Chapter 2 in: Contemporary Studies in Economic and Financial Analysis, Volume 93, The Impact of the Global Financial Crisis on Emerging Financial Markets, edited by Jonathan Batten and Peter G. Szilagyi-ISBN-9780857247537
by Douglas Sikorski
TABLE OF CONTENTS
ii. taming deficits
iii. future shock
THE GLOBAL FINANCIAL CRISIS: EXPLANATIONS AND IMPLICATIONS
Abstract: This essay analyzes the causes and effects of the financial crisis that commenced in 2008, and it examines the dramatic government rescues and reforms. The outcomes of this, the most severe collapse to befall the United States and global economy for three-quarters of a century, are still unfolding. Banks, industries, and homeowners stood to benefit from government intervention, particularly the huge infusion of taxpayer funds, but their future is uncertain. Instead of extending vital credit, banks simply kept the capital to cover other firm needs (including bonuses for executives). Industry in the prevailing slack economy was not actively seeking investment opportunities and credit expansion. The property and job markets languished behind securities market recovery. It all has been disheartening and scary – rage against those in charge fuelled gloom and cynicism. Immense private debt was a precursor, but public debt is the legacy we must resolve in the future.
In early autumn 2008 credit markets froze on Wall Street.[i] Following on to the credit crunch was a crisis in Confidence – that ephemeral commodity that is everything in financial markets. A wider financial crisis rapidly escalated, just as the June-July 1997 currency crisis had escalated in Asia, exacerbated by governmental paralysis. Politicians in America dithered, then took several iterations to come up with a plan, but still the damage accumulated faster than governments could come up with fixes. The contagion evolved into a global crisis initially reflected in a number of European bank failures, emerging economies’ currency declines, and crashes in stock indices worldwide.
As The Economist magazine put it, the panic choked the arteries of credit and we faced the danger of a global heart attack. Financial firms get preferential treatment to be rescued by governments because they constitute these arteries, extending vital credit to each other and the larger economy. (A major controversy was that bank executives and investors became primary beneficiaries of the bailout.) Banks used government-provided liquidity to strengthen their capital positions and were reluctant to make loans despite government guarantees. Well into 2009, the ‘arteries of credit’ remained blocked.[ii]
The Wall Street model had been a financial machine of globally mobile capital and highly leveraged, lightly regulated players with high-tech market instruments and instantaneous transactions, which displaced the ‘traditional banking’ model from about the 1980s. Its hallmark was securitization: the pooling and repackaging of debt assets by lenders into bond-like instruments, with differing risk tiers and other features, and these sophisticated securities were then marketed globally. With the lender’s balance sheet thus unburdened, the lender can lend again, with the original risk increasingly untraceable. The unregulated hedge funds[iii], with 30% of equity trades, added to the credit volume and market activity. Derivative products aided by computer[iv] applications created a dazzling array of instruments, which led to a complex and opaque derivative market with a volume in 2007 surpassing global output by 11x. Few financial institutions could calculate their own credit risk and fully comprehend the nature of their own assets and financing now. Such was the case of the world’s largest insurance company AIG (American International Group) with its mind-boggling array of financial ploys including synthetic ‘collateralized debt obligations’ (CDOs), ‘finite insurance’ policies, and ‘special purpose entities’ to hold underperforming assets; all contributed to the crash of AIG. (See endnote [v] on the AIG case.)
Perhaps the most prominent example, the CDS (‘credit-default swap’) was one financial innovation that served ostensibly as insurance and freed up capital that would otherwise be tied up as collateral for loans. Arguably, the swaps market creates liquidity and mitigation of risk; but neither buyers nor sellers completely understood the new risks they were creating, and much of the private deal-making was cloaked in secrecy and beyond the scrutiny of regulators. (See endnote[vi] for how a CDS deal works.)
Basically, the panic froze credit because no financial institution knew how much bad debt was out there and owed by/to whom. Credit and asset inflation had grown to many multiples of the basic underlying, say, mortgage, as loans were securitized, repackaged and resold at discount again and again, including pyramids of derivative instruments. In the aftermath of the panic, credit was so totally withdrawn that even viable business could not get a loan. The real risk became a great depression where economies approach ground zero and many venerable business institutions disappear.
Asset markets collapsed: Household net worth fell by $11 trillion in 2008. Total household debt fell in the 4th quarter 2008 for the first time since World War II. De-leveraging the hedge funds and others in the ‘shadow-banking system’ was most traumatic, as withdrawal of credit forced a massive offloading of assets. Restrictions to stem the meltdown eliminated some arbitrage activities (especially short selling), and hedge funds further wound down their long positions. Many American investment banks, that quintessential Wall Street animal that relied on high leverage and wholesale (interbank) funding, disappeared; and those institutions that survived reverted to normal, conservative commercial banking. (The two survivors, Morgan Stanley and Goldman Sachs, became bank holding companies in September 2008, increasing their dependence on retail depositors that had suddenly become more stable than wholesale funding.[vii])
LIBOR, a rate that represents what banks pay to borrow from each other, hit record highs; but when the rates subsided after massive interventions by central banks, still loans were not made. Money market funds also declined to take commercial paper from corporations for their working capital. The Federal Reserve created major new commercial paper programs to facilitate purchase of mutual fund assets and short-term notes from companies, but with only limited success in freeing up these markets.
One measure of the GDP (gross domestic product) is defined as equal to Money Supply x(times) Velocity which is its turnover. (Irving Fisher’s ‘quantity theory of money’ held this equal to the price level times economic output.) Velocity approached zero in the crisis, so GDP was falling whatever the Money Supply. This is the “liquidity trap”, where the Federal Reserve increases MS (buying T-bills or other securities such as T-bonds, Fannie Mae securities, corporate or state bonds), but there is no growth. Thus, monetary policy fails. The government then pursues its alternative option, fiscal policy – spending money and/or reducing taxes – where net government outlays increase velocity of the liquidity. (The ‘right wing’ argues for tax cuts instead of spending, but taxpayers can save the money –not spend it— which is especially likely in a bad economy.)
In such an economic climate how do we get bankers to lend, businesses to invest, and consumers to spend? Potential returns, no matter how high, are perceived as too risky, despite almost zero cost of capital. [viii]
The solutions to the Crisis in America have been varied, often complex, and continually evolving. Of course, there are implicit questions of equity: Who should get priority in any rescue attempt by government – Wall Street? Lenders, or alternatively borrowers? Homeowners facing foreclosure? States and municipalities needing to fund essential services? Or the American businesses suffering the knock-on effect of the original Credit Crisis – not to mention the subsequent Economic Crisis – that now threatened their previously viable enterprises?
There is certainly considerable doubt that government bailouts should be provided at all. If free-market initiative were to be relied upon to resolve the crisis, would private bailouts occur without too much damage incurred as investors await the ‘right market opportunity’? Do government bailouts tend to be misdirected or ineffectual? The amounts of taxpayer money committed – with questionable impact – were immense. Although conventional economists generally agree governments should help its citizens contend with a market collapse, there is considerable disagreement on how and to what extent.
The Obama Administration’s fiscal stimulus plan, despite the political wrangling, should be less controversial in principle than bailouts because deficit finance is a standard anti-recessionary tool for governments. As established by John Maynard Keynes, public expenditure counters recession by offsetting declining private outlays, and the economic downturn is thus abated. It is a case of government intervention in response to market failure. (However, fiscal policy may be less effective if credit markets remain frozen.)
The devil is in the details.[ix] Partisan debate raged around particular expenditure items (‘pork’, long delays in actual cash outlays, or misguided projects – ‘building a bridge to nowhere’). Of course, it is quite unreasonable to expect stimulus money to be appropriated, allocated, and finally spent in a way that precisely matches needs of the economy[x] –especially given the American political imbroglio.
The size of the fiscal package was a serious bone of contention because it dramatically escalated the already acute budget deficit, but it seemed to necessarily be immense because of the severity of the economic decline. The amount signed into law by the President on February 17th 2009 was $789 billion -- $507B in spending and $282B tax relief. (By mid-year 2010 other stimulus bills were being debated.[xi])
Cutting tax is the alternative to fiscal spending, favored by those who distrust government designs and prefer to put the money directly into the hands of consumers and businesses. However, tax rebates may be saved – especially likely in such a bad economy. Taiwan and China issued coupons[xii] to poor people for Chinese New Year shopping, instead of tax cuts, which guaranteed most of the amount would actually be spent; but the US Congress took no action in 2008, awaiting the first steps of the new administration.
Fiscal expenditure is amplified by a multiplier effect to the extent the cash infusion is spent again by whatever contractor or other recipient gets the money, and the process continues as long as the cash is recycled. Estimates were that the multiplier effect of the Obama stimulus would be 1.57 for the fiscal expenditure but only .99 for the tax cut. (Los Angeles Times, 17-1-09, p C3) Tax cuts would increase the money supply much sooner than government projects implemented after the tax rebates paid in 2009, but the multiplier only works for what the taxpayer actually spends –temporary tax cuts are less likely to be calculated into budgetary expenditure plans of recipients.
The official stated purpose for the stimulus was threefold: new investment to put citizens to work, increase productivity with improved industries and infrastructure, and create confidence in the economy. Confidence was eventually restored, as reflected in strong stock market performance, the Dow index breaking 10000 during October 2009.[xiii] The recession was officially declared ended when the economy expanded by over 3% in the 3rd quarter 2009. However, by 2010 there was considerable doubt that stimulus bills had provided value added in terms of quality infrastructure and industrial development.
By late 2010, the greatest criticism of stimulus expenditures was that the outlays had accumulated to a multi-trillion dollar fund transfer from taxpayers that was not perceived as doing the job. Politically, it had become increasingly difficult to justify any more fiscal spending, whereas the Federal Reserve had no such political constraints for its alternative to fiscal policy: monetary policy. Short term rates were held at near-zero but without sufficient impact on credit creation. Long-term rates emerged as the major policy focus, whereby the Fed buys long-term bonds with newly created money.
This so-called ‘quantitative easing’ of the Fed [xiv] contributed a much larger infusion of cash, going to even further extremes to stimulate demand than the grandest dreams of the Obama administration. Arguably, the loose monetary policy had potentially more dramatic knock-on effects than the fiscal deficits, since monetary policy was less direct and depended on the market response of the financial community to put the cash infusions to work.
Quantitative easing could result in economic growth by spurring borrowing and investment, boosting the value of market investments as well as other asset values, and making the currency less appealing due to its low real interest return. The latter effect had the most controversial international impact. The first channel for economic growth did not open effectively because investment was not forthcoming –neither in property nor industry. The primary assets to appreciate were in the securities markets rather than the ‘real economy’. Ultimately, of course, ‘printing’ more money creates more federal debt, which might be unsustainable in the long term. A strongly negative market reaction could lead to a severe decline of the dollar and even another global financial panic.
The greatest disappointment as it turned out was lagging job creation. The White House claimed it created or saved one million jobs by the 3rd quarter 2009, based on compiled reports from recipients of $160 billion of the stimulus money. The reports showed employers created or saved 640,000 jobs, rising to one million from indirect benefits as when a recipient of stimulus funds spends the money, and on track to reach 3.5 million jobs in 2010. However, the figures were very controversial. Certainly, ‘saved’ jobs were not clearly measurable, i.e., whether stimulus money legitimately saved a job about to be eliminated. Also, jobs were being lost much faster than they were saved or created, as job losses in one month alone often exceeded the touted 640,000 figure. The unemployment rate climbed relentlessly, exceeding 10% by October 2009.
If the new investment by government leads to further nationalization of industry or otherwise an enlarged management role for government, then the stimulus becomes something new; it goes beyond traditional fiscal policy – rather like the ‘bailout’.
The major bailout fund coming from the Treasury was the $700-billion Troubled Asset Relief Program (TARP), proposed on September 19th 2008 and passed by Congress October 3rd. (This early instance of political delays was costly in terms of the spreading contagion and market volatility caused by uncertainty, but such ‘political risk’ was of course encountered for every plan that had to pass Congressional scrutiny.)
Half the funds were released in 2008, the largest component being $250-billion channeled to selected banks to encourage them to lend. Stronger banks were selected, to shore up their balance sheets and instill confidence in the national financial system for the purpose of thawing the credit freeze. By yearend, 209 banks had received $162 billion.
The Obama administration renamed TARP the Financial Stability Plan. Including the huge infusions from the Federal Reserve for a combination of loans to banks and incentives for private capital participation to rescue the financial system, by autumn 2009 new commitments made the bailout effectively over $2.5 trillion. Total government expenditure including the stimulus and omnibus bills, and other costs, was estimated to reach potentially as much as $11 trillion (according to the BBC, March 6th 2009).[xv]
The Federal Reserve designed dozens of new programs to facilitate credit markets, most inconceivable before the Crisis. In November 2008 the Fed bought $600 billion in mortgage-related securities, with $850 billion more in March 2009, to push down interest rates. Numerous individually-tailored programs were introduced – for example, the Fed’s secured lending services for AIG and for buyers of securities backed by consumer loans. Thus, the Fed had created incentives to over-borrow reminiscent of the excessive lending that begot the crisis in the first place. (As economic conditions improved the Fed scaled back the plethora of programs it had initiated when the financial crisis began to emerge in late 2007.[xvi] Unwinding the emergency liquidity facilities would become the priority, to remove government props to the economy. The Fed announced on December 16th 2009 it would end ‘most’ emergency programs early in 2010.)
The Fed’s one-year, $1.25-trillion program to prop up the housing market by purchasing mortgages (ended March 31st 2010) made the Fed the world’s largest single holder of mortgages. Going forward, if private institutions did not step in to pick up the slack, mortgage rates could move up dramatically. It could be challenging for the Fed to perform its main job of managing interest rates. Also, major defaults would hurt the Fed’s balance sheet.
The Fed’s easy-money policy could not be sustained indefinitely. Interest rates began going back up in the spring of 2009, despite continued interventions by the Fed in long-term bond markets. As the supply of Fed bonds kept ballooning to fund deficit spending and melt the frozen debt markets, potential inflation was a concern. Purchasers of Treasuries were balking at the low coupons at new bond auctions, which forced yields up. Nevertheless, the Fed was determined to keep interest rates at “exceptionally low levels … for an extended period”. The Fed bought mortgage-backed securities in an effort to keep home loan rates down, and in March 2009 the Fed committed to buying $300 billion in its own Treasury securities over six months, hoping to restrain bond yields. [xvii] Still, bond yields were expected eventually to rise, which happened again in late 2010.
Initially, TARP funds were contemplated to be used for direct purchases of non-performing assets (mostly mortgage-related); but valuation was problematic, not to mention the question of which debtors to rescue. Instead, the favored bailout tactic employed (announced ex post facto by Treasury Secretary Paulson) was to provide capital to financial institutions.
Banks can generally expect to get paid back on their loans, presuming borrowers want to be creditworthy. This idea has always been a bulwark of financial systems; and it became the modus operandi of TARP that taxpayers would save the lenders rather than the borrowers. This central principle may come into question if municipalities, homeowners and businesses (not to mention entire countries, as in Europe) come to reasonably expect creditors to share the costs of financial ruin. However, any large-scale debt writeoff would be severely deflationary.[xviii]
TARP funds were provided in the form of preferred non-voting stock. It was contemplated that more capital would enhance credit creation on the basis of capital adequacy – presumably going further than the government simply taking over bad debts. Preferred stock offered the government and taxpayers more security than common stock, but it did not significantly boost the banks’ lending. Unlike with common equity, preferred dividends (and interest on debt) accumulate and to breach payment would risk default. Therefore, long-term capacity to absorb losses was unchanged. Conceivably, preferred stock can be required to bear losses along with common stock, but taxpayers are unlikely to tolerate high exposure to losses especially with limited scope for gains.
To allow taxpayers to share in potential improvement in the banks’ prospects, banks receiving TARP funds were required to supply warrants to allow the government to buy stock at an amount, price, and deadline set by contract. If TARP funds were repaid, the banks could make an offer to buy back the warrants. A problem that emerged later was determination of the price for the warrants. Public auctions were one possibility, but most warrants were not publicly traded.
The preferred stock can carry interest coupons to compensate taxpayers as well as other provisions such as veto power over management deals. Convertible features could allow conversion to common stock at an agreed price, thus increasing both the risk and the reward to the investor and providing the bank more ‘tier 1’ capital to be used for new loans or for paying off bad debts. The government investment was designed to be relatively short term and also put some political pressure on firms to perform according to expectations. However, few reporting and other oversight requirements were stipulated (which caused strong criticism of the initial TARP commitments), and the funds were not utilized for loans as the government had hoped.
New lending awaited a better market. A vicious cycle had emerged of more bank losses, reluctant private investors, and new bank appeals for federal help. The stock price of banks in the TARP scheme continued to decline, reflecting investor uncertainty about the future of banks still carrying bad debts in their accounts. Also, investors might not buy stock if their interests could potentially be pushed aside by government stockholders.
As the Obama Administration took over, the design of rescue policies remained in flux due to the great complexities in the policy options and their impacts. One idea was a federal entity similar to the Resolution Trust Corporation[xix] which had disposed of assets of failed savings & loan banks two decades earlier. However, pricing the debts purchased ran the risk of either hurting the banks by pricing too low or hurting taxpayers by pricing too high, which had deterred the government from this approach originally. Government can pay more for the bad assets because its cost of capital is less relevant than for private investors, and it can hold the assets until maturity; but private investment was preferred.
Another tactic was to take an immediate writeoff against market value of ‘toxic assets’ and put them into a ‘bad bank’, giving a clean break for the remaining ‘good bank’. Co-investment by private investors (especially the banks themselves) can be stipulated. Private equity provides profit incentive to get the price right, plus to negotiate workouts with the debtors. Government guarantees and insurance can cover the healthy assets that remain plus future loans. This keeps the assets in the hands of experienced bank managers instead of the government; yet the government may not be able to compel credit expansion by private institutions. Forced lending anyway was seen by the government as undesirable, and it instead only required the banks to submit plans explaining how they intended to improve lending.
Government had a great responsibility to get the price right, which held true for purchasing either bad debts or equity. The Congressional Oversight Panel for the TARP bailout released an estimate on February 5th 2009 that the Treasury Department had paid $78 billion too much for its investment in stock and other bank assets. The Panel also estimated the value of assets initially transferred from AIG to the government at only $14.8 billion, but AIG received $40 billion for them. In July 2009 the Panel reported that eleven smaller banks had repurchased their warrants held by the government for a total payment of $18.7 billion, but the Panel estimated the warrants were worth $28.2 billion.
In the event, Timothy Geithner’s Treasury chose a hybrid approach to bailouts, announcing on March 23rd 2009 a public-private partnership to back purchases of ‘toxic assets’ by private investors. Various federal agencies would provide very cheap loans or other resources to buy up as much as $1 trillion in bad debts.
The stock market responded with apparent approval at this stage with a major uptick, but critics raised many objections not least of which were doubts that $1 trillion was enough – bad debts were still soaring, estimated at $2 trillion by July 2009. Congress was not in the mood to provide more funds so the Treasury had to continue to tap TARP.
