The Political Economy of Last Week

It's been an intense week for political economics. Here's a rundown and one beltway denizen's view of what it all means.

McCain's Pain, Gramm version: Phil Gramm's economic policies from his days in the Senate are making life hard for millions of people right now. But it was his gum-flapping last week that was particularly tough for McCain. Gramm is McCain's top economic advisor, so when he described the current economic downturn as existing in people's heads ("a mental recession") and called us a "nation of whiners" -- well, I guess he gets points for calling it like he sees it. From McCain's perspective though, he's a bit off message.

One policy note caught my eye re Gramm's role in the current meltdown in financial markets, especially in a week where the problems at Fannie and Freddie came into light (more on that later). As I discuss in the link above, many believe that a bill Gramm championed -- Gramm-Leach-Bliley, which open up investment banks and insurers to commercial lending, but without the oversight of commercial banks--helped pave the way to the housing bubble, the credit crunch, and the current downturn.

But check out Dr. Phil's response from this obsequious interview with Gramm by Steve Moore of the Wall St. Journal's editorial page, itself a cauldron of crazed economics. When Moore "delicately" broaches the subject of Gramm's bill in today's crisis, he responds, "There's every evidence that the markets were made more stable by the diversification. J.P. Morgan could not have bought Bear Stearns and prevented a meltdown without Gramm-Leach-Bliley."

Markets more stable!? If they were any less stable, Wall St. would fall into the Hudson Bay. And how about the comment re Morgan buying Bear? It's like saying, "don't you get it? If I hadn't gotten rid of the cops, then one street gang couldn't have beat up the other street gang." The fact that Morgan had to bail out Bear is a bad thing, Phil. Shareholders and employees lost millions in equity and the deal has exposed the taxpayer to huge potential liabilities.

What kind of person thinks like that? Or perhaps the better question is: what kind of person hires that kind of person to be their top economic advisor?

McCain's Pain, self-inflicted version: McCain also hit us with some straight talk re Social Security this week, calling the program a disgrace. What he specifically found disgraceful was the fact that today's young workers sacrifice a portion of their paychecks to finance the guaranteed pensions of today's retirees. But that's the program.

To me, the quote sounded like he just discovered that this is how it works. But Social Security is the biggest single program we fund; at $600 billion, it's one-fifth of the damn budget. And he's been up there for almost 30 years. I'm not saying I want a policy wonk for president. But this betrays a scary lack of understanding of basic government functioning.

It also betrays something deeper. The intergenerational dimension of Social Security is one the wonderful things about it...sorry if I sound sentimental, but this part just always chokes me up. When they were younger, today's retirees worked to create the economy we have today. They produced the capital, the infrastructure, they taught us in our schools, and treated us in our hospitals. We've inherited these goods, public and private, and we're using them to create the growth that our families enjoy today. Under Social Security, we shave off a portion of that growth to help provide for those who came before us, while creating a new economy for our progeny, who will do the same for us ("Circle of Life" music swells up here...).

To the extent that McCain's thinks about stuff like this, he's a YOYO economist (you're on your own), which is why he wants to drain the risk pool that makes Social Security work, and introduce private accounts. Further evidence that the YOYOs are congenitally unable to appreciate anything that smacks of WITT (we're in this together).

The Ballad of Fannie and Freddie: The nation's largest secondary mortgage insurers are on the ropes. Fannie Mae and Freddie Mac are government sponsored institutions -- the feds created them, but they operate in the private market and the government does not guarantee their investments -- that buy mortgages from primary lenders (the people who lend them to you and me). This makes for a more liquid system of lending for home buyers--banks that make the loans are quickly recapitalized when they sell those loans to Fannie or Freddie.

But like so many of the institutions out there right now, the bursting housing bubble is wreaking havoc on the solvency of these two companies, as some of the debt they're holding starts to go bad. They're even less capitalized than Bear Stearns was -- they borrow a lot, take on lots of debt, and don't keep a lot of money lying around -- in part because they've always been able to borrow freely at very favorable rates. And the reason for this is that most lenders assume the government will backstop them.

