The Bailout Pork Effect: Short Term Rally, Long Term Disaster

Defeat of the Paulson bailout plan in the house last week was nothing short of a remarkable victory of democracy. All of our political leaders were for it, future ones included, showing more unity than the Chinese Communist Party. The mainstream media were so politically aligned with the Government, they put Xinhua to shame. Yet individual voter-tax-payers, with hardly any meaningful organizing effort, fought for their self-interest and won against all odds. Wow.

If only we had done it five years ago on Iraq war and the Patriot Act, today's American citizens would be hailed as a shining example of independent citizenry of a strong democracy for centuries to come.

Unfortunately, we hardly had time to throw a party before the Senate pulled an old political trick and forced the hands of the House and the voter-tax-payers on the same plan. Only with $170 billion added pork to punish the rebelion act. That ought to teach the citizenry a lesson about respecting the Leaders.

There's no doubt SOMETHING must be done, and quickly, to stop this financial crisis from spreading to the wider world and becoming an economic crisis. The question is what that SOMETHING is. There've been many ingenious ideas floating around the internet. The Leaders have supposedly even considered some of these alternatives. Yet they chose the most costly (to tax payers) possibility and gave us two choices: are you for action or gridlock?

It's the same false choice as the one five years ago: are you for freedom or terrorism?

I used to pull this trick on my kids sometimes: who would you like to wash your hands, mom or dad? They started realizing the Possibility Universe is far larger than what I presented, somewhere around six years old. And I actually felt a bit guilty.

The Leaders have been doing this to us. And we never have the intellectual and/or political capacity to see through the same old trick. And they never have any guilt, I'm afraid.

But, we have to face reality at the end of the day -- would that be Friday?

If the Bailout Pork Package is passed, I'm willing to go with the conventional wisdom that the markets (stocks, bonds, derivatives, USD, commodities, gold) would have a broad rally, with the only exception being the treasuries as money exits the bunker and goes to work. Not too shabby huh?

Well, with $700B you'd expect more. Much more, and much more long term. But long term will be ugly.

First of all, the government has totally abandoned fiscal discipline. Well, it's abandoned it for a long time but now the world cannot pretend it didn't know any more. Foreign investors will have to stop playing suckers and buying the treasuries. They wanted to sustain the pretend game as much as we do. But now we finally killed the chance. Even a pretend game has a limit, beyond which the players simply cannot pretend any more. With the double whammy of hugely increased debt and higher interest, maybe CDS on US is not such a dumb idea (nah, it's still a dumb idea for, if...when US defaults, whoever sold you the CDS will not be around to pay).

Secondly, whereas inflation was a strong possibility in summer 07, now it's a certainty. Excess liquidity (credit) is easy to suck out as long as the Fed is determined to (which they weren't when they had a chance to deflate the housing bubble). But what the Bailout Pork Package puts into the economy is not just liquidity, but a massive amount of capital. Excess capital will stay around in the system for much longer. Capital chases return. Excessive capital chases excessive return. Excessive return at the macroscopic level can come from only two sources: asset bubble or inflation. In this case, it will be both.

Which leads to the third long-term effect: commodities bubble (yes, again, the real one) driven by negative real interest rate. The only reason that can explain the commodities bubble until a couple months ago is negative real interest rate. Supply and demand may have the right sign during some periods, but cannot possibly account for the magnitude of the surge. Amount of speculative money is an ontologically flawed argument since it by definition cannot explain why there were so much of it. When the real interest is negative, it does not make sense to hold cash (and cash there will be a lot of it now).

Real assets is one of the best places to park this massive amount of capital windfall, especially through continuously rolled futures since you don't pay the storage cost. What kind of real asset? Housing (mortgage) was the obvious choice when real interest rate became negative during Greenspan years, and especially after the massive rate cuts in 01. But now people will be careful touching mortgages for at least a few years. The only outlet left is commodities -- gold, oil, metals, rice, corn, who cares what it is. Never mind that there will only be so many taking actual delivery, demand will only increase so much and supply will only decrease so much by the mot exaggerated estimates. The $1T+ excess cash must be parked somewhere and earn some return.

While the effect of the housing bubble on inflation could be indirect and delayed, the impact of commodities is direct and immediate, as we learned with pain earlier this year. As I mentioned above, it will be commodities bubble and inflation.

