It is all about the amount of money and the prices for assets when there is less money.  The American government has pumped several trillion dollars into the economy in the last two years.  However, the value of real estate has gone down many trillions more, in both commercial and residential real estate.  The value of stocks has still declined many trillions from the October 2007 high, even taking into account the substantial recovery since March 2009.  In short, there is a lot less money going around today than there was in October 2007, even when you add back in the trillions put back into the economy by the US government.

How does this affect prices and cause deflation?  Look at a hypothetical country that has assets of only 4 apples and $4,000.  What is the price of each apple?  Inevitably, the price of each apple is $1,000.  While economists do not have a problem with this simple example, it is much tougher in the real world.  Yet the fact is that if the amount of real assets remains constant and the amount of money goes down, the prices of things are going to go down.

In spite of the government pump priming of trillions, the real money supply is down because the value of assets that define money is down dramatically.  Furthermore, the prospects for 2010 are a continuing and likely dramatic further decrease in the amount of money.  Approximately one quarter the nation’s mortgages are owed by people whose house is currently less than the value of the mortgage.   (See details of housing risk (http://online.wsj.com/article/SB125903489722661849.html).  Mortgage workouts have not worked and a new explosion is coming.  Commercial real estate values are dropping.  Savings are going up as people are realizing they must borrow less meaning that debt at the consumer is level is not increasing which could help further new purchasing for business.  In short, the driving force of the economy, the consumer, is pulling back part by necessity and part because he realizes that he cannot go on as he has, particularly if he is now in the 1 in 6 people who does not have a job or works in an unsatisfactory part time job.

One problem in understanding this for many people is knowing what is money.  Traditional definitions of what is on commercial bank balance sheets have become almost meaningless.  The massive creation of bonds that keep getting repackaged and then resold sold as a new bonds shows how we can now almost have infinite money creation since for practical purposes there are no meaningful reserves to limit the creation of new money by relending. 

While few people doubt that money is created when stock market prices are going up, most people find it not logical that money disappears when stock market go down.  People say that someone must have the money, but it is not so.  If Google sells for $500 per share and there are 1 million shares, there is a monetary value of $500 million.  If just one person sells one share for $300, and no one comes along to argue with that evaluation, then all shares are worth $300 until some one comes with a new price, either higher or lower.  The reduction in value did not go into some ones pocket, the money simply disappeared.  As the stock market is 30% less today than October 2007, then the holders of those stocks have collectively lost 30% of the value that existed in 2007.  Likewise all the owners of homes in America have lost something like 20%, with some markets as high as 50% loss.  The decline in the value of stocks and housing far exceeds the stimulus money put in by the government, and it is for that reason we are at the beginning of the deflation, not the inflation currently expected by those buying gold.

Many readers may, at this point say, I understand how there can be deflation, but why is it necessary that this will lead to a depression?  The simple answer is that we have had decades’ long monetary creation that has little justification for the price except for the amount of money chasing it.  When there is a dramatic decline in the money supply, something which is clearly started but far from finished, this means that there will necessarily be a dramatic drop in prices.  A dramatic drop in prices means that those people living with high debt level will now proceed to go broke.  This is true at both the consumer level and the business level.   As individuals go broke, their capacity to consume drops dramatically.  As businesses find they have far fewer customers, particularly those who live with high debt levels hoping for ever increasing sales that will not now develop, end up going broke.  In short, declining prices means that people in debt will now go broke in large numbers.  These individuals and businesses going broke is what will bring on the depression.

We have had massive monetary creation for decades now which we have finally come to the day of reckoning.  Alan Greenspan in 1996 talked about “irrational exuberance” and was right on.  The only problem was that he was a decade or so early in picking the top.  We do not know if the top will be next month, next year or even later.  But we certainly are getting to the top where we cannot buy our way out of the problem through a new stimulus injection.