And most lenders are almost certainly right. Treasury Sec'y Hank Paulson stresses that the feds are not planning a bailout, by which I suspect he means the feds are planning a bailout. Because if anybody's TBTF (too big to fail), it's this guy and gal (Fred and Fan).

Yes, once again, Mr. and Ms. Taxpayer, you may well be about to hold the bag for a failing financial institution, infusing these firms with the money they need to keep buying and selling mortgage debt, while any sorry souls with stock in the companies will find themselves facing an "equity wipe," as they quaintly call it on the street.

So what can we learn from this, Dorothy? Here are a few random observations, all of which have bearing on the actions of the next administration.

-- Bubbles are much worse than we like to think, and we should work much harder to identify and prevent them. By "we" I mean, among others, the Federal Reserve, who, under Greenspan, had a fairly explicitly stated policy of waiting by the sidelines as the bubbles inflated, mops at the ready.

-- Overleveraging means undercapitalizing. See Fannie/Freddie/Bear Stearns and pretty much every hedge fund and investment bank that borrows short and lends long. It's one thing if big banks want to play with fire. It's quite another if I'm going to be called upon to put the fire out. If you're TBTF, then we must provide you with the necessary oversight to avoid charging a costly bailout to US taxpayers.

-- When derivatives are worth multiples more than the underlying value of the equity or bond from which their value is derived, that's not a hedge. It's a big, speculative bet and a recipe for greater volatility and risk ... risk which will typically be under-priced.

-- Speaking of pricing risk, yes, moral hazard is a big problem that contributes to the underpricing of risk (which, at some level, is the main factor behind all the bad stuff that's happening now). But the time to worry about moral hazard is not the weekend when the big bank is failing. It's years before, when you're setting up the regulations under which the financial system can flourish without going off the rails.

These are tough challenges, and deep-pocketed, powerful forces will fight reform every step of the way. It's going to take equally tough, persistent focus by the next administration and Congress to craft the regulations that truly promote greater stability in the financial system. Enough already with the shampoo approach to economic growth: bubble, bust, repeat.

Maybe it's me, but I don't think the McCain/Gramm team is up to the challenge.

Comments

[FreedomBeforeDemocracy]

As to one of the author’s other points, I agree there shouldn’t be anything too big to fail (I think that’s what you were advocating). The federal government already gets too much power by trying to favor the unproductive. Let’s at least agree they should stop “helping” the insolvent using taxpayer money.

[FreedomBeforeDemocracy]

It’s not the lack of regulation that caused the housing bubble. There is plenty of regulation to go around. The problem was the sudden low cost of financing, which in turn, drove up housing prices beyond reason. The Fed then returned things to semi-normal as all the 5-year fixed loan vehicles were coming due, financing costs had gone back up, housing prices had gone down, and a lot of people were in over their heads. Yes, lenders underestimated risk. Yes, people over-estimated appreciation. What would the regulation be? No second, third mortgages? Must have 20% down for purchases? The federal government goes out of its way to sponsor 3% FHA first time buyer loans.

As far as Social Security goes, McCain is right. Forcing young low income people to pay for high income retirees is disgraceful and smacks of WTF (WITT Thru Force). If progressives really cared about retirees, present and future, they would open their minds to at least the possibility of private accounts. It is working today. Over 30 countries have adopted the Chilean model (which has been working for 30 years). Please, read this link, http://www.cato.org/pub_display.php?pub_id=9404. Consider the possibility. Social Security as we know it will end. Don’t let it take the rest of the economy with it.

[Viper]

You are wrong on so many points. yes they were reguklatio­ns... but the regulators were terminated­./reduced Policies/Regs that no one audits are in fact unregulated.

The effect of massive deficits undr BUSH ( more than all other president combined) and massive trade deficits (laisez faire capitalism at work again.. a know failure ) created a huge money supply which devalued the dollar and also allowed our most desirable big bubble markets outside investment from other countries as they traded their sound currency for an ever increasing number of cheap dollars. Given the effect of this devaluation on what goes into the cost of a house, prices of a house are actually now selling below replacement costs.


