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The Financial Crisis of 2007 -  ??

by Bill Barclay

On October 9th, 2007, the Dow Jones Industrial Average and the S&P 500 both closed at new all time highs.  During the week of September 15 – 19, 2008, both indices dropped 10% (they were already down almost 20% from their October records) - and then recovered as the Treasury and the Fed decided that markets can’t always be trusted to do the right thing, at least not without a little help.  In the interim, home foreclosure rates reached their highest level since the 1930s, two major investment banks were wiped out and a recession has probably already begun. 

What happened - and why?  And what should progressives be saying and proposing in response?  This article argues (i) that the economic problems the U.S. now faces are long term and not readily amenable to the usual policy fixes; (ii) that the crisis is rooted in a convergence of three trends, two long-term and one more immediate; and (iii) that there are important policy ideas that progressives should be proposing, although their adoption will occur only as the result of political struggle and pressure. 

I.        The Crisis: How Serious is It?

So, how serious is it?  First, it is important to recognize that when people talk about a financial crisis in contrast to a crisis in the “real economy,” they are referencing the economy we used to have, not the economy we have now.  As late as the 1970s, manufacturing accounted for a larger portion of the GDP than did services – but that is no longer true.  By 2005, finance in all its forms – banking, insurance, mortgage brokers, etc. – represented nearly 25% of total economic production in the U.S.  A crisis in an industry that accounts for almost one quarter of GDP is a crisis in the “real economy.” 

Second, finance is linked to and facilitates the functioning of the rest of the economy in myriad ways.  The housing sector - consisting of mortgage lenders, construction, furnishings and related industries, accounted for a similar quarter of US output – that represents about 25% of the economy is the most important. 

Second, it is clear that the crisis is not and will not be restricted to the financial sector.  One in ten homeowners is or will be facing the threat of foreclosure over the next two years – a level not seen since 1933.  Defaults on corporate debt are rising with the second quarter of 2008 being the tenth consecutive quarter of increasing business bankruptcies. U.S. auto makers are on the ropes as demand drops for their large, energy intensive vehicles.  The companies – they used to be called the Big Three – are asking for a federal bailout of $25 billion.  Retail stores are already cutting back on sales staff and nationwide the unemployment rate rose to 6.1% in August, the eighth consecutive month with a decline in jobs. 

Third, today’s economic problems come at the end of a long period of global credit expansion and deregulation, placing constraints on the available policy alternatives.   While we can learn from the New Deal, the national and global economic environment and the U.S. relationship and role in the today’s global economic system is quite different.  We will not be able simply to copy New Deal programs.

II.      The Causes

There are, I think, three primary causes.  These causes intermesh in a variety of ways but each presents distinct problems and each needs specific policy responses.  These causes are (i) the long term trend towards economic inequality in the U.S.; (ii) the credit expansion/contraction and debt cycle, primarily driven by housing; and (iii) the role and value of the dollar in the international economy, with particular emphasis on the trade in oil. 

A.      Growth in Economic Inequality

The long term trend towards increasing economic inequality in the U.S. has been documented so many times that even conservatives have acknowledged its reality.  One simple measure: If workers’ salaries had increased as rapidly from the mid 1980s as those of the CEOs of the largest corporations, the average workers’ salary would now be over $200,000/year. 

What has been less commented upon is the significance of this growing inequality for the political economy.  First, the growing concentration of income and wealth constrains the consumption (purchasing power) of the population as a whole.  Savings rates dropped consistently over the past quarter century, actually turning negative in some recent years, as families tried to keep up with the American standard of consumption.  But consumption was not, of course, simply financed by drawing down or foregoing savings.  Don’t have the cash?  Put it on plastic.  As far back as 1977, Time Magazine had observed that  “insistence on buying only what can be paid for in cash seems as outmoded as a crew cut.” 

Second, the increased concentration of income and wealth reshapes the political terrain.  The cost of political campaigns has increased sharply in part because of the possibility of raising more money from people who literally have more than they know what to do with.  The importance of large donors has in turn increased because there is an increased need for money.  Thus the impact and influence of larger donors eclipsed that of competing institutions such as labor, civic and community groups.

