Ali’s blog

Mostly quant stuff with occasional digressions

The bailout will fail

Posted by alifinmath on October 6, 2008

I’m a great fan of Paul Craig Roberts and wait avidly for every new piece he writes at vdare.com. This is his latest, and with so much else that he writes, deserves to be mulled over:

… However, without the Soviet Union as a check on neoconservative ambition, the neoconservatives launched America on an unrealistic path of world hegemony. The economic restoration that Reagan achieved was not shored up by his successors. Instead, they used the Reagan restoration to run the American economy into the ground in ways that benefitted the super rich and the military-security complex. Some of America’s best jobs were offshored in order to boost share prices and executive compensation, and the financial sector was recklessly deregulated.

The Paulson bailout saves his firm, Goldman Sachs. The Paulson bailout transfers the troubled financial instruments that the financial sector created from the books of the financial sector to the books of the taxpayers at the US Treasury.

This is all the bailout does. It rescues the guilty.

The Paulson bailout does not address the problem, which is the defaulting home mortgages.

The defaults will continue, because the economy is sinking into recession. Homeowners are losing their jobs, and homeowners are being hit with rising mortgage payments resulting from adjustable rate mortgages and escalator interest rate clauses in their mortgages that make homeowners unable to service their debt.

Shifting the troubled assets from the financial sectors’ books to the taxpayers’ books absolves the people who caused the problem from responsibility. As the economy declines and mortgage default rates rise, the US Treasury and the American taxpayers could end up with a $700 billion loss.

If the $700 billion bailout is based on an estimate of the current amount of bad mortgages, as the recession deepens and Americans lose their jobs, the default rate will rise. The $700 billion might not suffice. The Treasury will have to go hat in hand to its foreign creditors for more loans.

As the US Treasury has not got $7 dollars, much less $700 billion, it must borrow the bailout money from foreign creditors, already overloaded with US paper. At what point do America’s foreign bankers decide that the additions to US debt exceed what can be repaid?

This question was ignored by the bailout. There were no hearings. No one consulted China, America’s principal banker, or the Japanese, or the OPEC sovereign wealth funds, or Europe.

Does the world have a blank check for America’s mistakes?

This is the same world that is faced with American demands that countries support with money and lives America’s quest for world hegemony. Europeans are dying in Afghanistan for American hegemony. Do Europeans want their banks, which hold US dollars as their reserves, to fail so that Paulson can bail out his company and his friends?

The US dollar is the world’s reserve currency. It comprises the reserves of foreign central banks. Bush’s wars and economic policies are destroying the basis of the US dollar as reserve currency. The day the dollar loses its reserve currency role, the US government cannot pay its bills in its own currency. The result will be a dramatic reduction in US living standards.

Currently Treasuries are boosted by the habitual “flight to quality,” but as Treasury debt deepens, will investors still see quality? At what point do America’s foreign creditors cease to lend? That is the point at which American power ends. It might be close at hand.

The Paulson bailout is predicated on cleaning up financial institutions’ balance sheets and restoring the flow of credit. The assumption is that once lending resumes, the economy will pick up.

This assumption is problematic. The expansion of consumer debt, which kept the economy going in the 21st century, has reached its limit. There are no more credit cards to max out, and no more home equity to refinance and spend. The Paulson bailout might restore trust among financial institutions and enable them to lend to one another, but it doesn’t provide a jolt to consumer demand.

Moreover, there may be more shoes to drop. Credit card debt could be the next to threaten balance sheets of financial institutions. Apparently, credit card debt has been securitized and sold as well, and not all of the debt is good. In addition, the leasing programs of the car manufacturers have turned sour. As a result of high gasoline prices and absence of growth in take-home pay, the residual values of big trucks and SUVs are less than the leasing programs estimated them to be, thus creating more financial problems. Car manufacturers are canceling their leasing programs, and this will further cut into sales.

According to statistician John Williams who measures inflation, unemployment, and GDP according to the methodology used prior to the Clinton regime’s corruption of these measures, the US unemployment rate is currently at 14.7% and the inflation rate is 13.2%. Consequently, real US GDP growth in the 21st century has been negative. [The Clinton regime (and the Boskin Commission) rigged the CPI in order to cheat retirees out of their Social Security cost of living adjustments and ceased to count discouraged workers who cannot find a job as unemployed. To be counted as unemployed, a person has to be actively seeking a job.]

This is not a picture of an economy that a bailout of financial institution balance sheets will revive. As the Paulson bailout does not address the mortgage problem per se, defaults and foreclosures are likely to rise, thus undermining the Treasury’s estimate that 90% of the mortgages backing the troubled instruments are good.

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One Response to “The bailout will fail”

  1. Luke Lea said

    Just discovered your blog, Ali, whoever you are. It is quite good, really good actually, and I plan to read through your archives. Meanwhile, a word of optimism in the quise of pessimism: the huge rip-offs going on now (you know this I am sure) are nothing new. Before this it was the Internet bubble (Enron, Global-what’s its name, etc) and before that the S&L scandals ($130 billion stolen, half in Texas) and so on back through history: drug cartels, the Gulag, slavery, opium wars, Peruvian silver mines, child labor, the South Sea bubble, you name it. Capital is stored servitude: the accumulated crime and sacrifice of centuries, plus interest. (The interest part is important, btw; don’t underestimate it). So where is the silver lining?

    Modern civilization may be built on a foundation of inhumanity and exploitation, but that is all the more reason to tax the rich to benefit the poor and those in the middle. Markets are good, efficiency is good, incentives are good, entrepreneurs are good — but still there is every reason to tax the rich and subsidize the poor. The only question is how? A progressive income tax won’t work because it destroys incentives. Welfare won’t work because it destroys incentives. A flat tax won’t work because it is not progressive. What’s left?

    Irving Fisher, Milton Friedman, Keynes, even Senators Domenici and Nunn knew the answer: a progressive consumption tax, made possible by computers and our modern international banking system. See my BornAgainDemocrats.com website for a brief sketch of how it would work. It is ambitious, I know, if for no other reason than because it would require the active cooperation of all our major allies. But these are ambitious times.

    best,

    Luke Lea

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