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February 05, 2009

Keynes, Upside Down
by Richard Benson

Every time I pick up a copy of the prestigious financial press, I can't help but read articles pushing Keynes theories. Writers point or wag a finger at the lack of liquidity and the fact that America is in a Keynesian-feared "Liquidity Trap". Indeed, almost every night, the talking heads on TV recite old quotes from textbooks taken out of context and use them to brainwash the last two generations of American college students with Keynesian notions. We can only marvel at the fact that the theory is actually being sold to us as religious dogma, straight from academics that have only lived through America's good times.

While these professional economists are certain to draft future Federal Reserve and Treasury policy for the next four years, they have never had practical business experience such as lending their own money and surviving only if the money is paid back. Without real experience, these Keynesians can't help but omit from the discussion the stunning reasons why the economy is stuck in a credit quicksand. Worse yet, they share the view that the only way out of this mess is to print up massive amounts of money from the Fed and push government spending to end the credit crunch, and get liquidity flowing again. If only quick fixes were so easy.

Calling the situation a liquidity trap is a misnomer. America, and now the rest of the world, is in an insolvency (not liquidity) trap. Banks don't want to lend to bankrupt consumers and businesses any longer became for years there was too much liquidity, and they've already borrowed more than they can ever pay back.

The first sign of just how bad the situation really is was when Hank Paulson (known as "Mr. Risk" at Goldman Sachs, and recently in charge of handing out $750 billion of goodies to banks and Wall Street) appeared on public TV about a month ago. During that broadcast he actually said, and I quote: "The economic problem is that consumers couldn't borrow to buy the necessities of life". Believe me, when you have to borrow to eat and pay the rent, you are already insolvent and on your way to bankruptcy; you just don't know it yet! Remember, it was Paulson and his Wall Street buddies at the major investment houses who got us into this mess by pushing lending on mortgages to unqualified people who could never afford them. When I heard Hank speak, it made me sick.

Let's take an honest look at what's really happening to the economy. Over the last 15 years or so, we were running a Hank Paulson-style economic model facilitated first by Alan Greenspan, and now Ben Bernanke. It was liquidity, liquidity, liquidity, so the average consumer could borrow against his house, buy a car for nothing down, and live way beyond their income on credit cards. The magical fairy tale, that housing prices only go up, was sold worldwide. Now, if you look around, you'll see what's left of Bush's "Ownership Society". Millions of Americans who fed into Bush's doctrine and craved homeownership and the good life, are on the brink of disaster. Liquidity, liquidity, liquidity, led to bad loans, bad loans, and more bad loans.

Businesses are suffering along with consumers because they, too, assumed too much debt and are scrambling to raise revenues to survive. Dwindling retail sales in stores and lower consumer spending mean revenues are far lower than expected. In turn, delinquent consumer and corporate loans cause major bank failure. State and local governments are also gearing up for ever-rising tax receipts but with the housing mess and escalating unemployment, receipts are way down. If local governments don't get bailed out, municipal debt defaults will pile up.

Basically, excess liquidity has left the private sector riddled with bankruptcy. We got here because far too many loans were priced based on the probability of being refinanced and not on the ability to be repaid! As long as liquidity was flowing, bad loans could be rolled over into bigger bad loans, but now the music has stopped for refinancing these loans. As in musical chairs where everyone races to sit down when the music stops, one player will always be left without a chair and is eliminated from the game. That eliminated player represents the millions of Americans and business owners who are suffering and can't face the music.

To say that America is facing a liquidity crisis is like saying a man suffering a massive heart attack is having chest pains. The Fed and Treasury are treating the economic symptoms with a stimulus package and TARP money, which have the curative powers of morphine and whiskey to deadbeats looking for handouts. Like a drug, liquidity can only temporarily make the pain go away.

The obvious cure for the credit problem is higher incomes, less credit, and more savings, just as the only real cure for a heart problem is a healthier diet and regular exercise. Neither are fun, and it won't be easy to change the habits of our debt-addicted society. But our government will try to get the American people to go along politically with the easy way out through massive government spending, liquidity and borrowing.

Keynesian theory says the fun never ends, and America used Keynesian nostrums to push up private spending through credit. Now we are going to use this same theory to justify creating new debt and spending in the public sector.

So, if too much liquidity and private borrowing caused mass insolvency, how can more liquidity, and public borrowing, be sold as the cure? Ah, welcome to government double talk. The government's motto is to never speak the truth, and by calling the insolvency trap a liquidity trap - forcing the public to look in the wrong direction - they can call out for fresh money without guilt!

If the Keynesian solution is to move the bankruptcy of the private sector to the bankruptcy of the public sector, how bad will that be for the taxpayer?

I estimate the bank bailout will cost the American taxpayer $2 trillion to $3 trillion, not $750 billion. The government will guarantee about $10 trillion of private assets, and will push Treasury borrowing to $2 trillion in 2009. (This is a deficit equal to about 14 percent of GDP). In order to save the banks and private sector, the US will be heading straight towards bankruptcy of the public sector. Insolvency of the public sector means higher Treasury deficits and the endless printing of money by the Federal Reserve, causing inflation. So I'll continue buying gold because it doesn't go bust like a private sector mortgage bond, and it doesn't get inflated away. What will you do?

Richard Benson
Benson's Economic & Market Trends
Specialty Finance Group, LLC

Prior to founding the Specialty Finance Group in 1989, Mr. Benson acted as a trading desk economist for Chase Manhattan Bank in the early 1980's and started in the securitization business in 1983 at Bear Stearns, and helped build the early securitization businesses at Citibank and E.F. Hutton.

Mr. Benson graduated from the University of Wisconsin in 1970 in the Honors Program in Math, and did his doctoral work in Economics at Harvard University. Mr. Benson is a member of the Harvard Club of New York and Palm Beach.

The Specialty Finance Group, LLC is a Florida Limited Liability Company and is registered with the NASD/SIPC as a Broker/Dealer.

Copyright © 2004-2009 Richard Benson

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