From Free Market Fundamentalism to State Capitalism
 
By
Henry C.K. Liu
 
Part I: US Government Pours Oil on Fire
 
 
 
Part II: Treasury’s “Troubled Assets Relief Program” in Trouble
 
This article appeared in AToL on October 30, 2008 as: Killer touch for market capitalism


 
Treasury Secretary Henry Paulson asserts that the full resources of the Treasury Department are being used to ensure the success of its $700 billion Troubled Assets Relief Program (TARP). The “full resources of the Treasury Department” commands the full faith and credit of the United States anchored by Treasury’s taxing authority as approved by Congress. Tax payments in the US are made to the US Treasury via the Internal Revenue Service.
 
The Congress can approve taxes for and spending by the Administration, but Congress cannot create money like the Federal Reserve can. Treasury’s money can only come from future taxes approved by Congress. Article I - Section 7.1 of the Constitution stipulates that “All Bills for raising revenue shall originate in the House of Representatives.”  The Federal Reserve has the authority to create money as part of its monetary policy prerogative but Treasury does not have any constitutional authority to expand the money supply. Treasury must depend on tax revenue for funds beyond which Treasury must sell sovereign debt to raise funds up to the national debt ceiling approved by Congress. Section 8.2 stipulates that only Congress have the power to borrow money on the credit of the United States. Proceeds from sovereign debt are advances on sovereign liability and not revenue, and must be paid back from future tax revenue.
 
Thus far, Congress has approved $700 billion of taxpayer funds to be used by TARP. President Bush also signed a $634 billion spending bill on September 30 that includes funding for $25 billion in low-cost government loans for the distressed auto industry. More public funds may be approved as needed. Since the Federal government is and has been operating on a fiscal deficit, these funds can only come out of future tax revenue and/or more fiscal deficits.
 
Also, Treasury is coming under increasing pressure to expand its financial rescue plan beyond banks to include direct assistance to the ailing auto and insurance sectors.

In recent days, lawmakers and interest groups have stepped up their efforts to persuade the Bush administration to divert part of the $700 billion authorized by Congress to additional categories of companies that were not originally expected to be rescued.
 
TARP gives the Treasury broad authority to buy any assets that are important for the stability of the US financial system. But participation in the sweeping $250 billion recapitalization plan has so far been confined to US banks. On October 24,  the Financial Services Roundtable, an influential lobbying group in Washington, sent a letter to Neel Kashkari, interim assistant Treasury secretary for financial stability, a former Goldman Sachs banker brought to the Treasury by Paulson, himself also a former Goldman Sachs banker, urging the administration to consider taking stakes in “broker-dealers, insurance companies [such as Ambac and MBIA], and automobile companies [such as GM and Chrysler]” as well as “institutions controlled by a foreign bank or company” that play a vital role in the US economy by providing liquidity to the market. A Treasury department spokeswoman declined to comment on whether the US would consider expanding the rescue in such a way.
 
Members of the Michigan congressional delegation also sent a letter to the Treasury and the Federal Reserve asking them to take steps to “promote liquidity” in the US auto industry. It is true that cars are not selling because leasing credit has frozen and collateral debt obligations (CDO) backed by auto loans. But everyone knows the automakers are facing insolvency in the long run beyond credit problems. 
 
Separately, AIG, the insurer that had been rescued by the government, revealed it had already used $72 billion of an $85 billion government loan and $18 billion of an additional $37.8 billion credit facility from the Fed.
 
An expansion of the recapitalization plan beyond US banks would mark a significant new chapter in the government’s response to the financial crisis.
 
TARP’s Seven Policy Teams
 
Ten days after the new $700 billion TSRP was signed into law on October 3, Treasury announced that it has created seven policy teams to develop several tools and other important elements that are required under the new law. 
 
1)         Mortgage-backed securities purchase program: This team is identifying which troubled assets to purchase with taxpayer funds, from whom to buy them and which purchase mechanism will best meet Treasury policy objectives “to protect taxpayers by making the best use of their money.”  Treasury is designing the detailed auction protocols and will work with vendors to implement the program.
 
