Bailout Bill Passes; What Happens Now?

by: Michael Shedlock October 04, 2008 | about stocks: DIA / QQQQ / SPY    
Michael Shedlock

Michael Shedlock

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Congress passed a $700 billion bailout package today. It was a total and complete waste of $700 billion. It further depletes the pool of real funding.

Yes, the Fed has started a monetary printing campaign. Yes, the SEC will suspend mark to market accounting. So what happens now?

Pretending Is Not Reality

What happens now is that pretending does not alter reality. I can pretend all I want that Madame Merriweather's Mud Hut is worth $1 trillion and I can pretend my pet rock is worth the same. The reality (sorry, Madame) is that neither is worth the book value I place on them.

Suspension of the mark to market rules will accomplish nothing but further mistrust of banks and bank stocks. Everyone will know banks are lying. No one will know by how much. What we still know is that Citigroup (C) alone holds $1 trillion in off balance sheet SIVs.

Pretending those SIVs are worth $1 trillion will not make it so. Yes, $700 billion is a lot of money. But let's see just how fast it comes and let's see if all of it comes.

The countless trillions in total bank assets that are not marked to market and will not be purchased by the Treasury are realistically still going to see credit contraction (on a marked to market basis, and that is what counts).

Foolish Effort To Spur lending

Bernanke and Paulson think that the Fed buying toxic garbage will spur institutions to start lending. It won't. Banks will still be holding more garbage than the Fed can possibly buy. The market will be able to smell that garbage, even if the rules allow banks to pretend that garbage is a rose.

Banks have no reason to lend in a world of overcapacity, rising unemployment, and increasingly sour consumer attitudes. It was disingenuous at best to suggest this would free up lending for Main Street as it was packaged.

Rescue The Market?

All hopes were that action by Congress would "rescue the market". It can't and it won't. No jobs are being created by this bill, salaries are not going to rise, outsourcing is not going to stop, and foreclosures are going to rise.

If there was a $700 billion jobs package passed instead of this monstrosity, especially if Davis-Bacon was scrapped like I wanted, tens of thousands of jobs would have been created and at least the US taxpayer would have gotten something for their money. Note: I am not arguing for $700 billion for jobs per se, I am merely pointing out that we would have at least gotten something out of it.

It was not to be. Stupidity won out as it usually does, but I am holding my head high for the effort that readers of this blog and others put in to kill this boondoggle.

Will Printing Lead To Hyperinflation?

Many have asked if the actions of the government would lead to hyperinflation. Others mockingly told me that it would. Nope. The answer is the same: Deflation.

There has never been hyperinflation in history with falling home prices. And home prices will continue to fall. Wasting $700 billion will not do the stock market any good either. The bottom is not in. Today's close proved it. There are new lows on the S&P 500, the Nasdaq, and the Dow.

Yes the Fed will print, but the money will sit, just as it did in Japan. Wasting $700 billion will only make things worse. Banks will still hoard cash.

Hyperinflation Dreams Are Way Down The Road

I am not the only one who has come to this conclusion. Please consider this audio with Austrian Economist Frank Shostak on Mises.

Shostak refers to Money AMS in the audio. An complete explanation of Money AMS can be found in Money Supply and Recessions.

A more recent update of Money AMS is in TMS: A Truer Money Supply?

Proper Definitions of Inflation and Deflation

Those who believe inflation is measured by the CPI, the PPI, or price increases of any kind desperately need to read Inflation: What the heck is it?, Interview with Paul Kasriel, and Deflation American Style.

The definition of inflation I am using is "A net increase in money supply and credit". Deflation is the opposite: "A net decrease in money supply and credit".

Looking at deflation in terms of money supply (money that is actually lent) and credit (marked to market), the proper conclusion is the bailout bill does not change the picture, and that picture remains deflation.

I have said many times the fed can print but it cannot force banks to lend or consumers and businesses to borrow. We are about to find out who is right.