There are many measures of a market and monetary top.  But one of the clearest is when the government virtually is assuming all the risk.  There is virtually no private sector housing financing going on.  Virtually all lending is being laid off to the government (Fannie Mae, Freddie Mac, etc) and these government agencies are all bankrupt.  The government lends trillions virtually for free, and it is not really fixing the problem.  When nearly interest free stimulus does not work, will the government pay to you to take money?  Money 1) that has little or no cost, 2) that is all borrowed and 3) with few opportunities to invest beneficially, cannot offset the  economic collapse.  Government stimulus works in the early and mid stages of economic expansion, but is largely wasted money in mature stages of the economic cycle where everything than can be done beneficially, has been done. 

Thus, it is not surprising that government stimulus money is going to the wrong places with the wrong result.  The payment of B of A of the TARP money is extremely illogical, worsens the position of the equity shareholders and exposes the banks to a much worse downside scenario when the economy further weakens.   (See this article on B of A)  seekingalpha.com/article/176687-behind-b...).  The payments of Goldman Sacks to its employees are equally bad.  The payments are made now before we see the results and the shareholders are left to hold the bad bag of problems likely to come.  The government money does not have good places which stimulate useful investment and is going to make another financial bubble which the world citizens will pay for shortly. Dubai is providing a cannon shot across the bow about the risks of unjustified massive spending that basically relies on the presumption that a government will bail them out and the borrower never really had good financial analysis to justify the loans.

This seems old fashioned, but government stimulus can only work where there are beneficial areas to invest.  Since we do not have good investment opportunities, the money is wasted and ultimately worsens the amount of problem that we have to deal with.

In short, what can we expect if this writer's view point is correct? In the coming months, we can expect to see a return to the down side with a loss of value in almost all categories of assets with the exception of the dollar.  Oil, gold, silver, and commodities generally, long term bonds, both government and private, currencies other than dollars, emerging market debt, high yield debt, municipal debt, stocks of all kinds and countries should be collapsing at some point during the next year or so.  While the dollar will be viewed adversely, it will look better than most of the rest.  Even so, this period will represent the end of the dollar’s dominance as the world’s reserve currency and countries such as China will come more into their own.  Protection of your assets principal value is your first priority, not "making money" on your investments.

For an analysis with many points in common with my analysis above,  read this summary of  an International Monetary Fund report. (seekingalpha.com/article/176664-the-cost...)

A more professional explanation of the cause for the Economic Problem: Economists, particularly at the FED, focus on the “Private Credit Aggregates”, which includes all household and non-financial company debt used to finance consumption and investment (mortgages, auto loans, home equity loans, credit cards,  etc).  Then economists compare this to the nominal GDP (gross domestic product).

For 30 years, from 1954 to 1984, there was an extremely close relationship between Private Credit Aggregates and GDP.  (Go to the underlying article ((www.pimco.com/LeftNav/Global+Markets/Glo...)) by Richard Clarida to see the chart demonstrating this.)  In 1984, $3.5 trillion of nominal GDP was supported by $3.5 trillion of Private Credit outstanding.  By 2007, $14 trillion of nominal GDP was supported by $25 trillion of private credit outstanding.  By 2007, we had nearly double the amount of private credit as a % of our GDP.   We believe much of this excess to be unproductive debt which simply could not be paid back.  This is the problem.

This unproductive credit is the reason for the crash of 2007 which continues today and will continue for at least some time more.  The break with the traditional relationship of Private Credit with GDP is the indicator that we were getting too much bad consumer credit.  Today we know that bad credit as liar loans for home mortgages, adjustable rate mortgage loans where after a couple of years the rates went to levels that simply were not payable by the borrowers.     As the increase in house value exploded upward, consumers took out home equity loans to spend on vacations.  Virtually everyone assumed the increase in real estate was a permanent increase in wealth and therefore one could spend more and borrow more because the consumer was rich enough to afford it.  Consumers took the attitude the credit card debt could be thought of as sort of permanent financing which did not really need to be paid off.  Then smart guys on Wall Street invented ways to make it easy to grant credit (mortgage backed securities guaranteed by companies who did not have the ability to honor their guarantee (AIG and bond rating agencies) and erroneously rated the debt as triple A credit.  This creative Wall Street financing made it possible for inherently bad loans to get financed.  This is the imprudent and unproductive consumer debt that has led to the current crisis.

