by Bill Barclay
[This article from Chicago DSA’s New Ground was written before the dizzying recent Federal actions on Freddie and Fannie Mac, Lehman Bros and AIG. The analysis and program is more relevant than ever.-TU]
On October 9th, 2007, the Dow Jones Industrial Average and the S&P 500 both closed at new all time highs. By late January 2008, both had lost more than 10% of their value and investors worried about a developing bear market. In the intervening three months the outlook the U.S. economy went positive to negative. In November and December 2007, the auction rate securities market, used by tax exempt borrowers such as hospitals, collapsed with no bids; on Dec 12th, the Fed announced the creation of by the Term Auction Facility which allowed banks to borrow anonymously for 28 days using a wide range of collateral to meet their pressing liquidity needs and stave off possible bank runs; in March, 2008, the Fed orchestrated the acquisition for Bear Sterns by J.P. Morgan Chase for $10/share, down more than 90% from the previous year’s high (Bear was the only major investment bank that refused Fed pressure to assist in the bailout of Long Term Capital Management in the 1990s); and, in that same month the U.S. Congress agreed to a “stimulus package” of $150 billion. At the same time the rest of the world began to realize that the 2007 2008 financial crisis was not restricted to the U.S. So much for the stock market as a leading economic indicator, a status it achieved under Alan Greenspan’s tenure at the Federal Reserve.
What happened? And why? And what should progressives be saying and proposing in response to what is now widely acknowledged as an economic downturn of potentially major significance? This article argues (i) that the economic problems the U.S. now faces are long term and not readily amenable to the usual policy fixes; (ii) that the crisis is rooted in a convergence of three trends, two long-term and one more immediate; and (iii) that there are important policy ideas that progressives should be proposing, although their adoption will occur only as the result of political struggle and pressure.
The Crisis: How Serious Is It?
The sense of an economic threat is relatively new, even among those who might be thought to be attuned this kind of issue. At the 2007 Take Back America Conference , the War in Iraq was seen as by far the most important political issue, chosen by over 30% of the attendees with the economy listed as the number one issue by only 13% of the attendees. By the March 2008 Conference, this had changed: the economy was now listed by 30% of the attendees as the number one issue facing the country. Still, the presidential campaigns, both Democratic and Republican, were slow to focus on the economy and, when they did, the attention was often dismissive as in the famous claim by Phil Gram, McCain’s chief economic advisor, that the recession was largely a mental one and that to focus on this issue was catering a nation of whiners.
So, how serious is it? First, when people talk about a financial crisis in contrast to a crisis in the real economy, they are referencing the economy we once had, not the economy we have now. As late as the 1970s, manufacturing accounted for a larger portion of the GDP than did services but that is no longer true. By 2005, finance in all its forms (banking, insurance, mortgage brokers, etc.) represented approximately 25% of total economic production in the U.S. A crisis in an industry that accounts for one quarter of GDP is a crisis in the “real economy.” Of course, finance is linked in myriad ways to the rest of the economy. One simple equation: the housing sector, consisting of mortgage lenders, construction, furnishings and related industries, accounted for a similar quarter of US output.
Second, it is clear that the crisis is not and will not be restricted to the financial sector. One in ten homeowners is or will be facing the threat of foreclosure over the next two years a level not seen since 1933. Defaults on corporate debt are rising with the second quarter of 2008 being the tenth consecutive quarter of increasing business bankruptcies. U.S. automakers are on the ropes as demand drops for their large, energy intensive vehicles. The companies (they used to be called the Big Three) are asking for a federal bailout of $25 billion and saying they may not survive in the absence of such assistance. Retail stores are already cutting back on sales staff and nationwide the unemployment rate rose to 6.1% in August, the eighth consecutive month with a decline in jobs. Today is not like the Fed’s rescue of CitiBank via Saudi investment in 1981 1982, the assistance the same entity gave to junk bonds holders and issuers by lowering interest rates in the early 1990s, or even the scale of assistance necessary to clean up the Savings and Loan fiasco of the late 1980s / early 1990s.
Third, today’s economic problems come at the end of a long period of global credit expansion and deregulation, placing constraints on the available policy alternatives. While we can learn from the New Deal, the national and global economic environment and the U.S. relationship and role in the today’s global economic system is quite different. We will not be able simply to copy New Deal programs.
