Guest Post by Richard Vague: Economic Crisis Report Card

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dollars pic.jpgThis is a guest post by a colleague and TWN regular Richard Vague
Handling the Economic Crisis – A Report Card
If we really want to have enduring, muscular economic growth, then where’s the enhanced support for the truly cutting edge things that will make that happen?
Repatriating telemarketing jobs from the Philippines and textile jobs from China isn’t going to do it. And it won’t just be “green” investment, a non-trivial part of which is misguided. It will instead be nanotechnology, stem-cell research, genetic engineering and the many other nascent industries that require highest order intellectual capital and can be the giant industries of tomorrow.
Period.
In the meantime, there’s an ugly, deep recession to fix.
The cause of the recession was straightforward, and the same as the cause of most other such booms and busts dating back to the start of the Industrial Age. Far too much leverage. In this case, it was too much leverage in the mortgage business, resulting in a stunningly rapid and massive $3+ trillion (or 80+%) build-up in mortgage loans in roughly four years, much of which went to unqualified buyers. And almost nobody noticed.
This overleveraging was brought by gross mismanagement of the government’s Fannie Mae and Freddie Mac programs, by underregulated lending entities including hedge funds and insurance companies, by conflicted rating agencies, and by too-low interest rates courtesy of the Fed. And whatever emergency “dry-powder” we had as a nation to deal with this kind of situation had already been spent on the multi-trillion dollar Iraqi War and other niceties, as evidenced by an increase in Federal debt under President Bush from $5 trillion to almost $11 trillion.
And then In the midst of this increasingly fragile mortgage crisis, somebody inexplicably let Lehman Brothers fail, and everybody went running for cover.
Ka-boom!
On the surface, navigating towards a solution to this crisis seems confusing, because so many people have used it as an excuse to drag out their pre-existing agendas. Pro-labor?
Well then voila! – the cause is the decline in manufacturing jobs – even though that has little to do with it.
But the path to recovery is fairly straightforward, and involves four items which I have previously outlined in TWN. The immediate-term steps to a solution I proposed – in order of importance – were accommodative money policy, lender recapitalization, stimulus by way of accelerated spending on necessary projects, the coordination of these actions internationally.
Here’s the interim report card on the actions of our government on each:
Federal Reserve Bank accommodation – the grade is A. For all the Fed’s bungling and mismanagement before and since, it stepped in quickly and assertively and did the two most critical things needed in any crash, 1) it increased the money supply and, 2) except for Lehman, it stepped in as lender of last resort to the financial institution industry. This is the biggest single difference between the current crisis and the Depression.
There, Fed restrictions and inactions caused the money to fall by a draconian 30% -drying up money across the nation – and no institution served as the lender of last resort to the financial services industry. (Add to that Smoot-Hawley and an increase in taxes, and you’ve got the ingredients that turned the Crash of 1929 into the Great Depression.) By way of contrast, in the Depression, GDP declined over 40%, as compared to today’s single digit decline, and unemployment reached a third of the workforce, as compared to today’s reported 10%.
With this monetary expansion, concerns of future inflation are justified, but that will need to be addressed after a recovery is underway.
Lender recapitalization. Grade is D. On the good side, no other institutional collapses have occurred since Lehman, but it is as if Rube Goldberg himself designed the many facets of the bank recovery plan, and the government felt that no straightforward solution should be used if a convoluted alternative were available.
Regardless of the government’s approach, a healthy banking system can preserve and create more jobs than any government stimulus program. So the needed end goal is banks that have appropriately recognized losses, and have then raised a full, new measure of capital so that they can provide unfettered support for deserving customers. But this has not happened, and bank loans across the country continue to decline steeply.
Contrary to the statements of some commentators, there are legions of borrowers – whether small, medium or large – that are deserving but are having their loans curtailed or withdrawn, causing them to shrink their businesses or shelve expansion plans. Anecdotally, we hear that while regulators are being accommodating to banks on existing problems credits, they are being very restrictive on the extension of new credit, resulting in enough “zombie”-ness to prevent them thus far from playing the robust role needed in the recovery.
