[IWE] Galbraith's OpEd on what should be done about the Bailout.

[Ben Tilly]

On Thu, Sep 25, 2008 at 4:04 AM, D. Scott Katzer <dskatzer@os2bbs.com> wrote:
> A Bailout We Don't Need:
>
> http://www.washingtonpost.com/wp-dyn/content/article/2008/09/24/AR2008092403033_pf.html
>
> I like it.

NPR had a commentator who I think hit the nail on the head.  Wall St
loves the bailout, economists hate it.  If the bailout doesn't happen,
you can expect a DOW below 8000 by the end of next week.

I know some economics.  I used to work on Wall St.  What do I think?

Well I happen to understand why dramatic action is needed.  Galbraith
may be an economist, and had a famous father, but he's entirely wrong
on the magnitude of the problem.  The problem is not simply that these
are illiquid investments that may some day be worth money.  They are,
and he's right that banks are equipped to handle that.  The problem is
that these are illiquid investments that may some day be worth money
that the market doubts have value.

Why should it matter that the market doubts they have value?  Well,
several reasons.  The first, and most important one, is that there are
a *lot* of companies that tie up money in long-term investments then
borrow short term to meet immediate cash flow needs.  This list starts
with more banks than you can shake a stick at.  If they can't supply
their immediate needs, then they go bankrupt no matter what their
long-term investments are.  But right now when they go asking for
short term cash, people won't loan it out of fear, and they are forced
to go under.  As more go under, the fear increases, and money becomes
ever harder to borrow for institutions.  Their operating costs don't
change though.  And so they go under.  With enough of this we'll get
runs on other banks.  (Contrary to Galbraith's assertion, people can
go for a run on the bank even though they know they will get their
money back eventually.  The fear driving that is that you might not be
able to pay your bills while you're waiting for your money.)

The second reason is regulatory.  (You wouldn't think from the news
that we have any kind of regulations, but we still do.)  Banks are
required by law to maintain a certain amount of equity to guarantee
solvency.  Equity includes this kind of bond.  However when these
bonds go down in market value, banks have to mark down the value on
their books, and then have to reduce their lending.  The lending they
can most easily reduce is their large short-term loans to
institutional investors, leading to a lack of banks that are willing
to lend.  Increasing the value of these securities solves that
problem.

The third reason is that money is being destroyed incredibly fast
right now.  Money is generated in many ways, but a lot of it is
through financial swaps and credit.  Now those transactions are
unwinding fast, and money is disappearing.  People are mostly aware of
this because their retirement portfolios and the cost of their houses
are shrinking, but it will have longer reaching implications than that
for a long time to come.

Also there is a real deadline here, and that deadline is Christmas.
When I say Christmas I don't mean that something needs to be done by
Christmas, I mean *for* Christmas.  The problem is that many, many
companies (for instance most of the retail sector) earn the bulk of
their money around Christmas.  If you add a bad Christmas on top of
everything else,that's where a real prospect of mass company failures
and mass layoffs could become reality next year.  Which, of course,
would feed back into the credit crisis in a really big way.

This is all common knowledge on Wall St where people live this
process.  Economists who don't specifically study the credit markets
(eg Galbraith) often lack the background to truly appreciate the power
of these mechanisms, or the power of what is happening.

So action is important, and action needs to happen now.  The problem
is that the way the proposed bailout is structured is the worst
possible way to do this.  It gives too much power to Paulson.  It is
guaranteed to upset the country.  Personally I would prefer to do the
bailout by introducing a program to evaluate what people can pay into
their mortgages and then covering the rest from government funds.
This would help keep people in houses, it would cause securities
backed by those loans to be re-evaluated upwards in price.  It would
increase house values.  Plus it wouldn't give too much control to any
one person (Paulson).

> Did anyone watch Bush's speech?  I missed it and honestly have no interest
> in even reading the transcript.

I heard it.  It was a reasonable summary of the facts.  I suspect it
would go over the heads of people who don't understand the subject
already though.  Which is, unfortunately, most of the country.

Ben