Implicitly, the government was relying on the money managers and insurers to become active investors in a bad market and start borrowing again just when they had been cutting back on leverage. Also, the government was depending on the banks to accept the current, very low market price to get rid of their ‘toxic assets’. Under accrual accounting, banks were booking losses over several years and were unwilling to take a larger loss all at once and thus reduce their capital dramatically.[xx] Also, banks that had already written down their debts hoped to recover some of their losses –possibly enhancing their chances to get out from under TARP obligations.[xxi]
Through a complicated formula, taxpayers were committed to cover most of the losses but only get half the profits. Geithner regarded this as a necessary price to pay to remove the bad debts from banks’ balance sheets, as the Resolution Trust Corporation had resolved the savings and loan crisis decades earlier. Political objections to giving hedge funds and other speculators a taxpayer-subsidized opportunity to profit from delinquent mortgages and other loans –by modifying terms, or selling them to debt collectors, etc— was negated by the common sense that the banks were not handling the problem themselves. Reworking a defaulting or delinquent mortgage is a labor-intensive process, not always well managed by bank officers with a large file of loan contracts.
One motivation to encourage the banks to sell their toxic assets was the ‘stress tests’ commencing on February 25th 2009. The Treasury audited the 19 largest banks to judge potential insolvency in mock scenarios, with a ‘worse-case’ given as a 2-year recession with rising unemployment[xxii] and declining house prices. The banks needed to demonstrate capital adequacy, determined by rather indefinite means to measure the worth of bank assets and the quality of capital. Any bank that was seen as needing more capital would be given 6 months to raise it from private sources but, if unsuccessful, would be proffered more bailout funds (preferred, dividend-paying stock). Thus, the banks would be compelled to fix values on toxic assets both to satisfy regulators and also presumably satisfy potential buyers of these assets,[xxiii] as well as justify potential new capital infusions from the government.
Stress tests took several weeks, and the whole drawn-out process allowed market players to anticipate results – not enhancing awareness but rather creating uncertainty.[xxiv] One fear was that the government would compel banks to accept only emergency capital to stay afloat but not restore financial health enough to encourage robust lending to resume. Furthermore, there were doubts TARP funds were available in sufficient quantity.
The Obama administration needed a strategy to communicate the results of the stress tests. The timing of any announcement and the extent of detail could destabilize markets. Market players eagerly sought this information and were prone to seize on any uncertainty. The market could anticipate which institutions got high marks as the banks either tried to raise capital or reported no need for additional capital. The government planned to reveal all results simultaneously; the banks were told not to disclose their performance on the tests during upcoming earnings announcements. If one banker bragged about receiving high marks, other banks could be punished by investors for keeping quiet. Unless all banks were dealt with at once, compelling one bank deemed insolvent to accept more capital could start a market sell off of many others. Uncertainty about such hesitant steps was costly and a self-fulfilling prophecy toward more bailouts for the financial sector. Borrowing costs were rising as bondholders anticipated they would be affected by government-compelled restructuring, which further pushed stock prices down and credit costs up and exacerbated the need for more government bailouts. (This was also true for the auto industry – see later. Auto purchases were deferred or going to foreign brands while consumers awaited ‘final’ deliberations by the Obama administration on the rescue of the US auto companies.)
The Treasury declined to endorse the idea of separating assets between two institutions, ‘bad’ and ‘good’ banks. Instead of a ‘bad bank’ there would be the ‘public-private partnership’ to take over the toxic assets. How this is not nationalization is indeed subtle: despite the massive government financing, private investors would be doing the whole exercise, with easy credit and co-investment by the government.
The British approach, to leave the assets with the banks and insure them for a fee, was also eschewed. The Treasury did that for Citigroup[xxv] but did not adopt the idea for the banking system as a whole.
The issue was to determine the best way to rid the financial system of the ‘toxic assets’. Taxpayers provide ‘patient’ capital, because the government is able to wait until maturity of any assets acquired to hopefully collect maximum interest plus principal. Private investors should be better at finding the right price for bad debts, will have incentive to chase after debtors or rework contractual terms to achieve the best market value of the asset, and sell the worst assets to ‘vulture investors’.
Although the government denied takeover intentions, it seemed to some pundits that ‘creeping nationalization’ of insolvent banks was in the cards, either as the outcome of the ‘stress tests’, or even by stealth – by surprise takeover, say, over a long weekend and forcing a restructuring exercise. However, probably it would be illegal for the government to takeover banks without agreed compensation. It would take a new law, and that seemed a daunting legislative challenge in the short term. (A ‘resolution authority’ to takeover failing institutions was enacted into law July 21st 2010.)
The bad assets for the most part were destined to remain with the banks even after they began paying back bailout funds to the government. Most banks elected to work out their own weak balance sheets by conservatively building up capital through stock issues and converting preferred stock to common. The market for ‘toxic assets’ improved after March 2009, enhancing banks’ ability to raise capital again.
In the end, the Treasury downsized its program to buy toxic mortgage-backed securities. It was finally launched on July 8th 2009 with the naming of nine investment companies to purchase the assets. Fund managers would raise up to $10 billion and tap up to $30 billion from the government. The original plan, called the Legacy Loan Program, also called for federal debt guarantees to attract investors into directly buying assets from banks. However, the initiative never became more than a pilot project under the FDIC.
The TARP program formally ended October 3rd 2010, with mixed reviews of its success. Of the total $700 billion authorized by Congress, only $475 billion was used --$205 for banks. Thus, $225 billion was never paid out, a considerably smaller bailout than anticipated. Of the $475, $290 was paid back with interest, leaving $185 billion still owed. Despite early concerns that much of the bailout would never be recovered, the Congressional Budget Office projected a final loss of only $66 billion.
The program had little success settling toxic assets and therefore had not helped the mortgage market and housing values. The $75 billion mortgage modification program under TARP had not stemmed foreclosures. Certainly, under TARP taxpayer money transferred to Wall Street had not rescued ‘Main Street’ –the most glaring failure. Also, using TARP for purposes beyond the bank bailout, including funding the bankruptcy plans for the Big 3 auto firms, was technically illegal because the law stipulated any repayments be used to pay down the federal debt.
Outright nationalization of troubled banks is the most controversial alternative. The government restructures the bank, revaluing its assets and sorting any loss between investors and taxpayers. Valuation is still a problem but the government is on both sides of the deal. The government can influence lending policies, but with the real danger of non-market failure – all the politicization and bureaucratization this entails. Another ideological difficulty is the timeframe: When will the takeover be reversed?
Nationalization would work in several steps:
1. Determine which banks are not going to survive without restructuring.
2. Take them over, simultaneously suspending market trading.
3. Restructure the balance sheet to cordon off nonperforming assets and devise a means to liquidate them. Now unencumbered, the bank would be sold on the market or to a strategic buyer, hopefully fit to lend and otherwise function normally.
Presuming a takeover is with compensation to stockholders and bondholders, the difference between what the government pays and what it gets for the liquidation of the assets will be net loss or gain to taxpayers. The government does not have the authority to takeover private property like banks without compensation so there would have to be a valuation process to put a price on the assets. This process takes time, and it not precise.
Bondholders generally would have priority in liquidation before the government’s preferred stock. If bondholders were forced to share the losses incurred by stockholders, they may need incentive in terms of sharing potential gain by debt-for-equity swaps. One difficulty in this arrangement is that many bondholders are foreign governments which then become owners of banks, perhaps unacceptable to American politicians.
Nationalization has a major advantage: breaking up the largest finance houses, which had become ‘too big to fail’. With the financial sector thus restructured in future, markets and bankruptcy courts could be left to sort out insolvent institutions instead of there being a need for a government rescue to save the overall economy.
Opponents called the entire rescue scheme ‘socialism’; indeed, the government role in the economy was greatly enlarged, at least for the moment. Such large investments as have been made in the private sector would take some time to divest and return a profit to taxpayers. Nevertheless, Britain used the same formula for its earlier bank bailout (October 8th 2008), and the British staunchly avoided repeating their mistake in the post-war era of the Nationalized Industries – the government takeover of the ‘commanding heights’ of the economy. The purpose of governments’ investments this time was limited to the rescue effort. However, the political debate only intensified over any government role in the private sector. It would seem that responsible leaders on all sides should agree: It was time to put dogma and politics aside and concentrate on pragmatic solutions.
There was also a need to support consumer financing and other evolving issues[xxvi], which became part of the financial reform law (see later). Perhaps the fundamental policy quandary was how to mitigate mortgage foreclosures, which we now address.
The current crisis has roots in the ‘sub-prime mortgage crisis’. Some bloggers (e.g., Muth’s Truths, 29-9-08) attributed the origins of the sub-prime mortgage market to President Carter’s 1977 Community Reinvestment Act and to President Clinton’s National Homeownership Strategy initiated in 1994.[xxvii] These policies encouraged measures to make home financing more accessible to the poor –what the 1977 Act referred to as “communities of color”. The Department of Housing and Urban Development (HUD) complied with this political imperative and compelled Fannie Mae and Freddie Mac[xxviii] to purchase such ‘affordable loans’. As late as 2006 this allowed Fannie and Freddie to classify “billions of dollars they invested in sub-prime loans as a public good that would foster affordable housing.” (Washington Post, June 10, 2008)
Fannie and Freddie had repurchased about 40 percent of all U.S. mortgages –a figure that rose significantly after takeover of 80% ownership by the federal government in September 2008. Until the government conservatorship in 2008, Fannie and Freddie were owned by private shareholders but chartered by Congress. They are effectively subsidized because implicit government backing means they can borrow more cheaply than other investors. In return, they are expected to serve public purposes including the policies to make home buying more affordable. These institutions were also motivated to maximize private shareholder wealth by participating in the new opportunities that emerged in recent decades.
Fannie and Freddie effectively were recipients of a federal bailout, like Wall Street banks, through their takeover (not funded through TARP) and thus were part of the debate about their own institutional failings and even misbehaviors. For 2009 and 2010 their chief executives were set to earn as much as $6 million, which provoked public outrage given the perceived blame of these institutions for the lax mortgage standards that led to the housing boom and subsequent financial crisis.
Compensation packages in the financial community were supported not by turning down imprudent business but by seeing how much business could be done. This epitomized the ‘moral hazard’ of government interference in the mortgage market. Given federal guarantees, it would seem that bankers had turned a blind eye to credit risk, and all the while Fannie and Freddie operated under the theoretical assumption that bankers would exercise prudence. As long as house prices continued to climb upward, it was a boondoggle for borrowers as well as lenders including Fannie and Freddie.
As the share of Americans who owned homes rose, the value of homes also rose, and loans thus became even less affordable to the poor. The sub-prime crisis emerged in this environment, along with securitization of existing loans and creating new ones. The housing boom exposed deficiencies in the underwriting and credit-rating practices by banks and investment houses, which under-priced risk and allowed excessive leverage, and was compounded by the creation and proliferation of complex and opaque financial products. Financiers failed to adjust to the shakier asset portfolios caused by lending to borrowers with weak credit histories. Boosted also by credit card debt, low inflation, Asian financing of the perennial current account deficit, all this contributed to a seemingly unending expansion of financing for American profligacy.
A ban on sub-prime mortgages might seem appropriate but that is simply one category. ‘Alt-A’ mortgages emerged in the space between prime and sub-prime categories, with features such as negative amortization where borrowers pay less than the accrued interest and add the difference to the balance due.
The Congressional Budget Office estimated in March 2009 the total cost to taxpayers of the takeover of the agencies would accumulate to $389 billion. [xxix] As Fannie and Freddie’s operating losses mounted, the Obama administration in December 2009 lifted a $400-billion federal commitment through 2012, to support Fannie and Freddie’s role in the vast majority of all new residential mortgages. During the crisis and through 2010 at least, the two companies almost single-handedly kept housing finance operating since private investors had fled the market.
During March 2009 the US Federal Reserve and Treasury began disclosing some ‘architecture’ for a new housing-finance system. The government had pledged more than $1.5 trillion to keep the mortgage market working but removing the risk from Fannie and Freddie. Fannie Mae and Freddie Mac already held over half of the $10-trillion US mortgage market and, with private investors sidelined by the crisis, were now issuing or guaranteeing 90% of home loans. Although Fannie and Freddie had raised their fees and tightened underwriting criteria, mortgages originated in 2006 and 2007 accounted for two-thirds of ongoing credit losses. The cost of any liquidation of damages would be high.
Options for policymakers to overhaul housing finance might include maintaining the existing hybrid public-private model, consolidating Fannie and Freddie into a single government agency, or else they might be completely broken up and a separate system of rules established to leave mortgage financing completely to private banks. New rules will evolve gradually, in fits and starts, striving to have successful funding and securitization of mortgages but without posing systemic risks to financial markets and the economy. Some federal role seems inevitable to facilitate and back up the mortgage market, but pricing of loan guarantees must be designed to recoup potential losses.
By August 2009 the concept of a ‘good bank, bad bank’ structure was being mooted, with the good bank attracting private investment in support of mortgage financing and the bad bank trying to settle past due ‘toxic’ loans. Among other policy measures on-the-table to promote loan refinancing were short-term moratoriums on foreclosures, tax credits for home purchases, allowing bankruptcy judges to order banks to reduce principal (in cases where foreclosure would yield less than loan modification), using TARP funds to pay down second mortgages that may be hindering a workout on the first mortgage, various schemes for mortgage refinancing, and other ideas. (See endnote [xxxi] for details of the program for federally-sponsored mortgage refinancing.)
Reducing principal on mortgages by judges –‘cramdowns’— was already allowed for commercial property and second/vacation homes. In a bankruptcy proceeding, the mortgage would be split in two: a secured claim equal to the current appraised value of the property and another claim for the remainder of the full loan amount. The borrower would pay on the secured portion, but the incremental claim for the additional unpaid balance would be treated like any unsecured debt. Lenders would in effect receive payment on the amount they should receive on a foreclosure, i.e., the market value of the loan collateral. Cramdowns had been adopted for agricultural loans when farming incomes declined precipitously in the early 1980s –Chapter 12 of the Bankruptcy Code was established by Congress to keep farmers from losing their homes.
Lenders dislike being at the mercy of a judge who may be more sympathetic with a troubled borrower than a rich bank. Bankers also argued that allowing cramdowns on home mortgages would cause financing costs to go up to compensate for the risk of bankruptcy court revisions, and investment in the mortgage market would decline. However, one study found that Chapter 12 “did not change the cost and availability of farm credit dramatically.” (Fitzpatrick & Thomson 2010)
On March 5th 2009 the House passed legislation approving cramdowns for primary residences, targeting abusive loan practices. The mortgage industry lobbyists[xxxii] won their argument in the Senate as the measure was voted down on April 30th.
The main government programs for homeowner-relief through 2009 primarily reduced interest payments, usually leaving the principal intact. Cramdowns were seen as problematic: They would only go to selected homeowners –or opportunistic borrowers—causing more moral hazard. Losses must be covered, whether by taxpayers or banks. Also, owners of mortgage-backed securities could sue if mass write-downs were attempted. Still, there was always an undercurrent of opinion that outright forgiveness of mortgage debt was more equitable than the bailouts – rescue the borrowers, not the lenders. The concept ranged from government refinancing for ‘underwater’ mortgages to turning part of the loan into an equity stake for the lender. A Fannie Mae loan could takeover the amount of the mortgage that covered the market value of the house, with the Treasury taking over the excess debt over equity with some provisions for leniency. However, this policy option never progressed, as taxpayers could not be coaxed to pay the bill.
Furthermore, it was never contemplated that every foreclosure should be stopped. Besides the moral-hazard issue, the fact was it would not be equitable (especially since borrowers often deserved their own fate). Also, it would be too expensive and probably would not succeed since many people had gotten into homes they simply could not afford.
Although government and private-lender attempts to stem the home foreclosure crisis mostly focused on loan modification and refinancing, loan modification was seldom the first recourse. Certainly loan modification programs were holding foreclosure rates below where they otherwise might be; but unemployment was still high and home prices still weak, making it more futile to achieve any refinancing, from both the lender’s perspective and the borrower’s. The government and lenders might have to revisit some ideas that had so far proved untenable such as reduction of the principal.
The Home Affordability Modification Program (HAMP) compelled banks and other mortgage servicers to modify rather than foreclose loans. However, the vast majority of borrowers entering the program failed to provide required documentation (especially proof of income) to last beyond the 3-month trial period. Foreclosure sales had initially been relatively low as lenders awaited details of the loan modification plans, but as it became clear the new programs would not save many borrowers in default, banks became anxious to clear up their large backlog of mortgages in default.[xxxiii] Many foreclosure moratoriums were expiring, and unemployment was disqualifying more borrowers from loan modifications. In 2009 over a million Trial plans were offered to borrowers, but less than 10% of the loans were permanently converted. Also, the number of defaults greatly exceeded the number of homeowners in the program. Nearly 3 million properties filed for foreclosure in 2009 (though only 871,086 were actually repossessed).
Housing finance in America had to address some particularities: For example, for primary mortgages in default bankruptcy judges were not allowed to change the terms or reduce principal, which was standard procedure for credit card, car, and other loans under court-ordered debt restructuring. Another difficulty was ‘no recourse’ mortgages in some American states, which limited the bank’s recourse in defaults to the home and other collateral alone. Banks recover insufficient costs and owners are more likely to allow foreclosure, both of which augment the overall downturn. Banks might be wise to write down the mortgage to keep owners in the home, but securitized mortgages may prevent any one bank from agreeing a deal to forgive debt. (Nor could banks easily foreclose on loans that had been securitized.) There seems a need for a formula whereby governments step in to change the terms of securitized loans when neighborhood housing prices decline significantly, or for government low-cost loans to supplement the outstanding debt. Larger schemes were afoot for the government to directly provide home loans (through Fannie and Freddie) at interest rates only slightly above government bonds.
The Federal Reserve ‘quantitative easing’ announced March 18th 2009 targeted long-term rates to ease the credit crunch affecting mortgages and corporate bonds.[xxxiv] Rejuvenating the market for mortgage securities was a fundamental concern.
To protect taxpayers from defaulting issuers, the Fed invests in high-quality bonds, strengthening the market for investment-grade debt. The price of mortgage and Treasury bonds in the marketplace would be forced up, lowering yields for new bond issues and hence reducing borrowing costs. This translates to support for equity markets, steering investment to firms with less risk of default, and it encourages new bond issues by these firms; but it might also be expected to exclude new or risky firms. Alternatively, pushing down long-term yields can chase investors into riskier investments for higher returns.
Quantitative easing directly reduces interest rates for targeted bonds only. It might not be effective at lowering costs and risks for individual borrowers and lenders. At best, there must be a significant time lag before any impact is felt in the broader market. Also, despite the gigantic size of the Fed’s market interventions, it was always possible that market forces would overwhelm the program. Bond traders might decide to liquidate holdings to take advantage of Fed demand, pushing borrowing costs up instead of down. If the power of the Fed’s printing press does not prevail, that could damage the Fed’s credibility and raise borrowing costs broadly (or even cause another market panic).
The effect of the government intervention was hampered by the complexity of the new housing regime. Mortgage rates and house prices were down, but tightened rules for underwriting, appraisal, etc, required adjustments by borrowers and loan officers. For example, Fannie and Freddie imposed extra fees for loans purchased after April 1st 2009 based on the type of property being bought or refinanced, credit scores, and the amount of down payment. Fannie and Freddie also required appraisals to conform to a new Home Valuation Code of Conduct, which incurred more fees. Banks added their own new rules.
