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December 17, 2008

Understanding the Financial Meltdown

This economic "downturn" did not need to happen.  I haven't followed the markets and financial news all that carefully, unlike political news.  I don't have the background to read the entrails of this current mess quickly.  But I know it did not need to happen.  It's been nagging at me and I've laid aside some time to dig into recent articles about how "this came to be" by the people I've begun to trust on the economy and "what can we do now". 

So, I'm going to integrate what I've learned from two renowned progressive economists and one exceptional historian.  Joseph Stiglitz, a Nobel Prize winning economist and professor at Columbia University has an article in Vanity Fair this month, entitled "Capitalist Fools".  James K. Galbraith, is professor in two different departments at the University of Austin and the Chair of Economists for Peace and Security.  His piece is from his remarks entitled "The Johnson Legacy and the Obama Challenge" which Galbraith recently gave at  the LBJ Centennial Conference, filling in for his famous father.  Andrew Bacevich is a Professor of History and International Relations at Boston University and author of, among many other books, "The Limits of Power: The End of American Exceptionalism"

As Stiglitz says, in his article,

There will come a moment when the most urgent threats posed by the credit crisis have eased and the larger task before us will be to chart a direction for the economic steps ahead. This will be a dangerous moment. Behind the debates over future policy is a debate over history—a debate over the causes of our current situation. The battle for the past will determine the battle for the present. So it’s crucial to get the history straight.

How We Got in This Mess

Joseph Stiglitz believes there were five key decisions made since the Reagan administration took office (this will be a theme) that cascaded into this tragic result:

1. Firing the Chairman:  Ronald Reagan fired Paul Volcker as chairman of the Federal Reserve Board in 1987 and replaced him with Alan Greenspan because Greenspan, a devoted follower of Ayn Rand, did not believe in regulation of the financial markets.  Volcker, whom of course is coming back to work in the Obama Administration, had brought inflation down from 11% to 4%.  Volcker worked to maintain the stability of the financial system at every turn and knew that regulation was a part of that stability.  Greenspan allowed complicated instruments such as derivatives, credit-default swaps, and so forth to develop with little or no regulation.  Greenspan's policies were responsible for two financial bubbles: the high-tech bubble of 2000–2001 and the housing bubble.  

2. Tearing down the walls:  Straight from Stiglitz - "In November 1999, Congress repealed the Glass-Steagall Act—the culmination of a $300 million lobbying effort by the banking and financial-services industries, and spearheaded in Congress by Senator Phil Gramm. Glass-Steagall had long separated commercial banks (which lend money) and investment banks (which organize the sale of bonds and equities); it had been enacted in the aftermath of the Great Depression and was meant to curb the excesses of that era, including grave conflicts of interest."  There were more foolish moves - the decision in April 2004 by the SEC to allow big investment banks "to increase their debt-to-capital ratio so that they could buy more mortgage-backed securities, inflating the housing bubble in the process".

3.  Applying the Leeches:  The Bush tax cuts of 2001 and 2001 for upper-income Americans and corporations shaped the conditions of the current taxes; they did very little to stimulate the economy.  The Fed tried to help - establishing exceptionally low interest rates and increasing liquidity.  Then along came the war which led to soaring oil prices.  By then, Americans were so dependent on foreign oil (another recurring theme) we spent hundreds of billions to purchase oil, money that would have been spent on American goods and services otherwise.  To prevent an economic slowdown, the Fed flooded the market with ready money for the mortgage market and American's household savings rates plummeted. 

4.  Faking the Numbers:  As a result of the Enron and WorldCom collapses, Congress passed the Sarbanes-Oxley Act but neglected to deal with stock options.  This was sort of like the Constitution choosing not to deal with the difficult issue of slavery; it just kicked the problem down the road and it got more and more beat up as it went along.  Stock options became a huge amount of the compensation for executives and that provided incentives for bad accounting to pump up share prices.  Then, added to that, the rating agencies, like Moody's or Standard & Poor's are paid by the people they grade, providing them incentives to give unrealistically high ratings. 

