Diatribes of Jay

This is a blog of essays on public policy. It shuns ideology and applies facts, logic and math to economic, social and political problems. It has a subject-matter index, a list of recent posts, and permalinks at the ends of posts. Comments are moderated and may take time to appear. Note: Profile updated 4/7/12

28 November 2008

Why the New $800 Billion Bailout is a Non-Starter


[For comment on Paulson’s and Bernanke’s performance generally, click here. For a skeptical comment on the earlier bank bailout, click here.]

1. Been there, didn’t do that.
2. Let’s leave stupid, greedy people in charge.
3. Let’s make moral hazard official government policy.
4. Pricing complex assets is hard.
5. Keep it simple, stupid!
6. If you build it, they won’t come.
7. The Plan poisons the well for the incoming president.

Coda: Paulson, Bernanke & Co. and the Decline of American Industry
Life Mimics Art

While we were all preoccupied with the Obama presidential transition and the Thanksgiving holiday, the Bush Administration laid its latest egg. It plans to spend $ 800 billion dollars buying securitized credit—$600 billion for mortgages and $200 billion for car loans, student loans, and loans to small businesses (the “Plan”). The Fed, not Treasury, will buy these assets, using its unlimited authority to spend taxpayers’ money.

Here are seven reasons why the Plan is a terrible idea:

1. Been there, didn’t do that. Less than two months ago, Congress adopted the TARP (“Trouble Asset Relief Program”), appropriating a separate sum of $700 billion to buy toxic assets. Paulson & Company never spent the money for that purpose. Instead, they preferred to “inject capital” into troubled institutions, in exchange for equity and a degree of government control.

Buying bad paper was a bad idea then because it’s risky and gives the taxpayer little or no upside or and no control over management or events. Nothing in that regard has changed. It’s still a bad idea now.

2. Let’s leave stupid, greedy people in charge. As far as I’ve been able to tell, not a single private-sector manager who helped cause our economic meltdown has been replaced (or even demoted) as a result of government action. Citigroup’s Board elected Vikram Pandit its new Chairman months ago, before the government got involved. The government did make management changes at institutions it now controls, like Fannie Mae and Freddie Mac. But I’m not aware of any management changes even at Sallie Mae (Fannie’s and Freddie’s counterpart for student loans), let alone any management changes forced by government action in the private sector.

Insofar as still-private financial institutions are concerned, the new bailout would spend another $ 800 billion without forcing any changes in the people who brought us this mess. Instead, it would reward their misfeasance, malfeasance, greed and stupidity by giving them new money to manage badly.

3. Let’s make moral hazard official government policy. The Plan implicitly asserts that the government now effectively controls credit markets. No one will lend, the story goes, without government aid. Yet the government has refused to exercise its control by curtailing imprudent and predatory lending.

The government may have exerted some indirect control over lending through the loan securitization process that it, through Fannie and Freddie, now controls. But if private institutions make the loans and package the loan-backed securities that the government buys, private parties will set their terms. The same dumb, greedy people who brought us this debacle will be free to make the same imprudent, predatory loans.

4. Pricing complex assets is hard. An important reason for Paulson’s dropping the earlier asset-purchase plan was pricing. No one knows how to price securitized loans or their derivatives because no one knows (1) how many there are, (2) what kinds there are, (3) what their value is, or (4) what real risk they entail.

The “clever” mathematical models used before the collapse to estimate risk and trade these instruments were self-evidently based on false assumptions. For example, most didn’t even try to assess the risk of a downturn in the housing market. They simply ignored that risk as unlikely or too hard to estimate.

As computer folk used to say in the old days, “Garbage in, garbage out.” That’s what the Masters of the Universe used to manage risk and price these instruments: mathematical garbage.

The housing-market meltdown and the current economic maelstrom only exacerbate the risk and uncertainty. Price too low, and no private party will sell, so credit markets remain frozen. Price too high, and you exhaust the bailout fund early, encourage risky behavior, and waste taxpayers’ money in useless expense that we can never recover. Nothing about any of these points has changed since Paulson rejected using TARP money for toxic-asset purchases. Instead, the problems have gotten worse.

5. Keep it simple, stupid! The Plan presupposes perpetuating the complex, opaque and risky financial practices that brought us our multiple economic crises. It will securitize loans and resell them in private markets. There the same clueless rating agencies, investment banks and financial institutions, without further regulation, will split up the securities, rate the pieces, and guarantee them with an unknown amount of poorly understood credit-default swaps and other derivatives.