By yearend 2009 it was clear that HAMP was not resolving the financial crisis for homeowners. HAMP had targeted helping 3-4 million homeowners avoid foreclosure through 2012. Foreclosures had been filed on 2.8 million homes, projected to reach 10-20 million by 2012. Over a million 3-month trial modifications had been started but less than 170,000 mortgages had been permanently modified; half of these defaulted again after 9 months. During 2009 a key measure of mortgage loan delinquencies –the percent of foreclosures plus 90-day past due payments – had reached the highest peak since tracking began in 1972 (LA Times August 21st 2009). Delinquencies (90-day) continued to rise to 1.6 million by yearend. In 2010 finally the number of loans going into delinquency was abating, but home foreclosures kept climbing as mortgage servicers worked through the backlog of troubled loans. Although home prices were stabilizing, the property market seemed unlikely to recover substantially until the bulk of foreclosures were worked out.
The first major pleas for government assistance of a national industry came from the so-called Big 3 automobile manufacturers: General Motors, Ford, and Chrysler. (Ford excluded itself but was implicitly part of the overall debate[xxxv] – hereinafter by ‘Big 3’ we refer to only Chrysler and GM.) At Congressional hearings on November 18-19, 2008, the Big 3 asked for only an emergency loan, testifying that their businesses were viable once the car market recovered in 2010 or 2011. Considerable progress had been made to restructure the companies already, stripping out 2 million units of capacity, converting to manufacture more fuel-efficient cars, and featuring a 2007 deal with the United Auto Workers union to cut costs per car by $1000 starting in 2009.
The UAW had to reduce so-called ‘legacy costs’ for pensions, healthcare, severance pay (the ‘jobs bank’ that paid nearly full wages to workers laid off), and allow more flexible work rules regulating what a unionized worker can be asked to do. However, the cost comparison was not straight-forward. The US car market was more open than many foreign markets, giving US domestic producers a disadvantage vis-Ã -vis foreign producers. Foreign carmakers in the US were not unionized and anyway had smaller legacy costs because of their briefer history, and they often benefited from large incentives offered for foreign investment by state and municipal governments.
The initial formula for federal ‘bailout’ was in the form of loans with warrants attached and other conditions stipulated. The warrants allowed the Obama Administration options for preferred stock investment, possibly attaching punitive dividends that would take the place of interest on a loan. Although this would presumably be non-voting stock, it was still equity and a recallable loan, allowing the government to maintain an ongoing influence on management. This approach would also deter other industries from requesting aid, to avoid government meddling. Potentially, the Obama administration could guide management toward the major industrial-policy goals that were being contemplated to combat global warming, reduce oil imports, etc.
Besides contributing to national plans for a future transportation system, a multi-billion dollar bailout investment might be much cheaper than the knock-on costs of bankruptcy. However, despite any bailout, much depends on the whims of American consumers – consumers might refuse to buy in to the trends desired by government and instead demand large, gas-guzzling cars as they have in the past.
The alternative to government bailout was Chapter 11 bankruptcy whereby a company effectively operates under bankruptcy-court ‘protection’ against lawsuits by creditors. The company remains in possession of its assets, operating the business under the supervision of a federal judge and for the benefit of creditors, but deferring payments to pre-bankruptcy claimants so as to fix its businesses as deemed necessary. Ostensibly, the difference with a bailout would be the supervisor: a court instead of the government. Also, the court would primarily be responsible to the firm’s creditors, whereas the government would be concerned with implications for the larger industry and economy.
‘Creditors’ to be satisfied included bondholders and other accountholders of legal liabilities, and also employees –both past and present— who had union-negotiated pay, pension, and healthcare contracts. Under Chapter 11, some contracts may be rejected if canceling them would be financially favorable to the company and its creditors.[xxxvi]
The Big 3 had argued that the industry’s future was bright and it required only a bridging loan, but there had been little confidence that total taxpayer support could be limited to the amount requested. Initially the bailout was planned at $25 billion, later reduced to $17.4 billion, then increased to as much as $50 billion for GM alone by June 2009 (although only a small part of these funds were initially utilized). Indeed, if bailouts were insufficient, bankruptcy was inevitable. Even higher costs might be incurred from the economic fallout of bankruptcy, impacting all businesses and individuals whose fortunes are tied to the auto industry.[xxxvii] In February 2009 GM estimated full-scale bankruptcy would cost taxpayers $100 billion, three times the total bailout to that point.
The supplier market would collapse along with the domestic automakers, which would affect even foreign-invested firms. On March 19th 2009, $5 billion was made available to auto suppliers, but it was funneled through the US automakers to give them the power to decide which suppliers would receive aid. This signaled the government’s intention to keep the Big 3 in business by helping only their supplier base.
President Obama pledged support to the automakers unequivocally in a speech to Congress on 24th February: “Millions of jobs depend on it. Scores of communities depend on it. And I believe the nation that invented the automobile cannot walk away from it.” A month later he observed, “We cannot, we must not, and we will not let our auto industry simply vanish.” Nevertheless, the dismal prospects of the American auto industry were leading consumers to abandon Big-3 products apparently because of uncertainties about warranties being honored, spare parts and components being manufactured and kept on hand, dealer availability, and resale markets drying up. A survey released in March 2009 by polling firm Rasmussen Reports found 63% of Americans would prefer not to buy a car from a bankrupt company. Worse, 88% preferred not to buy a car from an automaker receiving government aid. Consumers were reflecting perhaps the emotional response to long drawn-out appeals by the automakers for more government loans and the pressure from politicians for drastic reforms. To counter this consumer uncertainty, the Obama administration instituted a $650 million program in March 2009 to back up the warranties. Rationally, now with its warranties explicitly guaranteed and the supplier industry on government life-support, the Big 3 seemed a safer bet than consumers perceived.
It is unusual for the management of a company in Chapter 11 to be fired, as it may be reasonably assumed that the present management team knows far more about the firm and its customers than would new management. As GM faltered toward bankruptcy, the Obama administration replaced its CEO upon passing a second deadline on March 30th without satisfactory restructuring plans being received from his executive team. To many observers, the CEO had failed to muster the stomach for the drastic restructuring that ultimately was necessary. To many others, this government intervention into a usual prerogative of the board of directors was inappropriate in the USA, and it signified a politicization that had intensified in the private sector since the onset of the crisis.
Stockholders inevitably are displaced in the event of a bankruptcy. If the business' debts exceed its assets, then at the completion of bankruptcy the company's owners all end up without anything. The Chapter 11 plan, when confirmed, terminates the stock of the company rendering the stock valueless. Holders of unsecured debt might similarly be wiped out, but their legal rights were no different from the union. Secured debtholders, as in the case of Chrysler, had legal rights superior to the union. Thus, although equity and unsecured debt might be sacrificed, senior debt holders could benefit from bankruptcy.
A Chapter 11 plan of reorganization is confirmed only upon the affirmative votes of the creditors. If a plan cannot be confirmed, the court may convert the case to liquidation under Chapter 7. Chrysler’s secured creditors hoped for better treatment under Chapter 7. Other (presumably foreign) auto firms would cherry-pick the assets and keep them going, settling with holders of collateralized debt but shedding the cost burdens of expensive employee pensions, union contracts and healthcare. Chapter 7 is an unlikely option for viable enterprises; but Chrysler at least was saddled with out-of-date factories and brands, and the firm lacked sufficient economies of scale and scope.
On March 30th the government set a 30-day deadline for Chrysler to form a merger with Fiat (Fabbrica Italiana Automobili Torino), and on April 30th a complex deal was announced. However, not all Chrysler stakeholders had agreed (about 40 banks and hedge funds, some holding senior Chrysler debt obligations) so the deal needed to be settled in Chapter 11 bankruptcy court. President Obama was not disposed to consider these “holdouts” as deserving of return on their investments when the workers and the communities were so severely impacted by the plight of Chrysler. Obama said:
“In particular, a group of investment firms and hedge funds decided to hold out for the prospect of an unjustified taxpayer-funded bailout. They were hoping that everybody else would make sacrifices, and they would have to make none. Some demanded twice the return that other lenders were getting. I don’t stand with them.”
Debt holders responded that they had a responsibility to their investors to recover more of what they were owed and complained of being treated worse than other creditors. However, pressure mounted on the creditor outliers after the bankruptcy-court judge blocked their request to have their names kept anonymous because of death threats they said they had received after President Obama bashed the group publicly by calling them "speculators" only interested in money. On May 1st their resistance to the deal collapsed.
Chrysler was judged too small and weak to survive on its own; its only option, according to Mr Obama, was to complete the deal to merge with Fiat. In exchange for a 35% stake Fiat had offered such assets as fuel-efficient engines, small-car platforms, and distribution channels outside North America, but no capital injection. Fiat’s initial stake was reduced to 20% after discussions with the President’s auto task force, rising to 35% after fulfilling criteria set by the Treasury, and ultimately limited to 49% until Chrysler repaid American taxpayers for their bailouts. Fiat would not finance Chrysler until the full benefits of the partnership were evident, which Fiat estimated as two years.
The United Auto Workers’ healthcare trust fund for retirees would swap its $10.5 billion unsecured debt for a $4.5 billion note and a 55% equity stake, becoming the new majority owner. Four major banks with 70% of the firm’s debt would cut their nearly $5 billion debt down to $2 billion, but 42 other debt holders did not accept the Treasury’s offer of $2.2 billion on their $6.9 billion debt.[xxxviii] The Supreme Court on June 8th decided to release the asset sale to the bankruptcy court.
Chrysler would get as much as $8 billion in working capital from the Treasury, on top of $4 billion lent to Chrysler in January; the government anticipated losing all that investment. The US government would get an 8% stake and the Canadian government 2%. The US Treasury would select four independent members of the board of directors.
Before he was ousted by the Treasury’s auto task-force, GM’s chief executive said bankruptcy was not an option, fearing the company might be left in limbo for years and customers would abandon GM products. The President had implicitly promised that GM would not be liquidated, but he expressly allowed Chapter 11 as an option for both GM and Chrysler, to be done ‘quickly’. Such an accelerated bankruptcy had been termed a ‘prepackaged bankruptcy’ during early debate in Congress. Negotiations with the union and other concerned parties would be accomplished in advance, in this instance along with a loan advanced by the government. The government loan made it a creditor, giving the Obama administration a role in the court deliberations. The Bush administration had initially granted a $17.4 billion loan because it could still be called in if the industry failed to impress the new administration, leading to bankruptcy in the end.
A ‘quick rinse’ bankruptcy was increasingly the accepted concept. GM was to be reorganized into two firms: a new GM with the most competitive assets, immediately ready to offer the best products on the market; and an old GM[xxxix] with old factories, weak brands, etc to be slowly liquidated, as well as over $50 billion in legacy liabilities to bondholders and employees. The ‘new’ GM would have the brands, technologies, and seemed to have the economies of scale and scope to compete in the global marketplace.
On April 27th the new GM CEO put forward a restructuring plan to be negotiated by the various stakeholders and potentially a bankruptcy judge. The company proposed giving the government a 50% stake for half of $15.4 billion of bailout funds GM had already received and $11.6 billion more to be received at the new deadline of May 30th if GM’s plan was approved. The UAW would get 39% plus a $10.2 billion cash settlement for $20.4 billion owed to the retiree healthcare trust. Bondholders were offered a 10% equity stake in exchange for $24 of their $27 billion in debt, a price ¼ of UAW’s and less than 8 cents on the dollar. About $6 billion worth of the debt was unsecured debt in the hands of tens of thousands of retail investors – typically small investors and often former employees who had put much of their savings in company bonds upon retirement. Among the hundreds of banks and hedge funds that held the rest, some were protected from bankruptcy by credit-default swaps which provide insurance against default.
Just prior to entering bankruptcy, the GM deal had been re-negotiated in favor of the bondholders (but still with some debtors not signing on). The government would provide $30 billion in additional cash, converting most of the $50 billion total it had lent to 60.8% of the stock. The Canadian government got 11.7% in exchange for $9.5 billion in financing. The retiree healthcare trust of the UAW would own 17.5% plus warrants for an additional 2.5% (which seemed about half the previous offer) in exchange for forgiving about $10 billion in debt. The offer to bondholders was 10%, giving the bondholders a much lesser equity/debt exchange than the UAW and government. This last agreement gave the bankruptcy judge fewer contentious issues to handle so was more quickly settled by the court. GM exited the bankruptcy court even faster than Chrysler – remarkably fast compared to major instances of bankruptcy in the United States.[xl]
GM was closing many plants and dealerships. Without bankruptcy it was unlikely GM could so easily implement such restructuring, given the legal and political protection dealers enjoyed – onerous state franchise laws had long frustrated the Big 3 in their efforts to modernize their dealer systems. For example, GM had spent over a billion dollars to buy out retailers affected by its decision to eliminate its Oldsmobile brand in 2001. Bankruptcy allowed Chrysler and GM to overcome political resistance – car dealers, supported by umbrella organizations such as the National Automobile Dealers Association, were among the country’s most effective lobbyists, with close ties to the local communities. During May 2009, with Chrysler already in bankruptcy and GM on the verge, both firms announced a restructuring of their dealer networks. NADA estimated that nearly 200,000 jobs would be lost as a result of the closures.
The auto companies argued that too many dealers were a legacy of earlier decades when the Big 3 had dominated the American market. Chrysler said in a bankruptcy filing that Toyota, with about 1400 US dealers, sold an average of 1292 vehicles per showroom, whereas Chrysler, with 3280 dealers, sold only 303 vehicles per showroom. This so-called over-dealered status hurt profits and prevented upgrades of old showrooms. A dealer countered, “Dealerships don’t cost the automakers one cent, and cutting them doesn’t save them any money.” Chrysler was asking the bankruptcy judge to cancel the franchises of 789 of its 3200 dealers representing only 14% of sales; GM planned to cut 18% of its dealer network by the end of 2010, which accounted for only 7% of its sales.
The automakers said they had far too many dealerships for a market that had shrunk over 40% and that too many dealers caused individual showrooms to be unprofitable and uncompetitive. They claimed that too many dealers were financially weak and therefore inclined to slash prices to move inventory fast. Weak dealers also could not hold up their end on promotions or customer service. Thus, the automakers and administration task force argued that the overgrown dealer networks and weak dealers reduced both brand equity and profitability. Certainly a bad dealer could hurt its carmaker.
Dealers contended that cutting franchises would simply cut sales. NADA argued that dealers’ costs were not shared by the automakers; in fact they buy the cars from the factory, pay for their transport, and pay for local advertising. Historically, the carmakers took advantage of their monopoly supplier position, forcing dealers to take unwanted inventory, even cutting off franchisees in favor of more compliant local merchants.
The one advantage the dealers had was local political clout. Since the 1950s local businessmen had pressed their legislators to protect their franchises, giving them special rights versus the manufacturers that more than leveled the playing field. It became very difficult to terminate dealers or impose inventories or expenses on them. Indeed, the obvious way carmakers could overcome these constraints was through bankruptcy proceedings, where a judge’s authority trumped state franchise laws.
Now dealers (and their communities[xli]) would suffer considerable hardship, and many dealers had been in business for decades. NADA estimated the average dealer had around 50 employees and contributed $16.5 million into their local economy. Dealers also could be stuck with ending inventories, so Chrysler for example was asking surviving dealers to buy the 44000 excess vehicles leftover on lots of terminated dealers.
Difficulties of government ownership were manifest in persistent political pressures. For example, lawmakers complained that GM should build a small, fuel-efficient car at factories in their districts, as stipulated in the bailout agreement, and there was also criticism about dealership cuts. The House Appropriations Committee prepared legislation that required both GM and Chrysler to restore cancelled dealer franchises. Another bill in Congress would require post-bankruptcy carmakers to cover legal claims for accidents due to defective vehicles that had been cancelled in bankruptcy court.[xliii]
The ideological issue remains unanswered: Should government intervention be used to return major industries to profitability, or should ‘free markets’ be relied upon to run their course? The Big 3 initially favored a bailout, arguing that bankruptcy would be disruptive. The industry clearly perceived a better future allied with the government.
Few other national industries were considered to merit a similar rescue. Unless the overall economy was at risk, ‘free markets’ should presumably work to clear the recessionary imbalance between supply and demand at appropriate price levels.
An exception was made in June 2009 when the Federal Reserve’s Term Asset-Backed Securities Loan Facility (TALF) program[xliv] was extended to commercial real estate, offering credit for investors buying commercial mortgage-backed securities. Commercial property loans accounted for over 20% of American banks’ loans at that point, and commercial real estate prices had dropped by one-third.
A global fix is needed, one that accommodates all major national regimes. A rescue and reform program that is internationally coordinated will establish common principles –such as open markets— but especially be more potent than isolated national efforts. There were some early negotiations among world political leaders, national ministers of finance and central bank directors – for example, there was a coordinated cut in interest rates on 8th October 2008, but the rate only matters if a loan actually is made.
Reforms are being mooted to address issues for supranational regulation, even farfetched notions of a ‘Breton Woods II’ conference. A meeting on 14-15 November 2008 of the G-20 (20 leading economies) addressed some issues, particularly coordinated fiscal and monetary stimulus, but reform mostly awaited crucial deliberations at meetings in April 2009, again in September, and ongoing follow-up. The dual considerations of capital adequacy and global regulatory frameworks were mostly relegated to international bodies – individual countries agreed on little. The global response inevitably encountered conflicts with parochial interests in constructing a worldwide reform agenda.
Approaching the April meeting, the USA called for the G-20 to do more to stimulate demand, but there are intrinsic regional factors that led to differences in opinion. Europe has more automatic stabilizers such as social welfare and unemployment payments that may compensate for smaller fiscal initiatives, and anyway the European Union has rules limiting deficits. Europeans also have their own difficulties overcoming internal divisions to achieve a common economic policy, and the euro area generally needed a cohesive approach to keep its currency zone stable. Germany disagreed with applying the American approach worldwide, stressing a quick return to balanced budgets.
Europe’s reluctance to spend more on stimulus efforts portended slower recovery than in America but also less debt burden[xlv] (except countries with long-standing deficits, e.g., Greece). Fiscal stimulus in East Asia as percentage of GDP was even higher than in America, helping Asia bounce back from the recession strongly. Asian banking systems were in much better shape and sovereign debt dynamics supported economic expansion.
Possible ideas for future discussion, at least at a conceptual level, might be quite far reaching. The post-war Breton Woods arrangement would be renegotiated to create a new financial system less reliant on the US dollar as well as addressing concerns about America’s de facto veto power in global institutions. Although these notions will probably remain ‘academic’ for the foreseeable future, there must be ways to correct the huge imbalances – e.g., Asian saving and Western consumption – that fueled the boom.
According to The Economist (16-5-09:80), “the next monetary order is more likely to be made in Beijing than in New Hampshire.” As the major creditor to the US, China[xlvi] may be calling the shots. Pointing out that the global imbalances are due in large part to the reserve status of the dollar, the governor of the People’s Bank of China (Zhou 2009) called for the dollar to be replaced as the main reserve currency by the SDR. (The Special Drawing Right is an artificial currency created by the International Monetary Fund in 1969, now mainly used for IMF accounting with member countries. The value of the SDR currently is a weighted average of the dollar, euro, yen and pound.)