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This article has 74 comments:

  •  
    Oct 04 05:28 AM
    100% agree. Probably equity markets will rise after some serious pounding early next week again fooling many that the politicians "rescued" the world. Reality is DEFLATION after a period of stagflation. Check comments from Mr. Trichet... ECB is so behind (off) the curve that it is basically unimaginable. Europe will get a much worse hit then US, Japan will probably come out as a winner (of course only on relative basis). Those guys learned to survive in such environment and their economic structures are far better equiped to weather this storm.

    As to the US baby boomers coming to retirement, they will probably see their 401k's severely depleted...

    Nationalisation of homes in foreclosure and another check to average Joe (with a defined spending rules: pay mortgage and debt and of course spend some otherwise Chinese and other Asian nations will refuse to buy the newly issued US gov. debt) would in our opinion be a much better solution.

    For a guage of what the real economy globally is doing Baltic index (BDI) is still appropriate measure and it is showing severe slowdown (not just lower oil prices).

    The bailout bill is enough for GS and MS to stay afloat and if we drop the charade this is what the intention of Mr. Paulson was in the first place. Be sure GS and MS (if they survive) will reload equity positions from retired people who will sell their 401k holdings near bottom and this will mark the bottom of the cycle. This is the plan however the eternal question whether it is really different this time still hangs over us.

    It is different and as risk models showed in Aug07 once every 200 million years events can happen. So what we should really think about is how to avoid the global capitalism avoid transition into chinese style capitalism in order to survive. This is not a once in a 100 years event, it is an event unseen so far.

    People feel this is a cold, others say pneumonia, few of them say 87 crash was heart stroke and this is cancer. When average Joe realises this is cancer and looses the trust in fiat money, the system will have to change. Let's just hope PEOPLE put the pressure on politicians and really PRESSURE them (PUBLIC PROTESTS) so they will for once listen and not just think about their personal position.

    Chinese style of capitalism if not that bad for the Chinese actually at this point in their development cycle. However it would be disastrous in the western world and should be avoided at all cost.
    Reply | Link to Comment
  •  
    Oct 04 05:40 AM
    A simply amazing article! The author is certainly one of the few people on this planet to say it all,as it actually is. I will freely admit that my brain has serious difficulties accepting certain parts of the inflation/deflation argument, but until furthur, I will assume that the problem must be on my end, and not on the author's end. Many thanks for the article.
    Reply | Link to Comment
  •  
    Oct 04 08:03 AM
    An insightful article. But one question that concerns me with this statement:

    "Looking at deflation in terms of money supply (money that is actually lent) and credit (marked to market), the proper conclusion is the bailout bill does not change the picture, and that picture remains deflation."

    I'm not sure I agree with the conclusion in the short term. Here's why. You suggest the money supply has not been increased. But if the fed printing presses pay for the 700B then the money supply is increased, it buys the bad debt and allows (again in the short term) for banks to supposedly be more appropriately leveraged. Here is the question. Do the banks turn around and lend that money (increased by the money multiplier of going through the bank system). Short term that cash infusion (whether printed or by foreign investment in T-bills), will cause an increase in the money supply if the banks loan the proceeds of the sales out. Which if I recall is the intention of the bailout in the first place, allow banks to get back to lending.

    Medium to Long term I agree with you, the USA is overinflated and the only way back to equilibrium is deflation (assuming the US and its citizens ever decides to pay back their debt).

    I'm interested in your thoughts in response to this Michael.

    Cheers.
    Reply | Link to Comment
  •  
    Oct 04 08:15 AM
    "... the fed can print but it cannot force banks to lend or consumers and businesses to borrow."

    It doesn't have to. Banks will lend - that is what they do - and consumers and businesses will continue to borrow. Try to stop them.

    The bottom may not be in, but the bailout should provide a foundation of sorts, psychologically and economically. Fear will leave the markets next week or soon thereafter. The hyperbolic fear-mongering employed to sell the bailout by everyone from Cramer to Reid will stop. That will help.

