The Financial Crisis
In the past few weeks, the two giant GSEs (Freddie Mac, Fannie Mae) have been nationalized. Of the five biggest Investment Banks in the US (Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, Bear Stearns), three have ceased to exist. Congress has been stunned into inactivity as Harry Reid, the Senate Majority Leader admits the Congress has done nothing because nobody knows what to do.
The "doing something" part is in the court of Fed Chairman Ben Bernanke and Treasury Secretary Hank Paulson. Hundreds of billions of dollars have been spent on bailouts, billions "injected" into the global financial system. Financial institutions have been nationalized. Insurance companies have been taken over. Now there is talk of a "permanent solution" to the credit problems through setting up of a Government Institution to act to buy up bad mortgages from financial institutions so that they can clean up their balance sheets and survive. It is expected that 400-800 billion dollars of taxpayer money will be committed to this task. A word about the backgrounds of the two players would help illuminate the overwhelming nature of their response to the crisis. Bernanke is an academic and his specialization is the Great Depression of 1929. He has some firm ideas about how a different government response could have prevented that depression. Hank Paulson was the CEO of Goldman Sachs, mentioned above in the list of illustrious Investment banks. Their backgrounds seem to weigh heavily on what these gentlemen see in the evolving situation. Bernanke sees a Great Depression unfolding, while Paulson sees the end of the world as Investment Banks fail (not a surprise since not long ago, Investment Banking was his world). Both believe in a show of force to stub out problems before they spread. Bernanke reduced Fed interest rates by 1.25% in a single week. Paulson demanded a "bazooka" from the Congress, presumably for shooting a cockroach. Unfortunately things have not worked out as they had hoped, which is why there is now talk of a "bailout to end all bailouts".
A giant garbage bin would be opened so that financial institutions can dump their risky mortgages. The taxpayer will then be asked (nope forced) to eat. To repeat a phrase that has suddenly gained notoriety in the recent past, is this putting lipstick on a pig? That is, can the financial institutions really be saved by this "Bailout to end all bailouts". And more importantly, would the benefits of such a bailout outweigh the increasingly preposterous cost?
Firstly, a word on the crisis itself. Is this a just a course correction in how world finance works, or is this a more fundamental shift in financial paradigm? In other words, is this a "short cycle" event that will reverse itself in a few years, or is it a "great cycle" event that will take a generation or more to reverse? One widely recognized characteristic of the last generation was a worrying increase in indebtedness. As incomes increase, it becomes feasible for households to borrow more. This is a natural organic growth in debt. However, the ratio of income to debt would be expected to stay more or less stable over time. However, this has not been the case. Household debt as a percent of income has steadily increased over the last 30 years. The last eight have even seen an quickening in the pace of such activity.
Popular imagination places the source of this debt on the doorsteps of the out of control shopper swiping credit cards for the Guccis and Armanis when it is not necessary. However, there is plenty of evidence to suggest this is not the case. Average credit card debt in the US household is about $8000. At least a part of this is revolving credit (i.e. its on the credit card for convenience, not because your bank account is empty). However, the average mortgage debt is $70,000. This clearly takes the lions share of the debt obligations. By some measures, family incomes have stopped growing since the early 70s and lifestyle has been maintained chiefly though borrowing.
In the movie "Maxed Out", a professor at Harvard who looked into the indebtedness of Americans recalls asking credit card company executives as to what is the end game? How are these debt obligations ever going to be paid back? She remembers getting nothing but blank stares. Credit card companies also purposefully offer cards to people who are at high risk of default, since default as well as non payment of principle adds to the fees that reap profits. The sub-prime lending was nothing but a transplantation of this phenomenon to the mortgage world. The credit card industry just happened to recognize earlier the goldmine that lived among the poor and the desperate.
While a lot of Financial jargon like CDOs, or Mortgage Securitization have been blamed for the current crisis, the real problems seem to be much simpler. People cannot endlessly pay more than they earn, and at some point they will stop paying. The credit card industry, as usual was agile in recognizing this issue. The pushed through congress an appalling bankruptcy "reform" bill that made it practically impossible for anyone to file for bankruptcy. Their argument seems to that people may not be able to pay more than they earn, but we sure are going to try to make them pay! This may however, be a case of flogging a dead horse. You cannot make it run, no matter what the severity of the beating. People who are unable to pay will not pay irrespective of the harassment. It only leads to mental health issues and suicide.
As the repayments of debt started stuttering, business models based on lending against shaky assets valuations started breaking down. The investment banks with heavy exposure to such risk came under strain. The stock market started falling, led by financials and other businesses that depended on large debt to finance their operation. The government responded with all the impressive force under its control. Ideological arguments started to be waged. Should the government intervene? The governing orthodoxy of the last 8 years has been that the markets always work, and that what was necessary was deregulation. When people pushed into bankruptcy because of unexpected medical expenses (this is the most common cause of bankruptcy) asked for help, they were asked to pull themselves up by the bootstraps. Iraq war veterans were told the same even when they did not have boots, or even legs. However, when financial institutions started collapsing, there was "no choice" but to bail them out. The mass media lapped it up like flies licking vomit.
