Wednesday, January 14

Treat the patient

What has happened to the US bailout package? Ask top Senate Democrat majority leader Harry Reid who said on Tuesday the Senate was likely to approve the $US350 billion package this week as President-elect Barack Obama asked outgoing President George W. Bush to request lawmakers to unlock the second half of the bailout package approved last October. But many are echoing their concern about where the money is going “What we really need is something with more details so that we can truly make those decisions about how the money is gonna be spent," said Democratic senator Ben Nelson who echoed general concern.

But you may recall I agreed with what was originally planned under U.S. Treasury Secretary Henry Paulson’s troubled Asset Relief Program, or that the $700 billion rescue package would be used to repurchase the toxic debt securities held by institutions which were causing the underlying credit crunch and resulting in stalled lending. The amount of toxic debt removed would have been 4/5 times the original value, since the securities to be disposed of through the reverse auction system would have been at a fraction of their original value. In the longer term there was good chance the funds would be fully recovered when the securities were finally liquidated or sold and hence the cost to the taxpayer could be zero. But instead of proceeding on that basis funds were channeled into direct type bulk payments to recapitalize banks and rescue companies including American International Group Inc and Citigroup.

Yet the continued barrier to private investment in financial institutions remains the very large quantity of these toxic assets which remain in the Balance Sheets of the major institutions despite write offs amounting to nearly a trillion dollars. Until this cancer is finally removed the patient will continue to be in a dire position. I think there is real risk the new stimulus package to be approved by incoming president –elect Barrack Obama will be far less effective unless the financial system is itself cleared of the mess with accompanying adequate regulatory control that ensures less reckless risk taking in the future.


Anonymous said...

Hello, Lindsay.
Glad to see you writing about this.
I was involved in a discussion of this elsewhere recently, and I have yet to find any clear answers.

I would like to refer to the equation of exchange: M * V = P * Q

Now, traditional Keynesian stimulus relies upon the M; while supply-side stimulus relies upon the P; and trickle-down theory relies upon the V, although its set of assumptions as preconditions has proven it to be rather ineffectual.
So the choices appear to be huge inflation with Keynesian stimulus, or deflation with supply-side.
There remains the possibility that the Keynesian approach might result in less inflation that would otherwise occur, due to the 'irrational exuberance' priced in to the market.

Now, as GDP is calculated on the basis of household consumption, private investment, and government spending, with imports and exports taken into account, this would suggest that a recession is a dangerous time to cut gov't spending. Household consumption is down reflecting debt load. Investment is down reflecting a crisis of confidence.

That would leave imports/exports as the safest way to boost GDP. I'm sure the precipitous fall in oil prices would take care of some of that; but the real culprit is China.
But still, I don't see a system of tariffs as being particularly productive. On the other hand, we are at a time when many of our people have been poisoned by Chinese goods, and increasing tariffs to cover the costs of increased inspections would likely be prudent; a 'most suspicious nation' trading status, if you will.


Now, I was listening to a radio show with a British economist (sorry, can't remember the fellow's name-- you can call him 'Bruce'), and he appeared for all the world to be a proponent of regulation. But when asked directly about it, he stated that, "The problems are much more fundamental than that."

I am at a loss to decipher this. What could be more fundamental to the business environment than the regulatory environment? Perhaps the currency itself?

What do you say?

---Progressive Traditionalist
(who is unable to sign in to his blogger account)

lindsaylobe said...


Thanks for your visit and here are my thoughts:

Reference : Danger of a short term spike in inflation caused by the stimulus package.

The danger to what might otherwise be rampant inflation of the stimulus package is mitigated (if not eliminated in the short term) by your current low aggregate demand and the collapase of global commodity prices.

Reference : Danger of deflation or stagflation.

The danger of stagflation similiar to what Japan endured will be largely avoided providing the we learn from their mistakes and avoid them.

In Japan the government refused to acknowledge the insolvency of just about all of the leading banks which resulted in lending be curtailed for investment as banks tried to recover from their insolvent positions.

