Wednesday, July 21, 2010

An Economic Crisis Balance Sheet

An Economic Crisis Balance Sheet

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In April 2009, proclamations by Obama administration chief economic advisor Larry Summers, Treasury Secretary Tim Geithner, and President Obama himself assured the public that the Administration's $787 billion fiscal stimulus bill, together with measures to bail out the banks, would create millions of jobs and get credit flowing again. But neither jobs nor credit followed. Total job loss, measured by the Department of Labor's unemployment rate, the most comprehensive indicator of joblessness, rose from 15.4 percent in April 2009 to 16.5 percent a year later. At the same time total bank lending in the U.S. declined by 10 percent throughout 2009 and another 3.25 percent in the first three months of 2010.

This past spring, once again, the hype of emerging recovery was fed to the public. According to Summers, the recovery was well underway and was "more vigorous than was common in such crises." The U.S. economy was now "moving toward escape velocity" that would "result in increased job creation." Evidence cited included a nascent rebound of manufacturing and exports, plus net new jobs created since January 2010. A V-shaped (rapid bounce back) sustained recovery was claimed to be finally underway.

Such perennial premature proclamations have all proven wrong. To understand why, it is necessary to understand the recent three-year-long crisis within a broader general context. In fact, most released economic data for May-June 2010 point to the U.S. and other global economies once again either slowing, or about to slow, while global financial instability is growing worse.

August 2007-April 2009

August 2010 marks the third year of the economic crisis since its initial eruption in early August 2007, precipitated by the collapse of the housing and subprime mortgage market. In a matter of weeks, that financial implosion quickly spread to the shadow banking system of unregulated and highly speculative hedge funds, investment banks, private equity firms, finance companies, etc. It thereafter infected, in turn, the commercial banks (e.g., Chase, Citigroup, Bank of America, etc.), which after decades of deregulation from Reagan to George W. Bush, had become tightly integrated with the unregulated shadow banking sector. By December 2007, Commercial banks had virtually stopped lending, even to each other. By year end 2008, the entire financial system was, in effect, freezing up. Nothing remotely close to that had happened before, at least not since the 1930s.

The initial financial instability eruption that occurred in the form of the subprime mortgage bust and its spread to other financial sectors in 2007 soon precipitated a corresponding decline of the real (non-financial sectors) economy. By December 2007, the real economy in the U.S. rapidly slid into recession, followed soon after by most of the advanced economies of Europe, Japan, and elsewhere. Thus, unlike normal recessions, the crisis was synchronizing globally by 2008. Moreover, financial instability and the real economy were also becoming more interdependent, with each feeding off the other. That too was unique compared to prior normal recessions. Both the financial and the non-financial, real economy were becoming increasingly fragile—with fragility on the real side of the economy expressed in terms of consumption, as two-thirds of consumers' incomes stagnated while their debt levels rose.

By late summer 2008, the crisis shifted to a new, even more serious phase, leading to the well-known collapse of major financial institutions like Lehman Brothers, AIG, Merrill Lynch, and the effective insolvency of banking giants like Citigroup and Bank of America. With the banking panic of September-October 2008, financial fragility provoked an accelerated decline of the real economy within just a few weeks. Industrial production and business spending nearly shut down in the closing months of 2008. Lending by virtually all sectors of financial institutions dried up. Non-financial businesses rushed to cancel new investment plans, suspend investment projects in progress, and dramatically cut back even current production. Mass layoffs of a dimension not seen since the 1930s immediately followed in October-November 2008, at a rate of one million a month or more from November through April 2009—a rate of job loss that exactly tracked the collapse of jobs between 1929 and 1931. Six million were laid off in a matter of six months. To the six million were added an additional seven million reduced from full-time to part-time employment. Millions more were thrust into discouraged status and forced to leave the labor force. Millions of the employed were experiencing foreclosure, and tens of millions were experiencing collapse of retirement funds and housing values. After a quarter century of virtual stagnation of real weekly earnings for a hundred million workers in the U.S., and thus growing long term consumption fragility, consumption fractured after November 2008 concurrent with financial fragility in the banking system. Never before had both occurred more or less concurrently—at least not since 1929-30, or before that in 1907-08.

Throughout 2008 the Federal Reserve under its chair, Ben Bernanke, was late to respond and fell consistently behind the crisis curve. Treasury Secretary Henry Paulson performed even worse. He sat on the sidelines until the summer of 2008, allowing the Federal Reserve to expend nearly its entire available $900 billion of funds on hand bailing out the investment banks. Even more behind the crisis curve, trying to catch up with events, was the U.S. Congress under Bush. It passed a paltry $168 billion stimulus bill that was mostly composed of business tax cuts. That stimulus had virtually no effect on the deepening decline of the U.S. economy.

Paulson was finally forced to act in mid-summer 2008 with the imminent collapse of the quasi-government housing mortgage agencies Fannie Mae and Freddie Mac. Paulson bungled that as well and was forced eventually to intervene with $200 billion in July to assure foreign bond holders in Fannie/Freddie that the U.S. government would not let them fail. If it hadn't, the purchase of U.S. bonds by foreign investors and banks would likely have plummeted. Paulson allowed Fannie/Freddie common stockholders, however, to bear the brunt of losses, as Fannie-Freddie stock was also driven to near zero by short-sellers and other speculators.

