The Revolutionary Pen - beta

We Are All Keynesians Now

By Frank Schiavone

“Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief …“This modern risk-management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year. This crisis has turned out to be much broader than anything I could have imagined. It has morphed from one gripped by liquidity restraints to one in which fears of insolvency are now paramount… The evidence strongly suggests that without the excess demand from securitizers, subprime mortgage originations (undeniably the original source of the crisis) would have been far smaller and defaults accordingly far lower”.

The Maestro, Alan Greenspan in testimony before Congress

Our last really severe recession occurred in 81-82. Unemployment in the Inland Empire reached 14%. The economic contraction was caused by Paul Volker trying to ring inflation out of the economy. It ended when Volker thought we had “suffered” enough. Since that time, we’ve had two moderate recessions – in the early nineties and again in 2001 (severe if it was you who lost your job).

Our Nation’s political elite thought they had finally tamed the beast (the business cycle) once and for all. With monetary policy, they could steer the economy away from the shoals. They could throttle up money supply when the economy showed signs of decline and throttle it down when inflation reared its ugly head. The era of banking crises was over.

Since that bone crushing recession of the early eighties, the complexity and character of the nation’s economic engine has changed dramatically. As our industrial and manufacturing capacity declined, America turned to a new line of work. Over on Wall Street, America’s brain trust set out to expand wealth beyond all dreams. We became a nation of money changers.

Today, the financial sector represents 23% of the economy. Manufacturing is a mere 13%.

Our Nation’s financial wizards thought they could completely eliminate the risk inherent in all investments. With clever devices like the CDO, hedge funds, and other “financial innovations” there was now no end to wealth creation even if we didn’t actually produce much.

They were wrong. It’s totally befuddling how smart people like Alan Greenspan and Robert Rubin actually bought into theses fantasies.

Prior to the Great Depression, the economic history of the US was punctuated by several “panics” (e.g., the Panic of 1873 and 1907). The onset of each panic was wild speculation and bursting asset bubbles. The Great Depression, however, was like no the other economic downturn we as a nation had ever experienced. When FDR took office thirteen million Americans were unemployed (1 in 4 American workers). Starvation, deprivation, and despair pervaded our proud land.

New Deal programs did not end the Great Depression but they did go far to improve conditions and alleviate much of the suffering. In retrospect, many Keynesian economists believe that progressive policies did not completely work because the public sector didn’t go far enough. In the words of Paul Krugman, the Depression was ended by the largest public works project ever conceived – WWII.

We are now faced with another monumental economic downturn. Most economists do not believe it will rival the Great Depression but they are simply not sure. Many will be relieved if it’s only as bad as the 81-82 recession.

What happened? A financial crisis was triggered by a housing bust and its fallout. Our broken financial system turned a “run-of-the-mill recession” into something that will probably be far worse. That no one at the helm foresaw the housing collapse is simply amazing.

Okay, what caused the housing bubble to finally burst and the financial system to melt down? One mythology is that the Democrats (actually beginning with the Carter Administration) are to blame for pushing lending programs that gave loans to poor people. As this narrative goes, affirmative action lending programs aimed at poor and minority homeowners are the root of today’s crisis.

But herein lies the problem – the financial crisis was born in non-depository banks. The Community Reinvestment Act of 1977 only applies to depository banks. Most of the institutions that specialized in the subprime market were not regulated banks. Moreover, many of the biggest real estate flameouts had nothing to do with subprime lending.

Perhaps a little background is required. We have two banking systems, one that is regulated (albeit not very well) and one that is not. The one that’s not regulated is called the shadow (or parallel) banking system. Twenty-five years ago the money that passed in and out of “non-banks” was relatively inconsequential. Today, the shadow banking system rivals our traditional banking system which is dominated by the Federal Reserve. Assets in hedge funds, auction rate securities, commercial paper, structured investment vehicles, etc approached 7 trillion in 2007. In contrast, the top five banks had six trillion in assets and the total assets of the entire traditional banking system were ten trillion.

The collapse of the shadow banking system emanated from massive losses related to mortgage backed securities as the housing bubble began to deflate. The scale and scope of the losses caught the Nation’s financial sector completely flat-footed.

Securitization of mortgages is nothing new. What was new was the securitization of subprime loans made possible by a contraption called the CDO “invented’ in the mid 90”s and unleashed sometime around 2003. CDO’s were mathematically engineered to reign in risk. A Collateralized Debt Obligation is essentially a pool of mortgages sliced up into tranches (Thank You, Lafayette). The uppermost tranche was golden. The bottom slice held the dregs. Slices in between contained varying levels of risk. Each slice (or tranche) was designed (using mind boggling mathematical formulas) to negate the risk inherent in the slice directly beneath it. Shares in the CDO were sold based on the payments from the mortgage pool. But not all shares were equal. Some shares were “senior” meaning their claims on payments had priority. This is why the credit rating agencies gave these shares an AAA rating.

As long as houses kept appreciating, the Ponzi scheme worked even if some of the mortgages defaulted.

Obviously, the scheme failed as the system simply could not absorb the sheer losses it was experiencing. A bank run ensued causing the shadow banking to essentially dry up (very much like what happened to the Nation’s conventional banking system in the 30’s).

America now faces the perfect economic storm: a wave of bank runs: a liquidity trap very much like what the Japanese economy underwent in the 90’s and still hasn’t fully recovered from; a disruption of international capital flows; and numerous currency crises as the contagion has spread to other countries.

The baloney about how the collapse was caused by the CRA, Fannie Mae, Freddie Mac, and the Democrats is just that – BALONEY. The CRA was passed in 1977 for goodness sake and again only applied to depository banks which accounted for just a small fraction of bad loans. True, Fannie and Freddie did make some imprudent loans prior to 2004 but pretty much stayed away from them during the height of the bubble – 2004 to 2006. Remember that they were under some pretty intense scrutiny during this period. Besides, Fannie and Freddie were virtual late comers to the sub-prime mortgage market. And the pressure on them to accept risky loans didn’t just come from Congressional Democrats. It also came from Wall Street, loan originators like Countrywide, and investors looking for greater returns. Both agencies played only a minor role in the subprime fiasco.

To lay the blame of our current financial crisis solely at the doorsteps of Fannie Mae, Freddie Mac, and the Democrats is pure hackery (Republicans conveniently forget the Bush Administration’s “Ownership Society” initiative). Besides, the roots of this mess go far deeper than sub-prime mortgages. Massive deregulation, lax oversight, consumerism, overbuilding, market excess, incompetence, arrogance and corruption created the shaky foundation that our economy now rests on. Add to the list crushing debt, stagnant wages, and reliance on China for cheap imported goods and credit. (Private sector debt now dwarfs the public debt - 36 trillion vs. 11 trillion).

Simply put, our leaders have been asleep at the switch.

Perhaps the blame should also be pointed inward. We, as a people, have convinced ourselves that there are no limits or boundaries, that we are exceptional, that we are chosen, and that we are the center of the known universe. It’s time to stop acting like over-indulged children who expect everything and are denied nothing. We are but mere mortals after all. Milton Friedman was right about one thing, there is no such thing as a free lunch.

>Copyright © 2008 Frank Schiavone