Risk of major social upheaval likely if bank bonanza continues
Thursday, 06/25/2009 - 1:39 pm by Marshall Auerback | 15 Comments
Is a Democratic administration and a Democratically controlled Congress presiding over one of the most regressive wealth transfers in history? Roosevelt Institute Braintruster Marshall Auerback investigates.
State and local governments have been forced into draconian budget cuts, firing workers who are among the most reliable in making their mortgage payments–when they have jobs: firemen, policemen, teachers, civil servants.
Yet the Obama administration won’t spend even a small fraction of what it has wasted on the banks to cover state shortfalls. The guarantee of $5.5bn in short term notes for California was deemed to be fiscally irresponsible, yet hundreds of billions have already been allocated to the likes of Citigroup, AIG, and Goldman Sachs, all of whom have already beefed up salaries and bonuses as they emerge from the embrace of the federal government.
Good for the banks, bad for the economy
Banks are also benefiting from lending programs that effectively allow them to borrow at zero and reinvest in Treasuries at around 3%. A bank doesn’t have to do anything to make money. The banks’ return on equity is going to be very good. They are going to be able to restore their finances.
While this is good for banks, is it good for anyone else? The problem is the government’s “free money” program means banks have little or no incentive to do any actual lending. Combined with rising unemployment and the ongoing housing crisis, this means any recovery is likely to be muted, at best, especially given the ongoing weakness in the real estate market. Growing income inequality will likely be perpetuated and exacerbated with all of the resultant social strains. And in the meantime, the siren songs will grow that we are a nation addicted to debt, deficit spending our way to economic disaster.
Housing bubble lessons
Policy makers were slow to recognize the importance and magnitude of home price deflation. Keynes, Minsky, and Fisher understood that balance sheets matter to income and cash flow outcomes - it is not just the other way around, as convention has it, where income and cash flow results passively accumulate on balance sheets at a glacial pace.
The New Keynesians like Bernanke should have recognized this through their “financial accelerator” channels approach, but the near-ZIRP (zero interest rate policy) QE (quantitative easing) approaches have so far proven to be too little, too late. Moreover, there is now a wing of investors feeding fears that “monetization” and significant fiscal expansion may constrain the Treasury’s room to manoeuvre further. The upshot is that we have missed a golden opportunity to deal with the growing problem of income inequality. Instead, we have the paradoxical spectacle of an ostensibly progressive Democrat administration, and a Democratically controlled Congress, presiding over one of the most regressive wealth transfers in history.
As Keynes and Minsky realized a lifetime ago, durable asset markets, such as housing, do not clear as easily as markets for Chiquita bananas. This is especially true after asset bubbles have introduced structural excesses in parts of the capital stock - what the Austrians call “malinvestment” or distortions to the production structure. When there are large outstanding stocks of durable assets relative to the potential flow supply, lower prices are not necessarily the cure for low prices, as the traders in the Chicago pits are wont to assert. The bias toward viewing markets as self-regulating, self-adjusting mechanisms does not hold equally well across all markets in all conditions, as this generation has been brainwashed to believe.
Rather, lower prices can beget a stock overhang of existing owners who want to sell, especially if expectations about “normal” or future values are closely coupled with recent spot price trends. Following an asset bubble, when conventions about normal supply prices (or even legitimate valuation models in general) have been ruptured, recent price momentum does tend to become the main guide to expectations, as the trend extrapolating traders win the day against fundamental driven investors during asset bubbles.
Obama, Geithner, and Summers misguided
Obama, Geithner, and Summers misplaced their faith in lower prices as the cure to an excess supply situation in a durable asset market. They also they failed to understand that while lower spot prices may reduce new production, the desired selling out of existing stocks can swamp this flow supply reduction. Because of these misconceptions, they now think they face the choice of either having to let it all meltdown, or else using policy to synthetically reproduce the prior bubble credit conditions.
Or consider this analysis another way, from the increasingly prevailing view that US policy makers are somehow edging us toward a hyperinflationary abyss. Money created has to be spent on goods and services to get higher product prices. Professional investors are working with very simple quantity theory approaches. They are not thinking about transmission mechanisms from money to prices. There is no auction market for M1 and the CPI that automatically settles at the end of each day. The only auction market is spending by public and private sectors on produced goods and services each day, week, month, quarter or year.
Government is the only one increasing spending. The fact that nominal GDP is still falling tells us that the private sector is trying to save more than government is deficit spending, which is deflationary, not inflationary. Even arch monetarists such as Milton Friedman conceded that the path to inflation from money creation was through nominal GDP.
