The video is a little distracting, so you can just listen first, and then maybe watch the seemingly worthwhile video on South Korea in the 90s.
27 March 2009
The video is a little distracting, so you can just listen first, and then maybe watch the seemingly worthwhile video on South Korea in the 90s.
26 March 2009
There's an "ad" at the beginning for another documentary that's also well worth watching.
Posted by Doug at 9:15 AM
Labels: Bush, Chomsky, Class Warfare, Democracy, Democratic Socialism, Education, Europe, Free Video, Global Warming, Healthcare, History, Infrastructure, Iraq, Israel, Military-Industrial Complex, Neoliberalism, Nuclear Weapons, Obama, Oil, Palestine, Privatization, Propaganda, Psychology, Russia, Social Movements
25 March 2009
In February 2009, economic data across the board revealed an accelerating decline of the U.S. economy, both in its financial and non-financial elements. Gross domestic product (GDP) data for the U.S. economy for the fourth quarter 2008 was revised downward, showing the U.S. economy had contracted by more than 6.2 percent.
Unemployment levels from November 2008 through February 2009 show an official rise in joblessness of nearly two million, according to official U.S. government data. When properly adjusted, however, to include the six million new underemployed since the recession began, plus discouraged and other workers not recorded in the official data, the actual U.S. unemployment has risen by at minimum three million since November. Properly calculated, there are now more than 13 million unemployed in the U.S. By December, the unemployed will very likely exceed 20 million.
Meanwhile, in January-February 2009 the balance sheets of banking and finance giants like Citigroup, Bank of America, AIG, Fannie Mae, and more than 250 regional banks now on the FDIC's official danger list continued to deteriorate badly. As the financial crisis continues to drag on unresolved, a rapidly growing number of once financially sound banks and financial institutions entered the growing ranks of zombies (i.e. banks in name only and not performing the functions of banks in fact), while previous zombies became virtual cadavers—many of the latter are the top 20 largest banks in the U.S.
In an attempt to stabilize the financial decline the Obama administration proposed a four-part recovery program. The first part was the $787 billion fiscal stimulus bill passed in February. Of equal import to the fiscal stimulus package were three proposals to try to stabilize the financial system. These include the so-called PPIF (Public-Private Investment Fund), the TALF (Term Asset Backed Securities Lending Facility), and the HASP (Homeowner Affordability and Stability Plan).
20 Million Jobless vs. $3 Trillion More for Banks
The Obama $787 billion fiscal stimulus bill designed to resurrect the non-financial economy—now in virtual freefall—provides only $180 billion in total spending in 2009. Only $26 billion of that is allocated for job spending, according to the U.S. Congressional Budget Office. New jobs created in 2009, given that level of spending, will be in the low hundred thousands at best, while simultaneously a minimum of five to seven million new unemployed will be added to the jobless rolls in 2009. That's less than a half-million new jobs compared to 13 million new unemployed.
One thing is thus quite clear about the Obama fiscal stimulus plan: it is not designed to create anything near the number of jobs that have been, and will soon be, lost. That key fact means the Obama stimulus package will not appreciably slow the collapse of consumer spending currently underway in the U.S. Job loss is at present the main driver of that collapse, along with other forces previously driving the decline of consumption—collapse of 401k and defined pension plans, freefall in stock and homeowner equity, and sharp reductions in hours and earnings for the 90 million non-supervisory and production workers in the U.S. still with jobs.
Constituting more than 70 percent of the U.S. economy's GDP, consumption has literally fallen off a cliff since October 2008. For the first time in data collecting history, consumption declined absolutely in the U.S. the past year while the index for future consumer spending hit a postwar low at 35 out of 100. Business spending has fared no better. Business plans for capital expenditures show a decline of more than one-third. At the same time, exports and world trade are contracting at the fastest rate in decades.
The $787 billion represents a stop-gap program to try to offset in part the magnitude of consumption collapse, not a spending program to turn around the economy. Fully 38 percent of the stimulus is in the form of aid measures to offset job loss income with unemployment, food stamps, medical costs assistance, and various grants to state and local government. While worthy and necessary, it will not create any jobs. Another 38 percent of the stimulus is targeted for tax cuts, which will have no net effect on consumption. In fact, as many economists now note, the multiplier effect of the tax cuts may actually be negative—that is the tax cuts will produce spending in an amount actually less than the value of the cuts themselves. That leaves only 24 percent remaining for spending on potential jobs projects. Plus, the vast majority of the jobs that might be created will be longer-term, capital-intensive, infrastructure jobs in alternative energy and public works.
Both the magnitude of the direct spending on jobs creation ($26 billion in 2009 and less than $200 billion over the life of the package), as well as the composition of the jobs creation, are grossly deficient. Measured in terms of jobs, consumption, and general economic recovery, the stimulus package represents "too little too late." The likelihood is therefore high that a second stimulus package will be necessary within the next 12 months.
In sharp contrast to the paltry spending for jobs is the virtually unlimited, rapidly disbursed, and open-ended flow of funds now underway from U.S. government coffers to banks and other financial and quasi-financial institutions. This uninhibited flow includes a second $200 billion injection for Fannie Mae/Freddie Mac now that they ran out of the first $200 billion given them last August; another $60 billion for AIG, American Insurance Group, bringing its total to more than $200 billion to date; tens of billions more for Citigroup and Bank of America; hundreds of billions more for brokers of commercial paper and money market funds, for foreign banks holding U.S. securities, for credit card company giants like American Express, for auto companies, plus a long list of others waiting in the wings. The grand total is at least $3 trillion thus far—and rising—disseminated to the banks, the broader financial sector, and beyond. That includes $1 trillion designated to the PPIF for buying banks' bad assets; another $1 trillion to TALF for resurrecting the shadow banking system of hedge funds, private equity firms, and the like (the people who gave us runaway speculation in securitized assets, excess leveraging, and debt run-up, which underlies the continuing collapse of the financial system); and another $275 billion to HASP, which will be used primarily to subsidize mortgage lenders, servicers, and investors.
