To explain, Quantitative Easing (QE) is an unconventional monetary policy tool aimed at stimulating the economy when conventional methods have failed.

Normally, a central bank creates money by lowering interest rates on short-term government bonds. But, when interest rates have fallen to zero, a three-month Treasury bond and cash are equivalent; zero-yield government liabilities.

In these anxious times, with deflation staring us in the face, investors look for long-term safe securities. This leaves the short-term rates at zero with no buyers. The economy needs a kick start.

Money supply is created electronically through the process of Quantitative Easing.

This new money is used to buy up long-term financial assets from local banks. This electronic money gives the banks higher reserves to ease credit lending and stimulate the economy.

But what if banks don’t lend out the money locally, or lend it out instead to non-local opportunities or emerging markets?

This is where we are now with QE2 set to end June 30.

The $1.75 trillion the Fed paid out for mortgage-backed bank assets with QE1 as well as the $600 billion in 2 to 10 year Treasury notes under QE2 still sits in bank vaults as excess reserves.

Bankers cringe around their conference tables, burned by previous bad loans, afraid to take any chances on local business lending and reluctant to lend at the current low rates, when in their minds future interest rates should be much higher.

The bank reserve-to-deposit ratio has never been above 4.5 percent in the last 50 years. The ratio is now somewhere above 14 percent.

Local businesses that can pass the high lending requirements, are reluctant to incur debt to expand their business facilities, in case their business model hits a snag, like the impending required healthcare costs and possible tax increases. If they don’t expand their business, they can’t provide new jobs and don’t hire more workers.

On the consumer front, American households lost $14 trillion of their net worth in the recession, based largely on devaluation of their homes and retirement accounts. Consumers are now trying to replenish some of their household wealth, and are limiting their spending

“The [financial] system is clogged” is how Bob McTeer, former president of Federal Reserve Bank of Dallas, described it.

So how can it be unclogged?

The answer is to learn lessons from the past. During the great depression of the 1930s, consumers waited to spend because prices were dropping and promised to be cheaper in the future with deflation. The same thing is occurring today.

If the government does nothing, people and businesses would spend–eventually; but we should remember the depression of the 1930′s lasted well into the 1950′s, and that was with the flood of spending for World War II.

However, if prices promised to be higher in the future, people would be inclined to spend now to avoid the future inflated prices.

If QE is successful, long-term yields will float lower by the government buying up huge amounts of long-term investments; private investors will be herded into short-term notes, stocks and commodities in which to put their money.

Activity in short-term notes, stocks and commodities will, through increased demand and speculation alone, push short-term interest rates higher and create inflation. Banks will see an increase in interest rates and offer loans at the higher profitable rates.

Inflation will also push stocks, commodities and prices (including housing) higher. Consumers will spend to avoid anticipated price increases.

The government will hold down long-term interest rates, which will encourage homeowners to refinance their loans and establish mortgage payments they can afford.

The increase in money supply to the banks will devalue the paper dollar. The devalued paper dollar will help the manufacturing trade, increasing export sales.

Since consumer spending is the key to recovery, rising prices should make consumers feel the economy is improving, and with increased spending, it will improve.

That’s the plan.

QE has already been great for Wall Street stocks. Measured in paper dollars, the Dow has climbed roughly 20 percent from August 2010 to Jun 2011, the duration of QE2. In that time, the flood of cheap money has helped the big banks and commodity speculators rake in huge profits of paper money.

But in real terms, measured against the Swiss franc (an international standard for stability) in the QE2 time period, the US dollar value has dropped more than 19 percent, nearly eliminating the Dow’s increase.

And the ordinary investor? In that same period, they’ve been cashing out to the tune of $52 billion from U.S. equity mutual funds. More than 80 million baby boomers are reducing their exposure to equities as they approach retirement age.

