Fundmastery Blog

Kurt Brouwer December 23rd, 2008

The latest round in the bailout bonanza is the ‘loan’ that was just announced for GM and Chrysler.  Those companies are running out of cash so the Bush administration decided to give them enough to get through the next few months, which conveniently lets the long-term issue get pushed into the Obama administration. This New York Times piece illustrates the point [emphasis added]:

The emergency bailout of General Motors and Chrysler announced by President Bush on Friday gives the companies a few months to get their businesses in order, but hands off to President-elect Barack Obama the difficult political task of ruling on their future.

The plan pumps $13.4 billion by mid-January into the companies from the fund that Congress authorized to rescue the financial industry. But the two companies have until March 31 to produce a plan for long-term profitability, including concessions from unions, creditors, suppliers and dealers.

In February, another $4 billion will be available for G.M. if the rest of the $700 billion bailout package has been released…

As we take a look at various proposals for bailouts to get our economy rolling again, it’s important that we consider the lessons of history.  That is, when financial shocks, panics or crises struck in the past, what happened?  What solutions were tried and how did they perform?  Ideally, we would respond effectively when bad things arise, but unless we learn from history, we are doomed to repeat its mistakes.

This article is from Reason Online, which is an online and print publication that seeks to promote free minds and free markets.  This piece takes a look at what happened in Japan during the 1990s [emphasis added]:

Return of the Living Dead (Reason Online, December 17, 2008, Anthony Randazzo)

Today, our economy is plagued by struggling markets, liquidity concerns, and frozen credit. Twenty years ago, Japan faced nearly the exact same problems. Then they fell prey to the zombies.

After Japan’s asset bubble burst in the late 1980s, their economy took a sharp downturn, prompting government officials to try bailing out banks and investing in infrastructure, much like the activity and proposals floating around America today. The results were terrible.

With the government propping up poor business models rather than allowing further job losses, firms wound up operating over the long-term without making a profit or adding any value to society. Their utter lack of vitality earned these perpetual money-leaching entities the moniker “zombie businesses.” And unless American policymakers understand the failures of the Japanese response, we will suffer the same zombie fate.

Trying to keep failing businesses alive has already been tried.  Yet, into the breach we go.  Fortunately, we are better about letting companies fail than the Japanese were back then, but clearly a company like Chrysler simply is not viable on its own.  Rather than bailing it out (second time’s the charm?), we might want to consider something else such as a forced merger or bankruptcy.

Banks in Japan were caught up in very aggressive real estate valuations just are our banks were over the past few years.  Again, this is not exactly the first time this sort of thing has happened.  At the most basic level a large part of this financial crisis is that real estate valuations got too high.

I remember in the late 1980s being told that the value of real estate in Tokyo exceeded that of the value of California real estate.  At the time, I remember thinking that I would not trade California for Tokyo and, apparently, that comparison became widespread.  Tokyo real estate — along with Japanese real estate in general — fell in value, while California real estate appreciated. Now, in an ironic twist, the American real estate market is tumbling because it too was overpriced.

Remember that the Japanese asset bubble and the American housing bubble have eerily similar origins. Both were driven by aggressive behavior in financial institutions. Wall Street, which sought new ways to get quality returns on investments, turned to securitizing everything it could and issuing unwise subprime mortgages—all highly valued by the rating agencies, and all highly misunderstood. The Japanese aggressively pursued real property assets to the point where the inflated values were unsustainable.

In both cases, the rapid rise in rates of return led to over confidence. In Japan, it is said that the market experienced a sense of euphoria, and poor investments were driven by excessively optimistic expectations of future economic development.

…Given these similarities, U.S. officials should take a careful look at how Japan’s response to the crisis lead to the more than ten years of recession and stagnation known as “the lost decade.” We do not want to duplicate Japan’s mistakes.

First mistake. The Bank of Japan tried to ease economic pains during their downturn through the 1990s by loaning large amounts of money to businesses. However, such attempts to recapitalize the market were counteracted by underlying management problems endemic to the dying firms.

According to Shigenori Shiratsuka, Deputy Director and Senior Economist at the Bank of Japan, even though firms became unprofitable, the government still encouraged lending to them to prevent losses from materializing. There were heavy concerns about a failing firm increasing unemployment.