47 States saw what was happening and tried to tightend the state regulated banks... BUSH gave those banks Federal Charters.

We could go into the Enron loophole and the other deregs that brought us here.

BUSH increased both insolvency of SocSEc and Medicare. period. The Government borrows from the funds meant for those retiring at just 1.5% but at 5% from Communist China. The funds are there.. just now the government has to payback what it borrowed starting in a couple of years.

Regards

[FreedomBeforeDemocracy]

We agree deficits (both trade and spending) devalue our currency by increasing the supply of money. However, while spending deficits should be stopped now, trade deficits aren't so directly under our control. Yes, we can try to regulate our way to better trade deals, but the point is free trade. It's not completely unreasonable that wealthier nations spend more money on foreign goods. They can afford it. The poorer countries are trying to build wealth, and as they do, they will be able to afford more of our products.

I am not saying you are incorrect in any of your points about devaluing currency, but the major factor in housing price increases was the cheapening of financing and the feedback effect that was caused on housing demand.

Bush's progressive policies did increase the insolvency of both programs agreed. However, it's the Democratic congress that is now ignoring warnings from the Medicare Trustees on future solvency. At least Bush made a proposal.

[GeorgeWRumscroft]

FreedomBef­oreDemocra­cy, your analysis is great. But don't you ever wonder how Republicans can be so unlucky that whenever they are in control of the government nothing ever works out right. (I know, I know, of course it's not their fault. All their policies are correct. It's always just some act of God -- something beyond their control -- which is to blame.)

Did you ever happen to notice that under Bill Clinton the economy grew by 22 million jobs. Under George W Bush somewhere between 4 and 5 million jobs -- depending on how many more he manages to lose before he slinks out of office. And if you didn't take into account the huge expansion in Federal Government employment, Bush's record would be much worse. Pathetic even.

Such bad luck -- or do you believe like John McCain's principal economist that everything is just peachy keen?

[FreedomBeforeDemocracy]

Not that I advocate Republican policy over Democrat (Republicans are only slightly less progressive), but the first budget surplus since 1969 was done by a Republican congress and signed by a Democrat. 75% of Clinton's time in office was done with a Republican congress (the most successful time, GDP wise, by the way).

Bill Clinton's 22 million jobs were done in correlation with NAFTA and Welfare Reform. I assume you support both whole-heartedly.

If you're stating that you prefer the 70's over the 80's, fine. I just don't look at the President (whose main responsibilty is executing our laws) as the reason that the sun comes up in the morning. I look at what is actually done and how the economy reacts during a time when anyone is president. In fact, even though I tend to vote Republican, I lean towards the elected branches of government being different parties. You're right that it seemed to work for the 90's and I agree (although most likely I think for different reasons than you believe).

[daddyG56]

My problem with privatizing Social Security is that it opens the program to financial risk. As we see in the Fannie/Freddie, Bear Stearns examples, even the biggest and seemingly safest can go down with the right conditions.

Also, I have been paying into SS since I was a kid with the expectation that it would be there for me when I got old. I thought I was paying the tax so that I wouldn't have to work until death. My Problems of Democracy teacher ( Andrew Kvaka) in high school told me these problems were coming for social security in 1974. He even got the dates right, as I remember. What happened?

[FreedomBeforeDemocracy]

But social security has financial risk as well. Take a look at the private system. It might actually reduce risk while increasing benefits.

[bgregs]

No, the lack of regulation, COUPLED with the ultra low credit cost, coupled with the lack of regulation of the mortgage LENDERS, caused the housing bubble to form, which in turn caused the market crashes/dollar free fall that we are seeing right now!!!

[Kassandra]

Someone's been listening to Rush Limbaugh, that preeminent economist! You must also think it's a GOOD thing for us to be selling all the rest of assets of worth to other countries?

[TamysDMilo]

You're misrepresenting his point, Jared. McCain wants to eliminate social security so all of our citizens will have the opportunity to get rich by investing their retirement money in the stock market. And with all their new found wealth, McCain will insure that the heirs of the elderly whose estates are more than $5 million, will not have to pay inheritance taxes.

