My last post, “What Ails America? I. Complacency,” lays out the thesis of the economist Tyler Cowen that American society has become much too complacent, i.e. self-satisfied, in recent years. In particular:
Fewer Americans are moving.
Segregation (by income, education, social class and race) is increasing.
Americans have stopped creating. New business creation is down and monopolies are getting stronger.
Matching (i.e. assortative mating) is on the upswing.
Calm and safety above all is the predominant attitude.
These societal trends are normal and even desirable in many respects. But they can lead to stagnation. Eventually needed social change will boil over in uncontrollable ways and America will undergo a “Great Reset.”
This will likely involve major events such as:
A major fiscal and budgetary crisis. Currently our public debt (on which we pay interest) is 77% of GDP, the highest since just after WWII. It will keep rising steadily without a major change in public policy. When interest rates return to more normal higher levels, interest payments on our debt will be a huge drain, without letup, on our tax revenue.
The inability of government to adjust to the next global emergency which comes along. When the financial crisis came along in 2008, debt was at the much smaller level of 38% of GDP. This allowed for temporary fiscal stimulus and larger deficits to ride out the resulting recession. With our currently high debt level, we’ll have far less flexibility when the next recession comes along.
A rebellion of many less-skilled men. The median male wage (adjusted for inflation) was higher in 1969 than it is today. In fact, the take-home pay for typical American workers has been falling since the end of the Great Recession in June 2009. To a large extent this explains the rise of Donald Trump.
A resurgence of crime. A new crime wave will probably be internet related. There are now tens of millions of identity thefts, phishing attacks and successful but fraudulent pleas for cash every year. Internet crime is calmer than traditional crime and less visible. But the next crime wave could badly damage internet commerce.
Conclusion. Mr. Cowen paints a depressing picture for the future of American society. Of course, it is possible to turn some or all of these negative developments around. But will a complacent American populace have the political will to do it?
As we are just getting started on what so far is a confusing presidential election campaign, it would be easy to forget how incredibly lucky we are in America. Our country is very strong and we are isolated from many of the world’s problems. The terrorist attacks in Paris over the weekend are a grim reminder of this fact. But we still have responsibility for much of what is happening around the world.
George W. Bush’s biggest failing is not the Iraq War, draining Medicare funds with a new drug benefit or ramping up deficits with tax cuts that lose revenue. His biggest failing is not foreseeing the financial crisis and at least mitigating it if not heading it off entirely. His financial advisors (Greenspan, Bernanke, Geithner, Paulson) were asleep at the switch. As the Economist makes clear in its latest issue, “First America, then Europe. Now the debt crisis has reached the emerging markets.”
Barack Obama’s biggest failing is not the stagnant economy or massive debt buildup which occurred on his watch, although he could have eased their burden with smarter policies. His biggest failing is his unwillingness to assert sufficient power in the Middle East to head off the chaos we observe today. The enormous European refugee crisis with all of its attendant horrors is largely the result of his inadequate intervention in Iraq, Libya and Syria.
The main concerns of this website are the internal fiscal and economic problems faced by the U.S. We have to figure out amongst ourselves how to address these very serious issues. But, like it or not, what we do affects the whole world. If we fail to meet our responsibilities, the whole world, including us, will suffer with the consequences.
The U.S. economy has grown at the rate of only 2.2% since the end of the Great Recession in June 2009. This is much slower than the average rate of growth of 3% for the past fifty years. The economists Glenn Hubbard and Kevin Warsh, writing in the Wall Street Journal, “How the U.S. Can Return to 4% Growth,” point out that:
After the severe recession of 1973-1975, the economy grew at a 3.6% annual real rate during the 23 quarters that followed.
After the deep recession of 1981-1982, real GDP growth averaged 4.8% in the next 23 quarters.
Recent research has shown that steep recoveries typically follow financial crises.
The economist John Taylor, also writing in the WSJ, “A Recovery Waiting to Be Liberated,” explains that the growth of the economy, i.e. growth of GDP, equals employment growth plus productivity growth. He then points out that:
Population is growing about 1% per year. However the labor-force participation rate has fallen every year of the recovery, from 66% in 2008 to 62.9% in 2014. Even turning this around slightly would increase employment growth above the 1% figure coming from population growth alone.
Although productivity growth has hovered around 1% for the past five years, this is less than half of the 2.5% average over the past 20 years.
Given the strong headwinds of globalization and ever new technology affecting the U.S. economy, we especially need new policies such as:
Fundamental tax reform directed at increasing the incentives for work and driving investment in productive assets.
Regulatory reform that balances economic benefits and costs (e.g. lightening the burdens of Obamacare and Dodd-Frank).
Trade agreements to break down barriers to open global markets.
Education policies to prepare all young people for productive careers.
