Fundamentalism to State Capitalism
Henry C.K. Liu
Part I: US
Pours Oil on Fire
Part II: Treasury’s
“Troubled Assets Relief Program” in Trouble
This article appeared in AToL
on October 30, 2008 as: Killer touch for market capitalism
Treasury Secretary Henry Paulson asserts that the full
resources of the Treasury Department are being used to ensure the
its $700 billion Troubled Assets Relief Program (TARP). The “full
the Treasury Department” commands the full faith and credit of the United
States anchored by Treasury’s taxing
authority as approved by Congress. Tax payments in the US
are made to the US Treasury via the Internal Revenue Service.
The Congress can approve taxes for and spending by the
Administration, but Congress cannot create money like the Federal
Treasury’s money can only come from future taxes approved by Congress.
I - Section 7.1 of the Constitution stipulates that “All Bills for
revenue shall originate in the House of Representatives.”
The Federal Reserve has the authority to
create money as part of its monetary policy prerogative but Treasury
have any constitutional authority to expand the money supply. Treasury
depend on tax revenue for funds beyond which Treasury must sell
to raise funds up to the national debt ceiling approved by Congress.
8.2 stipulates that only Congress have the power to borrow money on the
of the United States.
Proceeds from sovereign debt are advances on sovereign liability and
revenue, and must be paid back from future tax revenue.
Thus far, Congress has approved $700 billion of taxpayer
funds to be used by TARP. President Bush also signed a $634 billion
bill on September 30 that includes funding for $25 billion in low-cost
government loans for the distressed auto industry. More public funds
approved as needed. Since the Federal government is and has been
operating on a
fiscal deficit, these funds can only come out of future tax revenue
Also, Treasury is coming under increasing pressure to expand
its financial rescue plan beyond banks to include direct assistance to
ailing auto and insurance sectors.
In recent days, lawmakers and interest groups have stepped
up their efforts to persuade the Bush administration to divert part of
billion authorized by Congress to additional categories of companies
not originally expected to be rescued.
TARP gives the Treasury broad authority to buy any assets
that are important for the stability of the US
financial system. But participation in the sweeping $250 billion
recapitalization plan has so far been confined to US banks. On October
24, the Financial Services Roundtable, an
influential lobbying group in Washington, sent a letter to Neel
interim assistant Treasury secretary for financial stability, a former
Sachs banker brought to the Treasury by Paulson, himself also a former
Sachs banker, urging the administration to consider taking stakes in
“broker-dealers, insurance companies [such as Ambac and MBIA], and
companies [such as GM and Chrysler]” as well as “institutions
controlled by a
foreign bank or company” that play a vital role in the US economy by
liquidity to the market. A Treasury department spokeswoman declined to
on whether the US
would consider expanding the rescue in such a way.
Members of the Michigan
congressional delegation also sent a letter to the Treasury and the
Reserve asking them to take steps to “promote liquidity” in the US
auto industry. It is true that cars are not selling because leasing
frozen and collateral debt obligations (CDO) backed by auto loans. But
knows the automakers are facing insolvency in the long run beyond
Separately, AIG, the insurer that had been rescued by the
government, revealed it had already used $72 billion of an $85 billion
government loan and $18 billion of an additional $37.8 billion credit
from the Fed.
An expansion of the recapitalization plan beyond US banks
would mark a significant new chapter in the government’s response to
TARP’s Seven Policy
Ten days after the new $700 billion TSRP was signed into law
on October 3, Treasury announced that it has created seven policy teams
develop several tools and other important elements that are required
securities purchase program: This team is identifying which
to purchase with taxpayer funds, from whom to buy them and which
mechanism will best meet Treasury policy objectives “to protect
making the best use of their money.” Treasury
is designing the detailed auction
protocols and will work with
vendors to implement the program.
