I’ve hesitated to posted about the mushrooming financial crisis and the proposed federal bailout until I felt that I could muster an informed opinion. I’m not an expert economist by any means, and this is a devilishly complicated situation that’s evolving from day to day. Still, after some diligent background reading, certain things are becoming clear. I just hope that our Congresscritters, as they prepare to debate the scope of the problem and the proposed solution(s), have put in at least as much effort.
That things are bad is not in doubt. But the causes and effects are complicated, and the usual partisan and ideological lines don’t seem to apply here. In the wake of Treasury Secretary Henry Paulson’s proposal last Friday for an unprecedentedly massive bailout of Wall Street, both liberal and conservative voices have come out both in favor of the proposal and in opposition.
Public opinion is likewise divided. People are scared but skeptical. Just a week ago, even as the $85 billion AIG bailout was being arranged, only seven percent of Americans polled supported public bailouts for troubled financial firms, across all political lines. By Monday, after a weekend of a no-holds-barred PR push from Paulson and saturation media coverage, the numbers were higher, although different polls found radically different levels of support, from 28% up to 62%. The public is following the story closely, but large numbers remain undecided, and even supporters fear that taxpayers will get the short end of the stick.
It’s no surprise that opinions are in flux. People are playing catch-up to events, barely getting a grip at this point on how things got to this point, let alone what’s likely to happen next and how, why, or whether the bailout is necessary. In a nutshell, it’s the result of leverage piled on leverage, risk piled on risk—the banking and investment industry turning small amounts of equity into huge amounts of debt, and using it to purchase unregulated exotic securities, derivatives that were themselves based on small amounts of equity and huge amounts of debt. Behind all this lay real estate, and as long as property values kept increasing, it was possible to keep rolling over the debt and reaping profits. But this was a pattern that incentivized greater and greater levels of risk, and anyone could (or should) have seen that the bubble would pop at some point. Some companies did, and have avoided the worst of the fallout. Most just put their blinders on and kept going. Now, just like a homeowner upside-down on a mortgage, most of Wall Street is undercapitalized as well, on the hook for debts that far exceed the value of its assets.
None of this happened by accident. It’s a result of deliberate policy choices made by those in power, officials of both parties with cozy ties to Wall Street. For years, Alan Greenspan insisted that there was no housing bubble, even as he facilitated the easy money that kept it growing. Back in the ’90s, Senators John McCain and his close friend and former economic adviser Phil “nation of whiners” Gramm were behind the deregulation that undid Depression-era safeguards and made this kind of industry-wide speculation possible. Just like Paulson, Clinton’s Treasury Secretary Robert Rubin was a former chairman of investment banking giant Goldman Sachs, and lobbied hard against stricter regulations. Paulson himself, along with Greenspan’s successor Ben Bernanke, was insisting until just weeks ago that the economy was stabilizing and the market could take care of itself.
For more than two decades now, the American economy has based its “growth” on one speculative bubble after another, rather than on goods and services with tangible value. A lucky few have accumulated vast wealth this way, while most Americans have based their lifestyles on increasing levels of consumer debt as real household incomes stagnated, and (in a perverse feedback loop) our GDP grew increasingly dependent on that unsustainable consumer spending. It doesn’t have to be this way: many European nations have charted a different course, and today have a far more stable banking sector, grounded in actual public savings. But far be it for U.S. policymakers to take any lead set by Europe, which have routinely been maligned for placing insufficient trust in “the market.”
Still, blame aside, the current crisis is real. What is the likeliest fallout? This goes far beyond distressed mortgages. It’s called a “credit crisis” because undercapitalized lenders can’t afford to lend, and those who can afford to are nevertheless afraid to due to unmeasurable risks. Without flows of credit to grease the wheels of commerce, even legitimate and responsible borrowers—individuals and businesses alike—are stopped in their tracks. Productivity falls, jobs disappear, consumer spending dries up (even more than they already have). As Paul La Monica of CNNMoney.com observes, “you’ve got nearly 11 million people, or just under 10% of the entire nation’s labor force, working in industries that could be directly (and negatively) affected if the financial services sector and housing market were left to just sort themselves out.”
So as archconservative William Kristol blithely sums it up in his New York Times column, “We’re going to have a recession. Unemployment will go up. Credit is going to be tighter. The challenge is to contain the damage to a ‘normal’ recession — and to prevent a devastating series of bank runs, a collapse of the credit markets and a full-bore depression.”
That’s not a worst-case scenario—that’s what happens no matter what, barring a miracle. What the financial sector desperately needs is “deleveraging”—but that’s almost impossible to achieve without triggering a vicious negative feedback loop. As PIMCO Managing Director Paul McCulley put it in a widely-read article earlier this summer,
“Once the double bubbles in housing valuation and housing debt burst a little over a year ago, everybody, and in particular, every levered financial institution – banks and shadow banks alike – decided individually that it was time to delever their balance sheets. At the individual level, that made perfect sense.
“At the collective level, however, it has given us the paradox of deleveraging: when we all try to do it at the same time, we actually do less of it, because we collectively create deflation in the assets from which leverage is being removed. Put differently, not all levered lenders can shed assets and the associated debt at the same time without driving down asset prices, which has the paradoxical impact of increasing leverage by driving down lenders’ net worth. …
“[The Fed’s] monetary easing is of limited value in breaking the paradox of deleveraging if levered lenders are collectively destroying their collective net worth. What is needed instead is for somebody to lever up and take on the assets being shed by those deleveraging. It really is that simple.“
In other words, the government is left to step in as a “buyer of last resort.” That was the principle underlying last week’s AIG bailout: per CNNMoney.com, “it gave AIG time… to unwind its sprawling operations — it has $1.1 trillion in assets and 74 million clients — in an orderly manner. Had the company been forced into bankruptcy, it would have to unload its subsidiaries quickly and at a deep discount.” This would have dragged the market down even further, undermined the asset values of other similar firms, and exacerbated the credit crunch.
This is the same philosophy behind Paulson’s proposed $700 billion sector-wide bailout. Paulson, and the Bush administration, have consistently tried to portray it as a necessary evil, a better alternative than “doing nothing.” But is it really the only available solution, much less the best one? Indeed, will it even work?
(More to come. This post is growing excessively long, and I need to break it in two.)Tags: bailout, economy, financial crisis, Paulson