October 05, 2008
The Bailout Will Fail
By Paul Craig Roberts
America has become a pretty discouraging place. If Ronald Reagan was still with us, I wonder if he would again refer to the United States as a city on a hill, a light unto the world.
I think not. Reagan brought America back from discouragement, but it didn't stick. Subsequent administrations erased Reagan's accomplishments. Reagan defeated stagflation and ended the cold war, producing a peace dividend to be divided among taxpayers, social programs, and national debt reduction. However, without the Soviet Union as a check on neoconservative ambition, the neoconservatives launched America on an unrealistic path of world hegemony. The economic restoration that Reagan achieved was not shored up by his successors. Instead, they used the Reagan restoration to run the American economy into the ground in ways that benefitted the super rich and the military-security complex. Some of America's best jobs were offshored in order to boost share prices and executive compensation, and the financial sector was recklessly deregulated.
Americans, for the most part, will never know what happened to them, because they no longer have a free and responsible press. They have Big Brother's press. For example, on September 28, 2008, a New York Times editorial blamed the current financial crisis on "antiregulation disciples of the Reagan Revolution."
What utter nonsense. Every example of deregulation that the New York Times editorial provides is located in the Clinton Administration and the George W. Bush administration. I was a member of the Reagan administration. We most certainly did not deregulate the financial system.
The repeal of the Glass-Steagall Act, which separated commercial from investment banking, was the achievement of the Democratic Clinton Administration. It happened in 1999, over a decade after Reagan left office.
It was in 2000 that derivatives and credit default swaps were excluded from regulation.
The greatest mistake was made in 2004, the year that Reagan died. That year the current Secretary of the Treasury, Henry M. Paulson Jr., was head of the investment bank Goldman Sachs. In the spring of 2004, the investment banks, led by Paulson, met with the Securities and Exchange Commission. At this meeting with the New Deal regulatory agency tasked with regulating the US financial system, Paulson convinced the SEC Commissioners to exempt the investment banks from maintaining reserves to cover losses on investments. The exemption granted by the SEC allowed the investment banks to leverage financial instruments beyond any bounds of prudence.
In place of time-proven standards of prudence, computer models engineered by hot shots determined acceptable risk. As one result Bear Stearns, for example, pushed its leverage ratio to 33 to 1. For every one dollar in equity, the investment bank had $33 of debt!
It was computer models that led to the failure of Long-Term Capital Management in 1998, the first systemic threat to the financial system. Why the SEC went along with Paulson and set aside capital requirements after the scare of Long-Term Capital Management is inexplicable.
The blame is headed toward SEC chairman Christopher Cox. This is more of Big Brother's disinformation. Cox, like so many others, was a victim of a free market ideology, itself a reaction to over-regulation, that was boosted by academic economic opinion, rewarded with Nobel prizes, that the market "always knows best."
The 20th century proves that the market is likely to know better than a central planning bureau. It was Soviet Communism that collapsed, not American capitalism. However, the market has to be protected from greed. It was greed, not the market, that was unleashed by deregulation during the Clinton and George W. Bush regimes.
I remember when the deregulation of the financial sector began. One of the first inroads was the legislation, written by bankers, to permit national branch banking. George Champion, former chairman of Chase Manhattan Bank, testified against it. In columns I argued that national branch banking would focus banks away from local business needs.
The deregulation of the financial sector was achieved by the Democratic Clinton Administration and by the current Secretary of the Treasury, Henry Paulson, with the acquiescence of the Securities and Exchange Commission.
The Paulson bailout saves his firm, Goldman Sachs. The Paulson bailout transfers the troubled financial instruments that the financial sector created from the books of the financial sector to the books of the taxpayers at the US Treasury.
This is all the bailout does. It rescues the guilty.
The Paulson bailout does not address the problem, which is the defaulting home mortgages.
The defaults will continue, because the economy is sinking into recession. Homeowners are losing their jobs, and homeowners are being hit with rising mortgage payments resulting from adjustable rate mortgages and escalator interest rate clauses in their mortgages that make homeowners unable to service their debt.
