Is Fiscal Stimulus The Right Medicine?

The asset bubble in the United States that has recently burst has wiped out an estimated $13-$14 trillion of net worth between declines in stock and real estate prices. The impact of this value loss is working its way through the economy with dramatic effect. GDP has fallen at a rate of over 6% for the past two quarters, several sectors of the economy are on life support from the government and the Federal Reserve, and we are now entering the 17th month of a recession that began in December of 2007. We already provided an economic stimulus package of approximately $160 billion under the former administration, and we are now looking at a much larger stimulus plan under the current administration. There has been some debate over the effectiveness of fiscal stimulus. Those opposing it claim that fiscal stimulus (that is, when the government borrows to spend and/or provide temporary tax relief) crowds out private sector investment thereby hurting the real economy. Another claim is that fiscal stimulus is ineffective because money that gets to individuals through the stimulus is used to repay debt rather than spent so the economy does not benefit from the multiplier effect of a dollar being spent several times over. I believe fiscal stimulus is the correct response to today’s economic situation, even if a large portion of it goes to repaying debt.

To work through the current situation we need a few economic basics. Individuals earn income. We spend some of this income and we save some. When we save we provide a source of funds for businesses to invest. Our savings flow to businesses through the financial system and the institutions that make up the financial system. Banks are the prime example. Banks take deposits and then use those deposits to make loans. Businesses borrow from the banks to invest in new opportunities. The stock market is another example where businesses raise equity capital to invest from the savings of individual households. Business investment means more jobs and that means more income, more spending, saving, and so on. This is how the economy grows in normal circumstances. Today, however, circumstances are anything but normal. For a long time we borrowed from our future income to consume more in the present (and support a price bubble) running up household debt relative to our incomes. We borrowed for lots of reasons, but the primary asset we borrowed against was our real estate. To put this in perspective, our household debt (that includes mortgages, credit cards, auto loans, etc.) to disposable personal income (that is, income after taxes) has increased from 66% in 1983 to 135% in 2007. The graph below shows the trend in household debt to disposable personal income (debt-to-income) from 1977 through 2008.


(DPI from BEA.gov. HH Debt from Federal Reserve Z1)

The debt to income ratio peaked in 2007 at 135%. It has since fallen back to 130% by the end of 2008. 76% of the debt was mortgage debt in 2007 as opposed to 66% in 1987. The 2008 decline in the debt-to-income ratio illustrates the fact that people are now borrowing less than they were relative to their incomes. The lower level of borrowing means less spending. In addition, we have begun to save again. While we were on our borrow-and-spend spree of the last decade we also spent more of our incomes and saved a lot less. The next graph illustrates the trend in the personal savings rate.


(Personal Saving Rate from BEA.gov)

From this perspective we now see the impact of the rapid declines in housing and stock prices. This mountain of debt, concentrated in mortgage loans, is no longer supported by the price of the underlying collateral. Many homeowners owe more on their home than it is worth and the home as a source of collateral for borrowing additional spending cash has dried up. In addition to this balance sheet impact there is also the cash flow impact. As payments adjust upward incomes are squeezed making it difficult to spend or to borrow more. It’s like a huge number of families borrowed as much as they could and blew it on a mega-vacation and are now saddled with paying back the debt for years to come. Finally, there is the wealth effect. If you thought you had a large portion of your retirement needs accounted for in the value of your home and investments in stocks you are feeling a lot less wealthy today. For all of these reasons households have switched from borrowing and spending to saving as illustrated by the personal savings rate turning up and household debt-to-income ratio turning down. So, this sounds like we are on the right path. If everyone saves we will eventually pay down the debt and everything will be OK, right? Wrong.

Welcome to the paradox of thrift. Saving is good for individuals and for the economy. Remember that savings becomes investment and that helps the economy grow. But when everyone increases saving at the same time overall spending goes down. As we collectively start saving and stop spending business contracts. In this environment business investment falls because there are fewer good business opportunities. So, at the very time individuals start to save businesses don’t need the savings for investment. This is why I do not believe that government stimulus crowds out private investment in the current environment. When businesses are investing less there is nothing to crowd out. And when businesses aren’t investing, people aren’t finding new jobs. As more businesses cut back, more people lose their jobs and can’t find new ones. That means less spending again, and that leads to less investment, and fewer jobs, and so on. This is one way economies fall down into long-term underutilization. How far down and how long depend on a multitude of factors, including the size of the bubble that burst. The losses in tax revenue and other costs to society can be very dramatic. So what do we do about this problem?

Enter the Federal Government, the one borrower that can raise cheap money when everyone else is too worried to borrow and/or can’t find anyone willing to lend (the willing to lend problem is the other side of the rescue plan - repairing bank balance sheets to assure loan supply). As the government spends the money it borrows it provides income to individuals just when individuals need the income because many are losing their jobs and needing to save. If the government provides enough stimulus it may stop the downward spiral of lower incomes and investment discussed above. If those receiving income from the stimulus spend the income there will be some immediate impact on demand in the economy and that could help jump-start business investment. On the other hand, if those who receive the income from the stimulus use it to pay down debt there will be less of an immediate impact on the economy but incomes will be supported while individuals pay down debt. Once debt levels are back to normal individuals should return to spending more of their income. In effect, we are replacing private debt with public debt by providing income through fiscal stimulus to avoid the potential devastation that can result from the de-leveraging of household balance sheets that needs to take place. So even if the recipients of stimulus income use the money to repay debt the economy benefits from the resulting de-leveraging necessary for economic activity to return to normal.

In the end, whether fiscal stimulus is a smart investment depends on its impact on the economy. If it helps to prevent a long protracted depression but costs less than a long protracted depression would, then the stimulus provides a positive economic return. Of course we will never know the true cost-benefit analysis because we will have no way of measuring exactly how much of an economic downturn was prevented.

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The Money Supply And The Credit Crisis

I have been reading about monetarism around the web lately and find the topic interesting. Most of the writings I have seen look to money supply measures as an indicator of whether we should expect inflation and discuss the monetary aggregates, M1 and M2. Some commentators are stressing that M3 and MZM are better indicators of the true money supply as they include institutional money market funds ("IMMFs"). I agree with this position, but I think it misses some issues of the current economic situation. I think of it this way: Under the traditional model of monetary expansion the Federal Reserve injects reserves into the banking system which then uses the reserves to make a loan. The proceeds of the loan are then deposited into a bank and this is new money! The bank receiving the deposit can use a portion of this new deposit to make a loan, and the proceeds of that loan will be deposited into another bank – more new money. This process continues expanding the money supply and debt, limited by the portion of each new deposit that must be kept in reserve rather than loaned out and the fact that in order to make a new loan, banks need capital. But what if debt could expand without expansion of the money supply or bank capital? There would be a decoupling of the relationship between the money supply and debt creation. This decoupling has happened as debt that is originated by banks is often removed from the balance sheets of the banks through securitization, and this process converts the money supply from M2 to M3 or even out of M3 completely. To see how this happens requires a rather lengthy diversion into an example, so here goes:


To see how an everyday transaction ends up converting M2 to M3, I have drawn the diagram above. Beginning with the asterisk in Bank Reserves and assuming the Fed has injected $100 in new reserves, the Bank would want to make a loan for $100. Assume the Bank makes a loan of $100 to Home Buyer to purchase a house from Home Builder. Home Buyer takes out the loan and the cash goes to Home Builder. Home Builder now takes the cash and deposits it into the Bank. (These transactions are the black lines.) This is a new deposit and it represents growth in all the monetary aggregates. But in today’s financial markets (at least before the current meltdown) the Bank is likely to sell the loan to remove it from its balance sheet. If it does so by selling the loan (either directly or through a securitization first) to a commercial paper conduit, then the blue lines would represent the transfer of the loan in exchange for cash. But where did this cash come from? Let’s assume Investor took $100 out of its account at the Bank to purchase a share in IMMF (institutional money market fund) (the red lines). IMMF used this new cash to purchase commercial paper from the Conduit, which is where the Conduit got the cash to purchase the loan (the green lines). At the end of this series of transactions, there has been no net change in bank deposits because $100 went in from Home Builder and $100 came out from Investor (no change in M1 or M2). The original $100 of reserves injected into the bank by the Fed has been replaced by the proceeds from the $100 loan purchase by the Conduit. The money supply has grown, but it is what used to be M3 that increased through an increase in IMMF balances. The Bank is now free to lend the entire $100 again, effectively eliminating the reserve requirement and bank capital as a limitation on money supply (M3) growth from the initial reserves. Because of this off-balance sheet financing of loans by banks it can be M3 that increases as loans are made and sold rather than M1 or M2. Also note that this financing structure is speculative, funding long-term assets with short-term debt. Since the funding source (commercial paper) is not generally guaranteed (as are bank deposits) it is prone to a run. If the bank simply securitized the loans and sold them directly to investors without a commercial paper conduit we could diagram the same result with respect to M2 without an increase in M3 or MZM, but it would not necessarily be speculative. In any event, we have already created the money underlying the loan, but we have converted it to something that is not measured by M2 and sometimes not measured by M3. Because of these conversions of money from one form to another the traditional concepts of money supply and monetary expansion have been altered. As debt creation escapes the bounds of the monetary system around which traditional debt expansion occurred we should monitor debt outside banks as well as M2 or M3.


To see the change in the relationship between deposit expansion and debt creation I compared M2 to non-federal-government debt (“NFGD”) using the first graph above. (NFGD is all debt less federal government debt.) NFGD has increased from a multiple of approximately two times M2 in 1980 to over 3.2 times in 2007. Historically, as debt increased through the banking system there would be a concurrent increase in M2 as the fractional reserve system of banking would multiply the monetary base through deposit expansion. Today, however, deposit expansion and debt expansion have become decoupled as banks sell loans to third parties. In addition to decoupling deposit expansion from debt expansion, the latter is no longer constrained by bank capital since the banks are no longer accumulating loans that require capital. This can create a monetary base outside of the traditional measures of money.


