Sunday, October 5, 2008

All the Beggars at the Table

With the approval of a pork laden Wall Street bailout package, Congress has opened the floodgates for beggars of all stripes to arrive, cup in hand, on the steps of the capital. Even before the ink on the ill fated legislation could dry, California Governor Arnold Schwarzenegger approached the Treasury lamenting the challenges that confront the most populous state in the union as they seek to raise $7 billion in short term revenue anticipation notes. While there is no denying that credit markets suffer from serious liquidity constraints and a general aversion towards risk, the primary dilemma is not of credit availability but of the cost of credit. As credit risk has become more salient amidst the failures of some of our largest financial institutions, investors have re-evaluated their counterparty exposures and the spreads required to compensate them for default and liquidity risk. These spreads have blown out to historically wide levels as municipal, corporate, and emerging market debt has experienced a dramatic revaluation in light of a slowing economy and prominent defaults. Inter-bank lending rates (LIBOR) have skyrocketed and the commercial paper market has dried up causing many companies outside of the financial industry to endure painful recapitalization campaigns. Given the carnage in the credit markets, what possible solution could exist outside of massive bailouts and government support?

In any capitalist economy, there will be economic cycles marked by dramatic growth and painful retrenchments where weak firms will fail. The individuals that derive their livelihood or wealth from interests in these firms will compete nobly until it becomes obvious that failure is on the horizon. Desperation overcomes reason and all methods of lobbying, coercion, and persuasion come to bear in a last ditch effort to resuscitate their golden goose. Just as a grieving family seeks every possible treatment for a terminally ill loved one, the vested interests of a decaying enterprise will clamor for government support as a means of preserving the status quo. The question that is seldom pondered is what are the consequences of providing life support to a patient at death’s door? Most often, intervention does little to ensure long term survival but instead just protects the interests of a select few at the detriment of the greater good.

For illustrative purposes, let’s assume that a fire threatens to ravage an old growth forest and destroy the homes of its inhabitants. The potential loss of a select few would be significant, but the new life that would emerge from the ashes would be stronger and more resilient to the challenges that are yet to come. The interested few, seeking to preserve their wealth and livelihood, argue that the systemic risk of failing to act threatens neighboring communities and that large scale coordinated action is necessary to prevent wider destruction. It is nearly impossible, in most cases, to quantify this risk and determine what measure of response is most appropriate. Efforts could be made to save the forest and protect all from harm, but focusing on a targeted solution may fail, allowing the fire to spread to neighboring communities. Sacrificing the forest, that is almost certain to succumb to the blaze, and focusing on the relatively stronger surrounding communities may minimize losses and preserve the region, but this larger response threatens to spread available resources too thinly. If a strong wind catches the blaze just right, the line of resistance will be broken and the remaining resources will be unable to prevent widespread destruction and loss.

Such are the challenges that confront our nation today. Thus far, we have seen concentrated responses to individual fires that have emerged at the GSEs, Bear Stearns, Washington Mutual, AIG, and Wachovia. In an effort to protect the remaining participants in the financial industry, the massive “rescue” plan was passed by Congress. Buying distressed mortgages, however, does little to improve the capital position of struggling institutions, but merely removes a degree of uncertainty about future losses that could materialize. The fire fighters have focused on the obvious inferno, at the bequest of those most vulnerable, while ignoring the hidden risks that exist in the depth of the blaze. Specifically, the availability of credit has diminished and the cost has skyrocketed. Markets are still functioning, but the participants have built their businesses on the availability of low cost credit and confront the risk of failure given the burden of current market rates. The U.S. automobile industry, for example, was destined for bankruptcy without the subsidized loans coordinated by the federal government. Similarly, the rates commanded by the market on municipal debt would lead to further stress in the budgets of states like California, leading the Governor to beg at the Treasury’s door.

While the rescue plan, combined with a little luck, may be enough to prevent the fire from spreading further, it does little to correct the excesses that have increased the risks of deadly disasters. A nation that has been drunk on cheap credit and unrealistic leverage now must confront a less extravagant existence based on real income rather than borrowed funds. Debtors of all stripes must come to grips with their addiction and realize that increasing leverage leads to greater dependence on creditors and a higher likelihood of default. Bailouts do little more than distort the market’s ability to efficiently distribute scarce funds to end users. As credit contracts and competition for available resources becomes more fierce, it is important to let markets determine prices and capital to be efficiently allocated. There will inevitably be bankruptcies and hardship, but the destructive process leads to the emergence of stronger, more competitive survivors. Unfortunately, it appears that the interests of a few will supersede the good of the economy as the government attempts to rescue the weak from the cruel realities of capitalism. If we fail to realize that the destructive process is a natural and healthy consequence of capitalism, we will relegate ourselves to mountains of national debt and decades of economic stagnation.