Moon of Alabama Brecht quote
September 16, 2008

Downturn, Inflation and Tax Policy

So Hank Greenberg says on CNBC that AIG is a "national treasure" and wants the Fed to loan it $70-80-90 billion. Last time I looked no nation's treasury owned AIG, but Hank Greenberg, who was kicked out of that company three years ago over dubious accounting practices, owns 11 percent of all AIG shares.

But anyway - should the Fed or Treasury loan money to AIG?

No. There is no way AIG can survive and while such a loan would cover part of its losses it would never be repaid.

Should the Fed lower interest rates?

No. Fed interest rates at this point do not matter at all.

The overnight interest rate for interbank loans was 6% yesterday, 4% over the Fed rate while it is normally only a quarter or a half percent over the Fed rate. What is missing now is trust in the solvency of any partner in the financial markets. The need to borrow $90 billion is not simply a 'liquidity problem'. Nobody wants to lend if their is quite a chance that the money will not come back and that there are now no longer ways to hedge such deals.

This insecure situation will continue. The Dow and S&P may rally a bit from here, AIG failure or not, and will tank again after a few days or weeks. The loan crisis - mortgages, HELOCs, car loans, credit card loans etc - which is the point of origin of the general economic crisis has not even reached its peak. That will come at the end of this year or next spring.

Only then will the system really falter and only then the rubber will really hit the road, i.e. Main Street. The really bad news will come from the big industrial companies in the 2nd quarter reports in  2009. Soon after that the Dow will see the low of the cycle and it will stay there for years to come.

Between now and then we will see lots of smaller banks fail and we will see some big ones going under. Hedge funds and private equity groups will silently close down as they will not be able to get more capital or credit. Leveraged Buy Out deals will be history. The FDIC will go bust and the taxpayer will have to carry that additional burdens. Private pension plans will be in very deep doodoo.

Next year there will be lot of talk about deflation and the Fed will use that talk as justification to inflate massively.

Does anybody remember any serious Fed talk and measures against inflation in the last 15 years? I do not. So while this whole bubble, first tech, than credit, build itself via a lax monetary policy, there never was official inflation that would have required some restrictive Fed measure. But as the bubble now finally breaks there will be serious talk about deflation and it will be used to seriously inflate and to devalue the dollar.

It is a totally dishonest scheme, but it will be the only way the U.S. will be able to repair its economy and balance sheet.

Inflation and currency devaluation is a very regressive kind of unofficial tax. It hits the poor and the middle class much stronger than the richer folks.

One can adjust fiscal policies to somewhat alleviate that effect. Increase the tax rate for income over $1 million to some 80%, over $500,000 to some 60% etc and lower regressive taxes like the sales tax.

With such a progressive tax policy the burden of inflation, which is needed to repair the national U.S. balance sheet, can be put equally on everyone.

Posted by b on September 16, 2008 at 18:28 UTC | Permalink

Comments

b, maybe the Chinese will send us lots and lots of money to buy more Chinese goods....

Posted by: alabama | Sep 16 2008 18:37 utc | 1

These Chinese?

they were a part of the bubble just like Russia - 17% down today - but they started earlier and have the money and nerve to take it.

Posted by: b | Sep 16 2008 19:24 utc | 2

Looks like one of those "Rivers and Mountains" scrolls of yore.... But then the Chinese just love to gamble.

Posted by: alabama | Sep 16 2008 19:46 utc | 3

The need to borrow $90 billion is not simply a 'liquidity problem'.

ouch

Posted by: annie | Sep 16 2008 20:28 utc | 4

Like I said a few threads ago, it's all very nice to "inflate", that means electronically printing more dollars. But the US is not an isolated economy; it means handing off the losses onto outside holders of dollars, or dollar-priced bonds. I can think of a certain number of countries who are not going to be too pleased; the others, who have no power, will just have to suffer.

This is wrecking US foreign policy, if the military aggression pursued by the US can be described as a foreign policy.

Posted by: Alex | Sep 16 2008 21:04 utc | 5

paul craig roberts

Posted by: remembereringgiap | Sep 16 2008 21:15 utc | 6

PC Roberts this morning:


Most Americans, including the presidential candidates and the media, are unaware that the US government today, now at this minute, is unable to finance its day-to-day operations and must rely on foreigners to purchase its bonds. The government pays the interest to foreigners by selling more bonds, and when the bonds come due, the government redeems the bonds by selling new bonds. The day the foreigners do not buy is the day the American people and their government are brought to reality.

This is not the financial position of a superpower.

Will what happened to Lehman Brothers today be America’s fate tomorrow?

