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BreakingViews: Bailout Bill to Worsen, Prolong Recession

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In the last few days, virtually all mainstream financial media outlets have taken up the banner for the passage of the deeply flawed bailout bill. A bit late in the game, BreakingViews, which is insightful but hardly extreme in any of its positions, argues that the Paulson plan directs capital to where it will not do much good at a time when funding is scarce, thus exacerbating an economic contraction. Welcome Japan.

From Martin Hutchinson at BreakingViews (free subscription available):

Treasury secretary Hank Paulson’s plan uses money borrowed by the US government to buy value-impaired debt left over from the credit bubble. In a period of freely available credit, that might not matter. Good investments would get funded and, since additional money is available, some bad investments would, too. Diverting some money into unproductive uses should affect mainly those bad investments, with only modestly negative economic effects.

When money is tight, however, as it is likely to be for some time, withdrawing $700bn from the funding pool to support failed, past investments has a more serious effect on the economy, because capital flows are restricted by market illiquidity and investor trepidation. If that reduces asset prices, it exposes more loans to losses. If it prevents good investments by crowding them out of any chance of getting funding, it reduces economic activity. Either way, it makes the economy less efficient.

Herbert Hoover’s Reconstruction Finance Corporation of 1931-32, which made loans to politically connected companies, didn’t do much to alleviate the Great Depression. An equivalent amount of welfare handed out through the “Veterans’ Bonus”, which Hoover opposed, might have boosted consumption and stabilised the economy more quickly.

Japan’s 1990s infrastructure spending spree also diverted capital from more productive uses, helping to cause consumption to stagnate and the downturn to extend for 13 years. Paulson’s plan differs from both these examples in some ways, but is similar in that it may divert capital from its most productive uses. The danger is that the rescue plan could have similar consequences.

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30 comments

  1. JCC

    Roosevelt’s actions certainly helped. The unimployment rate went from ~35% to 15% in about 3 years. It is absolutely absurd to watch the credit markets freeze and do nothing. Laissez Faire economics failed in 1929 and many other times through the centuries.

    It is obvious to most that when you arteries are clogged, the blood doesn’t flow. When you have blocked arteries it is an emergency, and to avoid a heart attack it is critical to get the blood flowing, which implies the use of a stent or open heart surgery. A complete blockage will result in a heart attack or worse. Time is critical, and the required correction is an emergency.

    Analogous to your vascular system, the financial markets are the arteries of the economy. Analogous to your arteries, when the financial markets are frozen, the monetary supply does not flow. This creates an emergency situation where it is imperative that we restore the monetary flow.

    In today’s environment it is critical that we on an emergency basis thaw the financial markets thereby enabling the required monetary flow. There is not a lot of time to react. Waiting too long will create a severe recession or a depression.

    Sorry, but it appears that your premises are incorrect!!!!!

  2. Anonymous

    Extending your analogy and drawing on the article, yes our arteries are clogged and the blood needs to flow, but if its all diverted to our foot it doesnt do much good.

  3. SlimCarlos

    I agree w/ JCC: all of the criticism of the bill presumes the pile-o-dough will be directed thusly or so’ly. There is nothing in the bill that restricts them from directing the dough anywhere they see fit. Nothing.

    Someone, pls someone, point out where is the clause in the bill that restricts them from using the money as helicopter dough? Someone!

    Until someone does point this out, all these criticisms based on *where* the dough will flow are ill-founded.

  4. Anonymous

    I think the point the article is making isnt even necessarily where the dough will flow, but where the dough will come from. There will be even more flight to quality as people rush to snap up the 700bn in treasuries, leaving 700bn less to invest where its needed. Is that a wrong analysis?

  5. Erich Riesenberg

    It is fascinating that people such as JCC and Slim blindly support a Plan they acknowledge does not even attempt to explain how $700 billion will be spent to save the global financial system. Shouldn’t the time for figuring it out be before the Plan is funded?

    Thank you for at least acknowledging what so many of the critics are saying. You just happen to think secrecy and absolute power in the hands of someone who caused the problem are good things.