For more than a year, the market has been unable to identify with clarity troubled assets, their owners and how such assets can be purchased and at what price. The uncertainty is real and it has created justified fear of yet unknown losses in the market. It is not likely that the new team at Treasury, no doubt highly capable, can solve this riddle quicker than the market can without the existence of a central clearing mechanism.  
 
2)         Whole loan purchase program: Regional banks are particularly clogged with whole residential mortgage loans that have not been securitized and sold to dispersed investors. This team is working with bank regulators to identify which types of loans to purchase first, how to value them, and which purchase mechanism will best meet policy objectives “to protect taxpayers by making the best use of their money.” This is not a simple task. It would involve value judgments and political calculations inherent in the policy objectives. It is not clear how this program will work more effective than market forces without distorting market value.
 
3)         Insurance program: Treasury said it is establishing a program to insure troubled assets. It has several innovative ideas on how to structure this program, including how to insure mortgage-backed securities as well as whole loans. At the same time, it recognizes that there are likely other good ideas out there that it could benefit from. Accordingly, on Friday, October 10, Treasury submitted to the Federal Register a public Request for Comment to solicit the best ideas on structuring options. The Treasury was requiring responses within fourteen days so it could consider them quickly, and begin designing the program.
 
With many insurance companies on the verge of insolvency from rising claims on counter-party defaults, the Treasury’s insurance program on troubled assets looks like an attempt to insure losses that have already occurred, in violation of the basic principle of insurance.
 
4)         Equity purchase program: Treasury is designing a standardized program to purchase equity in a broad array of financial institutions. As with the other programs, the equity purchase program will be voluntary and designed with attractive terms to encourage participation from healthy institutions. It will also encourage firms to raise new private capital to complement public capital.
 
On a voluntary basis, it is a puzzle why healthy institutions would need or want to sell equity to the Treasury. On Tuesday, October 14, an hour before the market opens in New York at 9:30 am, Treasury Secretary Henry Paulson, Federal Reserve Chairman Ben Bernanke and Federal Deposit Insurance Corporation (FDIC) Chairman Sheila Bair, supported by SEC Chairman Christopher Cox, Commodity Futures Trading Commission (CFTC) Chairman Walter Luken, Office of controller of Currency (OCC) Controller John Dugan and Office of Thrift Supervision (OTS) Chairman John Reich, announced that the government will invest up to $250 billion in preferred stocks, half of it at large banks. The lists of banks participating include Goldman Sachs Group Inc. ($10 billion), Morgan Stanley ($10 billion), JP Morgan Chase ($25 billion), Bank of America Corp. – including the soon to be acquired Merrill Lynch ($25 billion), Citigroup Inc. ($25 billion), Well Fargo ($25 billion), Bank of New York ($3 billion), Mellon ($3 billion) and State Street Corp. ($2 billion). These moves are designed to keep money flowing through the frozen banking system to keep the economy going.
 
The government will purchase preferred stocks, an equity investment designed to avoid hurting existing shareholders and deterring new ones. The preferred stocks do not have voting rights, and carry a 5% annual dividend that rises to 9% after five years. The government’s plan will be structured to encourage firms to bring in private capital. Firms returning capital to government by 2009 may get better terms for the government’s stake. Financial institutions will have until mid November to decide whether they want to participate in the government recapitalization scheme. The minimum capital injection will be 2% of risk-weighted assets and the maximum will be 3% of risk-weighted assets, with an overall cap at $25 billion. Critics are asking why the government is only getting 5% when Warren Buffet was getting 10% guaranteed dividend in his recent investment in Goldman Sachs.
 
