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The Politics of Trading Recession for Inflation

December 10, 2008

On virtually everything economic, the Bush administration and much of Congress have become the gang that can’t shoot straight — and their stray bullets could take down a good piece of the nation’s economic prospects. They have directed hundreds of billions of taxpayer dollars to financial institutions (and soon, auto companies), and they’re getting ready to direct several hundred billion more at the overall economy. In all of these instances, a political drive to display the will and capacity for large actions has overwhelmed deliberate thinking about the specific consequences of those actions. The Obama presidency and the country may pay a big price for this scattershot approach.

The latest example of this dangerous development is the ever-expanding size of the long-awaited, next stimulus. We’re in a deep and serious recession; and major stimulus was certainly needed — mainly six months ago, when the Bush administration and Congress provided tax rebates which were largely saved with little stimulative effect. Now we know how bad the downturn is turning out to be, and Congress and the administration-in-waiting are preparing another stimulus of a size commensurate with what’s already unfolding — once again, as if this were six or eight months ago. A stimulus providing another $200 billion to $300 billion in new federal spending makes sense, mainly as insurance for another shock to the economy. But a $500 billion to $750 package like the one now under discussion will miss its target by many months and mainly indicates that the new rule is, anything goes when you win and damn the consequences.

Congress seems intent on responding to this recession as if everything known about how the business cycle works can be ignored, and the consequences could be serious ones. The Obama team is focused on long-term investments in 21st century energy and transportation infrastructure, modernizing health care records, expanding training and education, and extending broadband and IT access for poor children. That’s all good news for the long-term health of the economy and for the incomes of many households. The catch is, long-term investments entail not a one-time boost in spending, but continuing funding. So, when we raise the ante on those investments from $100 billion or so to $300 billion, $400 billion or $500 billion, we’re implicitly choosing either to foreswear any other commitments, such as health care, or to embrace another round of dangerously large, structural deficits.

Since the new politics seems to involve never saying no, the likely result of the current course, on top of the extraordinary infusions of credit by the Federal Reserve, is serious inflation once the downturn begins to resolve itself. This pattern is disturbingly similar to the short-sighted and cavalier approach to long-term risks that got the nation into this mess. And it continues to develop alongside the Treasury and Congress’s continuing inability to address the rising foreclosures still driving the financial crisis and the credit freeze accelerating the downturn. Yet real responses are within reach: Place a moratorium on foreclosures while Fannie Mae and Freddie Mac renegotiate the terms of millions of troubled mortgages; and link financial bailout funds to a commitment to use them to extend credit to businesses. If we do that, the economy won’t need so much fiscal or monetary stimulus.

The current approach presents other serious risks. This pattern of fast-rising spending, on top of the bailouts already done and those to come, as well as more tax cuts, could push the U.S. deficit to levels that even the United States will have trouble financing. The Asian and Middle Eastern governments that provide much of our public financing could stop — either because they’ll see inflation coming, too, or because the global downturn and falling oil prices sharply reduce their savings and thus their ability to lend them to us. The United States Treasury will always find the funds it needs, but it may have to pay a lot more to borrow them, which means higher interest rates. So the current approach risks an interest rate spike on top of everything else, which at best would lead to a substandard recovery. With all of its talent and broad public support, the Obama presidency should be able to do a lot better than that.



The Financial Crisis and Crony Capitalism

December 1, 2008

The financial crisis and the profound economic reversals reverberating around the globe caught up last week with Citigroup, the world’s largest financial institution. Citigroup is still solvent, but it holds several hundred billion dollars of heavily-leveraged, troubled assets — and once the market began to focus on the potential losses, as it did last week, the bailout became a foregone conclusion. But the terms of that bailout — on top of the deals for AIG, taxpayer infusions for solvent institutions such as Wells Fargo and State Street, and new Federal Reserve loans for any financial firm holding a wide range of assets — are beginning to look like an American version of crony capitalism. The critical distinction lost or forgotten in much of Treasury and Fed’s dealings is that the government’s proper role in rescuing or bolstering private companies during a crisis is to help them only under specific terms that directly benefit the taxpayers footing the bill.

Crony capitalism is usually associated with the way many governments in Africa, Asia and Latin America conduct public business, where government contracts, budgets and other public activities are routinely channeled to the families, friends and associates of political elites, rather than being allocated through some open bidding or other democratic processes. Variants of crony capitalism occur in the United States, too. In one infamous example, Halliburton “won” billions of dollars in no-bid contracts for Iraq while its former CEO was Vice President; and crony capitalism lurks behind billions in pork barrel appropriations passed every year by Congress. But when it begins to infect huge government operations taken to deal with an emergency, it has more serious and insidious effects. Japan famously practiced crony capitalism in its multi-trillion-yen “rescue” operations for its failing banking system in the 1990s, and bought itself a decade of stagnation and at least another decade as the worst-performing advanced economy in the world.

