Government Solution: Re-Inflate the Bubble

The end of the recession will not come until the housing market has reached its bottom. The government knows this. Home starts are down. Foreclosures are up. Homes prices continue to fall.

Austrian schoolers warned that the housing bubble would burst, driving the country into a deep recession. They warned that the government had used artificially low interest rates, bank regulations like the Community Reinvestment Act, promotion of moral hazard through FDIC and Fannie/Freddie, and a general movement to expand housing to push up housing prices and ownership rates.

The bubble burst. The recession came.

What is the government solution? Simple. Re-Inflate the bubble.

Post-burst, the government launched what essentially amounted to a smear campaign against banks and other financial institutions. They accused them of being too greedy at the expense of the American citizen. They decried risky lending policies of the banks that brought us here. However, the government encouraged those risky lending policies. This is an entirely different topic, which I've addressed before here and in other mediums. Please see my review of Tom Woods' Meltdown in the new issue of YAR or, better yet, read Meltdown.

But, that is in the past.

It is a good idea to compare government rhetoric and government policy. Government said that lending was too speculative and dangerous. This was far too widespread because of lack of regulation and this caused the market to inflate and burst. Banks are absolutely leveled. Many of them got to the point of bankruptcy and were bought out or bailed out. How do banks respond? Why, naturally of course. They cut lending. This is the prudent thing to do, given that the future of the economy is/was unstable at the very best.

The government, the very same that lectured banks for not being prudent enough, is now doing everything in their power to get banks to lend against their better judgement. They have tried various avenues to accomplish this (primarily TARP). The general strategy is to throw money at them and hope that they lend it out.

Why is the government doing this? For many reasons. However, primary among them is the need to re-inflate the housing bubble, artificially stopping the slide to "save" the economy and end the recession.

This is from a WSJ article on Thursday April 16:

"Builders said sales have been improving in recent weeks due to low mortgage rates and U.S. government efforts to spur purchases by first-time buyers, such as an $8,000 tax credit. However, an indicator of future building resumed falling, according to Thursday's report"

The government is trying desperately to reinflate the housing bubble. The Fed has cut interest rates to zero. The government is throwing hundreds of billions of dollars at banks so that they continue mortgage lending, often to first time buyers (generally less qualified to buy). They are offering gigantic tax cuts to home buyers. They are slashing mortgage rates for homeowners so that less houses enter foreclosure (keeping them out of the market, thus keeping prices high). They know that, if they can push housing back up again, the recession is over.

It hasn't worked yet. However, it might. It might work in that the re-inflated bubble could work for a short time. But bubbles must burst. Prolonging the market correction by reinflating the bubble will only postpone the suffering at very best. The government originally inflated the housing bubble when the tech bubble burst. This postponed the pain of the tech burst, but created the housing monster, which eventually burst. What will happen this time if the government can reinflate the bubble? How badly will the next burst be?

Are We Done Yet? (sans Ice Cube)

After I presented my policy in class on Wednesday, I was met with an interesting question from Mitch. He asked (excuse me for paraphrasing) that, given the fact that the economy is already on the way back up, musn't I conclude that the New Keynesian policies have worked?

To my dismay, I didn't have time to give a full answer. I merely said that, if he were right, perhaps Austrian schoolers would need to rethink many of their objections to Keynesianism. However, that is a big, big if.

There are a series of indicators, both positive and negative, as to the health of our economy.



The positives:
-Q1 profits for firms like Goldman Sachs and Wells Fargo have been stellar. Wells Fargo posted what I believe was their biggest first quarter profit in history, $3 billion.
-The stock market has seemingly leveled out. After months of free fall, the Dow seems to have bottomed out. It has been hovering between 7500-8200 for a few weeks now, rallying for a few days and then taking another dive.
-Builders have marginally renewed confidence.
-New jobless claims fell for the week ending on April 11. This number fell 53,000 to 610,000. This is considered to be a good indicator of recessions' ends

The negatives:
-Unemployment is still on the rise. Unemployment was 8.5% in March and will likely rise again in April. New jobless claims have been volatile. This sharp decrease could have reflected seasonal hiring for a late easter.
-Building permits fell 9.0% for March. They had risen 6.4% for February and were expected to only decrease by 2.5%.
-Retail sales were expected to increase by 0.3% in March. However, they fell 1.1%. Consumer confidence is still low.
-Credit fell as business lending dropped 24 percent at 21 banks that have received more than $211 billion from the government. Auto and student loans have also fell. The only thing that hasn't fallen is mortgage lending.
-Foreclosure filings spiked by 17 percent from February to March. This exacerbates the fear that banks will dump the foreclosed houses on the market, drastically lowering home prices.