What are the ethics of a bailout? The government cannot create wealth. It can only redistribute income and pick winners and losers. The winners in this case are the bond holders in the companies that are being bailed out. The decision makers who took unacceptable risks are also being rewarded with protection from consequences of their actions. The stock holders are the losers. People who save money are also losers. Their bank interest no longer keeps pace with increasing inflation. The general public at large (both savers and adventurists) can be winners or losers depending on how the bailout pans out.
Sometimes bailouts work out well. Korean government bought stocks in order to stabilize its markets during the Asian Financial Crisis in the late 90s. They were able to sell them at handsome profits once the crisis abated. At other times, bailouts are disastrous. The Nixon administration expanded money supply by breaking the gold standard in the 70s. Printing unlimited amounts of money led to the debt binge whose effects are being sorted out only now, almost 40 years later. Greenspan's bailout in response to the Tech bubble also comes to mind. Most bailouts fail. However given that this is an election year, expecting the government to do nothing is wishful thinking. Prudence demands proceeding with the assumption that bailouts will continue.
Assuming that a bailout can indeed be "done right", then how should it happen? I think the any answer should look honestly at the root cause of the problem itself. The problem is clearly debt levels. When home prices gallop ahead of household income it is not "growth" but inflation. When 66% of the households are themselves home owners, increasing prices become a ponzi scheme supported by ever diminishing base of non-homeowners with ability to buy. The government should get out of the business of promoting home ownership for everyone. Now that the mortgage market is largely nationalized, the government should instead promote responsible home ownership. Lending standards should be tightened slowly so as to prevent people who cannot afford homes from buying one. This would lead to sustainable growth in home prices.
Increasing government debt for the bailouts would increase debt repayment obligations which in turn cramps the ability of the government to invest in its citizens by the way of education and training. Households have had to choose between credit card bills and college, sometimes postponing or abandoning college plans. Now, the government would have to do the same. This would have devastating long term effects since wealth is mostly created by upgrading human capital. Given that households have to pay higher taxes in future, the only way to reduce household obligations is by reducing credit card debt. Usury laws must be passed immedietly to limit credit card interests and fines. Regulation should also govern how much credit is offered to families. Bankruptcy laws must be reversed to make it possible for people to wipe out their credit card debt and make a fresh start. The credit card business is part of the same financial industry and while it may be argued that some financial institutions have to be bailed out for the sake of stability, the credit card business is definitely not one of them. Remember, the government cannot create wealth, but it can pick winners and losers. By necessity, the losers in this case have to be at least partly the American public. But the future of this country's economy is at stake if all of the losses are dumped on the public's head. The load that is being carried on that head is not this country's present, but its future.
The "doing something" part is in the court of Fed Chairman Ben Bernanke and Treasury Secretary Hank Paulson. Hundreds of billions of dollars have been spent on bailouts, billions "injected" into the global financial system. Financial institutions have been nationalized. Insurance companies have been taken over. Now there is talk of a "permanent solution" to the credit problems through setting up of a Government Institution to act to buy up bad mortgages from financial institutions so that they can clean up their balance sheets and survive. It is expected that 400-800 billion dollars of taxpayer money will be committed to this task. A word about the backgrounds of the two players would help illuminate the overwhelming nature of their response to the crisis. Bernanke is an academic and his specialization is the Great Depression of 1929. He has some firm ideas about how a different government response could have prevented that depression. Hank Paulson was the CEO of Goldman Sachs, mentioned above in the list of illustrious Investment banks. Their backgrounds seem to weigh heavily on what these gentlemen see in the evolving situation. Bernanke sees a Great Depression unfolding, while Paulson sees the end of the world as Investment Banks fail (not a surprise since not long ago, Investment Banking was his world). Both believe in a show of force to stub out problems before they spread. Bernanke reduced Fed interest rates by 1.25% in a single week. Paulson demanded a "bazooka" from the Congress, presumably for shooting a cockroach. Unfortunately things have not worked out as they had hoped, which is why there is now talk of a "bailout to end all bailouts".
A giant garbage bin would be opened so that financial institutions can dump their risky mortgages. The taxpayer will then be asked (nope forced) to eat. To repeat a phrase that has suddenly gained notoriety in the recent past, is this putting lipstick on a pig? That is, can the financial institutions really be saved by this "Bailout to end all bailouts". And more importantly, would the benefits of such a bailout outweigh the increasingly preposterous cost?
Firstly, a word on the crisis itself. Is this a just a course correction in how world finance works, or is this a more fundamental shift in financial paradigm? In other words, is this a "short cycle" event that will reverse itself in a few years, or is it a "great cycle" event that will take a generation or more to reverse? One widely recognized characteristic of the last generation was a worrying increase in indebtedness. As incomes increase, it becomes feasible for households to borrow more. This is a natural organic growth in debt. However, the ratio of income to debt would be expected to stay more or less stable over time. However, this has not been the case. Household debt as a percent of income has steadily increased over the last 30 years. The last eight have even seen an quickening in the pace of such activity.