Michael Cox, director of the William J. O’Neil Center for Global Markets and Freedom, SMU: “The Fed is trying to create some inflation. That’s what the economy needs right now. … It’s not that the Fed is trying to get long-term interest rates down. … It sells to say, ‘We’re going into the long-term market and hold down long-term rates … but the real objective is to create some inflation. … This is exactly the right thing to do. The solution is higher interest rates. How you get higher interest rates is inflation. Once the Fed pushes enough base currency into the economy, eventually you’re going to have inflation. A little bit of inflation cures a lot of recession. “

The government’s challenge is to create manageable inflation. Their target is 2 percent.

Inflation is not a painless solution especially to those on a fixed income; but it is the least painful solution. But many think that holding to a consistent 2 percent inflation is like flying a jet plane 10 feet off the ground — it really needs to be higher.

If QE is too successful at unclogging the stream of money, inflation could shift into high gear, forcing the Fed to engage a completely different set of financial mechanisms by raising interest rates to apply the brakes.

However, QE is expected to create a manageable inflation rate that could push the stock market and housing prices higher, stimulate businesses to go ahead with projects and banks to lend funding to them at the higher interest rates.

If the excess reserves resulting from the increase in money supply is liberated by the banks, in the form of business loans, inflation could be traded for a sustained increase in real production.

And how does that electronic money disappear from the system and allow the paper dollar to be once again be valued at its correct level? Each time one of those long-term liabilities is paid off, the government will adjust the QE balance sheet downward.

A little history here.

In 1965, President Lyndon Johnson started increasing deficit spending to fund the Vietnam war. This fiscal policy increased inflation and reduced unemployment.

Business owners, seeing the inflation and fearing more, raised their prices as protection and so created the monster they feared.

In 1973 and again in 1979, OPEC ( the Organization of Petroleum Exporting Countries) boosted crude oil prices to get their piece of the price increases.

This increase, combined with food harvest failures around the world, caused merchants who used trucks to deliver products or imported food to boost prices again.

In the 1960′s the Fed traded higher prices for lower employment, expanding the money supply to keep unemployment down. Businesses quickly learned to keep the money being fed to them and raise prices anyway instead of expanding by hiring new workers. This gave birth to ‘stagflation‘ where unemployment and inflation grew at the same time.

In 1980, President Jimmy Carter nominated Paul Volcker for the Chairman of the Federal Reserve Board. Volker said that the bitter medicine of recession was the only way to make the economy healthy again.

In 1980 and again in 1982, the Fed drastically tightened money supply, raising interest rates as high as 14 percent. This halted employment growth and higher wage demands from workers. Businesses slashed prices just to stay alive. Unemployment soared to more than 10 percent. It was called the worst recession since the Great Depression of the 1930′s. Of course, we know better today.

When inflation looked like it had been stopped, Volker dropped the Fed’s discount rate to 8.5 percent, sharply increasing the money supply flow. Within months, the economy roared to life, with a healthy recovery fueled by the large number of available workers.

The economic policies instituted by Volker under Jimmy Carter were continued under President Ronald Reagan. In addition to controlling the money supply to control inflation, three other pillars of Reagan’s economic policies were to reduce the growth of government spending, reduce taxes, and reduce government regulation in major utility industries such as railroads, banking and telephones.

Within four years the rate of growth of government spending and the federal deficit was cut in half. The composition of tax revenue was changed from capital gains on existing investments and taxing high earners to new investments and payroll with a very small effect on tax revenues. The significant increase in GDP growth caused a significant drop in unemployment.

Volker left the Fed in 1987, but was called to serve as the Chairman of the Economic Recovery Advisory Board under President Barack Obama from February 2009 until January 2011.

QE is meant to allow our financial ship to leave the dock and set sail. And it is working.

The country is in the midst of talking about reform; Medicare reform, healthcare reform, Social Security reform, and in general, entitlement reform.

What exactly is an entitlement? An entitlement is a guarantee of access to benefits based on established rights or by legislation. The ones we are most familiar with are Social Security, Medicare and Medicaid.

For fiscal year 2010, Social Security and Social insurance taxes contributed $865 billion or 40% of the $2.162 trillion government income. Individual income taxes contributed $899 billion or 42% of the government’s income.

