Tuesday, November 25, 2008

Henry Paulson's Approach is Bass Ackwards

Lets get it straight. The key underlying cause of the financial crisis is income stagnation and fall in real wages of the consumers. There has been a lack of growth in well paying jobs for past several years. The debt levels, including credit card debt and mortgage debt, have risen to alarming levels. What makes the rising debt levels really alarming is that they are not supported by a concomitant rise in incomes.

Henry Paulson's approach to deal with the crisis is to re-capitalize the banks so they can start lending again. This is exactly the "bass ackwards" approach that is not going to do anything to solve the financial crisis of the century. Let me explain. The real problem is not lending, in fact, it is reckless lending to credit unworthy masses which led to the problem in the first place. We will not solve the problem by simply lending more at a time, when income levels are stagnating, number of well-paying jobs are dwindling (outsourced by globalization) and consumers are neck deep in debt (mortgage & credit cards). Getting the banks to start the lending cycle all over again would be akin to treating an alcoholic by giving him more alcohol for medicine.

It would seem that Henry Paulson and his rescue team are either in denial of the underlying cause of this crisis or they are merely pretending to be ignorant. Unless a proper diagnosis is done to determine the root cause, only treating the symptoms would be pointless. The current freeze in the credit & lending markets is the symptom of the problem, and not the underlying cause. If a doctor treats only the external symptoms of a disease, it is only a matter of time before the disease symptoms would resurface. At best, it would only push the problem out a few years but the next relapse could be even more severe.

The long term solution has to be stimulating income growth by creating more well paying jobs. This can be done by investing in infrastructure projects, innovative technologies for the future and making investments in hi-tech R&D. To focus on short term results while ignoring investments in R&D for the long term is like eating seed corn. This economic stimulus has to be accompanied by common sense regulations on lending practices and complex financial instruments to ensure proper functioning of the financial markets in the future. Executive/CEO compensation should be linked to long term performance and not to short term stock movement.

These steps would be like nourishing the tree at the root, which would help restore the health of the entire tree including trunk, branches and leaves, as opposed to Henry Paulson's approach that merely waters the leaves at the top. It is common sense that a tree must be watered at root for proper nourishment, washing the leaves is cosmetic at best.

That said, in the short term, it is alright to take measures to ensure proper functioning of our financial system but over the long term these measures must be complemented with radical steps to support the economy at its roots: income growth for consumers who support the real economy. Eventually the economic growth will be restored only by re-emphasis on innovation leading to real products and services of real value and ultimately real income growth.

10 comments:

Oil Shock said...

Sorry for being straight and to the point. THis analysis is bullshit. You need to educate yourself using the resources available at Mises Institute, many of which are available for free.

Start with "Economics in One Lesson" by Henry Hazlitt. THen ready something like "What has GOvernment done to our money" or "Mystery of Banking". THen move on "Man, Economy and State", "Human Action".

CommonSenseThinker said...

Oil Shock, I appreciate your reviewing my article and posting a straight and blunt review of the article. It would have been nice if you had pointed out the weak points in my analysis. In any case, thanks for pointing me to resources on the Mises Institute.

Best Regards,
varun

Anonymous said...

I agree with you that we need to focus on the root of the problem, however I disagree with you from there out.

I believe that the root cause of the crisis is three-fold. I believe the rediculously low interest rates mandated by the federal reserve (eventually affecting mortgage rates) after the September 11th attacks, the government backed programs like Fannie and Freddie, and the speculative buying of houses are the root causes.

The global market is the goods that billions of human beings are trading every second of every day. Think of how many diffent emotions people have, and how many people there are in the world.

I don't believe there is any group of people in the world that could stand back and say, "Here is where we should invest the taxpayers money". Just like the U.S. government stepping in and regulating the housing market has blown up in our faces, the same will be said if they try to invest in infastructure. The market will become confused and another false bubble will be created.

With that being said, I believe the best immediate solution is to have the government get out of the way, reduce taxes, and reduce their spending. That would be a lot of money in the economy that can be used more efficiently without the endless beaurocracy.

Long term I believe we should at least abolish the central bank, go back to a gold and silver standard, and criminalize fractional reserve banking (counterfitting).

I appreciate that you are concerned about this "crisis" and are open to dialog. ; )

Ian

CommonSenseThinker said...

Ian,

Thanks for your invaluable comments. I do agree with you that artificially low interest rates and recklessly lax lending practices resulted in housing bubble which led to current financial crisis. My article is focused on proposing solutions to this problem. Now that the Feds are stepping in with taxpayer money, where could it be best directed. Re-capitalizing the bank so they can lend again does not solve the problem. That is the crux of my argument. Now, if we are going to use taxpayer money anyways, it is better directed at nourishing the roots, meaning invest in infrastructure, innovation and R&D. In addition, the Fed Reserve, SEC and Treasury should be held more accountable, there should be more oversight and more regulations to prevent abuse of the financial system. I have no disagreement with going back to Gold/Silver standard in the long term.