For more than a year, the market has been unable to identify
with clarity troubled assets, their owners and how such assets can be
and at what price. The uncertainty is real and it has created justified
yet unknown losses in the market. It is not likely that the new team at
Treasury, no doubt highly capable, can solve this riddle quicker than
market can without the existence of a central clearing mechanism.
loan purchase program: Regional banks are particularly clogged with
residential mortgage loans that have not been securitized and sold to
investors. This team is working with bank regulators to identify which
loans to purchase first, how to value them, and which purchase
best meet policy objectives “to protect taxpayers by making the best
their money.” This is not a simple task. It would involve value
political calculations inherent in the policy objectives. It is not
this program will work more effective than market forces without
program: Treasury said it is establishing a program to insure
assets. It has several innovative ideas on how to structure this
including how to insure mortgage-backed securities as well as whole
the same time, it recognizes that there are likely other good ideas out
that it could benefit from. Accordingly, on Friday, October 10,
submitted to the Federal Register a public Request for Comment to
best ideas on structuring options. The Treasury was requiring responses
fourteen days so it could consider them quickly, and begin designing
With many insurance companies on the verge of insolvency
from rising claims on counter-party defaults, the Treasury’s insurance
on troubled assets looks like an attempt to insure losses that have
occurred, in violation of the basic principle of insurance.
purchase program: Treasury is designing a standardized program to
equity in a broad array of financial institutions. As with the other
the equity purchase program will be voluntary and designed with
terms to encourage participation from healthy institutions. It will
encourage firms to raise new private capital to complement public
On a voluntary basis, it is a puzzle why healthy
institutions would need or want to sell equity to the Treasury. On
October 14, an hour before the market opens in New York at 9:30 am,
Secretary Henry Paulson, Federal Reserve Chairman Ben Bernanke and
Deposit Insurance Corporation (FDIC) Chairman Sheila Bair, supported by
Chairman Christopher Cox, Commodity Futures Trading Commission (CFTC)
Walter Luken, Office of controller of Currency (OCC) Controller John
Dugan and Office
of Thrift Supervision (OTS) Chairman John Reich, announced that the
will invest up to $250 billion in preferred stocks, half of it at large
The lists of banks participating include Goldman Sachs Group Inc. ($10
billion), Morgan Stanley ($10 billion), JP Morgan Chase ($25 billion),
America Corp. – including the soon to be acquired Merrill Lynch ($25
Citigroup Inc. ($25 billion), Well Fargo ($25 billion), Bank of New
billion), Mellon ($3 billion) and State Street Corp. ($2 billion).
are designed to keep money flowing through the frozen banking system to
the economy going.
The government will purchase preferred stocks, an equity
investment designed to avoid hurting existing shareholders and
ones. The preferred stocks do not have voting rights, and carry a 5%
dividend that rises to 9% after five years. The government’s plan will
structured to encourage firms to bring in private capital. Firms
capital to government by 2009 may get better terms for the government’s
Financial institutions will have until mid November to decide whether
to participate in the government recapitalization scheme. The minimum
injection will be 2% of risk-weighted assets and the maximum will be 3%
risk-weighted assets, with an overall cap at $25 billion. Critics are
why the government is only getting 5% when Warren Buffet was getting
guaranteed dividend in his recent investment in Goldman Sachs.
The senior preferred shares will qualify as Tier 1 capital
and will rank senior to common stock and pari passu, which is at an
in the capital structure, with existing preferred shares, other than
shares which by their terms rank junior to any other existing preferred
The senior preferred shares will pay a cumulative dividend rate of 5%
for the first five years and will reset to a rate of 9% per annum after
five. The senior preferred shares will be non-voting, other than class
rights on matters that could adversely affect the shares. The senior
shares will be callable at par after three years. Prior to the end of
years, the senior preferred may be redeemed with the proceeds from a
equity offering of any Tier 1 perpetual preferred or common stock.
also transfer the senior preferred shares to a third party at any time.
conjunction with the purchase of senior preferred shares, Treasury will
warrants to purchase common stock with an aggregate market price equal
of the senior preferred investment. The exercise price on the warrants
the market price of the participating institution's common stock at the
issuance, calculated on a 20-trading day trailing average.
Executive compensation, including golden parachutes will be
limited at banks that accept government investments. The Fed will
senior debts issued by banks over the next three years.
The FDIC, invoking a “systemic risk” clause in Federal
banking law, will provide unlimited insurance to all
accounts primarily used by businesses. The cost of this insurance will
from user fees paid by banks outside of the $700 billion TARP. It
joined the global race to guarantee bank deposits to prevent US
bank deposit from fleeing to countries with safer guarantee levels.
billed as a global coordination of all central banks while in reality
is a sign
of rising financial nationalism.
preservation: The Treasury said when it purchases mortgages and
mortgage-backed securities, it will look for every opportunity possible
homeowners. This goal is consistent with other programs - such as HOPE
aimed at working with borrowers, counselors and servicers to keep
their homes. In this case, Treasury is working with the Department of
and Urban Development to maximize these opportunities to help as many
as possible, while also protecting taxpayers.
