TARP Bailout Revisited

            About two years ago, as the Wall Street Collapse was unfolding, an old friend said that her European friend had asked why the U.S. financial collapse should cause the Dollar to appreciate against the Euro.  One would think it should cause the Dollar to fall.  I wrote a response, but before I mailed it I showed it to a few close friends who had been asking the same question.  They all said, “This is what you should be posting on your blog!”  I explained that I didn’t have a blog.  In fact, in the rural area in which I live, no high speed internet connection was available then.  This spring, air cards became available, and I began a blog, mostly in response to urging by friends who had read this opus.  This analysis is now two years old, but viewing it in retrospect, it holds up pretty well.  Keep in mind when reading this that it was written while the crisis was still unfolding—while Henry Paulsen was still trying to persuade Congress to pass the TARP bailout.                                                                       

                             ******WRITTEN  Oct 7, 2008:*****

Dear Jane, (Her name isn’t really Jane, but I try to protect the confidentiality of my friends.)

            Yesterday, you said your European friend was puzzled that the U.S. Dollar should be rising against the Euro, when it is our financial house that seems to be collapsing.  I gave you a brief, almost flippant answer at the moment.   Having thought about it, I believe it is a question that deserves an “in depth” answer, and I will try to provide one.

            Although it seems counter-intuitive, there are three main reasons why this happens:  the collapse of liquidity, the sell-off of commodities in exchange for Dollars, and the tendency to retreat to safe havens in times of trouble.  To wit:

·         The collapse of liquidity:  During the Great Depression of the 1930s, what puzzled most people was that no one could explain where all the money suddenly went.   In the 1920s, the country had been awash with Dollars—yet suddenly no one had any Dollars. Where did they go? Most people assumed that a few rich people still had all the Dollars, but were keeping them hidden in their mattresses, and were not spending them.  While such things actually happened, what mostly happened is that this money had simply, and instantly, ceased to exist.  Only about 5% of the money in circulation at any time is actually issued by the government.  Most of the money on which the country operates exists in the form of “commercial paper.”  This term refers to the IOUs which banks give to other banks.  These are various instruments of debt; they may be corporate bonds, bundles of mortgages, negotiable debentures, or may take many other forms.  But they are all really IOUs.  If you and I both owned banks, and my bank owed your bank 10 million dollars, I could repay this debt by delivering a suitcase containing $10 million worth of this commercial paper.   Your accountants would sort through it all, and then issue a receipt for “paid in full.” When instruments of debt are circulated as a form of cash, this process is called “monetizing debt.” It is how most money is created. The Fed makes a great pretense of controlling the money supply.  But any large corporation can add to the money supply by issuing debt, and these companies are completely beyond the ambit of the Fed.  But is this stuff really money?  It is as long as someone will accept it for payment of debts.  That is the litmus test.  A dollar bill says, “legal tender for all debts, public and private”--everyone has to accept dollar bills. And when times are good, most banks will cheerfully accept most commercial paper, in fact they prefer it. Dollar bills don’t yield interest—but these IOUs do.  A liquidity collapse occurs when some of these debt instruments, (i.e. sub-prime mortgages) become suspect, and serious doubt arises as to whether they will all be redeemed.  When this happens, then a bank which holds these instruments finds that no other bank will accept them, so they have a problem.  This drop in liquidity undermines their balance sheets so much that other banks become skeptical of the IOUs issued by any bank which holds such questionable assets. At this point, any bank which has loaned money to banks holding these questionable mortgages now has a problem on its own balance sheet, as does any insurance company who insures banks against default.  So as the problem spreads, the questionable loans undermine the credibility of all other classes of loans. Banks are supposed to keep cash reserves to offset losses from bad loans.  My own brokerage, Stiffel-Nicholas, has one dollar in cash for every three held in speculative assets.  But Merrill had a ratio of only one to thirty.  They were way over-leveraged.  But to get back to how the crisis can cause the Dollar to appreciate:  Everything Roosevelt did was aimed at trying to put more dollars back into circulation, and that is what Paulsen is trying to do.  One would think that an announcement that the U.S. was preparing to print 7 hundred billion more dollars would erode the value of the Dollar.  But remember that this amount is issued to partially compensate for the fact that a much larger amount, about 4 trillion, has just ceased to exist.  So Paulsen proposes to place into circulation only seven dollars for every 40 dollars which have just removed themselves from circulation.  The net effect is that U.S. Dollars are about to become much harder to obtain than was only recently the case. Therefore, a Dollar will buy much more.  This is already starting to occur with oil.  Since dollars are becoming scarce, the U.S is starting to enter a recession.  Americans will spend less, so any country exporting to the U.S. will find the U.S. Dollar harder to obtain, even though the new exchange rate, which values the Dollar higher, would ordinarily make it easier to export to the U.S.

