Dumbing economics down

[jillian]

How would you go about explaining the effects of the bailouts to the average Jo or Joann?

When they say, "the bank failures without the bailouts would have been horrific on a global scale", what should we reply with?

[jillian]

I've been saying that the markets would correct themselves and that government intervention is part of the problem....but I don't really know what else to say.

Economics is so darn complicated and very few people have a sincere understanding of how things work - in this regard.

[MoneyWhereMyMouthIs2]

How would you go about explaining the effects of the bailouts to the average Jo or Joann?

When they say, "the bank failures without the bailouts would have been horrific on a global scale", what should we reply with?

Here are a few...

Some banks have been irresponsible. Those banks should go out of business. If government really wants to bail someone out, they should bail out the consumers who did business with those banks. The banks (and employees) shouldn't be rewarded for their fraud.

Letting it go naturally will be painful. It will be more painful later if government keeps intervening. Pay now, or pay later.

This idea that our grandchildren will pay for these things is absolutely unrealistic. It ain't happening. Our problems will either be dealt with now or later, and it will be a lot worse later.

[jillian]

Here are a few...

Some banks have been irresponsible. Those banks should go out of business. If government really wants to bail someone out, they should bail out the consumers who did business with those banks. The banks (and employees) shouldn't be rewarded for their fraud.

Letting it go naturally will be painful. It will be more painful later if government keeps intervening. Pay now, or pay later.

This idea that our grandchildren will pay for these things is absolutely unrealistic. It ain't happening. Our problems will either be dealt with now or later, and it will be a lot worse later.

okay, and i thank you for your responses.

how do you feel about the failures making room for other companies? you know, like weeding out the access to make room for smaller companies...is that a fair arguement?

[noxagol]

It's simple. The reason those banks are going under is because they made a lot of bad choices. By bailing them out of their bad choices, they are going to think it is OK to make more, and make the situation even worse because they will issue more bad loans. It is pushing the cycle towards further and greater disaster.

It's like a heroin addict. The economy got shot up with some heroin, easy money from the FED, we felt good for a while, housing bubble, and now we need to suffer the withdrawals to get off the addiction. Instead of quitting, we are getting shot up with some more heroin.

[TER]

I tell them that the bailout basically follow socialism, which happens to be how most of the world is set up. The ones with the money and power privatize profit and publicize debt. Protection from this is exactly what the government is supposed to be doing, this is what the role of the government is, to protect every citizen's rights as defined in our Bill of Rights. Instead, the Fed prints up money out of thin air, creating in effect a tax on everyone of us, since every dollar printed makes the one in your pocket worth less. Who is effected most? Not the milllionaire who might have to sacrifice going on their winter vacation, but those who have the least, who now have to pay more for the bare essential such as food and gas.

Corporations have taken control of the government and have basically made the rest of us their indentured servants, always at greatest to harm to those whom have the least. Welcome to fascism.

[icon124]

The financial crisis is not over. Neither tax rebates nor low interest rates nor higher or lower exchange rates can do the job of reviving an economy that is burdened by debt loads that are too high. On the contrary: the policy measures that the US authorities have been applying will prolong the agony. Be prepared for the challenges of extended financial turmoil and economic stagnation.

Early this year, the US central bank decided to manage the debt crisis in the light-hearted belief that a few aggressive rate cuts would "unfreeze" the banking system. Yet as of the end of the third quarter of 2008, the arteries of the financial system are still cluttered, and the financial system has moved even closer to total collapse.

Those banks and brokerages that haven't yet failed have been kept alive by emergency monetary transfusions from the US central bank. The Fed has cast away all restraints of economic rationality and is acting in a purely political way. The Board of Governors of the US Federal Reserve System is pursuing the goal of getting the financial system through the mess — at least until the end of the year, no matter how high the costs will be thereafter.

The American central bank has adopted the financial equivalent of the military strategy of scorched earth. The economic philosophy of the current chairman of the US Federal Reserve System can be summarized in the slogan, "No depression under my rule!" He resembles a military leader who stubbornly declares, "No defeat under my rule!" the more the chance of victory is slipping away, and defeat can be denied no longer.