    Reply | Link to Comment
  •  
    Oct 04 08:24 AM
    Mish I love your work but regardless of how you define inflation, and no one has a monopoly on use of language, certain prices will rise relative to income. If unemployment grows and productivity declines, there will be a smaller supply of goods and income with some demand destruction but the same basic needs. If the printed money doesn't find its way to those with little income, they will experience crippling prices for food, clothing and shelter, which is commonly called "inflation", if not by economists. Forget the CPI. If deflation causes a drop in income and a rise in the price of food, it doesn't matter what you call it, it is nasty.
    Reply | Link to Comment
  •  
    Oct 04 09:22 AM
    Economics aside. Life as we have known and enjoyed it in America is ending. Government will "control" the essence of "mediocre" Life, "restricted" Liberty and "severely impede" the Pursuit of Happiness. Look at Europe as that is where we are headed. Study France and Germany and you will visualize our future. Upwardly mobile entrepreneurs will no longer be motivated to risk precious resources to build businesses. Corporations will move HQ's and production facilities to countries with more favorable taxation and regulation and litigation environments. Why would they stay and endure the US, with its uneducated and overpaid workforce of the future. The entitlement class in America is really facing Depression as the "trough runs dry" in the coming years. Trust is rapidly vanishing amongst the citizens, employers/employees and lastly this government has placed the final "nail-in-the-coff... Living within ones means, without massive credit card debts and mortgage refinancing ATM's is an adjustment that the spoliled "Millenium" generation will never be able to adjust to. The "over 50" folks either looking forward to, or in their golden ages will have the saddened facial expressions we often see in foreigh countries where Hope has vanished.
    America has enjoyed the "artificial" prosperity enabled by a spendthrift Federal Government and emulated at the State, local and personal level. The party has sadly ended, and we haven't seen what's coming next from our enemies or those who have been waiting to kick America when it is down. What happens when oil production is cut back 20% by Russia, Venezuela, Iran, etc? What happens if China, Japan and others "call our debt" as America is no loner creditworthy? Who will find the $11 Trillion Current Account Deficit? How will the $55 Trillion Unfunded Liabilities for Entitlements be honored?
    The Day of Reckoning is here, and you'll never hear it from your politicians. They have returned home to blow smoke up your butts, and you gullible citizens will reelect the same entrenched encumbants who brought you here, like you do 95% of the time...........
    God Bless America............We now really need it!!!!!!!!!
    IMHO
    Reply | Link to Comment
  •  
    Oct 04 09:47 AM
    Please forgive a foreigner a few typos, but ...

    1) On money supply and inflation: assume subprime assets were bought against payment in treasuries: the money supply would not rise!
    2) If under the package, banks lose risk assets for treasuries, they not only get rid of illiquid assets, but also get collateral for interbank lending. Leverage (in risk assets) and liquidity improve.
    3) Furthermore, capitalisation of banks will improve due to price recovery in risky assets. Everyone is focusing on the USD700bn. However, if these 700bn in hypothetical demand create something like a psychological price floor for what is currently sold at fire sale prices, the package is suitable to trigger the market entry of private equity investors in larger scale. As prices of risk assets recover, so will the capitalisation of banks.
    4) This package will hence improve bank balance sheets from the asset and the capital side, and provide liquidity / collateral to banks. Money markets are likely to calm.
    5) As far a lending to main street is concerned, a lot is gained by securing the functioning of credit markets going forward. Nothing wrong with your analysis of the American desease and that more saving is required. We hopefully agree that the complete collapse of the banking system is not the preferred way to get there.
    6) As concerns market to market and trust: Market to market is fine when prices reflect value. You are not however not honestly arguing that investors have higher trust into US banks for as long as there is need for two bailouts per week when accounting on market to market and fire sale prices? I guess we agree there is need to return to market to market when markets have calmed.
    7) How short are some of you? And what is your attitude towards social responsibility?
    Reply | Link to Comment
  •  
    Oct 04 09:51 AM
    Whether it is inflation or deflation the best defense is to buy gold and/or silver.
    Reply | Link to Comment
  •  
    Oct 04 09:58 AM
    How UnSocialistic. We need to change our paradym so we can capitalize on it. Everyone knows we are going to a one world order with a one world leader, it's just a matter of time, read your Bible.
    Reply | Link to Comment
  •  
    Oct 04 10:20 AM
    Here's a link to an article by Nouriel Roubini, Professor of Economics at the Stern School of Business at NYU - To view the full article you will need to register (free). This is a must read in my opinion.

