A Costless Bank-Rescue Proposal
Amid much fanfare, Treasury Secretary Paulson’s $700 billion plan to allegedly save the banking system passed last Friday. The Dow Jones Industrial Average was up 250 points before its presumed passage, but once reality set in about the inability of governments to fix economies, the Dow fell 150 points on Friday, and it fell another 369 points yesterday.
Much as government action didn’t stave off the Great Depression in the ‘30s, so will federal efforts today meant to ward off pain merely cheer scared investors in the near term ahead of a massive hangover. Indeed, there’s a pattern developing here: markets rally upon news of more government “help”, but with government intrusion into the marketplace nearly batting 1.000 when it comes to the opposite of success, the wiser among investors inevitably pour cold water on that which won’t work.
Politicians touted the Paulson plan as a way to liquefy markets that were supposedly frozen, but in doing so, they ignored the obvious truth that markets for certain securities were illiquid precisely because investors thought those same securities unworthy. The latter in mind, it never made sense that the federal government could take money from the already risk-averse private sector in order to create a market that previously was thin. The simple truth is that rather than normalizing markets, government insertions of private capital only serve to distort them more, thus making all-important price discovery necessary for recovery a distant object.
Some make the important point that since governments are behind the vast majority of economic calamities, that they should spend precious capital to fix what they've broken. But governmental mistakes that lead to market meltdowns don't justify a compounding of the initial errors that led to government involvement to begin with. What's important to remember is that governments can't fix economies; instead they can only aid them by getting out of the way.
Fortunately for Paulson, one option that he hasn’t considered would not require legislative approval. Given Treasury’s traditional role as dollar steward, Paulson could announce a new dollar definition free of congressional oversight. Right or wrong, it is the federal government that issues dollars, so in this case an intervention by the branch of government meant to oversee the greenback would not set the economy back.
And while there are varying opinions about how the dollar should be defined, many believe a dollar measured as 1/500th of an ounce of gold would be ideal in terms of matching the needs of both debtors and creditors. If Paulson were to move in such a direction, some believe this would require a contraction in the money supply. More realistically, it’s not the amount of money that matters, but instead the quality of money. A market-defined dollar would be highly credible, and odds are that monetary authorities would have to create quite a bit more of them to match increased demand.
Importantly, this would have very positive implications for the mortgage securities that presently weigh on the financial health of banks.
For one, the income paid on mortgage securities would immediately be more valuable given the newly strong dollar. This in itself would boost the value of the underlying asset.
As for the housing market that somewhat impacts mortgage securities, much of the commentary surrounding housing centers on reversing the decline in home prices. This is mistaken. Mortgage securities aren’t so much weak due to declining home prices as they sag due to the inability of some Americans to pay down their mortgages.
A stronger dollar would directly impact the ability of strapped Americans to make their mortgage payments.
The above is firstly true because all commodities, including oil and gas, are priced in dollars. As such, a stronger dollar would drive down the nominal costs of those commodities, most notably gasoline purchased at the pump.
So in a very real sense a stronger dollar would serve as a large income boost for every American. All of us would enjoy a tax cut of sorts free of the legislative wrangling that makes tax cuts in the literal sense so hard to pass. With money going further, mortgage payments wouldn’t be so onerous.
Secondly, when we inflate as we have over the last several years, investment is distorted in ways that harm the wage earner. This is so because dollar holders, seeking to hedge the decline of the unit of account, plow money into hard assets such as commodities, art, and yes, property.
A stronger dollar would reverse this process. Rather than trying to protect their wealth with investments in tangible assets, investors would be more willing to invest in the entrepreneurial economy free of inflation worries. The impact would be greater capital formation that would boost wages, thus making mortgage payments even less troublesome.
In the end, Henry Paulson’s ill-considered efforts to fix that which isn’t working have taken the form of a solution that misses the problem. Mortgage securities are for a variety of reasons under water due to a dollar that has been in decline for years. A stronger, more stable dollar would reverse the decline of the assets that weigh on our banking system, and it could be achieved free of the very expensive legislation the effectiveness of which investors seriously doubt.