Finance

A Better Approach to the Financial Crisis

James Pedestrian — Wed, 01 Oct 2008 17:38:31 GMT

A Conversation with the Honorable E. Wallace Bakeman

Although he is a relative newcomer to American politics—in fact, he was not even listed in the Congressional Directory as a member of the 110th Congress at the time of this interview—the Hon. E. Wallace Bakeman has attracted no small following on Capitol Hill.

Q: On Monday, the House of Representatives rejected a Wall Street bailout proposal. Is that a major setback to the economy?

A: We do need to take action quickly, but not so quickly that we find ourselves with a solution that is worse than the problem. This crisis took years to develop, and it will take a while to fix. It is worth spending a few more days or weeks to make sure that we fix it the right way.

Q: Why is a bailout necessary?

A: Because of widespread defaults, our financial institutions have a lot of securities that they are unable to sell at a reasonable price. Some of those assets will eventually turn out to have value, but others will not. The problem is that potential buyers are not confident that they can tell the difference. They do not have much money to spend, and they are not willing to spend it on assets of uncertain value.

Q: Why is that a problem for the rest of us?

Financial institutions often have to sell assets in order to meet their obligations. In the current market, it is possible for a lender to be forced out of business even if its assets will eventually turn out to be sound.

And even if they do not have to sell them right away, lenders need to keep track of what their assets are worth. When prices are low, they cannot afford to lend out very much money. Businesses then might not be able to get loans to cover their cash flow needs, and consumers might not be able to borrow money to buy a house or a car or a gallon of gas. That can lead to a loss of jobs, which causes the cycle to repeat with more defaults, more turmoil in the financial sector, and more unemployment.

Q: The bailout plan that was rejected calls for the federal government to purchase the questionable assets that you describe. If private buyers cannot determine what those assets are worth, do you think that the federal government can do any better?

A: In theory, we can imagine the government purchasing those assets at prudent prices. In practice, however, I am afraid that would not actually happen. The original bailout plan involves an astronomical number of assets held by a huge number of institutions. It calls for government employees to make thousands of complex decisions in a short period of time. Their urgent mission would be to transfer a huge amount of public money to Wall Street, and they would achieve that goal. But financial institutions know more about the value of their assets than the government. When the government offered too little, there would be no deal. When it offered too much, then the financial institutions would make out like . . . well, like bandits. The price of assets needs to be set through a market process, not an administrative process.

Q: Did you balk at the $700 billion price tag of the bailout?

A: No, my concern was with the strategy, not with the price tag. A huge amount of wealth has vaporized in the past few years, and the money that is left is not circulating very fast. This creates a need to inject additional liquidity into the economy. That would ordinarily cause inflation through excess demand, but now we need a substantial amount of new money just to restore demand to a normal level. The sort of bailout that was proposed is one of several ways to provide that liquidity.

Q: What is wrong with the strategy that was proposed?

A: The original bailout plan would reward financial institutions for the poor decisions that contributed to the present crisis. Although we do need to ensure that our financial institutions survive, we should avoid an approach that can make losers out of firms that acted prudently and winners out of those that acted recklessly. That is bad policy and a bad precedent.

Another reason to question the original bailout strategy is that the government is so much smaller than the economy. The government is big, but not big enough to underwrite all of the bad investments that have been made. Hubris is generally not a good basis for economic policy.

Yet another weakness of the original bailout strategy is that it offers only a temporary fix. Enabling lenders to start lending again is a good and necessary thing, but the fact remains that consumer debt is an unstable foundation for national prosperity. The conventional approach to promoting economic growth involves adjusting interest rates and relying on people to go deeper and deeper into debt. I think we have reached the limit of that approach. There are not very many consumers who will be better off with more debt, and there are quite a few who would be better off with less. Instead of transferring bad assets to taxpayers and relying on a new round of borrowing to revive the economy, we need to make those bad assets better by improving the financial health of businesses and consumers.