It is ridiculous to expect that all the foreign investors will continue to prop the system especially considering that the level of the hit taken by markets around the world seems to be in direct relationship to those markets exposure to the amerikan catastrophe.
A function of the level of investment that they traditionally made in US bonds. When doing something hurts, the usual decision is to stop doing it.


Posted by: Debs is dead | Sep 16 2008 21:25 utc | 7

To pursue, after r'giap's reference to Paul Craig Roberts @ 6, who repeats the importance for the US, the unmeasured issue is the effects on the rest of the world. All have lost vastly on their stock exchanges. Enormous loss of confidence in US bonds. So what is the reaction? Close down, look to other sources. That is going to cut the way the US financed the Iraq war, by borrowing, and no doubt other wars too.

Everybody has said how much the US has depended on world finance for its wars. Well that's over. US bonds will only be sold for a discount.

Posted by: Alex | Sep 16 2008 21:42 utc | 8

So what should the average joe be doing with their meager life savings? Should I turn it into pesos and hide it under my mattress? Seriously, I have no faith in the pros anymore, so where do I turn?

Posted by: Zedicus | Sep 17 2008 2:00 utc | 9

According to the BBC, the US Federal Reserve has just approved an $85 billion bailout package for AIG. The American media doesn't seem to be carrying it yet.

Posted by: Ensley | Sep 17 2008 2:12 utc | 10

@ Alex #8

While you would think that eventually foreign investors and banks would lose faith in U.S. government debt, there seems to be little sign of that now. Yields on the 10 year have fallen to under 3.5% in the past week. When we see those yields shoot up, then you will know that people are wary of lending to the government.

But for now, the U.S.G. still benefits from the "flight to safety" mentality which holds that U.S. bonds are zero risk.

Posted by: Lysander | Sep 17 2008 2:44 utc | 11

Also I would add that during the great depression, U.S. bonds yielded well under 1% while corporate bonds were 15-20. That was the only safe place to put money back then. Not in banks. When banks again become unsafe in the next few years, that's where a lot of money will go today as well. Perversely, economic instability helps the government borrow. (tax revenues will fall through the floor, though)

Granted, the U.S. was not a debtor nation in the 30s.

Posted by: Lysander | Sep 17 2008 2:50 utc | 12

Inflation and currency devaluation is a very regressive kind of unofficial tax. It hits the poor and the middle class much stronger than the richer folks.

That's how Milosevic striped us Serbs of our money. And additionally when we totally lost confidence in regular banks (that simply took our money declaring they do not have any money any more but still were open for God knows what reason) he invented those pyramid "private" (for sure cause money ended up in private pockets) banks. And that's how "primary accumulation of capital" happened in Serbia. Those guys who took our money now operate legally in Serbia being owners of everything worthy. Milosevic is dead but his family all though still "hiding" in Russia are very much in business.
That's how they actually do it. Put money in "right" hands.

Posted by: vbo | Sep 17 2008 3:43 utc | 13

Nice post, when did we last have 80% tax for mil incomes? I think Ronnie changed that, we are going to hear the words marxist and socialist on Obama fersures.

And, Morales..

D'oh. Like the line in there about 'not sure if 100% of the military is behind him'. Maybe Cheneyco will get another coup before they have to go


Posted by: aumana | Sep 17 2008 3:57 utc | 14

This is btw completely illegal: Fed’s $85 Billion Loan Rescues Insurer

Three days ago AIG asked for $40 billion, now it needs $85 billion - that should say it all. Dear U.S. taxpayer thanks for your money, we will waste it here. And why is the Fed? A private club doing this outside of Congress control, why not the treasury?

Fearing a financial crisis worldwide, the Federal Reserve reversed course on Tuesday and agreed to an $85 billion bailout that would give the government control of the troubled insurance giant American International Group.

The decision, only two weeks after the Treasury took over the federally chartered mortgage finance companies Fannie Mae and Freddie Mac, is the most radical intervention in private business in the central bank’s history.
...
the bailout is likely to prove controversial, because it effectively puts taxpayer money at risk while protecting bad investments made by A.I.G. and other institutions it does business with.
...
Under the plan, the Fed will make a two-year loan to A.I.G. of up to $85 billion and, in return, will receive warrants that can be converted into common stock giving the government nearly 80 percent ownership of the insurer, if the existing shareholders approve. All of the company’s assets are being pledged to secure the loan. Existing stockholders have already seen the value of their stock drop more than 90 percent in the last year. Now they will suffer even more, although they will not be totally wiped out.
...

Pure socialism for the rich.