The senior preferred shares will qualify as Tier 1 capital and will rank senior to common stock and pari passu, which is at an equal level in the capital structure, with existing preferred shares, other than preferred shares which by their terms rank junior to any other existing preferred shares. The senior preferred shares will pay a cumulative dividend rate of 5% per annum for the first five years and will reset to a rate of 9% per annum after year five. The senior preferred shares will be non-voting, other than class voting rights on matters that could adversely affect the shares. The senior preferred shares will be callable at par after three years. Prior to the end of three years, the senior preferred may be redeemed with the proceeds from a qualifying equity offering of any Tier 1 perpetual preferred or common stock. Treasury may also transfer the senior preferred shares to a third party at any time. In conjunction with the purchase of senior preferred shares, Treasury will receive warrants to purchase common stock with an aggregate market price equal to 15% of the senior preferred investment. The exercise price on the warrants will be the market price of the participating institution's common stock at the time of issuance, calculated on a 20-trading day trailing average.
 
Executive compensation, including golden parachutes will be limited at banks that accept government investments. The Fed will guarantee all senior debts issued by banks over the next three years.
 
The FDIC, invoking a “systemic risk” clause in Federal banking law, will provide unlimited insurance to all non-interest-bearing accounts primarily used by businesses. The cost of this insurance will come from user fees paid by banks outside of the $700 billion TARP. It appears that the US has joined the global race to guarantee bank deposits to prevent US bank deposit from fleeing to countries with safer guarantee levels. This is billed as a global coordination of all central banks while in reality is a sign of rising financial nationalism.    
 
5)         Homeownership preservation: The Treasury said when it purchases mortgages and mortgage-backed securities, it will look for every opportunity possible to help homeowners. This goal is consistent with other programs - such as HOPE NOW - aimed at working with borrowers, counselors and servicers to keep people in their homes. In this case, Treasury is working with the Department of Housing and Urban Development to maximize these opportunities to help as many homeowners as possible, while also protecting taxpayers.
 
Yet none of the government programs launched so far have been effective in helping homeowners because ready opportunities to help them have not been found. The bottom line is that it is not possible to help distressed homeowners and protect taxpayer money at the same time.
 
6)         Executive compensation: The law sets out important requirements regarding executive compensation for firms that participate in the TARP. This team is working hard to define the requirements for financial institutions to participate in three possible scenarios: One, an auction purchase of troubled assets; two, a broad equity or direct purchase program; and three, a case of an intervention to prevent the impending failure of a systemically significant institution.
 
Management would opt for bankruptcy protection if executive compensation should be more liberal under bankruptcy than participation in the TARP.  Also, the interconnected nature of financial markets nowadays has produced a large number of “systemically significant institutions.”
 
7)         Compliance: The law establishes important oversight and compliance structures, including establishing an Oversight Board, on-site participation of the General Accounting Office and the creation of a Special Inspector General, with thorough reporting requirements. The Treasury said it welcomes this oversight and has a team focused on making sure it gets it right.
 
The Impact of Leverage and De-leverage on Asset Price
 
The accumulation of assets via massive amounts of debt is known in finance as leverage, expressed as debt-equity ratio. Leveraging can push up the price of assets so acquired and de-leveraging can push down the price of such assets.
 
A broker-dealer trades securities for customers as well as for proprietary accounts. In US markets, a broker-dealer must register with the Financial Industry Regulatory Authority, a self-regulating organization under the Security Exchange Act of 1934 as part of the New Deal. When executing trade orders on behalf of a customer, the institution is said to be acting as a broker. When executing trades for its own account, the institution is said to be acting as a dealer.
 
Many broker-dealers had been routinely leveraged to over 30 times during the credit bubble released the Fed under Alan Greenspan. Firms are now frantically trying to bring leverage down to below 20 times, still twice as high as what was considered prudent by the SEC since 1975 until the net capital rule was exempted for five major institutions in 2004.
 
The net capital rule created by the SEC in 1975 required broker-dealers to limit their debt-to-net-capital ratio to 12-to-1, and they must issue early warnings if they began approaching this limit, and were forced to stop trading if they exceeded it, so broker-dealers often kept their debt-to-net capital ratios much lower than 12-1. The rule allowed the SEC to oversee broker-dealers, and required firms to value all of their tradable assets at market prices. The rule applied a haircut, or a discount, to account for the assets’ market risk. Equities, for example, had a haircut of 15%, while a 30-year Treasury bill, because it is less risky, had a 6% haircut. But a 2004 SEC exemption -- given only to five big firms -- allowed them to lever up 30 and even 40 to 1.
 