5.  Letting it Bleed:  Stiglitz argues that the October bailout package was just the worst in a set of jagging paths that the Bush Administration tried, each worse than the last.   None of which addressed the looming weaknesses in the economy. "The economy had been sustained by excessive borrowing. That game was up. As consumption contracted, exports kept the economy going, but with the dollar strengthening and Europe and the rest of the world declining, it was hard to see how that could continue. Meanwhile, states faced massive drop-offs in revenues—they would have to cut back on expenditures. Without quick action by government, the economy faced a downturn. And even if banks had lent wisely—which they hadn’t—the downturn was sure to mean an increase in bad debts, further weakening the struggling financial sector."  In sum, Stiglitz says,

The administration talked about confidence building, but what it delivered was actually a confidence trick. If the administration had really wanted to restore confidence in the financial system, it would have begun by addressing the underlying problems—the flawed incentive structures and the inadequate regulatory system.

Back to the Future

James K. Galbraith talks about a recommitment to a legislative agenda that builds on the foundation laid down by the New Deal and the Great Society.  "We have spent a generation trying to repeal the New Deal and the Great Society, and the fact that the results are disastrous is now clear to all. "

Galbraith notes that the scope of the economic stimulus package is so much more ambitious than what was being discussed back in the summer because of the financial collapse.  When he talks about why the collapse occurred, it seems eerily similar to what happened in the Great Crash, which his father wrote about.  "Amazingly, it took just nine years from the repeal of Glass-Steagall to reproduce the central pathology of that earlier time: the rampant peddling of toxic securities confected from worthless assets to an investing public that never quite gets the word."

Galbraith lays the blame squarely on deregulation:

The trouble arose primarily in unsupervised mortgage originators like Countrywide Financial and IndyMac, those who underwrote the resulting securities, like Citigroup and Lehman Brothers, and those who rated them, like Moody's and Standard and Poor's. At the bottom of the pile were borrowers, some fraudulent but most just naive victims of the hard sell, who accepted loans based on incomes and credit histories they didn't have, on houses that were systematically over-appraised, on terms timed to explode within two years or three. At the top were the Credit Default Swap speculators, whose bets on the chance of non-payment metastasized risk through the system. Overlooking all was a complaisant state - a Predator State - which combined commercial and investment banking, relaxed the underwriting rules, legalized and deregulated the default swaps, desupervised the mortgage originators and resolutely ignored warnings of massive fraud from the FBI and other sources.

Worse still, we have no decent economic models to work with.  The men and the ideas of the New Deal and the Great Society have been set aside in favor of the macroeconomics of Ronald Reagan.  It's not only the conservatives; it's the mainstream economic establishment.

He reminds us of what Roosevelt's and Johnson's economists came up with and about how well it worked.  Galbraith quotes from a new paper Marshall Auerback wrote summarizing the actual accomplishments of those years and debunking the debunkers (no link provided or found). 

The key to evaluating Roosevelt's performance in combating the Depression is the statistical treatment of many millions of unemployed engaged in his massive workfare programs. The government hired about 60 per cent of the unemployed in public works and conservation projects... It also built or renovated 2,500 hospitals, 45,000 schools, 13,000 parks and playgrounds, 7,800 bridges, 700,000 miles of roads, and a thousand airfields. And it employed 50,000 teachers, rebuilt the country's entire rural school system, and hired 3,000 writers, musicians, sculptors and painters... If these workfare Americans are considered to be unemployed, the Roosevelt administration reduced unemployment ... to 13 per cent in 1936, to less than 10 per cent at the end of 1940, to less than 1 per cent a year later when the U.S. was plunged into the Second World War. If the federal workfare employees are accepted as employed, the corresponding numbers are ... 7 per cent, 3 per cent and 0.5 per cent. Virtually all the genuinely unemployed received basic social benefit payments from 1935 on.

Galbraith adds that the unemployment rate under Johnson feel to under 4% for three years in a row.   Galbraith also says that most of the institutions put in place to deal with the Great Crash are still intact.  "The Roosevelt- Johnson legacy makes our lives vastly easier now, because we can retrace what they did, and because we can build on the institutions they built."

So, what to do?  Galbraith lays out his suggestions in order of sequence rather than urgency.

1. Stabilize the Financial System. This includes (a) expanded deposit insurance, (b) support for commercial paper and money market funds, (c) nationalization of Fannie Mae, Freddie Mac, and AIG, and (d) partial nationalization and recapitalization of the banks.  This has mostly been done after wasting time and money on buying back toxic assets.  Then cement the stabilization of the system with financial sector reform.

2.  Revive the Economy.  Galbraith supports a wide range of stimulus including revenue-sharing with the states, building and rebuilding infrastructure, reinvention of the Reconstruction Finance Corporation which lends to businesses while they develop new ways to use manufacturing and technology, and lowering the age of eligibility for Medicaid to 55. 