    Financial and Corporate System is in Cardiac Arrest: The Risk of the Mother of All Bank Runs (published Oct. 3)

    www.rgemonitor.com/rou...
    Reply | Link to Comment
  •  
    Oct 04 10:23 AM
    Great job Michael Shedlock, here's sanity!

    Start accumulating Gold and Silver, because it is real money.
    Reply | Link to Comment
  •  
    Oct 04 10:25 AM
    I knew it was only a matter of time until someone suggested we "read the Bible", please, this is a financial blog so let us stick to reality even if we all see it a little differently.
    Reply | Link to Comment
  •  
    Oct 04 10:32 AM
    not even considering the fact that Amerika is indebted for life, we have given the reins of power to a few unelected unaccountable "people" that now control all parts of our destiny. This may be the lead up to the introduction of the Amerio, North American Union latest fiat currancy for all of North America. You know it is kind of funny in a sick Nerco manic way. After surviving Iraq, I will soon come home just to be inslaved by a bunch of internationals that don't give a damn about the Republic for which it stands, the Consititution, you, me our future. Soon I return to be a slave for the rest of my grandchildrens lifes. Those of us that survive the bankers wars, maybe we should start again once we all come home. Time to clean house.
    Semper Fi, the sandspider
    Reply | Link to Comment
  •  
    Oct 04 10:37 AM
    vrspace, scary stuff (referring to your link to an article by Nouriel Roubini). I live in Mexico and most people I talk to are more or less unaware that there is a banking crisis and I am sure that sooner or later it will affect the banks here for as far as I can tell they are all affiliated with Citibank or Bank of America in some way-not sure about the brokerage companies as I live in a community that has no brokerage company.
    Reply | Link to Comment
  •  
    Oct 04 10:39 AM
    Eddie 64 touched on the bigger picture. The US is facing unimaginable entitlement spending for Social Security and Medicare that can only be met by a massive monetization of the Treasury debt by the Fed. A de-leveraging recession/depression in the general economy precludes an offsetting income tax increase. With this prospect staring us in the face the foreigners who hold Treasury obligations can be expected to act in self defense and, instead of increasing their funding of US government operations, will attempt to replace that debt with other assets. Perhaps there will not be general inflation if we accept the academic and mechanical monetary base theory, but there sure as Hell will be inflation in the price of gold and silver as the market realizes that the quantity of Treasury obligations is going to grow exponentially.
    And if the politicians of the world turn to the historically accepted method of defeating an economic slowdown, war, that inflation will be in spades.

    Can government confiscation of gold and silver defeat the protection they offer the common man? Such confiscation would require a lot of eggs to become unscrambled. Simply "calling in" a few billion dollars in gold coins is not possible today as it was in the 1930's.

    One can only hope that a Democratic administration will end the manipulation of the gold and silver futures markets and focus on the bottom up revival of the US economy. Hopefully, the bail out was the final grasping, choking act of the national socialists that are being kicked out of Washington this November.
    Reply | Link to Comment
  •  
    Oct 04 10:51 AM
    Someone has mentioned the Bible, good for him. No one has mentioned Ludvig von Mises. He predicted the first Great Depression. I wonder what he would say today?

    John Maynard Keynes,
    you've had your fun.
    Now we find we're living
    in your "long run."

    Since our economy is so based on "confidence"... why not just put anti-depressants in the water supply? Oh, you say, a sober recognition of reality is still necessary? Do tell.
    Reply | Link to Comment
  •  
    Oct 04 10:54 AM
    This moron has been preaching Deflation for at least the last 3 years and probably more.

    In the meantime, prices on everything have skyrocketed and now the government is printing hundreds of billions out of thin air and dumping them into the banking system.

    That money will find its way into the cost of everything you need to live and prices will continue to rise.

    Deflation in a Fiat money system with an infinite ability to electronically create dollars simply can't and won't happen.

    The Fed balance sheet has already expanded by 30% in just a few weeks and the monetary base and gone vertical.

    I fully expect stocks and commodities to stage a dramatic rally.. How many morons thought Deflation was coming when the internet boom went bust?

