such trust? Or was it that they thought they could frighten the American people and Congress into adopting their undefined plan? Would you trust $700 let alone $700,000,000,000, to anyone who did this sort of thing?
In urging Congress to adopt, in a "clean and quick" approach, the $700 billion plan to buy illiquid assets from banks, it would appear that Paulson and Bernanke desperately wanted to save overleveraged banks and hedge funds at an immense cost to taxpayers and future generations of Americans. This is the only plausible explanation for two such seasoned veterans. Their initial plan would have secured a dream exit strategy for imprudent bankers and speculators, rewarded all speculative gains and the giving of lavish executive salaries, and dumped all capital losses onto the federal budget and Main Street.
Both Paulson and Bernanke have claimed that their plan would be better for taxpayers and American families than any other alternative; they warned that the world would come to an end if their plan were not adopted. We have become accustomed to Paulson and Bernanke warning that the "sky is falling" each time they want to push their bailout agenda. Think Bear Stearns, Fannie Mae/Freddie Mac and AIG.
One thing is clear. Paulson and Bernanke have failed to cope with the financial crisis that broke out in August 2007. They have stubbornly prevented orderly adjustments from bursting speculative bubbles and have refused to foster long-term money and banking stability. Paulson and Bernanke's tunnel vision has afforded them only one approach to the crisis: remove illiquid speculative assets from the balance sheets of banks and dump them on the state. According to Bernanke, any problems that led to this crisis will be addressed, time permitting, at a later stage. Their original plan was not only inequitable and morally unacceptable; it was also in total contradiction to sound banking principles, dangerously inflationary and potentially highly disruptive for the long-term health of the US economy.
The US Congress balked at this outrageous proposal, as would have any sane human being. They went about modifying it. These changes included: oversight of the secretary of the Treasury (although his decisions could not be reviewed by any court in the land); the $700 billion was to be released in stages ($250 billion, followed by $100 billion at the discretion of the president and the balance of $350 billion after a congressional review); rules and regulation for firms hired to help the Treasury run the program; limits on executive compensation for firms whose assets are bought by the Treasury; limited equity participation for taxpayers in case the bailed institutions prosper; some relief for those who are facing home foreclosure, and the option for the secretary of the Treasury to issue insurance for the affected assets as a way to reduce cost to the taxpayers, with this latter feature added to bring House Republicans on board.
One sticking point, how to pay for losses for securities that are bought and sold for a loss, will be left to the next president. Two things are clear. First, Congress could have extracted more for the US taxpayer while still adopting the core of the Paulson and Bernanke proposal, which to some traded cash for trash. Second, in the rush of the moment, Congress, and everyone else, is simply clueless as to what may happen.
Paulson and Bernanke did not present any analysis of the financial and economic implications of their plan, but instead warned of dire consequences if their plan was not adopted soon. In addition, two of the main arguments they advanced for their plan are not as evident as they claim.
First, to quote Paulson: "The ultimate taxpayer protection will be the market stability provided as we remove the troubled assets from our financial system. I am convinced that this bold approach will cost American families far less than the alternative - a continuing series of financial institution failures and frozen credit markets unable to fund everyday needs and economic expansion."
Paulson fails to consider other alternatives that may be less costly. Even more importantly, contrary to Paulson's claim, credit is not frozen, the US banking system is still lending significantly to the economy, as clearly demonstrated by the Fed's data, with bank credit still expanding at a high rate of 9% per year as of July 2008. Certainly, banks have become more prudent, matching the maturities of their assets and liabilities better, and are no longer replaying the speculative mania that led to the present subprime loan meltdown.
There is so far little hard evidence of systemic risk to US commercial banks at large (note large investment banks have disappeared). Only speculative loans face problems. Loans invested in real and economic-generating activities in agriculture, industry and commerce remain sound. The non-financial sector continues to have access to credit at low interest rates.
Second, to quote Bernanke: "The Federal Reserve supports the Treasury's proposal to buy illiquid assets from financial institutions. Purchasing impaired assets will create liquidity and promote price recovery in the markets for these assets, while reducing investor uncertainty about the current value and prospects of financial institutions."
Bernanke, only concerned with investors' uncertainty, seems to ignore a basic and essential principle of central banking: it is the central bank, and not the Treasury, that manages, provides or withdraws liquidity from the financial sector. The Fed has injected massive liquidity since August 2007, put in place large lending facilities to banks and worked out large swap facilities with major central banks around the world to inject further liquidity. Banks do not the face the serious liquidity problems attributed to them, as inter-bank rates, including the federal funds rate, have not come under serious pressure.
