BAILOUT IS FUTILE AS AMERICA CRUMBLES
By Paul Craig Roberts
America has become a pretty discouraging place. Americans, for the
most part, will never know what happened to them, because they no longer have a
free and responsible press. They have Big Brother’s press. For example, on
September 28, 2008, a New York Times editorial blamed the current financial
crisis on “antiregulation disciples of the Reagan Revolution.”
What utter nonsense. Every example of deregulation
that the New York Times editorial provides is located in the Clinton
Administration and the George W. Bush administration. I was a member of the
Reagan administration. We most certainly did not deregulate the financial
The repeal of the Glass-Steagall Act, which
separated commercial from investment banking, was the achievement of the
Democratic Clinton Administration. It happened in 1999, over a decade after
Reagan left office.
It was in 2000 that derivatives and credit default
swaps were excluded from regulation.
The greatest mistake was made in 2004, the year
that Reagan died. That year the current Secretary of the Treasury, Henry M.
Paulson Jr, was head of the investment bank Goldman Sachs. In the spring of
2004, the investment banks, led by Paulson, met with the Securities and
Exchange Commission. At this meeting with the New Deal regulatory agency tasked
with regulating the US
financial system, Paulson convinced the SEC Commissioners to exempt the
investment banks from maintaining reserves to cover losses on investments. The
exemption granted by the SEC allowed the investment banks to leverage financial
instruments beyond any bounds of prudence.
In place of time-proven standards of prudence,
computer models engineered by hot shots determined acceptable risk. As one
result Bear Stearns, for example, pushed its leverage ratio to 33 to 1. For
every one dollar in equity, the investment bank had $33 of debt!
It was computer models that led to the failure of
Long-Term Capital Management in 1998, the first systemic threat to the
financial system. Why the SEC went along with Paulson and set aside capital
requirements after the scare of Long-Term Capital Management is inexplicable.
The blame is headed toward SEC chairman
Christopher Cox. This is more of Big Brother’s disinformation. Cox, like so
many others, was a victim of a free market ideology, itself a reaction to
over-regulation, that was boosted by academic economic opinion, rewarded with
Nobel prizes, that the market “always knows best.”
The 20th century proves that the market is likely
to know better than a central planning bureau. It was Soviet Communism that
collapsed, not American capitalism. However, the market has to be protected
from greed. It was greed, not the market, that was unleashed by deregulation
during the Clinton and George W. Bush regimes.
I remember when the deregulation of the financial
sector began. One of the first inroads was the legislation, written by bankers,
to permit national branch banking. George Champion, former chairman of Chase
Manhattan Bank, testified against it. In columns I argued that national branch
banking would focus banks away from local business needs.
The deregulation of the financial sector was
achieved by the Democratic Clinton Administration and by the current Secretary
of the Treasury, Henry Paulson, with the acquiescence of the Securities and
The Paulson bailout saves his firm, Goldman Sachs.
The Paulson bailout transfers the troubled financial instruments that the
financial sector created from the books of the financial sector to the books of
the taxpayers at the US Treasury.
This is all the bailout does. It rescues the
The Paulson bailout does not address the problem,
which is the defaulting home mortgages.
The defaults will continue, because the economy is
sinking into recession. Homeowners are losing their jobs, and homeowners are
being hit with rising mortgage payments resulting from adjustable rate
mortgages and escalator interest rate clauses in their mortgages that make
homeowners unable to service their debt.
Shifting the troubled assets from the financial
sectors’ books to the taxpayers’ books absolves the people who caused the
problem from responsibility. As the economy declines and mortgage default rates
rise, the US Treasury and the American taxpayers could end up with a $700
Initially, the House, but not the Senate, resisted
the bailout of the financial institutions, whose executives had received
millions of dollars in bonuses for wrecking the US financial system. However,
the people’s representatives could not withstand the specter of martial law and
Great Depression with which Paulson and the Bush administration threatened
them. The people’s representatives succumbed as they did during the New Deal.
The impotence of Congress traces to the Great
Depression. As Theodore Lowi in his classic book, The End of Liberalism,
makes clear, the New Deal stripped Congress of its law-making power and gave it
to the executive agencies. Prior to the New Deal, Congress wrote the laws. After
the New Deal a bill is merely an authorization for executive agencies to create
the law through regulations. The Paulson bailout has further diminished the
legislative branch’s power.
Since Paulson’s bailout of his firm and his
financial friends does nothing to lessen the default rate on mortgages, how
will the bailout play out?
If the $700 billion bailout is based on an
estimate of the current amount of bad mortgages, as the recession deepens and
Americans lose their jobs, the default rate will rise. The $700 billion might
not suffice. The Treasury will have to go hat in hand to its foreign creditors
for more loans.
As the US Treasury has not got $7, much less $700
billion, it must borrow the bailout money from foreign creditors, already
overloaded with US paper. At what point do America’s foreign bankers decide
that the additions to US debt exceed what can be repaid?
