[R-G] [BillTottenWeblog] Is America too big to fail?

[Bill Totten]

by Peter S Goodman

International Herald Tribune (July 20 2008)


In the narrative that has governed American commercial life for the last
quarter-century, saving companies from their own mistakes was not
supposed to be part of the government's job description. Economic
policymakers in the United States took swaggering pride in the cutthroat
but lucrative form of capitalism that was supposedly indigenous to their
frontier nation.

Through this uniquely American lens, saving businesses from collapse was
the sort of thing that happened on other shores, where sentimental
commitments to social welfare trumped sharp-edged competition.
Weak-kneed European and Asian leaders were too frightened to endure the
animal instincts of a real market, the story went. So they intervened
time and again, using government largess to lift inefficient firms to
safety, sparing jobs and limiting pain but keeping their economies from
reaching full potential.

There have been recent interventions in America, of course - the
taxpayer-backed bailout of Chrysler in 1979, and the savings and loan
rescue of 1989. But the first happened under Jimmy Carter, a year before
Americans embraced Ronald Reagan and his passion for unfettered markets.
And the second was under George H W Bush, who did not share that passion.

So it made for a strange spectacle last weekend as the current Bush
administration, which does cast itself in the Reagan mold, hastily
prepared a bailout package to offer the government-sponsored mortgage
companies, Fannie Mae and Freddie Mac. The reasoning behind this rescue
effort - like the reasoning behind the government-induced takeover of
Bear Stearns by JPMorgan Chase just a month before - sounded no
different from that offered in defense of many a bailout in Japan and
Europe:

The mortgage giants were too big to be allowed to fail.

Big indeed. Together, Fannie and Freddie own or guarantee nearly half of
the nation's $12 trillion worth of home mortgages. If they collapse, so
may the whole system of finance for American housing, threatening a most
unfortunate string of events: First, an already plummeting real estate
market might crater. Then the banks that have sunk capital into American
homes would slip deeper into trouble. And the virus might spread globally.

The central banks of China and Japan are on the hook for hundreds of
billions of dollars worth of Fannie's and Freddie's bonds - debts they
took on assuming that the two companies enjoyed the backing of the
American government, argues Brad Setser, an economist at the Council on
Foreign Relations.

Commercial banks from South Korea to Sweden hold investments linked to
American mortgages. Their losses would mount if American homeowners
suddenly couldn't borrow. The global financial system could find itself
short of capital and paralyzed by fear, hobbling economic growth in many
lands.

Nobody with a meaningful office in Washington was in the mood for any of
that, so the rescue nets were readied. The US Treasury secretary, Henry
Paulson Jr, announced that the government was willing to use taxpayer
funds to buy shares in Fannie and Freddie. The chairman of the Federal
Reserve, Ben Bernanke, said the central bank would lend them money.

The details were up in the air as the week ended, but some sort of
bailout offer was on the table - one that could ultimately cost hundreds
of billions of dollars. Whatever the dent to national bravado, or to the
free-enterprise ideology, the phrase "too big to fail" suddenly carried
an American accent.

"Some institutions really are too big to fail, and that's the way it
is", said Douglas Elmendorf, a former Treasury and Federal Reserve
economist who is now at the Brookings Institution in Washington. "There
are no good options".

Still, there are ironies. Since World War II, the United States has been
the center of global finance, and it has used that position to virtually
dictate the conditions under which many other nations - particularly
developing countries - can get access to capital. Letting weak companies
fail has been high on the list.

Paulson, who announced the bailout, made his name as chief executive of
Goldman Sachs, the Wall Street investment giant, where he pried open new
markets to foreign investment. As Treasury secretary, he has served as
chief proselytizer for American-style capitalism, counseling the tough
love of laissez-faire. In particular, he has leaned on China to let the
value of its currency float freely, and has criticized its banks for
shoveling money to companies favored by the Communist Party in order to
limit joblessness and social instability.

All through Japan's lost decade of the 1990s and afterward, American
officials chided Tokyo for its unwillingness to let the forces of
creative destruction take down the country's bloated banks and the
zombie companies they nurtured. The best way out of stagnation,
Americans counseled, was to let weak companies die, freeing up capital
for a new crop of leaner entrants.

But as Japan's leaders engaged in bailouts and bookkeeping fictions to
keep banks and companies breathing, they offered those words of
justification now heard here: The companies were too big to fail.