The next question is, logically, if we had the economic indicator, why are we talking it about it only now?  Why didn’t someone sound the alarm?  The simple reason is that the economists took their eye off the ball.  The economists simply did not take seriously the Private Credit indicator.  But there were several specific reasons for not following the indicator. First, Private Credit and Monetary Aggregates have lot in common as indicators.  But Monetary Aggregates were going through a transformation.  Monetary Aggregates, which include checking, time and savings deposits in banks, used to be a pretty good measure of the amount of money in the economy.  But this was before we got securitizations which are bank type loans but outside the bank system.  In the early 1980’s, the only securitized loans were some mortgage backed securities.  The shadow banking market which we have today did not exist.  As a result, Monetary Aggregates and Private Credit were nearly the same in the 1980’s but they very vastly different by 2007.  Furthermore, economists were in practice basically only tracking inflation and the increase in the GDP.  Since other indicators seemed to be better predictors of inflation and GDP, economists seemed to have stopped looking at private credit.  This was a serious mistake.

Summarizing, 25 years ago Private Credit started growing much faster than GDP.  This led to an immense amount of bad credit that had to explode at some point.  The housing market started exploding in 2005 and the financial markets in 2007.  We are now in the process of normalizing our credit with all the adverse attendant consequences.  When the consumer credit market stops working, it ultimately takes with it manufacturing, finance and other dependent sectors.

Two economic realities fall out of the decline of consumer credit.  They have serious ongoing consequences for the economy.

1.       Deflation is here and has much further to go.  While many thought deflation was not possible, it is not only possible but it is currently a primary factor in understanding much of what is happening in the economy.  For a free, outstanding description of “deflation”, get Bob Prechter’s description of deflation on the internet at this web site . ((http://www.elliottwave.com/deflation-survival-guide.aspx))  Relevant points.  Deflation is always initiated by credit excesses, which we clearly have now.  Webster defines deflation as a contraction in the volume of money and credit relative to available goods.  That is to say, price declines are a consequence of less money and credit for the same amount of goods.  This has important consequences in coming months for the value of all asset classes, including housing, commercial real estate, gold, oil other commodities as well as stocks and bonds.  They will all being going down as result of a reduction in available private credit.  While inflation, even hyperinflation (because of the government stimulus program) may be a problem down the road, for the coming months, maybe even a year or two, holding long any of the asset classes mentioned above is likely to cause a reduction in your net worth.  This writer believes we are currently in a Bear Market Rally and we will soon see the ongoing deflation effect lead to much further declines in the price of all asset classes.  This view has technical support in that there are clear signs the private credit will continue the make important reductions in the quantity of credit in spite of the government economic stimulus plan.

2.       The government economic stimulus will largely fail.  While the government is putting various trillions of dollars into economic stimulus, the reduction of private credit is in the tens of trillions and this makes economic stimulus look puny in terms of the market generated loss of private credit.  There is not enough government money to recover the loss of private credit.  This writer, perhaps erroneously, believes he has a unique insight which he calls the “Wood Limitation to Economic Stimulus”.  This rule says that government economic stimulus will work at the beginning of the economic cycle and in the middle where additional credit will be found for productive investment uses.  But at the peak of the business cycle, most useful applications of credit have been found and additional money goes to unproductive uses, condemning them to failure.  A New York Times article perfectly illustrates the problem.  The article says if we use the new mortgage lending guidelines, we are not going to have much lending.  The implicit suggestion is that we ease up on the lending guidelines, but the problem is that we will just generate more bad credit with lax credit standards.  The “Wood Limitation” explains why former Fed Chairman Alan Greenspan talked about conundrums (referring long term bond rates not following short rate increases) and Paul Krugman in his recent book “The Return of Depression Economics” says wistfully that economic stimulus “sometimes works and sometimes does not work”.  At this point in time, much of the stimulus money of the government will inevitably go to non productive purposes because we are at the end of an historic business cycle.