The terms of the Citigroup deal raise the specter of crony capitalism. The taxpayers will invest $20 billion in the company, receiving preferred stock that will pay 8 percent dividends, and Citigroup will bear the first $29 billion in losses from its current portfolio of $306 billion in troubled loans and assets. After that, the taxpayers absorb 90 percent of any additional losses in exchange for another $7 billion in preferred stock. The likelihood that Citigroup’s losses will far exceed the first $29 billion is disturbingly high. The financial crisis almost certainly will deliver additional shocks, because the current policies have done little to address the forces driving the crisis. The housing market continues to unravel; and with business investment, consumption and jobs all contracting rapidly, foreclosures continue to rise. As they do, more mortgage-backed securities and the derivatives based on them will go bad, and the consequent losses could claim much of the capital infusions that taxpayers have already provided.

As the IMF and others have warned, large additional losses also could come from other sources. Most notably, the spreading global recession, on top of national banking crises in other countries, are producing enormous pressures on government financing operations in a number of nations, including some in the Eurozone, which in turn may produce sovereign debt defaults. And most of the sovereign debt that could well default in coming months is held today by financial institutions, especially ours.

While the administration’s program barely acknowledges the implications of these dangerous dynamics in its bailout policies, President-elect Obama has at least pledged to address the underlying foreclosure problem and provide very large stimulus that could begin to ease the U.S. downturn and, with it, the global recession. The larger question is whether the new administration will also reject creeping crony capitalism by requiring that the bailouts almost certain to come next year oblige the financial institutions claiming all that cash to conduct themselves in ways that directly benefit the taxpayers picking up their bills.

Remarkably, the current administration has imposed no such requirements while doling out hundreds of billions of dollars to insulate our large financial firms from the worst consequences of their own decisions. In fact, even last week, as the Treasury was bailing out Citigroup, the Federal Reserve announced another $200 billion program for financial companies holding securities backed by consumer debt, now threatened by the recession triggered by the financial meltdown. Here’s a notion for the next administration: Since the essential reason to bail out all of these various institutions is to unfreeze the routine lending that keeps the U.S. economy going, tie future bailouts to specific commitments to reboot lending American businesses and households. This is precisely what Sweden did in the early 1990s when its financial sector melted down, and the strategy of tying capital assistance to renewed lending helped produce a genuine recovery.

Crony capitalization may be signature moral hazard of an administration which continues to believe that, even when taxpayers provide hundreds of billions of dollars to bail out powerful institutions, the government should have as little say as possible in the way they conduct themselves. It shouldn’t be good enough for an Obama presidency. When the next shocks hit our financial system and those institutions come back for more, the new administration should opt for democratic capitalism over crony capitalism, and apply lending requirements to actively open up the nation’s credit markets.



If Detroit Goes Down, Will It Take the Economy — and the GOP — With It?

November 19, 2008

In a remarkable spectacle, an Administration with a sustained record of economic blunders and failures finds itself aghast at the mistakes and mismanagement of U.S. automobile companies. Imagine Confederate General John Pemberton, after leading his forces to an historic defeat at Vicksburg, dismissing his cook for squandering the rum rations.

Yes, America’s big three automobile makers (with an assist from the auto workers’ union) have been so consistently unimaginative, self-regarding, and inept that they’ve brought themselves to the brink of bankruptcy. Now they find themselves pleading for a bailout which, under normal circumstances, most sane policy makers would dismiss out of hand. But circumstances today are as far from normal as most Americans have ever experienced, and the request requires a serious second look.

The automakers had been in deep trouble for some time; but until the economic crisis hit, their condition was far from terminal. The Bush administration’s inept strategies and incompetent management of the crisis then dealt a weak industry new, serious body blows. First, the sudden upheavals across the financial system, along with the administration’s inability to explain how it happened or how they intended to protect the rest of us from the fallout, bred such extreme caution and even panic among consumers, that most demand for Detroit’s products dried up. Moreover, much of the shrinking cohort of Americans still prepared to purchase a new U.S.-made car can’t find financing for it. That’s because two decades of deep federal distrust of regulating most financial institutions allowed them to speculate so recklessly with borrowed funds, that now, even with the bailout, their balance sheets are so precarious that they won’t provide a new loan to anybody who couldn’t pay for a new car without one. Finally, the crisis turned off the lines of credit and other routine financing that auto manufacturers need to operate. All three blows are consequences of the remarkable failures by the White House, the Treasury and the Federal Reserve to comprehend the dangers of the sub-prime mortgage market as it began to unravel and address effectively those dangers as the crisis snowballed.