Q: What kind of approach would you support?

A: I have proposed a two-part strategy for rescuing our financial institutions. First, we need to take action that helps Wall Street directly and trickles down to ordinary citizens. Second, we need to take action that helps ordinary citizens directly and trickles up to Wall Street. In the long run, the trickle-up part of my strategy will prove to have the greatest benefit for our financial institutions.

Q: The trickle-up concept sounds intriguing, but let’s start with what you call the trickle-down approach. What does that entail?

A: We need to help lenders maintain normal operations until the value of their troubled assets rebounds and they accumulate enough profit to cover their losses. Instead of purchasing questionable assets outright, I propose accepting them as collateral for government loans that financial institutions can treat as capital on their balance sheets. Each lender will then have the liquidity that it needs, but it will remain at-risk for the quality of its own assets. Provided that the institution takes appropriate steps to remain credit-worthy, the government can be a patient creditor while the value of the assets is sorted out.

Q: And what is the trickle-up component of your proposal?

A: What our financial institutions need most is good customers. Any bailout strategy will be futile as long as businesses and consumers are unable to pay their debts.

When the economy needs an infusion of money, the best approach is to provide it directly to taxpayers and retirees. That is what we did on a short-term basis with the economic stimulus checks that were mailed out last Spring. I propose doing the same sort of thing again, but with a few important differences.

Q: What changes would you make?

A: First, I would make sure that everyone understands that the payments are tax credits rather than simply free money that the government has created out of thin air. People who do not understand the nature of money do not like to watch it being made, but everyone can welcome a tax credit when the economy needs lower taxes in order to grow.

Second, I would make the payments on a monthly basis instead of as one lump sum. The size of the credits can then be adjusted from one month to the next to reflect the changing needs of the economy.

Next, I would urge citizens to use the money in whatever way is best for them, instead of suggesting that the only patriotic thing to do is spend it. Some people might keep the economy moving by spending their tax credits. Others might improve the liquidity of our financial institutions by reducing their debt or increasing their savings.

Finally, I would make the payments directly to creditors in cases where an individual has fallen behind in payments. That will directly increase the value of any troubled assets that are backed by mortgages or consumer credit.

Q: How would you know where to send the money?

A: People could request the credits with a simple computer-readable form in which they either affirm that they are not behind in their debt payments, or else provide amounts and account numbers for their delinquent debts along with instructions about how to split the payment. Some people might want to make payments on their delinquent mortgage in order to hold onto their house, for example, and others might want to pay off their highest-interest debts first. I would also give creditors an opportunity to report the amounts and identification numbers associated with their delinquent accounts, in order to verify that applicants have provided accurate information.

Q: How big would the payments be?

A: I am not an econometrician, so I will have to consult with Ben Bernanke before I can give you any amounts. The key question will be how much we can stimulate the goods-and-services economy without causing excessive demand that will drive up prices. Mr. Bernanke will have to answer that question on a month-by-month basis. But if these tax credits have to take the place of excessive consumer borrowing as a stimulus to economic growth, they may need to be substantial.

Q: Would these tax credits eventually have to be paid back?

A: Not exactly. However, any time the government injects money into the economy, it needs to be ready for the possibility that some of that money will need to come back out. The key factor in managing the money supply is not how much money there is, but how much circulation of money there is. The amount of money that was perfect last month can be excessive next month if it starts to circulate faster. That will happen when confidence is restored or if people start borrowing too much.

Fortunately, there is a very good way to slow down the economy when excessive demand starts to cause inflation. That can be accomplished very effectively through a combination of tax surcharges and reductions of government spending. For most taxpayers, a tax surcharge would be reflected right away by an increase in withholding.

Q: That will be the unpopular part of your plan. People might be willing to accept a tax credit when the economy needs to be stimulated, but they will never accept a tax surcharge.

A: That comment surprises me. I was expecting the tax surcharge to be the most popular part of my proposal.