This writer believes the undue expansion of consumer credit, and the resulting unproductive credit that cannot be paid, is the simple explanation for the economic problems we have today.  We were happy to see the prices go up, particularly our housing, because we felt rich.  But we are shocked when the bad credit explodes and the economy starts to right it itself to the new reality, including job loss and the decline of our asset values which makes us much poorer.  More prudent government management of the economy could have avoided both excesses, i.e. the artificial high from excessive credit and the terrible collapse from the resulting bad credit.  We need widespread agreement that greatly increased bad consumer debt is a root cause of our current problems, and that bad credit leads to the deflationary effect on prices.  If we can agree on that, we would probably hold better public discussions on the best actions for government to take to deal with the problem.

This article relies heavily on information taken from an outstanding article ((www.pimco.com/LeftNav/Global+Markets/Glo...)) written by Richard Clarida of Pimco.  I recommend you read his more professional telling of the facts.

The Obama stimulus plan is based on providing massive amounts of money to banks and the general economy in an effort to return the economy to growth.   While the private sector is deleveraging and reducing debt generally, the public sector is trying to provide economic stimulus with government funds.  The intellectual origins of stimulus go back to Lord Keynes in the 1930’s who first proposed this type of stimulus.  Today, the leading advocates of the Obama stimulus program are Ben Bernanke, Larry Summers and Paul Krugman.

It should be noted that this article focuses on financial stimulus through the banking system and does not refer to job creation programs such as building roads or bridges.

To my mind, the first problem is that the advocates of this stimulus plan are looking at only one side of the balance sheet. While it may work for one side of the balance sheet, it does not work for the other side.   A national balance sheet for mortgage debt, home equity debt and credit card debt, shows the general public owing money to banks and banks being owed money by the borrowers.  The government program has focused on getting more money out there into the hands of the public by getting more money in the hands of the banks, but there has little or no discussion whether the public can beneficially use this extra money.  And therein lies the fatal flaw.

First, let’s look at mortgage debt.  To get to the levels of indebtedness we now have, the mortgage industry had to have liar loans with no or poor documentation.  They had to have no down payment loans. There had to be the conviction that prices of houses would always go up and thus we could get many people trying to flip houses quickly and make a profit.  To fund all this, you had to have Collateralized Mortgage Obligations (CMO’s) which there had to be buyer sufficiently sucker to buy the story of Credit Default Swaps (CDS’s) to guarantee the bonds they were buying and triple A credit rating that we now know are simply not true.  In short, to get the mortgage market going again like it was, you would have to recreate all the stupid things that were done and that drove mortgage market to the unsustainable highs of 2006 and 2007.  This makes no sense what so ever.  Lending more money to people that cannot even repay what they currently owe is evidently not going to be a solution.

The Home Equity loans and the Credit Card Loans to the public are exactly the same situation.  People already maxed out on rational borrowing cannot now go out and borrow more. 

In summary, even if you put more money in the banking system, it is not going to end up with the consumer because he cannot rationally absorb more debt, and to do so will put the lending institution in greater risk of credit losses that risk destroying the lending institution.  If the money does not end up with the consumer and the consumer actually spends the money, the whole concept of economic stimulus becomes very dubious.

Now let’s go a step further.  The public has found out they owe too much and is cutting back.  The banks have found out they have too much bad credit and are now very cautious about making new loans.  I have recently reviewed most lending criteria that exist today.  They have gone from extremely lenient to, generally speaking, extremely demanding so that only well qualified borrowers get money.  In short, we are now in a situation where even if the money exists in the banks, it will probably be used to solve bank problems and strengthen capital ratios rather than take on a lot of new, high risk credit. I consider these “facts” to justify the conclusion that the economic stimulus program of the government will not work.

