US economic crisis: What solutions?

You have heard this before: Economies are like people. People make up economies, and economics is about people working, having a good time, saving, or borrowing.When we realize this to be true, then we find economics not just in business pages but in people’s hearts.

If we understand the root causes of the economic crisis, then we are closer to knowing the medicine to cure it. But if we disregard the need to understand the real cause of the ailment, then plainly any medicine will do.

In this article, we will go into problem-solving on the crisis. It is very complicated as the crisis changes in form and scale every day.

Let us review the major solutions advanced these past months.

Easing of interest rates

First, in response to the worsening economy, the US Federal Reserve decreased its Funds Rate from a high of 5.25% per annum in June 2006 to 1% on Oct. 29, 2008, and to a range of zero to 0.25% starting Dec. 16, 2008.

You may have missed the gravity of the figures.

If a bank borrowed from the Fed $100 million for a year, it would be charged an interest of $5.25 million in June 2006 for this loan. Today, at 0.25% funds rate, the bank would be charged only $250,000 — a savings of 95.2%.

For most financial markets operators, the cost of money is their cost of sales. After all, they make money on money. A reduction in the Funds Rate will bring down the cost of borrowing of established financial market operators.

How many of you in manufacturing and trade would wish that they had a fairy godmother who could wave away 95% of your company’s costs by fiat? I am in exports and imports of real goods and services, and I am a lonely boy indeed!

In general, changes in the Fed Funds Rate impact on the cost of borrowing among financial institutions and supposedly on their prime borrowers.

However, do not expect the interest rate charged on commercial loans, mortgages, student loans, and credit cards of people to adjust just because the Funds Rate goes down.

The free market takes care of people like us.

Inevitably, the Fed will print new money to increase the money supply, a process called quantitative easing

So, what is the real problem and how does dropping the Funds Rate and flooding of the market with newly printed money come as a solution?

To the Fed the problem is recession, loss of confidence in the financial markets, falling market indexes, and deflation.

I have triple questions.

First question: Why does the Fed see the real problem to be the recession, loss of confidence in the markets, falling market indexes, and deflation?

Second question: What if these perceived problems are mere symptoms or effects of a greater problem? Then the solution was for symptoms, not for problems.

Third question: Even if these were truly the roots of the crisis, is the reduction of interest rates and quantitative easing the effective solution?

Do they really work in making credit cheap and accessible to businesses in the grassroots? Have they boosted confidence of people in the economy, in making qualified people borrow, in increasing aggregate demand, and in generating employment?

These are the critical issues that need to be addressed in this strategy.

The TARP to the rescue

The second solution is the TARP. On October 3 the US Congress created the $700-billion Troubled Asset Relief Program — the bailout card conceived in response to the financial crisis in the USA.

The TARP was initially intended to buy mortgaged-backed security papers to allow credit to flow in the freezing financial markets. Those mortgaged-backed securities were referred to as “toxic papers” because they might end up being waste papers in the hands of the government when collection time comes.

Fortunately, within two weeks from the law passage the US government discarded the “waste paper” purchase plan and focused instead on buying senior preferred shares in financial institutions.

The most prominent of these financial market operators is the Citigroup.

According to the New York Times monitor of the $700-B bailout fund releases, aside from the $40-B advances to AIG, the following institutions received funds from the US Treasury: Bank of America ($15B), Bank of New York Mellon ($3B), Goldman Sachs ($10B), JP Morgan Chase ($25B), Morgan Stanley ($10B), Wells Fargo ($25B), PNC Financial Services ($7.579B), US Bancorp ($6.599B), SunTrust ($4.850B), and the Citigroup ($50B).

Around 200 other regional financial market operators participated in the TARP, ranging from $3.5B per participant to the lowest amount of $1.5M from October to Dec. 31, 2008.

The total funds allocated to financial markets operators now amount to $162.5 B. (See NYT’s website,http://projects.nytimes.com/creditcrisis/recipients/table

There are other programs under study by the US Treasury — the securitization of credit card receivables, auto loans, student loans, and similar products.

What is the problem being addressed by the TARP?

Treasury Secretary Henry Paulson says, “This market is currently in distress, costs of funding have skyrocketed and new issue activity has come to a halt…. This is creating a heavy burden on the American people and reducing the number of jobs in our economy.”

The solution: massive infusion of capital and provision of free- flowing cheap credit.

Once again I have my triple questions.

First question: Why does the Treasury see the real problem to be frozen credit, loss of confidence, foreclosures, employment, and recession?

Second question: What if these perceived problems are mere symptoms or effects of the real problem? Then, the solution would be addressed to symptoms, not the real problem.

Third question: Even if these were truly the roots of the crisis, is pouring money into the hands of financial market operators the effective solution? Has the release of funds to financial market operators made credit cheap and accessible to businesses in the grassroots, in boosting confidence of people in the economy, in making qualified people borrow? Has advancing $162.5 B contributed to increasing aggregate demand and in generating employment?

