Consulting by RPM || Free Advice Blog

Vernon Smith Calls Bailout Scheme "Ridiculous"

Here at Free Advice, we have been rather skeptical of the Paulson Plan, to say the least. In addition to its naked theft of $700 billion (at least) from taxpayers, the plan makes no sense economically. I.e. we are paying hundreds of billions for the government to kick the economy while it’s down.

To add fuel to the fire, in a recent WSJ op ed Nobel laureate Vernon Smith explained that the Treasury’s plan to buy up “toxic” debt is silly. Smith is quite literally one of the top 5 world experts on auctions and public policy.

The Senate spelled it out more clearly: “troubled assets are not limited to mortgage related assets but could include auto loans, credit card debt, student loans or any other paper related to commercial loans.”

“Any other paper?” Heaven help us! …

Auction designers should immediately note that we are talking about a market with one buyer and many sellers of a hodge-podge of items. The mechanism that will be used is a “reverse auction” — with sellers competitively submitting asking prices to sell Treasury a heterogeneous mix of good, some sour, apples and oranges whose content is better known to sellers than the Treasury.

Treasury expertise is in auctioning Treasury securities of a given maturity to multiple competing buyers: say $10 billion worth of six-month bills, or two-year notes. In either case every bill (or note) is identical to every other one. The only uncertainty is the final clearing price and Treasury is assured that it will get the best price.

Treasury has no expertise in this ridiculous new venture.

I note with some irony that although Smith is nobody’s fool when it comes to auctions, apparently he’s not good at market timing. When googling to find the above article, I came across a WSJ piece from May 23, 2007 that began like this: Vernon Smith, a Nobel laureate economist, is so bullish on stocks that he’s put money in small drug companies — investments he “wouldn’t have touched in the late 1990s,” he says.

Paulson Should Take a Mulligan

Pepe alerted me to Casey Mulligan’s blog. Some awesome stuff here, especially on the bogus crisis (outside of financial sector). If you’re a bailout junkie, I encourage you to just go to his blog and start scrolling. But for now, let’s focus on a recent post where he explains how incredibly stupid the new plan to purchase bank equity is:

Treasury capitalization would recapitalize the banking industry MUCH LESS than each dollar expended by the Treasury. I was hoping Professor Barro would voice this opinion, because I learned it from him (not in 2008, but back in 1989 when I enrolled in his courses). Quite simply, Treasury capitalization will crowd out private capitalization.

To see this, assume for the moment that future taxes are lump sum (with a known incidence) and the economy is closed — i.e., that all potential bank stockholders are also U.S. taxpayers. Professor Barro has explained that taxpayers will recognize that the Treasury has invested more in bank stocks, and has implicitly done so on their behalf because the taxpayers will reap the gains and pay the losses of those investments. As a result, taxpayers will attempt to reduce their holdings of bank stocks by the same amount that the Treasury increased them.

You might say that taxpayers cannot reduce their investments in bank equity, because those investments are already zero. If you say this, you err both in fact and in logic. In fact, Bank of America announced this week that it would issue $10 billion worth of stock. Even if we ignore that fact and accept the premise that taxpayers have no intention to invest in the equity of existing banks, I cannot believe that investors would not invest in new banks, or would not invest in alternative institutions that could compete with banks. Thus, at best, the Treasury plan reallocates capital FROM new entrants to the banking industry and TOWARD the existing (and struggling) banks. What a plan for strengthing an industry — to take from the young and strong and give to the weak and old! As I have written many times, public policy needs to ENCOURAGE entry, not discourage it.

We cannot assume that taxes are lump sum, or have a known incidence. But recognizing taxation deadweight costs and uncertain incidence only increases taxpayer exposure to bank stock risk, which might cause them to reduce their bank industry investments MORE than the Treasury increases them! What a plan for strengthing the banking industry — to decapitalize it!