There are, I think, three primary causes. These causes intermesh in a variety of ways but each presents distinct problems and each needs specific policy responses. These causes are (i) the long term trend towards economic inequality in the U.S.; (ii) the credit expansion / contraction and debt cycle, primarily driven by housing; and (iii) the role and value of the dollar in the international economy, with particular emphasis on the trade in oil.
Growth in Economic Inequality
The long term trend towards increasing economic inequality in the U.S. has been documented so many times that even conservatives have acknowledged its reality. It is hard to come up with fresh ways to demonstrate the extremes of economic inequality, but perhaps the following may serve to remind us both how recent this trend is and the extremes to which we have gone. First, from 1945 to the mid 1980s, the median family income for all U.S. families increased faster than that for the top 10%, 5% and 1% by income families. Since the mid 1980s, the exact opposite has occurred with the median family income declining for all groups except the top 5% and 1%. Between 2001 2006 the top 15,000 families, .01% of all families, captured 25% of total family income growth in the U.S while the bottom 90% grabbed only 4%. As to the extreme to which we have taken this trend, consider the following. If workers’ salaries had increased as rapidly as those of the CEOs of the largest corporations, the average workers’ salary would now be over $200,000/year.
What has been less commented upon is the significance of this growing inequality for the political economy. First, the growing concentration of income and wealth constrains the consumption (purchasing power) of the population as a whole. Savings rates dropped consistently over the past quarter century, actually turning negative in some recent years, as families tried to keep up with the American standard of consumption. But consumption was not, of course, simply financed by drawing down or foregoing savings. Don’t have the cash? Put it on plastic. Use of credit cards to finance current consumption was not, of course, a new development. As far back as 1977, Time Magazine had observed that “insistence on buying only what can be paid for in cash seems as outmoded as a crew cut.” However, the growth of consumer debt escalated in the past quarter century and is roughly equal to total U.S. GDP and is larger than the often cited government debt.
Second, the increased concentration of income and wealth reshapes the political terrain. The cost of political campaigns has increased sharply in part because of the possibility of raising more money from people who literally have more than they know what to do with. The importance of large donors has in turn increased because there is an increased need for money. Thus the impact and influence of larger donors eclipsed that of competing institutions such as labor, civic and community groups.
But the political use of concentrated income and wealth has not been restricted to the financing of campaigns. In fact its more significant impact has probably been in the reshaping of the universe of political discourse. Wealthy individuals and families have turned to founding and funding “research” institutes and think tanks. And the bias of these institutions is towards a system that has made their benefactors well off on a scale never seen before. Even as I write, there are proposals to found a Milton Friedman Institute at the University of Chicago with an initial target level of $200 million. It is very unlikely that the studies emanating from such an institute will find fundamental flaws in the functioning of markets or produce arguments for government intervention in the same.
Debt Financial Deregulation and Credit Expansion
What is the debt problem facing the U.S? Despite highly publicized, ideologically driven lamentations about government debt such as those put forth in the propaganda film I.O.U.S.A., it is not the debt of governments, whether federal, state or local that threatens the U.S. economy. Rather, it is private and corporate debt that poses the greatest risks and that has brought us to the current crisis. Credit card debt has been of concern for some time. However, credit card debt is far from the only source of debt financing of consumption and in fact is now a smaller percentage of total consumer debt than two decades ago. Its place has been taken by mortgage debt. It is the housing sector that defines the specific nature of this economic downturn and is the major reason why the outcome is likely to be so difficult to control. From the early 1980s to the mid 1990s housing prices rose more or less in line with general inflation levels. However, that changed dramatically in later 1990s and the first 5 6 years of the 2000s. In the decade 1995 2005, housing prices increased by 30% above inflation. Homes, our primary residence, also became our savings vehicle and our bank accounts.
Certainly home ownership is good, at least for most people, as recognized in the Bush mantra of the “ownership society.” So how did access to home ownership and rising house prices get us into so much trouble? There are at least three reasons for the mortgage and foreclosure crisis we face today. First, the banking model changed from a traditional, relatively conservative set of practices to an originate and distribute model. Second, as the housing boom continued while incomes lagged for the majority of the population, the standards on which mortgages were based deteriorated. Third, and perhaps most important for the individual home buyer, rising prices allowed the buyer to borrow against the appreciating value of the home.
