A Little Bit More on the State of the Financial System

I'm sorry for the last couple of posts, which have very little to do with medicine. We're in the midst of one of the most crazy reform periods in modern business, and I feel compelled to document what is wrong, what will go wrong, and why it will happen.

As of right now, the republican (supposedly conservative) plan to deal with the economic "crisis" is a 700 billion dollar bailout package. This package in perspective, is greater than $2,000 for every man, woman, and child in the US. It is more money than the entire cost of the war in Iraq. One might say that this would be a logical point for the democrats to crack down on corporate welfare, which is one of the few places that I tend to agree with democrat economic philosophy. Forget it. The democratic plan seems to be, "OK, we'll give $700 billion to corporations that we don't have, but only if we make even more fake money and give it to people who took out stupid loans over the last 5 years to buy houses that they couldn't afford." As I said at the end of my last post, I'm not optimistic.

There are three highly irresponsible parties in this mess. Number one is the government, who created that housing bubble with fake money and cheap credit from the federal reserve. Number two is the individual running the companies on Wall Street that used the fake money to make bad loans. Number three is the individuals who took the bad loans and used them to overpay for housing. Everyone agrees that this failure is largely secondary to the housing market failures. The solution seems to be to bail out parties #2 and #3 with party number one, using money from people who are not responsible. Brilliant.

However, this is becoming far more sinister. Rather than letting companies fail, the government is instead buying them with taxpayer money. At first, Fannie Mae and Freddie Mac were nationalized. Because they started as nationalized institutions that were later privatized, I wasn't sure what the effect would be. However, we have now effectively nationalized AIG, and as part of the bailout plan, we may look at a significant amount of nationalization on Wall Street, primarily in the insurance and financial sectors. This puts the government in charge of the majority of home mortgages and the largest insurer in the country. As opposed to allowing for a short term shake-up in the market, with some firms going under, we are going to insure that the government will compete within the private sector, using taxpayer money to prop itself up. In other words, this is the end of anything resembling true free market capitalism in the financial markets.

For those of you who think that this is a good thing. I will point out that the two periods with the greatest amount of new government intrusion into the market were the Great Depression and the Stagflation Seventies. To rescue the market the first time took a world war. The second time took deregulation.

What we are witnessing is an Atlas Shrugged style takeover of the financial markets, with Henry Paulson playing the role of Wesley Mouch (a reference to my objectavist readers). As the inevitable slide continues, we will continue to do things to "fix it" that will infact promote future slides. The right thing to do is let the insolvent firms fail. This will lead to short term chaos but long term stability. It will also make people much less likely to engage in this sort of behavior in the future, because every who does it now expects a bailout (we seem to never disappoint). It will also prevent the government from destroying the future of the financial system by nationalizing companies and then competing with an unfair advantage against private firms (causing greater distortions in the market). As I said before, I'm not optimistic, and nothing in the last week has done anything to change my feelings on the matter.

You know, as much as I really detest both major political parties, I never thought that the first steps towards true nationalization of the economy would be undertaken by the republicans.

An Economy in Crisis

Ok, Ok, so I haven't published in a long time. Between the kids, and a surgical Sub-internship, I've been a little bit preoccupied. However, I think that it's time for another post. This will lean a little more towards economics than healthcare, but I think that it's crucial at the current juncture to understand what is happening in the economy.

Yesterday, the Dow Jones Industrial Average (DJIA) crashed down over 500 points, the worst loss since trading resumed after 9/11. Financial giants Lehman Bros. and Merril1-Lynch essentially fell apart, with one going into bankruptcy and the other being bought out. AIG and Wachovia are still looking a little shaky. The government has actually seized control of Fannie Mae and Freddie Mac, the largest government takeover of companies ever. Gas spiked again in the face of plummeting commodity prices, especially oil. What's the deal?