So, the American auto industry now faces a kind of life-or-near-death moment, and if the President and Congress turn their backs, the results could drive down the economy much further. That’s the only reason to countenance a bailout for an old industry that doggedly resists modernizing itself — but under the current circumstances, it’s a compelling one. American businesses and consumers remain dangerously vulnerable to yet another economically bloody shock which could further shift expectations downward, which in turn could produce a depression-like state of mind and what economists call a “sub-optimal equilibrium.” That’s a very unpleasant condition in which markets produce much less wealth, jobs and incomes than they could, because consumers, businesses and banks no longer believe that the conditions to support better times can be sustained.

Since the Bush Administration is at least partly responsible for what now faces the auto industry — and now faces the rest of us, too — they should put their weight behind new help for automakers and auto workers. But the bailout shouldn’t be a handout. The industry needs both a shake-up and a technological shift, and strings tied to the federal assistance can help make both happen. The first part of the shake-up is simple: The current executive teams are out, and everybody takes real pay cuts — including some workers who at GM reportedly earn an average of $71 per-hour (including benefits), compared to Toyota’s U.S. workers at $49 per-hour. The aid also should be tied to a greater commitment to develop and produce new engines and cars with extremely high mileage per-gallon and a small carbon footprint, because that’s the market being created by high energy prices and climate change. And to provide additional motivation, the Government can conduct the kind of competition the Pentagon carries out routinely, in which the first automaker to produce a 75 or 100-mile-per-gallon, low-carbon automobile wins a ten-year contract to supply the Federal Government fleet. And the taxpayers providing the aid should not only get an equity share in return for their investments, but public-representative seats on their boards, to keep watch and keep tabs. Finally, the government should commit itself to cajoling or coercing the Big Three’s lenders to enter into debt-equity swaps with the auto companies, and so improve their balance sheets enough to attract new private investors (and so avoid a second bailout).

Rescuing the auto companies is, of course, a slippery slope; but the alternative may be to skip past the slope and head directly for the cliff. As it is, it still may not be enough. Home foreclosures continue to rise, and the additional losses to mortgage-backed securities and their derivatives may soon absorb much of the current Wall Street bailout. Further, the global recession has pushed a number of emerging-market and transition economies perilously close to sovereign debt defaults, which would deal another serious blow to the financial institutions that today hold the debt of those countries. At a minimum, neither the economy nor the auto industry will tread water while Americans wait for the new President and new Congress to take office. That’s why, this time, the extraordinary conditions to justify bailing out a failing industry are present. And if a Republican President and his party in Congress keep their ideological blinders on and ignore those conditions, Detroit’s demise could take the GOP with it, for a long time.



It’s 1980 again, not 1932

November 13, 2008

While nearly everyone recognizes that the current financial crisis is the worst since the Great Depression, the economic challenges and the changes in the political landscape hearken back more to 1980 than to 1932. The distinction matters, because a misplaced metaphor or inapt historical analogy that takes hold of the political imagination can produce serious missteps.

In 1932 and 1980 — and again less than two weeks ago — the country strongly rejected an incumbent presidential party, with the White House and substantial majorities in both houses shifting, respectively, to Democrats, then the Republicans, and now the Democrats again. In retrospect, it’s clear that the political realignment of 1980 and the years following was not the political upheaval of 1932 and the decades which followed it. 1932 began a revolution in the federal government’s role in economic and national life that persists today, while 1980 jumpstarted a continuing shift in political preferences from center left to mainstream right, with policy evolving within a familiar framework.

If our times were truly most like the turmoil of the early 1930s, the basic character of government, the basic path for the economy, and the country’s role in the world would all be at stake. Times like that require deep and fundamental changes in both policy and politics, with a realigned electorate eager to back seismic shifts. And that’s what we hear from some members of Congress, urging President-elect Obama to make deep and fundamental changes in the economy, the health care system, the way we use energy, and the Middle East — and do as much of it as possible as soon as he takes office. If this were 1932, we would need such basic changes to head off profound social divisions and political upheaval — and a president like Franklin D. Roosevelt who could recognize that need and take it on.

1980 provides a different model which seems much closer to the country’s present predicament. There’s no popular demand to change the government’s essential role in national life and the nation’s basic role in the world. Instead, much as in 1980, the public demands major improvements in the quality of the President’s economic performance and the success of his foreign policies. Yes, the economic crisis almost certainly will be the most damaging since the 1930s. But still there’s a profound difference between unemployment rates of 7 percent or even 10 percent, and the 25 percent jobless rates of the 1930s. One reason is that today we understand much of the sources of our economic failures — which we didn’t in 1932 — and so we can reasonably expect to be able to address them without fundamentally changing the government’s role in our lives. Similarly, we know that we face profound problems with our health care system, especially with the financing to ensure its universality and sustain its quality.