I deem the failure to get to the lending system at all levels fully recapitalized and ready to lend to be the biggest shortcoming of government’s efforts to date, and far more important than the stimulus package. I also find this to be the area where I am most pessimistic about the government’s ability to right its course.
Stimulus. The Grade is F. How can we give the stimulus any other grade when it is already July, and only the tiniest sliver of stimulus money has reached its intended destinations? And how can Paul Krugman continue to call for another stimulus bill when the current one is still largely undeployed? (His repeated invocation of 1937 ignores that the retrenchment of that year was just as likely the result of monetary and tax policy as reduced stimulus.)
Even if the stimulus package were comprised only of the most worthy projects, the fact that it has moved so slowly would warrant the F. However, the stimulus package was a slapdash bill filled with initiatives that won’t help. I continue to recommend a position somewhere between doing nothing and doing all that Krugman advocates – a stimulus effort that consist of as many truly necessary projects as can be found accelerated into the present, but no pork.
The truth is, the level of our nation’s debt to GDP is rising to perilous heights unseen since World War II – 70%? 80%? 100%? – and there will be hell to pay for this when the recovery begins. Stagflation anyone?
International coordination – the grade is B. We have avoided a repeat of Smoot-Hawley, even though the impulse to re-smoot is always present, and present in trace amount in places like the Waxman bill. Further, we have stepped up support to the World Bank and IMF. And we have maintained an active dialogue with other countries, though the actions of other countries in dealing with the recession have often seemed more appropriate than our own.
Overall – the grade is C. The economy is fragile, unemployment continues to rise, and the economy could just as easily retrench as go forward.
The longer-term structural changes needed are as follows. First and foremost, we need a regulatory structure that is broad enough to encompass all lenders, and powerful enough to impose appropriately high capital requirements, which is the essence of containing leverage. Further, we need some mechanism to prevent the Fed from adopting unnecessarily low rates – and thus inappropriate stimulus – in periods when the economy is growing; something along the lines of a Taylor Rule approach. And ultimately, after the recovery is underway, we will need to get federal debt to GDP levels out of the stratosphere.
A final structural issue that has been discussed frequently in this crisis is the disequilibrium between the countries with export economies that build up excess cash such as China, and the large trade-deficit countries such as the United States. In the view of some, the mortgage boom was unavoidable because the large surpluses of other countries were being reinvested in the U.S.
While I don’t disagree with some aspects of this view, I believe that higher short term rates and higher capital requirements applied appropriately to all lenders would have prevented most of the overbuilding and associated excess lending. Couple those changes with Soros’s plan to have a larger short-term loan facility available to other countries to obviate their need to build up cash reserves, and we will have addressed much of this problem. (Further, Soros’s fundamental concern about the structural post World War II increase in system-wide leverage could be addressed, at least in part, by capital requirements.
So let’s get the banks back lending again, let’s keep the stimulus focused on necessary projects, let’s support international liquidity efforts, and let’s hope the Fed continues to be accommodating.
Postscript:
I find the “too-big-to-fail” debate at least somewhat mystifying, because a bank failure can
be structured so that the bank continues to operate without missing a step. The bank closes one evening, and reopens under FDIC ownership the very next day. Most of the bank’s customer’s are unaffected; and most employees other than top management keep their jobs.
The stockholders and bondholders are wiped out, but they were investors who knew their capital was at risk. The board of directors and top managers are out, but they were the ones responsible. The government owns the bank, but it can readily sell the bank or make a public offering of new stock in the bank in due course as the internal problems are sifted through and bad assets are partitioned off to a separate entity.
— Richard Vague

