Stimulus, Banking and Bubbles

Thomas Woods, author of "meltdown" was speaking on the C-Span 2 Book Club discussing why government stimulus doesn't work. Up to this point, I have failed to hear any expert economists explain in a coherent manner what caused the latest economic downturn until this interview.

The first thing that Woods criticized is Keynesian Economics. Keynesian economics says that sometimes the free market can act irrationally and emotionally and cause instability in the markets especially in response to a natural disaster. Keynesian says that a government and central bank can stabilize irrational market fluctuations through stimulus and injecting capital into the system until the markets become rational again. The traditional example in support of this economic theory is the government investment in US manufacturing and US highways during and just after WWII which are seen as contributing to the post-war boom in the US during the Eisenhower's presidency.

Thomas Woods on the other hand favors the theories of Nobel Laureate Friedrich von Hayek of the Austrian School of Economics who observed that government stimulus during a market downturn is the worst possible thing a government could do. Woods gives the example of a brickmason building a structure out of bricks but not knowing that he doesn't have enough bricks to finish the job. At some point the brick mason will discover the shortfall and the sooner the better. If the mason discovers that he will be short early, then he can alter the plans and make the best out of the situation. If he finds out late, then the consequences are much worse.

Woods explains that the reason there are ups and downs in the markets is because we have a difficult time predicting what consumers will be doing next. Therefore, then a particular market sector is hot, businesses tend to invest a lot of money in hopes of earning future profits. But if that market falls off for whatever reason, then the business is left having invested all this money for nothing.

What has happened in the US, is that the US central banks have come in and bailed businesses out using billions of taxpayers dollars. Therefore, the consequences of all the risk taking by these businesses gets transferred the US tax payer. Government bailouts have several outcomes, none of them good. #1. Knowing that mom and dad will bail you out leads to excessive risk taking by companies. #2. Bailouts just continue to inflate the balloon. #3. Bailouts delay businesses from reorganizing, trimming and improving things.

According to Woods and Hayek, the government should never bail companies out. What should happen when the market turns south is that the Federal Governments should cut back on spending, and encourage saving by raising interest rates. Increased saving would cause deflation and an increase in wealth assuming US currency was still on the gold standard like it was in 1920. Companies during an economic downturn should cut back on spending as well. Some could use existing bankruptcy laws to reorganize their debt and trim off unprofitable parts of their business and come out of bankruptcy trim and more efficient. Woods laments that now because the US dollar has no backing and has lost considerable value due to continual inflation, the average American is forced to become a stock market speculator when saving money and now is subject to losing money either through inflation or with each market crash.

The current problems began with the Dot.Com bubble. The Internet stimulated all sorts of wild speculation and investment in companies with no hopes of profit. The Federal Reserve under Alan Greenspan offered low interest rates and people were borrowing money to invest in the stock market. Money was so cheap, individuals were taking out 10 billion dollar loans and buyout huge companies like HCA and Linen and Things. But, the party had to end eventually. Beginning in 1999 and 2000 the Fed raised interest rates 6 times and the over-inflated bubble burst. Instead of cutting back, The US Government and US companies believed they could spend their way out of a recession. So, the Fed reduced interest rates again and poured stimulus money into housing. In stead of housing prices and the housing market cooling with the rest of the market, housing prices continued to rise while wages were stagnant and US manufacturing jobs went overseas. Again, even the manufacturing boom was really a balloon which has been slowly and painfully deflating as well.

The continued growth in the US housing market gave the illusion that the US home mortgage market was recession proof. But no one recognized it was the government that was over-inflating the market and creating the next bubble. The illusion of stability led to banks issuing mortgage backed securities and assigning them AAA ratings. But it wasn't long before, like the dot.com bubble, the housing bubble burst as well. Because of inflation, and the devaluation of the dollar, wages could not keep up with the increase in housing costs. As I have said in other posts, it wasn't just the sub-prime borrowers who are to blame. There were just as many wealthy Americans who defaulted on their second homes as there were sub-primes who defaulted.

As I have explained previously, Banks who were leveraging their fractional reserves by owning toxic derivative mortgage backed securities were hurt by the meltdown because they lost their reserves which they needed to lend. No reserves, no lending. No reserves, no ability to pay withdrawals. AIG was hurt because they had been selling mortgage insurance to sub-prime borrowers and couldn't pay when so many defaulted at once. But AIG did end up paying the banks using US Taxpayer money.