What follows is an assessment and critique of these three elements of Obama's bank-finance bailout, showing why the bank bailout won't succeed in stabilizing the financial system and why a totally new kind of restructured banking system is required before the real economy halts its accelerating decline.
Public-Private Investment Fund (PPIF)
The PPIF is the inheritor of the failed TARP program launched in September 2008. Then Secretary of the Treasury Paulson panicked Congress into granting him a check worth $700 billion in order to buy the bad assets on the balance sheets of banks. Cleaning up the bad assets was necessary, he argued, in order to get the banks to begin lending again—to homeowners, the mortgage markets, and to general business.
Paulson was given the money and then did nothing about buying bad assets. He instead threw $125 billion at the 9 biggest banks, followed by another roughly $125 billion to scores of regional and smaller banks. Another $80 billion or so went to AIG in several installments. Tens of billions more to Citigroup. Nearly $20 billion to auto companies. Further billions were disbursed here and there, so that by February 2009 less than $190 billion of the $700 billion remained, none of it expended to purchase bad assets.
The reason why it was never used to sop up the bad assets is because Paulson faced the dilemma of buying the assets at their market price, which was virtually worthless. Since the banks were keeping the assets on their books at inflated, above market prices, they had no incentive to sell them at market prices and register even greater losses in doing so. They wanted Paulson to buy them at above market prices. If he did, however, he would be charged with providing a windfall profit to the banks. So he used TARP to purchase preferred stock in the banks, in the hope that it would at least partially close up the black hole on bank balance sheets that was ever-widening as the value of housing prices, mortgage bonds, and other securities continued to collapse. The fall in housing prices was in turn due to the flood of houses coming onto the market as a result of foreclosures.
In other words, pumping money into the banks via TARP addressed the symptom of collapsing balance sheets and not the cause. All the measures of the Treasury and Federal Reserve since the crisis began in 2007 share the common strategic error of throwing liquidity (read: taxpayer money) at the balance sheet hole while ignoring solutions to stop the cause of the hole's constant expansion.
PPIF and Geithner face the same dilemma, namely how to get the banks that are refusing to lend to begin doing so. Geithner's plan is TARP with a twist. The idea is to subsidize the price of the bad assets at government expense, and, by doing so, provide an incentive to both the banks to sell and investors to buy at well above their market price.
Here's how PPIF will work: Geithner will put in what remains of TARP ($190 billion) plus additional money up to $1 trillion (which will likely be expanded eventually well beyond $1 trillion). This trillion will be used to pay the banks the difference between the low market price and whatever the new price might be. In addition, the government will pay the investors another amount at taxpayer expense to entice them to purchase at a price above the market value. An auction-like event will be held. Whatever the seller (banks) and buyer (investors) end up with as a price, the government will subsidize the difference for both. That will, theoretically, establish a new market price at which subsequent assets might be sold.
But how much bad assets are out there that must be sold in order to clean up bank balance sheets? The estimates range from $3.6 trillion according to New York University professor Nouriel Roubini (who has been accurately predicting the crisis for more than a year now) to $4 trillion by Fortune magazine to $6 trillion by Treasury secretary Geithner in a talk he gave in June 2008 before becoming Secretary. So there's at least $2.5 to $5 trillion more that taxpayers may have to fork over to the PPIF before it's over.
The flawed premise of PPIF is that enough investors will enter the market if subsidized to buy such a huge amount of bad assets or that the banks will agree to sell at the auction-determined price or that the U.S. government will be able to throw in $2.5 to $5 trillion more.
Another problem is that the root cause of the bad asset price decline—i.e. the collapsing housing and other asset prices—will still continue despite PPIF. The $2.5 to $5 trillion is what the bad assets are worth at the moment. Those values can potentially fall further, as in fact they have for the past 18 months. Housing prices have fallen by 25 percent to date and may fall at least another 20 percent. Foreclosures are rising, as are delinquencies and defaults. Moreover, they are spreading from subprime to Alt-A to prime mortgage loans and bleeding into the commercial property mortgage markets as well. Homeowners with negative equity will also walk away from properties, throwing more supply on the market and further depressing prices. Then there are the millions more now experiencing unprecedented job loss. They too will add appreciably to the delinquency, default, and foreclosure downward pressures on home prices. Bank assets will continue to erode in value and bad asset totals will rise. The fundamental problem is thus still not addressed, let alone resolved.
This scenario is not unique or unprecedented. The same happened in the 1930s. Housing prices did not stop falling for more than five years into the Depression, until the Roosevelt administration created the Reconstruction Finance Corp (RFC) and revitalized the Home Owners Loan Corp (HOLC) and went into the mortgage market directly. The RFC arbitrarily determined a price and enforced it. It dissolved bad banks and wrote off their worthless assets. It forced mergers with those banks that could be saved. The HOLC then directly renegotiated with homeowners, resetting their interest and principal. That finally stabilized the housing market. It quickly produced an equity/stock market resurgence in 1935-36.
