Bailout May Be Misunderstood but Must Not Be Misused

The trillions of dollars in various "bailout" and stimulation initiatives are not intended to bail out wrong-headed investors or executives. In the case of Bear Stearns, notwithstanding the "bailout," shareholders still lost 90% of their investment. It is true that some lousy executives got away with undeserved golden handshakes and I agree this is wrong. Avoiding moral hazard, however, requires placing responsibility where it is due, and that means holding the decision makers responsible and accountable for their mistakes. I had been disappointed with the decision of Paulson not to "bail out" Lehman Brothers on that fateful September weekend, and that is not because I wanted Paulson to bail out the wrong-headed decision makers who brought Lehman to its knees. I was wary of the effects of the fallout of the bankruptcy of Lehman on innocent people, and events that unfolded proved me right.It is easy to say that we should let businesses fail if they cannot survive on their own. But policy makers have to worry about the chain effects each business failure brings about. If the cost of a business failure proves bigger than the cost of a "bailout," the bailout makes sense. I must repeat: such "bailout" is not intended and should not be misused to bail out or reward wrong-headed executives. The latter should still be held accountable.Some commentators say that Americans need to save more. I said that more than ten years ago. Exactly because this is so important, we need to spend the trillions of dollars of "bailout" money. If they helped save jobs, Americans will then have the income from which they can save. Without jobs, Americans cannot save.Some commentators also are "sure" hyperinflation is inevitable. I can assure them that hyperinflation is not going to happen. Hyperinflation is always caused by too much spending. During all episodes of hyperinflation such excessive spending is indeed financed by the printing of money. But printing money in itself does not imply excessive spending. Right now any printing of money earmarked for "bailout" or "stimulation" serves only to make up for inadequate spending. Because anemic spending is going to continue for quite a while because of the collapse in asset prices worldwide, how can hyperinflation take place?Finally, some commentators worry that the "bailout" money will create another bubble. Again, the various bailout packages serve only to fight deflation and to re-establish full employment. Can anyone find any sign that a bubble is forming because of a bailout?

Bailout May Be Misunderstood but Must Not Be Misused

The trillions of dollars in various "bailout" and stimulation initiatives are not intended to bail out wrong-headed investors or executives. In the case of Bear Stearns, notwithstanding the "bailout," shareholders still lost 90% of their investment. It is true that some lousy executives got away with undeserved golden handshakes and I agree this is wrong. Avoiding moral hazard, however, requires placing responsibility where it is due, and that means holding the decision makers responsible and accountable for their mistakes. I had been disappointed with the decision of Paulson not to "bail out" Lehman Brothers on that fateful September weekend, and that is not because I wanted Paulson to bail out the wrong-headed decision makers who brought Lehman to its knees. I was wary of the effects of the fallout of the bankruptcy of Lehman on innocent people, and events that unfolded proved me right.It is easy to say that we should let businesses fail if they cannot survive on their own. But policy makers have to worry about the chain effects each business failure brings about. If the cost of a business failure proves bigger than the cost of a "bailout," the bailout makes sense. I must repeat: such "bailout" is not intended and should not be misused to bail out or reward wrong-headed executives. The latter should still be held accountable.Some commentators say that Americans need to save more. I said that more than ten years ago. Exactly because this is so important, we need to spend the trillions of dollars of "bailout" money. If they helped save jobs, Americans will then have the income from which they can save. Without jobs, Americans cannot save.Some commentators also are "sure" hyperinflation is inevitable. I can assure them that hyperinflation is not going to happen. Hyperinflation is always caused by too much spending. During all episodes of hyperinflation such excessive spending is indeed financed by the printing of money. But printing money in itself does not imply excessive spending. Right now any printing of money earmarked for "bailout" or "stimulation" serves only to make up for inadequate spending. Because anemic spending is going to continue for quite a while because of the collapse in asset prices worldwide, how can hyperinflation take place?Finally, some commentators worry that the "bailout" money will create another bubble. Again, the various bailout packages serve only to fight deflation and to re-establish full employment. Can anyone find any sign that a bubble is forming because of a bailout?

Averting a Major Global Economic Meltdown

If two things are implemented, I am positive the world's financial markets will rebound, and the global economy will stop slipping.

The foremost is to have a credible plan that puts a floor on housing prices. I have suggested that the US Government offer a buy back program for existing homes below the median price, at the market price as of October 2008, calculated as the original purchaseprice plus or minus a percentage reflecting the price change since then, as indicated by the national housing price index or local price index, subject to minor reappraisal for fine-tuning.

The second is to have a joint effort to bring the exchange rates in line with growth sustaining levels. Currently the Yen is too strong for exporters to survive. The Yen has appreciated 30% against a basket of currencies since Jan. 1 2008 according to my figures. If the Japanese economy falters, the world suffers. The central banks can sell Yen together.

Once these two plans are announced, global financial markets will certainly rebound, confidence will revive, as gloom for US’s financials and for Japan’s manufacturing will disappear over night.
These two are worrying investors the most.

A Plan to Prevent Further Slip in the US Housing Market

A Plan to Prevent Further Slip in the US Housing Market

Everybody agrees that the economy faces a critical moment. What investors and practically everybody fears the most now is that the housing market may continue to slip, notwithstanding the massive bailout plan. This would reduce the quality of assets that financial institutions hold and erode their chances of survival, and would undermine the quality of the toxic assets that the government acquires with the bailout funds. Such fears reduce the credibility of the bailout plan. It is imperative that we stop the further slip of the housing market with a fool-proof plan.

