by Terry Coxon,
editor of The Casey Report

We don’t yet know how many trillions will be swallowed up by the government’s rapidly breeding herd of stimulus-bailout-help!help! measures. But additional bold steps are sure to come, some already in R&D and others to be invented on the fly to answer each new wave of bad news. Expect price tags suitable for proving how serious and determined the authors are.

The doubts that meet each new plan – does it really need to be that big... hasn’t something like that been tried before... is it smart to keep wrong-headed decision makers in high places... isn’t too much debt at the heart of the problem... if you don’t know what causes inflation, are you sure you know what causes babies – are all answered with the same rhetorical question: “We can’t just do nothing, can we?”

Yes, we can. But we won’t, because the decisions about our wealth and our freedom are being made by career politicians, for whom stepping aside is the only truly unacceptable plan. Nonetheless, even though the idea of government doing nothing in the face of credit crisis, bank insolvencies, and recession has been reduced to a hypothetical, such a policy deserves a little exploring, since it can tell us something about where all the big-dollar solutions coming out of Washington are likely to lead.

Background

It’s possible to train people to be crazy. If you’re acquainted with a psychotherapist (socially, of course), ask him to explain how it’s done. Training people to be crazy wasn’t what the U.S. government set out to do when it ended the dollar’s convertibility to gold in 1973. But it turned out to be one of the results.

Untethered from the gold standard, the Federal Reserve was free to create new dollars whenever it saw fit. But the policy it drifted into wasn’t steady inflation, day in and day out, it was rescue inflation. The Fed would step up the expansion of the money supply whenever it saw a risk of widespread defaults in credit markets. The unintended effect was to train both lenders and borrowers, by repeatedly rescuing them from damaging defaults, to appraise financial risk unrealistically and to regard what is in fact a source of danger as a manageable nuisance. It made the managers of financial institutions functionally crazy, and the longer rescue inflation continued, the worse they got. (When you read about investment bankers running a business with 30-to-1 leverage and tell yourself, “Those people must be crazy,” you’ve got it about right. But they weren’t born that way. They were trained.)

That’s how the credit crisis was nurtured. And here is what the government has done about it so far.

August 2007 . The credit crisis is just going public. Commercial banks, investment banks, and other financial institutions are waking up to the reason they were getting such great returns on junk paper – it really is junk. To ease the shock, the Federal Reserve begins a vast and unprecedented program of swapping out Treasury securities from its own sizeable (nearly $1 trillion) investment portfolio in exchange for the embarrassing and worrisome securities that seem to be paralyzing the lending departments of the banks that own them. A novel approach, and not really inflationary, since no new cash is produced.

September 2008 . Lehman Brothers informs the Federal Reserve that the novel approach, admirable though its inventiveness might be, isn’t working and drops dead in front of Ben Bernanke’s desk. The Fed abandons the hope of a non-inflationary remedy and begins a vast and unprecedented program of expanding the monetary base (buying Treasury securities and other IOUs in the open market with brand-new dollars).

October 2008 . President Bush signs a vast ($700 billion) and unprecedented bailout bill. It has been sold to Congress as a measure to help banks survive and keep lending, but the details are vague in the extreme, leaving the secretary of the Treasury with the authority to use the money for almost anything, including, if he should find it advisable, “for carrying on an undertaking of great advantage; but nobody to know what it is.”

Other vast and unprecedented programs have followed, including tens of billions for any car company willing to drive (not fly) to the teller window, hundreds of billions to get messy home mortgages house-trained, and unspecified mega-billions for Timothy Geithner’s proposal to unburden banks of bad assets through a plan of great advantage but nobody to know what it is.

And today, 21 months after the doctors started scribbling prescriptions, most markets continue down, the economy is still shrinking, and worries are still growing.

Now roll the tape back to August 2007. What would have happened if the U.S. government had simply kept its long-standing commitments (in particular, protecting FDIC-insured deposits and preventing the money supply from shrinking) and otherwise had done nothing? No good-asset-for-bad-asset swaps, no wild expansion in the monetary base, no bailouts, no arranged marriages with taxpayer-financed dowries for failing institutions.

Nothing.

If that sounds extreme, perhaps you’ll find it a little more acceptable if I put it this way: what would have happened if George Bush, Ben Bernanke, Nancy Pelosi, Harry Reid, Barney Frank, and Barack Obama had done nothing?

It would have been spectacular, a mass die-off of the incautious. Bear Stearns, Morgan Stanley, and other practitioners of ultra leverage, including perhaps Merrill Lynch, would have folded. When you borrow to carry $30 of investments for each $1 of company capital, it only takes a 3.4% drop in the prices of your assets to put you under water. And when you’re getting that 30-to-1 leverage through overnight borrowing, even a whiff of doubt can make it impossible to roll over your financing from one day to the next. Either way, you’re out of business.