Hence the economy was held hostage for a decade which resulted in a constantly declining market. Had the Japanese government recognized the insolvency of their financial banking system early on and ensured the banks wrote off all of the bad loans the economy could have recovered as confidence to invest originated from that clean start. Instead they relied exclusively on monetary policy with zero interest rates which led to crippling stag inflation.

The US in contrast has faced up to this problem quickly and mostly decisively but as I said in my posting I would much prefer to see the slate wiped clean and all of the toxic debt disposed of one way or another.

This would require an enormous degree of planning to minimize the collateral damage to certain industries but it would give a clean start to the financial system.

Reference: Importance of the investment multiplier

One needs to ensure the stimulus package directs investment in industries which have a known multiplier effect and to exporters or those competing against imports.

Hence any increase in exports and a reduction in imports will culminate in an improved trade Balance to expand the potential size of GDP and avoid any later drag on aggregate demand leading to inflation.

It is not difficult to identify those Industries with high Investment multipliers. E g for every initial dollar spent there is subsequently invested in new resources/ plant to support the increased demand a multiplier, usually pf the order of 3 to 1. Examples might be roads, bridges, new green field’s factories and so forth. These industries targeted preferably will also be either exporters or have the potential or assist ones that already export or are industries which compete against imported product.

The idea of a net overall tax cut is bad policy in my view. Give relief certainly to low income earners and where it is sensible but make sure overall the effect is neutral to overall revenue since your tax base is aleady unsustainable.

Exports and productivity will need to increase in my opinion for the US to emerge from the current downturn and once again become a vibrant economy.

There is no question the long term goal for future prosperity will require an export led recovery to avoid the risk of either inflation or deflation.

Reference: The US is probably one of the most over regulated economies if the western world.

I would argue that you need better quality more desciptive type regulation but less in the quantum.

Certainly there has been some very poor regulation under your prescriptive type controls as it’s easier for companies to give the regulators the impression they are confirming to the letter of the law rather any desire to adhere to its spirit- usually more important than the regulations themselves.

Hence I think you are better served under one regulatory umbrella with much more expertise and a commitment to repeal existing legislation and revert to wherever practical broad based principals with an accent more on the ‘spirit of the law.'

What I mean is an emphasis of having to demonstrate one met certain principles rather than on paper simply give the appearance of compliance to long onerous provisions.

Reference : China

China needs the US as much as the US needs China. The first priority for Obama I think is to visit China, before any stimulus package is even passed.

China will continue to buy US Treasurers but the US needs to engage China as a partner rather than as the enemy. Joint Ventures can be forged rather than the outsourcing nightmare of old which decimated some industries and led to the false claims about higher rates of productivity in the US economy which is essentially a myth.

Best wishes

Zee said...

OK - here are my two cents, spoken from someone who has very little understanding of the ins and outs of global financial schemes, may it be investment banks, government funds, or other...
My point is more simple. After spending more assets for decades that were really not existing, the US as a nation, the larger companies/banks - and also the individual households face the reality that you can't forever survive on borrowed money.
Growth is not exponentially measured by increasing debt.
What people don't understand, is that you can't create something out of nothing. There is no such thing as "endless growth".
In my view, the nature of the beast is such: Let it die!
The trillions (add the tally) injected by the US government in behalf and from the people, just further perpetuate the "same old, same old" and therefore is a desperate move to "save" capitalism as we always knew it.

Zee said...

... and I am no "socialist" - just making sure.

LINDSAY - make the psychedelic-word verification go away .... PLEASE!

lindsaylobe said...

Hi Zee - done. Check back and make a comment to confirm!
I agree in the long term with your idea.
But at the moment we have the opposite effect in the form of a world big time contraction, except for China.

What I am suggesting is that any stimulus package be limited to investments in the future, to generate longer term sustainability and not be of the type for currant consumption. Hence I am against increased borrowings for net tax reductions or for handouts to individuals or companies to try and ramp up consumption spending.

Most of the growth in the past was really a myth sustained by increased borrowing and leveraging of debt to untenable levels.

During the current time whist we are unhinging from this very unhealthy situation, long term investments will assist the transition to a more sustainable long term outlook which will mightily be less dependent upon endless growth.
Does that make more sense?
Best wishes

Gary said...