The day after Geithner's PPIF announcement, the press panned the plan and the market fell significantly. The spin in the business press was that the plan was not explained clearly. But the opposite likely occurred. The markets knew full well what the plan represented. They didn't believe investors would sufficiently enter the market to buy enough of the bad assets. This would mean the government would eventually have no alternative except to reluctantly engage in rolling nationalizations of the banking sector. That's why a debate on the meaning of bank nationalization emerged in the general business and political press, which still continues.
TALF As Plan B
Another problem with PPIF is what was the alternative if PPIF did not succeed in cleaning up the bad assets? How much longer and further would Congress and the public support throwing more money down the black hole of bank balance sheets? Enter TALF (Term Asset Backed Securities Lending Facility) as Plan B. TALF is another $1 trillion plan for financial bailouts at taxpayer expense. The idea originated at the Federal Reserve in the closing months of 2008 but was put on hold. Originally funded at $200 billion, Federal Reserve Chair Ben Bernanke held the program back until the Obama administration assumed office.
Unlike PPIF, TALF is envisioned as a plan to resurrect the shadow banking system and the securitized asset markets that collapsed after 2007. Approximately one half of total lending in 2007 ($5.65 trillion) occurred in the securitized markets. This declined to $160 billion in 2008 and to a mere several billion by early 2009.
The shadow banking system, a network of non-bank financial institutions, was responsible for much of the speculation driving the subprime and other asset markets until they busted in the summer of 2007. It is thus ironic that the Fed and Treasury now pursue via TALF the resurrection of those same markets and that same system.
The idea of TALF is to loan $1 trillion or more to the shadow banking system to have its various institutions (hedge funds and private equity in particular) buy up securitized assets that bundle auto loans, credit card loans, student loans, and even commercial property loans. These latter consumer credit markets are about to collapse and in doing so provide a subprime-like magnitude of losses for financial institutions, including banks. Credit card companies, for example, estimate that defaults on payments will rise from around 4 percent in early 2009 to 8-10 percent or more. TALF is designed to prevent the collapse of these securitized asset backed consumer credit markets.
But TALF represents something more significant. It represents the lack of confidence on the part of the Obama administration that the regular banking system can lead a lending recovery and restore financial market stability. The logic of TALF, moreover, is that if the shadow banking system does not rise to the incentive and finance the consumer credit markets, then the Federal Reserve will have to do so itself directly. Should that happen, the Fed will not only evolve from lender of last resort and lender of first resort (since 2007), to lender of primary resort—at least in the consumer credit markets. There is no other alternative. The consumer credit markets cannot be allowed to collapse. To do so would precipitate a bona fide depression given the current weakness of the economy and financial system.
The question is whether the hedge and private equity funds can sufficiently participate. Hedge funds in particular have lost half their value in the past 18 months due to losses and withdrawals. Once a $2 trillion industry it is now barely $1 trillion. Similar declines have characterized the state of the private equity funds. Furthermore, it is hard to see how the securitized asset markets can be revived, given their toxic reputation and the virtual total collapse of these markets.
Should the Fed have to go it alone, that would represent a major shift in banking structure. There is also the possibility that TALF and the Fed would serve as a holding action to buy time for the implementation of a Swedish Model of bank nationalization, such as occurred in that country in the early 1990s when the government took over the banks directly, and then spun them off to private interests again in a kind of capitalist form of nationalization.
HASP—Obama's Housing Recovery Proposal
Obama's housing plan has two parts. The first is another $200 billion funding set aside for Fannie Mae and Freddie Mac. This is a continuation of prior arrangements under the Bush-Paulson period. The two companies were partially nationalized in August 2008 and provided with $200-$300 billion to buy home mortgages. By February 2009 they had run out of those funds, and now another $200 billion is allocated as part of the Obama plan. The problem with Fannie/Freddie, however, is that they own only roughly 26 percent of the $12 trillion residential mortgage market. The major problem with subprime mortgages and foreclosures is occurring totally outside Fannie/Freddie's reach—in the securitized residential mortgage market segment.
Another major problem with this first part of the Obama Housing Plan is that any homeowner that is delinquent, in default, or in foreclosure proceedings is not eligible. Those who need it the most are thus excluded. And if the market value of your home has fallen more than 5 percent below the mortgage owed, forget it. You don't qualify. In other words, Part 1 is a subsidy to the industry, a gimmick to help lenders refinance safe mortgages and thus generate refinancing income for lenders; it is not a program to help homeowners in distress or to stop housing supply continuing to flood the market and depress housing prices.
As of late February, data show that the U.S. home price index has fallen 27 percent from its peak in 2006, for the 30th consecutive month. The last three months show an accelerating rate of decline. Should prices continue to fall at the rate registered between last November and January 2009, it will mean another 33 percent fall in median home prices this coming year, according to data from the National Association of Realtors.
A second part of the Obama housing program would provide a further $75 billion. These funds are committed to subsidizing mortgage lenders to lower their interest rates on new mortgages to 4-4.5 percent on average from current higher market rates at around 5.5 percent. Under Plan 2 loan principal may also be lowered to 31 percent of the homeowners' gross income, but only as a very last resort and for a temporary period of up to five years. And the government will pay (i.e., subsidize) the lenders the difference between the 31 and 38 percent, or 7 percent of the loan for that period. Part 2 may apply to homeowners who are delinquent, but it is still largely a voluntary program dependent on the agreement of lenders. If they are unwilling to modify rates and principals when requested by the homeowner, too bad for the homeowner. While progressive Democrats in Congress are attempting to give bankruptcy judges the power to force lenders to modify loans if they refuse after requested, that legislation has been vigorously blocked so far by industry groups like the American Bankers Association.
