Why Government may be the solution to a Problem.

"Government is not the solution to our problem, government is the problem." January 20, 1981.

Words you'd be awfully safe betting on for any given problem. Gospel practically. And yet I've become mostly convinced it isn't right for this latest financial mess.

Oh, the second part is definitely still correct. Government is the problem. It's made a huge mess. And it's important to realize that when talking about this problem. It's becoming a common talking point that government is bailing out bad financial decisions. This simply isn't the case.

A bit of background will help us to frame everything properly. Let's start with microeconomics.

Let us begin with Mr. Jones who has a million dollars. Mr. Jones finds 4 indigent workers and arranges to finance 4 quarter million dollar houses for them with no real down payments. A year later, Mr. Jones now owns 4 homes valued at an aggregate of 200,000. He's lost 20% of his investment. But that's how investments go. He's not become insolvent.
If you balance out the accounting columns, you'll find that there's a negative in Mr. Jones assets column and the corresponding expense entry moves out to the depreciation in the housing market. Depreciation that someone had to bear if prices were falling.

Let us move on then to Mr. Brown who has a quarter million dollars. Mr. Brown borrows 750,000 and then arranges to finance 4 quarter million dollar houses for indigent workers. He uses the houses as collateral against his debt. A year later Mr. Brown owns 800,000 dollars worth of houses. He also has debts of 750,000 and he doesn't have any cash. In addition, he now has interest payments due of 3-4 thousand dollars per month. Since Mr. Brown has a total of 50,000 in net worth, he is forced to liquidate his position. This causes the houses to sell for even less than they are worth. Mr. Brown ends up with nothing. That's the power of leverage.

Mr. Jones net worth also declines by 50,000 dollars because his houses are valued at the prices Mr. Brown sold for. Mr. Jones would prefer to think more rationally but the government won't let him.

For Mr. Brown, the accounts break down like this.
Mr. Brown has obviously posted a 250,000 dollar loss to assets. 200,000 went to depreciation and 50,000 went to liquidation costs.

But in both of their cases it's hard to argue they didn't get what they deserve in terms of what happened to their investment. Mr. Jones does have a strong case for being able to claim that he's still worth 800,000 dollars and not 750,000 dollars. This inequity is referred to as the "mark to market" rule. It does make some sense as you wouldn't want him pretending he was worth a million dollars. But it seems a stretch to say that Jones should suffer for Browns liquidation costs.


Now, let's bring in a bank to the situation. Let us suppose that we're in a small out of the way town 100 years ago with only one bank, 3 people and 1 house. The bank loans all of its capital -- a sizable deposit from person 1 -- to person 2 who buys the house from person 0 who then leaves town. Person 2 then defaults. Now, the bank has a house. It owes the value of the house to person 1. And person 3 would like to buy the house at 80% of what the bank has in it. The bank now has a pair of problems. It owes person 1 more than it can get out of it's assets. So it declares bankruptcy. Person 1 now owns the house. Person 2 is back where he started. Person 3 still wants the house. Unfortunately, the only bank in town just went belly up. So in our small example, person 1 rents the house to person 3. (Or finances the mortgage himself.) In real scenarios, the bank might well have money but just refuse to lend it because of our crazy times.

Person 1 who did nothing wrong except put his money in a bank loses out. What Person 1 needed was an insurance company for Depositors. Obviously town level is too small to socialize the risk. So maybe a Federal Deposit Insurance Corporation could be created. It could be called the FDIC. The premiums could even be paid out of the interest due Person 1 and he'd never realize he was paying for insurance.[*] Now this FDIC should put some rules on banks who buy the insurance to minimize the risk of paying out. But if the government owned it, why then we'd call those laws and they'd be subject to political pressure. The laws might -- perish the thought -- be made not for sound fiscal reasons but to garner votes.

Now, let us leave hypothetical land and make this all apply. The federal government forces banks to loan to indigents. It forces Freddie Mac and Fannie Mae to buy sub-prime mortgages. In our example above imagine that the bank had no choice but to give person 2 a house. It is interesting to note that the reasons the government did this all sounded good at the time. Who wouldn't want to help out the poor to reach the American dream. Remember that's the underlying message of It's a Wonderful Life. And it's not a bad message. But government is not the solution to that problem, it is the problem.

Further, government rules like "mark to market" are making the problem much worse. Now no one can afford to make loans. Well, housing prices are based on supply and demand. The harder it is to get a mortgage, the less demand. The more foreclosures, the more supply. That moves prices down. Downward price pressure makes the bank situation worse and it becomes harder to get a mortgage. This is the kind of cycle that can be very hard to break. Some people panic seeing the falling prices and sell their own homes at a loss. That would be an increase in supply.

