``We have a lot of money to play with. As long as foreigners have a lot of confidence in our ability to solve our problems, we can borrow the $1 trillion to $2 trillion we need to solve it….The real constraint is not a bookkeeping one…It is a sense of faith on the part of foreigners that the U.S. government will repay its debt. Our most precious asset is that credibility.”-Kenneth Rogoff, an international economist at Harvard (NYT).
In the carrot and stick approach towards negotiation, threats of a market meltdown to get the necessary votes represents as the stick. The carrot approach could be accounted for by bailout adherents suggesting that US taxpayers might be able to “profit” from the present bill.
They contend that the US could be faced with a “once-in-a-lifetime” opportunity to profit from the “greatest” of all carry trade by earning from 1) the spread of borrowing cheaply via US treasuries relative to prevailing mortgage rates and 2) profiting from future appreciation of depressed asset values.
One of the fundamental contention from which led to the earlier defeat in the lower house of the US Congress of the $700 billion out has been the issue of pricing.
It is said that if the US government were to acquire existing mortgages at lower prices, any transaction would thus be set a benchmark that would essentially exacerbate the price discovery problems via loss recognition (mark-to-market regulation) and thus require the necessary adjustments (raise capital or shrink balance sheets).
Remember, the reason why banks have been reluctant to lend to each other is because they don’t trust the underlying collateral within their contemporary’s balance sheets (which is why they can’t be priced-aside from being illiquid, their values are undetermined). Thus, the role of the government’s bailout is one of market maker.
On the other hand, concerns about the US government overpaying on illiquid assets would lead to unnecessary taxpayer losses.
Given that the US Congress has upheld the Bailout plan, it is so decreed that the relatively lesser evil would be for the US government to pay for higher prices on the worst possible assets held by major financial institutions in order to regain market confidence and reinstitute the normal flow of credit.
Opportunity Cost of Productive Investments
Let us set a hypothetical example to see whether such claim of profitability for the US taxpayers is valid.
Rewind to 2000; let say that US decided to pay 70 cents to a US dollar to all those who were unfortunate enough to have invested in the late stage mania of the dot.com boom as part of the bailout scheme.
Figure 2: Bigcharts.com: Nasdaq Bust Hasn’t Recovered After 8 years!Since the peak of the boom was at 5,000, 70 cents would mean the index at 3,500. Let us therefore further assume that every investor had been given a chance in 2001 to partake upon the US government’s “tender offer” to liquidate at the designated level at profit or loss to the account of the US taxpayer.
In figure 2, 8 years after the 2000 peak, the Nasdaq has hardly regained 50% of its losses even during the latest peak last October and is now 60% below its 2000 apex.
In finance 101 we have been taught in TIME VALUE of Money that a Dollar or Peso today is worth more than a Dollar or Peso tomorrow. And the reason we agree to defer spending today’s money is to get compensated for with a premium over our principal at a given future date or what is known as the interest rate.
Given that bailout schemes are commonly undertaken by either borrowing or printing (the last option would be the most politically unpalatable- raising of taxes), this means that the taxpayer losses from a theoretical Nasdaq rescue program even considering its annual dividend yield (.66%-Nasdaq 100 as per indexarb.com) would have not been sufficient to cover its deficit from borrowing in US treasuries (between 4%-6% for one year bills in 2001) or even considering Nominal (not inflation adjusted) terms.
In short, US taxpayer loses real money and continues to bleed aside from the opportunity cost of gaining from higher yielding return on productive investments.
Now going back to reality. The problem of today’s housing boom turned into a bust has been UNPRECEDENTED in US history since 1980! (take a look at figure 3.)
Figure 3: New York Times: Unparalleled Housing Boom!According to Satjayit Das, ``Analysis by The Wall Street Journal indicates that from 2004 to 2006, when home prices peaked in many parts of the country, more than 2,500 banks, thrifts, credit unions and mortgage companies made a combined US$1.5 trillion in high-interest-rate, high risk loans.” (highlight mine).
This means the US government would be paying for very high or steep prices for mortgages issued during the boom days even considering hefty discounts from the TOP. Using the above chart, at 50% off from the peak of 200 or at 150 from the baseline yardstick of 100 (since 1890), housing prices would still be about 35% higher than its 1950-2000 averages!
Besides, any profit assumption hinged upon an immediate recovery seems far fetched even when seen from the standpoint of the Nasdaq experience. The US would need to undertake another frenzied bout of PONZI pyramid type of credit bubble in order to push up housing prices back to its most recent highs…something which we think would seem unlikely even for the next ten years.
Thus the argument that a profitable carry trade exists seems to be illusionary or part of the political legerdemain, especially considering today’s highly charged political environment.
The Inflation Tax; Massive Inflation Amidst A Snowballing Deflationary Setting
Next is the issue of inflation.
Because of the limitations of charts I can attach to every issue of my newsletter, I posted how the US Federal Reserve has been undertaking an astounding series of intensive liquidity injection program largely unknown to the public but published on my blog post last Friday The Mises Moment In Pictures.
