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[Bill Totten]

The ABCs of Paulson's Bailout

by Michael Hudson

Counterpunch (October 20 2008)


Treasury Secretary  Paulson's bailout speech on Monday, October 13,
poses some fundamental economic questions: What is the impact on the
economy at large of this autumn's unprecedented creation and giveaway of
financial wealth to the wealthiest layer of the population? How long can
the Treasury's bailout of Wall Street (but not the rest of the economy!)
sustain a debt overhead that is growing exponentially? Is there any
limit to the amount of US Treasury debt that the government can create
and turn over to its major political campaign contributors?

In times past, national debt typically was run up by borrowing money
from private lenders and spent on goods and services. The tendency was
to absorb loanable funds and bid up interest rates on the one hand,
while spending led to inflationary price increases for goods and
services. But the present giveaway is different. Instead of money being
borrowed or spent, interest-yielding bonds are simply being printed and
turned over to the banks and other financial institutions.  The hope is
that they will lend out more credit (which will become more debt on the
part of their customers), lowering interest rates while the money is
used to bid up asset prices - real estate, stocks and bonds. Little
commodity price inflation is expected from this behavior.

The main impact will be to reinforce the concentration of wealth in the
hands of creditors (the wealthiest ten per cent of the population)
rather than wiping out financial assets (and debts) through the
bankruptcies that were occurring as a result of "market forces". Is it
too much to say that we are seeing the end of economic democracy and the
emergence of a financial oligarchy - a self-serving class whose actions
threaten to polarize society and, in the process, stifle economic growth
and lead to the very bankruptcy that the bailout was supposed to prevent?

Everything that I have read in economic history leads me to believe that
we are entering a nightmare transition era. The business cycle is
essentially a financial cycle. Upswings tend to become economy-wide
Ponzi schemes as banks and other creditors, savers and investors receive
interest and plow it back into new loans, accruing yet more interest as
debt levels rise. This is the "magic of compound interest" in a
nutshell. No "real" economy in history has grown at a rate able to keep
up with this financial dynamic. Indeed, payment of this interest by
households and businesses leaves less to spend on goods and services,
causing markets to shrink and investment and employment to be cut back.

Banks cannot make money ad infinitum by selling more and more credit -
that is, indebting the non-financial economy more and more. Government
officials such as Treasury Secretary Paulson or Federal Reserve Chairman
Bernanke are professionally unable to acknowledge this problem, and it
does not appear in most neoclassical or monetarist textbooks. But the
underlying mathematics of compound interest are rediscovered in each
generation, often prompted by the force majeur of financial crisis.

A generation ago, for instance, Hyman Minsky gained a following by
describing what he aptly called the Ponzi stage of the business cycle.
It was the phase in which debtors no longer were able to pay off their
loans out of current income (as in Stage #1, where they earned enough to
cover their interest and amortization charges), and indeed did not even
earn enough to pay the interest charges (as in Stage #2), but had to
borrow the money to pay the interest owed to their bankers and other
creditors. In this Stage #3 the interest was simply added onto the debt,
growing at a compound rate. It ends in a crash.

This was the flip side of the magic of compound interest - the belief
that people can get rich by "putting money to work". Money doesn't
really work, of course. When lent out, it extracts interest from the
"real" production and consumption economy, that is, from the labor and
industry that actually do the work. It is much like a tax, a monopoly
rent levied by the financial sector. Yet this quasi-tax, this extractive
financial rent (as Alfred Marshall explained over a century ago) is the
dynamic that is supposed to enable corporate, state and local pension
funds to pay for retirement simply out of stock market gains and bond
investments - purely financially and hence at the expense of the economy
at large whose employees are supposed to be gainers. This is the essence
of "pension-fund capitalism", a Ponzi-scheme variant of finance
capitalism. Unfortunately, it is grounded in purely mathematical
relationships that have little grounding in the "real" economy in which
families and companies produce and consume.