The five big firms wanted for their brokerage units an exemption from the 1975 regulation that limited the amount of debt they could take on to $12 for every dollar of equity. The exemption would unshackle billions of dollars held in reserve as a cushion against losses on their investments. Those equity funds could then flow up to the parent company, enabling it to invest in the fast growing but opaque world of mortgage-backed securities, credit derivatives, credit default swaps - a form of insurance for bond holders - and other exotic structured finance instruments.
 
In 2004, the European Union passed a rule allowing the SEC’s European counterpart to manage the risk both of broker dealers and their investment banking holding companies. In response, the SEC instituted a similar, voluntary program for broker-dealers with capital of at least $5 billion, enabling the agency to oversee both the broker-dealers and the holding companies. Ever since the Great Depression, the government has tried to limit the leverage available to the public in the US stock market by maintain margin requirements. But regulators, led by former chairman of the Federal Reserve Alan Greenspan, thought financial innovation would be hampered, and financial activity driven to unregulated market overseas, if there were any attempts to impose limits on leverage in the unregulated credit and capital markets. After all, innovation was viewed as the driving force in US prosperity. The global financial system embarked on a race to assume more risk under a mentality of “if I don’t smoke, somebody else will.”
 
This brave new approach, which all five qualifying broker-dealers - Bear Stearns, Lehman Brothers, Merrill Lynch, Goldman Sachs, and Morgan Stanley - voluntarily adopted, altered the way the SEC measured their capital. The five big firms led the charge for the net capital rule change to promote financial innovation, spearheaded by Goldman Sachs, then headed by Henry Paulson, who two years later, would leave Goldman to become the Treasury Secretary, who now has to deal with the global mess created by high leverage.
 
Using computerized models provided by the five big firms, the SEC, under its new Consolidated Supervised Entities (CSE) program, allowed the broker-dealers to increase their debt-to-net-capital ratios, sometimes, as in the case of Merrill Lynch, to as high as 40-to-1. It also removed the method for applying haircuts, relying instead on another math-based computerized model for calculating risk that led to a much smaller discount.
 
The SEC justified the less stringent capital requirements by arguing it was now able to manage the consolidated entity of the broker-dealer and the holding company, which would ensure better management of risk. “The Commission’s 2004 rules strengthened oversight of the securities markets, because prior to their adoption there was no formal regulatory oversight, no liquidity requirements, and no capital requirements for investment bank holding companies,” a spokesman for the agency rationalized.
 
In loosening the capital rule, which was supposed to provide a buffer in turbulent times, the SEC also decided to rely on the five big firms’ own computer risk models, essentially outsourcing the job of monitoring risk to the banks it was supposed to supervise. Over subsequent years, all would take advantage of the looser capital rule to increase leverage.
 
The leverage ratio - a measurement of how much the companies were borrowing compared to their total assets - rose sharply at Bear Stearns, to 33 to 1. In other words, for every dollar in equity, it had $33 of debt. The ratio at the other firms also rose significantly. This advantage enabled the Big Five to go on a frenzy of acquisition, expanding risk to the entire financial system. The abuse of leverage was particularly severe in the hedge fund industry in which the Big Five were big players both in proprietary funds and as broker-dealer for large hedge funds who in turn were highly leveraged.  
 
The SEC did reexamine its efficacy after the Bear Stearns collapse. “Immediately after the events of mid-March, when the run-on-the-bank phenomenon to which Bear Stearns was exposed demonstrated the importance of incorporating loss of short-term secured funding into regulatory stress scenarios, the Consolidated Supervised Entities (CSE) program revised the analysis of liquidity risk management, with enhanced focus on the use and resilience of secured funding,” Securities and Exchange Commission Chairman Christopher Cox testified at the July 2008 hearing. “The SEC has also worked closely with the Federal Reserve in directing this additional stress testing.”
 