Yet none of the government programs launched so far have
been effective in helping homeowners because ready opportunities to
have not been found. The bottom line is that it is not possible to help
distressed homeowners and protect taxpayer money at the same time.
compensation: The law sets out important requirements regarding
compensation for firms that participate in the TARP. This team is
to define the requirements for financial institutions to participate in
possible scenarios: One, an auction purchase of troubled assets; two, a
equity or direct purchase program; and three, a case of an intervention
prevent the impending failure of a systemically significant
Management would opt for bankruptcy protection if executive
compensation should be more liberal under bankruptcy than participation
TARP. Also, the interconnected nature of
financial markets nowadays has produced a large number of “systemically
The law establishes important oversight and compliance structures,
establishing an Oversight Board, on-site participation of the General
Accounting Office and the creation of a Special Inspector General, with
thorough reporting requirements. The Treasury said it welcomes this
and has a team focused on making sure it gets it right.
The Impact of Leverage and De-leverage on
The accumulation of assets via massive amounts of debt is
known in finance as leverage, expressed as debt-equity ratio.
push up the price of assets so acquired and de-leveraging can push down
price of such assets.
A broker-dealer trades securities for customers as well as
for proprietary accounts. In US markets, a broker-dealer must register
Financial Industry Regulatory Authority, a self-regulating organization
the Security Exchange Act of 1934 as part of the New Deal. When
orders on behalf of a customer, the institution is said to be acting as
broker. When executing trades for its own account, the institution is
be acting as a dealer.
Many broker-dealers had been routinely leveraged to over 30
times during the credit bubble released the Fed under Alan Greenspan.
now frantically trying to bring leverage down to below 20 times, still
high as what was considered prudent by the SEC since 1975 until the net
rule was exempted for five major institutions in 2004.
The net capital rule created by the SEC in 1975 required
broker-dealers to limit their debt-to-net-capital ratio to 12-to-1, and
must issue early warnings if they began approaching this limit, and
to stop trading if they exceeded it, so broker-dealers often kept their
debt-to-net capital ratios much lower than 12-1. The rule allowed the
oversee broker-dealers, and required firms to value all of their
assets at market prices. The rule applied a haircut, or a discount, to
for the assets’ market risk. Equities, for example, had a haircut of
a 30-year Treasury bill, because it is less risky, had a 6% haircut.
But a 2004
SEC exemption -- given only to five big firms -- allowed them to lever
and even 40 to 1.
The five big firms wanted for their brokerage units an
exemption from the 1975 regulation that limited the amount of debt they
take on to $12 for every dollar of equity. The exemption would
billions of dollars held in reserve as a cushion against losses on
investments. Those equity funds could then flow up to the parent
enabling it to invest in the fast growing but opaque world of
securities, credit derivatives, credit default swaps - a form of
bond holders - and other exotic structured finance instruments.
In 2004, the European Union passed a rule allowing the SEC’s
European counterpart to manage the risk both of broker dealers and
investment banking holding companies. In response, the SEC instituted a
similar, voluntary program for broker-dealers with capital of at least
billion, enabling the agency to oversee both the broker-dealers and the
companies. Ever since the Great Depression, the government has tried to
the leverage available to the public in the US
stock market by maintain margin requirements. But regulators, led by
chairman of the Federal Reserve Alan Greenspan, thought financial
would be hampered, and financial activity driven to unregulated market
overseas, if there were any attempts to impose limits on leverage in
unregulated credit and capital markets. After all, innovation was
viewed as the
driving force in US
prosperity. The global financial system embarked on a race to assume
under a mentality of “if I don’t smoke, somebody else will.”
This brave new approach, which all five qualifying
broker-dealers - Bear Stearns, Lehman Brothers, Merrill Lynch, Goldman
and Morgan Stanley - voluntarily adopted, altered the way the SEC
their capital. The five big firms led the charge for the net capital
change to promote financial innovation, spearheaded by Goldman Sachs,
headed by Henry Paulson, who two years later, would leave Goldman to
Treasury Secretary, who now has to deal with the global mess
Using computerized models provided by the five big firms,
the SEC, under its new Consolidated Supervised Entities (CSE) program,
the broker-dealers to increase their debt-to-net-capital ratios,
in the case of Merrill Lynch, to as high as 40-to-1. It also removed
for applying haircuts, relying instead on another math-based
for calculating risk that led to a much smaller discount.
