Today the world faces its largest economic challenge since the Great Depression of 1929. Ben Bernanke, who has been an avid reader of the causes and solutions to the Depression of 1929, has concluded that throwing a lot of government money at the problem will stimulate the private economy and help us work our way out of the problem. It worked pretty well in the Great Depression.
However, this time it will not work. The risk we face with a continuation of this strategy is destroying the value of the US dollar and causing a greater problem, hyperinflation, than we had with the 1929 Depression. The plans presented by Secretary Paulson and the Fed Chief Bernanke are not viable and will not achieve the objective of stabilizing the economy, preserving the banking system and promoting employment.
Let’s first see what the problem is. The root cause of our current problem is an excessive amount of money, highly leveraged and as a result, we have a lot of bad credit. While an excessive amount of money and bad credit are different issues, practically, they are intimately related. A reader of history finds that excessive amounts of money are almost always related to financial busts and panics.
What’s different this time from 1929 is the pervasiveness of the excessive credit and poor credit. In the 1930s, debt was about 150% of the GDP. Today it is about 350% of the GDP and this is before derivatives. While we do not know exactly how much derivatives increase leverage, it probably doubles the indebtedness. We probably have more than 5 times the indebtedness in terms of GDP now than we had in the Depression of the 1930s. In the 30s, we could increase further our indebtedness. Today, we are obliged to lower our indebtedness to assure the viability of our financial system. Fed Chief Bernanke is applying a solution for a 1929 problem which is not applicable to our highly over leveraged economy of today.
Starting late last year, the world started the process of deleveraging. Every type of financial class now recognizes we have excessive debt level which has created a situation where our financial institutions are not safe. We have many institutions with leverage ranging from 30 to as high as 100, when derivative leverage is taken into account. If you really want to see excessive leverage, look at Freddie Mac. They now have only about $9 billion of net worth going quickly to zero net worth, and they owe much more than $1 trillion in direct liabilities and guarantees. That is more than 100 to 1 leverage in a government supported institution. And it is equally bad in many unregulated and regulated financial institutions, particularly where there is a high use of Credit Default Swaps.
The rise of private equity, hedge funds and investment banking activities for the last 5 to 10 years has been predicated on higher leverage to increase profits. The leverage that made things so profitable in the past years is the same leverage that today makes investments so unprofitable in a down market. Only much lower leverage can make financial, industrial and commercial operations with acceptable risk levels in the markets for the coming few years while we are in the down market. (And if we are smart, we will not return to high levels of leverage even when the markets begin their upward climb)
The need to deleverage the economy is what makes the Bernanke strategy of providing more money to the economy a losing strategy. First, the old saying: You can lead a horse to water, but you cannot make him drink. The Fed can provide money to the banks, but the Fed cannot make the banks lend if they think they will not get back their money from the borrower. The Fed is completely powerless in this situation. They can put the cost of money at zero and they will not convince a bank to lend if the bank does not believe in the capacity of the borrower to repay. The $100+ billion given to the banks in recent weeks from TARP will have no direct benefit to bank borrowers. The recipient banks have said publicly they will hold the money as a cash cushion or they will use the money to buy other banks. Secretary Paulson says his measures are stabilizing the banks. The truth is a $100 billion will provide slightly improved liquidity for the banks for a few weeks but do nothing to fix the underlying problem.
Banks lend based on cash flow and security. First let’s look at cash flow. Profits are going to be dropping like a rock at the vast majority of borrowers. Who can say what they will earn in their business in the next year? Furthermore, many, perhaps most, people and businesses also find they have debts which their bank is asking to have repaid. Not only does the borrower have a problem of not earning what he hoped, but also banks now want their money back. That situation will cause many bankruptcies. Now look at the value of guarantees. Take, for example, houses. It is likely the value of houses will continue to decline for at least another year or two and very likely more. As a banker, if I do not know the value of my security, I do not know the relation of security value to the loan I have made. Prudent bankers, who are already losing fortunes, are unlikely to want to lend in this situation where they can neither determine the estimated cash flow for repayment nor the value of their security guarantee.
In short, the fundamental plan of Paulson and Bernanke will fail to stimulate new lending even if they give away $700 billion. The Paulson plan is primarily bailing out bank equity investors; it is not stimulating the economy and banks to lend. Increasing the money supply at this time runs the risk of creating hyperinflation and destroying the value of the US dollar. We are fundamentally in a deflationary cycle which needs to be worked through.
Summarizing
- The Bernanke and Paulson plan for the economy does not work because it depends upon pumping money into the economy. It might have been a solution in the 1930s, but it will not work today.
- The real problem with the economy is over leverage and we are obliged to dramatically reduce leverage in the economy today, not increase the money supply and leverage. Deleveraging will inevitably cause some very bad short term consequences in the economy as a result of deleveraging.
- The Bernanke / Paulson plan to provide liquidity to banks and ask them to on lend these funds is bound to fail because banks are afraid to lend to their borrowers
- The sad result is that the Bush government represented by Bernanke and Paulson does not have a viable plan to help the economy.
Conclusion: In a worst case scenario, still of low probability, the current administration plan could lead us to hyperinflation which is worse than the Depression of the 1930s. At a minimum, the current administration does not have a feasible work out plan. President-elect Obama needs new ideas because the current administration does not have a viable idea to cure the economic problems we have.