  6. Anonymous

    Anonymous said…

    I think the point the article is making isnt even necessarily where the dough will flow, but where the dough will come from. There will be even more flight to quality as people rush to snap up the 700bn in treasuries, leaving 700bn less to invest where its needed. Is that a wrong analysis?
    ——————

    There is no $700 billion to invest, just as there is no $2 to 3 trillion that has already been blown out. We are piling on debt on top of debt at an unprecedented rate to address this crisis, and not only will it be for naught, it will trash the fiat currency system as we know it. The USD and Euro will be particularly vulnerable once this initial scramble for liquidity is over … and that point is fast approaching.

    Only once currencies have been set on a new foundation will we begin building from a new base. That will be a very small base in the U.S. – I fear it will not be enough to support all 300 million of us.

  7. FairEconomist

    Really the most disturbing part of the whole mess is that Congress has nearly allocated 700 billion without any thought of how it’s to be spent or even whether the 700 billion is a net plus. This bill is like betting the world at a casino where you don’t even know the odds. Congressional procedure serves important purposes.

  8. Yves Smith

    JCC,

    First, one flaw of this debate, and frankly it pervades discourse in America, is that all decisions are presented as black or white. You incorrectly assume that by criticizing the bill (more accurately, featuring criticism of the bill) we are saying to do nothing. That could not be further from the case. We have cited a number of proposals that are far better targeted to the problem at hand.

    Second, the Treasury has itself said in its conference call to investors (again featured here, you can go listen to it), that they intend to do NOTHING for at least two weeks and let more institutions fail. And in the long story last night in the New York Times of the meltdown around the time of the Lehman failure, the article clearly indicated that Paulson and Bernanke are fixated on mortgage paper, when the crisis has moved well beyond that.

    Third, even if Paulson were to want to change gears and move faster with his new authority, I doubt he could. The Treasury lacks the infrastructure to turn this on overnight. It would have been far better, as we have also said, to have gone through the FDIC, which is by all account the best financial regulator in DC and better prepared than anyone, systems and staff wise, to deal with this situation. That does not mean that they are fully equipped, but they are far further down the curve.

    Third, our post earlier today addresses in some detail why this plan will make liquidity worse.

    I suggest you read the post earlier today, which discusses at some length why the Treasury program will only serve to crowd out private borrowers.

    Fourth, we have contacts with advisors to some of the very biggest credit market players, and others with substantial knowledge of conditions at foreign institutions and funds (some of the latter have substantial regulatory contacts). To a person, they deplore the Paulson program. These are people who have every reason to back a plan if it were going to make a difference.

  9. Anonymous

    The legislaton gives total discretionary power to Hank to distribute the money as he pleases.

    As his ‘advisors’ are all from Goldman Sachs, surely some of the money will be earmarked for purchasing the level 3 assets from Goldman. Goldman, whose traders never lose money, will give these up at less than fair value to those shrewd Treasury civil servants.

    Additionaly some of the money will go to buy CDS and other derivatives of weak counterparties that have GS as the other side. We can’t GS lose out due to failed counterparties.

    That should account for about $650 billion.

    Had Hank been around in 1905, he would have spent hundreds of millions of dollars to save the buggy whip industry.

  10. SlimCarlos

    @ Erich:
    >> It is fascinating that people such as JCC and Slim blindly support a Plan they acknowledge does not even attempt to explain how $700 billion will be spent to save the global financial system. Shouldn't the time for figuring it out be before the Plan is funded?

    This is helicopter money. It should be thrown at whatever wheel is sqeakiest on a given day. This, by definition, requires broad discretion. If I were in charge today, I'd first walk into the CP market. Tomorrow may be different.

    The sentiment on this board somehow feels this bubble can be unwound. It can't. Bubbles don't unwind. They get inflated away.

    Here is my problem with your general tilt: you all seem entirely oblivious to the damage this is causing in the real economy. This is a note I got from a mate last night. The broker referred to is from the midwest Ag community:

    "Last week we had this agri-analyst/broker [...] frothing at the month. He said banks have stopped lending the more risky smaller farmers money to buy seed, fertilizer pesticides and equipment and that the fertilizer demand is dropping. He also said there are a bunch of empty foreign carrier freighters off of San Fran as now one will lend them money to re-fuel and stock up."

