Now the US is in Real Trouble - Paulson and Bernanke Succeed

The breaking news in the Times is that the bailout of the US banking system will go ahead. Now, it looks like it is just a matter of detail, and the devil of how bad the decision will be will lie in the detail.

I have noted that, whilst visitor numbers are up, the percentage of returning visitors to the post is not keeping up (though is still high). That possibly means that some of the new visitors who are coming to this blog do not like what they are reading. I suspect that the reason for this is the belief that I am too pessimistic, that they just can not believe that governments can not 'fix' the problems. After all, 'something has to be done'. Government, apparently, can wave a magic wand of debt and fix the stored problems from at least ten years of erroneous financial management. If you reread the last sentence, the absurdity of the idea is self-evident.

Whatever the details, this magic wand will be damaging to the long term prospects of the US economy. When I first saw this crisis, the one thing that was impossible to predict was going to be how individuals would react to it. Whilst thinking that the US would go through some very unpleasant pain, I believed that the US economy would adapt and reinvent itself in light of the new market conditions. My optimism has significantly diminished.

For some reason I have not been discussing some of the hidden negatives in government borrowing. I suggest that you read here before continuing. The point is that government borrowing distorts the economy in more ways than you might imagine, in particular by hoovering up capital, by competing with productive uses of the capital. On top of this, there are the reasons I have outlined in several other posts as follows:

1. The bail outs are shifting the economic damage onto government balance sheets at a time when the governments of the OECD will need all the resources that they can get. As the world economy rebalances the Western governments will need to make structural adjustments to meet the challenges of the emerging economies, and the massive input of labour into the world economy that they represent. The bailouts will tie government finances in knots, and may actually precipitate a loss of confidence in the ability of governments to pay their debt obligations.

2. In taking on the damage from the financial system, governments are spreading contagion throughout the economy, including the healthy parts. This is due to the inescapable fact that, at some point in time, the healthy parts of the economy will be facing larger tax bills.

I have mentioned several times why this deal will do harm, even if it gives markets and confidence a lift in the short term. However, again as I have repeated many times, there are more problems in the banking system than just the toxic mortgage debt. The Times report has this to say about Paulson's purpose for the bailout:

'Mr Paulson hopes that once the market recovers, the Treasury will be able to sell the bonds back into the market and recoup taxpayer funds. He is also hoping that once the banks are able to rid themselves of such assets, they will begin lending to one another again and America's capital markets will return to normal.'

There is an assumption here that, if the current bad mortgage debt is cleaned off the books, that will be the end of the crisis. However, such a scenario does not account for the downward spiral of the economy - as it weans itself off consumer credit and house price growth, the drivers of the so called 'service economy'. Whatever is done to bailout the immediate bad mortgage debt, nothing will change the fundamental underlying problems, and those problems are going to reappear in the banking system. As the economy continues to spiral down, there will be a new tranche of mortgage based debt going bad, huge swathes of consumer credit going sour, as well as commercial lending going bad. Will the US government be able to continue with the bailouts? I think not.

A good example of the unwinding can be seen in the UK at the moment, in the troubles of B&B, a UK buy-to-let lender (for US readers, this means providing mortgages, often to private landlords, to rent out property). The Telegraph reports the following:

'Credit Suisse said: "Ultimately, B&B's biggest issue is asset quality and we doubt any major bank will want exposure to a £40bn mortgage portfolio with arrears almost double the industry, and where over 40pc of loans will be in negative equity if house prices fall 30pc peak-to-trough.'

The interesting point here is that B&B is particularly heavily exposed to a high risk part of the market, and they are therefore acting as a weathervane. Mortgage and consumer credit arrears are up (see here and here - both out of date so the situation will be far worse now), and will get far worse as unemployment climbs. This applies equally to the US and UK. The arrears are increasingly going to spread into what was seen as the safe lending, or the lending to those who were in employment and could previously manage their payments. Under normal circumstances, this would be a problem but would be a manageble problem. However, with balance sheets already in tatters, this becomes another crisis. The trouble is that the debt bubble has hidden the underlying weakness of the economy, and the banks have been acting and lending on a belief that the economy was strong. That has been a fatal miscalculation, and nothing can soak up the sheer scale of bad lending.

So will all of the financial institutions suddenly start lending to one another again? The answer is that they will continue to hoard capital, as they will be aware that they will need the capital to offset the losses in the coming months/year. The bailout will give them a breathing space, will prolong the life of the weaker institutions, but nothing can stop the ongoing losses and the next tranche of failures.

So what will this bailout, this 'doing something', achieve? It will just act to hobble the US economy, and at best delay the progess of the crisis without stopping it. It will buy time, but at the cost of the future speed of recovery of the US economy. The only upside will be that it will speed the devaluation of the $US, which will allow the US economy to become more competitive, albeit at the cost of the relative impoverishment that this implies.

It is not a good day for the US economy, and that also means that it is not a good day for the world economy.

Note: In some of my previous posts I have been discussing that the emerging market currencies will increase in value compared with those of the West ($US, Euro, £GB). I have neglected to mention that the same might be said of the big commodity producers. An interesting question will be whether the currencies that are pegged to the $US will free their currencies? My guess is that it will only be a matter of time, and I have noted others have a similar opinion (sorry, no refernces to hand on this point, as this note is a rushed afterthought).

Note 2: I recently discussed a report that was pessimistic about China, and have just found a new report that is far more positive about the prospects for China. As I keep saying, China is very opaque, and this means that it is a 'wildcard'. Even with $US devaluation they have significant resources available to carry them through the downturn, but will it be enough. See my post here for a discussion a discussion of why China is a question mark.

Note 3: Some time ago, I promised that I would write a further post on reform (in this case regulation), but have not managed to do this. The current events have been a bit of a distraction and I hope to return to reform in the future, as this is one of the main purposes of this blog. It is all very well to consider the problems, but what is really needed is solutions.

Note 4: I have found this in the Telegraph:

'Meanwhile, ratings agency Fitch said the vast bail-outs agreed yesterday by the US Congress do not add significantly to America’s public debt of 57pc of GDP since the money is being used to buy assets, which are backed by collateral. '

So let's get this clear. Nobody wants to buy this toxic waste, not even the sovereign wealth funds, even though the debt is available at firesale prices. Despite this, apparently the is backed by collateral, even though the collateral becomes worth less with every day that goes by. It is a bit like securing a loan against a burning building - fine if someone can put the fire out, but otherwise not really much use.

Final Note: I thought perhaps some light relief is in order; this from the Spectator:

'If you had purchased £1000 of Northern Rock shares one year ago it would now be worth £4.95. With HBOS, earlier this week your £1000 would have been worth £16.50, £1000 invested in XL Leisure would now be worth less than £5, but if you bought £1000 worth of Tennents Lager one year ago, drank it all, then took the empty cans to an aluminium re-cycling plant, you would get £214. So based on the above statistics the best current investment advice is to drink heavily and recycle.'

In current circumstances, this might be a popular investment tip......