Surplus countries such as China had little choice but to put their savings into dollars due to the dollar’s central role in world trade and finance. China’s concern was that the Federal Reserve’s response to the crisis would be inflationary and ultimately lead to devaluation of the dollar; China’s huge reserve assets were held around 2/3 in dollars.
The governor suggested a substitution account at the IMF where countries could deposit their dollars for SDRs, avoiding the market exchange rate and the adverse consequences of a dollar decline for the US, euro area, and China itself. However, the SDR’s potential is limited by the fact that only governments use them.
With the Federal Reserve leading the bank rescue effort by such huge expansion of credit, central bankers have risen to a prominence as never before; and they will ultimately have the added responsibility to help their countries (notably the USA, as well as Britain) meet the claims of foreign creditors on their debts. A new system, perhaps more to the liking of China with its capital controls and managed currency, must allow settlements to clear without sky-high interest rates or too much depreciation of the dollar.
Fixing financial management in the banks entails new emphasis by boards of directors and chief executives on the monitoring of risk itself, as opposed to the emphasis on the opportunities presented by high-tech trading mechanisms and investments. Financial engineering had advanced to such a high level of quantitative risk analysis that banks were lulled into complacency by their own sophisticated probability models, all figures indicating huge potential returns, and small risks estimated with great precision.
The ‘new paradigm’ that had led to crisis was that risk seemed to have been permanently reduced. Low perceived risk combined with macroeconomic policy errors such as low interest rates, promotion of home ownership, etc, lead to the huge growth in leverage, derivatives, and the securitization phenomenon for decomposition and distribution of credit risk throughout the financial system. Although financial engineers –the ‘quants’– could demonstrate low risk of particular investment strategies, they failed to foretell the consequence of broader market asymmetries and overruns that especially occur when every market participant mimics the successful risk-taking of everyone else.
Extremely unlikely but catastrophic events, called ‘black swans’, have become much more likely and greatly amplified in global financial markets, far more than the usual probability models indicate. The new strategy for managers must be to discount the precision mathematics and reawaken the old spirit of conservative fiduciary responsibility.
There seem to be no new tools for top management, only a return to cautious stress tests, scenario planning, and the like, with a shift in the balance of power in organizations from risk-takers to those who police them. Risk managers, rather than traders, became (for awhile) the hottest recruitment area in finance.
Is re-regulation the answer? The problem of unintended consequences argues against tight regulatory regimes. Technological and other innovation will focus on avoiding the strictures of rules, and the innovators will be smarter and have more incentive than the regulators. Regulatory improvements are obviously needed, but sometimes they should be modest to avoid chasing financiers offshore or interfering with new enterprising ideas. For example, short selling[xlvii] was a big problem in the 1997 Asian Crisis; and the regulatory approach was to ban it in some instances where it was perceived as actually or potentially harmful but, in most cases, simply impose new rules for transparency. When selling got too wild, market-makers were called in for discussions with a government minister and warned they could be in danger of losing their license – they tended to be sensitive to ‘moral suasion’ in their host country.
The Asian Crisis resulted in very little reform of global banking. In contrast to the way Asia was treated by the ‘Washington Consensus’,[xlviii] a decade later the United States Federal Government agreed to infuse huge amounts of cash to bail out banks and other American interests. Finally, regulation of American and global banking was considered very seriously—to avoid another bailout.
In the 2008-09 crisis, Asian countries at least had huge dollar reserves and well-capitalized, profitable banks. The region’s banks (except in South Korea) could finance their loans with deposits, which made them less reliant on strained money markets. Banks in Western countries even sought bailout by turning to such Asian savings. (Yueh 2008)
Global reform was primarily a project for international institutions, not national governments. The central bank for the world’s central banks is the Bank for International Settlements (BIS), in Basel, Switzerland (est. 1930). The so-called Basel Accords provide guidelines for capital adequacy; but the Accords gave responsibility for assessing risks to credit-rating agencies[xlix] and the banks themselves, which assessments have obviously been discredited. The riskiness of bank assets that brought on the Credit Crisis was quite impossible to measure. ‘Basel 2’ was partially in effect for the Crisis; now there is an emergent Basel 3 (see later), even suggestions that other disciplines such as computer science need to be incorporated to address the complications of modern finance. Basically, risk management and appropriate levels of capital are at issue.
The Financial Stability Forum brought together financial regulators, central banks, and treasuries from major Western economies, initially in advance of the G20 summit in April 2009. Deep divisions among participants prevailed, for example how to handle the failure of giants. The FSF was examining the issues of systemic risk, proper international leverage ratios, and off-balance-sheet exposures. The off-balance-sheet vehicles, which had allowed capital ratios to be manipulated and assets’ risks to be understated, were ruled out. Also forbidden were over-reliance on wholesale funding and excessive compensation policies. Simple ratios of equity to capital would be monitored, and banks would be required to build up capital during good times. Amounts of capital are addressed by Basel 3. Exact mechanisms and many other specific questions have yet to be decided. In April 2009 the FSF charged that the enforcement of rules needed to be less permissive. Those practices forbidden or ruled out were still very much in.
The US Federal Reserve was grappling with these and more regulatory issues. Regulators needed to scrutinize the risk of the system overall, not just individual lenders. However, relying upon a single global regulatory authority seemed unlikely. A nominal global watchdog was embodied in the FSF, in collaboration with the IMF, but it seemed unlikely their warnings or (heaven forbid) directives would get much attention. Certainly Americans would not have permitted a global regulator to disallow their sub-prime mortgages; nor would banks –for the sake of counter-cyclical provisioning— have set aside capital that was being loaned out so profitably during the credit boom. Appeals for limits on leverage would also fall on deaf ears (although fewer loans may do more to cap bankers’ bonuses than explicit regulations or any attempt at better corporate governance).
Obviously, no new regulations were binding and anyway many future reforms are less obvious now. American tax policy might be reformed in the longer term to remove tax incentive for leverage, but tax reform will not overcome political hurdles soon. Ideas include revising corporate tax codes that favor debt over equity, disallowing mortgage interest to be tax deductible on personal tax returns, a counter-cyclical tax on mortgages that rises during property booms and falls during busts,[l] and other structural changes.
Governments already provide extensive protection against crisis, including liquidity support from central banks, deposit insurance, and (explicit and implicit in the latest crisis) credit guarantees. Arguably, this has created moral hazard and allowed banks to relax their own fiduciary vigilance. Since 1988 global capital levels have been set by the Basel committee at 4% of risk-adjusted assets; before that, when banks did not rely on government backing, they often carried much bigger buffers to protect themselves.
The US Congress endeavored to establish new regulatory frameworks to provide oversight of the banking industry for
Ø insuring capital adequacy and liquidity,
Ø policing threats to the economy (systemic risk), and
Ø monitoring consumer banking (the job of the new Consumer Financial Protection Agency –CFPA— see below).
New agencies would strip powers from the Federal Reserve and other existing agencies, but in a political compromise the new consumer protection bureau (CFPA) became an autonomous division within the Fed. The Fed was denigrated for historically not treating consumer protection as a central part of its mission.[li] Still, consumer protection arguably should remain a responsibility of bank regulators – primarily the Fed.
To police systemic risk, the government wanted authority to seize and dismantle large firms that appeared near collapse and to regulate hedge funds and derivative markets. Supervision of institutions ‘too big to fail’ would be consolidated under the Fed (or else a new agency). The Fed would in turn be advised by a council of regulators that would scan the horizon for emerging risks. The priority was to create a mechanism to wind down financial giants – an alternative to either bailout or bankruptcy.
Creating a ‘resolution authority’ to move a failing firm’s assets and liabilities to newly created bridge financial companies implies a new insolvency regime beyond the existing bankruptcy code. Also, any special bank tax to fund such an operation (based arbitrarily on an institution’s size), plus the new regulatory agencies, could make the US an unattractive jurisdiction for financial companies. Certainly, creditors would lose access to assets taken over by the FDIC, Fed, or other authority.
Moreover, Congress wanted to establish oversight for ‘shadow banking’ –the vast market for derivatives that were ‘off balance sheet’ transactions as contingent liabilities or assets. Banks’ dealing and trading on their own account would also be restricted, to remove risky proprietary activities from access to the Fed’s discount window, FDIC insurance, and taxpayer guarantee. Although banks might engage in derivatives and other securities business on behalf of clients, the types of derivatives dealt by banks would be limited to specific instruments –allowing interest rate, currency and other hedging devices for clients but disallowing CDOs, for example. The intent was to prevent banks from making excessive speculative investments with their own capital and to compel transparency –to preclude banks from operating in ‘shadow banking’ arenas.
Of course, Wall Street banking goes far beyond simply taking deposits and lending to customers.[lii] Indeed, the vast majority of banks’ trading transactions is in the interbank market, i.e., within the financial community. So-called ‘proprietary trading’ is not easily separated from marketmaking and necessary hedging against clients’ trades. Balancing fiduciary roles as adviser, financier, and marketmaker for clients, plus ‘enlightened positioning’ of the bank’s own account, became more problematic as finance got more complex and as Wall Street thrived on the new opportunities.
Those who package loans for securitization would increase disclosure, plus retain a small ownership in any deal to encourage better underwriting. (However, instead of tying up capital in this way, requiring securitizers to sign warrantees and agree to buy back bad loans could have the same effect.) Arrangers’ fees would be paid over time and reduced if loans fail. Derivatives not cleared centrally or traded on an exchange would face higher charges. A new Consumer Financial Protection Agency (CFPA) would protect the public from rapacious lending practices, usurping a domain of the Fed.
Despite widespread agreement that regulation of financial institutions had been remiss, the banking industry opposed the proposals for a CFPA. The American Bankers Association said the new agency would have “powers to mandate loans and services that go well beyond consumer protection.” The Consumer Bankers Association said the proposed agency “would create a maze of regulations suppressing creativity and product innovation.” Arguably, the CFPA could even push banks to accommodate consumers at the expense of the banks’ financial soundness. Presuming competitive and transparent financial markets, financial services should compete and succeed by treating customers with integrity. But that had certainly not happened with mortgages and credit cards. In a speech on June 17, 2009, Obama observed that “a culture of irresponsibility” had taken root on Wall Street and elsewhere, that “there were millions of Americans who signed contracts [for loans, credit cards, etc] they didn’t always understand offered by lenders who didn’t always tell the truth. … Companies compete not by offering better products but more complicated ones, with more fine print and more hidden terms.”
The administration’s ‘concept plan’ intended to rationalize multiple regulating agencies.[liii] The advantage of multiple regulators was more oversight, but inter-agency conflict was problematic and banks tended to shop around for the easier regulators. This ‘concept’ was at odds, of course, with the legislative intent to create even more agencies.
All this (and more –see next section) required Congressional action,[liv] where jurisdictional and ideological disputes raged. There was also a need for a global strategy.
Regulating global finance might best be by function. Extending oversight to the unregulated frontiers of finance such as hedge and investment funds is necessary; also on the agenda are valuation and disclosure standards for the exotic new financial assets.[lv]
There is thus a need to formulate national and international Accounting Standards covering particular new financial instruments, as well as the need to address capital adequacy against failure in the wide range of new securities. Prevailing accounting standards (IAS37) did not require provision for contingent liabilities and assets where the future value, timing, and possibility of actual need for settlement were so indefinite in each instance. This allowed banks to hold the items off their balance sheets, and it created huge unknown potential losses. One improvement was the routing of some instruments such as “credit default swaps” through clearing houses rather than being settled privately.
Clearing houses, or central counterparties (CCPs), act as buyer to every seller in a market and vice-versa, collecting margins on every trade. A reserve fund is set up by members; thus traders only have to worry about the viability of one entity, with which they can net their trades. The failure of one big trader is less likely to bring down the whole financial system. However, derivative products might be too specialized to be marketable beyond the originator and the buyer so traders tend to deal directly with each other. Arguably, traders may take on risky positions if losses are ultimately borne by the CCP. Also, the CCP may not monitor the complex derivative positions of particular traders. Finally, CCPs become just one more institution ‘too big to fail’, as the big trading banks that act as CCPs are already.
Certainly the huge financial institutions that had become ‘too big to fail’ and the accumulating off-balance sheet positions needed to be regulated. Until April 2009 in the USA, only banks were supervised by federal regulatory authorities, while non-bank institutions were supervised on a state-by-state basis. The nature of liabilities of insurers,[lvi] for example, were less volatile because long-term policyholders were less inclined to cash in than nervous depositors in banks. Life insurers traditionally had lower gearing, and they balanced liabilities to holders of insurance policies by investing in long-term assets such as corporate bonds and commercial real estate. However, the reality of AIG’s misadventures with derivatives changed that perception. Along with the hedge funds, mutual funds, etc clustered in the financial centers of London and New York, these global financiers had become a major destabilizing factor. Nevertheless, insurers differed from banks in one important respect: They were not holding depositors’ money and counterparty positions so were less essential to bail out.
US Treasury Secretary Geithner on March 26th 2009 had proposed subjecting the entire US financial system including the non-bank sector to federal supervision. A single regulatory authority was contemplated for oversight of the 10-20 institutions that were so large and interconnected that potential failure represented ‘systemic risk’ for the entire economy. There were two schools of thought: either place tighter constraints on risk-taking of specific institutions or take measures to reduce their financial influence. The first approach could require them to maintain higher capital balances and submit to other special rules – implicitly promising bailout if these institutions got in trouble. The effect might be to discourage certain firms from growing, or alternatively attract investors and depositors toward these large institutions with implicit government subsidy – which would further enlarge the most ponderous firms. The alternative to de-concentrate financial influence could be accomplished by limiting mergers or restoring some of the previous (Glass-Steagal Act) boundaries between commercial and investment banking.
The Obama administration proposed a new rendition of the Glass-Steagall Act of the Great Depression, repealed in 1999, that had separated commercial and investment banking (the Volker Rule). The purpose was to both limit risky investments by banks and control their size and scope. Access to low-interest loans from the Fed and FDIC-insured deposits were a special advantage of commercial bank status, and the major investment banks had sought bank charters amid the crisis in late 2008 to protect themselves from the turmoil and avail themselves to the cost advantage. In the wake of the new policy approach, Goldman Sachs and Morgan Stanley might have to choose between their bank status exclusively or revert back to investment banking (if prevented from doing both).
The administration wanted to cap the size of banks, and also to ban or limit ‘proprietary’ trading and involvement in hedge funds and private equity which had incurred risky investments with bank capital. The plan was much more liberal than the old Glass-Steagall Act, allowing banks to continue some investment-banking activities such as underwriting and other market making. The purpose was to stop Wall Street from gambling with subsidized deposits. At least, entities with access to the Fed discount window (i.e., banks) would have to spin off the more speculative activities to non-bank subsidiaries; at most, there could be an outright ban. This would represent a huge loss of profits. Ultimately, the unintended outcome might be that the newly-regulated activities migrate to the large, independent hedge funds, increasing the unregulated financial sector. Then banks, being the biggest lenders to private-equity and hedge funds, incur risky asset portfolios all over again. Worse: new rules could drive such trading offshore.
The new legislation comprised many other measures, including a nonbinding vote by stockholders on executive pay and retirement packages. It seemed that nothing – neither contractual obligations the banks had undertaken in return for a bailout, nor moral suasion through public censure, nor repentance by the banks for past mis-investment – nothing had stemmed the tide of bonuses awarded to executives. In January 2010 Obama proposed a fee to be assessed against big banks’ liabilities (excluding domestic deposits), with accompanying rhetoric implying the measure was punitive. By the end of 2009, the big banks were awarding more high bonuses to executives even while bank lending continued to languish. Arguably, however, the fee was a legitimate way to offset the lower cost of capital for big banks that were implicitly guaranteed by the government: a systemic-risk tax. European governments were also proposing levies on their banks, with IMF and European Commission support, at significant potential cost to banks.
Regulatory unpredictability could raise perceived risk and hence the cost of debt. Furthermore, a global patchwork of ideas was emerging, with possible overlapping rules or inconsistencies. For example, regulatory reform in America to control institutions ‘too big to fail’ might not be well-coordinated with global reform efforts spurred by the G-20. The G-20 agenda (and Basel 3 –see next section) was emphasizing capital adequacy, having concluded that breaking up banks would be difficult and of uncertain benefit.
A new ‘macro-prudential’ regulatory approach is necessary that accounts for the health of individual institutions as well as systemic vulnerabilities. Even strong firms, acting prudently in times of crisis, can fail and undermine the system. It also would be appropriate to have different capital adequacy measures at different stages of the economic cycle. A possible mechanism is ‘dynamic provisioning’ for banks, setting aside profits in boom times as a reserve to offset bad loans in a future crisis; but such provisions potentially create opportunities for banks to manipulate earnings reports.
Proposals dubbed ‘Basel 3’ were published in December 2009 by the Basel club of bank supervisors. They addressed the issue of capital adequacy (rather than the issue of the size of institutions that is an American reform priority). Two capital components were contemplated: a coverage ratio of high-quality liquid assets, and a funding ratio requiring a higher level of longer-term financing of assets.
The new proposals defined capital more strictly, so that essentially only pure equity counted as core (‘Tier 1’) capital, disallowing equity-like instruments that might really be debt such as preferred stock. Core capital would be increased to maintain confidence of depositors, creditors, and counterparties, and further enhanced to withstand a market meltdown. On September 12th 2010 the Basel committee agreed to the new rules (Basel 3), requiring global banks to keep common equity equal to at least 4.5% of risk-weighted assets, compared to 2% now. This rule would not go into effect until 2015, with an additional 2.5% counter-cyclical buffer not due to take effect until 2019. The long lead times would soften the impact of bigger capital buffers on growth of banks. With reserves thus totaling 7%, capital for risky operations could be over three times larger.
The second component, augmenting quasi-capital or ‘Tier 2’ securities, imposes losses on creditors rather than only on equity (sparing taxpayers, in the event of government rescue). One such instrument is Coco, ‘contingent convertible’ capital, which is debt that converts to equity in the event of crisis. An unresolved issue is that Coco investors can insure against their Coco risk and thereby pass the risk onto counterparties like AIG, ultimately recreating the need for bailouts. An alternative to Cocos is partial bankruptcy, for example government guarantees only for deposit-taking parts of banks and allowing the rest to face bankruptcy, thereby avoiding depositor-runs on banks in crisis and also making banks –not taxpayers— pay for bank failures.
The Institute of International Finance, a bank lobbying body, argued that the cost of big new capital and liquidity safety ‘buffers’ would be excessive. Although banks had not experienced the erosion of capital earlier forecast by the Federal Reserve’s stress tests, reducing their structural reliance on short-term funding would require raising trillions in customer deposits or bonds to achieve a ‘net stable funding ratio’. Still, banks may be preempting imminent regulatory regimes by shifting towards stronger safety measures already. Risk adjustment of bank assets should also be more stringent and less dependent on credit ratings. There are many more ideas on the drawing board, and many criticisms.
Financial regulation will be approached differently for countries that value financial stability over innovation, directed credit and state banks to avoid financial-market failures (especially in developing countries), etc. It seems unlikely a single global regulatory agency with, say, a binding code of international conduct, would displace distinctive national approaches. By allowing a variety of national regulatory models to flourish, the best global regulatory regime can emerge (though with the possible overlap and inconsistencies mentioned above). The European Union mooted an idea for ‘colleges’ of national regulators to approach regulation with more sensitivity. Cross-border supervisory colleges could share information about global banks – but not to sacrifice national regulatory sovereignty to international agencies.