For fiscal year 2010, Social Security payments amounted to $701 billion or 20% of the $3.456 trillion government expenses. Medicare and Medicaid accounted for $793 billion or 23% of the government’s expenses while other mandatory expenses accounted for $416 billion or 12% of the government’s expenses. The total expenditure for entitlements was about $1.9 trillion.

Using simple math, the government took in nearly $1.3 trillion less than it spent.

As people live longer, the number of workers supporting the number of retirees continues to decline, especially as the baby boomers (born 1946 to 1964) attain retirement age and nearly double from 2010 to 2030.

So how do we fix this?

The ways of fixing it would be different under a king or dictator than under a democracy. Insulting the electorate in a democracy is the surest way to the exit door for elected officials so they are trying very hard to solve the problem without being associated with an unpopular view.

Democrats believed that the economic crisis made the electorate want security so they created large public programs, like the stimulus bill to save the economy, the healthcare law where all will be covered, and other expansions of government programs.

Republicans capitalized on runaway government and its runaway debt, and they ran for office on the promises of stopping the economic bleeding and reversing the spending binge.

The common problem is how to cut government spending while growing the economy. The national debt as of December 2010 is roughly $14 trillion.

Looking at the sheer size and potential horror of the problem causes many of us to freeze like a deer in the headlights.

What is the horror? What if the government was forced to cancel all entitlement programs because it didn’t have the money? The annual savings would be roughly the $1.9 trillion less the $865 billion which would no longer be returned as taxes, but instead millions of people would be left homeless, unable to pay either mortgage or rent, exploding public housing and collapsing the real estate market, making the most recent one look trivial. Millions of people would be left without paid medical care, forcing an explosion of federal medical facilities. Millions would be without money for food, exploding the use of federal food stamps and other assistance. So much for the $1.9 trillion which would be spent on these assisted programs and would make us not only a socialist state but a welfare state.

We all know entitlements must be reformed (as long as they don’t cut any of my benefits), and therein lies the problem.

Entitlement cutting is enormously unpopular with voters. But voters want real action to restrain spending, and entitlements are the only place that will make any real difference.

So what to do?

Republicans have come up with a strategy that will leave entitlements alone for seniors, at a cost to younger workers. Medicare would be transformed into a system of vouchers that would be used to pay for approved insurance coverage. The system would provide roughly the same coverage as for Medicare seniors, and would cause Medicare costs to grow more slowly and hopefully make consumers more cost conscious. Over time, such reform would yield enormous savings.

It is only a single step of cutting back now to help our grandchildren.

But will the voters go for it?

As Barack Obama raised his right hand and took the oath as the 44^th President of our country on the steps of the Capitol building, his left hand rested on a Bible. It was the same Bible, covered in velvet, used by Abraham Lincoln as he took the oath standing on the threshold of the Civil War that threatened to tear our country asunder.

To all, it is obvious Barack Obama is emulating his presidency after Abraham Lincoln, born 200 years ago this month.  They came from the same state of Illinois, Obama took the same whistle stop train route from Philadelphia to Washington for the inauguration, they used the same Bible to take the oath, Obama used the same “Team of Rivals” philosophy to choose members of his cabinet, and like Lincoln, he has taken responsibility for errors made and the course of action on which he will lead this country.

Lincoln possessed a talent for speaking and communicating with the people who elected him, as does Obama.  Lincoln was willing to learn on the job and adapt to changing circumstances.  Obama has stated he looks to Lincoln for inspiration, because as he systematically became better at the presidency, he didn’t become arrogant.

Lincoln considered his power a tool to be used for the good of his nation, not an entitlement to be wielded with disdain.  He understood leadership, even at the cost of his popularity.  With America at the brink of catastrophe in 1861, Lincoln worked to convince the Congress that the preservation of the Union was vital, even if it meant fighting a war with those who would drive it apart.  Overall, he was committed to preserve the Union, even at the cost of conflict with his own political party.

We all realize that President Obama inherited the monumental crisis that faces our country today as Lincoln inherited the impending division of the nation in 1861.  And like Lincoln, Obama is not afraid that big government can do good things for its people, and help them through times of calamity. 

