The art of deception: Hank Paulson speaks

The key problems that we face are all expressions of the fact that our monetary system is based on debt, and this enforces an exceptionally short-term investing and planning horizon, along with the need for continuous exponential expansion.

Thus our primary ailment today is a failure of our money system. Practically everything else that we read about today – bank failures, foreclosures, rapidly depleting resources, etc – are merely symptoms of this failure.

We are facing a money crisis, not a banking crisis. We are not experiencing a failure of our credit markets, but a failure of our money system. The apparent inability of our policy makers to understand this crucial distinction all but assures that their attempts to “fix things” will do more harm than good.

This OpEd piece by Hank Paulson, published today by the NYT, is a monument to wasteful, off-target thinking.

“Fighting the Financial Crisis, One Challenge at a Time”
By Secretary Henry M. Paulson, Jr.
The New York Times November 18, 2008

We are going through a financial crisis more severe and unpredictable than any in our lifetimes. We have seen the failures, or the equivalent of failures, of Bear Stearns, IndyMac, Lehman Brothers, Washington Mutual, Wachovia, Fannie Mae, Freddie Mac and the American International Group. Each of these failures would be tremendously consequential in its own right. But we faced them in succession, as our financial system seized up and severely damaged the economy.

My Comment:  So far so good, but all he’s done here is describe a few symptoms. No recognition of the causes of the problems yet (let alone assigning culpability). But this is just his opening paragraph; perhaps he’ll get to the causes later.

By September, the government faced a systemwide crisis. After months of making the most of the authority we already had, we asked Congress for a comprehensive rescue package so we could stabilize our financial system and minimize further damage to our economy.

My Comment:  Actually, the crisis was fully recognized by many observers several years back, but was obvious to everyone in the industry a full year earlier than September 2008, and Hank knows it. The August 17th, 2007 event (a credit dislocation and stock market swoon) was a full-blown systemic crisis that kicked off everything we are seeing today.  Astute observers of financial markets know that every warning bell in the engine room went off on that day.

Hank is avoiding raising that uncomfortable fact because it puts the lie to the “emergency” bailout bill, which was rammed through Congress and which has subsequently enriched many of his closest personal associates. So he is trying to reshape history by implying that the crisis erupted in September of 2008. It did not. It had been in the offing long enough that I remain confident that Ben Bernanke was handpicked in 2002 based on his recipes for fighting this exact sort of a battle. If this isn’t true, then I have to believe that one guy in Western MA with an Internet connection was able to diagnose and predict a set of ailments that eluded professionals with access to far better information. It’s possible, but not very likely.

There is no playbook for responding to turmoil we have never faced. We adjusted our strategy to reflect the facts of a severe market crisis, always keeping focused on our goal: to stabilize a financial system that is integral to the everyday lives of all Americans.

My Comment:  The goal here, while laudable, is very much directed at the symptoms and offers us no insights as to whether the cause has been identified. After all, is it worth “stabilizing” a system that is inherently unstable? Do we know why it was unstable? Will providing massive funds help, or hurt? How can we know unless we know that the cause of the instability has been identified? What if the cause was “too much debt?” How will going deeper into debt help? These are all valid questions and they are left unasked and unanswered, probably because confidence in our economic system would be eroded by any such introspection.

As we assessed how best to use the remaining money for the Troubled Asset Relief Program, we carefully considered the uncertainties around the deteriorating economic situation in the United States and globally. The latest economic reports underscore the challenges we are facing. The gross domestic product for the third quarter (which ended Sept. 30, three days before the bill passed) shrank by 0.3 percent. The unemployment rate rose in October to a level not seen since the mid-1990s. Home prices in 10 major cities have fallen 18 percent over the previous year. Auto sales numbers plummeted in October and were more than a third lower than one year ago.

My Comment:  Here Hank is connecting the bailout money to fixing the economy. He explicitly draws that connection and maintains it throughout the editorial. The application of TARP money, he implies, is the same as aiding the economy. But what this mechanism might be is never stated, and I’ve not yet seen any mention of it anywhere. For the millions out of work, new capital in a big bank is not helpful in the least. For an ailing company addicted to selling to overly indebted consumers, the TARP money provides no relief.

I have always said that the decline in the housing market is at the root of the economic downturn and our financial market stress. And the economy, as it slows further, threatens to prolong this decline, as well as the stress on our financial institutions and financial markets.

My Comment:  Um, no, Hank, sorry, this is not true. Here are some recent quotes from you:

April 20, 2007 — “I don’t see (subprime mortgage market troubles) imposing a serious problem. I think it’s going to be largely contained.”

July 26, 2007 — “I don't think it [the subprime mess] poses any threat to the overall economy.”

Perhaps “always” and “root” mean different things to Hank than to me, but when I say “I have always maintained,” I generally mean for a much longer period of time than, say, since last year.

