Secretary Paulson’s plan to fix the economy fails because he has not understood the problem.
What has been his plan? Get money into the hands of financial institutions so that they could continue to lend. Financial institutions initially were commercial and investment banks, but have been expanded to include insurance and even corporate borrowers that are important to the commercial paper market. This solution means that he assumed the prior asset values of say late 2007 and the related financial leverage was acceptable. He believed the problem can be solved by getting more money in the financial intermediary hands and let them work out the problem. In reality, this is equivalent to giving a drunk another drink in the morning to fix his hangover.
Here is the real problem. The problem is twenty plus years of excessive monetary creation and use of leverage as an instrument to aid this monetary creation. US authorities do not even have a mechanism which measures the real money creation, as much of this is in private hands that the government does not control or monitor.
When I was a young commercial banker, banks pretty much lived with their deposits. The Fed knew what was in the banks then. But in the last 10 to 20 years we have created private equity, hedge funds, collateralized debt obligations, special purpose vehicles in banks and other entities, plus packaging and reselling mechanisms for securities such as CDOs. Then there is the still undermined effect of the $50+ trillion in US credit default swaps; when, or if, they start to collapse they will have an enormous effect on perceived monetary creation. The practical effect of these new instruments was to create an incredible amount of new money that could be used to buy financial and real assets at increasingly inflated prices. Worse, easy credit conditions have resulted in many of these new loans being fundamentally unsound.
To take a sample from this week’s news, one hedge fund placed substantial money with Bernie Madoff and then they borrowed three times this amount to increase the profits for their investors. (Should we call this Ponzi Quadrupled?) There is a total loss on the loans to the hedge funds which invested in Bernie Madoff. AIG lives on Treasury support because of the fear of systemic losses of AIG fail to pay its creditors.
Thus 2007 valuations of assets are not price levels to which we can return in the next few years. Asset values are much overvalued and they will return to some lower norm (probably much lower than today) and Secretary Paulson’s injection of trillions of dollars will not be able to stop that. This is made worse by the leverage and intrinsic bad credit that will have to be written off. For many months, the financial system has recognized that they are over leveraged and every financial institution is now deleveraging. Deleveraging reduces money supply. Reduced money supply reduces prices. Redemptions in hedge funds will have some effect on overall price levels. Reduced prices bring financial losses and a decline of business activity. A decline of business activity brings on job losses. We entered into this process of decline in late 2007. Pumping trillions of dollars into financial intermediaries will not help.
By the second half of 2009, we will probably have public recognition that much of the $7 trillion dollars committed by Paulson will simply be lost and will have to be paid by the US taxpayers. AIG, Freddie Mac, Fannie Mae, purchase of second class assets by the Fed will lead the way to trillions of dollars of losses.
Political footnote. President Elect Obama seems to understand the above. He views it as improper for his future government to criticize the current Bush government. However, we are already seeing the outlines of his focus on creating jobs. A job building roads really gets money to a needy worker and we really get a road. Much of the Paulson money is money down a rat hole which will only benefit some bankers in the short term. The Paulson money will not achieve its primary objective of creating new loans for needy businesses and persons. Obama supports the temporary bailout for the auto companies so that he can provide a comprehensive solution when he is in charge. He has been totally silent on the perceived benefits of the Paulson type actions which he apparently understands do not work. The real question here is whether even a man as competent as Obama can fix in the short term the enormous problems we have.
