Can a Bailout Succeed?

By PAUL CRAIG ROBERTS

While the U.S. Senate predictably capitulated to the demands of Wall Street last night, for the first time in recent memory the House listened to the American people and blocked Paulson’s bailout of his rich buddies by US taxpayers. The same House that refuses the public’s demand that the Bush regime be held accountable and its gratuitous wars halted refused to hand over $700 billion to the financial institutions whose irresponsibility has brought the US to its worst economic crisis since the Great Depression.

We must be thankful for this sign that American democracy is not completely dead and supplanted by executive branch authority. However, whatever bailout package that emerges will fail unless it takes into account the following.

Any package that maintains the mark-to-market rule and permits the resumption of short-selling will undermine itself. In panic conditions without the existence of a market, the mark-to-market rule results in asset prices being driven below their values, thus eroding balance sheets and producing insolvencies. Short-selling permits short-sellers to profit by destroying the share prices of institutions suffering balance sheet problems, thus eliminating their ability to borrow and driving them into failure.

A bailout, however large, that maintains the mark-to-market rule and permits short-selling will pour money into a black hole.

A bailout that is treated as a mere addition to the US government’s already massive indebtedness will disconcert foreign creditors. There is a limit to the amount of debt for which the US Treasury can assume responsibility without undermining its own credit rating. The bailout, especially if the $700 billion proves insufficient and more is needed, could impair the Treasury’s credit standing.

In this event, foreign creditors might not provide the funds needed for the bailout or would provide them only at higher interest rates, which would themselves undermine the bailout’s success.

According to a September 29 report in the Washington Post:

“Twenty of the nation's largest financial institutions owned a combined total of $2.3 trillion in mortgages as of June 30. They owned another $1.2 trillion of mortgage-backed securities. And they reported selling another $1.2 trillion in mortgage-related investments on which they retained hundreds of billions of dollars in potential liability, according to filings the firms made with regulatory agencies. The numbers do not include investments derived from mortgages in more complicated ways, such as collateralized debt obligations.”

Leaving aside the collateralized debt obligations, adding the three mortgage-related instruments of the 20 financial institutions comes to $4.7 trillion of which $700 billion is 15 percent. If more than 15% of just these troubled instruments are bad, the bailout would require more money. At what point would foreign creditors see an endless pit?

If foreign creditors are to finance the bailout, it must be credible. The best way to achieve credibility is to combine the bailout with a reduction in other forms of US foreign borrowing, specifically the US government’s budget deficit and the US trade deficit.

Based on assumptions that do not allow for recession and, perhaps, the full amount of the wars’ cost, the US budget deficit is estimated to be in excess of $400 billion. Considering the urgency of the bailout, the $700 billion would also be near-term borrowing. This means a minimum of $1.1 trillion in new US borrowing over the course of the year, a sum that could cause foreign creditors to blink.

The bailout would gain credibility if the US budget and trade deficits were addressed as part of the package. The US government needs to choose between its financial system and its wars. As the wars serve no US interest except for those of a few powerful interest groups, the government should declare an immediate end to the wars, thus reducing the budget deficit by at least $200 billion annually.

The government should then turn to the military budget, which at about $700 billion is larger than the combined military spending of the rest of the world combined. The only justification for such an enormous amount of military spending is a policy of US world hegemony, a policy that financial collapse makes nonsensical. The defense budget needs to be cut sufficiently to bring the US budget into balance or, better still, into $100 billion surplus.

Such action would demonstrate to foreign creditors a responsible approach to the economic crisis. Instead of more than doubling the demands for new credit from foreign creditors, the US government could keep the current level of borrowing constant by eliminating the budget deficit. This would signal a new seriousness to foreign lenders.

The trade deficit also must be addressed. The US is dependent on the willingness of foreigners to finance its annual consumption of $800 billion annually more than it produces. This ongoing financing floods foreign creditors with dollar assets in such large quantities as to raise questions about the worth of the US dollar.

The offshored production of goods and services for US markets has added significantly to the US trade deficit as these offshored goods and services count as imports when US corporations bring them to the US to be marketed. Offshoring activity must be curtailed either with taxes, quotas, or tariffs. It would be difficult to impose tariffs or quotas on goods made by companies of our foreign creditors. But US firms that are producing offshore for US markets could be curtailed. Eventually steps will have to be taken to bring the US trade deficit into balance, but this could await the end of the financial crisis.

Over the last 20 years the US has made a collection of serious mistakes that may yet prove fatal. With the collapse of the Soviet Union, the US government launched a policy of world hegemony for which it lacked the means. The US government permitted much of its manufacturing base to be located offshore to the point of even being dependent on imports for its military capability. The US government deregulated the financial sector and permitted the rise of new highly leveraged financial instruments whose failures currently threaten the US with economic collapse.

University of Maryland economist Herman E. Daly points out that the current crisis is really one of the “overgrowth of financial assets relative to growth of real wealth.” Daly believes that “financial assets have grown by a large multiple of the real economy” and that “paper exchanging for paper is now 20 times greater than exchanges of paper for real commodities.” Exploding debt liens have simply outgrown the wealth.

The problem, in other words, cannot be bailed out. Historically, debt that cannot be redeemed has been repealed by inflation. The same inflation that wipes out debt will wipe out savings.

A failed bailout is the worst possible outcome. The chance of failure rises if the US government tries to turn bad private debt into good public debt without regard to the expansion of the public debt.

Paul Craig Roberts was Assistant Secretary of the Treasury in the Reagan administration. He was Associate Editor of the Wall Street Journal editorial page and Contributing Editor of National Review. He is coauthor of The Tyranny of Good Intentions. He can be reached at: PaulCraigRoberts@yahoo.com