Tuesday, December 9, 2008

Are the bailouts and stimuluses only postponing the inevitable?

I am concerned about the turn the economic debate is taking. First it was bailout of the financial markets, then came the fiscal stimulus for the real economy, and now comes the corporate sector. Even the most ardent adovcates of free market would not dispute that all the major financial institutions and the bleagured Big Three Detroit automakers have been guilty of greed, reckless investment decisions, and above all bad management. A worrying impression is gaining ground that such interventions can actually save the economy and its agents from facing upto the consequences of their sins, and can be a substitute for real belt-tightening.

The central dilemma facing policy makers and administrators across the world about what to do next, arises from the legacy of the Great Depression and the lost-growth decade of Japan in the nineties. It is felt that if Government is not aggressive enough in its interventions - bailouts, recapitalizations, and fiscal stimuluses - there is a very strong chance that the economy will slip into a long and protracted depression or stag-deflation or liquidity trap. Now the fundamental issue is who knows how much intervention is "enough"?

The moral hazard created by the consequences of the Lehman bailout and the "too-big-to-fail" arguements are being dusted up from the wood-works to justify these interventions. Paul Krugman feels that nothing could be worse than failing to do what's necessary out of fear that acting to save the financial system is somehow "socialist".

Having become used to living off bubbles, a generation is now unwilling to accept the inevitability of a downturn. So every downturn has to be hurriedly compressed and rolled into the smallest possible period, as opposed to be ameliorated or cushioned, through Government backed financial market interventions and economic re-engineering. Quick-fixes and band-aid solutions become the order of the day. When the going is good, Government is a paraiah and regulations are seen as detrimental to innovation and economic growth. However, at the slightest indication of a slowdown, Government gets re-incarnated as the saviour and the search for a new bubble starts.

Consumers and businesses do not have the patience or faith in systemic solutions. Nobody wants to face upto the reality that you cannot live on booster doses of steriods forever. The ailing economy, like the patient, needs treatment to clean off the excesses and distortions that have built up during the years of "irrational exuberance". Bailouts, rate cuts and stimuluses can at best be analgesics to attenuate the pain and downturn.

Over-leveraged financial institutions, insolvent banks, investors left with illiquid investments worth virtually nothing, homeowners with negative equities (mortgages exceeding home values), businesses with pension and other liabilities papered over by the illusion of comfort provided by Mark-to-Market (MTM) accounting, consumers with massive consumption debts, citizens with negative savings, and an economy relying on foreigners to finance itself, cannot be saved with mere stimuluses and bailouts. The "mother of all Ponzi schemes" has to be carefully dismantled. It does not require any great wisdom to know that all the losses will have to get squared up on each (and all) of the balance sheets for normalcy to be restored.

A period of belt tightening is necessary to re-build the foundations for a sustained period of future growth. A crash landing is inevitable, and the quest should be to make it as soft as possible! The extent and degree of downturn can be controlled, to atleast some extent, by appropriate Government intervention. Such interventions should invariably seek to minimize incentive distortions and keep the costs to the taxpayers at a minimum.

In markets characterized by information assymetry and beset with problems in locating and pricing risks, any selective (as opposed to universal, which is impossibel, given the costs involved) bailout is likely to fail. Such bailouts, especially in the maddeningly compex financial markets, are most certainly likely to be gamed by the same enterprising and greedy investors and borrowers, whose buccaneering spirit brought about the crisis in the first place. Further, the moral hazard ramifications of such bailouts, especially given the importance of "rational expectations" in financial markets, can be catastrophic for long-term good of the economy.

With bailout and stimulus calls flying in all directions, Ken Rogoff cautions us about the need to not lose sight of the underlying problems and advocates a systemic solution which revolves around a moderate dose of inflation to unwind the "epic debt morass". He is spot on in writing, "Securitisation, structured finance and other innovations have so interwoven the financial system's various players that it is essentially impossible to restructure one financial institution at a time". Despite the potential consequences and the probelms inherent in escaping an inflation spiral, moderate inflation (6% for two years, in his opinion), by debasing the currency reduces the real debt burden and values of real estate, can help weed out some of the excesses built up during the bubble years. He feels that fear of inflation, when viewed in the context of a possible global depression, is like "worrying about getting the measles when one is in danger of getting the plague".

Many of the contentions of the aggressive inerventionists have a circular ring to it. It is argued that the need of the hour is to sustain consumption and therefore any effort to increase savings will be counter-productive. It is hoped that the economy will soon recover (on the back of another bubble!), and then we can start saving again...! Similar logic is used to oppose any attempts to initiate efforts to regulate the financial markets now. "Let us do it after the economy stabilizes", goes the arguement. The proponents of this line of logic says that any effort to act tough now, will only upset the apple-cart, distort expectations and force the economy into even deeper turmoil.

I am not, for one moment, arguing against all forms of bailouts and stimuluses. Nor am I in favor of letting the market evolve out a solution to the crisis. Nor should we ignore the importance of market expectations. But we should not indulge in knee-jerk reactions that oscillate to the other extreme of suffocating regulations and excessive thrift. I am only suggesting that the government interventions to fix the failures can at best be palliatives, a long and painful period of convalescence is inevitable, reforms and restructuring should start now in gradual and phased manner, and systemic as opposed to selective solutions are the better (among all uncertain) remedies.

When the going was good everyone threw caution to winds, and lived well beyond their means in the mistaken belief that the good-times would last forever! The high-testosterone growth days are over and the pay-back time has come, and we need to face upto this reality! The fundamental tenet of life - anything that goes up has to come down - cannot be wished away. The spectacular growth of the past two decades are being balanced out by equally spectacular declines of today.

1 comment:

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