But the political use of concentrated income and wealth has not been restricted to the financing of campaigns.  In fact its more significant impact has probably been in the reshaping of the universe of political discourse.  Wealthy individuals and families have turned to founding and funding “research” institutes and think tanks.  And the bias of these institutions is towards a system that has made their benefactors well off on a scale never seen before

B.      Debt – Financial Deregulation and Credit Expansion

What is the debt problem facing the U.S? First, it is not the debt of governments, whether federal, state or local that threatens the U.S. economy.  Rather, it is private and corporate debt that poses the greatest risks and that has brought us to the current crisis.  Credit card debt is far from the only source of debt financing of consumption and in fact has largely been replaced by mortgage debt.  It is the housing sector that defines the specific nature of this economic downturn and is the major reason why the outcome is likely to be so difficult to control.  From the early 1980s to the mid 1990s housing prices rose more or less in line with general inflation level; however, from that point to 2005, housing prices increased by 30% above inflation.  Homes, our primary residence, also became our savings vehicle – and our bank accounts.    

How did access to home ownership – the ownership society so beloved by Bush and other neocons - and rising house prices get us into so much trouble?  There are at least three reasons for the mortgage and foreclosure crisis we face today.  First, the banking model changed from a traditional, relatively conservative set of practices to an originate and distribute model.  Second, as the housing boom continued while incomes lagged for the majority of the population, the standards on which mortgages were based deteriorated.  Third, and perhaps most important for the individual home buyer, rising prices allowed the buyer to borrow against the appreciating value of the home.

The 1999 repeal of Glass-Steagel allowed financial institutions such as CitiGroup or J.P. Morgan/Chase to combine banking, insurance and real estate for the first time since the 1930s removing the walls that the Act created.  Prior to repeal, mortgage banking was largely a business of making loans and managing the resulting portfolio of loans.  Mortgage lenders bore the financial risk and had an incentive to inquire into the long term probable financial resources of the borrower.  However, the repeal of Glass-Steagel offered another method of participating in the mortgage business: banks (and others who entered the business of offering mortgages) could make the initial loan (“initiate” in the language of the industry), then “package” the loan into a mortgage backed security, MBS (securitization), and sell the new security to investors (“distribute” the security), take the money from this sale and make another mortgage loan.  This model of banking turned out to very profitable – more so than the traditional approach.  In 2006 mortgage lenders originated $2.5 trillion in loans (3 times the 1997 amount) and 75% was securitized.

The “originate and distribute” model of banking (securitizing and selling off mortgages and other loans such as auto loans) provided little incentive for banks and other mortgage lenders to assess the long term financial viability of their borrowers.  Put most bluntly, the mortgage lender only faced “pipeline” risk, i.e., the risk that the borrower could not make the payments required before the loan was securitized and sold off.  The result was a lowering of standards for making mortgage loans.  Since housing prices were rising even borrowers who might have been rejected as near term risks could be offered “creative” loan packages, perhaps requiring interest only payments during the initial period of the loan.  Alt-A and NINJA (no income, no job, no asset) loans became increasingly popular.   

This scope of this accident waiting to happen was enhanced by the increasing draws that borrowers made on the equity in their homes in order to finance other consumption, whether that is a car, vacation, college, etc.  In 2005 net mortgage borrowing for purchases other than houses totaled $600 billion, about 7% of total family disposable income.  Refinancing commonly included taking out cash in return for taking on a bigger loan amount – after all, houses were worth more so they could securitize more debt.  These home equity loans (HELs) were securitized and sold to investors seeking high yield, high rated investments.

The only problem with this is the old problem of leverage.  Housing prices can not rise faster than income indefinitely.  When the music stopped, there would be some, actually many, people who were too highly leveraged to continue making payments on their mortgages.  With median down payments averaging 2% in 2005 – 06, housing prices did not have to fall very far before leverage destroyed the buyer’s original investment.  The result, beginning in earnest in 2007, has been a rapid increase in foreclosures with more to come as the number of borrowers behind on their payments, either original mortgage or home equity, also spiraling.  Estimates of the eventual default rate on the almost $1 trillion mortgages securitized are in the 20 – 25% range but no one really knows.  Leverage works just as efficiently on the downside as it does on the upside – it’s just scarier.

