FINANCIAL CRISIS AHEAD / BARRON´S EDITORIAL COMMENTARY ( VERY HIGHLY RECOMMENDED READING - A MUST READ )

MONDAY, FEBRUARY 1, 2010

EDITORIAL COMMENTARY

Financial Crisis Ahead

By THOMAS G. DONLAN

Political maneuvering is distracting lawmakers from what should be their primary mission: tackling the federal deficit.

AS A WARM-UP ACT FOR PRESIDENT Barack Obama's State of the Union address, Timothy Geithner flopped. It was like hearing Flatt & Scruggs open for the New York Philharmonic. We'd say he should keep his day job, except that he shouldn't. His tenure as secretary of the Treasury is getting shorter with each appearance before Congress.

Geithner made it clear Wednesday that he has no future as a poker player or Wall Street trader, either. It was almost amusing to see him squirm and make faces at the angry members of the House Oversight and Government Reform Committee, but not quite. His job is too important and the fiscal situation is too serious to enjoy watching him drown, no matter how much he may deserve it.

Twenty-five years of government and quasi-government jobs left him unprepared for the financial crisis. As he told the committee, "I have worked in public service all my life. I have never been a politician." Interesting, if true: Does he really not know that his entire career, from Kissinger Associates to the New York Fed, has been political?

The committee earned no praise, either. It focused on a relatively insignificant aspect of the financial crisis of 2008. Led by its clueless chairman, New York Democratic Rep. Edolphus Towns, members kept demanding to know what Geithner, then president of the New York Fed, had to do with a decision to "cover up" AIG's use of $62 billion in federal funds to cover its bets and pay its debts to big banks at 100 cents on the dollar.

Self-aware politicians in the room denounced the deal in purely political terms: Secrecy is bad; Geithner wasn't mindful of the taxpayers. Nobody mentioned the nation's investors, especially not the big investor with headquarters in Beijing that owns so much Treasury debt.

Fear and Loathing

Where did they think the money was going? AIG owed big bucks to the world; this we all knew. Anyway, disclosure wouldn't have stopped the deal; in 2008 everyone in Washington was too far gone with fear -- especially Geithner, who still shows signs of the shock and awe he suffered that September.

Memory loss and confusion dog his accounts of the crisis. Sometimes, he says the great danger to the financial system was the chance that the big banks wouldn't get what they were owed; sometimes the vulnerable parties were AIG's insurance subsidiaries.

Either story is laden with nonsense. The New York Fed had taken control of AIG. Geithner's colleagues in Washington were clearly ready to print all the money anyone needed and take any other form of paper in exchange. AIG's counterparties didn't need the money so desperately -- or if they did, they should have joined AIG in bankruptcy court.

Fiscal Poker

Geithner told the angry Congressmen that the payments to the banks had to be made in full, because he and then-Treasury Secretary Hank Paulson and Fed Chairman Ben Bernanke had no leverage to negotiate.

"If you are prepared to accept default, you can impose haircuts," the Treasury secretary said. "If you cannot accept the consequences of default, you do not have any leverage," Geithner said.

He said he believed a consequence of AIG's defaulting would be a Great Depression, and Paulson backed him up with the assertion that unemployment would be at least 25% today if they had let AIG go down.

Knowing that the other side was too terrified to call, the banks went all in. They stood firm in their demand for every penny.

Economic models can't prove that Paulson and Geithner and Bernanke were wrong, nor can the big shots and their modelling prove that catastrophe was otherwise inevitable. All we know is that AIG and the banks became wards of the Fed, and there is no Great Depression (yet). The nation's financiers were rolled by Wall Street poker players -- although we sometimes wonder which hand Paulson really was playing.

One thing needs no modeling: There is a yawning federal deficit, financed by the Fed's creation of money from that day to this, propping up the banks, the mortgage market, the money-market funds, the auto industry, the Treasury market and who knows what else, while the government yawns with indifference to the prospect of inflation and a financial collapse.

The Main Event?

When President Obama took the rostrum Wednesday night for his performance, he hardly talked about the real fiscal position of his government. Geithner's warm-up act had focused the audience on the wrong problem.

Obama did try to sound reasonable: "Rather than fight the same tired battles that have dominated Washington for decades, it's time for something new," he declared around the midpoint of his speech. "Let's try common sense."

Although he received applause nearly 100 times in a 70-minute speech, that line fell flat. There is no constituency for common sense in Congress. A bipartisan group of 47 senators just blocked a new attempt to have a commission deal with the coming fiscal disaster.

Obama offered only a spending freeze, applied to only 35% of the budget, ignoring Medicare, Medicaid and Social Security, exempting defense, intelligence and homeland security. It won't take effect until fiscal 2011 and isn't likely to be enacted or respected anyway.

The freeze applies to "domestic discretionary spending," which is the part of the budget most popular in Congress. It's where the government gets to do good things for nice people, where it creates jobs, where it saves the environment, where it promises high-speed rail lines, where it earmarks all sorts of porky projects for the folks back home. No wonder this spending is up 80% since 2000.

What's worse, the supposedly temporary stimulus spending will become part of the spending base, so postponing the freeze to fiscal 2011 will leave room for more spending, year after year. "That's the way budgeting works," as the president said.

This is how politics works to bring us ever closer to a fiscal disaster. Geithner's critics are wasting precious time worrying about the bank bailout. Congress, the president and the Treasury secretary should be worrying about how to bail out the federal government.

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