Posted on 03/16/2008 4:08:04 AM PDT by TigerLikesRooster
Financial system must tap the taxpayer
By Krishna Guha
Published: March 14 2008 19:00 | Last updated: March 14 2008 19:00
The notion that the US could suffer the kind of deep and protracted recession that plagued Japan in the 1990s no longer looks as far-fetched as it did a month or two ago.
House prices are in free-fall, spreading losses through the universe of mortgage-backed securities and making it very difficult for financial markets to stabilise. The labour market is cracking, with three consecutive months of job losses in the private sector. Consumer sentiment has soured and spending is faltering.
Financial markets have taken another lurch downward – triggering emergency responses, including Thursday’s rescue of Bear Stearns, the Federal Reserve’s $436bn liquidity support package and proposals in Congress for $300bn in housing loan guarantees.
A “financial accelerator” is taking hold as banks react to losses and falls in the value of collateral backing loans by pulling back on their capital at risk, intensifying the credit crunch and aggravating the economic downturn. The pull-back in credit lines is transmitting distress from the banking sector to hedge funds – which are being forced to reduce leverage and sell assets into markets at firesale prices to meet margin calls in a classic case of financial contagion. As hedge funds cut leverage they are amplifying the effect of the contraction in bank balance sheets on the economy. This “great unwinding” is putting enormous stress on the financial system, including the market for mortgages guaranteed by Fannie Mae and Freddie Mac. Mortgage rates are much higher now than they were when the Fed resorted to emergency interest rate cuts in January.
The Fed cannot halt this negative spiral through monetary policy, even if it can mitigate its severity. Interest rate cuts have been largely offset by the rise in risk spreads. And there are limits to how much further rates can be cut amid concerns about inflation.
The good news is that as long as inflation pressures remain, the US cannot get stuck in an outright debt-deflation trap as Japan did in the 1990s. Indeed, the more inflation, the less nominal house prices will have to fall to deliver a required change in real house prices. But asset prices could still fall far enough to generate a vicious contraction in credit – at a time when wealth is declining and inflation is eating away at real income growth. That could be a recipe for a severe contraction in demand.
Moreover, the US has structural vulnerabilities that Japan did not have: low household savings, untested derivative markets, and a large current account deficit.
What needs to be done? There is no silver bullet. Whatever happens, house prices will have to fall further to reach a fundamental equilibrium. But the key challenge now is to stop the financial accelerator in its tracks. That means one thing above all: additional capital for the financial system to stop the process of balance sheet contraction. That capital can come from one of two places – the private sector or the public sector.
By far the best solution would be for banks and Fannie Mae and Freddie Mac to raise large amounts of new private capital quickly – allowing them to treat estimated losses as sunk costs and start expanding their balance sheets again. There is more than enough private capital (and foreign sovereign capital) available. But there may be a conflict between the private interest of the banks and the public interest in continued credit expansion.
Many financial sector executives apparently believe that likely losses are greatly exaggerated by mark-to-market accounting in dysfunctional markets. Meanwhile, their cost of capital is very expensive. It may be in their shareholders’ interest to hunker down, preserve capital and ride out the storm rather than raise expensive new capital to provide additional cover for losses that may never fully materialise.
If this is the case, the new capital will have to come from somewhere else: the public sector and ultimately the taxpayer, as the International Monetary Fund pointed out this week. The public sector could provide capital to the private financial system – for instance, by purchasing preference shares on terms more favourable than those available in the market. Or it could deploy its own balance sheet directly: intervening either in the mortgage securities market or the housing market itself.
This could be done through the Fed (which took a half-step in this direction by offering to swap $200bn of mortgage securities for Treasuries) or the government, either on balance sheet or through a special purpose vehicle. There would be severe costs either way. Public money for the banks would bail out existing shareholders. Direct intervention would require the public sector to set a price for mortgage securities and/or houses themselves. Either would foster moral hazard and expose the taxpayer to large potential losses.
But the costs of not providing public funds could be greater. Japan showed that incremental policy initiatives may not work. Rising inflation risk signals the dangers of addressing the problem through ever greater macroeconomic stimulus rather than – albeit large-scale – microeconomic intervention.
For those who oppose the use of public money, time is running out to prove that the private sector can recapitalise and calm the credit crunch without taxpayer funds – the best solution. Meanwhile, advocates of public intervention must determine how much money is needed and how to employ it to greatest effect.