Lincoln lived through the major economic collapses of 1837 and 1857, struggling to shore up a failing bank while arguing for government spending on public works, and so came to believe that government should actively intervene when markets fail.

Lincoln spoke in 1832,”[Free trade is a system whereby] some have labored, and others have, without labor, enjoyed a large portion of the fruits…. To secure to each laborer the whole product of his labor, or as nearly as possible, is a most worthy object of any good government.”

Lincoln championed equal pay and the common person’s rise to success – the American Dream.  ”The penniless beginner in the world,” he once explained, “labors for wages awhile, saves a surplus with which to buy tools or land, for himself; then labors on his own account another while, and at length hires another new beginner to help him.”  Lincoln insisted this steady advancement is “the prosperous system, which opens the way for all – gives hope to all, and energy, and progress, and improvement of condition to all.”

In 1860, Lincoln said, “I don’t believe in a law to prevent a man from getting rich; it would do more harm than good. [But] while we do not propose any war upon capital, we do wish to allow the humblest man an equal chance to get rich with everybody else.”

Lincoln embraced the encouragement of individual initiative and entrepreneurship – and government spending.  Lincoln’s party, the Whigs, which later became the Republicans, favored publicly financed infrastructure improvements, especially expanding the country’s transportation system through railroads and canals, and founding a national bank and currency, as well as instituting the federal income tax. 

Earlier this year, Obama said during an economic address, “Only government can break the vicious cycles that are crippling the economy – where a lack of spending leads to lost jobs, which leads to even less spending.”

A professor of economics and co-director of the Political Economy Research Institute at the University of Massachusetts, is co-author of Green Recovery: A Program to Create Good Jobs and Start Building a Low-Carbon Economy.

This article (written November 6, 2008) appeared in the November 24, 2008 edition of The Nation.

Ed.Note: This article was interesting because it contains many of the points of the Obama Recovery Stimulus of 2009.  The article was slightly reformatted without omission or distortion of meaning to read easier online. 

Bolded passages are of particular interest; italic notes are my notes added for clarity.

A Green Public-Investment Stimulus

Recessions create widespread human suffering. Minimizing the suffering has to be the top priority in fighting the recession. This means expanding unemployment benefits and food stamps to counteract the income losses of unemployed workers and the poor. By stabilizing the pocketbooks of distressed households, these measures also help people pay their mortgages and pump money into consumer markets.

Beyond this, the stimulus program should be designed to meet three additional criteria.

1.      We have to generate the largest possible employment boost for a given level of new government spending.
2.      The spending targets should be in areas that strengthen the economy in the long run, not just through a short-term money injection.
3.      Despite the recession, we do not have the luxury of delaying the fight against global warming.

To further all these goals we need a green public-investment stimulus to
1.      defend state-level health and education projects against budget cuts
2.      finance long-delayed upgrades for our roads, bridges, railroads and water management systems
3.      underwrite investments in energy efficiency-including  building retrofits and public transportation-as well as new wind, solar, geothermal and biomass technologies.

This kind of stimulus would generate many more jobs–18 per $1 million in spending – than  would programs to increase spending on the military and the oil industry (i.e., new military surges in Iraq or Afghanistan combined with “Drill, baby, drill”), which would generate only about 7.5 jobs for every $1 million spent.

There are two reasons for the green program’s advantage.

1.      The first factor is higher “labor intensity” of spending-that  is, more money is being spent on hiring people and less on machines, supplies and consuming energy. This becomes obvious if we imagine hiring teachers, nurses and bus drivers versus drilling for oil off the coasts of Florida, California and Alaska.

2.      The second factor is the “domestic content” of spending-how much money is staying within the US economy, as opposed to buying imports or spending abroad. When we build a bridge in Minneapolis, upgrade the levee system in New Orleans or retrofit public buildings and private homes to raise their energy efficiency, virtually every dollar is spent within our economy. By contrast, only 80 cents of every dollar spent in the oil industry remains in the United States. The figure is still lower with the military budget.

What about another round of across-the-board tax rebates, such as the program the Bush administration and the Democratic Congress implemented in April?

