The consequences of the $700bn mistake

The purpose of Paulson's Bailout plan
The aim of any plan to restore the financial system must be to restore confidence and liquidity in the debts markets foremost, recapitalise the banks and control the effect of mark-to-market losses on hard-to-price assets. These assets are the 'toxic' debt creating the fear which has stopped banks lending to each other, resulting in LIBOR spiking last week. Fundamentally, these assets were highly mispriced (overvalued) during the credit boom and now, due to the lack of liquidity (trust), they are not even priceable. The goal must be to foster the conditions to create a market again for these assets, such that there is a discoverable price, and a reduction in the perceived risk of interbank lending.

However, the bailout plan appears to miss the mark by focussing on stopping gaps rather than solving problems. While it is admitted that a frozen credit market will have severe real-world implications, the merits of the use of $700bn of taxpayer money is questionable. The market response post the 'yes' vote is telling: the only increase in liquidity is in government bonds (a combination of being a safe haven and the issuance of new securities to fund the plan); the sharemarket is clearly telling us it isn't convinced; and moreover, the VIX (volatility index) is hitting unknown highs, meaning that the financial system is perceived as riskier and shakier than ever.

Where the plan has gone wrong
1. Inflation causing 'real' decrease in wealth above and beyond the nominal impact
The bailout will dilute the value of the USD, because the Fed doesn't have the reserves itself to carry out the proposed bailout. Printing money - or creating new treasuries - increases the nominal value of the USD in order to 'inflate away' debts, but will cause high systemic inflation. Of course, in the current environment, wages will not rise to keep up with inflation, while the economy is in recession, meaning Americans real wealth will decrease significantly. America has been one of the world's hungriest consumers post WWII and we are witnessing the break in this chain - one of the major reasons for angst and volatility) in sharemarkets across the world.

2. Distortion to the credit markets
One of the key goals of the bailout package was to kick-start the operation of the credit markets - to provide liquidity in the quasi-dry commercial paper market. However, just as electricity passes along the path of least resistance, so too do funds injected into a broken system. The issuance of treasury paper - seen as much lower risk than corporate bonds (look at the crisis in confidence at GE for instance) - has just meant that available funds have been invested in treasuries. Instead of a kick-start to all credit markets, activity in commercial debt has continued to fall, as money shifts to treasuries.

3. Government Spending Wasted
A Demand-side approach to recesssion/growth management suggests that government spending (the 'G' in the Aggregate Demand formula) can be used to help stimulate the economy. The theory is that government spending will be multiplied - infrastructure projects, for example, will employ workers, who will go on to spend the money in other areas of the economy. Alternatively, tax cuts or well-directed welfare grants can give consumer spending a boost, also with the associated multiplier effect benefit. The bailout plan, on the contrary, utilises government funds (ie taxpayer money) to fill what is essentially a black hole.

There are two issues here. Firstly, to boost aggregate demand, we would need to accept that the benefits of the bailout would 'trickle-down' to the consumer level. Unfortunately, the money is essentially being used to shore up money in financial institutions which have found themselves in a situation of infufficient capital backing. The money, then, reaches financial institutions and stops there. There will be no effect on demand, and certainly no multiplier effect. The government loses its chance at fiscal stimulus.

The second issue is that the structure of the rescue package would actually serve to prolong the downturn. $700bn divided across every US taxpayer is aroudn $2000 per head. Even if the presidential candidates are promising further tax cuts now, this will prove impossible by the time whoever wins takes the reins of the economy. The fact is, there is now an 'extra' $2000 which each taxpayer would have to pay in order to cover government spending as it was tracking pre-crisis.

4. Where to from here
The underlying fault with the US Government's chosen course of intervention is that it failed to recognise a) that the current problems stemmed from a prolonged period of cheap credit, which served to inflate the asset prices that were later used as underlying security for further debt (a virtuous-cum-vicious cycle); and b) that without addressing the cause of the problems, we will not see a return of confidence to the market. Contrary to Bush's claim that without the 'bailout', a failure of the banking system would cause a 1930's style depression, it is in fact a failure to arrest the spiralling real wealth of the American consumer (lack of economic stimulus, asset deflation, consumer price inflation), relative to their debt levels, which would send us there. That is not to say a decrease in real wealth is avoidable: it will absolutely be necessary for the American economy to feel significant pain in order to re-adjust for past excesses.

It is essentially the ability or otherwise of the American consumer/taxpayer to repay their mortgage - or at least the market's perception of their ability to do so - which affects the price of the very assets which spread surreptiously throughout the investment world, and have now become malignant, affecting the viability of financial institutions all around the world.