The History

I think that many people fail to grasp the significance of what has just happened. If you put all of the above problems in with the current real estate crisis, you've got a recipe for financial disaster not seen since the late 1920s. I'm not saying that I think that we're in for another great depression, though I don't think that anyone thought we were in for a great depression until the great depression occurred either. It is clear that something is terribly wrong. That something is a little bit complex, but I will do my best to elaborate on the problem.

In the early part of the 1990s, as Bill Clinton was taking office, and the DJIA lived below the 3000 mark, a couple of interesting things were happening. It was the beginning of a revolution in the way everyone did everything. Computers were becoming integrated into the fabric of day to day business. The internet was becoming available to private individuals, and communications were becoming cheaper than ever thought possible. We were also in a small recession. The Fed reacted to this small recession by pumping liquidity into the financial markets (fancy jargon for lowering the rate at which banks can borrow money or allowing banks to keep a smaller percentage of their total portfolios on hand so that more money can be lent out). This coincided with a progressive explosion communications and then the rise of the dot-com boom (anyone remember Silicone Valley?).

It was the beginning of a recipe for an economic boom. There was cheap money, new technology hitting the business world, and after the failure of the democratic party to keep congress after the first two years of Clinton's leadership, government gridlock with minimal regulation on the booming economy. Oil went down to close to $10/barrel. The DJIA soared over the decade, jumping from less than 3000 to well into the five-digit range. Small booms rippled through many industries. There were small spikes in real estate. Some of the biggest transformations however, occurring outside of the technology sector, occurred in the financial sector. Banks, which had been de-regulated in the 1980s, were now able to fuel the growing demand for start-up capital. They were aided by cheap money from the Federal Reserve, which allowed them to operate outside of the normal boundaries that contain risky practices in a true free market economy. That being said, a great part of the boom was the result of natural market forces reacting to unprecedented changes in efficiency afforded by changes in technology.

Around the turn of the century, this boom hit its peak, and a small recession took place afterwards. This was nothing catastrophic. Central bank liquidity always fuels a boom-bust cycle in business, as markets have to adjust from the distortions on the market imposed by newly printed money interjected into a market with no economic foundation to support it. Then it happened, 9/11. A couple of big explosions at the financial center of the US caused a number of big Wall Street players to become very concerned about the economic future of the US. When trading eventually resumed, there was a quick and fast drop in virtually all indicators of the health of the US stock market. What to do?

If you ask me, this is the turning point where things went bad. All damage done to the economy before this was correctable in a relatively painless manner. The market wasn't more distorted than the usual state of affairs. The average person was able to afford virtually everything he needed. However, Americans are not very patient people. We may have set up an economy in a hurricane zone before this point, but the next maneuver was when we finally started building on the sand.

Alan Greenspan, as head of the Federal Reserve, announced drastic rate cuts, allowing banks to borrow money at incredibly cheap rates. This essentially meant that banks could get money at far below market rates and lend it out at a profit. The Fed also began to print money the like the printing presses were gonna go out of style, reaching a rate of printing 8% of the entire US currency in circulation per year. This had two drastic effects on the market, and it was the sentinel time for setting up the current conundrum.

Effect number one was to distort the relative location of money within the economy. Financial institutions were receiving this money first, giving them greater relative wealth than other businesses (and individuals). The extra cash caused inflation, but not until it was spent by the big financial institutions and infused into the market. Contrary to popular belief, this phenomenon is what caused the "rich get richer while the poor get poorer," or the "squeezing the middle class," conflict. The big guy gets money for cheap or free and spends it at pre-inflation prices. By the time that money gets to the middle class, it has to be spent at post-inflation prices and the value of the assets owned by the middle class has been devalued by inflation. Thus, effect number one caused a mal-distribution of overall capital into the financial sector while squeezing the average person.