Paulson's bailout plan reflects a state of denial with regard to this
dynamic. The debt overhead is self-aggravating, becoming less and less
"solvable" and hence more of a quandary, that is, a problem with no
visible solution. At least, no solution acceptable to Wall Street, and
hence to  Paulson and the Democratic and Republican congressional
leaders. The banks and large swaths of the financial sector are broke
from having made bad gambles in the belief that money could be made to
"work" under conditions that shrink the underlying industrial economy
and stifle wage gains, eroding the market for consumer goods. Debt
deflation reduces sales and business activity in general, and hence
corporate earnings. This depresses stock market and real estate prices,
and hence the value of collateral pledged to back the economy's debt
overhead. Negative equity leads to bankruptcy and foreclosures.

By increasing America's national debt from $5 trillion earlier this year
to $13 trillion in almost a single swoop by taking on junk loans and
other bad investments rather than letting them to under as traditionally
has occurred in the "cleansing" culmination of business crashes
("cleansing" in the sense of clean slates for debts that cannot
reasonably be paid),  Paulson's bailout actions increase the interest
payments that the government must pay out of taxes or by borrowing  (or
printing) yet more money. Someone must pay for bad debts and junk loans
that are not wiped off the books. The government is now to take on the
roll of debt collector to "make a profit for taxpayers" by going around
and kneecapping the economy - which of course is comprised primarily of
the "taxpayers" ostensibly being helped.

It is a con game. Financial gains have soared since 1980, but banks and
institutional investors have not used them to finance tangible capital
formation. They simply have recycled their receipt of interest (and
credit-card fees and penalties that often amount to as much as interest)
into yet new loans, extracting yet more interest and so on. This
financial extraction leaves less personal and business income to spend
on consumer goods, capital goods and services. Sales shrink, causing
defaults as the economy is less able to pay its stipulated interest charges.

This phenomenon of debt deflation has occurred throughout history, not
only over the modern business cycle but for centuries at a time. The
most self-destructive example of financial short-termism is the decline
and fall of the Roman Empire into debt bondage and ultimately into a
Dark Age. The political turning point was the violent takeover of the
Senate by oligarchic creditors who murdered the debtor-oriented
reformers led by the Gracchi brothers in 133 BC, picking up benches and
using them as rams to push the reformers over the cliff on which the
political assembly was located. A similar violent overthrow occurred in
Sparta a century earlier when its kings Agis and Cleomenes sought to
annul debts so as to reverse the city-state's economic polarization. The
creditor oligarchy exiled and killed the kings, as Plutarch described in
his Parallel Lives of the Illustrious Greeks and Romans. This used to be
basic reading among educated people, but today these events have all but
disappeared from most people's historical memory. A knowledge of the
evolution of economic structures has been replaced by a mere series of
political personalities and military conquests.

The moral of ancient and modern history alike is that a critical point
inevitably arrives at which economies either adopt hard
creditor-oriented laws that impoverish the population and plunge
downward socially and militarily, or save themselves by alleviating the
debt burden. What is remarkable today is the almost total failure of
political leaders to provide an alternative to  Paulson's bailout of
Wall Street from the Bear Stearns bankruptcy down through the government
takeover of Fannie Mae and Freddie Mac to last week's giveaway to the
banks. Nobody is even warning where this destructive decision is
leading. Governments ostensibly representing "free market" philosophy
are acting as the lender of last resort - not to households and business
non-financial debtors, and not to wipe out the debt overhang in a Clean
Slate, but to subsidize the excess of financial claims over and above
the economy's ability to pay and the market value of assets pledged as
collateral.

This attempt is necessarily in vain. No amount of money can sustain the
exponential growth of debt, not to mention the freely created credit and
mutual gambles on derivatives and other financial claims whose volume
has exploded in recent years. The government is committed to "bailing
out" banks and other creditors whose loans and swaps have gone bad. It
remains in denial with regard to the debt deflation that must be imposed
on the rest of the economy to "make good" on these financial trends.