Yes, while the headlines carryover the riveting debate about the $700 billion of bailout, our favorite fund flow analyst CFR’s Brad Setser estimates that the US Federal Reserve have issued about $1.25 trillion in liquidity support, nearly double the cost of the fiscal bailout! And its not about to stop here.
Let us revert first to the theoretical Nasdaq bailout example above.
Figure 4: BLS.gov: Inflation CalculatorYou’d realize that based on the US government’s Bureau of Labor Statistics’ Inflation calculator, in figure 4, a US $100 in the year 2000 has an equivalent buying power of $127.23 today. This means that aside from cost of borrowing deficit and nominal deficits from asset values, US taxpayers would incur an inflation tax of about 1.5% per year! Thus this adds to our evidence why bailouts won’t be profitable for US taxpayers.
Besides, with the extent of inflationary “do something” measures being conducted to preclude what central bankers fear most as the “debt deflation” spiral this could likely add up tremendously to the future cost of today’s bailout.
While today’s environment would be considered “deflationary”, governments from around the world have been collaborating to address such concerns by flooding the world with money, from which if a recovery should take hold, we could likely see an inflationary spiral over the longer horizon. We could be sowing the seeds for the next more fatal crisis.
As a reminder, bank or investment losses are not the fundamental causes of deflation, because money issued will always be spent somewhere. It is the secondary effects from the negative feedback loop of reduced income and spending and the lack of borrowing and lending or specifically the “decrease in the velocity of the circulation of money (an increase of demand to hold cash balances)” are what the Austrian economist consider as “secondary deflation” (John Egger, The Contributions of William Hutt, p.18).
Figure 5: Wall Street Journal: FED FUND Rates Below Target RatesTo consider, part of the proposed bill is to allow the US Federal Reserve to go around the cumbersome way of injecting money into the system by pumping money while at same time sterilizing money by way of the Fed’s buying of US Treasuries, which at present has led to Fed Fund Rates below its target as shown in figure 5.
The bill thereby allows US Federal Reserve to pay interest rates to bank deposits held at the Federal Reserve giving enough leeway for them to pump money at liberty; since banks will not be required to lend to each other and thus put a floor to the Fed target. In short, Fed Chairman Ben Bernanke’s Helicopter seems ready for takeoff for the next sortie.
In addition, it is likely that given the sharply deteriorating conditions in the US and Europe, there is a strong chance for OECD central banks to embark on a coordinated simultaneous interest rate cut aimed at restoring liquidity conditions despite the ongoing solvency issue.
Yet we can’t discount or rule out extreme measures similar to a blanket guarantee on ALL deposits such as the recent actions by governments of Greece and Ireland. To reckon that in the US only 63% of the $7,063 billion deposits are insured, while leaving out $ 2,457 billion of uninsured deposits in the US could be a source of a destabilizing run.
Of course one may always argue that the collateral damage from a system wide failure could be nastier and costlier compared to charging the taxpayers for mitigating today’s crisis. But that would be speculation on our part.
As in the Japan experience, the TARF’s version was the Cooperative Credit Purchasing Corporation (CCPC) established in late 1992 which failed to bring about the end to Japan’s crisis whose crisis lasted for more than a decade.
According to Takeo Hoshi of RGE Monitor Asia, ``There is no guarantee that the TARP will be able to avoid those mistakes that the CCPC made. There are no tools that the Treasury can use to force the financial institutions to sell substantially all troubled assets. Even with the tax-related motivation, the Japanese banks were reluctant to sell bad loans to the CCPC. With the TARP, the restrictions on executive pays and others may discourage some financial institutions from coming forward. Similarly, how the Treasury will dispose of the purchased assets is not clear, yet.”
At the end of the day, it won’t be the issue of governments’ not doing anything but would be the issue of the public’s expectations that government actions will succeed even though the risk is that they won’t.
Have you not noticed, this has been going on for over a year and yet the crisis seems to be getting even worst!
Bureaucracies Exist To Spend Money Not To Earn You A Profit!
Besides even assuming that government does end up “profiting” from today’s undertaking, it is unlikely that US citizens will be mailed with their dividend checks from their share of capital appreciation profits or from the revenues streams from the profitable mortgage arbitrages. This isn’t how governments function.
Eventually, all these so called surpluses will end up in the coffers of the politicians who would, in no time, quickly find new boondoggles to spend it with.
As Ludwig von Mises wrote in the Bureaucracy (pp. 48–50), ``The objectives of public administration cannot be measured in money terms and cannot be checked by accountancy methods… In public administration there is no connection between revenue and expenditure. The public services are spending money only; the insignificant income derived from special sources (for example, the sale of printed matter by the Government Printing Office) is more or less accidental. The revenue derived from customs and taxes is not "produced" by the administrative apparatus. Its source is the law, not the activities of customs officers and tax collectors. It is not the merit of a collector of internal revenue that the residents of his district are richer and pay higher taxes than those of another district.”
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