The opportunities for Democrats politically from the economic crisis need to be met economically, or it will be a short honeymoon with the voters. I marked up three risks yesterday:
- The responsibility for the economic crisis has not been clearly assigned to Bush, Greenspan and the unregulated banking sector. Bipartisanship may turn out to be co-ownership.
- Democratic fingerprints are all over a stimulus plan that likely will not work.
- The political will will not be forthcoming to do what needs to be done to prevent a hard landing and a long Japanese-style malaise to follow. Democrats will sooner or later be viewed as inadequate, paving the way for a return to the Right Wing policies that have failed so well in the current circumstance.
Enough review.
What is needed to bring about a recovery? And why is it so risky?
To solve the problem:
First, see the problem. While there is enough fraud, incompetence and conflict of interest to go around, the housing bubble was well understood by many from the beginning. It germinated and grew from the extra low interest rates instituted by Fed Chairman Alan Greenspan. They were kept in place long after housing became valuable not as a functional investment, but as a re-sellable asset.
The Fed ought to be the leader of the financial sector. Instead it has become the tool of the financial sector. It had the authority and mandate to do something, but didn’t. There is no reason for weird mortgage instruments. In the 1920s it was the banks themselves that were shaky and unstable. There is no place for the cadre of unregulated mortgage originators that preyed upon the credulous, and now seems to have melted back into the shadows. Beyond this, there is no excuse for the packaging and selling of hundreds of billions of securities nobody understood.
It is absolutely critical to bring order, discipline, accountability and ethics back into the financial sector. Banks, hedge funds, private equity funds, the non-banking investment houses all need to come under the control of a single authority, as they do in other nations. Now there are more than a hundred different oversight agencies, most of which are in thrall to the industry they are supposed to regulate.
The danger here is that campaign financing exigencies will keep the presidential candidates from acting. That is, they need money and Wall Street is a source of money, and Wall Street is the source of this problem as well as being home to skilled sophistry that can persuade anybody that down is up and the only way out of the current problem is to allow the free market to further work its will.
But a Japanese-style malaise cannot be avoided if we do not allow the markets to clear, by which we mean find the housing price that is the market price for houses, not the ginned up price based on low interest rates. And to be clear, well-intentioned attempts to keep people in their homes work-outs will only establish new terms that themselves are untenable as prices continue to decline.
Yes, it will make the financial geniuses among us into fools, since we thought we were rich when we were only deceived. But it is absolutely essential. Otherwise equity values will recede as people approach retirement and no base will be found from which to begin the recovery.
The Home Owners Loan Corporation, circa 1933
The way to do this, as pointed out by Kuttner, is a resurrection of the Home Owners Loan Corporation of the New Deal era. At that time, home loans were often made for a shorter period of time and included a balloon payment at the end which buyers hoped to meet by refinancing. Starkly similar to the current adjustable rate mortgages of today, which are tenable only when refinancing is available on favorable terms.
The HOLC offered full amortization, meaning when the last payment was made the house was owned free and clear. It offered below market interest rates and close counseling and assistance for borrowers. The result was extremely low default rates for what were the subprime borrowers of the day. The program operated at a net profit. There was no net cost to the budget.
Today, as envisioned by Kuttner, the HOLC would purchase the securities that hold these mortgages for a deep discount, perhaps 30 to 40 cents on the dollar. It would then repopulate the homes by offering below market terms. It seems to us that these terms ought to include adjustments should market prices fall further. One very understandable reason for softness in the current market is that would-be buyers are on the sidelines. If these buyers could be insulated from the risk of falling prices, they would come into the market. If they came into the market sufficiently, prices would cease to fall.
There is more about the HOLC here, from the New Republic, and at DemandSide.net
But this just clears up the mess. It does not get the economy growing again.
One of the ironies of the current situation is that the architects of the financial economy, Bernanke at the Fed and the dozens or hundreds of banking officials and market gurus are reduced to a shamanistic incantation of how things are going to be okay. Bush begins to sound like Hoover, "The fundamentals are sound," Prosperity is just around the corner."
The economy is not sound. We need to stop the hemorrhaging of jobs, create industries in green technology and infrastructure and begin to rebuild the public infrastructure. Much, much more could be said about that, but this piece is about risks to the Democrats.
Putting our eggs in a deficit spending stimulus basket, no matter Larry Summers "Targeted, timely and temporary," mantra is a huge political risk. If it doesn’t work, as it won’t, the Democrats look as foolish as the Republicans. All of a sudden, all politicians are in the same boat. Never mind the whole affair was engineered by the Free Market fundamentalists. Republicans in the Senate may have done a great service to Democrats this past week when they blocked the extension of unemployment benefits. When the plan doesn’t work, it may be tenable for some to say it was because it didn’t go far enough.
On the other side of town, the Fed and Ben Bernanke are cutting interest rates like there is no tomorrow. This unseemly panic is proving problematic. It leads to a kind of contact anxiety in the Markets. Worse, it leads to an expectation that things will turn around soon as a result. Interest rate cuts do not turn things around soon, they take a year or more to fully work into the economy. More to the point, the credit crunch and deflation in housing are not susceptible to interest rate cuts. The credit markets are short of capital, no interest rate will be cheap enough. The housing market is deflating. Even zero percent loans on an asset that will be worth less tomorrow is not cheap enough.
What low interest rates and more liquidity does do is inflate the prices of energy and commodities. The liquidity flows to the rising asset. In this case it exacerbates inflation around the world. Fundamentals do not support $90 oil or extravagant grain futures. These are supported by speculation. Similarly, the fall of the dollar is in part the rise of other currencies, as dollars speculate on the euro and elsewhere. These rising currencies make imports more expensive. Again this helps inflation, not the economy. And the upshot of higher inflation will be higher private market interest rates. Irony of ironies, a recession-first policy will put inflation first.
The Fed should just drop the interest rate gun where it is and go about the regulation it is authorized and mandated to do, but refuses to do.
Let me leave you with a last major risk:
The stimulus package is deficit spending. A deficit spending strategy will lead to huge debt service and a busted budget. The fiscal house can be broken if interest rates kick up. Reagan and the two Bushes have put us trillions of dollars in the red. This is okay, so long as our lenders roll over the debt on favorable terms. If they don’t, and interest rates rise, and the budget booms with a Democrat in the White House, Who ends up taking the fall?