Paulson Plan Will Prove Devastating to IT

By Kurt Cagle
September 24, 2008 | Comments: 4

I wish to state upfront that this is an editorial, not an article per se, and reflects the view of this commentator and not necessarily O'Reilly Media.

As a systems architect, I usually provide architectural documents for clients for building web applications and related system. Even relatively simple applications take a fair amount of spelling out, definition of terms, constraints on system applications, timelines, recommendations of integration and software dependencies, and so will usually run anywhere from thirty pages to over a hundred for more complex projects.

On the 20th of September, Henry Paulson submitted an architectural plan to Congress to provide a foundation for keeping Wall Street functional and prevent the credit markets from seizing up, a task which he has been engaged in pretty much non-stop for at least the last year (since the markets started to crack in August 2007). This architectural plan, one that would involve potentially trillions of dollars and affect the lives of tens of millions of people, was not 1000 pages of detailed analyses, not even a hundred pages of recommendations and "to be filled in with details later". It was 2 1/2 pages long, about the size of a longish e-mail, and it boiled down to the following:

1. Give me $700B to fix Wall Street, with more as necessary, or Wall Street will tank.
2. I don't want anyone else telling me what to do with the money, and I want immunity for what I do.
3. This is money that will only go to the people I choose on Wall Street, who shall face no reprisals for anything that they have done in the past either.
3. I will have this power indefinitely into the future.

This isn't a plan ... it's a ransom note!

The credit markets are seizing up - they have been for a while, and the consequences are already proving to be fairly grim - but this is also a complex problem with a huge number of interdepencies, and Congress giving over the power of the purse to one person (a political appointee yet) is not the way to do it, especially when that person is screaming about how absolutely urgent it is that he gets this power right now!

What happens if such a bailout happens? If the United States were a corporation, you could think of each dollar that's printed as a share in the company. When the company does well, the share price goes up - the dollar attracts investment both internally and from foreign buyers and is better able to produce goods or services to outside. In some cases the dollar can get to be too strong - the share price reaches a level where it is too expensive for outside investors (or people who buy goods denominated in dollars) and both exports and investment falls.

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However, when a company is on the rope financially, it may decide to make investment into the company more attractive, so it splits its stock (prints more shares). This can work both for and against a company though - it dilutes the stockholder base - people holding dollars find that it purchases less than it used to. This dilution of stock is the core of what's involved with inflation. According to modern (mainly Keynesian) economics, a little inflation - perhaps 0.5% to 1% - isn't bad, because the population is also growing, causing a certain amount of intrinsic deflation in the economy.

However, what happens when that same company takes this policy to extremes by engaging in potentially reckless actions that prove counterproductive to the company's long term interests - specifically running up huge debts. Some debt can be productive - if you are investing in infrastructure, for instance, you can move things around more efficiently, if you are investing in the sciences, you are more inclined to get potentially game-changing technologies that emerge from that, if you invest in education you're creating a workforce that is better able to take advantage of those discoveries.

It can be argued that very little of this happened in the last eight years. Some of the investment went into the creation of a new department (Homeland Security) that was intended to consolidate the security infrastructure of the country - an investment which may have proved necessary, though the jury is still out on that. It went into two wars (think of them as hostile takeovers) that have been less than totally successful.

It went into tax rebates that benefited the top shareholders disproportionately ... think of them as sending out dividends to keep the shareholders happier - the bigger the shareholder, the more you want to keep them happy. And increasingly it has been going into attempting to prop up the stock and bond market - the analog of giving extra bonuses to your senior analysts and looking the other way when they get the results you want by perhaps bending the law a bit. It's also likely that the CFO may have been keeping a couple of different books - one for the auditors, one that actually showed the state of the economy, and the two were fairly distinct from one another.

Investors will buy your shares if they perceive that your company has value. Once the company loses that perception, investors will stop buying shares ... and worse, may even start selling those shares. If a lot of selling takes place, then the share price drops fairly rapidly, and other people start selling. Periodically, the share price will reach a stable value, as people think that the share price has fallen low enough and that the value is there. The same thing happens with dollars.

In the last six months, the US has created an obligation of more than $500 billion dollars just in bailout packages, not counting the Paulson plan, and this is conservative (and hence likely too low by about half). The Paulson plan would add an additional $700+ billion "officially" and likely more like $1,500 billion ($1.5 trillion). This means that we've added nearly two trillion dollars to the net obligation on the dollar.

How do you pay for that? USACo has four primary channels for paying off debt. First, you can increase taxes. This means that each person has a smaller percentage of their after-tax income left for spending, which means that for the vast majority of "consumers' out there, their spending dries up. Moreover, past a certain time, these same taxpayers get concerned about their ability to live after retirement (especially when the markets are causing their nest eggs to evaporate), this means that saving will increase, even at below inflation rates, and that too takes money out of the economy.

You can create more stocks (print more money). When you print a lot more money, you dilute the stock pool, and after a certain point this means that you have too much money chasing the same goods which makes these goods rise in price (i.e., you get inflation). This also reduces your consumer base - unless wages are rising in synch with inflation (they're not) this also reduces consumer spending, and business grinds to a halt.

