ROI, Paulson's Plan, and the Rise of Neo-Mercantilism

As our government continues to recklessly spend its way into an increasingly larger debt, it's about time that American society embraces a different disposition towards government. For years, we've all heard "pro-government" versus "anti-government" arguments but this strikes me as nothing more than an exercise in ideological hogwash. Government is absolutely necessary in certain areas and not needed in others; it's difficult to dispute this. Moreover governments are a lot like corporations --- sometimes they are run well and sometimes not-so-much. Hence, "more government" or "less government" is not the correct question; rather, the following questions should be asked in regards to any policy proposal:

1. Can the government provide a service more efficiently than the private sector?
2. If the government can provide something more efficiently, does the government plan being proposed achieve that objective?
3. Does the government plan achieve the greatest societal return on investment [ROI]?

It's a mystery to me as to why the concept of ROI is constantly evoked in the business world, yet almost never used when evaluating government policies. If the government can complete a task more efficiently than the private sector, then by all means it should do so. If it cannot, it should keep away.

Unfortunately, our government has a rather dismal record of providing things in a cost-effective manner. In fact, I'd argue that one of the biggest problems with the American government is not that we pay "high" taxes --- rather it's that we pay high taxes and receive very little in return when compared to other nations with similar taxes. In essence, we get a very poor return on our investment.

The Paulson Plan

All this brings me to the Paulson bailout plan. Make no mistake about it --- this could potentially be the most radical change to American economic policy in the past few decades. Certainly PNTR and NAFTA have changed American society to a great extent, but neither seemed to change the mechanisms of American capitalism quite like this bailout plan might.

There has been a scary trend going on in government for quite a while. It only occasionally makes the front pages, but it's there all the same. Various American governments have increasingly been taking the risk away from the private sector without gaining any of the rewards. The most notable parallel is the stadium construction proposals that various cities, states, and localities have given out --- the major complaint about these proposals is that the private sector profits while the taxpayer receives the bill. In essence, it is a shifting of wealth from the taxpayers (who come from lower, middle, and upper income classes) to individuals that are already wealthy. Or to put it another way, it does not provide much of an ROI to taxpayers.

The Paulson bailout plan is a stadium construction plan on a grand scale --- the only difference is, the taxpayers don't even get a football team out of it. Instead, we are being asked to subsidize the losses of major financial institutions without receiving any of the benefits. To their credit, a majority Democratic Congress has at least tried to pressure the Administrator into a modified package that would give the taxpayers (via the U.S. Government) an equity interest in these financial institutions in exchange for the bad assets. However, even at that, this policy does signal a frightening acceptance of a doctrine of shifting risks to the taxpayers while most of the rewards remain in the private sector. To go back to our theme of government and ROI, I am not seeing how this plan creates the highest ROI for the taxpayers.

So What's the Rush?

Congress is being pressured by the Administration to rush through the proposal. Apparently, it's imperative to pass legislation that could have far-reaching ramifications on the American economy system for decades to come in a few days' time.

Haven't we seen this before? It has become a pattern that this Administration uses any and every crisis as an excuse for usurpation of power from the Legislative Branch. Yet, Congress keeps biting. It was irritating when a Republican Congress passively accepted Executive attempts to seize power from it (presumably on the basis of party loyalty), but it's going to be even more infuriating if a Democratic Congress allows the Administration to do the same thing to it. All the same, it wouldn't surprise me if that is exactly the way it goes.

Will It Even Work?

While I've already mentioned some of the negative socio-economic ramifications of this proposal, it's worth asking if this will even work? Are we going to spend $700 Billion of taxpayer money on a plan that has maybe a 50-50 chance of achieving its short-term objective? Let's not even focus on the long-term questions yet (which are numerous!). Senator Richard Shelby (R-AL) has echoed these concerns stating:

In my judgment, it would be foolish to waste massive sums of taxpayer funds testing an idea that has been hastily crafted and may actually cause the government to revert to an inadequate strategy of ad hoc bailouts.

Reading over various articles, it's very clear that this wide-reaching proposal that has the capacity to change the functioning of the American economic system for many decades to come is nothing more than a skeletal draft. We don't know if this proposal only deals with "mortgage-related assets" or any "troubled assets." Little thought has been given to the scope and there appears to be virtually no oversight. This proposal sounds a lot like trying to bake a cake by randomly grabbing the first ingredients you can find in the cabinet. And if your idea of a great cake involves vanilla icing, cayenne pepper, and horseradish sauce, maybe this plan seems like a great idea.

