Curses! Foiled Again!

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You all know the movie plot: the Evil Sci­en­tist has laced the town’s water sup­ply with a poi­son. All will die unless The Anti­dote is added, and he holds the city to Ran­som. All seems lost until the Hero rides to the Res­cue with The Anti­dote. The Hero puts the Evil Sci­en­tist behind bars, and all is well (until The Sequel any­way).

Are there any par­al­lels here with Paulson’s cur­rent­ly ter­mi­nat­ed Wall Street bailout?

Well, score one for the Evil Sci­en­tist. Hen­ry Paul­son, the archi­tect of this Plan, was until 2006 the Chief Exec­u­tive of Gold­man Sachs, one of the Wall Street mer­chant banks that prof­it­ed from Sub­prime lend­ing when it was in full swing—and, telling­ly, also prof­it­ed on the way down by cor­rect­ly guess­ing that the bonds that financed the lend­ing would tank (along with Amer­i­can house prices).

The Ran­som was cer­tain­ly there—US$700 bil­lion is a pret­ty cool sum of mon­ey. And a lot of it would have gone to Paulson’s old firm, which stood to make mon­ey by dis­pos­ing of its hold­ings of tox­ic bonds for more than their cur­rent book value—as Michael West explained in yes­ter­day’s SMH.

But what about Paul­son also being The Hero? Here he was, rid­ing into the dis­tressed town, with The Anti­dote in his sad­dle.

But wait a minute… Paul­son as The Hero, when he was also The Evil Sci­en­tist? Then would­n’t he have known about the Poi­son when he was The Evil Sci­en­tist?…

Yes, unfor­tu­nate­ly, the real world is even stranger than fic­tion. At least in the movies, the Evil Sci­en­tist knows what he is doing. In the Sub­prime cri­sis, while there were cer­tain­ly some who knew it was a scam from the out­set, the major­i­ty con­formed to what Charles Mack­ay so well described long ago as “Pop­u­lar Delu­sion and the Mad­ness of Crowds”. Paul­son, like his many bud­dies in Wall Street who also paid them­selves enor­mous “wages” (Paul­son paid him­self US$37 mil­lion in 2005 as CEO of Gold­man Sachs), delud­ed him­self into believ­ing that Sub­prime lend­ing made eco­nom­ic sense.

So if he did­n’t under­stand that it was in fact a dis­as­ter wait­ing to hap­pen, why on earth should any­one think that he now knows what The Anti­dote to The Poi­son is?

Cer­tain­ly, buy­ing the bonds off financiers would have enabled them to replace their essen­tial­ly worth­less “assets” with real money—and they could then get back into the lend­ing game. With­out The Anti­dote, then soon­er rather than lat­er, they would be soon forced to record those bonds, not at “book” val­ue, but at mar­ket value—and they could become tech­ni­cal­ly insol­vent and unable to lend. The world finan­cial sys­tem could have come to a halt.

But how long would The Anti­dote have worked any­way? Even in the week­end that it was worked out, five major financiers failed—Wachovia in the USA, Brad­ford and Bin­g­ley in the UK, For­tis NV in Bel­gium, Hypo Real Estate in Ger­many, and even Ice­land’s major bank Glitnir—leading to state takeovers cost­ing well over US$100 bil­lion. How long would a US$700 bil­lion Anti­dote last­ed in today’s cli­mate?

Not long, because the root prob­lem is not the banks’ hold­ings of tox­ic bonds, but the pub­lic’s hold­ings of unnec­es­sary debt. A vast pro­por­tion of the US$41 tril­lion debt that Amer­i­ca’s pri­vate sec­tor has (almost 3 times the size of the US econ­o­my) was used to finance gam­bling on shares and house prices in the biggest spec­u­la­tive bub­ble in glob­al his­to­ry. That debt, ulti­mate­ly, is what is dri­ving the US econ­o­my into Depres­sion. Unless that is attacked, then a Depres­sion will fol­low, whether or not Wall Street is bailed out.

Telling­ly, Paulson’s orig­i­nal plan made no pro­vi­sion to reduce mort­gage debt. So Paul­son was­n’t being a Hero for Main Street—though I expect he believed he was. He was instead attempt­ing to save Wall Street from itself, as Greenspan did so many times when he was Fed Chairman—but each “save” only worked because it revived the fren­zy of irre­spon­si­ble lend­ing that has defined Wall Street and Amer­i­can bank­ing in gen­er­al.

This time, noth­ing can save Wall Street. There is, after all, no-one to lend to below the Sub­primes, apart from those who are already in gaol. But I have the feel­ing that some time in the future, many of Wall Street’s cur­rent lenders will indeed find them­selves doing busi­ness behind bars.

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About Steve Keen

I am Professor of Economics and Head of Economics, History and Politics at Kingston University London, and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous private debts accumulated globally, and our very low rate of inflation.