Tuesday, September 30, 2008

Bankruptcy, Not Bailout, Is The Right Answer

This bailout is a terrible idea. Here's why.

The current mess would never have occurred in the absence of ill-conceived federal policies. The federal government chartered Fannie Mae in 1938 and Freddie Mac in 1970; these two mortgage lending institutions are at the center of the crisis. The government implicitly promised these institutions that it would make good on their debts, so Fannie and Freddie took on huge amounts of excessive risk.

Worse, beginning in 1977 and even more in the 1990s and the early part of this century, Congress pushed mortgage lenders and Fannie/Freddie to expand subprime lending. The industry was happy to oblige, given the implicit promise of federal backing, and subprime lending soared.

This subprime lending was more than a minor relaxation of existing credit guidelines. This lending was a wholesale abandonment of reasonable lending practices in which borrowers with poor credit characteristics got mortgages they were ill-equipped to handle. Once housing prices declined and economic conditions worsened, defaults and delinquencies soared, leaving the industry holding large amounts of severely depreciated mortgage assets.

The fact that government bears such a huge responsibility for the current mess means any response should eliminate the conditions that created this situation in the first place, not attempt to fix bad government with more government. The obvious alternative to a bailout is letting troubled financial institutions declare bankruptcy. Bankruptcy means that shareholders typically get wiped out and the creditors own the company.

Bankruptcy does not mean the company disappears; it is just owned by someone new (as has occurred with several airlines). Bankruptcy punishes those who took excessive risks while preserving those aspects of a businesses that remain profitable.

In contrast, a bailout transfers enormous wealth from taxpayers to those who knowingly engaged in risky subprime lending. Thus, the bailout encourages companies to take large, imprudent risks and count on getting bailed out by government. This "moral hazard" generates enormous distortions in an economy's allocation of its financial resources.

The right view of the financial mess is that an enormous fraction of subprime lending should never have occurred in the first place. Someone has to pay for that. That someone should not be, and does not need to be, the U.S. taxpayer.

~Jeffrey A. Miron, Senior Lecturer in economics at Harvard University and Director of Undergraduate Studies


At 9/30/2008 8:47 PM, Blogger PeakTrader said...

The original three page bailout is needed to effectively respond to the poor government policies of export-led economies, who created global imbalances. Without accommodative monetary policy and expansionary fiscal policy, the country would be in a severe recession and the global economy would be even worse off.

Adam Smith believed (and my summation below):

"Wealth of Nations represents a highly critical commentary on mercantilism, the prevailing economic system of Smith's day. Mercantilism emphasized the maximizing of exports and the minimizing of imports. In Wealth of Nations, one senses Smith's passion for what is right and his concern that mercantilism benefits the wealthy and the politically powerful while it deprives the common people of the better quality and less expensive goods that would be available if protectionism ended and free trade prevailed."

We've seen U.S. policies of free trade, open markets, and unrestrictive capital flows benefit the U.S. masses at the expense of the wealthy and politically powerful.

Now, the U.S. is an export-led economy and the U.S. government is controlling corporations, somewhat similar to China. However, unlike China, the U.S. commands market power and has improved terms-of-trade to continue capturing the greatest gains of trade.

At 9/30/2008 10:06 PM, Anonymous Anonymous said...

What we have are really 2 problems:

1. subprime lending and a housing downturn
2 excess leveraging due to the proliferation of securitized mortgages

By trying to buy up the securitized products, those engaging in excessive leveraging effectively dump their risk onto taxpayers. One questions the excessive leveraging as well as the underlying value. Will the Treasury merely be stuck with the dogs?

These are not merely passive assets but loans that require active administration. Resolution Trust had 10,000 staff in the first year to administer the loans that they had to take over which gives one a fair idea of what the government is undertaking.

The American public has watched as the FED & Treasury have struggle to contain this crisis. Is it any wonder that the American public wonders whether the final bill will really be $700 billion or much, much more?

The more one looks at this, the more the rosey projections that this bailout is going to turn into a windfall for taxpayers seem to be pipe dreams.

Slice it how you will, this is a can of worms or there would be a private buyer.