The current economic disaster is the result of the combination of negligence, hubris, and wrong economic theory. For decades, an economic and monetary policy has been practiced based on the illusion of, "It doesn't matter." At first it was, "Deficits don't matter." From that, the policy of "it doesn't matter" got extended to money creation, the credit expansion, the stock-market bubble, and the housing boom. Now, we're being told that buying financial junk by the central bank to beef up banks and brokerages also doesn't matter.

As a byproduct of this mindless economic and monetary policy, financial market operators, too, have lost their heads. Trusting the official cheerleaders, investors hold on in the trenches until they will have lost their last shirt. Economic weakness is spreading around the globe. There is no new spurt of economic growth in sight. Yet many investors stay put because they have been conditioned to believe that government will bail them out.

The current financial crisis is not of a cyclical nature. The financial turmoil is the symptom of the structural imbalances in the real economy. Over decades, expansive monetary policy has gone hand in hand with implicit and explicit bailout guarantees, and this has distorted the process of capital allocation. Under such perverted conditions, those investors will win most who cast away the restraints of prudence. It is a game that can go on for a long time — up to the point when the irrationality has become systemic.

The behavior of the investment community reflects the incentive structure that has been put in place by the authorities. Investors have learnt to dance to the tunes of the pied pipers at high places. After all, the individual market player could see from those who were ahead of him in the abandonment of prudence how money is being made. In the wake of this, financial companies have become overextended and are now in need of deleveraging. Yet the core problem lies in the imbalances of the real economy.

In the Austrian theory of the business cycle, the distinction is made between the "primary" and "secondary" depression. The secondary depression is what catches the eye: the turmoil in the financial markets. Yet the underlying cause is the distortion of the economy's capital structure: the primary depression.

The simple fact is that the US economy is burdened with a highly lopsided capital structure as the consequence of a wide discrepancy between consumption and production, which, in turn, is the result of monetary policy. Persistent trade imbalances are the symptoms of this discrepancy. This means for the US economy that lower interest rates and government incentives aimed at boosting consumption work as pure poison. Instead of more consumption, more savings, less consumption and fewer imports are needed.

The current financial crisis reflects that many debtors have reached their debt limit and that creditors are lowering that limit. From now on, business and consumers, governments and investors must work under the restraints of lowered debt ceilings.

Economic policy as it is currently practiced is in a fix: lower interest rates may temporarily help to alleviate the financial crisis, but they exacerbate the fundamentals that are the cause of the financial crisis. Equally, a lower dollar would make imports costlier for the United States, while a strong dollar comes with lower import prices. But while a low dollar would help to expand exports, a strong dollar impedes export growth. Therefore, the United States will have high trade deficits as long as the economy does not fall deeper into recession.

Without an adaptation that would increase savings, decrease consumption, and reduce imports, the US economy can only go on in the old fashion with ever more debt accumulation. But the limit of debt expansion has been reached. The financial crisis has reduced the willingness of domestic and foreign creditors to extend loans.

Foreign creditors are getting ready to reduce their holding of US debt in a more drastic way. The governmental takeover of the mortgage agencies Fannie Mae and Freddie Mac bailed out the monetary authorities of China, Japan, Russia, and other foreign countries that hold agency debt. As a result of the socialization of the so-called government-sponsored enterprises, the Treasury opened a window of opportunity for these countries to unload their US assets at subsidized prices, all at the cost of the US taxpayer.

A profound restructuring of global capital has become unavoidable. Such a process is quite different from a recession in the traditional sense. In contrast to a sharp and typically short-lived recession, when, after the rupture, business as usual can go on, the restructuring of a distorted capital structure will require time to play out. Rebalancing the distorted capital structure of an economy requires enduring nitty-gritty entrepreneurial piecemeal work. This can only be done under the guidance of the discovery process of competition, as it is inherent in the workings of the price system of the unhampered market.

Anticyclical fiscal and monetary policies are of no help when it comes to the daily toil in business to work towards reestablishing a balanced capital structure. The so-called income multiplier won't work, and lower interest rates won't stimulate spending. On the contrary: these policy measures only make the task of the entrepreneur harder.

The difficulties ahead arise from the problem that business as usual cannot go on under conditions of a credit crunch, which has its roots in the distortions of the economy's capital structure. Thus, even if the financial market turmoil were to settle, there won't be the simple resumption of the old ways of doing business. The belief that, after the financial crisis is over, the real economy can reemerge unscathed, is probably the greatest error that many investors share with the policymakers.

