The bubble burst

Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke and [right] Sheila Bair, Chairperson of the Federal Deposit Insurance Corporation. The troika comprises the Working Group on Financial Markets entrusted with the task of handling the situation arising out of the fast-changing economic landscape.

THE financial dam burst on September 13, 2008. A flood of capital swept out of the stock markets and went into government-backed bank accounts, where they remain, pooled up and inert. These bank accounts are the equivalent of hiding money in one’s mattress. They are shelters from the turbulence of the financial storms. Governments from Japan to the United States struggled to take control over a vast continent of economic life that they had previously given up to the bandits of profit. To re-establish sovereignty over these regions has not been easy, and it has aged many of those who are trying to lead the charge.
In Washington, D.C., President George W. Bush has lost his swagger. Impetuous in front of the press, he now looks grave, grizzled even. Beside him, the members of his Working Group on Financial Markets look ashen-faced, stooped. Sheila Bair, whom Forbes called the second most powerful woman in the world (after German Chancellor Angela Merkel), runs the Federal Deposit Insurance Corporation. A few years ago, she wrote two books for children on sound money management; now she is in the position to act on her own advice. Beside her is Ben Bernanke, Chairman of the Federal Reserve and a former Princeton University professor of Economics (his colleague, Paul Krugman, won the Noble memorial prize in Economics this year). Towering above them is the U.S. Treasury Secretary, the dour-faced Henry Paulson, who studied alongside Bernanke at Harvard before building a fortune at the helm of Goldman Sachs.
This troika has been given the charge of handling the fast-changing economic landscape. There are few smiles from them any longer as they seek to lay their hands on the Wild West. Unwilling sheriffs, these are dyed-in-the-wool adherents of laissez-faire economics.
In 2002, Bernanke spoke at the 90th birthday celebration of Milton Friedman, the dean of free-market economics. Taking a cue from Friedman’s co-authored book on the Great Depression, Bernanke saluted him, saying sorry for having allowed it to happen, and “thanks to you, we won’t do it again”.
The principal lesson spelled out by Friedman, and underscored by Bernanke, was that the central bank must ensure a “stable monetary background” for the economy, keeping inflation low by properly regulating money supply. The other lesson is not an economic one per se but about leadership. Friedman’s book noted that with the death in 1928 of the talented and influential central banker Benjamin Strong, the Federal Reserve was unable to assert proper control over private banks in a time of crisis. What is needed, Bernanke said in 2002, is “an effective leader”. His time is now on hand, as is that of Sheila Bair and Paulson.Slide to bankruptcy
For the month after September 13, the topography of Wall Street changed radically. Bear Stearns (founded in 1923) had already collapsed in March, and was hastily acquired by J.P. Morgan (which later bought the ailing bank Washington Mutual). Lehman Brothers (founded in 1850) declared bankruptcy, and was swept up for a song by Barclay’s Bank. Merrill Lynch (founded in 1914) folded alongside Lehman, to be picked up by Bank of America.
A few days later, American International Group (founded in 1919), the world’s largest insurance company, went down the slope towards bankruptcy but was saved at the eleventh hour by an emergency infusion of $85 billion by the U.S. government (a few weeks later, the Federal Reserve provided an additional loan of almost $38 billion just as reports emerged that executives of the firm went off on a corporate retreat that included golf and spa treatments and cost $440,000).
The government-sponsored mortgage agencies Freddie Mac and Fannie Mae (created in 1970 and 1968 respectively) retreated from their autonomy into the embrace of the government. Finally, in mid-October, Wells Fargo Bank absorbed Wachovia Bank (founded in 1879). Meanwhile, J.P. Morgan (founded in 1824) and Goldman Sachs (founded in 1869) went from being investment banks to being bank holding companies (with Mitsubishi taking a stake in J.P. Morgan).