Who are the financial institutions that will benefit most from Plan 2? The banks. Two thirds of all the home loans in the U.S. are serviced by Citi, JP Morgan Chase, Bank of America, and Wells Fargo. Once again, we have a subsidy to the same institutions set to benefit from the PPIF. It is another version of trickle down, in which government-taxpayer money is given to companies to entice them to lower rates, which they should be doing on their own in the first place.
Like prior Bush initiatives, the HASP approach is to try to stimulate housing demand and in that way to slow the collapse of housing prices. But the supply of houses coming on to the market is massive, swamping any tepid attempts to put a floor under housing prices via a demand-side approach. Housing supply has been and will continue to overwhelm housing demand, with the consequent decline of housing prices continuing. Thus far no credible approach has been offered to check housing supply and stem price declines. In the end housing price decline can only be contained by a nationalization of residential mortgage markets and a fundamental reset of both interest and principle [sic, principal] for homeowners in stress, much as was done in the 1930s.
Summary and Predictions
The fiscal stimulus side of the Obama program fails to address the central need of massive job creation. It lacks in both magnitude and composition of its focus. A second stimulus package within a year is inevitable.
The bank and finance stability measures of the Obama program are no more likely to succeed. They do not focus on housing asset price collapse directly. PPIF attempts to create a market for bad assets by subsidizing banks and investors at taxpayer expense. That expense will eventually have to exceed the initial $1 trillion by several more trillions using the PPIF approach. Other less costly approaches exist and pursuing the PPIF virtually prevents any real stimulus spending. TALF represents a wild gamble that a revived shadow banking system and a resurrection of the securitized asset markets will somehow be able to prevent the collapse of the consumer credit (auto, student loan, credit cards) and the commercial property markets which will have to refinance more than $170 billion in 2009. This is unlikely to happen, given the declining condition of hedge funds, private equity, and the rest of the shadow banking community.
The cost of all this excess bank rescue spending to the U.S. taxpayer is a minimum of $4 to $5 trillion over the next few years. A recent study by two University of California economists, Alan J. Auerbach and William G. Gale, projects annual deficits of $1 trillion or more for each of the next 10 years. It is highly doubtful the U.S. economy can sustain that kind of deficit spending for that period of time without seriously threatening the U.S. Treasury markets and causing an eventual collapse of the U.S. dollar in world markets.
The U.S. and world economy are on the knife-edge of a transition from an epic recession to a bona fide depression. Any number of several severe events could precipitate this. A series of sovereign debt crises in Europe are a real possibility. A likely scenario is the collapse of one or more east European countries that might pull down, for example, Austrian and then Italian banks and spread thereafter to other banking institutions. Another scenario might be the continued escalation of job loss beyond 20 million in the U.S., TALF failure to rescue consumer credit markets, a collapse of the Treasuries markets, and the like. Another precipitating scenario might be the global collapse of bond markets, in particular investment grade bonds, or a severe crisis in the credit default swaps market globally as well. There are, of course, other potentially serious scenarios that might serve as precipitating events.
A new, alternative plan will have to be proposed and implemented before the end of 2009. That effort now moves to the battle lines being drawn over the Obama budget. The Obama administration will have to get much bolder and aggressive, as its enemies on the right, in corporate boardrooms, and among evangelical interests are now gathering forces. It will be interesting to see whether the Obama team can make the transition from a vision that is much like 1993 to one that is more like 1933.
Jack Rasmus's forthcoming book is Epic Recession And Global Financial Crisis (Pluto Press). His articles, speeches, and interviews are available at www.kyklosproductions.com
AIG and the Big Takeover: Matt Taibbi on “How Wall Street Insiders Are Using the Bailout to Stage a Revolution”
See also Taibbi's article: The Big Takeover (Rolling Stone)
Excellent lecture on historiography.
24 March 2009
No Return to Normal:Why the economic crisis, and its solution, are bigger than you think. James Galbraith
Here's a video version; more below:
Barack Obama’s presidency began in hope and goodwill, but its test will be its success or failure on the economics. Did the president and his team correctly diagnose the problem? Did they act with sufficient imagination and force? And did they prevail against the political obstacles—and not only that, but also against the procedures and the habits of thought to which official Washington is addicted?
The president has an economic program. But there is, so far, no clear statement of the thinking behind that program, and there may not be one, until the first report of the new Council of Economic Advisers appears next year. We therefore resort to what we know about the economists: the chair of the National Economic Council, Lawrence Summers; the CEA chair, Christina Romer; the budget director, Peter Orszag; and their titular head, Treasury Secretary Timothy Geithner. This is plainly a capable, close-knit group, acting with energy and commitment. Deficiencies of their program cannot, therefore, be blamed on incompetence. Rather, if deficiencies exist, they probably result from their shared background and creed—in short, from the limitations of their ideas.
The deepest belief of the modern economist is that the economy is a self-stabilizing system. This means that, even if nothing is done, normal rates of employment and production will someday return. Practically all modern economists believe this, often without thinking much about it. (Federal Reserve Chairman Ben Bernanke said it reflexively in a major speech in London in January: "The global economy will recover." He did not say how he knew.) The difference between conservatives and liberals is over whether policy can usefully speed things up. Conservatives say no, liberals say yes, and on this point Obama’s economists lean left. Hence the priority they gave, in their first days, to the stimulus package.