We have also seen a decoupling of the relationship between incomes and debt creation. In its simplest form this is the relationship between debt and GDP. The second graph shows NFGD as a percent of GDP and M2 as a percent of GDP. The divergence is striking, and I think gets to the heart of our economic crisis – the breakdown of the relationships between money supply and debt and between debt and income. With debt ballooning to new highs relative to income, the cash flow implication for consumers is less consumption and more saving – a recession. But what supports this balloon of debt in the first place? In part it is like any other bubble - the rising prices of the assets being financed by the debt provides collateral for more debt. The difference with this bubble, however, is that we have gone from a game where the ultimate size of the monetary bubble is regulated by the Fed through banking reserves, deposit multipliers, and bank capital to a system where any bubble can create its own monetary supply to support itself using securitization to multiply bank reserves in a virtually unlimited manner. At the same time we should be monitoring broader measures of monetary expansion because of financial innovation the Fed has stopped publishing M3 in the belief that it adds nothing to what M2 tells us.

So, other than restructuring how we monitor the financial system for the future, what should be done? Lets start by recognizing that doing nothing is unacceptable as the risk of a deflationary spiral is too great and the results too dire to chance. Once consumers are overburdened with debt service we should expect a recession because not only will consumers save to pay down debt, they will stop borrowing while they do so which will further reduce consumption. Reduced consumption could lead to falling incomes and prices, in which case relative debt burden increases making things worse. Assuming savings also decline through falling asset prices (stocks, home values, etc.) there would be no reason to expect an increase in consumption (save the increase in the value of cash net of the value of liquidity, if any, in such circumstances) or investment, and we could get stuck in a long-term underemployment of great proportions. If the true driver of the current financial crisis is the creation of too much consumer debt, then the only way we exit the crisis is by reducing the burden of the debt on consumers through some proactive means. There are several ways to go about reducing the burden of debt-service on consumers (other than simply using public funds to repay private debt). (1) We can try to inflate our way out of the impending cycle of deflation and recession by adding reserves to the banking system, but this assumes more reserves will result in more borrowing, investment, and consumption. Will companies borrow to invest when the economic outlook is dreadful because consumers are overburdened with debt? Will consumers borrow to consume when they are already overburdened with debt? In short, will traditional efforts to expand the money supply expand the money supply? The evidence is not in yet on this front. (2) We can make every effort to lower interest rates thereby supporting asset prices and reducing debt service payments. This would help to reduce the debt-service in the debt-service/income ratio and provide more income for consumption. The Fed’s efforts to reduce both short and long term interest rates should have some positive impact on reducing the debt burden by lowering rates and, therefore, debt-service payments and should, in turn, support asset prices. Note this is related to the inflation scenario in that monetary policy easing means lowering interest rates on the short end. The Fed has now gone to purchasing long-term securities in an effort to reduce long-term rates that have not responded to the short-term rate reductions. We can also attempt to restructure debt obligations so as to reduce the current payment obligations of consumers by, for example, extending the term of a loan. (3) We can have a major fiscal stimulus that creates employment to increase incomes relative to legacy debt-service. By increasing incomes the debt-service/income ratio would decline. The stimulus would, in effect, replace private debt with public debt, freeing up income for consumption. Based on recent reports, a major fiscal stimulus plan is probably in the works by the new administration.

While we wait to see if our efforts are successful, we can utilize the Fed and Treasury to (i) pump public money into bank capital so the banks have enough capital to make new loans when they hold excess reserves, and (ii) lend to ever increasing elements of the financial system to prevent major systemic collapse as speculative financing evaporates. None of this is news.

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Is M3 Important?

There is interesting discussion on Paul Krugman’s NYT blog today regarding monetary expansion and the Great Depression. For the current crisis, I think you need to look at the divergence of M2 and M3. As institutional money market investors fund commercial paper that funds asset sales by originators, M2 is converted to M3. The money multiplier becomes unlimited as the original reserves used to fund loans are returned in full to the banking system with no new net increase in deposit liabilities. What’s happening right now is the reverse – M3 is liquidating and the monetary base is expanding to, in part, accommodate the conversion. If you look at Institutional Money Market Funds on Z.1 you will see the reductions in this (and, I believe other) components of M3 relating to credit expansion in the modern financial system. I have been waiting for the next Z.1 to confirm these movements.

I believe M3 is important, notwithstanding the Fed’s decision to stop publishing it. I have not concluded that the M3 expansion is the cause of the bubble, but it certainly shows how monetary expansion and, in particular credit expansion, contributed. I plan to post more on this after the holiday weekend.

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Credit Markets

I have heard commentators (Larry Kudlow) making the argument that the credit markets are working OK because bank loans are up by some pretty high numbers. That got me wondering, so I looked at the percentage change in total bank credit plus asset-backed commercial paper from end of September to end of September the following year. The data include Loans and Leases in Bank Credit based on Statistical Release H.8 from the Federal Reserve (the "Fed") and asset-backed commercial paper outstanding from the Fed's Data Download Program. (In 2006 I had to use the October ABCP outstanding due to a gap in the data.) The first graph shows the results.

(Loans and Leases in Bank Credit plus ABCP)

As illustrated by the graph, total credit growth is actually quite meager. The true situation is, however, much worse. I illustrated this by taking out of total credit in 2008 outstanding loans made by the Fed and securities lent to dealers*. In other words, I am trying to isolate the private banking system itself as if the Fed's loans were to be repaid (of course, they cannot be). The second graph shows the result.

(Less Fed credit)

Credit coming from the private system is down - a lot - not up. Without the Fed's interventions we could be bartering by now. Now, there are a lot of other pieces to the puzzle, but this is certainly a more troubling view of the credit markets. Granted Mr. Kudlow was referring to the most recent 13 weeks, but if you calculate credit the way I have I still do not see any increases in credit coming from the private banking system.

* This includes the net Repo position of the Fed, the TAF, the PDCF, the Bear Stearns loan, loans to AIG, the TSLF, and the new asset-backed commercial paper financing. It does not include the new facilities announced by the Fed that are scheduled to begin Monday for the purchase of commercial paper and, as of the other day, other assets by the Fed.

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Fed Goes Nuclear

The Federal Reserve is going nuclear. The TAF is doubling to $900 billion, interest will be paid on reserves beginning October 9, and the rules prohibiting commercial banks from purchasing assets from affiliated money market mutual funds is being relaxed. This last move puts FDIC insured deposits behind money market mutual funds which is, I believe, a roundabout way to get taxpayers behind the funds. They previously did this for the investment banking affiliates. The interest on reserves is required because the Fed is flooding the system with reserves and if it did not pay interest on reserves its target rate would be meaningless, as overnight lending rates would plummet to near zero. This is amazing – unfortunately - and there is likely more to come. Who thought $700 billion was a lot?

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What the Plan Does (and does not)

Now that it appears Congress will pass the bailout plan the next logical question is “what’s next?” I don’t know the answer, but I have my concerns.

This plan may well deal with the current stresses in the financial markets. If so, we can all stop panicking that the world as we know it will come to an abrupt end and get back to the real economy. But, as one commentator just said on CNBC, this may put the fire out but the furniture is still burned. The problem is that the real economy isn’t doing too well. Unemployment is up, spending is down, people are concerned, so where are we headed from here? First, lets see what the current plan hopes to accomplish.

Here is the problem. If a bank has lots of bad assets on its balance sheet, it can’t sell them because if it does it takes a loss on the sale. That loss reduces the bank’s capital, and without adequate capital a bank cannot make loans. On the other hand, if the bank just holds on to the bad assets, it can’t raise new cash to make loans because no one wants to lend it money without knowing how bad the bank’s balance sheet actually is. So as long as these bad assets are being held by the banks lending activity slows or, in the worst case, stops all together. If this gets really out of hand and these bad assets start showing up in other places (like money market mutual funds) then investors start taking their money out of all the places they invest and all lending could stop. That would be the modern day equivalent of a run-on-the-banks. No loans, no economic activity and we fall into a very bad economic shutdown. The only difference between this kind of bank run and the classic depression era run is that the taxpayers stand behind the deposits in commercial banks today through the FDIC and Treasury so we collectively insure our deposits. This prevents a run on commercial banks. We don’t, however, insure the funding sources for all of the other financial institutions in our financial system. Money market mutual funds, insurance companies, investment banks, hedge funds, and private equity raise funds that are not insured against loss. When these bad assets start showing up in those places the sources funding them run. This is why the federal government announced an insurance plan for money market mutual funds last week, and is also why we have witnessed the demise of the independent investment banks. The investors in these banks have stopped funding them – a run on the investment banks. So, although commercial bank deposits that most Americans have in their bank are insured, there is an entire system of finance that doesn’t have this protection and is prone to a classic run. That run is in progress. The current plan hopes to remove bad assets from balance sheets of financial institutions so that lending will return to the economy and investors will stop running. It is intended to “unplug” the flow of money throughout the system by taking away the source of the clog – these bad assets. But even if it works, where do we end up?