Popular imagination places the source of this debt on the doorsteps of the out of control shopper swiping credit cards for the Guccis and Armanis when it is not necessary. However, there is plenty of evidence to suggest this is not the case. Average credit card debt in the US household is about $8000. At least a part of this is revolving credit (i.e. its on the credit card for convenience, not because your bank account is empty). However, the average mortgage debt is $70,000. This clearly takes the lions share of the debt obligations. By some measures, family incomes have stopped growing since the early 70s and lifestyle has been maintained chiefly though borrowing.
In the movie "Maxed Out", a professor at Harvard who looked into the indebtedness of Americans recalls asking credit card company executives as to what is the end game? How are these debt obligations ever going to be paid back? She remembers getting nothing but blank stares. Credit card companies also purposefully offer cards to people who are at high risk of default, since default as well as non payment of principle adds to the fees that reap profits. The sub-prime lending was nothing but a transplantation of this phenomenon to the mortgage world. The credit card industry just happened to recognize earlier the goldmine that lived among the poor and the desperate.
While a lot of Financial jargon like CDOs, or Mortgage Securitization have been blamed for the current crisis, the real problems seem to be much simpler. People cannot endlessly pay more than they earn, and at some point they will stop paying. The credit card industry, as usual was agile in recognizing this issue. The pushed through congress an appalling bankruptcy "reform" bill that made it practically impossible for anyone to file for bankruptcy. Their argument seems to that people may not be able to pay more than they earn, but we sure are going to try to make them pay! This may however, be a case of flogging a dead horse. You cannot make it run, no matter what the severity of the beating. People who are unable to pay will not pay irrespective of the harassment. It only leads to mental health issues and suicide.
As the repayments of debt started stuttering, business models based on lending against shaky assets valuations started breaking down. The investment banks with heavy exposure to such risk came under strain. The stock market started falling, led by financials and other businesses that depended on large debt to finance their operation. The government responded with all the impressive force under its control. Ideological arguments started to be waged. Should the government intervene? The governing orthodoxy of the last 8 years has been that the markets always work, and that what was necessary was deregulation. When people pushed into bankruptcy because of unexpected medical expenses (this is the most common cause of bankruptcy) asked for help, they were asked to pull themselves up by the bootstraps. Iraq war veterans were told the same even when they did not have boots, or even legs. However, when financial institutions started collapsing, there was "no choice" but to bail them out. The mass media lapped it up like flies licking vomit.
What are the ethics of a bailout? The government cannot create wealth. It can only redistribute income and pick winners and losers. The winners in this case are the bond holders in the companies that are being bailed out. The decision makers who took unacceptable risks are also being rewarded with protection from consequences of their actions. The stock holders are the losers. People who save money are also losers. Their bank interest no longer keeps pace with increasing inflation. The general public at large (both savers and adventurists) can be winners or losers depending on how the bailout pans out.
Sometimes bailouts work out well. Korean government bought stocks in order to stabilize its markets during the Asian Financial Crisis in the late 90s. They were able to sell them at handsome profits once the crisis abated. At other times, bailouts are disastrous. The Nixon administration expanded money supply by breaking the gold standard in the 70s. Printing unlimited amounts of money led to the debt binge whose effects are being sorted out only now, almost 40 years later. Greenspan's bailout in response to the Tech bubble also comes to mind. Most bailouts fail. However given that this is an election year, expecting the government to do nothing is wishful thinking. Prudence demands proceeding with the assumption that bailouts will continue.
Assuming that a bailout can indeed be "done right", then how should it happen? I think the any answer should look honestly at the root cause of the problem itself. The problem is clearly debt levels. When home prices gallop ahead of household income it is not "growth" but inflation. When 66% of the households are themselves home owners, increasing prices become a ponzi scheme supported by ever diminishing base of non-homeowners with ability to buy. The government should get out of the business of promoting home ownership for everyone. Now that the mortgage market is largely nationalized, the government should instead promote responsible home ownership. Lending standards should be tightened slowly so as to prevent people who cannot afford homes from buying one. This would lead to sustainable growth in home prices.
Increasing government debt for the bailouts would increase debt repayment obligations which in turn cramps the ability of the government to invest in its citizens by the way of education and training. Households have had to choose between credit card bills and college, sometimes postponing or abandoning college plans. Now, the government would have to do the same. This would have devastating long term effects since wealth is mostly created by upgrading human capital. Given that households have to pay higher taxes in future, the only way to reduce household obligations is by reducing credit card debt. Usury laws must be passed immedietly to limit credit card interests and fines. Regulation should also govern how much credit is offered to families. Bankruptcy laws must be reversed to make it possible for people to wipe out their credit card debt and make a fresh start. The credit card business is part of the same financial industry and while it may be argued that some financial institutions have to be bailed out for the sake of stability, the credit card business is definitely not one of them. Remember, the government cannot create wealth, but it can pick winners and losers. By necessity, the losers in this case have to be at least partly the American public. But the future of this country's economy is at stake if all of the losses are dumped on the public's head. The load that is being carried on that head is not this country's present, but its future.
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