But did they get the scale right? Was the plan big enough? Policies are based on models; in a slump, plans for spending depend on a forecast of how deep and long the slump would otherwise be. The program will only be correctly sized if the forecast is accurate. And the forecast depends on the underlying belief. If recovery is not built into the genes of the system, then the forecast will be too optimistic, and the stimulus based on it will be too small.
Consider the baseline economic forecast of the Congressional Budget Office, the nonpartisan agency lawmakers rely on to evaluate the economy and their budget plans. In its early-January forecast, the CBO measured and projected the difference between actual economic performance and "normal" economic performance—the so-called GDP gap. The forecast has two astonishing features. First, the CBO did not expect the present recession to be any worse than that of 1981–82, our deepest postwar recession. Second, the CBO expected a turnaround beginning late this year, with the economy returning to normal around 2015, even if Congress had taken no action at all.
With this projection in mind, the recovery bill pours a bit less than 2 percent of GDP into new spending per year, plus some tax cuts, for two years, into a GDP gap estimated to average 6 percent for three years. The stimulus does not need to fill the whole gap, because the CBO expects a "multiplier effect," as first-round spending on bridges and roads, for example, is followed by second-round spending by steelworkers and road crews. The CBO estimates that because of the multiplier effect, two dollars of new public spending produces about three dollars of new output. (For tax cuts the numbers are lower, since some of the cuts will be saved in the first round.) And with this help, the recession becomes fairly mild. After two years, growth would be solidly established and Congress’s work would be done. In this way, the duration as well as the scale of action was driven, behind the scenes, by the CBO’s baseline forecast.
Why did the CBO reach this conclusion? On depth, CBO’s model is based on the postwar experience, and such models cannot predict outcomes more serious than anything already seen. If we are facing a downturn worse than 1982, our computers won’t tell us; we will be surprised. And if the slump is destined to drag on, the computers won’t tell us that either. Baked into the CBO model we find a "natural rate of unemployment" of 4.8 percent; the model moves the economy back toward that value no matter what. In the real world, however, there is no reason to believe this will happen. Some alternative forecasts, freed of the mystical return to "normal," now project a GDP gap twice as large as the CBO model predicts, and with no near-term recovery at all.
Considerations of timing also influenced the choice of line items. The bill tilted toward "shovel-ready" projects like refurbishing schools and fixing roads, and away from projects requiring planning and long construction lead times, like urban mass transit. The push for speed also influenced the bill in another way. Drafting new legislative authority takes time. In an emergency, it was sensible for Chairman David Obey of the House Appropriations Committee to mine the legislative docket for ideas already commanding broad support (especially within the Democratic caucus). In this way he produced a bill that was a triumph of fast drafting, practical politics, and progressive principle—a good bill which the Republicans hated. But the scale of action possible by such means is unrelated, except by coincidence, to what the economy needs.
Three further considerations limited the plan. There was, to begin with, the desire for political consensus; President Obama chose to start his administration with a bill that might win bipartisan support and pass in Congress by wide margins. (He was, of course, spurned by the Republicans.) Second, the new team also sought consensus of another type. Christina Romer polled a bipartisan group of professional economists, and Larry Summers told Meet the Press that the final package reflected a "balance" of their views. This procedure guarantees a result near the middle of the professional mind-set. The method would be useful if the errors of economists were unsystematic. But they are not. Economists are a cautious group, and in any extreme situation the midpoint of professional opinion is bound to be wrong.
Third, the initial package was affected by the new team’s desire to get past this crisis and to return to the familiar problems of their past lives. For these protégés of Robert Rubin, veterans in several cases of Rubin’s Hamilton Project, a key preconception has always been the budget deficit and what they call the "entitlement problem." This is D.C.-speak for rolling back Social Security and Medicare, opening new markets for fund managers and private insurers, behind a wave of budget babble about "long-term deficits" and "unfunded liabilities." To this our new president is not immune. Even before the inauguration Obama was moved to commit to "entitlement reform," and on February 23 he convened what he called a "fiscal responsibility summit." The idea took hold that after two years or so of big spending, the return to normal would be under way, and the costs of fiscal relief and infrastructure improvement might be recouped, in part by taking a pound of flesh from the incomes and health care of the old.
The chance of a return to normal depends, in turn, on the banking strategy. To Obama’s economists a "normal" economy is led and guided by private banks. When domestic credit booms are under way, they tend to generate high employment and low inflation; this makes the public budget look good, and spares the president and Congress many hard decisions. For this reason the new team instinctively seeks to return the bankers to their normal position at the top of the economic hill. Secretary Geithner told CNBC, "We have a financial system that is run by private shareholders, managed by private institutions, and we’d like to do our best to preserve that system."
But, is this a realistic hope? Is it even a possibility? The normal mechanics of a credit cycle do involve interludes when asset values crash and credit relations collapse. In 1981, Paul Volcker’s campaign against inflation caused such a crash. But, though they came close, the big banks did not fail then. (I learned recently from William Isaac, Ronald Reagan’s chair of the FDIC, that the government had contingency plans to nationalize the large banks in 1982, had Mexico, Argentina, or Brazil defaulted outright on their debts.) When monetary policy relaxed and the delayed tax cuts of 1981 kicked in, there was both pent-up demand for credit and the capacity to supply it. The final result was that the economy recovered quickly. Again in 1994, after a long period of credit crunch, banks and households were strong enough, even without a stimulus, to support a vast renewal of lending which propelled the economy forward for six years.
