Wednesday, October 01, 2008

Barking Up The Wrong Tree

It was not just until two days ago that I realized here the laymen's opposition to the bailout, that was quickly taken up by politicians in the House to vote down the plan, was based on serious flaw: they think that the bailout is all about giving the taxpayer money to the undeserved Wall Street, the crooks who had just messed the things up.

You may agree or disagree with the plan, but I think it is imperative to at least understand that this is about how to deal with credit market, the heart of the economy that keeps its lifeblood flowing, that doesn't work. One lesson from the 1930 Great Depression and 1998 Asian Crisis is that the failure to do so will bring a prolonged credit crunch and output contraction. It could become indeed very nasty.

Unlike our fellow laymen, when economists disagree on that plan, they generally fall into three positions. First, the bailout lacks of convincing economics argument and detail to credibly support its claim to deal with the severely depressed credit market --and you can use different institutional setting. Or, second, they think that even without bailout, albeit painful, the current credit market will be able to recover by itself without plunging into the economic armageddon, the great depression. Or, third, the benefit of bailout doesn't add up with the cost, including the problem of (future) moral hazard.

To get you informed to the pro-bailout standpoint, these leader column and briefing from The Economist may help. Also apparently David Leonhardt has been trying to educate The Times' readers in his column here.


  1. Though I'm a stubborn layman, I lack the knowledge and courage to disagree with people who obviously know what they are talking about.

    Yet it's tough to see most of the Wall street bandits and their dedicated pundits (on average the 181000 bankers received a bonus on top of their regular income of over USD 200.000 in 2007, the year most of the banks suffered considerable losses) save their asses by this plan.

    I guess the problem is not solved by USD 700 billion. The problem is in the financial ( and economical) system. I am looking forward to a plan that changes all that and doesn't stop ( as this plan does) by putting a very permeable cap on the obscene habit of golden parachutes.

  2. Rizal,

    The economics of credit and its virtues are beyond me, I am a laymen. Frankly, I can't understand how one could continually expand on credit. Leveraging assets and hedging risk is all very well, but eventually, it's unnatural to assume that they don't carry risk anymore. The complex trust for mortgages were structured in such a way that - IMHO - underplay the actual risk carried. It's almost like betting on Heads and assuming you'll be luckier since you flip a thousand coins at once - but you're not, really. In the worst case scenario, it was hedged against the overall risk to the economy (they bet that the gov't won't let them crash and brought everything too much, cause the cost of everyone losing it was too much). Most risk management models are useless and serves only for formality in that respect. it was in effect, a fait a compli to the general public to extend the credit in the hopes that it won't explode too spectacularly and hurt everyone else.

    my problems with the plan presented was where the government acquires bad assets. Toxic assets are toxic - they're overvalued. However way you want to price them, you will always pay too much. If they're valuable we wouldn't have these problems in the first place.

    As it was with the Indonesian BPPN model, one of the main problems was appraisal. Appraising non-liquid assets are always difficult. Appraising complex giant trusts of over leveraged and possibly toxic mortgage is almost a guessing game. Indeed, in the approved plan, Paulson is hiring private asset management firms to handle it, but these are the same guys who created the skewed models in the first place.

    I'm not an expert here, but i can't find any good case study where you could create a market (liquidity and credit) for bad assets. Creating a $700bn market pool for bad assets in a few weeks, is well ambitious. The biggest effect is probably more psychological rather than immediate - they know now have the bottom line for a minimal value, but it won't get rid of the worst of the cancer - it will still tilt the market significantly, effectively preferring certain market players that held on to that magical bottomline - since now the gov't had announced that they will back the winner. The 'preferred' private players can continue to play the big game, with an artificially propped ZERO downside (look at Citigroup and Goldman in the last 3 weeks, or the assets restructuring for a lot of the Salim group during BPPN) - which is my problem with Friedman's comments last week. (on my page)

    Governments are not equipped to deal with this beyond providing the psychological insurance. The invisible hand is better when they remain invisible. Warren Buffet got much better deals into Goldman/GE - perpetual preferred shares with guaranteed 10% annual return, with fixed priced warrants exercisable within 5 years. He made a cool half a billion in under a week - both Goldman and GE took a bleeding in accepting the offer but they were betting that Buffet is a better boss than Paulson. It must've helped that Paulson is now backing Buffet with a $700bn treasure chest.

    It's not like they didn't know that American economy was leveraged to the hilt - they put it up in Times Sq. for extra glitz.

    Which brings us the urgency and the economic armageddon you mentioned. i think that's over exageration. By most measures, the size of the problem (relative to the overall economies affected) is actually much smaller than the Depresssion or others. It's hardly armageddon - do enlighten me if i am wrong here.

    Pardon the long comment, i'm an idiot struggling to understand these things - i'm not even sure i understand the half of it.

    I'm truly curious though, how do you think it affects ID economy in the immediate future?

    I just heard Aviliani on telly (along with some other pundits) but she didn't sound like she knew what to do either.

    Hope you had a good holiday!


  3. On what are the possible impacts on Indonesian economy, now I have some rough ideas (but, alas, still without the numbers in hand), like I wrote in another posting:
    - The end of commodity (agriculture and mineral based) output boom, as the world's demand will slow down. Anyone with CGE-GEMPACK simulation would kindly join in here?
    - The end of easy international capital, as seen from the JSX drop. But I am not really clear on how big this kind of capital as the source of real sector's investment financing. Probably not too much, since mostly short term ones.
    - Budget deficit financing (the government bonds) from international market will be more limited. Expect tighter budget, or higher bilateral/multilateral debt in the forthcoming year.