In 2002, the government engineered the rescue of Daiei, a huge,
debt-laden grocery chain. In 2003, it injected some $17 billion into
Resona Bank to keep it upright. Each time, Japan's leaders said failure
was not an option. It would pull too many others into a downward spiral.

Today, among strict adherents of laissez-faire economics, the offer to
bail out Fannie and Freddie is already being criticized as a trip down
the Japanese path of putting off immediate pain while loading up the
costs further along.

For one thing, this argument goes, taxpayers - who now confront plunging
house prices, a drop on Wall Street and soaring costs for food and fuel
- will ultimately pay the costs. To finance a bailout, the government
can either pull more money from citizens directly, or the Fed can print
more money - a step that encourages further inflation.

"They are going to raise the cost of living for every American", said
Peter Schiff, president of Euro Pacific Capital, a Connecticut-based
brokerage house that focuses on international investments. "The
government is debasing the value of our money. Freddie and Fannie need
to fail. They are too big to save."

Using public money to spare Fannie and Freddie would increase the public
debt, which now exceeds $9.4 trillion. The United States has been
financing itself by leaning heavily on foreigners, particularly China,
Japan and the oil-rich nations of the Persian Gulf. Were they to become
worried that the United States might not be able to pay up, that would
force the Treasury to offer higher rates of interest for its next
tranche of bonds. And that would increase the interest rates that
Americans must pay for houses and cars, putting a drag on economic growth.

Meanwhile, as American debts swell and foreigners hold more of it,
nervousness grows that, someday, this arrangement will end badly. The
dollar has been declining in value against other currencies. Some
foreigners have begun to hedge their bets by buying more euros.

"Obviously, this is going to come to an end", Schiff said. "Foreigners
are not charitable organizations, and they're going to demand that we
pay them back".

No single country owning large amounts of dollar-based investments is
inclined to dump them abruptly; nobody aims to start a panic. But fears
have begun to grow that one day a country may get spooked that another
is about to dump its dollars - and that could trigger pre-emptive panic
selling.

"Foreigners could decide it's just not worth the risk and sell", says
Andrew Tilton, an economist at Goldman Sachs. "The really dire scenarios
have become a lot more likely than they were a year or two ago".

Still, as Tilton and others are aware, one fundamental reality continues
to offer assurances that foreigners will still buy American debt: In the
global economy of the moment, the United States itself is too big to fail.

The logic for that assurance goes like this: The American consumer has
for decades served as the engine of world commerce, using borrowed cash
to snap up the accouterments of modern living - clothes and computers
and cars now manufactured, in whole or in part, in factories from Asia
to Latin America. Eliminate the American wherewithal to shop, and the
pain would ripple out to multiple shores.

Globalization, in other words, allowed China and Japan to amass the
fortunes they have been lending to the United States.

But globalization also emboldened American capitalists to take huge
risks they might have otherwise avoided - like borrowing to erect
forests of unsold homes from California to Florida, delivering the
speculative disaster of the day. They were operating with bedrock
confidence that money would never run out. Someone would always buy
American debt, delivering more cash for the next go.

And this same interconnectedness appears to have reassured regulators in
Washington about the health of the American financial system, as they
declined to intervene against highly speculative lending during the real
estate boom. Mortgages were being distributed to investors around the
globe, and so were the risks, the regulators reasoned. Anyone who bought
into that risk would have a strong interest in seeing that the American
financial system stayed upright.

In other words, in the estimation of people in control of money, the
United States cannot be allowed to collapse, just as Fannie and Freddie
cannot be allowed to fail. Too much is riding on their survival.

The central truth of that logic still seems to be apparent as the
Treasury keeps finding takers for American debt.

So the government offers its rescue of the mortgage companies, and
foreigners keep stocking the government's coffers. "They don't want the
US to go into the worst downturn since the Depression", Tilton says.

But all the while, the debt mounts along with the costs of an ultimate
day of reckoning. Debate grows about the wisdom of leaning on foreign
credit, and about how much longer Americans will retain the privilege of
spending and investing money that isn't really theirs.

Bailouts amount to mortgaging the future to stave off the wolf howling
at the door. The likelihood of a painful reckoning is diminished, while
the costs of a reckoning - should one come - are increased.

The costs are getting big.

Copyright (c) 2008 The International Herald Tribune | www.iht.com

http://www.iht.com/articles/2008/07/20/business/20fail.php


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