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Thursday, August 23, 2007


bill gross advocates the bailout

i certainly think one is coming, and pimco's main man seems to agree.

The ultimate solution, it seems to me, must not emanate from the bowels of Fed headquarters on Constitution Avenue, but from the West Wing of 1600 Pennsylvania Avenue. Fiscal, not monetary policy should be the preferred remedy, one scaling Rooseveltian proportions emblematic of the RFC, or perhaps to be more current, the RTC in the early 1990s when the government absorbed the bad debts of the failing savings and loan industry. Why is it possible to rescue corrupt S&L buccaneers in the early 1990s and provide guidance to levered Wall Street investment bankers during the 1998 LTCM crisis, yet throw 2,000,000 homeowners to the wolves in 2007? If we can bail out Chrysler, why can’t we support the American homeowner? The time has come to acknowledge that there are precedents aplenty in the long and even recent history of American policy making. This rescue, which admittedly might bail out speculators who deserve much worse, would support millions of hard working Americans whose recent hours have become ones of frantic desperation. And for those who would still have them eat some Wall Street cake as opposed to Midwest meat & potatoes (The Wall Street Journal editorial page suggested they should get darn good and used to renting once again) look at it this way: your stocks and risk-oriented levered investments will spring to life like the wild flowers in Death Valley after a flash flood. And if you’re a Republican office holder, you’d win a new constituency of voters – “almost homeless homeowners” – for generations to come. Get with it Mr. President and Mr. Treasury Secretary. This is your moment to one-up Barney Frank and the Democrats. Reestablish not the RFC or the RTC, but create an RMC – Reconstruction Mortgage Corporation. If not, make some modifications in the existing FHA program, long discarded as ineffective. Write some checks, bail ‘em out, prevent a destructive housing deflation that Ben Bernanke is unable to do. After all “W”, you’re “the Decider,” aren’t you?

the problem, however:

While market analysts can guesstimate how many Waldos might actually show their face over the next few years – 100 to 200 billion dollars worth is a reasonable estimate – no one really knows where they are hidden.

it's probably a lot more than $200bn. realtytrac was saying before the credit crunch that 1.8mm foreclosures with probable bank losses of something like $160bn were likely this year. but these losses will continue for several years forward. with a normalization of credit standards and massive supply piling onto the market, home prices must correct significantly -- and if that takes place in nominal terms, refinancing homeowners with 3- and 5-year arms are going to be upside-down in their mortgagtes and pinched by rate resets as their terms come up in 2008, 2009 and 2010. many of those mortgage holders, who were put into their loans by the same fraudulent practices that 2/28 subprime borrowers were, are going to be defaulting and requiring bailout.

a bailout that would keep these people in their homes is going to require something far more ambitious that $200bn -- so ambitious, in fact, that it will likely threaten the stability of the dollar and be no better/different than pursuing the problem by the monetary policy tools that gross would eschew.

that doesn't make it any less likely -- it's a politically perfect idea, and almost has to happen. but it will not be consequence-free. indeed, i sincerely doubt it will mitigate the ultimate damage at all and it may even compound it severely by putting the treasury market to flight.

UPDATE: perhaps unsurprisingly, gross' fund is deeply invested in the securities that he is essentially advocating a bailout of. whether he's right or wrong, he's definitely self-interested.

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hey gm -- I actually found your economic writing through your Cub blogging. I'm a Card fan but I've really enjoyed your baseball mind, and you were right on about Rich Hill, who I wanted to trade for from way back. anyway, I came across this today as I was jumping around -- it's a year or two old. lucid and pretty prescient, it seems to me -- I'd like to get your thoughts.

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hey perrone -- thanks for the kind words.

on the article, i think that's a good general summation. as i see it, there are two likely paths (and variations in between) that the dollar can take.

one is a crash. this should not be discounted. chinese and japanese central banks and petrodollar recyclers have little desire, i suspect, to precipitate such a thing -- but their intentions may not be the determinant in a very complex system. now that the world is finding that much american mortgage debt is toxic and even broadly fraudulent, these (sole and few) sources of deficit funding may diversify away from the dollar for their own good, if not sell it outright. so great is our need for deficit finance (especially with the military in the field) that even this seemingly mild step could precipitate a run on the dollar. this would be very inflationary, disastrous to credit and (because we are a credit economy) a truly terrible event.

the other is a long, slow decline punctuated by much jawboning and periodic crises as standards of living correct toward the global mean -- similar to the fall of the british pound. this sort of muddling through seems most probable, and built on the back of bumpy but continuing longer-term economic dynamism in the far east and eastern europe.

there is a third possibility -- a long-term continuing financing of the united states by the developing world, built on the back of deep markets and a strong military. this is much the system rome rode for its imperial period. but in a globalized world where china and india are building consumerist middle classes and capital is free to move there -- and a world where the awkward limitations of american military power are being exposed -- i doubt this is likely.

and there is a fourth -- deflationary depression. japan since 1990 is a good case study for how asset price deflation can become a general deflation regardless of monetary policy measures. few -- especially bernanke -- seem to conceive that printing money is not the same as building confidence, and credit is confidence first and foremost. they dismiss japan as the consequence of 'policy mistakes'. i don't think it was. i think it simply proved policy has limitations.

this last is the most dismissed possibility and maybe because of that the most dangerous. and i have to admit i don't see it as likely.

you may have noticed that i just covered every base. :) honestly, in a system this complex, the unintended and the unknowable are likely to dominate. there's a good case for and against each of these paths. the one thing that seems assured to me is the mean reversion of the american standard of living, based as it has been over the last 20 years largely on increasing debt and leverage beyond prudent limits.

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i have to say, though, that IF the government really does begin a monstrous debt-financed bailout of the housing collapse i cannot see forestalling a run on the dollar. on top of iraq, boomer retirement/prescription drug benefits and ridiculously low tax collections (as a percentage of spending)... who would take seriously the idea that profligate americans and their venal politicians are going to actually pay that back?

and indeed, that may be the plan -- as the article points out, inflation has been the favored political expedient of history when trying to escape onerous national debt.

but what the government of the united states may not realize yet is the extent to which they have already forfeited control of its own monetary policy by pursuing such a reckless fiscal policy (publicly and privately). foreign central banks now effectively control longer american interest rates, and may not be sensitive to the need for a slow and controlled unwinding.

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