A case could be made for this in light of the financial stresses middle-class families are facing. However, even if we assume that the middle-class households will spend all the money refunded to them, the net increase in employment will be about 14 jobs per $1 million spent-about  20 percent less than the green public-investment program (the main reason for this weaker impact is the lower domestic content of average household consumption, i.e. much of the consumption will be for foreign-made goods).

Also, it isn’t likely that the households would spend all their rebate money. Just as with April’s rebate program, households would channel a large share of the money into paying off debts. (paying off debts is not necessarily bad – it releases discretionary income for the family and increases reserves for the banks and credit card companies to extend more credit to others).

The Matter of Size

This is no time to be timid. The stimulus program last April totaled $150 billion, including $100 billion in household rebates and the rest in business tax breaks. This initiative did encourage some job growth, though as we have seen, the impact would have been larger had the same money been channeled toward a green public-investment stimulus.

But any job benefits were negated by the countervailing (counteracting) forces of the collapsed housing bubble, the financial crisis and the spike in oil prices. The resulting recession is now before us. This argues for a significantly larger stimulus than the one enacted in April.

But how much larger?

One way to approach the question is to consider the last time the economy faced a recession of similar severity, which was in 1980-82, during Ronald Reagan’s first term as president. In 1982 gross domestic product (GDP) contracted by 1.9 percent, the most severe one-year drop in GDP since World War II. Unemployment rose to 9.7 percent that year, which was, again, the highest figure since the ’30s.

The Reagan administration responded with a massive stimulus program, even though its alleged free-market devotees never acknowledged as much. They preferred calling their program of military expansion and tax cuts for the rich “supply-side economics.” (supply creates demand – see Trickle, Trickle, Up, Down, part I)

Whatever the label, this combination generated an increase in the federal deficit of about two percentage points relative to the size of the economy at that time. In 1983 GDP rose sharply by 4.5 percent. In 1984 GDP growth accelerated to 7.2 percent, with Reagan declaring the return to “morning in America.” Unemployment fell back to 7.5 percent.

In today’s economy, an economic stimulus equivalent to the 1983 Reagan program would amount to about $300 billion in spending-roughly double the size of April’s stimulus program, though in line with the high-end figures being proposed in Congress. A stimulus of this size could create nearly 6 million jobs, offsetting the job-shedding forces of the recession.

Of course, the green public-investment stimulus will be much more effective as a jobs program than the Reagan agenda of militarism and upper-income tax cuts. This suggests that an initiative costing somewhat less than $300 billion could be adequate to fight the job losses. But because the green public-investment stimulus is also designed to produce long-term benefits to the economy, there is little danger that we would spend too much. Since all these investments are needed to fight global warming and improve overall productivity, the sooner we move forward, the better. Moreover, under today’s weak job market conditions, we will not run short of qualified workers.

How to Pay for All This?

Let’s add up the figures I have tossed around. These include the $700 billion bank rescue operation being engineered by the Treasury, the $540 billion with which Fed chair Bernanke has pledged to bail out the money market mutual funds, along with unspecified additional billions to buy unwanted business debts held by banks. On top of these, I am proposing $300 billion for a second fiscal stimulus beyond last April’s $150 billion program. At a certain point, it is fair to wonder whether we are still dealing with real dollars as opposed to Monopoly money.

In fact, the whole program remains within the realm of affordability, albeit approaching its upper bounds. But major adjustments from the current management approach are needed. In particular, the Federal Reserve has to continue exerting control over the Treasury on all bailout operations. That is, we need more initiatives like Bernanke’s $540 billion program to stabilize the money market mutual funds and less Treasury fumbling with taxpayers’ money to buy either the private banks’ bad assets or ownership shares in the banks.

We need to recognize openly what has largely been an unspoken fact about these bailout operations: that the Federal Reserve has the power to create dollars at will, while the Treasury finances its operations either through tax revenues or borrowed funds (which means using taxpayer money at some later time to pay back its debts with interest).

The Federal Reserve does not literally run printing presses when it decides to inject more money into the economy; but its normal activity of writing checks to private banks to buy the banks’ Treasury bonds amounts to the same thing.

