Stimulus Plan Fails: Larry Summers, Listen Up

The US financial stimulus plan is based on two central concepts. The first objective is to get more money into the banks so that they can lend to their customers and be seen by their customers and bank counterparties as a safe depository of funds. The second is to get prices up, particularly in housing and financial instruments, so that many do not go broke, particularly including banks and homeowners. These policies have failed. The purpose of this article is to explain why they could never succeed. Furthermore, until there is a consensus that the current policy of stimulus cannot succeed, we cannot move on to more effective solutions to our problems.

This article is part 3 of a series. The first was “Obama Wants a 'Better Plan'? Here's One: Bite the Bullet” , which was a call to arms to get better policy for fixing US economic problems. The second, “Replacing Government Bank Liquidity Programs with Orderly Shutdown of Bankrupt Banks”, provides the outline for one part of the solution to the problems. This article focuses on why current financial stimulus policy does not and cannot work. Until we leave behind this failed policy, we cannot even begin to implement effective solutions.

Let's first look at the ability of the government to restore near parity to the value of the mortgage backed bonds, often called CDOs and other similar names. The initial value of these bonds rested on four conditions. First, they were triple A rated by bond rating agencies in terms of credit quality, and guaranty agencies promised payment if the bonds should ever fail payment. Secondly, they were cut and diced in a way that if there ever was a credit problem, the initial losses would be borne by others who assumed partially the first risk. Thirdly, all of these bonds were rated by “sophisticated” computer models which assured they would be paid. And fourth, “everyone knew” that housing prices were always going up, so in the worst case you sell the property to someone else for more money than your cost. You could not lose. But in reality, you could and did lose.

First, the bond guarantee companies promised to pay if there was a problem, but in reality did not have the capital reserves to pay if called on. Second, the fact that someone absorbed the first loss did nothing to cover the rest of the losses. A partial guarantee is not a full guarantee. Third, the “sophisticated computer models” turned out to have missed the point. They assumed that hurricanes could not hit the whole United States, which was true. However, the problem was that an economic downturn could hit the entire United States which made the computer models useless for risk analysis. And fourth, the final assumption of house prices always going up was equally wrong. House prices do tend to go up during long term economic expansions, but when a recession comes, the prices go down. And when the recession is more like a depression, the house prices go down a lot. In summary, all four justifications for the value of the bonds turned out to be erroneous. The bonds never were worth 100% of the initial value, but people simply did not know the truth when they bought them.

How can the people now say these mortgage bonds simply lack liquidity and will return to a more normal value? The people who initially bought these bonds did so because they did not know the true risk they were assuming. Today, however, it is simply a fact that the original assumptions of value were erroneous and subsequent events have shown them to be worth much less. Neither time nor a lot of artificial purchasing of these bonds, for example PPIP, will ever take them back to near their original value. The stimulus programs designed to return these asset prices to near parity are condemned to failure. The truth is that many big banks would fail if the bond were marked to their real market value. To avoid that, we kid oureselves about the value of these bonds.

The housing value analysis is very similar. Prices of houses are predominantly a function of available credit to buy the houses. The Bush government and congress purposely put into place lending standards that promoted buying of houses by people who could not afford them. The commercial banking system and shadow banking system (credit derivatives, hedge funds, special purpose vehicles, etc) created an enormous increase in the money supply which was made available for lending. This led to sloppy credit standards (liar loans, loans with interest rate resets in a year or two, widespread use of brokers who did not care whether the buyer could pay). The result of this is the credit debacle that we have today. To realistically get more credit and therefore raise house prices, we have to go back to at least the bad credit (that made the current problem we have) and probably have to give even worse credit to get prices going up through the US government stimulus program. The only thing that will happen here is a lot more bad credit. We have a splendid example of this in Fannie Mae (FNM) and Freddie Mac (FRE). They went broke and we nationalized them. There was an enormous public outrage. But then, we went back to the same poor credit standards that made the problem. We will soon have round two of Fannie Mae and Freddie Mac bankruptcies. Public policy social interests have prevailed over common sense and prudent credit. With the above facts in hand, we can be sure we cannot increase the prices of housing without shortly creating an even worse credit problem than now.

Now let’s deal with the first of the government objectives, get more money to the banks so that they can lend more and thereby stimulate the economy. To examine this, let’s say the same thing with a change of words from "lend" to "borrow". Let’s encourage the people of the United States to borrow more money so that they go further in debt (which they cannot pay) and to spend that new indebtedness on consumption goods that they can ill afford. When you talk about banks lending more, it sounds like a socially desirable act in general. But this is irresponsible when you talk of each individual, many of whom are struggling to stay in their house, to borrow more money. This policy means they have more interest to pay on their loans, which they cannot afford. Furthermore, to spend that money on consumption goods which they do not necessarily need sounds to me like an irresponsible policy at the individual level.

