Monday, 29 September, 2008.

Is Warren Buffett right? If this bail-out had been passed by congress, would it have halted the meltdown?

I don’t believe so. Here’s why…

First, this is a bail-out of a small number of shareholders and creditors with stakes in Wall Street financial institutions - people like investment guru Warren Buffett - and potentially some foreign banks.

Almost as an aside, Section 23 of the Act requires that Treasury Secretary Henry Paulson “take into consideration…..the need to help families keep their homes and to stabilize communities”.

He may well take their plight into consideration, but Congress has given him full discretion, and he is under no obligation to act.

But to understand why the bail-out is framed in this way, and why it will not work, let’s delve a little deeper into the economic policies that got us into this mess.
Reckless lending

The reason banks have excessive debts lies with government and Federal Reserve policies to de-regulate credit creation - policies introduced from the 1970s onwards.

This made it easy - and highly profitable - for banks to lend recklessly. The Fed and other central banks turned a blind eye to the terms on which banks, and the growing shadow banking sector, lent.

Second, the Fed, as with other central banks, effectively gave up its powers to control the rate of interest across the board, for safe and risky, and short and long-term loans. Instead interest rates - the price of credit - were effectively privatised.

Next the government’s policies ensured that the share of the national cake (GDP) going to employees in the form of wages and other compensation, fell for the three decades after the 1970s. That too, was no accident.

Third, all that ‘easy money’ or credit acted like a giant pump, and inflated the price of assets e.g. property. The rich on the whole own assets, and could use their assets to borrow even more ‘easy money’, flip condos, move up the property market, buy stocks, race horses, works of art etc.

So asset prices rose higher, and higher. This helps explains why the rich became richer and the poor, poorer.

Easy credit

The less well-off, those without assets, but with falling incomes, were not so lucky. To put a roof over the heads of their families, to go to college, they had to borrow. They even took to using credit cards to pay everyday food bills etc. The very poor - sub-primers - were given loans, but at very high, and very profitable, rates.

While the credit pump inflated asset prices, it also encouraged consumption. People used easy credit to go shopping - on a grand scale.

Anglo-American governments gave up on other sectors of the economy - i.e. manufacturing - and believed foolishly, that we could all live by shopping or by services, like hairdressing and financial services, while the Chinese manufactured our goods.

Now the credit pump is broken, and the bubble has burst. Asset prices are falling, and people are not shopping on the same scale.

What broke the pump? First and foremost, the very high, real rates of interest that had to be paid on these debts. Because of the privatisation of interest, these rates were high (eg: the rate charged on your credit card), even when official (i.e. central bank base rates) were low. Secondly, falling real incomes made it hard to repay rising debts. So people began to default.

These defaults began to expose the reckless lending of banks, and these institutions too began to fail. The rest is history.

Overhaul needed

What would it take to fix the system. A bail-out of banks?

No, what is required is an overhaul of the whole economic system; a system-wide fix.

• That means, first, dumping the orthodox free-market zealots responsible for the policies that got us into this mess. Frederick Hayek’s and Milton Friedman’s de-regulation policies have already been dis-credited, with Republicans obliged to disown Margaret Thatcher and Ronald Reagan’s contempt for government.

• Second, it will be vital to restore to the Federal Reserve and other central banks the power to set the rate of interest - across the whole spectrum of lending, so that all rates can be lowered on the massive debts incurred across the board in countries that followed the Anglo-American economic model.

• Third, we must abandon the policy of holding down wages and other forms of compensation, especially if we want people to repay debts, and help salvage the banks. Jobs will have to be protected, or even created by government, and incomes must rise.

• Fourth, we have to simply write off the debts of those poor people who cannot ever repay. Just as we write off the debts of companies or governments that can no longer pay, so we must recognise that many citizens are effectively insolvent. The refusal to acknowledge this truth lies at the heart of Mr Paulson’s plan - and that is why his plan will fail.

Only a system-wide fix of economic policies will help restore stability to the Anglo-American economies. But with orthodox economists like Mr Paulson and Fed chairman Ben Bernanke still at the helm - expect Anglo-American economies to keep lurching down the long road to Depression.