When the banks receive their checks from the Fed, they have more cash on hand than they did before they sold their Treasury bonds to the Fed. Especially during crises, there is no reason for the Fed to restrain itself from making good use (though of course not overuse) of this dollar-creating power.

The Fed is also supposed to be the chief regulator of the financial system. Now is the time to make up for Alan Greenspan’s confessed failures over twenty years in this role.

In exchange for the Fed protecting the private financial institutions from collapse, Bernanke must insist that the banks begin lending money again to support productive investments, while prohibiting them from yet another return to high-rolling speculation.  

Special measures are also needed to keep people in their homes.

The Deficit Looms

When the economy began slowing this year, the fiscal deficit more than doubled, from $162 billion to $389 billion. We cannot know for certain how much the deficit will expand. It could rise to $800 billion, $1 trillion or even somewhat higher, depending on how the bailout operations are managed.  Of course, it would be utterly self-defeating for the United States to run a reckless fiscal policy, no matter how pressing the need to fight the financial crisis and recession.  But in the current crisis conditions, even a $1 trillion deficit need not be reckless.

Let’s return to the Reagan experience for perspective. In 1983 the Reagan deficits peaked at 6 percent of the economy’s GDP. With GDP now around $14.4 trillion, a $1 trillion deficit would represent about 7 percent of GDP, one percentage point higher than the 1983 figure.

Of course, the global financial system has undergone dramatic changes since the 1980s, so direct comparisons with the Reagan deficits are not entirely valid.

One change is that government debt is increasingly owned by foreign governments and private investors. This means that interest payments on that debt flow increasingly from the coffers of the Treasury to foreign owners of Treasury bonds.

At the same time, as one feature of the crisis, Treasury bonds are, and will remain for some time, the safest and most desirable financial instrument in the global financial system. US and foreign investors are clamoring to purchase Treasuries as opposed to buying stocks, bonds issued by private companies or derivatives.

This is pushing down the interest rates on Treasuries. For example, on October 15, 2007, a three-year Treasury bond paid out 4.25 percent in interest, whereas this past October 15, the interest payment had fallen to 1.9 percent (currently 1.125 percent). By contrast, a BAA (investment grade) corporate bond paid 6.6 percent in interest one year ago but has risen this year to 9 percent (currently 8.24 percent).

As long as the private financial markets remain gripped by instability and fear, the Treasury will be able to borrow at negligible interest rates. Because of this, allowing the deficit to rise even as high as 7 percent of GDP does not represent a burden on the Treasury greater than what accompanied the Reagan deficits.

There is, then, no reason to tread lightly in fighting the recession, with all its attendant dangers and misery. Indeed, severe misery and danger will certainly rise as long as timidity-the path of least resistance-establishes the boundaries of acceptable action.

The incoming Obama administration can take decisive steps now to defend people’s livelihoods and to reconstruct a viable financial system, productive infrastructure and job market on the foundation of a clean-energy economy.

As a concerned citizen, I am trying to figure out how we got into this mess, where we are in this mess, and where is the exit door to this mess. Now, I as a concerned citizen have no influence with the powers that be in Washington, but that doesn’t stop me from trying to understand the problem and what is being done.

My focus starts out with Henry Paulson, Secretary of the Treasury. I looked up his record, because he has not impressed me with his financial guidance.

Secretary Paulson is a smart guy. He was an Eagle Boy Scout (for those of you who know, it is a tough rank to achieve for a teenager). He earned a Bachelor of Arts degree (English) from Dartmouth (good school) and an MBA from Harvard Business School. He was inducted as a member of Phi Beta Kappa, an academic honor society. It is considered by many to be the most prestigious college honor society in the United States.

Paulson rose to be CEO of Goldman Sachs, amassing a personal fortune along the way. In 2006, his income was projected to be $16.4 million. That year, after 32 years at the firm, he accepted the job as Treasury Secretary at a salary of $191,300 (all Cabinet Secretaries make the same).