The 1999 repeal of Glass-Steagel allowed financial institutions such as CitiGroup or J.P. Morgan Chase to combine banking, insurance and real estate for the first time since the 1930s removing the walls that the Act created. Repeal was also the impetus for changing the mortgage lending business model and allowed almost anyone to enter the mortgage lending business. Prior to repeal, mortgage banking was largely a business of making loans and managing the resulting portfolio of loans. Banks (and other mortgage brokers) made loans to home buyers based on their income and assets and then earned the interest on the loan. If the borrower was unable to make timely payments, it was the lending bank who bore the financial risk and whose profitability was threatened. This risk meant that banks had an incentive to inquire into the financial resources of the borrower and to determine that that the borrower was a good risk for the life of the loan (since the 1930s, usually 30 year terms but often paid off in less time). However, the repeal of Glass-Steagel offered another method of participating in the mortgage business: banks (and others who entered the business of offering mortgages) could make the initial loan (“initiate” in the language of the industry), then “package” the loan into a mortgage backed security (“securitization”), and sell the new security to investors (“distribute” the security), take the money from this sale and make another mortgage loan. This model of banking turned out to very profitable more so than the traditional approach. In 2006 mortgage lenders originated $2.5 trillion in loans (3 times the 1997 amount) and 75% was securitized.
The “originate and distribute” model of banking (securitizing and selling off mortgages and other loans such as auto loans) provided little incentive for banks and other mortgage lenders to assess the long term financial viability of their borrowers. Put most bluntly, the mortgage lender only faced “pipeline” risk, i.e., the risk that the borrower could not make the payments required before the loan was securitized and sold off, that is the risk was limited to the loans still in the lender’s pipeline. This inevitably led to a lowered set of standards for making mortgage loans; as long as the lender was confident that the borrower could make the first, or perhaps the first two payments on the loan, there was little reason to reject the applicant. Further, as it appeared that housing prices would rise indefinitely, even borrowers who might have been rejected as near term risks could be offered “creative” loan packages, perhaps requiring interest only payments during the initial period of the loan. Alt-A and NINJA (no income, no job, no asset) loans became increasingly popular as mortgage lenders flowed into the business, all planning to make the initial loan and pass the default risk on to someone else who bought the securitized package.
This scope of this accident waiting to happen was enhanced by the increasing draws that borrowers made on the equity in their homes in order to finance other consumption, whether that is a car, vacation, college, etc. In 2005 net mortgage borrowing for purchases other than houses totaled $600 billion, about 7% of total family disposable income. Refinancing commonly included taking out cash in return for taking on a bigger loan amount after all, houses were worth more so they could securitize more debt. These home equity loans (HELs) were securitized and sold to investors seeking high yield, high rated investments.
The only problem with this is the old problem of leverage. Housing prices could not rise faster than income indefinitely. When the music stopped, there would be some, actually many, people who were too highly leveraged to continue making payments on their mortgages. With median down payments averaging 2% in 2005 2006, housing prices did not have to fall very far before leverage destroyed the buyer’s original investment. The result, beginning in earnest in 2007, has been a rapid increase in foreclosures with more to come as the number of borrowers behind on their payments also spiraling. Nor is the problem restricted to subprime mortgages. The ability to refinance, take out cash and assume an increased debt burden that would, it was hoped, be covered by subsequent increases in housing prices was attractive not just to subprime borrowers but also to many home buyers who qualified for prime mortgages. An increasing number of these are now finding themselves with an asset, their residence, which is worth less than what they owe. Estimates of the eventual default rate on the almost $1 trillion mortgages securitized are in the 20 25% range but no one really knows. Leverage works just as efficiently on the downside as it does on the upside it’s just scarier.