If this time were a political and economic reprise of the 1930s, the health care debate would revolve around a government-run, single-payer system with comprehensive price and wage controls. Instead, President-elect Obama — and every other serious presidential candidate this year — could and did promise to address these problems in a serious way without fundamentally changing the government’s role there, too.

If our economic and political conditions recall 1980 and not 1932, what’s the best course for the new administration? The President-elect should be able to draw on an extraordinary level of public and congressional support for some time; and he has said, so many times and in so many ways, that his presidency will tackle the country’s problems from inside the policy discussions the two parties have carried on for the last decade. If that’s the path, the new President’s best strategy is to press for change step-by-step, rather than try to drive a wave of sweeping congressional actions in the storied, first 100 days. For one thing, when a president fails at sweeping initiatives, his political support for another go at it usually disappears. Anyway, step-by-step change doesn’t mean marginal or modest changes. Rather, it can describe a political process where the President’s initial round of reforms in, say, health care, regulation, energy and tax policies over the first year are followed by a second round of reforms the following year. And if the nation is lucky, there can even be a third and fourth round after that. This is the time for an Obama administration and Congress to finally fix the systems we have — and not, as it was for FDR, the moment to invent wholly new ones.



Stimulus for the Long Run

October 23, 2008

When Congress returns to Washington following the election, its first priority will be to pass another stimulus package for the sinking economy. It’s already clear that the package will involve about $200 billion in new stimulus or a boost equal to about 1.4 percent of GDP. The question is what form should the package take. The path of least political resistance is another round of tax rebates for American families, which they could spend to jumpstart demand and, ultimately, the business investments and jobs to meet that demand. The catch is, that path is very unlikely to work this time. Moreover, the new president-elect and Congress can put that $200 billion to uses that will stimulate long-term growth and income gains much more effectively.

Most people won’t spend small windfalls when they’re worried about losing their jobs or homes next month or finding themselves unable to pay their health care premiums or their kid’s tuition. Instead, they save such windfalls or use them to pay down debts. That’s just what happened this past spring with most of the tax rebate in the last stimulus. With unemployment rising, home values continuing to fall and the stock market down nearly 40 percent over the last year, most Americans are even more anxious today and feeling a lot poorer. In this environment, two-thirds of more of those rebate checks would simply be saved, providing virtually no stimulus.

But we still need that stimulus, if only as an insurance policy against future economic shocks that could deliver serious new blows to faltering economy, such as a run on the dollar that would drive up interest rates or another wave of financial failures if the deterioration in the housing market get worse. And since the recessions in countries that suffer financial meltdowns are usually longer and deeper than normal, we should prepare ourselves for another year or more of tight times.

There are better paths for the coming stimulus package than tax rebates. A piece of it should go to ease some of the recession’s immediate pressures and pain: Extend unemployment benefits for the millions more Americans likely to lose their jobs in 2009, and give states and cities infusion of funds so they don’t have to make sharp cuts in the payrolls of teachers, police and other public workers, or in Medicaid services for sick low-income people.

The President-elect-to-be and Congress, however, should direct the lion’s share of the $200 billion in a new direction: Investments in the basic elements of growth for next decade. In effect, we should use the stimulus to drive policy reforms that will affect the shape and strength of the next expansion, rather than simply its timing. A third or more of the new funding should go to infrastructure — and most of that not for traditional roads and bridges, but for the public requirements of the low-carbon, energy efficient economy we know we have to build. The package could provide, for example, the first support for modernizing the nation’s electricity grid. The Federal Government also could make itself a model of climate-friendly and energy-efficient ways of doing business, with large-scale, new investments to upgrade the heating, cooling and lighting systems of all federally-owned buildings for low-carbon energy efficiency and to shift the federal fleet to hybrid and other energy efficient vehicles. The package also could include new tax preferences for businesses and households to upgrade their systems.

Investments in public transportation could be another important focus for stimulus spending. Today, public transportation accounts for just one percent of U.S. passenger miles, compared to 5 percent in Canada, 10 percent in Europe and 30 percent in Japan. For the short term, the stimulus package could include subsidies for local transit systems to cut their fares by half or more. For the long-term, the package can include down-payments on a new national program to promote the construction or extension new light rail systems for metropolitan areas, which can also create jobs quickly.