Treasury Secretary

The Secretary of the Treasury is the head of the IRS, the U.S. mint, the Bureau of Printing and Engraving, and all other agencies concerned with money and finance matters of the U.S. He gets to sign all the currencies issued while he is in office (neat!).

Duties from the U.S. Department of the Treasury website:
“The Secretary of the Treasury is the principal economic advisor to the President and plays a critical role in policy-making by bringing an economic and government financial policy perspective to issues facing the government. The Secretary is responsible for formulating and recommending domestic and international financial, economic, and tax policy, participating in the formulation of broad fiscal policies that have general significance for the economy, and managing the public debt. [more …]

Paulson’s record

OK, let’s see how he has played up to now.

2004: at the request of major Wall Street investment houses, including Goldman Sachs, which at that time was headed by Paulson, the U.S. Securities and Exchange Commission agreed unanimously to repeal the net capital rule. The SEC net capital rule states the requirement that brokerage houses hold reserve capital limiting their leverage and risk exposure.

That year, SEC Chairman William H. Donaldson then established a “voluntary” risk management program for investment bank holding companies to monitor signs of any problems. This office was eventually discontinued by current SEC Chairman Christopher Cox, after discussions with Paulson because not one firm volunteered to show their books.

Changes to the net capital rule are thought to be an important factor in the credit market meltdown of 2008 due to unrestrained capitalism allowed to do anything in the name of profit with no one to say, “No”, or “Stop.”

Spring 2007: Secretary Paulson told an audience at the Shanghai Futures Exchange that “An open, competitive, and liberalized financial market can effectively allocate scarce resources in a manner that promotes stability and prosperity far better than governmental intervention.”

In other words, let things shake themselves out. Those are thoughts that can be expected from a wealthy free market advocate, who has no clue what it means in terms of financial change for us of the common class. More in another post on this view of economics.

July 2008: After the failure of Indymac Bank, Paulson reassured the public by saying, “it’s a safe banking system, a sound banking system. Our regulators are on top of it. This is a very manageable situation.” (Translation, “Don’t concern yourself with the iceberg collision. The Titanic is an unsinkable ship.”)

Paulson was then designated as leader of the Bush administration’s efforts to nationalize the cost of bad loans made by financial institutions. He led government efforts which he said were aimed at avoiding a severe economic slowdown.

August 2007: Paulson explained that U.S. subprime mortgage fallout remained largely contained due to the strongest global economy in decades. (Translation, “The rising sea water is contained in only the forward compartments of the ship. The Titanic will be fine.”)

August 2008: Paulson told NBC’s Meet the Press that he had no plans to inject any capital into government agency mortgage giants Fannie Mae or Freddie Mac. (Translation, “We have enough lifeboats for everyone.”)

September 2008: Paulson pushed through the conservatorship of Fannie Mae and Freddie Mac. (Translation, “Women and children to the lifeboats while we see if we can save the ship.”)

Questions arise

A note about Treasury Secretary Henry Paulson. No one would disagree that he is a smart guy who became wealthy mostly through his own efforts, but some questions come to mind:

· Why did he leave Goldman Sachs after 28 years, where he was CEO and expected to earn $16+ million in 2006, to take a job in government where his pay was roughly 1.2 percent of what he was making?
· What did he know that made him make the jump?
· Was he advised that Goldman Sachs would soon be in financial trouble and he would be able to help from the government side?
· Is he counting on a prestigious job after Treasury due to his high profile and insider contacts?

Appointing someone to Treasury secretary with an bachelor’s degree in English and an MBA does not make sense. The job requires more than an administrator. It requires an economist. It is evident to me that Secretary Paulson had no idea of the interconnectivity of financial elements of the economy. It is evident to me that he was acting on the guidance of advisors, who were following the supply-side economic policies of the administration, which as I understand it, comes down to throwing money at the problem.

In Paulson’s defense, it is easy to second-guess the people on the front lines, but looking at Paulson’s education and work history, I don’t know if his MBA qualifies him to perform “policy making by bringing an economic and government financial policy perspective to issues facing the government.”

He certainly did not act decisively and quickly enough, and tried to minimize the impact of the spreading economic blaze, on its way to becoming a four-alarm fire.

