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Demand, Finance, and Uncertainty Beyond the Great RecessionThe Great Recession: What Went Wrong – Where Do We Stand?
Barry Z. Cynamon , Steven M. Fazzari , and Marksetterfield
The view developed in this volume identifies both real and financial causes for the Great Recession, including the real income stagnation suffered by households across most of the income distribution on one hand, and deregulation and institutional change in the financial sector on the other.
The interplay of these factors led to massive debt accumulation, particularly by U.S. households seeking to supplement stagnant incomes in their pursuit of increasing consumption aspirations. Household borrowing was spurred on by a financial sector rendered ever freer of inter- and postwar financial regulations. These regulations came to be seen as unnecessary fetters on an inherently self-regulating “free market,” an idealized notion in which financiers and policy makers placed increasing trust and confidence. Ultimately, the self-reinforcing developments in the real and financial sectors proved deadly.
They led to the steady accumulation of financial fragility, even as we ostensibly experienced a “Great Moderation” celebrated by mainstream thinking as a permanent reduction in macroeconomic volatility. This is because the pattern of debt-accumulation we witnessed did not involve adjustment toward an optimal path for household consumption, facilitated by the removal of regulatory “imperfections” that constituted “sand in the gears” of otherwise perfect financial markets. Instead, it constituted an unsustainable trajectory, but one that was for decades reinforced by steadily increasing confidence in consumption and financial norms that evolved to guide behavior in an environment characterized by uncertainty about the future. As the trajectory progressed, itseemed all the more plausible and reasonable to households and financiers alike, even as it became increasingly precarious.
What all this implied, in the language of the financial instability hypothesis developed by Hyman Minsky , was that by the late 2000s, the growth regime in the U.S. economy was thoroughly dependent not just on the “ordinary workings of the goods and labor markets” (necessary to generate the income flows required toservice outstanding debt), but also what came to be perceived as the “ordinary workings of financial markets” – more specifi cally, their proclivity to roll over existing debt, and keep expanding new credit (Pollin , 1997 ). These “ordinary workings” were required because of both the increasing dependence of the growth regime on debt accumulation, and the increasingly risky nature of the financial postures adopted by borrowers and lenders. The U.S. economy was, as a consequence, increasingly vulnerable to any bad news in the short run that would give pause for thought to the households and/or financial institutions participating in the run-up of indebtedness that undergirded theseemingly impressive macroeconomic performance of the economy.
Furthermore, the system came to depend on falling (or at least not rising) interest rates that allowed heavily indebted households and financial units to refinance their fragile positions. In the end – and perhaps not surprisingly given the mixture of real and financial forces that gave rise to the preceding boom – the “trigger” for the Great Recession arose from an untimely (and interrelated) confluence of real and financial events:
Rising short-term interest rates that the Fed (perhaps naively) assumed were necessary to preempt inflation. It seems clear, however, that the Fed did not realize how precarious financial conditions had become. Higher short rates had devastating consequences on the riskiestsegments of the housing market that relied on adjustable-rate mortgages.
• The end of the housing bubble. Housing prices stopped rising, in part because of the rise in short rates and the spillover to the cost and availability of risky, adjustable-rate mortgages. WiThstagnant home prices, the collateral engine for massive equity extraction that had fueled an ever-increasing consumption-income ratio shift ed abruptly into reverse. In addition, the end of the housing bubble suddenly and drastically revised the refinancing options for households vulnerable to default in the event that their introductory “teaser” mortgage repayment terms should expire.
• A historic collapse in new housing construction.
• The subsequent failure of many subprime mortgages, and the consequent writing down or writing offof many mortgage-backedsecurities. Thosesecurities, issued in abundance as highly rated financial instruments, were suddenly deemed “toxic.”
What followed was a sharp lesson in the fundamental Keynesian maxim that money and finance matter for the aggregate demand-generating process and hence for macroeconomic performance. Minsky’s “ordinary workings” failed. As wealth was destroyed and, in particular, as credit froze in the initial stages of the financial crisis, so aggregate demand fell – both as the direct result of wealth destruction and the credit freeze, and indirectly,
1 In the middle 2000s, there was much discussion of what Alan Greenspan labeled a “conundrum”:
the remarkably modest rise in mortgage rates after the Fed began raising the overnight federal funds rate in mid-2004. It is true that thirty-year conventional mortgage rates rose very little between 2004 and 2006. The one-year adjustable rate, however, rose almost 250 basis points from its trough in early 2004 to its peak in mid-2006. as wealth destruction and the credit freeze suddenly diminished confidence and animal spirits. Even solvent and liquid households and firms began cancelling expenditure plans. The decline in aggregate demand and consequent rising unemployment only worsened conditions in the housing market, making the whole process dangerouslyself-reinforcing. And so the Great Recession began, with a frighteninglysevere economic decline in late 2008 and early 2009.
At this point, raw fear (if not a well-informed understanding of what was happening among policy makers) ignited the most significant Keynesian policy actions that the world has, perhaps, everseen. Whatever the faults in its design – and there were arguably many – the monetary and fiscal stimulus response to the events of 2008–09 actually engineered something of a “soft landing.” Ultimately, we were spared the experience of asecond Great Depression and instead experienced “only” the trauma of the Great Recession. The re is no doubt that the primary objective of these policies was to stabilize aggregate demand, in large part by shoring up finance and by containing the panic created in the mostsevere outbreak of economic uncertainty since the early 1930s.
Policy put a floor under the downward trajectory of a structurally flawed growth and financial regime and thus saved us from the worst-case scenario in the short term. However, it now falls to public policy to “pick up the pieces” and to reconstruct the U.S. economy so that it is once again capable of generating widespread and sustainable prosperity going forward. At the time of writing, policy has already faltered in the pursuit of this agenda. The national debate in the United States has been “hijacked” by “austerity buzzards” (to use Epstein’ s phrase from Chapter 9 ), whose focus on public deficits and debt conceals their true desire for smaller government at any and all costs. Governments in Europe, meanwhile – many shackled by the institutional constraints that accompany membership of the euro zone – have already gone further along the path to repeating the errors of the late 1930s, when fiscal retrenchment motivated by a perceived need for “sound finance” repeatedly threatened recovery from the Great Depression (until the massive build-up of public spending that accompanied World War II finally eliminated the problem of chronic demand-deficiency).
No one said the path to redemption would be easy. So what have we learned from the experience of the last fewyears – and more particularly, from the reflections on this experience contained in this volume – that would inform an appropriate policy agenda from this point onward?
2. Where Do We Go from Here?
The first point that deserves to be emphasized is that the “government as the problem” versus “government as the solution” dichotomy thatseems to polarize much public debate is false, misleading, and unhelpful. The simple fact is that government is quite capable of playing both roles – that of hindrance and help. Hence, many of the chapters in this book identify sources of error in public policy in the run-up to the financial crisis and Great Recession, even as they advocate policy responses designed to redress the economic circumstances in which we now find ourselves. Clearly, then, informed public policy needs to formulate and promote policies that will aid recovery while remaining wary of andseeking to eliminate those that will obstruct it. This disarmingly simple rule is far more useful in today’s economic and financial climate than any broad, ideologically motivated rule expressing either “zero tolerance” for government (beyond certain minimal functions associated with law enforcement and defense), or proclaiming government as the universal solution for problems that emanate only from unruly “free markets.” As Nobel Laureate Peter Diamond recently opined, “To the public, the Washington debate is oft en about more versus less – in both spending and regulation. The re is too little public awareness of the real consequences of some of these decisions. In reality, we need more spending on some programs and less spending on others, and we need more good regulations and fewer bad ones” (Diamond, 2011 ). Diamond’s ethos provides a useful starting point, but beyond this general rule, what, specifically, is to be done?
Financial Reform and Monetary Policy
Each of the chapters in this book recognizes the central role played by financial instability in creating the conditions that led to the Great Recession, and inseveral chapters financial instability is the central theme. It therefore seems clear that rethinking financial regulation is a necessary and appropriate part of any response to what has transpired. As Kregel , Chapter 4 , and Wray , Chapter 3 , point out, however, we cannot simply put the financial system back into the old Glass-Steagall box. The Depression-era regulatory structure was in large part responsible for the relatively tranquil financial environment of the postwar decades, but it has become anachronistic. Just because the old rules were anachronistic, however, does not mean that all rules must be abandoned (as was commonly argued in the deregulatory march that led to the Great Recession). The first major financial reform package emerging from the financial wreckage of 2008 and 2009, widely known as the Dodd-Frank reforms, have some useful elements, as pointed out by Epstein in Chapter 9 . However, Epstein and many of the other authors of this volume (particularly Wray and Kregel, Chapters 3 and 4) find the approach taken so far both too weak and, in certain fundamental respects, misguided.
The economy needs finance to betterserve the public purpose, which requires effective structures toserve both of the “two masters” identified by Kregel : a stable payments system and effective channelling of finance to foster the economy’s capital development. Wray argues that this means returning banks to their traditional role of “underwriting,” that is, assessing risk and project quality as a means of determining the directions that capital development will follow. As Kregel points out, this role was largely lost in the decades prior to the Great Recession as banking shift ed from an “originate and hold” model, in which the bank assessed risks that it would then hold on its balance sheet, to an “originate and distribute” model, in which the objective was to maximize the number of loans that could be made and then sold offinsecondary markets. Wray asks why banks deserve the public-private partnership implied by institutions such as deposit insurance and discount-window lending if they do not act in the social interest? In Chapter 9 , Epstein suggests further direct public intervention in finance, moving in the direction of what he has aptly named “finance without financiers.” Crotty , in Chapter 5 , meanwhile, highlights the importance of making financial sector remuneration schemes properly compatible with a greater pursuit of social purpose by the financial sector. This is an essential ingredient if the systemic ambitions of Kregel, Wray, and Epstein are not to be “sabotaged from within” by inappropriate managerial behavior that is actively incentivized by the structure of corporate compensation.
Although financial reform is undoubtedly important, both to restart necessary demand growth and to foster capital development, it certainly isn’t the be-all and end-all. In particular, financial reform – indeed, any policy – that has as its objective simply “getting the private sector borrowing and spending again” isn’t what we need. The objective is not to create another unsustainable, debt-fueled growth e pisode thatserves only to leave us wondering when the next crisis will occur (and lamenting its destructiveness when it does).
This perspective diverges somewhat from the mainstream preoccupation with restoring what came to be thought of as “normal” credit market activity prior to the Great Recession. In particular, the Fedseems focused on getting the banks to lend again. Various policy makersseem frustrated by the massive and unprecedented (at least since the 1930s) accumulation of excess reserves in the banking system, which has a parallel in the oft - cited accumulation of cash on corporate balance sheets. Commentators ask a question thatseems to follow, at least superficially, from a Keynesian view of the world: why don’t they lend and invest, which would then stimulate demand? The answer developed in this volume is that the old way of generating demand through excessive household borrowing is broken. As Wray provocatively asks in Chapter 3 : why “should government policy try to get banks to make loans they do not want to make! Aft er all, if banks are our underwriters, and if their assessment is that there are no good loans to be made, then we should trust their judgment. In that case, lending is not the way to stimulate aggregate demand to get the economy to move toward fuller employment.”
These observations lead to another important common perspective that emerges from this book: monetary policy as practiced for much of the past two decades has been singularly ineffective in its ability to cure stagnation in the aftermaThof the Great Recession. This stands in contrast to the widely held view, perhaps associated most prominently with Ben Bernanke , that monetary policy can effectively restore full employment when demand falters, even if policy rates push up against the “zero bound.” These ideas emerged in large part as mainstream economists criticized the Japanese monetary authorities for not responding more aggressively to their “lost decade” problem. However, it nowseems clear that such policies as raising inflation expectations so that real interest rates decline even with a constant zero nominal rate are much easier to model and talk about than to implement in a persistently stagnant economy. Moreover, It seems clear in retrospect that when monetary policy did restore demand after macroeconomic hiccups in the decades prior to the Great Recession, it did so, in Palley’ s words from Chapter 2 , “by lowering interest rates and opening the spigot of credit” to facilitate a path of private-sector debt accumulation that was anything but sustainable. It is for these reasons that many of the chapters in this volume propose outside-the-box thinking about monetary policy and financial reform. In addition, we obviously cannot rely exclusively on monetary policy to emerge from stagnation. Indeed, Epstein argues that perhaps the most important role for monetary policy going forward is to keep interest rates low as a means to support expansionary fiscal policy, a topic to which we now turn.
