On the Contrary

A while back as the housing bubble was deflating, I was listening to a discussion between two rather frugal and conservative friends of mine discussing how if people would have just not taken loans they couldn’t afford, this collapse would have never happened. It was the blame game that we all participate in and sadly it only touched on the final straw that broke the camel’s back, not the whole underlying failure of our system.  There are multiple causes that snowballed in the last ten years but started over 30 years ago.  By the way, there were two recent television shows that touched on all these problems, CNBC’s House of Cards, and Frontline’s Inside the Meltdown for those of you who like your information delivered by video.  The following are all of the contributing factors that built into the perfect storm:

• “Government is the Problem” – Set the stage for an economic climate that believed that either the stockholders or the board of directors would put the brakes on risky investment and thought government regulation just hindered these natural processes
• Arrogance of the Fed – The belief that the Fed can control all booms or busts with monetary policy (print money or raise or lower interest rates).  Said another way, a belief that Depressions are a thing of the past which led to an environment of unbridled risk taking with a belief the Fed will bail them out (Moral Hazard)
• The Unbridled Growth of Private Debt – Between the 1980s and 2006 private debt (the debt you and I hold, not public debt by federal state and local governments) rocketed from less than 150% of GDP to over 335%.  “…credit markets increasingly are being used less to facilitate economic activity and more to leverage bets on changes in asset prices” (Bad Money, Reckless Finance, Failed Politics, and the Global Crisis of American Capitalism, Kevin Phillips)
• Financial Sector Expansion – “Goods production lost the 2:1 edge in GDP it had enjoyed in the seventies – In 2005, on the cusp of Greenspan’s retirement, financial services – the new uber-category spanning finance, insurance, and real estate – far exceeded other sectors, totaling over one fifth of GDP against manufacturing’s gaunt shrunken 12 percent” (Bad Money).  Basically we no longer invest in goods and services, but in financial markets.  In essence what we were now importing to the world was securitized debt investments.  This one is really important if you want understand that the real money to be made in the stock market is in debit instruments not in investing in business that make anything
• Fed Policy – Fed policy was instituted such that whenever the market’s rate of growth decreased, monetary policy was used to keep the growth strong, encouraging ever growing bubbles.  Some think that growth needs to be managed around a reasonable amount, with policy focused at deflating bubbles and not allowing them to grow out of control.  This means sometimes we have to force small recessions
• Our Psychology of Wealth Creation – A psychological state in which those who create wealth are “the Masters of the Universe” and the wealth is good by definition because it benefits us all.  Although the reality is that only a few rich have benefited from the growing credit bubble, there is a pervasive attitude that no one should question or interfere with their wealth creation since all wealth creation is good by definition
• Exponential increase of unregulated securitized debt instruments – Creation of debt instruments to package debt and the profits from selling these debt instruments.  This by itself is not bad since it provides money for investment, but the investment was primarily in other debt instruments grossly expanding the credit bubble without sufficient equity (in this case a realistic assessment of the equity backing these loans)
• Lack of Regulation – No regulation of the markets selling these instruments and the multiplier effect of leveraging (using debt to invest) which allowed investments that were leverage 30:1 or greater (thirty dollars of borrowing or every one dollar of your own equity).  The effect of this multiplies the gains when your bet wins, but multiplies your losses when you lose
• Failure to Correctly Evaluate Risk – Risky debt repackaged in CDO’s using faulty risk models that assumed normal distribution on price variations (The Origins of Economic Crises:  Central Banks, Credit Bubbles, and the Efficient Market Fallacy, George Cooper) and did not take into account black swan events. The result was a gaming of the rating system to allow these assets to be improperly rated as AAA.  Basic to this risk model was the assumption that the underlying equity backing up these risky loans, home values, would keep rising forever
• Failure of the Rating Agencies – Rating agencies that were dependent on those they rated for their income and no regulation by the SEC which was a revolving door for the industry
• Credit Default Swaps – Creation of “insurance” called credit default swaps which required no equity backing the insurance and no regulation of their markets.  If the market collapsed, there was no ability to pay these obligations.  You could make these bets even if you didn’t own the stock you were betting on.  Maybe even turning Wall Street into a casino
• Interdependence of all the Banks – With these massive debt and insurance instruments held by almost everyone, based upon housing prices, there was incredible interconnectiveness of the financial institutions so that any default would ripple throughout the industry.  In other words if one institution failed, others would be dragged in
• Greed – Then we get to greed and the idea that greed is good, part of the flow down litany and Masters of the Universe mentality.  In order to continue the amazing profits that were being made by these financial institutions, there was tremendous pressure to keep creating debt so they could repackage it and sell it.  That is when exotic loans for housing really took off
• Risk Transfer – The transfer of risk to the investors relieved the lending agency from holding the loans or being responsible if the loans defaulted. The more loans they issued the more money they made with no risk to them
• Housing Bubble – The belief that housing prices would always rise, allowed almost everyone, even if they couldn’t afford the loan, to take the money thinking they could bail themselves out later if they had to sell.  This is how many of these loans were fostered off on people who had no way to repay
• International Effect – The international impact of this crisis came about because the banks were selling these toxic assets as AAA rated investments and stockholders/voters were demanding more and more return on their investments because everyone else was getting that level of return which leads to the final real straw that broke the camel’s back (bank)
• Group-Think – Finally we have group-think throughout the whole system.  Everyone was making a bundle and everybody wanted a piece of the action.  It is easy to justify what you might consider risky or foolish if everyone around you is making a bundle and you look like a fool for not taking advantage of the easy money.  Anyone who say there is a problem and wanted to put the brakes on, put their institution at risk, not getting the return others were making and were therefore sidelined by their management.  The prevailing mentality was to take the money and run

