New Sherwood

What should be done about the economy?

Paul Craig Roberts is making sense:

“A compassionate government would handle the crisis in this way:

The trillions of dollars in credit default swaps (CDS) should be declared null and void. These “swaps” are simply bets that financial instruments and companies will fail, and the bulk of the bets are made by people and institutions that do not hold the financial instruments or shares in the companies. The ideology that financial markets were self-regulating allowed illegal gambling free rein. There is no reason under the sun for taxpayers to bail out gamblers.

The bailout money, instead of being given to favored financial institutions to finance their acquisition of other institutions, should be used to refinance the defaulting mortgages. This would slow, if not stop, the growing inventory of foreclosed properties that is driving down home prices.

The mark-to-market rule should be suspended until the real values of the troubled properties and instruments can be determined. Suspension of the rule would prevent the failure of sound institutions and lessen the need for a bailout.

Interest rates have to be raised in order to encourage saving and to provide incomes to retirees.

To preserve the dollar’s status as reserve currency, a credible policy of reducing both budget and trade deficits must be announced. In the near term the budget deficit can be reduced by $500 billion by withdrawing from Iraq and Afghanistan and by cutting a bloated defense budget that represents the now unattainable goal of US world hegemony.

The trade deficit can be significantly reduced by bringing offshored jobs back to America. One way to do this is to tax corporations according to the value added to their output that occurs in the US. Corporations that produce their products for US markets abroad would have high tax rates; those that produce domestically would have low tax rates.”

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January 23, 2009 - Posted by | Uncategorized

8 Comments »

  1. Very very wrong. Refinancing bad mortgages is useless, especially if you INCREASE the interest rate. The problem is that so many people have bought houses that they are unable to pay for. Twiddling the interest rate or term of the loan won’t make enough of a difference. IF one were to bail out everyone who is behind on their payments (arguably the only real way to clean up the mortgage mess), the result would be that everyone with a mortgage will get behind in their payments, just as everyone who handles money is suddenly a bank.

    And suspending mark to market rules just prolongs the crisis. The real problem in the credit and capital markets is non can tell who is bankrupt and who is not, so no one is willing to lend money. Hiding bankruptcies in the credit markets is a bad thing.

    The solution is to clear the market by allowing the bankruptcies to occur. Execute a cramdown on every bank or other financial institution that wants a bailout. That means that the common stock is wiped out, and new stock is issued to the debt holders, replacing their claims against the company.

    The companies immediately become solvent and are able to start lending again. Too bad about the shareholders, but buying stock in lying cheats is a risky game.

    Oh, you also need to start putting some people in jail for fraud, including the executives of most investment banks and brokerages.

    Capital markets run on confidence. The investor has to be confident that he can assess the risk of his investment. Hiding extremely relevant information, such as the fact that an institution is bankrupt, by suspending mark-to-market rules may seem like a good idea, since the institution will not be immediately thrown into bankruptcy. But without that clarity, what smart person will invest? and without investors, how can we restart the credit markets? This complex game of hide and seek was the Bush administration’s approach dealing with the crisis, and we can see how well that’s worked out.

    Instead of hiding the problems, we need to flush them out and get them dealt with. Yes, it will be painful, but we’ve been putting that pain off by blowing asset bubbles for 12 years now. It just gets worse each time.

    Comment by danby | January 23, 2009 | Reply

  2. CDSs on the other hand, must go:

    http://us1.institutionalriskanalytics.com/pub/IRAMain.asp

    Comment by danby | January 23, 2009 | Reply

  3. I would add that this stick-rather-than-carrot approach to offshoreing has always seemed to me misguided. I’d like to see a carrot-rather-than-stick. Give every company that can prove that X percent of its jobs are on sovereign American soil a break on taxes and, I would argue, on negotiation imperatives with unions. Perhaps also on the minimum wage law. In other words, this is where we really need to start addressing root causes–the root causes of offshoring. Hint: “Nasty capitalist greed” is probably not the correct answer.

    Comment by Lydia | January 24, 2009 | Reply

  4. How about this, for a long term solution… one more Catholic, as well. End the Wage System. Move towards a system of Ownership.

    ” The law should favour ownership. Its policy should be to induce as many as possible of the humbler classes to become owners.” Pope Leo XIII, Rerum Novarum

    Comment by James | January 24, 2009 | Reply

  5. Danby – Amen to all that. I’ve never heard my own sentiments expressed so clearly.

    Comment by Chris | January 24, 2009 | Reply

  6. “Very very wrong. Refinancing bad mortgages is useless, especially if you INCREASE the interest rate.”

    Since Mr. Roberts was speaking of using the bailout money in this context, I think he clearly means refinancing in the sense of making the payments affordable. Obviously that will involve reducing the overall mortgage debt in many cases. Whatever it takes to halt the foreclosures.

    I’m not an economist, but that makes good sense to me. If we’re going to have a bailout, that is.

    “IF one were to bail out everyone who is behind on their payments (arguably the only real way to clean up the mortgage mess), the result would be that everyone with a mortgage will get behind in their payments, just as everyone who handles money is suddenly a bank.”

    That would be a danger, but it wouldn’t be difficult to put safeguards in place. Homeowners would have to qualify for this benefit just as they would for a loan.

    “The real problem in the credit and capital markets is no one can tell who is bankrupt and who is not, so no one is willing to lend money. Hiding bankruptcies in the credit markets is a bad thing.”