The Challenges of Fiscal Policy
In 2011, American politics was consumed with hyperbolic debates surrounding what should have been a routine legislative process to raise the country’s legal debt limit. The major parties take different positions in most respects, but almost all of the participants in the fiscal policy debateseem to agree that a primary goal of U.S. economic policy should be to eliminate deficits and even to pay down the national debt. The perspectives presented in this book argue strongly that these goals are fundamentally misguided. The common vision presented in this volume supports a basic critique of the demand generation process of the two decades leading up to the Great Recession: rising household debt in an environment of increasing income inequality precipitated the collapse. This engine of demand growth will not rev up again, at least for an extended period, which explains the persistent stagnation of the U.S. economy that conventional macroeconomics has failed to anticipate. 2 Aggressive fiscal stimulus is an alternative source of demand that can at least partially offset the spending lost as the household sector retrenches to repair its collective balance sheet. In sharp contrast to the political rhetoric in Washington, large deficits in times like these are fiscally responsible. The goal of fiscal policy is not to achieve some artifi- cial and arbitrary target for deficits or debt. Instead, fiscal policy should be functional, that is, designed toserve a particular economic function. In Tcherneva’ s words from Chapter 12 , “a bold and imaginative approach is required, which weds fiscal policy to the goal of full employment.” A first step that may appear bold in the current environment, with austerity buzzards circling everywhere, is to assess what evidence tells us about the size of deficits and debt and the effects they have on actual macroeconomic activity. Most of the authors who contributed to this volume are of an age to remember the widespread criticism of Reagan’ s supposed fiscal irresponsibility in the 1980s. At that time, the politics of deficit bashing favored the Democrats, but the arguments were similar in direction (if not intensity) to recent Tea Party rumblings: a profligate government living beyond its means would saddle future generations with unsustainable debtservice, high interest rates, and low productivity as deficits “crowded out” capital 2 Here is a telling quote from economics reporter David Leonhardt more than two years after the supposed recovery from the Great Recession began. “The past week brought more bad news . . . causing economists to downgrade their estimates for economic growth yet again. It’s a familiar routine by now. Forecasters in Washington and on Wall Street keep saying the recovery’s problems are temporary – and then they redefine temporary” (from “We’re Spent,” Newyork Times, July 16, 2011).
investment. A full generation has passed since those fears were rampant; what has happened? Interest rates are down, federal debtservice is a smaller fraction of GDP, and productivity has risen. On the surface of things, the debt legacy of the Reaganyears hasn’t hamstrung the current generation. More systematically, Baker in Chapter 10 concludes that smaller government deficits (or larger government surpluses) have not done much, if anything, to improve U.S. economic performance over the past two decades. In Chapter 11 , Cynamon and Fazzari take a careful look at the concerns about the burden on future taxpayers arising from current U.S. indebtedness and argue that we could enact massive fiscal stimulus over the next fewyears, with minimal cost. Thesense that federal finances require immediate tightening because “we’re broke” (as Republicans like to say) has no basis in fact. What is truly “irresponsible” is the hyperbolic rhetoric of austerity buzzards that scares the citizenry into believing that a catastrophe in public finance is imminent.
Because of the deeply compromised private demand-generation process in the aftermaThof the Great Recession, the U.S. economy is likely to need large federal deficits well into the future. A rising federal government debtto- GDP ratio is likely to result, at least for awhile. Perhaps this outcome, in isolation, is unfortunate (it is certainly viewed that way in political discussion).
However, as either higher government spending or lower taxes that stimulate private spending employ otherwise idle resources, the perspectives developed in this volume imply that social benefits will far exceed what are likely minimal costs. The analysis in Chapter 11 implies that debt service would be easily manageable for the United States with a debt-to- GDP ratio of 100 percent or more, nearly double the value of privately held debt to GDP in 2011. Such an increase would support a huge contribution to demand generation, either public or private, in coming years. At a higher debt ratio, the “sustainable” size of the deficit is higher than almost any conventional discussion suggests. A simple example proves the point. Suppose the economy has a nominal long-term growth rate of 5 percent (3 percent from real output and 2 percent from inflation). If the debt-GDP ratio were 100 percent, a federal deficit equal to 5 percent of GDP, much higher than historical values in all but the worst recessions, would leave the debt-GDP ratio unchanged (see GalbraiTh, 2011 , for further discussion). 3 3 Government debt critics oft en point to the long-term future liabilities of entitlement programs, particularly Medicare, for an aging population as the reason that we need current fiscal austerity. We agree that society will have to come to terms with the future resource cost necessary to provide adequate health care. However, destroying jobs today does nothing to make this task easier. Indeed, effective demand stimulus today will lead to a stronger
Although the need for fiscal stimulus emerges rather obviously from the Keynesian perspective on the Great Recession and its aftermath, the most desirable form that such policy should take is less clear. The most obvious class of policies that receives the strongest support from the political left in the United States imagines large public works. Public expenditure projects, in addition to stimulating aggregate demand, can also influence what is demanded.
That is, expenditures could target infrastructure to get benefits on the supply side as well as generating demand, as discussed in Chapter 10 by Baker . In addition to enhancing the traditional public capital stock, public expenditure can be designed to meet broader social goals, perhaps most obviously to transform the U.S. economy into a more energyeffi cient, “greener” economy. The gaping hole in demand, unprecedented since the Great Depression, implies that there are plenty of resources for large projects that could capture the imagination of the country. Indeed, we believe it is important to help both politicians and voters to recognize that the unused resources provide a social opportunity. We need to focus on what can be accomplished, with the twin objectives of mobilizing idle resources and transforming important parts of society. This message will serve the interests of society dramatically better than obsessing about public debt or deficit ratios, the costs of which are greatly exaggerated. We do not presume, however, that useful fiscal policy in these times should take the form of higher government spending only. As argued by Cynamon and Fazzari in Chapter 11 , the demand gap is so large that even an aggressive and imaginative program of expanded public projects may not be enough to push us toward full employment. The United States has a long tradition of manipulating taxes to meet fiscal goals. As a rough rule of thumb, if the economy still suffers from substantial demand slack even when government spending is, in asense, optimized given existing political alignments, this is prima facie evidence that tax revenues are too high. One way to think about the relative role of tax cuts versus spending increases as appropriate demand stimulus is to recognize that any fiscal action has two dimensions. First, there is the effect on aggregate demand and how that demand relates to the goal of employing idle resources.second, there is an allocation dimension: any actual fiscal stimulus policy affects the specific way in which unemployed resources will be used. Government spending programs use the political process to determine thesecond dimension, whereas tax cuts cede the specific allocation process to private decision-making. future economy that would be better able to handle the challenge of providing health care for the entire population.
Of course, if there are costs to government debt, even if those costs have been exaggerated in recent mainstream analysis, one objective of any fiscal stimulus program is to maximize “bang for the buck.” In the case of higher government spending, the initial demand impact is dollar-for-dollar by definition and maximizing impact implies choosing the best projects to enhance social value. In the case of tax cuts, however, their effectiveness as stimulus depends fundamentally on whether or not they will raise spending. This simple principle therefore implies that effective tax cuts should flow to groups that will turn them into aggregate demand. The most obvious implication is that tax cuts should accrue to lower- and middle-income/ wealth groups. 4 Furthermore, although distributive justice is not the focus of this book, we would be remiss to not acknowledge the obvious synergy between fiscal policies that most effectively stimulate demand and those that create a more just society.
We also echo Tcherneva’ s call in Chapter 12 for public policy that does more than just target short-run aggregate demand. Even when the offi- cial unemployment rate was low by historical standards, as it was prior to the Great Recession, the U.S. economy suffered substantial problems with long-term joblessness among certain subsets of the population. Those afflicted by this problem are mostly invisible in standard unemployment statistics. Direct job-creation programs have promise in addressing this issue, and we believe they are also an important complement to more conventional stimulus programs that raise aggregate demand in the face of a recession. This point is underlined by the recent tendency of U.S. recoveries to look “jobless,” as has been evident again in the aftermaThof the Great Recession.
Returning to a theme we presented in Chapter 1 , we argue that it is essential tosee the policy response to the Great Recession and its aftermaThas a problem that the United States (and other countries) must confront for a number ofyears to come. This isn’t the kind of recession we have become familiar with in the postwar period. That is, the Great Recession isn’t a merely temporary disruption. It is evident that the stagnation will be protracted. In 4 Political considerations may lead to the conclusion that there is little gained from completely excluding the wealthy. Suppose a tax cut is allocated as a fixed amount per person or per family. The “bang-for-the-buck” argument suggests that the tax cut not be applied to the wealthy. Recognizing that a few percentage points of additional public debt has minimal cost, however, it may be politically expedient to simply give everyone the same amount of tax relief. Problems arise, however, when the wealthy, who spend proportionately less of each additional dollar of income, receive massively greater tax cuts than the middle class, or when lower-income people receive little or nothing, as was the unfortunate case with many tax cut programs in recent decades.
that context, the policy response should be both more significant and longer in duration. On the one hand, that makes the challenge more daunting and raises the stakes when we contemplate the consequences of failure. On the other hand, the need to support demand generation over a longer period means that we can and should think more imaginatively. All indications are that the economy will have sufficient unused resources to undertake large, long-term infrastructure projects. Permanent tax changes to boost consumption spending, especially among lower- and middle-income households who haveseen their standards of living stagnate in recent decades (see Chapters 2 and 7 by Palley andsetterfield ), have the potential to be much more effective than the tax cut policies of recent years, which have been either temporary or largely skewed toward high earners. One somewhat paradoxical aspect of a big crisis is the opportunity, indeed the need, to think big about solutions.
Wages, Productivity, and Global Engagement
Although fiscal policy can and should play a central role in demand generation, larger government alone is not likely to fully replace the pre-Great Recession consumption and housing boom as a source of adequate demand growth indefinitely. Indeed, it is not clear that more government activity on the level we need to once again approach full employment is socially desirable, even if it were politically feasible. This is not to say that there are not significant needs that the government must address. Rather, this perspective recognizes that the demand problem is huge. As such, part of the policy challenge in the aftermaThof the Great Recession is to reconstitute the private aggregate demand-generating process on a more sustainable basis.
As Stiglitz ( 2011 ) recently remarked, “[prior to the Great Recession] output growth in the United States was not economically sustainable. WiThso much of the U.S. national income going to so few, growth could continue only through consumption financed by a mounting pile of debt.” Central to the mission of reconstituting the aggregate demand-generating process, then, are policies and institutional changes that reduce the dependence of U.S. households on debt accumulation as a source of rising consumption expenditures and increase the extent to which rising consumption can be funded by income growth.
Picking up on the theme emphasized bysetterfield in Chapter 7, this suggests that, looking forward, a major ambition of public policy should be to revive the income share of working and middle-class households, and to realign wage and productivity growth. Achievement of this ambition would create steady growth in household consumption expenditures that is funded by steady, across-the-board real income growth, and that is therefore financially sustainable indefinitely. On the domestic front, rethinking the changes in labor law that have weakened the bargaining power of workers over the past thirtyyears could help reach this goal. Reform of laws that have made unionization by workers harder and union busting by firms much easier would at least begin to address the institutional changes in the labor market that have created the disconnect between real wage and productivity growth. Workers have a vested interest in increasing (and then maintaining) the wage share of income. Alleviating existing legal constraints on the exercise of thisself-interest would therefore facilitate some reconstruction of the aggregate demand-generating process within the private sector by the private sector.
However, domestic initiatives alone will likely not suffice on this front. As noted in Chapter 2 by Palley and Chapter 8 by Blecker , the unsustainable, debt-fueled U.S. growth regime that policy must nowseek to replace has a distinctly global dimension. In the first place – as argued by Blecker – the fabled global trade imbalances that have garnered such attention over the past decade and more are essentially a symptom of an international growth regime that emerged as numerous countries responded in different ways to the same phenomenon plaguing their domestic economies: wage stagnation and the concomitant inability of households to fund sufficient consumption expenditure from their real income. Ultimately, then, the reliance of the U.S. economy on household debt accumulation not only provided a temporary salve for its own latent demand deficiency, it also had spillover effects elsewhere. Specifically, it facilitated the reliance on external demand to top offinadequate domestic demand in countries such as Germany and China, as U.S. households became “consumers of the last resort” for the world economy.
Global phenomena have not merely refl ected but have also contributed to the structural flaws in the aggregate demand-generating process that have come to plague the United States and other economies. As emphasized by Palley in Chapter 2 , trade agreements (coupled with the steady reduction in shipping costs since the 1960s) have created an anything-but-level global playing field on which footloose corporations can credibly threaten to relocate between national political jurisdictions unless their demands for wage and tax concessions are met. This has contributed – both directly through the resulting pressure on wages, and indirectly through its distortion of the tax system – to wage stagnation. Putting the pieces together, this analysis suggests that fixing the private aggregate demand-generating process requires concerted international action that wouldsee multiple nations attend to the income stagnation afflicting their working and middle-class households. It would also involve commitment to common labor standards to prevent otherwise desirable cross-border trade in goods andservices from degenerating into a “race to the bottom” that eviscerates both wage growth and working conditions.
If it is not already obvious, implementing these sort of policy initiatives constitutes an enormous task. It is well to remember, then, that as intimated at the end of the previous subsection, some progress can be made through more modest means. Specifically, fiscal policy can act as a surrogate for labor market and broader institutional reforms by addressing the distribution of after-tax income, and therebyseeking to offset and correct imbalances created by the distribution of pre-tax income. This task is made easier if, as suggested by Crotty in Chapter 5 , many of the biggest incomes at the top of the income distribution are composed largely of rents – in which case they can be taxed without impairing productive effort. The revenues raised in this fashion can then be used to either boost the “social wage” (through expenditures on the direct public provision of goods that enhance the consumption of lower- and middle-income households – parks, public transportation, etc.), or through transfer programs designed to enhance the low and stagnant real incomes of the same households.
Finally, it is important to remember that however achieved, restoring robust real income growth to working- and middle-class families will reduce their debt-dependence and enhance their ability toservice the debts they do carry – developments that are obviously conducive to financial stability. The sorts of policy proposals discussed in this subsection, then, address more than just the problem of fixing structural flaws in the private aggregate demand-generating process. It follows that monetary and financial policy need not bear sole responsibility for the job of restoring the financial sector of the U.S. economy to good health: revitalizing real income growth across the entire income distribution also has an important role to play. This observation onlyserves to add to the appealingly “ bottom up” character of the recovery proposals in thissection. Policy targets incomes, and hence purchasing power, from the bottom of the income distribution up through the middle class. The result is more robust and sustainable aggregate demand conditions and better household debt-servicing capabilities. In what might be referred to as a “trickle up” process, strong income growth below the top quintile benefits the rest of the economy, including corporate and financial sector balance sheets, as well as profits and other capital income.
