Refried beans

Posted: December 27th, 2008 | Author: Wayne Weddington | Filed under: Opinion | Tags: bailout |  Email This Post 3 Comments »

“In the past decade, China has invested upward of $1 trillion, mostly earnings from manufacturing exports, into American government bonds and government-backed mortgage debt. That has lowered interest rates and helped fuel a historic consumption binge and housing bubble in the United States. China… lulled American consumers… into complacency about their spendthrift ways.” Mark Landler, NYTimes, December 25, 2008

“Japan should write-off its holdings of Treasuries because the U.S. government will struggle to finance increasing debt levels needed to dig the economy out of recession, said Akio Mikuni, president of credit ratings agency Mikuni & Co.  The dollar may lose as much as 40 percent of its value unless Japan takes “drastic measures” to help bail out the U.S. economy… “  Bloomberg Magazine, December 24, 2008

Many ask about the consequence of the bailout. Is it a good thing? Sure sounds like staving off a recession is a good idea… but at what cost? The US is poised to borrow trillions (an incomprehensible number) to accomplish the bailout and to stave off a deep recession. Understanding the consequence is no more complex than budgeting our own lives.

Think back to the most amount of money you have ever borrowed from a friend. The fact that you borrowed from a friend indicates that your alternatives were limited.  No bank was willing to do it. Your friend was therefore a lender of last resort.

The reason may have been a perfectly good one: to start a business, to pay for unexpected hospital bills, or to put a down payment on a house.  It would be normal to plan paying back the loan on the expectation of a windfall such as a promotion, a tax rebate, a salary increase or a new job. You know that you could make ends meet, in the worst case, by keeping to a strict diet of refried beans for a couple of years.

Even under the best of circumstances, paying back a debt is tough, particularly if your income has not increased.  And you can imagine what a strict diet of refried beans would get you.  What happens when the rosy picture turns to red?  If income declines or is lost, you still have the ordinary bills to pay and, on top, payments to the friend. What do you do? The only thing you can do: borrow more money. This time it is “secured” by writing post-dated checks, tied to the even more desperate hope that circumstances will improve.

Well, America is now writing post-dated checks with the bailout.

The future is a tight one. We have already borrowed extensively to sustain our lifestyles in the years since the balanced federal budget, and we have done so on both a personal and a municipal level.  Now it is time to pay. But we still do not have the resources. So we borrow more, encroaching upon the income of future generations.

The bailout is probably necessary, but it does not come for free.  As fiscal conservatives point out, the  cleanest way to ‘fix’ the economy is to let the poorly run institutions fail.  They point to Japan, who  tried to prop-up its own economy in the 90s:  today the Nikkei remains 80% below its high in 1990.  But the free market solution does not take into account the deep pain of the hands-off cure.  The soft landing scenario sounds palatable because it delays the deepest sacrifices… but it is only a delay and potentially multiplies the pain down the road.  The US is asking our friends around the world to make us the loans of last resort on the promise of getting a “higher salary” or a new “job.” The problem is that our lenders are already weary and the windfall change looks unlikely.

We have not yet changed our profligate ways. It reminds me of a friend who like clockwork shows up to borrow money every few months. I have never seen him change his lifestyle: he still likes fine wines and dresses in labels that I covet. Hell, he even treats me out sometimes. How long would I be enthused and confident to continue lending him money?

Moreover the value of the dollar has declined precipitously. If your lending friend were European, he would not be too happy. Foreign lenders to the US are getting back cents on the dollar because the dollar has devalued as much as 50% against the euro.  In return, the US interest rates on Treasury bonds debt is paltry… the 2.5% yield for the 30-year bond(!?) is barely above inflation.  With Japan, China and other G8 nations hinting of exhaustion on writing checks to the US we could be in a precarious position indeed.

So where is the “bull market?” Is there a way to benefit?   There are scarce opportunities.  Depending upon your horizon, high dividending stocks (use the google stock screener ), can provide a cash-on-cash return that is attractive.  Obviously the companies must remain healthy in order to sustain it.  If you have the experience (and the stomach) distressed debt will offer equity-like returns for the sufficiently brave.  Search the yahoo bond center for the combination of yield and risk (look for discounted bonds) that meets your objectives.

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