Issue XXI: Who Killed the Economy?

30 Sep

By now you’ve heard that a bipartisan group of Congressmen killed George Bush’s $700 billion bailout for Wall Street.  A left-right alliance thumbed their noses at the leadership of both parties and let the stock market tank 777 points today.  Since my last post, the last investment banks went out of business or transformed into regular banks.  Today Wachovia, the nation’s second biggest bank, got bought out by Citigroup while Washington Mutual went under last week, the biggest bank failure in American history.

But who killed the economy?
Rome wasn’t built in a day, but it sure burnt down in one.  The tinderbox that is the American financial system took a long time to be prepare like the Aggie Bonfire.  Who chopped down the trees, set the pyre, and lit the flame are all different, but they’re all guilty in their own way.  Here’s a partial lineup.

Suspects

  • Senator Enron aka “The Professor” aka Phil Gramm, the former Senate banking chairman (R-TX).  A corrupt Aggie fathead of the Texas school this ex-Democrat now is the chief economic adviser to a certain president candidate named John McCain.  When he isn’t calling the American people a “bunch of whiners,” he pushed outrageous bankruptcy legislation at the behest of his credit card and banking donors.  His wife Wendy deregulated energy trading, retired, and then took a job on the Enron board of directors.  Ol’ Phil also wrote the law than repealed the Glass-Steagall Act, a law from the Great Depression intended to prevent the concentration of economic power.  The deregulation he pushed directly lead to mammoth corporations involved in insurance, stock brokerage, retail banking, and investment banking which was forbidden after the Depression while easing the ability to speculate without oversight.  It’s alright though, he cashed out chips to become vice-president at Union Bank of Switzerland (UBS AG).
  • The Citigroup Boys aka “The Bagman” aka former Treasury Secretary Rob Rubin.  Rubinomics brought deregulatory free market fundamentalism into the halls of a Democratic White House.  Bill Clinton and the neoliberal DLC Democrats swallowed whole, signing off on legislation from Congress while permitting the massive mergers that formed the monsterous Citigroup Inc. with its fingers in every financial pie under the sky.  No business was too dirt for Citigroup: it paid $125 million in fines for predatory lending and bought Banamex (a former government-owned bank in Mexico) to become the banker of choice for narcotraffickers.  Rubin cashed out to work for Citigroup, the house that Clinton Democrats made.
  • Bonnie and Clyde aka Freddie Mac and Fannie Mae.  Fannie and Freddie are two huge government-sponsored enterprises that are not officially part of the federal government but are understood to have a public service role.  They work by buying mortages from banks to inject more cash into banks so that they can lend more to homeowners (see this Explainer for more).  Of course, rather than actually lower the cost of homeowner lending for the average American, Freddie and Fannie used their government backing to make even more money for their stockholders and a bipartisan cast of hacks appointed to the company.  The entire world, including many Asian central banks, is invested heavily in Freddie and Fannie, and their asses had to be saved in the recent nationalization of the companies if the whole world’s economy wasn’t going to topple over with them.

Links
David Sirota – “Top 5 Reasons to Vote Against Wall Street’s $700 Billion Bailout
James Galbraith (UT Professor and Obama adviser) – “The Predator State” and “A Bailout we don’t need
The Economist –End of Illusions

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6 Responses to “Issue XXI: Who Killed the Economy?”

  1. BS September 30, 2008 at 10:55 am #

    And so….

    it all falls apart.

    It’s clear that the system is broken as a result of a number of the reasons you’ve cited, among others.

    The bailout as it stands is a bad, bad idea. Nobody has the least clue as to whether it works. Assuming that it does work (at least in the short term), the long term picture is murky at best. Basically, there will be some temporary liquidity in the credit markets as a result of the bailout (probably), but then what? The markets recover? (maybe) Firms take reasonable risks in spite of the moral hazard? (not likely)

    So, what is a treasury secretary to do if he can’t get a blank, limited-oversight check for $700+ billion?

    Options:

    1. Let them fail. The Wall Street boys got a little too risky for their own good, so let em go into bankruptcy. On its face, not a bad idea. In bankruptcy, their counterparties (who maybe should have taken a better look at their financials) get pro rata and the “owners” (shareholders) most-likely get nothing. The good bits survive, everything else goes kaput. Sounds nice and free market…until highly leveraged businesses can’t get money from the credit markets to make their payrolls….(yes, still free market, but probably not a reasonable solution).