    Case Closed.
    Reply | Link to Comment
  •  
    Oct 04 10:54 AM
    anarchist - what is scary is that Nouriel Roubini is not some out there alarmist wacko - he is a credible economic commentator with a track record of calling things accruately - for him to offer his newsletter for free is an indication of just how serious things have become. What's also of concern is when you hear guys like Dennis Gartman taking delivery of gold - and even saying that he hopes he loses money on it e.g. the alternative is worse.

    Here's the Roubini link again - it is a must read

    www.rgemonitor.com/rou...
    Reply | Link to Comment
  •  
    Oct 04 11:01 AM
    jonathon weil has a great piece onna bailout at
    www.bloomberg.com/apps...

    i'm with mish on deflation...anna rest!
    Reply | Link to Comment
  •  
    Oct 04 11:07 AM
    What happens now depends on trust on part of US lending firms and International lending firms. How fast the US can Create jobs ,get people into homes with good loans? got700billion.blogspot.../
    Reply | Link to Comment
  •  
    Oct 04 11:12 AM
    i sincerely doubt you can have inflation when trillions of dollars have been evaporated, and you print money like made to purchase worthless assets. money has to move to have inflation.

    money will not move because the consumer has had trillions removed from their net worth. they are going to hunker down because they have a lot of lost ground to make up. they will only spend on what they need.

    the economy is in a tail spin. there will be more unemployment. the equity market will remain sluggish. real estate will flounder. who in hell is going to be needing a loan. oh, maybe the poor bastard who owns the laundry down the road who can barely make payroll.