Posted by: b | Sep 17 2008 4:44 utc | 15

Saudi Billionaire to Wall Street: See You Later

If Wall Street is hoping that Prince Alwaleed bin Talal will ride to the rescue of America's crumbling banks, here's the word from the Saudi billionaire: Thanks, but no thanks. Having bailed out Citicorp on a couple of occasions — most recently by helping in its recapitalization earlier this year — Al-Waleed says he's not in the market for any more U.S. financial sector assets.
...

Posted by: b | Sep 17 2008 5:00 utc | 16

"although they will not be totally wiped out."

Not totally wiped out???? AIG falls a $1.15 in after hours trading. Doesn't sound like much until you realize that's a 30% drop to 2.60. That's down from 70 a year ago. AIG is a "safe" Blue Chip stock, a Dow 30 component which means every pension fund holds it. The "buy and hold" strategy has been talked up for decades. CNBC spouts it non stop. The market goes up 10% a year and all. It is now going to crush the middle class. And no one is going to warn them.

But did you guys catch the OJ trial?

Posted by: Lysander | Sep 17 2008 5:05 utc | 17

Pure socialism for the rich.

Yes indeed, the rich are getting their valuables converted into something safer, super-duper rich like bin-Talal are keeping their chestnuts out of the fire.

One more element though, maybe it's a case of paranoia, but could it be that somebody wants to keep the ship looking like it won't really sink -- at least not until after November 4? Or until after the Inaguration if somehow Obama manages to get (s)elected?

Posted by: Chuck Cliff | Sep 17 2008 5:31 utc | 18

Pissing in the wind...

Posted by: alabama | Sep 17 2008 6:00 utc | 19

Just a reality check, NMV US exports to China now exceed Chinese imports into US.
Just a reality check, Japan has run a 0.5% lending rate "carry trade" for years.
Just a reality check, "gold bugs" (inflation hysterics) lost their gilded asses.

Other than a talking point, "socialism for the rich" meme is wearing pretty thin.

"Monetizing the deficits" would be more accurate, without all the dire hyperbole.
If you have a milkshake, and I have a straw that reaches all the way over to here,
and I pay you a dollar, you're holding a dollar, but I'm drinking your milkshake!

Posted by: Ata Hamp | Sep 17 2008 6:01 utc | 20

"conspiracy theorists" are looking less crazy every day. main street will drown while smart capital stays dry.

and everyone thought the amero had no legs.

Posted by: Lizard | Sep 17 2008 6:26 utc | 21

@20 - The Economy Is Sound.
---

Just a reality check, NMV US exports to China now exceed Chinese imports into US.
Just a reality check, Japan has run a 0.5% lending rate "carry trade" for years.
Just a reality check, "gold bugs" (inflation hysterics) lost their gilded asses.

I have no idea what NMV US exports are, but I know the general trade balance - by the way - the Fed only yesterday warned that U.S. exports will again shrink.

The "carry trade" is about over

I bought some gold in 2000 and 2001 - 300% up so far, thanks.

Posted by: b | Sep 17 2008 6:38 utc | 22

Is AIG a "national treasure" woth preserving? I would like to see the government give the same treatment to other "national treasures" that are not entirely in private hands, like the education and health-care systems, the infrastructure and our water and other natural resources.

Probably has to do with the fact that a forest cannot make a campaign donation, but a logging company can.

Posted by: ralphieboy | Sep 17 2008 6:50 utc | 23

From fool's highly informative link in the Wild Ride thread :

In addition, The Fed has announced that it will take equities as collateral for loans. "Equities" is a fancy name for stocks.

That's right - for the first time in history, now banks can take stocks to the discount window. Maybe even their own stocks.

The Fed has gone from taking only the highest-quality securities - "AAA" rated debt instruments - to taking everything up to and including the most dangerous (common stock) all at once!

Now I may be blind but I've read The Federal Reserve Act multiple times and nowhere do I see where equities can be taken to the window (or anywhere else for that matter) for Fed Credit.

If they intend to actually do this, its quite clear they don't care what the law says. They're going to do it anyway, and their precedent is that you sat back and allowed them to take equity when they bailed out Bear Stearns, and said nothing! They will do anything they want by citing "exigent circumstances" and claim blanket authority.

What's worse, this effectively makes The Fed a margin lender on the equity markets! You think they don't have a reason to interfere in the market eh? Oh boy, now they have billions of reasons, all of them sitting on their balance sheet! Fair and open markets? Bah!

Note carefully folks - this effectively makes The Fed LONG (that is, a "buyer") of STOCKS.

What's even better is that they don't eat their own losses if there are any - they're yours!