Two months after Chairman Cox testified, however, two more broker-dealers collapsed, and one of the two remaining broker-dealers - Morgan Stanley - was in talks to merge with Wachovia which itself was in trouble and had to be taken over by Wells Fargo. It is now clear that the SEC leverage modification in 2004 is a primary reason for the massive losses that have occurred in 2008.
 
On Sept. 26, 2008, Chairman Cox announced a decision by the SEC Division of Trading and Markets to end the Consolidated Supervised Entities (CSE) program, created in 2004 as a way for global investment bank conglomerates that lack a supervisor under law to voluntarily submit to regulation. Chairman Cox also described the agency’s plans for enhancing SEC oversight of the broker-dealer subsidiaries of bank holding companies regulated by the Federal Reserve, based on the recent Memorandum of Understanding (MOU) between the SEC and the Fed.
 
Chairman Cox made the following statement along with the SEC announcement on ending the CSE:

The last six months have made it abundantly clear that voluntary regulation does not work. When Congress passed the Gramm-Leach-Bliley Act [on November 12, 1999 to repeal the Glass-Steagall Act of 1933 which had prohibited a bank from offering investment banking and insurance services], it created a significant regulatory gap by failing to give to the SEC or any agency the authority to regulate large investment bank holding companies, like Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Stearns.

 
The SEC said it has no plans to re-examine the impact of the 2004 changes to the net capital rule, yet it put out a proposal to revise the rule once again. This time, it is looking to remove the requirement that broker-dealers maintain a certain rating from the ratings agencies.
 
On Sept. 26, the commission formally ended the 2004 program, acknowledging that it had failed to anticipate the problems at Bear Stearns and the four other major investment banks.
 
When the need to de-leverage is triggered by insufficient revenue, asset prices will fall and insolvency can result. Undercapitalization is merely a euphemism for insolvency unless new capital can be raised quickly. Recapitalization is a euphemism for dilution of sunk equity with new capital. Recapitalization alters the capital structure of a corporation. It is often accomplished by an exchange of bonds for stocks. Pending bankruptcy is a common reason for recapitalization. Debentures might be exchanged for reorganization bonds that pay interest only when earned.
 
Under US law, a healthy company might seek to save taxes by replacing preferred stock with bonds to gain interest deductibility from its tax liabilities. In corporate finance, in-substance defeasance is a technique whereby a corporation discharges old, low rate debt prior to maturity without repaying it. The corporation uses newly purchased securities with a lower face value but paying a higher interest or having a higher market value. The objective is to produce a more debt free balance sheet and increase earnings in the amount by which the face amount of the old debt exceeds the cost of the new securities.
 
The use of defeasance in modern corporate finance began in 1982 when Exxon bought and put into an irrevocable trust $312 million of US government securities yielding 14% to provide for the repayment of principal and interest on $515 million of old debt paying 5.8% to 6.7% and maturing  in 2009. Exxon removed the defeased debt from its balance sheet and added $132 million – the after tax difference between $515 million and $312 million – to its earnings in that quarter. In-substance defeasance may well the magic bullet to get out from the curse of over leverage.
 
Global stock markets staged a historic rally on Monday September 13 as European governments pledged a total of €1.87 trillion ($2.55 trillion) to shore up their banking system and the US prepared to unveil its own comprehensive rescue plan a day later. In New York, the S&P 500, which the week before fell 18.2%, rose 11.6% – the biggest daily gain since the volatile trading of the Great Depression. The Dax index of the Frankfurt stock exchange closed up 11.4% while the CAC40 in Paris rose 11.2%. In London, the FTSE 100 rose 8.3%, its second largest one-day gain in history, and in Hong Kong, the Hang Seng index rose 10.24%. Yet, the Treasury announcement on Tuesday September 14 failed to extend the one-day market rally that had greeted every one of the government’s precedent–breaking previous measures.  All the governmental spectaculars failed to break the secular bear market in which each rebound fails to breach the previous low.
 
