The Game is Over. There Won't Be a Rebound
Interview with Michael Hudson
By Mike Whitney
Mike Whitney: Fed chairman Bernanke has been on a spree lately, delivering three speeches in the last two weeks. Every chance he gets, he talks tough about the strong dollar and "holding the line" against inflation. Treasury Secretary Henry Paulson even said that "intervention" in the currency markets was still an option. Is all of this jawboning just saber rattling to keep the dollar from plummeting, or is there a chance that Bernanke actually will raise rates at the Fed's August meeting?
Michael Hudson: The United States always has steered its monetary policy almost exclusively with domestic objectives in mind. This means ignoring the balance of payments. Like the domestic U.S. economy itself, the global financial system also is all about getting a free lunch. When Europe and Asia receive excess dollars, these are turned over to their central banks, which have little alternative but to recycle these back to the United States by buying U.S. Treasury bonds. Foreign governments – and their taxpayers – are thus financing the domestic U.S. federal budget deficit, which itself stems largely from the war in Iraq that most foreign voters oppose.
Supporting the dollar’s exchange rate by the traditional method of raising interest rates would have a very negative effect on the stock and bond markets – and on the mortgage market. This would lead foreign investors to sell U.S. securities, and likely would end up hurting more than helping the U.S. balance of payments and hence the dollar’s exchange rate.
So Bernanke is merely being polite in not rubbing the faces of European and Asian governments in the fact that unless they are willing to make a structural break and change the world monetary system radically, they will remain powerless to avoid giving the United States a free ride – including a free ride for its military spending and war in the Near East.
MW: How do you explain the soaring price of oil? Is it mainly a supply/demand issue or are speculators driving the prices up?
Michael Hudson: It’s true that enormous amounts of speculative credit are going into commodity index funds. But bear in mind that as the dollar depreciates, OPEC countries have been holding back supply largely to stabilize their receipts in euros and to offset their losses on the dollar securities they have bought with their past export proceeds. For over 30 years they have been pressured to recycle their oil earnings into the U.S. stock market and loans to U.S. financial institutions. They have taken large losses on these investments (such as last year’s money to bail out Citibank), and are trying to recoup them via the oil market. OPEC officials also have pointed to a political motive: They resent America’s military intrusion in the Middle East, especially in view of how much it contributes to the nation’s balance-of-payments deficit and federal budget deficit.
The U.S. press prefers to blame Chinese, Indian and other foreign growth in demand for oil and raw materials. This demand has contributed to the price rise, no doubt about it. But the U.S. oil majors are receiving a windfall “economic rent” on the price run-up, and are not at all unhappy to see it continue. By not building more refining and shipping capacity, they have created bottlenecks so that even if foreign countries did supply more crude oil, it would not be reflected in refined gasoline, kerosene or other downstream product prices.
MW:: The Fed has traded over $200 billion in US Treasuries with the big investment banks for a wide variety of dodgy collateral (mostly mortgage-backed securities). How can the banks possibly hope to repay the Fed when their main sources of revenue (structured investments) have been cut off? Are the banks secretly using the money they borrow via repos from the Fed to dabble in the carry trade or speculate in the futures markets?
Michael Hudson: The Fed’s idea was merely to buy enough time for the banks to sell their junk mortgages to the proverbial “greater fool.” But foreign investors no longer are playing this role, nor are domestic U.S. pension funds. So the most likely result will be for the Fed simply to roll over its loans – as if the problem can be cured by yet more time.
But when a bubble bursts, time makes things worse. The financial sector has been living in the short run for quite a while now, and I suspect that a lot of money managers are planning to get out or be fired now that the game is over. And it really is over. The Treasury’s attempt to reflate the real estate market has not worked, and it can’t work. Mortgage arrears, defaults and foreclosures are rising, and much property has become unsaleable except at distress prices that leave homeowners with negative equity. This state of affairs prompts them to do just what Donald Trump would do in such a situation: to walk away from their property.
The banks are trying to win back their losses by arbitrage operations, borrowing from the Fed at a low interest rate and lending at a higher one, and gambling on options. But options and derivatives are a zero-sum game: one party’s gain is another’s loss. So the banks collectively are simply painting themselves into a deeper corner. They hope they can tell the Fed and Treasury to keep bailing them out or else they’ll fail and cost the FDIC even more money to make good on insuring the “bad savings” that have been steered into these bad debts and bad gambles.
The Fed and Treasury certainly seem more willing to bail out the big financial institutions than to bail out savers, pensioners, social Security recipients and other small fry. They thus follow the traditional “Big fish eat little fish” principle of favoring the vested interests.
MW:: According to most estimates, the Fed has already gone through half or more of its $900 billion balance sheet. Also, according to the latest H.4.1 data "the current holdings of Treasury bills is $25 billion. This is down from some $250 billion a year ago, or a net reduction of 90%." (figures from Market Ticker) Doesn't this suggest that the Fed is just about out of firepower when it comes to bailing out the struggling banking system? Where do we go from here? Will some of the larger banks be allowed to fail or will they be nationalized?
