"I've abandoned free-market principles to save the free-market system"
George W. Bush
I think there has been a lot of misunderstanding about the latest financial crisis. The media tend to emphasize deficits and the stock market. They also seem to confuse the real economy (jobs, employment rate, CPI, GDP, PMI, etc.) and the financial economy (stock prices, bond yields, interest rates, credit spreads, etc.) Lately, the media have been cheerleaders because of the rising stock market (financial economy) while the real economy has been taking a major dump. Unemployment is now at 9.5 percent but the picture gets even worse. If we include discouraged workers and partially-employed workers, the unemployment rate is already above 16 percent. Firms are also inducing workers to reduce hours and hourly wages. Plus, job losses should continue for the next year and a half and peak somewhere near 11 percent.
At the center of this whole crisis is the $8 trillion housing bubble. Again, the media have been focused on stock market. Since 1996, the housing prices started to rise and ever since then we’ve been listening to people scream about the deficit. We listened to the deficit hawks whine about a problem that really wasn’t that big (at least by comparative standards) and they let the bubble continue.
Well, the deficit hawks are back. They say you and your children and their children and on and on will have to pay back $12 trillion. Are you terrified yet? You shouldn’t be. Don’t change your underwear just yet. Let me break this all down.
It should first be noted that almost 100 percent of this money is in the form of loans. It’s not like the government is just giving this money away. So, no, your children won’t being paying this back. The people who got the money will be paying it back and paying interest on it. This potentially means that the government will make money.
About $1 trillion of that money is in the form of TARP. This program was the creation of the Bush Administration and is still being injected into the failing banks. Why were the banks failing? Because they were gambling with Collateralized Debt Obligations (CDOs) and loaning out massive amounts of leveraged cash in the form of Credit Default Swaps. After the government let Lehman Brothers fall, just about every bank in the country stopped lending out money. It turns out that all these banks are highly connected. Not just here but around the world. That means nobody, not even large institutions could get a loan. What most people don’t understand is that most major corporations receive loans everyday. Some companies might take 10 or 15 loans out everyday because they just don’t have the cash on hand. At the time, even McDonalds couldn’t receive a loan.
I know it’s popular to say, “just let the banks fail,” and I would love to agree. But our whole system as we know it would fall into a dark spiral without the rescue plan. Not only would all money in the US freeze up, there would be a domino effect in the corporate world. Every bank in the US would have to let their employees go. Everyone invested in these companies would take a huge hit. Because all these companies are so tightly knit, both smaller and larger businesses would fall. “Too big to fail,” isn’t some nice little statement. It’s a new reality. One that needs to be dealt with.
Everybody thought it would be okay if just one large bank failed. It turned out they were wrong because after Lehman Brothers went bankrupt, the entire world banking system, along with the financial economy, headed straight down.
This is why Hank Paulson, somebody who was famous for saying, “The best government is no government,” agreed to the bailout.
The second part of the rescue plan has been Obama’s stimulus package. This will cost $787 billion over the next 10 years. Again, people have many misunderstandings about this. Close to 1/3 of this bill goes out in the form of tax cuts. That’s already taken place. Instead of giving this money out in one large payment like the Bush Administration did, they are opting to have the money trickled into each paycheck. They did this because it turned out that most people who got their $500 dollar check in the mail saved that money which isn’t a stimulus at all.
So far, more than 60 percent of the stimulus takes the form of lower tax rates and higher benefit levels for programs like unemployment insurance. The lower tax rates and higher benefit levels already went into effect at the start of the spring. This means that people already have higher take-home pay or government benefit checks.
More than a quarter of the remaining stimulus is devoted to state and local government stabilization funds. This spending will limit the cutbacks at the state and local level, but will not lead to additional growth. The remaining funds are projected to be spent out at an $80 billion annual rate over the course of 2010.
Even if we assume that we are starting from zero spending at the moment, this is a boost of just over 0.5 percent of GDP. By contrast, the collapse of housing construction trimmed $450 billion or 3.0 percentage points of GDP from annual demand. The decline in consumption due to the loss of bubble wealth is in the range of $600 billion to $800 billion a year.
In other words, the remaining stimulus is an order of magnitude too small to give much of a boost to the economy. It should be noted that this was completely expected by economist but has somehow confused the media and the pundits.
The last part of the rescue plan is by far the biggest. One trillion was pushed by the Bush Administration, $787 billion by Obama, but the Federal Reserve is spending the remaining 10 trillion. The government has no control over the FED. They can do whatever they want as opposed to what most people think.
So, what are they doing? Because the banks are no longer lending out money, the FED has stepped in and started doing what the banks use to do: lend money to companies. Again, they aren’t giving the money away. They are just loans.
Since there was a $8 trillion dollar hole blown into the economy, the FED has started printing more money. Many people say this will lead to massive hyper-inflation. This is highly doubtful. At the moment, we’re having a problem with deflation. Plus, the US, compared to some other countries are not that far in debt. Other countries, including Japan and Canada have been further in debt and they didn’t see the inflation that people are talking about today. I should also mention that fact that the FED is sending money to the bank who are just sitting on that money because they don’t want to lend it out. Eventually, the FED will get it back so in reality, the FED isn’t really spending the money.
Many of you know that I was talking about the housing bubble in 2004. It seemed pretty obvious even though just about every economic pundit was saying that everything was okay even while everything was falling apart. What’s really annoying is that the media is talking to the economic pundits who got everything wrong about that economy and they continue to talk to them. At the same time, they completely ignore the people who both predicted the crash and everything that happened afterwards. Instead, they opted to talk to fear mongering deficit hawks. The reason for this might be simple. Everybody can relate to debt. We know it’s bad. End of story. It’s like when they talk about Iraq. The coverage is terrible. It mostly come down to how many soldiers died that day. They don’t talk about the all the different political factions and statistical information because it’s just too hard to grasp.
Last, I should mention all the hype about how Obama is turning the US into a Socialized country. This is all nonsense. Especially since Republicans practically invented corporate bailouts. Historically, Republicans have done the same thing.
PLEASE CHECK OUT THIS CHART. The US has taken over many companies including Nixon's takeover of the railroad industry. Almost every bailout in history has turned a profit for the US government. Obama has said he has absolutely no intension of running these institutions and when they are better, he will sell them back to private hands. So unless there is some conspiracy I don’t know about, that is likely to happen.

What does the future look like? Well, it’s hard to say. I’m predicting, that home prices will continue to drop another 10 percent. This is pretty large since it has already dropped about 30 percent. The next year and a half, unemployment will continue to drop but should peak at around 11 or 12 percent. Growth will also be sub par with maybe 1 percent in 2009 and 2010.
If the unemployment rate is going to peak around 11 percent next year, the expected losses for banks on their loans and securities are going to be much higher than the ones estimated in the recent stress tests. You plug an unemployment rate of 11 percent in any model of loan losses and recovery rates and you get very ugly losses for subprime, near-prime, prime, home equity loan lines, credit cards, auto loans, student loans, leverage loans, and commercial loans – much bigger numbers than what the stress tests projected.
It’s bad but the country is by no means going to go bankrupt. You don’t have to worry about your kids being strapped with $12 trillion in debt. By 2011, things should start to pick up. Until then, things will be slow economically. Anyway, go change your underwear and stop worrying.