Treasury Secretary Paulson leads us across the Rubicon

Summary:   The government’s solutions to our financial crisis is creeping nationalization, as becomes more obvious wth every new step.  This is history in the making, a major change in America.’s economic system — biggest since the New Deal — taking place with little public debate or consideration of the long-term effects.   That this happens during an election, without becoming an issue in the election, is an irony to be enjoyed by future historians.

Things are developing as I predicted in “A happy ending to the current economic recession” (12 February 2008).  Excerpt:

There are four ways we can unwind the excess debt of American households, ending the post-WWII debt supercycle.

1.  Growth:  given time and rapid wage growth, the debt burden becomes manageable.  We can pay it off ever more easily as incomes grow.  That was the dream solution to America’s high levels of household debt and large long-term government obligations.  It burst in 2000, and will not return in time to help us.

2.  Inflation, reducing the real weight of our debt.  This requires two things.  First, real growth in wages (no signs of this).  Second, either the cooperation or blindness of bond investors — they must either accept negative real after-tax yields, or remain oblivious to rising inflation.  The consequences are severe if our creditors (domestic and foreign) rebel.

3.  Defaults on loans, the equivalent of surgery without anesthesia — resulting in bankruptcies, homelessness, decaying neighborhoods, and bank failures.

4.  Socialization of the debt.  The government can spread the burden of debt in many different ways (that so many of our creditors are foreigners makes this even more attractive).

The US is already moving towards #4 through de facto nationalization of the banks, as loans by the Fed (and foreign governments) become the primary source of new capital. … A recession – especially if long and deep – will accelerate deterioration of both household and business balance sheets, forcing this nationalization process to continue.  The “Japan solution” is the course of least political resistance:  prop up the banks with lightly hidden government help and wait for natural forces to “heal” the economy over time.

There are many ways to socialize the debt.  The government (via the Fed or the Treasury) could expand its loans to banks in both size and duration, similar to what Japan did when they re-capitalized their banks with convertible preferred stock.  Or government-sponsored mortgage agencies could be the hidden hand providing support. 

Bringing this up to date

Since the deleveraging cycle started in December 2006 with the collapse of many mortgage brokers, the government’s response has been small incremental steps toward #4.  Now Secretary Paulson has taken the first large steps:

• nationalizing the Government-sponsored Enterprises, and
• announcing that the government will buy mortgage-backed securities (MBS).

The first was widely expected but still noteworthy, the government taking over the two key private financial institutions in the US.  This will not cost us anything — or so say the people who have been wrong about every step of this process.  It certainly puts us firmly on a road away from a free-market economic system.

The second was lost in the noise, but equally significant.  We — through our government — will borrow money (mostly from foreign central banks) to buy mortgage-backed securities (MBS).  We simultaneously will be debtor and creditor on the same loans, with others governments in the middle.  To illustrate the result, we collectively borrow from China 4% and lend to ourselves at 6%.  Nice, while it lasts.

Each step by the government is considered a big thing at that time — the various mortgage relief plans (“Project Hope”), the Q2 tax rebates, and now the nationalization of the GSE’s. All are just small steps in a larger process of unwinding the debt supercycle.

Something new in American history

Secretary Paulson has taken us across the Rubicon, as US public policy moves from the New Deal policy of macroeconomic stabilization (Main Street) to directly supporting the financial system (Wall Street).  While there have been isolated instances of this in the past, the scale of this move has no precedents since the Great Depression.  And in my opinion, few or no precedents including the Depression era.

Compare the costs and public benefits of this bailout with its Depression-era equivalent, the The Home Owners’ Loan Corporation (HOLC).  From Wikipedia:

A New Deal agency established in 1933 under President Franklin D. Roosevelt. Its purpose was to refinance homes to prevent foreclosure. It was used to extend loans from shorter loans to fully amortized, longer term loans (typically 20-25 years). Through its work it granted long term mortgages to over a million people facing the loss of their homes. The HOLC stopped lending circa 1935, once all the available capital had been spent. HOLC was only applicable to nonfarm homes, worth less than $20,000. HOLC also assisted mortgage lenders by refinancing problematic loans and increasing the institutions liquidity. When the HOLC ended its operations and liquidated assets, HOLC turned a small profit

What next?

Like each previous step, the government assures us that this will end the crisis.  Since the driver of the housing crisis is the above average rate of vacant housing units (4 -5 million surplus units), tinkering with the financial system probably will have little effect. 

I suspect that the economy will continue to slow, that more businesses will fail, and that this precedent (bailing out the GSE’s) will lead to more bailouts.  Once we have crossed the Rubicon, it will be difficult to change course.  There might be no shortage of likely candidates, such as

• the automobile manufacturers
• FDIC
• the holders of credit card and auto loans
• The pension benefit guarantee corporation (PBGC)

Who approved this?

Note the the important aspects of this decision, true of every step in this process so far.

(1)  Bipartisan, like most major policy initiatives in America.

