Here is the problem in a nutshell: our economic well-being depends crucially on the provision of finance for all sorts of useful purposes—to move goods, launch new enterprises, retool old ones, pay college tuition, buy things like houses and cars that would otherwise take decades of savings. Most of the financial system is privately owned and operated for profit. The profit paradigm of the past generation was based on a systematic bias toward risk, a bias built into all limited liability institutions but compounded by deregulation and hubris. Now the system is reeling under the weight of trillions of dollars in losses. This has led to a seizing up of credit supply and has turned a typical recession into a potential economic abyss.
In the spirit of London Banker, let’s keep our eye on the ball. The financial losses incurred by banks, hedge funds, insurance companies and those who invested in them are their problem. The breakdown of the financial system is our problem. The bailout solutions being pushed in the US and elsewhere are based on the premise that we have to solve their problem first in order to deal with our own. Throw enough money at the financial sector, turn their red ink to black, and some day they will be willing to lend to the rest of us.
How to begin with what’s wrong with this?
1. This is a program for a systematic looting of the public. The 90+% of us who never enjoyed the profit bonanza of the last 20 years are going to pay through the teeth so that the rich get to stay rich. This is perfectly clear in the case of AIG, for instance. We hear about a $150B “investment” of public funds into this company, as if the money were going to, oh, upgrade their computer networks. The word is dishonest: this very large sum, which could do a lot of good things if spent intelligently, is going right through AIG to those it sold credit default insurance (asset swaps) to. Institutions leveraged themselves to the max in order to rake in profits by investing in high-risk, high-return mortgage-backed securities, insuring themselves against default risk by buying CDO’s from a company (AIG) that never had the capacity or intent to actually follow through if defaults became widespread. Seen in its entirety, the process was a scam. Now extraordinary amounts of public money are being transferred to the jilted investors who bought this insurance. We will never see this money again. The value of our public “investment”—80% of AIG’s ultimate capitalization—will be a few percent of what we have paid in, if the firm even survives.
2. By solving the problem of the financial institutions first, the bailout is making our problem worse. It isn’t just a question of banks who get public cash infusions not lending enough, although this is important. Finance that ought to be supporting the real economy is being diverted to the bailout. This sentence is in italics so you will read it two or three times. It is very, very, very important. You can see this in the Fed’s decision to pay competitive interest rates to attract excess bank reserves, which now amount to more than $400B. This is money that, in normal times, would amplify itself through the money multiplier and find its way to borrowers in the real economy. Now it finances the Fed’s acquisition of troubled assets at far above their market value—in other words, bailouts of private investors. Similarly, the Treasury has been selling hundreds of billions of dollars in new issues to finance the bailout, and much of the money it is sopping up would otherwise be available for normal lending.
2a. The corollary is that the world economy is sinking fast and deep. This will mean great hardship, especially in less developed countries were the margin between prosperity and penury is all too thin. It also means that the epicenter of financial crisis will shift toward sectors now being decimated by the downturn, particularly consumer credit and corporate debt. (A side note: this is the real fear about GM. Honda and Toyota can make our cars as energy-efficient as technology allows, and they can do this in their US plants. If GM is allowed to go belly up, however, it could trigger a run on a wide range of corporate debt.) Hence the bailouts, by soaking up credit and bleeding the economy, are adding to the losses that they seek to defray.
3. The resources available for these bailouts are not endless. You wouldn’t know this by following the discussion in the media. Commentators do complain about how expensive it all is, but there is no sense that a limit exists, and that we are at risk of reaching it before the financial system is repaired. But this is exactly what makes people close to the situation very nervous. The rest of the world is buying vast amounts of treasuries. The Fed takes this money and hands it to investors facing losses, receiving in return paper assets that might have value, maybe, sometime well into the future. If those holding treasuries should change their mind, this process cannot be run in reverse. The Fed is in no position to sell its damaged portfolio in order to buy back even a fraction of the huge overhang in public debt. Monetization—settling claims by simply creating new bank reserves—is not an option, because it would almost certainly trigger a run on the dollar, a threat for which no institutional antidote currently exists. What this all means is that the bailout strategy puts us in a race: will we reach our financial limit before the losses that paralyze the system are erased? It is extraordinary to me that this question is not being asked in public.
If these arguments are correct, the bailout agenda needs to be challenged. We are following a course of action that is indefensible from a social justice perspective and at best extremely risky on its own terms. An alternative exists: rapidly putting into place a public system that can make available the finance needed by the real economy. This would mean allowing a large swath of existing wealth-holders to be ruined. Such an option would be unthinkable to those who inhabit the existing world of finance: for them, repairing the system means first of all restoring the profits of investors. There is also a bit of class interest at stake, I would guess. For these reasons, it would take a mighty movement to change the way governments are responding to the financial crisis. I don't know where this will come from, but for starters it would be nice to see some real live public debate.