Early in the year I expected the first thing the new president, whoever it may be, will do is to call up Uncle Ben and tell him to raise rates and kill off inflation. Yes, there will be short-term pain. But he could always blame that on his predecessor, however well deserved it may be, and take credit for the long-term benefits to the economy. I believe this is the main reason why the bubble contracted in the last two months.

Now, however, no matter how much the new president wants to play the game and Uncle Ben wants to be a good political lapdog, they cannot possibly do enough to kill the pending inflation without causing another crisis.

Yes, taxpayers may make money when the $1T+ toxic asset the Leaders will be buying for us matures or gets sold. But only before inflation adjustment.

Five years ago, the Leaders of both parties committed this once-great country to the Iraq war, with unspecified amount of lives and money for unspecifiedlength of time. "Imminent! Danger! We must act! Now! Don't ask questions! We don't have time for that! Just give me the power and money! Trust me!" Even if future Leaders were willing and capable, they cannot escape the commitment.

Now, the same Leaders will commit this country to years of inflation and generations of massive debt. "Imminent! Danger! We must act! Now! Don't ask questions! We don't have time for that! Just give me the power and money! Trust me!" Even if future Leaders were willing and capable, they cannot escape the commitment.

I'm still holding out hope that this Bailout Pork Package will somehow miraculously be defeated and some better alternatives will be considered with sincerity.

Nah, we don't have time for that. Let's just trust the Leaders. It's not like we have any other choice.

Don't we?

Stock position: None.

Comments

[whidbey:]

Did the Iraq war, or patriot Act have anything to do with the misbehavior on Wall Street,...or is just part of the liberal manta that no cheap shot will be left unsaid?

The Bailout has yet to be organized and we have not insights as to how it will work in the marketplace. The pricing mechanism is likely the sticking point, it is literally cutting the babe in two for the Treasury and the Banks. It will not b easy nor likely to help much. Inflation? wait and see how badly the economy is hurt. Stagflation looks more likely and infinitely more probable.

You are too glib, and too wordy, not to mention uniformed,but keep going you can only improve.

2008 Oct 03 10:03 AM

[waf76:]

i agree with your assessment...commoditi... will be on the rise big time and this quarter...

2008 Oct 03 10:56 AM

[anarchist:]

Whidbey, the point was, in case you missed it, Like the war in Iraq and Like so called "Patriot Act" Congress will vote on the wall street bailout pressured by fear from the Bush administration. Hank Henny and Ben Penny's rendition of the "mushroom cloud". No other options give just "give me the power quick to prevent Armageddon".

2008 Oct 03 01:11 PM

[Larry House:]

Very thoughtful piece. I share your viewpoint, but, unfortunately, that doesn't make either of us right. I think we are in for some horrible, very bad, no good, terrible, rotten days. I am a baby boomer, and I do feel for my kids and my grandkids. God help them. I am buying gold bullion to do for them what I can.

2008 Oct 03 01:51 PM

[Yankee Runn...:]

I would guess one might make a case for deflation instead of inflation... Let me see, the interest rates drop to 0.0%, banks still do not come out of their bunkers, business earnings drop like a meteoroid and capital spending dries up and prices start to fall... Read your history from 1929 to 1932.

In case you have not looked at the charts recently, all the industrials and materials are headed straight down, China has quit importing oil..


Only time will tell the name of the game, deflation or inflation.

2008 Oct 03 09:02 PM

[Bo Peng:]

Zooey, I think I made it abundantly clear in the first paragraph that the debate about the rescue plan cuts across traditional party lines. It's not even about fiscal policy. It's about the insatiable greed of the establishment vs self-interest and independence of the people.

YR Dog, today's market showed that it's smarter than I gave it credit for. It actually appears to be thinking longer term. The short term outlook is further complicated by the mess in Europe, where banks are in even deeper trouble than here. But the report of Europe's disappearance is greatly exaggerated, just as when Bernanke told Schumer et al "if we wait until Monday, there won't be an economy for us to save" (I'm paraphrasing from memory) two Fridays ago. US, Europe, BRIC, we're all in this together. Financial crisis can often hurt economy, but for a financial crisis to become an economic CRISIS, it takes extraordinary ignorance and neglect. I never believed the world would allow the current financial crisis to become a real economic one, even before Paulson started talking about his plan.

Maybe we will have a recession. Maybe we already have if you use the real inflation to adjust GDP. But, in this particular case, it hardly matters to the question of inflation. The surge of capital created by this Bailout Pork Package will drive up inflation even in a recession.

I'm sticking with commodities for at least a few more months.

2008 Oct 03 10:22 PM

[RSAAKKS:]

What happened this week is exactly what it takes to transform a great country into a weak one. Populace is still complacent, leaders have no guts. Power and wealth of a great country is being shipped out right before our eyes, and there is not much anyone can do, because reversing the course of wreckless spending and borrowing is the only option on the table. The only question asked is do you want to borrow more or less, has anyone ever asked if we should borrow at all and reduce the spending.

2008 Oct 04 08:23 AM

[bearfund:]

Those of you insisting that long-term deflation is a certainty and commodities are headed to zero are committing one of the cardinal sins: you are fighting the Fed.

Interest rates will go lower, for starters. Even the futures market finally agrees with me, though no one can be certain of the exact timing. Multiple pundits are now predicting 1% or even 0% as the cycle low. Then there's another little item in the bailout. The real reason the Fed wants to pay interest on reserves isn't that it will help manage the Fed Funds Rate during liquidity crises (though it will) but rather that the interest paid is a direct and immediate increase in the money supply. There is no way the Fed can sell Treasuries to offset the interest they pay; they don't have any left. So right there you have a nice source of monetization. The real channel for money creation, however, will now be from the Fed through the Treasury and thence out multiple channels: the multiple bailout funds, new bailout loans, and especially more "fiscal stimulus" which will amount to nothing more complicated than printing money and dropping it out of helicopters (minus the physical printing and the helicopters). They will continue to hand out money to those whose finances and/or behaviours match those they favour; it may take the form of free medical care (money flows from the Fed to the Treasury to hospitals through their staff and out into the economy while the money that used to go there now remains with corporations and individuals who no longer need to pay for medical care). It may take the form of more "rebates" which work in obvious enough ways. We already have extended unemployment benefits; there may be more of that. And it would not surprise me if widespread "infrastructure investment", once discussed widely before the crisis stole the headlines, gets under way. Some of the projects might even be good investments, though the real purpose will be to reward loyal contractors and Congressmen with porky deals and get money flowing into the economy, not make a long-term improvement in American competitiveness (and that's a shame, because if done properly such investment not only sterilizes the money but also delivers real returns - see WPA).

The bottom line is that Helicopter Ben was dead-right. There will be no deflation. However deep the recession, you can be certain that more money will be printed and that prices will rise. Whether it will help to end the recession will be a topic for argument in economic history papers, but that it will cause prices of basic goods to rise is unquestionable. The market for such goods is global, and price controls are ineffective. If you are printing money and other governments are not, you will have to offer more of your currency to outbid the rest of the world for commodities. And if everyone is printing, the price will simply rise with the money supply: the supply of the commodity is only so great, it changes slowly, and demand for life essentials has a clear floor. There is no way to avoid this fate when you print money.

2008 Oct 04 11:31 AM

[StateofConf...:]

Bearfund, Well stated. I would just add that if wages don't keep up and jobs are lost at higher rates (I think this is likely) then non-essential goods like iPods, new furniture, etc. will deflate. Of course there is a fight between rising costs (oil and materials) and low demand. We already see this in big cars and SUVs.

Bo Peng, thanks for the article. You have described the Shock Doctrine. This is a book by Naomi Klein and explains disaster capitalism.
To see a funny interview with her check out www.naomiklein.org/fil...

2008 Oct 04 06:09 PM

[bearfund:]

StateofConfusion, sure, that may be. But all that will cause is further economic contraction: the makers of such goods will find their margins squeezed by higher input costs and lower selling prices, and their employees will demand higher pay to compensate them for their higher cost of living. In short, employees will demand more just as employers offer less, and the net result will be fewer people working and fewer productive enterprises. All those ex-Apple employees will still need to eat ever more expensive bread, and they will get the money to pay for it from the government. But no one will be working or turning a profit, so no one will be paying taxes, and the printing presses will rev ever faster even as the basic underpinnings of the economy collapse. The inevitable result is a blowout in Treasury yields and a run on the dollar.

The real-economy effect will be that the essentials become ever more expensive while everything else becomes relatively cheaper but also dramatically scarcer. The logical conclusion of this process is an economy in which the sole employment available is work on a government-owned farm, and the only pay one receives is a daily ration. This should be quite familiar to economic historians; it's the essence of the global economy circa 800, and of the Russian and Chinese economies as recently as 1980.

2008 Oct 05 03:50 PM