The SEC justified the less stringent capital requirements by
arguing it was now able to manage the consolidated entity of the
and the holding company, which would ensure better management of risk.
Commission’s 2004 rules strengthened oversight of the securities
because prior to their adoption there was no formal regulatory
liquidity requirements, and no capital requirements for investment bank
companies,” a spokesman for the agency rationalized.
In loosening the capital rule, which was supposed to provide
a buffer in turbulent times, the SEC also decided to rely on the five
firms’ own computer risk models, essentially outsourcing the job of
risk to the banks it was supposed to supervise. Over subsequent years,
would take advantage of the looser capital rule to increase
The leverage ratio - a measurement of how much the companies
were borrowing compared to their total assets - rose sharply at Bear
to 33 to 1. In other words, for every dollar in equity, it had $33 of
ratio at the other firms also rose significantly. This advantage
the Big Five to go on a frenzy of acquisition, expanding risk to the
financial system. The abuse of leverage was particularly severe in the
fund industry in which the Big Five were big players both in
and as broker-dealer for large hedge funds who in turn were highly
The SEC did reexamine its efficacy after the Bear Stearns collapse.
“Immediately after the events of mid-March, when the run-on-the-bank
to which Bear Stearns was exposed demonstrated the importance of
loss of short-term secured funding into regulatory stress scenarios,
Supervised Entities (CSE) program revised the analysis of liquidity
management, with enhanced focus on the use and resilience of secured
and Exchange Commission Chairman Christopher Cox testified at the July
hearing. “The SEC has also worked closely with the Federal Reserve in
this additional stress testing.”
Two months after Chairman Cox testified, however, two more
broker-dealers collapsed, and one of the two remaining broker-dealers -
Stanley - was in talks to merge with Wachovia which itself was in
had to be taken over by Wells Fargo. It is now clear that the SEC
modification in 2004 is a primary reason for the massive losses that
occurred in 2008.
On Sept. 26, 2008, Chairman
Cox announced a decision by the SEC Division of Trading and Markets to
Consolidated Supervised Entities (CSE) program, created in 2004 as a
global investment bank conglomerates that lack a supervisor under law
voluntarily submit to regulation. Chairman Cox also described the
plans for enhancing SEC oversight of the broker-dealer subsidiaries of
holding companies regulated by the Federal Reserve, based on the recent
Memorandum of Understanding (MOU) between the SEC and the Fed.
Chairman Cox made the following statement along with the SEC
announcement on ending the CSE:
last six months have made it
abundantly clear that voluntary regulation does not work. When Congress
the Gramm-Leach-Bliley Act [on November 12, 1999 to repeal the
Act of 1933 which had prohibited a bank from offering investment
insurance services], it created a significant regulatory gap by failing
to the SEC or any agency the authority to regulate large investment
companies, like Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman
and Bear Stearns.
The SEC said it has no plans to re-examine the impact of the
2004 changes to the net capital rule, yet it put out a proposal to
rule once again. This time, it is looking to remove the requirement
broker-dealers maintain a certain rating from the ratings agencies.
On Sept. 26, the commission formally ended the 2004 program,
acknowledging that it had failed to anticipate the problems at Bear
the four other major investment banks.
When the need to de-leverage is triggered by insufficient
revenue, asset prices will fall and insolvency can result.
is merely a euphemism for insolvency unless new capital can be raised
Recapitalization is a euphemism for dilution of sunk equity with new
Recapitalization alters the capital structure of a corporation. It is
accomplished by an exchange of bonds for stocks. Pending bankruptcy is
reason for recapitalization. Debentures might be exchanged for
bonds that pay interest only when earned.
law, a healthy company might seek to save taxes by replacing preferred
with bonds to gain interest deductibility from its tax liabilities. In
corporate finance, in-substance defeasance is a technique whereby a
discharges old, low rate debt prior to maturity without repaying it.
corporation uses newly purchased securities with a lower face value but
a higher interest or having a higher market value. The objective is to
a more debt free balance sheet and increase earnings in the amount by
face amount of the old debt exceeds the cost of the new securities.
