Even if the $700 Billion Wall Street Bailout, together with the $Trillion or more pumped by the Federal Reserve into Wall Street banks and their counterparties, succeed spectacularly in rescuing the economy from financial meltdown, even if they succeed in generating +GDP and economic recovery for years to come -- in short, even if they succeed beyond just about anyone's wildest expectations -- they will almost certainly still work harm on the average American household.
The political bailout of Wall Street will do harm because it is the biggest single example of "trickle down" economics in our nation's history, a particularly toxic "trickle" because the inflation it creates will affect prices long before the cash wends its way from fatcat corporate cronies to average consumers. This is the problem of "first/early receivers" vs. "late/non-receivers" of new money or credit. How it applies to the Wall Street Bailouts I will explain below.
First, we need to explore briefly why the economy of the last decade was bound to collapse.
The asset bubble economy of the last decade was aptly described by the late heterodox economist named Hyman Minsky, who described how easy credit can get out of control. When most orthodox, neoclassical economists generally believed in the efficiency of markets, Minsky took the opposite view: that markets tended towards excess and upheaval. If you haven't heard before, here is a synopsis of his theory:
His main contribution to economics was a model of asset bubbles driven by credit cycles. In his view periods of economic and financial stability lead to a lowering of investors’ risk aversion and a process of releveraging [my note: releveraging = increasing debt financing]. Investors start to borrow excessively and push up asset prices excessively high. In this process of releveraging there are three types of investors/borrowers. First, sound or “hedge borrowers” who can meet both interest and principal payments out of their own cash flows. Second, “speculative borrowers” who can only service interest payments out of their cash flows. These speculative borrowers need liquid capital markets that allow them to refinance and roll over their debts as they would not otherwise be able to service the principal of their debts [my note: in other words, increasing asset prices, e.g., house prices]. Finally, there are “Ponzi borrowers” cannot service neither interest or principal payments [my note: this is referred to as "Ponzi finance"]. They are called “Ponzi borrowers” as they need persistently increasing prices of the assets they invested in to keep on refinancing [my note: interest as well as principal of] their debt obligations.
This process perfectly describes the stock mania of the 1920s, the "dot-com" mania of a decade ago, and the housing bubble earlier this decade. The point at which the bubble begins to burst has become known as the "Minsky moment":
It refers to the time when over-indebted investors are forced to sell even their solid investments to make good on their loans, sparking sharp declines in financial markets and demand for cash that can force central bankers to lend a hand.
At its core, the Minsky view was straightforward: When times are good, investors take on risk; the longer times stay good, the more risk they take on, until they've taken on too much. Eventually, they reach a point where the cash generated by their assets no longer is sufficient to pay off the mountains of debt they took on to acquire them. Losses on such speculative assets prompt lenders to call in their loans. "This is likely to lead to a collapse of asset values," Mr. Minsky wrote.
When investors are forced to sell even their less-speculative positions to make good on their loans [my note: because no counterparty will bid at the formerly high asking prices], markets spiral lower and create a severe demand for cash. At that point, the Minsky moment has arrived.
Minsky is generally described as an adherent to the heterodox Austrian Business Cycle Theory. That school of economics has problematic and unnecessary policy biases and prejudices, specifically, applying all blame on government actions generally and central bank actions particularly; and ignoring the actions of speculators. Nevertheless it has a particularly apt view of the role created by central banks in the genesis of asset bubbles by allowing the creation of too much easy money and credit (warning: pdf). Here, we come to the core of the problem -- the direct recipients of the easy money gain directly as well; those who receive the easy money late or not at all face asset and other prices already inflated by the paper money:
Money creation might be of gain for the receiver of the new money, who receives it without a productive effort. The newly created money spreads through the economy as the first receiver spends it on particular goods, bidding up prices and, thus, raising the revenue of the sellers of those goods. But it is at the expense of those who are the ones that are the last to receive part of the new money, while at the same time have to pay higher prices. And then there is the risk of bank failures, a risk everybody will be affected by. Hence, we see that the bankers, the merchants and the government are the first to benefit by the creation of fiduciary media. But this also means that it is at the expense of other parts of the population. And at a crisis, everybody is likely to lose.