3. Toward a Better Future
The Great Recession and subsequent stagnation has created profound social adversity, some of it represented in statistical measures, and some incalculable . Tens of millions of U.S. citizens have been forced to confront unemployment or significant underemployment directly. Tens of millions more must deal with the stress of unemployment, either because they fear threats to their own jobs or because the incomes of other members of their household have been directly affected. Of course, unemployment is a waste of resources. Society has obvious needs for more production, and idle workers are both willing and able to meet more of those needs.yet for reasons discussed extensively in the pages of this volume, the economic systems of the most developed countries of the early twenty-first century cannot coordinate their activities to bridge the gap between resources and needs. Outfitted with their statistical measures and quantitative proclivities, this failure is the single most prominent feature of the Great Recession in the minds of most economists, and we certainly agree that the material waste caused by the Great Recession is of first-order importance.
However, material waste may not be the greatest problem that has arisen since late 2007. Unemployment does not just waste resources, it also rips at the identity of those it afflicts and tears apart the fabric of their social life. In the United States, our jobs define to a large extent who we are as individuals. We all know that the question “what is it thatyou do” refers to our occupations. Consider also howyoung children are acculturated to an identity largely defined by work by the question asked of them from a veryyoung age: “what doyou want to be?” The expected answer is never along the lines of “I want to be a healthy, well-adjusted human being who has meaningful relations with those around me and contributes to the social good.” Instead we expect “fireman,” “doctor,” “teacher,” and so forth. In addition, what has come to be known as the American Dream suggests thatyou can be whateveryou want to be ifyou play by the rules of the idealized economic game – that is, ifyou takeyour educationseriously, work hard, live withinyour means, and behave responsibly. Of course, the idea that with good behavior and dedication a person can obtain literally any professional outcome is exaggerated. Nonetheless, such ideas permeate deeply into our culture. A natural reaction for people thrown out of work, therefore, is to feel at least partially responsible for their plight and to begin to question their worth. The fact that they are just one of millions of people suffering the same fate probably does not offer much comfort. The objective reality may be that it is the system that has failed unemployed workers and their families but, it is hard to not reflect blame and the associated loss of self-esteem on oneself.
Furthermore, even if people can protect their psychological identity from the ravages of unemployment, there is no firewall for the household budget. The United States has notoriously stingy safety nets, especially when it comes to health insurance. Of course unemployment compromises living standards, but it also adversely affects physical health and family relations. What is particularly tragic is that there is no physical reason why people must bear these costs. Workers after the Great Recession are neither less motivated nor less skilled than they were in 2006 or 2007. Indeed, labor productivity has risen remarkably in recent years. We have not suddenly forgotten how to apply modern technology to produce high living standards. Our capital has not been destroyed by natural disaster. It is our economic system that has failed to coordinate our ability to produce with our ability to purchase. The unstable dynamics of finance and uncertainty leading up to the Great Recession have finally ground the debt-fueled, consumption led growth e ngine to a halt, shutting down the aggregate demand-generating process that the United States and world economies came to rely on during the late twentieth century. In the United States, the core problem, as analyzed extensively in this volume, is that a system that distributes its income so unequally cannot generate growing aggregate demand without unsustainable household debt growth and financial excess. We can complain about individually “irresponsible” behavior in taking on too much debt. We can rail against the captains of finance for their greed that led to financial bubbles. The fact is, however, we had come to rely on excessive household borrowing and financial bubbles to maintain the demand growth we needed to even get close to full employment over the past two decades. We can rely on that approach no longer.
The contributions to this book argue that we need a new model to sustain demand growth in coming years. That model requires a greater public role in guiding finance to socially useful activities. It also needs mechanisms to generate more government demand to fill the gap created by the end of the debt-financed consumption boom. This perspective stands in strong contrast to the political ideology that has gripped much of the developed world recently, as it clings to the neoliberal “small government” ideas of the past several decades and promotes government fiscal “austerity” as virtuous. Perhaps most important, the new model must find a way to share more equally the fruits of what could be a highly productive economy . Of course, more balanced distribution will improve social justice. However, faster income growth across the social spectrum is also necessary, we argue, tFinancial crash of 2008e a new kind of aggregate demand-generating process, one that moves the economy toward – and n maintains – full employm of our resources. It is not just jobs that are at stake. Strong demand growth is also necessary to support the financing and innovation that are necessary for sustained increases in our standards of living.
These problems highlight the fundamental interdependence of individuals in modern society. Economic models that treat the country as a whole as if it were Robinson Crusoe on his own island will neither explain the Great Recession nor offer much help to guide us out of its stagnant aftermath. The Keynesian perspective that underlies this book fundamentally recognizes social interdependence: one person’s income is another’s spending; we cannot earn income on our own unless others spend. However, interdependence requires coordination. To a remarkable degree, market forces unguided by a centralized authority coordinate social activity. Nevertheless, the inability to fully utilize the economy’s productive resources reflects a failure of the market. It seems clear that individual incentives alone are inadequate to assure the social coordination necessary to reach and maintain full employment. As the perspectives developed in this book point out, the solution involves expanding the government’s role in coordination. That role may involve the creation of spending and incomes when the private sector will not. It may involve guiding the private sector away from destructive financial behaviors that arise from the unfettered pursuit of private interest in complex and uncertain modern markets. It may involve establishing institutions that raise the prospects for lower- and middle-class income growth in an increasingly globalized world that has concentrated a disproportionate share of the rewards from rising productivity at the top of the income distribution. These actions might appear to threaten private interests, but the reality of social interdependence is that good private outcomes cannot be secured by private action alone. The failure to recognize this point in the ideologies that guided economic policy in recent decades is, in a broad sense, responsible for the crisis we now confront.
The Great Recession marks the end of an era in which neoliberal policies that suppressed or completely ignored the inherent social interdependence illuminated by Keynesian macroeconomics could be plausibly argued to deliver prosperity, stability, and social justice. The results of recent years have been tragic. The immediate prospects for significant improvement are also unfavorable, as It seems that the economic policy establishment has yet to come to terms with the challenges of demand generation without some kind of financial bubble that leads to exploding debt. It is important to remember, however, that although robust and sustainable recovery is not assured, it is not impossible to achieve: it won’t come about automatically, but the right policy interventions can help resolve the current crisis. We hope that these difficult times give way to a new approach to macroeconomics that is reflected in both theory and policy – an approach that, in the decades to come, allows modern economies to realize their immense potential and to share that potential with all of their citizens.
Diamond , P. ( 2011) “When a Nobel Prize isn’t enough,” Newyork Times , June 5.
GalbraiTh, J. K. ( 2011 ) “Is the federal debt unsustainable?” Levy Economics Institute of Bard College Policy Note, 2011/2.
Pollin , R. ( 1997 ) “ The relevance of Hyman Minsky ,” Challenge , March/April, 75 –94.
Stiglitz , J. ( 2011 ) “The ideological crisis of Western capitalism,” Project Syndicate blog, July 6. www.project-syndicate.org/commentary/stiglitz140/English
Someday people will look back and wonder, What were they thinking? Why, in the midst of a stalled recovery, with the economy fragile and job creation slowing to a trickle, did the nation's leaders decide that the thing to do-in order to raise the debt limit, normally a routine matter-was to spend less money, making job creation all the more difficult? Many experts on the economy believe that the President has it backward: that focusing on growth and jobs is more urgent in the near term than cutting the deficit, even if such expenditures require borrowing. But that would go against Obama's new self-portrait as a fiscally responsible centrist.
Lawrence Summers, Obama's recently resigned chief economic adviser, said on The Charlie Rose Show in July that he found it "dispiriting" that "all of the energy is on the projected deficits…when the problem right now is that the economy is in danger of stagnating from lack of demand." The Republicans had made it clear for months that they would use the need to raise the debt ceiling as an instrument for extracting concessions from the Democratic President in the form of more cuts in federal programs. And the President assented to their premise, but only if there should also be some additional revenues. Were they all insane? That's not a far-fetched question.
The President argued that it's critical to make cuts that will "get our fiscal house in order," so that the American people and the politicians would accept the idea of new programs leading to growth and more jobs. But there are numerous indications that the public is ready for such programs now, and serious analysts see no reason why he should not also be taking such steps now, even if this increases the deficit in the short run. But that would be at odds with Obama's current self-portrayal. People who are looking for work, or worried about their unemployment insurance, or getting their kids to college, may not be impressed with the argument that they must be patient while the President adjusts his fiscal image in time for the 2012 election.
Since the President wanted to cut spending but also increase taxes and the Republicans insisted on cuts with no new taxes, they were for months too far apart to find much agreement on a budget plan to be attached to the debt ceiling increase-which had to be enacted by August 2 to avoid a default. No one could quite believe that this would happen, because it was so unthinkable; it was assumed that the two parties would reach agreement. Each side actually expected the other to be more flexible. The Republicans assumed that the President would be pliable; the Democrats didn't expect the Republicans to be so inflexible about raising taxes.
It didn't turn out that way. The Republicans were actually divided-the older guard against the Tea Party. But this old guard was by nature further to the right than the former old guards, and the Tea Party drove it further right still. The Republicans adopted their partly ideological, partly fearful, position that none of the reductions in projected deficits could come from increased tax revenues. The President agreed that tax rates would not be raised-though they are at their lowest level in sixty years, since the presidency of Harry Truman. The administration and other Democrats had thought that it would be easier to remove some tax breaks from the tax code.
The Republicans, with Alice in Wonderland logic, termed any elimination of a tax break a tax increase. Moreover, the breaks included in the tax code were there because they had been sponsored by an important member of Congress, or supported by a powerful lobby on behalf of one interest or another. After the President, in a press conference in late June, inveighed against tax breaks for corporate jets, the industry quickly insisted that such a change would cost jobs.
The very basis of the negotiations was odd. A vote to raise the debt limit simply validates spending decisions that had already been approved by Congress, and it is usually automatic. It does nothing to curb spending. But there is nothing usual about the current Congress. The recent negotiations over raising the debt limit could have been seen as having an absurd, antic quality, if they hadn't been so risky to most people living in this country and so unfair in their potential impact on the various income groups, with consequences, too, for the global economy. The negotiations were ridiculously contorted-when one side refused to discuss a major topic, such as taxes, were they actually negotiations at all? Similarly, Democrats balked at serious cuts in entitlement programs. So there was a standoff.
As August 2 approached, the possible effects of default should have become familiar to anyone paying the slightest attention. The particulars had been recited, and published, over and over again by the President and some officials in the hope of scaring the members of Congress or their constituents. They spoke of not enough money being available after interest on the debt was paid. There might not be enough for popular programs such as Social Security or Medicare or veterans' benefits-of which just about everybody was either a beneficiary, or knew or was related to someone who was. As the possibility of default grew near, the President wasn't above warning that he couldn't guarantee that Social Security checks would go out. There were predictions of rising interest rates and Treasury Secretary Timothy Geithner spoke of a second recession.
These warnings did result in a shift of opinion in mid-July in favor of lifting the debt ceiling. Standing against them were the countless number of people who didn't believe anything the federal government said, and their know-nothingism was reinforced by opportunistic political figures. The self-appointed head of the congressional Tea Party and presidential candidate Michele Bachmann made denial a major part of her campaign: "Don't let them scare you by telling you that the country's going to fall apart."
Thus the year 2011 had come to be dominated by the Politics of Calamity. There was a pattern. In the spring, with the threat of a government shutdown for the rest of the fiscal year, the Republicans, with the Tea Party representatives in the lead, had set the terms of the debate over a continuing resolution. They backed the President-who in his eagerness to establish his credentials as fiscally responsible hadn't engaged them in a fight-into a corner. Obama and House Speaker John Boehner engaged in frantic negotiations at the White House. What these two men had agreed on wasn't known for days, as aides scrambled to figure out what they had decided. Finally a continuing resolution was passed.
Months later, with the threat of a government default if the debt ceiling was not raised by August 2, the Republicans once again seized the agenda and demanded that there be a ten-year budget with major spending cuts. The President had yet to put forward a serious long-term budget of his own. The regular legislative process was then superseded by policy being made, in a room out of sight of the press and the public, by negotiators facing the threat of the United States government going into default. It takes the threat of something awful happening to drive the politicians-fearful of the effect on their careers-to bring deliberations to a close.
The hitch was that Republicans chose to use the statutory increase in the debt limit-by about $2.2 trillion on top of a $14.2 trillion debt-as a lever to exact more cuts in spending, from funds that had already been authorized or even spent. In a speech on May 9 before the Economic Club in New York, John Boehner advanced the novel theory that every dollar by which the debt ceiling was increased had to be offset by cutting a dollar in spending.
The Tea Party's strength was larger than its numbers-about eighty in the House and as few as four in the Senate-because the entire House Republican freshman class and some more senior members were sympathetic to its views, and because the ghost of Bob Bennett now haunts many Republicans. Bennett (still alive), a solid conservative three-term senator from Utah, was, astonishingly, rejected for reelection last year by the Utah Republican caucus for having been insufficiently pure in his conservatism. (His vote in 2006 against a constitutional amendment to ban flag-burning was seen as heresy.)
If Bob Bennett could be dumped, no one was safe. Boehner himself was facing a possible primary challenge. Some Tea Party members dug in on the debt ceiling because they, too, feared attacks or challenges, principally from people who would accuse them of not forcing sufficient cuts or of failing to keep their pledge not to raise the debt limit.
The Republicans embraced a philosophy of no new taxes or revenues that had little relation to reality-except for the fact that their long-standing goal has been to shrink the size of the federal government. This began with the major tax cut passed early in George W. Bush's presidency, which purposely put serious pressure on domestic programs and which some saw at the time as folly-folly with grim implications for the future.* That tax cut, renewed in December with Obama's assent (he didn't have the votes to stop it, and he got some stimulus money in exchange), began the Republicans' march from the $137 billion surplus Bill Clinton had bequeathed the country to the deficit of $1.2 trillion when Bush left office. It accounts for more than one quarter of the current deficit.