    2. Have the government offer insurance on these financial institutions’ lending to one another. We know that the credit markets remain frozen unless these institutions can lend to one another. So, free of charge, the government offers to backstop these borrowings. The catch? If you use the backstop, the government gets your equity (all of it) and your other creditors are subordinated. The good of this? The credit markets can begin to flow immediately (if the full faith and credit can’t guarantee the indebtedness, we have much much bigger problems). The bad…WHEN things go bad, there WILL be a cost to taxpayers (how much is anybody’s guess, but if it’s less than $700 billion it’s a win).

    3. The government takes a chunk of the proposed bailout and buys mortgages (then they can renegotiate/foreclose, etc.). This is a long-term and difficult solution. A large part of the problem is that mortgage interests are held by very very large numbers of people and no amount of coordination can bring them together, but a few hundred billion on the table might do it. This cleans up the dirty MBOs, but doesn’t fix the derivatives on them (credit-default swaps). Why won’t it ever happen? It forces the companies holding the MBOs to write them down…no one needs a balance sheet that reflects reality. If there’s any prospect of a bailout (that would take the MBOs and derivatives off the balance sheet with a minimum of write down, this will never happen).

    The best solution is a combination of 2 & 3, but we’ll see what happens….in the meantime, get ye a bunker and gold bars (okay, that may be a bit of overreaction).

  2. BS September 30, 2008 at 10:58 am #

    A decent(if threadbare) argument for Option 1: http://www.time.com/time/business/article/0,8599,1845209,00.html?cnn=yes

  3. Kate October 5, 2008 at 1:41 pm #

    so what’s the take now that the (revised) bail out passed?
    I’ve heard steady, slower slump-maybe ten years to return the market to its August state, but at least no out and out nose dive. Agree? Disagree? Please discuss.

  4. BS October 6, 2008 at 10:06 am #

    “so what’s the take now that the (revised) bail out passed?
    I’ve heard steady, slower slump-maybe ten years to return the market to its August state, but at least no out and out nose dive. Agree? Disagree? Please discuss.”

    That is the $700 billion question, is it not?

    But let’s dig down, shall we? The market? Which one? The credit market? Stock market? Market for pork bellies?

    “The market” if by that you mean the stock market is a rather poor indicator of the overall health of the economy. I mean, it bears looking at (as it is an aggregate of expectations), but I’d prefer not to speak in terms of it.

    Basically, it boils down to this. The gov’t, through the bailout, goes in and takes the most troubled assets: (1) on the assumption that this will free up the deadlock in the credit markets by returning some credibility to the balance sheets of large financial institutions and (2) on the promise that they could possibly be some underlying value in the “bad” assets (this is the whole line about the bailout not actually costing taxpayers $700 bil.). In a perfect world, the credit markets come back, the assets (mortgage backed securities) appreciate in value, the government gets its money back (the taxpayers don’t suffer the burden, etc.).

    What I think really happens?

    The credit markets flow temporarily, at least until the next tranche of bad assets starts to look stinky. Why the decline? The assets backing these securities are mortgages — in a lot of cases, mortgages in default.

    So, what happens? The assets the gov’t bought become valueless, the credit markets seize up again, and we have to make a choice….do we bailout more or do we make some alternative choice?

    The first time is a mistake…the second time is stupid.

    The only way this works is if this is a completely temporary, non-fundamental market blip. If you think that’s true, the bailout is the perfect solution.

  5. bhatany October 6, 2008 at 9:02 pm #

    Is this a temporary blip? I’m not an economist, and I didn’t go to business school. But I’ll wager that it ain’t a single blip, and that BS’s prediction of a temporary alleviation (which thus far isn’t much) until the next cooked books are exposed will be the most likely scenario. When the Enron whisleblower says the Wall Street Boys are more crooked than Kenneth Lay, I’d predict more fireworks for a while.

    Two analogous situations come to mind: Texas in the 1980s and Japan in the 1990s with 7-10 year slumps. I think the Japan situation is quite apt because American banks (like the Japanese) are probably sitting on more even bad debt than they are willing to admit. Rather than bail in/bail out, people need to declare what their losses are and how many assets are non-performing. Take the hit/recession now, and then re-grow afterwards. Then re-regulate and re-direct the economy to make sure this never happens again.