A while back I posted an article that explained how the level of household debt to personal income has grown too high and until consumers pay down their debts to a level they can afford the economy will not do well. This is parallel to what is happening in the housing market. Until prices return to a level that makes purchasing a home affordable for the average homeowner prices will decline. As far as overall household debt is concerned, until it returns to a level supportable by personal incomes debt must be reduced. How do we reduce debt? We save rather than spend. Saving more and spending less means less economic activity, and that means a possible recession. So how does the rescue plan deal with this issue? I don’t think it does because it doesn’t deal with the bottom up issue that consumers are in too much debt. How much debt are US consumers in? Total household debt is about $14 trillion, or approximately 145% of 2007 annual disposable personal income. What was this ratio the last time we went into a banking crisis in, say, 1991? It was approximately 85%. That leads us to a thought experiment. What would it take to get us back to the levels of debt to income that we had during the last crisis? If we assume disposable personal income will grow by 2% for this year, then personal income for 2008 should be approximately $9.8 trillion dollars. At 85%, household debt would be approximately $8.4 trillion. Since actual household debt is currently in the $14 trillion range, we need to de-leverage about $5.6 trillion to get back to the 85% ratio we had in 1991. In a $14 trillion economy that represents about 40% of one year’s GDP. In fact, it’s even worse than that because if we stop borrowing in order to save then we also lose the GDP funded by debt (another $880 billion). Comparing other developed countries that have seen similar increases in household debt to disposable personal income, Japan stands out as it went over 120% in – you guessed it, 1991 (see page 47). This was the start of the “lost decade” for Japan.

I don’t expect we would make up all 40% of our adjustment back to 1991 in a short period of time, nor am I convinced that we will ever actually get there without a major new boom in real economic activity (such as discoveries relating to new energy technologies) or a major bust where debt gets written down in mass quantities. The situation does, however, point us to what we can expect next. Expect a rather protracted recession and/or more government interventions into the economy before this is over. I expect the next intervention will be of the bottom up sort, and eventually if the Federal Government owns enough mortgages I can see debt forgiveness of underlying mortgages owned by taxpayers.

Debt numbers: here
Personal Income numbers: here.

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Credit Market Developments

Treasury has proposed a $700 billion taxpayer funded (through issuance of debt) purchase program to acquire real estate assets from the financial industry. This has been coming for a long time, and goes all the way back to the failed Super SIV that was being discussed last Fall. Of course, the numbers have grown from what was a $70 - $100 billion plan to the current $700 billion plus plan, and this plan has the taxpayers purchasing the bad assets directly. The accounting issues of valuation, however, have not changed. What has changed is that the crisis has become so bad we are probably willing to throw out the rules to save the game.

The plan is essentially a $700 billion revolving line to acquire real estate assets at whatever prices and from whatever sellers Treasury wants. There is no protection for taxpayers in Treasury’s proposal, and I can only assume Treasury has left this aspect of the plan for Congress to address. If this isn’t ringing alarm bells all over Washington and Main Street I don’t know what will.

Treasury Secretary Paulson has submitted a very broad plan that gives him extraordinary discretion and prohibits any agency or judicial review. You can see a copy of what was submitted in this CNN article and read a description of the plan at the Treasury’s website. The submission raises many questions, three of which I will point out.

1. There is no provision for protection of taxpayers. As written, it seems that Treasury will simply purchase, at whatever price Treasury determines,

Mortgage-Related Assets.--The term "mortgage-related assets" means residential or commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages, that in each case was originated or issued on or before September 17, 2008.

The big question – at what price? If Treasury purchases securities at current market prices it doesn’t necessarily help the financial institutions that own them. Right now losses that would occur at market prices are being deferred through secured lending by the Federal Reserve, but this is obviously insufficient. If these assets are in addition to those pledged to the Fed, then this is a multi-trillion dollar problem. If Treasury pays more than current market prices, then how is the taxpayer protected? Not to get off on a rant here, but it seems to me that any financial institution that sells securities to taxpayers pursuant to this program should, at a minimum, direct all dividends to the Treasury until taxpayers have been fully repaid, at which time they can have the balance of the securities returned. It really irks me to think that financial institutions could sell the crap they profited from so handsomely over the past decade to taxpayers, letting us assume the risk, while the owners continue to collect dividends. Absolutely horrible result that I truly hope Congress will address. Some may argue that this would make it difficult for these institutions to raise capital, but that should be irrelevant now since the taxpayers are providing the capital if we pay above market prices for their securities. Another point – why are we purchasing commercial real estate assets and what are the limitations on commercial vs. residential?

2. I think there is a lack of transparency. The current proposal provides for a report to Congress three months after the program begins and then every six months. As a taxpayer whose money is being spent on these assets I want to know every week how much, who, when, and so on. I want to know which institutions are benefiting, how we are getting compensated for it, what is the asset rated, what is the mark-to-market value, and so on. Without full disclosure this plan is ripe for abuse and all purchases need to be fully disclosed. I suppose there is an argument that disclosing which institutions are selling assets to taxpayers could jeopardize the institutions, but since they would be receiving a capital infusion from the purchase this should not be an issue. Poor disclosure is one of the issues that got us here in the first place and any plan to address this crisis must include full disclosure.

3. The amount of this bailout is unclear. It specifies that:

The Secretary’s authority to purchase mortgage-related assets under this Act shall be limited to $700,000,000,000 outstanding at any one time

. This means we could be purchasing a lot more than $700 billion worth of this stuff, we just will not own more than $700 billion at any one time. How do we account for the value of these assets? If Treasury purchases an asset for $1 million and receives principal payments that reduce the face amount of the asset, do those payments reduce the $700 billion even though we may still take a loss on the balance of the $1 million we paid? If so, this is more likely a $1 trillion plan (or more).

In other bailout news (post AIG taxpayer bailout), the Fed established a line of credit that is reportedly $230 billion to purchase asset-backed commercial paper on a non-recourse basis (meaning the Fed will own the stuff). Asset backed commercial paper was at the heart of this crisis to begin with and is where funding dried up last week. What does this commercial paper fund? Everything, including auto loans, credit cards, and so on. If this market freezes your credit card may not work, and the resulting panic could be devastating. Think how you would react if told you could not charge your groceries on your credit card because Citibank doesn’t have the money to lend you. In addition, companies could find it impossible to fund payrolls causing more panic. This is one of the reasons Treasury acted on its plan – justified fear. (For a good explanation about how asset backed commercial paper works see this fitch report).

So what happened in the commercial paper market? In general, money market investors put money into money market mutual funds that then use the money to purchase assets including asset-backed commercial paper. But when a large money market mutual fund reported that it took a loss and that investors would lose money, money market mutual funds in general received calls for redemptions from investors who feared losing their money – a run on money market mutual funds. As night follows day, the mutual funds stopped purchasing commercial paper and put their liquidity into Treasury securities, driving the interest rate on short term Treasuries to negative on at least one issue and the interest rate on commercial paper way up. This is a clear dislocation in the credit markets and the Fed jumped in to provide liquidity for commercial paper. In addition to the Fed’s new plan to purchase commercial paper, Treasury reached back to a depression era law to insure money market mutual funds. Funds can buy into the plan that will insure investors against losses. This has irked some banks that believe this places them at a competitive disadvantage to insured money market mutual funds and could cause their funding to dry up – more unintended consequences (do I hear whack-a-mole?).

One more item on the list of things being done to avoid a total meltdown – relaxation of regulations on financial firms. Since these firms cannot raise any capital because their business models are in question regulators have relaxed capital requirements – temporarily, of course. Another thing regulators did was relax the restriction on using commercial bank deposits to fund investment bank operations. After the great crash of 1929 and the ensuing depression, Congress split up the investment banks and commercial banks because investments made by investment banks in equities were too prone to value fluctuation that could wipe out depositor funds. The FDIC was established to insure deposits and banks were limited as to what they could do with those deposits (to protect the taxpayers from having to bail out excessive risk taking). The law that kept investment and commercial banks separated was repealed in 1999, but there was regulation in place that prohibited these new combined banks from transferring commercial bank deposits to investment bank affiliates. Some of this regulation is currently being relaxed so that investment banks that are affiliated with commercial banks can get access to the stable deposit based funds of the commercial banks. The result is that to some extend the FDIC and taxpayer are now behind assets of the investment banking affiliates of the large commercial banks that have such affiliates. We have gone backwards (I bet Merrill Lynch and Bank of America appreciated this change that occurred the same time they merged).

For a time I was keeping tabs on the total cost of this credit implosion and the risk to taxpayers but the numbers are getting hard to follow. Based on current media reports the Fed is now up to $700 - $800 billion in credit and commitments, Treasury is asking for a $700 billion revolving credit facility from the taxpayers that is likely to be more than $700 billion in aggregate purchases, and so far the Federal Home Loan banks have issued some $250 - $300 billion in new taxpayer guaranteed debt to lend to banks against mortgage collateral. Oh yes, FHA has approximately $100 billion in new loan guarantees from FHA Secure and has another $300 billion authorized guarantee capacity to refinance defaulted mortgages. Are we at $2 trillion yet? If not, just add the GSE loans and MBS purchases Treasury plans (there are no limits on the amounts here) and whatever funds the GSEs need to stay solvent, and we have taxpayer exposure of well over $2 trillion even before the federal guarantees of the GSEs’ debt. These numbers don’t include losses that banks have reported on write-downs of securities. The result so far - Treasury has asked for an increase in the debt ceiling twice, this time to $11.3 Trillion (approximately 80% of GDP). One more point. If the total of all residential mortgages in The United States is in the $10.6 trillion range, and taxpayers now explicitly guarantee $5.5 trillion through Fannie and Freddie and are or will be at risk for say $2.5 trillion through all of the interventions noted above, then taxpayers could ultimately be on the hook (either through guarantees or ownership) for some 75 - 80% of the entire outstanding amount of residential mortgages in The United States. I find that staggering.