I agree with your assessment Lindsay. These bubble bursts will continue without a system change. Next bubble: green energy companies (I believe).

Cart said...

During the Iraq ‘reconstruction’ I referred often to the efficacy of the JK Galbraith version of Keynesian economics. As author of the Marshall Plan, the reconstruction of post war Europe Galbraith held that effected communities had to be fully engaged in the effort.
In the history of economic recoveries there has been one constant, the success and speed of recovery is directly related to how much the wider community is onside with the plan. I guess that reflects a higher level of confidence needed to drive economic health.
My point here is that if bail outs are directed toward the big institutions without a corresponding balance of responsibility to the wider community the effort will fail. I would posit that ‘balance of responsibility’ would include a high level of ‘public’ control of funded institutions until such times they have paid back the bail out funds.
Our economies simply can’t continue to reward failure, and the heads of major institutions have failed to monitor and control excesses in the banking, finance and much of the industrial sector.
I do not recommend nationalisation of institutions, rather a close, hands on control over their recovery process. Some economic pessimists warn of a slow recovery process; I can only say – I hope so! This recovery must be well paced and slow enough to ensure an effective base for the longer term. If the wider community can see the progressive effects of a controlled recovery, become involved in the process, there is real hope for the future.

susan said...

An interesting post followed by some very astute comments. Personally, I go along with those who suggest the only answer at this point is to nationalize the banks. The next bubble has already arrived and that's the US essentially daring the rest of the world to dump the currency. If it were you or me or a third world country printing money beyond its means, we all know what would have happened by now.

lindsaylobe said...

History repeats itself in thinly disguised versions, to convince many it’s all entirely different this time around!! Speculative bubbles and the psychology that surrounds euphoric speculation could well see a future emissions trading scheme as the next cab of the rank.


There is no doubt JK Galbraith was an outstanding economist who was not only able to implement price control and keep inflation low during WW2 but successfully presided over sustained economic growth and stability for the post war reconstruction period and beyond.
It is true his policies were all very straightforward and comprehensible to the man in the street unlike the current confused situation. Hence I agree with you that the community should be heavily involved in any stimulus package and witness tangible positive results as they occur to help engender confidence.

However a feature of the current mess is its global complexity and the unprecedented increase in credit leverage aided and abetted by rampant corporate malfeasance. So it makes sense to first thoroughly clean up the prior mess before you embark on any ambitious recovery plan as I suggested in my post. The certainty of the need to do this is already evident in the daily reminders of widespread deleveraging across the full spectrum of lending activity.
E.g. - Small business allocated reduced facilities, curtailment of consumer credit limits, student loans, long term leasing of capital equipment, and corporate lending to small to medium enterprises and continuing reductions in credit facilities one way or another across the board. It’s the only game in town, in just about every country.
The benefits of any stimulus packages during deleveraging risks being ineffective.

I think whether or not you wanted to nationalize some lending Institutions is entirely incidental to the need for current clarity.
Either way the toxic debt needs to be cleared by regulatory oversigt as I suggested in my post.

China and the rest of the world will not dump the US Treasuries in the mid term but in the longer term your borrowing position is untenable. Hence I agree you cannot continue with the idea you can go on printing money and financing larger and larger deficits in the longer term ; ultimately will come the time to return to savings to remain sustainable.

Best wishes

Seraphine said...

only time will get us through this mess. it's a process of unwinding the excesses of the past. there is no shortcut. i hope the tarp funds can soften the blow somewhat.

lindsaylobe said...

Sera - I hope that’s the case, since the hugh excesses were spread far and wide abroad.
The UK is currently suffering a very severe recession aggravated by a failure of their banking system to be able to sustain lending, even from the recently nationalized bank Northern Rock.

I notice they have just issued a further $150 billion bail out package to buy securities from the banks which they hope will help banks to maintain lending. But in the short term those Institutions remain frightened to extend any credit or maintain it because they don’t know what lies behind the Balance Sheets of the many who have been adversely affected. EG A good example is the hugh losses just reported by the Bank of Scotland.

Best wishes

lindsaylobe said...

