So whatever happens, we’re going to hurt a lot?
Yes. It’s going to hurt. A deflationary crash would be quick, and extreme. People who watch too many Hollywood movies think this means blood in the streets, but it really just means a lot of hard working people will be on the streets trying to find a way to be productive. People who would rather cry to the government for help than work will be screaming blue murder and politicians will be trying to prove they can help by doing something. If they give in and do anything that forces the US Government to borrow, they could make things worse or just make the crash last longer.
An inflationary crash means that we’ll have many living-dead companies, and many people just on the edge of bankruptcy. House prices will still crash as it will be impossible to borrow money to buy them, and impossible to pay the interest on a mortgage if people do buy them. The government will constantly be borrowing more and more to try and make the problem go away. If it borrows too fast, the entire economy crashes as the US Government defaults on its debt. If it borrows at just the right rate, the inflationary crash lasts ten or twenty years.
Is there anything the government can do to make it less awful?
Yes. The primary problem is that nobody is willing to deal with anyone else, because they don’t know who is hiding bankruptcy. A realistic government solution would break down into three parts:
- Make it possible to figure out who should be bankrupt. This can be done by changing reporting requirements in quarterly reports, and sending the SEC at any signs of fraud.
- Set up a system to put a company in a special state where PRIVATE individuals and companies can invest their money to bail out a company if they think it will be worth saving. This would be done by wiping out all current shares and bonds and issuing new shares based on the debt of the company (this is called an debt/equity swap). People buying the shares would be buying the mixed good and bad debt of the company, but they would be buying it at the price they think is worth paying, so they can pay far less than full face value. Investors would make a lot of money if they choose correctly, and lose it if they choose poorly, but it would at least be real money already in the system. There is far more private money out there than government money, it’s just that private entities don’t know where it’s safe to put it.
- The government needs to stop spending money, stop borrowing money, and cannot use any of its money to convert fairy money to real money or to insure bad debt.
If the government did this, there would be a deflationary crash, but it would be as short as possible, and the economic growth after the crash would be phenomenal.
I doubt this will happen though, as politicians would be (rightly) afraid of being thrown out of office because they let their constituents hurt so much. I doubt they would have the strength to do the right thing.
Shouldn’t people be going to jail for this?
Yes.
I think you can see that in my opinion, a deflationary crash is the best way for us to go, and we have to stop the US Government from borrowing any more money than it already is. The government will probably attempt to inflate out of the problem, and potentially blow itself up in the process. If it doesn’t blow up, it will probably fail in stopping the deflationary crash (because they can’t inflate fast enough), but the crash will hurt more and last longer as people will have a higher tax burden.
The only place I think it would be worth allowing some government debt is in covering FDIC insured deposits in banks. Exposure there is fairly limited compared to trying to save the roughly 60 trillion dollar debt markets, and it will largely protect innocent bystanders from much of the carnage as banks are forced to come clean about their finances and get shut down.
Other than that, the government needs to conserve its powder, and restore trust by forcing companies to tell the truth about their finances. The economy will be frozen as long as businesses are afraid that they will be paid with counterfeit money.
{ 2 trackbacks }
{ 6 comments… read them below or add one }
Lisa 10.02.08 at 5:43 pm
Fascinating article — I wish our political leaders were this clear. Related to that: how do you think the ‘bailout’ will function within your scenarios?
Ray 10.02.08 at 6:00 pm
Well, this bailout is interesting, because it is being rushed through despite very vocal opposition by constituents. The Secretary of the Treasury is supposed to have scared the powers that be with the news he brought when he requested the bill.
Unfortunately, what he said is secret, and there haven’t been any leaks. I can speculate though:
1) “A deflationary crash is coming!”
2) “China just contacted me and said they won’t buy any more treasuries unless we buy all their bad debt!”
3) “Our 16 Primary Distributors and The Federal Reserve Bank are all on the edge of insolvency, and if we don’t bail them out, we won’t be able to sell any Treasuries next year!”
Section 112 of the bailout specifically allows the buying of foreign bad debt, and Bush has announced that he will veto any bill that doesn’t carry that section.
Given that some of the Primary Distributors are largely foreign banks, and that tax income will absolutely suck next year, I am guessing Paulson said some mixture of all three.
So, the government is going to try to inflate hard, and is going to try to buy up the rest of the world’s bad debt while doing it. The rest of the world may have promised to keep buying treasuries to fund this operation.
Of course, if I were a foreign power, I would threaten to stop buying treasuries unless the USA bought all my bad debt (by effectively swapping treasuries for them). Then, I’d sell all my US treasuries and refuse to buy any more. The US Government would be bankrupt in a matter of days.
That assumes the foreign country would find someone to the treasuries to. In reality they are probably just trying to bail themselves out too. So I guess that means multiple governments will all attempt to inflate out of this together. I think it unlikely they will succeed, though if they are lucky, the entire world economy could try to pretend nothing is wrong and stagger along for a few decades.
Ray 10.02.08 at 6:41 pm
Dealers, Primary Dealers. There’s a Freudian slip if I ever saw one.
Short answer, the current bailout looks like it will do little to help and much to hurt. It will certainly be expensive.
Lisa 10.03.08 at 7:46 am
That’s what I was afraid of. There’s an interesting breakdown of the ‘pork’ over at DINKs (http://www.dinksfinance.com/2008/10/bailout-pork.html). Looks like its typical Washington/Wall Street incest.
Adeel Ahmad 10.13.08 at 8:38 am
How I miss you Ray…
You’re bang on as always. I was talking about Depression in ‘08 a couple summers ago back when people were sure Iraq would remain the top issue for voters.
I think the old farts in power are trying to steer back to the 70s as a best-case scenario - the new ’soft-landing’ they were insisting a couple years ago would occur now. They will be dying off soon and don’t want a devastating deflationary crash on their conscience.
I don’t think it’s easy to engineer stagflation so here’s hoping for Door #1.
Ray 10.13.08 at 10:03 pm
Adeel! Long time no see.
The latest wave of government action is looking ominous. It really does look like they are trying to inflate everyone out together, and take on government debt doing it. They’re trying to treat trust issues by using the government as a backstop for banks.
Eventually, one or more governments are going to be forced to default, and then the others won’t be looking so rosy. I’m not sure which will do more damage to the system: banks going under, or countries.
Interesting times!