Friday, February 06, 2009

TARP: Anodyne or Asinine?

This is no place to comprehensively review TARP and the sub-prime mortgage crisis, and I know for a fact that there are more authoritative sources than the me, a political hobbyist. But in light of yet another “stimulus” bill, it is helpful to have a fundamental understanding of the underpinning ingredients of this unprecedented government intervention in our economy.

To understand how a burst housing bubble can cause so much misery, one needs to understand first the function of prices in a market economy. Prices are what coordinate economic activity. They are, fundamentally, information. If you were charting a cross country road trip, you would look at a map and decide which roads to take in order to satisfy your interests. For businesses operating in a dynamic economy, prices are the GPS on the windshield. Through financial calculation of the predicted profit and loss, business decide what is feasible (profitable) and impossible (loss). In terms of material satisfaction of the population, only accurate pricing can help create new wealth because it allows this calculation.

Prices are expressed in terms of money – that is, they find numerical expression in dollars, pounds, euros, pesos, etc. Money, for this reason, is considered one of the most useful inventions in human history. Monetizing preference, i.e., individual judgments of value, allows for economies of huge scale and complexity to emerge from free and disparate economic actors (that is, we the people). It does not really matter how much money is in circulation, just that the quantity remains stable.

And while money serves the important role of rationally expressing preference, its primary function is one of exchange. It eliminates the main obstacle posed by a pure barter system: the double coincidence of wants. Basically, money allows people to exchange all sorts of services indirectly through a commonly accepted medium. This gives rise to specialization, arguably the foundation upon which modern society is built. Such an understanding should also clarify the difference between money and wealth, wealth being the goods and services we actually consume, among other things, and not the currency.

If the above is true – that money exists (in part) to express preference, allow for economic calculation, and help facilitate coordination – then the effects of increasing the money supply, or inflation, are obvious. In the long run, prices rise proportionately to the monetary expansion, adding no real wealth. But in the short and medium term, before the new money has been properly re-valued, the increase in the monetary base distorts economic calculation of new enterprises. One likely consequence is adding fuel to the fire of a speculative bubble. Can you say “housing?”

Anyone who has taken an introductory macroeconomic course knows how our government adds money to the economy: the Federal Reserve buys U.S. Treasury bills on the market. It does this through the digital age’s equivalent of a money printing press – the computer, the “0” key. Facing likely recession in 2001, the Fed sought to lower their target rate, and thus began purchasing these securities. A graph is available here:

This new rate allowed banks to extended mortgages (and other loans) at previously unthinkably low rates. Inevitably, projects that before were unprofitable became so due to a lower discount rate. Coupled with the Community Reinvestment Act, this was a recipe for disaster in the housing market. Yet this happened in every industry, housing being only the most prominent. As money slowly came to its new market value corresponding to its expanded base, companies were unable to redeem the dollars for goods/services (this was termed a “credit crunch,” a bit of a misnomer). The economic dislocation brought on by inflation was finally brought to light, and markets and banks began to tank.

Instead of letting markets self-correct, the government, through the Federal Reserve, began buying these “toxic assets,” i.e., conglomerations of solvent and insolvent loans, from banks to help their balance sheets. Consequently, banks are sitting on hundreds of billions of new TARP dollars, food for yet another round of boom/bust. Through monetization, the government socialized the losses of banks, losses that the government helped precipitate.

It’s difficult to understand why our government would do so wittingly. In their defense, academia has its fair share of inflationary apologists (see Paul Krugman), and the philosophy is similar to that of the New Deal (that’d be Fascism and Keynes). The new spending bill, unlike TARP, is not aimed solely at banks (instead, it’s aimed at Democrat special interests groups). It’s purported that it will save 3 million jobs. The truth is that it would shift 3 million jobs into projects that the government, perhaps as few people as a small committee, deems necessary, not the people. It does so through deficit spending, either through borrowing or additional monetary expansion. All this spending adds additional risk to the future validity of the American dollar, teetering already under inflationary fears.

Unless you’re into politbureaus, there is every reason in the world to oppose this bill.

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