A couple of nits that I have:
1. Too bad Treasury didn’t go out and raise the money last week when interest rates on Treasuries were at historic lows. Probably would have saved a lot in interest.
2. CNBC should stop praising Jim Cramer as though he is some sort of visionary for talking about a bailout plan like this one. Everyone has always known that the government could step in and get behind lots of private debt to shore up the markets. In fact, everyone has been talking about it for some time. Treasury just didn’t until it was necessary because if it did it wouldn’t get approval for it. No great vision here. When Cramer comes up with a way to protect taxpayers that Congress will pass and that will resolve the credit crisis call me.
3. If there was ever a time to fix the unfair and disproportionate tax treatment for hedge fund and private equity managers (the 15% rate on “carried interest”), now would be it. In fact, several years ago would have been better. When this was in the public discourse several months back industry pundits argued that if you taxed hedge funds you would get less of them. Right now that sounds like a good idea. Fewer hedge funds, fewer credit default swaps, less systemic risk.
4. Like many of the talking heads on television, I am angered by all of the blatently excessive amounts of compensation paid to Wall Street bankers and executives over the past six years or so that is ultimately proving to be gains from the largest Ponzi scheme in the history of the world. There should be some recourse, though I don't claim to know how that could work.
5. With absolutely no proof that trickle down Reagan/Bush-onomics has ever worked, an exploding national debt, an exploding national deficit, and the impending baby boom retirement isn’t it time to stop talking about tax cuts for the investor class?
6. And finally, when will we, as a taxpaying and voting public, stop allowing the politicians to distract us with witch hunts for evil short sellers from the real issues – the fact that the political system has been for sale to the highest bidder and the highest bidder often turns out to be Wall Street and Wall Street.

PS - there are other developments, such as the Fed now accepting equities as collateral for certain loans under the Primary Dealer Credit Facility. To find out more about what the Fed is up to you can go to its website and click around the press releases.

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Some Hidden Costs of the Credit Crisis

The Federal Reserve (the Fed) is likely causing dramatic distortions in the markets by lowering interest rates below the level of inflation and the impact may only be evident in retrospect. One side effect of the Fed's actions is a massive shift of the costs associated with the credit crisis from borrowers to savers. While negative real interest rates are helping some homeowners keep their payments down they are also fueling inflation resulting in a tremendous loss in value to those who have saved for retirement. Artificially low interest rates are also causing pain for those living on a fixed income through both inflation and loss of investment earnings. Here are a couple of hypothetical situations based on real stories I am hearing from friends and relatives to illustrate these distortions I am referring to.

The first story is about a hard working middle-class family headed by Dick and Jane. Dick and Jane grew up in the 1950s and 1960s. They have worked full time for almost 40 years, raised a family, a dog and several cats, and have been preparing to retire. They have contributed to Social Security from every paycheck they have ever received, and have been frugal and lucky enough to put aside some money for retirement. They purchased their home 30 years ago and have paid off the mortgage through 360 consecutive monthly payments of principal plus interest. Everything was going along according to plan until, suddenly and without warning, the earnings on their investments began to plummet.

They couldn’t understand what was happening at first. Because they were getting close to retirement they had allocated much of their portfolio to fixed income investments, and some of those were falling in value at the same time they could not get more than a 3% return on CDs and Treasury securities. They went to their bank to get advise and were told that because the Federal Reserve had lowered interest rates safe investments were yielding very low returns. They took out their calculator and figured that if inflation is around 4% and the real interest rate is 2.5%, they should be earning 6.5% on a risk free investment. Instead they are being offered 2.5% on a CD, so the cost to them is 4%. Based on their retirement portfolio of $750,000 they are losing $30,000 per year! Even if they can get a 3.5% return the cost is still $22,500 per year. But that’s not all. If we believe that these low interest rates are also causing inflation in basic goods such as energy and food, the value of their retirement savings is declining. Where $750,000 may have been enough based on all reasonable forecasts just a year or so ago, now it is not enough because of the cost of living increases.

Confused and angry, Dick and Jane reconcile to the fact that they will likely not be retiring as planned unless they cut back dramatically and save as much as possible. They will delay any major expenditure until absolutely necessary, and because of inflation they have less to save. The $1,100 fuel oil bill drove this point home last week. A portion of their retirement has disappeared through no fault of theirs, and they wonder why. Why is it that with inflation getting worse interest rates are going down? Shouldn’t it be the other way around?

The second story is about Cathleen, a neighbor of Dick and Jane. She retired from her clerical position ten years ago. Her husband passed away several years back and she now lives on Social Security and the income from the $250,000 portfolio of treasury securities, money market accounts, and CDs left from their lifetime savings and her husband’s live insurance. She can’t understand what is happening, but for the first time since retirement she must liquidate some of her retirement portfolio to pay all of her bills. Her Social Security income of $1,500 per month doesn’t come close to covering all of her expenses so she has relied on the interest from her portfolio for the rest. Last year her interest income was $13,750, giving her total income with social security of $31,750. This year her interest income was $8,750 giving her total income of only $26,750. Adding the rising costs of her medications, property taxes, food and energy she is for the first time concerned that she could run out of money. She wonders why, and she has decided she must cut back to only the necessary expenditures.

While lower interest rates are helping some homeowners with adjustable rate mortgages they are hurting savers and those living on a fixed income. Inflation also harms savers but benefits borrowers. At the same time, as between the average savers and the average adjustable rate mortgage borrowers it is the latter who have more culpability for the crisis in the first place. It is clear that the American people are paying the price of this credit crisis one way or another, and the question at hand is whether the distortions resulting from the remedy are making things better or worse as the burden is shifted from borrowers to savers?

There are at least three reasons for the Fed to be lowering rates right now. Let’s take a look at each of the primary reasons for the Fed to be lowering interest rates.

The first reason to lower interest rates when the economy is soft is referred to as the wealth effect. When interest rates are lower asset values tend to be higher. If mortgage payments are lower house prices can be higher because it is more affordable based on the payments. This applies to financial assets as well. As interest rates fall, in general, the value of financial assets rise. In practice, this effect makes people feel better off because their assets are worth more and this is good for the economy because when people feel wealthier they tend to spend more. This sounds great, but there is dark side.

When inflation becomes a problem rising asset values tend to be offset by rising costs. While keeping interest rates depressed may help support the value of certain assets it is also fueling inflation, and the inflation is countering the wealth effect. Low interest rates don’t always spark inflation, but in the current global economic situation commodity prices are rising dramatically and inflation is becoming a real issue. Lower interest rates in the US hurts the value of the dollar and sparks price increases in dollar denominated commodity prices. Anyone who goes to the grocery store or drives a car or heats a home knows that inflation is a rising problem today. So assuming low interest rates are in fact supporting asset prices the resulting inflation could be countering the impact because real values (adjusted for inflation) are not changing or are, perhaps, even falling. Is the wealth effect of lower interest rates working this time? I question its efficacy under current conditions when real interest rates are negative AND we have supply shocks in energy, food, and metals all at the same time.

The second intended effect of lowering interest rates is to spur business investment by making it less expensive for businesses to borrow and invest. This should also lead to increased employment as businesses hire more workers. Before businesses invest, however, they must believe that consumers will consume. Helping to keep mortgage payments down for a portion of the population will certainly help consumer sentiment, as will the resulting benefit of slower price depreciation in housing. But there is also a downside to consumers of low interest rates and the inflation we are now seeing. The retirement savings of the baby boom population are losing value to inflation, while at the same time low interest rates are cutting into the income of those living on their savings. The loss of real savings and real income (from both depressed interest rates and the impact of inflation) to the population of savers and spenders is likely to have a negative impact on consumption, especially as those close to retirement increase savings and those in retirement are forced to cut back on spending. This, in turn, could offset the positive impact of low interest rates on consumer sentiment. Consumers also have more debt as a percent of their personal income now than at any time in the past several decades and probably need time to pay it down rather than consume more. So will lower interest rates spur investment under these circumstances or simply prolong the reckoning while causing a very troubling inflationary spiral? There is certainly room to question the efficacy of further rate cuts on business investment in the current economic climate.

The third reason for lowering interest rates right now is to help rescue the financial industry in the US and prevent a collapse of the financial system. A major meltdown of the financial industry would certainly be a problem that would have a negative impact on all of us because it could result in a severe recession or even a depression. If the banking system becomes insolvent (meaning the banks do not have capital and cannot make loans) then anything people purchase on credit could suddenly experience dramatic reductions in demand, while at the same time businesses would find it very difficult to obtain funds for investment. When things get really bad you get deflation because there is simply not enough demand for anything to keep prices from falling. This may sound OK at first but in fact it is worse than inflation in many ways. Who will lend you money to buy a house if the value of the house is expected to decline next year? The same logic holds for a car or any other major purchase. Imagine your mortgage payment staying the same while your home value and wages drop – that’s deflation and it can spiral down the same way inflation can spiral up. At the same time unemployment would rise dramatically because businesses facing falling demand and lack of funds for investment would be laying off workers. This is certainly a situation to be avoided. So how does lowering interest rates help us lower the risk of this happening? Aside from the wealth effect and business investment helping the economy stay afloat, the lower interest rates help to support the value of assets on banks’ balance sheets (remember these are interest bearing financial assets). That means fewer write downs and, in turn, lower losses and more capital. The low interest rates also reflect banks’ cost of obtaining funds to lend, and when their costs go way down their profits can go up. More profit means more capital and more incentive to lend. So lowering interest rates helps the banks to preserve and add to their capital helping to lower the risk of financial system insolvency. Of course, if this is truly the reason for lowering interest rates right now one must wonder why banks continue to pay dividends to investors. If they are under-capitalized that should be the first place they go for capital preservation, not to the policies of the Fed. This is especially true when the Fed policies are creating distortions in the market and may not be helping to support the economy for reasons discussed above. If the financial system is in fact under-capitalized perhaps the Fed should be reaching back into its bag of tricks and figuring out another way to add capital to the banking system.

