01 January 2009


This year begins with economic turbulence continuing throughout the world. Statistics in the Wall Street Journal each day are discouraging, and the economic gloom everywhere is palpable. Most people alive today have never seen anything like this. If this were a normal post-war recession we would be almost halfway through it at this point. But this is not a “normal” recession judging by the market meltdown and the continuing financial paralysis. Projections for an upturn by the second quarter of this year are very optimistic, and it is more likely to be prolonged because nobody knows what they are doing and the government will likely make things worse. If there is growth at all it will be anemic because of industrial policies that are likely to be put in place by the new administration. 

It is well known that the root of the problem began with the Community Reinvestment Act, and Fannie Mae, and Freddie Mac overextending credit to people who never should have received it ,which in turn encouraged banks like Countrywide and Washington Mutual to push out loans to anyone, with virtually no credit standards or safeguards. Although this began during the Clinton administration, George Bush liked to brag about increasing home ownership and continued to encourage these policies. People could lie with impunity on applications while suffering no consequences. Ironically during the Savings and Loan crisis other people were actually prosecuted for doing the same thing. Thus, all players dispensed with standards and created the resulting housing bubble. Loan originators could be lax because they would sell loans to other institutions or in packages with slices of mortgages, which presumably spread the risk and seemed virtually guaranteed because the good mortgages would more than make up for the few bad ones. Wall Street further muddled these securities through credit default swaps and excessive leverage. The problem now is that no one knows what these securities are worth as they are unable to unravel the labyrinth of slices spread across the market. Until this is resolved there can be no stability in the housing or credit markets. 

But let’s just look at the loans that haven’t been securitized, and are still on the books of the banks as nonperforming loans. Because so many mortgages were made on houses with little down payment, and which are now worth less than the original mortgage amount, homeowners can simply walk away. It all really comes down to this: there is a spread between what these houses were worth during the bubble and what their current market value is. The question then becomes who is going to take the hit- the homeowner, the lender, or the taxpayers? This is further complicated by the fact that these assets have no fixed value and eventually may appreciate again. That argues for the homeowner to sit tight where possible, but mark-to-market rules are making financial balance sheets appear far worse than they are. If the taxpayers eat the difference on the assets everyone describes as “toxic,” who gets the benefit when these assets appreciate again? 

Right now the best stimulus the economy has is low oil prices, which have the added virtue of hampering unfriendly states like Iran, Venezuela, and Russia. Government spending on public works such as roads and bridges will take years to have any impact. Leaving aside the merits of these projects, and although I naturally oppose any tax increase, if ever there was a time to increase the gas tax this is it, with oil prices so low. Such projects should properly be funded this way rather than through more debt. It is also a far better way to encourage the sort of behavior this government desires, as opposed to more regulation, management of auto mileage and production, CAFE standards, Cap and Trade schemes, and “green” expenditures there is no market for. But tax cuts are still the surest and fastest way to encourage growth. 

However this is the sort of situation than feeds upon itself. Psychologically, people believing that things will be bad makes things worse. When things get tight people stop spending on stuff they don’t need, which is a considerable portion of our economic activity. When they do not spend, there is no investment, and less investment means less innovation, and less innovation means less growth. On the other hand with deflation there is more savings and less debt, the downside being increased unemployment.

It seems as though we should know more after so many decades of study and experience, and economic swings should not be so severe. But clearly this situation shows that we know less than we thought we knew, which should also inspire some prudence in attempting to solve the problem. We already have a $1.2 trillion deficit in FY 2009 before the Obama spending program arrives and congress is about to expend another trillion or so. But what if it doesn’t work?

No comments:

Post a Comment