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Wednesday, October 1, 2008

Where Did $700 Billion Go?

$700 billion dollars did not vanish into thin air. Some of it was wasted, and some of it wound up in people's pockets. Where did that money go?

A lot of that money was paid out as salaries and bonuses to executives and workers in the financial industry. A lot of that money went to CEOs and insiders. Every single worker in the financial industry also benefited. A typical worker in the financial industry does no real productive work, yet they make nice salaries. A professional trader like to believe he's a brilliant risk-taker, but he's merely helping rake in a massive State subsidy.

Over time, the financial industry receives a massive State subsidy via inflation. The current bust is so severe that an explicit bailout is needed. Even with no explicit bailout, the Federal Reserve could slash interest rates, which would subsidize bank profits. Right now, the Fed Funds Rate is only 2% while inflation is 20%-30%. However, only insiders may borrow at an attractive rate. Individuals may only borrow at a higher rate, or not at all.

The $700 billion bailout is *IN ADDITION* to the massive State subsidy the financial industry already receives.

During the housing boom, a lot of new houses were built. The boom made these investments seem more attractive than they actually were. The investment in housing was speculative. It was not justified by an increase in the population. Some of that $700 billion was wasted building houses that weren't justified by an increase in demand.

The current problem is rather perverse. Individuals are evicted from their houses for not paying their mortgage. At the same time, a lot of houses are empty and can't be sold. A debt contract with a bank is really a no-interest contract. When a bank makes a loan, it literally is printing brand new money and loaning it. The average person must perform actual real work to earn money repay their loan. Individuals will always be the slaves of the bankers, because they don't have the magic money-printing power that banks have. Due to the Compound Interest Paradox, it is statistically guaranteed that some people will be stuck during each economic bust.

Suppose I performed $10,000 of work and put that money in a bank. That money was then used to purchase mortgage bonds. Under normal circumstances, the bank profits on the spread between the rate credited to depositors and the yield on the mortgage bond, times very high leverage ratios. Due to defaults, some of those mortgage bonds are only worth 10% of their face amount. When I want to withdraw my $10,000, there is no reserve of purchasing power or wealth to back my withdrawal. 90% of the wealth I deposited in the bank was squandered.

People deposited money/wealth in banks, but that wealth was squandered. Now, a bailout is needed to make banks' creditors whole. However, this bailout is massively inflationary. The bailout is merely taking money from one group of people and redistributing it to another group of people. The primary beneficiaries of the bailout are financial industry insiders. The bailout allows financial industry insiders to continue their loot and pillage operation.

Under a sound banking system, there would be no boom/bust cycles. Suppose I make a time-deposit of 100 ounces of gold in a bank, and the bank issues a mortgage on a house worth 100 ounces of gold. Even if there's a default on the loan, then the bank gets the house. With a sound banking system, prices are stable, so the house would still be worth 100 ounces of gold. Further, in a free market, there's no limited liability incorporation. If the bank is insolvent, then the management and owners are personally liable for any shortfall. This encourages honest and responsible behavior.

In the present, limited liability incorporation encourages dishonest behavior. Management of an nearly insolvent bank may cheat its creditors in bankruptcy court. If the bank is "too big to fail", a bankruptcy can affect many other businesses. The "too big to fail" problem and a corrupt financial system guarantees that bailouts are periodically needed.

When the Federal Reserve cuts interest rates to "stimulate the economy", that is a financial industry bailout. An interest rate cut increases inflation. This subsidizes profits for businesses that print and spend the new money. New money is primarily created by banks and by large corporations that have lots of debt.

"Too big to fail" is another perverse feature of the financial industry. Suppose I own a pizza store and one of my competitors goes bankrupt. My competitor's insolvency does not threaten my business. In fact, the loss of a competitor slightly helps me. In the financial industry, JP Morgan Chase and Goldman Sachs are theoretically competitors. Due to complicated derivative transactions, a bankruptcy at JP Morgan Chase could threaten Goldman Sachs and other banks.