Q: Why would you expect that?

The usual approach to cooling down the economy is to raise interest rates. That causes extreme hardship to some individuals and businesses—often the ones that can afford it the least—while others bear no burden at all. It causes sharp cutbacks in some sectors of the economy, such as housing and auto sales, while inflation continues unabated in other sectors. A tax surcharge would control inflation in a much more effective and equitable fashion.

People should be happier when they pay a tax surcharge than when they receive a tax credit. After all, the credits will be provided during hard times, but a surcharge will only be needed in times of high consumption and high employment.

What makes you think that people would not like a tax surcharge?

Q: That should be obvious. The more money I pay in taxes, the less I have left to spend on other things.

A: But a reduction in spending is precisely what needs to be accomplished when the Fed decides that inflation needs to be brought under control. I do not think that anyone can ever devise a way to reduce spending that does not involve reducing spending. In fact, I would argue that a reduction in spending to control inflation should not be seen as an economic burden at all. If a tax surcharge is implemented correctly, the inflationary portion of spending will be reduced while employment and consumption remain at optimal levels.

Q: I look forward to seeing how the public responds to your proposals. Do you have any other message that you want to convey to the American people about the financial crisis?

A: I just want to assure them that their legislators are taking the financial crisis very seriously. The defeat of the original bailout proposal does not mean that Congress will fail to act. It may have looked like a negative development at first, but it can open the door to better approaches that will preserve jobs and provide the solid economy that our financial sector needs in order to prosper.

If the Honorable E. Wallace Bakeman is a member of Congress, then James Pedestrian is a free-lance journalist who lives in Lincoln, Maryland.

Are Democrats Bad for the Economy?

MoneyTalks — Fri, 02 May 2008 20:28:55 GMT

Heck, I'll jump into this. The Democrats are wanting to raise the corporate and personal cap gains tax possibly to 25-30%, apply protectionist policies to "preserve American jobs" and potentially abandon NAFTA in order to pressure the other countries to strengthen its labor and environmental provisions.

Obama continually has said he wants everything to be fair. And the money these hedge funds and private equity groups are making is not fair to everyone else. Well, private equity firms are taking substantial risk in order to make their money. They participate in a very important facet of the economy...funding entrepreneurs. There are so many more small businesses than larger ones in America. And they employ millions of people. If you raise the taxes and make it harder to get a reward for the risk you're taking, the seed capital will dry up. As a result, less jobs will be created for new businesses. Larry Kudlow makes a great point that you cannot have capitalism without capital.

Furthermore, Charles Gibson pointed out at the April 16th Democratic debate, raising the cap gains tax has actually led to a reduction in revenues the gov't collected. And each time it has been lowered it has led to an increase. On the flip side, there is the argument that the lower cap gains tax is a only short term benefit and not a long term one. Ok...whatever. What I’m lacking is finding a solid reason in this current economic climate to raise them.

What I do think could be more damaging would be the protectionist policies Hillary and Obama are considering. Like restricting free trade agreements. In this current globalization of economies, now is not the time to put up barriers or apply tariffs. NAFTA has not hurt our economy...it's helped create more jobs than it has lost. Yes, certain sectors of the economy like manufacturing have been hit. But this was inevitable due to our inability to remain competitive.

I remember when John Kerry wanted to allocate a substantial amount of money to get back the textile jobs that were lost to China. Little did he know there was no way we could get them back. It was impossible. Chinese labor was too cheap. So cheap that India was losing its textile jobs to China as well!

It's hard to point to a good solution on that, but, our manufacturing sector is still one of the best in the world. Maybe all those recalls in China will facilitate a resurgence to go back to America pay a premium and get high quality products that are not going to be recalled b/c of lead paint, counterfeiting or worse.

In my opinion, the Democrat's economic policies are economically counter productive. Although Hillary and Obama may seem like they are "behind the American worker" and making it "fair" for everyone, the ramifications of these policies if they were passed would have a severe negative economic effects and create a worse scenario as a result.