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A Long Article about the Credit Markets

OK, here is my take on the current goings on in the financial markets. I want to preface this with the fact that this is not investment advise and it is my opinion. I do not have the time to provide backup for all of the numbers but they are readily available from current news sources. Where I don’t know the exact number I tried to be conservative. It is very difficult to try to boil this down to any reasonable length so a lot is left unsaid and what is said is meant to stress the risks we currently face. Many if not most professional economists believe we will have a mild recession and return to growth in the second half of 2008. That said, here goes:

1. The US has relied on foreign capital to support a large and long-term trade deficit. As we consume more than we produce, the net difference is imported from overseas. At the same time we export dollars to pay for these things we import. Those dollars often find their way back here in the form of investors looking for return. With all of these dollars looking for investments added to the normal amount of available investment capital, the markets work their way down the food chain. First they make good investments until those run out, then they make mediocre investments until they run out, then they make bad investments until the cracks begin to show as with the subprime mortgage meltdown. While this is going on the economy is booming because people are buying things, in fact, spending even more than they are making. Once investors realize they have made some very bad investments, however, they do exactly the opposite and run from these investments. Foreign investors take their money out of the US and bring it home or invest it elsewhere. This causes the value of the dollar to fall as everyone is trying to sell it in exchange for their own currency, and it reduces the amount of financing available to support asset prices and economic activity in the US.

2. As foreign investors pull their money out of the US and domestic investors run from financial assets prices of financial assets in the US fall because there is less demand for them. This is especially true when investors realize that the assets they invested in are not of the quality they expected. Mortgage backed securities, private equity buyout loans, and so on are all worth less than they were last year, not just because of defaults but because there is just less money around looking to buy these assets. This is referred to as re-pricing of risk. This flight to quality is seen in the dramatically low interest rates on Treasury securities that fall as demand for these safe investments increases – investors are selling riskier assets and purchasing safer ones. They are also purchasing hard assets as seen in the recent explosion of commodity prices.

3. As asset prices fall and capital flows out of the country and out of certain financial assets, banks begin to feel pressure. They need to raise funds to meet the demands of deposit withdrawals and to fund loans to customers who can no longer raise money in other markets such as the commercial paper market (again because the flow of money has reversed from in to out). Normally banks will borrow from other banks or depositors, and/or sell assets to raise the liquidity necessary to meet these demands. Today, however, they cannot do enough of either because they are all in the same boat and because there is a lack of demand for their assets – remember the capital is going out, not coming in. In order to sell assets and raise liquid funds the banks would be forced to take big losses on their assets, and that would reduce bank capital. The more they have to sell the lower the price they will get and the more bank capital is reduced. This could ultimately lead to insolvency of the banks, which is worse than illiquidity because it means that even if the banks had liquidity, they could not make any loans. No loans, investment plummets and employment follows. Of course, if this happens the loans on the banks’ balance sheets get even worse because as employment falls loan defaults increase in this downward spiral.

4. The Fed is using all kinds of tools, new and old, to prevent the system from collapsing under the weight of this de-leveraging (the term for when investors who provide capital leave the markets). First, it is lowering interest rates rapidly, with the federal funds target rate down from 5.25% in September to 3.0% now and another cut expected on Tuesday. Lowering interest rates is targeted at two things: lower rates in general means the rates on investments should go down and the re-pricing of assets should be less severe; and lower rates should support additional investment and consumption assuming those rates make it to the borrowers. The problem is that the lower rates are not making it to the borrowers and so the intended effect is not yet being felt. One reason this is happening could be that the banks are, in fact, insolvent based on current asset prices so they cannot make loans even if they have the liquidity. The other reason this could be happening is that the liquidity crisis is so severe that the banks are simply keeping up with their own balance sheet changes without making many new loans. Either way this is very troubling.

5. In addition to lowering interest rates, the Fed normally acts as lender of last resort to commercial banks. If a bank has a liquidity problem it can pledge collateral to the Fed and the Fed will then make a short-term loan to the bank through the discount window. This has also run into to trouble, however, because none of the banks want to borrow from the Fed this way. They are worried that if they do it will signal a problem and everyone will withdraw their funds from the bank – a classic run-on-the-bank scenario. To deal with this, the Fed created a new program called the Term Auction Facility, or TAF. Under this $100 billion facility the banks bid for loans from the Fed, and if they win they pledge collateral and get a loan for 28 days. The Fed has opened up the collateral pool to include basically anything the banks have to pledge (they can pledge anything they could have pledged for a discount window loan). The names of borrowing banks are not made public, and there is no schedule of the collateral the Fed takes to secure these loans released to the public.

6. The TAF was a very good idea, except it did not provide liquidity directly to the investment banks because they cannot borrow from the Fed without drastic action. In order to address this issue, last week the Fed announced a new $200 billion swap facility called the Term Securities Lending Facility. Under this facility an investment bank can give the Fed mortgage backed securities and other collateral and the Fed will give the bank Treasury securities from its own portfolio. The investment bank can then sell the Treasury securities for cash to get liquidity, and 28 days later it reverses the transaction by returning the Treasury securities for the collateral. Unfortunately this facility is not yet operational so it was too late for Bear Stearns. Bear experienced a run-on-the-bank Thursday and Friday of last week, and the Fed took that drastic action to lend directly to Bear Stearns through JP Morgan Chase. The Fed has not done this since the Great Depression.

So between lowering interest rates (the cost of funds to banks) and providing a source of liquidity (the loans and swaps) for the banks’ assets that are re-pricing, the Fed is hoping to avoid a major collapse of the system that could include runs on many institutions such as the one experienced by Bear Stearns last week. If the banks cannot raise liquid funds then they cannot meet the demands of depositors and borrowers and once this is known, there is a run on the bank. All told, the Fed has announced at least $400 billion in new facilities to provide liquidity to the banking system, which is about 44% of its entire balance sheet. Unfortunately interest rates to borrowers are still not declining signaling an even deeper liquidity crisis or an insolvency crisis. The falling dollar confirms the exodus of capital from the US markets and no one knows how far this will go. In the interim, the economy looks worse as banks do not extend credit for investment or consumption in large enough quantities to support economic growth. The very interesting and as yet unanswered question is what happens if the banks cannot repay the loans from the Fed and the pledged collateral ends up being worth less than the loan?

7. The Fed has a dilemma on its hands and there may be no solution available to it. On the one hand interest rates must be low to stimulate the economy by promoting borrowing and investment/consumption. If interest rates are high businesses will not invest and consumers will postpone purchases, so low rates traditionally help spur the economy. This is the standard policy response to a declining economy, and we are in a declining economy. On the other hand, however, low rates drive more capital out of the markets as it seeks better returns elsewhere. Witness the current boom in commodities, surely the next asset class to bubble over, and the continuing decline in the dollar. These trends are also leading to higher inflation as witnessed at the pump. So lower rates help to spur the economy and hopefully place some floor under the assets being re-priced, but at the same time chase away much needed capital (perhaps worsening the re-pricing because of lack of purchasers) and create a higher inflation risk. If the capital stays away because of the lower rates banks will not lend and we could have a severe economic downturn. Raising rates may help attract the much-needed capital, but it will slow the economy at a time when it is already vulnerable possibly resulting in a severe economic downturn. Therein lies the dilemma. It is very possible the Fed does not have a solution to the current problems.

8. Remember from number 1 above that this cycle of asset pricing and re-pricing was at least in part created by the unsustainable trade deficit of the US. The trade deficit reflects the fact that we have been consuming more than we have been producing, and paying for the difference by borrowing (and, in some cases, selling our assets). We have simply blown our credit beginning with the subprime mortgage meltdown, and it is now time to pay down some of the debt because our lenders are cutting off the flow of funds. That means a combination of selling our assets (as in Citigroup equity sold to foreign sovereign wealth funds) and saving. Saving is the opposite of consuming, so the more we need to save the less we can consume. The less we consume the lower the GDP, unless of course we cut all spending only on imports which is impossible, especially with our dependence on foreign oil. So I predict a fairly substantial slowdown in our immediate future as all of this works its way through the economy. If the flight of liquidity is severe enough we could also witness even more stress in our financial system, without which our economy comes to a halt. Because of this don’t be surprised if there is a large Federal bailout of the banking system on the horizon, regardless of what noise comes out of the White House about free markets and the like. If Bear Stearns is too big to fail so are all of the other major banks, both commercial and investment.

9. A taxpayer bailout of any magnitude is the last thing we need right now, especially with rising budget deficits, two wars, and ever increasing health care commitments. Tax increases may be unavoidable, even if they do further depress economic activity (though there is debate over whether this would be the case under these circumstances). The flight to commodities and resulting price pressure may or may not be sustained, depending in part on how long and how deep the economic downturn turns out to be. If the economy falls into a very deep recession, and especially if the global economy follows, we could see a reversal of the commodity price boom and, potentially, a period of deflation as all asset prices fall (this would be a worst case scenario).

10. How big of a crisis do we have on our hands? We can look at what the Fed and the Federal Government have done so far. At least $400 billion of liquidity facilities have been announced beginning in December and this does not include whatever loans have been made to Bear Stearns. Approximately $200 billion of mortgages have been funded by The Federal Home Loan Banks, an extraordinary increase on a historical basis. The FHA is in the process of refinancing defaulted subprime loans, and there are proposals in Congress to increase the total amount they can refinance to $300 billion. Congress and The President have passed an economic stimulus package estimated to cost approximately $160 billion. All the foregoing is taxpayer backed in one form or another. On the private side, banks have so far written off approximately $150 billion in losses on their assets and many expect another $135 billion to follow. Are we over $1.3 trillion yet? I think so. This sounds like a big problem.