Here's why the plan for the government to recover the money is whistling
in the dark: It calls for banks to "earn their way out of debt" by
selling more of their product - credit, that is, debt. Homeowners and
other consumers, students and car buyers, credit card users and their
employers - the "taxpayers" supposed to be helped - are to pay the
repayment money to the banks, instead of using it to purchase goods and
services. If they charge only six per cent  per year, they will extract
$93 billion in interest charges - $42 billion to pay the Treasury for
its $700 billion, and another $51 billion for the Federal Reserve's $850
billion in "cash for trash" loans.

If you are going to rob the government, I suppose the best strategy is
simply to brazen it out. To listen to the mass media, there seemed no
alternative but for Congress to ram the plan through just as Wall Street
lobbyists had written, to "save the market from imminent meltdown",
refusing to hold hearings or take testimony from critics or listen to
the hundreds of economists who have denounced the giveaway.

Hubris has reached a level of deception hardly seen since the 19th
century's giveaways to the railroad barons. "We didn't want to be
punitive",  Paulson explained in a Financial Times interview, as if the
only alternative was an enormous gift. Europe did not engage in any such
giveaway, yet he claimed that England and other European countries
forced his hand by bailing out their banks, and that the Treasury simply
wanted to keep US banks competitive. Wringing his hands
melodramatically, he assured the public on Monday that "We regret having
to take these actions". Banks went along with the pretense that the
bailout was a worrisome socialist intrusion into the "free market", not
a giveaway to Wall Street in the plan drawn up by their own industry
lobbyists. "Today's actions are not what we ever wanted to do",  Paulson
went on, "but today's actions are what we must do to restore confidence
to our financial system". The confidence in question was a classic
exercise in disinformation - a well-crafted con game.

Paulson depicted the government's purchase of special non-voting stock
as a European-style nationalization. But government's appointed public
representatives to the boards of European banks being bailed out. This
has not happened in America. Bank lobbyists are reported to have
approached Treasury to express their worry that their shareholdings
might be diluted. But the Treasury-Democratic Party plan invests $250
billion in government credit in non-voting shares. If a recipient of
this credit goes broke, the government is left the end of the line
behind other creditors. Its "shares" are not real loans, but "preferred
stock". As  Paulson explained on Monday: "Government owning a stake in
any private US company is objectionable to most Americans - me
included". So the government's shares are not even real stock, but a
special "non-voting" issue. The public stock investment will not even
have voting power! So the government gets the worst of both worlds: Its
"preferred stock" issue lacks the voting power that common stock has,
while also lacking the standing for repayment in case of bankruptcy that
bondholders enjoy. Instead of leading to more public oversight and
regulation, the crisis thus has the opposite effect here: a capitulation
to Wall Street, along lines that pave the ground for a much deeper debt
crisis to come as the banks "earn their way out of debt" at the expense
of the rest of the economy, which is receiving no debt relief!

Paulson shed the appropriate crocodile tears on behalf of homeowners and
the middle class, whose interest he depicted as lying in ever-rising
housing and stock market prices. "In recent weeks, the American people
have felt the effects of a frozen financial system", he explained. "They
have seen reduced values in their retirement and investment accounts.
They have worried about meeting payrolls and they have worried about
losing their jobs." He almost seemed about to use the timeworn widows
and orphans cover story and beg Americans please not to unplug Granny
from her life support system in the nursing home. We need to preserve
the value of her stocks, and help everyone retire happily by restoring
normal Wall Street financial engineering to make voters rich again.

European executives who steered their banks into the debt iceberg have
been fired. England wiped out shareholders in Northern Rock last summer,
and more recently Bradford and Bingley. But in America the culprits get
to stay on. No bank stockholders are being wiped out here, despite the
negative equity into which the worst risk-taking banks have fallen or
the prosecutions brought against them for predatory lending, consumer
fraud and related wrongdoing.