Shifting the troubled assets from the financial sectors' books to the taxpayers' books absolves the people who caused the problem from responsibility. As the economy declines and mortgage default rates rise, the US Treasury and the American taxpayers could end up with a $700 billion loss.
Initially, the House, but not the Senate, resisted the bailout of the financial institutions, whose executives had received millions of dollars in bonuses for wrecking the US financial system. However, the people's representatives could not withstand the specter of martial law and Great Depression with which Paulson and the Bush administration threatened them. The people's representatives succumbed as they did during the New Deal.
The impotence of Congress traces to the Great Depression. As Theodore Lowi in his classic book, The End of Liberalism , makes clear, the New Deal stripped Congress of its law-making power and gave it to the executive agencies. Prior to the New Deal, Congress wrote the laws. After the New Deal a bill is merely an authorization for executive agencies to create the law through regulations. The Paulson bailout has further diminished the legislative branch's power.
Since Paulson's bailout of his firm and his financial friends does nothing to lessen the default rate on mortgages, how will the bailout play out?
If the $700 billion bailout is based on an estimate of the current amount of bad mortgages, as the recession deepens and Americans lose their jobs, the default rate will rise. The $700 billion might not suffice. The Treasury will have to go hat in hand to its foreign creditors for more loans.
As the US Treasury has not got $7 dollars, much less $700 billion, it must borrow the bailout money from foreign creditors, already overloaded with US paper. At what point do America's foreign bankers decide that the additions to US debt exceed what can be repaid?
This question was ignored by the bailout. There were no hearings. No one consulted China, America's principal banker, or the Japanese, or the OPEC sovereign wealth funds, or Europe.
Does the world have a blank check for America's mistakes?
This is the same world that is faced with American demands that countries support with money and lives America's quest for world hegemony. Europeans are dying in Afghanistan for American hegemony. Do Europeans want their banks, which hold US dollars as their reserves, to fail so that Paulson can bail out his company and his friends?
The US dollar is the world's reserve currency. It comprises the reserves of foreign central banks. Bush's wars and economic policies are destroying the basis of the US dollar as reserve currency. The day the dollar loses its reserve currency role, the US government cannot pay its bills in its own currency. The result will be a dramatic reduction in US living standards.
Currently Treasuries are boosted by the habitual "flight to quality," but as Treasury debt deepens, will investors still see quality? At what point do America's foreign creditors cease to lend? That is the point at which American power ends. It might be close at hand.
The Paulson bailout is predicated on cleaning up financial institutions' balance sheets and restoring the flow of credit. The assumption is that once lending resumes, the economy will pick up.
This assumption is problematic. The expansion of consumer debt, which kept the economy going in the 21st century, has reached its limit. There are no more credit cards to max out, and no more home equity to refinance and spend. The Paulson bailout might restore trust among financial institutions and enable them to lend to one another, but it doesn't provide a jolt to consumer demand.
Moreover, there may be more shoes to drop. Credit card debt could be the next to threaten balance sheets of financial institutions. Apparently, credit card debt has been securitized and sold as well, and not all of the debt is good. In addition, the leasing programs of the car manufacturers have turned sour. As a result of high gasoline prices and absence of growth in take-home pay, the residual values of big trucks and SUVs are less than the leasing programs estimated them to be, thus creating more financial problems. Car manufacturers are canceling their leasing programs, and this will further cut into sales.
According to statistician John Williams who measures inflation, unemployment, and GDP according to the methodology used prior to the Clinton regime's corruption of these measures, the US unemployment rate is currently at 14.7% and the inflation rate is 13.2%. Consequently, real US GDP growth in the 21st century has been negative. [The Clinton regime (and the Boskin Commission) rigged the CPI in order to cheat retirees out of their Social Security cost of living adjustments and ceased to count discouraged workers who cannot find a job as unemployed. To be counted as unemployed, a person has to be actively seeking a job.]