As a result of the bailouts and the socialization of the mortgage agencies, the financial system is now fully infected with moral hazard. The disastrous effects of these government interventions will show up soon. The major task of bringing the capital structure in order is still ahead and more pain is in the waiting.

As long as governments and central banks continue to focus on the monetary symptoms of the "secondary depression" and continue to ignore the structural aspects of the "primary depression," they act like quacks. Ignorant of the lessons of the Austrian School, the authorities will most likely continue with their disastrous policies.

Read through that it should help you some...Also look at it like this:

Before all of these banks failed the private sector had the opportunity to look over their financial statements. IF there were some type of assets worth purchasing then the private sector would have purchased them. Obviously they failed for a reason. So basically the Government is taking over what the private sector didn't want. IF there was some sort of potential profit trust me the private sector would have seen it. So with that in mind basically the Government is making us pay for something that will never have a return. It's a lose lose situation.

Also, do you understand fiat money and the effects of printing money out of thin air? The effects won't be felt in the short term, but once the money passes through the economy and hits the average persons pocket inflation will come full effect.

You can also say the failure of the banks ARE neccessary because their is to much inflated value out here. Weeding out the failures only leaves companies that produce real value. As long as you keep around companies that don't benefit the economy we are only hurting ourselves.

Here is an article on why Fannie Mae and Freddie Mac should not be bailed out:

On Sunday, September 7, 2008, the US government seized control of mortgage finance companies Fannie Mae and Freddie Mac. According to the government's statement, the financial health of both Fannie and Freddie (FF) had deteriorated to such an extent that it could have posed a serious threat to the US economy.

Congress established the FF in order to provide support for the housing market by keeping money flowing in the mortgage market. (Fannie Mae was established in 1938 as part of Franklin Delano Roosevelt's New Deal; Freddie Mac was established in 1970.)

The FF market share of all new mortgages reached over 80% early this year. From this one can infer that a deterioration in FF financial health, which undermines their ability to keep the flow of money going to the mortgage market, is likely to hurt the housing market and the economy. Hence most experts have concluded that the seizure of the FF by the government was a responsible act, one which could restart the flow of money to the mortgage market, reviving the housing market and in turn the rest of the economy.

How Fannie and Freddie Keep the Mortgage Market Going
The key to FF operations is the buying of home loans from mortgage originators such as banks. The FF then bundle the loans they purchase into mortgage-backed securities (MBS), which are sold, with a guarantee of payment to investors. (The FF guarantee that the principal and interest on the underlying loan will be paid back regardless of whether the borrower actually repays.) The FF makes money by charging a guarantee fee on loans that it has purchased and securitized into MBS. By buying mortgages and repackaging the loans for resale via MBS, or by owning mortgages outright, the FF have provided banks and other financial institutions with fresh money to make new home loans.

Due to an implied government guarantee, the FF were able to raise funds relatively cheaply by selling their debt to investors. This in turn enabled them to pay higher prices to the originators of mortgages than potential competitors could pay. On average, between January 2000 and August 2008, the yield on the 10-year Fannie Mae debt was 0.589% above the yield on the 10-year Treasury debt. In contrast, the yield spread between AAA corporate debt and the 10-year Treasury debt stood at 1.446%. This means that on average, from January 2000 to August 2008, the Fannie cost of funding was below the AAA corporate by 0.857%.

Given the fact that the debt issued by FF was considered almost as good as Treasury debt, they could attract money from around the world. In 2007, foreign holdings of US Government Sponsored Enterprise debt (the FF are part of the GSE) stood at $1.304 trillion — an increase of 33% from the previous year and an increase of 165% from 2002. (Note that in 2007, China's investment in the GSE debt comprised 29%, Japan's 17.5% and Russia's 5.8%.)

As a result, the FF have become the dominant force in the housing market. The combined assets of the FF jumped from $160.2 billion in Q1 1990 to $1.77 trillion by Q2 2008. The two companies own or guarantee $5.4 trillion in outstanding home-mortgage debt.

