Why it can’t work–Crikey follow up
on September 26th, 2008 at 6:55 pm
In my column in Crikey yesterday (see below) I promised to provide some “back of the envelope” calculations on why the Paulson plan can’t work.
It’s not my usual standard or style of analysis–just a simple text-only flowchart mapping out of the possible consequences of a US$2 trillion bailout, financed by either bond issues or printing money–but a promise is a promise, so here it is. Since the images are quite difficult to read, I’ve attached the Powerpoint file as well.
Images from the two relevant slides
Incidentally, one thing I noticed simply by chance when taking a humour break to read Doonesbury’s Daily Dose was the following statement on it’s “Say What?” link:
“It’s not based on any particular data point. We just wanted to choose a really large number.”–Treasury spokeswoman on the $700B bailout figureWhat is not surprising is that fact. What is surprising is that someone admitted it in public. The so-called experts don’t have a clue–and of course don’t forget, their total inability to see this coming is in part why this crisis occurred in the first place.
I subsequently found that the source of this breathtaking piece of honesty was an article in Forbes Magazine.
Crikey Column–”Paulson’s Plan is like bailing the Titanic with a thimble”
The Paulson rescue plan looks massive at first glance — US$700 billion of government money will be spent buying the shonky bonds that Wall Street sold to Main Street (and foolishly also kept on its books, hence the effective extinction of US merchant banks in the last month). Surely that will bring the crisis to a halt?
If only. While $700 billion sounds like big bikkies, it’s chicken feed compared to the scale of outstanding private debt in the USA of $41 trillion. Some of that is legitimate debt-money borrowed to finance production rather than speculation, and lots of it has gone “up in smoke” in the subprime meltdown; but what is left still dwarfs the size of this rescue.
And there’s the rub. While the rescue might keep what’s left of Wall Street solvent, and could provide a boost to Main Street’s economy, it will be dwarfed as the Great De-leveraging begins, as American families and corporations, by choice or by bankruptcy, start reducing their debts rather than piling them forever higher.
That has already begun. In September of 2007, private debt was growing at a rate of $4.75 trillion a year; nine months later, that growth rate had dropped to $1.8 trillion. That represents almost a US$3 trillion reduction in demand, which is a large part of the reason that US asset markets have tanked, and the real economy is moving rapidly into recession.
Some “back of the envelope” calculations I’ve done imply that, even if the rescue package totalled $2 trillion, and even if it were financed entirely by printing money (rather than selling newly minted Treasuries), the best it could do would be to boost aggregate demand by 5%. But the collapse in private borrowing could cut aggregate demand by 30%.
The beneficial impact would be negligible if, as is almost 100% certain, the “rescue” were funded by selling Treasuries to the public-Michael West’s column on this in yesterday’s SMH was spot-on.
So this rescue won’t bail out the Ship of Fools, but it will make the American Ship of State even more insolvent than it already is (aggregate US government debt is now running at 53% of GDP). As Michael West concluded yesterday with profound understatement, “America is in trouble”.
The bailout has been sold as a solution but it seems to be aimed more at preventing an immediate crash, and to a certain extent it has been sold that way. Imagine an America where in a few weeks time borrowing was greatly restricted, so property prices fell dramatically and manufacturing stopped as it now relies heavily on credit.
If they weren’t already so in debt it wouldn’t be a problem, just relax fiscal policy and go, but fiscal policy has been a joke in the US so this isn’t really an option. Another basket case is the UK, they are looking at running a 6% deficit.
This kind of gross incompetence is not limited to regulation in the finance sector. i work in energy policy and regulation and the number of decisions that are made because they were dreamed up by a consultant, or because someone did it somewhere else in the world is staggering.
There is very little willingness to engage with the practicalities of issues. Theory and naval gazing abounds and it suits the ego to remain aloof and intellectually abstract.
Is there a sector in our economy that is benefitting from foresight and oversight provided by our elected representatives and their officials?
I was speaking to someone about the issues in the US and he said ‘when the rule makers are the rule breakers, regulation will not solve the problem’.
I have to say as a young Australian I am cmopletely disenfranchised with our system of government and law and I’d say there are many aronud the world who are in the same boat.
Dear Steve,
Thank you for another terrifying blog. Do you really believe the U.S will have a 30% reduction in GDP? I hope not as this would not bode well for my baby’s future.