·         The sell-off of commodities.  Between July 1 and Oct 1, the U.S. stock market, (S&P 500 index) fell 13%.  In the same period, commodities declined an average of 25%.  Deutsche Bank calls this commodity crash “the most aggressive sell off ….in recorded history.” Corn is down $3.00, (from $7.00 per bushel to $4.00)  a decline of 38%;  wheat is down 26%, soybeans 36%, cotton 27%.  Oil, copper, and other commodities have also dropped precipitously. As mentioned earlier, all the large Wall Street investment Banks were dangerously over-leveraged.  So when the crisis began, they all had to sell assets in exchange for cash, to improve their ratio of cash to speculative assets. But what can be sold quickly? Certainly not real estate mortgages, not even the good ones. But corn (maize) and wheat, or oil can always find buyer. So the banks all dumped their commodities futures contracts. The effect on this region could be disastrous. At $7.00 per bushel, corn was selling for well above the cost of production. Farmers were making record profits, and were aggressively buying John Deere tractors, which is what we manufacture here in Waterloo, Iowa.  But a price of $4.00 per bushel is slightly below the cost of production, even without considering land costs. What farmer will buy new equipment when he is losing money?  And it all happened overnight. The day that The House of Representatives rejected the first bailout bill, the stock market lost 700 points on the Dow Jones average. But corn fell from $5.50, (still a profitable level) to $4.00, a much steeper drop.   In one day, American farmers went from having the brightest future they had ever known, to having none whatsoever. (I’m reminded of Rudolfo’s air in La Boheme, where he laments, “En Un Coupe.”)  Besides the disastrous effect which this grand sell-off has on those who earn their living from producing commodities, there are another couple of effects. One is that cheaper prices of oil, wheat and corn in Dollars means the Dollar will buy more--therefore the Dollar is worth more, and will command a higher price. The other effect is that as banks frantically sold these assets for cash, they took in tens of billions of Dollars, effectively removing these Dollars from circulation. They are not going to spend this cash; they will hold it in reserve, since low cash reserve is at the heart of the problem.  And this removal of Dollars from circulation will make Dollars even harder to obtain, which will also raise the price which bidders will pay for them.

·         The retreat to “safe havens” in times of crisis.  In about 1924, my mother’s family barn was struck by lightning, was immediately engulfed in flame, and burned to the ground.  The horses were outside the barn when the lightning struck, and the barn door was open.  They were frightened, and they did what frightened horses always do—they ran into the barn—where they died. The U.S. Dollar and its economy is the great barn of the world, and it’s where everyone runs when they are frightened. Are those who are now buying dollars behaving as irrationally as the horses—running into a barn which is burning? Perhaps they are; Perhaps not.  While it is probably true that the current crisis began in the financial sector of the U.S., the smaller economies of Europe, to which it is now spreading may be less able to cope with it. In 200 years, the Dollar is the only major currency that has never become completely worthless. Its value will fluctuate, but it will always be there.  When you consider the large trade deficit which we routinely run, and the large budget deficit, you’d think foreigners would shun our currency.  But as Warren Buffett, who has been the most outspoken critic of these deficits points out, they really don’t.   When the treasury offered $40 billion in short term notes last week, all 40 billion were snapped up in 20 minutes. The bidding was so aggressive that the last few bidders were accepting interest rates lower than 1/20^th of 1% per annum.  Considering inflation, this is a very negative interest rate.  The U.S. can still instantly borrow whatever amount it chooses, in its own currency, at a negative interest rate.  The reason, as Buffett points out, is that our deficits are still not large compared to the massive size of our economy.  Although, every day, we consume 2 billion dollars more in goods than we produce, we still export 17% of our GDP, and produce products that are in demand all over the world. If we were to shrink our consumption a mere 2 billion dollars per day, we could have a trade surplus.  According to Buffet, we could do this at any time, and everyone knows this. Also, even the modest tax reforms of the Clinton administration ended the budget deficit and produced a surplus. We could do this at any time also. We allow other countries to sell more to us than they buy because we have been willing to be the “buyer of last resort” for the world.  We probably do this because somebody has to do it, and we have the only economy large enough to withstand that kind of strain.  There is a little hypocrisy here.  Many of the foreign governments who publicly criticize our profligacy, our irresponsibility in running these deficits, are privately trembling in fear of what will happen if we ever stop. To sum up, for all its problems, the U.S. is still the safest place to put money.  The largest banks in the world and many foreign governments still aggressively bid for our treasury notes, even at zero interest.