The Real-Estate-Market Crisis and the Demise of Fannie and Freddie
In response to a fall in home prices, coupled with a growing number of home foreclosures, the FF have been required to write off some of the MBS held on their balance sheets. They also had to pay out on guaranteed mortgages that defaulted. As a result the FF have reported nearly $14 billion in losses in the last four quarters. The yearly rate of growth of the FF net worth fell to negative 17.3% in Q2 from negative 23.2% in the previous quarter. Net worth as percentage of assets fell to 3.1% in Q2 from 3.4% in Q1.

As the housing market continued to deteriorate, it started to put pressure on FF stock prices. After increasing to 35.8% in June 2007, the yearly rate of growth of the Fannie stock price fell to negative 89.6% by the end of August this year. Year on year, the price of Freddie's stock fell by 92.7% in August after falling by 85.7% in July. (Note that in May last year, the yearly rate of growth stood at 11.2%.) This made it difficult for the FF to raise capital. The deterioration in their solvency raised the risk that the FF would not be able to secure funding through selling their debt to large buyers such as various central banks. As a result, the prospects for the FF to buy mortgages from lenders and supply fresh funds to the mortgage market were severely hampered.

Will the US Treasury Plan Cause Banks to Lift Mortgage Lending?
So how then can the government seizure of FF fix the problem? According to the plan, the government will inject up to $200 billion over time into the FF and it will also engage in the active buying of MBS from various financial institutions that are currently trying to get rid of these assets. By buying MBS, the Treasury aims at pushing their prices higher and arresting the asset-price deflation.

Also, by injecting money into the FF, government officials hope to restart the flow of money to the mortgage market and bring things to normality. By "normality," they mean that the FF can start buying mortgages from the banks and, after bundling them into the MBS, sell them to the market as before. Treasury officials and various experts are hoping that this will lift home prices and, in turn, lay the foundation for the improvement in consumers' wealth. Subsequently, this will revive the pace of economic activity, so it is held. (Remember that the increase in mortgage lending results in more money being directed to the housing market. This means more money per house, i.e., higher house prices.)

But why should banks consider lifting the pace of mortgage lending? According to a Federal Reserve July survey of loan officers, in excess of 80% of banks have reported that they have tightened their lending standards on residential mortgages. In the previous survey, this figure stood at 72%. Observe that in the July survey last year, the figure stood at 37%. In August, the yearly rate of growth of commercial bank home loans stood at negative 2.2% after being negative at 1.6% in July. This was the third consecutive monthly decline in home loans by commercial banks.

At present, the major concern of most US banks is to improve their net worth, i.e., to strengthen their solvency. This means that the volume of lending is not going to increase if the quality of borrowers does not meet the more stringent standards. According to the Federal Deposit Insurance Corporation (FDIC), commercial banks' and savings institutions' net worth fell by $10 billion from Q1 to Q2. This was the first decline since the data were made available in Q2 2000.

Also, it is questionable that various investors who are at present trying to dispose of MBS would all of a sudden welcome them back into their investment portfolios. We suggest that the FF will have difficulty finding willing buyers of MBS. However, one could argue here that, since the US government guarantees MBS, investors might find them attractive — after all, it is held, the US government cannot default on their debts. From this perspective, one may conclude that the US government plan to take over Fannie and Freddie is a great idea and might work. (Most experts, including the Fed Chairman, are of the view that this is a great plan.)

Confusing Capital with Money
It seems that most experts are confusing capital with money. Treasury officials and Fed policy makers give the impression that they have a hidden pool of resources that can be employed in emergency cases. This is not the case. Neither the Treasury nor the Fed has any real resources as such. All that they can do is redistribute the existent wealth by means of taxes or by means of printing money. (Remember that it is real savings that makes real economic growth possible and not money.)

The act of real wealth redistribution can only weaken wealth generators and make things much worse. Pushing more money into the FF cannot set in motion an increase in lending if the pool of real savings is under pressure. After all, the essence of credit is not lending money as such but lending real stuff. Lending amounts to a transfer of real savings from a lender to a borrower by means of the medium of exchange, i.e., money.

The existence of banks enhances the use of real savings. By fulfilling the role of middleman, banks make it easier for a lender to find a borrower. When a bank lends money, it in fact provides the borrower with the medium of exchange that can be employed to secure real stuff that is required to maintain people's lives and well-being. It is therefore futile to urge banks to lend more if real savings are not there. Likewise, it doesn't make much sense to suggest that the Treasury or the Fed could somehow replace nonexistent real savings. Again all that such actions will produce is the depletion of the existent pool of real savings.