In an inflation, people are eager to trade money holdings for produced goods and services or tangible assets. In a hyperinflation, even more so.
That is not what we have today. Banks are hoarding $1 trillion of cash on their balance sheets. Companies are in cash conservation mode and stripping down inventories, headcounts, and reducing capital spending. Households are saving and building exposure to near cash instruments.
Robust stimulus needed
When an economy experiences sharp and sustained shifts in private liquidity preferences, the policy response must be to create money and additional aggregate demand via government fiscal stimulus, or let debt deflation rip. The latter tends not to be terribly acceptable to democracies for the obvious reasons which Fisher had to learn first hand.
Statements by President Obama that “we are out of money” do not help, because they imply that there is an operational constraint on fiscal policy, beyond which the government dare not go. They feed the prevailing paradigm about “debt sustainability” and “national solvency” and thereby work at cross purposes. What President Obama, Fed Chairman Bernanke, and Treasury Secretary Geithner must say is that until the government deficit spending and the improvement in the trade balance exceeds desired net private sector saving, we can create all the money we want - it simply will not be enough to driver final product prices higher unless and until we succeed in restoring aggregate demand to sufficiently high credible levels where a self-sustaining economic recovery can take place.
In one sense, it is pointless blaming Wall Street for exploiting a system heavily rigged in its favour. They know that the game is stacked in their favour, so they are rationally taking advantage. But the sickest part about the whole episode is that the casino rule makers, Obama, Geithner and Summers, are perpetuating a flawed game that they had in their power the chance to end. In my more cynical moments, I have to wonder why TARP, which is essentially a purchase of financial assets (and, hence, better left in the hands of the Fed, as Treasury is supposed to buy ‘real things’) was placed in the hands of Treasury. It’s almost as if this was planned deliberately so as to provide the anti-government folks with a cudgel with which to beat back supporters of activist government. My issue with Obama and his fiscal package is the same as Rob Johnson’s: taxpayer money is being deployed in hugely inefficient ways like Citi, BofA, AIG, and GM and discrediting fiscal policy in the process. Contrast this with the achievements of the New Deal. As Adam Cohen in his new book, NOTHING TO FEAR ,
“[WPA] workers constructed or repaired more than 125,000 buildings, including 83,000 schools; 800 aiports; 950 sewage plants; and 650,000 miles of roads. They built or improved 78,000 bridges and 25,000 playgrounds; terraced 271,000 acres of eroded land; and taught two million people to read. They also ran a famous Federal Art Project, which hired destitute artists to create murals for public buildings, posters, and paintings. The WPA produced a highly regarded series of state guidebooks and an acclaimed collection of interviews with former slaves, and it played a major role in building the San Antonio Zoo, New York City’s LaGuardia and Washington’s Reagan airports, and the presidential retreat at Camp David. In 1965, on the program’s thirtieth anniversary, The New York Times quoted a dispossessed North Carolina tenant farmer living in an abandoned gas station, who had been rescued by a WPA job. ‘I’m proud of our United States, and everyting I hear The Star Spangled Banner I feel a lump in my throat,’ he said. ‘There ain’t no other nation in the world that would have had the sense enough to think of WPA.”
This kind of puts the paucity of Obama’s fiscal goals in stark relief, doesn’t it?
The key is building a political case for the stimulus. This means getting people around a common objective where everybody is perceived to be benefiting and that the sacrifices are being borne fairly. This was clearly the situation in WWII when the budget deficit as a percentage of GDP got as high as 30.3% of GDP, yet nobody complained about the “sustainability” of government expenditures. The upshot was that by 1946, the GDP per capita was 25 percent higher than it had been in the last peace years before the War. GDP per capita continued to grow during the Marshall Plan years. Despite giving away two percent of U.S. GDP, American residents (and taxpayers) experienced a higher standard of living each year. And nobody spoke about us running out of money.
Bank bonanza must end
By contrast, the current bonanza for banks is neither economically efficient, nor politically sustainable.
What is driving the change in portfolio preference shifts is not only a misguided paradigm, but also an inability for the Obama administration to make a sensible, coherent case in what they are doing and why they are doing it. Their actions, in fact, seem to suggest that everything is ad hoc and that they are operating out of their depth, in effect continuing the same policies of the Bush/Paulson period, but on a much greater scale.
Ironically, this ultimately will also prove highly inimical to the interests of finance itself. When most of the home owning voters cannot pay their major debt or have no incentive to pay their mortgage debt, there will either be a debtors revolt that society will sanction or there will be a bailout of such a magnitude that mega moral hazard will affect private lending forever. Once these things happen, you will no longer have the social rules for private risk based lending. In other words, financial markets will be unlike anything ever seen before in private economies. Is this really what Wall Street wants, let alone American society as a whole?
