This week the Obama administration released the details of its plan to stimulate the flow of credit and reduce the cost of borrowing by subsidizing the purchase of mortgage and other debt-backed securities, the market for which has completely dried up since the onset of the crisis. The plan is designed to encourage so-called public-private-partnerships (PPPs) between private investors and the US government, in an arrangement in which the US Treasury will put up billions in low-interest, nearly risk free loans to private investors willing to purchase the toxic assets- now politely dubbed ‘legacy assets’ by the administration- that have been straining the balance sheets of the banks that hold them. The idea is that if investors can be enticed into buying these debt instruments, then the banks will be able to move them off of their balance sheets and thus be able to begin issuing new loans to consumers, in turn helping to stimulate the debt-fueled demand that has fallen off sharply since the bursting of the housing bubble and the collapse of the ‘originate-and-distribute’ model of debt creation.
After Treasury Secretary Tim Geithner divulged the details of the plan on the morning of 23 March, the markets responded by surging upwards, with banks leading the way: the S&P Financial index gained an impressive 19%, driving overall gains of 7% in the broader S&P 500. Optimists began suggesting that the ‘bottom’ is in sight, perhaps marking a turning point in a global recession in which 50 trillion in global wealth has faded into oblivion , stock markets have plumbed lows not seen in a decade, and global unemployment has skyrocketed.
Yet the terms of the arrangements are suggestive of the enormity of the problem. In order to entice private investors to buy these securities, the government is taking on almost all of the risk of the venture and loaning up to 97% of the purchase price of the securities to investors. In order to provide such an incentive the US Treasury will put up nearly $100 billion of its own funds from the Troubled Asset Relief Program (TARP) and use its leverage from the Fed and the FDIC to borrow up to $900 billion which it will loan out to potential investors. The New York Times described the arrangement:
[The] crucial incentive for investors — traditional fund managers, hedge funds, private equity funds, pension funds and possibly even banks — is that the government would lend as much as 85 percent of the purchase price for each portfolio of mortgages….On top of that, the Treasury would invest one dollar of taxpayer money for every dollar of private equity capital to cover the remaining 15 percent of the portfolio’s purchase price….The biggest inducement in all the programs is the government’s willingness to provide “nonrecourse” loans to institutions that buy up the unwanted assets. A nonrecourse loan is secured only by the underlying home or building….If the borrower defaults, the government would only be able to seize the real estate. If the mortgages or the securities generate bigger losses than expected, the government and not the private investors would have to absorb the brunt of those losses.
The money generated from the TARP-backed plan could result in up to $1 trillion being handed over to investors- yet this is not all. The Troubled Asset-backed Loan Facility (TALF), will also create close to $1 trillion in loans for roughly the same purpose as the TARP fund.
How are we to explain the administration’s willingness to have the US taxpayer shoulder the risk of the TALF and TARP plans while at the same time exposing the dollar to immense inflationary pressures and potential devaluation? Amidst the recent AIG bonus scandal public outrage has been directed at the crony-capitalism of the Fed-Treasury-Wall Street nexus exemplified by figures like Geithner, whose conflicts of interest and ties to big Wall Street firms compromise their ability to make good policy decisions. Indeed, as David Harvey recently wrote on this site, the class-warfare dimension of the current crisis should not go un-noticed. The current plan will no doubt continue the trend in the redistribution of wealth toward the wealthy. We should supplement this analysis of the class-warfare dimension of the crisis with one that explains why the plan will fail, even on its own terms.
Geithner’s wager is based on three erroneous assumptions. First, that hidden in that titanic morass of debt backed securities is value. Second, that the fundamentals of the US economy are essentially sound. And third, that the foreign governments that buy up our debt will continue to do so regardless of the fiscal and monetary profligacy of the Obama administration and the huge global imbalances that have been growing for half a generation. There are significant problems with each of these assumptions, and I will deal with them in turn.
The Geithner plan assumes that the debt-securities and credit-derivatives bogging down the banks’ balance sheets are not being purchased because their values are unknown; thus, for obvious reasons, investors are loth to take on the risk these assets conceal. Nobody knows if the low prices of these securities simply reflect an unduly large risk premium, or, alternatively, if the low prices are an indication of the underlying toxicity of the asset. A recent Financial Times article describes the problem:
The scheme should clarify the degree to which current depressed prices of traded securities reflect a liquidity risk premium – absence of financing – as opposed to expected credit losses, and may lead to a new, higher price level being established….”We are trying to tease out the liquidity premium,” said Sheila Bair, chairman of the FDIC. The plan could reveal that the liquidity risk premium was large – as Ms Bair expects. Or it could show that the premium was not that big and expected losses are very large.
Currently, the banks are caught between a rock and a hard place, as selling off their debt-securities at current prices would entail even more losses, while not selling them off will inevitably lead to future write-downs and the prolonging of the credit crisis. Geithner’s hope is that the huge incentives and cheap financing provided by the government will restart the market for these troubled assets, raising their prices and lowering their risk premiums.
Yet it is far from clear that the Geithner plan will be able to square this circle, as the market forces driving down prices and pushing up risk premiums may be too strong to overcome. Again, the New York Times:
Risk-taking institutional investors, like hedge funds and private equity funds, have refused to pay more than about 30 cents on the dollar for many bundles of mortgages, even if most of the borrowers are still current. But banks holding those mortgages, not wanting to book huge losses on their holdings, have often refused to sell for less than 60 cents on the dollar.…The result has been a paralyzing impasse. Banks, unwilling to sell their loans at fire-sale prices, have had less capital available to make new loans. Mortgage investors, unable to leverage their investments with borrowed money, have been unwilling to pay more than fire-sale prices.