This is not a picture of an economy that a bailout of financial institution balance sheets will revive. As the Paulson bailout does not address the mortgage problem per se, defaults and foreclosures are likely to rise, thus undermining the Treasury's estimate that 90% of the mortgages backing the troubled instruments are good.
Moreover, one consequence of the ongoing financial crisis is financial concentration. It is not inconceivable that the US will end up with four giant banks: J.P. Morgan Chase, Citicorp, Bank of America, and Wachovia Wells Fargo. If defaulting credit card debt then assaults these banks' balance sheets, who is there to take them over? Would the Treasury be able to borrow the money for another Paulson bailout?
During the Great Depression of the 1930s, the Home Owners' Loan Corporation refinanced one million home mortgages in order to prevent foreclosures. The refinancing apparently succeeded, and HOLC returned a profit. The problem then, as now, was not "deadbeats" who wouldn't pay their mortgages, and the HOLC refinancing did not discourage others from paying their mortgages. Market purists who claim the only solution is for housing prices to fall to prior levels overlook that rising inventories can push prices below prior levels, thus causing more distress. They also overlook the role of interest rates. If a worsening credit crisis dries up mortgage lending and pushes mortgage interest rates higher, the rise in interest rates could offset the fall in home prices, and mortgages would remain unaffordable even in a falling housing market.
Some commentators are blaming the current mortgage problem on the pressure that the US government put on banks to lend to unqualified borrowers. The proliferation of privilege that bureaucrats pulled out of the Civil Rights Act led in 1993 to Shawmut National Corporation's acquisition plans being blocked by federal regulators until its subsidiary entered into a consent agreement with the US Department of Justice to racially norm its mortgage lending. This agreement was quickly incorporated into the growing body of regulations. Next, Chevy Chase Federal Savings Bank was forced by the DOJ to open new branches in "majority African-American census tracts." Chevy Chase had to provide below-market loans to preferred minorities at interest rates "at either one percent less than the prevailing rate or one-half percent below the market rate combined with a grant to be applied to the down payment requirement." In 1995 the DOJ forced American Family Mutual Insurance Company to sell property insurance to preferred minorities on uneconomic terms. [See Roberts and Stratton, The New Color Line ]
Thus, it is true that it was the federal government that forced financial institutions to abandon prudent behavior. However, these breaches of prudence only affected the earnings of individual institutions. They did not threaten the financial system. The current crisis required more than bad loans. It required securitization and its leverage. It required Fed chairman Alan Greenspan's inappropriate low interest rates, which created a real estate boom. Rapidly rising real estate prices quickly created home equity to justify 100 percent mortgages. Wall Street analysts pushed financial companies to improve their bottom lines, which they did by extreme leveraging. The full story goes far beyond the propaganda videos put out by Republicans blaming Democrats.
An alternative to refinancing troubled mortgages would be to attempt to separate the bad mortgages from the good ones and revalue the mortgage-backed securities accordingly. If there are no further defaults, this approach would not require massive write-offs that threaten the solvency of financial institutions. However, if defaults continue, write-downs would be an ongoing enterprise.
Clearly, all Secretary Paulson thought about was getting troubled assets off the books of financial institutions.
The same reckless leadership that gave us expensive wars based on false premises has now concocted an expensive bailout that does not address the problem, which will fester and become worse.
Paul Craig Roberts [email him] was Assistant Secretary of the Treasury during President Reagan's first term. He was Associate Editor of the Wall Street Journal. He has held numerous academic appointments, including the William E. Simon Chair, Center for Strategic and International Studies, Georgetown University, and Senior Research Fellow, Hoover Institution, Stanford University. He was awarded the Legion of Honor by French President Francois Mitterrand. He is the author of Supply-Side Revolution : An Insider's Account of Policymaking in Washington; Alienation and the Soviet Economy and Meltdown: Inside the Soviet Economy, and is the co-author with Lawrence M. Stratton of The Tyranny of Good Intentions : How Prosecutors and Bureaucrats Are Trampling the Constitution in the Name of Justice. Click here for Peter Brimelow's Forbes Magazine interview with Roberts about the recent epidemic of prosecutorial misconduct