The use of defeasance in modern corporate finance began in
1982 when Exxon bought and put into an irrevocable trust $312 million
government securities yielding 14% to provide for the repayment of
and interest on $515 million of old debt paying 5.8% to 6.7% and
maturing in 2009. Exxon removed the
defeased debt from
its balance sheet and added $132 million – the after tax difference
$515 million and $312 million – to its earnings in that quarter.
defeasance may well the magic bullet to get out from the curse of over
Global stock markets staged a historic rally on Monday
September 13 as European governments pledged a total of €1.87 trillion
trillion) to shore up their banking system and the US
prepared to unveil its own comprehensive rescue plan a day later. In
the S&P 500, which the week before fell 18.2%, rose 11.6% – the
daily gain since the volatile trading of the Great Depression. The Dax
the Frankfurt stock exchange closed up 11.4%
CAC40 in Paris rose 11.2%.
the FTSE 100 rose 8.3%, its second largest one-day gain in history, and
in Hong Kong, the Hang Seng index rose 10.24%.
Yet, the Treasury
announcement on Tuesday September 14 failed to extend the one-day
that had greeted every one of the government’s precedent–breaking
measures. All the governmental
spectaculars failed to break the secular bear market in which each
fails to breach the previous low.
Three-month Sterling Libor was just 2 basis points lower at
about 6.25%, more than 2 percentage points above where markets are
interest rates and higher than where the rate set before the
interest rate cuts by major economies in the second week of October.
euro three-month Libor, which was down 7.37 basis points at 5.225% on
14, remained high. There were only weak signs of relief in the frozen
markets at the centre of the financial crisis, as three-month dollar
eased to 4.75% from 4.82%, even after the Fed lowered the Fed funds
to 1.5% on October 8 and 3-month treasuries were yielding 0.5%. This
so-called Ted spread, which measures the difference between inter-bank
rates and risk-free government lending rates, at a hefty 420 basis
Recapitalization, while lowering leverage to protect the
market value of debt, further depresses asset value. Such are the laws
finance in market economies. For this reason, taxpayers may never
investment in the Treasury’s nationalization program of the banking
government funds received by banks are used to de-leverage rather than
government’s misguided approach of monetizing illiquid assets held by
distressed institution to remove insolvency threats is self defeating.
step, it has predictably failed to jump start credit and capital
seizure because excessive liquidity cannot be cured by more liquidity.
become illiquid because their price stubbornly stays above their market
Such assets will stay illiquid until price adjustments bring about
transactions. Government monetization of illiquid assets will only
their illiquid life span.
Markets are not the best intermediaries of long-term value,
because for market economies, markets are the prime intermediaries of
short-term value. This is why economist Hyman Minsky thought that a
public sector is needed to moderate short-term volatility in the
sector. When the private market sector dominates the economy, the price
will be excessively tilted by short-term conditions.
Markets can only function when there are matching numbers of
willing buyers and sellers at any one time. When the number of sellers
larger than the number of buyers, prices will fall, or in a reverse
prices will rise until the number of buyers and sellers match up. Price
point where willing sellers and willing buyers meet for a fair
Until the price is right, the market remains in suspension. Price
then is the key factor in addressing imbalances between buyers and
the market. This is both the strength and the weakness of market
Free markets require an equal degree of market power between
buyers and sellers. Ideally, a truly free market always leaves both
sellers happy, each being satisfied that the transaction price reflects
differing judgment of fair market value at t he point of transaction.
thinks he will gain from future appreciation and the seller thinks he
avoid loss from future depreciation. Only one party in the transaction
turn out to be right at any future point in time. The probability of
wrong is the risk in the transaction. That is the basic principle of
fundamentalism, which is governed by the principle of fluctuating
demand through time, intermediated by fluctuation in price.
When market power is not equally distributed among market
participants, a free market is replaced by a coerced market. A coerced
is one when one side, either buyers or seller, has more market power.
market power distorted prices to generate market inefficiency. A failed
is one when there are no buyers or sellers at any price.