    So, the farmers aren't planting and the ships aren't shipping. But not a word on this board about this? You'd think some balance would be in order. But no.

    You guys are living in la-la land.

  11. SlimCarlos

    >> We are piling on debt on top of debt at an unprecedented rate to address this crisis, and not only will it be for naught, it will trash the fiat currency system as we know it.

    Yes, and there is no way to avoid this. The ultimate victim of this crisis will be the currency. It always is.

    Again — why doesn't anyone admit that the debt in the 30's was inflated away? I mean, that's big part of why things got kick-started again. But not a word on this here.

    We now have two options: reflate slowly, or reflate quickly. Doing this slowly will cause tremendous damage to the real economy and we will end up in the same place — confetti for money — as if we were to recognize the prognosis now and get on with the revaluation forthwith.

  12. Anonymous

    Some ex-IB friend’s of mine would like to invite you to precipitate in strategerycapital a unique government funded hedge fund.

    It is the largest in the world, with expected initial capital of $700 billion. It has a free and unlimited credit line should it need more. It has no fixed mandate, though it is expected to initially focus on mortgage-backed securities. And it is the only fund backed by the full faith and credit of the U.S. Government.

    strategerycapital is a way for you to be more patriotic. Supporting this fund is an American duty. Many people have already taken to wearing a green, red, and blue ribbon to symbolize and broadcast their support for this newest American institution.

  13. Anonymous

    I’m not sure SlimCarlos laid out his case as tactfully as he might have, but I do agree that there’s no way a country with the world’s reserve currency is going to let the bubble deflate when it has the option of inflating the currency. We should probably do it sooner rather than later. Sure, it is regressive, but hey, the middle class in this country voted for Bush not once, but twice. They deserve what’s coming. I wish they didn’t deserve it. I wish they didn’t elect these “thieving plutocrats.” But they did, and they deserve what’s coming. Neither I nor you can save them now.

  14. SlimCarlos

    @ Yves:

    Your criticism of our criticism seems to be:

    1. They said they’d focus on MB paper;

    2. They said they’d go slow;

    3. You have friends in high places who don’t like the plan.

    As to [1]: Are you going to believe what these jokers say? Or are you going to believe what the bill actually says? If there is one lesson from this administration it is that what they say is totally meaningless. Hank will use the money as he sees fit. Or did you believe they were actually looking for Weapons of Mass Destruction back in ’03 too? As is the case w/ anything that comes out of Goldman Sachs: ignore the pitch doc and read the prospectus very carefully.

    As to [2]: When they begin to throw the money around is far less important than the fact that they’ve secured the dough and are warming up the helipcopters.

    As to [3]: Well, I have friends in low places and they are about to be put out of business.

  15. eh

    What the bill is certain to do is suck billions out of the credit markets for no productive purpose whatsoever.

    Per an AP story, here’s what is passing for thinking on the bill by some House members:

    Republican Rep. Jim Ramstad of Minnesota also switched to “yes,” partly because the Senate attached the bailout to legislation he spearheaded to give people with mental illnesses better health insurance coverage.

    Maybe he’s in line to benefit from his own legislation, who knows.

  16. Matthew Dubuque

    Yves-

    The “all or nothing” approach you mention used as a negotiating tactic seems to fool huge numbers of the Washington press corps every time.

    We were given a false choice of all out war with Iraq or “doing nothing”.

    Actually, in four more months the UN Weapons Inspection team would have finished their work. If we had let them do so (with their conclusions that there were no WMDs) that would NOT have been the same as “doing nothing”.

    Yet the press seems to fall for this cheap gambit every time.

    It’s like they don’t teach critical thinking skills in journalism school anymore.

    Matt Dubuque

  17. melpol

    The best way that we can get our economy quickly moving again is not by bailing out the big bad banks with 750 billion dollars but by giving that money to the homeless. It is estimated that there are three million homeless people in the United States that are costing the government billions each year to feed and shelter them. A grant of 250 thousand dollars to each person that can prove that they have been homeless for over a year would cost less money then the amount that the government is ready to waste on bailing out the banks. The results would produce the greatest spending spree in American history and jump start our economy. An added benefit would be that many of the homeless would purchase homes that have been foreclosed and bring added life to the housing market. Some Americans would be envious of the new found wealth of our most unfortunate citizens, but instead they should welcome their large contribution to our economy.