Following the temporary bailout of Fannie/Freddie, Paulson refused to bail out either bond or stockholders at the investment bank Lehman Brothers, the main competitor to Paulson's own company, Goldman Sachs, where he was once CEO. Lehman collapsed, followed quickly by a string of others, precipitating the banking panic of 2008. At that point, the economy crossed the economic rubicon from normal to epic recession, with mass layoffs, a collapse of production and investment, and a freefall in U.S. gross domestic product (GDP) not witnessed since the 1930s.

Most of the big 19 banks were technically insolvent by October 2008. Paulson's answer was to browbeat Congress into giving him a $700 billion check called TARP (term asset relief program) to buy the bad assets from the banks, thereby releasing reserves for them to lend to get credit flowing again. But the banks refused to sell except at inflated prices, not at the real collapsed market values of the bad assets, and Paulson couldn't buy at inflated market values with funds provided by Congress. So nothing happened. The bad assets remained on bank balance sheets and lending continued to free fall. For cover, Paulson threw the money around to institutions that didn't need it, often forcing them to take it. Other uses were found for the funds, such as the auto companies and their finance arms, or the buying of insurance giant AIG, which amounted to merely a money pass through to AIG's biggest debtor, Goldman Sachs, Paulson's old company.

Much attention has been given to TARP and the $700 billion. But TARP was just a minor back story. The real plot and real money spigot involved the Federal Reserve. Bernanke's Federal Reserve didn't need Congress's appropriation and money. It could print its own if needed. Moreover, it didn't have to tell Congress a thing about how it dispensed its bailout funds, to whom, on which terms, etc. The Fed threw more than $3 trillion at the banks, essentially giving them free money at near zero interest rates. In fact, it actually paid them to take the money by paying them interest on the money it gave them. Of course, the banks took the free money. Both the big 19 name banks, as well as many of the remaining 8,000 regional-community banks. So did many of the unregulated shadow banks, like market funds, finance companies, and insurance companies. But they didn't lend to businesses in the U.S. to create real products and jobs. Instead they lent to other hedge funds and shadow banks that speculated in foreign currency, offshore real estate, commodities, gold, emerging market funds, and the like. The business press euphemistically calls it trading. In fact, it is financial speculation—practices that created much of the current financial instability in the first place. The arrangement did result in rising profits for banks, which in turn drew in more investors buying bank stocks. Those profits and the bank stock appreciation were sufficient to just about offset half of the bad assets and debts remaining on bank balance sheets. By the end of 2009, banks would accumulate about $1 trillion in cash and sit on it, except for speculative investing forays offshore.

Key conclusions from the first 18 months of the crisis are as follows:

  • Normal fiscal and monetary policies designed to engineer a recovery from normal recessions have little effect on epic recessions
  • Leaving bad assets on bank balance sheets and offsetting the values of those assets with temporary trillion dollar injections by the Fed and Treasury only partially stabilizes the banking system
  • Bailing out the banking system cannot generate a sustained recovery of the real economy
  • Only massive fiscal spending on job producing investment can produce sustained recovery
  • The fiscal stimulus of 2008 represented a token attempt, with virtually no prospect of success, at generating economic recovery as it was mostly free tax cut handouts to business and a one-time consumer tax rebate, little of which was actually spent

From Collapse to Stagnation

As late as June 2009 the economy was still losing 500,000 jobs a month. The two key measures proposed by the early Obama administration to engineer recovery were the $787 billion stimulus package of spending and tax cuts, roughly half each, and a series of three banking stabilization measures: the PIPP, TALF, and HAMP. The PIPP was merely TARP warmed over. It, too, like TARP, proposed the government assist the removal of bad assets clogging bank balance sheets. Unlike TARP, the government would not buy the assets directly, but subsidize buyers' and sellers' market prices for the assets. But neither banks nor investors rose to the occasion. Banks still did not want to sell at below inflated prices; and investors didn't want to buy risky assets, often worth a tenth of their original value, above the deflated true market price. PIPP was dead on arrival and dismantled within months. Similarly, TALF was designed to subsidize investors to buy up the bad securitized mortgages, consumer credit, and auto and student loans. But again few takers. It was largely dismantled by the Fed within months. Finally, HAMP was designed to subsidize mortgage lenders and servicers to entice them to offer lower mortgage rates for new home buyers. The idea was to get them to buy up the large volume of new housing inventory (thus aiding home builder companies) still on the market that couldn't be sold due to accelerating foreclosures and excess housing supply. At merely $75 billion allocated, HAMP had little effect as well. It was given a second boost, however, with the supplemental first-time homebuyers subsidy program enacted by Congress after the passage of the original $787 billion stimulus.