I can’t remember if it was Thomas Sowell or Walter Williams (they all write the same to me…) who said something like, “If the Grand Wizard of the KKK aimed to destroy the black community, he could have done no better than the Great Society.”

By the same token, if a Marxist set out to destroy the American financial sector, he could not have outdone Paulson and Bernanke’s actions of the last 14 months. It’s not merely that their actions aren’t helping. On the contrary, they are CAUSING the very instability they claim to be trying to quell. We just had the worst week in the stock market’s history, after the bailout plan was passed, which (you’ll recall) was supposed to avoid unprecedented bleeding in the stock market.

During Times of Crisis, People Turn to the Austrians

Jonathan M. brought the below chart to my attention. Apparently people are dissatisfied with the neo-Keynesian and supply-side explanations of what the heck is happening–probably because none of these folks saw it coming. The title didn’t come through in the picture link, but it is Google’s report on how many people are searching for “austrian economics”.

Credit Crunch Bogus? Yea and Nay

For the first time today, I actually thought that maybe this “credit crunch” isn’t a pure invention* of Paulson and a few (other) investment bankers. Here’s a news story saying that grain is piling up in Canadian ports, because exporters don’t trust the banks backing up their foreign buyers.

On the other hand, “English Bob” emailed me and said he just got an offer in the mail for a mortgage, and I replied that I still see the ads on my screen when I check my Yahoo! account, showing a bunch of people gyrating because mortgage rates are so low.

* Newcomers should note that I am slightly exaggerating. My actual views are laid out here.

"Radical Measures May Be in the Wings"

So says a CNBC headline, as the market is down more than 2% on the day. Oh, it is accompanied by the below picture. If I were adept at PhotoShop, I would put in some horns and the Ring of Power.

UPDATE: Ben Osborne offers the following in the comments:

Me Myself and Murphy

A Friday twin spin for you… Here’s Art Carden and me talking about the SEC ban on short-selling, and here’s my college radio interview when I went to Penn State a few weeks ago. What is interesting is this radio host grills me for about 10 minutes on whether speculators are driving up oil prices. At the time I thought he was out to get me, but afterward it was clear that he was a staunch libertarian and was just playing devil’s advocate. (Or at least, he wanted to believe that it was all supply & demand, but really needed me to convince him.)

Markets Get Crushed Again

Well, for what it’s worth, people in the stock market are at least starting to wake up to the fact that a printing press isn’t nearly as useful as those replicators in Star Trek (the episodes with Patrick Stewart, not the earlier ones with William Shatner). The S&P 500 lost 7.62% TODAY, and is down more than 34% year-to-date.

I hate to spoil everyone’s day, but imagine how bad it is going to be when the next president–and I think it hardly matters which of the two wins–tries to “fix things”? E.g. I saw a clip of McCain saying if elected, he will take care of the rising gasoline and food prices causing American families to suffer. And I don’t think he had in mind a return to the gold standard.

It sure looks like there will be double digit inflation (even by official measures) by the spring, which will probably lead to price controls and hence shortages of essentials. If only the politicians would first try out the price controls on things like Chia pets and tofu, before applying them to gasoline and milk.

A Very Scary NYT Article On Involuntary Acquisition of Equity (aka Stealing)

I have read some scary NYT articles, but I think I just found the winner (HT2EPJ). Just try to remember what it was like back in, oh, say, August 2007. Try to remember what types of things the government of the USA could and could not do. Now check out these excerpts:

WASHINGTON — Having tried without success to unlock frozen credit markets, the Treasury Department is considering taking ownership stakes in many United States banks to try to restore confidence in the financial system, according to government officials.

Treasury officials say the just-passed $700 billion bailout bill gives them the authority to inject cash directly into banks that request it. Such a move would quickly strengthen banks’ balance sheets and, officials hope, persuade them to resume lending. In return, the law gives the Treasury the right to take ownership positions in banks, including healthy ones.