Three-month Sterling Libor was just 2 basis points lower at about 6.25%, more than 2 percentage points above where markets are pricing UK interest rates and higher than where the rate set before the coordinated interest rate cuts by major economies in the second week of October. Similarly, euro three-month Libor, which was down 7.37 basis points at 5.225% on October 14, remained high. There were only weak signs of relief in the frozen credit markets at the centre of the financial crisis, as three-month dollar Libor eased to 4.75% from 4.82%, even after the Fed lowered the Fed funds rate target to 1.5% on October 8 and 3-month treasuries were yielding 0.5%. This left the so-called Ted spread, which measures the difference between inter-bank lending rates and risk-free government lending rates, at a hefty 420 basis points.
 
Recapitalization, while lowering leverage to protect the market value of debt, further depresses asset value. Such are the laws of finance in market economies. For this reason, taxpayers may never recoup their investment in the Treasury’s nationalization program of the banking system if government funds received by banks are used to de-leverage rather than new lending.
 
The US government’s misguided approach of monetizing illiquid assets held by distressed institution to remove insolvency threats is self defeating. In each step, it has predictably failed to jump start credit and capital markets under seizure because excessive liquidity cannot be cured by more liquidity. Assets become illiquid because their price stubbornly stays above their market value. Such assets will stay illiquid until price adjustments bring about market transactions. Government monetization of illiquid assets will only prolong their illiquid life span.
 
Markets are not the best intermediaries of long-term value, because for market economies, markets are the prime intermediaries of short-term value. This is why economist Hyman Minsky thought that a substantial public sector is needed to moderate short-term volatility in the private market sector. When the private market sector dominates the economy, the price regime will be excessively tilted by short-term conditions.
 
Markets can only function when there are matching numbers of willing buyers and sellers at any one time. When the number of sellers is larger than the number of buyers, prices will fall, or in a reverse situation, prices will rise until the number of buyers and sellers match up. Price is the point where willing sellers and willing buyers meet for a fair transaction. Until the price is right, the market remains in suspension. Price fluctuation then is the key factor in addressing imbalances between buyers and sellers in the market. This is both the strength and the weakness of market economies.
 
Free markets require an equal degree of market power between buyers and sellers. Ideally, a truly free market always leaves both buyers and sellers happy, each being satisfied that the transaction price reflects their differing judgment of fair market value at t he point of transaction. The buyer thinks he will gain from future appreciation and the seller thinks he will avoid loss from future depreciation. Only one party in the transaction will turn out to be right at any future point in time. The probability of being wrong is the risk in the transaction. That is the basic principle of market fundamentalism, which is governed by the principle of fluctuating supply and demand through time, intermediated by fluctuation in price.
 
When market power is not equally distributed among market participants, a free market is replaced by a coerced market. A coerced market is one when one side, either buyers or seller, has more market power. Uneven market power distorted prices to generate market inefficiency. A failed market is one when there are no buyers or sellers at any price. The ultimate coerced market is one where the government, which by definition possesses overwhelming market power by virtue of it s ability to print money by fiat, is the only buyer or seller. Market fundamentalists are right in their belief that government should stay away from the market to avoid destroying the market. Yet they are wrong in thinking that government should deregulate markets to keep it free. And above all, they are dangerously wrong in thinking that markets can satisfy all economic needs. The truth is that there are large segments of the economy that only government can handle effectively and efficiently, national defense being one obvious example. This government economic segment is known as the public sector in a market economy. As economist Hyman Minsky pointed out insightfully, the public sector performs a much needed function in stabilizing the business cycle in the private sector. A society without an adequate public sector leans towards economic anarchy that will eventually implode.
 
In finance, to make a market means maintaining ready, firm bids and offer prices in a given security by standing ready to buy or sell at publicly quoted prices in round lots (generally accepted units of trading on a securities exchange – on the New York Stock exchange, a round lot is 100 shares for stock and $1000 or $5000 par value for bonds). The dealer is called a market maker in the over-the-counter market outside of exchanges. On the exchanges, the dealer is called a specialist. A dealer who makes a market over a long period is said to “maintain” a market.
 