Through this recession and into the next expansion, wage and productivity gains will increasingly be tied to a person’s capacity to operate in workplaces dense with information and telecommunications technologies. Knowing that, we also can direct some of the stimulus to a plan we developed and which Senator Obama has endorsed, to provide grants to community colleges to keep their computer labs open and staffed in the evenings and on weekends for any adult to walk in and receive free computer training. Since we know that every American student also needs to develop computer and Internet-based skills, the stimulus also can include the first funding for an innovative program to provide inexpensive laptops developed by the MIT Media Lab for every sixth-grade student. Finally, the stimulus package can fund the extension of broadband installation and service for users in every school, local library, and local and state human services offices.

These are all investments which we know we have to do, if we really intend to make the U.S. economy more efficient, innovative, and sustainable. We also know that Congress will pass some $200 billion in new stimulus within a month’s time. The new president-elect can use this coming occasion not only to create more jobs, but to do so in ways that will help drive the development of a real, 21st century workforce and genuine 21st century economic infrastructure. And taking this course could be an early and important opportunity for him to practice both his new politics and a new form of economic leadership.



Who’s in Charge?

October 17, 2008

As American tangle with an accelerating economic downturn, scarily-volatile stock markets, and an array of bailout and other emergency programs, yet another pitfall has become apparent: There’s no one at the helm of the economy or efforts to help it. President George W. Bush is nearly entirely absent, the Treasury Secretary cannot commit the nation to new policies, and now Congress has left the city to campaign. The two presidential candidates, including the next president, also cannot assert any authority even if either of them wanted to, since Congress is adjourned and the president couldn’t respond to an Obama recommendation without undermining his party’s candidate, nor respond to a McCain proposal without reinforcing the Democrats’ case that the two are in joined at the brain.

So, the economic crisis continues to worsen. The problems in housing, finance and now the overall economy aren’t on recess, nor will they take hold their fire until the next president is inaugurated. In fact, more problems will emerge, both political and economic. For example, this week, three of the nine banks slated to get the first bag of cheap, federal bailout money reported very respectable third-quarter profits. Wells Fargo, State Street Bank and J.P. Morgan-Chase together earned $2.6 billion in profits for the quarter, even as they agreed to accept $25 billion each in new capital from American taxpayers. Of course, they agreed: The money will cost them 5 percent, or half of what Warren Buffet received for his $5 billion capital investment in Goldman Sachs last month, so now they can expand their business at a cut rate. The CEO of J.P. Morgan-Chase called his $25 billion injection a “growth opportunity.” But by what methods of accounting do they need emergency government assistance? And the deciders in the administration? The spokesman said, ‘We are not here to make money off these companies,’ a view which I expect would draw attacks from most members of Congress if they were here, both campaigns, and the public. In fact, if interest rates rise before the banks pay back the capital, these loans to healthy, profitable banks will actually cost taxpayers plenty, since every cent of their $75 billion will be borrowed, and the recipients are paying below-market rates.

Presumably the Treasury has criteria for extending these bailout loans, but since there is no transparency and, with Congress gone, no one to call for it, we cannot know what they are. But can they be, if sound, profitable banks qualify? With a sinking economy sinking and millions of Americans facing unemployment and home foreclosures, is it the first priority of those in charge today to finance new growth opportunities for profitable banks? Is that their government’s reward for their managing to avoid bankruptcy?

In fact, it looks like one of the final and morally corrupt acts of an administration that has introduced a big dose of Asian-style “crony capitalism” between the most senior of the White House and the Treasury, and Wall Street.

This is happening, in part, because in the midst of a genuine crisis, the United States finds itself nearly leaderless. British Prime Minister Gordon Brown and other European leaders this week called for a ‘Bretton Woods II’ summit to redesign the global financial architecture. They want to meet within a few weeks to begin the figure out how the International Monetary Fund, World Bank and the Bank of International Settlements in this new era and, presumably, to discuss new terms for overseeing capital flow among countries. Who would speak and negotiate for the United States? It’s likely that Barack Obama will be the president-elect by the time they meet, but he won’t be the president, and therefore unable to exercise presidential authority. The man who will still be president, George W. Bush, with be utterly without domestic support or credibility in economic matters. He will have no way of selling a new international package to the American people or Congress. These kinds of issues arise during any presidential transition, but they’re especially acute this time, because we find ourselves in the middle of a cascading economic crisis that will not wait until next January.

Senators Obama and McCain need to prepare now. Both candidates should convene a group of trusted economic advisors to review all the options for dealing with the deteriorating housing market, the instability in our financial system, and the real economy’s accelerating problems, without reference to the campaigns. This group should report its findings and recommendations to the president-elect on November 5, and he should present his recommendations to a lame-duck Congress that same week. Campaign operatives may assume we have until January, but the man who becomes president-elect must know that he will have to take action as soon as the votes are counted.

Our next blog will take us through what actions the president-elect ought to recommend.



