Page 1 of 2 Danger - Ben and Henry at work
By Hossein Askari and Noureddine Krichene
The US House of Representatives' 228 to 205 rejection of the financial bailout
plan put forward by US Treasury Secretary Henry Paulson and Federal Reserve
chairman Ben Bernanke may usher the end of inflationary policies and a
readiness to address more orderly financial and economic adjustment. But for
now one thing is for sure. The bailout is dead. Long live the bailout!
After so much hype about the absolute need for the bailout and with so much
political capital on the line, there may be little choice but to pass some form
of a financial rescue, albeit drastically modified and reduced in size.
Financial markets around the world had expected the bill to pass and its
rejection may now fuel more financial turmoil than might have been previously
expected, something that US politicians may not be
able to stomach. So where did Paulson and Bernanke go wrong and where might we
go from here?
If, before the Paulson-Bernanke plan was submitted to Congress, you had heard
that the Fed chairman and secretary of the Treasury planned to request US$700
billion from Congress based on a three-page document, you would have laughed
about the plausibility of such a rumor.
If you had been told that the three pages allowed for no congressional
oversight and no controls on how the secretary of the Treasury used these
funds, you would have been incredulous and further dismissed the rumor as
absurd and utter nonsense. Were these gentlemen on to something when they chose
this modus operandi? Are they so arrogant as to think that their record merits
such trust? Or was it that they thought they could frighten the American people
and Congress into adopting their undefined plan? Would you trust $700 let alone
$700,000,000,000, to anyone who did this sort of thing?
In urging Congress to adopt, in a "clean and quick" approach, the $700 billion
plan to buy illiquid assets from banks, it would appear that Paulson and
Bernanke desperately wanted to save overleveraged banks and hedge funds at an
immense cost to taxpayers and future generations of Americans. This is the only
plausible explanation for two such seasoned veterans. Their initial plan would
have secured a dream exit strategy for imprudent bankers and speculators,
rewarded all speculative gains and the giving of lavish executive salaries, and
dumped all capital losses onto the federal budget and Main Street.
Both Paulson and Bernanke have claimed that their plan would be better for
taxpayers and American families than any other alternative; they warned that
the world would come to an end if their plan were not adopted. We have become
accustomed to Paulson and Bernanke warning that the "sky is falling" each time
they want to push their bailout agenda. Think Bear Stearns, Fannie Mae/Freddie
Mac and AIG.
One thing is clear. Paulson and Bernanke have failed to cope with the financial
crisis that broke out in August 2007. They have stubbornly prevented orderly
adjustments from bursting speculative bubbles and have refused to foster
long-term money and banking stability. Paulson and Bernanke's tunnel vision has
afforded them only one approach to the crisis: remove illiquid speculative
assets from the balance sheets of banks and dump them on the state. According
to Bernanke, any problems that led to this crisis will be addressed, time
permitting, at a later stage. Their original plan was not only inequitable and
morally unacceptable; it was also in total contradiction to sound banking
principles, dangerously inflationary and potentially highly disruptive for the
long-term health of the US economy.
The US Congress balked at this outrageous proposal, as would have any sane
human being. They went about modifying it. These changes included: oversight of
the secretary of the Treasury (although his decisions could not be reviewed by
any court in the land); the $700 billion was to be released in stages ($250
billion, followed by $100 billion at the discretion of the president and the
balance of $350 billion after a congressional review); rules and regulation for
firms hired to help the Treasury run the program; limits on executive
compensation for firms whose assets are bought by the Treasury; limited equity
participation for taxpayers in case the bailed institutions prosper; some
relief for those who are facing home foreclosure, and the option for the
secretary of the Treasury to issue insurance for the affected assets as a way
to reduce cost to the taxpayers, with this latter feature added to bring House
Republicans on board.
One sticking point, how to pay for losses for securities that are bought and
sold for a loss, will be left to the next president. Two things are clear.
First, Congress could have extracted more for the US taxpayer while still
adopting the core of the Paulson and Bernanke proposal, which to some traded
cash for trash. Second, in the rush of the moment, Congress, and everyone else,
is simply clueless as to what may happen.
Paulson and Bernanke did not present any analysis of the financial and economic
implications of their plan, but instead warned of dire consequences if their
plan was not adopted soon. In addition, two of the main arguments they advanced
for their plan are not as evident as they claim.
First, to quote Paulson: "The ultimate taxpayer protection will be the market
stability provided as we remove the troubled assets from our financial system.
I am convinced that this bold approach will cost American families far less
than the alternative - a continuing series of financial institution failures
and frozen credit markets unable to fund everyday needs and economic
expansion."