The NASDAG requires that there be at least two market makers for each stock listed in the system. The bid and asked quotes are compared to ensure that the quote is a representative spread. Registered competitive traders in the NYSE are market makers because, in addition to trading for their own accounts, they are expected to help correct an imbalance of orders. Registered competitive traders are NYSE members who buy and sell for their own accounts. Because their members pay no commission, they are able to profit from even small changes in market prices, thus tend to trade actively with high volume. Like specialists, registered competitive traders must abide by exchange rules, including a requirement that 75% of their trade be stabilizing, meaning they cannot sell unless the last trading price on a stock is up, or buy unless the last trading price was down. Orders from the trading public take precedence over those of registered competitive traders, which normally account for less than 1% of total volume. 
 
The central bank cannot be a market maker because the central bank is empowered to create new money. This power to create new money gives the central bank unequalled market power and turns it from a market maker into a market destroyer. Throughout history, the sovereign who enjoys the power of seigniorage refrain from being a market participant for good reasons. When the sovereign owns everything, there is no way to tell how much the sovereign is worth.  This is why even in a communist society where the people as sovereign own the means of production, markets are still required to establish prices to efficiently allocate economic and financial resources.
 
The government’s intervention has created a relative advantage for companies to raising funds through guaranteed bank paper versus the asset-backed markets. The ability of banks and other financial groups to raise money via government guarantees means funding through more traditional routes like asset-backed securities will be much more expensive. In the short-term, the government moves is having an effect. There has not been any issuance in credit cards because all the major banks now have another, cheaper option. In addition to offering banks cheaper sources of funding, the explicit government guarantees on many bank securities has led to a sell-off in bonds issued by mortgage financiers like Fannie Mae and Freddie Mac, as well as asset-backed securities. As a result, the cost of borrowing in asset-backed markets has soared, with the premiums over US government bonds at record highs. This makes private sector funding even less attractive.
 
There are also signs that government funds are being used by banks to buy rivals, rather than provide new lending. On Friday, October 14, PNC Financial became the first bank to make use of the US government’s bank recapitalization program to merge with a weaker rival. In the longer term, credit card debt securitization have to be revived because the government programs are not large enough to cover all the banks’ funding needs.
 
Central Banks Have Become Market Destroyers
 
The recent opening of the Federal Reserve discount window to borrowings by commercial banks, collateralized by illiquid assets, and the extension of discount window access to investment banks have pushed the central bank across the line of being a lender of last resort to being a market destroyer. It is no wonder that its liquidity injection moves have failed to moderate seizure of global credit markets. This is because the central bank, not constrained by the supply and market value of money, can set the price of illiquid asset by fiat, thus destroy the very function of the market in setting meaningful prices that can defuse market seizure.  Central bank intervention into credit markets to artificially support asset prices above market levels carries no fundamental market implication, save the impact of future inflation. The market knows that asset prices assigned by the central bank are not real and will be adjusted downward as soon as central bank intervention ends. And until central bank intervention ends, the market remains in suspension.
 
This explains why despite central bank intervention, and perhaps even because of it, inter-bank lending stayed halted, with LIBOR (London Inter-bank Lending Rate) rising high above normal spread over Fed funds rate targets. In the non-banking financial sector, new commercial paper issuance, the short-term funding source of choice for financial and non-financial corporations, could not find buyers. In sum, global credit markets continue to fail despite escalating and increasingly desperate government intervention measures.
 
One of the key objections behind the House of Representative initial rejection of the Treasury’s $700 billion rescue package was that at the end of the rescue term of 30 years, the public may not be paid back on account that the illiquid collateral might still not yield returns that match after inflation face values. The overvaluation of such illiquid assets cannot be made whole through inflation because de-leveraging made possible by inflation will keep the market value of such assets below its after inflation face value. The congressional opposition wanted prearranged authority to tax the finance industry to recoup the investment for the public whose tax money was being used for the rescue of distressed institutions. 
 
The market was more honest than most paid pundits and special interest policymakers. Market participants knew the crisis was not merely a passing liquidity crunch, but a widespread insolvency created by excessive asset value unsupported by compensatory revenue. Insolvency will translate into sharp declines in asset price. The government can destroy the market in the name of saving it but the laws of market cannot be negated by government intervention.
 