The intense lobbying from special interest groups representing various sectors of the Japanese economy further perpetuated these ill-fated loans, funneling additional funds to zombie businesses. As Shiratsuka notes, “under such circumstances, loans to unprofitable firms become fixed and funds are not channeled to growing firms, holding down economic activity.”

Unfortunately, we’re seeing a disturbingly similar trend in America today, as the cost of bailing out AIG continues to rise and Congress moves forward with a bailout for the auto industry. The $8.4 trillion (and growing) cost of “saving” firms deemed too big to fail completely ignores the inefficiency and poor quality of the very businesses the government is trying to save.

Second mistake. With all those loans, the Japanese government was simply too integrated into the market to have adequate incentives to create the right policies. Daniel Okimoto, former director of the Asia-Pacific Research Center, points out that the interests of Japan’s economic bureaucracies, such as the Ministry of Finance, became interdependent with the banking industry.

Moreover, government officials suppressed data revealing the intense scope of the economic malaise, all while regulations were developed with government interests in mind. Transparency and public accountability were basically nonexistent.

America now finds itself in the same position. The Treasury has taken equity stakes in many major financial institutions and insurance companies, not to mention the pending partial nationalization of Detroit’s Big Three. This has created a myriad of conflicting interests as well as vast potential for fraud.

Consider that while the bulk of what the Treasury, FDIC, and Federal Reserve have spent has been tracked, it’s far from clear what the banks and other institutions have done with that money. Without this information, it’s difficult to measure whether the $8.4 trillion has been effective. Fighting fraud is equally difficult.

Third mistake. The length of Japan’s asset deflation, recession, and liquidity struggles has been blamed largely on the lack of foresighted policies and political leadership. Politicians bent on retaining their power took action that sought to solve the present day concerns, such as infrastructure projects, without regard to their long-term effects. As a result, economic growth was not sustained.

America suffers from a similar vision problem. Intent with avoiding any semblance of economic pain, federal officials have thrown moral hazard and laissez-faire principals to the wind. Creative destruction has been rejected, despite long historical proof that it is the best way for an economy to grow.

Fourth mistake. Japan tried to climb out of its economic mess by raising taxes and cutting interest rates. Okimoto cites a series of policy mistakes in a report on Japan’s economic stagnation that includes a consumption tax hike, business taxes, and heavy-handed reliance on interest rate cuts that reduced investment incentives.

President-elect Obama has backed down temporarily on his oil industry windfall profits tax and his promise to end the Bush tax cuts. But he still plans on letting the Bush tax cuts expire in 2010 and has set an arbitrary cap of $80 per barrel as the most profit oil companies can make before a windfall tax.

Neither Obama nor Congress has seriously considered cutting business taxes, cutting capital gains taxes, or creating an investment tax holiday. Any of these would encourage capital investment and the growth of businesses, thereby spurring on an economic recovery. Meanwhile, the Fed continues to slash interest rates with the goal of encouraging lending today, thereby limiting investment rates of return over the long-term.

Fifth mistake. With the Japanese government enabling lending to zombie businesses, taking cash away from productive ventures, and passing tax laws and other regulations that did not promote growth, the private sector was actively discouraged from investing.

Japan’s economic growth during the 80s was due in large part to consumption growth and heavy capital investment. However, during the 90s, that money dropped-off as savings increased due to uncertainty, leading to a sharp drop in demand that further hurt prospects for recovery. The same problems contributed to the flight of foreign capital from Japan as well.

To counteract the lack of private investment, the Japanese government turned to large-scale infrastructure programs. They built roads, bridges, and airports, all with the goal of creating jobs and saving the economy. But it didn’t work. Public debt skyrocketed (it is now higher than GDP), unemployment doubled, and the economy remained stagnant.

While private sector investment isn’t totally stalled in America today, there is great uncertainty about what the government will do next, whether taxes will increase, and what future rates of return will be considering the Fed’s rate-slashing binge. Foreign investment dollars are slowing as well, partially due to the global economic dip, but also because of errant policy.