The guarantee that the Treasury is going to assume for the mortgages could be very costly to the taxpayer if the housing-market slump continues. We suggest that if the pool of real savings is declining, then the real economy will follow suit irrespective of various plans by the Treasury and the Fed. In these conditions, even if banks follow the Treasury plan and renew lending, this would be an exercise in futility. A falling economy and decreasing real incomes will reduce individuals' ability to service their debt. Consequently, the government (i.e., the taxpayer) will have to foot the bill.

However, we suggest that, if the pool of real savings is falling, the banks are likely to curtail their lending as a result of a diminished number of viable borrowers. Now, if the pool of real savings is still OK then there is no need for the Treasury plan. The growing pool of real savings will fix the problem.

The Fallacy of "Too Big to Fail"
Most experts are in total agreement that the government seizure of the FF was a necessary act since it has most likely averted a massive economic disaster not only in the United States but worldwide. It is held that, if the FF were allowed to go belly up, this could have inflicted heavy losses on foreign investors in FF debt, which, it is held, could also have eroded foreigners' willingness to invest in US government debt.

The view that some institutions are far too big to be allowed to go under is another fallacy. According to the popular way of thinking, if a large institution is allowed to go under, this could cause severe damage to the economy, since the failure of a large institution would generate large disruptive shocks. Since everything in an economy is interrelated, this means that a major shock could end up in a massive disaster.

In a market economy, a business that reaches the state of bankruptcy is most likely pursuing activities that do not contribute to real wealth but rather squander wealth, i.e., activities that make losses. Since such activities cannot support themselves, it means that real savings must be taken away from activities that do generate real wealth.

The longer a losing activity is allowed to stay alive, the more damage is being inflicted on real wealth generators. So, on the contrary, the liquidation of a losing activity cannot cause more damage; rather, it is going to arrest the damage inflicted on wealth generators. Once the losing activity is gone, the wealth generators with more real savings at their disposal can start expanding wealth-generating activities and lay the foundation for healthy economic growth.

The proponents of the "too large to fail" argument maintain that allowing a large institution to fail will lead to a sharp increase in unemployment and unacceptable human suffering. This is true. However, the reason for the hardship is not a loss of jobs as such but the erosion of the pool of real savings. The erosion of the pool means that there is not enough funding to support various economically nonviable activities. Allowing such activities to stay alive only weakens the pool of real savings further and leads to the further erosion of people's real incomes and makes things much worse. Furthermore, activities of a large entity absorb in absolute terms more scarce savings than a smaller entity, both directly and indirectly. We can infer from this that a large misallocated business is too big to be kept alive rather than too big to be allowed to fail, as the popular thinking has it.

The argument that the government seizure of the FF prevented the downgrading of US Treasury debt by foreigners is suspect. The key factor that has been providing the high rating to US government debt is the perception that the US economy is still very wealthy. Every investor implicitly or explicitly holds that, without support from private-sector wealth, US Treasury debt would have been worthless.

As long as the economy still generates wealth, the government debt will be considered safe. Once the pool of wealth starts to shrink, foreign buyers of US government debt are likely to abandon the sinking ship, irrespective of government "rescue" plans. If the US pool of real savings is falling and the housing market remains depressed, then this will result in the US Treasury incurring large losses in order to maintain so-called credibility, i.e., by not allowing the FF to go under. Needless to say, this is likely to further undermine the pool of real savings and the process of wealth formation. We suggest that a less wealthy US economy is going to hurt all other economies through the channel of international trade.

Allow the Market to Fix the Current Credit-Market Crisis
An alternative solution is to allow the FF to go belly up and allow the market to allocate in the best way scarce real savings. The free market will eliminate nonproductive, wealth-consuming activities and promote wealth-generating activities. The fact that Fannie and Freddie have reached the stage of bankruptcy is the manifestation of a severe misallocation of scarce savings. (In addition to being able to secure cheap money, the FF was given a boost by the extreme loose-interest-rate stance of the Fed between January 2001 and June 2004.)

Allowing the FF access to cheap money has resulted in far too many houses being built, relative to peoples' ability to fund them. This misallocation has robbed the wealth producers of real savings and has impaired their ability to generate real wealth and promote true real economic growth (please don't confuse it with the GDP rate of growth).