In a true free market, the bankruptcy of a competitor does not threaten your business.

If you don't want to support a corrupt financial system, agorism is your best option.


Anonymous said...

The current problem is much more perverse!!! The gov of US probably doesn't have these $700bn, so it is going to take them from somewhere at interest rate. It is hard to chase the money flow nowadays if you are not insider. It may happen that the gov will take the money as credit from some Wall Street banks to provide them for free to some other WS banks. It's crazy!!!

I believe it is the smaller evil this bailout plan to be executed. Otherwise the crisis will develop more and the impact will be much more severe and the guilty one will be the gov, not the banks. And the banks are much more interested the crisis to get bigger, it is amazing how history repeats, first by inflation and then by deflation and voila the rich are getting richer and the poor are getting poorer!!!

Dick said...

The bailout contained provisions for foreign banks to transfer their "underwater" assets to their US-based branches, and then for the US Treasury to purchase those assets.

This is a way to make good on the promises by us mortgagees. Either they pay as agreed, or they default, in which case the treasury will pay for them.

If done, it will pave a way for future interest rates to stay low, so that housing market can be purchased without lowering the prices.

If this bailout doesn't happen, then foreign mortgage holders won't be paid as homeowners default. This will prompt higher rates, and thus the decrease in house prices. That, in turn, will prompt yet more defaults, yet higher rates and yet lower prices. Repeat ad nauseum.

Thus we can say, that this bailout is about all of us helping current home owners, not foreign bankers.

Somebody has to pay up, or current home owners will lose their houses. Future homeowners will not be affected as their purchase prices will trend lower to compensate for the higher cost of financing at a future time.

ReasonableCitizen said...

On the internet someone postulates that every adult American can be given $425,000 and this will solve the mortgage crisis for $85B rather than $700B. The assumption being that people would pay down their mortgages or pay them off.
Is this true?
If true, why would it not be employed?

Anonymous said...

I'm interested in your saying that financial workers perform no real work. You've also said that insiders know it's a scam.

I think that mentality would make a very interesting article in it's own right, given your background.

ReasonableCitizen said...

Never mind. New-fangled calculators just aren't as good as longhand division and multiplication.
The curse of electronics...

Dick said...


First of all, you're right, the math is all wrong here. The whole 700 bln will make just 3,800.00 per adult citizen (roughly).

But, this is not the crux of the issue. Let us imagine that each adult had received 1000000 dollars. Now what you think will happen? The prices will go right up to compensate for this and no one would feel any richer than before (roughly).

An even easier way of imagining that is to assume that by a government decree, tomorrow, everyone can exchange their every dollar for a thousand of new ones.
The prices will immediately adjust up exactly 1000 fold and we will be where we are now.

This process is now very much looking like a regular inflation, which it actually is, i.e. the process where a saver (creditor) is made to pay for a spender (debtor). This is because if you'd borrowed 1000 bucks from me yesterday, you'd give me back today 1000 of new notes, but I can only buy what was worth 1 dollar before.

This is the reason why we have treasury paper, bank deposits, savings accounts, etc. Through these mechanisms, our government extracts value from gullible people in favor of those who like to spend it. Note that our real inflation rate is higher than the highest interest rate paid, which makes our real interest rates absolutely negative. This means ANYONE who holds his money on interest in treasuries or savings or money market accounts or even stock market, is actually paying for the privilege. His purchasing power continually declines faster than his money can multiply in nominal terms.

You didn't actually think otherwise, did you? :)

Wes said...

"Somebody has to pay up, or current home owners will lose their houses."

Sounds ok to me. I already have my house to pay for, I don't know why I'm expected to pay for yours, too. (I think Rick Santelli already famously covered this.)

House prices are too high and need to come down and should come down. Propping them up is just a transfer of wealth.

What a strange country we live in when people don't want to let the "free" market work.

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