Tuesday, March 10, 2009

A few words in support of our government

Our government has made the decision that there will be no more Lehman's. That's probably a decision forced upon them by the specter of a complete collapse of the financial system if a big bank like Citi were to go under. Furthermore, our government has concluded that it can't convince Congress to provide the funds to bail out the banks without some help from private sources. But, private funds sit on the sidelines, too afraid to invest in the toxic waste.

The government has given the banks bailouts at little or no interest to beef up their balance sheets. And, since the government has driven down interest rates to near zero, the banks are also getting deposits from private sources at near zero rates. The government has noticed noticed that the banks have developed a strong revenue stream from these sources of funds, due to the huge spreads between the cost of funds and the rates they can charge on new, healthy loans. Both Warren Buffet and John Hempton have provided evidence for this.

These revenue streams will enable the banks to write down their toxic loans against income, if they withhold dividends. The government can apply pressure to ensure this gets done. As the loans are written down they can be sold off to private buyers, who, in turn, can renegotiate the terms with the distressed borrowers and make a reasonable profit on the deal.

But private buyers are wary that the downside risk is too great to be buying up the toxic loans, even at a discount. To reduce the downside risk and bring buyers into the market, the government is willing put a floor under the losses on prospective buyers of problem loans and are willing to make low interest loans to the buyers to leverage the investment and increase their return. This all is part of the Geithner plan.

So the question arises, why should the government do this? The government is essentially using taxpayer resources to bail out the system? True, but if the system will collapse if it's not done, what is the alternative?

There are a couple remaining question to be answered. First, where is all this bailout money coming from. And, second, can the taxpayers be made whole, or at least partially compensated. To answer the first question, we must ask what private investors are doing with their money if they are not spending it to stimulate the economy or investing in, or lending to, businesses, including banks. Mostly, they are buying treasuries at little or no interest. So, if the investors won't spend or invest, and are giving the money to the government, all the government has to do is spend and invest it for them, which is what they are doing by bailing the banks and funding the stimulus. What better use could the government put this money toward than saving the country from the calamity that could arise if the system crashed?

Now, is there a way to make the taxpayers whole, or at least partially compensate them? If the government really wants to compensate the taxpayers who did not contribute to the problem they first have to identify who these taxpayers are, as opposed to the ones that contributed to the problem. This shouldn't be that hard. If we look at who profited from the bubbles, it was clearly the investor class, particularly high income investors and speculators, and the financial and insurance sectors that were so busy profiting that they overlooked the fact that what they were doing was putting the whole country in jeopardy. Some investors have already suffered from losses on their investments, but others have still prospered more than they suffered.

Obama has already taken steps to try to correct the problem. He has proposed raises taxes on the high income investor class, and taxing profits from investments at higher rates than currently are in effect. This is not soaking the rich. It's just taxing them to pay for the trouble they've caused with their hedge funds and derivative investments that have nearly driven the country into a second depression. This is one way of partially compensating low income people who have not profited from the bubbles over the last couple decades, who have seen their paychecks stagnate, and now are losing their jobs. They have suffered enough. And, their children and grandchildren don't need to be saddled with debt that more properly belongs to those who have profited from the growth in the financial sector over the last several decades.

Further measures may need to be taken. A financial transactions tax may need to be implemented after the crisis to make taxpayers whole. The whole financial and insurance industry may need to be restructured to prevent the development of businesses that are to big to fail. Laws to reign in greed and irrational exuberance seem not to have worked, so it may be time for the government to take a more active role in the financial and insurance industries which have caused this crisis. When finance grows from 19% of GDP to 30% in a couple decades it saps the talent from other industries that actually produce goods and services that are necessary to the economy. It's time to reign in these industries to a more reasonable size relative to the rest of the economy.