theweek.com/article/index/94743/The_crisis__and_Geithner_plan__explained -> www.theweek.com/article/index/94743/The_crisis__and_Geithner_plan__explained
Email image image YOUR E-MAIL RECIPIENT E-MAIL SUBJECT YOUR COMMENT (optional) send The e-mail addresses that you enter will only be used to send the requested article and will not be stored or shared with third parties. The crisis -- and Geithner plan -- explained Q: What is the problem? A: The problem is that unemployment is rising like a rocket. A: Because those businesses that normally would be expanding and hiring right now are not expanding and hiring. This is compounded by the fact that businesses that would normally be contracting right now are indeed contracting -- rapidly. Q: Why aren't the businesses that ought to be expanding and hiring doing so? A: Because they cannot borrow money or sell bonds on terms that make it profitable for them to expand and hire. A: Because banks and investors are loath to take on any more risk, they're demanding that businesses seeking financing offer them usurious terms, which the businesses cannot do and still profitably expand. Q: So why are the securities on Wall Street right now distressed and low-value? A: Because banks, investors, and other financial intermediaries don't think they are worth very much. Q: Why don't banks, investors, and other financial intermediaries think they are worth very much? A: Six factors: the housing boom was accompanied by the creation of a lot more assets--principally mortgage-backed securities and their derivatives. As supply and demand dictates, when there is more of something, it is worth less; some of these securities were initially sold at prices that only a fool, thinking a bigger fool would come along to buy them at an even higher price, would ever pay; there is a recession on and so firms have a greater chance of defaulting on their securities; traders working for Wall Street firms are irrationally panicked after having been hammered for a year and a half; those working for Wall Street firms that are now undercapitalized (because they have been hammered for a year and a half) assign a very high cost to risk because it materially increases the chance that their firm will vanish next month; the risk level of these securities is much higher than normal because professional investors no longer trust their own financial models or know how their models compare to the models of other traders. A: Well, some economists don't think we should fix this. Some welcome high unemployment, thinking it's the best way to get workers out of declining industries and into growth industries. They consider a period of high unemployment a way of convincing people who were previously employed "pounding nails in Nevada" to go do something else -- part of the respiration of the capitalist organism, as Josef Schumpeter said. They tend to like the fact that financial asset prices are now low, and condemn attempts to raise them as efforts to keep the feckless financiers who bought them during the boom from suffering their just punishment. Followers of this line of argument -- I call them the Marx-Mellon-Hayek-Hoover axis --tend to say things like: "What's to fix?" Q: But at least some economists know how to fix this, right? We recommend four things: The Federal Reserve should purchase Treasury bonds for cash in as large a quantity as needed to push their prices up as high as possible. For if Treasury bonds are expensive, then investors will likely shift some of their demand to mortgage and corporate bonds, push up their prices somewhat; Even after the Federal Reserve has pushed Treasury bond prices as high as they can go, it should keep buying Treasury bonds for cash in the hope that if people's pockets are full of cash, they will spend more of it, and that extra spending will directly pull people out of joblessness and into employment; The government should run big, even extra-big, deficits so that its spending--like the government's wave of spending during World War II, like the wave of spending that followed the Reagan tax cuts of 1981, like Silicon Valley's wave of spending during the late 1990s, like the wave of spending on housing in the 2000s -- will also directly pull people out of joblessness and into employment; and The government should undertake additional measures to boost financial asset prices and thus make it easier for those firms that ought to be expanding and hiring to obtain finance on terms that allow them to expand and hire. Q: "Additional measures to boost financial asset prices"? The Geithner Plan is to take about $465 billion of government money, combine it with $35 billion of private-sector money, and use it to buy up risky financial assets. Q: Why is the government making the private sector kick $35 billion into this $500 billion fund? The Treasury doesn't want them taking excessive risks with taxpayers' money, buying financial assets at more than their long-term hold-to-maturity value, for example. So it's requiring that private investors put some of their own money on the line, as well. Q: Why should private-sector investors be willing to kick in $35 billion? A: Because they stand to make a fortune if and when markets recover and financial asset prices rise toward normal values. The government will be taking $13 billion a year out of the fund off the top in interest, and splitting the remaining profits with the private-sector fund managers. If the fund does well over the next five years--returning profits, say, of nine percent per year-- then the private investors get a rate of return on their super-risky equity investment of 14 percent, plus the equivalent of an "annual management fee" equal to two percent of the capital under management. If the portfolio does less well--say, profits of four percent per year-- they get a still-healthy but sub-market return of 10 percent per year on their equity. And if the portfolio does badly--loses one percent per year--they still have to pay back their loans from the FDIC and consequently lose 5/7 of their investment. A: Whether the financiers who invest in and run this program will make fortunes time alone will tell. But they will be a different set of financiers than those who got us into this mess. And if they make fortunes, they will make the government a bigger fortune. A "management fee" of two percent of assets under management per year is one that many sophisticated investors have been willing to pay to private hedge funds, and they have topped it off with an extra 20 percent of annual profits - a fee the Treasury won't be paying. Q: How does having the US government invest $500 billion in the world's largest hedge fund operations reduce unemployment? A: The sudden appearance of an extra $500 billion in demand for risky assets will reduce the quantity of risky assets other private investors will have to hold. And the sudden appearance of between five and ten different government-sponsored funds making public bids for assets will convey information to the markets about what models investors are using to value assets in this environment. That sharing of information will reduce the perception of risk somewhat. And when there are fewer assets on the market, their prices rise too: it's simple supply and demand. With higher financial asset prices, those firms that ought to be expanding and hiring will be able to get money on more attractive terms that make expanding and hiring more profitable, etc. A: And the recession will end, and unemployment will drop back to normal? My guess is that we would need to take a total of $4 trillion in assets out of the market in order to move financial asset prices to a point at which it becomes profitable for businesses that should be hiring and expanding to actually hire and expand. "Toxic" assets account for only $2 trillion of this total; the government has to sponge up additional assets because the big problem now is not the inability of some people in the desert outside Los Angeles to pay their mortgages. The problem is that among financiers everywhere, the tolerance for holding risk has collapsed. The Geithner plan supplies $500 billion to acquire assets. The Federal Reserve's quantitative easing plan will add another $1 trillion. And I should hasten to say that the administ...
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