In other words, rather than accepting our current situation as “the new normal” or as unalterable “secular stagnation,” we need to “give growth a chance”!
My last post, ”Fixing the Debt: Creating a Greater Sense of Urgency,” expresses my dismay that our huge debt problem does not receive enough serious attention from the American people. Yes, most Americans deplore the national debt and the deficit spending that leads to it, but it only too seldom affects how they vote for candidates for federal office, thus giving a pass to the big spenders in Congress.
Here is a good example of this refusal to take the debt seriously. The advocacy group FAIR (Fairness and Accuracy in Reporting) ridicules NPR for addressing this problem, “Look a Deficit: How NPR Distracts You From Issues That Will Actually Affect Your Life.” Here is what FAIR is saying:
Interest on the national debt is projected to be only 2% of GDP in 2016 and 3% of GDP in 2024, which is tiny. (But this is because the interest rate for the debt is now abnormally low, approximately 1.7%).
If the Fed keeps interest rates low, then interest on the debt will continue to stay low indefinitely and so the debt will continue to be a trivial problem. And the President appoints 7 of the 12 voting members of the Fed Open Market Committee which sets interest rates.
The reason the Fed raises interest rates is to slow the economy and keep people from getting jobs. (Actually the real reason is not to keep people from getting jobs but to keep inflation under control. Once inflation takes off, it is very difficult to bring it back down as we painfully discovered in the late 70s and early 80s).
Anyhow, if the Fed raises interest rates to keep the labor market from tightening, as it did in the late 1990s, this would effectively be depriving workers of the 1.0 – 1.5 percentage points in real wage growth they could expect if they were getting their share of productivity growth. (A rise in interest rates need not choke off economic growth which is primarily affected by supply and demand. Fiscal policy (tax rates and spending), established by Congress, has a far greater effect on the rate of economic growth than does monetary policy).
If our debt is not soon placed on a sustainable downward path, we will soon have another financial crisis, much worse than the Great Recession of 2008. This will affect everyone’s life in a substantial and very unpleasant way.
“It was a great mistake to push lower-income people into housing they couldn’t afford and couldn’t really handle once they had it. former Congressman Barney Frank, 2010
“Only by understanding the factors that led to and amplified the crisis can we hope to guard against a repetition.” former Federal Reserve Chair, Ben Bernanke, 2010
As I explained in my last post, my views on the financial crisis are most heavily influenced by John Allison, President of the CATO Institute; Sheila Bair, former Chair of the FDIC; and Peter Wallison, a financial policy analyst at the AEI, as follows:
The primary cause of the crisis was the affordable housing policy, created by Congress and administered by HUD, under which higher and higher percentages of mortgages acquired by the GSEs Fannie Mae and Freddie Mac had to be made to low and moderate income borrowers. This policy, aided by the very low interest rates maintained by the FED from 2002-2004, created the housing bubble which burst in 2007 leading to an unprecedented number of delinquencies and defaults.
Subprime lending abuses could have been avoided if the FED had used the authority it had under the Home Ownership Equity Protection Act of 1994 to require appropriate mortgage lending standards. In other words, lax regulation, but not deregulation, was a major contributor to the crisis.
Investment Banks, such as Bear Stearns and Lehman Brothers, magnified the misallocation of credit to the housing market with financial products such as CDOs and derivatives.
Clearly congressional action was needed to address the financial abuses leading up to the crisis. But the Dodd-Frank Act is an overreaction. It requires 398 new regulations which are taking a big toll on the economy as shown by the chart below from the American Action Forum. Dodd-Frank should be scaled back so that its provisions apply only to the very largest financial institutions where the abuses were the greatest. This can be accomplished with capital requirements which increase proportionally with the size of the institution so that smaller banks are better able to compete with the giants.
Faster economic growth is critical for our future. It will not only create more jobs and higher paying jobs but will also alleviate our deficit problem by bringing in more tax revenue. Paring back and streamlining Dodd-Frank would be a big step in the right direction.
The Financial Crisis in 2008 was one of the most disruptive events in U.S. history. It is crucial that we understand what caused it so that we can recover from it more fully and avoid a recurrence. My favorite books about the crisis are: The Financial Crisis and the Free Market Cure by John Allison, President of the CATO Institute and former CEO of the large financial services company, BB&T; Bull By the Horns by Sheila Bair, Chair of the FDIC from 2006-2011; and Hidden in Plain Sight by Peter Wallison, an economics policy scholar at AEI and former member of the FCIC. Not surprisingly, these three very well informed individuals have somewhat different points of view.
Mr. Wallison says that the government’s affordable housing policies caused the financial crisis by essentially requiring the GSEs Fannie Mae and Freddie Mac to acquire increasingly large numbers of subprime mortgages. The financial power of the GSEs forced private lenders to lower their own lending standards in order to compete (this last assertion is in dispute). When the resulting housing bubble burst, large numbers of subprime mortgages defaulted causing huge losses for both GSEs and private financial institutions alike.
Ms. Bair says that “the subprime lending abuses could have been avoided if the Federal Reserve Board had simply used the authority it had since 1994 under the Home Ownership Equity Protection Act to promulgate mortgage lending standards across the board.” In March 2007 she testified strongly in favor of the Fed issuing an anti-predatory lending regulation under HOEPA and was rebuffed by the Fed. As FDIC Chair she constantly urged, largely without success, that other federal agencies use their regulatory powers to curtail the abuses of private lenders.
Mr. Allison agrees with Mr. Wallison that “the whole origination market relaxed its standards to compete with Freddie and Fannie.” However he goes on to say that “the investment banks (including Bear Stearns and Lehman Brothers) magnified the misallocation of credit to the housing market. They created a series of financial innovations (CDOs, derivatives, etc.) that leveraged an already overleveraged product. … Investment bankers unquestionably made irrational decisions based on pragmatic, short-term thinking. … Those who made these mistakes should have been fired and their companies allowed to fail.”
Can these disparate points of view be melded into a coherent framework for the financial crisis which suggests a way forward from where we are today? I will attempt to do this in my next post.
The Department of Housing and Urban Development gradually increased the requirement that loans acquired by Fannie Mae and Freddie Mac be made to low- and moderate-income borrowers from 30% in 1992 to 56% in 2008.
As a result of these policies, by the middle of 2008 there were 31 million Nontraditional (low down payment and/or poor credit) Mortgages (NTMs) in the U.S. Financial system, more than half of all mortgages outstanding, with an aggregate value of more than $5 trillion. At least 76% of these were on the books of government agencies such as Fannie, Freddie and the FHA or banks and S&L institutions, holding loans which they were required to make by the Community Reinvestment Act.
The 24 million NTMs acquired or guaranteed by government agencies were major contributors to the growth of the housing bubble and its lengthy extension in time.
The growth of the bubble suppressed the losses that would ordinarily have brought NTM type Private Mortgage-Backed Securities (PMBS) to a halt but rather made these instruments look like good investments.
When the bubble finally burst, the unprecedented number of delinquencies and defaults among NTMs drove down housing prices.
Falling home prices produced losses on mortgages, whether they were government backed or PMBS.
Losses on mortgages caused investors to flee the PMBS market, reducing the liquidity of the financial institutions that held the PMBS.
Once the housing bubble burst, four major errors were made by our top government financial officials: The first and major error was the rescue of Bear Stearns. The moral hazard created by this action reduced the incentive for other firms to restore their capital positions. Once Bear had been rescued it was essential to rescue Lehman Brothers. Treasury Secretary Paulson and Fed Chairman Bernanke’s arguing that they did not have legal authority to rescue Lehman provided an excuse for Congress to pass the destructive Dodd-Frank Act. Finally, TARP accomplished little but caused much popular resentment against the banks which supposedly got bailed out.
Conclusion: as long as the American people don’t understand that government housing policies were the main cause of the financial crisis, we are likely to repeat the same mistakes over again.
It is now commonly agreed that the Financial Crisis of 2008 was caused by the collapse of the housing bubble beginning in 2007. There were three main aspects to the huge collapse of wealth caused by the Financial Crisis:
It Destroyed Mainly Middle Class Wealth. During the Great Recession housing values collapsed by $5.5 trillion, a large fraction of the total $14 trillion economy. As shown in the above chart, most of this loss of wealth came at the expense of middle- and lower-income families.
Foreclosures on Underwater Mortgages Lowered Housing Values across the Board. When foreclosed houses are sold at steeply discounted prices, the appraised value of all other houses in the area are lowered as well.
The Loss of Wealth of Indebted Households Forced Them to Cut Back on Their Overall Spending. The decline in aggregate demand due to wealth loss of the indebted then becomes a problem for everyone in the economy.
In a new book, the economists Atif Mian and Amir Sufi have proposed a new way to set up mortgages, called Shared Responsibility Mortgages (SRM), to protect holders of underwater mortgages during a housing crisis.
Consider a house bought for $100,000 with a 20% down payment and a 30 year mortgage of $80,000 at 5% interest. The annual mortgage payment is $5,204 per year. Suppose the value of the house drops 30% to $70,000. With an SRM the owner’s equity drops to 20% of $70,000 or $14,000. The annual mortgage payment would also drop 30% to $3,643. It would continue to be adjusted each year until the house returns to 100% of original value at which point the payment would revert to and remain at the original amount unless the value again drops below 100% of original value.
In return for sharing in the loss caused by a drop in value, the mortgage holder would receive 5% of any capital gain realized whenever the house was sold or refinanced in the future.
