February 13, 2009
There is nearly universal agreement that the opening salvo of the Obama Administration’s campaign to restore health to the financial system, delivered this week by new Treasury Secretary Geithner, fell with a loud and ugly thud. The most common criticism is that the announcement was short on detail. What is abundantly clear, however, is that the new Administration intends to push spending back up to pre-crash levels and to fill the entire credit void that has disappeared into the black hole of the American financial system. Whether or not the prior levels of spending and lending were justified by market conditions then, or now, appears to be largely unexamined.
In the worldview of Geithner and like-minded economists, credit, rather than savings, is the central figure in the economic equation. Therefore, he sees anything that eases the process of lending to be an effective economic policy. With such a view in mind, the centerpiece of Geithner’s plan is the commitment of up to $1 trillion to revive the collapsed market for securitized debt. In the lead up to the Crash of 2008 securitization, more than anything else, permitted Americans to borrow more than they had ever borrowed before.
Developed primarily over the last 10 years, securitization permitted loans of all shapes and sizes to be packaged into investment-ready securities. The system worked, fueling unprecedented levels of lending in the home, auto, student, and credit card sectors. But in the last few years as the collateral underpinning these securities has collapsed in value, the trillions of dollars of securitized debt now in circulation has become the toxic sludge at the bottom of our financial pit. Geithner is making the false assumption that cleaning up and rebuilding the securitization market is a prerequisite for a healthy economy.
Our nation’s short history with wide securitization has simply shown that the process can lead to massive mispricing of assets and risk. By artificially rebuilding the securitization market, and committing taxpayer funds as collateral, the U.S. economy will be pushed farther and farther out on a leveraged limb, until no amount of market medicine can prevent a total economic collapse.
In truth, the only vital function provided by securitization was that it offered foreign savers a pathway to lend directly to American consumers, and Wall Street executives a new asset class to over-leverage for massive profits. Our economy must dispense with these gimmicks if it hopes to pursue a meaningful recovery.
After more than a decade of unsustainable borrowing and spending, the private sector is currently attempting to restore balance through reduced consumer and mortgage credit, greater savings, and lower asset prices. With its trillions of dollars of credit injections and stimulus programs, the government hopes to allay this process by force-feeding Americans a diet of more borrowing. They feel that a restored securitization market will help. It won’t. It will just grease the skids for a quicker collapse.
Credit, whether securitized or not, cannot be created out of thin air. It only comes into existence though savings, which must be preceded by under-consumption. Since savings are scarce, any government guarantees toward consumer credit merely crowd out credit that might otherwise have been available to business. During the previous decade too much credit was extended to consumers and not enough to producers (securitization focused almost exclusively on consumer debt). The market is trying to correct this misallocation, but government policy is standing in the way. When consumers borrow and spend, society gains nothing. When producers borrow and invest, our capital stock is improved, and we all benefit from the increased productivity.
Consumers default on credit much more frequently than businesses. This is because businesses typically use loans to expand, and then have greater cash flow to repay the debt. In contrast, consumers typically borrow to consume and in the process do not improve their ability to repay. As a result, one would expect consumer credit to be harder and more expensive to obtain. But that is currently not the case. Government guarantees have altered the playing field, so that now consumers are still being offered credit while businesses are being shown the door. By shifting credit away from producers, fewer goods and services will be produced for consumers to buy and fewer employment opportunities provided for them to earn money with which to buy the goods.
To restore prosperity, credit (derived from savings rather than a printing press) must flow to producers. Greater liquidity for business will lead to legitimate job creation, increased production, and rising living standards. By further encumbering the economy with burdensome regulation, and by transferring business decisions to vote-seeking politicians who will bail out the irresponsible, reward failure and punish success, the government will create a society destined for misery.
In an interview following his announcement, Geithner stated that government should replace the demand lost by the private sector. However, those with even a marginal grasp of economics know that demand is unlimited. It is the ability to spend that is not. While Americans still want all the things they wanted years ago, they have made the rational choice that they can no longer afford to buy at the same levels they once did. Using a printing press to replace this lost ‘demand’ will simply cause consumer prices to rise. Printed money does not create new purchasing power, but merely redistributes it from savers to borrowers. And since the plan will severely undermine the real productive capacity of our economy, there will not be much purchasing power left to redistribute!
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