The one thing I cant reconcile is the affect asset prices have on GDP. If a house goes for $500K one day and the same house $600K and $300k the following day apart from all the paristes who feed of these transactions, nothing has been created, nothing has really changed whether it is financed by debt or equity there may be an increase in the money supply but no new good or service has eventuated. A true Ponzi scheme. So is it possible that the collapse of the wave of credit directed at property will not have such a severe effect? As resources are directed at more profitable enterprises.
Thanks
Stephen
While $700 billion sounds like big bikkies, it’s chicken feed compared to the scale of outstanding private debt in the USA of $41 trillion.
But the 700Billion can be recycled indefinitely if you read the language of the proposal. It says “at any one time” Nothing stopping them from offloading those and getting more.
Hello All
I may be wrong here but the main reason that we need to keep the banks alive is so that they can borrow enough foreign currency. The foreign currency is needed so that we can buy our much needed cargo. Much needed to keep the whole of the economies alive.
Our CAD was 32 billion for the first half of this year so if we have 16 billion of assets to flog we still need to borrow about 16 billion to see us to the end of the year. The US problem is about 10 times worse.
We can’t earn this because the NEOs have destroyed our means of production. They have turned OZ and US the into lands of merchants, bankers and rust belts. There is no market in the productive countries for our merchants and bankers and we have already sold the important parts from the rust belts.
So to rescue the situation they offer a fraction of it in home made notes which does not even cover Australia to the end of the year and the US for a little longer?? We need even more next year!
How are we going to import the;
“Brummagem good and slops
For paler faced Australians
To sell in our sordid shops”
(words of Henry Lawson c1900)
Sound fundamentals indeed?
Hi Ponder,
That then justifies my hypothetical that the $2 trillion causes a $500 billion per annum expansion in private sector demand under the “print money” scenario–still chicken feed compared to the probably $5 trillion turnaround in annual debt-financed expenditure.
And yes Stephen, I do expect a turnaround of that scale. As I’ve been arguing for some time now, aggregate demand in a credit economy is the sum of GDP plus change in demand. Since the growth in private sector demand last year added US$4.5 trillion to expenditure, it was responsible for 27% of US expenditure last year (there are some inaccuracies here–I should be using GDI rather than GDP for example–but the ballpark is still correct).
As we go from expanding to contracting private sector debt, we could go from a 27% boost from credit growth last year to a 3% cut next year.
Hi All,
I’m keen to hear everyones opinion on our governments recent decision to buy 4 billion worth of AAA rated mortgages? Is this the beginning of our own home grown Freddie and Fannie?
Is this the same securitisation model that got us into this mess in the first place? The private sector generating the debt, taking a fee then passing the risk on to government – “us”.
Thanks for posting this here – I don’t read Crikey but I read your blog. Wouldn’t want to miss out on your analysis (which is generally excellent, altho today it is over my head).
Hello guys!
Have you read about Ben Bernanke’s economic ideology? I’ve written up an article, Bernankeism and hyper-inflation, which summarise Marc Faber’s Gloom, Boom, Doom report titled “Towards Hyperinflation?” in 2006 (there’s link to Mac Faber’s report in PDF format at my article).
Now, let me summarise my article here (which in turn summarise Marc Faber’s report)…
** NOTE: BTW, Ben Bernanke and company wrote a lot of papers saying all these- these ideas are straight from his mouth (or pen)**
1. Ben Bernanke believes that deflation (i.e. Depression) must be avoided AT ALL COST.
2. Conventional means to fight deflation will never win…
3. …because of the zero-bound problem. (i.e. Japan’s zero-interest-rate policy is an example of the zero-bound problem).
4. Therefore, unconventional means must be used.
The scary thing is that the Ben Bernanke and company has talked a lot about all these ‘unconventional’ means in their papers at the Fed. These ‘unconventional’ means are “absurd, bizarre, and preposterous monetary crank schemes ever proposed by anyone calling themselves an economist.”
Ben Bernanke and company has written up many papers about the heaps of freaky ideas they have up their sleeves. So far, they have only utilise only a small fraction of their freaky ideas. That means, they still have heaps of bigger guns to pull out if they still cannot win the war against inflation.
These freaky ideas are, “increasingly exotic plans,” from the “merely unsound to the bizarre and terrifying.” Also note that some of them are currently illegal (which means the laws would have to be changed if they are to be implemented).
Now, back to Steve Keen’s PowerPoint slide. If treasuries are issued, there will be a Greater Depression. If money is printed, there will be a Lesser Depression. Given Ben Bernanke’s thinking, I guess he will choose the money printing route.