Again, allowing various misallocated structures to go under will stop the bleeding of wealth generators. (Note again that the misallocated structures must be funded all the time. This means that wealth generators will have less real funding than they could have had at their disposal as long as these structures are allowed to exist.)

The US government and the Fed could learn from the Japanese experience: schemes to fix the economy don't work if the pool of real savings is not there. In order to lift banks' lending between 2001 and 2003, the Bank of Japan (BOJ) had been aggressively pumping money into the financial system. The average rate of growth of monetary pumping, as depicted by the bank holdings of balances at the BOJ, had increased by 93% during that period. In April 2002, the yearly rate of growth stood at 293%. Yet bank loans had continued to fall. The average yearly rate of growth of loans from 2001 to 2003 stood at negative 4.5%.

Conclusion
We suggest that the seizure of Fannie Mae and Freddie Mac (FF) by the government cannot help the housing market or the economy. Most people hold the mistaken view that the government has extra real resources that can be used in emergencies. This is erroneous. The government is not a wealth generator; it can only consume and redistribute real wealth. What is needed to revive the economy is a growing pool of real savings.

Neither the US Treasury nor the US central bank can create real savings. In order to keep the failing FF going, the taxpayers will be forced to foot the bill. This means a further squandering of the already depleted pool of real savings. Only wealth generators can revive the economy by accumulating enough real capital. In this regard, no government or central-bank policies can replace wealth generators.

The only way wealth generators can act effectively is when they are not disturbed, i.e., in a free-market environment. The sooner the government allows them to move ahead, the sooner we will have economic improvement. Any government or central-bank policies that are intended to improve on the free market — in particular during difficult economic times — are likely to make things much worse and prolong the economic crisis.

both are from www.mises.org I really recommend you set aside some time to just browse that site and read what they have to say. They post a new article daily and it usually takes no more than 5-10 minutes to read them. A few weeks of that and you will have a real understanding of how the economy and free market operates.

[misericordia]

"the bank failures without the bailouts would have been horrific on a global scale", what should we reply with?

Sure, it would have crashed a few markets. But now we've got hyperinflation, where in a matter of months a loaf of bread will cost more than a house.

Tell them to google Zimbabwe, and then go buy rice and beans.

[LiveFree79]

Start with the basics. Most Americans/people have no clue how money is even created in this world/country. Get people to understanding the evils of banking and the FED and then most of the other pieces will fall into place. It's scary just how many Americans think the Federal Reserve is part of Government and answerable to the people.

[Paulitician]

Banks have been failing for hundreds of years. Like Jim Rogers says, it's not the end of the world.

By bailing out failure, you encourage it and you also encourage moral hazard. This will start to compound, and then you'll have an even bigger problem. Letting them fail now saves us from such trouble.

Why should banks that make mistakes or don't have right business practices be forced exist? We're better off without them. That way capital can be freed up for other, better uses.

We don't have the money to bail out every bank... this is just going to cause inflation, and every single person will be poorer because of it.

[jillian]

I can't sleep but I did just read all of that information from mises and the other comments. I think I have a *fairly* good understanding of how capitalism works and about the feds printing money. It's so hard to talk about this stuff because it's very complex. But I guess when you get to the heart of things it's actually fairly simple. I don't know....just hoping I can help some other people wake up.

[MoneyWhereMyMouthIs2]

how do you feel about the failures making room for other companies? you know, like weeding out the access to make room for smaller companies...is that a fair arguement?

Sure it is. When an inefficient or fraudulent bank goes down, other more efficient banks will step in to fill the need.

[Isaac Bickerstaff]

Think about this:

In the Untied States (spelling error intentional), ALL money is loaned into existence. The money used to pay debt is destroyed. The money used to pay the interest on debt is loaned into existence.

The cycle continues until all money loaned into existence cannot even pay the interest on the outstanding debt.

Individual bad decisions or even a collection of bad decisions do not cause a massive financial meltdown. It is our money itself that has caused this mess.

The reason economics seems so complicated is that no-one is addressing the basics of money creation before jumping into the mechanics of money circulation.

The major disinformation coming from the classroom is basically the assumption that the money does not go away once created. The complication is trying to reconcile what is happening in the economy to the assumption of permanent money.