The IMF remains the global institution best suited to attend to a dysfunctional international payments situation. Besides quotas and standing arrangements to borrow from members, the IMF has the ability sometimes to elicit funds from reserve-rich member countries willing to provide extra funds beyond their ‘tranche’ such as Japan, China, the Middle East, or the Nordic countries. The IMF had been responsible to deal with the Asian Currency Crisis, but the conditions it applied to its loans were controversial. IMF ‘conditionality’, plus the stigma of an IMF bailout, make some countries reluctant to take the IMF route. There also were doubts that the Stand-by Arrangement, designed for short-term balance of payments difficulties, is appropriate for the problems that exist today. Thus, on 29th October 2008 the IMF announced a new Short-Term Liquidity Facility for 3-month loans awarded to countries without the previous conditionality, which in turn was replaced in 2009 by a Flexible Credit Line.
The intent was to have a less strict, more accessible IMF. At the April 2009 G20 London summit, it was decided that the IMF would require additional financial resources to meet prospective needs of its member countries resulting from the global crisis. IMF resources were tripled to $750 billion. At the height of the crisis from November 2008 – March 2009, nine countries (all lower-income) were awarded IMF loans, with Mexico first in line for the FCL in April. (East Asian countries that felt abused by the IMF a decade earlier –Korea and Indonesia— demurred.) By 2010 the IMF was mounting rescue efforts in the euro zone, starting with a record bailout for Greece (110 billion euros) in May 2010, to prevent a new financial crisis starting in the European Union.
This crisis has required massive, globally coordinated mobilization of capital –with the ultimate goal of establishing global financial stability and balance of payments equilibrium. The US is the only country immune from balance of payments difficulties because, the dollar being the world’s main reserve currency, the US simply ‘prints’ more dollars which are accumulated by its creditors such as China and Japan. The limit to this ‘Faustian bargain’ is unknowable, but it seems we are destined to find out as the US government deficits, current account outflows, and national debt soar to new heights.
For decades, the American consumer seemed immune to the usual laws of economics in the sense they could spend and borrow with seeming impunity, and the US$ would hold its value despite persistent deficits. Classical theory of international economics purports that foreign exporters would redeem their surplus dollars for gold or other reserves from the US central bank, the dollar would devalue (due to less reserve backing and/or increased supply of dollars in the economy), and Americans would be prevented from importing so much. However, exporters to America were willing to save their surplus dollars and invest them back in America, in the form of debt (Treasury Bills or other loans to Americans) or capital (so-called FDI –foreign direct investment in new business, or other equity such as property investments). From 2000-07 America received nearly $6 trillion from overseas, counterbalancing a persistent current-account deficit that peaked at 6% of GDP in 2006. (A level of 4% is considered dangerous, portending devaluation.)
The problem, it seemed to many economists, was not that Americans spent too much but foreigners saved too much[lvii]. Savings in America declined from around 10% of disposable income in the 1970s to 1% after 2005. In contrast, high saving was a key element of the Asian economic ‘miracle’, along with export-oriented industrialization. Asians were willing to invest at low interest the dollars they earned by selling to America, effectively underwriting American consumption. The American economy conformed to the normal case scenario of individual utility maximization, an economy that aimed for maximum benefit to consumers; whereas Japan was ‘different’. Lester Thurow (then Dean of MIT’s Sloan School of Management) famously dubbed Japan’s system “producer economics” because they seemed to prefer producing rather than consuming.
It would take many decades for America’s colossal deficit spending to finally come home to roost, as China for example willingly accumulated 2 trillion dollars in reserves. (Such high reserves were deemed useless by many economists.) If China were to liquidate their dollars, it would have a devastating effect on both China and the US. China’s dollar reserves would be devalued, and their own currency would revalue upwards and kill their export industries; and for America its long consumption and investment boondoggle would end. China had witnessed the same imbalance between the US and Japan in the 1980s, which finally resulted in a revaluation of Japan’s currency and a halt to Japan’s rapid growth in the postwar era. China, keeping its part of the ‘Faustian bargain’, invested trillions of dollars earned mostly from manufactured exports into American government bonds and government-backed mortgage debt. This kept interest rates low and fueled America’s consumption binge and housing bubble. Both countries were happy: America got cheap imports, low inflation, and low-cost foreign financing for economic growth, and China industrialized rapidly with financial stability and a strong export platform. Not unlike Britain’s financing of American railroads and other infrastructure in the 19th century, it was mutually beneficial. Economists were cognizant of the danger from the tremendous trade and financial imbalances, but there seemed no solution without better international cooperation.
Clearly, the global imbalances that were the contributing cause to the crisis should be corrected, but the status quo is imperative for the moment. China’s fortunes remain tied to America’s and vice versa.[lviii] The US Treasury needs China to finance its trillion-dollar bailout to banks and Obama’s stimulus plan and upcoming programs. China needs the US market to keep its trade from collapsing and causing social unrest. The American proclivity to overspend now must be the initial solution to America’s own dilemma – indeed, saving is not helpful and politicians entreat Americans to shop as a patriotic duty.
The government’s initiatives to stimulate spending have been huge –with doubtful success. Transition to global economic balance will be a much greater challenge.
Do speculators deliberately promote runs on markets and cheer as currencies, stocks, and other target markets plummet – and economies collapse? It seemed, as always, that the only participants in the market turmoil to be actually savoring uncertainty and the misfortunes of others were the traders.
Thus, the eternal issue is who to blame for capitalist abuses and how to reform.
Hedge funds have been important, even dominant, investors worldwide and often have more funds available (through leverage) than individual governments. The biggest hedge funds certainly thrive on market volativity, and it matters not which way the market is moving, only that they can get on the bandwagon. With hedged positions, they are on both sides of the markets and benefit from the volume. With unhedged positions, if they bet wrong they can still win. The strategy is simple: Well before they mount an assault on a particular asset, the hedge funds borrow huge amounts of the very asset they want to bring down. They might borrow many multiples of the amount they intend to sell. When they start selling, interest rates spike up as a result. Lending at, say, 20% what you borrowed at 5% is indeed lucrative; it yields huge profits when you are lending in the billions. Even if the central bank succeeds in defending its markets and inflicts losses on speculators, the hedge funds would have made large profits in the lending market. What if the central bank buckles and allows its assets to fall? Then the funds hit a double jackpot. When the Thai baht was attacked in this way in June 1997 – said to be led by George Soros – the major funds walked away with profits of billions of US$. A few months later, it was the turn of the Indonesian rupiah, then the Hongkong dollar. When interest rates exploded with the force witnessed in the Asian markets, the first to plunge were the stock markets. The next to come under pressure were the real estate markets. And if interest rates stay high, the whole economy slows down. As they launch their attack, the hedge funds short-sell the stock market, knowing that other, less agile, market players have to sell their stocks to maintain liquidity. The stock sell-off can frighten genuine long-term investors into selling out too; that is how it all snowballs.
Given the tremendous size and scope of the US government role in 2008-09, it is sad in retrospect that the Washington Consensus disparaged any financial rescue during the 1997-98 Asian Crisis, preferring to ‘let the markets decide their fate’. [lix] At the onset of the current crisis, this amorphous alliance of dictators was less reverent about market discipline.
Job losses in America in September and October 2008 totaled 723,000, increasing to nearly 600,000 monthly November through January 2009, and approaching 700,000 in both February and March.[lx] Since the recession officially began in December 2007 until then, the economy had lost over 5 million jobs.[lxi] A later Economist Survey (“The Long Climb,” October 3rd 2009 p5) estimated that before the crisis is over 25 million may lose their jobs in the 30 rich OECD countries. Indonesia saw 25 million become unemployed in the early days of its crisis in 1997, and they hit the streets looting and raping.
The lesson of history is that early, decisive government action can stem the panic and the costs. However, this crisis was so much more complicated, affecting more types of markets in many more countries than any past crisis. Comprehensive solutions seemed sensible enough but had to overcome global political hurdles. The world blamed this on America, McCain blamed greed and corruption (though legal ‘intent’ in the disclosure and valuation shortcomings would be impossible for prosecutors to prove), but some wonder if this simply reflects the need to change our entire lifestyle. Nevertheless, boom and bust is an ancient story – just worse in today’s globalized markets. Emerging countries share some blame for financing the boom by continuing to loan to America.
The banking system was stricken by what The Economist on October 11th 2008 (p93) identified as a 3-headed monster: solvency, funding, and liquidity. Thus, there were three related developments associated with the collapse of the asset and credit bubble: bank insolvency, requiring capital injection; the inability of banks to borrow longer-term to finance the share of their assets not covered by deposits; and the need of still-solvent banks for liquidity to compensate for the inability to access money market funds for short- and medium-term needs. Then there was a need to keep any available funds from walking out the door in the form of withdrawals by customers, distributions to owners, mergers and acquisitions, etc, or simply held for liquidity needs to offset the reduction in capital from the massive charges taken for bad debts. Ultimately, there was the severe impact on the ‘real economy’ as well as the impact on public financial burdens. Means of governance over the ‘3-headed monster’ were extremely inadequate.
Deregulation had been the value orientation of the ‘Washington consensus’ since at least 1981. Complex, potentially dangerous financial instruments can into vogue, and the new academic field of ‘financial engineering’ provided legitimacy –and new graduates— for the boom in finance. It became possible for banks to simultaneously float risky loans and minimize their exposure to default by passing on the debt as marketable securities that were highly lucrative and seemed risk free. CDSs even made it possible to both market unreliable securities and profit from their failure. Innocents abounded to take part in the boom in property values, sub-prime mortgages, derivative trading and other speculations.
The burst of the property bubble created credit losses, financial institutions lost capital, but illiquidity was a problem even for strong businesses and banks. Most banks could still lend, but uncertainty about their own and their customers’ access to funds made them hold their money. Government priorities were to unblock credit, using central banks for adding liquidity and other actions such as selling guarantees for private sector loans, buying commercial paper, interest rate cuts, etc. Providing capital to enable banks to expand credit seemed a sensible solution, but banks kept new capital infusions simply to cover ongoing losses or other firm needs (including bonuses for executives). So none of this quickly and completely worked through the system, and global stock markets[lxii] reflected the uncertainty over the outcome or that enough had been done.
This begs the question: how much capital is needed worldwide to stop the rot, and how should it be raised: from taxpayers, or will the private sector finally come forward? Nobody knows the answer, and figures tended to keep going up, awaiting the contagion to stop spreading and business to resume investing. But many central banks had lots of cash, especially in Asia. It seems there are no limits to what can be done, all the way to financing and operating entire economies. When global finance stops, only governments can get it started again. Although the private sector in the U.S. could afford to recapitalize the banking industry, it could not have been expected to step forward on its own.[lxiii]
Some of this runs the risk of ‘moral hazard’ (incentive for banks to behave recklessly and depend upon government bailouts). The government may also politicize the allocation of funds or disregard the ultimate purpose of maximizing the profit for their taxpayers’ reluctant investment in the bailout. Governments resolve blithely to eschew these temptations and also not reward managers and shareholders of rescued institutions.
Moral hazard is only a theoretical concern, though it was compelling enough to overrule American participation to bail out Asia in 1997-8. Today, the ideologues must take a back seat, as even the American right wing should allow (with sensible exceptions) that government funds and government intervention must lead the rebuilding of balance sheets, and ultimately the whole economy will need rebuilding. Capitalism, freedom, and the American Way are not under threat, but governments are responsible to help their countries withstand the biggest asset and credit collapse in history. The free market system without government support, constraints and oversight can become unsustainable, harmful to the players themselves, and even harmful to society.
Another ‘theoretical’ concern is the efficacy of industrial policy. The government rescued both old, struggling sectors such as car manufacturing and new, dynamic sectors (mostly through the stimulus) such as high-speed rail, green technologies, etc; but it is widely believed that these business ventures will mostly become ‘white elephants’. Of course, the US government has long helped business – for example, the Small Business Administration was established in 1953, but the Obama administration is finally funding the SBA better and setting up a national network of business incubators. The government even bailed out Chrysler before (1979), but this time around Obama observed (2009) that the government must make “strategic decisions about strategic industries”. The size and scope of industrial policy has greatly expanded, in contrast to earlier administrations (since Reagan) that tried to eliminate industrial policy wherever possible. “Today the US federal government is the world’s biggest venture capitalist by far.” (Rodrik 2010)
The loans and equity investments by governments cannot be reimbursed soon, as such huge amounts of capital cannot be liquidated without depressing markets further. This raises two very important questions: What effect might a longer-term government stake have on the banks, car companies, etc? In the modern era there is less inclination for socialist-style management as there once was, for example in the era of the Nationalized Industries in postwar Britain. Nevertheless, taxpayers and politicians will certainly speak out and expect to be heard by managers of national industries. There must then be some confusion added to the corporate objective function.
This impact can be positive, as it was in some instances of Asian industrial policies for example, if government capital develops infrastructure and institutions for more sustainable future industry. However, in the United States the experience may be chaotic with such extreme politicization of business decision-making.
ii. taming deficits
The second question is the sustainability of such deficit spending, the impact on the national debt, and the need for eventual debt reduction. The US government cannot hope to reduce its burden soon, with important implications for interest rates and the value of the US$. At the onset of the Credit Crisis, the US$ rose significantly, due to its safe-haven status and also due to the widespread need to purchase US$ for funding international debt obligations. If this dollar strength had prevailed (ending a six-year decline), it would hamper recovery of US industry, because any new demand resulting from fiscal stimulus or general market recovery would be dissipated on cheaper imports. Thus, the US could be stimulating other countries’ industrial recovery, not its own.[lxiv]
The dollar continued to appreciate until March 2009 despite poor economic growth and low short-term interest rates in the US, for a complex of reasons. Because of the deflationary conditions, real yields on Treasury bonds were relatively high, attracting capital flows into the US. The global slowdown along with a falling oil price caused the US current account deficit to shrink, further boosting the dollar. American investors were also repatriating investments from overseas so the dollar benefited from stock market sell-offs. Some emerging economies were impacted worse from the severe decline in exports. Finally, American economic policy was perceived as more credible than the cautious Europeans, and also the euro zone happened to have more scope for interest-rate cuts. (From March 2009 the dollar began a new, but gradual and irregular, decline.)
In the longer term, the huge increases to the federal deficit, current account deficit, and national debt will tend to be inflationary, and the US dollar might decline precipitously. Certainly the US dollar has been most compromised since the USA was at the epicenter of the crisis. The dollar’s reserve status will be questioned in some quarters if it declines significantly. Currencies worldwide might decline as they did in the 1970s, except some emerging-market currencies (especially as the Chinese yuan appreciates). Commodities considered a store of value, such as gold and eventually property, increase in value and should once more become hedges for inflation.
The task for the US government is fundamental tax and spending reform to control inflation and interest rates in the long term, especially addressing the federal budget outflows for ‘entitlements’ (Social Security, Medicare, etc) which are way more expensive than all stimulus and bailout costs.[lxv] Inflation and the value of the dollar are very much a result of market expectations after all, and ‘the markets’ are watching how America will correct the immense expansion in all its deficits in the long term.
Deflation may be a greater threat than inflation, both short-term as a result of the severe recession and long-term in a world where jobs are disappearing, massive wealth has been lost in the stock and housing markets’ crashes, and manufacturing overcapacity is prolonged. In this bleak future of permanently reduced demand but increasing global competition for production opportunities, low growth and deflation may be endemic.
These dismal projections for the future consequences of the global financial mess are alarming, but the huge debt and expenditure on bailouts, stimulus plans, and job creation and unemployment benefits were essential at least in the near term. Without the bank bailouts the financial crash would have been far worse, and without stimulus spending the recession would have been deeper and longer. A prolonged downturn does much greater damage to public finances. However, the present fiscal policies are not sustainable, and world governments must eventually deal with immense debt burdens.[lxvi]
Obviously, America needs to drastically cut national spending. This argument is generally associated with an emphasis by conservative proponents on getting the government out of the economy –and cutting taxes, instead of the need to raise tax revenues to fund the spending. Leaving aside the conservative argument, let us address the deficit directly, by examining means to cut spending and increase revenue-raising potential. Finally, we question the real impact of the primary means for financing of the net fiscal imbalance between outflows and inflows which may make the whole debate moot: US Treasury Bills.
Taxes in America are already low as a ratio to GDP compared to other OECD (Organization for Economic Co-operation & Development) countries –though corporate tax is 2nd highest. Flying in the face of our penchant for cutting taxes, government expenditure persistently exceeds tax revenue (augmented by the need to finance the added costs of American ‘exceptionalism’ – especially the inordinate expenditures incurred for national defense, policing foreign conflicts, rescuing disaster areas, and other fairly unique priorities). Indeed, public debt seems to be the only part of the economy that can be relied upon for growth! Ideas put forward to cut costs often advocate stopping our involvement in wars or eliminating superfluous weapon systems, shrinking government services and payrolls, and programs for the poor, or questioning items in the stimulus, jobs bills, or other purportedly misguided policies. However, cost cutting efforts in the most essential areas have seldom been sufficient, especially America seems unable to avoid spending increasing amounts on core entitlement programs such as Medicare.
Fundamental tax reform was unfortunately not yet on the agenda despite growing advocacy[lxvii]. Politicians stymied progress by pouncing on any mention of ‘the T word’. Economists have long favored a greatly simplified, progressive tax with few loopholes, and reducing the corporate tax rate to improve competitiveness and retain jobs (and correcting the bias toward debt finance). Other sensible but unlikely changes in the basic structure might include a national sales tax – a ‘value-added tax’ to tax consumption rather than income and saving. A better tax system must reduce consumption, which is a central problem with the American economy that has not abated, and instead encourage investment and innovation –and of course boost revenues.
The concept of ‘fiscal subsidiarity’ may be attractive to both Republicans and Democrats. The idea is to pass federal revenues down to states and municipalities for solving problems at the grassroots, relying less on direction from Washington. Taxes collected by the federal government would be transferred to where the programs have local design and backing, whether for infrastructure, healthcare, clean energy, etc.
A broad principle should be to rely upon private initiative whenever possible. This implies, for example, private insurers and providers in the healthcare industry not be eliminated, only regulated better, as we do with public utilities. Minimal tinkering with the market would be preferred, such as a simple carbon tax rather than an unwieldy cap-and-trade system to move us toward a low-carbon energy system.
The other facet of the tax-and-spend conundrum: financing the difference, is actually a simpler issue than we tend to assume. As explained earlier, the Fed is the only central bank that can print money (expand credit) almost with impunity –the ‘Faustian bargain’. The Chinese, and even the global investment community (that puts prime value on liquidity and safety), seem willing to accumulate US Treasury bills indefinitely, which allows the Fed to finance deficit spending at a very low interest cost. Concerns for rising interest rates, inflation, and taxes, dollar devaluation, and an intergenerational debt burden that seems too big to be paid off in the foreseeable future, all these are more emotional than real issues for the present. Interest rates remain low so the pain of repayment of debt is not currently felt. Even if investors someday demand higher yields on government securities, in America more expensive government borrowing still just pumps more money into the economy to spur growth and encourage private lending. US Treasuries are still snapped up at auction at whatever interest, and bond traders still want Treasuries more than any other instrument for liquidity and safety. The global financial community has no alternative to the US Treasury market.