I probably missed some stuff, but those are the major elements.  So just blaming it on the end of the chain and people who knowingly took risky loans is a grossly oversimplified view of what happened.  Yes, people lacked discipline and good judgment, but that went throughout the system.  If the system was not so tightly interconnected and we now have a world economy, maybe the damage would have been limited.

Alan Greenspan in the Frontline segment, Meltdown, said he thought that this could not happen because the board of directors would recognize the high level of risk and take the appropriate action to limit these risky bets.  They did not and he was troubled by this.  One might ask why he didn’t take the appropriate action.  The answer that he gave when asked was that he could not imagine that this could happen.  It would appear that a lack of imagination not only is fatal in our Iraq policy, but in our economic policy.

But then he said something very interesting.  To paraphrase him, even if this results in a depression, it is still the best system we have devised to create wealth for the majority of players and we will have to learn to live with it even though these contraction will occur again in the future.  I would agree with him although there are important lessons to be learned here.

First on the wealth issue he is correct and also not so much correct.  In China, millions were being pulled up to a middle class standard of living while in our country, the middle class and poor were losing ground.  One possible conclusion is that the capitalist function of manufacturing and exporting of goods works well to expand wealth in society, while the creation of financial instruments and betting on them with leveraged investments only focuses wealth on the wealthy.

Second it is clear that when we enter a bubble, greed clouds our judgment until the “house of cards” collapses (pun intended).  This says that regulation is the only way to stabilize this system.  Somehow sanity must be restored even though everyone is making money.  We thought we learned this lesson after the Great Depression, but most of these rules were cast aside as impeding profit and being out-dated.

One last thought:  In my essay on Marcoeconomics, I raised the point made by George Cooper in his book The Origins of Economic Crises:  Central Banks, Credit Bubbles, and the Efficient Market Fallacy, which is that markets are inherently unstable and maybe the real job of the Central Banks is not only to stop down turns, but to also moderate growth so that bubbles are small and will not have a destructive effect when they are deflated.

It will be interesting in the days to come to see how Republican laissez-fare dogma will argue against the needed change in rules and how the Fed and our banking system should function in the future.  Since they were the ones who mostly benefited from the old failed system, they will try to reinstitute it while reinventing history.  The question is have we learned our lesson and will we let them.

Note:  No I am not an economist and I could have this wrong but I don’t think so.  I think it is critically important that all of us understand what happened because the future of our system rests on us getting it right.  It is not and has never been about who is to blame.  There is plenty to go around.  It is about understanding what happend to prevent it in the future.  As long as we let experts talk and understand for us, we will be forever be at their mercy, thus my attempt to put into words what I understand, probably only for my own benefit.  There is a excellent web site that explains many of these basic concepts called The Baseline Scenario written by real economists.

“It is often stated that the Victorian historian Thomas Carlyle in the 19th century gave economics the nickname “dismal science” as a response to the late 18th century writings of The Reverend Thomas Robert Malthus, who grimly predicted that starvation would result as projected population growth exceeded the rate of increase in the food supply.” (Wikipedia)  Eventually he may still be right.  I like to think it is a dismal science because it really isn’t a science at all.  If you are listening to competing economists today recommending what our way forward should be, it is clear that each has a different set of “facts” or root causes.

Recession, depression, deflation, inflation, stagflation, pick your economic malady.  For fixes we have monetary policy (interest rates and controlling the money supply), and economic stimulus (direct government spending and tax policy).  We all know that there are business cycles.   Sometimes people spend and sometimes they don’t.  When they don’t, we go into a recession.  When people are spending (assuming they have money to spend) then goods and services are flowing, there are jobs and incomes.  If they are spending enough, then the economy grows to match their demand.  So what causes them to not spend or not to spend enough to keep us growing?  That is the critical question of economics because if we understand the root cause of these problems, we can prevent downturns or at least control their severity.  But based on the recent battling economists made all the more shrill by the ideological needs of the Republicans, and our inability to control our problems in our current economy with monetary policy, it is clear that the evidence for root causes is still open to debate.