Long-Term Ramifications

In the short-term, the plan might work or it might not work. But even given a best-case scenario, what are the long-term ramifications? For starters, the plan will create even more inflationary pressures. That's a frightening thought given that Former Federal Reserve Chair Paul Volcker already believes the actual inflationary rate to be around 11% at the present time. Could the U.S. experience 20%+ inflation in the near future? It doesn't seem all that far-fetched. Better hoard up on precious metals!

Then there's that whole "housing bubble" thing. You see --- for some reason, Federal policymakers have convinced themselves that the problem is not ineffective market mechanisms that allow prices to become extremely out-of-whack with underlying valuations. Rather, we've heard from many policymakers that the real problem is that housing prices have gone down. Hence, the solution is to drive them back up. Yet, isn't this essentially the same boneheaded wisdom behind rent controls? Just because the government forces prices upwards does not mean, what we'll call the "market reality" for a lack of a better term, will necessarily follow.

Until the recent bursting of the bubble, it was no stretch to suggest that housing prices had gotten insane. Lower and middle income earners had an extremely difficult time affording housing in that environment. In a sense, the bursting of the housing bubble was the greatest thing to happen for a lot of people who couldn't afford things at the overpriced rates things were going for. The only reason prices skyrocketed upwards was because reckless lending practices were increasing demand to absurd levels.

With the bailout proposal, the Feds are sending the message to the lending institutions to start handing out loans without much of a care again. So in essence, if I read the Feds correctly, the problem wasn't the nature of a system that encouraged reckless lending practices, drove housing prices sky-high, and created a bubble that was bound to burst. Rather, the problem was that the Feds did not come up with policies that allowed the bubble to stay artificially inflated for all of eternity.

So here we are with a bailout proposal that attempts to reinflate the bubble. Another 3, 5, 10 years down the road, the thing merely bursts again and it's even worse than it was this go around because we have a government that refuses to address underlying issues, only thinks in short-term, and is more concerned about symbolic reform that makes the national airwaves rather than fixing real problems in our society.

The Rise of Neo-Mercantilism

To be sure, the short-sighted economic policies of our government have put us in a lose-lose situation and, at this point in time, all that is left is to find the least-worst solution. Yet, the Paulson plan seems far, far from that. Rather, it affirms a dangerous trend of redistributing wealth via taxpayer monies to a class of people that are already wealthy. It's yet another step towards destroying the American middle class. And without the American middle class, the American economy suddenly becomes only a fragment of what we have become accustomed to in the not-so-distant past.

What's even worse is that the plan completely undermines basic market mechanisms like risk-reward. This isn't a simple tweak to the system like Paulson suggests --- rather, this is a shift towards an alternate system. Some have called it "socialism" --- a strange misnomer since socialism involves the working class taking power and essentially redistributing wealth to the lower and middle classes. This isn't socialism at all, but history does reveal a somewhat similar system we used in the past.

Remember mercantilism? It was an early form of capitalism where the government and certain business interests acted in concert. Government established monopolies and hindered real competition with policies that favored certain interests over others. It was this exact system that Adam Smith criticized in The Wealth of Nations for the extreme inefficiencies that resulted. Yet, we appear to officially be entering an age of neo-mercantilism here in America.

The Alternatives

If we are indeed in a lose-lose situation, what are we to do? There seem to be few good options. We could keep government out of this, let the institutions that fail go ahead and do so and ride this out. One way or another, we are going to have to suffer the consequences. It might take a few years to see the light, but contrary to what some suggest, I believe we will emerge eventually.

Another plan I am intrigued by is one mentioned by Seeking Alpha blogger Jason Lindt. His plan calls for a Reconstruction Finance Corporation that invests in preferred stock of financial institutions, which would increase their capital cushions and potentially allow them to ride this thing out. While this still gets into the sphere of government investing in companies, it is an infinitely less intrusive plan than Paulson's, it would probably cost much less, and it makes a whole lot more sense. Though, I worry more about the second part of his plan since it would seem to reinflate housing prices to some extent.