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A History of The Great Economic Collapse of 2008

Looking back several decades at the economic downturn in the United States that began in the third quarter of 2007 and lasted for the better part of a decade, the causes seem predictable and inevitable. The United States had been consuming more than it produced for many years, running massive trade deficits. At the same time consumers were borrowing from international sources of capital to finance consumption, the United States Government was also running budget deficits, financing its expenditures largely from foreign investors and the retirement funds of the baby boom population – some 75 million Americans. Some of this over-consumption was funded through asset sales, especially after the initial decline in the dollar, as foreign investors thought they were getting bargains purchasing US assets.

The cracks in the system began showing up in earnest in 2007 with the great Subprime Mortgage Meltdown. This crisis in the subprime real estate market ultimately spread to the rest of the market and triggered an exodus of capital from the financial system as investors realized they had been taking on too much risk for the promised returns. Notwithstanding valiant attempts by the Federal Reserve to provide liquidity to the banking system, the risk re-pricing forced historic write-downs of assets on the books of the major banks, both commercial and investment, resulting in capital shortfalls at the major institutions. The first bank to experience a run was the 83-year old investment bank Bear Stearns, which was temporarily kept afloat through emergency loans from the Federal Reserve. This marked the first time such a loan was made since the Great Depression of the prior century. The resulting lack of financing into the economy drove investment to levels not seen in decades and unemployment soared. At the same time as the employment picture soured, many in the baby boom generation were retiring. Unfortunately the insolvency of the Federal Government resulting from tax cuts for the wealthiest Americans and deficit spending required massive cuts in health care and social security as well as large tax increases, further depressing the economy. A massive portion of the population retired into poverty.

In an attempt to fight both the re-pricing of assets and the lack of financing in the economy the Federal Reserve lowered interest rates dramatically, from 5.25% to 1%, at the same time inflation was running up. The interest rate targeted by the Federal Reserve at the time, the Federal Funds Rate, was negative in real terms for the second time in a decade. Unfortunately, these lower rates did not pass through to borrowers because the banks’ lack of capital prevented them from making loans regardless of how low their cost of funds was, and the fear of insolvency prevented banks from lending to one another which was how the system worked at the time. In fact, the monetary easing resulted in a further flight of capital as investors sold dollars to invest elsewhere where returns were better. The resulting fall of the dollar was also historic in nature as it hit all time lows against a basket of currencies week after week. This would have been a bright spot due to its impact on net exports, except that the decline in the US economy spread to the rest of the developed and developing nations reducing demand for exports.

Ultimately the Federal Government had to step in and bail out the financial system that had profited so handsomely for many years prior to the meltdown. The size of the bailout dwarfed the S&L bailout that was still visible in the rear view mirror, enraging much of the population. At the same time, those who had amassed fortunes during the boom years were able to acquire vast holdings of productive assets thereby widening the already large gap between the wealthy and the poor. Despite passing law after law and amending regulation after regulation in favor of the banking lobby for two decades, Congress professed shock at the actions taken by some of the major financial institutions during the ensuing hearings. The conflicts of interest of the rating agencies, the off-balance sheet accounting, the lax capital requirements, and several other issues resurfaced in the public view. Once the population at large learned that all of these issues had been brought to the attention of Congress years before, but ignored at the behest of the finance industry, there was a near revolt in the streets. This resulted in what we now refer to as the Great Political Restructuring.

Between the devaluation of the dollar and the massive infusion of funds to rescue the financial system inflation raged out of control for some time until the collapse progressed, after which deflation took hold as the world economy followed suit and demand for everything fell off globally. The lessons of this era remained strong and bank regulation was revised and strengthened. However, due to advances in technology and other systemic changes, the banking industry is now lobbying Parliament for additional powers such as combining their commercial and investment banking operations and allowing them to export interest rates from their home state to other states. They are also seeking reform to the bankruptcy laws and a declaration of Federal Preemption for protection from state regulators. Some argue that we should honor the lessons of the past and deny these powers to the banks, especially since the banks are ultimately backed by the taxpayers as lender of last resort. The neo-neo-conservatives, however, argue that the free markets will provide better competitive results for all consumers and the bankers, notwithstanding their incentives to take excessive risk, will adequately manage any potential risks to a systemic crisis. Paul Krugman, the sage economist now in his 98th year, declared such proposals outrageous and claimed they will lead the economy on a path to great divergence of wealth and the rebirth of the poverty population. Larry Kudlow, the underground talk show pundit whose age none can ascertain, pronounced this to be a great day for America, the likes of which he has not seen since the Great Political Restructuring. Time will tell which of these elder statesmen is still connected to the political economy and which is simply disconnected.

[Of course, I hope none of this is true and we see a rebound in the second half of 2008 as many predict. I just could not help having a bit of fun with this. I may do a serious analysis if time permits.]

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Proposals for Taxpayer Bailout of Banks

I was reading this article in The Wall Street Journal Online Edition titled Worried Bankers Seek to Shift Risk to Uncle Sam about proposals being shopped around DC to move defaulted subprime loans to FHA. According to the article:

The banking industry, struggling to contain the fallout from the mortgage debacle, is urgently shopping proposals to Congress and the Bush administration that could shift some of the risk for troubled loans to the federal government.

One proposal, advanced by officials at Credit Suisse Group, would expand the scope of loans guaranteed by the Federal Housing Administration. The proposal would let the FHA guarantee mortgage refinancings by some delinquent borrowers.

This will almost certainly lead to a taxpayer bailout in my opinion. I have been writing about this for months and the fact that it is being considered in DC is truly troubling. Congress has been warned about the consequences of this in 2006 testimony before the Committee on Banking, Housing and Urban Affairs. You can read that testimony here. If you would like my article on this issue you can find it here. The ideas discussed in the WSJ article referenced above go beyond what I wrote about back in December.

If you object to taxpayers bailing out the banking industry, again, I urge you to write to your congressional representatives.

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Income, Debt, Taxes, and The Economy

I have been trying to figure out why so many people (including myself) have been so negative about the direction of the economy so I have been playing around with some data published by various governmental sources, primarily the Bureau of Economic Analysis tables and Federal Reserve Z.1 from December 2007. I created a few graphs because I believe a picture says a thousand words and I wouldn’t expect anyone to read so many of my words. So, here goes.

The first chart I think really lays it out. This is Consumer Debt plus Mortgage Debt as a percent of Personal Income. I also charted Personal Disposable Income and it looks the same except the percentages are a little higher. This ratio has increased from 51% in 1974 to 112% in 2006 and an estimated 111% in 2007. So the good times for consumers over the past three decades appears to have been funded through incremental relative debt burden as opposed to income gains. This is simply another way of saying that we have been spending more than we are producing (unless we are borrowing to save, but keep reading), and perhaps we are close to hitting the proverbial wall.

The second graph titled Debt to GDP breaks out some components of debt as a percent of Gross Domestic Product. Note the sharp rise here too. One reason this is so steep is because I have added the National debt to the mix. This does not include State and Local debt, but believe it or not as a percent of GDP those items are relatively unremarkable. Business debt to GDP has also increased, but not at an alarming rate. It averaged 60% over the 1974-2007 time period and is currently high at 69.5%, the highest point in the time series. This is not a net number so it does not take into account cash that businesses have, so if businesses are flush with cash the higher number could be meaningless.


The graph titled Percent Change in GDP Components illustrates the makeup of GDP over this time period. The reason I like this graph is because it gives you an idea what is driving the economy; business investment, personal spending, or residential real estate. What I would like to point out here is the surprising suggestion that business investment is not what has driven the economy since the Bush tax cuts. In fact, with the exception of one spike in 1984, business investment doesn’t look very strong during the Reagan and Bush I presidencies either. I find it hard to see in this data support for the idea that tax cuts on high incomes lead to business investment raising all boats (you know, the trickle down theory). What, then, has been driving growth in this decade? We know from our Debt to GDP graph that mortgage debt increased dramatically over this period in both absolute and relative terms. Is it consumers borrowing against real property and spending that has fueled the economy? Add that to the fiscal stimulus of continuing budget deficits and maybe that’s the answer. To put this into perspective, take a look at the final graph, Personal Consumption and Business Investment. These amounts are in nominal dollar amounts. As the graph illustrates, we have been increasing our consumption at a much faster rate than business investment, and it appears this is what has fueled our economic growth. Borrow and spend, at the personal and federal government level. And this is why, I believe, there is so much bad feeling out there. Unfortunately it may be justified.

So where do we go from here? Well, if we have a major economic downturn we could go through an extended period of hardship as debts are written off and asset values decline. This is one school of thought – that we are headed for a period of deflation (not just disinflation but actual falling prices and values). On the other side is inflation. If you owe a lot of money, inflation is good for you because as overall prices and wages rise, the debt you owe becomes a smaller and smaller amount in real terms. So we could inflate our way out of this by flooding the system with money – but this creates more debt. Ah, and therein lies the problem. How much debt will it take to inflate our way out of debt? Looking at the Debt to GDP graph I am not feeling very good about this approach.

I want to go back here to the economic policies of the past 27 years, since we began the reduction in marginal tax rates. I don’t have the numbers yet to support this so consider it an unsupported hypothesis for now. If I find some time I will look for the numbers, if they are even available, to try and support this. What if, instead of tax cuts that benefit the wealthy resulting in business investment the tax cuts actually resulted in cheap available consumer credit? Lets take an example. Person A makes a very good living, say $2 million a year. Person A gets a tax cut and finds they have an extra $100,000 at year-end. What happens to that 100,000? Perhaps some gets spent, and that could account for some of the increase in personal consumption. But what if a large portion of it goes to a hedge fund for investment? Perhaps much of it flows into safe investments such as CDs and money market funds. What is the impact of the additional savings? The result would be an increase in the supply of funds available and, if our Eco 101 is working, a decrease in the cost of capital. If business does not use this capital to invest, it will find its way into some use because sitting idle it makes no return at all. We can speculate where this money may have ended up, and I speculate that over the past few years it ended up in places that include exposure to subprime mortgages and other consumer debt funded through securitization and commercial paper. If this is correct, then tax cuts to the wealthy do not in fact trickle down to the rest of the population through employment and income. Rather, they trickle down through debt, leaving the wealthy to accumulate more wealth and many of the not-so-wealthy wondering how they will make their next credit card payment.