Varun

Anonymous said...

Varun,

"Now that the Feds are stepping in with taxpayer money, where could it be best directed."

I understand what you are saying, but my point is to say that it is not possible for our government to know something like this. Again, look at their meddling in the housing market. It created a huge distortion and it blew up. The same thing will happen no matter where they invest the money.

My other argument against this approach is that there is no money for these adventures. The money will just be printed out of thin air and we will pay the price through inflation. This is placed on the backs of future generations.

I agree that there needs to be more transparency (especially in the Fed), and that some need to be held accountable. Unfortunately the only way to do that is to stop electing representatives that encourage this behavior.

I disagree that we need more regulation to prevent a crisis like this from happening in the future. As long as we don't bail out the banks then the system works. They will go bankrupt and other banks will learn to be more careful in their adventures. As long as investors are able to see what the banks are up to (transparency) then they can make an informed decision as to whether or not to invest in the banks.

My other argument against more regulation is that in the end big businesses use the regulation to shut out competition. Big business is able to afford the lawyers who can find the loopholes and they can also afford to pay whatever new fees come with the regulation. Smaller businesses are at a bigger disadvantage and can't compete.

More stuff to chew on. ; )

Ian

Anonymous said...

I agree with Oil Shock. Your thesis is correct but not for all the right reasons. you are also way off regarding your suggestions in what to do. Government spending to stimulate our economy? Come on, you don't want to fall for those fallacies. I like the readings suggested by Oil Shock from the Mises Institute. They will make you change your analysis. THere is no doubt here.

CommonSenseThinker said...

Ian,

Thanks again for you insights. First of all, let me make one thing clear: I am against all bailouts. Those who made bad business decisions should be forced to live with the consequences even if it means failed banks. However, my article points out the best use of taxpayer money if the Feds insist on using it for economic stimulus.

As for the regulations, we need some common sense federally mandated regulations. In absence of such regulations, we have to depend on the players in the financial systems to regulate themselves. While this might sound like a nice idea in theory, in practical world, human nature takes over. In practical world, some people will always be smarter and more influential than others and thereby exert greater control on the financial systems. This would lead to mafia or cartels driven by greed (basic human nature) controlling the financial markets. Cities like Chicago and New York have been through their mafia days. And, these mafia and cartels would not be accountable to common people. Markets do not drive human nature, ultimately human nature drives markets. However, flawed our democratic system might be, it at least allows common people to have some say or influence on federal policies and regulations.

It is better to have the rules & regulations set and enforced by people's representative than have those rules set by mafia or cartels.

tzboy said...

I think many businesses that could create new jobs (or preserve existing ones) are being directly affected by the dearth of loans. The govt's hope is that by infusing cash into banks, the lending process can be re-started. This is needed more for businesses than to risky borrowers.

However, banks are not using any such monies to do any lending, but instead hoarding cash to brace themselves.

To some extent, govt. involvement is needed to mitigate a crises in confidence that's currently gripping the financial system.

BTW, I heard a really good argument by Robert Reich (Professor at UC Berkeley) on NPR yesterday. He remarked that in comparison to the financial industry, it was more important to bail out the automakers who touch a lot more jobs than the banks. In the worst case, if a bank goes under, shareholders and creditors would be affected, but not many jobs would be lost. Any pension funds, or other accounts are guaranteed by the FED and would be transferred to the next institution.

Once, the automakers provide a good business plan, bail them out with contingencies... but let the banks die.

Paulson needs a job after he leaves office... so he's looking out for his pals on Wall Street!

-rj

CommonSenseThinker said...

Hi RJ,

I see your point. In that case, why depend on banks to lend to the businesses who need money. Why not create an agency to lend directly to the businesses that are viable, credit worthy and will create new jobs.

As for Paulson, I simply cannot believe than an ex-investment banker (Goldman Sachs) is in charge of fixing the mess made by the investment banks. He is like a fox in the henhouse or like a crook appointed to police the crooks. He would be back on Wall Street after Obama administration takes over. Forbes has already called him the worst treasury secretary in recent history.

I am for fundamental restructuring of the auto industry, whether Big Auto CEOs willingly agree to it or are forced by bankruptcy. Ofcourse, there has to be strict oversight to ensure restructuring takes place.

Better yet, let them go bankrupt first and then Govt funds the restructured entities post-bailout.

Varun

Anonymous said...

Varun,

It seems you and I will just end up going in circles when it comes to where "best" to spend the money. I understand you're point for asking the question because it is obviously inevitable that they are going to spend the money. I just don't believe that there is any good answer to this.

If you are against cartels you ought to look into the federal reserve and the member banks. This is a cartel at it's finest. It's also a monopoly. I suggest watching the video "A Second Look at the Creature From Jeckyll Island" on google video. It gives the history of the federal reserve and the governments role in this scam.