Michael Hudson: You need to look at what the Treasury as well as the Fed is doing. The Fed can monetize whatever it wants. And as you just pointed out in the preceding question, it has been buying junk securities in order to leave sound Treasury securities on the banking system’s balance sheets. Government bailout credit will keep the big banks alive. But many small regional banks will go under and be merged into larger money-center banks – just as many brokerage firms in recent decades have been merged into larger conglomerates.
False reporting also will help financial institutions avoid the appearance of insolvency. They will seek more and more government guarantees, ostensibly to help middle-class depositors but actually favoring the big speculators who are their major clients.
What we are seeing is the creation of a highly concentrated financial oligarchy – precisely the power that the Glass-Steagall Act was designed to prevent. A combination of deregulation and “moral hazard” bailouts – for the top of the economic pyramid, not the bottom – will polarize the economy all the more.
Cities and states will preserve their credit ratings by annulling their pension obligations to public-sector workers, and raising excise taxes – but not property taxes. These already have fallen from about two-thirds of local budgets in 1930 to only about one-sixth today – that is, a decline of 75 percent, proportionally. While the debt burden and the squeeze in disposable personal income is pressuring workers, finance and property are using the crisis to get a bonanza of tax relief. Democrats in Congress are as far to the right as George Bush on this, as their base is local politics and real estate.
MW:: According to the Financial Times: "Analysts at Citigroup said a planned tightening of the rules regarding off-balance sheet vehicles would force banks to reconsider arrangements and could result in up to $5,000bn of assets coming back on to the books. The off-balance sheet vehicles have been used by financial institutions to keep some assets off their balance sheets, thereby avoiding the need to hold regulatory capital against them." Is there any way the banks can find investors with "deep enough pockets" to provide the capital they need to meet the requirements on $5 trillion dollars? Are most of these off-balance sheets assets mortgage backed securities and other hard-to-value bonds?
Michael Hudson: The practice of off-balance-sheet accounting already has become quickly obsolete this year. The United States is going to adopt Europe’s normal “covered bond” practice of bank head-office liability for mortgages and other loans. (The Wall Street Journal had a good article on this on June 17, anticipating that the U.S. covered bond market might rise quickly to $1 trillion as early as next year.)
This coverage is what has given European banks protection. In view of the heavy losses of German banks in Saxony and Düsseldorf in the U.S. subprime market last summer, it’s unlikely that investors will buy mortgages that no major bank or government agency stands behind.
Regarding more investor bailouts, I don’t see that it makes sense to lend money to a bank today without getting preferential treatment over existing holders, plus secure collateral. Government guarantees might help, especially for foreign investors. But then, the dollar’s plunge is a problem here.
MW:: Many of the TV financial gurus --as well as Henry Paulson--keep assuring us that the worst is behind us, but I don't see it. Foreclosures are increasing, the dollar is falling, unemployment is rising, manufacturing is sluggish, food and fuel are soaring, and consumers are backed up on their credit cards, student loans and house payments. Where would you say we are in the present cycle? What will it take to rebound from the current slump? Will the stock market take a beating before all this is over? What do you think the greatest problem facing the economy is; inflation or deflation?
Michael Hudson: The idea that we’re even in a business “cycle” is whistling in the dark. If we’re in a cycle, then that implies there’s an automatic recovery in store. This happy free-market idea was developed at the National Bureau of Economic Research by opponents of government regulatory policy. But the economy doesn’t move by a sine curve. There is a slow buildup, and a sudden plunge, so the shape is ratchet-shaped. This is why 19th-century writers didn’t speak of economic cycles, but rather of periodic financial crises.
Today’s plunging real estate and stock market prices are not a self-correcting ebb and flow in which downturns set in motion automatic stabilizers that produce recovery. Each U.S. recovery since World War II has started out from a higher level of debt. The result is like driving a car with the brakes pressed more and more tightly. Alan Greenspan at the Federal Reserve flooded the banking system with enough credit to enable debts to be carried by borrowing against the rising price of homes and office buildings, corporate stocks and bonds. In effect, the interest charge was simply added onto the debt balance.
But today, the prospects are dim for paying off debts out of further price gains for homes and real estate. Speculators have pulled out of the market – and as late as 2006 they accounted for about a sixth of new purchases. Asset-price inflation fueled by the Federal Reserve – is giving way to debt deflation. The United States and other countries have reached a limit in which scheduled interest and amortization absorb the entire economic surplus of so many individuals, companies and government bodies that new construction, investment and employment are grinding to a halt. Families, real estate investors and companies are obliged to use their entire disposable income to pay their creditors or face bankruptcy. This leaves them without enough money to sustain the living standards of recent years.
This means that there won’t be a rebound, and it will take longer than 2009 to recover.