Government aid will be used to pay exorbitant salaries to the executives
who drove these banks into insolvency. "Institutions that sell shares to
the government will accept restrictions on executive compensation,
including a clawback provision and a ban on golden parachutes",  Paulson
pretended - only to qualify it by saying that the rule would apply only
"during the period that Treasury holds equity issued through this
program". The executives can stay on and give themselves the usual
retirement gifts after all, prompting Democratic Congressman Barney
Frank  to complain about how weak the Treasury restrictions are.
"Compensation experts say that the provisions, though politically
prudent to appease public anger, will probably have little real impact
on how financial executives are paid in coming years. They predict banks
will simply pay higher taxes and will find other creative ways of paying
their executives as they see fit. Some say there could even be a sudden
surge in compensation as soon as the government program ends, in a few
years, leading to eye-popping numbers down the road ... When Congress
limited the tax deductibility of cash salaries to $1 million, for
example, it simply led to an explosion in stock options used as
compensation and even higher total payouts."

And speaking of stock options, the government shortchanged itself here
too, despite its promises to ensure that it will shares in the gains
when banks recover. Senator Schumer went so far as to assure voters that
"under any capital injection plan that Treasury pursues, dividends must
be eliminated, executive compensation must be constrained, and normal
banking activities must be emphasized". This was mostly hot air. England
and other countries have insisted that banks not pay dividends until the
government is reimbursed. The idea is to avoid using public money to pay
dividends to existing shareholders and continued exorbitant salaries to
their mismanagers! But the terms of the US bailout is made simply call
for banks not increase their dividend payouts - a policy they most
likely would follow in any case in view of their earnings crunch.

Schumer verged on the ridiculous when he proclaimed: "We must operate in
the same way any significant investor operates in these situations -
when Warren Buffett invested in Goldman Sachs and General Electric in
recent weeks, he demanded strict, but not onerous terms. The government
must be similarly protective of taxpayer interests." But  Buffett
obtained a much better deal for his $5 billion investment in Goldman
Sachs, including warrants to buy its stock at a price below the going
price when he helped rescue the company. Likewise in England, the
government took stock ownership at low prices before the bailout, not at
higher prices after it! But instead of exercising its warrants at the
depressed prices where bank stocks stood at the time Paulson detailed
the bailout terms, the US Treasury would be able to exercise its
warrants (equal to fifteen per cent of its investment) only at prices
that were to be set after the banks had time to recover with the
Treasury's aid. Existing stockholders thus will benefit more than the
government - which is why bank stocks soared on news of the bailout's
terms. So the government does not appear to be a good bargainer in the
public interest. In fact,  Paulson may be guilty of deliberate scuttling
of the public interest that, as Treasury Secretary, he is supposed to
defend.

Given his financial experience,  Paulson had to know how deceptive his
promise was in placing such emphasis on the government's stock options,
the sweetener that has made so many executives fabulously wealthy:
"taxpayers will not only own shares that should be paid back with a
reasonable return, but also will receive warrants for common shares in
participating institutions", he explained. But the "reasonable return"
is only five per cent annually, just above what the government typically
has to pay, not a rate reflecting anything like what the "free market"
now charges Wall Street firms with negative equity. The government's
$250 billion in preferred stock will carry a dividend that rises to nine
per cent after five years, with no limit on how long the loan may be
outstanding.

All I can say is, Wow! If only homeowners could get a similar break: a
reduction in their interest rate to just five per cent, rising to a
penalty rate of just nine per cent - without the heavy penalties and
late fees that Countrywide/Bank of America charges! By contrast, German
banks that receive a public rescue will pay "a fee of at least two per
cent annually of the amount guaranteed. The UK will charge 0.50 per cent
plus the cost of default insurance on a bank's debt". A British banker
wrote to me that "the government offers twelve per cent preference
shares, and ordinary shares at an absolutely huge discount to asset
value to provide the cash". But the US Government agreed to exercise its
stock options at the post-bailout price, not the price prior to rescue.
It even gives up most of these options if the banks do repay the
Treasury's loan. On the excuse of encouraging private Wall Street
investors to replace government "ownership" and "intrusion" into the
marketplace, banks can "cut in half the number of common shares the
government will eventually be able to purchase. That can be done if a
bank sells stock by the end of 2009, and raises at least as much cash as
the government is investing."

