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Marshall Auerback

Marshall Auerback

Posted: June 25, 2009 05:05 PM

Risk of Major Social Upheaval Likely if Bank Bonanza Continues

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State and local governments have been forced into draconian budget cuts, firing workers who are among the most reliable in making their mortgage payments -- when they have jobs: firemen, policemen, teachers, civil servants.

Yet the Obama administration won't spend even a small fraction of what it has wasted on the banks to cover state shortfalls. The guarantee of $5.5bn in short term notes for California was deemed to be fiscally irresponsible, yet hundreds of billions have already been allocated to the likes of Citigroup, AIG, and Goldman Sachs, all of whom have already beefed up salaries and bonuses as they emerge from the embrace of the federal government.

Good for the banks, bad for the economy

Banks are also benefiting from lending programs that effectively allow them to borrow at zero and reinvest in Treasuries at around 3%. A bank doesn't have to do anything to make money. The banks' return on equity is going to be very good. They are going to be able to restore their finances.

While this is good for banks, is it good for anyone else? The problem is the government's "free money" program means banks have little or no incentive to do any actual lending. Combined with rising unemployment and the ongoing housing crisis, this means any recovery is likely to be muted, at best, especially given the ongoing weakness in the real estate market. Growing income inequality will likely be perpetuated and exacerbated with all of the resultant social strains. And in the meantime, the siren songs will grow that we are a nation addicted to debt, deficit spending our way to economic disaster.

Housing bubble lessons

Policy makers were slow to recognize the importance and magnitude of home price deflation. Keynes, Minsky, and Fisher understood that balance sheets matter to income and cash flow outcomes -- it is not just the other way around, as convention has it, where income and cash flow results passively accumulate on balance sheets at a glacial pace.

The New Keynesians like Bernanke should have recognized this through their "financial accelerator" channels approach, but the near-ZIRP (zero interest rate policy) QE (quantitative easing) approaches have so far proven to be too little, too late. Moreover, there is now a wing of investors feeding fears that "monetization" and significant fiscal expansion may constrain the Treasury's room to manoeuvre further. The upshot is that we have missed a golden opportunity to deal with the growing problem of income inequality. Instead, we have the paradoxical spectacle of an ostensibly progressive Democrat administration, and a Democratically controlled Congress, presiding over one of the most regressive wealth transfers in history.

As Keynes and Minsky realized a lifetime ago, durable asset markets, such as housing, do not clear as easily as markets for Chiquita bananas. This is especially true after asset bubbles have introduced structural excesses in parts of the capital stock -- what the Austrians call "malinvestment" or distortions to the production structure. When there are large outstanding stocks of durable assets relative to the potential flow supply, lower prices are not necessarily the cure for low prices, as the traders in the Chicago pits are wont to assert. The bias toward viewing markets as self-regulating, self-adjusting mechanisms does not hold equally well across all markets in all conditions, as this generation has been brainwashed to believe.

Rather, lower prices can beget a stock overhang of existing owners who want to sell, especially if expectations about "normal" or future values are closely coupled with recent spot price trends. Following an asset bubble, when conventions about normal supply prices (or even legitimate valuation models in general) have been ruptured, recent price momentum does tend to become the main guide to expectations, as the trend extrapolating traders win the day against fundamental driven investors during asset bubbles.

Obama, Geithner, and Summers misguided

Obama, Geithner, and Summers misplaced their faith in lower prices as the cure to an excess supply situation in a durable asset market. They also they failed to understand that while lower spot prices may reduce new production, the desired selling out of existing stocks can swamp this flow supply reduction. Because of these misconceptions, they now think they face the choice of either having to let it all meltdown, or else using policy to synthetically reproduce the prior bubble credit conditions.

Or consider this analysis another way, from the increasingly prevailing view that US policy makers are somehow edging us toward a hyperinflationary abyss. Money created has to be spent on goods and services to get higher product prices. Professional investors are working with very simple quantity theory approaches. They are not thinking about transmission mechanisms from money to prices. There is no auction market for M1 and the CPI that automatically settles at the end of each day. The only auction market is spending by public and private sectors on produced goods and services each day, week, month, quarter or year.

Government is the only one increasing spending. The fact that nominal GDP is still falling tells us that the private sector is trying to save more than government is deficit spending, which is deflationary, not inflationary. Even arch monetarists such as Milton Friedman conceded that the path to inflation from money creation was through nominal GDP.

In an inflation, people are eager to trade money holdings for produced goods and services or tangible assets. In a hyperinflation, even more so.

That is not what we have today. Banks are hoarding $1 trillion of cash on their balance sheets. Companies are in cash conservation mode and stripping down inventories, headcounts, and reducing capital spending. Households are saving and building exposure to near cash instruments.

Robust stimulus needed

When an economy experiences sharp and sustained shifts in private liquidity preferences, the policy response must be to create money and additional aggregate demand via government fiscal stimulus, or let debt deflation rip. The latter tends not to be terribly acceptable to democracies for the obvious reasons which Fisher had to learn first hand.

