Page 1 of 2 Paulson plan throws oil on fire
By Hossein Askari and Noureddine Krichene
With the creation of the so called Mortgage and Financial Institutions Trust
(MFI), the unfolding financial crisis, considered by many to be the worst in
over 60 years, has become ever-more dangerous.
While such an institution has not existed in any country, the MFI could prove
to be disastrous for US public finance, economic growth, the dollar, relations
with major foreign holders of dollars, the global financial system, and could
ignite the worst inflation in the economic history of the United States and
reverse globalization to levels not seen since the Great Depression.
The initial cost of the MFI, put at US$700 billion, could easily
escalate to trillions of dollars. At the same time, the Congressional Budget
Office had previously projected a record fiscal deficit of US$500 billion for
2009. The MFI will further blow up the deficit to an unprecedented level,
exceeding US$1.4 trillion. US debt, jumping with the takeover of Fannie Mae and
Freddie Mac to 86% of GDP, has moved to an unsustainable level.
The financing of previous large fiscal deficits under the George W Bush
Administration has already caused external deficits (current account) to widen
to 5-7% of GDP, turned national savings negative, sent the dollar plummeting,
and ignited rapid inflation, particularly in food, energy, and housing prices.
Further financing of extraordinary large fiscal deficits, as required by the
MFI, can only disrupt economic stability both in the US and world-wide. It will
only further undermine the dollar, exacerbate widening external deficits,
soaring energy and food prices, and rising unemployment.
Nonetheless, the main architects of the MFI, Messrs Henry Paulson and Ben
Bernanke, Treasury Secretary and Federal Reserve chairman respectively, are
determined to protect Wall Street. They have decidedly transformed the US
budget and the US central bank into vehicles that only care for the welfare of
Wall Street and divert public resources to bankers, under the guise of
protecting the economy and averting systemic risk.
Albeit evidence of a systemic risk has not been established, vast public
resources have so far been devoted to bailouts at the expense of
growth-generating spending. The Fed has been pouring billions of dollars into
financial institutions, buying worthless paper, and incurring huge losses. To
quote Paulson "I am convinced that this bold approach [that is creation of the
MFI] will cost American families far less than the alternative - a continuing
series of financial-institution failures and frozen credit markets unable to
fund economic expansion."
Contrary to Paulson’s claim, domestic credit is still expanding at a fast rate,
at 9% per year as of July 2008, and the notion of frozen markets cannot be
supported by Fed’s published monetary data. Banks have excess liquidity and are
still extending loans to safe customers. Certainly they are no longer in the
mood of reigniting a new speculative euphoria by lending to speculator and
impaired credit.
And contrary to Paulson’s belief, the MFI will in the end cost American
families more than other alternatives. As Philip Stephens from the Financial
Times put it, it is horrifying to think that the huge liabilities of failing
institutions have now been loaded on to the backs of taxpayers: a case, as far
as speculators are concerned, of heads, we win, tails you lose.
Paulson and Bernanke, by designing the MFI to secure banks’ assets, have
enticed investors and speculators into buying financial stocks, made most
attractive on expectations that all banks’ assets will be secured by the
government. With the MFI, banks can only make profits and will always be able
to dump their nonperforming assets to the MFI.
Since the outbreak of the crisis in August 2007, the narrow view of Paulson and
Bernanke has always been to protect Wall Street at the expense of the rest of
the economy. While their previous attempts failed to re-inflate asset prices,
mainly housing prices, and save exposed financial institutions, they found in
the MFI the only direct way to save troubled financial institutions. They
decided to join together both fiscal and monetary policy to serve bankers'
interest.
A broader look at the MFI needs to explore its potential disruptive effects,
which can make its original objective of financial stability self-defeating and
will lead to unavoidable financial instability and disorder in a near future.
The MFI has both political and economic and financial pitfalls. The US should
not give any secretary of the Treasury, let alone one who has been so wrong and
who keeps reassuring us that everything is under control, so much power with no
oversight on how taxpayers' money is spent.
While Paulson wants to use the MFI to buy toxic assets, he may end up poisoning
the whole US and the global economy. On the political side, there is growing
frustration at seeing taxpayers' money being spent on nonproductive and
exorbitant bailout schemes instead of being spent on productive and
growth-generating education, health and infrastructure.
By becoming heavily dominated by subsidies to the banking sector, public
expenditure will have very small impact on economic growth and social welfare.
There is also growing dismay about increasing inequity when the government
transfers private bank losses to the public while it keeps speculators' profits
private and protects high salaries and gains of bankers, all this in a country
that today has it worst income distribution in about 100 years.
On the economic and financial side, potential adverse effects are too many and
cannot be exhaustively enumerated. The moral hazard is certainly increased. All
mortgage holders, seeing that the MFI is buying impaired mortgage loans, will
be tempted to default in the name of equal treatment among mortgage debtors.
Similarly, for consumer and small business loans, debtors will default, knowing
that these loans are secured by the government. Such strong motivation for
default can turn the amount of defaulted loans into trillions and push
liabilities of the MFI to forbidden levels. The mechanism of credit and
financial intermediation can be seriously impaired. In addition, the MFI will
set a precedent, and will make default very appealing in the future for all
debtors, impairing long-term financial stability.
The effect of the MFI on economic growth is certainly detrimental. By diverting
excessively large resources to buying useless financial papers, billions of
dollars will be taken away from social and economic sectors. Hence, long-term
growth will be undermined by lack of productive investment.
On the financing side, in view of past and current large US fiscal deficits,
the MFI is simply not financeable. Only inflation is left as a financing
option. The monetization of incredibly large deficits can degenerate into most
destabilizing hyperinflation in the US history, and could cause an economic and
social ordeal.
It will extract the heaviest tax from fixed-income recipients and wage earners
and spark large real income cuts as well as large wealth redistribution from
creditors to debtors. Food inflation has already exceeded tolerable levels and
forced malnutrition or reduction in food standards for average - and low-income
families. Exacerbating already high inflation could impoverish millions of
American families. It will intensify unemployment and social discontent.
If the fiscal deficit exerts pressure on interest rates, then the deficit will
rise even further, the cost of monumental private debt increase, and mass
default both nationally and internationally will set off.
As previous fiscal deficits during 2001-2008 clearly showed, the financing of
excessively large deficits will take its greatest toll on the US dollar and
will undermine confidence in it as reserve currency. For the US to run a
current account deficit, the rest of the world must be willing to finance it.
This financing task would principally fall on China and a few major
oil-exporting countries. These countries, instead of throwing good money after
bad, will try to diversify out of dollars in an orderly fashion.
Foreign holders of dollars are unlikely to finance ever-growing US current
account deficits but will instead convert their dollar holdings into stable
currencies or gold. This would, in turn, cause a major economic contraction in
the US, possibly exceeding 10%.
That will have adverse repercussions on international trade and these will be
reinforced by exchange-rate instability. Asian
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