Most experts came out in strong support for the package. Without the rescue package many large institutions that are too big to fail could go belly up. The consequences of all this could be very severe to the real economy, so it is held. We don’t have any issue with the argument that the financial system must be rescued. However, we suggest that the system must be rescued from various institutions that are draining real funding whilst adding very little in return. Consequently, this prevents wealth generating activities in the financial sector and the other parts of the economy to promote real economic growth.

The essence of economic adjustment

Conventional thinking presents economic adjustment, also labelled as economic recession, as something terrible, which can bring the end of the world. In fact economic adjustment is about allowing scarce resources to be allocated in accordance with consumers priorities.

On this score, we know now that allowing the market to do the allocation always leads to better results. Even the founder of the Soviet Union, Vladimir Lenin, understood this when he introduced the market mechanism for a brief period in March 1921 to restore the supply of goods and prevent economic catastrophe. Yet for some strange reasons most experts these days cling to the view that the market cannot be trusted in difficult times as we have it now.

But if central bankers and government bureaucrats can fix things in difficult times surely they could also do a great job in good times. Why then not have a fully controlled economy and all the problems will be fixed forever? The collapse of the Soviet Union’s centralised system is the best testimony that one can have that controls don’t work. A better way to fix economic problems is to allow entrepreneurs the freedom to do this.

So in this sense the best rescue plan is to allow the market mechanism to operate freely. Allowing the market to do the job will result in some activities disappearing all together while some other activities will in fact be expanded.

Take for instance a company, which has six profitable activities and four losing activities. The management of the company reaches a conclusion that the four losing activities must go. To keep them alive is a threat to the survival of the company since these activities rob scarce funding from profitable activities. Once the losers are shut down the released funding can be now employed to strengthen the “good guys”. The management can also decide to use some of the released funding to acquire some other profitable activities.

This is precisely what the government rescue package is not going to do. The government package is not going to rescue the economy but rather will rescue activities, which the economy cannot afford to have. These activities are far too large to be kept alive. (Remember government is not a wealth generator, it can only take resources from A and give it to B).

Can the rescue package prevent economic disruptions?

Some supporters of the package are of the view that the package is necessary in order to prevent unnecessary economic disruptions. They mean by this that various phoney activities should be kept alive by wealth generators for a little bit longer until a proper system is established. By proper they mean more controls.

As long as the pool of real savings is still around the government package can appear to be working — the reason being that there is still enough real savings to support good and bad activities. If, however, the pool is shrinking then nothing is going to help and the real economy will follow the declining real pool.

If the pool is still ok then there is no need for a rescue package and if the pool is falling then the rescue package will make things much worse. This means that the rescue package cannot prevent so-called economic disruptions. If anything these disruptions would get much worse. Again a better alternative is to let the market do the job. That the market can make swift adjustments without much drama was vividly illustrated only a few weeks ago when the very large investment bank Lehman Brothers was allowed to go belly up.

One could have made the case that when Lehman was on the brink that it was too big to fail — assets of $639 billions and employing over 26,000 people. Yet in a few days the market once allowed to do the job reallocated the good pieces of Lehman to various buyers and the bad parts have just vanished. Likewise Merrill Lynch, which was bought by the Bank of America, will see the good parts of it reinforced while the useless parts are likely to be removed. On this Jeffrey Tucker made the following observation:

But as wonderful as the daily shift and movements are, what really inspires are the massive acts of creative destruction such as when old –line firms like Lehman and Merrill melt before our eyes, their goods assets transferred to more competent hands……This is the kind of shock and awe we should all celebrate. It is contrary to the wish of all the principal players and it accords with the will of society as a whole and the dictate of the market that waste not last and last. No matter how large, how entrenched, how exalted the institution, it is always vulnerable to being blown away by market forces – no more or less that the lemonade stand down the street.

It is also important to establish the source of the present financial crisis and not to blame the symptoms. It is amazing that most commentators have unanimously accepted that the root problem of the current financial crisis is the lack of proper control over mortgage lending. But the out of proportion explosion in the mortgage lending didn’t occur out of the blue. Without the aggressive lowering of interest rates by the Fed mortgage lending couldn’t have exploded. (The Fed lowered the fed funds rate target from 6 per cent in January 2001 to 1 per cent by June 2003 the 1 per cent was kept until June 2004).