That's because The Federal Reserve Act says that the profits (or losses) from The Fed flow through to the Treasury (after operating expenses) which means that now, suddenly The Federal Government is potentially directly exposed to losses in the stock market!

Now it has always been true that The Government "loses" when the market goes to hell as it gets less in the way of tax receipts. But that's different than suffering an actual capital loss - and that is now possible.

The implications of this tectonic shift within the banking framework are as yet to be seen, but this lowering of securities standards by the Feds is essentially the transfer of risk for shonky investments in equities from the commercial money houses to the US taxpayer, and with the risk the obligations to cover the losses. In times when the S&P could easily fall another 20% by years end, this will have grave consequences, possibly triggering a ruinous domino effect throughout the US and entangled nations.

Although AIG has an alleged $1 trillion in assets, it can’t raise $50 billion. Who would have this sort of money at this point in time anyway? Certainly not people who can afford to loose it. So they wonder how much the assets are really worth. How much risk have they insured for loans which will or have already gone bad? When you hear announcements of “imminent death if $75 billion aren’t raised within 48 hours”, then one doesn’t have to be a rocket scientist to predict the future of this company in a downward spiralling economy. Too big to fail they say. Hah, too big to succeed I say, the giant has already stumbled and lost its balance, and no arm will be extended for fear of being dragged down with the helpless giant. So instead the Fed roles out the safety blanket to catch the falling juggernaut, taking on a 80% stake in the insurance colossus, in effect becoming the insurer of many commercial risks across the world. The costs of this venture could potentially be catastrophic for the US treasury.

The US government coffers, already running on empty, haemorrhaging from ridiculously expensive wars on foreign shores and tax cuts to the high income earners, will have to cop further billions of dollars in losses. The thrashing of equity values, the current implosion of global stock markets will continue for quite some time, but from now on the losses will be crystallising in the US treasury’s P&L. Where exactly is the treasury going to get the money from that will be needed to cover the deficits?

Tax increases? Sell the Empire State to China? Reduce the public service budget by 5% and start laying of employees? With an at best stagnating economy, falling corporate earnings, the tax revenue will decrease. A rise in unemployment figures means more social security outlays. The foreign capital drip which keeps the patient alive for the moment, apart from positioning the US in a dependency that could easily translate into being controlled by foreign powers, is under current global conditions slowly drying up and shouldn’t be taken for granted.

Who ever wins the next election will have to make some tough decisions, but won’t. The mugs in congress, no matter which tentacle they belong to, motivated by self-interest, have been sitting on their hands forever. Stooges, most if not all of them, people who taught us for decades that we best expect nothing so we won’t be disappointed. And that all talk-no action squad, strikingly ignorant and lame for as long as they’ve been in office, are representing us in the battle with the conglomerates. Shudder.

The consolidation happening on Wall Street will leave even less people in control over even more money. One has to wonder if this wasn’t the name of the game in the first place. The incestuous relationship between the oligarchs we have become used to, is lately presenting its more ferocious side, showing that in their passionate love they are not afraid of devouring each other. And this mounting concentration of financial power is producing gorillas too large to measure in pounds.

Even without a degree in business law or economics, people should be starting to see the writing on the wall. Judging by the euphoria generated by both parties’ presidential candidates, I doubt that this awakening is taking place though. All this talk now by Obama & McCain about how they will reform the financial sector, introduce regulations and enforce them, is warm air, blown into the sails of their respective election ships on the swelling oceans of public fears and disillusionment. The crucial decisions in the landscape gardening project on Wall Street will be made by the same tweed suits who caused this mess in the first place, and the conditions imposed on the banking orgs will have loopholes big enough to push in 4 years the next election ship through.

As B pointed out, in terms of interest rates, the Fed has become irrelevant. In the current climate banks will be hording cash and offer interest rates way above the fed rate. Following a predestined path, the flight from falling equities into securer cash assets means interest rates will eventually come down again, allowing the businesses that will survive the current squeeze, bruised but alive, to slowly rebuild their balance sheets. Lower rates would also help to jump start the mangled housing sector, however for that to happen, house prices will have to drop further. Much further. Unrealistic expectations of asset values will need to be adjusted, not just in board rooms but also around kitchen tables.

A painful process, for sure. Financial stress causes marriages to break up, children being yelled at, depression and dispair. And so this financial melt down will bring about social hardships for the many caught up in this spider web of too closely related business interests. The anger and frustration will not be helped by the realisation that their perceived worth didn’t just disappear into thin air, but that it has been in scandalous fashion redistributed up the pyramid and the perpetrators are buying up foreclosed villas.