Further to my last comment I notice the Bank of Scotland, according to Bloomberg is expected to now post a loss of 28 billion pounds ($41 billion) for year 2008.
As U.K. Prime Minister Gordon Brown's government increases the cost of further bailouts it is disappointing to see his regulators are not taking the necessary definitive steps to ensure the removal of all of the ‘bad assets’ from corporate balance sheets. Until this happens progress will be continue to be stymied, anemic or ineffective.
Likewise I notice Obama’s advisers are now saying they are trying to get credit to consumers and businesses rather than just helping banks in relation to he second half of the $700 billion rescue fund. But you need to do likewise to ensure those Institution charged with that responsibility have their houses in order, however painful that may be to rectify.

Best wishes

Zee said...

If you think of it Lindsay, who needs banks as we know them as of now anyway. Their philosophy is based on highway robbery.
Look, I'll be honest. I have an Optima AMEX card from the American Express institution. My credit line is around $8000 - and I don't owe them a penny. But if I chose to get into debt, my interest rate would be a whopping 19%!!!
Many people suffer by this.
And there are other banks that choose to charge over 25% on the owed credit of their personal customers, that's insane!
And these institutions we are going to bail out - because they didn't make enough money, or they messed up their funds????
Give me a break!!!!
The DOW was under 8000 today, does that that tell you something?
Well, it sure tells something to me. There is actually no more real money which could represent a certain value, a value that either represents labor or goods.
Banks have made a killing over the years (centuries) by sucking out the savings of "little man", they became increasingly greedy (still are) and now we (the people) have to bail them out, just like that?
To be honest with you, I wouldn't mind a total financial collapse. Maybe then, people will start to think locally and fuck the globalization economy.
Sorry for the harsh wording Lindsay, but I just had to steam out tonight.

lindsaylobe said...

Hi Zee
You are most welcome to convey your thoughts at any time on this blog. In fact I think that is one of the benefits of blogging since it provides a welcome forum that allows one to post about something that is bugging one or to make comment in the same vein.
In so far as the operation of banks is concerned in relation to credit card transactions I tend to agree with you. I have a card from a large Australian bank with a credit limit but I never incur any interest cost since interest only accrues when you fail to pay for or all of your prior purchases taken out on credit within the allowed zero interest credit period of up to 55 days. But if you don’t pay the full amount off each time and leave a balance owing (as many people do) you are charged over 20% interest rate on the total amount owed. When the banks were questioned about these outrageous interest rates on credit cards their reply was to say that these type of credit card loans are riskier and accumulate larger bad debts which can only be recouped through very high interest rates. There is very little credit risk analysis on the issue of the cards and many become caught is a debt trap and having to pay exorbitant rates of interest. On that score the credit card business needs an overhaul.
Apart from that aspect the larger Banks in Australia otherwise enjoy a reasonable relationship with the public and make available a range of services to small and large businesses, retail depositors, pensioners and so on. Usually the spread is about 2- 3%, e.g. the interest rates charged as opposed to the interest rates paid on deposits. Fortunately we have avoided the worst excesses of greed and irresponsibility lending practices that has plagued so many elsewhere but will be forced to curtail operations by about 20% as they no longer can rely on funding assistance from large overseas banks and particularly in the USA. Instead they now will need to rely on depositor’s funds.
But overall there are still many Institutions that are not diseased, that are going to survive and prosper again. I think there exists a need for banking services providing they are carried out in a reasonable manner. For a long time in Australia many of our larger banking Institutions were 100 % government owned such as the Commonwealth Trading Bank and we were also served by a smattering of state government owned banks. State government even engaged in so called development funds which used taxpayer funds to invest in green field entrepreneurial type investments which would not normally be supported by the traditional banks or investment banks.

Hence behaviors of government owned or publically listed Banks has not been materially different, it depends more upon how they are regulated........or should I say the lack of any form of supervision that prevailed within those large Investment Banks that exported the toxic securities al over the world.

We also have many community banks which assist local business and their record has been exemplary in lending and in the provision of banking services to the community. Its helps when your customers are better known and part of your community and those perusing the loan applications are usually prudent and responsible. Another undesirable aspect of your large banks is they have become too big, too big to fail as they say which is a position that needs to be avoided in the future.

Best wishes