(2)  An essentially discretionary act by the Executive branch, only vaguely authorized by Congress (with little deliberation).  Compare with the highly specific text of the Home Owner’s Refinancing Act which created the HOLC.

(3)  Weak or no basis for these actions in the Constitution.

That is how our government works today, with the Constitution just a fading dream.  Note how these momentous events have no role in the Presidential or Congressional campaigns. 

Where does this end?  Another excerpt from my February post

The US is already moving towards de facto nationalization of the banks, as loans by the Fed (and foreign governments) become the primary source of new capital.

… A recession – especially if long and deep – will accelerate deterioration of both households and businesses, forcing this nationalization process to continue.  The “Japan solution” is the course of least political resistance:  prop up the banks with lightly hidden government help and wait for natural forces to “heal” the economy over time.  For Japan this resulted in a period of slow growth which began in 1989 and continues to this day.

… Rescuing the financial system would not distract the Democratic Party {and perhaps the Republicans} from its major public policy goal:  nationalization of the health care sector (like that of other western nations).  Together these would represent a massive expansion in the scope of the US government, a repudiation of the post-1980 bias towards private-sector solutions. 

These steps are only the first phase in the end of the post-WWII economic and geopolitical regime. Looking beyond these takes us far into the unknown.

It’s all about choice.  Every downturn gives us the opportunity to determine what America will become.  We weigh our fidelity to our principles, our history, our forefathers — vs. our ability to collectively withstand pain (financial, social, political).  These are collective decisions, because all large-scale economic events have a decisive political component. 

We have an election in November.  Let’s make the candidates talk about these issues.  Act to make your voice heard by donating time and money to the candidates of your choice.

Please share your comments by posting below.  Please make them brief (250 words max), civil, and relevant to this post.  Or email me at fabmaximus at hotmail dot com (note the spam-protected spelling).

Key Treasury Department documents

We cannot plead the “we didn’t know the details in the fine print” excuse. The important details about this massive nationalization have been clearly spelled out for us.  See this page for a current list of Treasury Department documents.

Some FM posts about the current crisis

1. Treasury Secretary Paulson leads us across the Rubicon, 9 September 2008
2. High priority report: a geopolitical sitrep on the financial crisis, 15 September 2008
3. Say good-bye to the old America. Welcome to our new socialist paradise!, 17 September 2008
4. Another voice warning about the nationalization of AIG, 18 September 2008
5. A vital but widely misunderstood aspect of our financial crisis, 18 September 2008
6. A new sitrep, as we move into phase 3 of the financial crisis, 19 September 2008
7. Another step away from our Constitutional system, with applause, 19 September 2008
8. What do we know about the financial crisis? What are the key questions?, 20 September 2008
9. Slowly a few voices are raised about the pending theft of taxpayer money, 21 September 2008
America appoints a Magister Populi to deal with the financial crisis, 21 September 2008
Legal experts discuss if the Paulson Plan is legal, 21 September 2008

For a full listing see the FM reference page about the Financial crisis – what’s happening? how will this end?.

A few of the most important posts warning about this crisis

This crisis has long been forecast by many, including in articles on this site.  Even now that we are in the whirlwind, these provide valuable background material on its causes — and speculation about the results.  Here are some of those posts.

1. A brief note on the US Dollar. Is this like August 1914?, 8 November 2007 — How the current situation is as unstable financially as was Europe geopolitically in early 1914.
2. The post-WWII geopolitical regime is dying. Chapter One, 21 November 2007 — Why the current geopolitical order is unstable, describing the policy choices that brought us here.
3. We have been warned. Death of the post-WWII geopolitical regime, Chapter II, 28 November 2007 — A long list of the warnings we have ignored, from individual experts and major financial institutions (links included).
4. Death of the post-WWII geopolitical regime, III – death by debt, 8 January 2008 – Origins of the long economic expansion from 1982 to 2006; why the down cycle will be so severe.
5. Geopolitical implications of the current economic downturn, 24 January 2008, – How will this recession end?  With re-balancing of the global economy, so that the US goods and services are again competitive.  No more trade deficit, and we can pay out debts.
6. A happy ending to the current economic recession, 12 February 2008 – The political actions which might end this downturn, and their long-term implications.
7. What will America look like after this recession?, 18 March 208  — The recession might change so many things, from the distribution of wealth within the US to the ranking of global powers.
8. The most important story in this week’s newspapers , 22 May 2008 — How solvent is the US government? They report the facts to us every year.
9. Prof Nouriel Roubini describes “The Decline of the American Empire” ,18 August 2008
10. The World’s biggest mess, 22 August 2008 — A brillant ex pat looks at America from across the ocean.
11. “The changing balance of global financial power”, by Brad Setser, 22 August 2008
12. “The Coming US Consumption Bust”, by Nouriel Roubini, 6 September 2008

To see the all posts on this subject, go to the FM reference page about The End of the Post-WWII Geopolitical Regime.