However, there is a second line of reasoning which also explains why the government stimulus program cannot work.  We are at the peak of the mother of all financial bubbles.  This is the largest bubble we have had since the Great Depression of the 1930’s and this will probably be considered bigger than the bubble at 1929.  This is true because this is the first worldwide financial and business crisis since that time.  This bubble has already had the largest effect on the worldwide banking system since that time.  While we did have a limited problem with the savings and loans in the 70’s, this is a worldwide effect affecting all parts of the financial system and is now progressing to the consumer demand parts of the economy. I consider this a factually irrefutable statement today.  However, it is the explanation of this that will be subject to some controversy.

I believe that economic stimulus can be beneficial at the beginning and middle of long term upward business cycles.  But at the peak of long term cycles, economic stimulus cannot be beneficial because of the excesses, maxed out lending to the public and business, bad credit, and poor business investment decisions that are so dominant at the peak of any long term cycle.  To my knowledge, this is a new economic view that I have not seen elsewhere and quite important to understanding business cycles and creating effective public policy, particularly relating to effective stimulus programs.

This view explains the famous “conundrum” of Alan Greenspan with respect to interest rates not working as expected in the dot.com bubble.  It explains Paul Krugman’s puzzlement why economic stimulus sometimes works and sometimes does not work, as explained in most recent book “The Return of Depression Economics”.  In an important respect, Paul Krugman’s support of the stimulus plan is puzzling.  He blames Alan Greenspan, in his newest book, for the causing the 2006 housing bubble by putting in place his stimulus plan to solve the dot.com problem in 2002.  The logical conclusion for Krugman should be that this year’s stimulus plan will have an equally deleterious effect on the future, in the dubious case that he does in fact short term reflate the economy.

I believe this above position is supported by the economic facts.  However, historical economist’s and technical analyst’s give much more support to this theory.  Economic historian Niall Ferguson in his “The Ascent of Money” describes business cycles and the events taking place within each phase of the business cycle.  The Austrian School with their focus on the business cycle (but I am not referring to their view on gold which I do not support) and Bob Prechter of Elliot Wave Theory give much support to business cycles and what happens in the different phases of the business cycle (or “waves” as Bob Prechter describes them).   Once one sees clearly the different circumstances occurring in each phase of the business cycle, one can see much more clearly why economic stimulus will work in one situation and not in another.

In a couple of years from now, we will look back to today and ask where our stimulus money went.  A very large amount of stimulus money will then clearly be seen as wasteful, and primarily helpful to banks and bank equity investors from bailing them out of bad loans and bad investments.  Much as there is a cry today about the retention payments to AIG officials and water boarding approved by Busch government officials, there will be a cry who did theses silly deals which had little or no benefit.

In summary, stimulus has a noble objective.  However, without looking at both sides of the balance sheet to see whether the incentive money can be beneficially used, we ignore a critical element in forming effective government policy.  Without understanding that we are at the peak of a historic bubble and the enormously bad economic conditions prevailing within this historic bubble, we cannot understand why indiscriminately pumping more money into the banks and the economy is doomed to failure.

We can put all the money we want into financial institutions, but we will not force the banks to lend nor the borrowers to borrow.   Without a beneficial use for the funds, we may create inflation, and in an extreme case even hyperinflation, or find the money is lost through misuse.  A more probable risk of the stimulus policy at this moment is that the US dollar will become discredited and foreign borrowers will no longer be willing to accept it, particularly at low interest rates.  While this possibility is still of relatively low probability, we are already seeing China cut back on it exposure to US securities, particularly Fannie Mae and Freddie Mac.  We start to see growing support for using Special Drawing Rights as the world’s reserve currency.  In a few years, we may look back and find this was the beginning of the end of the US dollar dominance and thus the ability for the world to fund the US deficits. 