The Bush-era disasters guarantee that these happy patterns will not be repeated. For the first time since the 1930s, millions of American households are financially ruined. Families that two years ago enjoyed wealth in stocks and in their homes now have neither. Their 401(k)s have fallen by half, their mortgages are a burden, and their homes are an albatross. For many the best strategy is to mail the keys to the bank. This practically assures that excess supply and collapsed prices in housing will continue for years. Apart from cash—protected by deposit insurance and now desperately being conserved—the American middle class finds today that its major source of wealth is the implicit value of Social Security and Medicare—illiquid and intangible but real and inalienable in a way that home and equity values are not. And so it will remain, as long as future benefits are not cut.
In addition, some of the biggest banks are bust, almost for certain. Having abandoned prudent risk management in a climate of regulatory negligence and complicity under Bush, these banks participated gleefully in a poisonous game of abusive mortgage originations followed by rounds of pass-the-bad-penny-to-the-greater-fool. But they could not pass them all. And when in August 2007 the music stopped, banks discovered that the markets for their toxic-mortgage-backed securities had collapsed, and found themselves insolvent. Only a dogged political refusal to admit this has since kept the banks from being taken into receivership by the Federal Deposit Insurance Corporation—something the FDIC has the power to do, and has done as recently as last year with IndyMac in California.
Geithner’s banking plan would prolong the state of denial. It involves government guarantees of the bad assets, keeping current management in place and attempting to attract new private capital. (Conversion of preferred shares to equity, which may happen with Citigroup, conveys no powers that the government, as regulator, does not already have.) The idea is that one can fix the banks from the top down, by reestablishing markets for their bad securities. If the idea seems familiar, it is: Henry Paulson also pressed for this, to the point of winning congressional approval. But then he abandoned the idea. Why? He learned it could not work.
Paulson faced two insuperable problems. One was quantity: there were too many bad assets. The project of buying them back could be likened to "filling the Pacific Ocean with basketballs," as one observer said to me at the time. (When I tried to find out where the original request for $700 billion in the Troubled Asset Relief Program came from, a senior Senate aide replied, "Well, it’s a number between five hundred billion and one trillion.")
The other problem was price. The only price at which the assets could be disposed of, protecting the taxpayer, was of course the market price. In the collapse of the market for mortgage-backed securities and their associated credit default swaps, this price was too low to save the banks. But any higher price would have amounted to a gift of public funds, justifiable only if there was a good chance that the assets might recover value when "normal" conditions return.
That chance can be assessed, of course, only by doing what any reasonable private investor would do: due diligence, meaning a close inspection of the loan tapes. On the face of it, such inspections will reveal a very high proportion of missing documentation, inflated appraisals, and other evidence of fraud. (In late 2007 the ratings agency Fitch conducted this exercise on a small sample of loan files, and found indications of misrepresentation or fraud present in practically every one.) The reasonable inference would be that many more of the loans will default. Geithner’s plan to guarantee these so-called assets, therefore, is almost sure to overstate their value; it is only a way of delaying the ultimate public recognition of loss, while keeping the perpetrators afloat.
Delay is not innocuous. When a bank’s insolvency is ignored, the incentives for normal prudent banking collapse. Management has nothing to lose. It may take big new risks, in volatile markets like commodities, in the hope of salvation before the regulators close in. Or it may loot the institution—nomenklatura privatization, as the Russians would say—through unjustified bonuses, dividends, and options. It will never fully disclose the extent of insolvency on its own.
The most likely scenario, should the Geithner plan go through, is a combination of looting, fraud, and a renewed speculation in volatile commodity markets such as oil. Ultimately the losses fall on the public anyway, since deposits are largely insured. There is no chance that the banks will simply resume normal long-term lending. To whom would they lend? For what? Against what collateral? And if banks are recapitalized without changing their management, why should we expect them to change the behavior that caused the insolvency in the first place?
The oddest thing about the Geithner program is its failure to act as though the financial crisis is a true crisis—an integrated, long-term economic threat—rather than merely a couple of related but temporary problems, one in banking and the other in jobs. In banking, the dominant metaphor is of plumbing: there is a blockage to be cleared. Take a plunger to the toxic assets, it is said, and credit conditions will return to normal. This, then, will make the recession essentially normal, validating the stimulus package. Solve these two problems, and the crisis will end. That’s the thinking.
But the plumbing metaphor is misleading. Credit is not a flow. It is not something that can be forced downstream by clearing a pipe. Credit is a contract. It requires a borrower as well as a lender, a customer as well as a bank. And the borrower must meet two conditions. One is creditworthiness, meaning a secure income and, usually, a house with equity in it. Asset prices therefore matter. With a chronic oversupply of houses, prices fall, collateral disappears, and even if borrowers are willing they can’t qualify for loans. The other requirement is a willingness to borrow, motivated by what Keynes called the "animal spirits" of entrepreneurial enthusiasm. In a slump, such optimism is scarce. Even if people have collateral, they want the security of cash. And it is precisely because they want cash that they will not deplete their reserves by plunking down a payment on a new car.
The credit flow metaphor implies that people came flocking to the new-car showrooms last November and were turned away because there were no loans to be had. This is not true—what happened was that people stopped coming in. And they stopped coming in because, suddenly, they felt poor.
Strapped and afraid, people want to be in cash. This is what economists call the liquidity trap. And it gets worse: in these conditions, the normal estimates for multipliers—the bang for the buck—may be too high. Government spending on goods and services always increases total spending directly; a dollar of public spending is a dollar of GDP. But if the workers simply save their extra income, or use it to pay debt, that’s the end of the line: there is no further effect. For tax cuts (especially for the middle class and up), the new funds are mostly saved or used to pay down debt. Debt reduction may help lay a foundation for better times later on, but it doesn’t help now. With smaller multipliers, the public spending package would need to be even larger, in order to fill in all the holes in total demand. Thus financial crisis makes the real crisis worse, and the failure of the bank plan practically assures that the stimulus also will be too small.