Regardless, if the government is going to create a plan, it needs a much more cost-efficient and well thought out plan than Paulson's. We can't simply rush forward a plan that radically changes the American economic system while giving little thought to the ramifications.

Conclusions

The Paulson proposal increases our Federal debt substantially without guaranteeing any real return. The question we all as taxpayers should be asking is whether or not we will see a good return on our investment. If we adopt Paulson's original version, the answer is undoubtedly no! The Democratic proposal is a bit iffier since the taxpayers would at least own an equity interest in these companies. However, even that modified plan seems too expensive and way too intrusive. We should consider alternative plans that are not quite as intrusive to market mechanisms such as the Lindt plan.

The Paulson plan also seems to signal a dangerous shift away from liberal market mechanisms into an age of neo-mercantilism. This should concern both American conservatives (destruction of Smith's Liberalism) and American liberals (since the system naturally favors certainly wealthy interests at the expense of largely lower and middle income taxpayers). While it's unlikely we'll all line up around the country while holding hands and decide to agree everything, certainly we should agree that a government that takes our taxpayer monies and distributes it out to already-wealthy individuals who have shown a reckless disregard for managing that money in the past does not provide us with much of an efficient return on our own investment.

Disclosure: none

Comments

[kks:]

Excellent analysis!

2008 Sep 24 11:55 AM

[whidbey:]

This is not a serious issue, Neo-Mercantalism. Rather,it is American pargmatic values that honor the demands of the situation rather than purity of political-economic values or idealism. Your attempts at fanning class warfare are amusing, but you might recall that Pareto suggested that in any society 20% of the population would control about 80% of the wealth. the US is a little more skewed possibly since about 30% of the population pays about 100% of the income taxes. So it is not like anyone is being favored. Yes being a low achiever has its price, low income, but it has other benefits of the welfare state: subsistence. Apparently you have not noticed the compromises that have been made by certain groups in American where they support the sophist and get a modest stipend in return. It all works out over time and you are just discovering the people and processes. By the way do you perchance pay any income taxes, just a way of finding out who you are.

2008 Sep 24 11:59 AM

[CM in MA:]

H.J., I enjoyed your article. Here are my answers to your three questions:

1. No, except for providing for the common defense.
2a. See #1, 2b. Rarely, if ever.
3. ROI or your "societal ROI"? The word "societal" expands both the equation and the solution to it. For example, the government might provide a decent "societal return on investment" by compelling companies to take environmental issues into consideration while at the same time being unable to provide the product or service of that company efficiently.

Your comments on neo-mercantilism are interesting, and accurately capture the current situation. And yes, the Democrats will likely go along with the Paulson proposal in some form. Which brings me to my point. That is, anyone expecting either the Republicans or Democrats to rise above short-term political expediency is kidding themselves. They are a power-sharing oligarchy which has no fear of being voted out of office, from a party perspective, for an extended period of time. Americans must give up their allegience to the two major political parties, which in many cases comes down to "my daddy was a Republican/Democrat and so am I", and vote for a third-party or true independent candidate. To keep putting representatives of these two parties into office, while expecting different results, is foolish.

I'll end with two quotes:

- "Warring against [the principles] of the people,... there is no length to which [the delusion of the people] may not be pushed by a party in possession of the revenues and the legal authorities of the United States, for a short time indeed, but yet long enough to admit much particular mischief. There is no event, therefore, however atrocious which may not be expected." --Thomas Jefferson to Samuel Smith, 1798

- The meek shall inherit the Earth, but not its mineral rights. --J.P. Getty

2008 Sep 24 12:00 PM

[Invest On F...:]

