The Limits of Government Intervention

by: Julian Van Erlach

World markets soar because governments promise to buy into banks with money borrowed from the public who -  wouldn’t? A double-down leveraged bet with your money on the dead assets banks hold and that worried us so just a trading day ago? …Or did I just miss the real details of the Coordinated Global Plan?

Let’s see… bank liabilities (which they couldn’t service) against the bad assets are still there…and we’re going to borrow more to buy those assets…but I am getting ahead of the topic here...

In addition to the question of effectiveness of government intervention is the further question of confidence in its ability to deliver - solvency. To remain credible, government must demonstrate the ability to honor its obligations; which it can only do by taxing, selling its assets, further borrowing or fiat money creation (other revenue such as from fees and licenses is minimal). The limits of government intervention can then be assessed by relating the prospective cost of new liabilities assumed in relation to the revenue that it can reasonably and sustainably obtain and the effect on economic growth from which those incremental revenues come.

First, let’s be clear about the underlying premise of the various governmental bailout plans as they currently exist: the premise is that since private capital is unwilling to invest in activities with certain losses (buying assets with no hope of recovery and investing in companies and banks that are or will be bankrupt) – then governments will, by weight of their ability to borrow private capital, (which they will pay for by taxing the private sector to pay it a return on its own capital), forcibly make said investments. This then is the basis for hope in a world recovery. This is a redistribution of capital plan resting on the assumption that this is a better deployment of trillions of private capital than markets would make.

Capital has not suddenly disappeared – the money supply has not fallen- rather, the value of investments has fallen because expected returns and cash flows are much lower. Private capital is being very choosy about where it goes and what price it pays for new investment. Against this backdrop:

The fundamental issues with the current plans of world governments and academic and industry proposals to address this crisis are four-fold:

  • addressing principally sunk investment (already bad assets) by investing new, good capital into assets rejected by the markets instead of facilitating incremental capital investment that spurs growth – investing $250B of new equity into US banks just might offset a fraction of the write-downs yet to come from further plunges in real estate, consumer and corporate loans let alone derivatives whose nightmare risk exposures are about to come true;
  • ignoring the valuation mechanism of plunging assets (nearly all classes at this point: most commodities, real estate, equity and non-government risky bond prices). For example: cutting taxes on capital gains, dividends, interest and real estate boosts after-tax returns and asset valuation; counterbalancing some of the decline coming from lowered cash flow and earnings expectations;
  • failure to institute policies that encourage new investment and employment by decreasing marginal investment ROI hurdles so that more new investment projects become attractive (cutting or eliminating taxes from new investment);
  • by virtue of the first, governments are assuming such gigantic new liabilities in relation to their credible prospective revenue streams that a loss of faith in their own credit may ensue – instead of implementing a mechanism that encourages the far greater pool of private capital to invest in new projects by, say, assuming some of the incremental principal risk that it faces while acting as intermediaries (e.g. holding borrower collateral) for the flow of capital rather than borrowing…

A Limit to Intervention?

Governments appear to face two absolute limits to intervention: the first is a limit imposed by hyperinflation caused by the choice to create money to pay for liabilities and spending; the second, which we now may face, is the cost to the real economy (growth) of incremental service of debt to fund government interventions to buy dead assets; and the faith in government’s ability to tax the economy to service that debt. 

There is a distinction between taxation to fund critical government services such as security, justice, education, infrastructure, and R&D – which do drive some gains in productivity; and taxation to pay for dead assets that have no productivity offset. The question becomes: how much of these assets can be bought before the service of the associated debt affects the faith in government solvency?

The potential real growth of the US economy is about $430B per year, which is a 3% real growth of the $14.2T nominal economy (the 3% comes from 1% population growth and 2% sustainable real per capita productivity growth). Any incremental service of government intervention debt must first be charged against this real growth rate. This is especially true when that debt is incurred not to build needed infrastructure or fund useful education – which have some productivity payback – but to buy literally dead assets such as MBS on real estate that will never be inhabited and loans against cars that will never be driven and corporate projects that will never go forward. (Consider that currently excess real estate will sit rotting for years; and if it is inhabited at some future date, then it must subtract from real growth in that industry – we cannot have it both ways)

Government (Federal, state and local) revenue for years to come will plunge from all sources further widening deficits even with no intervention expenses. States and municipalities will require bailouts in addition to banks, deposits, and corporations. Nor will international trade help much because the rest of the world faces similar if not more severe problems.

The second limit may be approached when the debt of a government incurred against non-productive expenditures approaches its national GDP or the nominal cost to service that debt risks approaching its real growth rate. At that point, government must tax away real growth which also depletes the reinvestment rate into an economy, thus further slowing real growth and quickly implodes the taxable base – halting government’s ability to honor its obligations.

So what is the likely incremental cost of intervention on top of the current Federal on balance sheet debt of $5.5T (and growing $2.8T state and local debt)? Structural deficits alone will add several trillion to the Federal debt over the next two years compounded by the sure to come additional “stimulus” packages, unemployment and other benefits.

At my last rough count (see “Why This Bailout Can’t Work - And What Will”), the US government incrementally assumed liabilities were $7.8T, excluding insured deposits. I estimate at least 30% of these, or $2.3T, will be a total loss for reasons I give below. I further estimate at least one more trillion in debt incurred for further bailouts in sectors noted above that is a total loss.

The affect of $3.3T in such debt on the real economy is the equivalent of eliminating the return that the borrowed capital would have earned if productively invested or about $165B of real potential GDP growth. Secondly, this debt must be serviced initially through taxation. For a time, the government can borrow very cheaply at the short end of the Treasury yield – but faces rollover risk just as the disappearing investment banks and hedge funds do. An imputed 3% borrowing cost would present taxpayers a $100B bill against the now impaired real GDP growth rate of some $265B – leaving razor-thin real reinvestment into the economy.

This situation would be developing just as structural deficits widen dramatically and need funding. At such levels of combined impaired real growth and taxation to cover incremental debt service costs, faith in government solvency slips. Required Treasury yields may begin incorporating risk premia demanded by lenders, thus hastening a credit deterioration spiral.

Real estate has historically maintained a constant real price per unit – which implies at least a 20% further decline on a Case-Shiller index; worse if deflation and/or severe recession emerge. Moody’s is projecting a more than tripled corporate loan default rate in the 7.9% range next year; and consumer credit is fast deteriorating. Municipalities are crumbling under plunging revenue and debt service – all at the same time.

Much more comprehensive action should be taken that addresses liquidity, growth and asset valuation simultaneously. The risk for a truly perfect storm that taps out even the government’s solvency is rising.