Before going on to the last cause of the current crisis it is worth considering briefly who is at risk in the collapse of the subprime mortgage market. Subprime mortgages coincided nicely with the politics of the ownership society, the idea that minorities and lower income people could have an economic stake in political stability and that they would thus be more benefit the Republican Party. Almost all of the net increase in family wealth reported for the bottom 80% of wealth holders during 2001 – 2005 came from increased prices for housing. A large portion of subprime mortgages were made to African-Americans, Hispanics, and single (usually female) parent families. These are the groups now suffering most from the escalating foreclosure levels. Their suffering is not just a current economic problem but has important long-term implications for these groups. For most people, particularly in the bottom half of the income distribution, a house is their primary, often only wealth asset. Thus the foreclosure boom is draining wealth away from a large number of families who had only just begun to acquire it. Estimates of wealth loss from these foreclosures are in the $170 190 billion range for African-Americans and $75 100 billion for Hispanics. Although these groups were three times as likely to have subprime mortgages as whites, the evidence strongly suggests that half or more of those granted subprime mortgages actually qualified for prime mortgages but the profitability of the former was greater than the latter.
The Value and Role of the U.S. Dollar
One of the reasons for believing that this economic downturn will be more severe and longer lasting than those of the past three decades is the convergence of a domestic credit and housing crisis with some negative (for the U.S.) international tends. In the 1970s the U.S. moved from being an international creditor nation to an international debtor and is now the largest such debtor. This is one of the important differences between today and the 1930s when the U.S. was a major creditor nation, giving FDR greater policy latitude.
In the early years of the shift to debtor status the primary concern as what an ally, Japan, might someday do with all that debt. Nothing, as it turned out. However, the debt is larger now and the primary holders include nations such as China whose relationship with the U.S. is quite different, today and over the strategic long term, than the Japanese. Further, a major reason for the growing debtor status of the U.S is increased, and increasingly costly, imports of the largest single commodity in world trade: petroleum. During the Bush administration the cost of oil imports more than doubled, rising from $130 billion in 2003 to over $300 billion in 2006.
And what do we have to offer in return? After all, trade is trade. During the period that the U.S. shifted from being a creditor to a debtor nation, we also shifted from making and exporting “things” to the buying and selling the representation of things, e.g. claims to income streams from assets. Financialization remade the structure of the U.S. political economy as policy makers made a long term bet an implicit industrial policy on the finance sector. As the growing U.S. trade deficit increased the dollar holdings of foreigners, these investors looked for ways to put this money to work. In response we exported securitized debt, primarily asset backed securities (ABS) including their mortgage back security (MBS) and collateralized debt obligation (CDO) components. Government debt was also marketed abroad. As early as mid-2007, the Deutsche Bank estimated that non-US investors held 40% of all MBS, the instrument largely responsible for initiating the crisis. These exports helped spread the negative economic consequences of the current crisis even to small towns in Norway and beyond where, relying on the ratings given to the tranches of ABS by S&P, Fitch and Moody’s (the role of the rating agencies in the current debacle deserves considerably more attention than it has received to date) and seeking higher yields on pensions and other investments, portfolio managers around the world purchased these AAA and AA rated securities.
So now we face a challenge to the dollar as the ultimate reserve currency, this time on two fronts. First, as the value of the dollar has declined, central banks have diversified their reserves, adding Euros and other currencies to their holdings. This gradual shift will probably continue; whether it will reach some kind of tipping point is difficult to predict. It required almost three decades for the dollar to replace the U.K. pound as the preferred reserve currency. What would more directly impact the average U.S. citizen’s standard of living is the possibility that petroleum producing nations will shift pricing out of dollars and into either a basket of currencies or a specific currency. The only serious current candidate for the latter is the Euro, but it remains an unlikely event. It is clear that some petroleum exporters, particularly Venezuela and Iran, have priced some of their oil in currencies other than the dollar and the Asian debt market is moving towards pricing in local currencies rather than the dollar.
All of this is overlaid with the very real possibility that the age of petroleum is much nearer its end than its beginning. If the peak oil argument is valid, our trade deficit will continue to grow and the costs of transporting people and things in a domestic built environment that is based on the gasoline powered car will become prohibitive. The beginnings of doubts about the long-term economic viability of suburban sprawl are another restraint on the possibility of any rapid recovery of housing and the U.S. economy as a whole.
What Can Be Done Thoughts on Policy
I have argued that the 2007 domestic economic crisis is not restricted to the financial sector, that it is likely to be more severe than anything we have experienced since WWII and that it coincides with unfavorable international economic trends. But of course, challenges are also opportunities and I think there are real opportunities, as well as risks, for the Left. In this concluding section I will suggest some ideas for policies to address our current economic situation. First, however, two points: we need to emphasize, insist, that the current crisis is systemic, and that piecemeal responses will be inadequate to remedy the situation and that market fundamentalist approaches of the current administration as well as the Republican presidential candidate fall woefully short of what is needed. This is the task of removing the underbrush before building the new structure.
