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.

Admit it! The root cause of current crisis is OVERVALUED DOLLAR

….and the only solution is to devalue it.

The world leaders are giving the current crisis different name like “Sub Prime Crisis”, “Liquidity Crisis” etc etc. But any person with basic common sense can tell that sub-prime or liquidity can’t be a big enough issue to put the world economy in doldrums. The root cause needs to be diagnosed. Until we admit to the problem, we would be taking wrong medicine.

Let’s diagnose the disease. We have divided the symptoms based on the partial diagnosis made by leaders till date:

So called “Sub-prime Crisis”

1. US consumers are defaulting on housing loans & other loans in big numbers
2. Per capita consumption of US nationals has been 2x-3x in comparison to that of nationals of other developed nations. (per capita consumption of cars, steel, cement, crude oil etc)
3. USA’s fiscal deficit for the last few years is in excess of $ 400 billion each year

So called “Liquidity Crisis”

4. The world holds their savings / foreign currency reserve in USA securities. As it’s the world’s standard currency. And as the return on govt. securities has been falling other the years, nations have started investing in quasi-government organization’s securities like Feddie Mac and Fannie Mae.
5. The world has been buying these debts having faith in USA’s credit worthiness and credit worthiness of its institutions
6. USA financial institutions have packaged and repacked housing, credit card and other debts in form of CDOs etc and sold it to the world. Now these financial institutions are going bankrupt

So called “Outsourcing” problem

7. USA is dependent on China and other countries for most of its consumption. USA is importer of almost everything. Salary and cost differential in USA is leading to outsourcing of major chuck of goods and services from developing countries
8. Most of USA manufacturing industry is dead. US automobile companies are about to go bankrupt. Japan & others are able to build better cars at lower cost. IBM has sold out the hardware business to Lenovo.
9. Salary level in USA is substantially higher than in developing countries, which is leading to brain drain problem for developing nations and job loss problem for USA.

So called Consumption led "growth”

10. Standard of living is higher than rest of the developed world. Per capita consumption of US nationals has been 2x-3x in comparison to that of nationals of other developed nations. (per capita consumption of cars, steel, cement, crude oil etc)
11. Consumption has been growing without increase in jobs. Salaries are high despite of limited skill advantage. Imports has been growing and exports have been falling
12. China & other countries had been investing their foreign exchange reserve in US securities against nominal return of 2-3% when opportunity cost of the fund is much higher

Diagnosis:

Point 1-3: USA as a nation and US nationals has been living beyond their means. Consumption led growth has been financed by debts which has started to haunt USA

Point 4-6: World has been duped by the financial engineering of US financial institutions and misplaced faith in USA’s credit worthiness. However, now the world is slowly realizing the risk & mistake

Point 1-6: The world economy growth in last few years was led by unsustainable debt driven consumption by USA. Problem in servicing of debt is leading to world economy going into financial crisis.

Point 7-9: USA has become inefficient and high cost economy. They are unable to compete even in traditionally strong sectors like automobiles, IT hardware etc.

Point: 10-12: Consumption in USA has been growing despite of fall in production activities because developing countries had been subsidizing USA consumption by investing in dollar denominated securities with nominal return.

Actual Disease:

Dollar is Overvalued

Point 1-12: USA currency is overvalued. Due to overvaluation imports are cheaper and exports are costlier. Hence import led consumption is increasing while manufacturing is falling. Overvalued dollar has killed domestic industry and has made US economy inefficient.

“Invisible hand” is absent

Point 1-12: If it was any other country the demand and supply of Dollar would have corrected the currency imbalance. However, as Dollar is the world’s standard currency of trade – the excess supply of dollar had been leaking away into foreign currency reserves of other countries in form of US securities. As other nations were ready to lend to USA against its nominal rate securities USA has accumulated unsustainable amount of debt which it is not in a position to pay back.

SOLUTION – DEVALUE DOLLAR!!!!!!!!

Therefore the only solution to the current problem which we prefer to call ‘Dollar Hegemony’ is to devalue dollar. My estimate is: 40 to 50% devaluation in dollar is required to bring it to parity. And of course dollar should loose its “World’s standard currency of trade” status.

The implications:

Positive for US:

1. Fall in real value of outstanding debt: As dollar value will fall by 50% the value of debt in real terms will also fall by 50%. Again value of houses in dollar terms would double. This would be a big relief for the mortgage market and can help turn it around. It will help US nationals deeply in debt.

2. Manufacturing will become competitive: Salaries in USA will adjust automatically. They are at unsustainably high levels which is making USA uncompetitive. Once dollar is devalued by say 50% automatically salary in USA would fall in 50% in real terms. Making USA industry competitive again. Companies like General Motors etc will be able to compete against Japanese and German cars. Salaries & other retirement benefits of US employees is the major issue pulling these companies down.

3. Imports will become uncompetitive: Imports from countries like Chine etc are undervalued due to overvalued US dollar. Once exchange rate is readjusted imports will become uncompetitive restricting unsustainable level of import driven consumption

4. Job creation: Increased manufacturing activities and reduced imports will lead to job creation in the economy. Foreigners like Indian nationals who are taking up large chunk of US jobs in IT, technology research, doctors, nurses etc will find it no longer viable to move to US as in rupee terms their salary is US would be reduced substantially. Outsourcing problem would be solved to a great extent.

Negatives:

International Impact: Devaluation of Dollar will have a huge international impact. Countries like China which hold substantial foreign reserve in dollar denominated securities will suddenly see their reserves depreciating by as much as 50%. Devaluation of dollar will make their exports to USA uncompetitive leading to large scale unemployment and bankruptcy in their country. This will create social unrest through out the world. It can lead to war between nations for resources.

Crash of financial system & global trade: The whole financial system which is today based on faith in US dollar will come crashing down. The world will need to devise a new order for trade and financial settlement.

Elasticity of import & exports: Not all exports and imports are perfectly elastic. Oil imports will not fall substantially in volume in short term. Similarly replacing IT talent of India would be difficult in short term. Similarly for exports, even if the prices fall substantially volume of exports might not increase for arms and ammunition etc.

Savings & Retirement fund: People who had been saving rather than going for debt driven consumption would be penalized due to wrong doing of borrowers. It will create a moral hazard. Their saving would depreciate by 50% overnight in real terms and they might not have enough retirement funds to take care of their old age.

Conclusion:

The international repercussion of Dollar devaluation is so grave that it can’t be done overnight. It has to be a slow process with enough time for nations to adjust. Countries need to be given time to liquidate their dollar denominated foreign exchange holding. World also need time to device and operate new financial and trade order.

But what need to be done immediately is to recognize the real Disease. The world currently suffers from Dollar Overvaluation. Admitting to the disease is the first step. Denial will only aggravate the disease and create other complications due to wrong medicine. Unless we come out of denial mode world will not start moving in the right direction. Bush & Paulson of the world might say that ‘fever’ called sub-prime crisis / liquidity crisis has been cured but it will come back again and again in some form or other – Bear Stearns / Lehman Brothers / AIG / Citi Bank / General Motors / Ford / Chrysler / …………………………………………