In other words, the whole opaque, complex and wholly unregulated house of cards that created this mess will continue to stand. Not only will it stand; we will make it higher and shakier with $800 billion of new taxpayers’ money.

The notion that new credit alone can halt the housing-price collapse is a doubtful proposition at best. Yet even if it has some merit, wouldn’t giving the same money directly to Fannie and Freddie be more effective?

Surely $ 600 billion of new loan money will support our catatonic housing market at least until President-Elect Obama takes office. Fannie and Freddie could use the money to make prudent loans on standard, sensible, government-prescribed and nonpredatory terms, that is, if anyone wants them. If necessary, Fannie and Freddie could securitize the loans and sell the securities later, after Congress had time to study the debacle and prescribe new, sensible regulations for securitization and derivatives markets. Shouldn’t we repair and rationalize these dangerous, failing markets before we dump the better part of another trillion dollars down the same rat hole?

6. If you build it, they won’t come. The Plan is based on the assumption that lack of liquidity is the only thing holding credit markets back. That assumption appears false. At least nothing resembling evidence or careful study supports it.

Common sense suggests that much more powerful forces are retarding our credit markets. No one is buying homes now because their prices are still in free fall. Who wants to take on so much debt, only to watch the purchase’s value drop? As for cars, people are holding back because: (1) they don’t want to spend money when they don’t (or soon may not) have a job and (2) they think the Big Three might go bankrupt early next year.

There may be a few people who want house and car loans and can’t get them. But many of the new home loans will be refinancings, which don’t help build anything or stimulate the real economy. Anyway, general economic uncertainty and fear are much bigger factors in the financial slowdown than unavailability of credit. The same holds true for small businesses. They are loath to take on new debt in the current economic climate.

The only exception might be student loans. Perfecting one’s education is always a good idea. It’s an even better idea when no jobs are available. But most student loans are already committed for the current academic year, and there is plenty of time to arrange new ones after January 20 and before next September.

7. The Plan poisons the well for the incoming president. As I write this, the government has committed over $ 2 trillion dollars to stabilizing credit markets. And that’s not counting guarantees, which bring the total close to $ 7 trillion. A trillion here, a trillion there, and soon you’re talking real money.

Judging the Bushies by their actions, not their words, a cynic might conclude that their motives are political. Are they are trying to deprive the incoming Administration of all financial flexibility and kill its chances for economic success? Or are they simply acting with all the haste and impulsiveness—and with the consistent disdain for deliberation, care, evidence and study—for which they are notorious?

* * *

I don’t lightly impute evil motives. But the Plan is so inconsistent with common sense and good governance as to invite conspiracy theories. If we wait but a few weeks, we can base economic policy on the broader expertise and more careful study and planning that the new administration promises.

In the interim, what can we the people do? We could raise holy hell, writing letters to the editor, fomenting on talks shows, and filling the streets with grass-roots protests. Many probably will. We could demand that the new Congress (which meets two weeks before President-Elect Barack Obama takes office), begin summary impeachment proceedings for Bush, Cheney, Paulson and Bernanke as its first order of business.

But there is no need to flail about. It’s the holiday season. Let’s enjoy it, secure in the knowledge that we will have rational government in a few weeks.

All we need do is remain rational economic actors and react to current economic conditions. Let’s sit on our hands. Let’s adamantly refuse, individually and collectively, to burden ourselves with new debt until our government does something—anything—to rectify the meltdown in the real economy. At least let’s wait to incur new debt until the new president takes office.

No doubt the financial system is important. But we have spent far too much time, effort and money on it already, much of it fruitlessly. If we continue to focus on shuffling loan paper (let alone derivatives), rather than putting people back to work and money in their hands, we will only make things worse.

We must have real economic activity to have any reason to borrow or lend. The new administration promises to take care of that, and its economic team is smart enough to tell cause from effect.

From now until January 20, let’s all help rationalize the credit markets by buying, if at all, only for cash. That’s not a bad habit to get into, especially for a nation that has gorged itself on credit for the last twenty years.

Coda: Paulson, Bernanke & Co. and the Decline of American Industry

Let me be clear. I do not believe Paulson, Bernanke & Co. have ill motives. Furthermore, I don’t doubt their expertise. Although he talks like Dubya (do inarticulate folk flock together?), Paulson is reputedly one of the smartest guys on Wall Street. Bernanke is a well recognized macroeconomic and monetary-policy expert. He made an additional specialty of what caused the Great Depression, which we soon may repeat.