Also, they can see no currency alternative to the US dollar –certainly neither the euro nor the yen can replace the dollar. If US deficit spending does spark a crisis and currency devaluation, as long as it does not turn into a dollar rout American private assets will still have their intrinsic value and money will flow back.
The argument that we are passing an insurmountable debt burden to future generations may also be countered by pointing out a need to spend more, not less: Sacrificing education, job creation, healthcare, and other spending priorities is really the way to burden the next generation with an insurmountable disadvantage.
America’s huge debt burden is certainly a matter of grave concern, but for the federal government unemployment now trumps deficit worries. High permanent debt reduces growth potential at some point (once the original benefit of leverage is served) – a figure of 2% reduction in GDP growth was found where national debt in developed economies exceeds 90% of GDP (Reinhart & Rogoff 2009). Reduced growth of course impacts the ability to pay off debt, a vicious cycle of economic decline. For many other countries, sovereign default has ultimately occurred; but not the USA— at least, not yet.
Governments must commit themselves to fiscal prudence for the long term and establish principles for how to proceed. The concept of a binding framework of fiscal rules, perhaps enforced by an independent ‘fiscal council’ (as in Hungary), might embrace various approaches; but even if one administration complied there would be no guarantee the next administration would commit to the same restraints. Procedural rules are conceivable, such as a cap on growth of public debt, public-sector pay, or spending. Budget-balancing targets could be consistent with a stable or falling debt burden, allowing politicians to make tax and spend decisions only within those limits (similar to set-ups in Chile and Sweden). Fiscal projections that address when and how deficits will be controlled would reduce uncertainty. The PAYGO plan (pay as you go) proposed by the Obama administration on June 9th 2009 and signed into law February 13th 2010 obliges Congress to pay for new spending either by raising taxes or cutting outlays.
Budgetary restraint will thus be an essential priority. Defense and discretionary spending might shrink, and farm support and other programs trimmed or decentralized. Other conceivable fiscal strategies include lifting the age ceiling on retirement, means testing or other tinkering with benefits, to boost tax revenues (as people work longer) and cut future pension costs. Another target for reform is healthcare costs, especially in America which allegedly has the most wasteful system in the world (disregarding here new laws enacted in early 2010). Another is efficiency-enhancing tax reform such as the deductibility of employer-provided health care and mortgage interest. Essentially, economists believe tax reform should be biased in favor of taxing consumption and perhaps property instead of income and payroll taxes (which penalizes work and encourages borrowing and consumption). Certainly, less complexity is desirable –tax exemptions, credits, and miscellaneous loopholes cost trillions of dollars in revenues.
iii. future shock
There has long been an undercurrent of dissatisfaction with ‘maximizing’ principles – profit maximization in particular, to instead emphasize social values for example. The banks were especially criticized for pursuing short-term profit rather than serving their community. Such re-thinking seems especially relevant in the current era.
Ultimately, the more idealistic wing of the Obama Administration hopes to seize the opportunity of the great investment of national wealth and energy the United States is putting into resolving the huge financial and economic malaise. The new administration thus seemed well-placed to help address wider problems in the global environment; but political opposition became inexorable. Presuming someday there is a national and international political consensus (unlikely now), a sort of New World Economy might gradually emerge – a new financial regime will certainly be essential, but also we might look forward to global trends emphasizing cross-border coordination for eco-system conservation, sustainable industries, ‘green hubs’, nature reserves, options and futures trading for pollutants and depleting resources, and the like.
In early 2009 the World Social Forum, expected to be too radical for practical policy ideas, suggested the United Nations be charged with preventing large trade imbalances from accumulating, controls on exchange rates and international movement of capital, reform of credit-rating agencies, bank risk-taking and pay incentive reform, and the elimination of ‘shadow banking’ institutions such as hedge funds and private equity firms and their instruments such as over-the-counter derivatives (OTCs) and collateralized-debt obligations (CDOs). A ‘speculator pays’ principle should apply to systemic losses. The Forum recommended a global stimulus plan in the form of a green New Deal. Bits of this platform may some day become reality.
Government stimulus spending under the administration of Franklin Delano Roosevelt is touted as the precedent that proved the Keynesian theory. When FDR took office in 1932 unemployment was almost 25%. The Civilian Conservation Corps was created to put men to work in national parks and forests, but with limited success. Then the Federal Emergency Relief Administration was charged with feeding and sheltering the poor, which put 2 million people to work by the fall of 1933. The next effort, during the winter of 1933-34, was the Civil Works Administration which put 4 million more people to work mostly repairing roads and public works. (It expired, as planned, after five months.) The Works Progress Administration addressed a wide range of infrastructure needs starting in 1935, taking 3.5 million on its payroll by the fall of 1936. By the spring of 1937 the unemployment rate had dropped to 14%, and the infrastructural improvements provided necessary and lasting benefits to the country.
Several major contrasts with today’s stimulus can be drawn. Deficit spending and the national debt incurred by the FDR administration were relatively new, though alarming concerns. Obama instigated deficit spending at a time when a growing national debt had been institutionalized for 3 decades already –yet suddenly the opposition Republican Party resisted more spending (as happened in FDR’s Congress also). FDR had a much stronger majority in Congress that overcame weaker political resistance and passed his bold stimulus programs. Another contrast is that current stimulus and other programs may not have been sufficiently well designed – the jury is out on that verdict. The ultimate contrast was that FDR’s debt was paid off by the economic boom of the postwar era, whereas today there is real concern that economic growth in the future might be modest, at best.
A debate prevailed amongst economists (and politicians) as to which was the most appropriate policy for emerging from recession today: Keynesian stimulus, or austerity. Government stimulus supports short-term demand; whereas government austerity can be considered a supply-side means to foster growth, implying need for boosting longer-term availability of factors of production supplied from the private sector. Austerity still might necessitate an activist –yet frugal— government, for example to facilitate labor mobility and training, enhance market confidence and availability of capital, etc.
Those who favor more stimulus to revive the US economy emphasized the need for urgent action to rescue the economy, and the risk to the recovery of withdrawing budgetary liquidity. Advocates of this strategy posited several arguments:
· Government debt was relatively cheap at prevailing interest rates, and any resulting weakness in the dollar should also benefit exporters.
· The ‘crowding-out effect’ of government spending and borrowing was minimal because in the prevailing slack economy the private sector was not actively seeking investment opportunities and credit expansion.
· If government spending leads to inflation, interest rates must rise, but nominal GDP will also expand, keeping the GDP/debt ratio steady.
· There is no operational limit to US government debt because of its monetary sovereignty –it prints money as needed.
· The equity purpose of government taxing and spending must also be considered, i.e., it redistributes wealth –though sometimes with adverse effects such as the overspending on least productive members of society.
Of course, the downside of government deficits is the debt burden and interest cost that must ultimately be borne by taxpayers. The real danger is that financial markets may judge that the debt is unsustainable and will detract too much from future growth, and the US currency and financial markets may then come under sustained selling pressure. The austerity school of thought posits further arguments:
· Government deficit spending had already transferred funds to the private sector, so the real problem was that the private sector was not investing it sufficiently. The market was awaiting more certainty, not more deficits.
· Low prevailing interest rates and other direct or indirect government subsidy can cause the economy to misallocate resources.
· Low rates also subsidize borrowers at the expense of savers.
· The government was repeating Japan’s mistake of the 1990s of creating ‘zombie’ borrowers, as a result of cheap debt and the failure to resolve the problem of ‘toxic’ loans where defaulting mortgages and companies’ unpaid debt were not compelled into liquidation. Bad loans clogged the banks’ books and capital was not being reallocated for new investment.
· The austerity school is strengthened by the concept of ‘generational accounting’ which attempts to measure not only current deficits but also future anticipated tax and spend figures. The gap grows larger with adverse population trends, i.e., the aging of societies results in senior citizens paying less tax but becoming costly for the younger generation to support. (Kotlikoff & Fehr 1997)
In the heated political debate it seemed that both austerity and stimulus schools of thought existed obliviously side by side. Governments must have coherent strategies to boost both demand and supply. Of course, the direct cause of the economic crisis –as well as the weakness of the subsequent recovery— was the dramatic withdrawal of the private sector. The argument that governments have no role to play in such circumstances seems spurious.
The four-decade long creed that ‘the free market’ would be rational, efficient and far-sighted has been exposed as false. The intellectual edifice of this belief, the Efficient Market Hypothesis (EMH), led us to a misguided trust in ‘market forces’ and a false sense of security that resulted in financial and economic disaster.
The EMH came to prominence from about the 1970s, holding that the price of a financial asset reflects all market information accurately and completely, with estimations of future relevant information discounted to the present value. Asset prices are thus driven by economic fundamentals.
Skeptics and revisionists have relied more on behavioral economics (although there was always considerable credence given to such ‘perfect market’ theory as the EMH). One behaviorist practitioner, George Soros, ironically was making his fortune by exploiting market imperfections as a hedge-fund trader.[lxviii] Soros suggested a ‘reflexive’ theory of markets. Reflexivity meant that traders acted not on economic fundamentals but rather on how they expected other market participants to act. The point was to exploit market movements faster than other traders, thus to ride market trends to their advantage. According to the EMH, market trends do not exist because future trends should be discounted into current market prices.
One implication of behavioral aspects of financial markets is that bankers become overconfident with prolonged success of a particular strategy and then extrapolate prevailing trends into the future, a tendency that contributes to market bubbles. On the other hand, losses can create irrational risk aversion, causing market panic despite what the economic fundamentals might indicate.
The belief that an existing market price is kept in correct equilibrium has taken a serious hit. Economists now see a more legitimate role for government to oppose market forces when there is an impending bubble or crash – ‘leaning against the wind’ to reduce market volatility. Another priority is to have improved information on what all players are doing to better monitor situations when too many players were leaning in one direction, to anticipate systemic risk. Furthermore, there is a need to manage ‘moral hazard’ if government regulation or implied guarantees encourage market players to take bigger risks than they might undertake without any reliance on government safety nets.
The pre-Keynesian mode of thought held that full employment would prevail because supply created its own demand (Say’s Law). In a classical economy, whatever people earn is either spent or saved, and savings is invested.[lxix] The classical assumption was that when market demand faltered asset prices would fall until markets cleared at a lower price level, leaving no unsold goods or unemployed workers; and efforts by governments would do more harm than good. This lack of faith in government prevails today, with real justification.
The pragmatic Keynesian view was that wages and prices might fail to adjust and policymakers must step in. Modern economists accepted the necessity for government intervention to support the prices of goods and services, but they had too much faith that financial markets would get asset prices right. Asset prices were deemed to be determined by economic fundamentals, not panics or other market irrationality, so policy should address these fundamentals. A corollary assumption was that prices exist for everything at any time, so that market players could always borrow money or sell assets at the going rate. By this logic, mortgages or other debt could always have a market. When funds dried up and markets thinned out in late 2008, the Credit Crisis was upon us.
Economists need to better understand why liquidity suddenly dries up. Economic theory still relies on Keynes’ ‘liquidity preference’ notion. In the face of uncertainty savers might decline to invest or spend, and therefore government must intervene to cut interest rates or create public works to restore market demand.
Thus, there is a need for more understanding of bankers’ behavior and the inner workings of the financial system. In modeling the economy, financial intermediaries like banks might never be mentioned and insolvencies cannot occur. In recent decades, theorists have been paying more attention to institutional questions, including the controversial issue of pay and bonuses for executives. Arguably, the finance profession is human-capital intensive, like law and medicine, with individual talent wresting relatively more of the economic rents away from stockholders (which is why partnership ownership structure was preferred in traditional banks, like law and medical practices).
Although executive-pay decisions thus have behavioral aspects, competitive enterprises should structure incentives based on long-term economic performance. At least, bonuses for making new loans should be deferred until the borrower establishes a reliable payback record. Incentive in the form of long-term stock options rather than cash aligns management incentive with ownership which is theoretically the best approach.
Pay and bonuses cannot be regulated easily, and managers arguably should be rewarded for their contribution to firms. However, compensation practices have allowed great disparities in income and strongly encouraged risktaking over prudence. Even the banks subject to conditions for bailout funds still dished out lavish bonuses. Despite rules enacted in February 2009, for the first half of 2009 nine banks gave out more than $32 billion in bonuses, even as the banks took $175 billion in taxpayer dollars. Nearly 5000 people received $1 million or more. At yearend 2009 large bonuses were awarded again.
The administration proposed new rules on February 4th 2009, and again on June 10th. A ‘pay czar’ would oversee pay packages to the highest-paid employees of the largest institutions that received bailout funds, including limits on bonus and severance packages. He could ban pay packages at large institutions that would encourage ‘inappropriate’ risk-taking, but it was unclear how to judge when a pay plan could fuel ‘inappropriate’ risks. The criteria were arbitrary, for example, oversight applied to only the top 100 executives of seven selected firms. During October 2009 the ‘pay czar’ cut the pay of the top five executives and 20 highest-paid employees at the seven banks; in December a $500,000 pay cap was imposed (with exceptions granted), at least half total pay deferred three years (including stock options), and cash limited to 45% of bonuses. The ‘czar’ decreed bonuses be based on “real performance measures” and be taken back if results they were based on “prove illusory”. However, he resisted suggestions of a broader authority over more banks or to require corporate-governance changes.
The Treasury Secretary said government would not meddle in the details of compensation packages, and it would not impose restrictions such as caps on pay on other companies outside the bailout scheme; but companies should adopt a series of broad principles and improve stockholder oversight. The principles might include to avoid rewarding short-term risk-taking and ‘golden parachutes’, and to ensure compensation committees are independent of management. Consultants who advise such committees sometimes work for bigger firms that are concerned with keeping other business with bosses under scrutiny; so their independence is also in question. The Sarbanes-Oxley Act, which restricted auditors’ ability to cross-sell other services, might apply to compensation consultants who should be similarly restricted to bolster their independence. Any such rules would certainly be tested for loopholes by the job market – all affected firms and employees would look for an escape.
One proposal was to let stockholders vote on executive compensation –a ‘say on pay’ resolution (passed in July 2010). However, the vote would not be binding. Another voluntary measure was a ‘brake provision’ to withhold such payments in a financial crisis. The Obama administration also proposed legislation to give the Securities and Exchange Commission power to ensure that compensation committees are independent in ways similar to corporate audit committees and can hire independent consultants.
The traditional argument against modifying bonus systems has been that each institution had to reward talent handsomely or competitors would poach its people, but after the crisis any bank failing to reduce its bonuses tended to be publicly challenged by the media, politicians, and be scrutinized by regulators.
Banks need to use risk-adjusted measures in calculating the size of the bonus pool and allocating it. Economic-capital models designed to allocate capital based on expected losses are being studied by firms and may be used increasingly in the future (Economist, 16-5-09 “Special Report on International Banking” p15). Cost of capital for investment in talent as well as new assets must properly reflect risk.
However, such theoretical strictures are impractical. Perhaps our best hope is for widespread public disapprobation to compel some change in the culture of firms – pay for top executives in the US was estimated to be 400x the pay of workers, whereas the difference is only 12x in Japan and 11x in Germany (BBC World Service 29-10-08).
In American society, the capitalist culture has long considered it legitimate, even desirable, to embrace the reality of a growing income gap between the rich and poor, management and labor, etc, –i.e., the legitimacy of the notion that star performers should collect inordinately greater rewards for their efforts than average. However, the economic reality of a wide income gap –between salaries of executives versus average workers at least— is relatively recent. Almost all income gains in America since 1975 have been among the richest 20% of households. The richest 1% of Americans accounts for 24% of national income; yet that share of national income was only about 18% in 1915, the era of worsening class warfare and relatively wide sympathy for Marxism.
While a few employees were thus getting bonuses, vastly more workers lost their jobs or were having their pay reduced – a payroll tug-of-war between the rich and poor being won by the rich. Job scarcity, not to mention scant pay raises, further depressed consumption that was needed to spur job-creating investment. Existing businesses used the opportunity to reduce the labor burden that was perennially a major business cost.
Never had business shed so many workers so fast, and unemployment totaled so many workers looking for work or dropping out of the labor force, creating a serious national (and international) dilemma. As with the issue of the eternal rich-poor gap, there were no long-term policy solutions agreeable to mainstream economics. At a Forum on Jobs and Economic Growth in early December 2009 the President challenged the participants to come up with ‘fresh perspectives’ and ‘new ideas’. However, the proposals were primarily short-term spending initiatives revolving around Obama’s stated priorities of bolstering small business growth, providing emergency aid to people and places, advancing the energy efficiency of homes, and expanding investments in transportation and communications infrastructure. Practical solutions for more stimulus-created jobs, especially infrastructural projects, seem attractive but are economically problematic. Worse, nations resort to ‘beggar-thy-neighbor’ job protectionism.
According to the concept of ‘hysteresis’, employment capacity may suffer lasting decline due to deleterious effects on the workforce and other causes. (Blanchard & Summers [1986] developed the concept to contest Milton Friedman’s 1968 argument for a ‘natural’ rate of unemployment equilibrium.) Hysteresis is poorly understood in practice. Essentially, the unemployed workers’ skills atrophy or become outdated; also, existing workers demand wages that create barriers to new hiring. Governments of course agree rising unemployment justifies urgent policy actions. Solutions have included wage and hiring subsidies, early retirements, retraining or other services for job seekers, enlarging the public sector, or even taking an opposite tack to minimize the moral hazard of their own benefits for unemployment insurance and welfare. Such policies persist worldwide, with mixed results and no widely accepted long-term policy solutions.
Employment is inevitably a lagging indicator of economic recovery from recession, but in this case the problem did not appear to be abating. There are exotic ideas out there involving ‘job sharing’.[lxx] However, government-designed schemes and subsidies may only delay job losses and inevitable closure of unviable firms.
A great question loomed as a threat to labor relations (and political stability) in the future: Could high unemployment become the new normality? Many American businesses had little incentive to start hiring or to raise pay and benefits, simply because labor remained in surplus supply worldwide. Economic revisionists are coming to believe that putting America’s army of jobless back to work will require a deep reduction in labor costs – to become competitive with overseas workers who have reached high productivity at lower wages. The decline of the US dollar had slowly been achieving a cost adjustment since 2001, but a faster adjustment was indicated for the desperate jobless. A steep pay cut is a terrifying idea, a nightmare scenario which could compel a downward spiral in pay expectations –a ‘race to the bottom’. Even if American workers improved their relative competitiveness, the global workforce surplus might remain unacceptably high. American consumers cannot resume indefinitely buying the products of global producers because this would recreate the imbalance that was largely to blame for the current economic demise. Ultimately, a future sustainable world economy may feature an abundance of production capacity and job seekers, chasing inadequate consumers.
Perhaps the central lesson of the entire economic fiasco is the failure of leadership in American business. What we have witnessed is a clear case of market failure, despite recriminations from the right wing about the risk of non-market failure (political and bureaucratic consequences of government intervention, government demand for funds crowding out private investment, etc). It is free markets that have wrecked havoc, not governments. Bankers went on a high leverage binge of proprietary risk-taking and executive self-aggrandizement, and the car industry experienced decades of mismanagement and union intransigence.[lxxi] Free-market capitalism itself has been discredited, and we can only hope a new model of business and financial management will emerge from the ruins. Asians had a sad lesson in 1997 about the fallacy of free capital markets – this was the mantra of the Washington Consensus and it disallowed government rescue as country after country experienced devastating financial turbulence. Those few voices who appealed for reasonable help for the East-Asian countries were denigrated as ‘economic revisionists’. Now that calamity has come to Americans, economic revisionism might proceed with less opposition.