HJ,
I have to chuckle a little at your earnest attempt to sort this situation out, and I agree with you on your ROI concept, but I have to say, you vastly mischaracterize the reality of the situation. You are quick to draw (innacurate) conclusions, but more importantly, you completely miss the whole point.
First, it is astounding that you assert that we are "being asked to subsidize the losses of major financial institutions without receiving any of the benefits..." Then, to further illustrate your ignorance, you ask "So what's the rush?" I have to say, these comments clearly highlight that you are simply a reporter and not a thoughtful businessman or economist.
Let me be very clear: We will all receive the main and primary benefit of Paulson's plan--a financial system that avoids financial Armageddon. To those who understand the events quickly unravelling last week, our financial system, and the world's financial system to some extent, was on the brink of partial collapse (or worse). Paulson's plan has bought us a brief period of time to put in an imperfect but functional way to stop a financial panic that would cause at least a very severe recession or possibly a depression. No plan is perfect, but Paulson's plan has a high probability of success (and where did you get your 50-50 chance? Convenient for you to say, but I doubt you base that on any analysis whatsoever). Remember the S&L RTC process in the early 90's? It worked well, and the net cost after the RTC sold off the assets was low. This is the same kind of plan, based on a previously successful model. Get a clue. If you don't believe me, listen to Buffett's interview on CNBC this morning. He is certainly smarter than you are and he said last week would look like "nirvana" if Congress didn't pass Paulson's plan. He also thought that the government could make a NET PROFIT after it eventually sold the assets that it plans on buying at a very low current price. People like you and certain members of Congress are strutting around talking about how outrageous a $700B price tag is, but they and you don't even understand how it works. The $700B is an upfront cost, just like when you invest in stocks, and then you can sell those stocks at your convenience when the market is in a better condition at a higher price. Remember the old saying to make a profit, buy low, sell high? That is exactly the plan.
People who say that the plan is outrageous and they don't agree should ask themselves this: if the plan is not approved, and hundreds of banks go bankrupt, the entire world pulls its money out of the US, the stock and credit markets are decimated, unemployment skyrockets, and we're back in the Great Depression Part II, are these same people willing to stand up and take full responsibility for their stupidity? I highly doubt it. And yet there is a high probability of at least some of these events taking place if Paulson's plan, or one very similar, isn't put in place very quickly.
Next time, get your facts straight and think about things before you reveal your stunning ignorance and publicly perpetuate false concepts.

2008 Sep 24 02:26 PM

[H.J. Huneycutt:]

CM in MA, I agree with you on the parties. You can't expect much in the way of prudent policy from either of them. There are only a handful of individuals in Congress that I actually respect.


Anonymous User, how would taxpayers profit on Paulson's original plan? The original plan was to "purchase" the assets without receiving anything in return (other than the junk assets). It is the equivalent to a government price subsidy.

You might possibly be confusing Paulson's plan with the Democratic alternative that has been floating around. In that alternative, the government would purchase the bad assets in exchange for an equity interest in the companies. Hence, it's possible the government could profit. It still doesn't resolve the underlying problem, however, and creates a murky situation where the government will come to the rescue any time reckless actions are taken by the private sector. Moreover, if "successful", it would most likely simply re-inflate the bubble before another more dramatic falldown.

I wouldn't deny that Warren Buffett does have greater knowledge than me on the market and the economy. However, I own a few billion dollars less than him in stocks of financial institutions (many of which he bought back in the early part of the year somewhere near the middle of the plunge).

2008 Sep 24 03:16 PM

[H.J. Huneycutt:]

Btw, I think I should point out one of the major problems with the Bad-Assets-for-Equity plan. In a sense, it looks like it could be a good deal for the government. These financial stocks have taken a beating on Wall Street and stand to make some gains. With U.S. government backing, most of the financial institutions stay afloat and eventually rebound, thereby driving prices up.

However, it's not really all that simple. The financials are already up quite a bit off their lows a few months ago. Moreover, if the bailout is officially announced, they are destined to go up some more.

Meanwhile, it's unlikely the financials will ever reach their previous highs any time in the next decade. And keep in mind that $700 Billion is a lot of money to pump into the system --- so the stock prices go up as people believe the financial institutions' have a better chance of survival and the U.S. government suddenly is purchasing equity with very little upside.

Hence, while it's possible the government could profit off of this (which would help on the national debt front), the prospects for this are not as great as many might be thinking. Warren Buffett's prospects, on the other hand, are pretty damn good. He'd probably be the single biggest benefittor from the government bailout. I like Buffett, but I don't think we should pretend he doesn't have a pretty huge vested interest here.

2008 Sep 24 03:50 PM

[mortgage mess:]

Of course Buffett would like taxpayers to help along his Goldman investment. Paulson's plan is a massive subsidy to the debt capital markets, a few large investment banks that were grossly over-leveraged and over-leveraged homeowners. Anyone that agree's with the plan lacks an ability to truly understand financial markets, financial institutions balance sheets and the often overstated complexities of the credit default swap market and counterparty risk.

