Unintended consequences of the bailout?

Discussion in 'Economy' started by gonegolfin, Oct 2, 2008.

  1. gonegolfin
    Offline

    gonegolfin Member

    Joined:
    Jul 8, 2005
    Messages:
    412
    Thanks Received:
    36
    Trophy Points:
    16
    Location:
    Austin, TX
    Ratings:
    +36
    As discussed in my previous letter below, the principal problem with this bailout is that it perpetuates a problem that has been caused precisely by the same measures that are being proposed to fix the problem. It is more government interference with what are supposed to be free markets. Such interference leads to instability and is inefficient by nature (after all, the government is involved). With that in mind as a guiding principle (you may also want to reread the second paragraph in the letter below), I thought that it would be interesting to look at an example or two of some of the non-obvious things that could happen as a result of this bailout. The obvious things that will happen have been discussed ad nauseum in past missives. I will attempt to keep the core of the message as high level as possible, while providing a little necessary background.

    The primary reason in support of this bailout is that credit must flow again in this country (and worldwide) if our economy is to recover. Lenders must be willing to lend, banks must be willing to lend to each other, banks (and our money market vehicles) must be willing to lend to corporations. Now, let us forget for a moment that excessive and artificially cheap credit got us into this mess to begin with. Let us focus on how the bailout plan proposes to solve this "credit crisis" (even though we know it is both a credit and a solvency crisis) and what may be a consequence of such action.

    The bailout plan proposes to sell Treasury debt to fund the $700 billion that is supposedly required (it will no doubt become much more expensive - after all, we need our wooden arrows). The Treasury debt that will be sold will be of the much shorter term variety. I am sure the Treasury did not want to risk driving long term interest rates much higher (affecting mortgages) by selling 5-year, 10-year, and 30-year bonds, so it makes sense that they stay on the short end of the treasury yield curve. Of course, selling on the shorter end of the treasury yield curve means that these loans will come due much more often and each rollover of debt into a new debt issue will put our credit as a nation to the test. This gives investors more opportunities to decline further investment. If you are wondering why auctioning more treasuries drives up interest rates on these treasuries, it is due to simple supply and demand. The bigger the supply of treasuries in the open market, the lower the price you will fetch for them. Since price and yield are inversely proportional to one another, a lower price will result in a higher yield. That is, if there is a lack of demand for this debt, a higher interest rate must be offered to attract investors. There is also the facet that issuing more debt (we will now be up to $11.3 trillion and counting) wears on the currency and eventually investors will demand more yield for their debt purchases as their confidence in repayment wanes.

    Now, we know that one of the primary issues in our credit markets at present is the practically frozen commercial paper market. Commercial paper is used by many corporations to fund short term obligations, including payroll and the purchasing of inventory. It is also the primary investment in most traditional money market mutual funds. Individuals and financial institutions have been selling these money market funds and buying treasuries (as they are deemed more safe). But the auction of all of these new treasuries will crowd out more investment in commercial paper (making this particular credit market even tighter) as the additional supply of short term treasuries will drive up short term treasury interest rates, making them even more competitive with commercial paper rates (from which investors are already flocking). In other words, the spread between treasury interest rates and commercial paper interest rates will tighten making commercial paper less attractive. Obviously, a reactionary rise in interest rates paid on commercial paper will be more expensive for businesses. So, once again, government debt crowds out legitimate economic investment. It seems that it would make more sense for the Fed to simply expand their balance sheet by buying more treasuries and thus inject new money into the system. This would provide additional liquidity while widening the spread between commercial paper and short term treasuries (treasuries would fall in yield as there is less supply). But it is entirely possible that some conversations with key Asian Central Banks made it clear that they would not stand for $700 billion of newly created money in the monetary base.

    Another unintended consequence may ultimately be the SEC short ban on more than 900 companies involved in financial services. I think that this may backfire on the regulators. Non-naked short selling does provide important liquidity to the markets. It is also an essential tool for hedge funds that are significantly net long. Short positions are used to hedge large long positions. I think that you will see this result in hedge funds being much less likely to jump back into the market on the long side (if they are not allowed to hedge their long bets). In the meantime, there will be more losses for the hedge funds as they will be forced to sell good assets (and many long positions) to raise cash for redemptions. Hedge funds will be interesting to watch in the coming weeks.

    This all goes back to the fact that our financial system (and the world financial system) is tightly coupled. Interventionist measures, such as these, often have unintended consequences because in a tightly coupled system, problems are much less likely to remain localized and can spread much more easily.

    Brian

    --
    Mon, Sep 29, 2008 at 9:42 PM

    Mr. O'Reilly,

    I was stunned when I heard some of the comments from Cheryl Casone and yourself tonight concerning the repudiation of the bailout plan in the House of Representatives today. The lack of understanding with respect to economics, monetary policy, and our financial system from both you and Cheryl is absolutely staggering (to be fair, it is not just limited to your show). My vehement opposition to the proposed bailout bill has nothing to do with any opposition to bailing out Wall Street, bailing out homeowners, etc. that I might have. It has everything to do with perpetuating a problem that has been caused by precisely the same measures that are being proposed to fix the problem.

    Recession is a natural part of the business cycle. Especially so in the unfortunate Central Bank/Fractional Reserve System that we have in this country. Prices must be allowed to correct and find their natural equilibrium, not find an artificial floor (this is a form of price fixing) established by irresponsible monetary policy (executed by our Federal Reserve) that inevitably results in another asset bubble. The excesses and mis-allocation of capital (malinvestment) must be purged in a truly free market system. This is paramount in bringing the economy back into balance. Creating more money and taking on more debt does just the opposite, benefits a minority, and creates a bigger problem in the future. Namely, it benefits the folks that spend the the newly created money first, before prices react to the upside as the new money works its way through the economy. Meanwhile, taking on more government debt crowds out legitimate economic investment as increasingly scarce capital is the source for this expansion of government debt, leaving less for legitimate economic investment. If we pass any sort of bailout, we are going to make the problem considerably worse (somewhat better in the short term, much worse in the long term). Government intervention in our markets will create more instability in the future along with a considerably more painful recession or possibly depression. This is not to mention the tremendous moral hazard present in the solutions being proposed. The free market must be allowed to work.

    This problem was not difficult to see coming with just a reasonable background in the aforementioned subjects. I have been warning my friends and family about this for several years. Yes, it is going to be painful to do the right thing. But it is time that we take our medicine (finally ... after several chances that would have yielded a considerably less painful correction) because the cost of papering over these problems (via a foolish bailout measure) will be a much higher cost in the not too distant future.

    I hope you take the time to read this and seriously consider it. I also hope that you share this with Cheryl Casone. If you like, I can propose some good reading material that might facilitate a better understanding with respect to the real root cause of the crisis we find ourselves in.

    Regards,
    Brian Benton (a fiscal conservative wondering if there are any left)
    Austin, TX
     
  2. dilloduck
    Offline

    dilloduck Diamond Member

    Joined:
    May 8, 2004
    Messages:
    53,240
    Thanks Received:
    5,552
    Trophy Points:
    1,850
    Location:
    Austin, TX
    Ratings:
    +6,403
    I would much prefer that we concentrate on THAT fact. You simply cannot screw up our economy like this without it.
     

Share This Page