Money supply has expanded at the very high rate of 16% in 2008. Bernanke's goal is to rid banks of mismatched maturities and acquire billions of worthless speculative paper for the state. While the amount of writedowns by banks have so far exceeded $500 billion, it would appear that Paulson and Bernanke do not want banks to incur any further losses and that all their worthless and speculative paper will be put on the backs of US taxpayers.
The congressional debate of the Paulson-Bernanke plan has taken place in a vacuum of economic and financial analysis. Congressmen have been pressured into believing the Paulson and Bernanke statements of impending doom and thus coerced into approving their massive bailout plan. It was important for Congress to analyze all potential dangers of this plan, not only in terms of its financial costs, but all its political, economic and social implications as well as the long-term damage to the financial sector. Congress should have analyzed the root causes of the financial crisis and designed reforms that would have safeguarded financial stability. But Paulson and Bernanke, supported by a weak President George W Bush, sought to railroad Congress into the realm of the euphoric unknowns.
On the fiscal front, the Paulson/Bernanke approach will inflate the US fiscal deficit to an unsustainable level. With the national debt spiking to 86% of gross domestic product, the deficit may seriously undermine US solvency. The Congressional Budget Office has already announced that the cost of the plan is very difficult to assess and could turn out to be trillions of dollars.
To a previously projected 2009 record deficit of $500 billion, the bailout's $700 billion price tag combined with $200 billion for Fannie Mae and Freddie Mac and $85 billion for AIG, the fiscal deficit would explode to about $1.5 trillion. We should also ask after this $700 billion is spent, what will Congress say to another request say of $300 billion to save the day?
And so on into the future. Won't the purchase of worthless paper by the Treasury reveal the existence of more worthless paper on the books of financial institutions and cause even more panic? This process has no end. Congress must see that going down this road may be throwing good money after bad money.
As with past and recurring deficits under the Bush administration, the financing of such a monumental deficit can only be achieved through monetization, inflation and exchange-rate depreciation. This will considerably widen external deficits and aggravate food and energy price inflation. The fast depreciation of the US dollar will trigger a run on the dollar, sharp commodity price inflation and a resurgence of the oil and food crisis. A serious run on the dollar will make gold the de facto monetary reserve asset, with foreigners becoming less willing to buy US financial assets.
Economic growth will without a doubt be curtailed by a considerable fall in savings and a significant decrease in real government and private expenditures; real government spending will diminish because most of the expenditures will consist of buying worthless financial papers at the expense of spending on social and economic programs. Rapid food and energy inflation will erode real incomes and reduce private spending in real terms, and contribute to rising unemployment, further aggravating already deteriorating trends in the unemployment rate.
On the financial sector side, knowing the government will secure their loans mortgage borrowers will be tempted to default. Similarly for consumer and business loans, debtors will be tempted to default. The amount of defaults will rise; this will in turn push the purchases of impaired assets to forbidden limits and will aggravate fiscal imbalances. The moral hazard will increase and financial disorder will be compounded.
On the equity side, it is unacceptable that tax money be used to subsidize banks, more specifically the speculative component of bank practices that has no direct bearing on investment and growth. Besides increasing distributive injustice, such spending is non-productive and yields no social benefit to taxpayers and to the broader economy in the form of health, education and infrastructure.
It is absurd to have the government (ultimately the taxpayer) pay for the speculative losses of banks and hedge funds. Had banks invested wisely in productive activities they would not have faced their current problems of frozen speculative assets. In the case of hedge funds it is even more galling in that their billionaire executives pay a lower tax rate than do their secretaries! Will these funds now use the taxpayers' money to lobby Congress for continued, or even enhanced, tax preferences?
Let's not forget that the current financial disorder stems in part from the Fed's over-expansionary policy and the monetization of large fiscal deficits, and inadequate regulation and supervision of financial institutions. Speculative credit has expanded at dangerous rates at the expense of credit worthiness. Securitization has absorbed ever-increasing liquidity injected by the Fed to keep interest rates very low.
Economists have often argued that excessive credit can cause financial disorder and may result in financial dislocation as many borrowers will simply default both at the government (for example, developing countries) and private sector level. The policy mistakes of the Fed are too numerous and carry severe implications. Besides following too cheap a monetary policy that led to the credit boom, the Fed under Bernanke has persisted with the same policy, propelling speculation in commodities and assets markets and undermining financial stability. At the same time, the Fed did not pursue adequate supervision of financial institutions.
