Walking the Tightrope

The US Government has come to the rescue.  Unlike after the 1929 Stock Market Crash, policy makers in the US and across the globe are taking action to contain the spread to the wider economy of the losses mounting in the financial sector.  Years of speculation in housing, fed by interest rates held too low for too long by the Greenspan Fed, have come to a crashing end.  The government has begun to use its powers to foster an orderly adjustment of home and stock prices, while attempting to avoid what is known as “systemic risk,” i.e. when problems at some financial institutions threaten the integrity of the whole financial system on which our economy depends. 


Three problems remain: 


First, the government only has so many levers at its disposal.  It can pump money into the financial system, but cannot get financial institutions to lend or consumers and businesses to spend.  It can spend its own money, which it is doing with the stimulus package.  It can inspire confidence in its management of the economy, an elusive but necessary task. 


Second, warriors tend to fight the last battle, unable to see what new threats are on the horizon.  Will the government perceive what the critical problems are?  Is it the banks?  The investment banks?  The hedge funds?  The complex, often crazy financial products called “derivatives?” Which problems should they focus on? 


Third, politicians are involved.  They blame each other, can’t resist the impulse to partisanship, especially so in an election year.  This crisis does point up the need for voters to consider who among the candidates for president and Congress is up to the task of managing a financial crisis.  Right now, it seems voters have other considerations in mind.

The dimensions of the problem: There are roughly $10 trillion of mortgages in the United States, representing nearly three-quarters of our GDP, which was $13.8 trillion last year.  The next largest economy in the world is Japan’s, which is about one-third as large, then Germany’s and China’s, each about one-fifth the size of the US economy. You can see how the US economy dwarfs the rest of the world, how dependent the rest of the world is on us through trade, and how large and menacing our housing crisis could become.

The American consumer drives our economy, responsible for 70% of purchases, yet many US consumers are feeling the pain of the real estate crisis. Some have negative equity in their homes (their mortgages are larger than the value of their homes). Some are losing jobs (more will), and many are nervous.  Consumers are slowing their spending, and the economy is in recession. 

Of the $10 trillion in mortgages, about $1.5 trillion represent “subprime,” the marginal borrowers who are losing their homes. There are signs the subprime problem is spreading.   The banks that made loans during the boom are seeing some of their loans go bad.  But the banks also sliced and diced loans into mortgage-backed securities and sold them to the likes of Bear Stearns, the investment bank that went under over the weekend.

Because the banks, investment banks, hedge funds and others borrow and lend to one another, sound financial institutions could be at risk when a Bear Stearns fails.  This is “systemic risk.”  The government’s job is to prevent systemic risk from becoming, well, systemic. 


The government has another, conflicting goal.  It seeks to avoid what is called “moral hazard.”  Moral hazard occurs when the government bails out institutions, causing bankers to learn that they can bet the bank and not worry because the feds will bail them out.  Hence, the government seeks to teach these bankers a lesson from time to time, while avoiding systemic risk.  It’s like walking a tight rope.


Hank Paulson, appointed Secretary of the Treasury by Bush, Tim Geithner, President of the New York Fed and a protégé of Democrat Bob Rubin who ran the Treasury under Clinton, and Ben Bernanke, Chairman of the Fed and a Bush appointee, as well as many of their talented subordinates, did an excellent tight rope walk over the weekend.  They burned Bear Stearns shareholders by paying them $2 a share for a bank worth $160 a share in January 2007.  Ouch!  Thirty percent of Bear Stearns stock is owned by its employees.   Double ouch!  Hopefully, the deal won’t unravel.

A disorderly bankruptcy of the Bear was avoided, which could have dragged others under.  They did it with some public money, while putting a large and strong financial institution, JP Morgan, on the hook for all the risk (and, mind you, all the potential reward).  Bravo Gentlemen!  Bravo Ladies!  A job well done.  You are avoiding the ignominy of your predecessors who mishandled the 1929 Crash. 