Effect number two was to put a huge amount of money into the market with zero justification. There was simply no logical place for the money to go. Interest rates were low however (a side effect of two much money), so the borrowing commenced. People bought SUVs, personal watercraft, fancy vacations, etc... However, the more unpredictable effect was that on the real estate markets across the country. The cheap money went into housing. At first, prices rose at a level that was proportional to the cheaper cost of borrowing, but it soon turned into a spiral. As prices rose, more money was pumped into the market to allow people to buy more houses. Speculative fervor took over, based solely on the back of fake money. At the end of 2005, most people couldn't afford to buy housing in the major metros of the US, and some of the speculators were left holding a financial hot potato. Prices couldn't rise forever.

In response, the fed dropped interest rates again (yes, again). Inflation started to become a huge problem. Food was up, healthcare was way up, education was up, housing was up. However, as most Americans were now deeply in debt, the new fake money failed to have the same economic impact as previous infusions. The new money did find its way into the economy though. In concert with irresponsible printing across the world, new money chased commodity prices. Oil and foodstuffs went through the roof. However, the beleaguered economy didn't have the strength to support that boom long term, and we're already seeing it fizzle out.

One more impact of rising real estate prices. The government originally created Fannie Mae to provide mortgages to those who could get them on the private market. This of course has had the obvious effect of rising real estate prices (increased demand) and more irresponsible lending. When the government decided to privatize Fannie, they decided that competition was good, so they created a fake company out of thin air to compete in the bad loan business. This company is called Freddie Mac. As the fake money piled on, and loans got more exotic, Fannie and Freddie went from being involved in ~20% of real estate in the US to the majority.

Whew.... That was long winded.

What Happens Now

The government takeover of Fannie Mae and Freddie Mac has now had the unintended (or perhaps intended) consequence of making the majority of mortgaged real estate holdings in the US indebted to the US government. It has also exposed the US taxpayer to losses sustained by these companies as they attempt to discharge all of the bad debts that they accumulated over the 3-5 years of real estate boom. This exposes every responsible investor to the excesses of the last 5 years. It also gives the Feds a huge amount of control over the private real estate market.

Many of the crashing financial giants were also well exposed to sub-prime real estate. If you ask me, we should let them crash. The market is a mess, and they are at least in part responsible. However, we have seen a strange combination of letting them fail, industry bail out, and private bail out by the Feds.

The crashing of oil is simply a correction of the short lived commodities bubble.

We are really at a crossroads. The economy is distorted, but there is a lot of fundamental goodness in the US economy. We really do create and produce. There is a foundation to recover. However, we have five years of the distortion of capital towards financial companies and real estate holdings. Jobs have to be lost. Companies have to disband, and the economy as a whole needs to rearrange itself. Over a few years, in a good capitalist system, that should happen. Let the recession occur, let unemployment go up for a couple of years, and let business slowly adapt to the reality of non-distorted market demands. It really is better in the long run. We don't need to waste manpower that could be driving the economy forward building unnecessary houses in the Arizona desert. Removing the market distortions (by removing the infusions of fake money) will accomplish that.

All of that being said, I'm not optimistic. The feds are already talking about lowering interest rates again to "stimulate the economy." The average American seems to want a short term bail out a whole lot more than a correction to a sound economy. The fake money might was well be green cocaine, and we are seriously addicted. It felt good at first, but now we just can't let it go. Neither of the current major party candidates for US president opposed the takeover of Fannie or Freddie, and I suspect that both will promote economic policies that continue to let the Federal Government and the Federal Reserve meddle in the US economy.

Many economists have looked back at the great depression, and even many of the more liberal members of this group have conceded that the policies of FDR did wonders to expand the length and breadth of the depression. The New Deal took real money out of the economy and put fake money to work on projects that really did nothing to solve any problems that faced the country. The US economy has a firm foundation, but it is what we do next that will determine how this plays out. Will we have a bumpy ride for a couple of years or will we bear hug the economy with such restrictive rules to fix it that we love it right down into another depression. As they say, hope for the best, but prepare for the worst.