    no baby, print money until your face falls off - but if it is not spent we are deflating in a real sense. i do not have to make up a special meaning for deflation - things will be cheaper tomorrow than today.
    Reply | Link to Comment
  •  
    Oct 04 11:39 AM
    The biggest problem now is consumer confidence. A few months ago we were all fat, dumb, and happy. Now we're all Chicken Little's. New confidence and we'll all be back where we were two years ago. We have the herd mentality. Do we actually think the banks were donig the smart thing two years ago or even ten? What I don't understand is why the sub-prime mortgages blew up anyway. What's better for a bank; to collect payments at 5% or to raise the ARM to 7 or 8% and not be able to collect, then force forclosure? I'd rather have some payment than none anytime.
    Reply | Link to Comment
  •  
    Oct 04 11:46 AM
    At first ,skeptics did not think the bill (700billion dollars aid )would be passed .
    Now that it has ,critics are disseminating a lot of economic garbage.
    The700 billion dollars package is a collateralized loan.
    True ,the collateral at this time appears to be shaky.
    Behind the collateral (CDOs and others) we have a real estate .
    In truly inflationary enviornment the real estate appreciates
    significantly.
    In this case the collateral is deeply discounted .Once we stabilize economy (and we will) ,the collateral could easily double or triple in value from the current levels .
    The tax payers will likely reap a significant rate of return on this "loan".
    This "aid " package will have (allow for the 1-2 month slag) ,an explosive impact on the economic /market rebound.
    The 700 billion dollars injected into American banking system will create almost 5 trillion dollars stimulus(using multiplier of 7 ).
    That is equivalent of of approximately 40% of the current GDP.
    This is an explosive economic catalyst which will bring U.S economic growth to above average trend level. by 2009.
    In fact we will see significant economic improvement by December.
    Yes ,the banks will lend aggessively ,once liquidity is injected because
    lending is their "life line",although I am sure the loan criteria will be tightened.
    Toxicity? of this collateral-there is no such thing.
    It is simply a misrated product as the rating agencies had underestimated the embedded risks in the CDOS and other structures collateralized by "real estate"
    Then again,the author of this article could have issued a warning two years ago.Then ,that warnig would have a credibility value.
    I have warned investors about the risks in June of 2005 in an interview with Bloomberg(Mark Gilbert).
    I have issued the warning again on September18 ,2007 on the(Bloomberg TV-Brian Sullivan).
    It took a while for the market to comprehend the risks which I have enumerated .
    Now,we have identified the risks and are effectively addressing them.
    Friday's pacakge ,allowing for a minor lag ,will be an effective antidode for the past errors.
    In fact as the Treasury purchases the illiquid collateral at a minor premium,the banks will be able to reduce the required reserves,further adding liquidity into the system.
    The FED should provide addition stability be easing incrementally by perhaps 50 bps(twice).
    Further market /economic stimulus should eminate from mega dollar inflows as the European and Emerging market economies become
    more unstable (and they will).
    It will be more complex issue for the ECB to address their problems becuase of diverse multinational objectives and opinions.
    These mega dollar inflows will be channeled into the equities and the real estate as the economy stabilzes providing further stimulus.
    The GDP expanding at 5% by the second half of 2009 is a reality.
    I must confess that this time the only toxicity that I find are the articles as the one written by Mr Schedlock's which basically preach economic anarchy wich would lead to unprecedented global economic implosion and misery for the Americans and others.
    As of now the Congress has addressed the issue with a "super" bazooka ,and it will work.
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  •  
    Oct 04 11:51 AM
    So the big question lots of us are asking is what should we do with our retirement and other investment accounts. Cash? Gold? Quality stocks? Bonds?
    Reply | Link to Comment
  •  
    Oct 04 11:53 AM
    Job creation and energy independence are two things that we can achieve if we start a massive mass transportation projects that we so badly in the USA. If we address these two issues, the rest will fall into place. If people have jobs, they dont have to foreclose, and less of our money will be going outside for oil.
    Reply | Link to Comment
  •  
    Oct 04 12:23 PM
    Mike, it is a great article.
    Here is why what you are saying is very close to what is happening.
    On average, we American are in debt (mortgage and credit cards combined) for $150,000 or so per family. The median income of American family is $50,000 before tax per year and out of that each pays about $15,000 of interest to various lenders.
    Any bank, even you, would be out of their or your mind to lend any more money to this bunch of people. I believe this is the root cause of today’s problem. We American are simply not credit worthy. It is not that banks do not want to lend. It is that more than half of us or not fit for borrowing.
    Until this situation is corrected, the Fed can print as much money as they want but no prudent banks or persons, including you and me, would be willing to lend a penny. There will be job losses and economy downturn. We need some good and cool heads to get us out of this mess.
    By the way, those investment bankers are in a bigger hole than you and I are. This $700 billion is to rescue them, not us. At least Paulson was honest at the beginning. All he said was to buy up bad credits from themselves, I mean the investment bankers. But, after the defeat of the bill in the Congress, the Democrat controlled Congress had twisted the whole thing and said this was a rescue of us average American. That scared everyone including us the voting average American and their mindless representatives. Now, just wait, we will all soon see very clearly that our tax money (whatever the government spent will eventually come out of our taxes) will be used to rescue these investment bankers with scarcely a drop trickled down to the average American.
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  •  
    Oct 04 12:29 PM
    if all else fails[covered by blog and comments], the soution could be to nationalize the banks. then gov't could lend, print, withdraw funds as appropriate and resolve all fears.

    there must be a name for this situation???
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  •  
    Oct 04 12:37 PM
    You don't seem to understand what "Helicopter Ben" really means. Yes, the Fed can print, but it takes a government to give away money. If no one will borrow or lend, then your conclusion that the banking system will not support inflation is correct. So other channels will have to be found to support it, and those channels will involve the Fed lending to the Treasury, which will in turn give away money. Don't believe for an instant that they won't do it. TPTB are determined not to allow deflation, and there is extensive precedent for varying forms of "fiscal stimulus", many of which amount to nothing more complicated than borrowing money and using it to cut checks to some subset of the citizenry. It's remarkable that you can't see past your academic biases about how the market works to the obvious conclusion.
    Reply | Link to Comment
  •  
    Oct 04 12:39 PM
    So, why aren't banks lending?

    * The fed has printed billions and, it is ready to "give away" billions.
    * Real state values are lower (and thus less risky).
    * The banks can pick low risk loans and credit worthy individuals.
    * The banks as businesses make money on the spread between the fed rate and the loan rates (and, of course the huge fees they charge for next to no work, but that is the subject of another comment), no loans, no revenue...no way to save a business.
    * Some bankers claim that, on avera