Bailout: Theory and Crisis

Theory and Crisis

Any bailout plan that is believed to be potentially effective must be based on a theory. Otherwise it would merely be a shot in the dark. If you asked a TARP advocate why the intervention is necessary, he presumably would explain the problem and how the bailout would remedy it. For example, he might say that when the government borrows $700 billion in order to buy banks' bad mortgage-backed securities, it will inject liquidity into the credit markets and improve the economy. But that is a theory. (It's a bad theory, but it is a theory.)...

Free-market theory can explain the cause of the crisis -- government intervention in the mortgage market through promotion of easy home-buying and implicit guarantees to lenders and underwriters, including its privileged creatures, Fannie Mae and Freddie Mac. Given that genesis of the problems and the general theory of markets, the solution is for government to back off -- way off -- and to let the economy adjust to real conditions and recover without subsidy, guarantee, or regulation.

What is the alternative theory used by those who have jettisoned free-market theory in "this time of crisis"? Why should we believe that things will be fine only if the government has the discretionary power to transfer resources from those who haven't screwed up to those who have?

read the entire essay

My thoughts: Markets work, socialism does not.

Cartoon: AIG Junket

Cartoon: Bailout Pork

Cartoon: Bush is a Socialist

Cartoon: The Bailout Fails

The Credit Problem

Two weeks ago Monday, markets traded down 300 points at the open. The sell-off seemed to be in anticipation of what was widely considered to be a poorly thought-out bailout plan. As it became clear that the $700 billion package was not going to be approved by the House, the Dow Jones Industrial Average plummeted another 500 points. Stock jockeys had apparently decided that a bad bailout would have been better than none.

Fast-forward to the end of last week: During Friday’s House vote, the Dow rallied 300 points . . . but once the bill passed, they promptly reversed and sold off. It’s been more or less straight down ever since. Since the highs of October 2007 one year ago, the Dow has lost 39%, or about 5,500 points.

How did this happen? Why are markets reacting so negatively to a near $1 trillion bailout? The short answer is that the Federal Reserve and the Treasury Department have been focusing on the wrong issues. They have been treating falling asset prices—houses, stocks, bonds—as well as the lack of confidence between banks, as the actual issue. This is the wrong approach. Falling asset prices and a lack of confidence are a result of the underlying problem. You don’t cure alcoholism by getting rid of a hangover; you cannot resolve confidence issues by merely cutting rates.

The primary problem is that banks are refusing to extend credit to each other. Why? Because they do not understand the liabilities of their counterparties. Translated into English, that means they don’t know if the other bank whom they are dealing with will still to be standing tomorrow. The thing roiling markets today is not the lack of confidence; It is capital, or more accurately, the lack thereof. Thanks to a series of very poor trades—excessively leveraged and absurdly risky to boot—banks are now dramatically undercapitalized.

As we have seen in just about every historical financial crisis, the shortage of capital is the underlying cause of monetary mayhem. Too much debt, too little equity,makes any financial system cease to function...

from the Big Picture

Cartoon: Bailout and the Dow

Cartoon: AIG Retreat

Capitalism: RIP

I suppose I posted a whimsical item about moral hazard because I was too angry to write anything about the Financial Irresponsiblity Bailout and Reward Act of 2008, the moral-hazard story of the decade. Buy more house than you can afford? Sign a mortgage contract you can’t understand? Invest in risky mortgage-backed securities that lose money? Run your financial institution into the ground? Don’t worry, the hapless US taxpayer will pick up the tab!

I have nothing but contempt in my heart for all who asked for, drafted, and voted for this odious piece of legislation. If there were any doubt that the US is, in many ways, a socialist economy, this massive socialization of financial market risk should put such doubts to rest. Capitalism, requiescat in pace.

Peter Klein

Mark Thornton Answers a Journalists Questions

1) In which way do the central banks contribute to the problems we see now?

The central bank created the problem in the first place...

2) Can or should the government or central banks do anything to prevent a collapse of the banking system, at this point? Why not?

No...

3) What will be the consequences of the continued attempts by the authorities to prevent more bank failures and the seizing up of the credit markets?

Bailout policies are what turn normal recessions into depressions...

4) Is a world without central banks possible or desirable? Please explain.