Even if the Geithner plan is able to attract investors, a further very serious problem remains: the size and scope of the plan. According to the Financial Times, even a $1 trillion plan will remove only a portion of the debt-backed securities from the banks’ books. The IMF has estimated that US bank losses on bad assets will reach $2.2 trillion, while Nouriel Rubini has revised his estimate upward to $3.6 trillion.
The upshot is that the current plan may be able to cover only a fraction of the assets that the banks stand to lose. The hope is that once the government plan jump-starts the market for these securities the engine of debt-creation and speculation on debt-derivatives will start turning over, in turn stimulating credit-driven demand thus pulling the US and the rest of the globe out of the recession. This will probably prove to be wishful thinking, as the problem facing the global economy runs deeper than the ‘financial sector.’
In order for the Geithner plan to work it would have to be the case that the current crisis is confined to the banking and financial sector and that the rest of the economy is fundamentally sound. Assuming this, the only problem is to revive the credit markets so that banks can start lending, investors start buying banks’ debt-securities, and American consumers get back to the old routine of buying cheap foreign goods with the credit that they need to supplement their stagnating incomes. But this assumption makes the error of completely overlooking the very deep-rooted problems that lie at the heart of the global capitalist system. In a recent interview with the Asia Pacific Journal, economic historian Robert Brenner spelled out the problem, stressing that the system wide overcapacity in the global manufacturing sector has led to a declining rate of profit, slow growth in investment in plant and equipment, stagnating wage growth, and finally the expansion of huge bubbles in equities and housing. As Brenner puts it:
It’s understandable that analysts of the crisis have made the meltdown in banking and the securities markets their point of departure….From Treasury Secretary Paulson and Fed Chair Bernanke on down, they argue that the crisis can be explained simply in terms of problems in the financial sector….[They] assert that the underlying real economy is strong, the so-called fundamentals in good shape. This could not be more misleading. The basic source of today’s crisis is the declining vitality of the advanced economies since 1973, and, especially, since 2000. Economic performance in the U.S., Western Europe, and Japan has steadily deteriorated, business cycle by business cycle, in terms of every standard macroeconomic indicator — GDP, investment, real wages, and so forth. Most telling, the business cycle that just ended, from 2001 through 2007, was — by far — the weakest of the postwar period, and this despite the greatest government-sponsored economic stimulus in U.S. peacetime history.
Under the Clinton administration the US turned to a policy of low interest rates and easy money policies that allowed consumers to take on unprecedented debts, driving up asset prices and increasing the ‘paper-wealth’ of holders of securities and owners of homes. The bubbles of the last ten years must be seen as a direct result of the overproduction that has plagued the manufacturing sector since the beginning of the ‘long downturn’ in 1973. By 1995, with the Reverse Plaza Accord agreements, the US effectively ceded the field in manufacturing to Japan, Germany, smaller Asian countries, and eventually China.
The US agreed to maintain a high-dollar policy and an ever-growing current account balance, which it financed by issuing credit instruments to its creditor countries: this is why China now holds close to $2 trillion in dollar denominated reserves.
As long as the US’s creditor nations continued to accept credit instruments (government and corporate bonds, etc.), and hold these in dollar denominated reserves, it is conceivable that the colossal imbalances of the global capitalist system could be maintained. This, however, is looking increasingly less likely. Recently, China has begun questioning the stability of the dollar. Here is Chinese premier Wen Jaibo, from a recent Financial Times article. ‘”We have lent a huge amount of money to the United States”….”Of course we are concerned about the safety of our assets. To be honest, I am a little bit worried. I request the US to maintain its good credit, to honour its promises and to guarantee the safety of China’s assets.”’ And in a recent essay Zhou Xiaochuan, governor of the People’s Bank of China, expressed his concern over ‘the potential inflationary risk of the US Federal Reserve printing money,’ going so far as to call for a new reserve currency. Clearly the Chinese state is not interested in financing the US current account gap indefinitely.
Geithner’s plan to pump trillions into the markets will only exacerbate the problem of international faith in the stability of the dollar. In order to finance the purchase of the debt-backed securities, the Fed has to finance these purchases. How does it do this? A recent article by Stanford economist John Taylor explains:
The Fed can borrow the funds, or it can ask the Treasury to borrow the funds, or it can do it the old-fashioned way: create money. The Fed creates money in part by printing it but mostly by crediting banks with deposits at the Fed. Those deposits are called reserve balances and are the key component – along with currency – of base money or central bank money which ultimately brings about changes in broader money supply measures….These deposits or reserves have been exploding as the Fed has made loans and purchased securities. Six months ago reserves were $8bn, in a range appropriate for its interest rate target at the time. As of last week, reserves were nearly 100 times larger at $778bn, the result of creating money to finance loans to banks, investment banks, AIG, central banks and purchases of private securities….With last week’s dramatic announcement, the Fed will have to increase reserves…to $3,365bn by the end of the year if the securities purchases are financed by money creation.
The coming year will witness three interrelated pressures put on the dollar. The first will be the current account gap, the second the enormous expansion of the money supply that will result from the bailout plan, and the third are the gargantuan budget deficits projected by the Obama administration- already estimated at $1.75 trillion for 2009.
The Geithner plan assumes that the toxic assets that the banks hold can be detoxified to re-start lending; it assumes that there is no problem with the fundamentals of the global economy; and it assumes that China and the rest of the world will have the patience and the political will to allow the US to print money at astonishing rates in order to keep the system afloat. Maybe this is not impossible, but it is extremely unlikely.
PATRICK MADDEN is a PhD student at the University of California at Santa Cruz. He can be reached at: email@example.com