The Destructive Implications of the Bailout - Understanding Equilibrium

One of the features that has enabled the bureaucratic abuse of the public during the past year has been the frantic, if temporary, flight-to-safety by investors. The Treasury has issued an enormous volume of debt into the frightened hands of investors seeking default-free securities. This has allowed the Treasury to finance a massive and largely needless transfer of wealth to bank bondholders so easily over the short-term that the longer-term cost has been almost completely obscured. But by transferring wealth from those who did not finance reckless loans to those who did – providing monetary compensation without economic production – the bureaucrats at the Treasury and Federal Reserve have crowded out more than a trillion dollars of gross investment that would have otherwise have been made by responsible people in the coming years, shifted assets to the control of those who have proven themselves to be irresponsible destroyers of capital, and have planted the seeds of inflation that will cut short any emerging recovery.

In order to understand the impact of these interventions, you have to think in terms of equilibrium - recognizing that all securities that are issued must also be held by someone - and then follow the money. Initially, suppose you have a banking system with $12 trillion in assets, financed with about $7 trillion in deposits and other liabilities to customers, about $4 trillion in debt to the bondholders of the banks, and about $1 trillion in shareholder equity as a buffer against insolvency.

Now, suppose that the value of the assets deteriorates by $1 trillion, effectively wiping out the shareholder equity and putting much of the banking system in an insolvent position. Suppose also that government bureaucrats refuse to properly take receivership of insolvent banks, to impose haircuts on the debt to bondholders or to require them to swap debt for equity. Instead, suppose these bureaucrats prefer to defend the private bondholders who funded the bad loans from experiencing any loss whatsoever, and are willing to use public funds to do it.

In order to do this, the Treasury issues $1 trillion in government debt, with a preference toward shorter “money market” maturities (since it doesn't want to drive up long-term interest rates at the same time the Fed hopes to invigorate the housing market). It may seem like this means that there is $1 trillion of new “liquidity” in the economy, but you have to think carefully.

If you look at various individuals in the economy, including yourself, notice that except for cold, hard currency in your wallet, whatever savings you have accumulated in the past have been allocated to finance investments that have already occurred. You may think that your stocks and bonds and bank CDs and money market securities represent your “savings,” but they are actually securities that exist as evidence of money that has already been spent by some borrower, and on which you have some claim to future income or repayment. And this is crucial: the securities that represent those claims – the stocks, the bonds, the CDs – will all continue to exist until and those securities are retired. If you sell your stocks, or bonds, or money market securities, you have to sell them to someone who presently holds cash. In other words, in order for you to get cash that you can spend, you have to sell your securities to someone whose savings have not already been allocated to something.

So where does the money come from to buy these new Treasury securities? Clearly, the sale of those securities must absorb the savings of someone in the economy whose savings have not already been claimed. Alternatively, the Fed can directly purchase those Treasury securities and literally print money. In practice, we have a third option. The Fed can acquire $1 trillion of commercial mortgage-backed securities and other assets from banks and create an equivalent amount of “reserves” (which is essentially printing money) at the same time that the Treasury issues the $1 trillion in new Treasury securities. In this case, which is in fact exactly what has happened, the banks that previously held $1 trillion in commercial debt securities can now use their newly acquired reserves to buy the $1 trillion in newly issued Treasuries. Having done this, they have no more money to lend than they had before. There is no more “liquidity” in the system than there was previously, except that the “quality” of the bank balance sheets has improved.

The Fed has turned its balance sheet into a garbage dump, in order to accommodate all of the additional Treasury issuance required to finance the rescue of bank bondholders.