Both FDR and JFK had a brain trust that could help forge public opinion. Obama has his halo, Geithner, and Summers. We’ve known from the start that was a misstep.
In the meantime, beyond automatic stabilizers, the door appears to be shutting to further active fiscal ease. I wonder if the stage is already being set for tax hikes, as rumors of a federal VAT (value added tax) have been floating around of late. Add this to rising commodity prices and interest rates, and the profile of any recovery may become increasingly in question, a la 1937-8. Add to that additional bank write-offs, further credit contraction and a minimalist welfare system which leaves nothing in the way of social cohesion, and the prospects for major social upheaval look dangerously likely. What is missing is a vision of a new growth path for the US. If a public backlash is to be marshalled to something more than retribution, that needs to come to the fore. Once you get beyond the pothole and school patching, what industries can be pushed forward through public seed capital or public private partnerships? The economist Hy Minsky pointed out a better way to solve both the liquidity and the income problem, while also providing full employment: by channeling government expenditure through an employer-of-last-resort program.
The current crisis could have been mitigated if increased household consumption had been financed through wage increases and if financial institutions had used their earnings to augment bank capital rather than employee bonuses.
The current system has failed because it was built on an incentive system that did just the opposite.
Great. The “responsible” Republicans create an insane deficit and the “peoples’” Democrats practice Bank-down economics. Seems like we need a new dictionary as well as a new financial system.
Posted by Follies | June 25th, 2009 at 2:36 pm
Thanks for this informative article. It answer a lot of questions about the unwise policies of the Obama administration. It still puzzles me what motivates the architects of this obviously flawed policy (Geithner, Summers). It’s hard to imagine they are only out to help their banker friend on Wall Street.
Posted by John Kirk | June 25th, 2009 at 9:46 pm
@ John
The reson Larry & the tax cheat are going easy on wall st is because they want big $ paying jobs once they leave the administration.
If they crack down hard no wall st firm will hire them.
Look what happened to Art Levitt he was only just hired by Gov’t Sachs after years of being ignored by wall st.
Its also why Volcker has been cast aside he’d be too tough and ruin Summers & turbo Timmy’s chance for big $.
Its a corrupt system that John Doe doesn’t understand or cares too. Though I agree with the author eventually this will change my bet is on a debt revolt.
Who knows what happens after that I’m not very optimistic about it though.
Posted by percolator | June 26th, 2009 at 2:03 am
Well argued. The last decade, the Powers that Be have camouflaged the decline in real income for average American families by easy credit, which artificially sustained consumption (and boosted the real income of the upper classes). Now the credit risk turns out to have been the taxpayers’ - i.e. average Americans’ - all along. Ergo, they are finally going to experience the postponed pain of years of pillage.
This pain is going to be felt either through debt deflation (rightly mentioned above as a socially and morally highly risky option) or higher taxes. But, as many comparisons - including the one above - of the current situation and the New Deal conveniently leave out, Roosevelt had a world war to spend on. Before that, in spite of WPA and other programmes, increased government spending could not keep up with deflationary forces.
It remains to be proven whether it is possible for any State to spend its way out of asset price deflation without a major war. And with a government, but much more importantly, a population as indebted as the US, even large scale warfare may not be ’stimulus’ enough.
Posted by Bas | June 26th, 2009 at 2:40 am
We do need a significant change in our economic system. In particular, I would love to see Obama embrace Minsky’s idea of government as employer of last resort. It’s much more socially useful and economically efficient to have a buffer stock of EMPLOYED people. As Paul Davidson, Randy Wray, Warren Mosler, Jan Kregel and others have also argued, the U.S. Government can proceed directly to zero unemployment by offering a public service job to anyone who wants one as a supplement to the current budget. Furthermore, by fixing the wage paid under this ELR program at a level that does not disrupt existing labor markets, i.e., a wage level close to the existing minimum wage, substantive price stability can be expected.
The ELR program allows for the elimination of many existing government welfare payments for anyone not specifically targeted for exemption, as desired by the electorate. Minimum wage legislation would no longer be needed. Labor would welcome the safety net of a guaranteed job, and business would recognize the benefit of a pool of available labor it could draw from at some spread to the government wage paid to ELR employees. Additionally, the guaranteed public service job would be a counter- cyclical influence, automatically increasing government employment and spending as jobs were lost in the private sector, and decreasing government jobs and spending as the private sector expanded.