Who will pay the largest price for the collapse of the subprime mortgage market.?  Subprime mortgages coincided nicely with the politics of the ownership society, the idea that minorities and lower income people could have an economic stake in political stability and that they would thus be more benefit the Republican Party.  Almost all of the net increase in family wealth reported for the bottom 80% of wealth holders during 2001- 05 came from increased prices for housing.  A large portion of subprime mortgages were made to African-Americans, Hispanics, and single (usually female-headed) parent families.  Thus the foreclosure boom is draining wealth away from a large number of families who had only just begun to acquire it. Estimates of wealth loss from these foreclosures are in the $170 – 190 billion range for African-Americans and $75 – 100 billion for Hispanics.  These groups were three times as likely to have subprime mortgages as whites even though the evidence strongly suggests that half or more of those granted subprime mortgages actually qualified for prime mortgages.   

C.      The Value and Role of the U.S. Dollar

One of the reasons for believing that this economic downturn will be more severe and longer lasting than those of the past three decades is the convergence of a domestic credit and housing crisis with some negative (for the U.S.) international trends.  Unlike our international creditor status in the 1930s, the U.S. is now the largest international debtor. 

In the early years of the shift to debtor status the primary concern as what an ally, Japan, might someday do with all that debt.  Nothing, as it turned out.  However, the debt is larger now and the primary holders include nations such as China whose relationship with the U.S. is quite different, today and over the strategic long term, than the Japanese.  Further, a major reason for the growing debtor status of the U.S is increased, and increasingly costly, imports of the largest single commodity in world trade: petroleum.  During the Bush administration the cost of oil imports more than doubled, rising from $130 billion in 2003 to over $300 billion in 2006.    

And what do we have to offer in return – after all, trade is trade.  During the period that the U.S. shifted from being a creditor to a debtor nation, we also shifted from making and exporting “things” to the buying and selling the representation of things, e.g. claims to income streams from assets.  Financialization remade the structure of the U.S. political economy as policy makers made a long term bet – an implicit industrial policy – on the finance sector. As the growing U.S. trade deficit increased the dollar holdings of foreigners, these investors looked for ways to put this money to work. In response we exported securitized debt, primarily asset backed securities (ABS) including their mortgage back security (MBS) and collateralized debt obligation (CDO) components (of course, government debt was also marketed abroad).   As early as mid-2007, the Deutsche Bank estimated that non-US investors held 40% of all MBS, the instrument largely responsible for initiating the crisis.  These exports helped spread the negative economic consequences of the current crisis even to small towns in Norway and beyond, as portfolio managers relied on the AAA and AA ratings given tranches of ABS by S&P, Fitch and Moody’s.   

So now we face a challenge to the dollar as the ultimate reserve currency, this time eon two fronts.  First, as the value of the dollar has declined, central banks have diversified their reserves, adding Euros and other currencies to their holdings.  This gradual shift will probably continue.  What would more directly impact the average U.S. citizen’s standard of living is the possibility that petroleum producing nations will shift pricing out of dollars and into either a basket of currencies or a specific currency (Venezuela and Iran have already done so for some of their exports).

All of this is overlaid with the very real possibility that the age of petroleum is much nearer its end than its beginning.  If the peak oil argument is valid, our trade deficit will continue to grow and the costs of transporting people and things in a domestic built environment that is based on the gasoline powered car will become prohibitive.  The beginnings of doubts about the long term economic viability of suburban sprawl are another restraint on the possibility of any rapid recovery of housing and the U.S. economy as a whole.

