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Tuesday, September 30, 2008

Alan Greenspan and the Lessons of Artificial Liquidity

I put most of the blame for the start of this crisis on Alan Greenspan. By dropping the Fed Funds Rate below 1% (.75% to be exact) he created artificial liquidity. At the time, we were facing a different sort of liquidity crisis. It wasn't that banks were under capitalized. They had enough capital. The problem then was that no one had confidence in the economy and so lending and borrowing was grinding to a halt. In order to spawn business, he dropped the Fed Funds Rate below one percent, and he artificially created liquidity. That artificial liquidity found its way in a massive way into real estate. That started the ball rolling.

Just as it was irresponsible for Greenspan to create artificial liquidity by dropping the Fed Funds Rate so low, so too, would it be irresponsible for the government to create artificial liquidity through this bailout. There seems to be a strain of thought that acknowledges just how irresponsible it is but says it is necessary in order to create enough liquidity to do business. Of course, the exact same thought was used to drop the Fed Funds Rate as low as it was when that was done.

The reason there is a liquidity and confidence crisis is because all sorts of financial institutions took massive bets, sometimes on massive margins, on bad loans. No one can change that through any sort of bailout. There should be a liquidity crisis. Those that are supposed to have liquidity acted foolishly. Some believe that a crisis on Wall Street doesn't spill onto Main Street. They are themselves foolish. Wall Street controls the money and once you control you control everything. Of course, this liquidity crisis will affect businesses and consumers. It will be tough, and so be it. Massiv mistakes were made and there must be some payment for those mistakes. Anyone that says that capitalism comes without ever having a bump in the road is lying. Anyone that says there will never be a big bump is also lying. Yet, attempting to erase a mistake with a bailout only makes the chances of future mistakes even greater.

The problem with this bailout isn't merely that let's a lot of fat cats off the hook, though it does. Beyond that, what it does is place into same irresponsible hands $700 billion in fresh capital. Banks are much like crack addicts. Only their crack rock is loans. Banks want to do loans. They need to do loans. If they are given $700 billion in fresh capital, that's exactly what they will do. Some think that's a good thing. After all, business can't get loans, people can't get car loans, and they can't get student loans. Yet, if loans are suddenly generated through an artificial infusion of capital, we will start down the exact same road that landed us here.

Once these banks get their hands on a fresh set of money, they will lend like there's no tomorrow. That's is the problem. They've probably learned their lesson on mortgages, residential at least. Maybe they will move into commercial loans now. Commercial loans were relatively unscathed because they work on a somewhat simple premise. A bank won't loan money unless monthly income on the commercial property is at least 120% of monthly expenses. Of course, with all that money, there will be more money then loans. Maybe, soon enough, banks will loosen that up or forget about it entirely. Maybe they will go all into small business loans. Maybe soon, you won't even need a business plan, or maybe banks will disregard weak and troubling balance sheets.

You think that is just ridiculous. I bet you would have also though it ridiculous to give multi hundred thousand dollar loans without ever verifying income and assets. They did, and that's because artificial liquidity caused there to be more money than loans. So, banks created new ones to keep up with the money. Now, the Federal Government is about to infuse banks again with more money. It will be more money than they will have loans. So, they will create some new ones. We will be here again a few years from now.

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