Paulson fails to consider other alternatives that may be less costly. Even more
importantly, contrary to Paulson's claim, credit is not frozen, the US banking
system is still lending significantly to the economy, as clearly demonstrated
by the Fed's data, with bank credit still expanding at a high rate of 9% per
year as of July 2008. Certainly, banks have become more prudent, matching the
maturities of their assets and liabilities better, and are no longer replaying
the speculative mania that led to the present subprime loan meltdown.
There is so far little hard evidence of systemic risk to US commercial banks at
large (note large investment banks have disappeared). Only speculative loans
face problems. Loans invested in real and economic-generating activities in
agriculture, industry and commerce remain sound. The non-financial sector
continues to have access to credit at low interest rates.
Second, to quote Bernanke: "The Federal Reserve supports the Treasury's
proposal to buy illiquid assets from financial institutions. Purchasing
impaired assets will create liquidity and promote price recovery in the markets
for these assets, while reducing investor uncertainty about the current value
and prospects of financial institutions."
Bernanke, only concerned with investors' uncertainty, seems to ignore a basic
and essential principle of central banking: it is the central bank, and not the
Treasury, that manages, provides or withdraws liquidity from the financial
sector. The Fed has injected massive liquidity since August 2007, put in place
large lending facilities to banks and worked out large swap facilities with
major central banks around the world to inject further liquidity. Banks do not
the face the serious liquidity problems attributed to them, as inter-bank
rates, including the federal funds rate, have not come under serious pressure.
Money supply has expanded at the very high rate of 16% in 2008. Bernanke's goal
is to rid banks of mismatched maturities and acquire billions of worthless
speculative paper for the state. While the amount of writedowns by banks have
so far exceeded $500 billion, it would appear that Paulson and Bernanke do not
want banks to incur any further losses and that all their worthless and
speculative paper will be put on the backs of US taxpayers.
The congressional debate of the Paulson-Bernanke plan has taken place in a
vacuum of economic and financial analysis. Congressmen have been pressured into
believing the Paulson and Bernanke statements of impending doom and thus
coerced into approving their massive bailout plan. It was important for
Congress to analyze all potential dangers of this plan, not only in terms of
its financial costs, but all its political, economic and social implications as
well as the long-term damage to the financial sector. Congress should have
analyzed the root causes of the financial crisis and designed reforms that
would have safeguarded financial stability. But Paulson and Bernanke, supported
by a weak President George W Bush, sought to railroad Congress into the realm
of the euphoric unknowns.
On the fiscal front, the Paulson/Bernanke approach will inflate the US fiscal
deficit to an unsustainable level. With the national debt spiking to 86% of
gross domestic product, the deficit may seriously undermine US solvency. The
Congressional Budget Office has already announced that the cost of the plan is
very difficult to assess and could turn out to be trillions of dollars.
To a previously projected 2009 record deficit of $500 billion, the bailout's
$700 billion price tag combined with $200 billion for Fannie Mae and Freddie
Mac and $85 billion for AIG, the fiscal deficit would explode to about $1.5
trillion. We should also ask after this $700 billion is spent, what will
Congress say to another request say of $300 billion to save the day?
And so on into the future. Won't the purchase of worthless paper by the
Treasury reveal the existence of more worthless paper on the books of financial
institutions and cause even more panic? This process has no end. Congress must
see that going down this road may be throwing good money after bad money.
As with past and recurring deficits under the Bush administration, the
financing of such a monumental deficit can only be achieved through
monetization, inflation and exchange-rate depreciation. This will considerably
widen external deficits and aggravate food and energy price inflation. The fast
depreciation of the US dollar will trigger a run on the dollar, sharp commodity
price inflation and a resurgence of the oil and food crisis. A serious run on
the dollar will make gold the de facto monetary reserve asset, with foreigners
becoming less willing to buy US financial assets.
Economic growth will without a doubt be curtailed by a considerable fall in
savings and a significant decrease in real government and private expenditures;
real government spending will diminish because most of the expenditures will
consist of buying worthless financial papers at the expense of spending on
social and economic programs. Rapid food and energy inflation will erode real
incomes and reduce private spending in real terms, and contribute to rising
unemployment, further aggravating already deteriorating trends in the
unemployment rate.
On the financial sector side, knowing the government will secure their loans
mortgage borrowers will be tempted to default. Similarly for consumer and
business loans, debtors will be tempted to default. The amount of defaults will
rise; this will in turn push the purchases of impaired assets to forbidden
limits and will aggravate fiscal imbalances. The moral hazard will increase and
financial disorder will be compounded.
On the equity side, it is unacceptable that tax money be used to
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