Reflections on Recent Government Market Intervention and the effect on the US Dollar

It is evident that free markets are finally dead, as noted in the recent string of US Government interventions in the highly-touted free markets. The argument goes that taxpayer dollars must be spent now to prevent a further erosion in the financial markets that would lead to a credit-freeze of lending by banks which in turn would spur the continued downward plunge in home prices.

The two primary actions of the government this week were to a) agree to purchase upwards of $1 Trillion in toxic assets from the very banks who profited from the real estate boom, and b) ban short-selling of financial stocks. I want to explore both of these ideas:

Short-selling is the act of borrowing shares of x company, selling them, with the assumption the price would drop, allowing the borrower of those shares to buy them back on the open market at a lower price, and return the borrowed shares, pocketing the difference between the original price they sold them at and the new price for which they were purchased. Financial companies have been the targets of late, with share prices of many of the largest firms cascading 50-90% this year. Some forms of short-selling are already illegal, but in the end, market participants should not be forced to only bet in one direction (buy) and should be able to benefit in the other direction. Furthermore, it is rare that sound companies can be annihilated by shortsellers because as the price might be pressured to drop, savvy investors would buy the shares at lower price. Case in point, it is extremely unlikely that Warren Buffet's Berkshire Hathaway could be bullied by shortsellers, given the quality of the underlying assets owned by the firms. Conversely, it was easy for shortsellers to see their bets against Fannie Mae, Freddie Mac, Lehman Brothers, and Bear Sterns become profitable because those firms held incredibly toxic assets on their books and had inflated their values and balance sheets improperly. The roll of shortsellers must not be limited as the scapegoat for the falling values of vulnerable companies.

To speak to the first point: the use of taxpayer dollars to purchase toxic mortgage assets will only prolong the agony facing the US economy. The heart of the problem is NOT those assets themselves, but instead is the fact that homes across the US are OVERVALUED nationally based on the easy credit supply in the form of low-cost, low standards mortgages over the past 10 years. Instead of allowing the market to painfully correct these excesses, the US goverment is going to spend incredible and today-unmeasurable ammounts of everyone's dollars to artificially attempt to create a floor for the drop in prices, buy assets from the banks, and hope they again lend freely to potential home buyers which should lead to further inflation of the very home values at the root of the problem.

There is an enormous question that must be asked, however: if the Treasury and the Fed are going to buy these toxic assets from the banks, these mortgage backed securties, CDO's, and other pools of mortgage debts, what price should the government pay for them? The primary dislocation in the market is that these banks CAN'T put a value on these assets themselves because there are no buyers willing to pay for them. If you are holding a bag of apples that originally cost you $20 but the fruit market is empty today and tomorrow and the next day, how do you know what the value of apples are? You don't. So if the free market can't put a price on these assets, how will the government be able to come in, put a price on them, buy them from the banks, purging them of the toxic sludge, while assuring the American public that it didn't just overpay for terrible assets that NO ONE in the free market wanted to buy themselves?

I heard a price quoted on Bloomberg Radio yesterday speculating that the government would buy these assets for 65 cents on the dollar, meaning the government would buy them for 65% of what the banks thought they were worth, mind you, through the banks internal models of valuating these pools of mortgages. That price sounds high to me, if the free market wouldn't even pay that much. At most the government should pay a price like 10 cents on the dollar for banks to have that right to cleanse their balance sheets. Yes, that would mean banks feel the pain but at least they could start fresh.

The pricetag ventured by Paulson and Bernanke is $700 Billion. But what it doesn't take into account is the fact that there are estimates that not only subprime, but now Alt-A and Prime mortgages could begin to default as well, as more Americans lose their jobs. These will increase the amount of toxic asset pools on banks' balance sheets and lead to more purchases of such assets with tax payer dollar. Where does the government draw the line?

The larger reality that NOT ONE politician will discuss, when touting the merits of the largest bailout in history: the effects of these massive expenditures by government entities on the value of the US dollar!

Is anyone asking where these massive amounts of dollars are going to come from? Is the government also stating that it will increase taxes to increase revenues into the government coffers so that it can increase spending to increase its purchasing of these mortgage pools? No. Instead, the government is going to print dollars buy taking on more federal debt and borrowing from abroad most likely. Today the government announced it is raising the limit of US Federal Debt to over $11 Trillion to finance these bailouts.

Do these amounts seem surreal? They should. What does it mean if the US is $11 Trillion in debt to you and me? Does it mean anything? It should because I venture the results will be like partaking in a game of monopoly: we all know that as more and more dollars are supplied into the economy, each individual dollar is worth less and less. This downward trend in value for what is known as our 'fiat' money, or dollars that are backed by nothing other than the obligation of the US taxpayers to pay back the loans from wence those dollars came, has been in place for the last 40 years.

So let's put the pieces together: the government takes on more debt now to prop up artificially the values of assets that need to drop further in price, while those very actions lead to a decrease in the value of the dollars saved by the very Americans the government is trying to protect. Retirement accounts are valued in dollars, along with savings accounts, and most other forms of dollar-denominated assets. As the government prints more dollars to 'buy' these devaluing assets, it will become inevitable that the dollar itself will get pummeled.

This is of course good for our exports which will be cheaper for the strengthening Chinese citizen to buy but as noted in recent reports made public, our manufacturing base continues to erode, as the US continues to shift towards a service-based economy from a producer-based economy.

Instead of printing dollars to bailout banks and their bankers who made huge fees by creating these toxic pools of assets, the government should invest that money in US infrastructure projects and other such efforts to actually create jobs! That is the cornerstone of rebuilding the economy. These bailouts will probably cost $1-2 Trillion, plus the $1.3 Trillion for the wars in Iraq and Afghanistan. That is over $2 Trillion conservatively that could have been spent developing jobs here in the US, allowing workers to have the opportunity to save again and eventually buy homes, which would eventually lead to the much-desired end result of a bottom/turnaround in home values. Instead, these bailouts will lead to more risk-taking by bankers, knowing that if they only make the problem large enough, the government will socialize all the risks to the 300 million taxpaying Americans.

Where are all of the free-market pundits now? Show me a free market. They only exist when the US needs to pilage a country of all of its natural resources and doesn't want any protectionist regimes getting in the way. The rest of the world should be grinning now as the US government has effectively dissolved any notion of a 'free market'.

I reiterate that buying gold, betting oil up, the dollar to fall, longterm, and taking stakes in Chinese and Indian companies that pay dividends is the way to protect against the effects on your family's life savings by the current government's fiscally irresponsible policies. Don't be fooled by the cloak of national security in which these policies are enshrined: the consequences will actually be worse when the rest of the world realizes that the IOU's of the US Federal Government can never be paid back and the value of the dollars they are sitting on will have far less purchasing power in the years ahead. The yuan will become the Reserve Currency of the world overtaking both the Dollar and the Euro.