3.  Foreclosure Moratorium and Mortgage Renegotiation.  This will require a huge number of people to monitor and manage but is critical to stabilization.

4.  Raise the Level Social Security Benefits.   Seniors have lost 40% of the value of their equities in the last year.  An across the board raise of 30% in basic Social Security benefits would help seniors regain some purchasing power.

5.  Should More be Needed. . . Galbraith suggests that the government pay the payroll tax contributions of both employee and employer for three to five years.

6.  Help Design a Functional World Economic System.  The New Deal and Great Society economists understood the importance of stable world economy to the U.S and every other country.   Stable economic development is critical to the reduction of poverty and to the protection of a fragile and endangered planet.

The Limits of Power: The End of American Exceptionalism

I have been recommending this book to everyone I know who reads political books and I intend to write a longer summary of the book at another time.  Bacevich is a historian and his time perspective on our economic crisis is longer term that our economist friends above, although he pinpoints the same timeframe - the Reagan years - as they do for the start of the current crisis. 

Bacevich says that America has always been about making money and about acquiring "more".  He talks about how our ideas of freedom and abundance have been intertwined.  The blessings of our abundance have given us the liberty to expand our freedoms.  Our ability to tell ourselves that we are exceptional allows us to feel okay about taking way more than our fair share of the resources on this earth.   Over many years, we did it almost blithely, without paying attention to the impact that taking has on other people and on the planet.  Bacevich quotes Reinhold Niebuhr, American theologian, activist and writer, who was quite prophetic when he wrote, "Our dreams of managing history - born of a peculiar combination of arrogance and narcissism - posed a potentially mortal threat the the United States".

As we all know, the U.S. came out of WWII with an unprecedented economic boom, which meant more power abroad and more abundance at home.  That unique prominence stumbled over the Vietnam War, both the cost and the misuse of power, and over the increased need for foreign oil.  Bacevich argues, though, that we can pinpoint the precise tipping point. 

It came in the time period between two presidential speeches four years apart.

The first was President Jimmy Carter talking to the nation in July of 1979.  He spoke of the turning point that the nation was at.  In that earlier time of high oil prices and an uncertain economic future, he said " the true problems of our Nation are much deeper" and went on to add, "too many of us now tend to worship self-indulgence and consumption".  Carter went on to talk about the choice between two paths.  "One is a path I've warned about tonight, the path that leads to fragmentation and self-interest.  Down that path lies a mistaken idea of freedom, the right to grasp for ourselves some advantage over others.  That path would be one of constant conflict between narrow interests ending in chaos and immobility."  Carter went on to outline out a 6-point plan to end our dependence on foreign oil but that it would require sacrifice. 

Talk about a downer!  That speech marked the end of Carter's chances to win the election of 1980.

Reagan, while portraying himself as a conservative, was "the modern prophet of profligacy, the politician who gave moral sanction to the empire of consumption".  No wonder so many loved and continue to love Reagan!  He asked for no self-awareness and indulged our self-indulgence.  He simply asked his fellow citizens to carry on.  Use all the oil you want, he implied; just make sure you can get access to it.

The bookend speech to Carter's call for sacrifice was given in March, 1983, when Reagan announced his Strategic Defense Initiative.  In that speech, Reagan "introduced the proposition that Americans could be truly safe only if they United States enjoyed something like permanent military supremacy".  Under his leadership, the national security consensus emerged that suggested the U.S. could dominate the planet as well as outer space.  Never mind that all the economic indicators turned negative, personal savings shrank and consumer debt increased. 

American profligacy during the 1980's had a powerful effect on foreign policy.  The impact manifested itself in two ways.  On the one hand, Reagan's willingness to spend without limit helped bring the cold war to a peaceful conclusion.  On the other hand, American habits of conspicuous consumption, encouraged by Reagan, drew the United States ever more deeply into the vortex of the Islamic world, saddling an increasingly debt-ridden and energy-dependent nation with commitments that it could neither shed nor sustain.

From there, the path to Afghanistan, Osama bin Laden, and Iraq was fairly straight.  As was the path to the current economic meltdown.  It's time we understand our history, economic and otherwise.  

Posted by Lynn Allen on December 17, 2008 at 12:45 PM in Current Affairs, National and International Politics, The Politics of Business | Permalink


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