You can take a horse to water, but you cannot force him to drink.  The government can pump money into the banks, but that will not cause it to be lent or to solve the current problems we have.  I believe we have a strong case that the Obama government economic stimulus program will not be effective and that it may in fact create new, very harmful conditions for both the United States and the word in general.

Disclosure: No positions.

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” (http://seekingalpha.com/article/129524-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 ”. (http://seekingalpha.com/article/130008-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.

Lets first look at the ability of the government to restore near parity to the value of the mortgage backed bonds, often called CDO’s 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 and Freddie Mac.  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

The government is trying to stabilize banks through liquidity programs such as TARP, TALP and PPIP.  These programs will fail for the reason provided below.  These programs should be replaced with a program to shutdown failed financial institutions in an orderly and socially responsible way.  This change will shorten the readjustment period of the recession/depression by years and will reduce the total cost of the government adjustment plan by trillions of dollars

This article is an extension of my earlier article “Obama Wants a 'Better Plan'? Here's One: Bite the Bullet” (http://seekingalpha.com/article/129524-obama-wants-a-better-plan-here-s-one-bite-the-bullet).  Readers asked for more details on how we do this.  This article provides some insights on implementing “Bite the Bullet”.

First, let’s look at why the current government programs to stabilize the banks through liquidity programs are condemned to failure.  Trillions of dollars of financial instruments (bonds, CDO”S, CDS’s, etc) are now worth 20% to 90% less than their original value. These programs rest on an erroneous assumption that government liquidity programs can return the value of these financial instruments fairly close to their original value, and certainly avoid 50% and even 90% write-downs which now appear likely.  The following three explanations show why this is an impossible dream. 

1. The financial instrument in question do not have a liquidity problem, they have a price problem.  One of the great myths now being spread is that there is a liquidity problem for the assets often described as toxic.  That simply is not true.  The banks are not willing to sell them for “market value” in part because they would be bankrupt.  Bonds of General Motors sell for less than 10 cents on the dollar and they are 100% current in payment of interest.  General Motors bonds do not have a liquidity problem.  Yet mortgage backed bonds owned by the banks, which may or may not be current on payment of interest, are offered by the banks for, say, 60% of the original value and they have no buyers.  They do not sell for these prices not for lack of liquidity, but rather because buyers do not think they are worth 60 cents on the dollar.  Assume all your neighbors have their house on your block up for sale for $500,000 and you are asking $1,000,000. The reason you cannot sell your house is not for lack of liquidity.  The reason you cannot sell your house is because you have too high a price. In short, trillions of dollars are going to “provide liquidity” to the banks which is not the problem. 
2. Prices must go to real value, not the erroneous initial value.   Our current problem was created by massive monetary creations assisted by new financial instruments which made things look better than they were.  Our financial institution leaders induced the bond rating agency to rate these bonds as triple A so that they could sell the bonds.  Now we know that many of these bonds are really junk or near junk.  It is not liquidity that is missing, but lack of good credit that has reduced the value of these bonds. All of these bonds were rated through a computer program which did not adequately rate the risk.  These bonds are worth less today not because of liquidity, but because we now know the original credit assumptions were flawed.  The original prices of the bubble high are not reflective of the real value of the instruments.  While the government has said that time will fix the prices of many of these assets (and thus the totally illogical reversal on the use of mark to market accounting), the truth is likely to be that the assets will continue to decline in value over time as more bad news comes out about the underlying credit worthiness.
3. Printing money has a history of bad results.  While it is true that less liquidity affects prices of the bonds, the above two explanations show why the bonds are worth less.  But history is replete with governments trying to solve their problems by printing money.  Germany in the 1920’s and the last two centuries of Brazil and Argentina show what happens.  The lessened liquidity in the US economy is a necessary part of the adjustment process.  There is growing consensus the Alan Greenspan’s attempt to fix the “dot.com” boom of 2000 through easy money was a direct cause of the problem we now have.  Printing the money to increase the money supply to inflate the value of the bonds is a fatally flawed strategy which history shows clearly will have a bad outcome.