Economic revisionists may conclude that banks needed to be temporarily nationalized to compel them to do what was needed at the height of the financial crisis: to provide vital loans and to purge bad debts from their portfolios. However, one obstacle to pragmatic action was the fear that public perceptions would interpret this course as ‘creeping socialism’. American politics continues to impede rational policy-making and implementation. The great Jeffersonian legacy of government of the people and by the people must make way for the Hamiltonian politics of governmental empowerment for the collective purpose of nation-building. Such arguments have increasing urgency.
The final quarter of 2009 ended with the fastest pace of economic growth in six years (5.6% APR) and a surge of 8% in corporate profits which was the biggest year-on-year gain in 25 years. Although corporate profits might be attributed to restructuring and cost-cutting, some companies claimed to be experiencing stronger consumer purchasing, climbing exports, and more business investment (eg, Caterpillar Inc. and Boeing Co). (LA Times, 25-3-2010:B5) Still, unemployment and home foreclosures continued to increase.
The world economy did seem safer from immediate crisis in 2010, but recovery was hesitant. The economy was expected to perhaps encounter a ‘double-dip’ of recovering, then waning, growth as stimulus spending wound down and private business was not yet confident enough to take up the slack. Another crash could be on the horizon if the massive government ‘debt bomb’ sparked a crisis of confidence. Paradoxically, bank bailouts by governments led to a need for banks to support governments, but the herd-like behavior in financial markets was prone to panic.
Worldwide, though some economies faced possible new debt crises, the global system would hopefully be anchored by resilient economies elsewhere. Many of the most dynamic ‘emerging markets’ –Brazil, Singapore, South Korea, Taiwan— had contracted in the last quarter of 2008 twice as badly as rich countries but by the end of 2009 had recouped their losses generally better than the rich economies. Emerging economies had suffered disproportionately because of their trade and financial links with the West, and indeed exports had plunged and capital flows dried up; but many had instituted policy measures that led to quick turnaround. East Asia had learned a healthy skepticism toward American free-market financial theory, having taken painful medicine prescribed for their own crisis a decade earlier; and they have seen that their own model for market development –with less freedom and more control— was quite a legitimate formula.
The American economic and political establishment had lost some credibility just as it needed renewed energy to deal with many unresolved problems: establishing the new mechanisms for monitoring systemic risk and disposition of financial firms ‘too big to fail’, handling trading in fragile markets, winding down the government’s huge stakes in banks, autos, housing (Fannie Mae and Freddie Mac), and over-spending generally.
What really changed was social spending. Although some countries had to turn to the IMF and tighten fiscal policy, others (notably China) instituted stimulus programs bigger as a share of GDP than most rich economies. China’s spending arguably did more to combat global recession than the West; and their people and infrastructure benefited. China’s policies forestalled the looming disaster of migrant-labor unemployment.
American business (especially smaller enterprises) awaited a more certain environment for investment. The job market continued to lag securities market recoveries. Consumers cut down personal debt rather than spend. Changes in the financial, healthcare, energy, and other industries would take years to resolve. In the long term, the feeling in the air seemed to be that a new type of economy had to emerge, but would producers be stifled by regulation or seize new opportunities; would consumers be ebullient or was the future more bleak for the next generation? These unknowns created a cloud of doubt over corporate boardrooms, government offices, and kitchen tables all over the world.
Endnotes:
[i] A timeline of failure might identify the precipitating event on Wall Street as the bankruptcy of Lehman Brothers (and the acquisition of Merrill Lynch by Bank of America) on September 10th 2008. The government announced an $85 billion rescue of American International Group on September 16th, and on September 19th the US Treasury and Federal Reserve approached Congress with a $700 billion plan to buy ‘toxic assets’, which passed two weeks later. On September 25th Washington Mutual became the largest US bank failure. (The 2008 credit crisis had first emerged as severely tightened liquidity in August 2007, with the financial storm striking markets dramatically one year later.)
[ii] By the autumn of 2009 the crisis appeared to be abating as stock markets rebounded and credit flows resumed at a modest pace. However, few economists believed there would be a return to business as usual. Wall Street will struggle to regain its swagger, and regulators and reformers are poised for a major revamping of financial capitalism, as this article will explain. Arguably, Wall Street’s muted resurgence reflected primarily immense government liquidity infusions and guarantees for systemically-important banks, artificially cheap borrowed funds, and temporary tax incentives – the ‘invisible wallet’ of taxpayers.
[iii] A hedge fund invests money contributed by wealthy individuals, pension funds, and others willing to undertake big-ticket investments. Unlike mutual funds, hedge funds were not open to the public or required to register with the Securities and Exchange Commission (although the financial reform legislation signed in July 2010 mandated hedge-fund reporting to the SEC). Of course, funds typically provided audited information to contributors, but such voluntary disclosures only gave regulators limited scrutiny.
[iv] Computers themselves may have contributed to the financial uncertainty. Globally fragmented IT (information technology) systems can obfuscate rather than clarify risk. (The Economist, 12/5/2009:83-4)
[v] The potential for a collapse of AIG to bring down other financial giants worldwide, because of what the insurer owed them, was the major justification the government cited for its biggest single bailout of one firm, totalling $182.5 billion. (Initial funding consisted of $85 billion from the Federal Reserve using its emergency lending power, with additional Fed money later, and Treasury bailout funds of $70 billion – TARP.) The government's initial payment to AIG in September 2008 was deliberately calculated as also a bailout of major Wall Street banks that were owed money by the insurance giant. As a result of the rescue the government owned 80% of AIG, which AIG was paying back largely by selling off its profitable business units. There was considerable doubt taxpayers would get all their money back.
[vi] Holders of debt instruments buy credit default insurance from dealers. The dealer in turn hedges its position by selling the insurance contract at discount. Traders of swaps need not own the underlying debt and may simply be speculators. The swap market can become quite frenzied and volatile, and not necessarily economically rational. (For California debt, adverse speculation in swaps implied a real default risk, which may make state bond issues more costly.) In the event of a missed loan payment the actual obligation to pay the contract is determined by auctions run by a trade association of swap dealers.
[vii] Becoming a bank holding company provided Goldman Sachs and Morgan Stanley a strong competitive advantage. Their customer deposits were protected by the Federal Deposit Insurance Corporation (FDIC) as with any depositor-based bank, and they had access to the Federal Reserve’s ‘discount window’ and other facilities only open to commercial banks. Thus, their risk was smaller because of explicit and implicit government support, thereby making even private borrowing cheaper. While still engaged in much of their old investment banking business, these two institutions could ‘have their cake and eat it too’, with a cost-of-capital advantage and the opportunity just as before to participate in marketmaking as a major player.
However, the risk to the overall economy could be considered to have worsened -- the market concentration of investment banking was now much greater, with only two institutions in the market.
[viii] If interest rates on T-bills become negative, the government gets paid for borrowing rather than paying investors –an absurdity. Investors would thus prefer to buy the T-bills rather than hold cash. Implicitly, investors trust the US government more than its money. Theoretically this cannot happen – reflecting risk of cash itself, yet the T-bills are paid off with cash.
[ix] Implementation of the stimulus also became an issue. It was necessary for the package to go through the appropriations process and allocated over time. Through the height of the crisis (the end of the first half of 2009) only $56 billion had been spent, with $158 made available, and only about ¼ of the package would be spent by the end of 2009. Also, some was not spent as intended. Money going to the states was applied to fill budget gaps (90% going to Medicaid) instead of being invested in job-creating projects.
[x] In this instance, the worst of the credit crisis was already past before any spending bill was passed by Congress; tax cuts and other financial incentives were largely hoarded by banks, businesses, and consumers, adding to savings but not investment; and the stimulus was dissipating just when more economic impetus was needed in 2010. The most visible impact was on the deficit, which further deflated market confidence.
[xi] Republicans in Congress disallowed more spending, but renewal of the ‘Bush tax cuts’ signed into law on December 17th 2010 constituted an $858 billion stimulus –and ballooned the deficit.
[xii] The concept of alternative currencies that compel consumption is not new. Irving Fisher in 1933 wrote a pamphlet “Stamp Script” about a type of currency that, if hoarded, would be taxed with a stamp. In Bavaria today a script called chiembauer is used alongside the euro for some purchases. The notes have an expiry date after which they require renewal with a sticker costing 2% of their value.
[xiii] The Dow ended 2009 up 11%, and was up 19% in 2010; other securities markets did even better. In 2010 Standard & Poors 500 (a benchmark for retirement accounts) increased by 12.8% and the Russell 2000 (small-company stocks) by 25.3%, indicating that investors were betting on economic recovery.
[xiv] The Federal Reserve from early 2009 to early 2010 bought $1.75 trillion in debt, targeting long-term rates to ease the credit crunch affecting mortgages and corporate bonds.
Despite the Fed’s political neutrality, it chose the day after the November 2010 congressional elections to announce a new $600 billion program of quantitative easing; and even more was anticipated. The impact on global markets was also destabilizing, with global cash flows swamping the more attractive Emerging Markets, giving them appreciating currencies and falling exports, as well as frothy asset markets. Ultimately, it was argued that this would force some rebalancing in world trade, which was essential in the long run to solve the problem of America’s longstanding current account deficit, and it would compel many major surplus countries to consume more. (See 4. a. The American current-account deficit)
[xv] According to a later report (Need to Know, PBS, September 3rd 2010), federal bailout money lent, spent, or guaranteed to Wall Street was $12.8 trillion. Estimated figures varied widely.
[xvi] For example, by summer 2009 the Fed had reduced the amount of money available to its Term Auction Facility, decreased the amounts lent by the Commercial Paper Funds Facility, and let the Money Market Investor Funding Facility expire – because it had never been used.
[xvii] The corporate bond market benefited, as investors were more optimistic about private debt and equity markets and putting their money there instead of buying Treasuries. Potentially, declining demand for Treasuries may be tantamount to an indictment of US monetary and fiscal policy and rejection of the $.
[xviii] Major sovereign defaults have occurred before (eg, the Latin American debt crisis of the 1980s, Argentina’s bonds in 2001, Russian bonds after the communist revolution and again in 1998), and also bankruptcy compels bondholders to accept restructured debt (eg, General Motors in 2009).
Certainly the Treasury must pay back its bonds or the global monetary system will collapse. As long as the Fed can print more dollars the US government will meet its immense debt obligations.
[xix] A ‘resolution authority’ was included in the July 2010 reform law for future takeover of assets.
[xx] On April 2nd 2009 the Financial Accounting Standards Board, which oversees US accounting rules, changed the so-called mark-to-market accounting convention on mortgage-backed securities in effect since November 2007. The FASB now gave banks more leeway to revalue many ‘toxic assets’ depending on prices that might be realized in ‘an orderly transaction’ rather than at prevailing distressed prices. This potentially allowed banks to boost the asset values on their balance sheets and hence augment their lending capacity. Critics observed that banks could now understate potential losses to bolster their capital positions and that the FASB had acted under political pressure. Bankers responded that their current valuation practices would not be significantly altered since they would continue to exercise prudential valuation.
[xxi] Banks seemed to be deciding there was no free lunch to be gained from government bailout. By April 2009 five banks had repaid a total of $353 million in TARP bailout funds to escape the tough restrictions placed on participants in the rescue program. (In addition, they paid $5.4 million in dividends.)
The Treasury was chary to allow repayment until the safety of the financial system was assured. Regulators gave 10 banks permission in June to repay their bailout funds in full. On June 17th $68 billion was repaid; the Treasury still had about $129 billion invested in about 580 financial institutions. By December 2009, of TARP outlays totaling over $200 billion more than half had been repaid including $10 billion in dividends and interest. (However, some loans were more problematic –eg, AIG and the Big 3 auto firms; and unutilized TARP funds were being channeled for other government stimulus priorities.)
[xxii] Unemployment reached 10.2% in October 2009, already nearly equaling the Treasury’s worst-case, ‘adverse’ scenario of 10.3% in 2010, which made it clear the forecasts had not anticipated such a weak recovery in employment. (In February 2009, the same month that the ‘baseline’ and ‘adverse’ scenarios were announced, unemployment in California reached 10.5% --soaring to 13% by 2010.)
[xxiii] The issue of ‘asymmetric information’, identified in 1970 by Nobel-prize winning economist George Akerlof, may come into play here. Buyers need the same information and the same capacity to judge value as sellers. It was difficult for either side to be confident about the value of such a tangled web of derivatives, sub-prime mortgage-backed securities, etc. The liquidity crisis would be rekindled for the same reasons it occurred in the first place: neither borrowers nor lenders would step forward.
[xxiv] The actual results of the tests were announced on May 7th and were not as bad as some had feared – bank executives and the stock market welcomed the news. Ten of the 19 banks were told to develop detailed plans by June 8th to boost their capital by a combined total of $75 billion through stock offerings, selling business units or other assets, merging with competitors, converting government preferred stock into ownership stakes, or other means, with the government providing more bailouts as the last resort. (Already $216 billion had been provided to the 19 banks from TARP.) The tests found that the 19 banks would have needed $185 billion at the end of 2008 but had trimmed their losses; and they would face total losses of $600 billion in 2009 and 2010 in the specified ‘worse-case scenario’ and thus needed to raise more capital.
[xxv] The government reached tentative agreement with Citigroup on February 27, 2009 (contingent upon agreement by the other preferred stockholders), to convert some of its preferred stock to common stock at a premium of 32% over the previous market close. Becoming Citigroup’s biggest owner, the government came closer to nationalizing a bank since the takeover of failed Continental Illinois in 1984. Existing common stockholders responded with a market sell-off, pushing the price down 117% below the conversion price and topping the record trading volume set by WorldCom in 2002. Remarked a congressman: “The only thing worse than nationalizing a bank is to pay for the entire bank and only get a third of it!”
[xxvi] A Credit Cardholders’ Bill of Rights was signed into law on May 22nd 2009 designed to curb industry practices such as raising interest rates on existing balances without notice, sudden and unexplained fees, and marketing cards to people under 21. The bill had strong political support but was opposed by issuers who argued it might have the unintended consequence of constraining credit. By the time the bill went into force on August 20th, banks had taken steps to try to ensure that their credit card operations, historically one of their most lucrative businesses, remained that way. Banks had raised fees, interest rates, tightened lending standards and credit limits, and taken other measures, effectively revising their business model.
[xxvii] The broader origins of the crisis are attributed by some to the Reagan era. The Depository Institutions Act of 1982 ended restrictions on mortgage lending in effect since the 1930s. The ballooning of both public and private debt following Reagan deregulation culminated in the near-zero savings rate that prevailed on the eve of today’s great crisis. Household debt was only 60 percent of income when Reagan took office, about the same as it was during the Kennedy administration. By 2007 it was up to 119 percent.
[xxviii] Fannie Mae is the nickname for Federal National Mortgage Association, established in 1938 as part of President Roosevelt’s New Deal. Freddie Mac is the Federal Home Loan Mortgage Corporation, established in 1970 to compete with Fannie Mae. The two provide a secondary market for mortgages by buying mortgages from lenders, securitizing them, and reselling them as guaranteed investments. (A third government-sponsored enterprise, Ginnie Mae –Government National Mortgage Association, would keep its explicit government support and continue to back loans to low-income families.)
[xxix] However, this estimate seemed high. Later estimates by Federal Housing Finance Agency ranged from $238-$363 billion. The FHFA was suing for repayment by banks that sold bad loans to Fannie and Freddie, on the basis that the loans did not meet underwriting standards. Most bad loans had been incurred before the government intervention that had compelled Fannie and Freddie to reform lending practices.
(The FDIC also was initiating claims against officers and directors of banks it had shut down since 2008. As federal receiver for failed banks, the agency sells bank assets and backs up the liquidation process with its deposit insurance fund. The FDIC has three years from the date of the failure to file lawsuits for compensation for wrongdoing; thus the claims were just beginning –as was the case for FHFA lawsuits.)
[xxx] Legislative stalemates and the difficulties of reform delayed the administration from issuing a complete overhaul proposal for the housing-finance system (to include Fannie and Freddie) until 2011.
[xxxi] A $75 billion Homeowner Affordability and Stability Plan announced March 4th 2009 was a two-part program: First, loans held or securitized by Fannie and Freddie would qualify for refinancing to prevailing lower interest rates. The program was available to borrowers current on their payments where the mortgage balance due exceeded the value of the home by less than 105%. Such loans were otherwise likely to end in foreclosure. For those mortgages not qualified, a second part of the anti-foreclosure program provided a subsidy for mortgage-servicing companies to modify loans to lower payments to 31% of the borrower’s income. A series of actions were possible: reducing the interest rate to as low as 2%, extending the repayment period to 40 years, skipping interest payments, or forgiving a portion of the debt. The plan was controversial because many loans exceeded the 105% loan-to-value limit and also were beyond the price limit for Fannie and Freddie financing – notably in California where property values were much higher.
Due to the complexities of the program, eligible homeowners often failed to take advantage of their opportunity to refinance. Also, the voluntary nature of the program meant banks failed to initiate loan refinancing despite the subsidies offered. Foreclosures did not quickly subside as hoped.
On May 14th the plan was expanded to allow lenders incentive payments of as much as $1000 even if a loan modification was not possible, by allowing the borrower a short sale in which the lender accepts less than the value of the mortgage, transferring ownership to the lender without a foreclosure. This constituted an acknowledgement by the government that not all distressed borrowers would be able to save their homes. Lenders had been initiating foreclosures despite the government program. To that point, the government announced that more than 50,000 homeowners had been offered lower-cost mortgages, and lenders representing 75% of US mortgages had agreed to participate; but implementation was uneven.
On March 26th 2010 the administration proposed further adjustments: to give jobless homeowners a break on payments, give lenders more incentives to reduce principal, and other steps. Bank of America had proposed its new mortgage modification program a day earlier to cut the principal for some borrowers, an estimated debt forgiveness of $3 billion. Banks were desperate to keep borrowers from simply walking away from their properties, since 24% of mortgages exceeded their property value at the end of 2009.
[xxxii] Despite President Obama’s efforts to block influence on his government by special interests, the legion of Washington lobbyists was growing, evidently to take advantage of stimulus funding opportunities. The number of registrations filed with the Senate Office of Public Records during the first quarter of 2009 was up from the year before. Mr Obama had barred lobbyists from speaking with administration officials about stimulus projects, and any written communication had to be posted online. However, lobbyists could try to influence Senators and Representatives to carry clients’ messages to the White House.
[xxxiii] Mortgage banks were accused of abuses, such as the infamous ‘robo-signing’ scandal that uncovered banks’ approvals of improper foreclosures. Indeed, banks were quite overwhelmed by the wave of mortgage defaults, foreclosures, and modifications the crisis unleashed. Misguided incentive systems were also evident. For example, where mortgage servicers charged fees based on loan principle, banks were averse to reducing principle through modification and instead preferred foreclosure to gain full reimbursement for servicers’ fees and costs. This also constituted incentive for simply stretching out delinquent loans without either foreclosure or modification.