  18. GET_OFF_THE_CREDIT_ADDICTION_AMERICA

    I apologize for the following rant.

    There are posters that seem to believe the way out of the debt deflation rests on inflating our way out.

    Two problems with the thesis:

    1) Liquidity trap–Fed can toss liquidity at banks, banks can choose to hoard cash. Or, banks can extend credit and the consumer says no thanks.

    2) Even IF–and its a big IF the U.S Central bank can reflate, it will end up squeezing the U.S consumer. In a world of global labor arbitrage, U.S nominal wages are likely to tread below the rate of commodity inflation.

    Before the credit bubble burst last year, we saw signs of wage inflation failing to keep up with rising commodity prices, healthcare costs, and tuition-related expenses.

    America is in big trouble. The issues are STRUCTURAL as opposed to cyclical. There is no easy solution. Unfortunately, the consistent Greenspan put in place the last decade has led us to believe in the miracle of central bank intervention. So we keep thinking we can erase a twenty-year credit orgy with a few “rescue bills”, a few stimulus packages, a tax cut, or futher monetary easings.

    What is ironic about the seizing of the credit markets? Everyone realizes that lax lending standards got us into this housing mess, yet we hear commentators proposing the U.S guvmint refinance all trouble mortgages at 5.5%.

    What’s even more ironic? Most experts agree the American consumer has a god awful balance sheet and needs to retrench. Yet, “they” kick, yell, and scream when the banks decide to pull our HELOC’s, credit card limits and other consumer-related debt vehicles.

    You don’t treat a hangover by serving the guy another drink.

  19. SlimCarlos

    @ Anon (6:34):

    Apologies for the lack of tact — point well taken. For the record, I do agree with all of you that the guys steering the ship right now are self-interested buffons and this cluster f-ck of a situation should have been headed off years ago. And I also agree that this is bill is a crock, hastily conceived and evidence that, as Harry Reid put it: “We don’t kow what to do.” So we agree a lot more than it may first appear.

    But what has struck me off the bat, and led me to post in a rather petulant way here, is my take that the discussion here is completely removed from the consequences on the ground. I mean, not even lip service is paid to the ramifications of choices made.

    Compounding this is the sense here that if you could just get the “right plan” you could “fix the problem”. This seems like too much conceit by half, like saying if you had the right plan, you could have fixed Pets.com too. It’s too late for all of this. The damage has been done and a “better plan” plus $1.50 will get you a cup of coffee at this point.

    The gov’t is set to throw massive amounts of paper money at this problem Expect a blizzard. Most of it will be ill-deployed but that’s just tough. You want to make sure that the wealth producing sectors – farms, factories, software shops – don’t get dragged down with the froth. And the only way to do that is by massive injections of indiscriminate liquidity.

    Yes, the money will suffer, but is that not a better fate than Pets.com?

  20. SlimCarlos

    >> There are posters that seem to believe the way out of the debt deflation rests on inflating our way out.

    >> Two problems with the thesis:

    >> 1) Liquidity trap–Fed can toss liquidity at banks, banks can choose to hoard cash. Or, banks can extend credit and the consumer says no thanks.

    You can always reflate. Let's take the example posted above: give each homeless person $250,000. And then promise 250k more when they are done with that. Or spend a trillion on filling in pot holes with another trillion to come to sweep the streets. The key is to induce inflation expectations — use it or lose it. That gets the money flowing.

    >> 2) Even IF–and its a big IF the U.S Central bank can reflate, it will end up squeezing the U.S consumer.

    The consumer should be squeezed. The consumer has been the problem in the US. What you want to do is protect the genuine wealth producers. And the debtors. Inflation helps the debtors (who will never be able to crawl out from under their load anyway) and the wealth producers will also benefit from a cheaper currency.