The loose monetary stance set the platform for various false activities that wouldn’t have been around without the loose stance. Now even if authorities would have kept strong controls over mortgage lending whilst at the same time pushing money out of thin air we would have had excesses but in some other less controlled activities. The banks would have ended up having plenty of bad non-mortgage related assets.

One can rest assured that bubble activities would have been created on the back of the loose monetary stance of the Fed – this is the crux of the problem. So rather then blaming the symptoms what is required is to close all the loopholes that allow the creation of money and credit out of thin air.

Financial sector is far too big relative to the rest of the economy

The fact that currently large financial institutions appear to be very vulnerable could be indicative that the financial sector of the economy has become far too large relative to the real economy. We have far too many paper shufflers and far too little activities that generate the real stuff that promote our life and well being.

No one denies that a modern economy must have bankers, brokers, accountants and lawyers — but not so many. The wealth generators are not large enough to support so many non-productive financial activities. For instance, the percentage of the S&P500 financial stocks capitalisation from the overall S&P500 capitalisation stood at above 15 per cent so far in September.

• In the so-called “normal” times i.e. before monetary explosion since early 80’s the average figure stood at around 5.6 per cent.

• The percentage of financials out of non-financials is currently at 18.6 per cent against the “normal” times figure of 5.9 per cent.

• This in turn raises the likelihood that the capitalisation of financials could fall in a big way if things were to revert to “normal”, all other things being equal.

Even in terms of gross domestic product (GDP) the share of the financial sector has been on a constant increase. For instance, in 1947 the financial sector GDP was 2.3 per cent of total GDP by 2007 this figure stood at 8.1 per cent.

Can making banks balance sheet look good “fix” the economy

Recall that Treasurer Paulson and the Fed chairman are of the view that once banks bad assets are removed the banks are likely to move ahead and start lending. We suggest that making the balance sheet look pretty is not going to alter the essence of the problem, which is the poor state of the pool of real savings. The essence of credit is not about lending money as such but actually lending the real stuff that people require by means of money. Without the real stuff no lending is possible.

We suggest that the decades of non-productive consumption (consumption that is not backed up by production) that emerged on the back of loose monetary and fiscal policies has most likely severely damaged the pool of real savings. If this is the case then it will be futile to try to boost lending by pushing more money into the banking system. (After all how could more money generate real stuff. If this could have been done then world poverty would have been eliminated a long time ago).

All that we will have is build-up in monetary liquidity, which banks are likely to place in Treasury bonds. Banks that are currently striving to fix their balance sheets will be ready to lend to those individuals who create real wealth. But if the pool of real savings is falling then it means that there are still far too little wealth generators and far too many non-wealth generators. As long as this is the case no increase in credit expansion is likely to emerge.

By allowing the market to take charge as far as cleansing is concerned at least things will be brought into a proper perspective. At last we will know which activities are genuine and which are phoney.

Does the fall in stock prices cause an economic slump?

The proponents of government intervention maintain that one cannot allow the market to take charge since this will result in a large fall in stock prices, which will be bad for the economy. According to this way of thinking a fall in stock prices and a fall in other asset prices is the key factor that leads to an economic slump. In this way of thinking stock market prices are an agent of economic growth.

(A fall in stock prices it is held results in a fall in consumer wealth. This in turn curtails consumer outlays, which in turn weakens overall economic activity).

Within the confines of this way of thinking it is not surprising that Bernanke and Paulson panicked on Thursday September 18 2008 once a large money market mutual fund – the Reserve Primary Fund - was on the brink. (A collapse of a large financial player such as a money market mutual fund would have resulted in a large fall in the prices of stocks so it is held). If not for the Fed’s injecting $105 billion and the subsequent announcement of the rescue package experts are saying the stock market would have had massive fall.

Also the massive monetary injection had prevented a run on money market mutual funds and prevented a major disaster, so it is argued. According to various commentators if people had taken the money out of their money market mutual funds then banks wouldn’t be able to secure money to fund credit cards, and various consumer and business loans. This in turn would have paralysed the economy.

Let us say that people would have taken their money from the money market mutual funds, surely they would have placed them somewhere. Most likely the money would be placed with commercial banks. Hence money wouldn’t disappear and banks could continue to fund things as before. (Money less the amount held by individuals is always in the banking system. The only time money can disappear if loans extended out of “thin air” are repaid and not renewed by commercial banks).

If large money market funds were to go under some of their assets would be sold and the shareholders would have suffered losses, this however, cannot provide justification for the Fed to pump money and to introduce a rescue package. After all how does the money pumping and the rescue package undo the bad investments decisions of the money market mutual fund managers? Why then should some other individuals that didn’t invest in the fund pick up the tab?

We suggest that a fall in asset prices including stocks and a run on financial institutions is just a symptom and not the cause of anything. The key factor behind the current difficulty in the credit markets is the lagged effect coming from the Fed’s tighter stance between June 2004 to August 2007. The federal funds rate target was raised from 1 per cent to 5.25 per cent.

Once the tighter stance took charge it started to undermine various bubble activities, which emerged on the back of the previous loose stance. A tighter stance slowed the diversion of real savings from wealth generators towards bubble activities. Without an adequate supply of real funding these activities started to crumble. Obviously then banks that have been providing support to these activities by providing loans have ended holding a large amount of bad assets.

As a result bank stock prices started to come under pressure. Now on account of the time lag bubbles in the various other parts of the economy are also likely to come under pressure and this again is going to hurt financial stocks. So as one can see, the fall in economic activity is not the result of a fall in stock prices but comes on account of the tighter Fed stance that arrested the supply of real savings to non-wealth generating activities.

Now would the stock market come under pressure if the Fed had kept the interest rate at 1 per cent for an indefinite period of time? A prolonged loose stance would have given rise to a much greater amount of non-productive bubble activities. As a result the pace of real wealth generation would slow down. Consequently the growth momentum of profits would have come under pressure. In response to this commercial banks would have become more cautious in their expansion of credit out of “thin air”.

All this in turn would have undermined the existence of bubble activities. (Remember every activity must be funded all the time for it to continue to exist). Bubble activities cannot stand on their own feet, hence once the rate of growth of money supply slows down the pace of the diversion of real savings towards false activities follows suit. As a result the survival of these activities is threatened.

From this we can infer that a fall in non wealth generating activities, also labelled an economic slump, is not on account of a fall in the stock market as such but on account of the previous loose monetary policy that has weakened the pool of real savings.

The central bank policies aimed at preventing a fall in the stock market cannot prevent a fall in the real economy. In fact the real economy has already been damaged by the previous loose monetary stance. All that the fall in the stock market does is inform us about the true state of economic conditions. The fall in the price of stocks just put things in a proper perspective. (The fact that a stock price of a company declines because the company’s fundamentals are shaky and not what investors thought they are didn’t cause the bad fundamentals. The fall in the stock price is just an acknowledgment of the way things are).

In the meantime, last Thursday September 18 2008 Washington Mutual Inc the largest US saving and loan bank was forced into liquidation. The bank had $307 billion in assets and $188 billion in deposits. What prompted the closure are heavy losses on its $227 billion book of real estate loans of which a large portion was in subprime mortgages.

The bank lost $6.3 billion in the nine months ending June 30. Against this background and coupled with customers withdrawing $16.7 billion over the past ten days Government regulators decided to close the bank.

Observe that this was the largest US banking failure. Note that the closure of the bank didn’t result in the end of the world. JP Morgan Chase bought some of the good assets of Washington Mutual for $1.9 billion.

Conclusion

Most experts have expressed strong support for the $700 billion package to rescue the US financial system. Without the rescue package many large institutions that are too big to fail could go belly up. The consequences of all this could be very severe to the real economy so it is held.

We don’t have any issue with the argument that the financial system must be rescued. We, however, suggest that the system must be rescued from various institutions that are draining real funding whilst adding very little in return. While agreeing that in normal times the market should be in charge of the allocation of resources, most experts are of the view that the same market cannot be trusted in difficult times.

Only a few weeks ago we saw that the liquidation of a large bank such as Lehman Brothers and the sale of Merrill Lynch didn’t cause massive disruptions as conventional thinking has it. In fact the adjustment was swift and almost invisible.

The reason for the smooth adjustment because the market was allowed to do its job. If Government and Fed bureaucrats were to make the adjustment by means of various financial packages the whole process would have taken a long time and would have been very costly in terms of real resources.

Dr Shostak is a former professor of economics who now works in the private sector