Obama's proposal to end the Bush tax cuts for those making over $250,000 was of course not expected to go anywhere, especially in the House. That left tax expenditures-or "loopholes" permitting tax deductions. But when, on June 23, the Democrats offered their list of revenue-raising possibilities in the bipartisan talks presided over by Vice President Joe Biden, House Majority Leader Eric Cantor dramatically walked out. The bipartisan group had already agreed to over $1 trillion in spending cuts, but this was contingent on increasing revenues as well. Cantor's abrupt exit was generally interpreted as an act intended to keep his fingerprints off any revenue increases. He would leave that to Boehner, whose position Cantor is understood to covet.
Moreover, Boehner was known to have met privately with the President just before the walk-out; if there were to be anything that could remotely be called a tax increase, a revenue increase, what have you-let Boehner do it. Meanwhile, Cantor would keep his much closer ties with the Tea Party intact. If Boehner stumbled, he'd be ready to take his place.
The politics of the debt ceiling were particularly tricky: Boehner-and the President-knew that perhaps all of the Tea Party members were, "on principle," unlikely both to vote to raise the debt ceiling and to vote for any measure that had even a suggestion of an increase in revenues. The Speaker would therefore need a large number of Democrats to get a vote through the House. Boehner hadn't realized at first that he'd have so many Republican defectors-fifty-four-who voted against the continuing resolution he'd negotiated with Obama in early April, on the ground that it didn't cut spending enough, though Boehner had, in effect, taken Obama to the cleaners. This established in both Democrats' and Republicans' minds the thought that Obama was a weak negotiator-a "pushover." He was more widely seen among Democrats and other close observers as having a strategy of starting near where he thinks the Republicans are-at the fifty-yard line-and then moving closer to their position.
Finding a solution to reducing the deficit that was agreeable to Boehner, to Cantor, to former Speaker Nancy Pelosi, to Senate Minority Leader Mitch McConnell, and to the President was no small task. The men, who had rudely and unwisely excluded Pelosi, now the minority leader, from their deliberations, could no longer avoid dealing with her. They'd considered Pelosi a bit of a pain, insistent as she was on standing up for liberal principles.
Boehner and Cantor, and also Boehner and McConnell, have had their political differences and conflicting political exigencies. Boehner of course wants to retain Republican control of the House-it's not inconceivable that the Democrats could pick up the necessary twenty-four seats to recover it. Therefore, Boehner didn't want his flock to have to cast a controversial vote anytime close to the election. On the other hand, with twenty-three Democratic senators up for reelection, McConnell has had his eye on a Republican takeover of the Senate. His party would need to pick up only four seats. Therefore, he was looking for a way to force a controversial vote closer to the election.
In early July, when Obama suddenly injected Medicare, Social Security, and Medicaid into the deficit and debt negotiations, many, perhaps most, Democrats were dismayed. They believed that the President was offering up the poor and the needy as a negotiating gambit. (His position was that if the Republicans would give on taxes, he'd give on entitlements.) A bewildered Pelosi said after that meeting, "He calls this a Grand Bargain?" And she came down firmly against any changes in those programs that would hurt beneficiaries.
Moreover, the Democrats had their own political reasons for opposing reductions in Medicare benefits. They had had great success in campaigning against Paul Ryan's bizarre proposal, adopted by the House (despite even Boehner's expressed misgivings), that would turn Medicare into a voucher system. According to Ryan's plan the government would give future eligible Medicare recipients $6,000 and let them shop for private insurance. (Good luck.)
Having made Ryan's proposal the centerpiece of the campaign, the Democrats had recently won a special election in a New York district that had been held by the Republicans since the 1950s. The Democrats believed they were onto a good thing.
The question arises, aside from Obama's chronically allowing the Republicans to define the agenda and even the terminology (the pejorative word "Obamacare" is now even used by news broadcasters), why did he so definitively place himself on the side of the deficit reducers at a time when growth and job creation were by far the country's most urgent needs?
It all goes back to the "shellacking" Obama took in the 2010 elections. The President's political advisers studied the numbers and concluded that the voters wanted the government to spend less. This was an arguable interpretation. Nevertheless, the political advisers believed that elections are decided by middle-of-the-road independent voters, and this group became the target for determining the policies of the next two years.
That explains a lot about the course the President has been taking this year. The political team's reading of these voters was that to them, a dollar spent by government to create a job is a dollar wasted. The only thing that carries weight with such swing voters, they decided-in another arguable proposition-is cutting spending. Moreover, like Democrats-and very unlike Republicans-these voters do not consider "compromise" a dirty word.
The President proposed at least two modest plans for stimulus spending, someone familiar with all these deliberations told me, "but he's not as Keynesian as before." This person said, "If the political advisers had told him in 2009 that the median voter didn't like the stimulus, he'd have told them to get lost." By 2011, in his State of the Union address in January he moved from jobs creation (such as the stimulus program) toward longer-term investment.
The speech Obama gave on April 13 marked his conversion to fiscal centrism; to being the fiscally responsible Democrat. In that speech he stated that he wanted to reduce the debt by $4 trillion-thus aligning himself with the Republicans-but also asked for revenues to partly offset that reduction. It was all about reelection politics, designed to appeal to this same group of independents. "And that's why," I was told by the person familiar with the White House deliberations, "he went bigger in the deficit reduction talks; bringing in Social Security is consistent with that slice of the electorate they're trying to reach." This person said, "There's a bit of bass-ackwardness to this; the deficit spending you'd want to focus on right now is the jobs issue."
This all fits with another development in the Obama White House. According to another close observer, David Plouffe, the manager of Obama's 2008 presidential campaign, who officially joined the White House staff in January 2011, has taken over. "Everything is about the reelect," this observer says-"where the President goes, what he does."
Plouffe's advice to the President defines not just Obama's policies but also his behavior. Plouffe tells the President, according to this observer, that the target group wants him to seem the most reasonable man in the room. Plouffe is the conceptualizer, and Bill Daley, the chief of staff who shares Plouffe's political outlook, makes things happen; Gene Sperling, the director of economic policy, and Tom Donilon, the national security adviser, are smart men but they come out of politics rather than academia or deep experience in their respective fields. Once Austan Goolsbee, chairman of the Council of Economic Advisers, departs later this summer, all of the President's original economic advisers will be gone. Partly this is because the President's emphasis on budget cutting didn't leave them very much to do. One White House émigré told me, "It's not a place that welcomes ideas."
Because of the extent to which the President had allowed the Republicans to set the terms of the debate, the attitude of numerous congressional Democrats toward him became increasingly sour, even disrespectful. After Obama introduced popular entitlement programs into the budget fight, a Democratic senator described the attitude of a number of his colleagues as:
Resigned disgust at the White House: there they go again. "Mr. Halfway" keeps getting maneuvered around as Republicans move the goalposts on him. According to a report in The Hill newspaper in late June, the tough-minded, experienced, and blunt Democratic Representative Henry Waxman of California told Obama in a White House meeting that he'd asked several Republicans about their meeting with him the day before, and, "To a person, they said the President's going to cave." Then the congressman said to the President of the United States, "And if you're going to cave, tell us right now." The President was reported to have been displeased, and responded, "I'm the President of the United States; my words carry weight."
Much discussion went on about whether the result of the negotiations would be a "big" deal, reducing the debt by $4 trillion, with $1 trillion coming from revenues and some sort of savings from entitlement programs, as the President and Boehner had privately discussed-although Boehner's dream of a bipartisan deal was dashed by Cantor on behalf of numerous other House Republicans-or a "small" deal, cutting the debt by about $2 trillion. It was easy to lose sight of the fact that the President was using a lot of his time and energy (he looked very tired) on the wrong subject. And that was even before the arduous, almost daily meetings with the two parties' leaders.
With the negotiations stalled and time running out, McConnell, worried that the President had manuevered his party into a position where if there were a default the Republicans would be blamed, introduced his own proposal to break the impasse. The very shrewd McConnell warned his Senate colleagues that if they did not take this way out of the impasse, the party's "brand would be badly damaged." McConnell's proposal handed over to the President the authority to raise the debt ceiling, which his own party had been trying so hard to exploit and never dreamed it would surrender to the President.
Under McConnell's plan, the President would raise the debt ceiling three times for a total of $2.4 trillion before the November election. Each time, Congress would vote on a resolution of disapproval. The proposals Obama could offer would consist of spending cuts only, in keeping with the Republicans' position that there would be no savings from the tax code. Thus McConnell had maneuvered the Democrats into having to cast three votes on the debt limit. He said that a major goal of his plan was to "reassure the markets that default is not an option."
McConnell persuaded Harry Reid, the Democratic Senate leader, to cosponsor his proposal, incorporating Reid's idea of setting up a bipartisan commission of members of the House and Senate who would draw up new budget proposals that would then go to both houses and be considered under a special procedure that would allow no filibuster and no amendments.
The new proposal also contained $1.5 trillion in budget cuts that had been agreed to by a bipartisan group of Senators presided over by Vice President Biden. These were the only cuts that the two parties could agree on, guaranteeing that the cuts would be much more painful for the Democrats.
With two weeks remaining before the day of default, McConnell and Reid were negotiating the fine points of their proposal, and Boehner had made a quiet overture for Nancy Pelosi's support. (Pelosi had told people that she would demand future protection for Medicare and Social Security.) Some House Republicans expressed opposition to the Senate leadership's plan. At the same time some conservative members were urging that Congress allow a default, saying that they didn't believe the results would be as dire as the administration was warning. And then, suddenly, on July 19 the so-called Gang of Six, a bipartisan group of senators led by Democrat Kent Conrad, rode into town with a plan about the size of the one Obama and Boehner had been considering.
The plan envisaged cutting $3.7 trillion from the debt, but the details were vague, and it seemed very unlikely that such a complex plan-offered in the form of a four-page outline-with legislation involving several committees, could be drafted and passed by the Senate and the House within two weeks. The group had been holding back its plan at the White House's request, but became impatient and fearful that Obama would cave again. The President said he liked the new plan though he had to know there was plenty in it for others to object to. It called for, to begin with, both tax revenues and deep cuts in entitlement programs. Substantial tension was growing in Washington, but to some extent it seemed a phony tension. McConnell and Boehner had vowed there would be no default. Now it was up to them and others to work out what to do instead.
The Republicans displayed a recklessness that should have disqualified them from being taken seriously. Any deal that was reached would contain substantial cuts in the coming fiscal year-too soon, as Fed Chairman Ben Bernanke and the head of the Congressional Budget Office Doug Elmendorf have recently warned.
The antitax dogma of the Republican Party is strongly rooted in mythology. The theory that tax cuts create jobs has been discredited by the results of George Bush's tax policies. The Republicans cling to the myth that "small business" owners are the "job creators," and so they oppose proposals to eliminate the Bush rate cuts for even those earning over $250,000. But relatively few small business owners earn $250,000-in fact, fewer than 3 percent of the 20 million people who file business income on their personal tax forms (the 1040s) earn that much.
Finally, the antitax position of many conservatives would seem to be illogical, since they also hate deficits: but their real aim is to reduce or eliminate federal programs. They call efforts to redistribute wealth "socialism," but have no problem redistributing from the poor and middle class to the wealthy through taxes, as set forth in Paul Ryan's budget plan, which the House approved on April 15. Under the Ryan plan, the taxes of the richest one percent of Americans would be cut in half, while taxes would be raised on most of the middle class. People earning over $1 million would be taxed at a lower effective rate than the middle class.
Consistent with the philosophy of Ryan's idol Ayn Rand, this scheme would by 2050 eliminate virtually all federal programs other than defense and Social Security, much of which would be privatized, while his voucher program would replace Medicare. The Ryan plan was so radical that even Republican candidates have been distancing themselves from it though the party higher-ups had declared it a "litmus test" for Republicans seeking office.
Still, liberal-leaning budget analysts agree that the budget is on an "unsustainable" path, with debt constantly rising as a share of the Gross Domestic Product. As of now, the debt is close to 70 percent of GDP. James Horney of the highly respected Center on Budget and Policy Priorities says that that's a workable percentage, but that steps should be taken to stabilize it by the end of this decade. That would require, Horney says, a substantial amount of deficit reduction-no easy task-including increases in revenues.
This does not mean, Horney adds, that we need to balance the budget to reach that goal. If there are needs to be met by borrowing-especially now, to boost economic growth and employment-we should borrow. The borrowing today should go to extend unemployment benefits (scheduled to expire in December), create infrastructure programs that will provide jobs (for which there are a number of ideas floating around), as well as provide more fiscal relief to the states. (In the recent dismal unemployment figures, public employees were particularly hard hit-partly because they were a target of Republican governors.)
But even more significant is the question of how our leaders, in particular the President, ended up with such misguided policies-emphasizing budget- cutting over growth. The Republicans exploited the need to avoid an economic collapse that could result from not raising the debt limit by demanding that programs that Congress had agreed to should now be unagreed to.
The President began the year with the unfortunate slogan "Win the Future"-which emphatically meant growth and investment. He ended up in Republican territory, at least rhetorically accepting the highly flawed conception equating the federal government with a household: he and Goolsbee repeated the sampler-stitched maxim "We must live within our means," ignoring that at times the government simply must borrow in order to meet the people's needs, as is the case now, with high unemployment. It's no time for austerity. Instead, the government is borrowing in order to give tax cuts to the wealthy and pay for at least two wars.