So, allow me news a little. Profits from Wells Fargo and Goldman Sachs are encouraging indeed. Hto dissect this owever, these companies were relatively stable before they received bailout money. With the government funds they received plus their already solvent and profitable business, profits were expected (however, not this high). The only real indicator of the recession's end has been the drop in new jobless claims. Economists rely on this data to predict the end of recessions. However, these claims are volatile. They likely reflect both the later Easter and an unwinding of pronounced layoffs in the automobile sector. The housing data is much less promising. February was a fantastic month of statistics for housing. Housing starts were up. Foreclosures weren't too bad. However, foreclosures spiked massively in March. People still aren't buying retail goods. Banks still won't lend to businesses, students, or families. And unemployment is still on the rise.

Recession over?

Not yet, Mitch.

Global Stimulus Rejected

Barack Obama, on a whirlwind rockstar tour around Europe, participated in the G20 conference with the goal of global stimulus. He failed to acheive this goal.

This article provides a good summary of what happened at the G20 meetings:http://www.guardian.co.uk/commentisfree/cifamerica/2009/apr/06/g20-us-economy-obama

However, I shouldn't sell Obama too short. A trillion dollars was pledged to the IMF, mostly to benefit the poorest countries that are suffering through this worldwide recession. However, Obama and US Prime Minister Gordon Brown had been calling for more far-reaching solutions to handle this recession.

Spanish finance minister Pedro Solbes spoke out a few days earlier on a similar package from Gordon Brown:

"In these conditions I and the rest of my colleagues from the eurozone believe there is no room for new fiscal stimulus plans"

German chancellor Angela Merkey had similar sentiments:

"I will not let anyone tell me that we must spend more money"

When numerous European countries sees your policies as too socialist, you're probably pushing it, Obama. lolzjk.

Timothy Geithner pushed for AIG bonuses

Timothy Geithner has done it yet again. First, we found out that he lied about his taxes. That wasn't too bad. It showed he had some character flaws, but it could have been just a really bad mistake. Then, he went in front of Congress and laid out the most vague, idealogical plan for rescue that I have ever heard. In a time where I wanted to hear specific details of how Geithner, entrusted almost soley with hundreds of billions of dollars to give to Wall Street, would boost the economy, we got rhetoric that would have made even Obama blush. But, he was new on the job.

But, I must say, I really think this is the straw the breaks the camel's back.



Yes, that's right folks. Timothy Geithner is the one that fought for AIG to get their bonuses. After days of posturing and rhetoric, Geithner has admitted that he is at fault.

I have been a nay sayer on the bailouts since the very beginning. At every turn, we've seen that giving these companies bailout money cannot and will not work. The banks just kept it without increasing loans. AIG is trying to give it to their executives. 90% of the executives from the bailed out companies are still employed. Yes, 90% of these "captains of sindustry" (did you like what I did there?) are still running their companies.

I've talked about moral hazard incessantly. But this is really taking that concept to the next level.

This is the government saying, directly, "if you run your company into the ground, we will save you. If that wasn't enough, we'll make sure you get a bonus."

Results of Government Bailouts

AIG has received $170 billion in bailouts fromt the government (in 3 separate installments). AIG has announced that it will pay $160 million in bonuses to some of its execs. The Government appointed AIG Chairman, Edward Liddy, has said that these things are necessary to keep top talent.

I feel like I don't even really need to say anything to highlight the lunacy. But, this is a part of my grade so.... here goes.

First of all, I'll issue a simple appeal to reason. Should the executives that brought this gigantic corporation to the point of collapse, to the point of needing $170 billion (at least) to stay afloat, be given extra money while millions of Americans have seen their retirement accounts dwindle to 0? These execs were given bonuses so as to keep the "skilled" execs on board. Call me crazy, but I probably wouldn't consider any of the AIG execs remarkably skillful. You are REWARDING people that are the architects of a corporate failure of enormous proportions. Enough said on that front.

Now, let me highlight several economic... short comings (I'll be nice) with this government sanctioned business decision.

First of all, it is necessary to point out that the US government funded these executive bonuses. What I hear, mainly, from democrats I know is that the collapse was caused by greedy businessmen and bankers. I will save my analysis on that point for another post. However, here is an example of the government providing incentives for businessmen. The government is telling us that, no matter what the execs do, no matter if they succeed or fail miserably, they will be rewarded with millions of dollars.

This is an egregious example of an extremely important concept: moral hazard. Moral hazard was implicit in the security packaging of Fannie and Freddi; moral hazard resulted from the government bailouts of companies like AIG, the banks, the Big Three, telling us that, if you're big enough, we won't let you fail no matter how many poor decisions you make. Essentially, the government has rewarded both individuals and companies that make poor decisions. This sends the message that the government will fund you if you take horrible risks. This is moral hazard.