The cost in revenue to the Federal Government of the Bush tax cuts is estimated to be approximately $1.7 trillion through 2011. This begs the question: what if those tax cuts went to the middle and lower income taxpayers who would be more likely to have spent it rather than invest it. On average, that would be like getting the current stimulus plan being rammed through Congress every year for ten years. Would Greenspan have felt it necessary to keep interest rates as low as he did after the 2001 recession? Would the economy have rebounded faster? Would we have had the real estate bubble without the historically low interest rates? We will never know the answers to these questions, but I think they are well worth asking.

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Why I Think We Will Have A Recession

Here is why I think we will have a recession. The graph above plots the Financial Obligations Ratio from the Board of Governors of the Federal Reserve. This ratio is an estimate of consumers' fixed payment obligations as a percent of their disposable income. Here is how the Board describes it:

The household debt service ratio (DSR) is an estimate of the ratio of debt payments to disposable personal income. Debt payments consist of the estimated required payments on outstanding mortgage and consumer debt.
The financial obligations ratio (FOR) adds automobile lease payments, rental payments on tenant-occupied property, homeowners' insurance, and property tax payments to the debt service ratio.

So this ratio tells us the estimated percentage of the average person's disposable income that is already committed to making these fixed payments. The rest of the disposable income goes to pay for everything else including food, clothing, energy, education, savings, and so on.

The wavy line is the FOR for the third quarter of each year and the dark straight line is the trend line. I think this graph says a lot about why I hear people talking about being "tight" and not having extra income to spend lately. Add rising food and energy prices and I think there is just less truly discretionary money in the average household. This is also why I think any stimulus should be focused on consumers.

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Where Should The Stimulus Go?

There is a lot of talk today about a stimulus package from the Federal Government to help counter the slowing economy. A lot of generalities were discussed during Fed Chairman Ben Bernanke's testimony before The House Budget Committee. You can read his prepared statement here.

Some pundits and politicians are arguing the stimulus should be focused on business with ideas such as accelerated depreciation. The thinking behind this is that it will stimulate businesses to acquire capital goods and the only cost to the government is the time value of money because businesses get the tax benefit now instead of over time. I haven't heard anyone yet limit such a plan to goods manufactured in the US, and without that this idea could be very watered down. That's also an issue with any of the other plans, however, but using a depreciation incentive to spur purchases of capital goods could be targeted toward domestic manufacturers as other plans may not be. Of course there are likely trade partner issues with any such limitations.

On the other end of the spectrum is giving to the poor. Expand the food stamp program and other help to the poor. The argument here is that these people will immediately spend the money and it will have the most immediate stimulative impact on the economy. If the stimulus is limited to tax breaks these people will see no help at all because they are not taxpayers to begin with.

Then there is tax relief for the investor class, otherwise known as the good old trickle down theory. According to this thinking, if we cut taxes on investing businesses will have access to capital and will invest thereby putting people to work and lifting all boats. Of course, if business in general is already sitting on large piles of capital then this plan would have no impact other than to add to the coffers of the wealthy.

Also under consideration is a tax break for the middle-class. The thinking here is that many people will spend it because times are tough, and so the stimulative impact will be relatively quick. An argument against this is that so many middle-class families are in so much debt that a large portion of such stimulus will go to paying down credit cards rather than new expenditures. This would help in the long run as consumers in too much debt can't consume, but there would be a delay in the impact. This plan could be attractive to the banks and credit card companies, so I think it has a pretty good chance of being at least part of any plan.

There are those who argue that this is the time to make the Bush tax cuts permanent. This just goes to show how extreme the position of this wing of the Republican party is. This would have zero impact until 2011, and is simply not relevant to the discussion of a stimulus plan. You can, however, count on those regular foot soldiers of the neocons who have gone a long way to destroying the fiscal health of our country to come out and tell us why this would be a good idea now.

As far as the Fed Chairman is concerned, he was non-committal on any particular stimulus package although he clearly warned that any plan that increased the structural fiscal deficit must be avoided, and government must address that issue sooner rather than later. He avoids recommending the solution to Congress, as he should, because he is not political (not supposed to be anyway) and this is clearly a political issue. What he does say is that the long term problem is simple arithmetic. What comes in must equal what goes out or at some point we have a crisis (and that point is within the next decade or two). In crafting a stimulus package:

As I have discussed on other occasions, the nation faces daunting long-run budget challenges associated with an aging population, rising health-care costs, and other factors. A fiscal program that increased the structural budget deficit would only make confronting those challenges more difficult.

I have a suggestion for Congress and the President. Since the years of following a policy of tax-cuts, borrow and spend have left us in the painfully foreseeable position of a pending fiscal crises, perhaps it is time to change course. As a place to begin, I suggest the research of Romer and Romer oft-cited by supporters of tax cut policies as evidence that their way is the best. What we do not hear about is the conclusion reached in that very same research report that a tax increase to repay an inherited deficit does not have a negative impact on economic growth. Just in case those tax cut pundits misplaced their copy, here is a link to it.

For tax increases to deal with an inherited budget deficit, the results are more interesting. The
point estimates imply that output does not fall at all following deficit-driven tax increases.

(From page 24)
If you would like a really good example of how the tax cut soldiers use this kind of report, here is a link to a recent Art Laffer report, as in the Laffer Curve. If you search this report for "Romer" you will find that he relies on it heavily. I cannot, however, find any reference in his report to an inherited deficit. I also love the title of his report: THE ONSLAUGHT FROM THE LEFT, PART I: FACT VS. FICTION. The true onslaught is a 28 year old attack on the poor and middle class from the right.

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Stagflation and Stupidity

The two things I heard from Ben Bernanke’s testimony before the Joint Economic Committee yesterday: stagflation and stupidity.

On stagflation:
Mr. Bernanke’s testimony started out OK:

“On preliminary estimates, real gross domestic product (GDP) grew at an average pace of nearly 4 percent over the second and third quarters despite the ongoing correction in the housing market. Core inflation has improved modestly, although recent increases in energy prices will likely lead overall inflation to rise for a time.”

OK, 4% GDP growth with a little inflation pressure, not bad. Sounds like there should be a neutral policy with maybe a slight bias toward a rate hike. Not so fast. There’s a bit of trouble afoot in the credit markets. The Chairman acknowledged that investors got a lot of the risk calculation wrong on many financial instruments. He said “At one time, most mortgages were originated and held by depository institutions. Today, however, mortgages are commonly bundled together into mortgage-backed securities or structured credit products, rated by credit-rating agencies, and then sold to investors. As mortgage losses have mounted, investors have questioned the reliability of credit ratings, especially those of structured products.” (I hope Senator Schumer was listening to the part about the rating agencies as that point was absent from his report on the subprime mess – see my commentary for more on that.) The impact of this has not yet run its course.

“To be sure, the recent developments may well lead to a healthier financial system in the medium to long term: Increased investor scrutiny of structured credit products is likely to lead ultimately to greater transparency in these products and to better differentiation among assets of varying quality. Investors have also become more cautious and are demanding greater compensation for bearing risk. In the short term, however, these events do imply a greater measure of financial restraint on economic growth as credit becomes more expensive and difficult to obtain.”

In other words, the credit market issues are only beginning to spill over into the broader market, and the “short term” impact will be slower economic growth. He later made some comments that would suggest his estimate of short term is the spring of 2008, but he did not have much conviction on that point.

The Chairman then went on to review FED actions over the past few months leading up to the October meeting, including the injection of excess reserves into the system and 50 basis point reduction of the discount rate in August, and the September 50 basis point cut in the federal funds rate and discount rate. Then came the reasoning behind the 25 basis point rate cut in October (which I thought was a mistake).

“Looking forward, however, the Committee did not see the recent growth performance as likely to be sustained in the near term. Financial conditions had improved somewhat after the September FOMC action, but the market for nonconforming mortgages remained significantly impaired, and survey information suggested that banks had tightened terms and standards for a range of credit products over recent months. In part because of the reduced availability of mortgage credit, the contraction in housing-related activity seemed likely to intensify. Indicators of overall consumer sentiment suggested that household spending would grow more slowly, a reading consistent with the expected effects of higher energy prices, tighter credit, and continuing weakness in housing. Most businesses appeared to enjoy relatively good access to credit, but heightened uncertainty about economic prospects could lead business spending to decelerate as well. Overall, the Committee expected that the growth of economic activity would slow noticeably in the fourth quarter from its third-quarter rate. Growth was seen as remaining sluggish during the first part of next year, then strengthening as the effects of tighter credit and the housing correction began to wane.”

So, in the committee’s judgment, there is downside risk to the economy and, in fact, every expectation that economic growth will be anemic for the next couple of quarters. In addition to the outlook, however, there is also downside risk that could make things worse. “One such risk was that financial market conditions would fail to improve or even worsen, causing credit conditions to become even more restrictive than expected. Another risk was that, in light of the problems in mortgage markets and the large inventories of unsold homes, house prices might weaken more than expected, which could further reduce consumers' willingness to spend and increase investors' concerns about mortgage credit.” This is recession speak in my view. If the expectation is already for weak economic growth, worse than that likely means contraction. So we see some real concern here about the economy from the FED leading up to the October rate cut. So absent inflation concerns, the accepted strategy would be a rate cut. Lets look at what he had to say about inflation.