Statements by President Obama that "we are out of money" do not help, because they imply that there is an operational constraint on fiscal policy, beyond which the government dare not go. They feed the prevailing paradigm about "debt sustainability" and "national solvency" and thereby work at cross purposes. What President Obama, Fed Chairman Bernanke, and Treasury Secretary Geithner must say is that until the government deficit spending and the improvement in the trade balance exceeds desired net private sector saving, we can create all the money we want - it simply will not be enough to driver final product prices higher unless and until we succeed in restoring aggregate demand to sufficiently high credible levels where a self-sustaining economic recovery can take place.

In one sense, it is pointless blaming Wall Street for exploiting a system heavily rigged in its favour. They know that the game is stacked in their favour, so they are rationally taking advantage. But the sickest part about the whole episode is that the casino rule makers, Obama, Geithner and Summers, are perpetuating a flawed game that they had in their power the chance to end. In my more cynical moments, I have to wonder why TARP, which is essentially a purchase of financial assets (and, hence, better left in the hands of the Fed, as Treasury is supposed to buy 'real things') was placed in the hands of Treasury. It's almost as if this was planned deliberately so as to provide the anti-government folks with a cudgel with which to beat back supporters of activist government. My issue with Obama and his fiscal package is the same as Rob Johnson's: taxpayer money is being deployed in hugely inefficient ways like Citi, BofA, AIG, and GM and discrediting fiscal policy in the process. Contrast this with the achievements of the New Deal. As Adam Cohen in his new book, Nothing to Fear.

"[WPA] workers constructed or repaired more than 125,000 buildings, including 83,000 schools; 800 aiports; 950 sewage plants; and 650,000 miles of roads. They built or improved 78,000 bridges and 25,000 playgrounds; terraced 271,000 acres of eroded land; and taught two million people to read. They also ran a famous Federal Art Project, which hired destitute artists to create murals for public buildings, posters, and paintings. The WPA produced a highly regarded series of state guidebooks and an acclaimed collection of interviews with former slaves, and it played a major role in building the San Antonio Zoo, New York City's LaGuardia and Washington's Reagan airports, and the presidential retreat at Camp David. In 1965, on the program's thirtieth anniversary, The New York Times quoted a dispossessed North Carolina tenant farmer living in an abandoned gas station, who had been rescued by a WPA job. 'I'm proud of our United States, and everyting I hear The Star Spangled Banner I feel a lump in my throat,' he said. 'There ain't no other nation in the world that would have had the sense enough to think of WPA."

This kind of puts the paucity of Obama's fiscal goals in stark relief, doesn't it?

The key is building a political case for the stimulus. This means getting people around a common objective where everybody is perceived to be benefiting and that the sacrifices are being borne fairly. This was clearly the situation in WWII when the budget deficit as a percentage of GDP got as high as 30.3% of GDP, yet nobody complained about the "sustainability" of government expenditures. The upshot was that by 1946, the GDP per capita was 25 percent higher than it had been in the last peace years before the War. GDP per capita continued to grow during the Marshall Plan years. Despite giving away two percent of U.S. GDP, American residents (and taxpayers) experienced a higher standard of living each year. And nobody spoke about us running out of money.

Bank bonanza must end

By contrast, the current bonanza for banks is neither economically efficient, nor politically sustainable.

What is driving the change in portfolio preference shifts is not only a misguided paradigm, but also an inability for the Obama administration to make a sensible, coherent case in what they are doing and why they are doing it. Their actions, in fact, seem to suggest that everything is ad hoc and that they are operating out of their depth, in effect continuing the same policies of the Bush/Paulson period, but on a much greater scale.

Ironically, this ultimately will also prove highly inimical to the interests of finance itself. When most of the home owning voters cannot pay their major debt or have no incentive to pay their mortgage debt, there will either be a debtors revolt that society will sanction or there will be a bailout of such a magnitude that mega moral hazard will affect private lending forever. Once these things happen, you will no longer have the social rules for private risk based lending. In other words, financial markets will be unlike anything ever seen before in private economies. Is this really what Wall Street wants, let alone American society as a whole?

Both FDR and JFK had a brain trust that could help forge public opinion. Obama has his halo, Geithner, and Summers. We've known from the start that was a misstep.

In the meantime, beyond automatic stabilizers, the door appears to be shutting to further active fiscal ease. I wonder if the stage is already being set for tax hikes, as rumors of a federal VAT (value added tax) have been floating around of late. Add this to rising commodity prices and interest rates, and the profile of any recovery may become increasingly in question, a la 1937-8. Add to that additional bank write-offs, further credit contraction and a minimalist welfare system which leaves nothing in the way of social cohesion, and the prospects for major social upheaval look dangerously likely. What is missing is a vision of a new growth path for the US. If a public backlash is to be marshalled to something more than retribution, that needs to come to the fore. Once you get beyond the pothole and school patching, what industries can be pushed forward through public seed capital or public private partnerships? The economist Hy Minsky pointed out a better way to solve both the liquidity and the income problem, while also providing full employment: by channeling government expenditure through an employer-of-last-resort program.

The current crisis could have been mitigated if increased household consumption had been financed through wage increases and if financial institutions had used their earnings to augment bank capital rather than employee bonuses.

The current system has failed because it was built on an incentive system that did just the opposite.


This piece was originally posted on New Deal 2.0