What else have they done?  They are attempting innovative solutions geared toward the current, not the last, crisis.  The Fed announced over the weekend it was lending to investment banks, which has not been done in the past, and accepting dodgy collateral, such as mortgage-backed securities.  Critics cry “Moral Hazard!” but these are difficult times.  As long as the Fed has an exit strategy for these innovative measures, once a sense of normalcy has returned to the markets, they can limit the damage from a moral hazard point of view. 

The US government is seeking to avoid what happened to Japan in the 1990s and make amends for what Sir Alan wrought. 

Alan Greenspan’s Fed failed to act against the rapidly rising prices of real estate and stocks earlier this decade because his 1970s thinking dictated that you raise interest rates only against rising prices of goods and services, what we commonly know as inflation, not against rising prices of financial assets.   It was a mantra he repeated.  It was accepted monetary orthodoxy.  Goods price inflation was low earlier this decade, but financial asset prices were run amuck.  Economists know that when financial asset prices rise – when the value of your home and stock portfolio increases — people feel richer and ultimately spend more, bidding up goods prices and ultimately causing the more traditional inflation. Sir Alan stayed too long in the job. 

The Bank of Japan in the 1990s after its stock market and real estate bubble burst also stuck to monetary orthodoxy.  Instead of purchasing corporate debt to inject money into the financial system, the BoJ sat on the sidelines and Japan experienced its “lost decade” of low growth.  The Bernanke Fed, I expect with some consultation with Secretary Paulson, is seeking to avoid a Japanese-style “lost decade,” lending money to investment banks and accepting mortgages as collateral.


Thus, US policy makers are attempting to confront the problems of “limited policy levers” and “fighting the last war.”  Yet the third problem is more nettlesome. 




Last week Senator Chuck Schumer, in the middle of the Bear Stearns crisis, was running around calling Bush, “Herbert Hoover,” the man widely credited with doing nothing as the Great Depression took shape.   Barney Frank got into the fray with similar rhetoric, as did the two Democratic presidential candidates.  Okay, it is an election year. 

Today, on the other hand, Schumer was more careful.  I saw him interviewed on MSNBC.  He extolled Republicans Paulson and Bernanke, but still couldn’t resist at the end of the interview, pounding Bush for doing nothing.  Pollsters must be advising the Dems that Bush is so unpopular that he should serve as the lightning rod of all criticism in their adrenaline-rushed dash to recapture the White House, even at the expense of undermining confidence in the government in the middle of a financial crisis. 

Alas, as part of this mad dash, the Democrats have boxed themselves in on trade.  One of the dynamics that exacerbated the Great Depression in the thirties was the vicious cycle of protectionism that took place, the so-called “beggar-thy-neighbor” policies that sharply restricted international trade.  I erect tariffs and quotas against your exports to my country; you erect them against my exports to your country.  We’re both worse off.  Both of our economies shrink. 

In Ohio, Obama and Clinton promised to scrap NAFTA, the free trade agreement with Mexico and Canada, and to be very cautious on future trade agreements.  Democrats in Congress constantly threaten trade protection against China.  Good politics perhaps.  Bad economics. 

NAFTA has been good for the United States; ask people living in border communities in Texas.  Sure, some manufacturing workers in Ohio and elsewhere have lost their jobs.  It is not clear that this is a result of NAFTA.  It could be the result of a Japanese car company opening up a plant in Alabama at lower cost than plants in Ohio or Michigan.  Nevertheless, to soften the blow of adjustment due to trade, we need government-sponsored retraining and job placement services.  But don’t damage the overall US economy, which is resilient and strong, in an effort to postpone the inevitable.  I don’t care what Barack Obama promises you in his speeches. 


The Democrats have boxed themselves in on trade, making it virtually impossible to pass a free trade agreement with Colombia, an ally that badly needs it, or to liberalize trade with the wider world.


Which brings us to the choice in November and for those of you in Pennsylvania (and North Carolina) over the next couple of months.  Bush picked Hank Paulson to head the Treasury, and he is doing a fine job.  Bill Clinton picked Bob Rubin to head the Treasury, and he helped navigate our economy through a number of crises.  Who will the candidates choose to help manage the economy and walk the next tightrope? 


And don’t forget that elusive role of government in a crisis.  Who among the candidates has the gravitas and credibility to inspire confidence in his/her management of the economy?   Have a think on that.

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