For instance, a lot of talk about the AIG bailout centered around ~500b of CDS contracts and a counterparty risk tsunami ensuing if something wasn't done. Treasury could have guaranteed policy holders and left debt holders to fend for themselves where they belong - negotiating in bankrupcty court. Here's just one illustration of reality - most of those contracts (more than 70%) were written on (once) AAA securities of mortgage securitizations and CDO's. Most of those contracts were sold by AIG to large (often european banks attempting to take advantage of recent basel changes that allowed them to attain a 0 risk weight asset once a CDS contract was in place) banks. My point - because of a knee jerk bailout reaction, the US (and I would venture to say, unknowingly) just subsidized several foreign banks SIV's and mortgage books- conservatively to the tune of 200billion.

So I would say to "Invest on Fundamentals" - maybe you need more real world experience

2008 Sep 24 08:58 PM

[DavyJ:]

The biggest question of all is "is the bailout really necessary?". The current situation is touted as the biggest crisis since the great depression. Treasury's Paulson and the Federal Reserve's Bernanke stressed the critical nature of an expedient rescue plan, with Paulson saying the bill needs to be passed this week. Yet so far, less than a dozen banks have failed out of the thousands in the U.S., and AIG, Bear Stearns, Lehman Brothers, Morgan Stanley, Fannie Mae and Freddie Mac had to through in the towel.

All except Lehman have been taken care of.

Show me some hard proof that the world's financial system is on the brink of collapse.

Bernanke warned that failure to act could push the economy into a recession, and already-fragile markets could become even less stable. Aren't occasional recessions an expected part of capitalism to correct for excesses in the system?

I think everyone should read axelrod608's first post on seekingalpha.com/artic...?

Also worth reading is John Hussman's open letter to congress. www.hussmanfunds.com/w...

2008 Sep 24 10:09 PM

[bitterboy:]

Unless you know what a securitization is and how it works, what "mark to market" means (and it's pluses and minuses), bank capital requirements and how they calculate how much they are legally allowed to lend, how REO assets work, the valuation of mortgage or other asset backed security, the difference between market price and underlying value, etc etc.... you are not educated enough to opine on this topic. The author and Huney in particular haven't a clue and yet feel the need to spread their ignorance......

2008 Sep 25 12:24 AM

[ASG:]

Invest - your comments are excellent as is your take - there are too many wildly inaccurate comments out there, and its worse when we have someone like here that comes across as knowledgeable

The comment "Instead, we are being asked to subsidize the losses of major financial institutions without receiving any of the benefits. " shows a complete misunderstanding of the plan ... this is NOT an investment in supporting a company, as with AIG or others - this is the Fed purchasing the assets

And it is not making the selling entity whole or giving them a windfall - they will take haircuts, and likely big haircuts on the sale of these assets

The claim the taxpayers get none of the benefits is simply false - the taxpayers will own these assets and when the assets are sold - or if they are held to maturity - the TAXPAYERS - the government - will receive 100% of the profits

Many in congress and most of the public, including alleged experts, simply haven't a clue what this plan is intended to and NEEDS to, accomplish - and it is much more than taking these assets off the books

... it is to recapitalize, increase solvency, increase liquidity and increase confidence in these entities - to allow them to be able to lend and to encourage other they are worth doing business with

.... more importantly this plan si intended to stop the death spiral created by the ridiculous mark to market rules - which have caused perfectly good, non impaired in any way, assets to be written down to fire sale prices ...which write downs casue liquidations at fire sale prices - which then become the new "value" for mark to market forcing a whole new round

This plan - brilliantly IMO - addresses this massive problem.

The Fed is not a vulture buyer - if there was credit available these assets would be purchased today for fair values based on their cash flows and performance, both historic and projected ... there is no credit however and the only buyers today are the vultures ... the Fed has no pressures and plenty of access to cash - they can easily afford to hold these assets and collect the cash flow and other distributions.