[DrFitz]

"-- When derivatives are worth multiples more than the underlying value of the equity or bond from which their value is derived, that's not a hedge. It's a big, speculative bet and a recipe for greater volatility and risk ... risk which will typically be under-pric­ed."

Fantastic analysis!! One other thing that never gets mentioned:
Tax policy and other structural aspects of economic policy that concentrate wealth upward will lead to more and more tendencies toward the types of speculation in the latest trendy investment vehicle that inflates one bubble after another. The wealthy tend to be more likely to put a fair portion of their vast investing power in the newest flavor of the month financial instrument that Wall St collectively gets behind and flogs aggressively. Usually, these ideas recognize something that's a moderately good idea until WAY too many people jump in. Then the upward momentum itself makes it first temporarily have even more value until things are bid way out of proportion and none of the fancy risk models can keep up with how the risks in the underlying security are shifting. Rinse repeat when the bubble eventually bursts and the rich need a new hot place to park their cash.

[argeec]

The larger part of the cure for this mess is to just reverse all the financial legislation of the last ten years.

[tc399]

I believe the middle class is now de facto extinct. I am certainly not 'middle class' anymore. Cauliflower was $7 a head in the store last month. I eat what I can grow. It's amazing how fast one can go from being a scientist to a subsistence farmer.

[truthandjustice]

The first dollars to go for any bail out needs to start with an immediate increase of the income tax for the top 10%, who are making over $500,000, back to the 95% range. They have been the ones to profit from all this malfeasance it is time to make them pay it back.

As for all the free market ideologes, wouldn't these companies failing just be the invisible hand of the market correcting itself? Oh yeah, I forgot that is only ok if the ones with the most money at risk don't have to suffer like the suckers at the bottom.

[Viper]

Sorry only the top 2 percent make over 500K a year or maybe even a samller percentage.

People who made their money working/ via salary/wages did not benefit from the tax cuts on capital gains and dividends even if they earned alot. Thye paid huge amt of atxes. . I made over 250K per year , have been paying at around 35%.. last year 220K in taxes before property taxes and etc. . Never got any tax break , it was income from running a business 7 days per week, 24 hours a day, no vacations. I and Wife working together made 10 times my average worker ( per hour much less)... not the 400 times the CEOs of Corporate America are making. No stock options. No dividends. What investments I had were in retirment funds and like everyone else they are not subject to those special rates.. and when withdrawn will be at normal tax rates. And like everyone else my retirement funds after 8 years of BUsgh in real dollars are worth half as much as when he came into office.

Regards

[RamonBackwards]

free market "ideologes" as you call them do not support government bailouts of these companies. try not to lump disingenuous parrots in with people who actually have consistent principles and stick to them.

but i'm curious, are you of the impression that the Democrats are against the bailout? that Obama is against the bailout? are you of the impression that Obama is against the policies and programs that allowed poorer people access to loans they couldn't afford?

i would be pleasantly surprised if i find out that he was against them, and is openly working to change those policies now. until i hear that, i will work from the assumption that Obama
A) supported the unsustainable policies that put people in homes they couldn't afford and
B) supports the bailouts now taking place

[Meggie]

Only if Mr. and Mrs. Taxpayer can put a good long list of those responsible in jail until it's paid off. If not, then too bad. Let it fail. We're going to suffer anyway, let George Bush and the Republicans who scammed taxpayers suffer the full brunt along with the rest of us.

[Chillinout]

Problem with that scenario is that it isn't going to be GW or the rich Repugs that suffer the full brunt. It is going to be the people that are working two and three jobs to stay afloat, the millions of seniors on a fixed income, and pretty much all of the middle class.

[argeec]

The way to avoid that would be to let institutions fail as the market dictates, put them into conservatorship (liquidating the equity) and then resell them when they are again viable.
This would have the great advantage of imposing a very large penalty for misfeasanc­e/malfeasa­nce and would limit most of the pain to wall street.