Nothing to Fear More than Fear Itself

October 9, 2008

Congress tried late last week to stall the financial crisis by pledging to spend $700 billion on devalued securities held by financial institutions, and by Monday morning it was clear that the pledge wasn’t enough to reassure investors or restart lending. Instead, a classic panic has set in here and around much of the world as public confidence in banks, other financial institutions and the markets themselves nosedived, along with confidence by banks and other financial institutions in most potential borrowers. This panicked mindset threatens the economy more today than the continuing turmoil in the housing and financial markets. Now we have to recreate baseline confidence before we can repair the continuing damage to our financial and housing markets.

Financial and broader economic panics thrive on a combination of huge and unexpected setbacks and a serious absence of information. They unfold when people face enormous uncertainty about matters vital to them, such as the value and security of their homes and, retirement accounts and college savings — and see everyone else, including those with the power and position to manage those matters, struggling with the same uncertainty. People feel threatened and powerless to do anything about it not because they have no options, but because they have no basis to evaluate or choose among them, and worry that more unexpected calamities could overtake whatever course they take. That’s where tens of millions of Americans — and Europeans and Asians as well — have found themselves this week. They don’t understand why the value of their homes and investments has plummeted so suddenly, and see that those ostensibly in charge of the economy in Washington and on Wall Street have little grip on of this as well. The result is that spending and investment are shutting down, dragging the entire economy into what seems very likely be the worst downturn since the 1930s.

The remedy to this panic is information, which only the nation’s leaders can generate and demonstrate they understand. For example, the Federal Reserve and the FDIC should have legions of examiners working around the clock re-auditing the conditions of all major financial institutions, starting with commercial banks. The Treasury and Fed could then report to the public on each institution’s financial health and their confidence in its continuing financial health. The largest group would still be judged healthy; another group could be designated as worth watching, with measures to help it move to the first group; while those in trouble would be identified with a plan of action to help them recover, if possible. Without this information, most people have been panicking that almost every institution and every investment might well be in serious trouble.

This program won’t solve the capitalization crisis across financial institutions, much less the crisis gripping housing markets which itself has driven so much of the current upheaval. But it would staunch the panic as investors, business owners and families come to feel that they finally know where the problems lie and what the government and nation’s business leaders will do to address them. At the same time, our leaders can finally begin to address seriously the housing and capitalization crises in an economic environment in which businesses and people will be able respond reasonably and predictably.



Congress Acts: A Little Better Than Nothing

October 3, 2008

The $750 trillion bailout plan that the Senate approved, and which the House is expected to endorse reluctantly, could give us all a little more breathing room in the current economic crisis, but it won’t resolve anything. It’s much the same plan the House voted down a few days ago, with a bushel of tax breaks calculated to draw more votes but unrelated to the turmoil in the capital markets. It should stave off a short-term panic, but it won’t stabilize the credit or housing markets. Such a little impact seems hardly an effective use of $750 billion.

It’s hard to know how many members of Congress understand the forces seizing the financial system or how this plan would actually affect it, especially since the Treasury’s original three-page plan outline has become a highly complicated, 750-page piece of legislation. Most lawmakers know they have to act quickly to at least begin to address a crisis that’s become a critical focus for the voters most of them will face in five weeks. The truth is, economists don’t agree on the best course, with a broad range of theories and proposals — and telling agreement on not much more than the likelihood that the government’s plan won’t do the job. It’s not even likely to get all of us through the general election on November 4 without further upheaval.

To be fair, most members of Congress are caught between two opposing and very discomforting forces: Pass a bailout plan that will anger many of their constituents, or reject it and be held responsible for the next wave of economic shocks. It’s a fact that the markets will slide sharply and quickly if they believe that the government cannot pass any response — but also that this plan will only modestly soften or delay those consequences.

Why are we all left with these two sorry alternatives? I’m afraid we’re all prey to what economists call path dependence, when an outcome is heavily influenced by how a development began. A classic example is the ubiquitous success of Microsoft Windows. It’s arguably not the most efficient, powerful or effective operating system, and a rational market would normally have moved to other systems over time. But personal computing started with DOS, people and institutions became invested in its particular approach to the technology, and it continues to prevail. In this case, the Treasury hadn’t developed a plan even as the crisis unfolded, responding in an ad hoc way to the collapses of Bear Stearns, Merrill Lynch, Freddie Mac and Fannie Mae; bailing out some and not others based on their judgment of the moment about whether a rescue was needed to avoid system-wide panic.

By last week, after letting Lehman Brothers fall and facing a real prospect of multiple major failures and bank runs, the Treasury pulled together a three-page outline which it called a plan. And once that plan was distributed, it became the focus and organizing principle for the congressional debate, and path dependence took hold. The plan is inadequate — it doesn’t recapitalize financial institutions nor address the underlying deterioration in the housing market — but without a substantial period to bone up and consult experts, most members of Congress don’t have the ability to step back, ask basic questions of the plan, and approach the crisis in a different way.