Some critics have mistakenly complained that the US government has turned to socialism for solution to the current financial crisis in a capitalistic system. Yet what the US government has done is merely turning failed market capitalism into state capitalism. Nationalization alone does not lead to socialism. Socialism is not merely collective ownership of the means of production. It must also subscribe to an operative goal of fair sharing of the fruits of the economy through collective ownership of the means of production.
 
In a socialist state, state-owned enterprises are the venue of socialist ownership of the means of production which is deployed to support the interests of workers. But in a capitalist state, state-owned enterprises do not entertain such populist goals. State capitalism continues to oppress workers for the benefit of capital while the state represents the interest of capitalists rather than workers. State capitalism subscribes to the trickling down theory – saving the banks to save the citizenry. What is needed is for government to save the citizenry by direct assistance with job creations and wage guarantees, not inter-bank loan guarantees. 
 
Incoming data for September showed unemployment at 6.1% and still climbing, above the non-accelerating inflation rate of unemployment (NAIRU) of 6%. Non-farm payroll employment declined by 159,000; in a civilian labor force of 154.7 million, with a labor force participation rate of 66%.  Total employment was 145.3 million and the employment-population ratio was 62%.  Since a recent high in December 2006, the employment-population ratio has declined by 1.4 percentage points.  The number of persons who worked part time for economic reasons rose by 337,000 to 6.1 million in September, an increase of 1.6 million over the past 12 months.  This category includes persons who would like to work full time but were working part time because their hours had been cut back or because they were unable to find full-time jobs. These data suggests an extremely weak economy going forward.
 
The entire global market economy, fueled by decades of excess liquidity and debt denominated in fiat dollars imprudently released by the US Federal Reserve, had turned even prudent debt to equity ratios in normal times into precariously over-leveraged debt structures. Asset price inflation, defined as growth by central banking doctrine, had allowed the global market economy to assume debt levels that could not be serviced by relatively stagnant or even falling wage income. In an asset price bubble unsupported by corresponding rise in wage income, even normally prudent debt-equity ratios will result in precarious debt leverage.
 
Either wage income must rise, or asset prices must fall to restore financial equilibrium. Government intervention to prop up inflated asset prices without compensatory wage rise will only end in hyperinflation.
 
A sharp decline in assets prices will unavoidably spell widespread bankruptcy for many financially overextended companies and individuals. This will constrict demand temporarily to delay inflation effects but hyperinflation will result as certainly as the sun will rise because modern democracies cannot allow deflation to cause widespread bankruptcy even in a debt bubble. In my January 11, 2006 AToL article: Of debt, deflation and rotten apples, I wrote (Central banks fear deflation more than inflation): “Although Greenspan never openly acknowledges it, his great fear is not inflation, but deflation, which is toxic in a debt-driven economy. ‘Price stability’ is a term that increasingly refers to anti-deflationary objectives, to keep prices up rather than down.”
 
By now, it is becoming clear that government policy has been mostly focused on maintaining asset price at levels that the market has rejected. Logic suggests that such a policy will result in hyperinflation at the end of the day that will lead to more bankruptcies down the road in a protracted downward spiral. The government’s attempt to save overextended financial institutions may well cause the total destruction of market capitalism. And if past experience is any guide, unless wage income is indexed to inflation, the dilution of asset value through inflation will only hasten the arrival of total market failure and a total melt down of the market economy.
 
So far, not much is heard from official circles that suggest the solution to the current credit crisis can only come from an immediate and substantial rise in wage income. Instead of bailing out insolvent financial institutions, the government should use sovereign credit to maintain full employment and boost wage income to catch up with inflated asset prices. If the Fed must print new money to save the system, the new money should go to job creation and wage increases rather than to recapitalize insolvent corporations.  Full employment and rising wages will halt the fall of asset prices with a rising floor.
 
The approach adopted by the Bush administration is not designed to rescue a collapsing global economy from total meltdown but to resurrect free market capitalism from ideological bankruptcy with state capitalism.

October 26, 2008