MW:: I read about 8 or 9 articles every day about the meltdown in housing. I always tell my wife that its like reading a Tom Clancy novel except the ending is less certain. As Yale economist Robert Schiller pointed out last month; the decline in prices is now greater than it was during the Great Depression. Will prices find a bottom in 2009 or will it take longer? If prices keep falling then how are the banks going to sell the hundreds of billions of dollars of mortgage-backed securities that they are presently holding?
Michael Hudson: Prices will keep going down, because they have been fed by plunging interest rates, zero-amortization mortgages and low or zero (or even negative) down payments in recent years. That world has ended.
It means that the banks can’t sell their mortgage-backed securities – except to the government, at a loss except to insiders. The actual losses are much worse than the present price statistics show, because many people are frozen in with negative equity. So instead of price declines, we’ll simply see many more foreclosures.
MW:: How serious is the current crisis in the financial markets and housing and what steps do you think Obama or McCain should take to stabilize the markets, reduce the deficits, strengthen the dollar, increase employment, and put the economy on solid footing? Is it possible to have a strong economy without policies that distribute the nation's wealth more equitably? As chief economic advisor to Rep Dennis Kucinich, what one bit of advice would you give to Obama to restore America's economic vitality and put the country on the right path again?
Michael Hudson: In academic economic terms, America has never been in as “optimum” a position as it is today. That’s the bad news. An optimum position is, mathematically speaking, one in which you can’t move without making your situation worse. That’s the position we’re now in. There’s nowhere to move – at least within the existing structure. “The market” can’t be stabilized, because it was artificial to begin with, based on fictitious prices. It’s hard to impose fiction on reality for very long, and the rest of the world has woken up.
In times past, bankruptcy would have wiped out the bad debts. The problem with debt write-offs is that bad savings go by the boards too. But today, the very wealthy hold most of the savings, so the government doesn’t want to have them take a loss. It would rather wipe out pensioners, consumers, workers, industrial companies and foreign investors. So debts will be kept on the books and the economy will slowly be strangled by debt deflation.
The US can’t reduce the balance-of-payments deficit without scaling back its foreign military spending. Congress is refusing to let foreign governments invest in much besides overpriced junk here, so central banks are treating the dollar like a hot potato, trying to buy foreign assets that can play a role in their own future economic development.
I think that at some point Obama will have to tell the public the bad news that restoring vitality will take radical measures – probably ones that Congress will try to water down so much that things are going to get worse – much worse – before the needed reforms will be made. He can say this before taking office, blaming the Republicans for their regressive tax policies and at the same time bringing pressure on the new Democratic Congress to back a return to progressive taxation and serious financial restructuring. As president, he will have to do what FDR did, and challenge the financial oligarchy with new government regulatory agencies staffed with real regulators, not deregulators as under the Bush-Clinton-Bush regime.
He should make large depositors and “savers” take the losses on their bad bets. And he should repeal the Clinton repeal of Glass Steagall.
Most of all, he will have to make the tax system back progressive again if the domestic market is to recover. He should remove the tax-deductibility of interest payments, and do what the original 1913 income tax did: tax capital gains at normal income rates rather than subsidizing speculation. The great majority of such gains do not accrue to entrepreneurs, but to real estate speculators. A good tax code should encourage equity financing rather than debt pyramiding.
Social Security and medical care should be paid out of the general budget, not as user fees. And until this change is done, FICA withholding should be levied on total income, without an upper cutoff point. There should be a LOWER cut-off point, however: Only people who earn over $60,000 a year should contribute. This would end up being fairly revenue-neutral. Pres. Obama should say that his policy is not to “soak the rich.” It is to make them pay their way once again by favoring a strong middle class.
Unless he does this, what used to be a democracy will be turned into an oligarchy. And oligarchies historically are so short-sighted that they stifle the domestic economy, driving enterprise and emigration abroad. This threatens to reverse America’s long-term affluence, which means literally a flowing-in – an inflow of capital, of skilled immigrants and other labor, of technology, and of foreign support. All this has now been put in danger by the policies pursued at least since 1980.
Michael Hudson is a former Wall Street economist specializing in the balance of payments and real estate at the Chase Manhattan Bank (now JPMorgan Chase & Co.), Arthur Anderson, and later at the Hudson Institute (no relation). In 1990 he helped established the world’s first sovereign debt fund for Scudder Stevens & Clark. Dr. Hudson was Dennis Kucinich’s Chief Economic Advisor in the recent Democratic primary presidential campaign, and has advised the U.S., Canadian, Mexican and Latvian governments, as well as the United Nations Institute for Training and Research (UNITAR). A Distinguished Research Professor at University of Missouri, Kansas City (UMKC), he is the author of many books, including Super Imperialism: The Economic Strategy of American Empire (new ed., Pluto Press, 2002) He can be reached via his website, firstname.lastname@example.org