At 10/01/2008 12:36 AM, Blogger PeakTrader said...

qt, that's the result of one problem, i.e. excess capital, from 20 consecutive quarters of double-digit U.S. earnings growth and massive foreign capital inflows to keep foreign employment levels high. When you say taxpayers, you really mean mostly rich taxpayers. Savers, which tend to be rich, are the big losers already. The U.S. will emerge from this crisis even stronger. Also, below is some info on the Real U.S. Economy:

The U.S. created 17.6 million jobs between 1993-98, and created only 3.7 million jobs between 2001-06. However, U.S. real GDP growth was only slightly higher from 1993-98 than from 2001-06. So, the U.S. became much more productive in the 2000s, i.e. using fewer inputs to produce more output.

The quick and massive U.S. Creative-Destruction process, generally between 2000-02, freed-up resources, e.g. labor, capital, raw materials, energy, etc. Freed-up capital was redeployed into firms that generated even more capital, including U.S. Agricultural and Industrial Revolution firms. Older U.S. firms gained greater market power, since they focused on higher quality "core" products, while offshoring less profitable goods to Third World countries for larger profits (rather than discontinue operations of those products). Consequently, U.S. corporations generated double-digit profit growth for a record 20 consecutive quarters in the 2000s, which resulted in strong balance sheets. Much of the redeployed capital flowed into business start-ups, which helped keep the U.S. unemployment rate low. U.S. Information and Biotech Revolution firms continued to lead the rest of the world combined (in both revenues and profits) after the Creative-Destruction process. The only way to move from one economic revolution into the next is through efficiencies, which free-up limited resources. It's all interrelated, and inevitable, which is why the U.S. leads the world in the Agricultural-Industrial-Information-Biotech Revolutions.

It's important to note that U.S. actual output has generally been below U.S. potential output throughout the 2000s. Export-led economies have been absorbing U.S. dollars to maintain acceptable levels of employment and output. Just like the volume of output in itself will cause declining prices and induce demand, the volume of capital will in itself cause interest rates to fall and induce demand. The gains of U.S. assets increased faster than the gains of U.S. liabilities. Similarly, the increases in U.S. output exceeded the rises in U.S. inflation, which induced demand and raised living standards. Export-led economies needed to accept small gains of trade to spur export growth (which imply the U.S accepts large gains of trade). Also, while the U.S. dollar depreciated, export-led economies were required to accept even smaller gains of trade to maintain export-led growth. The U.S. had abundant capital from foreign capital inflows and capital creation of U.S. firms. Much of that capital flowed into the U.S. housing market creating an oversupply of houses and causing a crisis, i.e. Americans who couldn't really afford to buy houses were able to buy them, and Americans who couldn't really afford to buy more expensive houses were able to buy them. The U.S. economy can be viewed as a Black Hole attracting imports and capital. Now, the U.S. is also attracting foreigners who own that capital, e.g. through the depreciated dollar, relatively low prices, low interest rates, etc.

U.S. GDP was $14 trillion in 2007, while U.S. exports were about $1.5 trillion (in 2000 dollars). Currently, 20% of U.S. households earn over $100,000 a year, while U.S. Agricultural and Industrial firms are producing higher quality/ higher paying/more profitable "core" goods. U.S. median family (household) income is $60,000 (half earn more and half earn less), including $50,000 from wages and salaries. With low interest rates and deflation in the housing market, along with falling prices of many goods, because of "excess" assets and goods, except for many commodities, U.S. living standards rose at a steeper rate. U.S. per capita income was $45,000 in 2007, which was over $10,000 more than E.U. per capital income. The U.S. with less than 5% of the world's population produces about 30% of the world's output, and consumes more than it produces. Americans have proven adept at maintaining autonomous consumption (or higher living standards). So, Americans in general will attempt to at least maintain their higher living standards, while some will lose and others will gain. Consequently, U.S. labor will work longer to pay-down debt and build-up saving, which will add to future economic growth and postpone retirements. U.S. income will be more than $160 trillion over the next 10 years and U.S. assets are over $100 trillion, while the U.S. captured real gains in assets and goods in the global economy. The U.S. is both the largest manufacturer and largest exporter in the world.

The U.S. is a most diverse and fragmented society. There has been tremendous U.S. upward mobility and increases in absolute living standards. Millions of Third World immigrants moved to the U.S., and had tens of millions of children, to raise their living standards. Many of those immigrants, who earned less than $3 a day or didn't have jobs in their countries, earn $20,000 to $50,000 with overtime in the U.S. Major U.S. cities would have become ghost towns without Third World immigrants. Almost the entire overextended U.S. housing boom took place in upper and middle class neighborhoods, which expanded and new neighborhoods were created. It's important to understand the U.S. housing boom. Throughout the 2000s, U.S. actual output was generally below potential output. Without the U.S. housing boom, actual output would have been even lower. Deflated housing prices will also add to future economic growth and postpone retirements. The NeoKeynesians believe building pyramids benefits society when output is too low. Obviously, houses are more useful.