The Treasury plan was still preliminary and it was unclear how the process would work, but it appeared that it would be voluntary for banks.
…
In a coordinated action, the central banks reduced their benchmark interest rates by one-half percentage point. On top of that, the Bank of England announced its plan to nationalize part of the British banking system and devote almost $500 billion to guarantee financial transactions between banks.

The coordinated rate cut was unprecedented and surprising. Never before has the Fed issued an announcement on interest rates jointly with another central bank, let alone five other central banks, including the People’s Bank of China.

Yet the world’s markets hardly seemed comforted. Credit markets on Wednesday remained almost as stalled as the day before. Stock prices, which had plunged in Europe and Asia before the announcement, continued to plummet afterward. And stock prices in the United States went on a roller-coaster ride, at the end of which the Dow Jones industrial average was down 189 points, or 2 percent.
…
There is no shortage of ideas, ranging from the partial nationalization proposal to a guarantee by the Fed of all lending between banks.
…
As Washington casts about for Plan B, investors are clamoring for the Fed to lower interest rates to nearly zero. Some are also calling for governments worldwide to provide another round of economic stimulus through expensive public works projects.
…
Treasury officials worry that aggressive government purchases, if not done properly, could alarm bank shareholders by appearing to be punitive or could be interpreted by the market as a sign that target banks were failing.

At a news conference on Wednesday, the Treasury secretary, Henry M. Paulson Jr., pointedly named the Treasury’s new authority to inject capital into institutions as the first in a list of new powers included in the bailout law.

“We will use all the tools we’ve been given to maximum effectiveness,” Mr. Paulson said, “including strengthening the capitalization of financial institutions of every size.”
…
At the Federal Reserve in Washington, officials insisted they had not run out of options and made it clear they were willing to do whatever it took to shore up the economy.

Fed officials increasingly talk about the challenge they face with a phrase that President Bush used in another context: “regime change.”

This regime change refers to a change in the economic environment so radical that, at least for a while, economic policy makers will need to suspend what are usually sacred principles: minimal interference in free markets, gradualism and predictability.

Now I hardly need to add commentary to the above, jaw-dropping excerpts. As I said, please try to remember what things were like back in August 2007. If I had shown you the above and said, “This will run in the NYT in 14 months,” you would have blown me off as a paranoid nutjob. “At worst,” you would have said, “they’ll surreptitiously increase their power over the financial sector. But obviously pro-market Republicans can’t come out and openly nationalize banks. This isn’t Venezuela.”

Here’s another interesting twist: In the original Paulson Plan, he didn’t ask for authority to acquire equity in the banks. Remember, that provision was slipped in later, allegedly with the “free market” Republicans kicking and screaming, at the insistence of “liberal” Democrats who wanted “taxpayer protection.”

Now, they haven’t even started buying up the $700 billion worth of bad assets, as far as I know. I know for sure that as late as YESTERDAY, Bush and Paulson were saying, “You’ve got to give this plan [of buying assets] time to work.”

And yet, now they have decided that that option by itself is NOT working (even though this contradicts the timetable they laid out just YESTERDAY for it), and have decided instead that the government needs to “aggressively” purchase ownership in banks, though it might be seen as “punitive” by some analysts.

Now how the heck is an injection of capital in exchange for equity going to be construed as “punitive”? Oh, well maybe it’s because the new plan isn’t even clear if bank participation will be VOLUNTARY, and even HEALTHY banks may not be safe.

Do you folks see what that means? Once you take away the requirement for the recipient bank to sign off on the transaction, then there’s no way to determine a “fair” price. So if those two vague principles come down on the side of more government power (and why wouldn’t they?–the markets will be in need of “help” for years to come), that means the government can look around and spot a company it wants. Then it gives some bogus reason that it needs to ensure stability with this company–remember, the company itself doesn’t need to be in trouble–and it can say, “We’ll give you $x billion and in exchange we own y% of your stock.” And remember, the company can’t even say, “No thanks.”

This is not good.