Turbulence on the stock market now resulted in a downward slide for the Dow Jones and, as a consequence, for the world’s stock markets. By September 18, sellers flocked to the pits, asking for their money back, and put whatever could be made liquid into cash backed by governmental assurances. Credit markets seized up, which threatened economic activity outside stock exchanges, investment firms and their computer networks. The pulses of electricity now began to make inroads into the confidence of those who hire and fire, who make and break. It is no surprise that these events aged Paulson.Bush unpopular
Bush and Paulson tried to put the best face on events, even as these escalated out of control. A year ago, as the mortgage crisis threatened the stability of the U.S. economy, Bush told the country: “The fundamentals of our economy are strong.... Job creation is strong. Real after-tax wages are on the rise. Inflation is low.” Each time he faces the country these days, the Dow Jones plummets. Nothing he can say helps, and his approval rating continues to go the way of the stock indices (around 22 per cent of the population now approves of him).
Until recently, Paulson also tried to put a cheery face despite the slide of the stock markets. In the spring of 2007, when all indications turned towards a major lurch downward, Paulson lectured the Shanghai Futures Exchange about the need for an open society: “An open, competitive, liberalised financial market can effectively allocate scarce resources in a manner that promotes stability and prosperity far better than government intervention.” Every once in a while Paulson tries to be optimistic, even as his body language is gloomy. He often looks as if he is searching for the nearest exit.On September 19, Paulson proposed the Emergency Economic Stabilisation Act, which promised to put $700 billion into the credit market, mainly to purchase toxic assets off the books of the financial firms. No one knows the exact size of this toxic pool, and even Paulson admitted that the figure he chose was largely a guess (the Treasury Department said the number was “not based on any particular data point”, jargon for speculation). Asked what he might do if this plan did not work, Paulson responded, “We have nothing else.”
The plan was quickly attacked by right-wing Republicans who saw it as, in the words of Representative Jeb Hensarling from Texas, the “slippery slope to socialism”. They preferred a package that included a cut in capital gains tax and further deregulation. Sections of the Democratic Party found the plan objectionable because it gave Paulson unlimited authority, and did not constrain the way the CEO class in Wall Street do business or earn. Bush and Paulson threatened the Representatives with a wholesale collapse of the system, and even with the promulgation of some kind of martial law. Pressure from Wall Street on the mandarins of both parties finally moved Congress to pass the Bill.
The ambit of the $700 billion bailout was limited. It was designed to clean up the balance sheets of the financial firms and to restore the credit that flowed between banks and to the public. Paulson assumed that as this credit entered the system, normal economic vibrancy would pick up. In other words, the Bush team saw this as a solvency crisis created by bad loans made by irresponsible bankers and not as a wider problem of debt in American society. Two bubbles
In the 1990s, the U.S. economy experienced a boom thanks in large part to two bubbles: one generated by the hype over the Internet and information technology in general and the other generated by consumer debt. The first bubble burst in 2000-01, when dotcom firms failed to live up to their overblown expectations. The second bubble shuttled back and forth between different areas of the consumer economy, from credit cards to mortgages. Disposable incomes, already curtailed, are being haemorrhaged toward debt servicing; more money goes to pay off debt than to buy food.
The household debt crisis erupted in the 1990s, largely because of the stagnation in real wages (more than a quarter of U.S. workers labour for wages below the poverty line). As ordinary people struggled to hold on to jobs, they turned to the generous credit markets to pay off their overpriced homes, their cars, their college tuitions and their everyday expenses.
The federal government kept interest rates very low to enable this expanse of debt, which was one easy way to maintain the illusion of the American Dream as U.S. manufacturing disappeared and pay packets in service jobs shrank. The total consumer debt in the U.S. is now about $2.6 trillion (22 per cent more than in 2000). Mortgage debt is around $10.5 trillion (in 2000 it was $4.8 trillion). This debt will not be written off by the bailout. It is indeed a major flashpoint for the next explosion.
Alan Greenspan, as head of the Federal Reserve, maintained interest rates to enable the large expansion of the 1990s. But that money did not go towards infrastructure development or investment in industry. Rather, it went towards the consumer debt bubble and to the vastly expanded market in financial commodities (such as the mortgage securities, the derivatives market and also the debt itself, now packaged as securities).
No one knows the exact size of the fictitious sector, but some estimate that the credit default swap market alone is about $62 trillion. The danger this poses to the financial architecture is considerable. This is particularly the case as the major banks and investment houses now consolidate into four companies (J.P. Morgan Chase, Citicorp, Bank of America and Wachovia Wells Fargo). The toxic fictitious sector and the equally unstable consumer debt bubble are within the balance sheets of these four entities. The bailout does not address this toxicity, which will inevitably corrode the remaining banks.