This question was ignored by the bailout. There
were no hearings. No one consulted China, America’s principal banker, or the
Japanese, or the OPEC sovereign wealth funds, or Europe.
Does the world have a blank check for America’s
This is the same world that is faced with American
demands that countries support with money and lives America’s quest for world
hegemony. Europeans are dying in Afghanistan for American hegemony. Do
Europeans want their banks, which hold US dollars as their reserves, to fail so
that Paulson can bail out his company and his friends?
The US dollar is the world’s reserve currency. It
comprises the reserves of foreign central banks. Bush’s wars and economic policies
are destroying the basis of the US dollar as reserve currency. The day the
dollar loses its reserve currency role, the US government cannot pay its bills
in its own currency. The result will be a dramatic reduction in US living
Currently Treasuries are boosted by the habitual
“flight to quality,” but as Treasury debt deepens, will investors still see
quality? At what point do America’s foreign creditors cease to lend? That is
the point at which American power ends. It might be close at hand.
The Paulson bailout is predicated on cleaning up
financial institutions’ balance sheets and restoring the flow of credit. The
assumption is that once lending resumes, the economy will pick up.
This assumption is problematic. The expansion of consumer
debt, which kept the economy going in the 21st century, has reached its limit. There
are no more credit cards to max out, and no more home equity to refinance and
spend. The Paulson bailout might restore trust among financial institutions and
enable them to lend to one another, but it doesn’t provide a jolt to consumer
Moreover, there may be more shoes to drop. Credit
card debt could be the next to threaten balance sheets of financial
institutions. Apparently, credit card debt has been securitized and sold as
well, and not all of the debt is good. In addition, the leasing programs of the
car manufacturers have turned sour. As a result of high gasoline prices and
absence of growth in take-home pay, the residual values of big trucks and SUVs
are less than the leasing programs estimated them to be, thus creating more
financial problems. Car manufacturers are canceling their leasing programs, and
this will further cut into sales.
According to statistician John Williams [ http://www.shadowstats.com/section/commentaries
] who measures inflation, unemployment, and GDP according to the methodology
used prior to the Clinton regime’s corruption of these measures, the US
unemployment rate is currently at 14.7 per cent and the inflation rate is 13.2
per cent. Consequently, real US GDP growth in the 21st century has been
This is not a picture of an economy that a bailout
of financial institution balance sheets will revive. As the Paulson bailout
does not address the mortgage problem per se, defaults and foreclosures are
likely to rise, thus undermining the Treasury’s estimate that 90 per cent of
the mortgages backing the troubled instruments are good.
Moreover, one consequence of the ongoing financial
crisis is financial concentration. It is not inconceivable that the US will end
up with four giant banks: J.P. Morgan Chase, Citicorp, Bank of America, and
Wachovia Wells Fargo. If defaulting credit card debt then assaults these banks’
balance sheets, who is there to take them over? Would the Treasury be able to
borrow the money for another Paulson bailout?
During the Great Depression of the 1930s, the Home
Owners’ Loan Corporation refinanced one million home mortgages in order to
prevent foreclosures. The refinancing apparently succeeded, and HOLC returned a
profit. The problem then, as now, was not “deadbeats” who wouldn’t pay their
mortgages, and the HOLC refinancing did not discourage others from paying their
mortgages. Market purists who claim the only solution is for housing prices to
fall to prior levels overlook that rising inventories can push prices below
prior levels, thus causing more distress. They also overlook the role of
interest rates. If a worsening credit crisis dries up mortgage lending and
pushes mortgage interest rates higher, the rise in interest rates could offset
the fall in home prices, and mortgages would remain unaffordable even in a
falling housing market.
Some commentators are blaming the current mortgage
problem on the pressure that the US government put on banks to lend to
unqualified borrowers. However, whatever breaches of prudence there may have
been only affected the earnings of individual institutions. They did not
threaten the financial system. The current crisis required more than bad loans.
It required securitization and its leverage. It required Fed chairman Alan
Greenspan’s inappropriate low interest rates, which created a real estate boom.
Rapidly rising real estate prices quickly created home equity to justify 100
percent mortgages. Wall Street analysts pushed financial companies to improve
their bottom lines, which they did by extreme leveraging.
An alternative to refinancing troubled mortgages
would be to attempt to separate the bad mortgages from the good ones and
revalue the mortgage-backed securities accordingly. If there are no further
defaults, this approach would not require massive write-offs that threaten the
solvency of financial institutions. However, if defaults continue, write-downs
would be an ongoing enterprise.
Clearly, all Secretary Paulson thought about was
getting troubled assets off the books of financial institutions.
The same reckless leadership that gave us expensive
wars based on false premises has now concocted an expensive bailout that does
not address the problem, which will fester and become worse.
Paul Craig Roberts was Assistant Secretary of the Treasury in the Reagan
administration. He was Associate Editor of the Wall Street Journal editorial
page and Contributing Editor of National Review. He is coauthor of The Tyranny of Good Intentions.He can be reached
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October 13, 2008)