You can sell assets. This is in essence what the stock market does. The stock market is down about 15% on the year, but it has held up remarkably well ... almost exclusively because the low dollar has attracted lots of foreign interest, meaning that more and more of the American capital base is now in the hands of people outside of the US, including those that may not have America's best interests at heart. However, as American businesses fail, investing in America (which is generally intended to get a better return than you can get locally) also dries up.

You can eliminate expenditures. This always sounds good when running for office, but the reality is that after nearly thirty years worth of cutting expenditures, it becomes difficult to find places where you can trim that won't have an adverse effect on the ability of the government to function. This is much like a major software company significantly cutting its research and development wing - it looks good on the books, but in practise it's much harder to justify (of course, there are those two wars ...).

Realistically, every single one of these will impact IT negatively. For consumer facing software and hardware companies, the shockwaves due to the inability to get credit is already hitting hard - cut off consumer spending, and it will likely precipitate another tech nuclear winter.

Inflation will likely hit less hard, if only because inflation can serve to make exports more attractive, but on the other hand inflation also means that outsourcing becomes increasingly prohibitive. Additionally, inflation carries with it the potential for significant oil price rises, again which hits software producers less than most because of the Internet as a distribution platform, but it will hit hardware companies far harder because they still have to ship goods.

The wholesale sell-off of the US IT sector has been underway for some time, with more and more companies now wholly owned subsidiaries of companies in China, Japan, Dubai or other places outside of the US. This in turn means that wages will likely fall as harmonization of wages tend toward the lower salaries (US IT wages are high compared to most places on the planet), and considerably less control over the direction of the company. It will also result in layoffs of non-essential personnel.

Raising taxes on businesses have the same effects as raising taxes on consumers - to a point. Large corporations could readily absorb such taxes and probably should, as they have been particularly guilty of doing things such as moving corporate headquarters offshore and negotiating lucrative (and often one-sided) tax advantages. However, for the increasingly large IT SOHO market, raising taxes will likely prove devastating.

Finally, cost cutting will hit IT, primarily because a significant amount of the IT infrastructure in the US is currently supported by government contracts. While these contracts may result in long term cost savings, if these cost savings cannot be easily codified in a handful of sentences, this funding WILL be disappearing.

So what if some kind of emergency plan doesn't get passed? The financial services sector collapses - you're looking at anywhere from 1000 to 5000 banks and financial institutions, insurance companies and related companies going out of business. Why? At the heart of the financial crisis is a financial vehicle called a Credit Default Swap, or CDS. In simple terms, a CDS is a bet that's made that a given fund will or won't go bankrupt. So long as the fund looks fine, the person selling the CDS gets what looks like free money. However, when a fund "breaks the bank" - its obligations exceed its available capital - then the CDS has to be paid.

Used intelligently, CDS's can be an efficient way of providing a hedge against risk and making it easier to manage accounts, but they weren't used intelligently. Instead, current obligations from CDS's worldwide are in the neighborhood of $1,000 trillion dollars - which exceeds the whole planet's net GDP by a factor of 10 or so. In other words, if the entire world production output were devoted solely to servicing the debt, it would still take ten years to pay this debt off.

This is another reason why the Paulson Plan is so bad - for all the money involved, it's much like trying to hold back a hurricane with a spoon. It throws money away paying out the people who caused the problem in the first place without even beginning to address the real problem.

Some solution is needed, but its a solution that is needed at the global level (it's a global problem) and its one the requires a serious rethinking about the entire financial infrastructure rather than just a few businesses on Wall Street. It's a solution that IT can and should have a hand in - after all, it was our technology that enabled the financial big-wigs to pull this off in the first place. Engineers have a traditional distaste for working in the financial realm, in great part because things get political when money is involved, but perhaps if we start thinking about this as an engineering failure rather than an economic one, there may be ways that we can address this where the money guys can't.

Kurt Cagle is Online Editor for O'Reilly Media.

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All I can say is "Wow".

Your clarity in this issue is well-structured and clear. I can only hope your assessment of $1000 trillion on CDSes is off by some factor, because with that kind of debt service - it makes the US National Debt look anemic.

The challenge we face is one that will require smart thinking - not only of a logical kind, but one of service and sacrifice. Will we see this in the short-term? The long-term? Time will tell...

What is the alluded-to solution? How would the engineering perspective differ from the economic? Most importantly, how would the solution be implemented in a way that, unlike the devastating Paulson Plan, won't substantially increase government debt?

Thank you for simplifying this crisis.

This sounds like a complicated problem. It is not rocket science, though. I am sure there is an answer to solving the immediate problem and a solution to prevent this from happening again. If engineers had an interest in solving this financial problem, it could be solved ( and most likely it would have never happened ). It is simply a matter of moving resources at the right time and to the right places, right? Isn't that what engineering is?

Typo in the first sentence in the last paragraph.
You want 'that' to replace 'the' before "requires a serious". Also, "its" in the same sentence should be "it's", because "it's" means "it is"

Bailing out your buddies... nothing more.

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