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Clinton on economics, Part One

It seems Comedy central finally found something funnier than Colbert.

I will be reviewing a segment on the Daily Show regarding the current bailout situation. Part two of this blog will cover the second half of Clinton’s interview.

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Hopefully, by this point you’ve heard at least part of the outrageous legislature proposed by U.S. Treasury Secretary Henry Paulson.

Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.

Seriously??? This guy should be replaced and charged with treason for even proposing such a bill. Fortunately, many citizens have been calling their Senators and Representatives, demanding that they vote against it. What we’re seeing now is an upwelling of constituents and members of Congress who recognize that we’re in an untenable situation. Unfortunately, it seems most lack a fundamental understanding of how we arrived at this predicament in the first place.

Clinton says if we put up this $700 billion, we should have a moratorium on foreclosures, and then have each mortgage reviewed for possible write-downs. It sounds like a good plan, but let us examine just how it would work:

The moratorium would have to be very short term and the manual reviews completed quickly. On the surface, it seems like “homeowners” (I use that term loosely, because I would not consider someone who has a 0.5% stake in a house the owner) would get a break. They get a chance to have the bank write down their debt without losing their house. The bank only loses interest they would’ve earned with the larger debt, and it doesn’t become insolvent and risk a run — the federal government underwrites the loss (that means we pay for it). Even assuming that congress could find qualified reviewers and implement this plan quickly, there are fundamental flaws.

Foreclosure is simply a means of enforcing debt. If you can’t pay your mortgage, the bank is able to keep the interest you’ve paid them over time, and the property which was collateral for the loan. The borrower loses any money he or she has invested in the house, and is unlikely to secure another loan for some time, due to credit reporting. You might be asking yourself a few questions at this point. If the banks have been implementing so many foreclosures, and if they have gained both the property and the interest paid since the origination of the loan, then why are they failing? It would seem that they are now richer than they were when they started. That makes sense, but it is not the truth. If you read my post about creating money from debt, you’ll remember that when you obtain a mortgage, the bank is not actually loaning you their own money. Literally, they are just writing that amount into your account out of thin air. Our government allows that check to be treated as real currency and to be payable in real dollars at other financial institutions where the seller might deposit or cash it.

In order to keep their balance sheets straight, the banks keep two separate accounts. One says how much they have written on all those outstanding loan checks, and the other says how much they have been paid back. Just like they didn’t actually have that money to lend you in the first place, they don’t get to keep it when you pay it back. When you make a payment, part goes to principle and part goes to interest. The principle amount is deducted from your overall debt to the bank, and hence it is also deducted from the total amount the bank has lent out on those loan checks. In simpler terms, the money disappears back into nothing since it didn’t exist to begin with. The banks have a limit on how many of those loan checks they can lend out from thin air, and this is called fractional reserve banking. Typically, they can lend up to 9 times the amount they have on reserve at the central federal reserve bank. So, when they get principle payment back from you, they are free to lend out that money again to someone else and earn even more interest on it. The interest amount is the bank’s profit which goes to pay employees, stockholders, or it may even be deposited at the central bank to allow them to lend out even more money.

What happens when there is a foreclosure and you can’t pay it back? In that case, the overall amount the bank has lent out on those checks stays high. Therefore, the money is not freed up for them to lend out to others. They have lost both the interest you would have paid them and the interest they’d earn if they had freed up that money to lend out to others. On the upside, they do have the house and land as collateral. So… can’t they just sell that? Yes, but it will usually not cover the amount of unpaid principle, and it costs the bank money to take over the maintenance of the house. When someone loses their house due to foreclosure, they’re usually not a happy camper. When I was trained in mortgage lending, I was told that often people will destroy the house out of spite or take whatever materials can be sold for scrap (metal, wood, etc.). Even if the house is in good condition, there is another problem. Too many houses on the market drives the price down, which means the bank cannot recuperate their costs. As you can see, foreclosure isn’t going to make the bank richer.

You might also ask yourself why the Congress can’t just change the laws and allow the banks to lend out more money to gain interest. If the fractional reserve requirement allows nine dollars to be lent out for one dollar on reserve, why not make it ten? Or twenty? Or a hundred? What difference does it really make as long as we save the banks? Wouldn’t this be better than paying 700 billion dollars to bail them out? Absolutely not, and the reason is inflation. As the banks are creating money from debt, that money is being circulated in the economy. More money being moved around for the same amount of goods and services is called inflation. It means the money is worth less than it was before. Now you understand why a dollar doesn’t go as far as it used to; there are too many dollars in the system. Sometimes less really is more. The federal reserve wouldn’t want to increase the ratio because it would lead to hyper-inflation, a severe and rapid reduction in the value of money. This is one of the factors that caused the Great Depression, it is why counterfeit money is illegal, and it is the cause of economic turmoil in many other countries.

So then, what if Clinton’s moratorium on foreclosures becomes law? Consider this: why would someone worry about paying their mortgage if they can’t lose their house? They wouldn’t. You pay your mortgage before you pay your cell phone bill because you can’t live without your house. Once the threat of losing it is gone, you are free to use your money for other purposes. People won’t pay back their mortgages because foreclosure isn’t an option. The banks will have lent out the $700 billion from the government as new mortgages, which also won’t be paid back in a timely fashion because, once again, foreclosure isn’t an option. In this case, the banks are still out of money and back in the position they were, only now the government has invested stockpiles of money to stave off collapse for a short period of time. Not only this, but it exacerbates the inflation problem described above. The money out there from these bad loans is not being repaid so that it can disappear back into nothing. Also, $700 billion are being infused into banks allowing them to create even more money from debt. This will cause hyper-inflation and the complete collapse of the dollar much sooner than even the first scenario I described above.

In the second half I’ll discuss how Congress plays into all of this, President Bush’s plea for cooperation, and what it would look like if we just let the banks fail. See you then!