A final deal became exigent for the major players: naturally, Obama didn't want to preside over a calamity; and just as urgently, the Republican leaders didn't want to be pinned with the blame for bringing about the calamity-which poll after poll suggested they would be. Thus it was assumed that a deal would be reached not because the Republicans had a sudden surge of responsibility but because they feared the political consequences of not appearing to be responsible.
Anyway, they had lured the President so far onto their territory that any deal would represent a substantial victory for them-the President's rhetoric notwithstanding. It was all about theater and politics. But Obama-and the country-would still have to live with the consequences of the policy.
Both the President and the House Republicans, the major parties to the negotiations, are running longer-term political risks. The Tea Party, which has dominated the entire eighty-five-member freshman class, or one third of the Republican House caucus, has pulled the House Republican Party so far to the right that it risks coming across to the public as too obdurate, as putting its own ideology and own partisan interests ahead of the nation's needs. (And given the possible effects of a default by the United States, perhaps other nations as well.) The "old boys"-the "establishment" Republicans, represented by Boehner-were willing to compromise, while Cantor, as majority leader, had to pay attention to the rambunctious Tea Party group. Each was useful to the other.
In the end, the President had made the Republicans look bad, but what did he get for it? He ended up agreeing to new restrictions that will hamstring his policies for as long as he serves in office. His own actions will have led to new laws that forbid him to borrow money for any government policy-unless, at some time, he goes out and campaigns hard for raising taxes in any form. His actions so far shed light on how likely that is.
This country's economy is beset with a number of new difficulties, among them that recovery from the last recession remains more elusive than was generally expected, while the US is confronting a variety of international economic instabilities, especially the large debts and possible default of several countries in the eurozone, bringing on unpopular austerity measures. Recent experience with what should have been a simple matter of raising the debt ceiling, normally done with no difficulty, is reason for deep unease about our political system's ability to deal with such challenges.
-July 19, 2011
November 29, 2010 | US News and World Report
The modern world has for centuries been dominated economically, intellectually, and physically by the civilization that arose in Western Europe in the wake of the Renaissance and Reformation and spread across the Atlantic.
Will that one day be seen as a passing phenomenon doomed to ascend ever upward and then slowly fizzle out like a firework?
It is nearly a century since that gloomy German mathematician and philosopher Oswald Spengler published his 1918 classic The Decline of the West. His arguments were complex, but basically he suggested that the future of the West was not as limitless as his peers imagined after the ghastly World War I. His thesis was that civilizations had an underlying trajectory, an organic rise and fall; his metaphor was to compare the stages of this process to the stages of our seasons-but seasons of many centuries. In the 19th century we were, he suggested, in the winter of the West, witnessing the triumph of materialism, socialism, and money and that the era of individualism, liberty, and humanitarianism was nearing its end. (When the Nazis rose to power he seemed vindicated-he was a vehement critic.)
Read today, Spengler's forebodings have an uncanny and chilling association with our present predicaments. He was not saying Western civilization would vanish overnight in a puff of smoke. It would erode more slowly, as did some ancient civilizations-not to vanish forever but with symbols of their power and influence surviving (the Pyramids, the Aztec temples, the Parthenon), with the potential to re-emerge as civilizations many centuries later.
Myopic self-indulgence. Are our current plagues-the riots first in Athens and then in Paris, our global economic crisis manifest in the riots and rampant sovereign debt-merely a symptom of a deeper decay of a civilization in the autumn of its existence? A civilization unable to recognize its own vulnerability? The riots were certainly as much an example of myopic lethal self-indulgence as the sovereign debts in all the leading countries of the West. In France, students took to the streets protesting against a rise of just two years in the age of subsidized retirement-a system destined to bankrupt the state long before they, too, want the comforts that will be impossible to sustain.
Among Spengler's convictions was that money, instead of serving mankind, would betray the Western civilization as it had others-and money in politics and media especially. If he could have seen this election season, he would have been even more downcast! Money is surely the great corrupter of American democracy. Congressmen have to spend more of their time raising money for misleading and defamatory television commercials-and resisting briberies of one kind or another-than they spend studying our predicaments.
The global prosperity of much of the 20th century would seem to belie the pessimists, but I don't think there is much doubt the moral authority of the West has dramatically declined in the face of the financial crisis. It has revealed deep fault lines within Western economies that have spread to the global economy.
The majority of Western governments are running fiscal deficits of 10 percent or more relative to GDP, but it is increasingly clear that there will be no quick fixes, that big government and fiscal deficits will not bring us back to the status quo ante. Indeed, the tidal wave of red ink has meant that the leverage-led or debt-led growth model is dead.
Developed countries will be forced to deal with their debt on every level, from the personal to the corporate to the sovereign. Being able to borrow may have made people feel richer, but having to repay the debt is certainly making them feel poorer, particularly since the unfunded liabilities that many governments face from aging populations will have to be paid for by a shrinking band of workers. (Ecoutez, mes amis!)
Demography is destiny. As a result, there is a burgeoning consensus that we are witnessing an inevitable rise of the East and a decline of the West.
The prognosis for America is especially discouraging. We have relied too heavily on surplus savings from abroad on top of running massive current account deficits. Until recent times, we ran deficits of this order only when we were engaged in a titanic war; otherwise we sought to achieve budget balances over a complete business cycle. But now we are running annual deficits of $1.4 trillion, about 10 percent of the total economy. We have compounded the deficits we accumulated over the last decade, so they now reach 61 percent of GDP. Only once before has the ratio of federal debt to GDP come in above 60 percent. That was after World War II. And our federal debt ratio today doesn't even take into account Social Security and Medicare. Total liabilities and unfunded promises for Medicare and Social Security were about $62 trillion at the end of the last fiscal year, tripling from the year 2000, according to the calculations of former Comptroller General David Walker. Sixty-two trillion dollars is $200,000 per person and $500,000-plus for the average household. As Walker put it, the problem with these trust funds is "you can't trust them [and] they're not funded." Therefore, he asserts, we ought to count them as a liability, which would bring the debt-to-GDP ratio to 91 percent.
The present model of global growth had served excess Western consumption with inexpensive products from the East. The result is plain to see: The West has excessive debt, while China has excessive capacity and inadequate consumption, as well as high levels of savings and our debt.
The deficits we face are a dagger pointing at the heart of the American economy. They threaten that the United States will evolve into another aging welfare state, where fiscal expenditures shift from defense to social welfare, and America's power in the world will shrink. It has clearly happened in Western Europe, which can no longer defend itself but relies on the United States.
Foreign lenders. We clearly need to reduce our dependency on foreign lenders. Quite simply, we are mortgaging the future of our young people at record rates while we fail to improve education, healthcare, and a decaying infrastructure. How is it that we manage this while spending double per person what the average industrialized nation spends on such programs? Who could be surprised that so many Americans now fear that their children and grandchildren will not have as good a life as they had? Whose American dream?
For the last half century, the United States gave priority to defending against serious security threats because no other nation could step up to that responsibility, just as today no other country can lead coalitions against terrorists and the planetary menace of nuclear proliferation. But economics has become the center of geopolitics. As the former president of the Council on Foreign Relations, Les Gelb, points out,
"There is no arena in which the vital interests of great powers seriously clash. Indeed, the most worrisome security threats today-rogue states with nuclear weapons and terrorists with weapons of mass destruction-actually tend to unite the great powers more than divide them."
It's the defense readiness of the United States that makes it possible for the world to focus on economic priorities, including trade, investment, access to markets, and a better life for the people.
China makes the best case for the primacy of economics. It is daily demonstrating that a country can become a global economic giant without becoming a global military power. Its strategic response to what's been happening is to shift the sources of GDP growth from external to internal markets.
In the United States, gloom has spread to our policymakers on how to deal with our economic dilemmas. Monetary policy is relatively ineffective because we are in, or near, liquidity trap conditions. Our economy is so weak that lower interest rates and other monetary tools are not working. In the liquidity trap, no matter how much money is thrown into the system, people have so little confidence that they tend to hoard it. Similarly, fiscal policy is beginning to reach its limits. High debt levels can raise concerns about the creditworthiness of our government. This in turn could lead to higher long-term interest rates that would aggravate the economic contraction.
There is a real danger of a global double dip. We face a general slide in confidence, the unwinding of the temporary fiscal boost to growth, and the negative reaction to the fiscal profligacy. Government budgets have been tightened around the world since Europe's crisis in May, providing additional headwinds to an economic recovery. Every country is facing ballooning government debt. In the countries of the Organisation for Economic Co-operation and Development, which are mostly in Europe but include the United States, government debt will go from 73 percent of GDP when the recession started in 2007 to over 100 percent next year.
What we clearly need is leadership with the will and the moral authority to govern on the basis of the long-term interest of the country. It will not be easy given the fact that any attempt to cut future entitlements will be opposed by those in or approaching retirement. They form a powerful voting constituency, in contrast to their children who somehow will have to pay the bill.
Fiscal responsibility and discipline are going to be critical issues in the formulation of public policy. The debates in this election season, sidetracked on emotional but marginal issues, have been depressing. We cannot continue to mortgage our future by reducing investments in our future, whether it be for education, infrastructure, or basic research. We still possess the most appealing popular culture and public values, as well as the most innovative and competent business culture. American exceptionalism endures. But we must confront our dysfunctional and profligate government. America was founded on the principle of creating a better life for our children and grandchildren. We can do it. We aren't doing it.
- See editorial cartoons about the economy.
- See photos of the Obamas abroad.
- See which industries donate the most to Congress.
"Reagan proved that deficits don't matter." - American VP Dick Cheney
"We need to manufacture an [economic] crisis in order to assure that there is no alternative to a smaller government." - Jeb Bush - Imprimus magazine 1995
Starve the Beast.
Frederick of AZ
Simply Amazing The reporter points to the costs of the last election. Spengler would have been the first to try to tell this fellow that the election costs are not a problem. Besides the fellows who lost seats spent more than the guys who won more seats in this last cycle.
I would also like to advise the yahoo writing this that neither Palin nor Beck are in Government. They cannot be the problem, at least at this time. And neither has been in federal government in the past.
Now Obama, has been in government and is the present President who until January, has his party in control of every elective branch of Government. It has only been his own whining and his supporting media that have been desperate to blame the folks with no power for what has happened in the last two years.
The underlying problems started 70-80 years ago. Beginning a retirement program that was not actuarially sound. Later came medicare, then trying to put folks into homes they could not afford. And it continues with the march towards socialized medicine, nationalizing the Auto industry to keep the Unions well funded to contribute to future campaigns. The control of the banks and finance industries.
If we are serious about saving this country, we must begin to do two things. Stop giving away other peoples property, and make people, including elected officials liable for their actions.
For bankers, put them in jail if they bake a certain percentage of bad loans. For politicians first require them by law to have read the law. Then in their own words tell us what they expect from that law. If that law doesn't give us what it was supposed to, then require the elected official to resign and spend a period in jail/prison.
We also need a media that is more interested in informing the people than pushing or following an agenda.
"The problem with socialism is that you eventually run out of other people's money." ~~Margaret Thatcher
"We can evade reality, but we cannot evade the consequences of evading reality" --Ayn Rand
TJ Knowles of CO
Nero Fiddled While Rome Burned
We are the headless horseman riding blindly toward the cliff. We are the frog in the slowly heating, deadly water. We are led by criminals- yours and mine.
The noble elements have gone missing....
We choose to be pitiful.
We can choose not to be.
Dec. 30, 2008 | Bloomberg
The year 2008 will be remembered as one that exposed the fatal flaws in free-market capitalism, sending it to an untimely death.
Or will it?
That capitalism's obituary is already being written suggests the enemies of the free market were waiting to pounce.
Last week, Arianna Huffington, co-founder of the Huffington Post, wrote that laissez-faire capitalism, "a monumental failure in practice," should be "as dead as Soviet Communism" as an ideology.
On National Public Radio, Daniel Schorr pronounced "the death of a doctrine" in his year-end review.
All I could think of was Winston Churchill's assertion about democracy. Capitalism is surely the worst economic system, except for all the others that have been tried.
With its ideology under fire and its practice falsely maligned, it is to the defense of free markets that I devote my final column of the year.
Before you can declare free markets a failure, you have to establish that they exist, says Paul Kasriel, chief economist at the Northern Trust Co. in Chicago.
"We do not have free markets in credit in the U.S. or anywhere else that I know of," he says. "The price of short- term credit is fixed by central banks. It would only be by accident that a central bank would fix the price of short-term credit" at the precise level that a free market would.
Fixing the price of any other commodity, including labor, has proven to be a failure, an affront to the inviolable invisible hand. Yet when it comes to setting the interest rate that will keep the economy on an even keel, we put our faith in a chosen few to get it right.
All sorts of unintended consequences flow forth from central bankers' fixing of a short-term rate. Hold the rate too low, and it leads to a misallocation of capital into, say, housing or dot- com stocks. That's what happened in the late 1990s and again in the early part of this decade.
"We are now experiencing the economic and financial market fallout from (Alan) Greenspan's interference with the free market," Kasriel says.
In a true free market, risk-takers are punished for bad bets. Not so in the current crisis, where financial institutions -- with the exception of Lehman Brothers -- are deemed too big to fail and rescued, merged or recapitalized.Army of Regulators
One supposed nail in capitalism's coffin is the assertion that deregulation created the problems. This is curious, given that banks, which are at the root of the credit crunch, are among the most highly regulated institutions.
"There is a small army of people overseeing the banking industry," says Paul DeRosa, a partner at Mt. Lucas Management Corp. in New York. And yet "we've had a banking crisis every 15 years since 1837. The number of people devoted to regulation doesn't seem to matter."
Regulators from the Federal Reserve, Securities and Exchange Commission, Office of the Controller of the Currency and New York State Banking Commission are "on the premises 365 days a year," he says.
