Many financial news and magazines are now overwhelmed with the news on latest US Federal Reserve’s creation – a pool of fund which worth $700bn. Apparently, the purpose of this fund is to bailout traumatized financial institutions, which of cause include the world’s largest insurer, American International Group (AIG).
Honestly, ever since I first learned about the Fed’s bailout plan, the mechanism of the bailout is never part of my concern. Yes, I’ve studied some finance and economics and I’ve even attended some management classes… So does it mean that I can just go back to my dusted books and decode the Fed’s plan?
Not only that the plan is “supposedly” to be complex, the plan is too opaque to be deciphered… You see, ever since the plan was revealed, no solid structure on the execution of the plan can be found anywhere… So why bother to think of it when I’ve something else more meaningful to do?
Is sad to imagine how a country which has been seen as a forerunner for free market and market transparency behave in such a way? The reason can only be one… They do not wish the peoples to understand the mechanism and they do not want the analysts to estimate how much the bailout plan will cost the Federal Government and the American economy…
Just to give you a brief picture on the bailout… Bailout is not the Fed giving the bank the required funding. Basically what the Fed does is merely giving the traumatized banks a so called “quality” asset in-exchange for the bank’s toxic-assets. The whole process is like the Fed says: “Ok, take this piece of paper and you can increase your balance sheet value by $80bn!” The whole process might not even involve any transaction or a single cent, just cheap accounting entries!!!
At the end of the day, the bank will have strong balance sheet figure boosted by the so called “quality” assets from the Fed in exchange for the assets which intoxicated the banks. The whole idea of bailout is to slow the deteriorating process of bank’s balance sheets thus taking advantage of the time gap for banks to restructure their finances!
Then you may ask a question like "Fine with the accounting entries… What if the banks really need the money?"
The Fed do not always have billion of dollars in reserve to bail the banks out (I doubted they even have the $700bn). In layman term, what the Fed literally meant by the bailout is a promise of an empty sum (is like opening an empty “cheque”). Then you can go to your creditors and tell them you have this “cheque” from the Fed as a backup!
If the banks need to “cash in” the “cheque”, the Fed has no choice but to print the amount of money required (printing money is the Fed’s ultimate authority). However, over printing of money will (or might, I don’t know… there are instances of good bailout plan but in economics, bailout is never good!) cause irreparable damages to the economy…
Let me give you a layman example. Assume that your monthly household income is $1,000 (well, this $1,000 will be used to feed your dad, mum, brother, sister, you and even your dog for a month). Imagine you suck at bet one day (this will be the subprime) and it cost you $700 from the bet. Unfortunately you don’t have the money to pay your opponent, so you run back to your dad asking for help… Your dad now have two options – First, to bail you out and pay the $700 on your behalf or secondly, kick you out of the house and let you and your sibling learn the lesson?
Let me tell you what will happen if your dad chooses to bail you out. Firstly, your dad is disregarding the benefits of the rest of the household… How is your dad going to feed the whole household with just $300?
Secondly, your dad is lucky if you’ve learn a lesson and never bet again… Tell you what; the truth is you will bet again because you know someone is there to back you up. (This is what an economist called a moral hazard!) On top of that, your brother and sister will learn nothing and they will possibly follow your footstep in the future… These are the consequences the father cannot afford to disregard.
Now the US Feds is rescuing the traumatized banks in the expense of the taxpayers. Firstly - Printing money will bring the value of dollar down… In layman term, this means what you buy with a dollar before can will now cost you more than a dollar!
Secondly – As the value of dollar slipped, the Government will require more funding to finance its expenditure. In other words, increase in the Federal budget deficit. As a result, they will have to issue more bonds to finance the deficit… Additionally, as the maturity of these debts approach; the US Government will either issue new debts to finance old debts or to increase taxes levied to honor the debts. Either way, is bad for the people!
Thirdly – as the value of dollar plunges, commodity prices shoot up… this will cause inflationary pressure on the economy.
Forth – US financial assets lose value. This will ultimately creep into the investors’ wealth! Accoriding to official estimation, the initiation of the bailout plan will cost each American man, woman and children $2,300.
If you spell everything out, you can have thousand and one implication for the bailout plan…
Ok, I wasn’t planning to write a long story, just penning down my thoughts… Anyway, if the Fed really decide to go for it, we can only hope that the plan is a good one!
I am not quite a secretary guy and I was asked to write minutes of a meeting today!