The current $250 billion capital purchase program is strong medicine for our financial institutions. More capital enables banks to take losses as they write down or sell troubled assets. And stronger capitalization is essential to increasing lending, which is vital to economic recovery.

My Comment:  This is technically true, but in a very, very slippery way. What Hank is leaving unsaid is that the banks are not really taking losses to anywhere near their true extent, because the Federal Reserve is buying their assets at prices far above fair market value. So you’ve got Hank shoveling taxpayer money into the capital/equity side of banks (at very unfavorable terms to the taxpayers, especially compared to European efforts), while on the other side of the balance sheet you’ve got the Fed lifting damaged assets off their books at above-market rates so that the banks can avoid an honest appraisal of their true condition. So the slippery part was for Hank to mysteriously leave out the Fed's efforts in describing the scope of the bailout help.

Worse, this paragraph displays the pro debt-growth bias that will lead to our eventual ruin as a nation. Hank is parroting a thoroughly unquestioned premise on Wall Street, which is that “stronger capitalization is essential to increasing lending, which is vital to economic recovery,” but you and I might reasonably question whether this is true. Increased lending has brought us to the highest levels of debt ever and is the precise cause of the current mess. So, clearly there is a type of lending that is not good and should be avoided at all costs. Instead we need to actively begin paying down our debts, not increasing them. But as a creature of the banking system, Hank only knows one thing: more debt.

Recently I've been asked two questions. First, Congress gave you the authority you requested, and the economy has only become worse. What went wrong? Second, if housing and mortgages are at the root of our economic difficulties, why aren't you addressing those problems?

My Comment:  These straw-man questions are ducking the main issues. The continued espousing of the myth that mortgages are “at the root of” our problems either displays an appalling lack of awareness or a deliberate attempt to deceive. The root of our problems is primarily composed of excess leverage and a reckless disregard for risk by big financial institutions. It was Hank himself who oversaw the dangerous accumulation of leverage during his tenure as the captain at the helm of the flagship Wall Street firm Goldman Sachs. Reckless lending was the cause, mortgage foreclosures are the symptom. This utter failure to distinguish between cause and effect is what worries me most about our chances of pulling through all this with minimal pain.

The answer to the second question is that more access to lower-cost mortgage lending is the No. 1 thing we can do to slow the decline in the housing market and reduce the number of foreclosures. Together with our bank capital program, the moves we have made to stabilize and strengthen Fannie Mae and Freddie Mac, and through them to increase the flow of mortgage credit, will promote mortgage lending.

My Comment:  Given that Hank cannot spot the cause of the disease, it is unsurprising that he’s decided to treat the symptom. Here he advocates “access to lower-cost mortgage lending” as the solution to the housing crisis, delightfully unaware that he is prescribing more of the very toxin that caused the sickness in the first place. No, we do not need more low-cost lending. Yes, we do need to wring out the excesses of the past and have house prices fall back into a lower equilibrium with incomes. With this one statement, Hank Paulson is effectively saying, “We’ve decided to treat the alcoholic with a fifth of scotch.” Perhaps it’s time to get a new doctor?

The rest of the article closes with three paragraphs of gratuitous self-congratulation for operating boldly in an uncertain market environment. There’s nothing to gain from parsing that out, so I’ll stop here.

In summary, these are the things that are not helped, but rather hurt, by the actions of the US government going deeper into debt to repair failed banks:

1. Insolvent entitlement programs. Our government is already fully insolvent with regard to the entitlement programs. Going deeper into debt at this time only exacerbates that problem, which is no longer far off into the future, but only a decade away from being a full-blown crisis of its own. Instead, a program of saving and cutting government spending needs to be implemented immediately.
2. Lack of readiness for a new energy future. We need to make trillions of dollars in investments into preparing for a very different energy future. A smart grid, electric high speed railroads, reforming our ‘exurb’ living/work arrangement, and the complete replacement of our auto fleet are all essential components of arriving at the future gracefully.  To use this recent weakness in oil prices to encourage people to borrow more to buy SUVs is about the most cynical and shortsighted policy I can imagine.
3. A deficit and crumbling infrastructure. To be a first-world nation, you need an elegant and modern infrastructure. Drive from JFK to NYC with this in mind, and you will know the meaning of ‘embarrassing.’ Have you heard about any major bridges falling into rivers in any major country besides the US recently? We have vast investment needs just in rebuilding and maintaining our current infrastructure. Going into debt to bail out Wall Street does nothing to help in this regard, and very likely sabotages our future ability to borrow, should we ever decide that investing in ourselves is a priority. 
4. A national failure to save. Ending our raw-consumptive spending and rebuilding savings (the only way to support true capital formation) is an absolute must if we want a future of prosperity. By showing zero willingness to do anything other than spend whatever it takes to return to a zero-saving society, the federal government is setting a bad example. Instead we should be exploring ways to cut spending where possible and redirect funds to places where some investment could yield a decent return. Green energy comes to mind.