Tuesday, March 24, 2009
The Devil Is In The Definitions
If you think the problem is low house prices and a poor economy, then of course the Geithner plan is doomed to make the problem worse.
Obviously the Geithner plan constitutes a massive taxpayer subsidy given to a few large institutions (less than 30) about which there are genuine fears of failure. No one can honestly dispute that. But look at what one of the defenders of the plan has to say about it:
The basic plan, as has been well-rehearsed by now, is for the government to provide generous loans to private investors for buying the banks' depressed, mortgage-related assets.So this subsidy (which is hidden) will be succeeded by a yet larger subsidy? That doesn't sound like much of a confidence-builder to me.
The banks will want to unload their bad, mortgage-related assets even if they have to sell them at a discount relative to where they currently value them. The banks will do this, assuming the discount isn't too great, because hanging onto the assets is creating uncertainty about the amount of capital they have, and the uncertainty is discouraging them from making loans. (Better to take a small, certain loss and be done with it than to keep facing the prospect of a very large loss later on.) Of course, this will still leave the banks undercapitalized. But, without the prospect of large future losses hanging over them (which the Treasury program will have eliminated), private investors might be more willing to provide banks with capital. More plausibly, having demonstrated to American taxpayers that it can manage something tricky like getting the bad assets off the banks' books, Treasury will find it easier to get more money from Congress to recapitalize them.
The link between the fate of this large institutions and the economy is asserted to be a decline in lending, which causes lower spending and lower monetary velocity throughout the economy. But will buying bad assets at inflated prices restore lending to previous levels? The answer is that of course it won't, and if you pin any halfway sane economist down, they concede that it won't. The reason why banks pulled back on lending is that there had been too much lending, and poorly underwritten loans were defaulting, which led to the bad debt securitizations.
The only way to keep from writing new bad debt is to tighten lending standards. Further, the public at a whole has a much higher level of absolute debt in comparison to incomes and assets than it did in 2000, so new creditworthy borrowers are harder to come by. This means that lending can't even return to the norms of the late 1990s or early 2000s, because of this:
Note that household absolute debt levels about doubled from early 2000 to the middle of 2008. That is an impressive accomplishment of sorts that we cannot repeat. This debt was accumulated on cars, RVs, boats, credit cards, and homes (and a lot of auto, boat and CC debt was moved into home debt). In more detail:
The problem of expanded household debt is somewhat exacerbated by the declining employment/population ratios. First, for perspective, the long series:
Note that the movement of the baby boomers into prime working years, plus the movement of women into the workforce jacked workforce participation rates up to remarkable highs in the 1990s. This cannot be repeated even if the economy were booming, because the boomers are aging rapidly. Demographics alone ensure that workforce participation rates will continue to drop for a time. Detail:
And there's one more little piece to this puzzle - the development of the US current account deficit (trade deficit) over the last 15 years:
This means that we are earning less and borrowing more not just as individuals, or households, but as a nation.
One potential strategy proposed to deal with high debt loads is to deliberately induce inflation, which reduces debt in relationship to incomes. That was the goal of the first part of the Geithner plan, which involved having the Treasury create money and buy US Treasuries and other debt. And it succeeded instantly. The price of oil has risen over 10%, for example.
However, this strategy cannot work for the US for two reasons. First, it is inflationary, and although existing debt will be deflated in relationship to incomes, existing incomes will be deflated by the higher cost of imports. Thus, the US will experience lower incomes from demographics even as the real debt burden deflates. Declining incomes don't help in conjunction with declining debt - it is the ratio that's important.
Second, demographics have produced a situation in which we owe a big debt to our own citizens in the form of retirement benefits. If we cut those benefits, we cut their incomes. If we maintain those benefits, we rapidly ratchet up our debt to our citizens even as our household debt declines. An inflated currency buys less of external goods, and we are importing massive amounts of consumer goods and energy. Therefore the US does not have the option to inflate our currency to escape our debt. You can do that to escape internal debt, but not to escape external debt when you are a substantial net importer.
Third, most of US economic activity at this point stems from the consumer service economy, which is a derivative of private real incomes. Since private real incomes will be deflated by higher import costs of clothing, shoes, medicine, chemicals and petroleum, to name a few, the consumer segment of the economy will continue to decline.
There is only one economic way out for the US, and that is to boost production on a broad scale. We need to produce more energy (but it must be at a price to keep our manufacturers competitive in the global economy), but we also need to produce more of many goods for export or domestic sale. And this will happen regardless of what we plan to do, because inflating our dollar will literally prevent the US population from being able to buy as much goods from the world at large.
If the current administration inflates energy prices by taxes (carbon cap and trade) or by restricting production, the US population will just end up being able to buy less goods overall due to diversion of their incomes to the basics of living.
In short, the jig is up. All this BS about education is nonsense. Spending more on education won't help the economy at all - it will hurt it. We need to produce goods. To the extent we don't jack up production, consumption will continue to fall over time.
There are two interviews with Galbraith available at these links. Essentially he says the same thing I have been writing - that the problem is not that the banks can't lend, but that borrowers have borrowed too much.
In effect, Joy's question about using stimulus money simply to pay off consumer debt comes a lot closer to redressing the immediate economic problem than any of the Obama administration's moves so far. It would tend to shunt money back to banks, it would jack up real incomes, and it would boost consumer spending somewhat.
As a result of the recent Treasury moves, US structural inflation is now at about 7% for the next year. That is the minimum figure I could come up with. It may well be more. So that cuts US real incomes, which is hardly the recipe for escaping a recession. Recessions end when real incomes rebound, because even though 5 percent of the people may have lost jobs, the percentage of those still working is much higher overall. As the working majority cuts debt and increases savings, plus sees easing in price pressures, their incomes rebound.
If you deliberately inflate, you can induce temporary asset price increases, but real incomes deflate, so after a few years you are left with a net negative. That's pretty much how the series of three recessions in the 70s and early 80s was produced, and Volcker ended the bleeding by stopping the inflation.
The immediate effect of Treasury's deliberate devaluation of the dollar was to raise the cost of oil-based energy about 15%, and it will go higher. The increase in home sales and retail sales in January and February was entirely produced by declines in energy and energy-produced costs for the consumer, and Treasury just reversed that trend.
The bozos in Washington saying "We need to get banks lending again" have obviously never run a business that requires a banking realtionship. Banks lend, it's how they make money. But, they evaluate the borrower's financial situation via a balance sheet and credit rating (among other factors). If there is no "margin of safety", there is no loan made.
At least that's how banks in the typical sense of the word work.
Links to this post: