There isn't a level playing field in the U.S. economy. The government gives major advantages to banks and other financial companies. Banks are subsidized by the Federal Reserve, which gives them very cheap credit compared to say, Boeing, Ford or Disney. It also buys funky assets (like mortgage-backed securities) from them and stabilizes their counterparties (like AIG) when the latter get into trouble. When the going gets rough in the financial markets, the banks don't have to get tough. The government brings in a stretch limo and drives them to Easy Street.
The government also tilts the playing field in favor of residential real estate. Government alter egos like Fannie Mae, Freddie Mac, Ginnie Mae and the FHA provide financing at interest rates lower than market forces would justify, and tax benefits like the mortgage interest deduction and now buyers' credits. When liquidity for mortgages dries up, the Fed buys a trillion dollars plus worth of mortgage-backed securities with printed money, holding down interest rates and propping up residential real estate while putting wage earners at risk of inflation.
Thus, capital flows into financial services and residential real estate, where the generosity of taxpayers reduces the chances of loss and increases the potential for profit. Other sectors of the economy can only imitate Oliver Twist holding an empty bowl. Since those other sectors, especially medium-sized and small businesses, might otherwise create jobs crucial to economic recovery, putting them on a starvation diet for capital steers the economy toward stagnation.
News media stories report that Wall Street is about to reveal record or near record earnings, and pay record or near record bonuses. Although no one in the government will admit it, this is a problem created by the government. By giving the banks such massive subsidies and benefits, humongous profits were predictable. Indeed, they're exactly what the Fed and Treasury intended, as buffers to stabilize the financial system. But putting huge profits on bank financial statements is like putting mountains of corn and rice in front of ravenous hogs. What do we think will happen? That bankers will retain profits in the banks' capital accounts for the good of the nation?
No doubt, senior officials at Treasury, the Fed and the White House, as well as almost all members of Congress, are preparing their statements of outrage over the soon-to-be announced bank mega-bonuses. They should save those statements and back them up--twice--because they'll be using those statements a lot. Given the way the government has tilted the playing field in the economy, banks will be making headline profits at taxpayer expense, and paying headline bonuses, as far into the future as one can see.
America is more like to prosper long term if there is a level playing field for capital. But undoing a federal subsidy is greater challenge than climbing Mt. Everest blindfolded. Practically no one in the government, in either party, wants to make major changes to these rules of the game. Meanwhile, back at the ranch, unemployed formerly middle-class Americans are hoping for one day a week when they can have franks and beans instead of rice and beans. Small businesses are looking for anyone who can lend them a dime.
Showing posts with label financial crisis: aid for real economy. Show all posts
Showing posts with label financial crisis: aid for real economy. Show all posts
Tuesday, January 12, 2010
Tuesday, September 1, 2009
The Economic Crisis: Is There a Policy Beyond Loss Transfer?
Today's 185 point drop in the Dow Jones Industrial Average is attributed by many in the financial press to the market being "overbought" or "ahead of itself." More specifically, price-earnings ratios for the S&P 500 are above 18, whereas the historical average is around 16. At the recent market low in March 2009, the p/e ratio was around 11. Maybe a sell-off makes sense. However, there is nothing inevitable about a drop from a p/e ratio of 18. In the late 1990s, the S&P 500 had a p/e ratio in the high 20s, yet the index proceeded to go higher. Why, then, would the market drop from a p/e ratio of 18? Because the future is uncertain. (Actually, it was uncertain in the 1990s but people deluded themselves into thinking it wasn't.)
The federal government has relied heavily on the financial equivalent of methadone to get the economy through the past year. The Fed printed money nonstop, while the Bush and Obama administrations greatly increased deficit spending. These measures treated the symptoms of the problems, and soothed some of the pain. But they didn't get at underlying causes. Doctors don't treat cancer by administering painkillers. They employ surgery, chemotherapy, radiation therapy and other measures aimed at removing or suppressing the disease. But federal policy has been ineffectual at dealing with underlying problems.
This recession began as a crisis of the financial system, not the real economy. The financial system made a vast quantity of really dumb mortgage loans, and extremely well compensated Wall Street executives managing the big banks somehow couldn't figure out that this gargantuan mass of future losses was looming. Perhaps they were too busy counting their enhanced compensation. We're now familiar with the mess that followed. Real estate, previously thought by Wall Street not to be subject to ordinary market forces such as downward price movements, fell in value. The vast ocean of bad mortgage loans then did what bad loans do--they defaulted and created losses. A lot of losses, since there were really a lot of bad loans. The flow of losses persists, since rising unemployment leads to more defaults and foreclosures. At this point, many of defaults are of seemingly good, prime mortgages owed by people who lost their jobs. With unemployment expected to rise, mortgage losses will be hitting the banking system for years.
There probably are trillions of dollars of unrecognized losses in the banking system, especially when one considers the foreclosures to come. Banks continue to cut back on lending in order to preserve their capital to cover more mortgage and other recession-related losses. There won't be a lively flow of bank credit to revive the economy any time soon.
The Federal Reserve printed trillions of dollars to keep the banking system propped up, and has managed to prevent Armageddon. But that approach does little to ameliorate the trillions of dollars of unrecognized losses that haunt the banks. The Fed's approach simply transferred most of the losses to the future. Federal bailout measures, like TARP, transferred a lot of losses to taxpayers. The largely ineffectual mortgage modification programs tend to transfer losses to taxpayers as well. (Banks and investors in mortgage-backed securities are taking some losses, but the total number of mortgage modifications is so low that the result is like a tiny drop in a 55-gallon barrel.)
It seems to be the federal government's strategy--a strategy that is little more than hope--to keep the financial system on life support long enough that the real estate market revives and rising real estate values erase the unbooked losses. But with mortgage credit scarce and consumers now embracing newly found prudence, real estate prices will probably not return to 2006 levels for a decade. Meanwhile, the banking system will remain crippled by its vast pool of unbooked losses. Credit will continue to be tight. Economic growth will be slow.
Hope won't win the day. The PPIF program, a public-private sector concept that would supposedly buy up toxic assets from banks, isn't very active, because banks are allowed by a recent politically coerced relaxation of accounting rules to sweep dodgy assets under the carpet instead of recognizing their losses. If they sell those assets to PPIF, they would have to book losses. That would detrimentally impact executive bonuses, something to be avoided at all costs.
The federal government's focus should shift from loss transference to spurring economic growth. Targeted stimulus spending, focused tax breaks, public works spending (especially for needed infrastructure repairs and improvements), and other growth-oriented measures are in order. Measures to maintain retiree buying power could enhance consumer confidence. Social Security retirees are not likely to get a cost of living increase this coming January because of the absence of inflation. But their medical insurance expenses will rise, so their real incomes will shrink. If you want to see people pull back on spending, reduce their incomes. A consumer-driven economy such as America's cannot recover in an environment where incomes are shrinking. When Wall Street bankers are collecting multi-million dollar bonuses because the federal government saved their employers, it's really weird to get wound up about "windfalls" like a 1% increase for Social Security recipients, whose average benefit is slightly over $11,000 a year.
A growing economy can more easily absorb the impact of the unbooked losses remaining in the financial system. A stagnant economy will only be made more stagnant when the losses have to be recognized. The government should concentrate on stimulating the real economy.
The future direction of the stock market is likely to depend on earnings growth--real earnings growth, not the contrived stuff that we've recently seen. With ultra-cheap federal credit and the politically coerced relaxation of accounting standards, the banking system has pushed a lot of losses into the future and returned to "profitability." But a strategy of loss transference has a limited half-life; the losses have to booked sooner or later and the impact on the economy is likely to be ugly. The stock market can't continue to thrive on "earnings" resulting from federal loss transference policies. The market--and the economy--need real earnings if the future is to be bright.
The federal government has relied heavily on the financial equivalent of methadone to get the economy through the past year. The Fed printed money nonstop, while the Bush and Obama administrations greatly increased deficit spending. These measures treated the symptoms of the problems, and soothed some of the pain. But they didn't get at underlying causes. Doctors don't treat cancer by administering painkillers. They employ surgery, chemotherapy, radiation therapy and other measures aimed at removing or suppressing the disease. But federal policy has been ineffectual at dealing with underlying problems.
This recession began as a crisis of the financial system, not the real economy. The financial system made a vast quantity of really dumb mortgage loans, and extremely well compensated Wall Street executives managing the big banks somehow couldn't figure out that this gargantuan mass of future losses was looming. Perhaps they were too busy counting their enhanced compensation. We're now familiar with the mess that followed. Real estate, previously thought by Wall Street not to be subject to ordinary market forces such as downward price movements, fell in value. The vast ocean of bad mortgage loans then did what bad loans do--they defaulted and created losses. A lot of losses, since there were really a lot of bad loans. The flow of losses persists, since rising unemployment leads to more defaults and foreclosures. At this point, many of defaults are of seemingly good, prime mortgages owed by people who lost their jobs. With unemployment expected to rise, mortgage losses will be hitting the banking system for years.
There probably are trillions of dollars of unrecognized losses in the banking system, especially when one considers the foreclosures to come. Banks continue to cut back on lending in order to preserve their capital to cover more mortgage and other recession-related losses. There won't be a lively flow of bank credit to revive the economy any time soon.
The Federal Reserve printed trillions of dollars to keep the banking system propped up, and has managed to prevent Armageddon. But that approach does little to ameliorate the trillions of dollars of unrecognized losses that haunt the banks. The Fed's approach simply transferred most of the losses to the future. Federal bailout measures, like TARP, transferred a lot of losses to taxpayers. The largely ineffectual mortgage modification programs tend to transfer losses to taxpayers as well. (Banks and investors in mortgage-backed securities are taking some losses, but the total number of mortgage modifications is so low that the result is like a tiny drop in a 55-gallon barrel.)
It seems to be the federal government's strategy--a strategy that is little more than hope--to keep the financial system on life support long enough that the real estate market revives and rising real estate values erase the unbooked losses. But with mortgage credit scarce and consumers now embracing newly found prudence, real estate prices will probably not return to 2006 levels for a decade. Meanwhile, the banking system will remain crippled by its vast pool of unbooked losses. Credit will continue to be tight. Economic growth will be slow.
Hope won't win the day. The PPIF program, a public-private sector concept that would supposedly buy up toxic assets from banks, isn't very active, because banks are allowed by a recent politically coerced relaxation of accounting rules to sweep dodgy assets under the carpet instead of recognizing their losses. If they sell those assets to PPIF, they would have to book losses. That would detrimentally impact executive bonuses, something to be avoided at all costs.
The federal government's focus should shift from loss transference to spurring economic growth. Targeted stimulus spending, focused tax breaks, public works spending (especially for needed infrastructure repairs and improvements), and other growth-oriented measures are in order. Measures to maintain retiree buying power could enhance consumer confidence. Social Security retirees are not likely to get a cost of living increase this coming January because of the absence of inflation. But their medical insurance expenses will rise, so their real incomes will shrink. If you want to see people pull back on spending, reduce their incomes. A consumer-driven economy such as America's cannot recover in an environment where incomes are shrinking. When Wall Street bankers are collecting multi-million dollar bonuses because the federal government saved their employers, it's really weird to get wound up about "windfalls" like a 1% increase for Social Security recipients, whose average benefit is slightly over $11,000 a year.
A growing economy can more easily absorb the impact of the unbooked losses remaining in the financial system. A stagnant economy will only be made more stagnant when the losses have to be recognized. The government should concentrate on stimulating the real economy.
The future direction of the stock market is likely to depend on earnings growth--real earnings growth, not the contrived stuff that we've recently seen. With ultra-cheap federal credit and the politically coerced relaxation of accounting standards, the banking system has pushed a lot of losses into the future and returned to "profitability." But a strategy of loss transference has a limited half-life; the losses have to booked sooner or later and the impact on the economy is likely to be ugly. The stock market can't continue to thrive on "earnings" resulting from federal loss transference policies. The market--and the economy--need real earnings if the future is to be bright.
Wednesday, October 15, 2008
Enough for the Financial Crisis. Now Let's Focus on the Economic Crisis.
Easy come, easy go. The stock market dropped about 8% today, two days after leaders of all the major nations of the world pledged coordinated action to deal with financial crisis. The Dow Jones Industrial Average today finished just about 1% above where it closed last Friday, before the announcement of coordinated international action. The S&P 500 and the Nasdaq indexes are lower than where they closed last Friday. So much for the effectiveness of government action in stopping the stock market slide. As has happened so many times before, each announcement of a new government initiative produces a temporary sugar high, to be followed by a sickening drop.
The truth is that no government action will stabilize the stock markets now. The reasons for the credit crunch are too large and complex for a quick solution. The root cause--the largest morass ever in the mortgage markets--will require years for recovery. The derivatives market added layers of complexity to the mortgage problems, and the convoluted liabilities it created will take years to sort out. The Federal Reserve's and U.S. Treasury's tools for addressing the credit crunch don't, for the most part, fix the underlying problems. They are life support measures, meant to maintain some sort of pulse at the heart of the financial system until the underlying problems work themselves out. Fed Chairman Bernanke said today that the government has the tools it needs to address the credit crunch, and that now he needs time.
Time is what stock market investors don't want to risk. With the way things are going, stocks could drop how much more tomorrow? If it was 8% today, is there any limit for tomorrow? (Okay, the New York Stock Exchange closes if the market drops 3350 points, or 2200 points after 2:00 p.m., and you get a trading halt for an hour or maybe just a half hour if the market drops 1100 points before 2:30 p.m.; but how much comfort is all that?) Much of the selling today is driven by fear, and there is no way to know when that fear will subside. This is the fear of the unknown. The financial markets have become so complex that Wall Street executives and government regulators don't understand them. The average investor, who probably has trouble figuring out how to manage a 401(k), can be forgiven for viewing all this as little more than witchcraft. It's no wonder that so many of them prefer to sell stocks and hold cash than continue to dabble in witchcraft.
Even the smart money is taking a breather. Prominent hedge fund managers are reportedly selling their stockholdings and sitting on their cash. They can't understand what's going on, and choose not to invest when they can't invest intelligently. That point explains, among other things, why Secretary Paulson's decision to let Lehman Brothers go under created so much havoc. Paulson reportedly decided to not to save Lehman because its exposures to the rest of the financial markets were relatively limited, and he wanted to make a point about people--even senior executives on Wall Street--being held responsible for the risks they took. Abstractly speaking, that's a good reason for not bailing out Lehman. But the problem was that no one else in the world has the level of information that Secretary Paulson has. He knows enough about each major bank that he can decide which needs to be saved and which can be allowed to fail. No one else, though, knows what Paulson knows and is thinking. Therefore, it is logical that no one would want to lend to the large banks. Interbank lending today is sensible only if you can get inside Hank Paulson's head and see who will get a thumbs up and who will get a thumbs down. Otherwise, better to sit on your cash. The credit freeze is not based on fear or panic; it's actually quite understandable.
To get around this problem, the Treasury Department revived the Selective Service System and drafted a number of large banks for national service. They were told they would be receiving federal infusions of capital and would give the federal government preferred stock. They were told they would lend out the money they received and couldn't hoard it. They were informed that limitations on executive compensation would be imposed on them. They were told they all would participate; any resistance to induction was swiftly quashed (maybe after one or two were ordered to do some push-ups).
Oddly, perhaps, in this hour of financial socialism, we can see a way to softening the impact of the recession (the one we all know is coming but which the Federal Reserve resolutely avoids acknowledging). Federal capital infusions should be made in regional and local banks, the ones that finance small businesses, farmers and other independently employed persons. The small business sector is a vital part of the economy, employing about a third of all employees and typically creating more jobs than big business. Small businesses are vulnerable to credit crunches, often having fewer resources than large companies. Money pumped into the big, money center banks may not wend its way to Elm Drive in Middletown, U.S.A. Much has been done to protect Wall Street, and the Federal Reserve has all the tools it needs. More must be done now to protect the real economy. Regional and local banks are a good pipeline of funding for small business. They also make a fair number of mortgage loans (with real credit standards, so there's a chance the loans will be repaid). It would be prudent to diversify the bailouts and send some money to Main Street. Who knows: a recovery in the real economy could help revive the real estate market and lift some of the storm clouds over Wall Street.
The truth is that no government action will stabilize the stock markets now. The reasons for the credit crunch are too large and complex for a quick solution. The root cause--the largest morass ever in the mortgage markets--will require years for recovery. The derivatives market added layers of complexity to the mortgage problems, and the convoluted liabilities it created will take years to sort out. The Federal Reserve's and U.S. Treasury's tools for addressing the credit crunch don't, for the most part, fix the underlying problems. They are life support measures, meant to maintain some sort of pulse at the heart of the financial system until the underlying problems work themselves out. Fed Chairman Bernanke said today that the government has the tools it needs to address the credit crunch, and that now he needs time.
Time is what stock market investors don't want to risk. With the way things are going, stocks could drop how much more tomorrow? If it was 8% today, is there any limit for tomorrow? (Okay, the New York Stock Exchange closes if the market drops 3350 points, or 2200 points after 2:00 p.m., and you get a trading halt for an hour or maybe just a half hour if the market drops 1100 points before 2:30 p.m.; but how much comfort is all that?) Much of the selling today is driven by fear, and there is no way to know when that fear will subside. This is the fear of the unknown. The financial markets have become so complex that Wall Street executives and government regulators don't understand them. The average investor, who probably has trouble figuring out how to manage a 401(k), can be forgiven for viewing all this as little more than witchcraft. It's no wonder that so many of them prefer to sell stocks and hold cash than continue to dabble in witchcraft.
Even the smart money is taking a breather. Prominent hedge fund managers are reportedly selling their stockholdings and sitting on their cash. They can't understand what's going on, and choose not to invest when they can't invest intelligently. That point explains, among other things, why Secretary Paulson's decision to let Lehman Brothers go under created so much havoc. Paulson reportedly decided to not to save Lehman because its exposures to the rest of the financial markets were relatively limited, and he wanted to make a point about people--even senior executives on Wall Street--being held responsible for the risks they took. Abstractly speaking, that's a good reason for not bailing out Lehman. But the problem was that no one else in the world has the level of information that Secretary Paulson has. He knows enough about each major bank that he can decide which needs to be saved and which can be allowed to fail. No one else, though, knows what Paulson knows and is thinking. Therefore, it is logical that no one would want to lend to the large banks. Interbank lending today is sensible only if you can get inside Hank Paulson's head and see who will get a thumbs up and who will get a thumbs down. Otherwise, better to sit on your cash. The credit freeze is not based on fear or panic; it's actually quite understandable.
To get around this problem, the Treasury Department revived the Selective Service System and drafted a number of large banks for national service. They were told they would be receiving federal infusions of capital and would give the federal government preferred stock. They were told they would lend out the money they received and couldn't hoard it. They were informed that limitations on executive compensation would be imposed on them. They were told they all would participate; any resistance to induction was swiftly quashed (maybe after one or two were ordered to do some push-ups).
Oddly, perhaps, in this hour of financial socialism, we can see a way to softening the impact of the recession (the one we all know is coming but which the Federal Reserve resolutely avoids acknowledging). Federal capital infusions should be made in regional and local banks, the ones that finance small businesses, farmers and other independently employed persons. The small business sector is a vital part of the economy, employing about a third of all employees and typically creating more jobs than big business. Small businesses are vulnerable to credit crunches, often having fewer resources than large companies. Money pumped into the big, money center banks may not wend its way to Elm Drive in Middletown, U.S.A. Much has been done to protect Wall Street, and the Federal Reserve has all the tools it needs. More must be done now to protect the real economy. Regional and local banks are a good pipeline of funding for small business. They also make a fair number of mortgage loans (with real credit standards, so there's a chance the loans will be repaid). It would be prudent to diversify the bailouts and send some money to Main Street. Who knows: a recovery in the real economy could help revive the real estate market and lift some of the storm clouds over Wall Street.
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