The ultimate coerced market is one where the government,
which by definition possesses overwhelming market power by virtue of it
ability to print money by fiat, is the only buyer or seller. Market
fundamentalists are right in their belief that government should stay
the market to avoid destroying the market. Yet they are wrong in
government should deregulate markets to keep it free. And above all,
they are dangerously
wrong in thinking that markets can satisfy all economic needs. The
that there are large segments of the economy that only government can
effectively and efficiently, national defense being one obvious
government economic segment is known as the public sector in a market
As economist Hyman Minsky pointed out insightfully, the public sector
a much needed function in stabilizing the business cycle in the private
A society without an adequate public sector leans towards economic
will eventually implode.
In finance, to make a market means maintaining ready, firm
bids and offer prices in a given security by standing ready to buy or
publicly quoted prices in round lots (generally accepted units of
trading on a
securities exchange – on the New York Stock exchange, a round lot is
for stock and $1000 or $5000 par value for bonds). The dealer is called
market maker in the over-the-counter market outside of exchanges. On
exchanges, the dealer is called a specialist. A dealer who makes a
a long period is said to “maintain” a market.
The NASDAG requires that there be at least two market makers
for each stock listed in the system. The bid and asked quotes are
ensure that the quote is a representative spread. Registered
traders in the NYSE are market makers because, in addition to trading
own accounts, they are expected to help correct an imbalance of orders.
Registered competitive traders are NYSE members who buy and sell for
accounts. Because their members pay no commission, they are able to
even small changes in market prices, thus tend to trade actively with
volume. Like specialists, registered competitive traders must abide by
rules, including a requirement that 75% of their trade be stabilizing,
they cannot sell unless the last trading price on a stock is up, or buy
the last trading price was down. Orders from the trading public take
over those of registered competitive traders, which normally account
than 1% of total volume.
The central bank cannot be a market maker because the
central bank is empowered to create new money. This power to create new
gives the central bank unequalled market power and turns it from a
into a market destroyer. Throughout history, the sovereign who enjoys
of seigniorage refrain from being a market participant for good
the sovereign owns everything, there is no way to tell how much the
is worth. This is why even in a
communist society where the people as sovereign own the means of
markets are still required to establish prices to efficiently allocate
and financial resources.
The government’s intervention has created a relative advantage
for companies to raising funds through guaranteed bank paper versus the
asset-backed markets. The ability of banks and other financial groups
money via government guarantees means funding through more traditional
like asset-backed securities will be much more expensive. In the
the government moves is having an effect. There has not been any
credit cards because all the major banks now have another, cheaper
addition to offering banks cheaper sources of funding, the explicit
guarantees on many bank securities has led to a sell-off in bonds
mortgage financiers like Fannie Mae and Freddie Mac, as well as
securities. As a result, the cost of borrowing in asset-backed markets
soared, with the premiums over US government bonds at record highs.
private sector funding even less attractive.
There are also signs that government funds are being used by
banks to buy rivals, rather than provide new lending. On Friday,
PNC Financial became the first bank to make use of the US
government’s bank recapitalization program to merge with a weaker
rival. In the
longer term, credit card debt securitization have to be revived because
government programs are not large enough to cover all the banks’
Central Banks Have
Become Market Destroyers
The recent opening of the Federal Reserve discount window to
borrowings by commercial banks, collateralized by illiquid assets, and
extension of discount window access to investment banks have pushed the
bank across the line of being a lender of last resort to being a market
destroyer. It is no wonder that its liquidity injection moves have
moderate seizure of global credit markets. This is because the central
not constrained by the supply and market value of money, can set the
illiquid asset by fiat, thus destroy the very function of the market in
meaningful prices that can defuse market seizure. Central
bank intervention into credit markets
to artificially support asset prices above market levels carries no
market implication, save the impact of future inflation. The market
asset prices assigned by the central bank are not real and will be
downward as soon as central bank intervention ends. And until central
intervention ends, the market remains in suspension.
This explains why despite central bank intervention, and
perhaps even because of it, inter-bank lending stayed halted, with
(London Inter-bank Lending Rate) rising high above normal spread over
rate targets. In the non-banking financial sector, new commercial paper
issuance, the short-term funding source of choice for financial and
non-financial corporations, could not find buyers. In sum, global
markets continue to fail despite escalating and increasingly desperate
government intervention measures.