  21. Seven Star Hand

    Hello Yves and all,

    One must understand the truth before any true solution is possible. There’s much more to this unfolding story than meets the eye. Be a little patient to understand it and then hold their feet to the fire!

    Money Karma comes home to roost !!!

    This is the long awaited opportunity to finally “kill the beast” and kick all the bums out, forever. Read what I have been saying for insights into another way to manage this civilization, without money and without evil cabals running this world. The keys to a “New Earth” are wisdom and cooperation, not the fears and follies of the past.

    It will soon become painfully obvious, to even the most clueless, that it will be far easier to step away from the deceptions of the past (money, religion, and politics) and finally fix our civilization so it works for everyone, not just for a self-chosen and abominably greedy few. Why should humanity struggle and suffer any longer to repay massive debts and endure great debacles created by amazingly greedy and deceptive monetary and political leaders? Are you familiar with the ancient concept of a Jubilee? It’s time has come, and the power of the rich and arrogant is about to be blown away on the winds of long-overdue and irresistible change.

    Here is Wisdom…

    Peace…

  22. Anonymous

    “You don’t treat a hangover by serving the guy another drink.”

    Since when? A drink in the morning is an alcoholics first line of defense. In Hi-Fi it’s “more margin, more margin”

  23. Anonymous

    I am welcoming Japan. The only other option is no bailouts, no capital injections. This leads us into a depression, just like the Great One. We have to weigh our options here. Its Depression or prolonged recession. There is no other alternative and a depression today would be worse than in the 1930′s. Think violent anarchists.

    My belief is that the government has weighed the options and decided “we will take Japan over 1930′s America”.

  24. joe

    I agree with everybody.

    This is a terrible, wasteful use of the taxpayers money and it will result in deeper, longer repression, er…., um I mean destruction, of the American economy.

    But, the bankers are the wolves at the door, and they are demanding $700LARGE now, with further installments as needed.

    To bend over, or not to bend over, THAT is the question.

    You’ve got the failed bullshit capitalist holding a knife to your throat on the one hand, and some uppity disconnected keyboardists who don’t care squat about Mainstreet on the other.

    The smart money goes with the knife-wielding tuxedo. The rest of you can play next game.

    If there is a next game.

    I say call them on it.
    And be prepared to inject government-issue, debt-free capital to those guys that Carlos wants to represent.

    That’s the only deal that will guarantee that anything positive happens on Main Street.

    Paulson’s fiasco is not a government bailout.
    And it’s not the full faith and credit of the government.

    It’s a bailout by the taxpayers, and it is founded on the full faith and credit of the taxpayers.

    If you want to provide financial aid to the hedge-funders, then Paulson is your man, and this $700 BIL is your plan.

    If you want to make sure this shit never happens again, then either tune in to Seven Star Hand, or begin our national monetary transformation now.

  25. Been there

    Martin Hutchinson:

    “…When money is tight, however, as it is likely to be for some time, withdrawing $700bn from the funding pool to support failed, past investments has a more serious effect on the economy, because capital flows are restricted by market illiquidity and investor trepidation…”

    Anon @ 5:24:

    “…There will be even more flight to quality as people rush to snap up the 700bn in treasuries, leaving 700bn less to invest where its needed…”

    I agree with both comments -so-

    If the bailout proceeds go to support those who made the failed past investments

    And…

    Those folks, including some of the bad guys, reinvest the bailout proceeds received by selling the crap assets in treasuries (the only safe alternative)

    Then…

    Taxpayers could conceivably wind up paying interest on the additional debt arising from the bailout to some of the very same bad guys who caused the problem in the first place.

    Maybe that’s part of the plan.

  26. Moopheus

    “Compounding this is the sense here that if you could just get the “right plan” you could “fix the problem”.”

    It seems just about everyone recognizes that there is no “right plan.” We blew by the good solutions long ago. Also, everyone realizes there will be deep difficulties out in the real world. But we could still do better than what’s on offer now.

    I’m still sending messages to my congressman (who voted yes) to encourage him (in vain, I’m sure) to change his vote in the likely event it comes up again tomorrow.

    Also, does anyone know, or think, if this can be challenged on legal or constitutional grounds if it passes?

Comments are closed.