Paulson’s scheme

To understand this, we have to unravel the contradiction infecting much of the commentary and analysis regarding the current financial crisis. While there isn’t perfect unanimity on this, it is widely acknowledged that a significant part, if not the root, of our difficulties originated with the low-interest-rate policy implemented by the Alan Greenspan-led Fed in 2001-2005. This generated a housing boom, which was further stoked by the financial engineering of Wall Street in securitizing mortgages, by obliging bond rating agencies in evaluating these securities and by portfolio managers eagerly willing to buy them, hungry for extra returns in a low interest rate environment.

To the extent that this assessment has been made, it represents an important victory for a school of thought that has long hung on the margins of the economics discipline: the Austrian school of economics, whose most illustrious figures include the Nobel prize winning Friedrich von Hayek and Ludwig von Mises. Austrian economists hold that downturns are the inevitable aftermath of loose monetary policy, thus opposing explanations typically heard prior to the current crisis that attributed recessions to price shocks, underconsumption or central bank tightening of monetary policy.

But if, to rephrase a well-known Nixon quote, we are all Austrians now, it illogically only extends to the diagnosis of the crisis and not to the school’s market-based cure. For it is just not consistent to simultaneously assign blame to Greenspan’s easy money and then support government intervention to fix the damage, as so many of the business op-ed writers and talking heads on CNBC have.

As the Austrian tradition points out, the dilemma with easy money is that the central bank sets rates below that which the market would naturally set. The natural rate reflects people’s willingness to trade present for future satisfactions. When the actual rate is established under this, entrepreneurs and firms are issued a false signal that people are willing to defer more consumption into the future than they really are. As a result, excess investments in capital goods industries, such as housing, are made on the expectation that these will pay off in the long-run. The boom ends when monetary conditions are tightened back to natural levels or the passage of time makes clear that the demand was never really there to sustain the investments made. At this point, a crisis takes place in which capital investments get liquidated and resources are shifted such that the economy’s productive capacity more appropriately reflects people’s time preferences.

As we are witnessing now, this stage is not pretty, since the banks and creditors who financed the boom activities see the value of their loan assets impaired, forcing them to restrict credit to even credit-worthy customers. Financial institutions that became heavily exposed to the boom activities either go bust, like Lehman Brothers, or they become prey, as Merrill Lynch did to Bank of America, and to those who wisely minimized their participation in the bad investments. Depositors start to doubt the security of their funds and bank runs become a threat. This is, to be sure, less of a problem now thanks to government deposit insurance, though this security blanket comes at the price of giving banks incentives to take undue risk with the and thereby gain the confidence to provide credit to worthy customers at more normal interest rate spreads to government debt.

This stratagem would represent an authentic liquidation if the banks were to sell their mortgage debt at its real present value and the government, in turn, had no compunction in pursuing foreclosures on non-performing loans, no matter what the impact on house prices. But, as hinted by CIBC’s recent deal with Cerberus to reduce its exposure on US$1.05-billion in problem mortgages, there is a sea of cash sitting in private equity, hedge and vulture funds waiting to buy distressed securities if the price is right. That they haven’t bought much yet suggests the banks are resisting lowering their price. There being pressure to expedite the transfer of securities and assist the banks, the government is very likely to acquiesce to this resistance, pay above market and effectively institute a price support mechanism for mortgage assets.

Besides the public relations mess of having a throng of failed borrowers compelled to give up their homes by a government agency, the fear of contributing further to the decline in the real estate market means foreclosures will probably be kept to a minimum. In this way, the Paulson scheme will also turn into a price support regime for housing.

Most commentators resist following the Austrian logic through to the end out of the fear of repeating the policy mistakes that led to the Great Depression. This reflects the orthodox interpretation of that period, according to which the economy fell apart in the early 1930s while U. S. president Herbert Hoover took a laissez-faire approach to the downturn and the Fed ran an overly tight monetary policy.

The truth is that the Fed at the time did try to add liquidity, lowering its rediscount rate until late 1931 and continuously increasing reserves under its control. Money supply nevertheless fell, but that was because people lost faith in the financial system and hoarded currency. Meanwhile, Hoover met the downturn with interventionist gusto. He passed the Smoot-Hawley tariff to help domestic industries and obtained the co-operation of business leaders to support wages and investment. We haven’t gone down this protectionist and corporatist road yet but Hoover’s attacks on short selling and his creation of the Reconstruction Finance Corporation, which among other things loaned money to banks, bear an eerie resemblance to the current policy response.

"We might have done nothing",Hoover said, "[but] we determined that we would not follow the advice of the bitter-end liquidationists." Thus has the Bush administration decided as well, having successfully cajoled a recalcitrant Congress to follow Hoover’s example.