    I’ll also agree with BS about “which economy” are we talking about. Capital should be in service to the actual economy. The financiers are to help the economy PRODUCE, not to BECOME the economy. The “financialization” of American business at the expense of the real economy has been a long-term trend going back at least two decades. In Mike Davis’s 1990 urban history of Los Angeles (City of Quartz), the author describes a “post-industrial economy” not based on any actual industry (the irony of LA is that people came to LA before an actual economy did instead of the other way around).

    LA historically functioned as a parasite on the rest of America’s wealth bringing millions of white middle class Midwestern Protestants to Southern California bringing their fortunes with them. The “wealth” of LA became single-family houses and the lots they were built on rather than oil or steel or anything worthwhile. LA is/was a real estate economy based on housing prices, nothing more. As long as people bought the California mystique and promise, the value and economy held. Now the governor begs for a federal loan.

    As much as conservatives would hate to admit it, America BECAME Los Angeles in every which way by 2008. Fueled on other’s people’s money, easy credit, and a smug satisfaction that our houses built in the middle of nowhere (Nevada, Inland Empire, outer suburbia, etc.) would rise in value to infinity.

    Tulipmania people. Tulip-fucking-mania.

  6. BS October 8, 2008 at 10:47 am #

    “Two analogous situations come to mind: Texas in the 1980s and Japan in the 1990s with 7-10 year slumps. I think the Japan situation is quite apt because American banks (like the Japanese) are probably sitting on more even bad debt than they are willing to admit. Rather than bail in/bail out, people need to declare what their losses are and how many assets are non-performing. Take the hit/recession now, and then re-grow afterwards. Then re-regulate and re-direct the economy to make sure this never happens again.”

    I thought I’d comment on these a bit, as you’ve brought them up.

    Texas – This looks a lot like Texas in the 1980s, but let’s add a couple of wrinkles: (1) as everyone knows, that was a regional downturn in the days before everyone was so connected — now any downturn quickly becomes market-wide; (2) the other value we can get from looking at Texas in the 1980s is to make a comparative evaluation of possible solutions.

    (1) The observation here is that something needs to be done, and by something, I mean doing nothing IS an option. Basically, a clear policy needs to come out of this so the market can properly adjust (not just a seemingly open-ended bailout). If that policy is to do nothing — so be it; alternatively, you could do something else. As long as there is the possibility for recovery by governmental or other means, no one will ever accept their losses.

    (2) It is worth looking at a comparison to Texas in the 1980s at this point. Let’s look at a seemingly ideal solution (and at the same time evaluate the bailout). John McCain proposed last night that the government buy the troubled mortgages and then work with the “homeowners.” That, is a great solution, if you could get it to work. It allows for true valuation of the mortgage assets on the books of the financial firms, it helps the average person in a mortgage, etc. (the list of potential benefits is long — of all the things you could do, this is not a bad option – Barack Obama’s solution isn’t bad either i.e. allowing mortgages to be modified in Chapter 13 Bankruptcy). The problem? Unlike Texas in the 1980s, these mortgages are not held by individual banks/S&Ls, they are held in fractional pieces by any number of entities (MBOs) – sorting these out, let alone buying them becomes an issue. A slight modification of this plan was espoused by Professor Howell Jackson in the Christian Science Monitor involving the federal government taking these loans by eminent domain — but what you think of that depends on how comfortable you are with government intervention in general (link : http://www.csmonitor.com/2008/0925/p09s02-coop.html).

    To address the Japanese comparison, we risk running into a similar slump if we don’t find a bottom in this market.

    Conclusion, any ideal solution looks at two major parts of the problem: (1) the credit markets need to be unstuck and (2) we have to find/create a floor. Truth be told, we could do without the first, but the economic implications could be troubling – it’s possible that businesses completely outside of the financial markets could have serious liquidity problems even if their underlying business is solid (and the ripple effects of that could be devastating).

    The current bailout may not even address the first, and buying the mortgages could be a road (albeit with serious bumps) to the second without resorting to a crash into the floor (in some sense it would raise the floor such that the fall wouldn’t hurt as bad).

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