There’s A Hole In Your Bucket, Dear Geithner…

Jim, I don’t believe that the authorities can bail out the financial system, even if they want to. And in my view the big mistake of last September was not the Lehman collapse, but the AIG rescue.Tuesday’s US stock market action – a near 5% slump in the S&P; 500 index – came in reaction to the announcement of the Obama/Geithner bank bailout plan.

I actually feel sorry for the officials that are having to come up with these repeated rescue packages. As investors’ anticipation rises, their task gets ever more difficult. And it gets more difficult because the amount of bad debts in the banking system is increasing faster than the rate at which new taxpayers’ money can be poured in. There’s a hole in Tim Geithner’s bucket.

I don’t expect Messrs. Bernanke, Geithner and Summers to change – bailouts, after all, are what they have specialised in for years. But I do expect them to fail.

Why? Because the vast amount of debt created in the bubble can no longer be supported by an economy that is shifting quite rapidly to a lower level of activity. Bailouts merely have the effect of replacing private debt with public debt, with resulting tax rises and a depressing effect on the population that has to pay them.

Ultimately, there really is no way out, in my view, except to recognise that part of the vast stock of bubble-generated debt is not going to be repaid. As Steve Keen says in his latest blog, we either have to inflate it out of existence, or abolish it selectively (or both).

And this is what the monetary authorities are seeking to avoid at all costs, as it will mean banks’ shareholders being wiped out but, more importantly, bank bond holders also taking a hit. But the rigid opposition to a partial writedown of debts makes less and less sense.

Of course this would mean the end of the current power base of Wall Street, as many large institutions would get taken over in bankruptcy or broken up.

But if the powers-that-be try to convince us that this prospect is the end of the world, I disagree. Markets and economies have dealt with large-scale debt defaults before, many times, and survived.

The public will accept this outcome as well, I think, as long as people see that the burden of the clear-up is being shared fairly. Most people have already taken huge hits to their personal wealth through stock market declines, the fall in property values, and the rise in unemployment, in any case. What people will not accept, though, is bankers being paid bonuses while the taxpayer foots the bill for the bubble.

If the authorities keep trying to muddle through and save the markets with smoke-and-mirrors schemes like MLEC, TARP, and the latest plan, all of which are designed to hide the basic fact of bank insolvency rather than to address it, then I think the outlook for the markets and the economy is very bleak indeed. Confidence can be restored only by facing reality.

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