[xxxiv] The Fed boosted its program to buy mortgage-backed securities from Fannie and Freddie to $1.25 trillion from a previous commitment of $500 billion, and it also said it would spend $300 billion to purchase longer-term T-bills and up to $200 billion on other agency debt. Rates were held low successfully.
On April 29th the Fed opted not to buy long-term Treasury bonds despite rising yields (declining prices), thus ‘staring down’ bond traders. Traders reacted by dumping Treasuries, driving yields sharply higher. On the same date the Treasury announced plans to boost sales of long-term bonds, to fund Treasury borrowing that had reached unprecedented levels. The Treasury seemed willing to get lower prices on its bond issues because mortgage rates were still low and investors were buying corporate bonds and stock.
[xxxv] Ford lost $14.7 billion in 2008 but it was soldiering on, without much government help. While GM and Chrysler were rationalizing their union and dealer obligations, rebuilding their balance sheets – all using bankruptcy protection and $62 billion in bailout funds from the Treasury, Ford was less able to overcome its own heavy debt and contractual obligations. On the plus side for Ford, its customer relations definitely benefited from its decision to eschew government help. Ford’s market share in America leaped by over 2% during 2009 mostly at the expense of Chrysler and GM.
[xxxvi] It seemed unlikely the Big 3 hoped to abnegate their obligations for all pension plans, labor union agreements, health-care insurance, and supply or operating contracts, unless eventually it becomes management’s intention to forsake US operations as the mainstay of the company.
However, it was conceivable that management (though not the employee ‘creditors’) would be happy to further curtail their efforts in their home market where they had been uncompetitive for decades. The Big 3 had some remaining strong businesses and popular brands in Europe and in emerging markets with vast potential including China. With global markets likely to account for nearly all market growth in the future, North American operations had already been significantly reduced. Car sales in the so-called BRIC economies –Brazil, Russia, India, China— surpassed the American market in 2008 and was 10 million cars bigger than the size of the American market by 2010, after being 10 million cars smaller as recently as 2005. (Financial Times 16/8/10; Economist 15/11/08) Nevertheless, some Big 3 operations overseas had been losing money for years and were earmarked for divestment (e.g., GM in Europe).
[xxxvii] Bankruptcy would hurt advertising, impacting TV stations, newspapers and magazines that already were suffering from the recession. The multi-million dollar sponsorships for professional teams and other sports franchises had to be cut back. GM, Ford, and Chrysler were respectively the 2nd, 6th, and 10th largest advertisers in the US in 2008, but firms trying to emerge from bankruptcy cannot afford such big budgets. The Obama administration had asked Chrysler to halve its proposed marketing budget.
[xxxviii] Ultimately it was a small group of investors, called the Indiana pension funds, who appealed their case to the nation’s top court. They argued that their senior and secured investment status should be paid in full before lower-priority creditors receive anything (and also arguing that use of TARP funds was illegal).
[xxxix] GM ceased to be a publicly traded company, with stock in the former GM tied to a new entity, Motors Liquidation Co., which remained in bankruptcy court along with the bad assets.
[xl] Lengths of notable bankruptcies (source: LA Times July 11, 2009, pA12)
| Company | Year | Number of days |
| General Motors | 2009 | 39 |
| Chrysler | 2009 | 41 |
| Delta Air Lines | 2005 | 593 |
| Northwest Airlines | 2005 | 624 |
| Worldcom | 2002 | 669 |
| UAL | 2002 | 1150 |
| Manville | 1982 | 2286 |
| Dow Corning | 1995 | 3305 |
[xli] The federal and state governments scrambled to channel aid from existing programs and find ways to help communities impacted most by all the business closures resulting from the bankruptcies. The Obama administration extended unemployment benefits, research grants for clean diesel engines, enlarged credit lines for small business, retraining and diversification support for clean-energy jobs, money to hire police officers, and used the bankruptcy process to facilitate the sale of closed plants. Although the bailout may have prevented liquidations that would have been even more destructive to the economy, some critics (e.g., Robert Reich 2009) believed the huge cash injections for GM and Chrysler were misdirected; instead the bailout should have been allocated more towards communities in the states hardest-hit, such as tax breaks for relocating companies or seed capital for startups.
[xlii] Unexpectedly, good news began to emerge in 2010 about the financial performance of the Big 3 (including Ford), bolstering the government’s case for its various interventions. The Obama administration argued that its rescue operations had saved over a million auto-industry jobs. Then on August 18th 2010 GM filed for an initial public offering to sell part of the stock owned by the US and Canadian governments, UAW, and former creditors. The timing of the IPO seemed driven by political, not market, considerations.
Banks also recovered (though they were not lending), and even AIG was promising to repay the government for its bailout (though it was not paying dividends on the 80% of its stock –largely preferred— owned by the government). What had been considered sunk costs for taxpayers had significantly declined.
[xliii] Liability was eliminated for accidents that occurred prior to bankruptcy filing for both companies, although GM is liable for future accidents involving cars built before bankruptcy. Bankruptcy thus lifted a burden from lawsuits that cost the industry dearly, though obligation to victims of accidents due to alleged defects would seem to be morally justified. Arguably, industry in America (notably healthcare) faced inordinate legal costs compared to foreign competition because of the litigious nature of American society.
[xliv] TALF had been implemented in March 2009 to revitalize securitization and stimulate lending to small business and consumers. The Fed committed up to $1 trillion to investors in top-rated securities backed by auto and student loans, credit cards, and other debt. The idea was that the program could finance not only new asset-backed debt but also be part of the public-private program to purchase toxic assets from banks’ balance sheets. However, the $200-billion consumer-lending part of TALF was poorly utilized, with only $6.4 billion in loan requests during March-April. One reason for lack of demand was the bureaucratization and politicization of the lending process; participants were afraid of interference by Congress including executive-pay curbs, possible constraints on excessive profits or marketing budgets, and restrictions on hiring foreigners or investing overseas.
[xlv] Moody’s projected American government debt (including states) to hit 100% of GDP in 2010, higher than other AAA-rated nations – though greatly exceeded by Japan’s debt at over 200%. Japan was downgraded to AA in 1998 after its prolonged banking crisis, low growth, and numerous stimulus plans.
[xlvi] China’s surplus seemed likely to continue indefinitely despite the problems caused by global financial imbalances. The Chinese government was intent on maintaining high employment in export industries. To keep its economy growing faster than any other major country in 2009, the central government invested heavily in infrastructure – placing restrictions on exports of key raw materials to support the investment, but raising tax rebates on exports of manufactured goods. The central government also ordered local governments to use only Chinese goods and services when spending money tied to the national stimulus plan. The restrictions on imports of foreign goods were partly in response to “Buy American” provisions in the US stimulus package.
[xlvii] Short-selling, or selling securities by borrowing them with the idea of buying them back later at a lower price, is generally viewed as beneficial to market liquidity; but it can contribute to market collapse in a ‘bear’ market. The ‘uptick rule’, a Depression-era law, had prohibited short sales of stock unless the prior trade was at or above the previous price, to hamper relentless downward pressure on prices. Seen as ineffectual in modern liquid markets, the rule was eliminated in 2007. From September 19th to October 8th 2008 the Securities & Exchange Commission reinstated the ban on shorting to nearly 1000 financial stocks, to counter widespread panic and concern that the financial industry was being trashed.
On February 24th 2010 the SEC imposed fresh curbs on short-selling when a stock fell by 10% in a day. At that point short-selling would be allowed only if the sale price is above the market bid price. This was less strict than the former uptick rule, triggered only for stocks under severe pressure. Critics argued that such restrictions could sacrifice market integrity and efficiency.
[xlviii] Asian leaders were blamed by western bankers, politicians, and media for causing their own crisis with misguided policies, government involvement in their businesses and banks, and profligate spending. Only the IMF would offer funding, but that institution insisted on economic orthodoxy that was inappropriate and worsened the crisis in Asia. Americans believed that Asian companies and banks should go under, and governments should liberalize their capital markets to allow money to leave, which it promptly did. Today American bailouts for their own institutions seem an unfair ‘double standard’.
[xlix] Credit rating had emerged as something of a scam. The three major bond raters: Standard & Poors, Moody’s and Fitch were of doubtful veracity. As a ludicrous example, AIG and Citigroup enjoyed AAA ratings – far better than the state of California which has never defaulted and seems unlikely to do so. California is constitutionally obligated to make debt payments before paying almost anything else. After the state’s credit was downgraded in late March 2009 to the lowest rating of any state, California had its largest and most successful bond issue in history according to the state treasurer’s office. Evidently, investors disregarded the credit rating. It seems a credit rating can be realistically irrelevant.
Yet the rating agencies are deeply embedded in the financial system. The Federal Reserve only accepts AAA-rated securities for collateral purposes. The Securities and Exchange Commission disallows money market funds to invest in paper below a certain rating. Pension funds are required to buy only bonds above a certain rating. For corporate issuers a top credit rating means lower borrowing costs.
The rating agencies earn fees from issuers for rating their securities, because that allows them to make all their ratings public without charging a subscription. However, the fees create a clear conflict of interest. Testimony before the Senate Permanent Subcommittee on Investigations indicated that executives at credit-rating agencies felt pressure to ‘give Wall Street what it wanted’. (LA Times, April 24, 2010, B4)
The obvious option to replace these agencies is to eliminate the agencies’ official ‘nationally recognized’ status and open the business to competition. Ideally, the market itself should gauge credit risk, and the onus should be on investors to conduct their own due diligence and diversify their portfolios.
[l] An expanding mortgage market acts as ‘financial accelerator’, raising the value of the real estate collateral. Increasing property prices in turn augment capacity of the mortgage market. During a downturn, the accelerator acts in reverse. This market externality of borrowing imposes costs on others and therefore might justifiably be paid in the form of a tax on borrowers. (Posen & Korinek 2010)
[li] For example, Congress authorized the Fed in 1994 to write rules protecting consumers from predatory lending, but it took 14 years for the Fed to write the rules. In the interim, the Fed was seemingly oblivious of the rise and fall of the subprime mortgage market.
[lii] Goldman Sachs, for example, in the 1st quarter 2010 reported revenue as 80.2% trading and principle investments, 10.5% asset management and securities services, and 9.3% investment banking.
[liii] The Office of Thrift Supervision was merged into the Office of the Comptroller of the Currency.
[liv] On June 17th 2009 the Obama administration unveiled an 88-page ‘white paper’ to regulate finance, constituting ideas which resurfaced later in Congress and elsewhere.
The November 10th 2009 Senate (Dodd) bill proposed 3 new regulatory agencies, including the CFPA. The House bill passed December 11th (besides addressing the CFPA) proposed a $150 billion fund collected from Wall Street, plus additional government loans as necessary, for a ‘resolution authority’ to take over and restructure large financial firms instead of bailing them out. The House bill contemplated the FDIC handle the task, but the FDIC had not managed non-bank rescue efforts before.
A revised Dodd bill was published March 15th 2010 and passed May 21st. A new Financial Stability Oversight Council would identify financial firms ‘too big to fail’. An ‘orderly liquidation’ of a failing firm by the Fed (rather than the FDIC) would impose losses on stockholders and unsecured creditors. A $50 billion resolution fund collected from big banks (the House had approved $150 billion) had been dropped. Republican political resistance was based on the argument that such a fund would encourage future bailouts; but without such a fund available, taxpayers would likely be the first recourse for funding some future government-led financial rescue. Instead, the bill required post-resolution assessments on the financial industry to recoup any losses. Also, the FSOC would have the authority to impose stringent standards – capital, liquidity, concentration limits, and heightened disclosure requirements.
The CFPA idea was retained but disallowed authority over the smallest banks – even though these banks were sometimes guilty of egregious consumer exploitation. Although housed in the Fed, the CFPA would nevertheless be autonomous. The Fed also would not have authority over small banks (and consumer protection), but it would retain its authority over big banks as well as authority over non-bank financial firms traditionally regulated by the states. However, the Fed’s independence was at issue, with added political appointments and added pressures to be more responsible for financial stability.
New restrictions would be imposed on credit rating agencies, and stockholders given a say in corporate affairs. (Other, less significant, provisions are disregarded here.) One controversial provision not voted on would force big banks to spin off the very lucrative derivatives business altogether into separately capitalized corporate entities. The alternative approach, the Volker Rule, would only constrain such proprietary trading (though significantly reducing total profit potential for the banks): Banks’ investment in hedge and private-equity funds would be limited to 3% of tier-one capital.
The legislation finally cleared a House-Senate conference committee and was signed by the President July 21st 2010; but the actual rulemaking would take years –involving complex negotiations between regulators, the financial industry, and other interested parties. Most sides agreed financial regulation was essential, but it was a global problem without easy solutions. Washington politics seemed to compel either too much government intervention, or too little.
[lv] On May 13th 2009 the Obama administration proposed a broad framework to regulate derivatives. There were an estimated $400 trillion in outstanding contracts at the end of 2008. The administration wanted standardized derivatives to be traded through regulated central counter-parties, or middlemen. Major dealers would be subject to supervision and regulation including reporting requirements and minimum levels of capital. Trades in customized derivatives would have to be reported to regulated trade repositories that would publicize aggregated data such as volumes and open positions. The Securities and Exchange Commission and the Commodity Futures Trading Commission would have joint oversight with increased powers to monitor the markets for fraud, abuses and signs of risk to the overall financial system.
[lvi] Treasury officials announced on April 8th 2009 that applications from life insurers for TARP money were now being considered since they too had been affected by the downturn in market values for their conservative investments in real estate and long-term debt. Insurance companies also had to boost capital reserves to reflect increased risk from the lowering of credit ratings on their holdings of corporate bonds.
Insurers had applied for support in 2008, and the Treasury granted preliminary approval on May 14th 2009 for a half-dozen applicants to receive TARP funds. The legislation creating TARP suggested insurers could participate, but qualifying for federal supervision required consultation with state regulators.
[lvii] The perennial Asian current-account surplus by definition equals savings minus investment, indicating either too-high savings or too-low investment. By achieving savings rates of around 35% over several decades and using their surplus to invest in infrastructure and new industry, Asians have indeed sacrificed consumption; but future output and consumption have been enhanced.
Of course, too-high investment can result in excess capacity and falling returns on capital. Other concerns include over-valued asset prices and excessive expansion of credit. However, we cannot infer such misallocation from high investment alone. Developing countries generally have much less capital stock than rich countries, so they are unlikely to be adding too much unless there are evident productivity problems (poor capital/output ratios or total factor productivity –TFP).
[lviii] China also perceives its fortunes tied to the European Union, as evinced by large Chinese bond purchases from the most troubled governments in the euro zone. Effectively, China is the “lender of last resort” to both the US and Europe, assuming a position of importance beyond the IMF and even the Fed.
[lix] Yet in the credit crisis, emerging markets like in SE Asia did not suffer so much (except when the crisis got so much worse). China especially was relatively resilient because their financial system is tightly controlled, but China could not sell their exports; nor could SE Asia despite depreciating currencies there. Singapore has a large container port which suffers from any decline in trade. Singapore has supervised its banks well and had little bad debt initially, and it has relatively high capital reserves in the banks and government coffers including its sovereign-wealth fund. Singapore, however, as a financial center shared the pain of global financiers. Singapore also experienced the race out of emerging-market currencies and institutions to US dollars to cover US$ debt obligations. (The Japanese yen also appreciated, due to unwinding of the so-called ‘carry trade’, in which investors borrowed money cheaply in Japan and invested it overseas. This made Japanese goods more expensive on world markets and precipitated a steep plunge in Tokyo stocks.) A strong US$ seems counterproductive because any American economic stimulus may only bail out foreign exporters, but the upward swing of the $ continued inexorably into 2009.
[lx] Monthly job loss totals started falling finally, with 539,000 in April and 345,000 in May. Total jobs lost in the 1st quarter 2009 were 2.1 million, declining to 1.3 million in the 2nd quarter. Thus, although total unemployment was obviously still rising, the rate of job loss was subsiding.
[lxi] From December 2007 to yearend 2009, 7.2 million jobs were lost and the number was still increasing.
[lxii] The Economist (Oct 18, 2008, p86) divided the investment cycles of the 20th century into 6 phases:
Bear markets: 1901-21, 1929-49, and 1965-82
Bull markets: 1921-29, 1949-65, and 1982-2000
From December 1999 to March 2003 the new Bear Market was characterized as the bursting of the dotcom bubble. From March 2003 to June 2007 we had the last full-fledged Bull Market. Lately, a new era has emerged, with an 86% gain from March 2009 to yearend 2010. Both these recent bull markets were accompanied by low interest rates and growing corporate profits. (The latest boom may also be artificial, sustained by stimulus spending and other government manipulation such as extremely low interest rates.)
Within these bear/bull timeframes there were of course many ups and downs. The Dow Jones passed 1000 in 1972 but fell to 616 by the end of 1974. In 1975 it rallied to 852 but then gained only 23 points in the next 6 years. In the current timeframe, the Dow dropped below 9000 on October 15th 2008, a level it had passed in 1997; so the decade seemed to have been a wash. The recent downturn (since mid-2007) persisted until March 2009 when the depressionary mood seemed to be dispelled.
Subsequent growth in industry and jobs lags by far any growth in market investment. Profits fall rapidly in recessions because firms are relatively slow to cut fixed costs by closing factories and laying off workers. Profits recovered in the current recession after significant corporate downsizing.
[lxiii] The new approach after the Republican victory in November 2010 was to stop government spending and rely on the private sector to step forward. See Austerity versus Stimulus later.
[lxiv] Even with a weak US dollar much of America’s spending goes to imports. In the 2nd quarter 2010 America’s economy grew at an annual pace of 1.7% but imports grew by 33.5%.
[lxv] The present-value of the fiscal cost of healthcare and pensions in the rich world by 2050 is ten times the fiscal cost of the financial crisis. (The Economist, June 13th 2009:13; IMF calculations)
[lxvi] The Moment of Truth, a report released on December 1st 2010 by the Obama administration’s National Commission of Fiscal Responsibility and Reform, became the starting point for congressional action to reduce the deficit. It included a cap on discretionary spending, overhaul of the tax system, reforms to entitlement spending, healthcare and other policy spending (such as agriculture support), and other very controversial measures. Other proposals such as Domenic-Rivlin added to the policy options. However, most specific reforms on the table seemed distant future possibilities at best.
[lxvii] Inspired blueprints were being proposed, such as the Mirrlees Review released November 10th 2010.
[lxviii] Soros himself, a respectable intellectual as well as market manipulator, decried his very own business model that profited so handsomely from big-ticket market trades. In genuine intellectual honesty he once observed, “I’m afraid that the prevailing view, which is one of extending the market mechanism to all domains, has the potential of destroying society.”
[lxix] It is an economic truism that savings must equal investment, equalized via the level of interest rates.
[lxx] There seems to be growing interest in innovative schemes and possible policy approaches to the “job sharing” concept, for example, the German Kurzarbeit formula to subsidize workers on a shorter work week. British higher education also developed a model.
[lxxi] British Petroleum’s 2010 oilspill in the Gulf of Mexico is beyond the scope of this essay. However, certainly this event can be seen as another instance of management (and government) failure to fully comprehend their own technologies, exercise full control over risky operations, conduct careful contingency planning, and indeed to plan for more than just the predictability of revenue streams.
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