So what can we suggest? There are both near-term policies that may have long-term consequences, and policies that we can pursue only in the intermediate or longer term.
· Empowering the Working Population: The Employee Free Choice Act (EFCA).
We will only reverse the long-term inegalitarian trend in the U.S. if we make it possible for working people to build institutions that are powerful enough to push a political agenda that can effectively mobilize against policies that will increase inequality, e.g. the privatization of social security, and for egalitarian policies, e. g., removing the income cap on FICA (the social security tax). The EFCA is already endorsed by a majority of congressional Democrats but we need a president that will sign it or a 2/3 majority to pass it over a McCain veto.
· Increase and Index the Minimum Wage.
I will not repeat the economic facts about the lag of the minimum wage behind inflation here but I do want to note something that is not usually acknowledged. Opponents of minimum wage increases often claim that the primary beneficiaries would be teenage workers earning extra spending money. Besides the reality that most minimum wage workers are not teenagers, the earnings of teenagers are not simply spending money. For example, when I attended college in the 1960s (at a state university) I was able to pay my own way by working, full time during the summer and part time during the school year, at jobs that paid the minimum or just above the minimum wage. That would not be possible today because of the gap between the growth in college costs and the lag of the minimum wages behind inflation. What should the index be? I am tempted to say congressional salaries but use of the CPI is probably a better political decision.
· Reinstate, Index and Make Progressive the Estate Tax.
The Estate Tax, which the Left should insist on labeling the Paris Hilton Tax, will revert back to pre-Bush levels in 2010 if no action is taken by Congress. The complaints against the tax, driven by the financing of a few very wealthy families who seek to found their own dynasties, have made this a tougher issue than it should be. We should tie the proceeds of the tax to the funding of specific programs so that the “who pays / who benefits” equation is clear. This requires some additional thinking and economic modeling of the expected revenue (United for a Fair Economy has done a lot of the latter) but the Paris Hilton tax could fund universal health care or a subsidy to help with college costs. The most important aspect of the tax is, however, that is a tax on wealth, a taxation concept that is worth fighting for.
· Tax Surcharge on Incomes Above $250,000
John McCain may think that middle income is anyone with incomes below $5 million but the reality is that an income of $250,000 or more puts a family in the top 2% of all families. Rather than spend political capital arguing about how to make the existing tax code more progressive, let’s just do it the simple way: impose a surcharge on high income recipients. As in the case of the Paris Hilton tax, the revenue generated should be targeted for specific social investments, perhaps in this case in alternative energy technology.
· Develop a Jobs Program.
Unemployment is certainly not at 1930s levels and probably will not rise that high; it is, however, a serious and growing problem, particularly when the uncounted unemployed are included. A jobs program should have three foci. First, it should focus on social investment such as schools, roads, bridges, light rail, etc. Second, we should seek to reaffirm the importance of public employment, training and employing people in the health care sector, education, and the recreational environment we have lived off the wonderful work the CCC did in our parks and trials for a long time.
There also need to be a set of policies that address both the deep problems of the housing sector and the out-of-control financialization of the US economy. For starters we should consider the following.
· Create a New Home Owners Loan Corporation (HOLC).
In this case we can draw directly on the New Deal experience. The HOLC acquired mortgages that were or were about to be in default at a discount to the original value, renegotiated the terms of the mortgage, both the duration (effectively creating the 30-year mortgage we know today) and the interest rate. When the HOLC closed up operations, it had actually turned a small profit for the taxpayers. Two things are important here: first, the HOLC had the power to require that mortgages be placed into this system and second, it was the mortgage lender who absorbed the difference between the original mortgage amount and the payment made by the HOLC to acquire the mortgage. This will not, of course, be welcomed by banks and other mortgage lenders or by MBS investors but if the alternative is default and/or becoming a landlord, this approach is less painful medicine.*
· Empower Bankruptcy Judges to Adjust the Mortgage Terms.