The regulatory structure may have been antiquated and overlapping. That's no excuse for the regulators to be caught napping.
Censuring the free market is a way of deflecting blame from the true source, according to Dan Mitchell, senior fellow at the libertarian Cato Institute in Washington.Compromised Overseers
"The genesis of the problem is bad government policy," Mitchell says, pointing to everything from easy money to "affordable lending schemes" to the "corrupt system of subsidies from Fannie Mae and Freddie Mac" to the tax code's favorable treatment of debt (the interest is deductible) versus equity.
Fannie's and Freddie's generous campaign contributions (anywhere else, these would be called bribes) encouraged Congress to look the other way as the two housing finance agencies used their implicit government guarantee to increase their leverage and buy riskier mortgages.
Those clamoring for more regulation as a solution to the current crisis are forgetting that Congress has oversight responsibility for the regulator of those agencies.
"I have no confidence regulation will solve the problem," says Allan Meltzer, professor of economics at Carnegie Mellon University in Pittsburgh. "Lawyers and bureaucrats make regulations. Markets figure out how to circumvent the costly ones."Imperfect Like Us
As a case in point, Meltzer pointed to the Basel Accords, which "required banks that hold more risky assets to hold more reserves. So they held them off their balance sheet, where they went from being poorly monitored to not monitored at all."
Capitalism has spread across the globe, lifting millions out of poverty as "a direct consequence of government stepping out of the way," DeRosa says.
Yet critics of free-market capitalism are implicitly arguing for a bigger role for government.
Alas, government isn't some benevolent matriarch acting in the public interest, even if it knew what that was. It is a conglomeration of politicians acting in their own self-interest, guided by payoffs from special-interest groups. That's a poor substitute for the market's price signals, not to mention a guarantee of inefficiency and waste.
"Capitalism is the only system that produces both growth and freedom," Meltzer says. Unlike socialism and communism, "it doesn't depend on someone's ideas of perfection."
Yes, markets are guilty of excess, greed, even corruption.
"We're not perfect people," Meltzer says. "Capitalism matches mankind."
October 10, 2008 | washingtonpost.com
The worst financial crisis since the Great Depression is claiming another casualty: American-style capitalism.
Since the 1930s, U.S. banks were the flagships of American economic might, and emulation by other nations of the fiercely free-market financial system in the United States was expected and encouraged. But the market turmoil that is draining the nation's wealth and has upended Wall Street now threatens to put the banks at the heart of the U.S. financial system at least partly in the hands of the government.
The Bush administration is considering a partial nationalization of some banks, buying up a portion of their shares to shore them up and restore confidence as part of the $700 billion government bailout. The notion of government ownership in the financial sector, even as a minority stakeholder, goes against what market purists say they see as the foundation of the American system.
Yet the administration may feel it has no choice. Credit, the lifeblood of capitalism, ceased to flow. An economy based on the free market cannot function that way.
The government's about-face goes beyond the banking industry. It is reasserting itself in the lives of citizens in ways that were unthinkable in the era of market-knows-best thinking. With the recent takeovers of major lenders Fannie Mae and Freddie Mac and the bailout of AIG, the U.S. government is now effectively responsible for providing home mortgages and life insurance to tens of millions of Americans. Many economists are asking whether it remains a free market if the government is so deeply enmeshed in the financial system.
Given that the United States has held itself up as a global economic model, the change could shift the balance of how governments around the globe conduct free enterprise. Over the past three decades, the United States led the crusade to persuade much of the world, especially developing countries, to lift the heavy hand of government from finance and industry.
But the hands-off brand of capitalism in the United States is now being blamed for the easy credit that sickened the housing market and allowed a freewheeling Wall Street to create a pool of toxic investments that has infected the global financial system. Heavy intervention by the government, critics say, is further robbing Washington of the moral authority to spread the gospel of laissez-faire capitalism.
The government could launch a targeted program in which it takes a minority stake in troubled banks, or a broader program aimed at the larger banking system. In either case, however, the move could be seen as evidence that Washington remains a slave to Wall Street. The plan, for instance, may not compel participating firms to give their chief executives the salary haircuts that some in Congress intended. But if the plan didn't work, the government might have to take bigger stakes.
"People around the world once admired us for our economy, and we told them if you wanted to be like us, here's what you have to do -- hand over power to the market," said Joseph Stiglitz, the Nobel Prize-winning economist at Columbia University. "The point now is that no one has respect for that kind of model anymore given this crisis. And of course it raises questions about our credibility. Everyone feels they are suffering now because of us."
In Seoul, many see American excess as a warning. At the same time, anger is mounting over the global spillover effect of the U.S. crisis. The Korean currency, the won, has fallen sharply in recent days as corporations there struggle to find dollars in the heat of a global credit crunch.
"Derivatives and hedge funds are like casino gambling," said South Korean Finance Minister Kang Man-soo. "A lot of Koreans are asking, how can the United States be so weak?"
Other than a few fringe heads of state and quixotic headlines, no one is talking about the death of capitalism. The embrace of free-market theories, particularly in Asia, has helped lift hundreds of millions out of poverty in recent decades. But resentment is growing over America's brand of capitalism, which in contrast to, say, Germany's, spurns regulations and venerates risk.
In South Korea, rising criticism that the government is sticking too close to the U.S. model has roused opposition to privatizing the massive, state-owned Korea Development Bank. South Korea is among those countries that have benefited the most from adopting free-market principles, emerging from the ashes of the Korean War to become one of the world's biggest economies. It has distinguished itself from North Korea, an impoverished country hobbled by an outdated communist system and authoritarian leadership.
But the repercussions of crisis that began in the United States are global. In Britain, where Prime Minister Margaret Thatcher joined with President Ronald Reagan in the 1980s to herald capitalism's promise, the government this week moved to partly nationalize the ailing banking system. Across the English Channel, European leaders who are no strangers to regulation are piling on Washington for gradually pulling the government watchdogs off the world's largest financial sector. Led by French President Nicolas Sarkozy, they are calling for broad new international codes to impose scrutiny on global finance.
To some degree, those calls are even being echoed by the International Monetary Fund, an institution charged with the promotion of free markets overseas and that preached that less government was good government during the economic crises in Asia and Latin America in the 1990s. Now, it is talking about the need for regulation and oversight.
"Obviously the crisis comes from an important regulatory and supervisory failure in advanced countries . . . and a failure in market discipline mechanisms," Dominique Strauss-Kahn, the IMF's managing director, said yesterday before the fund's annual meeting in Washington.
In a slideshow presentation, Strauss-Kahn illustrated the global impact of the financial crisis. Countries in Africa, including many of those with some of the lowest levels of market and financial integration and openness, are now set to weather the crisis with the least amount of turbulence.
Shortly afterward, World Bank President Robert Zoellick was questioned by reporters about the "confusion" in the developing world over whether to continue embracing the free-market model. He replied, "I think people have been confused not only in developing countries, but in developed countries, by these shocking events."
In much of the developing world, financial systems still remain far more governed by the state, despite pressure from the United States for those countries to shift power to the private sector and create freer financial markets. They may stay that way for some time.
China had been resisting calls from Washington and Wall Street to introduce a broad range of exotic investments, including many of the once-red-hot derivatives now being blamed for magnifying the crisis in the West. In recent weeks, Beijing has made that position more clear, saying it would not permit an expansion of complex financial instruments.
With the U.S. government's current push toward intervention and the soul-searching over the role of deregulation in the crisis, the stage appears to be at least temporarily set for a more restrained model of free enterprise, particularly in financial markets.
"If you look around the world, China is doing pretty good right now, and the U.S. isn't," said C. Fred Bergsten, director of the Peterson Institute for International Economics. "You may see a push back from globalization in the financial markets."
Staff writers Blaine Harden in Seoul and Ariana Cha in Washington contributed to this report.
March 23, 2008 | The Independent
The Western world is in an economic crisis similar in scale to the oil shock of 1973. What we are seeing is nothing less than the unravelling of neo-liberalism – the dominant economic and ideological model of the last 30 years.
The disintegration of Anglo-Saxon-inspired markets has come about largely because of the confluence of two tendencies of the "free market": speculation and monopoly capitalism. Contrary to received opinion, free markets – unless subject to civil regulation, asset distribution and persistent intervention – always tend to monopoly.
Similarly, there is nothing inherently efficient about free markets – they do not of themselves promote sound investment or wise management. Rather, when markets are conceived wholly in terms of price and return, and when asset wealth and the leverage that this provides becomes as concentrated as it was in the 19th century (which is a scenario we are approaching), then markets encourage nothing other than gambling masking itself as sound investment.
For example, before 1973 the ratio of investment to speculative capital was 9:1; since 1973, these proportions have reversed. So huge have the numbers, leverage and derivative instruments become that their value now far exceeds the total economic value of the planet. For instance, in 2003 the value of all derivative trading was $85 trillion, while the size of the world economy was only $49 trillion.
These ratios have risen with the latest estimates that the value of all traded paper instruments exceeds the underlying value of the assets on which they are written by 3:1. The fact that these assets may themselves be devaluing by up to 50 per cent (US housing values have declined by 25 per cent in two years) means that the overall ratio of global paper value to its leveraged base may indeed double.
This average global figure itself masks even more extreme levels of leverage. The Carlyle Group de-faulted on $16.6bn (£8.4bn) of debt last week. The private equity firm had been speculating assiduously on its AAA-rated mortgage base – by some estimates, at the end of its life, Carlyle's loan-to-value ratio and hedge exposure was at 36:1. There are, of course, many other private equity firms in a similar position.
This incalculable level of speculation is abetted by the huge concentration of wealth that has occurred since 1973. Why? Because if markets tend to monopoly then smaller groups of people control larger amounts of assets. The latest figures demonstrate this admirably: the richest 10 per cent of the UK population increased their share of the nation's marketable wealth (excluding housing) from 57 per cent in 1976 to 71 per cent in 2003. Over the same period, the speculative capital that could be deployed or invested by the bottom 50 per cent of the British population fell from 12 per cent to just 1 per cent. Indeed, the wealthiest 1 per cent of the population, on current government figures, now control more than a third of all the marketable wealth – and this ignores the vast sums held in offshore tax havens.
The New Economics Foundation has shown that global growth has not aided the poor. In the 1980s, for every $100 of world growth, the poorest 20 per cent received $2.20; by 2001, they received only 60 cents. Clearly neo-liberal growth disproportionately benefits the rich and further impoverishes the poor.
Real wage increases in the top 13 countries of the Organisation for Economic Cooperation and Development (OECD) have been below the rate of inflation since about 1970 – a situation compounded in Britain as the measure of inflation massively underestimates the real cost of living.
Thus wage earners – rather than asset owners – have faced a 35-year downward pressure on their standard of living. Indeed, the golden age for the salaried worker, as a share of GDP, was between 1945 and 1973 – and not this vaunted age of liberalisation.
The trouble is that nobody in power recognises this crisis for what it is – an asset insolvency crisis brought about by massive debt leverage. Neo-liberals are still reacting as if the emergency was one of liquidity. They are wrong. Governments should bail out not banks and speculators but the customers who now have every reason to fear for the future.
Endgame 5: Maintaining a Facade of "Free Market Capitalism" (January 26, 2009)
As the Federal government sinks ever larger sums in the flailing U.S. banking and financial-services sectors to cover privately held bad debt, ideology and a conduit for future private profits require that a facade of "Free Market Capitalism" be maintained at all costs.
Charts and metrics are useful tools, but they provide little explanatory force when it comes to greed and ideologically driven decisions. Thus we can study the charts of money supply, credit expansion, bad debts, illiquid CDS and CDOs, plummeting real estate values and the insolvent balance sheets of U.S. banks, and conclude that outright liquidation of Citicorp et al. and the nationalization of what's left is the only rational way forward.
But instead we have public money being used to backfill private losses to "recapitalize" the banks and mortgage industry while leaving current shareholders in place: in other words, socialize the risks/losses but leave a conduit for future private profits at taxpayer expense.
Thus even as private-sector banks are essentially being socialized on a heretofore unimaginable scale (and government agencies take small "preferred shares" positions in lieu of 100% nationalization), private ownership is being "saved" so that once the sector is stabilized the profits will again flow to private hands. You know the drill: socialize risks, privatize (future) profits.
One way to accomplish this was to arrange "shotgun marriages" between failing financial houses like Merrill Lynch and (apparently) better-capitalized cousins like Bank of America. As the Wall Street Journal reported:(BofA CEO) Lewis thought about scrapping the deal (to acquire Merrill) but decided against it after federal officials urged him to reconsider.
"Urged him to reconsider." That's rich. You mean if I keep you awake for 24 hours under hot lights and twist your arm behind your back to the breaking point until you agree to marry a massive liability, I'm simply "urging" you? How very cricket of you to agree. No doubt Wells Fargo was similarly "urged" to acquire the collapsing Wachovia.
Why not liquidate the losers and sell off what's left to the survivors? Or if we're picking up the tab, why not ensure taxpayers own the entire bank so future profits (if any) flow to those making the investment?
A facade of "private ownership" is being maintained, at enormous public expense. Why? Clearly, the one obvious reason is to protect the assets and incomes of current players and owners; were a bank to be nationalized in all but name, as was the case with AIG, then current owners get a mere fraction of their once-mighty asset.
So why not pay off the current owners and fully nationalize the banks? There appear to be powerful ideological reasons for U.S. banks to be socialized behind a facade of "free market capitalism."
The implosion of the entire global banking/mortgage industry has essentially delegitimized the "free market capitalism" ideology which the U.S. has been pleased to espouse as the royal road to prosperity for decades.
