Monday, December 29, 2008

How the Financial crisis could have been handled better by the Bush Government


The way USA government is handling the Financial crisis is blasphemous and I believe they are living in fool’s paradise. A country which is threatened by outsourcing of jobs to country like India & China is able to dole out bailout of a Trillion dollar with such frequency!! To put things in perspective India’s GDP is around $ 1 Trillion per annum and that of China is around $ 4 Trillion per annum. (USA GDP is around $ 14 Trillion per annum). According to my estimates USA government has doled out around $ 8 Trillion as bailouts in the last 12 months. It works out to 8 times India’s GDP, 2 times China’s GDP and almost 57% of USA’s GDP!!! If USA government is made to payout 12% interest (rate of interest in India) on the bailout amount, USA would be paying interest equivalent to India’s GDP each year!!!

I believe everybody agrees that the financial crisis had been handled very poorly by USA and they have managed to survive due the Dollar Hegemony, otherwise they would have had the fate similar to that of Zimbabwe – mindboggling inflation rate with domestic currency rendered worthless. (I believe eventually USA will have to pay for it and dollar will crash soon).

I believe the Financial crisis could have been handled by following simple steps listed below. Why it was done the way it was done puts in question both - Bush government’s intelligence and the vested interest:

1. Guarantee total current, saving and fixed deposits in banks for 5 years: (currently FDIC guarantees deposit upto $ 200,000 per customer per bank). This would have taken care of the confidence crisis and people would have deposited money in banks without fear. It would have helped increase liquidity with banks and increased their deposit : lending ratio
2. Make all deposits in banks tax free for 5 years: This would have given incentive to save to US nationals. Currently savings rate in USA is almost negative and is one of the biggest reasons for the current crisis. This would have also reduced the cost of funds for the banks as deposit rate expectations of customers would have decreased. It would have also made bank deposits more attractive investment option in comparison to other options.
3. Provide banks with tax holiday on interest income for 5 years: This would have reduced the cost of funds in the economy and would have increased investment activities in the economy. This would have also made the banks balance sheets stronger.
4. Let the weak bank to fail and file for bankruptcy under Chapter 11: No bailout should be provided to any bank or company before it files for Chapter 11. Chapter 11 has been designed to provide businesses an opportunity to reorganize and survive if the possibility exists. If the banks / companies donot have inherent strength to survive they should be allowed to die. Contrary to the myth created by the Bush government, closing of few banks will not destabilize the system if depositors are protected. Jobs are not lost or created by such bailouts. If the business makes sense somebody will buy out in part or whole of the bank otherwise some other banks will grow to fill the void left by the failed banks – creating more jobs and business activity.
5. Strictly penalize wrong doers: The current US government plan is rewarding the wrong doers by giving out bailout. It should be doing exactly reverse. Negligent and reckless traders and bankers should be strictly penalized to create examples for others.

The above plan is superior to the plan used by USA government due to following reasons:

1. Incentivizes savings rather than expenditure: USA government has created a myth that an economy grows by spending more rather than saving (& investing) more. And hence they had been spending recklessly specially during the last 8 years. Sooner they get rid of this false notion the better.
2. Takes care of the confidence crisis: Full security of deposit creates confidence in banking system. People will park their saving in banking system without any fear as it would be as safe as US government security. We can see that there is so much fear currently that people are willing to park their funds in US government securities at almost 0% rate of return.
3. Makes banking fundamentally stronger: Tax holiday of 5 years on both deposits and advances makes the banking business fundamentally stronger. The spread for the banks improve, thus improving their profitability. It also reduced the cost of fund in the economy, which would stimulate investment and demand.
4. Fair and equitable: One of the most important reasons why this system is better than the Bush government’s plan is that it’s fair and equitable. It doesnot protect only the banks which are “too big to fail”. It spreads the benefits to depositors, borrowers, mortgagees, small and medium enterprise & businesses. Who should survive and who should not is decided by the market forces and not by Mr. Paulson.
5. No moral hazard: The proposed system doesnot provide any incentive to wrong doers. It also doesnot create a feeling of being cheated to people who had been handling their finances properly. It stops the practice of expecting bailouts on the pretext that others have got the same.
6. Lets the market decide: The incentive (in form of reduced taxes) is fairly divided among people who are saving and people who are borrowing for justified causes. On the other hand banks which are reckless and negligent are thrown out of the system. It’s the survival of the ones who manages their business well and Chapter 11 for the one who can’t.
7. Substantial less cost to the taxpayers: The cost to taxpayers in form of reduced tax collections from deposits and advances and from protecting of deposits would be substantially less than the billions of dollars of bailouts currently being doled out.

1 comment:

sanjay said...

Nice points Neeraj!

I feel US is still living in denial mode and not accepting its mistakes. They are thinking, they will again fool people by some workaround. In fact, read any article written by Friedman or economists like Krugman, they all talk about petro-politics etc but never mention how this system (Dollar Hegemony) actually lubricated their economy in the past three decades. For that matter, i appreciate the guts of people like Ron Paul who openly accepts the mistakes and stresses on fundamental shift in the US policies.