Sunday, 1 February 2009

A big bang clean up, why didn't anyone think of it before?

The new Obama administration is preparing for a "big bang" financial clean up. Everything will be sorted out in one go; unmerited bonuses, toxic loans, undercapitalized banks and foreclosures. The hope is that after the big clean up, banks will be back in business, lending money, taking deposits and generally boosting economic growth.

The architects behind this plan hope that it will compare favourably to the lethargic response of the Bush administration and its discredited treasury secretary - Hank Paulson. Yet contrary to popular perceptions, the Bush administration was not made up of stupid people. So why didn't Paulson and the US Treasury put together a similar rapid response plan?

There are two answers to this question. First, there is the thorny matter of burden sharing. The "big bang" clean up plan will pile all the costs onto the taxpayer. It will be one huge unmerited and extremely expensive gift to the banks and their shareholders.

Paulson understood this and tried to limit the fiscal costs of the bailout. He knew that banks would exaggerate their difficulties and try to dump every dubious loan onto the taxpayer. He also recognized that once the banks got their hands on public money, other industries would immediately produce a similar begging bowl. He was, of course, right about that.

The second reason was the magnitude of the clean up costs. Once US treasury bondholders begin to comprehend the cost of a one-sided and over-generous bailout, they will begin to question US long run fiscal sustainability. Eventually, the risk of financing a huge fiscal shortfall will be priced into long run treasury yields. This would lead to a self-defeating cycle of higher interest rates, lower investment and consumption and ultimately lower economic growth.

A big bang financial clean up might seem a good idea right now, but just wait until bondholders and taxpayers see the price tag. Paulson understood the dangers of a hasty and ill-considered bailout. He knew that it would mean handing over the US treasury to the banking system. He also understand that if the banks took control of the process, the US economy would suffer the consequences for generations.

16 comments:

Mark Wadsworth said...

They're going at this from the wrong end, see my comment on your previous post.

AntiCitizenOne said...

Yep, MW is right we need financial triage, not permanent vegetative companies on taxpayer funded life support.

Anonymous said...

The optimism of youth.

Mitch said...

It may well get him re elected though if he can keep them plates spinning for 4 years.

Irrational Doomsday Blog said...

I find it interesting the Bush policy was labeled as "lethargic." Discredited, absolutely, but lethargic?

But from October to January, there has absolutely never been as much pledged or done in a similar period of time, by even an order of magnitude. The dollar value on the pledges is much more than even WWII, and had little effect.

I found myself reading the news on what policies they were enacting, and was shocked on a daily basis. Sometimes if the fundamentals are good and there's a confidence crash, you can get a response from this slap in the face approach. But they've been slapping harder and harder, putting a gun to the head of the markets, and screaming, "have confidence!"

The patient is already dead, it's not going to respond to a slap in the face. There is going to be a huge downturn in economic health regardless of how big the moves are- and I really doubt we can afford even what we've done so far.

Zed said...

Irrational Doomsday Blog

Enjoyed reading your comment.

Anonymous said...

Have the pussies of our modern age not noticed something: Bush had to fight a war for the past eight years. That, kind of like, cost some money. And you know what? Most people just got to ride it out stuffing their faces with cupcakes and mealy mouthed platitudes about how muslims were hard done by. Pathetic. Buck up and move on.

Vado said...

There aren't many people who will stand up and defend Paulson.

Anonymous said...

Far too generous to Paulson IMHO.

His supposed 'caution' was in fact due to the proximity of the US Presidential election which the Republicans were likely to lose. Most of his measures were therefore to keep the banking system standing just long enough to allow him to get out of the door. It was an exercise in kicking the can down the road.

aSteve said...

Yesterday, I'd have considered the apparent anti-Democrat tone of this post to be misguided... Today, I'm not so sure - but I'm convinced that the Bush administration and Paulson are being viewed through rose tinted spectacles.

I think most of the moves made by the Obama team have been sensible and above board. I was reassured, for example, that Paul Volcker was brought onto the team... hardly the man I'd chose to advise me if I intended to take an inflationary strategy. I began to worry, however, when I read a recent piece by Soros in the FT - where he seems to claim financial realities that don't add-up, but that might radically alter the markets for financial assets... and where he talks about massive "destruction of wealth." Sure, his investments might be collapsing, but wealth isn't being destroyed - it is merely being transferred.

I guess we will see soon the extent to which the Obama presidency is able to act independently of the lobbying of vested interests... given that Soros has been a major sponsor of the Democrats.

Anonymous said...

Anyone who understands what Hank Paulson did at Goldman, understands what he was doing as Treasury Secretary and for whom. These observations about the quality of his work at Treasury are hopelessly misguided.

Peter Young said...
This comment has been removed by the author.
Anonymous said...

Either we've spent the future, or it's been spent for us. Whichever, the future is now the present and the debt collector as at the door and there's no money in the savings jar.

economicvoicedotcom

Nick von Mises said...

I see I'm not the only one to see you are treating Paulson with far too much respect (total contempt being the appropriate treatment)

Witold said...

Alice, with all due respect to your usually penetrating remarks, Paulson and company are much less than what they seem. They are engaged in magical thinking about "quantitative easing" and other nonsense of this kind, thrashing aimlessly between their bankrupt ideology and pressure of the situation. Their primary aim is to preserve the wealth of the top 0.1% of US population, while pretending concern about social consequences. They are flying blind. What US needs, is not more debt; it needs transparent accounting, clear rules, accountability, and - yes - collapse of insolvent institutions. There are 1000's of banks in US that are in perfectly good shape, that are now being slowly squeezed by the bunch of yahoos in power, who try to rescue a small number of insanely huge banks (Citi, BofA, etc.) from having to suffer the consequences of their negligence, studpidy, and greed - with a tab carried by the working stiffs of America. Obama's task is to prevent a revolt of poor versus the rich; but if they continue in this manner, they may not succeed. Those bozos are really no different than the clowns in UK; they may be less prone to openly idiotic statements, although with Ben Bernanke talking about printing their way out of trouble, they become more and more similar to UK fellows every day.
Great blog. Keep up the good work.

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