Comments

4 comments on “Guest Post by Richard Vague: Economic Crisis Report Card

  1. bob h says:

    “In the meantime, there’s an ugly, deep recession to fix.”
    In fact, the recession strictly defined is probably over already. The consensus view discussed by Brad DeLong is for GDP contraction to have ended in June, and about 2% growth by years end. So it seems the stimulus is well-timed in terms of helping accelerate the climb back from the recession.

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  2. JohnH says:

    Vague is of the school that looks to the restoration of the financial system as the key to recovery.
    Yes, there was excess debt and leverage, but this economic disaster is deeply embedded into the very structure of the American economy. Excess debt is a cancer pervasive to the entire American economy.
    1) US consumers over borrowed to keep up a standard of living made impossible by the flight of good paying jobs overseas.
    2) The US government over borrowed to fund the DOD and its imperial military ventures.
    3) The US economy over borrowed to maintain its strong dollar, its imperial currency, thereby causing good jobs to flow overseas and hollowing out the economy.
    Stimulus? What’s to stimulate? Consumers will use any stimulus to pay down debt or to buy goods manufactured in China. Government debt, financed by China, replaces consumer debt. Consumers and banks become better off while the federal balance and the US’ international financial position both deteriorate.
    Robert Reich has a good, apposite analysis:
    http://robertreich.blogspot.com/2009/07/when-will-recovery-begin-never.html
    “Recovery doesn’t depend on investors. It depends on consumers who, after all, are 70 percent of the U.S. economy. And this time consumers got really whacked.”
    An even better, longer analysis is provided by the Brazilian economist André Lara Resende, who argues that this downturn is partly caused by excess financial leverage and partly by massive, global economic imbalances. Any solution will have to address not just banking problems, but also the massive overvaluation of the dollar and the resulting trade imbalances.
    http://blogs.ft.com/maverecon/2009/06/after-the-crisis-macro-imbalance-credibility-and-reserve-currency/#more-1831

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  3. Dan Kervick says:

    Mr. Vague, I’m having a hard time understanding your perspective on stimulus.
    You point out that a problem with the first stimulus is that only a small bit of it has been spent. Yet you say the stimulus should only have been used to fund necessary projects, and no “pork”. I don’t see how these claims fit together comfortably. Any stimulus package that is geared only toward the funding of necessary public investment projects is going to require some sort of administrative process of allocation. And that process will take time.
    You complain about calls for a second stimulus, apparently because you feel that we have already reached the limit of the debt the government can or should take on, but also because the slow-moving first stimulus is only now beginning to take effect. If it is only now beginning to take effect, how can its effect be measured or graded at this time?
    Somehow what is missing in these reflections is any discussion of consumer demand and spending. Economic activity and jobs in this country are sustained at their foundation by consumers buying stuff. Many of the layoffs and collapses in earnings are due to the fact that in many areas consumers have drastically curtailed their spending, and so sales have collapsed. These collapsing sales lead directly to layoffs, which lead to more drops in consumer spending. Consumers are overleveraged as well as the banks. But in addition to the perfectly rational belt-tightening we see from consumers as they dig out from debt, there is also a certain amount of fear and hysteria out there leading to additional compulsions toward frugality, compulsions that have the feeling more of a religious revival than a rational economic response.
    My initial impression is that your perspective suffers from same limitations that are apparent in many of the dominant discourses about this recession, limitations that are a by-product of the fact that the epicenter of the collapse was the financial sector. The policy decisions are being driven from people at the top of the capitalist finance food chain, who have lost touch with the real economy down where the business rubber meets the customer road.
    These masters of the universes seem to promote the myth of a capital-driven, business-only recovery: As long as banks have money to lend, things will happen. As long as businesses can get the capital they need, and get funding for their necessary projects, their ongoing operations and their long-term development plans, then somehow the products that come out the other end will make magic money. The Economy will be restored to life even if no one is buying the stuff these businesses are making. The picture is painted of a world of hungry consumers with wads of cash in their hand, just waiting for businesses to get their capital needs satisfied by bailed-out banks so that those businesses can make and deliver products into their eager arms. But is that accurate? Not from where I sit
    So here’s an idea about what to do with those consumers. Give them money. Hand them cash. Cancel or alleviate parts of their debts. Get them spending again.
    But no! Our economic masters wouldn’t hear of that! That would only reward bad behavior: years of irresponsible, spendthrift impulsiveness by those stupid overfed, over-stimulated vulgarians we call “Americans”. We must restore a thrifty and responsible working class!
    So ordinary people? They must be punished for their greed and intemperance, and forced to dig out and ride it out on their own dime. But financial institutions? They are to get all the handouts they need to recapitalize and recover from their bad decisions. Now maybe there is sound, long-term puritan logic to the desire to reform the habits and restore the prudence of economic actors in America, financial institutions as well as consumers. But how can you have a recovery based on investment alone?
    Isn’t ‘restructuring” through directed public investment something we need to spend more time on *after* we have restored economic activity, employment and government revenues to healthy levels? It’s great that in 2015 the shelves will be filled with a new generation on nanoproducts; it’s awesome that after health care is reformed, and after ordinary Americans have jobs and rising income again, and can stop deferring all of their medical expenses, they can then avail themselves of a new range of genetic therapies; it’s terrific that when people can afford to buy a home again, they will be able to buy a new energy efficient green home, powered by the latest green technologies.
    But don’t we need to get people back on their feet again first?