In the free market system, when demand exceeds supply, prices rise, and there's excess profit. So, new supply is created, until excess profit disappears. This is a mechanism to keep supply and demand in equilibrium. "Speculation" helps keep future supply and demand in equilibrium, to prevent future shortages.

The price of oil has risen from $50 to $135 a barrel over the past 18 months. In the 2000s, the U.S. underproduced and overconsumed, while export-led economies overproduced and underconsumed. The price of oil is linked to the value of the dollar, i.e. a negative correlation. For example, when the U.S. Fed increases the money supply, economic growth is stimulated. So, demand for oil increases. China's economy is linked to the U.S. economy. Consequently, when the U.S. economy is stimulated, China's economy is also stimulated, i.e. when the U.S. raises actual output towards potential output, China overproduces even more. However, China is adding "fuel to the fire" by subsidizing oil, which adds to overproduction.

The U.S. has made the proper adjustments. On the production side, U.S. firms became substantially more energy efficient. However, on the consumption side, there was less energy efficiency, because U.S. houses, autos, etc. became even larger. However, China has not made the proper adjustments to slow its overproduction. Instead, it continued to subsidize oil, with dollars, including shifting the flow of dollars from U.S. Treasury bonds into barrels of oil. China continues to squander its gains of trade to maintain high output and employment, while the U.S. has captured its gains of trade. The free market system has allowed the U.S. to either gain the most or lose the least, in the global economy, while Chinese economic policies created a lose/lose situation in China.

The free market system contributed to least three major booms in the U.S. during the 2000s. U.S. households had a consumption boom, including the housing & related goods booms (through rising incomes, abundant & accessible capital, low interest rates, and low prices). U.S. firms had a profit boom, because they offshored low profitable goods for higher profits, imported those goods at lower prices, and shifted limited resources into higher quality/higher priced/higher wage/more profitable goods. The U.S. government basically was able to refinance its debt at lower interest rates. Consequently, U.S. living standards rose at a steeper rate, while the U.S. economy strengthened substantially.

At 10/01/2008 3:26 AM, Blogger juandos said...

"that's the result of one problem, i.e. excess capital, from 20 consecutive quarters of double-digit U.S. earnings growth and massive foreign capital inflows to keep foreign employment levels high"...

Well said in a nutshell...

Funny how 'excess capital' can be seen as a problem...

Very informative post peaktrader...


Hey qt thanks for that link regarding the Resolution Trust...

At 10/01/2008 7:44 AM, Anonymous Anonymous said...

I really can't understand how this bail-out is a good idea way in any capacity.

At 10/01/2008 11:15 AM, Anonymous Anonymous said...


> I really can't understand how this bail-out is a good idea way in any capacity.



...or ELZE!!


At 10/06/2008 2:44 AM, Blogger Arman said...

The more the fed tinkers, the worst things get. Get ready for another black Monday. Now that the Fed has even more powers, it won't be able to help itself from trying to help.

At 8/25/2009 3:53 PM, Anonymous zeroKnots said...

"The original three page bailout is needed to effectively respond to the poor government policies of export-led economies, who created global imbalances. Without accommodative monetary policy and expansionary fiscal policy, the country would be in a severe recession and the global economy would be even worse off."

Oh look! It's aug 2009 and it seems every last thing Peak Trader said was exactlly 180 degrees wrong.

Oh look! Seems Obama is proving the hard way that free-market trade = prosperity and Dr. Milton Friedman was right. Anything beside that is destitution.

Oh look! Seems Arman, with his few words, blew you whole thesus into orbit, Peak Trader.

What a SHOCK! Almost as if the whole process should have been a no-brainer, rather than the hyperactive idiots who are the Federal government.

HEYYY, seems the Constitution could have prevented this entire desaster! Who'd have thunk?

HEYYYY! Kind of makes for investent initiative! wwwWOW! Almost as if the Germans have been rock solid for the last 40 years because theyre better Constitutional Americans than Americans are..

WOW! seems that leaving stuff alone = stability! I never learned THAT unfathomably immense complexity in my silly little month long G.E.D. class.

No prob. His oneness who does not in the slightest desopise this country.. is on it! Hope n Change!


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