Another rescue program

The third solution is the GM and Chrysler bailout. Pres.ident Bush announced on December 19 his decision to pump emergency money into GM and Chrysler as part of TARP.

The following amounts have been released according to the New York Times monitor: $13B to GM as of December 31 with additional $4B pending, and $4B to Chrysler as of January 2.

The condition for the bailout is hinged on the submission by these two companies not later than March 31 of their long-term plan to prove their viability.

Do not miss the irony of the sequence of events: GM and Chrysler may have their money now and then later they are required to submit their plan to show their ability to survive. Very Bush-like.

The NYT monitor also records that $5B has been released to GMAC Financial Services in preferred equity shares. GMAC used to be the automobile financing subsidiary of GM. It has now been turned into a bank-holding company to qualify to borrow low rates from the Federal Reserves and avail itself of the TARP.

With such facilities, GMAC is offering loans to borrowers and buyers of GM cars at a new round of low financing rates with special offers of zero percent interest on some models.

What is the problem being addressed?

Crumbling companies in Detroit, loss of employment in the automobile industry, economic slowdown in the real economy.

The solution: massive infusion of credit to ailing GM and Chrysler and providing low-interest funds to the new bank, GMAC, so that it can lend money to buyers and borrowers.

Again, I would like to pose my triple questions.

Are the two failing automobile manufacturers the root cause of the crisis? Or is their loss of viability only a symptom of some other problems? If the problem is mismanagement, then how does placing more money in a losing venture make that venture succeed?

If the crisis of these two manufacturers is only a symptom of an even greater problem, then the solution was for a symptom, not for the real problem.

Other automobile manufacturers in the USA, such as Ford, Toyota, Honda, Mercedes Benz and Porsche, are not availing themselves of any bailout funds from government.
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Obama to the rescue

The fourth proposed solution is the stimulus program of the next US President. President-elect Barack Obama, who takes his oath of office in Washington DC today (early tomorrow morning in Manila), warns that things are going to get worse before they get better.

He says he is focusing on the growing loss of jobs, frozen credit markets, falling home prices and other economic turmoil as his “number one priority.”

In a January 8 radio address, Mr. Obama said he aims to double the production of alternative energy in three years, computerize all medical records, modernize 75% of federal buildings and improve energy efficiency in 2 million homes, upgrade school facilities, and develop broadband access in rural areas. He also aims to provide tax credits to individuals and families and greater tax breaks to employers.

What is the problem being addressed? Weakening demand, growing unemployment, lost confidence in the financial markets, falling prices in the property sector, and saving the green environment for the future.

The solution: massive infusion of funds in the real economy by creating employment, developing impact projects, providing measures to save the environment. Another solution is to impose less taxes and offer tax credits to firms and consumers. Very Keynesian, indeed!

Again, I am posing my triple questions. Is Mr. Obama on the right track in the identification of the true problem?

Or are the problems perceived mere symptoms of an even greater problem?

Even if these are the real problems, will the release of funds close to $1 trillion in the real economy stimulate aggregate demand and build up confidence in the financial system? Will these Keynesian expenditure strategies work as they did in the time of Franklin Roosevelt during the Great Depression? Or, are we simply adding fuel to the fire?

Note that the US Congressional Budget Office revealed last week that the federal budget deficit for 2009 is now estimated to reach $1.2 trillion even before the addition of the cost of Mr. Obama’s rescue plan.

Financial crisis boiling over

As I write this article, the following events are blowing in our faces.

First, prices in world’s stock markets are gyrating. One day they are up, the next day they are down.

Second, with the last Fed’s Fund Rate reduction to a historic range of zero to .25% per annum, isn’t it obvious that zero is the lowest rate one can charge a loan and the Fed has now run out of options on its Funds Rate?

Third, there is less and less money to be made on government bonds, treasury bills, and other forms of “rock-stable” securities. The cash-rich are willing to park their money in government treasuries and bonds paying, in some cases, nothing in yield just to ensure the return of their principal.

Fourth, the value of the dollar vis-a-vis other currencies are going down. This is an interesting phenomenon that is indicative of unseen major developments about to come.

Fifth, really big bad wolves are now being exposed in the financial markets. One of them is called Bernard L. Madoff, the respectable hedge-fund operator accused of carrying on the biggest Ponzi schemes in world history amounting to $50 billion.

Sixth, the prices of commodities, like oil and metals, are on the downswing and financial markets operators are warning, “Deflation, deflation, deflation!”

Seventh, other economies led by Japan, UK, Singapore, Taiwan, etc. are reported to be on recession now.

Eighth, the US economy is getting worse even as government is putting all possible solutions into action and announcements of good news are not taking effect.

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