About to FAIL – Fiscal, Monetary, and Regulatory Policies and what the heck is happening on Wall Street

About to FAIL, originally uploaded by jeffmcneill.

## Confused ##
I have been confused, and quite annoyed as well, by this whole bailout fiasco. My sense was don’t do it. Now I am reaching the conclusion that it needs to be done (but not how it was done). Thereby we may actually have doomed ourselves, rather than doing good. But the predominant experience of all of this is still quite a bit of confusion. I think now I know why…

## What Happened ##
It all comes down to policies. but there are several different kinds of policies. If we can parse them out, perhaps this will all make more sense. Let’s rehearse the policy timeline:

* Congress, with the help of McCain and Bush, deregulate investment banks, making reporting to, and regulation by, the SEC optional. Big news, none of those banks actually reported to the SEC.
* Billions (trillions?) of dollars in bad loans were created based on the demand for the most profitable financial instruments, US mortgage-backed securities.
* Those companies which were the first to create these securities, slice and dice them up, and sell the parts, have all failed, been acquired, or (the final two in existence) transformed themselves into commercial banks. No more investment banks exist.
* With the failure of mammoth Lehman Brothers, credit markets effectively seized up. Short term credit had become the vital lifeblood that an astoundingly large segment of the financial sector to survive, as leverage had gotten out of hand.
* So the cause of all of this is bad judgment which was able to grow to the scale it had through a combination of greed and lack of oversight.

## The Bailout ##
* Secretary of the Treasury Paulson and Chairman Bernake should serve terms in Prison for criminal negligence, as far as I can tell. A cell mate should be Chairman Greenspan. They had been overseeing the crisis (bailing out Freddie and Fannie, etc.), and came to the conclusion that the only way to deal with this issue is to encourage the banks to get some transparency into their books.
* The way they could do this, the thinking went, would be to reward transparency with purchase of bad debt. Hence the $700bn bailout package was aimed at banks in that way. The basic concept was that transparency would somehow help restart the seized credit situation.

## The Policy Problem ##
* The problem with the bailout is that trying to solve a monetary problem, caused by a regulatory problem, with a fiscal solution. Let’s parse through these different policy areas and see what goes where.
* __Monetary policy__ has to do with the amount of money in circulation. The only real lever on this is the interest rate for central banks to lend to commercial banks. Greenspan realized that we had lost control over monetary policy during the last rate increase he oversaw because as he raised interest rates, the flow of money was not thereby controlled. Why? Because the world had become global and money was raised offshore, from the Chinese government and other sovereign wealth funds. Note that the Federal Reserve comes under the Executive branch of the US Government.
* __Regulatory policy__ is the ability of Congress to regulate commerce as well as international trade. The regulatory gutting which began with Regan, continued under Bush Sr. and Clinton, reached a frenzied spectacle and apotheosis under W. and the Republican-held congress.
* __Fiscal policy__ is the budget making process which is held by Congress. Of course the Executive can veto, but Congress can override.

## What Really Happened – The Short Answer ##
Here we are back to the point of confusion. Why would the Executive (in terms of the Federal Reserve, which sets and executes Monetary policy) actually request of Congress a change to Fiscal policy, which was due to a lack of Regulatory policy?

* Short answer: Because we are in deep doo doo.
* Longer answer: Because Monetary policy doesn’t work very well anymore, and Regulatory policy is not well understood by people such as Secretary Paulson who has run organizations on Wall Street (and is himself worth hundreds of millions because of it) and whose career is avoiding such regulations.

## What Should have Happened – And Will Happen Next ##
* It is likely that the credit markets are seizing up, and the $700bn didn’t actually solve anything (other than create another $700bn in debt for the US, which is not a good thing).
* We should have waited until the markets unwound and then went through all the books. That would have gotten us the transparency we needed.
* We should then (and still will likely have to) set some short-term Fiscal policies which will look like a bailout but would be (what it really is) a nationalization of certain market segments
* And finally, regulatory policies should be put in place that make sense and prevent a repeat of this same sorry state of affairs.


## Update 2008-10-15 ##
* [Told you so](http://www.nytimes.com/2008/10/15/business/economy/15bailout.html)


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