Tuesday, January 20, 2009

The World Without TARP: A Thought Experiment



Supporters of TARP have over and over proclaimed that without it we would have seen a credit freeze that would have lead to a global economic meltdown. We'll of course never know but let's try a thought experiment and see what would have happened without TARP.

Now, there is something inherently illogical in proclaiming that a credit freeze would lead to a global financial meltdown. The economy isn't supposed to run so that loans are necessary to make ends meet. In fact, this is the major problem with the economy. It was far too leveraged. You don't solve the problem by feeding the leveraging frenzy.

This is in fact what Peter Schiff said in this clip.


There were a lot of companies out there that would have trouble meeting payroll without access to credit lines. There were a lot of banks that would have trouble providing credit lines without significant infusions of cash into their own bottom lines.

So, what would happen? Many companies wouldn't be able to meet payroll. Those with some business acumen would be able to navigate in the short term and others would have to liquidate.

Furthermore, without significant infusions of cash, many banks would also have failed. So, what is the short term effect? First, it would have created even more short term economic chaos. Rather than having unemployment currently at 7.2%, we would likely be above 8%. The economy would look even more dire. More banks would fail and more businesses would fail.

Yet, to me at least, that is not such a bad thing. Those businesses that couldn't go on without a credit line would fail, but they should also fail. These businesses are going to fail at some point either way. A business is not viable for any long term period of time if it needs a credit line to meet pay roll on any consistent basis. The assets of all such businesses would be bought up at a deep discount by those businesses that are viable. What would happen is a rearrangement that would strengthen those that are already strong and eliminate those that are weak. This could take weeks or months but as soon as it ends the economy would have much more long term viability. Why would we want an economy in which thousands of businesses rely on credit lines to meet payroll?

As for banks, something similar would have happened. In fact, the model is Citigroup. Citigroup is through as an entity as we know it. What will happen is that it will sell off assets and wind up a shell of its former self. Had the government allowed AIG to fail, something similar would have happened as well. We heard all sorts of noise about how auto and home loans would have been threatened. To me at least, this is nonsense. Any number of entities would have bought out those assets at deep discounts. Again, it would have taken the banking system weeks if not months to rearrange, but once they did, the strong would have gotten stronger and the weak eliminated.

So, what would have happened? In the short term, the economy would haver worsened even worse, possibly much worse. Yet, once the shake out occurred, that would have been the bottom. How do I know I am right? Here is how the Wall Street Journal once described the bottom of a market and what needs to happen to begin a recovery afterwards.

To get to a real solution, speculators and investors need to believe that home prices are hitting bottom, that any mortgage debt they might buy today for 80 cents on the dollar today won't be worth 30 cents tomorrow. Then the vultures will pile in: The transfer of wealth from the overleveraged banks and hedge funds to those who kept cash handy will be shocking, ugly and cathartic -- but it will also be relatively quick. Credit markets will begin to function again. The economy will grow.

Yet, that's exactly what would have happened. In the chaos, those without the ability to function without credit would have been eliminated. Meanwhile, those with money on the sidelines would have swooped in and acted like economic vultures. Then, what would have come out of it would have been an economy in which those with strength would have been stronger and those that couldn't function would have been liquidated.

Even those that support TARP will tell us that things will continue to get worse before they get better. It remains to be seen how much worse, but ultimately, it is likely to get so bad that it will get as bad as it would have gotten right away without it. In fact, that massive shock to the system is exactly what the economy needed. That's what would have brought the vultures out. Instead, bad entities are carried and vultures have less opportunities to take advantage. All TARP does is protract the economic chaos.

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