Geithner vs. Schiff: A Thought Bridge Between Two Wrongs

Mar.25.09 | About: SPDR S&P (SPY)

Tim Geithner is pulling every lever possible to "restart lending" and recreate the securitization market - now backstopped by the government.

Every effort made comes with a govt subsidized "cost of debt," which has the effect of crowding out private capital entirely because no private entity owns a printing press. As a result, government is "centrally planning" asset prices. Karl Marx would be proud!

All one needs to do is compare the borrowing rate on a conforming mortgage (Marx) v. a Jumbo mortgage (Adam Smith) to see the difference in risk premiums for publically funded assets v. privately funded ones.

For Geithner, the road to prosperity is to expand credit, on the taxpayer's dime.

Angry yet?

Peter Schiff argues that Geithner's plan is a fool's errand. He supposes that what we need is more saving in this country and that those savings need to find their way into the hands of private enterprises who will borrow to invest in productive capital, hire more workers, and then we'll grow our way back to prosperity.

Both men are partly right but mostly wrong. Here is why:

Peter Schiff needs to go back and read his Irving Fisher and the profound risk of debt deflation. The Paradox of Thrift (Keynes) demonstrates too that when an entire nation starts to hoard and save, aggregate demand collapses, and a deflationary spiral ensues, which has the effect of "crowding out" the benefit of the savings that Mr. Schiff advocates. Oops! Not so simple.

So, on paper, increased savings might seem like a good idea, but in practice, too much saving will take the entire economy down.

Ergo: Fiscal and Monetary Stimulus is Just when people start hoarding - provided it is handled properly

On the other hand, Tim Geithner and his reflationist crew need to switch their focus to balance sheet capacity/debt to equity ratios v. the cost of credit. You can lower the price of money all you want, but if the target balance sheet lacks additional capacity for debt, then the new price of the debt remains irrelevant.

The trouble the US faces is not an absence of credit nor too little savings on a go forward basis.

On the contrary - the answer is that the US (households, business, etc.) has a debt burden that might reasonably resemble that of a 3rd world nation and needs to file for Chapter 11.

Policies that continue to attempt to "step over" this elephant in the room are destined to lead to economic stagnation.

The only way to free-up future savings and or credit flows for future investment or consumption is to lower the amount of outstanding debt. This means the debts need to be either "worked off" (Japan) or "charged off" (Chapter 11).

If, as a nation, we work off our debts because policy makers continue to prop-up creditor's interests (the banks) with artificially low refi rates and zero bound monetary policy, our stagnation will continue until debt to equity ratios mean revert, which could take a very long time.

Alternatively, if bad debts are discharged/haircut, etc. The creditor takes it on the chin, but the bad debt is then flushed from the system so that future economic cashflow can be turned towards consumption v. debt service. In other words, debt to equity ratios correct quickly versus very slowly.

I have no issue with the Fed and Treasury providing liquidity, but I think their ridiculous efforts to crowd out private money with uber-low rates is a ghastly enterprise that simply makes any and all assets prices a complete artifice (eg. housing).

Perhaps there is a middle ground?

How about this for a policy solution:

  1. Government should reset the cost of capital to a "rational level," e.g. 30 Year mortgages at 5.5% that incorporate a reasonable risk premium v. no risk premium at all (isn't that what got us into this mess?).
  2. Contrary to Mr. Schiff's opposition, government should reasonably step in to provide credit access to credit worthy borrowers where none is available, provided the money cost has some link to private market reality, i.e. it includes a risk premium
  3. Let the solvency chips fall where they may. If debtors can't pay creditors, they should default and then work out the loans. If they can survive, then they should earn it off. Call it "Creative Destruction" based upon a market-based interest rate.
  4. Assets that leave the hands of the weak due to insolvency should find their way into the hands of the strong through a proper workout, not by re-amortizing notes over 50 years or introducing PIKs, etc.
    If durable asset prices (housing) fall to a new equilibrium, so be it! Better to take the pain now than to drag it out over a decade.
  5. Government should stand prepared to recapitalize any "systemically important" creditors, e.g. Citi (NYSE:C), who might see too many defaults on their books. But, to be clear, shareholders, preferred shareholders, and bondholders should take the losses, and govt should only recapitalize these institutions at the top of the capital structure, with a view to vending them back to the private sector in the future. The current enterprise of immunizing bondholders from losses is sheer madness.
  6. Government should also stand ready to provide a fiscal stimulus to help restart the economy.

Q. If a man owes a $1,000 and needs a new start, are you better to forgive him the $1,000 and then give him $100 to start over...or do you continue to anchor him with the $1,000 at a lower interest rate while still giving him the $100?

Which scenario frees up more cashflow for him to consume or stimulate the economy?

In summary, too much savings (Schiff) = Aggregate Demand collapse.

Too much cheap money disintermediates "laissez-faire" price discovery and balance sheet restructuring.

Isn't it time that we accept that the cure for a debt binge is just one big Chapter 11, with Uncle Sam standing at the ready to provide "restart" financing/fresh capital v. what they are doing now - throwing good money after bad, and simply manipulating the cost of money below market rates in the hopes that the debtpile will just simply go away.

Oil prices, stock prices, etc. have all corrected 50% in less than a year because these markets are liquid. The housing market is "sticky" on the way down but still needs to correct the full distance. Instead of letting this happen, govt is interfering with price discovery and the downstream consequences, engineering social policy instead of financial policy.

This will only sentence the US economy to a stagnant economic purgatory - that is, until free markets are permitted to flush the system clean.

Perhaps betweem Schiff and Geithner - a Thought Bridge might exist?

Stock position: None.