Posted by Marshall Auerback | June 26th, 2009 at 8:32 am
One final point: people like Summers and Geithner have basically embraced the economics of the rentier class when they discuss the “sustainability” of government deficit spending. They don’t look at this from the perspective of aggregate demand, which is the right way to look at this problem. The supposed technical and financial limits imposed by the federal budget deficit and federal debt are a vestige of commodity money. Today’s fiat currency system has no such restrictions. The concept of a financial limit to the level of untaxed federal spending (money creation/deficit spending) is erroneous. The former constraints imposed by the gold standard have been gone since 1971. This is not to say that deficit spending does not have economic consequences. It is to say that the full range of fiscal policy options should be considered and evaluated based on their economic impacts rather than imaginary financial restraints. Current macroeconomic policy can center around how to more fully utilize the nation’s productive resources. True overcapacity is an easy problem to solve. We can afford to employ idle resources. Obsolete economic models have hindered our ability to properly address real issues. Our attention has been directed away from issues which have real economic effects to meaningless issues of accounting. Discussions of income, inflation, and unemployment have been overshadowed by the national debt and deficit. The range of possible policy actions has been needlessly restricted. Errant thinking about the federal deficit has left policy makers unwilling to discuss any measures which might risk an increase in the amount of federal borrowing. At the same time they are increasing savings incentives, which create further need for those unwanted deficits. The major economic problems facing the United States today are not extreme. Only a misunderstanding of money and accounting prevents Americans from achieving a higher quality of life that is readily available.
Posted by Marshall Auerback | June 26th, 2009 at 8:35 am
While you are correct about the attempt to re-inflate the speculative derivatives bubble by the current crew that is in there, I’m afraid you fall short in appreciating the problem and its cure. The US financier class and its allies have been acting like Imperial Rome for quite some time now. That is, by looting its cheap labor 3rd World satraps through military might. All the while, our own physical economy (such as plant, equipment, machine tools and infrastructure) has been allowed to decay or shut down. Without dumping the insane post industrial policies which have gotten us here, the revolt you speak of will probably be an excuse for the same financiers that caused this mess to impose harsh austerity and martial law conditions. What is needed is a Chapter 13 reorganiztion of the multi trillions derivative bubble and a new Bretton Woods financial reorganization that returns our nation’s leadership in rebuilding a technology vectored physical economy with energy intensive nuclear power construction, machine tool and infrastructure spending by providing long term credit for that sole purpose.
Posted by Bob | June 26th, 2009 at 9:20 am
Bob,
Don’t disagree with you, and have discussed the CDS issue in previous posts. I would love to ban the things, but they are too embedded in our current financial structure. liquidity problems (in CDS) caused solvency problems which then caused further liquidity problems (in funding markets) which then caused additional solvency problems, and so on and so forth in a downward spiral. This liquidity-solvency cumulative process worked to inflate the bubble on the way up, and it is now working to deflate the bubble on the way down.
This way of thinking about the problem has implications for policy, both short term and long term. Short term, it means that there are probably quite a lot of relatively sound assets out there that are being undervalued by a mark-to-market exercise such as that used by the IMF to calculate likely losses. Of course there are also a lot of fundamentally unsound assets, both because of faulty underwriting and because of deterioration of the fundamentals. And of course the price of the underlying real assets has yet to return to fundamental value, so outstanding credits can be expected to continue to deteriorate. These are both big caveats, but if the liquidity-solvency cumulative process is real, then it stands to reason that sound assets have been taken down along with the unsound assets. Those holding the sound assets know what they have and are reluctant to sell at prevailing prices, but at the same time they are under pressure to mark their positions to market and that constrains them from doing any new lending. Hence the freeze.
The short run challenge is therefore to put a floor on this cumulative process, and to begin sorting out the sound from the unsound. The Fed has provided a floor on the liquidity spiral by its willingness to provide funding to keep assets in place. Presumably the PPIP is intended to sort the sound from the unsound, and to establish some market marks for the sound that will put a floor on the solvency spiral. Once we have market marks for the underlying assets, presumably the CDS marks will become irrelevant.
The long run challenge is to reconstruct the system in order to put more permanent bounds on the liquidity-solvency cumulative process, both on the upside and on the downside. I suspect an insurance model is the way to go, but the government has to run this not the likes of AIG and we should certainly charge more than 15 basis points!
Posted by Marshall Auerback | June 26th, 2009 at 10:11 am
“Even arch monetarists such as Milton Friedman conceded that the path to inflation from money creation was through nominal GDP.” – so, how do you explain the Weimar Republic? They were in a recession\depression with nominal GDP falling… History is more than simply American experiences; there are other areas that have lessons to teach as well.