Now, taking it from the megabank perspective. You have mortgage securities valued at 1 Trillion dollars. 20% of that debt is so b ad that no one will buy it from you. That makes it worthless. But if held to maturity, there are real houses underlying that debt. So you have a debt which isn't worth the paper it's printed on now but will be worth real houses in a few years. Unfortunately, you also have real current liabilities. And you can't cover them with bad debt. And you can't borrow any more money to pay the current liabilities because your balance sheet is a mess with the 20% bad debt floating around.

So, suppose you had a long term view and wanted to make some money. Suppose you also had 100 Billion dollars laying around. You might buy 200 Billion Dollars in debt with it. Of course the debt is bad so you'd probably only clear 50 or 60 Billion on the deal. And it'd probably take you 4 or 5 years to recover anything. But that's still not a bad rate of return. Of course there's plenty of risk which when weighed might scare you away from doing it.

Besides which, be honest now, how many of you can really afford to throw 100 Billion Dollars at a problem.

But, if you're the government, you have to look at an investment like that versus the costs of letting the system fail. Deflation is of course a potential big problem. In addition, you run into the problem of who owns these big banks. Principally you find it's those with money in the bank. There is after all only so much insurance. And after that it devolves back to person 1 in our example. Grandma and Grandpa who saved away all their lives are left with not a retirement living but instead with a house in a run down neighborhood of San Francisco. Mom and Dad who owe 15,000 dollars more on a house they bought 20 years ago for 100,000 see the price of the house go from 200,000 down to 15,000. Which wouldn't be so bad except that they can't make any money because the factory he works for can't sell parts to companies that can't finance their operations. Now that's worst case scenario and maybe the banks don't all cascade down, but the set up is so bad that they just might if this is mishandled.

JCPenney won't sell clothes in a world where people are trying to figure out where the next meal is coming from. There certainly won't be private engineering research. Financial analysts won't have much to do either with no finance happening.

So big downside to doing nothing and a potential to do a lot of good and keep the system stable. But there's a second hidden upside. You see, the government can print money. And that's how they may solve this problem. Normally that's not the greatest thing. As more dollars chase the same amount of goods, consumer prices rise. But, in this case, the problem is the potential for a deflationary depression.

Let's look at how inflation affects everyone in our scenarios. Mr. Jones has 800,000 dollars in houses. After 25% inflation he now has a million dollars in houses. But there worth intrinsically exactly what they were before so he has no change. Mr. Brown has the same million dollars in houses and he still has his 750,000 dollars in debt. He still has to liquidate them but he ends up with say 150,000 dollars. (He takes a 40% loss). Mr. Brown's creditors get their 750,000 dollars back. Unfortunately for them, this means they've lost money. Because the 750,000 they gave up isn't worth what they got back. But they made a foolish investment so we shouldn't feel too bad for them. Person 2 doesn't have anything change. Person 1 takes exactly the same loss.

Unfortunately, there is a forgotten man in this scenario. Person 3 had enough money to make a reasonable down payment on a house. Unfortunately, as the house inflated in value, his capital became insufficient to buy the house. The only way he can keep up with inflation is to invest his money somewhere. That's not real great for him because times are risky. But it is great for the economy to get more capital involved. Person 0 left town. Now he's in the same bucket as person 3 if he hasn't already invested that money in a way that he can be protected.

The biggest argument against this is almost becoming a mantra. Don't socialize the risk when the profits are privatized. There are a couple of problems with this logic though. First, the risk is already socialized. The reason everybody cares about this is that everyone is at risk. My job, yours, and the man next door, all rely on a functioning economy. Now, the farmer may have a job that can't go away. But his farm can go away from under him.

Claiming the profits are privatized is a stretch as well. Who really makes out well here? In the fix, no one does. When things were going well, who was profiting? I was. You were. Maybe not as much as some other people, but let's not get greedy. And if we let things break down, who makes out well? No one.

So, I favor this fix or one like it. There are details to be worked out and I'm not ready to take a position on any particular detail yet. But the basic idea of using inflationary tactics to gobble up cheap investments to stabilize our monetary system just doesn't seem so bad. It does have all the negatives of being the government taking my money and giving it to someone else; but if they're going to do that anyway at least they might do some good for once.

There are a couple of large risks. First, this is a government program. In a few months, a new resident of 1600 Pennsylvania Avenue might decide that the money should be funneled to minority owned businesses first. Or he might take money from these organizations to resist necessary reforms. As I say this seems a necessary evil, I am very concerned that the next necessary evil be much more imaginary and much closer. Second, the economy must have some real growth. There are real losses involved here. We need to be able to absorb those. Our current high spend mentality has to be reigned in or we won't have a chance at that. Secondly, we need to get tax rates down to encourage the flow of capital through the system.

This is one reason why I've said that it's not a hard choice between the Presidential candidates. One has at least a 10% chance of doing something in that realm. The other has a negative chance. And there are only two viable candidates.