Suppose that all mortgages in 2007 had been SRMs. All three of the problems outlined above would have been avoided. The financial crisis would have been much less severe!
“If stupidity got us into this mess, why can’t stupidity get us out?”
Will Rogers, 1879 – 1935
The Financial Crisis of 2008 and the subsequent Great Recession, from which we are still slowly emerging, is the greatest shock to our fiscal and economic health since the Great Depression of the 1930s. There are many explanations available for what happened, the most believable ones being written by the major participants themselves. My favorite reference for these events is the book, “Bull by the Horns,” written by the former Chair of the Federal Deposit Insurance Corporation, Sheila Bair, who held this post from 2006 – 2011. Ms. Bair could see the crisis coming. She interacted with all of the prime players but was too late on the scene, and with too little clout, to have a major effect on the outcome. Another persuasive account is provided by Richard Kovacevich, Chairman Emeritus of Wells Fargo, in a recent speech, “The Financial Crisis: Why the Conventional Wisdom Has It All Wrong.” According to Mr. Kovacevich:
Forcing all large banks to take TARP funds, in October 2008, even if they didn’t want or need the funds, was one of the worst economic decisions in the history of the U.S.
If Bear Stearns had been allowed to go bankrupt in March 2008, Lehman Brothers would have been sold and the subsequent financial crisis greatly reduced. A total of just 20 financial institutions caused the crisis, half investment banks and half savings and loans, yet 6000 commercial banks are being punished by Dodd-Frank.
Dodd-Frank does not address the major causes of the recent crisis and offers few approaches to prevent the next one.
Since regulatory agencies are not capable of using the authority they already have to prevent failures, we need a regulatory system which limits the damage of failures. In case of failure, all creditors, other than insured depositors, should take a “haircut”.
Requiring excessive levels of capital will only cause financial institutions to take on greater risks. If equity and long term debt, at both the bank and bank holding company levels, is required to be maintained at 30% of assets, it is unlikely that the FDIC will ever incur losses.
The quasi-private/public agencies Fannie Mae and Freddie Mac need to be abolished.
The Glass-Steagall Act, passed in 1933 and repealed in 1999, should not be reinstated because investment banking is far less risky than commercial banking, and therefore the two forms of banking need not be separated.
There are three warning signs when a financial institution is approaching the danger zone: concentration of risk, inadequate liquidity and significant exposure to capital markets. Competent regulators, not Dodd-Frank, are needed to address these risks.
Recoveries from past recessions have been much more vigorous than our anemic 2.2% rate of GDP growth for the past five years. Mr. Kovacevich believes that because of the Dodd-Frank legislation, and the current monetary policies of the Federal Reserve, the bottom 25% of Americans on the economic ladder have restricted access to mortgages and personal loans. This is inhibiting economic growth and contributing significantly to the inequality gap.
The financial crisis of 2008 was the biggest shock to our financial system since the Great Depression of the 1930s. It caused a deep recession from which we are still recovering. To aid the recovery the Federal Reserve launched an unprecedented expansion of the money supply, referred to as quantitative easing, as well as keeping short term interest rates near zero. As explained by James Rickards, a portfolio manager at West Shore Group, in his new book, “The Death of Money, the coming collapse of the international monetary system,” such a severe recession would normally have caused a corrective period of deflation. Quantitative easing has warded off deflation and, so far, without igniting inflation. We are now in a catch-22 situation. Congress could and should adopt several policy changes to speed up the recovery as I described several days ago in “The Federal Reserve Cannot Revive the Economy by Itself.” But, if and when the economy does start growing faster, it will require great skill by the Fed to exit from its current policies without harm. If it contracts the money supply too quickly, it risks a sharp rise in interest rates. If it contracts the money supply too slowly, it risks a sharp rise in inflation. Mr. Rickards doubts that the Fed will be able to accomplish this fine tuning without another major crisis. Here are his Seven Signs of what to look for:
The price of gold ($1300 per ounce today). A rapid rise to $2500 will anticipate inflation. A rapid decrease to $800 signals severe deflation.
Gold’s continued acquisition by Central Banks. Large purchases by China, for example, will announce inflation.
IMF governance reforms, e.g. towards more voting power for China, will be an inflation warning.
The failure of regulatory reform, i.e. reinstatement of Glass-Steagall in addition to the Volcker Rule, will increase the chances of systemic failure.
System crashes, resulting from high-speed, highly automated, high volume trading. An increasing tempo of such events will cause disequilibrium which could close markets.
The end of QE, could give deflation a second wind and lead to a new round of QE.
A Chinese collapse (predicted by Rickards), will lead first to deflation and then inflation.
We all hope that the Federal Reserve can steer clear of a new, and much deeper, financial crisis. But it doesn’t hurt to have guideposts and Mr. Rickards knows what he’s talking about.