At first glance this may sound radical but there has already been congressional legislation drafted to grant this power. It did not get out of committee. There is a precedent: these very same judges now have that power for mortgages on second homes. This policy would bring additional pressure to bear on lenders to seek accommodation with their borrowers.
· Restrict Leverage in the Finance Sector.
Leverage, at approximately the 30:1 ratio, is what brought Bear Sterns down, and, as I have argued above, leverage is at the root of many of the problems in the mortgage meltdown. Leverage is also the problem faced by many of the large investment banks such as CitiGroup and Lehman (the latter may be the next victim of the deleveraging that is going on today), and leverage has gotten Freddie Mac and Fannie Mae into their current troubles. Both of these entities own and or guarantee over $2 trillion in mortgages on capital bases of less than $50 billion. The proper maximum ratio can be left to further analysis buy it is probably in the 12 15:1 range. Will some financial engineers and high flying hedge funds object and threaten to move offshore? Yes, and they shouldn’t let the door hit them in the ass on the way out. If you can’t turn a reasonable profit at 10 or 15:1 leverage, you should not be in the business.
· Extend Regulatory Control Over All Entities That Can Create Credit and That May Be “Too Big To Fail.”
This may be the most important of the long-term policies. It was necessary to bail out Bear Sterns. But it was not necessary, in fact it only encourages moral hazard activities among the financial sector, to do so without acquiring the basis for a significant return to taxpayers, perhaps in the form of senior preferred shares issued by J.P. Morgan Chase, the acquiring entity. While this policy seems so obvious that it is amazing there is the need even to suggest it, there has been virtually no recognition of the socialization of economic risk and the privatization of economic reward that underlies the Fed’s and Treasury’s actions to date. It is time to insist that those who want to dine at the public trough also accept public regulatory control. Further, this regulatory control should not reside in the Fed, both because that entity has enough to do already and because the Fed and its representatives are treated by both Congress and the press as economic oracles whose word is not to be questioned but simply appreciated by us lesser mortals. We need a new agency with the same reforming spirit that drove the early New Deal.
· Implement a Wealth Tax.
Almost all of us pay a wealth tax already it is the property tax, paid directly by homeowners and indirectly by renters. The tax targets the asset that constitutes the bulk of total wealth for most Americans. Primary residence is half or more of total net worth for almost all US households up to about the 95th percentile of net worth. Above that level, however, the story changes dramatically; primary residence becomes less and less important in total net worth while financial assets (stocks and bonds) become increasingly important. Among the top 2% of households by net worth, primary residence drops to 5% or less of total wealth. If we added a broad wealth tax, say a 0.5% levy on only the top 1% of wealth households, we would generate $50 75 billion annually. Again the revenues should be targeted so that the “who pays / who benefits” equation is clear.
The reference to the New Deal was deliberate. To date in the presidential campaign the economic crisis into which we are entering has received little attention. At the Republican Convention neither Joe Lieberman nor Sarah Palin mentioned the economy in their speeches and McCain barely touched on it. I think, however, that will change over the remainder of the campaign. Whether it will change enough to insure John McCain’s defeat I am not sure. But, with respect to Obama, it is useful to remember that FDR did not walk into the White Hose in 1933 with a program that resembled what we came to know as the New Deal but only with a commitment to help his fellow citizens. In fact, had he spelled out something that looked like the New Deal during the campaign, he might well not have been elected and that was when the GDP had dropped by more than 10% and the unemployment rate was over 20%. It was the commitment to bettering the lives of other that drove what came next and in this campaign that is probably the best we can expect.
* 09.08.2008 Postscript:
As I write, the federal government is implementing the take over Fannie Mae and Freddie Mac with the stated intention of reassuring the financial markets, encouraging mortgage lending to continue access by new home buyers ad taking less risk. Whether all of this can be accomplished plus the additional goal of shrinking these two entities beginning in 2010 remains to be seen. This action is a halfway house, a compromise between those who oppose any government-sponsored enterprise and those whose primary concern is stabilizing the economy and the housing market.
Bill Barclay is an adjunct professor at the University of Illinois in Chicago. He worked for 22 years in the finance industry at various exchanges (MCE, CBOT, CBOT, CHX). He is a currently a member of Democratic Socialists of America, Progressive Democrats of America and the Oak Park Coalition for Truth and Justice. He also paddles white water.