In summary the government programs designed to solve the problem by pumping liquidity in the markets are condemned to failure.  Not only will these policies greatly extend the time necessary to adjust the economy (read about Japan in the 80's and 90's), but they will create massive trillion dollars losses which in large part are neither necessary nor beneficial.  What alternatives do we have?

Extending the currently authority the FDIC has to create an orderly and socially responsible shutdown of banks to other major financial institutions represents a viable way to deal with the problem of bankrupt institutions.  Let’s look at how this works.

FDIC closures have been an outstanding success.  One measure of this success is that no one talks about it.  A bankrupt institution is taken over at night and opens the next day under new ownership.  A decision is made as to what assets and liabilities are absorbed by the new buyer.  The government ends up with losses, or at least assets with deferred collectability, but life is generally uninterrupted for the normal person using the bank.

These rules apply to commercial banks.  They do not apply to insurance companies like AIG, nor do they apply to hedge funds, private equity, or merchant banks.  Also they have not been applied in recent times to mega commercial banks, although the actions at WaMu and Wachovia are certainly relevant to this discussion.

Let’s first look at the benefits of FDIC type rules for financial institution closure.  First, there is the legal authority to abrogate contracts that really harm the interests of the bank creditors.  There is the ability to remove the people who are more a part of the problem than the solution.  If AIG were operating under these rules, the problems of the contractual bonuses are solved immediately and simply.  Secondly, there are independent people who come in and make decisions.  Things happen and happen quickly.  The only difference between Citibank and the Bank of Podunk with $50 million in assets is 3 to 6 zeros more in the value of assets in Citibank, but the concept of what to do and how to do it is the same. (It should be pointed out there is more complexity, as 5 mega banks havve 96% of derivatives and other complex financial instruments which small local banks do not generally have.) I do not suppose that FDIC is perfect, but in a world where there are a lot of crazy, illogical things happening, they really seem to work pretty well.   Since extending FDIC type control over pseudo banks requires new legislation, we might want to think of it as “emergency regulations” which have a specific life of 5 years, so that we have the chance to get out of our current problems and then reevaluate the need for continued use.

Some readers may say “Is this really biting the bullet” if the government (and therefore the people) are going to end up with part of the bill?  My answer is yes, this is biting the bullet.  Here is why. First there is a consensus, I believe in the US, that smaller, less sophisticated depositors should in some degree be protected from a collapse of the financial system.  In terms of dealing with the bad assets, they are known and quantifiable things.  Maybe not quantifiable if we can sell a mortgage backed CDO for 100 cents on the dollar or 5 cents on the dollar, but at least we know a worst case number.  Independent people can probably put a pretty reasonable number on the current value.   In short, US government policy must be to close banks large and small which do not have the liquidity and capital to justify being open.  This will involve a cost.  So where is the benefit?

The benefit must come from shutting down the mega bailout liquidity programs of the government, wrongly presented as a solution to the bank problems.  These trillion dollars programs must be stopped as a part of implanting this new legislation.  The objective of the bailouts is to deal with the banking and subsequent credit problems for the nation.  The proposal here is to junk the non effective bailouts based on massive liquidity injections and close down the banks where they really cannot survive.  In summary, we should support Secretary Geithner’s idea to increase FDIC type coverage to other types of financial institutions with the proviso that this will be done only on the quid pro quo of eliminating or winding down the current bank liquidity type programs (TARP, FALP, PIP etc.) which this writer considers as damaging and costly.  At a bare minimum, we stop PPIP and other new programs of this type.

There is another, hard to quantify benefit from this proposal.  I believe the mangers of America’s business are for the most part competent people doing their best.  However, the government bailout programs have given all the wrong incentives for these mangers to look for effective, independent solutions to their problems.  When survival becomes largely dependent upon finding market place solutions instead of deals with the government, we are going to find a lot of creativity which is currently hidden by being forced to game the system with the government.  PPIP is probably the most incredible new way to game the system to the detriment of the larger society.

Disclosure: No positions