Ironically, this suggests the same ‘best case scenario’ thinking that the Treasury and Federal Reserve have brought to this problem for two years, and which the Bush Administration has used for even longer in Iraq.

For now, this is the only plan we have. It should have some benefits. For $750 billion, or several million dollars per-American, we will place a floor under the losses of financial institutions for their speculations in the market for housing-based securities and derivatives. Our own best-case scenario is that this floor will be enough to attract outside equity investors for these institutions, recapitalizing the system over the next six months or so. But the bill includes only weak and marginal steps to help stem the foreclosures and falling housing values driving this crisis; and if the floor is not enough the attract outside equity investors, we will be right back where we started fairly quickly.

We could face the next phase of this systemic crisis soon, and as the problems spread across Europe and into Asia, intensified by a deepening recession, it could well be a dominant problem well into 2009 and the first great test for the next president of the United States.



It’s a Bad Bailout

September 24, 2008

Congress is now embroiled in an important and passionate debate about the Bush Administration’s rescue-bailout plan. Get past the anxiety, and it seems clear that the plan will not resolve the underlying problems driving the crisis, the deterioration of the housing market. And in another instance of the Bush economic doctrine, it would transfer untold billions of dollars from ordinary American taxpayers to the shareholders and executives of some of the country’s wealthiest financial institutions.

The administration’s first mistake — that’s more polite than calling it simple distortion — is the premise that the bailout is needed to provide liquidity for a financial system short on it. This claim is then elevated to a matter of national urgency bordering on potential catastrophe by the assertions from Treasury Secretary Paulson, echoed by Federal Reserve chairman Bernanke, that this liquidity shortage will soon prevent businesses from securing normal bank loans and lines of credit for their investments and operating expenses. The explanation is that no one is willing to lend to banks, even on an overnight basis, because they don’t trust their ability to repay even the next day. It’s a fact that intra-bank overnight lending has fallen, and so has very short term loans to banks from other financial institutions. But there are no reports of sound businesses unable to secure loans and credits to meet their payroll or carry out planned investments. Moreover, the Federal Reserve has opened its discount window to all financial institutions, offering as much funds as banks want at very low, below-market rates. If a liquidity crunch should emerge, we already have the traditional mechanism to address it.

The administration’s second gambit is closer to reality, though it, too, does not necessitate the administration’s solution. They argue, correctly, that many financial institutions are on the brink of insolvency, because their huge losses from their highly-leveraged mortgage-backed securities and the derivatives based on them have overwhelmed their capital base. That’s correct –– and presumably after this round Congress will be sufficiently chastened to apply reasonable capital requirements to all financial funds and institutions that issue or purchase securities and their derivatives.

It’s too late this time, but the administration’s bailout would be either nonsensical or very inequitable. If the government intends to buy the toxic instruments at their market price, it won’t much help the institutions, since they will just have to take their losses. The alternative is the government buys the securities and derivatives at above-market prices, which would constitute the largest, regressive direct transfer in our history. And as an economic matter, how would this above-market price be set? And once it is, the government’s intervention in the financial markets to buy hundreds of billions of dollars of assets at above market prices would constitute the most dangerous moral hazard imaginable.

If the financial market problem is a genuine and pressing need to recapitalize America’s financial institutions, then those who provide the capital should receive the normal equity share. If the money comes from taxpayers, the government should claim preferred equity position in the institutions receiving the capital infusion. Those institutions won’t much like that, since it would give government leverage over their activities. There’s an alternative: Don’t ask taxpayers to recapitalize institutions that have squandered their capital through reckless mismanagement. They can find it somewhere else, as Goldman Sachs has done with Warren Buffett. Or, Congress could effectively require that the lenders to these institutions take equity shares, in what’s called a debt-equity swap.

The advantage of all threes approaches is that they don’t require direct transfers from taxpayers of modest means to shareholders and executives with much greater means – or if they do, the taxpayers get something real in return, as they would in any market transaction.

That will leave the larger problems still unresolved. First, we’ll still need to address the underlying cause by slowing or ending the waves of foreclosures dragging down the housing market by creating either a direct loan facility for homeowners facing foreclosure or terms for them to renegotiate their current mortgages. Once that’s done, Congress will have to turn to the equally serious business of establishing transparency, capital and other regulatory requirements for all financial institutions, so we never find ourselves on this path again.



Crisis on Wall Street

September 18, 2008

This week’s financial developments have unfolded in the ways that keep people up at night and spark panic in even seasoned investors. And it’s not over yet — we’re perhaps midway through the financial crisis (which actually could get much worse), and headed fast into a serious and disturbing recession.