Our current condition certainly was caused by the housing market bubble, or more specifically the implosion of the financial markets.  Michael Lewis and David Einhorn wrote an intriguing piece in the New York Times a week ago about the multiple factors that lead to the financial bubble and burst (“The End of the Financial World as We Know It”).  So much for the Masters of the Universe and unrestricted/unregulated capitalism.  One more conventional wisdom hits the dust.  I am probably oversimplifying, but what this did was take a great deal of money out of the system (devaluation or outright loss of equity).  So this shrank the system, but more importantly made people fearful.  And here is the bottom line on the economy:  Confidence.  Not only did a great deal of wealth go away (ability to buy and invest), but people’s willingness to spend or invest went away also, beginning the contraction of our economy.  Coupled with that is the unwillingness of banks to lend (if people wanted to borrow) because they know there is still a great deal of bad debt out there that is unexposed (another outcome of no regulation) and banks have no confidence in who really has the ability to pay it back.  Put another way, risk is out of control right now and everybody is holding on to their money.

So one way to look at what the Fed did was to put a whole bunch of money back, and lower interest rates (increase the money supply), but it was not near enough and did not restore confidence. People are still turning inward and hunkering down, financially speaking, for the bad times (except for me of course doing my best to keep the economy running through Amazon.com).  In other words the economy is still shrinking and it is feeding on itself and continuing to shrink.  Confidence said in another way, is the mood in the nation that says tomorrow will be better than today, I can buy stuff today (or invest) because I will be able to pay it off tomorrow (still have a job, with an increasing income), or my investment will grow.  Now monetary policy has failed to stimulate the economy and we are left with our only other tool, direct economic stimulus.  That leaves us with direct government spending and cutting taxes.  That is where the games begin.

In either mode, cutting taxes or direct government spending with a contracting economy is going to start pushing the deficit skyward and we have all been conditioned to fear a growing deficit.  But the argument against worrying about the deficit right now is that if we don’t get our economy jump-started, the deficit growth will look like small potatoes to the damage that will be done to our economy.  So the argument has boiled down to, not whether to stimulate our economy, but with tax cuts or government spending and by how much.  Now enter the ideology (Note: An extremely good analysis of how the conservatives are reinventing history to defeat the Economic Stimulus Package can be found on MediaMaters.com).

If you look back at the Great Depression, it is argued that the massive spending program that President Franklin Roosevelt embarked upon saved us and put people to work.  So the argument goes that because private spending will not mobilize the capacity of our economy, public spending must.  Lessons from the Japanese experience (10 years of stagnation) seems to tell us that to be cautious and timid in using government spending to stimulate the economy is worse than no spending at all.  It simply raises the deficit without the commensurate growth in the economy.  I say “seems” because we have different economists interpreting the data differently (The Dismal Science).  But now enter the conservatives.  Most economists are telling us we need a major investment (read spending) by our government.  But government spending is anathema to Republicans.  They would much rather see tax cuts that puts money into the hands of consumers (private spending).  They are also against raising the deficit which ought to give you pause since they created it.  The end result here is going to be a real fight between massive spending and tax cuts, along with an attempt to reduce the overall spending effort.

President-Elect Obama has proposed a spending plan that is about one-third tax cuts and two-thirds public spending.  My and others arguments against the tax cuts are they are very ineffective in stimulating the economy as the last round of tax cuts and rebates demonstrated.  People either spend it on foreign made consumer goods or more likely, save it.  So what we get for the expenditure is nothing.  The other argument is why would business (who get a tax credit for hiring people) hire people in a declining market?  They wouldn’t and once again this is an example of how the Republicans have failed to recognize that private spending can no longer get us out of this shrinking economy.

Finally there is the issue of the size of the spending effort.  Republicans want to limit this using the public’s fear of deficits as their fear card.  They are good at using the fear card but usually not to good ends.  My fear is the same as many Democrats, that President-Elect Obama has not been aggressive enough on the spending plan.  As this argument rages, we sink further into oblivion.  Just keep this in mind:  Public spending on infrastructure gets us something for our money besides jobs.  It gets us the stuff to run our economy on in the future.

So the fight is on.  My thought is that conservative economic ideology, in some ways co-opted by Democrats over the last 30 years starting with Ronald Reagan, has brought us to the brink.  If they win the arguments about being tentative, it may just push us over the edge.  We need real change and that means real courage to try something new.  I am not sure we are up to it and we don’t have a World War II to rally the nation like Franklin Roosevelt did.

Restoring confidence is the key to economic recovery.  That is only going to happen when most of us believe we are on the right path.  Prior to the election almost three-quarters of our population thought we were on the wrong path.  Continuing Republican economic ideology just continues us down a path that we have already rejected.  Real change that will result in confidence in our future means that we have a vision for that future that we all believe in.  I haven’t seen that vision yet, but the outline of that vision is starting to form as we start to formulate our recovery plan.  If it is big enough and is focused on a green and technological future, we may all get our confidence back.  If it is pumping money into the free market so it can decide our future with its magic hands, we are doomed.

Note:  Paul Krugman has written a wonderful book (“The Return of Depression Economics”) if you want to understand how our economy works.  He wrote it for us regular people and it is worth your time.