D.      What can Be Done – Thoughts on Long Term Policy

I have argued that the 2007 – 200? domestic economic crisis is not restricted to the financial sector, that it is likely to be more severe than anything we have experienced since WWII and that it coincides with unfavorable international economic trends.  But of course, challenges are also opportunities and I think there are real opportunities, as well as risks, for the Left.  In these concluding sections, I will suggest some ideas for policies to address our current economic situation. First, however, two points: we need to emphasize, insist, that the current crisis is systemic, and that piecemeal responses will be inadequate to remedy the situation and that market fundamentalist approaches of the current administration as well as the Republican presidential candidate fall woefully short of what is needed.  This is the task of removing the underbrush before building the new structure.

Empowering the working population: The Employee Free Choice Act (EFCA).  We will only reverse the long-term inegalitarian trend in the U.S. if we make it possible for working people to build institutions that are powerful enough to push a political agenda that can effectively mobilize against policies that will increase inequality, e.g. the privatization of social security and for egalitarian policies, e. g., removing the income cap on FICA (the social security tax).  The EFCA is already endorsed by a majority of congressional Democrats – but we need a president that will sign it or a 2/3 majority to pass it over a McCain veto.

Increase and Index the Minimum Wage.  I will not repeat the economic facts about the lag of the minimum wage behind inflation here but I do want to note something that is not usually acknowledged.  Opponents of minimum wage increases often claim that the primary beneficiaries would be teenage workers earning extra spending money.  Besides the reality that most minimum wage workers are not teenagers, the earnings of teenagers are not simply spending money. For example, when I attended college in the 1960s (at a state university) I was able to pay my own way by working, full time during the summer and part time during the school year, at jobs that paid the minimum or just above the minimum wage.  That would not be possible today because of the gap between the growth in college costs and the lag of the minimum wages behind inflation. 

Reinstate, Index and make Progressive the Estate Tax.   The Estate Tax, which the Left should insist on labeling then Paris Hilton Tax, will revert back to pre-Bush levels in 2010 if no action is taken by Congress.  The complaints against the tax, driven by the financing of a few very wealthy families who seek to found their own dynasties, have made this a tougher issue than it should be.  We should tie the proceeds of the tax to the funding of specific programs so that the who pays/who benefits equation is clear.  For example, we could allocate proceeds from the Paris Hilton tax to fund universal health care or a subsidy to help with college costs.  The most important aspect of the tax is, however, that is a tax on wealth, a taxation concept that is worth fighting for.

Tax Surcharge on Incomes Above $250,000  John McCain may think that middle income is anyone with incomes below $5 million but the reality is that an income of $250,000 or more puts a family in the top 2% of all families.  Rather than spend political capital arguing about how to make the existing tax code more progressive, let’s just do it the simple way: impose a surcharge on high income recipients.  As in the case of the Paris Hilton tax, the revenue generated should be targeted for specific social investments, perhaps in this case in alternative energy technology.

Implement a Wealth Tax.  Almost all of us pay a wealth tax already – it is the property tax, paid directly by homeowners and indirectly by renters.  The tax targets the asset that constitutes the bulk of total wealth for most Americans.  Primary residence is half or more of total net worth for almost all US households – up to about the 95th percentile of net worth. Above that level, however, the story changes dramatically; primary residence becomes less and less important in total net worth while financial assets – stocks and bonds – become increasingly important. Among the top 2% of households by net worth, primary residence drops to 5% or less of total wealth.  If we added a broad wealth tax, say a 0.5% levy on only the top 1% of wealth households, we would generate $50 – 75 billion annually.  Again the revenues should be targeted so that the who pays/who benefits equation if clear. 

Develop a Jobs Program.  Unemployment is certainly not at 1930s levels; it is, however, a serious and growing problem, particularly when the uncounted unemployed are included.  A jobs program should have three foci.  First, it should focus on social investment such as schools, roads, bridges, light rail, etc.  Second, we should seek to reaffirm the importance of public employment, training and employing people in the health care sector, education, and the recreational environment – we have lived off the wonderful work the CCC did in our parks and trials for a long time.  Finally, it should be forward looking in terms of social investment, with a particular orientation towards green technologies. 