But, a Lesser Depression is still a Depression. So Ben Bernanke and company will pull out the rest of their freaky ideas in order to pump up the economy even more in an attempt to ‘prevent’ it.
So, the question is, are they crazy enough and able (legally) to implement all these ideas? I mean, these guys have written up quite a number of papers contemplating all these freaky ideas.
Another thing to think about: Hank Paulson may be gone in 4 months, but Ben Bernanke and company may stick around for much longer. And they are the ones with all these mad mad mad ideas. If they have their way, they will eventually destroy the US dollar. That’s the view of Marc Faber, by the way. Marc Faber disparagingly calls Ben Bernanke the “money printer.”
Given that as Steve Keen said, the bail out is teeny tiny compared to the coming de-leveraging, these mad guys at the Fed may trying something really really mad.
Sorry, another typo error. When I wrote,
The last word “inflation” should be “deflation.”
Contrarian Investor,
I read your article and it is very interesting – although I think I will need to read the quotes in the context of the rest of the FED papers before I draw any conclusions.
Will the FED want to hyper inflate though? Bankers make money by having inflation just high enough so that you need to put your money in the bank to earn interest but they don’t want it so high that they have no claim to your labor for previous debts. I think that the interests of the banks will be served by the FED first and I am not sure that they will want to induce a hyperinflation that renders their ability to create wealth diminished as money essentially becomes a depreciating asset that can’t be leveraged to create wealth.
That said, this exact scenario is worrying for people that have positioned themselves for the debt deflation. If this does happen, I imagine money will pour into oil and energy. It will be the only medium left standing that had a claim over something that creates tangible wealth. I would like to see a Central Bank print their way out of that conundrum!
Hi Emil!
The problem is not whether the Fed wants to hyper-inflate or not. They don’t think of these freaky ideas with the intention of wanting to hyper-inflate.
Rather, they think of these mad ideas with the intention of preventing deflation.
I don’t think Ben Bernanke wants hyper-inflation. But I think the issue brought forward by Marc Faber is that Ben Bernanke, in his misguided intention of preventing deflation, stuffs up and ‘accidentally’ hyper-inflate instead.
I guess this brings to Steve Keen’s point that central bankers do not know what they are doing because their economic philosophy is misguided. In the same way, Marc Faber have a dim view on Ben Bernanke’s ability to understand “simple economics.”
Keep it up Steve! Sometime soon they’ve got to start listening to those of us who forecast this and previous recessions. Last year, every federal politician was given a copy of the Land Values Research Group’s report “Unlocking the Riches of Oz”, a study showing each property bubble since 1972 – and how enormous this bubble has been. We even defined a bubble for them. [Has anyone else in the world quantified and defined a real estate boom?] They weren’t interested, but let’s keep the pressure on the Bs!
BTW, Ben Bernanke has written that has to be in a period of deflating asset values is to run the money printing presses. Oh yeah? Keynesian pump-priming only worked after the Great Depression had had its way with us, and this will be no different – unless we give up on this bailout for the biggies nonsense and start proposing real solutions!
Dan,
I’m not sure why the govt thinks it is necessary to provide $4 billion to lenders who can’t make a go of it in the current environment.
I have always understood (but not necessarily agreed with) the role of the RBA is as ‘lender of last resort’.
We now have the federal govt, independently of the RBA becoming ‘buyer of last resort’.
As to the statement that they only be purchasing AAA debt – well we know how that worked out in the US and UK. In any case, this sounds a little bit inflatonary.
In answer to your query, I for one am totally opposed to this action. It has never been govt policy to my knowledge, until the last two days.
I think I will do a bit of digging in the data to ascertain why the RBA for instance is not willing to provide the usual (these days) repo finance.
What is the consequence if it doesn’t work?
How bad does it get?
What are the particulars of how this will play out?
Hi Steve. I found out about you via your appearance with Peter Schiff. It’s an eye opener to see Oz in the same kind of trouble.
Will
Welcome aboard Bryan!
I think they ultimately will have to listen, but for some time yet they’ll keep following the advice of their uniformly neoclassically-oriented economic advisers who, as you note, didn’t see this crisis coming–and yet seem to have the solutions to it.
Such as this idea of throwing more borrowing power onto the housing market… Just what it needs, more loans! I agree with Keith here. It will be inflationary all right–but of house prices, not the physical economy or commodity prices.
And VVi11, the best description of what will transpire is still Irving Fisher’s outline of the process of debt deflation. I’ll post something detailing that shortly.