Independent of the fact that most will conclude it is wrong to push more borrowed money down the throat of the mass of the people, the fact is that the United States is deleveraging and paying off debt at record rates. This is true at both individual levels and corporate levels, particularly those companies which use very high leverage. The commercial banking system and the shadow finance market (hedge funds, private equity, special purpose vehicles and derivatives) are all reducing the amount of indebtedness they have. Leverage was good when the market was going up. Leverage in a down market only increases the rate of losing money. Excessive leverage now creates fear in the minds of depositors and regulators that the bank will go broke. Business survival now depends that your customers and bankers believe you are not subject to bankruptcy. Excessive leverage is the biggest red flag now of potential insolvency. This new "fact" about leverage will continue to drive leverage and loan oustandings down, regardless of what the government does to provide stimulus.

It is true that many companies need more debt for the normal conduct of their affairs, and this article is not directed at those companies. It is directed to those borrowers who do not have either the credit ability to assume more debt or the justified needs for credit. And when these people are taken into account (those who cannot afford more credit or do not need more credit), total credit will be declining no matter what the government does. For the public to pay trillions of dollars for stimulus programs designed to stimulate banks lending and public consumption, we are doomed to lose most of the money and not create a public benefit. In fact, this stimulus could well lead to an even worse situation.

The public interest is best served by ending those stimulus programs which pump money into the market when it cannot be beneficially used. This includes most of the bank stimulus programs and particularly includes PPIP.

This article is presented as one of a three part series of articles which are designed to make constructive public policy suggestions. The objective is to stop those parts of government programs condemned to failure and put in their place programs which will provide, in time, more effective help to the people of the United States.

Disclosure: No positions

Comments

[lucky lenny:]

Mr. Wood, your article is excellent. Thanks for a breadth of common sense.

Apr 20 06:38 AM

[Frealess Frank:]

Your comment that there will be a round two of mortgage defaults is correct, but not due to FNMAE and Freddy going back to sloppy credit standards. Their standards now are tighter than they have ever been, even before this debacle began. Round two of defaults will be waves of Option Arm mortgages resetting within the next two years. These loans were the worst products on the market and were strongly promoted by the lenders by offering double or triple normal rebates to mortrgage brokers. The banks liked them because they could carry the negative amortization on their books as profit.

Apr 20 11:04 AM

[Radardoc:]

The only problem I see with this article is that there is far too much forethought, research, and independent thinking that went into it. Those qualities automatically disqualify you from widespread acceptance of your ideas.

Seriously, I'm sorry to say you are right on the mark. Add one more follower...

Comment for Frealess Frank:
It makes absolutely no difference what Freddy and Fanny have for credit standards today. It's the trash paper written before the crisis that are the problem.

Apr 20 11:43 AM

[Applegator:]

Fine series of articles, Mr. Wood.

The stimulus and bailout programs are all "hair of the dog" approaches to a hangover. Better to go "cold turkey" to detoxify the system. Then map out a course to a healthier state of affairs.

Despite a general feeling that that the future will be much less opulent than the past, the nation seems incapable of producing (or even contemplating) a blueprint for a more sustainable long-term economy.

Let's face it, we'll be living more off our own assests and less off our incomes into the foreseeable future. Best to re-build an economy around that premise instead of a Utopian return to limitless consumer credit and spending.

Apr 20 01:28 PM

[Allan Frain:]

Nobody likes a downturn, but they accomplish one critical role--they purge the system of resource misallocation.

We may actually get the downturn without its corrective effects. Hence it will be prolonged and more severe.

Apr 20 01:47 PM

[ArkansasAngie:]

Allan -- that is exactly what I fear.

I want things to improve, but dad gum I want them changed, too.

If we can't get at the root cause the pain will be for naught.

Apr 20 03:01 PM

[wg:]

Your statement that the "Bush administration" is responsible for the lenders making loans to people who could not afford them is so preposterous as to discredit everything else you have said. If you don't understand by now that it was the Carter sponsered Community Reinvestment Act, ramped up by the Clinton administration, and pushed on lenders, Fannie Mae, Freddie, etc. by the Democrats, such as Barney Frank, Schumer, et' al., then why should anyone take anything else you say seriously? The Bush administration and Republicans tried to rein all this in, but were thwarted by the Democrats on the Financial Services Committees.

Apr 20 07:21 PM

[John G fro...:]

As I watched TV on the day Obama was being sworn in , I was amazed at the crowds in Washington. Then it occurred to me ,they may of been there to make sure Bush got on that helicopter afterwards !!

Apr 22 12:15 AM

[Barbara Horne:]

Thank You for this Article, especially the section on bonds, very informative. I agree we may be headed for round two of mortgage defaults particularly in the area of commercial real estate. It is difficult to estimate the impact, because a single commercial real estate default could result in a large number of jobs lost. As much as I would love to blame the Bush administration for everything, the problem runs a lot deeper than them; however as with many other problems they made them a lot worse a lot faster.

Apr 23 05:54 PM