Bailout philosophy

Folks have asked me why the bailout money is going to the institutions rather than the people.

In receivership or bankruptcy, all possible assets and receivables are called in, converted to cash, mostly through auction, and the proceeds distributed among the creditors. Let’s say a large investment banking house goes bankrupt, because more credit defaulted than they had reserves for. Some of their assets might be mortgages that would be called in for their cash value.

Homeowners who faithfully paid their monthly mortgage payments would be presented with a notice that their entire outstanding amount was due. Not many people have that kind of cash, so they would lose their house. That would just aggravate the housing crisis.

This problem would be the same for businesses who were debtors of the bankrupt institution. Businesses rely on credit for operational cash flow. If they could not come up with cash, then their business would fall bankrupt in this game of financial dominoes.

The cascading bankruptcies would release vast numbers of workers into the unemployment arena, as well as put tremendous burdens on the shrinking number of remaining firms who would pick up some of the assets at auction and try to work them.

U.S. government bailout of 2008

September 2008: The bailout begins. Paulson is the point man for the bailout, but it is easy to see he is starting to listen to wiser financial minds.

Paulson was harshly criticized by economists for initially refusing to consider injecting large amounts of cash into financial institutions directly through stock purchase. Other countries in similar circumstances had led the way with this option, it had historical precedence in this country, it was the path favored by Federal Reserve Chairman Ben Bernanke, and it was the one that was eventually followed.

Bernanke and Paulson influenced the creation of a credit facility through bridge loans & warrants to American International Group for up to $85 billion to avoid bankruptcy. From the government’s viewpoint, it was investing in AIG with the hope they could sell the stock at more than a loss when the crisis was over.

Paulson, now joined by Bernanke and SEC chairman Christopher Cox, led the effort to help financial firms, using $700 billion dollars of Treasury funds to purchase bad debt they had incurred. The money was to cleanup nonperforming mortgages that threatened the liquidity of those firms.

Since Paulson was the most visible through public appearances on this issue, it became known as the “Paulson financial rescue plan.” He became the manager of the United States Emergency Economic Stabilization fund with the passage of H.R. 1424 (the $700 billion). He also sits on the newly established Financial Stability Oversight Board that oversees the Troubled Assets Relief Program.

See, it pays to be an Eagle Scout.

The Emergency Economic Stabilization Act of 2008 is the law authorizing the bailout. The Act authorizes Paulson as the Secretary of the Treasury to spend up to $700 billion to make capital infusions into banks and buy distressed assets, especially mortgage-backed securities.

The Troubled Assets Relief Program (TARP) is another law which created the Emergency Economic Stabilization fund, authorizing Treasury to spend up to $250 billion for immediate use, with the next $100 billion certified by the President that they are needed. The final $350 billion is subject to Congressional approval.

Within two weeks of enactment, the rules changed. Mortgage-backed securities took a back seat. As of November 25, Treasury spent $250 billion on preferred stock and equity warrants for 8 national banking institutions and $36.5 billion for senior preferred stock in 44 other banks under the Capital Purchase Program as part of TARP. Treasury also gave $40 billion to AIG.

Confused yet?

The Financial Stability Oversight Board was created to review Treasury’s actions. The chairman is Ben Bernanke, Chairman of the Board of the Federal Reserve system. Other members include the Chairman of the SEC, Secretary of Housing and Urban Development (HUD), Director of the Federal Housing Finance Agency, and Paulson.

A Congressional Oversight Panel also reviews Treasury’s actions and reports to Congress every 30 days on the management of TARP, the state of the markets and the current regulatory sytem. To be fair, the five members were chosen (one each) by:
· the Speaker of the House,
· the minority leader of the House,
· the majority leader of the Senate,
· the minority leader of the Senate,
· the Speaker of the House and the majority leader of the Senate jointly.

Will it work?

Historically, our government has done this before. In the 1930s, the Herbert Hoover administration bought stock and made loans to 6000 banks, spending $1.3 billion (equivalent to $200 billion today). When the economy stabilized, the government sold its holdings for about the same amount it paid.

We’ll see.