In short, if we are in a true collapse of finance, our models will not serve. It is then appropriate to reach back, past the postwar years, to the experience of the Great Depression. And this can only be done by qualitative and historical analysis. Our modern numerical models just don’t capture the key feature of that crisis—which is, precisely, the collapse of the financial system.
If the banking system is crippled, then to be effective the public sector must do much, much more. How much more? By how much can spending be raised in a real depression? And does this remedy work? Recent months have seen much debate over the economic effects of the New Deal, and much repetition of the commonplace that the effort was too small to end the Great Depression, something achieved, it is said, only by World War II. A new paper by the economist Marshall Auerback has usefully corrected this record. Auerback plainly illustrates by how much Roosevelt’s ambition exceeded anything yet seen in this crisis:
[Roosevelt’s] government hired about 60 per cent of the unemployed in public works and conservation projects that planted a billion trees, saved the whooping crane, modernized rural America, and built such diverse projects as the Cathedral of Learning in Pittsburgh, the Montana state capitol, much of the Chicago lakefront, New York’s Lincoln Tunnel and Triborough Bridge complex, the Tennessee Valley Authority and the aircraft carriers Enterprise and Yorktown. It also built or renovated 2,500 hospitals, 45,000 schools, 13,000 parks and playgrounds, 7,800 bridges, 700,000 miles of roads, and a thousand airfields. And it employed 50,000 teachers, rebuilt the country’s entire rural school system, and hired 3,000 writers, musicians, sculptors and painters, including Willem de Kooning and Jackson Pollock.In other words, Roosevelt employed Americans on a vast scale, bringing the unemployment rates down to levels that were tolerable, even before the war—from 25 percent in 1933 to below 10 percent in 1936, if you count those employed by the government as employed, which they surely were. In 1937, Roosevelt tried to balance the budget, the economy relapsed again, and in 1938 the New Deal was relaunched. This again brought unemployment down to about 10 percent, still before the war.
The New Deal rebuilt America physically, providing a foundation (the TVA’s power plants, for example) from which the mobilization of World War II could be launched. But it also saved the country politically and morally, providing jobs, hope, and confidence that in the end democracy was worth preserving. There were many, in the 1930s, who did not think so.
What did not recover, under Roosevelt, was the private banking system. Borrowing and lending—mortgages and home construction—contributed far less to the growth of output in the 1930s and ’40s than they had in the 1920s or would come to do after the war. If they had savings at all, people stayed in Treasuries, and despite huge deficits interest rates for federal debt remained near zero. The liquidity trap wasn’t overcome until the war ended.
It was the war, and only the war, that restored (or, more accurately, created for the first time) the financial wealth of the American middle class. During the 1930s public spending was large, but the incomes earned were spent. And while that spending increased consumption, it did not jumpstart a cycle of investment and growth, because the idle factories left over from the 1920s were quite sufficient to meet the demand for new output. Only after 1940 did total demand outstrip the economy’s capacity to produce civilian private goods—in part because private incomes soared, in part because the government ordered the production of some products, like cars, to halt.
All that extra demand would normally have driven up prices. But the federal government prevented this with price controls. (Disclosure: this writer’s father, John Kenneth Galbraith, ran the controls during the first year of the war.) And so, with nowhere else for their extra dollars to go, the public bought and held government bonds. These provided claims to postwar purchasing power. After the war, the existence of those claims could, and did, establish creditworthiness for millions, making possible the revival of private banking, and on the broadly based, middle-class foundation that so distinguished the 1950s from the 1920s. But the relaunching of private finance took twenty years, and the war besides.
A brief reflection on this history and present circumstances drives a plain conclusion: the full restoration of private credit will take a long time. It will follow, not precede, the restoration of sound private household finances. There is no way the project of resurrecting the economy by stuffing the banks with cash will work. Effective policy can only work the other way around.
That being so, what must now be done? The first thing we need, in the wake of the recovery bill, is more recovery bills. The next efforts should be larger, reflecting the true scale of the emergency. There should be open-ended support for state and local governments, public utilities, transit authorities, public hospitals, schools, and universities for the duration, and generous support for public capital investment in the short and long term. To the extent possible, all the resources being released from the private residential and commercial construction industries should be absorbed into public building projects. There should be comprehensive foreclosure relief, through a moratorium followed by restructuring or by conversion-to-rental, except in cases of speculative investment and borrower fraud. The president’s foreclosure-prevention plan is a useful step to relieve mortgage burdens on at-risk households, but it will not stop the downward spiral of home prices and correct the chronic oversupply of housing that is the cause of that.
Second, we should offset the violent drop in the wealth of the elderly population as a whole. The squeeze on the elderly has been little noted so far, but it hits in three separate ways: through the fall in the stock market; through the collapse of home values; and through the drop in interest rates, which reduces interest income on accumulated cash. For an increasing number of the elderly, Social Security and Medicare wealth are all they have.
That means that the entitlement reformers have it backward: instead of cutting Social Security benefits, we should increase them, especially for those at the bottom of the benefit scale. Indeed, in this crisis, precisely because it is universal and efficient, Social Security is an economic recovery ace in the hole. Increasing benefits is a simple, direct, progressive, and highly efficient way to prevent poverty and sustain purchasing power for this vulnerable population. I would also argue for lowering the age of eligibility for Medicare to (say) fifty-five, to permit workers to retire earlier and to free firms from the burden of managing health plans for older workers.