Central banks are unnecessary and harmful...

source and more detailed answers

Dow Drops Below 8,600

Stocks tanked Thursday afternoon - with the Dow falling nearly 700 points during the session - as panicked investors dumped stocks across the board.

Bank lending remained tight as nervous institutions continued to hoard cash. Treasury prices fell, raising their corresponding yields. The dollar gained versus the euro and the yen. Oil and gold prices fell.

According to early tallies, the Dow Jones industrial average (INDU) lost 679 points, or 7.3%, after hitting its lowest point since May 27, 2003 during the session...

To put in perspective just how hard the stock market has been hit over the past 12 months: a year ago today the Dow closed at an all-time high of 14,164.53. As of Wednesday's close, it had lost 33%.

read the CNN story

National Debt Clock

Cartoon: Marx Comes to Wall Street

Top 1% of Taxpayers

The top 1% of taxpayers earned $1.79 trillion (22.06% of the total) in 2006 and paid $408.4 billion in taxes (about 40% of the total). The bottom 95% of taxpayers earned $5.14 trillion (63.34% of the total) and paid $408.1 billion taxes (about 40% of the total).

from Carpe Diem

Stock Market

The Dow is now 35% below its record finish a year ago, on Oct. 9, 2007. It has fallen 15% over the past six trading days.

source WSJ

Cartoon: Reckless Borrowers

Cartoon: Who is the Moron?

Bailout Commentary

Government has no resources of its own, no elves working overtime to produce something of value, just promoters who espouse Santa Clause economics. It can only transfer wealth from one group to another (skimming a nominal transaction fee in the process). The current $700 $800 billion bailout (sorry, rescue) package is nothing more than a looting of the responsible and productive by the reckless and profligate.

read the entire essay

Cartoon: No Free Lunch

Bailout and Markets

So much for all those predictions that the markets would begin to recover once members of the U. S. House of Representatives summoned the courage to resist the populist outcry and vote for Hank Paulson's $700-billion rescue plan...the market appears to have arrived at a more considered view of the U. S. Treasury Secretary's scheme. Sadly, the market's negative verdict is on the mark...

While there isn't perfect unanimity on this, it is widely acknowledged that a significant part, if not the root, of our difficulties originated with the low-interest-rate policy implemented by the Alan Greenspan-led Fed in 2001-2005.

This generated a housing boom, which was further stoked by the financial engineering of Wall Street in securitizing mortgages, by obliging bond rating agencies in evaluating these securities and by portfolio managers eagerly willing to buy them, hungry for extra returns in a low interest rate environment...

Austrian economists hold that downturns are the inevitable aftermath of loose monetary policy, thus opposing explanations typically heard prior to the current crisis that attributed recessions to price shocks, underconsumption or central bank tightening of monetary policy...

Most commentators resist following the Austrian logic through to the end out of the fear of repeating the policy mistakes that led to the Great Depression. This reflects the orthodox interpretation of that period, according to which the economy fell apart in the early 1930s while U. S. president Herbert Hoover took a laissez-faire approach to the downturn and the Fed ran an overly tight monetary policy.

The truth is that the Fed at the time did try to add liquidity, lowering its rediscount rate until late 1931 and continuously increasing reserves under its control. Money supply nevertheless fell, but that was because people lost faith in the financial system and hoarded currency. Meanwhile, Hoover met the downturn with interventionist gusto. He passed the Smoot-Hawley tariff to help domestic industries and obtained the co-operation of business leaders to support wages and investment. We haven't gone down this protectionist and corporatist road yet but Hoover's attacks on short selling and his creation of the Reconstruction Finance Corporation, which among other things loaned money to banks, bear an eerie resemblance to the current policy response.

"We might have done nothing", Hoover said, "[but] we determined that we would not follow the advice of the bitter-end liquidationists." Thus has the Bush administration decided as well, having successfully cajoled a recalcitrant Congress to follow Hoover's example.

read the full article

My thoughts: We are repeating the mistakes of the past. Bush is following the Hoover playbook of intervention to re-inflate a bubble. Commentators either through ignorance or ideology are blaming free markets. We are going to elect a president who will openly embrace more intervention, regulation, and socialism. The question now becomes will this be worse than the Great Depression?