“The Committee projected overall and core inflation to be in a range consistent with price stability next year. Supporting this view were modest improvements in core inflation over the course of the year, inflation expectations that appeared reasonably well anchored, and futures quotes suggesting that investors saw food and energy prices coming off their recent peaks next year. But the inflation outlook was also seen as subject to important upside risks. In particular, prices of crude oil and other commodities had increased sharply in recent weeks, and the foreign exchange value of the dollar had weakened. These factors were likely to increase overall inflation in the short run and, should inflation expectations become unmoored, had the potential to boost inflation in the longer run as well.” Sounds like there is some upside risk to inflation here as well, so maybe a rate cut is a bit risky? Here is what the Chairman said about it:

“Weighing its projections for growth and inflation, as well as the risks to those projections, the FOMC on October 31 reduced its target for the federal funds rate an additional 25 basis points, to 4-1/2 percent. In the Committee's judgment, the cumulative easing of policy over the past two months should help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and promote moderate growth over time. Nonetheless, the Committee recognized that risks remained to both of its statutory objectives of maximum employment and price stability. [emphasis added] All told, it was the judgment of the FOMC that, after its action on October 31, the stance of monetary policy roughly balanced the upside risks to inflation and the downside risks to growth.”

In other words, at the time of the rate cut there were risks that economic growth could slow significantly, and that inflation could become a problem. What has happened since the October 31 rate cut decision (only 8 days prior to the testimony)? According to the Chairman:

“In the days since the October FOMC meeting, the few data releases that have become available have continued to suggest that the overall economy remained resilient in recent months. However, financial market volatility and strains have persisted. Incoming information on the performance of mortgage-related assets has intensified investors' concerns about credit market developments and the implications of the downturn in the housing market for economic growth. In addition, further sharp increases in crude oil prices have put renewed upward pressure on inflation and may impose further restraint on economic activity. [emphasis added]”

There it is – stagflation. Slower economic growth AND inflation equals stagflation. Now, the Chairman did not say we are experiencing stagflation. If inflation does get worse, that could be because the economy continues to grow. If growth suffers, that could limit inflationary pressures. But both of those possible outcomes are now clouded by the specter of both slowing economic growth and inflation, or stagflation, because of rising oil prices plus the pressure on the dollar and its impact on prices of imported goods. The inflationary impact of the dollar decline is somewhat muted by our trade imbalance with China because the exchange rates of the currencies are manipulated, but I hate to count on that for economic security in the US. Ron Paul summed up the negative outlook by pointing out that so long as we inflate our way out of excess consumption the dollar will decline leading to inflation, and given the lose monetary policy of the recent past we are now without options to fight either inflation or slow economic growth unless we align consumption with output – i.e. recession. This is the Senators way of saying the credit binge must end somewhere, and it may just be here. That would mean that the FED is stuck between the proverbial rock and hard place. If it follows an expansionary policy of lower rates inflation could spiral up, and if it follows a contractionary policy to contain inflation it could depress an already shaky economy. What did Mr. Bernanke have to say about all of this?

“The FOMC will continue to carefully assess the implications for the outlook of the incoming economic data and financial market developments and will act as needed to foster price stability and sustainable economic growth.” Is it time to redefine “price stability” and “sustainable economic growth”? Maybe it is. For now we are “data dependent.”

On Stupidity:
Every now and again I here a stupid idea thrown about or I read a “report” to some congressional committee that makes no sense. I don’t mean an idea that just sounds different. I mean one that you hear with disbelief followed by a realization that you actually did hear what you thought you heard. You expect it once in a while, but when it comes directly from elected officials and their appointees, it takes on a whole different character.

Yesterday I witnessed an exchange between Senator Schumer and Ben Bernanke before the Joint Economic Committee of Congress. Senator Schumer pressed Mr. Bernanke on ways in which Congress could help the mortgage market, and whether increasing the caps on the size of mortgages that Fannie Mae and Freddie Mac can make (currently $417,000.00) would be helpful. Mr. Bernanke went on to say that the caps could be increased to $1 million per loan, and that to reduce the risk to Fannie Mae and Freddie Mac from this increased exposure, the federal government could guarantee those loans. That’s right, you read that correctly. The government sponsored entities set up to help expand affordable homeownership should be used as vehicles to make mortgages of up to $1,000,000.00, and your tax dollars should guarantee those mortgages. I almost broke the television set when I heard it. If you need verification, you can read about it in The WSJ Online Edition.
(I was going to forget about this whole exchange until it gained some validity through publication of this WSJ article.)

Lets start with the missions of Fannie Mae and Freddie Mac. First from Fannie: “Fannie Mae is a shareholder-owned company with a public mission. We exist to expand affordable housing and bring global capital to local communities in order to serve the U.S. housing market.


And here is Freddie Mac:

“Our mission strives to create:
· Stability: Freddie Mac's retained portfolio plays an important role in making sure there’s a stable supply of money for lenders to make the home loans new homebuyers need and an available supply of workforce housing in our communities.
· Affordability: Financing housing for low- and moderate-income families has been a key part of Freddie Mac’s business since we opened our doors. Freddie Mac’s vision is that families must be able both to afford to purchase a home and to keep that home.
· Opportunity: Freddie Mac makes sure there's a stable supply of money for lenders to make the loans new homebuyers need. This gives everyone better access to home financing, raising the roof on homeownership opportunity in America.”

In short, these entities exist to “expand affordable housing” by providing a “supply of money for lenders to make the home loans new homebuyers need and an available supply of workforce housing,” and “Financing housing for low-and moderate-income families” and “new homebuyers.”

Just what is “affordable housing?” Here is what The Department of Housing and Urban Development has to say about it: “The generally accepted definition of affordability is for a household to pay no more than 30 percent of its annual income on housing. Families who pay more than 30 percent of their income for housing are considered cost burdened and may have difficulty affording necessities such as food, clothing, transportation and medical care. An estimated 12 million renter and homeowner households now pay more then 50 percent of their annual incomes for housing, and a family with one full-time worker earning the minimum wage cannot afford the local fair-market rent for a two-bedroom apartment anywhere in the United States. The lack of affordable housing is a significant hardship for low-income households preventing them from meeting their other basic needs, such as nutrition and healthcare, or saving for their future and that of their families.”

Nope, doesn’t sound like a homebuyer with a $1 million mortgage to me.

What is “workforce housing”? According to Wikipidia, “Workforce housing is a relatively new term that is increasingly popular among planners, government administrators and housing activists, and is gaining cachet with home builders, developers and lenders. ‘Workforce housing’ can refer to almost any housing, but always refers to ‘affordable housing’.”
Nope, that doesn’t sound like a homebuyer with a $1 million mortgage either.

What are low- and moderate-incomes? Whatever they are, they are not applicable to the purchaser of a home with a mortgage of $1 million. I don’t even need to look that one up!

Mr. Bernanke is generally a very reasonable person in my view, although I disagree with FED action on occasion. In light of this, I decided to look up more about his position on Fannie and Freddie going outside the scope of their missions to provide mortgage financing for people purchasing homes in the $1 million range (actually with a mortgage of $1 million the purchase price could be as high as $1,250,000 at 80% loan-to-value). Here is what I found from a March 6, 2007 MSNBC report: “Federal Reserve Chairman Ben Bernanke urged Congress on Tuesday to bolster regulation of mortgage giants Fannie Mae and Freddie Mac, and suggested limiting their massive holdings to guard against any danger their debt poses to the overall economy.

“Bernanke has previously supported efforts to pare the two mortgage companies’ huge portfolios. This time, however, he was a bit more specific and recommended that their holdings might be linked to a ‘measurable public purpose, such as the promotion of affordable housing.’”

There is that phrase again – affordable housing. I wonder what caused Mr. Bernanke to do a complete about face on this issue between March and November from affordable housing only to non-conforming loans up to $1 million. I suppose if taxpayers guaranteed these $1 million loans they would not pose any additional danger to the overall economy (at least not immediately).

Now I must preface the balance of this piece with a thought about Senator Schumer. I always liked him and, it seems funny now, I have heard other people say the same thing about him. He is likeable. But since I started writing about issues of policy and economics, I have discovered that Senator Schumer shows up on the wrong side of many issues (that would be the side opposite mine). (I have written about such issues twice before here and here.) This is another good example because it appears Senator Schumer and Chairman Bernanke are concerned about the mortgage crises fall out on people with mortgages and homes valued at $1 million and more. This seems to be a little out of place given the current housing market crises impact on lower- and middle-income families. In addition to this incongruous line of thinking is the plainly stupid idea that the federal government should be guaranteeing mortgages in the $1 million range. Of course this leads me to the inevitable question – where do I apply!

I am against any taxpayer bailout of mortgagors who bit off more than they could chew. If you would like to read my opinion on this topic and my reasons for it you can see my post from October on that subject here. I am absolutely against any taxpayer guarantee of mortgages on non-conforming loans anywhere near the $1 million mark. In fact, I am dumbfounded by that entire exchange unless it was meant to soften us up for some other bailout proposal. At this moment in time, with two wars, a $9 trillion national debt, a falling dollar, inflation concerns, and tightening credit I believe there are much more important things to do with the credit of the American taxpayer than to put it behind purchases of $1 million homes. Focusing help on the wealthiest among us at a time when income distribution is coalescing at the top and raising taxes on high income is met with staunch criticism is indicative of a government that is completely out of touch. I am also concerned about the future unintended consequences that could result from this type of market manipulation and the distortions that it would create.

I am left hoping that Chairman Bernanke was not serious in his comments and/or Senator Schumer dismissed the concept out of hand. Unfortunately I have become a bit cynical in these times of mortgage meltdown and wealth transfers, and I fear there is a legislative proposal being prepared right now by one of Senator Schumer’s aids. I hope my fears prove unfounded.

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