One of the key objections behind the House of Representative
initial rejection of the Treasury’s $700 billion rescue package was
that at the
end of the rescue term of 30 years, the public may not be paid back on
that the illiquid collateral might still not yield returns that match
face values. The overvaluation of such illiquid assets cannot be made
through inflation because de-leveraging made possible by inflation will
the market value of such assets below its after inflation face value.
congressional opposition wanted prearranged authority to tax the
to recoup the investment for the public whose tax money was being used
rescue of distressed institutions.
The market was more honest than most paid pundits and
special interest policymakers. Market participants knew the crisis was
merely a passing liquidity crunch, but a widespread insolvency created
excessive asset value unsupported by compensatory revenue. Insolvency
translate into sharp declines in asset price. The government can
market in the name of saving it but the laws of market cannot be
Some critics have mistakenly complained that the US
government has turned to socialism for solution to the current
in a capitalistic system. Yet what the US
government has done is merely turning failed market capitalism into
capitalism. Nationalization alone does not lead to socialism. Socialism
merely collective ownership of the means of production. It must also
to an operative goal of fair sharing of the fruits of the economy
collective ownership of the means of production.
In a socialist state, state-owned enterprises are the venue
of socialist ownership of the means of production which is deployed to
the interests of workers. But in a capitalist state, state-owned
not entertain such populist goals. State capitalism continues to
workers for the benefit of capital while the state represents the
capitalists rather than workers. State capitalism subscribes to the
down theory – saving the banks to save the citizenry. What is needed is
government to save the citizenry by direct assistance with job
wage guarantees, not inter-bank loan guarantees.
Incoming data for September showed unemployment at 6.1% and
still climbing, above the non-accelerating inflation rate of
(NAIRU) of 6%. Non-farm payroll employment declined by 159,000; in a
labor force of 154.7 million, with a labor force participation rate of
66%. Total employment was 145.3 million
employment-population ratio was 62%. Since
a recent high in December
2006, the employment-population ratio has declined by 1.4
percentage points. The number of persons
who worked part time for economic reasons
rose by 337,000 to 6.1 million in September, an increase of 1.6 million
the past 12 months. This category
includes persons who would like to work full time but were working part
because their hours had been cut back or because they were unable to
full-time jobs. These data suggests an extremely weak economy going
The entire global market economy, fueled by decades of
excess liquidity and debt denominated in fiat dollars imprudently
the US Federal Reserve, had turned even prudent debt to equity ratios
times into precariously over-leveraged debt structures. Asset price
defined as growth by central banking doctrine, had allowed the global
economy to assume debt levels that could not be serviced by relatively
or even falling wage income. In an asset price bubble unsupported by
corresponding rise in wage income, even normally prudent debt-equity
will result in precarious debt leverage.
Either wage income must rise, or asset prices must fall to
restore financial equilibrium. Government intervention to prop up
asset prices without compensatory wage rise will only end in
A sharp decline in assets prices will unavoidably spell
widespread bankruptcy for many financially overextended companies and
individuals. This will constrict demand temporarily to delay inflation
but hyperinflation will result as certainly as the sun will rise
democracies cannot allow deflation to cause widespread bankruptcy even
debt bubble. In my January
deflation and rotten apples, I wrote (Central banks
fear deflation more than inflation):
“Although Greenspan never openly acknowledges it, his great fear is not
inflation, but deflation, which is toxic in a debt-driven economy.
stability’ is a term that increasingly refers to anti-deflationary
to keep prices up rather than down.”
By now, it is becoming clear that government policy has
been mostly focused on maintaining asset price at levels that the
rejected. Logic suggests that such a policy will result in
the end of the day that will lead to more bankruptcies down the road in
protracted downward spiral. The government’s attempt to save
financial institutions may well cause the total destruction of market
capitalism. And if past experience is any guide, unless wage income is
to inflation, the dilution of asset value through inflation will only
the arrival of total market failure and a total melt down of the market
So far, not much is heard from official circles that suggest
the solution to the current credit crisis can only come from an
substantial rise in wage income. Instead of bailing out insolvent
institutions, the government should use sovereign credit to maintain
employment and boost wage income to catch up with inflated asset
prices. If the
Fed must print new money to save the system, the new money should go to
creation and wage increases rather than to recapitalize insolvent
corporations. Full employment and rising
wages will halt
the fall of asset prices with a rising floor.
The approach adopted by the Bush administration is not
designed to rescue a collapsing global economy from total meltdown but
resurrect free market capitalism from ideological bankruptcy with state
October 26, 2008