And please everyone... prove me wrong. Am I missing anything?

Paul McCulley's 'The Paradox of Deleveraging'

Kevin Lynn — Tue, 29 Jul 2008 01:47:49 GMT

Having just finished Paul McCulley's 'The Paradox of Deleveraging' I said to myself, "This man must be in banking" but then I reread Mr. Mauldin's intro and saw that it makes even more sense McCulley works for a fixed income asset manager who has a vested interest in being able to offload funky mortgage and other asset backed securities.

The personal savings paradox only holds true in a closed national economy or a national economy that doesn't want to run up current account deficits like the U.S. seemingly does. If U.S. consumers save a little more and and buy less from overseas, this strengthens the U.S. as a whole by decreasing the flow of wealth out of the U.S. to our trade "partners": the Middle East, China, etc. This combined with the weakened dollar allowing for competitive pricing of U.S. produced goods makes us stonger. Instead of foreign central banks buying up U.S. Treasurys and hoarding U.S. dollars with their citizens' money, these bankers should convince their governments to lower taxes so that their citizens can buy more goods produced in the U.S.

There are other reasons that financial institution deleveraging is stalling out. Publicly traded banks and their CEOs are "managing losses" by taking them a little bit at a time. We keep hearing that no more capital needs to be raised and the writedowns of asset values are over. But every month we learn of more asset writedowns and new investors providing capital to financial instutions want common shares now, not preferred. By managing losses bank CEOs get to keep their jobs longer, rather than taking immediate big bath writedowns and resigning like they should. There is no way in Hades Kerry Killinger of WaMu should still be in his job as CEO.

The other reason banks are not unloading their assets faster is there is no proper pricing mechanism right now for those securitizations created by the idea that traditional lending heuristics can be replaced by combining weak credits with statistically low chances of defaulting simultaneously, or at least that was the bill of goods sold by the underwriters, the credit rating gencies, and the bond insurers. Since traditional lending heuristics were not used to create CDOs, traditional valuation techniques won't work. How do you value NINA, NINJA, and LIAR loan portfolios created partially with bogus appraisals?

It makes no sense whatsoever for U.S. taxpayers to buy funky assets if these assets cannot be priced. Does the Treasury pay whatever the banks say the portfolios are worth and do we think the banks will ask for a fair price? I think not! The only thing dumber than overpaying for something and hoping for the best is overpaying with debt, which is what the U.S. taxpayer would be doing by swapping Treasurys for the funky assets.

Keynes was no economic genius, he was just a very persuasive, old money, Cambridge grad who only took one economics course while there. Politicians of all stripes abuse Keynesian economics to fund projects that help keep politicians in office.

Finally, there is nothing the most brilliant microeconomist can tell you that a small business owner, the household money manager, or a mediocre accountant cannot tell you but with a better explanation. Let microeconomists go back to counting utils and keep them out of the pockets of U.S. citizens.

Friedman left us too early.

INDYMAC and the FDIC

ndallasj — Tue, 22 Jul 2008 15:41:58 GMT

Given that the FDIC estimates the cost of bailing out IndyMac at $4-8Billion, why did they offer 50% payments up front for deposits in excess of $100,000? Anyone with over $100K in an account with IndyMac had to be either greedy (chasing a few BP higher yield), careless, or ignorant. That limit is well-publicized; why should FDIC partially bail out these folks?

Was Greenspan Wrong?

MoneyTalks — Tue, 08 Apr 2008 14:29:12 GMT

Greenspan has been taking A LOT of heat lately for his management or mismanagement of the U.S. Economy before he retired. I'm very interested in knowing everyone's thoughts. Do you believe Greenspan's low rates (for too long) and laissez-faire regulatory oversight during his final tenure at the Fed was the foundation for the debacle we find ourselves in currently? Or is he being wrongly accused?