And by doing that - paying the fair discounted present value these assets are worth based on their performance - they address many important goals ... as noted it provides liquidity, it also however establishes a real market value that will then be used by all company's to value their remaining assets - it allows assets to be written up to current fair value greatly enhancing balance sheets that were unfairly impacted by the ridiculous fire sale values on non-impaired assets - it eliminates the "paper" insolvency - allowing them to accurately reflect values on their books

AIG has said the forced mark to market write downs on their assets were more than 4 times the actual losses expected if they hold the assets - as planned - to maturity ... this plan addresses that

Some say we should let the market collapse - that we should let the vultures buy these assets - which is ridiculous in many ways ... especially considering the majority of these vulture buyers are foreign ... corporations, country's, sovereign wealth funds ...

If we allow that we have done oursleves what Osama and AL Qeada couldn't - we;ve given away our country to the Chinese, Arab Emirates, Koreans etc - and we've given it to them for 25 cents or so on teh dollar

The author talks about ROI ... but ignores the huge benefits - the ROI - this plan provides ...

Buffet, BlackRock, the CBO and many, many others have said the taxpayers and govt will<b> profit</b> in the purchase of these assets

Add to that restoring solvency, liquidity and most importantly confidence in the markets and the players - and preventing the collapse of the financial markets and Americas position as a leader ... THAT is ROI ....

China has already begun promoting the idea in the media that there should be a new world financial order - without the US at the center ... how do you think all the folks whining and compalining about this plan will feel then ...??

2008 Sep 25 03:31 AM

[ASG:]

And same to you bitterboy - well said - a more succinct version of my comments

2008 Sep 25 03:33 AM

[cjct:]

While the internet is good for many things--the ability of the ill-informed to opine on a subject of such national importance is certianly not one of them...I would liken what will happen on Monday if the TARP has not found Congressional support to a credit cascade where one default leads to another and then to another and then to another. That Congress is actually wasting time asking Paulson and Bernanke whether "Wall Street executives should have to publicly apologize to the American people" is just one of many examples of the dearth of leadership that exists inside the Beltway...We are honestly staring into the abiss, one of the greatest crises in recent history and Senators and Congressmen want to play the blame game...truly a sad day for the Republic.

2008 Sep 25 04:53 AM

[cjct:]

I might also add that if held to maturity, the government should stand to recoup all of its initial investment, plus a healthy profit. Given the government's low cost of borrowing and the distressed levels of most mortgage-backed assets, even with a high level of defaults within the underlying pool of mortgages, there exists and high probability that the government can turn a healthy profit for its willingess to lever-up during a period of mass-deleveraging.

2008 Sep 25 04:57 AM

[H.J. Huneycutt:]

220nph,

I'm not sure what planet you are living on, but the one I live on, companies don't sell their best assets at discount prices to the government. Rather, they are going to sell the debts least likely to be collected for inflated values. If there were a high probability of collection, there would be little need for a "bailout".

These assets have been marked down for a reason and it's not because the great probability of successful collection. If you want to re-capitalize the institutions, go with a plan that buys preferred stock from the banks --- not one that buys junk assets. Technically, the government could profit off those assets, but technically, aliens could fly in, donate $10 trillion to the United States government, and share with us a fool-proof regulatory system for financial institutions that has worked for millions of years on their planet.

2008 Sep 25 06:49 AM

[H.J. Huneycutt:]

So, I'm getting the sense that those in favor of this deal believe the financial institutions are going to sell the government the debts at their market-down values since 'mark-to-market' gets mentioned. I'm not sure why that would make any sense for the financial institutions, especially if they are "undervalued" as people also claim (I don't necessarily disagree they are undervalued --- but the government is paying a premium for them).

This is a very lousy solution to the problem. A better idea would be to have the government directly invest in the financial institutions at prices negotiated now (as opposed to buying assets as the institutions decide to sell to the government). No businessperson in their right mind would make this deal that the government is giving to the financial institutions.

2008 Sep 25 07:02 AM

[H.J. Huneycutt:]

"If you want to re-capitalize the institutions, go with a plan that buys preferred stock from the banks --- not one that buys junk assets"

That should read, "if you want to re-liquify the institutions ..."

It's way too early in the morning.

2008 Sep 25 08:14 AM

[Gopi Padaka...:]

Jake,
Jake,

I liked the way you associated ROI to the solution. Especially, poor risk management and planning (of AIG, Lehman and other) being the root cause of the current economic turmoil, a comprehensive ROI driven approach to solution alternative analysis and solution selection is imperative.

2008 Sep 26 11:47 PM