Secondly, these exec bonuses will keep these people at AIG. If they are truly talented, their expertise could be bought by successful firms on the cheap after the failure of AIG. But, instead, they are tied up managing a "zombie company" (credit to Tom Woods for the apt nick name; READ MELTDOWN). Peter Schiff's earlier video, on the downfalls of TARP, adresses this issue nicely. These talented execs could be bought by emerging firms. But, the government is picking winners, investing in AIG. Behind the rhetoric that this is good for the American people lies the truth: people are hurt by these actions, and not even just the taxpayers. Companies, competitors of AIG, could be benefitting from AIG's downfall. But, because the gov't essentially owns AIG, they really don't have a choice but to support them. This means that the government has a vested interest in the success of AIG. The success of AIG means the loss of benefits (cheap execs, new customers) for competing companies. This, ergo, means that the government has a vested interest in hurting AIG's competitors. This is corporate cronyism at its worst...

Economy worsening, Obama policies are detrimental

The Dow dropped another couple hundred points today. I'm not surprised. Judging the market's wellbeing by the Dow alone, however, is rather foolish. Aditionally, a record number of Americans are behind or in foreclosure on their mortgages (including 48% of subprime mortgages). January unemployment was at 7.6% from 7.2% previously (with February's stat coming soon, likely to be higher). Inflation rose 4 times as much as the Fed predicted it would (surprise, surprise) and the banks still won't bump up the loans.

On a side note, I think it's hilarious that the government criticized the banks for being too lenient in their lending policies, when the government used GSE's, the Community Reinvestment Act, lower interest rates, and etc. to encourage more lending. And now, after too much lending exploded in their faces, the government is now criticizing the banks for not lending enough. It makes sense to not lend when the prospects or quick recovery are increasingly bleak. The government is, again, trying to push banks into extending their lending practices to people that they wouldn't otherwise give loans to. This caused the problem. Doing it again will not fix the problem. Banks are naturally tight in their lending policies because they judge the economic landscape as being very troublesome. It isn't because they're run by horrible rich people who hate the economy... they just don't think that it's a good time to be lending. This is natural. This is what we want as an economy. Too much credit, encouraged by artificially low interest rates, leads to the boom and bust cycle (as argued by Hayek and the Austrian School).

But, back to the whole idea of government intervention. I direct your attention to the oft-forgotten recession of 1920-21.

This is a topic covered at length in Tom Woods' book Meltdown, about which I wrote a review for the YAR. I encourage you all to buy the book (it's fantastic) and check out the review in the next issue of YAR.

This recession is often overlooked by economists. Why? The answer is quite simple... it's because it undermines the policies they are employing.

In this recession, price levels fell far more sharply than in the Great Depression. Prices of retail goods declined by 36.8 percent for 1920-21, which was the the largest one-year decline on record. By many estimates, the economy suffered a decline significantly worse than it suffered at the start of the Great Depression. Why, might you ask, did the economy recover completely only 22 months after the recession's bottom?

In this recession, the government's response was extremely minimal. Unemployment rose from 2.3% in 1919 to 11.9% in 1921. However, government rescue procedures were not enacted, other than marginally increased support for the unemployed.

There are several reasons for this, as explained by Woods and the Austrian School. Firstly, when the government intervenes minimally in the economy, it allows the economy to follow its natural recovery mechanism. Wages are allowed to fall, bad assets are purged, and unproductive business ventures are slashed.

However, in the current crisis, the Obama Administration is doing all that it can to keep these bad assets on the books. This slows the recovery process down to a crawl. Instead of letting bad companies go bankrupt (e.g. Chrysler, GM, AIG, etc.) the government keeps these unprofitable companies afloat. What's wrong with that? Well, isn't it obvious? The government has paid out billions to all of these companies. Did that work???? Absolutely not. Within only a few months, each of them came back to the government to ask for even more money, on occasions even more than the initial recovery. Bad companies, bad assets, bad business procedures (i.e. loose lending, malinvestment) need to be purged. This can only happen if the government lets it happen.

Every single action that the government has enacted has failed. I have illustrated TARP's failures below. I illustrate the failure of the big three bailouts above in extremely small detail (though this failure was already evident). The jury is still out on the bailouts, the new $200 billion consumer credit plan (...yeah), and the continually changing effort to make the banks lend again (buying bad assets, making a government-run bad bank, etc.).

The government has already committed ~$2 TRILLION dollars of taxpayer money to combat these problems. People deserve to know that it's not just the strategies are failing, it's that these strategies are actually slowing down the recovery process.

NOTE: The 1920-1921 recession economy had much more wage flexibility than is present in our economy. This is one of the reasons for the quick recovery. However, we don't have this wage flexibility by government design.

Oxy Weekly Article

Sorry for the inactivity everyone. I've been hard at work on a book review of Tom Woods' Meltdown for the upcoming issue of YAR! So please be on the lookout for that :)

In the meantime, this is an article I wrote for the Oxy Weekly. I regret how little space I had and how vague I had to be, but please check it out everyone. I'll have more substantive posts coming shortly.

you can find the article here: http://media.www.oxyweekly.com/media/storage/paper1200/news/2009/02/25/Opinion/Economic.Stimulus.Plan.Says.No.Money.No.Problem.Just.Keep.Spending-3647067.shtml