So it seems we have had an orgy of borrowing from overseas going on at least since financial deregulation – first in the 1980′s with unproductive company takeovers and since then as speculative bubbles in housing and the share market. My question is, what is to stop the government from restricting borrowing from overseas to confine it to productive purposes only? Would this be possible or desirable?
What happened before deregulation?
Also, Steve Keen, are you saying that the Australian government’s policy response is going to keep our housing asset bubble continuing to grow?
The extra $4b that is supposed to increase competition with banks (who are about to get another reducton in the cost of money that they don’t want to pass on to mortgage payers) so that interest rates might fall. I presume that this hoped for downward pressure on interest rates is designed to keep people borrowing and spending with the consequence that their debt and the whole debt bubble continues to increase.
Eventually this will have to be repaid.
If, in faact there is a “global slowdown” in trade and manufacturing, then Australia will sell less of its mined raw materials and, in Australia, employment and incomes will be reduced. It will be harder and harder to pay off these debts that are still increasing.
The $4b invested by the federal government will only add to the long term problem.
My real concern is that the cabinet and government either don’t see what is happening (scary enough) or don’t care what happens in the long term and that is scarier for my grandchildren.
Hi Steve, we met at Bobs on Boxing Day, and our debt discussion did not include much on Inflation and its consequences, and I haven’t seen any real mention in your blog.
Why the IOUSA will continue to print money (counterfieting)and debasing its own currency, is because inflation debases its debts – social aecurity, medicare, military pensions and treasury bills to name a few. Hyperinflation is a real possibility, and hence the flight by investors world wide (especially in USA) to Gold and other prescous metals. Australians seem to blithly unaware that inflation will affect all fiat currencies, and God help Australia if the China/commodity booooom story looses power – depression here we come. aweb site http://www.financialsense.com is a must listen to get a handle on why informed Americans are so despondent about the situation and are turning to Gold and Oil for salvation. Peak Oil remains an ominious threat, which has slipped of the radar, but Americas aging decrepit infrastructure will soon bring this genie back out of the bottle with a vengeance.
Batten down your (gold)hatches.
Cheers, Gary
PS mortgage problems in IOUSA are being grossly compounded by the wilful stripping and destruction of abandoned, unoccupied houses.
MORE MORTGAGE MADNESS
The obscene escalation in Australian house prices was triggered and force-fed by easy money. The Howard government started a stampede with its doubling of the First Homebuyers Grant. Australian lenders then rushed in to fuel the fire with a massive pile of easy, low-priced debt, carelessly doled out. The effects were exacerbated by pressure from mortgage brokers to cut rates and cut corners in lending practices. On top of all this, securitisation shifted mortgages off lenders’ balance sheets thus enabling them to lend even more.
The unfortunate results of all this were debt and housing bubbles of of unprecedented proportions. These bubbles need to be sensibly deflated to to bring house prices and debt back to affordable levels.
So what does the Rudd government do? It injects another $4 billion of fairly easy money into the system using the same sort of securitisation process that caused a problem originally. It does this with the intention of promoting more competition, which was at the heart of lending malpractice in the first place.
About the only good thing is that the $4 billion is local money and not borrowed from overseas wholesale sources. However, the non-bank lenders who sell the mortgages to the government may well borrow overseas. This latter practice of borrowing overseas for housing and consumption is economic insanity. It adds enormously to our interest on foreign debt and creates practically nothing in export income to offset that debt. It also discourages domestic saving, which we so desperately need.
Bill Edwards
To either Crikey or Contrarian-
Please advise.
Either treasury issue or printing money.
Please explain “printing money”.
Are they not both “printing money”?
Do they both not result in the creation of new debt, denominated in USD?
And if they are both new debt, then, after the asset trade-off, why aren’t both still contributing to debt deflation?
Please.
Hi joebhed!
Issuing Treasury means borrowing from the private sector i.e. government selling Treasury to private sector. This will drain out money from the financial system.
‘Printing’ money means the government sells Treasury to the Fed. The Fed will create money out of thin air to buy it from the government. This will inject money into the system.
joebhed, debt deflation happens when there is a large debt and creation of new debt stops, so demand decreases and prices drop. Obviously to alleviate this the government can go into debt and push money into the economy, until public debt is so great that everyone loses faith in the currency and bonds.
I see management of this as a massive balancing act. Try to keep the economy “wonderful” and it will eventually break with both high public and private debt. If the government isn’t prepared to spend money then it will break big time. The problem for the Americans is they already have huge public debt so expansion is limited, except that foreign governments seem prepared to purchase $US even though they know the Americans are going to devalue them by printing more.