Posted by Thomas | June 26th, 2009 at 12:22 pm
Excellent piece. However, without placing the analysis in a global context, said analysis falls short. Limiting one’s perspective to domestic concerns fails to get at the heart of the matter.
In Asia over production mirrors our over consumption. Their over capacity to produce relies on cheap labor, just as our debt driven consumption also relies on their cheap labor.
Our consumption and funding of debt relies on re-cycling dollars back from China to the US to fund the deficit. Continued funding of an expanding deficit requires ever growing US consumption to fuel China’s production, which then allows China to lend the US the funds to pay for the deficit - by buying US Treasury bonds. Thus the re-cycling of dollars. Consequently, any success in any deficit driven increase in consumption requires maintaining this status quo. Even if US wage earners saw their wages increase along with more jobs created, they won’t restore economic growth here unless they get back to their spending ways. Saving their money and buying Treasury bonds to fund the deficit won’t work. So will continue to rely on China (and the Middle East and other countries).
It is this very status quo that is not sustainable and is now breaking down, irreversibly in my opinion. What is needed is a re-structuring of the global economy. This is what we are experiencing today. It just isn’t occurring as a result of intent but instead as a consequence of the global imbalances that have developed over many decades. Any attempt to restore this imbalance will not succeed, no matter how much deficit spending the US does.
One final thought. It must be recognized that there are ecological limits to growth, so we must engage in an analysis that is not only global but ecological, something few in the realm of economic analysis are able to do.
Posted by don | June 26th, 2009 at 6:53 pm
It all makes sense once one realizes the purpose of the game is to ensure the survival of Goldman Sachs and friends and their political hangers-on, among whom is the President. The impoverishment of the middle class is not a bug, but a feature. The game has been played over decades, and has now reached the point where hiding the mechanism is hardly necessary. New Deal 2.0? Impossible as long as Goldman Sachs and friends continue to stock the executive branch, subsidize the legislative branch and supply central bankers to the Fed. Obama and the Dems are every bit as much tools of Wall Street as are the Reps, and most of the citizens know it, despite the daily administration of the Blue Pill by government and media. Debtor’s revolt? No. Think Iran.
Posted by Scott Walker | June 27th, 2009 at 12:43 am
I think you underestimate the weakness of the US economy and the political power of the financial firms, and so underestimate the constraints on Obama/Summer/Geithner. If they succeed in getting some new “green jobs” economy running, they can afford to let the banks tip over. Until then, they are utterly hemmed in. When demand started to increase in FDR’s America, manufacturing output increased and there was a virtuous circle. That circle cannot be created by increasing demand for chinese manufactured goods and indian technical services.
Posted by rootless-e | June 27th, 2009 at 2:00 am
I think we are missing the big picture. We are all being returned to a form of indentured servitude. We are all so in debt that we won’t ask for raises or demand fair treatment in our job for fear of losing our jobs. with unemployment as high as 15% in Michigan, there are more people clamoring for jobs than there are jobs. so employers have the power. and Obama is just facilitating this. solidarity has been eliminated so that everyone is on their own. each person is left to fend for themselves so that those with the resources and the connections can continue to oppress those that don’t. it would be an economic type of Mad Max.
Posted by ep3 | July 19th, 2009 at 7:07 pm
Thank you for this excellent piece. I keep reading that sytems that are unsustainable will collapse. The issue of course, is the timing of a collapse. I feel that the promised change ( I voted for) by Obama was a massive PR triumph with no substance and few seem to be questioning the moves he has made, while dancing to the tune of wall street. I keep waiting to see Obama make the Billionaires list faster than any President in history.
I can only wonder what the tipping point will be to get large numbers of the lower tier of our two tier society out into the streets. I’ll bet the next stimulus package includes a free 60″ flat screen TV with surround sound and a 600 channel cable package (including the porn channels) for any underemplyed/unemployed person who has room in the refrigerator box they are now living in. Of course the set up will include an IV feeding system and catheters so there is no need to get up and move around for anything.
I wrote a short piece called “Going Down With the Joneses” that is posted at http://www.box.net/shared/2qbiqdetak about the death of our middle class.
I am particularly distressed that there is no publicly funded effort to retrain workers in sustainable industries (High Tech and Health?) What possible rallying cry do you envision that would move the masses to action?
Posted by Ant With a Megaphone | July 29th, 2009 at 11:35 am
зачем так палится!!!!!!!!
Posted by Babyman | September 2nd, 2009 at 4:41 am