The Economic Crisis. Part 2: The Solutions

This posting could really be called Part 2: More Problems. The law of unintended consequences has staked dominion over our lives for the past 15 months, and threatens to do so for the next several years until a proper regulatory system gets put into place, and the demons work their way through the broader world economy. By then, I’ll be writing about the next bubble, though.

There are three entry points, or nodes, for a solution to the economic crisis. The first is at the top, or the supply side. The second is at the bottom, or the demand side. The third is outside the financial system altogether, the so-called real economy.

Piddle Down Economics
The Treasury’s bailout plan (as modified by the Senate) is your classic supply side corporate welfare. Granted, there are some provisions that will punish the financial industry, but the solution will most directly assist financial institutions. By infusing cash into the banks (in exchange for shares of stock), the banks will then have enough money on hand to minimize their overnight borrowing needs. In theory, the banks could just not dip into their reserves and use the taxpayer’s money to develop more stable lines of cash flow. For example, instead of taking high risk measures in order to simply gamble on survival, Bank of Brokeback can instead concentrate on issuing commercial loans in the money market, develop a broad portfolio of prime mortgages, and work out lines of credit for businesses for bridge loans or long-term capital investment.

The other aspect to the bailout is the option to buy off the CDOs from the banks. That makes the banks’ balance sheets look better and gives them some cash. Their share prices should go up.

Piddle Down Pros: Relatively simple in that there are only a few actors who stand to get involved. Long-term gain to the taxpayer if the financial institutions remain solvent and the CDOs eventually return on their coupon.

Piddle Down Cons: Very little direct benefit to Main Street. Dilution of stock will hurt shareholders, especially those looking to retire. Long-term risk of taxpayer losses.

Hot Gasses Rise
McCain recently announced a solution that seemed to come from a common source of hot gas. Yet, despite the flatulence of it all, the demand side solution merits discussion. Here’s how it would work (in general, since McCain has not offered a concrete blueprint). The government would assist homeowners who are having trouble paying their mortgages by making payments on their behalf. This serves the double benefit of keeping people in their homes and restoring value to the toxic CDOs. Basically, the government would be replacing the mayo on the CDO sandwich with ketchup. On the other hand, though, it would be a big do-over for imprudent buyers and flippers who got ahead of themselves. Further, it serves the secondary unintended consequence of preventing the housing market correction. Each house that is foreclosed upon or sold at a loss helps the housing market come down to reasonable levels. People should eat losses on bad investments. That’s the way the market is supposed to work. If the government gives support to the bubble values of these houses, then supply of houses is artificially reduced. This keeps the prices on available houses higher than they would be if the market was allowed to correct itself. Thus, flippers and fools get a subsidy to reward their bad behavior while prudent would-be home buyers remain on the sideline, punished for others’ excess.

Basically, preventing foreclosures on houses that people can’t afford anyway prevents those houses from being sold to people who can afford them at an affordable price. So, I sit on the sidelines waiting to buy a house, not willing to put money down on a house that I know is overvalued, and which will remain overvalued as long as the market gives the illusion that the overvalued sale price is

Hot Gas Pros: Neighborhood salvation in keeping people in homes. Restores value to CDOs and thus restores interbank lending.

Hot Gas Cons: Prevents recovery of housing market for the next decade or longer. Complex to implement because there are hundreds of thousands of potential actors looking for a bailout.

Down on Main Street
While the banks and the housing market toil in pandemonium, the rest of the market it taking a beating. Entrepreneurs can’t find seed money. Consumers are taking credit rating hits because banks are taking away their credit cards (thus worsening the consumers’ debt to available credit ratio). Importers and other producers can’t find commercial paper (that’s why Treasury made a guarantee on money market accounts, to prevent the total collapse of our economy). Tax revenues are way down, thus threatening to bankrupt states, municipalities, and Iceland. Lack of consumer confidence is killing retail, even with the holidays around the corner. The panic sprint out of equity and into the commodity market has driven up the cost of everything from rice to oil (I bet Ron Paul thinks he’s scored some kind of coup with the chaos in the currency markets).

Ideally, it would be great to isolate the financial industry and housing market from the rest of the economy. You know, let them stew in their own juices. Tasty? Anyway, that is a difficult task. Again, there are supply side and demand side solutions for this. One way to manage the feat would be for the Fed to open up its lending facilities to every entity incorporated in the 50 states. Another would be to dump $700 billion into the wallets of consumers. That translates to roughly $2,300 for each American. The question then becomes, how would you spend two grand? If we all paid down debt, it would still cause a recession because of the impact on retail and manufacturing. If we all spent it on Christmas gifts, we would still be vulnerable to the next crisis because Americans’ debt levels are still dangerously high. Plus, the aggregate spending might not be enough to stave off a recession given the global meltdown in the markets.

I wonder what it must be like for Ben and Hank. Do they sleep at all, knowing that their actions may determine whether or not we see Depression II? Or, maybe the sleep just fine, knowing that the success of their actions will ultimately be determined by a fickle goddess. Fortuna gives in plenty, but she also robs without regard to Justice.