These are experts with relevant expertise. The problem is that their expertise is narrow and their team shallow. They have no one who represents or understands industry, let alone science.

If you hire a plumber and an electrician to build your house, you’ll get great bathrooms and lighting and lots electrical outlets, but little else. We are trying to rebuild our economic house with finance and banking alone. But what we need is new industry and new basic research. We also need an architect, someone with all-encompassing strategic vision.

By now it should be clear to anyone that we have holistic problems that demand holistic solutions. The collapse of our housing bubble tanked our construction industry. Our auto industry needs life support because it has high costs and has had bad management and virtually no innovation for half a century. Microsoft has become a sleepy, stagnant, unresponsive monopoly, like IBM in the 1970s. Boeing is nearly a year behind in delivering its fuel-saving “Dreamliner.” Kodak, although still in business, had lost its lead in cameras to the Japanese. Big pharma has produced no big new class of drugs (like the statins) in over a decade. The impact of DNA’s discovery, now half a century old, is still experimental. Google is a marvelous company, but it doesn’t make anything tangible.

What real domestic industry have we left but Apple with its Macs, iPods and iPhones? Our few remaining excellent industrial companies, like Boeing, Caterpillar, Cisco and the non-financial part of GE, seek growth abroad because their domestic markets are saturated and declining.

So we have simultaneous collapse or stagnation in finance, housing, cars, drugs, biotechnology, computers, aircraft, and cameras. We long ago outsourced consumer electronics to Asia.

Part of the explanation is lackluster investment in basic scientific research. Over the last three decades we have diverted our industrial research spending almost entirely into applied research. Even that money is aimed mostly at narrow, short-term product improvements. The great industrial basic-research laboratories of our Golden Age, such as the old AT&T Bell Labs and IBM’s materials science labs, are gone, or they are shadows of their former selves. In their place we have lemming-like venture capitalists chasing the latest Internet fad.

We have neglected the oldest fields of basic science: astronomy and physics. NASA focuses on popular “demonstration” projects like Mars missions, neglecting basic exploration of the Universe and our nearby extraterrestrial environment. CERN’s Large Hadron Collider—humanity’s latest and most impressive effort to explore basic physics—sits near Geneva, not in the United States. Nothing better illustrates our fall from global scientific leadership than that single troubling fact.

We desperately need to ramp up investment in basic physics, basic biology (including stem cells), and basic materials science (including research that might lead to good batteries)—among other fields. And we must do so under the management of real scientists, not political commissars. Spending $800 billion on securitized loans and financial derivatives without a new dime for basic research is about the most short-sighted thing we could do.

As if these troubles were not enough, the stupidity, short-term thinking, arrogance and greed that ruined our financial markets have infected our industry, albeit (we hope) to a lesser extent. How else can you explain all the backdating of stock-options in Silicon Valley (including Apple!), or the torrent of venture capital flowing into “me, too!” Internet “community” companies that are travesties of real industrial innovation?

We’ve put far, far too much emphasis on finance and software. It’s not just Paulson and Bernanke, Microsoft and Google, or all those look-alike Internet startups. Even Warren Buffet (except for his recent GE bailout) has devolved from real industrial companies to finance, insurance and reinsurance.

We’re at risk of becoming a nation of farmers and paper pushers (if you classify software as paper, which I do). We are forgetting how to explore our natural world and how to design and build real things. We have forgotten how to dream.

Although no industrialist or scientist himself, Barack Obama understands all this. That’s why he wants us to get back to basics like real science and real industry, including rebuilding and enhancing our infrastructure. That’s why he’s ready to mold industrial policy for, and invest money in, wind power, solar power, a new health-care infrastructure, a new air-traffic control system, and (I hope) nuclear power. He knows that we cannot maintain our wealth, our greatness, our world leadership, or even our standard of living, if we stop exploring our universe and designing and building things that have weight and heft. He is our architect in chief.

So with all due respect to Paulson and Bernanke and their frantic, sleepless effort to put their fingers in our economic dike, we need a new team. We need more industrialists and basic researchers and fewer financiers. We need a broader range of builders, and we need an architect in charge.

The best we can do for ourselves—in the short, the medium and the long term—is to put Obama and his team in place as quickly as possible, ready to hit the ground running. And we can best insure a successful transition by not spending all of our money before the transition comes.

Life Mimics Art:

This Ann Telnaes animation captures perfectly the spirit of the Bush Administration in its final days.

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