It’s as if the economy entered a time warp and we found our way into a 19th century boom and bust cycle — and the bust phase is never pleasant. It started, as everyone can now understand, when the bubble in the housing market opened up a new flank in subprime borrowers, Wall Street hotshots packaged those subprime mortgages into securities, bought by the tens of billions with tens of billions in borrowed money; and then even hotter shots created trillions in “credit default swaps” that guaranteed those securities against default. Once the housing market swooned, the rest was dominos, from mortgages to mortgage-backed securities to credit default swaps to the institutions that provided all the borrowed money for both.

You know the rest as the financial system began to crack under the monumental weight of defaulting securities — the denizens of free-market capitalism in the Bush administration bailed out Bear Stearns, then took over Fannie Mae and Freddie Mac, and then threw $85 billion in loans at AIG, with all of its assets as the collateral. Lehman Brothers and Merrill Lynch are gone, and in another month, so a number of other major financial institutions will join them.

The time to tackle these problems was during the boom, not during the bust, in extremis. That’s especially true with a boom where the risks are as graphic and obvious as they were this time. Instead, the potential costs were consistently denied, set aside, or ignored, and the biggest responsibility lies with those who should have made the long-term health of their companies and our economy their top priority. The titans of Wall Street and senior officials at the Federal Reserve, the Treasury and the White House economic council all understood the nature and extent of the risks. They are the “Michael Brownies” of the current financial crisis. (And lest we forget — as if anyone could — most of the Wall Street titans are walking away with tens of millions of dollars, because their compensation agreements reward them for high profits based on speculative risks and impose no penalty when it all collapses.)

This is a bust that was inevitable. With the enormous expansion in the global capital pool and the stream of hundreds of billions of dollars a year of that capital into the United States, financial institutions found increasingly risky ways to earn fees and other income from all that capital. Our government sat by as largely unregulated funds and investment banks create new securities and then sold them to investors leveraged up to 95 or 97 percent — including new funds they created themselves to buy the securities they issued themselves. Where was the Fed, the Treasury and the White House — or John McCain — when these instruments proliferated into the trillions with little collateral behind them. Ironically, many of these new instruments were intended to diversify risk, such as the credit default swaps. With those, the owner of assets like mortgages, auto loans or credit card debt exchanges a piece of the income stream from those assets for a guarantee that he’d be covered if the debtors defaulted. It works only if the incidence of default is very low — and those issuing the guarantees can make good when defaults happen. Indeed, a good of the colossal failure of the Federal Reserve, the Treasury and the administration involves their negligence in insuring that such defaults would remain rare and that those providing the guarantees when did happen could make good on them. Even as the defaults began to rise and the guarantees began to fail, they remain aloof, and their oversight and regulation virtually non-existent. The market became an inverted pyramid that inevitably would topple.

We’re in the middle of a slow-motion, cascading systemic crisis, and it’s not over yet. In fact, it probably won’t end until the housing market stabilizes and begins to recover. Meanwhile, it will continue to slowly grind down the economy for everyone. As the institutions that remain absorb more losses, they will have to sell more assets to restore their balance sheets, driving down asset prices, and limit their new lending to businesses. To get some sense of the dimensions, consider that the global market in credit default swaps is an estimated $60 trillion — that’s equal to the estimated value of all assets in the U.S. economy. If five percent of those swaps go bad, that’s $3 trillion, or six times the size of the Savings & Loan crisis and a nearly one-quarter the size of U.S. GDP. That’s another measure of the dimension of the criminal negligence committed by the Federal Reserve, the Treasury, the managements of Lehman Bros., Bear Stearns, AIG, Fannie Mae and Freddie Mac — and while we’re at it, thousands of smaller hedge funds.

Now we’re headed for recession. The economy has taken three massive hits — first housing, then energy, and now finance — and the inevitable result will be real cutbacks in both consumer spending and investment, and with them, growth and employment. The government is spending trillions of dollars to prop up failing institutions, but it has probably reached the limit of its capacity for bail outs, or will soon. That’s why, for the first time, the market is pricing the possibility of a U.S. government default.

For now, the best steps we could take would be measures to stop foreclosures and stabilize the housing market. Instead of just lending AIG, which speculated in mortgage-backed securities and the credit default swaps on them, $85 billion, we should make a comparable sum available as special loans to homeowners facing the possibility for personal default and foreclosure. Americans periodically go through phases where they believe that markets can do no harm. But markets fail as well, and this time, the lesson is an especially painful one. Hopefully we’ll learn, and begin at least to regulate financial transactions, wherever they occur, to ensure their basic transparency and a reasonable measure of probity.