Why the efforts to rescue the economy may fail

In an attempt to resolve the present credit crisis, the United States government has taken many steps. Since September, it placed Fannie Mae and Freddie Mac, the mortgage giants under conservatorship, taken a majority stake in the American International Group and passed a $700 billion rescue package for the financial sector. The Treasury is injecting $125 billion into the nation’s nine largest banks.

One cannot accuse the government of being a mute spectator. But what everyone wants to know is will these efforts and the rescue plan succeed?

No doubt everyone wants it to succeed. At the heart of the rescue plan is an effort to keep the credit crunch from sending the economy into a tailspin. The economic downturn is going to be much worse if the financial system doesn’t get working again.

Somewhere in all this, one thing seems to be forgotten – the rescue plan and efforts doesn’t directly address the root cause of the crisis: falling home prices. It was the falling home prices that ultimately resulted in the present crisis. According to the National Association of Realtors, home prices are off 12 per cent from their peak and are expected to fall an additional 10 per cent to 15 per cent between now and mid-2009. Much needs to be done to stimulate demand for homes and to reduce mortgage delinquencies and foreclosures.

The steps taken by the government so far does not do anything to stop the spiral in home prices. This is reducing net worth and creating a falloff in consumer spending. To stimulate demand for homes, the federal government could offer low-interest loans to replace 20 per cent of homeowners’ mortgages. It is unlikely that the crisis will be resolved without addressing falling home prices.

Falling home prices leads to an increase in mortgage delinquencies and foreclosure. Many homeowners end up owning more on homes that their current worth. They then default on their mortgage payments causing foreclosures. The rise in foreclosures results in a negative market psychology. It is a vicious cycle.

The supply of homes on the market remains stubbornly high, while demand for those homes remains relatively weak. The $7,500 tax credit passed by Congress in July has failed to jump-start home sales.

Another factor which led to the present crisis is the total breakdown in the integrity of asset valuations. The government efforts do not address this. The government has not yet disclosed the pricing logic on which the US government will purchase bad debt from faltering financial institutions. It now appears that the prices will be determined on a case by case basis.

While some lawmakers want the government to exert influence over private companies in which taxpayer money is invested while some are calling for a ban on lobbying activity, bonuses and perks among the companies that have been bailed out by the government, nobody has suggested taking remedial action to rectify either the impaired status of asset valuation techniques.

Lawmakers are probably aware of the need to revamp asset valuation methodologies but they lack the will and fear the explosive political impact of any efforts that will directly challenge the qualifications of real estate brokers, appraisal specialists, bank managers, certified accountants, project engineers, corporate monitors and financial analysts.

4 comments to Why the efforts to rescue the economy may fail

  • In my view, the real “root cause” is massive government intervention in the economy. Until the American people get it into their heads that big government tends to make things worse in the long-run, we will again revisit these same problems in the future. I think we would be better off if we allow market-forces based mainly on individual decision-making-to work things out rather than to use another form of “government stimulus.”

    How many more billions of dollars of tax-payer money must we waste before we realize these mistakes?

    Somebody once said, “If we subsidize failure, we will get more of it.”

    I hope you folks don’t mind. I’d like to direct you to an essay on price controls which I wrote for microeconomics class last semester.

    I placed it on my blog:

    http://expandingyourknowledge.com/2008/10/23/economic-fallacy-price-controls/

    I haven’t updated the site in awhile because I have tons of school work, but there are some interesting tidbits including my personal review of economist Ha-joon Chang’s “Bad Samaritans”-which is a book critical of free trade. A number of other economists-such as Joseph Stiglitz (Columbia University), Edward Glaeser (Harvard), and Ann Kreuger (Johns Hopkins) have also reviewed this book.

    http://expandingyourknowledge.com/2008/10/23/bad-samaritans/

  • Dirk

    One of the actual enumerated powers (and responsibilities) of the Federal government is to PRINT MONEY. Given the massive growth in population, technology, and trade, not to mention an entire cyberspace universe crying to be monetized, it should have been a major alarm that the money supply was constrained the past three years until very recent Fed easing.

    And when money is constrained, economic activity soon falls. First, because those with money have more incentive to hoard it instead of spend or invest it. Second, because as asset values fall, a negative wealth effect causes the kind of downward spiral we’re seeing.

    There is no way out of this current malaise without a major increase in money and credit. The ultimate effect will be inflation, but this is not necessarily bad. Higher inflation will mean more incentive to innovate (think solar for oil). Higher inflation will mean more incentive to spend, invest, and hire. Higher inflation will mean a reduction in the unemployment amongst underqualified workers created by a higher minimum wage.

  • Raymond

    Scene for the ER:

    Nurse: But Dr Ben, you are prescribing the very medicine that made the patient violently sick!

    Dr Ben: Nonsense. Nurse inject the patient with our new liquifying elixir, TARP, pronto. And who told you Dr Keynes
    had a stunted training in economic theory —one course in economics?

  • Raymond

    Scene from the ER, Act 2

    Nurse : Dr. Ben, what happens if the patient still doesn’t recover?

    Dr Ben: Nurse I’ve made up my mind so don’t confuse me with facts.

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