I am reading a book called The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession, by Richard Koo. His explanation of how and why Japan is in a recession is logical and convincing, and made me realise just how brilliant Bernanke’s ‘credit easing’ move was. It was simply an amazing masterstroke that has never been done.
At that time, I would think that the Fed was left with 3 choices with respect to those companies that received aid (e.g. AIG, Citigroup, etc.):
- Let them fail and go bankrupt, and let the mess sort it out by themselves.
- Let them continue paying down their debts using their cash flows, and disallow technical bankruptcies where assets < liabilities but the company can still meet all payments on time.
- Remove the poison (the worthless securities) from the system, effectively resetting the system as though the bad stuff didn’t happen.
The righteous side of me would argue for Option 1. People that made bad investments, knowingly compromise the system, took unnecessary risks, trusted non-credit-worthy companies and insurance firms, etc. should be accountable for their past actions. Shareholders ought to pay for their own folly in choosing a bad management team. The question of course is, can the country take the hit? How far reaching will be the consequences to the broader economy? How long will it take for it to recover? These are all big unknowns. While the immediate impacts are clear (Citigroup might collapse and be supplanted by better companies like JPMorgan, AIG would be broken up and sold off, etc.), there is always the fear of unintended ‘butterfly effects’ with all the complex linkages that are difficult to entangle.
For Option 2, as what Richard Koo shows, the resultant mess from an asset bubble (housing) fallout would hit the entire economy and can lead to decades of recession, deflation, and the like.
Considering the above, Option 3 turns out to be a really good solution. You effectively reset the system, everybody goes about their own merry profit-maximizing ways, their bad decisions all erased. The Fed basically buys over worthless paper (figuratively, I know it has some value), and gives real cash back to people that made bad decisions. Effectively, its as though the Fed handed out free cash to a selected group of people. With the poison removed, you can see why the investment banks recovered very quickly from what could have been a mega-disaster.
If you think about it, what the Fed did was not as bad as it seems. In a normal quantitative easing, the Fed can be buying Treasuries that keeps paying interest but the Fed may effectively not get back the principal as the debt kept being rolled over. In the credit easing move, they basically knowingly swallowed the principal impairment upfront. Not much difference between the two in terms of the monetary easing sense.
Of course the influx of money into the system due to the bailout essentially accelerates the nation towards inflation, increases real exchange rates, depreciates nominal exchange rates (at least in the short-term, this may be negated if other export-countries in turn depreciates their own currencies).
Nonetheless, the fact is that the spanner has been pulled out from the works. Due to the credit crunch fears, companies now have accumulated a huge cash pile of trillions of dollars waiting to be put to use. That’s why M&A activity is picking up and paid for in cash (e.g. HP buying 3PAR and Arcsight, Intel buying McAfee for $7.68bn, Mastercard buying DataCash, etc.).
Hopefully cash held in companies will be channeled towards increasing production, hiring employees, and consumers will shrug off their pessimism and continue to fuel economic growth. Warren Buffett was recently quoted as seeing broad-based economic recovery ahead. His favorite indicator (railcar loadings: AAR Source, Charts) also shows the economy gradually recovering.
Despite the emerging shoots, the U.S. still faces a challenge with its debt to other countries and its persistent budget deficit spending. That is a topic for another post.