To nationalize the U.S. banking, financial services and mortgage sectors entirely would be a total capitulation, admitting that this model was fatally flawed.
Now we all know the U.S. financial system is "free market capitalism" in name only; the Federal Reserve (itself a private institution) manipulated interest rates to dangerously unprecedented levels for years, for instance; that was hardly a free-market mechanism.
Nonetheless, that "capitalism in name only" is still a powerful global "brand" which the U.S. seeks to maintain at all costs for macro geopolitical reasons: The Great Crash, 2008: A Geopolitical Setback for the West (Foreign Affairs)The financial and economic crash of 2008, the worst in over 75 years, is a major geopolitical setback for the United States and Europe. Over the medium term, Washington and European governments will have neither the resources nor the economic credibility to play the role in global affairs that they otherwise would have played. These weaknesses will eventually be repaired, but in the interim, they will accelerate trends that are shifting the world's center of gravity away from the United States.
A brutal recession is unfolding in the United States, Europe, and probably Japan -- a recession likely to be more harmful than the slump of 1981-82. The current financial crisis has deeply frightened consumers and businesses, and in response they have sharply retrenched. In addition, the usual recovery tools used by governments -- monetary and fiscal stimuli -- will be relatively ineffective under the circumstances.
This damage has put the American model of free-market capitalism under a cloud. The financial system is seen as having collapsed; and the regulatory framework, as having spectacularly failed to curb widespread abuses and corruption. Now, searching for stability, the U.S. government and some European governments have nationalized their financial sectors to a degree that contradicts the tenets of modern capitalism.
Much of the world is turning a historic corner and heading into a period in which the role of the state will be larger and that of the private sector will be smaller. As it does, the United States' global power, as well as the appeal of U.S.-style democracy, is eroding.
I doubt if anyone is fooled by this facade or the legerdemain of treating taxpayer bailouts as "investments." (I also doubt the debt-serfs (I am certainly one) will arise to overthrow the Manor House Lords; we're too atomized and distracted by the pressures to make ends meet/pay our debts. That's what they're counting on, of course....)
But with this ideologically loaded "cloud" darkening U.S. influence and policy, I think it is a very safe bet indeed that Bank of America and Wells Fargo will never be allowed to go under or be nationalized. Their "show weddings" to Merrill and Wachovia have significance far beyond our own shores, and for this reason alone the "marriages" will be "made to work" to the benefit of all parties--including current shareholders of BAC and WFC.
Only the hapless taxpayers will be left with the trillion-dollar bill.
April 07, 2010
Botox (botulinum toxin), a highly toxic neuro-toxic protein produced by Clostridium Botulinum, is commonly used in cosmetic procedures to improve a person's appearance by removing facial lines and other signs of ageing. The effect is temporary and can have significant side effects.
The global economy is currently taking the "botox" cure. A flood of money from central banks and governments – "financial botox" – has temporarily covered up unresolved and deep-seated problems.
Bad Risks …
In 2009 there was a 'recovery' in financial asset prices. The low or zero interest rate policy ("ZIRP") of major central banks helped increase asset prices. Very low returns on cash or near cash assets forced investors to switch to riskier assets in search of return.
The chase for yield drove rallies in debt and equity markets. Low interest rates acted like amphetamine as investors re-risked their investment portfolios.
High credit spreads for investment quality companies, driven by the panic of late 2008 and early 2009, subsided and rates returned to pre-Lehman levels. Credit spreads for investment-grade borrowers fell to just over 100 basis points from their highs of 300 basis points in March 2009. Credit spreads for non-investment grade or junk borrowers market fell to over 500 basis points from the high of 1,300 basis points in the same period, driving returns of over 50% per annum. Extremely low rated bonds, such as CCC rated bonds (a mere one notch above default), generated even higher returns, falling from rates of 30-40% per annum to around 10%.
Re-risking was helped by the return of the "carry trade" as investors used near zero cost funds, especially in dollars, to finance holdings of risky assets. Any asset offering a reasonable return rose sharply in value. Morgan Stanley analyst Greg Peters outlined the outlook for 2010 in the Financial Times: "We like the junkiest of the junk …"
As the recovery spread across most asset classes, naysayers were dismissed as perma-bears. As everyone knows: "A bubble is a rising market that one is not invested in; if one is invested, then it is a bull market."
In contrast, the real economy, at best, stabilized during 2009. Most economies, with the exception of Australia and some emerging markets, most notably China and India, contracted during 2009. In Australia, which avoided a recession, GDP per capital actually fell (by around 1.5% per annum). Key real economy indicators, including employment, consumption, investment and trade, remained weak.
Massive government intervention helped arrest the rate of decline of late 2008/early 2009. Without government support, it is highly probable that most economies would have been in serious recession. Elements of the package resembled Soviet Gosplans. Just as China practiced capitalism with Chinese characteristics, developed economies discovered socialism with Western characteristics.
Despite speculation on the "shape" of the recovery – "V," "U" or "W," key issues are unresolved. Major risks in the financial and real economy remain and may disrupt the hoped for resumption of business as usual.
Bad Banks …
Capital injections, central bank purchases of "toxic" assets and explicit government support for deposits and debt issues helped stabilize the financial system. Changes in accounting rules deferred write-downs of potentially bad assets. Despite these actions, the global financial system remains fragile.
In their September 2009 Financial Stability Report, the International Monetary Fund (IMF) forecast total losses from the Global Financial Crisis (GFC) of $3.4 trillion, of which $2.8 trillion would be borne by banks. Approximately $1.5 trillion of those losses, around half of which was attributed to European and U.K. banks, had not been recorded and were expected between Q2 2009 and Q4 2010. In December 2009, the European Central Bank ("ECB"), which is more optimistic than the IMF, forecast that euro-zone bank write-downs between 2007 to 2010 could potentially reach €553billion ($774 billion), of which some €187 billion ($262 billion) (34%) have not been recognised to date. The ECB feared a second wave of losses reflecting weak economic conditions.
Despite capital injections from governments and/or share issues taking advantage of the recovery in stock prices, bank capital positions remain under pressure from the risk of further losses. For example, the four largest U.S. banks have bad debt reserves of $130 billion (4.3% of loans) and capital of $400 billion against total assets of $7.4 trillion. Difficult to value Level 3 Assets (known as "mark-to-make believe" assets) are estimated at around $346 billion, slightly less than the capital available. The current market fair value of loans for these banks is estimated to be $76 billion below the carrying value.
Banks are likely to remain capital constrained in the near future reducing availability of credit. The capital shortage is estimated at around $1-2 trillion implying a potential contraction of 20-30% from pre-crisis levels. Commercial and consumer loan volumes have declined reflecting a lack of supply but also a lack of demand as companies and individuals reduce leverage.
Constraints on availability of credit and its higher costs are a risk to economic recovery.
Bad Loans …
Further losses are likely from consumer loans, including mortgages. In the U.S. mortgage market, one-in-10 householders are at least one payment behind (Q3 2009), up from one-in-14 (Q3 2008). If foreclosures (now at 4.47 % up from 2.97% one year ago) are included, then one-in-seven mortgagors are in some form of housing distress.
Recent stability in U.S. house prices may be misleading, reflecting the effect of government incentives (the $8,000 first time homebuyer tax credit) and low mortgage rates driven in part by the Fed's mortgage-backed securities (MBS) purchases.
The value of 20-30 % of properties is less than the loan outstanding. Home sales remain modest with around 25-30% of sales of existing homes being foreclosures. Housing inventories also remain high in historic terms. With more adjustable rate mortgages resetting in 2010 and 2011, the risk of further losses on mortgages cannot be discounted unless economic conditions improve.
Rising vacancy rates, falling rentals and declining values of commercial real estate (CRE), primarily office and retail properties, are apparent globally.
In London, Nomura, the Japanese investment bank, secured a 20-year lease of a new office development on the River Thames – the 12-storey Watermark Place – for £40 per square foot. This was over 40% lower than the rents of nearly £70 per square foot demanded prior to the GFC. Nomura will also not pay any rent until 2015. Mark Lethbridge, partner at Drivers Jonas who advised Nomura, told the Financial Times: "… I'm unlikely to see [the terms] again in my career."
Global commercial property lending is around $3.4 trillion, 25% of which has been repackaged into commercial mortgage backed securities ("CMBS"). Current values of many properties are substantially below the loan amounts outstanding. Many CRE loans are in breach of covenants. Lenders have waived breaches of loan conditions and extended maturities. CMBS Delinquencies are currently around 3.5%, expected to peak at an estimated 10-12%.
Leveraged or private equity loans also face difficulties. Terra Firma's £4 billion purchase of EMI, financed in part by a £2.6 billion loan from CitiGroup, is an example of the problems. In the recession, EMI's revenues fell by around 20% and losses tripled as cost savings were offset by higher interest charges. Analyst's estimate that EMI's value is around £1.4 billion, below the level of its debt. In 2009, Terra Firma wrote off half its investment in EMI and offered to inject £1 billion in equity but only if CitiGroup would write off a similar amount of debt. The bank refused. Subsequently, Terra Firma commenced legal proceedings against CitiGroup claiming unspecified punitive damages on top of the £1.5 billion plus write down of its investment.
Many recent private equity loans were cov lite (covenant light); that is, they lacked usual protective covenants requiring borrowers to meet financial tests, typically minimum amount of shareholders funds, loan to equity ratios and minimum coverage of debt and interest payment by the borrower's earnings or cash flow. Some loans, known as 'toggle' loans, included a pay-in-kind (PIK) feature where borrowers have the option to pay interest by issuing an IOU. This means that the lender cannot declare in absence of a failure to make scheduled cash payments default deferring recognition of problems. In the absence of a significant recovery in economic conditions, further losses may occur.
Borrowers face significant refinancing risks. Over the next 5 years over $4.2 trillion of debt will need to be refinanced, including $2.7 trillion of CRE loans (peaking in 2011) and $1.5 trillion of leveraged loans (peaking in 2014).
Securitization (CMBS and CLO (Collateralised Loan Obligation)) markets were crucial in funding CRE and private equity transactions remain troubled. According to one estimate, if the CLO market remains closed and half 2012-14 leveraged loan maturities were refinanced in the high-yield bond markets, then issuance volume would need to be double 2006 peak in high-yield bond issuance to accommodate this requirement. Similarly, the equity injection needed to re-finance commercial real estate debt maturing by 2014 is estimated at between $200-750 billion.
Default and re-financing risk remain high. The problems of Dubai World, in substantial part, relate to commercial property and refinancing risk.
The real economy remains fragile. Government actions, such as fiscal stimulus and special industry support schemes (cash for clunkers; investment incentives, trade credit subsidies), have boosted demand and industrial activity in the short term. As Wells Fargo CEO John Stumpf told The Wall Street Journal on September 19, 2009: "If it's not a government program, it's basically not getting done." Private demand remains somnolent. The problem remains as government incentives encourage current consumption and investment but ultimately "steal" from future demand.
Employment, a key indicator given the importance of consumption in developed economies, continues to decline albeit at a slower pace. In the U.S., unemployment reached 10%. Despite attempts to put positive spin on the numbers, the rise in U.S. unemployment was the highest recorded since World War II.
In many countries, enforced reduction in working hours and taking paid or unpaid leave reduced the rise in unemployment levels significantly. Working hours and personal income have fallen.
Changes in the structure of the labour force also distort the real picture. If workers working part time involuntarily and looking for full time employment are included, the U.S. underemployment figure is in the 16-18% range. Long-term and youth unemployment also remains high.
European economies, especially countries such as Spain, are also experiencing significant unemployment. In some economies, unemployment is a new "export" as guest workers are shipped back to their country of origin or remittances home fell sharply.
U.S. economic activity is not generating the 200,000 to 250,000 jobs per month that would allow unemployment levels to fall. In addition, newly created jobs are part-time, casual or at lower income levels.
Economic uncertainty has increased saving levels further crimping consumption.
In developed countries where an increasing part of the population is nearing retirement age, wealth effects affect consumption behaviours. Low interest rates and reduced dividend levels limit income and expenditure. In the U.S., dividend cuts have resulted in investors losing approximately $58 billion in income in 2009. It is unlikely that dividends will recover to 2007 or 2008 levels until 2012 to 2013. The ability to borrow against rising asset prices to fund consumption is no longer readily available.
In 2009, global trade stabilized after precipitous earlier falls. According to the CPB Netherlands Bureau for Economic Policy Analysis, as of September 2009, world trade was 8.0% above the low of May 2009 but 14% below its peak of April 2008. The OECD reported that G7 exports stabilized in Q2 2009, levelling off at a year-on-year decline of 23.3%. There is concern that trade flows in late 2009 were stagnant or declined as the effects on government stimulus, inventory restocking and Chinese commodity purchases slowed.
Trade protectionism threatens recovery in global trade. Despite repeated statements reaffirming a commitment to free trade, most countries have implemented implicit and explicit trade barriers. Traditional techniques (tariffs, embargoes, subsidies) have been supplemented by "buy local" programs, selective industry support schemes and directed lending to domestic borrowers. Emerging markets have been aggressive in introducing protectionist policies. Trade disputes may increase, particularly if economic recovery stalls and unemployment remains high.
Stock prices assume a rapid recovery in corporate earnings. Beating much reduced expectations and a return to previous earnings levels are easily confused.
The "E" in the P/E ratio remains difficult to forecast. Equity pricing assumes a return to 2006 levels when U.S. corporate earnings represented a record share of profits in GDP.
In 2009, full year earning per share for the S&P 500 were around $60, down from $65 in 2008 and 30% below peak earnings of $85 recorded in 2006. In 2009, company results reflected the effects of aggressive cost cutting and the benefits of government support. To return to pre-crisis levels and rates of growth, improvements in revenue and underlying demand are necessary.
