TOPICS IN POLITICAL ECONOMY

NOTES ON "WHAT'S OLD, WHAT'S NEW" IN THE 2007-08 FINANCIAL CRISIS

See the one-pager I used in a recent roundtable discussion of the financial crisis:

• Six traditional factors common to all major financial disturbances, with their manifestations in the current case.

• Five factors distinctive in today's situation, and which have contributed to its' above-average severity.

SENSIBILITY AND SPENDING SPLURGES

All of a sudden, spending splurges are the hottest thing in Washington.  With the Federal Reserve having brought interest rates down to near zero, politicians of all stripes (and a sizable percentage of economists) are now embracing massive spending (and borrowing) programs as the way to “stimulate” an economic recovery.

 

A Work in Progress.The result is an emerging proposal from President-elect Obama’s team for a $750+ billion “recovery” package. It is split between roughly 60% for spending and 40% for lower taxes (most of which involves, indirectly, eliminating or reducing Social Security payroll taxes for lower income households - more on this in a later post).  No doubt the House and Senate versions of the bill will differ – and the “compromise” will simply be to include each other’s spending proposals. Look for a final price tag approaching $900+ billion.

Much of the spending is standard anti-recession fodder: extending unemployment benefits, increases in food stamp allotments, federal funding for highways, and additional funding for Medicaid programs.  But a sizable chunk is for states to spend on infrastructure and education and for federal programs emphasizing “green” technology and the like. 

The incoming Chairwoman at the Council of Economic Advisors, Christina Romer, has dutifully cooked up heroic “job impact” estimates for the various components of the package totaling 3-4 million jobs saved or created.

The direct short-term economic impact of the “stimulus” package is likely to be trivial, despite the hard work by Professor Romer.  By the time the checks are in the mail, the environmental impact statements approved, and the competitive bidding process completed, it will be close to the third quarter of 2009. 

 

Four Factors. In the meantime, four important factors already present should be working their way through the economy:

1.        Lower gasoline prices.  If sustained at current levels, compared to the average price in 2008 this stimulus will be running at a $130 billion annual rate, according to the economists at PNC Bank.

 

2.     Healthier credit markets. Commercial paper volumes and maturities are increasing;  money market funds are venturing beyond investment in short-term Treasury securities. In other words, firms' ability to borrow for working capital should be increasing.

 

3. Inventory reductions by business.  These should be over well before the start of the third quarter, and new orders at distributors and manufacturers will be rising once again.

 

4. The drop in “financial uncertainty indicators” over the past several weeks. Spreads between interest rates on risk-free assets (e.g. Treasury bills) and private sector risk have narrowed; volatility in key stock market indices has been reduced, and the use of the word “uncertainty” in the press has declined.  Such indicators are the basis for two Stanford University economists to declare, “economic uncertainty is now dropping so rapidly that we believe growth will resume by mid-2009.” (They called the start of the recession with commendable accuracy).

 

Who Needs It?  So, who really needs a splurge in spending?  I suggest there are three categories of players (at the Washington level) in this game:

• Politicians who promised an expansion of government during the 2008 campaign (much of Obama's "stimulus" package consists of his specific campaign spending promises).

• Economists who mistakenly believe they can micro-manage the economy and its key sectors (energy, housing, etc.) with targeted spending programs.

• Anyone, politicians and economists included, who is reassured (or who thinks other people are reassured) by seeing government "do something" (e.g. spend money) rather than do nothing.

The rest of us will grind our teeth, remind people that all taxes start with spending, and just hope that the recovery becomes apparent soon enough to encourage fiscal conservatives in Congress to block any legislation needed to fund the remaining parts of the “stimulus” package. If there is one clear issue shaping up for the 2012 election, it is deficit reduction and major tax increases.

 

THE CREDIT CRUNCH: A HELPFUL EARLY POST-MORTEM

Michael Lewis is a deservedly esteemed commentator on matters financial. He and David Einhorn, a hedge fund manager, have recently published in the New York Times an incisive if early post-mortem of the credit crunch/crisis.  (Lewis' recently-published compilation of articles on recent financial crises, "Panic," is useful background.)

Entitled "The End of the Financial World As We Know It," the Times essay's primary contribution is its analysis of the common factors linking the subprime debacle with Bernard Madoff's giant Ponzi scheme. The authors' central point is that in U.S. financial markets "the tyranny of the short-term has extended itself with frightening ease into the entities that were meant to . . . discipline Wall Street and force it to consider its enlightened self-interest." They point to three major "short-term" realities:

1. The intense pressure for short-term financial gains at publicly-held investment banks tends to lead to excessively risky strategies.  As Lewis and Einhorn point out, these pressures are as much internal as external - CEOs who decline to follow the latest apparently profitable play in risky assets risk losing bonus-hungry subordinates who can jump to less responsible competitors, even before the cautious CEO is fired by angry shareholders for being "behind the pack" in earnings gains. 

2. Rating agency oligopolies that are sanctioned by the SEC.  The rating agencies, "in pursuit of the their own short-term earnings . . . did exactly the opposite of what they were supposed to do: rather than expose financial risk, they systematically disguised it."  Case in point:  MBIA was a triple AAA in 1990, insuring municipal securities with a debt/equity ratio of 21%; still a AAA in 2006, but heavily engaged in insuring collateralized debt obligations, etc. and a debt/equity ratio of over 360%.  Underlying issues: regulatory mandates that institutional investors hold agency-rated securities and a business model where issuers, rather than investors, pay for ratings (see my blog of 5/1/2008). 

3. A one-way revolving door between SEC enforcement staff and Wall Street. Thanks to the ease with which SEC staff can migrate to highly-paid positions on Wall Street, "the Commission has somehow evolved into a mechanism for protecting financial predators with political clout from investors."  Apparent case in point: Bernard Madoff and his billion dollar Ponzi scheme. I would add another example:  the April 2004 decision to permit the major investment banks to leverage up their investment/trading exposures. It is clear from the SEC inspector general's testimony this week that the process of regulatory oversight, as well as the particulars of contacts between SEC staffers, Madoff, and others after several alerts, will be reviewed in depth.  

Compared to their analysis of the past, Lewis and Einhorn are less on the mark when it comes to remedies for the future, particularly when it comes to credit default swaps.  But I do like their solution to the "too big to fail" problem  (the practice of bailing out financial institutions whose demise would have "systemic" consequences for many others): "Break up any institution that becomes too big to fail."  I daresay Citibank shareholders might have appreciated that policy step some time ago.

They might also have considered the implications of the fact that many unregulated multibillion dollar hedge funds have come and gone this cycle without creating any systemic problems.

Bottom line:  you don't have to agree fully with either their analysis or recommendations to profit from an enjoyable and instructive read of Lewis and Einhorn's sprightly essay.