Let me explain by way of a hypothetical example. Let's imagine a simple economy of necessities, which cost $250; widgets, which cost $2500; and luxury chatchkis, which cost $250,000. Suppose we create $500,000 money or credit out of thin air and give it to one selected individual or business. They can now buy 2 more luxury chatchkis, 200 more widgets, or 2000 more necessities, or any combination thereof. As demand increases but supply cannot keep pace, inflation appears. Meanwhile the spent or invested money diffuses through society. By the time a later receiver might receive $10,000 of the newly created money or credit, necessities might cost $275, widgets $2750, and luxury chatchkis $275,000. This later receiver must spend $260,000 of their prior wealth on the chatchki --i.e., more than their new money. Or they could purchase 3 more widgets or 36 more necessities, or some combination thereof. By the time we get to a very late receiver, who might receive $250 of the new money or credit, prices might have gone up to $300 for necessities, $3000 for widgets, and $300,000 for luxury chatchkis. This late receiver has an actual loss: the amount of money they have received is less than the price increases for even necessities
A real world example of how this problem of first/early receivers of easy money and credit vs. late/non-receivers played out in the housing bubble was well-described in 2004 by Frank Shostak:
the entire banking system is built around the ongoing support provided by the Fed's monetary pumping.... [D]ue to the Fed's loose monetary policies we [ ] have undesired symptoms regarding the housing market.
As a result of loose monetary policy, which aims to "protect" the financial system, financial institutions always receive the new money first. Obviously this gives rise to an expansion of activities of the earlier receivers of money. An early receiver of money can afford, so to speak, to become more of a risk taker and undertake various risky activities.
In reality however, the new money leads to an exchange of nothing for something. It leads to the enrichment of the earlier receivers and to the impoverishment of the late or nonreceivers of the new money. Money and credit out of thin air leads to a redistribution of real wealth.
There is no doubt that the spreading of risk across an economy as a whole is much better than having it concentrated in a few large institutions like Fannie and Freddie. So when Greenspan complains about this state of affairs he shouldn't blame the GSE's for it but rather the Fed's loose monetary policies which prevents an even distribution of risk.
In fact, the uneven risk spread is the structural manifestation of the loose monetary policies of the Fed. This is because the first receivers of money can undertake larger risks while the late receivers, on account of their resulting impoverishment, can only afford to take less risk. This is the source of the 'skew' that leads to the resulting imbalance.
Greenspan is absolutely correct that once the size of Fannie's and Freddie's assets and debts become too large there is the risk of a financial accident. However, this accident never emerges out of the blue, but rather as a response to and effect of the erosion of the pool of real savings brought about by the loose monetary policies of the central bank. The erosion of the pool of funding undermines real growth and the formation of real wealth, which in turn triggers the burst of the bubble. With real wealth falling people's capacity to support their liabilities diminishes.
It seems to us however, that Greenspan is already preparing the public for the likely bust of the housing market. This in turn means that he is likely to fight off the burst of the housing bubble by an aggressive monetary pumping. However, if the pool of funding is already in trouble, which is most likely the case, given the present level of indebtedness in the economy and shrinking savings, then monetary pumping won't be able to "revive" the economy.
There are a lot of similarities in this regard with Japan in the 1980's and early 1990. During that period the trend-adjusted price index followed an accelerating growth path. A major reversal in this growth path took place after 1990 with the trend adjusted house price index plunging to -350 in Q3 2003 against a peak of +640 in Q3 1990.
From the vantage point of 5 years later, we can see that Shostak's analysis was incorrect in only one respect: Alan Greenspan retired, and so it is Ben Bernanke who is "fighting the burst of the housing bubble by an aggressive monetary pumping", aided and abetted by Congress and the Treasury department. This new "monetary pumping" shows up dramatically in this graph of the amount of money in circulation, called the monetary base:
Yet the gifting of Wall Street and its counterparties directly with $Trillions creates the exact same first/early receiver vs. late/non-receiver problem as with the gifting of fog-the-mirror credit to purchase houses: this is real money, and it is going into concentrated hands. Those parties can -- indeed are intended to -- use that cash in an effort to prop up the value of assets they hold. That money will only slowly spread into the general economy (remember how we were told in September that we needed to rescue Wall Street so that they would continue to lend to Main Street businesses?), by way of certain business, and lastly of all, if at all, to the average American household -- who will be faced with even more inflated values for assets compared with their households' purchasing power.
In summary and conclusion, even if the various Wall Street bailouts succeed, they will continue and amplify the trend that has been in place for 30 years: creating yet a wider gulf between the wealthy and the financially connected, and the average American and his/her family, rewarding the former while punishing the latter, who already during this last business cycle, for the first time since the Great Depression, saw their real wealth and income decline.