Fed Chair Ben Bernanke then got Congress to also put up money to buy all the toxic assets or these worthless derivative mortgage backed securities. This money for toxic assets is what is known as TARP (troubled assets relief program). Astonishingly, not one dollar of TARP money so far has gone to buy any of these toxic derivatives. Instead, the 700 billion dollars went directly to the banks as a zero interest loans to replace their lost fractional reserves. It appears the banks are holding onto the MBS. Why? Because not only is the taxpayer bailing them out by giving them free money to lend back to us, but eventually the volatile MBS will regain value and I bet you the banks are planning to sell those assets later at a profit to the banks and at an additional lose to the US taxpayer. And we are supposed to think Bernie Madoff is a swindler.

American Economic Empire
As a side note, I also listened to an interview by John Perkins who wrote "Confessions of an Economic Hitman." Perkins discusses how the US in conjunction with US businesses strong armed developing countries to accept huge loans from the World Bank which were used by US businesses to steal their resources and then left the country with the unpaid debt. After getting these countries deep into debt, the US manipulates these countries to sell their natural resources to the US for cheap in exchange for assistance in helping them pay the debt. For those government leaders who refused to play ball, the CIA sends "Jackals" who have been responsible for several assassinations.

Swiss Banks and Tax Evasion
60-Minutes ran a story this week about Bradley Birkenfeld who was a mid-level banker for UBS, the largest Swiss bank. Birkenfeld suffered intense guilt while working at UBS and eventually went to the US government as a "whistleblower" confessing that he was an accomplice to assisting thousands of rich Americans shelter money and evade taxes using secret Swiss Bank accounts. The US demanded UBS turn over the names of some American account holders. According to the 60-min interview, the US is not investigating all account holders but only the big ones. When I hear this, what I hear is, the US is conveniently picking and choosing who they are investigating based on politics. Also, the US is currently offering amnesty to all American's with overseas bank accounts to pay back taxes without penalty while Birkenfeld is being prosecuted and going to jail. Birkenfeld was initially offered complete immunity, but he failed to disclose his #1 client and is going to jail. Birkenfeld lawyers are trying to see if he is entitled to millions which according to recent "whistleblower" legislation he may receive.

Bursting of the Manufacturing Bubble
During WWII, the US invested billions of dollars in manufacturing. The government built huge factories for the production of tanks and bombers only to turn these facilities over to private companies following the war. Emerging from the war, the US became the most powerful country of the free world. But the US had a considerable debt burden which peaked at 120% GDP. Currently our national debt is approaching 80% GDP. Nearly 50% of this debt is owned by the Federal Reserve whose shareholders are private banks and ultra-wealthy investors. An increasing amount of our US Treasury Bonds are now owned by foreign countries (30%) like China, Japan, and the United Kingdom. As the US debt is transferred over to emerging countries like China, India, and Brazil, the private investors and banks are cashing out on T-Bills and moving their money to take advantage of the capital needs of the emerging economies and their emerging middle classes. The US has large trade deficits with other countries like China. This means we buy much more of their stuff then they buy of ours. If we were still on the gold standard, those countries would have been draining our gold reserves by trading in those extra dollars sitting around. Instead, they have nothing to do but buy our T-Bills and stock in US companies. Now the value of our currency and the value of Chinese wealth in US dollars is increasingly dependent upon China continuing to purchase our T-Bills to fund our national debt instead of allowing our government to print money which would cause inflation and devalue those dollar. This pressure is allowing the Fed Private investors and Banks the leverage they need to cash out, which they have been doing steadily.

My View on Stimulus
First, I consider the collection of interest an act of war, and modern day slavery. Second, I agree with Woods that government stimulus which encourages companies to keep on doing more of the same in the face of a downturn is wrong. However, I don't think that all government stimulus and incentives are wrong. I believe that the United States government, as part of its primary role to protect this country, should have focused on our countries self-reliance instead of blackmailing and economically enslaving other countries into selling us their resources cheaper. What we should have done is build our nation based on our local natural resources. Our countries' economy is petroleum based, but we have been blessed with huge coal and natural gas reserves. Why do we depend upon gasoline and oil when electricity can be generated using coal and nuclear and cars can run on natural gas? I don't know. But our dependence on foreign resources makes our country vulnerable. And it should have been the duty of our government to use the power of tariffs to protect American jobs, manufacturing, steel production, and farms as well as the value of our currency which should have remained on the gold and silver standard. The last 100 years has seen the homogenization of America and there are forces that would like to have McDonald's and Walmart in everywhere. But I live in Georgia, and figs and pecans grow well here, coastal fishing produces shrimp, but each year I see less and less local commodities and more and more imports. Our just-in-time, and homogenized society is more vulnerable than ever and all it would take is another World War, or Pandemic, Natural Disaster causing a transportation interruption and the people of the US are gonna be in a world of hurt. A lose of self-reliance is what sets an Empire up for the big fall.