This suggestion is meant, in part, to call attention to the madness of talk about Social Security and Medicare cuts. The prospect of future cuts in this modest but vital source of retirement security can only prompt worried prime-age workers to spend less and save more today. And that will make the present economic crisis deeper. In reality, there is no Social Security "financing problem" at all. There is a health care problem, but that can be dealt with only by deciding what health services to provide, and how to pay for them, for the whole population. It cannot be dealt with, responsibly or ethically, by cutting care for the old.
Third, we will soon need a jobs program to put the unemployed to work quickly. Infrastructure spending can help, but major building projects can take years to gear up, and they can, for the most part, provide jobs only for those who have the requisite skills. So the federal government should sponsor projects that employ people to do what they do best, including art, letters, drama, dance, music, scientific research, teaching, conservation, and the nonprofit sector, including community organizing—why not?
Finally, a payroll tax holiday would help restore the purchasing power of working families, as well as make it easier for employers to keep them on the payroll. This is a particularly potent suggestion, because it is large and immediate. And if growth resumes rapidly, it can also be scaled back. There is no error in doing too much that cannot easily be repaired, by doing a bit less.
As these measures take effect, the government must take control of insolvent banks, however large, and get on with the business of reorganizing, re-regulating, decapitating, and recapitalizing them. Depositors should be insured fully to prevent runs, and private risk capital (common and preferred equity and subordinated debt) should take the first loss. Effective compensation limits should be enforced—it is a good thing that they will encourage those at the top to retire. As Senator Christopher Dodd of Connecticut correctly stated in the brouhaha following the discovery that Senate Democrats had put tough limits into the recovery bill, there are many competent replacements for those who leave.
Ultimately the big banks can be resold as smaller private institutions, run on a scale that permits prudent credit assessment and risk management by people close enough to their client communities to foster an effective revival, among other things, of household credit and of independent small business—another lost hallmark of the 1950s. No one should imagine that the swaggering, bank-driven world of high finance and credit bubbles should be made to reappear. Big banks should be run largely by men and women with the long-term perspective, outlook, and temperament of middle managers, and not by the transient, self-regarding plutocrats who run them now.
The chorus of deficit hawks and entitlement reformers are certain to regard this program with horror. What about the deficit? What about the debt? These questions are unavoidable, so let’s answer them. First, the deficit and the public debt of the U.S. government can, should, must, and will increase in this crisis. They will increase whether the government acts or not. The choice is between an active program, running up debt while creating jobs and rebuilding America, or a passive program, running up debt because revenues collapse, because the population has to be maintained on the dole, and because the Treasury wishes, for no constructive reason, to rescue the big bankers and make them whole.
Second, so long as the economy is placed on a path to recovery, even a massive increase in public debt poses no risk that the U.S. government will find itself in the sort of situation known to Argentines and Indonesians. Why not? Because the rest of the world recognizes that the United States performs certain indispensable functions, including acting as the lynchpin of collective security and a principal source of new science and technology. So long as we meet those responsibilities, the rest of the world is likely to want to hold our debts.
Third, in the debt deflation, liquidity trap, and global crisis we are in, there is no risk of even a massive program generating inflation or higher long-term interest rates. That much is obvious from current financial conditions: interest rates on long-maturity Treasury bonds are amazingly low. Those rates also tell you that the markets are not worried about financing Social Security or Medicare. They are more worried, as I am, that the larger economic outlook will remain very bleak for a long time.
Finally, there is the big problem: How to recapitalize the household sector? How to restore the security and prosperity they’ve lost? How to build the productive economy for the next generation? Is there anything today that we might do that can compare with the transformation of World War II? Almost surely, there is not: World War II doubled production in five years.
Today the largest problems we face are energy security and climate change—massive issues because energy underpins everything we do, and because climate change threatens the survival of civilization. And here, obviously, we need a comprehensive national effort. Such a thing, if done right, combining planning and markets, could add 5 or even 10 percent of GDP to net investment. That’s not the scale of wartime mobilization. But it probably could return the country to full employment and keep it there, for years.
Moreover, the work does resemble wartime mobilization in important financial respects. Weatherization, conservation, mass transit, renewable power, and the smart grid are public investments. As with the armaments in World War II, work on them would generate incomes not matched by the new production of consumer goods. If handled carefully—say, with a new program of deferred claims to future purchasing power like war bonds—the incomes earned by dealing with oil security and climate change have the potential to become a foundation of restored financial wealth for the middle class.
This cannot be made to happen over just three years, as we did in 1942–44. But we could manage it over, say, twenty years or a bit longer. What is required are careful, sustained planning, consistent policy, and the recognition now that there are no quick fixes, no easy return to "normal," no going back to a world run by bankers—and no alternative to taking the long view.
A paradox of the long view is that the time to embrace it is right now. We need to start down that path before disastrous policy errors, including fatal banker bailouts and cuts in Social Security and Medicare, are put into effect. It is therefore especially important that thought and learning move quickly. Does the Geithner team, forged and trained in normal times, have the range and the flexibility required? If not, everything finally will depend, as it did with Roosevelt, on the imagination and character of President Obama.
James K. Galbraith’s new book is The Predator State: How Conservatives Abandoned the Free Market and Why Liberals Should Too. He holds the Lloyd M. Bentsen Jr. Chair in Government/Business Relations at the LBJ School of Public Affairs, University of Texas at Austin, and is senior scholar with the Levy Economics Institute.