Monday, September 14, 2009

It's all in the context

Mr. Galbraith contends that the problem of economic stabilization has been "fixed" by government spending. Believe it or not, I agree with him. Federal borrowing and transfer payments have stimulated the economy to some degree. Federal guarantees on bad debt, TARP payments and cash conduits to the major investment banks, and the legalization of accounting fraud have helped more. So in the short term, he is correct.

However, increased government spending through borrowing crowds out investment and prevents people from being able to make good business decisions because there is a chance that your line of business could be legislated away at a moment's notice. So the problem that Mr. Galbraith is talking about is simply a side effect of the real problem, which is that the disconnect of the currency from assets of real value causes structural istability in the banking system.

Think about how a 20% reduction in housing values puts a $100,000 no money down mortgage under water, when the bank has committed $10,000 against the loan. If the mortgage defaults, the bank recovers $80,000 and takes a $20,000 hit to capital. Systematically, this reduces capital margins to below solvency and will eventually make the banking system insolvent. What the government has done by guaranteeing these insolvent banks bad investments is transferred liability from bank shareholders, depositors, and bondholders to taxpayers. The banks are likely being instructed to "earn their way out" by gouging customers with massive fees and low payouts on interest bearing products (savings and CDs).

Once again we have smart people ignoring the root of the problem and instead trying to solve symptoms.

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