To make matters worse, Obama is planning a Japanese-styled infrastructure investment project, with the goal of restarting the economy and creating 2.5 million jobs. But the plans are unlikely to encourage long-term economic growth, the jobs are not sustainable, and the spending will increase national debt…

During Japan’s great stagnation, the country employed several of the techniques we are trying right now.  Japan tried to grow its way out of economic recession by investing in infrastructure and creating government jobs, which is what President-elect Obama seems to favor. For example, Obama made a proposal recently to create 2.5 million jobs.  The price tag? $280,000 per job.  Yikes.  Give me $280,000 per job and I could create them too.

If these ideas did not work in Japan — and they did not bring Japan out of its slump for the entire decade of the 1990s — is there any reason to thinks similar techniques will work well for us?

This piece from the Washington Post spells out some of the problems with government-led infrastructure spending.  The projects undertaken may make political sense, but not economic sense.  In Japan’s case, it built an airport and a big highway that few use.  In addition, government spending is notorious for cost overruns, waste and fraud [emphasis added]:

The Perils of a Cement Tsunami (Washington Post, December 10, 2008, Amity Shlaes)

…Japan put up the longest suspension bridge in the world. Airports? Kansai International, yes, on an artificial island, but also local fields such as Ibaraki Airport near Mito. Roads? Japan built new streets and highways, including the famous New Tomei Expressway. For biotech and telecommunications, Japan poured out the subsidies.

When one plan proved insufficient, another was begun. In 1999, Japan announced a scheme to create 700,000 jobs, much as Obama recently announced a plan to create or save 2.5 million jobs. As with the U.S. example, politicians were precise about the number of new jobs . . . and less precise about their cost. Between 1992 and 2000, the Japanese launched 10 stimulus packages that included public works. The Land of the Rising Sun became the Construction State. Other worthy issues, such as consistent tax reform, lagged. In fact, fiscal reform overall was postponed. After the 1995 Kobe earthquake claimed thousands of lives, the focus on infrastructure was reinforced.

Some of these projects were valuable, some risible. As Bloomberg News recently reported, Japan Airlines Corp. and All Nippon Airways, which run nearly all flights within Japan, don’t even expect to fly to the Ibaraki Airport. With the Japanese turning to trains, the New Tomei Expressway seemed a waste.

The spending yielded painfully little for the rest of the economy. The Nikkei stayed down. The country’s standard of living failed to keep pace with the rest of the world’s. The average Japanese’s purchasing power had been moving closer to that of the average American, Ronald Utt of the Heritage Foundation has noted. But in the 1990s the Japanese saw few advances. The gap between America and Japan widened again.

…Worst, though, was the failure on jobs. Unemployment fell in many nations in the 1990s. In Japan, the ’90s were a lost decade: The unemployment rate more than doubled and surpassed the U.S. rate — an unthinkable occurrence just a few years earlier…

With all the bailout proposals and other initiatives, we seem to be saying our economy cannot operate without the heavy hand of government.  The conundrum of course is that government bailouts cost money.  And taxpayers have to cough up the dough. Instead of a government-run program, why not free Americans to make their own decisions about priorities?  Why not cut income taxes for example or payroll taxes or capital gains taxes?  With lower taxes, I believe we would see a much faster rebound than we will if government taxes us and then decides how the money should be spent.

Harvard economics professor, Greg Mankiw elaborates on this at his blog.  First, he posts an AP piece and then comments on it:

An AP story reports:

Obama advisers, including Christina Romer and Lawrence Summers, have been contacting economists from across the political spectrum in search of advice as they assemble a spending plan that would meet Obama’s goal of preserving or creating 2.5 million jobs over two years….Only one outside economist contacted by Obama aides, Harvard’s Greg Mankiw, who served on President Bush’s Council of Economic Advisers, voiced skepticism about the need for an economic stimulus, transition officials said.

[Mankiw writes] …Skepticism, rather than unequivocal opposition, is the right word. When contacted, I said the same things I have been saying on this blog: that monetary policy is not out of ammunition, and that tax cuts are potentially more potent than spending increases. I could have added that a spending-based stimulus to address the current short-term crisis might lead to a long-term increase in the size of government, but I doubted that concern would sway Team Obama…

So far, we have enacted roughly $8.7 trillion in bailout proposals.  Now, we are hearing from the President-elect that he plans a $1 trillion economic stimulus program.  If $8.7 trillion did not do the trick, why would anyone think another $1 trillion will?