The most enlightened understanding of the present crisis and its solution comes from the maverick Congressman Ron Paul. To quote him:
Unfortunately, the government's preferred solution to the crisis is the very thing that got us into this mess in the first place: government intervention. �This lowering of prices (ie, home prices) brings the economy back into balance, equalizing supply and demand. This economic adjustment means, however, that there are some winners - in this case, those who can again find affordable housing without the need for creative mortgage products, and some losers - builders and other sectors connected to real estate that suffer setbacks.
The government doesn't like this, however, and undertakes measures to keep prices artificially inflated. This was why the Great Depression was as long and drawn out in this country as it was. I am afraid that policymakers today have not learned the lesson that prices must adjust to economic reality. The bailout of Fannie and Freddie, the purchase of AIG, and the latest multi-hundred billion dollar Treasury scheme all have one thing in common: they seek to prevent the liquidation of bad debt and worthless assets at market prices, and instead try to prop up those markets and keep those assets trading at prices far in excess of what any buyer would be willing to pay.
There is no easy way out of the mess the Fed has created. The proposed bailout - or whatever it takes when it eventually secures Congress backing - will only aggravate the financial crisis. The Fed's attempt to prevent highly inflated speculative prices from adjusting to market fundamentals has disrupted financial markets and created more disorder in the banking sector.
By lowering interest rates and injecting massive liquidity with a view to re-inflating already high home prices, Bernanke has brought economic growth to a halt and on a declining trend from here on, undermined the dollar, destabilized food and oil markets, disrupted the airline industry and brought the US and world economy to a long-term slowdown. Highly expansionary monetary policy is only setting the ground for an even more severe credit crisis, nationally and internationally.
Financial sector crises are not a novelty, and no single country has been immune to them. Approaches to solving these crises are classical. Responsibility of the financial sector falls under the central bank jurisdiction. Depositors are usually covered under the Federal Deposit Insurance Corporation. Failing banks have to be audited, on a case by case basis, and the root cause of their difficulties must be properly assessed. Solutions should be bank-specific.
Besides rediscounting safe assets, solutions may involve reinforcing contracts and recovering impaired assets through legal means, making provisions against losses, increasing the capital base and reducing costs. If financial difficulties are not solvable, they will go through judiciary liquidation. The disappearance of a bank or of a number of banks does not mean the disappearance of the financial system. Extending unlimited subsidies to speculative banks is not the way to solve a financial crisis.
Paulson and Bernanke should allow the price mechanism to operate more freely to find its long-term equilibrium. They should remember that a credit boom has to be followed by a temporary recession. Their present course of overloading the government with intoxicated speculative debt, undertaking massive bailouts and blowing up the fiscal deficits to unbearable levels will only undermine further macroeconomic stability, turn present inflationary pressure out of control and heighten social discontent. Soon their successors will face the same realities.
The option of doing nothing is far better and safer for taxpayers and American families than adopting Paulson and Bernanke's inequitable plan to save speculative bankers while the house burns.
Most ominous is how the Paulson/Bernanke approach will play out on the world stage in the months to come. Will the rest of the world finance America's exploding deficits? Will the US economy contract into a double digit and prolonged recession if global financing is not forthcoming? Will the dollar go into a freefall? Will cross-border flows of capital remain relatively stable? These are the questions that are likely to haunt us in the days to come.
But one thing is absolutely clear. The United States has consumed beyond its means for far too long. It has borrowed from the rest of the world (running current account deficits) and has used this borrowed money to finance consumption and not investment. If the rest of the world decides that it is time to stop throwing good money after bad money, then we are in for a severe and prolonged recession, a recession that will also significantly affect global prosperity.
Where do we go from here? We are in somewhat unchartered territory. The US president and congressional leaders have been unable to deliver a bill that they have touted. Stock markets around the world have plummeted. Financial experts and economists cannot agree what will follow. US elections are only five weeks away. Politicians may dislike the bailout but how can they go home to campaign with financial markets and the economy in such a disarray?
A modified bill, with the purchase of debt largely replaced by a much smaller equity participation by the federal government, will probably come back to the House. It is sad that this whole process was fueled by scare tactics and not by thoughtful analysis over the last few months. But here we are and some form of a bailout is all that politicians have to hang their hats on.
For historians, the real innovation in Paulson and Bernanke's approach, both toward political Washington and the US public, may have been to act as chicken littles and try to frighten US savers, retirees and politicians (who want to get elected or re-elected) into submission by shouting that the sky is falling. If this legacy gains traction and becomes the way of doing business in Washington, heaven help us all from the falling sky!
Hossein Askari is professor of international business and international affairs at George Washington University. Noureddine Krichene is an economist at the International Monetary Fund and a former advisor, Islamic Development Bank, Jeddah.
Original article posted here.
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