Treasury Secretary Timothy Geithner revealed the Obama administration’s long-awaited economic rescue plan Feb. 10. For weeks, the national media had fanned citizens’ hopes that this plan would be a comprehensive, viable solution to the credit crisis and the wave of home foreclosures that currently undermine the nation’s banking system.
As Geithner spoke, however, the markets, already down for the day, began to plunge precipitously. Indeed, the Dow Jones Index lost a total of 382 points, one of its worst declines of the year. Many observers were at a loss. The plan lacked crucial details about how the Treasury would calculate potential write-downs of non-performing loans. A New York Times article went so far as to cite experts describing the plan as “relying too heavily on the same vague solutions proposed by the Bush administration.”
During the last year, many analysts weighed in on how markets, especially credit markets, had become “dislocated,” “out-of-sync” or “malfunctioning.” In fact, the opposite is true. Financial markets simply reflect basic economic sentiment — that is, supply and demand. Corporate bonds that once yielded six percent could easily yield 12 percent today. While seemingly an abnormal jump in yield, this change indicates that buyers of corporate debt have become fewer, and those that remain demand a higher return on their investment. The markets are not “shut down.” One could instead argue that there is too much supply and too little demand. In time, maybe many years, yields will fall as more buyers enter the market. Given that markets actually function quite well and are highly sensitive to flows of information, it would be very useful to analyze the market reaction to Geithner’s proposal.
What we learned from this episode is that financial markets — or rather the traders and financial analysts who play a role in them — have become surprisingly good at quickly sifting through large amounts of policy data, identifying the relevant economic proposals and passing an instantaneous (and from a shareholder perspective, destructive) decision about whether the plan might actually work. The Obama administration’s plan left investors’ most pressing questions unanswered.
It was not so much that the plan lacked details — it does include many new lending programs for banks and consumers. Also, the Geithner plan seeks to further stabilize the banking system by injecting more capital into major U.S. financial institutions. The plan, however, also relies on assumptions that could only be termed as highly unlikely. Take, for example, the Treasury’s belief that distressed debt investment firms will buy bad assets from banks. These billions of dollars in defaulting mortgages, commercial loans and credit card debt have market values far below the prices at which they were originally purchased. Private sector investment firms looking to invest in distressed debt would likely not buy them unless for a steep discount, and the banks would have to record massive losses on the sales.
It is also unreasonable to suggest that these investment firms would buy hundreds of billions of bad loans; usually, firms only make purchases of a few billion dollars. Finally, details about how the government and investment firms would work to value these loans at reasonable prices were not apparent in the plan.
Thus, the problem with the plan was not what it offered but what it lacked. Injecting even $2.5 trillion (the approximate size of the plan) into the economy through lending and equity programs will not solve the calamity that bears down upon the economy. These are in fact half-measures — the equivalent of prescribing cough drops to cure pneumonia. Additional bank capital injections might help today, but other banks will need more money tomorrow. Likewise, the ranks of companies that do not have enough cash to finance their businesses will continue to grow. General Motors and Chrysler, for example, survive only on government funding. Indeed, the problems facing our economy are so great that they are difficult to quantify. Here is one example, though, that might help:
Historically, the U.S. economy operated with leverage (the amount of outstanding debt in the economy) of about 250 percent of gross domestic product (GDP is a measure of overall economic activity). That is, if the economy was a single person with a $100,000 yearly salary, it would have a mortgage debt of $250,000. Our economy produces about $12 trillion in goods and services, and, by the end of 2007, had become leveraged by about 370 percent of GDP. This is equivalent to saying that a person with a $100,000 salary had debts of $370,000. From a historical perspective, the economy was overleveraged by at least 120 percent, or $14.4 trillion. In the case of our example, it is not easy for a single person to pay down $120,000 in a short amount of time. Thus, to decrease outstanding debt to historically manageable levels, the American people, corporations and government would need to pay down at least $14.4 trillion in debt throughout the economy. There is not enough money in the economy to pay off our debts, and it is financially impossible to forgive all of it. Uncle Sam is walking around with a $14.4 trillion credit card bill, and there is no simple way to pay it off. Faced with the prospect of massive deleveraging and confusion about how to remove illiquid assets from bank balance sheets, financial investors reacted to the Geithner plan by fleeing the market.
The new financial aid package does not come close to $14.4 trillion, and few policy makers have even broached the subject of how the actual deleveraging of the economy will take place. Two existing possibilities are also the most extreme. First, policy makers could allow the economy to deleverage on its own, which would mean the instant collapse of several major financial institutions and of a large amount of American corporations. The other option is for the government to continue to expand the money supply. Consumers and corporations could then use money borrowed from the Fed to pay off loans and make interest payments. Still, expanding the money supply to address the needs of all distressed companies would eventually lead to massive inflation and weaken our economy for years to come.
Not surprisingly, market participants dislike both of these options and continue to hope that government leaders will devise a middle path, whereby some companies would collapse but most other companies could be saved. Such a scenario appears increasingly unlikely. Confidence in the country’s leadership continues to wane.
And so the market plods on; brief rallies come and go, but a pall is cast over the financial landscape. Many market participants are apprehensive, as if waiting for the real economic turbulence to arrive. Indeed, during these difficult economic times, only one factor seems to stir the markets to action: fear.
Andrew’s column runs biweekly Thursdays. He can be reached at a.golden@cavalierdaily.com.
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