E.       We Believe in the Market – Except when we Don’t  (written after the Treasury/Fed actions of Sept 18/19)

The events of Sept 15 – 19 offer almost too much in irony, humor and idiocy for an author to appreciate.  The conservative regime most ideologically committed to market outcomes finds itself second and even third guessing the market, undertaking the greatest ever government intervention in US markets.  The decisions reached were probably the result of several factors.  First, the Republicans desperately want to get the economic crisis off the political agenda before the November election.  Second, and connected, institutional memories of the 1930s remind the GOP that, if you let the economy go to hell in a hand basket by waiting for the market to find equilibrium, i.e. doing nothing, voters remember for very, very, very long time.  Third, it appears that Paulson and probably also Bernanke are pragmatists.  They certainly think that markets are wonderful things.  However, they also recognize that markets may suffer from contagions, when I sell because you are selling and you are selling because she is selling, etc.  Thus they came up with a solution that simultaneously solved the liquidity and solvency problems.  Current estimates are $700 billion cost but that is undoubtedly low.  For perspective, the US S&L debacle cost about $275 billion, the Japanese banking collapse almost $800 billion and the Asia banking crisis about $400 billion.

So where do we stand?  The most significant aspect of politics in the 1930s was the delegitimation of the business elite as the font of economic wisdom.  It opened the possibility for significant economic reforms that, while they certainly did not produce an American socialism, did alter the political-economic dynamics for two generations.  There is a chance – a small one but a real chance – that this could happen again.  There are extremely important battles that have to be fought immediately and may even be decided before you read this. 

(1)    The federal government should acquire the securitized, risky assets held by investment banks and others at a significant discount to par.  Something like eighty cents on the dollar is probably reasonable.  This is the equivalent to saying your $400,000 house is now worth only $320,000, about where we are.  Note that this does not insure that the issuers of questionable mortgages will eat the losses, only that holders of the same will. 

(2)    These mortgages should then be renegotiated with home owners facing foreclosure and/or significant economic stress at prices that reflect (a) the reduced face value of the mortgage and (b) the new, lower interest rate environment created by the Fed’s flooding the markets with liquidity.  Under the Paulson/Bernanke plan we have the basis fore a new Home Owners Loan Corporation – let’s use it to the advantage of home owners.

(3)    Extend regulatory authority over the financial markets on the clearly fair and just principle that if we, the people, are ultimately responsible for financing your deleveraging, then we are also responsible for preventing you from getting into this mess to begin with.  This implies (a) limits on leverage for all financial institutions to the 10 – 15:1 range.  A very large amount of what goes on under the rubric “financial engineering” is simply complex ways to increase leverage to levels in the 10 – 15 range and (b) outlawing off balance sheet entities immediately – they’re only off balance sheet when things are going well. 

Who should exercise this regulatory authority?  I want to make two points here.  First, we need to scrap many of our overlapping but incomplete agencies that currently try to oversee parts of the financial industry.  The problems here are structural since many were designed for a different era.  Second, the new regulatory authority should not reside in the Fed.  Too much deference is paid to Fed officials in both their appearances before Congress and in the press.  We need regulatory agencies and personnel who can be questioned and whose decisions can be probed.  We need a new agency with the same reforming spirit that drove the early New Deal.

Conclusion

The reference to the New Deal was deliberate.  During most of the year, the presidential campaigns were short on discussions of our economic crisis.  At the Republican Convention neither Joe Lieberman nor Sarah Palin mentioned the economy in their speeches and McCain barely touched on it.  That has changed - whether it will change enough to insure John McCain’s defeat I am not sure.  But, with respect to Obama, it is useful to remember that FDR did not walk into the White Hose in 1933 with a program that resembled what we came to know as the New Deal but only with a commitment to help his fellow citizens.  In fact, had he spelled out something that looked like the New Deal during the campaign, he might well not have been elected – and that was when the GDP had dropped by more than 10% and the unemployment rate was over 20%.   It was the commitment to bettering the lives of others that drove what came next and, in this campaign that is probably the best we can expect. 

 

Bill Barclay is an economist with expertise in financial product creation and business strategic planning. He is a member of the Chicago Political Economy Group (CPEG), Oak Park Coalition for Truth and Justice, Oak Park Chapter of Democratic Socialists of America, and the Illinois Chapter of Progressive Democrats of America.