Stocks are also not cheap. Jeremy Grantham, founder of Boston-based fund manager GMO, recently noted ruefully that after 20 years of more or less permanent overpricing of the S&P 500, the market saw just five months of underpricing after the March 2009 trough.
Growth in emerging markets reflects the effect of aggressive government policies to stimulate the economy both at home and in developed countries. Emerging markets, led by China, India and Brazil, implemented anti-cyclical spending programs that in percentage terms were larger than those in developed markets. Emerging markets preserved or introduced social spending programs to protect more vulnerable parts of the population. They also benefited from the government spending in developed economies, which flowed into emerging market exports.
The spending has fueled speculative booms in emerging markets and also in commodity suppliers who now function as proxies for direct exposure to China and India.
The boom was exacerbated by the rapid flow of funds into emerging markets. In 2009, inflows into emerging market equity funds increased to $80.3 billion, well above the $29.5 billion previous record in 2007 and the highest since 1997 when data was first recorded. The inflow compared to outflows of $86 billion from developed world equity funds in 2009 as investors sought exposure to faster growth and better prospects in emerging markets, especially the BRIC (Brazil, Russia, India and China) economies.
The small size of emerging markets accentuated the effect of these inflows, with emerging markets trading at about 20 times their trailing 12-month earnings at the end of 2009, compared to about 8 times at the March 2009.
Potential disappointments in the rate of improvement in developed economies or a reassessment of the prospects of emerging markets remain potential risks during 2010.
Bad Fiscals …
From late 2008 onwards, government intervention, on an unprecedented scale, has been a dominant factor in economic matters.
Governments have spent aggressively, going into or increasing deficits, to increase demand within the economy to offset weak private sector consumption and investment.
Central banks have maintained low interest rates, pumped liquidity into the financial system and "warehoused" toxic assets to support the financial system. In the U.S., Fed holdings of MBS reached around $1 trillion. The purchases provided much needed liquidity to banks and reduced potential write-down on these securities. They also helped keep interest rates low and maintained the supply of housing finance.
The takeover of and government support for Government Sponsored Enterprises (GSE), such as the Federal National Mortgage Association (FNMA or Fannie Mae) and the Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac), was an integral part of the process. The U.S. government has now agreed to provide unlimited support to Fannie and Freddie.
Governments and central banks around the world followed the U.S. lead, implementing similar measures. Even emerging markets introduced aggressive cash transfer and make-work schemes allowing their fiscal positions to deteriorate. Brazil expanded its popular "Bolsa Familia" assistance scheme for poor families. India also expanded a program guaranteeing 100 days public work employment scheme in rural areas.
Financing these initiatives presents significant challenges. In the five quarters ending September 30, 2009, U.S. Treasury borrowing and outstanding GSE-guaranteed MBS increased by $2.8 trillion, a rise of around three times from the level of previous years. The U.K. and European countries increased public debt by similar or higher amounts (in percentage terms).
In 2009, investors readily bought large new issues of government debt, despite relatively low interest rates. Rating agencies maintained sovereign debt ratings, especially for major countries despite deteriorating public finances. Credit default spreads on sovereign debt for most issuers decreased in line with the general fall in credit margins.
Central bank purchases under quantitative easing (read: printing money) programs helped the market absorb the volume of new issuance. According to estimates by Morgan Stanley, Fed asset purchase, quantitative-easing programs and other liquidity support programs reduced private sector net purchases of new Treasury issues to $200 billion in 2009. In 2010, in the absence of continued Fed support, private buyers will have to absorb $2 trillion.
Large deficits are likely for some years. Continued spending and reduced tax income will ensure significant ongoing financing requirements. In the absence of a sharp and significant return of growth, the budgetary position will remain difficult. In many countries, the deficits are structural and not entirely related to the GFC.
Foreign purchases of U.S. debt (the largest single borrower) have increased in dollar terms but decreased as a percentage of the total, as new issuance outpaces growth in demand. If the global economy slows and the inevitable adjustment in global imbalances takes place, the U.S. will purchase fewer foreign goods, reducing foreign current account surpluses and the U.S. dollars available for purchasing future Treasury securities.
Chinese demand, which has underpinned recent foreign purchases, is uncertain in the future. Zhu Min, Deputy Governor of the People's Bank of China, recently observed that "the world does not have so much money to buy more U.S. Treasurys." He added that "the United States cannot force foreign governments to increase their holdings of Treasurys …"
While increasing domestic savings and mandatory purchases by banks may provide some demand, it is not clear where successive large deficits are to be funded. Most deficit nations face similar challenges.
Recently, large investors including Pimco, one of the world's biggest bond fund managers, have reduced exposure to U.S. and U.K. government bonds, warning that the record levels of issuance is becoming increasingly problematic.
Current initiatives mean that public debt in most countries, even many emerging markets, will increase sharply straining fiscal flexibility. For example, Japanese public debt is approaching 200% of GDP and government borrowing now exceeds tax revenues. In emerging markets, many new spending programs may prove difficult to discontinue politically.
The problems of government finances are not confined to national governments. In the U.S., the fiscal problems of major states, some larger than many countries, is well documented.
Ultimately, governments will have to balance the books. With projected public debt as of 2014 at or around 80-100% of GDP (with the dishonourable exception of Japan), the IMF estimates that just to maintain public debt levels, major developed economies will have to run budget surpluses of around 3-4% of GDP.
Ireland, Greece and Spain provide an insight into the actions necessary. In order to restore fiscal stability, the Irish government introduced a special 7% pension levy and implemented the toughest budget in the country's history. Public sector salaries were cut between 5-15%. Unemployment and welfare benefits were also cut. More recently, Greece and Spain proposed austerity programs focused on major spending cuts and tax increases. The impact of such fiscal programs on growth and social harmony is likely to be severe.
Credit rating agencies may downgrade sovereign borrowers. Many major government bond investors, such as central banks, sovereign wealth funds, pension funds and asset managers, have investment mandates that limit them to AAA and AA securities. Central banks typically restrict the use of lower rated government bonds as collateral in repos (repurchase agreements) in secured borrowings. Downgrades below AA may increase the difficulty for some countries to raise debt, particularly international markets.
Lower ratings will increase the cost of borrowing that, in turn, will affect the ability to continue to finance government spending. In particular, the large outstanding stock of government debt means a large portion of the budget will need to be directed to servicing interest further restricting government spending on other initiatives.
The need to maintain the confidence of rating agencies and investors as well as access to markets may ultimately force the required disciplines. As James Carville famously observed: "I want to come back as the bond market. You can intimidate everybody." Politicians everywhere will learn the reality in Thatcher's terms: "You can't buck the markets."
Focus in the short run will be on the PIGS (Portugal, Ireland, Greece, Spain). Net external debt of the PIGS is: Portugal €177 billion (108% of GDP), Ireland has €123 billion(68 % of GDP), Greece is €208 billion (87 % of GDP), Spain is €950 billion (91% of GDP). If the risky debt of Eastern European countries is added, the total amount of debt in question approaches €2 trillion.
In the longer term attention will shift, inevitably, to major economies with high levels of government debt – the FIBS (France, Italy, Britain, States). At least, Japan has its very large pool of domestic savings.
In February 2010, after the U.S. Governments announced budget estimates forecasting large deficits for the foreseeable future, ratings agency Standard and Poors issued the following warning: "The ratios of general government debt to GDP and to revenue are deteriorating sharply, and after the crisis they are likely to be higher than the ratios of other Aaa-rated countries. If the current upward trend in government debt were to continue and become irreversible, the rating could come under downward pressure. The trend and the outlook would be more important than any particular level of debt." The markets ignored this warning with the S&P 500 rallying the dollar remaining largely unchanged.
Bad Policy …
Governments and central banks have dealt with symptoms but not addressed the underlying causes of the GFC.
The need to reduce the overall level of debt in certain economies has not been fully addressed. Public debt has been substituted for private debt.
Despite some regulatory initiatives, many of the excesses of the financial system remain. The reliance of debt fuelled consumption and the related issue of global imbalance remains in the "too difficult basket."
Few, if any, lessons have been learned, especially by bankers. Large bonuses are merely emblematic of a return to old practices. Leverage and pre-crisis lax lending conditions are returning in sections of the market.
Policies assume that the problems relate to temporary liquidity constraints resulting from non-functioning markets for some financial assets. They fail to acknowledge the severity of the problems and the extent to which the previous high prices of some assets reflected excessive liquidity that overstated their true value. Policy makers assume that liberal application of liquidity – financial botox – represents a permanent cure. In Albert Einstein's words: "You can never solve a problem with the thinking that created it."
At best, governments are hoping that loose money will create inflation allowing reflation of asset prices alleviating the worst of the problems. The morality of punishing savers and rewarding excessive borrowing has not been debated.
The reflation hypothesis itself may be flawed. Inflation probably needs convergence of several conditions – excessively loose money supply, active lending by banks to increase the velocity of the money and an imbalance between supply and demand. Loose money supply by itself may not be sufficient to create inflation. In Japan, years of loose monetary policy and quantitative easing have not prevented significant deflation over the last two decades. The other conditions are not currently observable. Problems within the financial system have slowed the velocity of money. Capacity utilisation is generally low and over capacity exists in many industries.
Excess capacity is being increased by government actions. Support for industries, such as the automobile manufacturers, prevents required adjustments to capacity. At the same, government spending, for example in China, is increasing capacity in anticipation of a return of demand. If demand does not re-emerge, then there is a risk that excess capacity may exert deflationary pressures. Further trade problems, through dumping and other defensive trade tactics, may also result.
In the short term, high levels of inflation appear unlikely. Higher energy and food prices have prevented outright deflation in recent times.
These two items represent a high proportion of spending in emerging markets. High energy and food costs reduce available disposable income reducing demand of other products at a time when these economies are trying to increase consumption.
Given that re-risking assumes high inflation, changes in inflationary expectations may affect asset markets and in turn the path of the recovery.
Bad Choices …
The last few decades have seen an economic experiment where increasing levels of debt have been used to promote high growth. This policy had the unintended consequence of increasing risk in the global economy, which was not fully understood by the individual entities taking this risk or regulators and governments.
This experiment is now coming to an end. In the post World War II period, the U.S. and global economy enjoyed strong growth and increasing living standards. Despite higher debt levels, economic growth and improvements in income and wealth have slowed significantly.
For the U.S., the first decade of the 21st century – the noughties – have been disappointing. Economic growth has been the slowest in the post war era. There has been no net job creation over the decade. Median income and in particular income levels for middle income earners declined in real terms. Household net worth, representing the value of their house, pensions and other savings, also declined.
A similar pattern is evident in many developed economies. Emerging countries and their citizens have done better but off lower base levels.
Some of the money, largely borrowed, was invested in assets that produced and will produce little, relative to the prices paid. This includes overpriced housing (the "McMansions"), commercial real estate and consumer "must-haves." Investment in these assets distorted economic activity around the globe. The excesses must be worked-off. The problems are pervasive. Few groups – consumers, businesses, governments – or countries are unaffected.
The real risk is of long-term economic stagnation. A period of low growth, high unemployment or underemployment and overcapacity is possible while individuals, firms and governments repair balance sheets.
Bad Love …
The financial market rally may not be over. There is a chance of a melt-up before any meltdown. Riding an irrational price bubble is sometimes an optimal investment strategy for even rational investors As an unnamed banker told Charles MacKay, author of the 1841 book, "Extraordinary Delusions and the Madness of Crowd" (1841): "When the rest of the world is mad, we must imitate them in some measure."
Governments may introduce provide further support if economic and financial setbacks occur. Further fiscal stimulus packages are likely to be unveiled. Credit Suisse's Neil Soss summed up the monetary policy position succinctly: "Central banks … have maxed out the amount of 'love' they're willing/able to give. … They probably won't take away much, if any, of the "love" they're giving us now in terms of low short-term interest rates and large central bank balance sheets for quite some time, but the change in momentum from 'more love' to 'no incremental love' is palpable and bound to influence markets."
The risk of policy errors is ever present. Inopportune withdrawal of support or policy mistakes has the potential to be destabilising. High levels of volatility are likely to persist.
Governments and central banks continue to inject liberal amounts of botox to cover up problems, at least, while supplies exist. In absence of any definite solutions, policymakers are deferring dealing with the problems, rolling them forward. This means that the unavoidable adjustment when it occurs will be more severe and more painful. The ability of policymakers to cushion the adjustment will be restricted by constrained balance sheets.
In the words of David Bowers of Absolute Strategy Research: "It's the last game of pass the parcel. When the tech bubble burst, balance sheet problems were passed to the household sector [through mortgages]. This time they are being passed to the public sector [through governments' assumption of banks' debts]. There's nobody left to pass it to in the future."
The exact trigger to end the current period of optimism is unpredictable. While several areas of stress are apparent, as Keynes observed: "The inevitable never happens. It is the unexpected always."
The summary of 2009 and the outlook for 2010 may be the logo on a black T-shirt worn by Lisbeth Salander, the heroine of Steig Larsson's "Girl with the Dragon Tatoo": "Armageddon was yesterday – Today we have a serious problem."
Satyajit Das is a risk consultant and author of soon to be released "Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives" – Revised Edition (2010).
Views are as of April 7, 2010, and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security.
S&P 500: An unmanaged capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate value of 500 stocks representing all major industries. Indexes are unmanaged and investments cannot be made in an index.
Gross Domestic Product (GDP) is a broad measure of the economy that measures the retail value of goods and services produced in a country.
Price-earnings multiples (P/E) reflect the ratio of stock prices to per-share common earnings. The lower the number, the lower the price of stocks relative to earnings.
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