These bailout terms suggest that what Wall Street wants is pretty much
what colonialist Britain achieved for so many years in India and Africa:
puppet leaders with an imperial political advisor, in America's case a
Secretary of the Treasury and a vice-regent as head of the Federal
Reserve System. But what the rest of the economy needs is a genuinely
free leader able to impose better and more equitable laws to write down
debt, not build it up and bail out more bad loans. Within the present
administration itself, Sheila Bair, head of the Federal Deposit
Insurance Corporation, complained in a Wall Street Journal interview
that she didn't understand "Why there's been such a political focus on
making sure we're not unduly helping borrowers but then we're providing
all this massive assistance at the institutional level". She "described
painstaking efforts made by lawmakers in crafting the federal Hope for
Homeowners program to make sure it limited resale profits for borrowers
who received affordable home loans", by giving the government a share of
the rising sales price.

The imbalance between creditor demands and debtors' ability to pay is
indeed the problem.  Paulson claimed in his Monday address that he
needed to get to the root of the economic problem. But in his view it is
simply that the banks "are not positioned to lend as widely as is
necessary to support our economy. Our goal is to see ... that they can
make more loans to businesses and consumers across the nation". As he
explained in his Financial Times interview, "for the first time you have
seen an action that is systematic, that is getting at the root causes"
of the financial crisis. But his perspective is remarkably narrow. It
denies that the problem is debt above and beyond the ability of the
economy at large to pay, and higher than the market price of property
and assets pledged as collateral.

Creating a system for the banks to "earn their way out of debt" means
creating yet more interest-bearing debt for the economy at large.
Mortgage loans are what is supposed to restore high housing prices and
office costs - precisely what caused the debt meltdown in the first
place.  Despite  Paulson's and Ms Bair's characterization of the present
crisis as merely a liquidity problem, it is really a debt problem. The
volume of real estate debt, auto debt, student loans, bank debt, pension
debts by municipalities and states as well as private companies exceed
their ability to pay.

Shortly after  Paulson's Monday speech a Dutch economics professor, Dirk
Bezemer, wrote me that: "In my thinking I liken it to a Ponzi game where
in the final stages the only way to keep things going a bit longer is to
pump in more liquidity. That is a solution in the sense that it restores
calm, but only in the short run. This is what we now see happening and -
despite the ten per cent stock market rally today - I am still bracing
myself for the inevitable end of the Ponzi game - suddenly or as a long
drawn out debt deflation". He went on to explain what he and other
associates of mine have been saying for many years now: "The actual
solution is to separate the Ponzi from the non-Ponzi economy and let the
pain be suffered in the first part so as to salvage what we can from the
second. This means bailing out homeowners but not investment banks, et
cetera. The qualification to this general approach is that those Ponzi
game players whose demise is a real 'system threat' need support, but
only with punitive conditionalities attached. And just like Third World
countries, they won't have a choice.

The problem of "debt pollution" is being "solved" by creating yet more
debt, not by reducing its volume. Neither the Treasury nor Congress is
helping to resolve this problem. The working assumption is that giving
newly created government debt to the banks and Wall Street will lead to
more lending to re-inflate the real estate and stock markets. But who
will lend more to the one-sixth of US homes already said to have fallen
into negative equity territory? As debt deflation eats into the domestic
market for goods and services, corporate sales and earnings will shrink,
dragging down stock prices. Wall Street is in control, but its policies
are so shortsighted that they are eroding the underlying economy - which
is passing from democracy to oligarchy, and indeed it seems to a
bipartisan financial kleptocracy.

_____

Michael Hudson is a former Wall Street economist He was Dennis
Kucinich's Chief Economic Advisor in the recent Democratic primary
presidential campaign, and has advised the US, Canadian, Mexican and
Latvian governments, as well as the United Nations Institute for
Training and Research (UNITAR). A Distinguished Research Professor at
University of Missouri, Kansas City (UMKC), he is the author of many
books, including Super Imperialism: The Economic Strategy of American
Empire (new edition, Pluto Press, 2002) He can be reached via his
website, mh at michael-hudson.com

http://www.counterpunch.org/hudson10202008.html

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