    True. But homeowners with suitably refinanced mortgages will demonstrably not be bankrupt, nor will their lenders.

    “The solution is to clear the market by allowing the bankruptcies to occur. Execute a cramdown on every bank or other financial institution that wants a bailout. That means that the common stock is wiped out, and new stock is issued to the debt holders, replacing their claims against the company. The companies immediately become solvent and are able to start lending again. Too bad about the shareholders, but buying stock in lying cheats is a risky game.”

    Forgive my ignorance but I don’t understand how this would be accomplished. Is the bailout money even close to enough to justify the banks making loans again? Are you talking about replacing the boards of these institutions? A federal takeover? (Not that there’s anything wrong with that …) And how much of the economy depends upon the prosperity of the shareholders? Wall Street will be starting over.

    “Hiding extremely relevant information, such as the fact that an institution is bankrupt, by suspending mark-to-market rules may seem like a good idea, since the institution will not be immediately thrown into bankruptcy. But without that clarity, what smart person will invest? and without investors, how can we restart the credit markets?”

    Again, with the mending of the foreclosure crisis, these institutions will not be facing bankruptcy – real or imagined. At least that seems to be Roberts’ argument. I’d like to know what’s wrong with that argument if anything.

    Comment by Jeff Culbreath | January 24, 2009 | Reply

  7. Jeff,
    The crisis in the financial markets is much, much, much bigger than sour mortgages and you don’t have to be an economist to understand it. In fact, all for the bad mortgages in the country could have been paid in full with the money we’ve ALREADY spent, and Obama has made it clear that we’re not anywhere close to finished with the spending.

    The essence of the crisis is that all of that bad debt, through the magic of unregulated leverage, exceeds the ability of even the US govt to pay. Bad mortgages are only a few percent of the problem.

    The biggest problem is that credit is disappearing from the market. The usual channels for commercial paper and business lines of credit are drying up. Small businesses, especially those dependent on ready credit, like trucking and trans-oceanic shipping, are feeling it the worst. If Joe the trucker can’t fill his tank with his business line of credit, the economy will collapse.

    Where is the credit gone? Banks loan out the money, but they are not the source of the money. The banks borrow the money from depositors, bond purchasers and each other. Normally it’s not a problem, since a bank is a pretty good investment most of the time. But if you don’t know whether the bank will be seized by federal regulators on Friday afternoon, you’re unlikely to loan the money. You won’t purchase the bonds, or, if you’re another bank, you won’t make the loan.

    This is where CDSs and mark-to-market come in. A Credit Default Swap is essentially a bet. You and I write a contract that says I will pay you some amount if MegaBank fails to meet it’s obligations. You can see where that would be useful if you were holding paper from Megabank. For a price of 0.5% or so, you would have the assurance that you could recover say 50% of your investment. Banks hold trillions of dollars worth of these contracts. The problem is that CDSs are a totally unregulated market. Anyone can write a CDS, and THEY’RE NOT REQUIRED TO ACTUALLY BE ABLE TO PAY. That’s where AIG got into trouble. They were holding lots of CDSs against both collateralized mortgage securities and the major investment banks. The total liability exceeded the GDP of the United States. When mortgages started going bad, AIG just couldn’t meet it’s own obligations. This made it obvious that many CDSs are not worth the paper they are written on. These are one of the securities that people like Roberts want to not have to mark-to-market, since they are worth about 10cents on the dollar.

    The other side of the problem is the mortgages. The only way to fix mortgages is to simply shovel money and yet more money into the black hole of the banks’ balance sheet. Renegotiating the mortgages is a non-starter, experience over the last few months has shown that over 60% of the renegotiated loans are in default within 3 months, and over 30% within 1 month. The problem here is that the loan amount is simply too large for the borrower to pay. Unless you reduce the APR to 0% and extend the loan to 50 or 60 years, they simply don’t have the money. This is a consequence of the housing bubble that was intentionally blown by the Fed and the Government over the last 8 years, in a desperate attempt to re-inflate the economy after the tech stock bubble.

    Face it, $400,000 is just too much for a person of average income to pay for a house. Yet, in many areas, particularly SoCal, that was an average price. At 5%, a 30-year loan on a $400,000 house means payments of $28,000 a year. A person making $40,000 a year just can’t pay that mortgage and his taxes, let alone actual living expenses. Even at 1%, it’s still $15,000 a year. The price of houses must come down until the average price of an average house is not more than 3x the average income. That is a sustainable price. Refinancing an unsustainable loan is mostly a waste of effort.

    Comment by danby | January 25, 2009 | Reply

  8. Rereading that, I realize I seem to be advocating shoveling “money and yet more money into the black hole of the banks’ balance sheet.”

    Just want to make it clear that I am advocating mass bankruptcies, to clear the credit markets, so that credit can once again start flowing.

    Oh, and I should explain cramdowns. A cramdown is what is done with public corporations in a bankruptcy. The shareholders are wiped out, and the ownership of the company is handed over to the creditors to do with as they wish. If the new owners want to retain the board and management, they are free to do so. If they want to sell everything down to the carpets, they are free to do that. If they want to sell the stock to whoever might want to buy it, they are free to do that as well.

    Since most of the large banks in this country are actually bankrupt, and fighting desperately to hide that fact, they should be handled in the same way.

    Comment by danby | January 25, 2009 | Reply


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