How the toxic assets came onto the balance sheets of the banks is a story that Wall Street, the Bush team and those who worked in Bill Clinton’s Treasury Department want to ignore. Before the entire issue could be swept under the rug, presidential contender Barack Obama came out fairly strongly against deregulation as “a philosophy that views even the most common-sense regulations as unwise and unnecessary”.
It is true that since Bill Clinton’s second term (1997-2001) and through the eight years of George Bush’s presidency the entire legal framework for regulation of financial markets had been eroded. Whatever laws remained on the books could not be regulated as the Bush team studiously sliced the small remaining staff at the Securities and Exchange Commission, where the enforcement team is now 1,209 and will drop to 1,177 next year. (There are more lawyers on one floor of an investment bank than in the entire SEC enforcement division.)
The General Accounting Office reported that the SEC’s budget is so meagre that it is forced to “be selective in its enforcement activities and… [this has] lengthened the time required to complete certain enforcement investigations”. In 2004, before he became head of the Treasury Department, Henry Paulson led a group of bankers to the SEC and lobbied successfully to exempt investment banks from holding reserves against losses on investments. The investment banks subsequently leveraged their fictitious investments beyond reason. The current bailout does not address this erosion of responsibility, even as Obama has made it a central part of his own plan were he to become President.
Bankers were not enthused by the bailout, which is why they did not renew lending to each other. The market was starved of credit, and so the $700 billion bailout seemed ineffective. The normally staid Wall Street Journal, a reliable free-market periodical, weighed in, with one of its seasoned columnists arguing that the “government needs to inject capital directly into banks”. In other words, the government needs to seize control of the banking industry.
The Working Group apparently paid attention to this, and on October 14, convened in the Cash Room of the U.S. Treasury to call reluctantly for the government to “purchase equity stakes in a wide array of banks and thrifts”. Paulson, who made the announcement, could not bring himself to say that the government had nationalised the banks. Indeed, his laissez faire carapace made him apologise for the action: “We regret having to take these actions…. Government owning a stake in any private U.S. company is objectionable to most Americans – me included. Yet the alternative of leaving businesses and consumers without access to financing is totally unacceptable. When financing isn’t available, consumers and businesses shrink their spending, which leads to businesses cutting jobs and even closing up shop.”
Reasonable estimates suggest that the Treasury Department will have to expend about $2.25 trillion on this extended bailout. To this must be added the already significant national debt and the escalating military budget and war expenditure (the Iraq and Afghanistan war bills now total in the vicinity of $1 trillion).
In 2004 and in 2005, the International Monetary Fund (IMF) warned the U.S. about its big budget deficits and consumer spending. The U.S. economic engine, the IMF warned in 2005, was “fuelled by increasingly unsustainable fiscal stimulus, as well as housing prices that are ignoring the laws of gravity”. Unlike most other governments, the U.S. administration sneered at the report and its recommendations.
“We want to make sure that the way we address the imbalances maximises growth,” said a Treasury official, making it clear that the government wanted to ride the boom for as long as it lasted, regardless of the consequences. As September moved into October the Treasury Department did not adequately take the measure of its main creditors: Europe is in the doldrums, China did not respond with its considerable treasure, Japan fears a repeat of its own long-term stagnation, and the sovereign funds of the oil lands preferred to put their billions into their own fledgling stock exchanges rather than into Wall Street or Washington’s coffers. In 2004, the IMF warned that “higher borrowing costs abroad would mean that the adverse effects of the U.S. fiscal deficit would spill over into global investment and output”. This has indeed come to pass.Decline in spending
On October 15, the Federal Reserve released The Beige Book, its report published eight times a year on current economic conditions in the Federal Reserve districts. It showed that in September consumer spending had declined in retailing, auto sales and tourism.
This is the first formal indication of the impact of the crisis. Things are so bad that General Motors released a statement that “bankruptcy is not an option” for the company. The Labour Department announced that the U.S. lost 159,000 jobs in September, up from 73,000 jobs lost in August. The Wall Street Journal released its survey of 52 economists who pointed out that things can only be negative.