Just to put those numbers in perspective, here is a great chart that puts this bailout bonanza in perspective with other historical costs:

Source: Voltage Creative

This bailout is absolutely enormous.  By taking this bailout route, I’m afraid we will only delay the economic recovery.  Why would it delay things?  Because higher government spending inevitably leads to either higher taxes or more government debt (see Dark Days for the Golden State). After all, debt requires interest and principal payments and those payments come from one source — taxpayers.  If we keep ratcheting up taxes, we will simply delay economic recovery.

And, just to point out another historical point, raising taxes was done once before in an economic downturn.  And, we all know how that worked out:

Source: Carpe Diem

Higher income taxes were not the only factor that prolonged the Great Depression, but they certainly did not help. The movement for higher income taxes started under the Republican administration of Herbert Hoover.  Franklin Delano Roosevelt just kept it going by raising rates through the war years. Other factors that prolonged and deepened the Depression were barriers to free trade (Smoot Hawley Tariff Act of 1930), a contractionary monetary policy and sharply higher energy prices.

Here is a good description of what we need to pursue going forward.  George Mason University Economist and blogger, Tyler Cowen, gives us his 14 bullet points on the financial crisis.  I actually agree with many of them.  I don’t think he put these in any particular order.  I’ve highlighted those that I think are most important.  My thoughts follow each point:

3. The crisis represents a massive conjunction of both market and governmental failure.

There are those who will try to claim that this is solely a problem of free markets or capitalism that were largely unregulated or recently deregulated.  And, there are those who will say that this is purely a problem of government interference and guarantees in housing markets, credit markets, financial markets i.e. too much regulation.   Neither point of view is sufficient in and of itself to be the cause for the financial crunch we are in.

6. My first choice is to induce and if need be to force more information revelation, identify the insolvent banks, close them up, and give the battle-tested FDIC a much greater role in the whole process.

I too think the FDIC has to play a much more active role in identifying problem banks, helping them get additional capital or helping them get purchased by stronger competitors.  There are useful methodologies dating from the savings & loan crisis that can be dusted off and used again.

7. In the meantime the Fed should not worry much about inflation.

If anyone at the Federal Reserve is worried about inflation right now, they should just give ECB Chairman Trichet a call.  He has been beating the inflation drum for eons and now he finally admits that European interest rates are too high and inflation is not the most important issue Europe faces.

8. The critical deregulatory mistake was allowing excess leverage.  Many deregulations get blamed but in fact contributed little to the problem.

My only quibble with this one is the word deregulatory.  The SEC regulates capital requirements for securities firms and it maintained those, but shockingly, it waived those requirements for five firms — Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch and Morgan Stanley.  It continued to regulate all five, but loosened the regulations considerably. Today, none of those firms exist in their previous forms.  Bear Stearns went under as did Lehman.  Merrill was sold to Bank of America and Goldman and Morgan now fall under commercial bank regulations.  This smacks more of favoritism to these five entities than deregulation.  Nice job SEC.  I’m sure the other brokerage firms are happy they were not given such a poisoned favor.

10. Libertarians are overrating the moral hazard argument, as many equity holders have been wiped out.

Absolutely.  Common stock holders at the five firms mentioned above in number eight have certainly suffered.  The same is true of Fannie Mae, Freddie Mac, AIG, Countrywide, Washington Mutual, Wachovia and so on.

12. I have a long and complicated view on the relevance of Austrian Business Cycle Theory which resists easy summation, but markets could have and should have been more cautious in response to Greenspan’s easy money policies.

After the recession of 2001 and the terror attacks of 9-11, then Fed Chairman Alan Greenspan dropped short-term rates to 1%.  Too low.  And, rates stayed too low for too low.  In hindsight, we should have realized how much that would alter the appeal of leveraged investments.  Right now, interest rates are even lower.  That may be necessary, but it would be very dangerous to maintain such rates for very long.

As Tyler Cowen pointed out though, this financial panic came about through a massive conjunction of governmental and market failure.  Those who are calling stridently for more regulations might want to stop and figure out why existing regulations did not work.  And, those who believe in free markets also have to determine what went wrong.  Why did banks, insurance companies, brokerage firms and many others load up on very risky investments without regard for that four letter word — RISK?

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