Tuesday, September 30, 2008

What Happened to the Money?

I've seen many people asking, if the markets crash and a trillion dollars are lost, where did the money go? Did it just evaporate?

I'm not an economist, but I'm nevertheless startled that many Americans simply don't understand what's being revealed in this crisis. So I've created this response: hopefully, for those of you trying to understand what's happening here, this will clarify a few things.

Let's start with the question, if we stand to lose trillions of dollars, what happened to the money? And shouldn't we find the criminals who "took" it and punish them?

The question is a little like asking, if I buy a work of art and find that the artist's value doesn't justify what I paid for it and I can't sell it to get my money back, what happened to the money? Shouldn't I sue the guy who sold it to me?

Well - it depends...did he intentionally MISLEAD you about the value of the artist? Or did something happen to make the artist less valuable: let's say suddenly people find he made hundreds of such paintings, instead of just one, so it's not really that unique and worthwhile. If it's the former, you'd sue. But if it's the latter, what do you do?

There's an argument to be made that the CEO's have been intentionally misleading shareholders about the true value of their firms. If that's true, it's criminal - like the seller who intentionally sells a fake painting - and the FBI should go after that and that's what they are doing: investigating companies like AIG and Lehman Brothers. But it seems that's just a small portion of the problem. The real problem is that we're suddenly finding out that our artist: the US economy - just isn't as great as everyone has previously thought.

So most of the money is disappearing because this banking crises has revealed something that the world never really suspected before: that Americans simply don't produce much tangible good to the world, other than movies and war, even though everyone still thought our economy was so valuable. But as it turns out, other than movies and war, most of the rest of what we produce was just highly overvalued fluff.

The world is suddenly realizing that we're not really a virtuoso; we're more like a third-rate hack. So that's where all your money has gone: to the people who thought the American economy was much stronger than it really was, and sold you a piece of it.

So here's the corollary to this question: why is the bailout needed? And how come the bailout stabilizes the markets?

The answer is as if when you found out that your prized artist had actually produced a lot of hackneyed paintings, someone comes along and says, "well, those hackneyed paintings are pretty valuable after all, because even though there were hundreds of them, each one is slightly different and blah blah blah," and now everyone thinks the painting is valuable again.

Not just any Joe can come along and say this and make a difference. You need an authority.

The government is the only authority left. It's a little like this art appraiser coming along and saying to the world: actually, the U.S. economy isn't so bad, the government has faith in it, it'll do okay. And then, the theory goes, everyone else will have faith in it again too.

The problem with this approach is two-fold: the appraiser needs to have a pretty good explanation for why the painting is really valuable; and people need to believe the appraiser.

Right now, the reworked Paulson plan is like a kind of half-assed explanation as to why our economy is actually worth a hill of beans. Not great. But there's a lot of good will in the world, so it's probably passable. The problem is, not many people put much faith in our appraiser. So if Paulson and the plan becomes discredited, our economy really will be worthless.

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