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  4. John Robert BEHRMAN says:

    The postscript on bank failures is, I think, key to the rest of the bad grades. Today’s financial management class are not 1920’s WASP-types.
    They are not “top management” or “directors”. They are not even most of the stockholders: Those would be retired middle managers.
    No, they are contingent-fee “transaction lawyers”, formerly called “bond-lawyers”, from top schools. And, in between “deals”, they are, far and away, the most powerful lobby, surpassing defense contractors, unions, Hollywood, as well as Big Pharma and the contingent-fee trial or hybrid-fee intellectual property lawyers.
    They are voracious termites of government — all branches, all levels: slicing and dicing simple monetary and potentially robust fiscal policy into complex, innovative deals, “convoluted alternative(s)”, that maximize short-term gains from intermediation, commissions, fees, and so on.
    Lender recapitalization
    Compare and contrast Lehman’s and Goldman’s
    lawyers to find out why the former “inexplicably” failed and the latter is rolling in that fresh, new money. You gonna “follow the money”? Good luck with that! The bond-lawyers co-own the “chartered accountants” along with the spooks.
    Stimulus
    While the bond-lawyers are, actually, “Wall Street” today and primus inter pares on “K Street”, that pales in comparison with their death-grip on state capitols, county courthouses, city hall, and school boards — “Main Street”. By taking the lead on “affirmative action” and “minority-majority” redistricting under Nixon, they came to own state and local governments to an extent that old-time political “machines” could not possibly imagine:
    They slow down, channel, and turn stimulus funding into two-bit patronage “jobs”, “arts”, and relief programs for the clients of non-partisan relief agencies or “public, private partnerships” in which slum-lords and land-speculators get rich quick and government ends up with bridges to nowhere or, in the South, jails and prisons they cannot maintain or operate competently.
    International coordination
    Oh, yeah, the Marines will be enforcing our liens on the British West Indies and the Airborne are getting ready to parachute into Switzerland. How do we coordinate effectively with countries, not England or Holland, that oppose piracy?
    Where, indeed, is the line between bond-lawyers, spooks, bankers, and “government” most blurred? Why it is not the commercial or investment bankers, it is the “merchant bankers” — arms and drug peddlers, pirates, slavers, or, as John LeCarre calls them, “The Worst People in the World”. Of course, they have exquisite taste and very good educations as well as the best criminal defense — hybrid fee — lawyers in the world.

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