Ping!
why not just cut the corporate tax rate, make the bush tax cuts permanent (the market assumes they will go back up soon) and announce our money will be as good as gold?
And, by golly, just when the axe is about to fall we will all get a chance to elect one of the two socialists running for president who understand what has to be done to fix the economy.
With Obama's 20% tax increase and Hillary's socialized heath care, the economy will be humming again in no time.
Thank God this article came out before November.
BTTT ... READ AGAIN
living in the peoples’ republic of NJ....
1) increase of property taxes - no more homeowners rebates
2) increase of state sales tax
3) increase in gas and food prices
vote lib/dem
1) increase fed taxes
2) increase in health care costs
3) increase in social security rates
4) re-distribution of wealth to those that don’t pay taxes
Happy times are coming soon!!!!
How nice. An article arguing for yet another taxpayer funded bailout of private banks and financial companies. Isn’t it interesting how this works? If the mega-banks and Wall Street financiers win on risky investments, they get to keep the profits. But if those same risky investments lose, the Fed and the taxpayers can be relied upon to bail them out. How do I sign up for this deal? All the upside risk of investments, but none of the downside risk.
For comparison sake, we spend about $25 billion a year on AFDC in this country. Just last week, the Fed provided liquidity subsidies to the tune of $200 billion to the mega-banks and Wall Street financiers. And they went through it like it was a small appetizer. I guess the *real* taxpayer funded porkfest is on it’s way.
Talk about welfare queens!
As if there was any question whether socialism is rearing it's ugly head.
It has been that way for a long time. Time to carefully redefine what it means to be "private finance."
Whenever I look at this stuff, I’m reminded of the “crony capitalism” that existed in the Marcos-era Phillipines.
That is what Marcos couple did when Marcos was elected last time right before he is booted out of Philippines.:-)
Imagine Hillary and Bill sing old "hippie" song together after Hillary wins. Puke!
Didn’t the Democrats just vote to NOT extend the Bush tax cuts?
Hand the bill to our grandchildren.
This is so immoral.
This almost HAS to happen. For years the Democrats have taken and been given full credit for what Republican administrations have created. (Reagan/Bush II) A 20 year economic boom.
This time however, the Democrat doctrine of overtaxing will show immediate results on the economy. Besides the fact that this is the cause for economic decline, the American people need to learn a lesson they will never forget. For once in most or their young lives, they are about to learn what it means to live with less, to work for what they earn, not have it provided.
Let the Democrats make fools of themselves, they certainly will try to redistribute the wealth, but that always fails. At first they will try to blame Bush for the economic crash they will create, but the MSM will also feel the crunch and reach fewer people to indoctrinate. The blame will be squarely placed on the backs of the Leftist/Socialist Democrats. Carter tried to blame Ford for his mess, and a much more powerful and influential media tried to cover for him, but even that did not work. The Democrats took full blame for it. That brought us Reagan and 2 Bush’s.
If McCain wins, the economy will go sour anyway, probably faster because he will spend more on the foreign war effort and The GOP will become even more hated than they are now. On the other hand, the Democrats will pull the troops out, (out of harms way included) putting 100 billion a year back into domestic issues, slowing the decline initially. But the long term damage will accelerate the decline exponentially.
The writing is on the wall. In the mean time, I will not buy anything on credit, (I already don’t) I will not live beyond my means of support, and I will save my surplus money for future emergencies as well as invest in solid securities. (Much like I rode out the Carter years) And, we will survive, while the Liberals, who build their houses out of straw and cards, will look at Conservatives doing just fine in their houses of brick. The example will be clear as will the solution.
If we lose this election, (And probably will.) that means we actually win in the long run, but only if we rebuild the party from the ground up and don’t settle for just any idiot the RNC forces down out throats.
Another Reagan is out there, Conservatives just need to find him/her and not let the party be pushed further to the left. This is really our opportunity to get this party and this country back on track. It sometimes takes short term pain to enjoy long term gain.
Don’t you know that the Democraps are happy as clams that the economy collapse under a Republican administration, and will continue to threaten future tax increases (just on the wealthy of course), as irresponsible as that policy is in the face of recession/depression. Another proof of the vile evil animating this party to do us in.
however most of the problem is the result of the weak dollar and Bush is responsible for that.
If we don’t want to drill for our own oil, we shouldn’t bitch when the ragheads raise their prices.
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