The major aspect the Americans seem to be missing is the need to fix the intrinsic problems in their economy but after the election is over maybe that will change, but probably not until the next election when they discover economic rationalism.
Recommended reading: P.J. O’Rourke “Parliament of Whores: A Lone Humorist Attempts to Explain the Entire U.S. Government”
I was amazed when I heard about the 4 Billion package for Australia. Here we have massive problems because of lax lending and oversupply of money and now our government wants to participate by giving more of the same and trying and mess with market forces.
The interesting thing going forward will be the demand for credit as Steven points out in his slides. If the demand is weak, then asset prices cannot keep moving up because the buy side simply won’t be there. In this case, while the banks remain solvent, that money is likely to just go into treasuries, or, carry trades. The real suffering will be on main street if the US dollar drops and asset prices decline.
It will be very interesting to see how this plays out for Australia. With global demand weakening, I can’t see how we will continue on with our excellent terms of trade. Then our dollar drops and we are left with the highest house prices in the world as well as the highest personal debt levels. Scary times ahead for Oz one would think.
Steven, I would be interested to hear what you would propose as some of Australia’s policies going forward. I think our politicians are going to need some help going forward. I would be keen to know if you think we can sustain historically abnormal house prices (Labor looks a little mixed on whether they are trying to defend the asset prices or not) and if you think we should try to support them by giving out more credit and keeping the party going.
Ultimately, there is little the federal and state governments can do to continue to prop up the housing bubble, and little they can do to prevent it’s eventual deflation. $AUD4 billion is but a fraction of the value of Australia’s housing stock, which would be valued in the 100′s of billions, if not a couple of trillion.
The government could put price floors into place once the debt de-leveraging and housing deflation takes place, but this would just be an insane and desperate action.
The U.S. housing bubble created $US8 trillion in paper wealth at its peak, and now $US4-5 trillion has been lost due to its current and continuing deflation. The crime is that the prices of houses were able to climb the way it did without the government and Fed officials noticing it and putting a stop to it. It is not beyond the ability of Harvard/MIT/Chicago educated economists to realize that a housing bubble was in place, and its eventual deflation would have severe consequences, as Keen has outlined for at least two to three years.
From the research that has been performed on Australia’s housing bubble, it is comparatively larger in size than the U.S.’s, in relative terms. While Australia has less subprime or low-doc mortgages than the U.S., the average size of mortgages is much larger in Australia.
True to form, RBA and Treasury economists (including the vast majority of economists) have missed (and dismissed) the housing bubble. Once again, I find it difficult that economists trained at ANU/Melbourne/Sydney Unis, etc would have missed this, but they have.
One would think that given the disaster unfolding in the U.S. at the moment, economists would perhaps question the economic theory that markets are based upon. I wonder how long it will take for neoclassicism to be thrown into the intellectual rubbish bin.
The debt de-leveraging and falling asset prices will devalue the AUD, aggregate demand will fall dramatically, unemployment will rise, government will go into debt by attempting to pump-prime, and individual/household/business bankruptcies will climb. Wages may also stagnate. Some banking and financial institutions are likely to go bankrupt as well. Deposits in these institutions are not guaranteed by the government. If a bank/credit union goes under, the average depositor will be lucky to get anything (as the big depositors tend to get their way first).
On the upside, rents and property prices will fall, hopefully temporarily overshooting long-term averages (CPI) which may be a prime time to buy. The RBA will predictably lower interest rates in an attempt to stimulate the economy, which allows the prudent Australian to take on a mortgage to purchase a property, at much lower interest rates and interest burden. Furthermore, Rudd and Swan are talking about bringing in deposit insurance of up to $AUD20,000 per deposit.
The Treasurer Wayne Swan has repeatedly stated that Australia’s economic fundamentals are strong, yet this was the song sung by Paulson and Bernanke. If Swan doesn’t know about the coming housing deflation, he is incompetent. If he knows, but doesn’t speak up about it for reasons of state, he is a liar. Either way, it is not a good position for any politician to be in.
I wonder if there is any way to profit from the housing deflation, but to my knowledge, Australia doesn’t have a housing property index that can be shorted, such as the U.S.’s ABX. John Paulson, a U.S. hedge fund CEO who “earned” $US3.5 billion in compensation last year, made a fortune by shorting the ABX index. He was a rare figure inside the Wall Street establishment who saw that subprime mortgages and RMBSs were going to become near worthless.
In short, there is little that politicians can do, especially when they are advised by economists who are educated in the religion of neoclassicism.