My proposal may sound drastic. But it will cost the US taxpayers the least money and will produce the greatest bang for the buck.

To be specific, I propose that the US Government, with backing from the Fed., announce that it stands ready to buy any housing unit that costs below the national median price at a price equal to the last actual transaction price indexed against the national housing price index. The government will hold any units thus acquired until the market is ready to absorb them at a price no lower than this acquisition price.

Now let me analyze the effects of this proposal.

Given the backing from the Fed., the announcement is credible. It immediately puts a floor on the housing prices of the cheaper 50% of the second-hand units currently on the market.

The announcement will at once strengthen the confidence of homebuyers for the cheaper units. The prices of these units will not slip any more. Financially able homebuyers will resurface. Some sellers of homes will withhold their units. Some homeowners who plan to default will think twice. The actual number of units that the government has to acquire will be much smaller than might be thought.

The announcement will also benefit more costly homes indirectly. Some of the owners of the cheaper units, upon selling their units, may buy the more expensive homes that they can afford.

The announcement will immediately improve the prospect of the “toxic assets” held by financial institutions. The outlook of these firms will improve at once. The stock market will advance, further boosting confidence.
Confidence worldwide will rebound. Global capitalism is saved.

Finally Paulson and Bernanke Did the Right Thing

Paulson and Bernanke finally moved to restore investor confidence by effectively underwriting or buying many of the bad loans that had been undermining the health of financial institutions in the US. The financial markets worldwide cheered with close to 10% jump in two days.

This behavior of the financial markets once again confirmed the importance of confidence. When confidence comes back, firms that otherwise would fail are saved. When confidence collapses, firms that otherwise were healthy could fail.

I had lamented Paulson's failure to act as a guarantor to facilitate the takeover of Lehman Brothers by potential buyers because that really rocked the financial market and triggered a "tsunami" across the world's financial markets. If this time around Paulson and Bernanke failed to act promptly, it is entirely possible that the US and the world slip into the second Great Depression.

For now the world is saved. I am sure despite the cost in terms of direct taxpayers' money, taxpayers will thank Paulson and Bernanke for what they did.

I hope, though, that they will still take necessary action against real moral hazard: i.e., whose who win big if their bets are right and have little to lose if their bets are wrong. If they are sincere about guarding moral hazard they should be after the decision makers who created the mess, and not the innocent savers both in the US and in the rest of the world.

Paulson Made a Mistake

In allowing the demise of Lehman Brothers instead of salvaging it with taxpayers’ money Paulson and his associates claim that this is to avoid moral hazard, so that risky investors will not be protected from the results of their own risky ventures. The fact, however, is that the risky ventures were undertaken by other people without the knowledge of the shareholders. It is ironic that the decision makers get away from dire consequences while the innocent suffer in the name of avoiding moral hazard. With Wall Street falling over 500 points it is clear that taxpayers are losing far more than what they possibly “ saved” if the government had stepped in to facilitate the orderly take-over of Lehman Brothers by the suitors. This is yet another instance of the lack of understanding about systematic effects or what I had called the ecology of market economy.

The fact of the matter is that global capitalism requires a good dose of common sense. Who in their right mind would believe that the mortgage loans are “backed” by collaterals, when borrowers have hardly any down-payment or equity in their homes in the first place? Who in their right mind would believe that the market can self-regulate, when market participants are subject to a conflict of interest. There is no need for a “financial engineering” degree to tell that we need effective safeguards when a few people are playing with huge sums of other people’s money. Without proper safeguards, it is not surprising that “rogue traders” like Jérôme Kerviel and Nick Leeson would take advantage of the loopholes that are there to benefit themselves. Without proper safeguards, we have seen fake transactions inflating balance sheets and yielding handsome fees to officials of some thrifts during the 80s contributing to the Savings and Loans Crisis in the US. Without proper safeguards, we have seen how the auditor conspired with company executives in the case of Enron.

The market place offers both crooks and innocent people opportunities. But the opportunities of the crooks are the risks of the innocent. Our choice is definitely not over having more versus having less regulation. Our choice is over appropriate regulation versus inadequate or inappropriate regulation. Some say that too much regulation stifles markets. The fact is that the right kind of regulation enables markets to run smoothly and fairly.

Inflation Fight with Inflation-Indexed Interest Rates

One problem with traditional monetary tools is that as inflation heightens, real interest rate falls, which actually fuels inflation because inflation reduces expected real interest rates. Central banks have then to raise interest rates, but with inflation expectations uncertain, how much nominal interest rates need to be raised is not clear. As a result, there is a tendency for gradualism, as central banks need to take one step at a time and watch what happens. It is anybody's guess as to where the interest rate hike is going to reach, and conversely when interest rates are to fall, it is anybody's guess as to where the interest rate decline is going to end up.

With a currency anchored to the WCU, or with indexed instruments, however, real interest rates will not fall when inflation rises. So there is an automatic check against borrowing on the assumption that inflation will relieve real borrowing cost. With a currency anchored to the WCU or with monetary policy directly determining real interest rates using indexed instruments, therefore, the inflation fight will be easier.