The real tragedy though becomes apparent when one puts the figures in context. While the Feds pours $80 billion into the bottomless pit Wall Street has become, people all over the world are starving to death, starvation that http://www.usatoday.com/news/world/2008-07-16-aid_N.htm”>could be prevented by a fraction of that money:

UNITED NATIONS (AP) — The United Nations blamed the global food crisis Wednesday for a $3.4 billion global shortall in emergency humanitarian aid for 34 nations.
U.N. officials said that higher food and fuel costs, along with natural disasters and worsening conflicts, are making it more difficult to raise funds from donor nations, mostly Western governments.
"The donors will need to dig deep into their pockets to try to find that money," said John Holmes, the U.N.'s humanitarian chief.
So far this year, $2.9 billion has been raised, representing about 46% of what's needed to respond to the world's most severe crises, Holmes said...
What a shame.

Posted by: Juan Moment | Sep 17 2008 9:20 utc | 24

Safe Money Market funds - think again: Money market fund 'breaks the buck' on Lehman IOUs

The credit crisis has taken a new and dangerous turn: Shares of a large money market mutual fund have "broken the buck" -- fallen below the standard $1 a share -- because of losses on IOUs from brokerage Lehman Bros. Holdings Inc.

The Reserve Primary Fund in New York, which had $65 billion in assets at the end of August, said it cut its share price to 97 cents after marking down the value of $785 million in Lehman debt securities, following the brokerage’s filing for bankruptcy court protection on Monday. Read the fund's statement here.
...
The woes of Reserve Primary Fund -- the nation's oldest money fund -- are sure to set off a public relations blitz by other mutual fund companies to forestall an investor panic.
...
Money market funds, which hold a record $3.5 trillion, have long been considered relatively safe because they're supposed to limit their investments to high-quality, short-term securities. The funds don’t guarantee that they can keep their share prices steady at $1, but before today only one other fund has broken the buck -- and that was a small institutional fund, in 1994.

Money funds overall have taken in $400 billion in fresh cash this year alone as nervous investors have sold stocks, bonds and other assets and sought a haven where they believed their principal was protected.
...
There’s high irony in the Reserve Primary Fund's troubles: The fund’s founder is 71-year-old Bruce Bent, who is considered to be the father of the money fund industry, which dates back to the early 1970s.

Just last week Bent was quoted in a Wall Street Journal story saying that "the purpose of [a] money fund is to bore the investor into a sound night's sleep."

A call to the company’s offices in New York wasn’t returned.

Posted by: b | Sep 17 2008 9:31 utc | 25

So funny ..

Today, Wed, Sep 17, 2008
European stocks rebound, led by banks on AIG rescue (Wed 3:39am)
European stocks turn negative; HBOS tumbles (Wed 3:56am)

That euphoria lasted exactly 17 minutes ...

Posted by: DM | Sep 17 2008 9:39 utc | 26

And they thought 911 changed everything - looks like we're going to see what "change" really means.

Posted by: anna missed | Sep 17 2008 9:49 utc | 27

looks like we're going to see what "change" really means.

Prof. Buiter in the Financial Times: The end of American capitalism as we knew it

There is a long-standing argument that there is no real case for private ownership of deposit-taking banking institutions, because these cannot exist safely without a deposit guarantee and/or lender of last resort facilities, that are ultimately underwritten by the taxpayer. Even where private deposit insurance exists, this is only sufficient to handle bank runs on a subset of the banks in the system. Private banks collectively cannot self-insure against a generalised run on the banks. Once the state underwrites the deposits or makes alternative funding available as lender of last resort, deposit-based banking is a license to print money. That suggests that either deposit-banking licenses should be periodically auctioned off competitively or that deposit-taking banks should be in public ownership to ensure that the tax payer gets the rents as well as the risks.

The argument that financial intermediation cannot be entrusted to the private sector can now be extended to include the new, transactions-oriented, capital-markets-based forms of financial capitalism. The risk of a sudden vanishing of both market liquidity for systemically important classes of finanial assets and funding liquidity for systemically important firms may well be too serious to allow private enterprises to play. No doubt the socialisation of most financial intermediation would be costly as regards dynamism and innovation, but if the risk of instability is too great and the cost of instability too high, then that may be a cost worth paying.

The FT against private bank ownership "change" indeed.

Posted by: b | Sep 17 2008 9:57 utc | 28

What happens now to common shares of, say, Fannie Mae and Freddie Mac if they are in conservatorship?

Posted by: mystified | Sep 23 2008 23:29 utc | 29

The comments to this entry are closed.