Sorry not to have chimed in sooner on the whole bailout deal, but I’m an investment advisor and I’ve been Awfully Busy.
Armey is right. Vin Weber makes some good points, he is very smart and very good. But Armey is right.
The overriding concern motivating the Fed and the Treasury right now is that the assets of financial institutions consist almost entirely of promises from other financial institutions. If I’m a bank and you are too, and you come to me right now asking to borrow $100 million for 12 hours so that you can write checks to cover normal transaction flow, I have to wonder if you are creditworthy. I can know all about your balance sheet, but I can’t know about the balance sheets of all the institutions whose debts constitute your assets, let alone the balance sheets of all the institutions whose debts constitute their assets. If everyone in this network of promises decides at the same time that they need to take a lot less risk—i.e., that they can tolerate a lot less uncertainty than felt comfortable to them a few months ago—then the danger is that no one will be willing to take the risk of loaning money overnight.
This will mean that lots of outfits, such as GM, who are accustomed to participating in the overnight markets so as to finance short term obligations like meeting payroll, will not be able to secure short term financing. If that should happen—and the market for overnight paper did freeze up briefly last Wednesday evening, by far the most disconcerting moment of this whole adventure—then transactions costs would go through the roof for every financing transaction in the economy. This could greatly increase the cost and hassle of borrowing and loaning, thus slowing the velocity of money, no matter how much liquidity the Fed pumped into the money supply. Inflation could soar, due to the easy money provided by the Fed, even as the number of transactions per day (also known as economic activity, or “sales”) slowed due to the increased friction and transaction costs imposed by increased uncertainty and increased requirements for due diligence. The term for that situation is “stagflation.”
If that liquidity crisis were to become very severe—which is what would happen if it persisted for a long time (how long? dunno)—then banks and other firms who owed a lot of money, like GM, might have to close their doors. This could cause a profound depression.
Such is the fear. And there are good arguments to justify it. But it is perhaps equally likely that, once the players see that no bailout is forthcoming, they will read the handwriting on the wall, and the wave of massive mergers already underweigh in the financial sector will accelerate. Under normal circumstances, corporate management avoids merging, because it results in the loss of manager jobs and perquisites. Why fire yourself? But if your employer is insolvent, then, faced with a choice between losing your job and losing the whole value of your equity position in your employer, then like most of the upper echelon of American management in the financial sector you will elect to sell, preserving the value of your portfolio as much as possible, in the confidence that another good job will come along.
Such mergers write down the value of collateralized debt obligations. But they have the effect of keeping the vast majority of the valuable employees of the financial sector in their jobs, so that the system as a whole can continue to work as it normally does. Most businesses can then proceed pretty much as usual.
This process is already far along, as the healthier commercial banks have swallowed their less-healthy brethren. Every time one of those massive mergers happens, the uncertainty in the money markets ratchets down. These mergers are the way things are supposed to work in a free market economy: the deposits don’t go away; the loans outstanding don’t go away; GM continues to make payroll, because the market for overnight paper remains active (albeit at recalibrated prices for some of the instruments); and the capital markets pick themselves up, dust themselves off, and get back to it.
The only real danger here is that the underlying source of the problem—a government mandate to play “let’s pretend” with hundreds of billions of dollars of investor money, in service of a public policy goal (below market home equity handed out to poor folks) that would not fly if exposed to taxpayer scrutiny—is scheduled to continue unchecked. The thing about lying is that it costs money. If the financial system is forced to keep lying about the creditworthiness of deadbeats, well, some checks will have to be written.
One way of looking at the bailout is that it is compensation to the investment banks, the commercial banks, and the insurers for their assumption of massive risk assumed by them in service of a public policy goal that, in a sane universe, the US Treasury would itself have covered directly in the first place, in the form of transfer payments to the indigent. In a classic Clintonian subterfuge, a masterpiece of off-budget liberal social engineering, the government required the financial sector—that is to say, investors—to write bogus loans, and keep them on their books. It is only fair that the government then pay those investors when the bogus loans go sour. Anything else would constitute an uncompensated taking of private property, which is unconstitutional. Why is anyone surprised by any of this?
So in a sense the Wall Streeters who are likelier to keep their jobs if the bail out passes and their firms likewise survive are only being paid for their services to the Congress. But, the Wall Streeters are no fools. They of all people will figure out how to recover from this game, should the Congress welsh on its commitments.
I would argue that the overriding goal of US citizens and taxpayers should be that the financial system, the Congress and the Treasury should begin to deal with the assets as they really are, rather than as we have pretended them to be. Until that happens, the noise introduced to the resource-valuation procedure we variously call “the market” or “the economy” will continue to cloud the vision, and thus the judgment, of every economic agent, thus making us all poorer and poorer.
The irony here is that no “bail-out” is really needed. The whole liquidity problem could have been avoided if the Fed had decided to sell Treasury securities (this is a normal operation for the Fed), which are now in great demand—i.e., they are fetching a high price—and use the proceeds to buy tons of CDOs for its own portfolio. The liquidity that the Fed is now pumping into the markets would stay there, but instead of competing with the investing public for high priced Treasury securities, the Fed would be unloading dollars on super cheap CDOs. The “toxic” CDOs would vanish from the balance sheets of the troubled institutions, so that their ratios improved and they avoided insolvency. And that’s good, all else equal, because insolvencies create a lot of quite concrete economic dislocation and real cost to real people, just like a big hurricane would do.
The CDOs are, of course, selling for almost nothing, as compared with the discounted net present value of their cash flows. The Fed, as the investor of last resort, has the patience to hold those CDOs for the long term, understanding that most of the debts that undergird them are performing, and will continue to perform. Sooner or later the market would discover that the CDOs are worth more than they are now selling for, and their prices would be bid back up. At that point, the Fed could sell CDOs and buy Treasuries. Sell Treasuries high and buy CDOs low, then turn around and sell CDOs high and buy Treasuries low—what’s the problem?
I don’t know whether the Fed is actually doing this already or not—I’d be surprised if they weren’t—but somebody is. Indeed, this is just the game that Paulson would like the Treasury to be able to play, and him the maker of the whole market, and thus able to tilt the field in his direction. This is the biggest buyer’s market for productive assets of all kinds since 1973, and the fact that transactions are still happening means that there are still buyers out there with capital to spend on cheap assets. So I’m not buying the whining from Wall Street. Most of those guys are playing both sides of the market, anyway. They’ll do OK. It’s Congress that will be snookered. They always are; or, rather, we always are, thanks to the geniuses whom we choose to represent us.
There’s an iron rule of public policy: whatever the government does to change the way society does things, the markets will find a way to get around it, and to frustrate it. All that public policy can do is dam the stream, at great cost; the water finds its way downhill, no matter what. This is because markets are the way that people communicate with each other about what they really want to do, and thus about how social resources should be allocated. People vote with their superego, but they shop with their id. The id always wins.
Don’t assume that the id is amoral; that is a Freudian conceit; is a base lie. The id is a function and florescence of the basic process of the world, which is good, and rational, and which, despite creaturely error, more or less faithfully expresses the Divine Providence.
Andrew E. writes: