Too Big for the Average Joe

Recently an acquaintance of mine, sent me an email with several questions in it.  One of these questions I found more intriguing then the others, and it goes as follows.

How can we have a legitimate democratic political system without a democratized economy? In other words, when wealth and power are concentrated in the hands of a few at the expense of the many, what’s to stop the rich and powerful from buying up, owning, and operating the American government, and running it to suit their own self serving ends?

The answer as unpleasant as it may be, is NOTHING.  The other day I was listening to David Cay Johnston a New York Times best selling author and Pulitzer Prize winning journalist and economist talk about the fiscal imbalance in America and how the poor are getting poorer and the rich are getting richer.  Although this is not shocking in and of itself, what is shocking is some of the subject matter he addressed.  Here is a link to his article on Mother Jones I think everyone should read – http://www.mojones.com/news/feature/2009/01/fiscal-therapy.html

David Cay Johnston mentions in this article that the top 1,000 wage earners in America make one percent of the total salaries paid.  In other words, out of the 200 million or so employed people in the United States 1,000 of them take 1 penny for every dollar earned by the rest.  This is amazing, truly amazing.  Furthermore, the lower 90% of wage earners, or roughly 180 million people earn less money on an equivalency basis then they did in 1973.  Yep that is correct, you are truly worse off than your parents, if you do the same work.

It really does make since if you think about it.  The poor rarely vote, the poor never lobby and the poor never become representatives of the people, so who cares about them.  It costs money to be in office, it costs money to run for office, it costs money to get politicians to care about you, so if you do not have money what good are you?

There are several key points in the Johnston article that deserve their own post, so I will stop this one now, and address the others later, but keep the question in mind, and if you come up with a different answer, please let us know.

A recent article in the New York Times ( http://www.nytimes.com/2008/10/25/business/25nocera.html ) purports to establish that the capital injections provided to the banking industry by the U.S. Treasury are being provided under false pretenses with the intent to reshape the industry as opposed to making loans to help reinvigorate the economy.

I am not taking issue with the facts presented in the story other than that the reporter highlights his lack of understanding of lending as a business and the relationship between the banking system and the economy.

The first thing to understand is that a healthy banking system is crucial to the functioning and growth of our economy.  With a healthy banking system (a well capitalized banking system), banks can make loans to companies whose future prospects and asset value support borrowing.

Banks will absolutely expand lending as conditions and their balance sheets permit.  They have every incentive in the world to do so.

To lend, just for the sake of lending, without regard for the financial condition of borrowers is exactly what got us into the current situation in the first place.

History provides a lesson for us on this point.  Following the collapse of the Japanese asset bubble in the 80’s/early 90’s the Japanese continued to make loans to support the system and prevent the market adjustments (however painful) required to correct the excesses.  As a result, the Japanese suffered a decade of economic stagnation and is still working off the consequences of its many failures to deal with the problems created during the bubble years.

The second thing to understand is that consolidating weaker banks is a normal and healthy part of the process of recovering from the economic calamity in which we find ourselves.

While the Treasury is theoretically making loans available to all banks, the fact is that many banks have proven – as a result of the weakened position in which they find themselves – that they are poor stewards of depositor, lender and shareholder capital.

Consider Washington Mutual.  Had the capital injection plan been approved by Congress earlier, would anyone really want to see the U.S. Government invest $25Bn into an institution that had so horribly managed its capital?  Is it not ultimately a good thing for the depositors of Washington Mutual (and the U.S. tax payer who backs those deposits through the FDIC) that it is now being managed by a company that while they certainly did not dodge the bullet of sub-prime entirely, at least they did not inflict on themselves a fatal wound?

This gets to my final point.  If we make loans to all banks – both good and bad stewards of capital – we, the tax payer, will make some good investments and many bad investments in banks that would be better off having been gobbled up by better management teams.  In the long run our economy will be better off as well.

Now, if on the other hand the Treasury made the loans available to only the “good” stewards, while letting the “bad” stewards of capital struggle with their problems the net impact on the economy in the long run would be muted.  The “good” stewards would have more money to lend.  Unfortunately, because many banks would be left to struggle the loan growth by the good banks would be offset to a great degree by contraction in the “bad” banks.

More importantly, the whole of the banking system would not be healthy and this would prolong the uncertainty in the system as a whole.

To conclude, use of this capital by banks to make acquisitions is not against the interests and the intent with which this program was undertaken.  Rationalization of the banking system will create healthier surviving banks and a healthier banking system as a whole.  As the banks get healthier they will make all of the good loans they can find.

We did not get ourselves into this gigantic mess in a few months or even a few years.  To expect us to get out of it in a few weeks or months by assuming that banks will pump hundreds of billions of capital into an economic future that no one understands is silly.

Let the banks rebuild their foundation.  Growth will follow.