The official bank bailout programs of the Obama administration were largely programmatic cover for the real bank bailout strategy, which included Congress lifting the requirement that banks report their losses at true market value, suspending what was called mark to market accounting. Banks could now legally lie and misrepresent their actual losses and bad assets, making them appear more profitable. A second measure was the Administration's way to make it appear that the big 19 banks were not insolvent. The third was the Administration's encouragement of the banks to engage once again in trading—i.e., speculative investing in offshore financial markets in order to quickly raise profits. And bank profits did rise as a result. The combination of false accounting, phony stress tests, and renewed speculation did the trick. Stockholders re-entered the market buying bank common stocks, further capitalizing bank losses.

All these measures originated circa April 2009, once it became clear PIPP and TALF were essentially dead on arrival. Almost immediately bank stock prices surged. Speculative profits flowed in, enabling bank stock prices to continue to grow. This continued throughout 2009 into early 2010, when a host of events slowed bank profit accumulation and stock price gains. In the interim, however, the big 19 banks did accumulate a hoard of about $1 trillion in cash—although their bad assets, according to the International Monetary Fund, still amounted to about twice that amount. Further banking collapse had been avoided, but at the cost of more than $3 trillion in loans and spending by the Fed, the FDIC, and other government bank bailout agencies. The bad assets had been offset, temporarily, but at the cost of a corresponding increase in bad assets on the public balance sheet of the U.S. government.

On the fiscal side, the Obama $787 billion official package of spending and tax cuts was even less successful. Half of it was comprised of tax cuts, mostly targeting business, nearly all of which had little impact over the next 18 months. On the spending side, the remaining $400 billion or so was not designed to create jobs. The stimulus was primarily designed to offset the growing consumption collapse by spending on extended unemployment insurance, subsidizing medical insurance premiums for the millions more newly unemployed, plugging up state and local governments' massive loss of tax revenues due to the deep recession, providing aid to schools, and a one-time $250 check to social security recipients.

While useful measures in the very short run, these programs did not generate jobs any more than did the business tax cuts. In other words, it was a completely "free market" approach to ending the crisis. The Obama strategy was never to create jobs directly, but to buy time for markets to recover to do the task.

Dissecting GDP and a Faltering Recovery

In the third quarter of 2009, the first positive growth of Gross Domestic Product (GDP) occurred, at a 3.5 percent rate. However, almost all of that growth was the consequence of two programs, cash for clunkers and first time homebuyers credit, plus a slowdown in the rate of inventory depletion compared to the previous quarter, which gets recorded as a technical growth in GDP. The first two programs accounted for nearly two-thirds of the 3.5 percent and inventory technicalities just under another third. In other words, the $787 billion stimulus accounted for less than .5 percent of the 3.5 percent. In the fourth quarter, GDP surged even more, at 5.7 percent. But 3.5 percent of that was technical inventory adjustment. Another .5 percent was due to a manufactured export surge driven by Asian and European demand for U.S. products, which had become more competitive as the dollar declined. Another 1 percent was due to the twin supplemental programs, leaving less than 1 percent due to the original stimulus.

In the first quarter of 2010, GDP began to falter after only two quarters, to 3.0 percent. This reversal was significant. In normal recessions, for example, GDP growth continues to accelerate beyond two quarters and at levels far higher than what has been occurring this time. Typically, GDP growth surges at quarterly rates of 8-9 percent for at least four quarters. Moreover, 1.6 percent (or more than half) of the 3.0 percent gain was again due to inventory change, with another .75 percent due to cash for clunkers boosted by its announced discontinuation at quarter's end and a similar surge in first time homebuyers also anticipated to be ending at the time. The remainder first quarter growth was due to exports-manufacturing, driven by foreign factors once again. Data for the second quarter of 2010 is not yet available but may well show a further slowing in GDP growth rates.

The point of the above data is twofold. First, what growth and economic recovery has occurred since mid-2009 has been driven by temporary programs, temporary adjustment factors, and exports. The $787 billion has had little effect due to its poor composition of spending, excessive business tax focus, and insufficient magnitude. Second, the temporary factors driving the last 12 months of tepid growth have come or are about to come to an end. As of June 2010, both the cash for clunkers and first time homebuyers programs have been suspended. Both the auto sales and housing construction blip likely only pulled future sales into the present, rather than generated net additional long-term output. The technicalities of inventory adjustment have all taken place. And the export-manufacturing mini-surge is about to end, as China, Brazil, and other countries have recently moved to cool off their economies and the dollar rises against the Euro. Finally, the Federal Reserve is preparing to raise interest rates once the November elections are over, and will no longer buy back trillions in bad mortgages.

It is increasingly clear that the deficit cutting hawks are gaining momentum in Congress. States, cities, and school districts will turn to massive layoffs, wage cutting, and local tax hikes as a consequence—all of which will impose further pressure on an already slowing economy. Should Democrats lose further seats in the House and Senate, a highly likely event, federal spending will be almost certainly be further reduced in 2011. Even extending unemployment benefits has run into trouble at mid-2010 and both parties in Congress have agreed that the unemployed will no longer have medical insurance premiums subsidized by government spending.

The Truth About Jobs

Perhaps the best indicator of the faltering recovery is the jobs numbers since January 2010. Much has been said about the economy having turned the corner based on an alleged positive upturn in job creation. But a closer look reveals, for example, that since January a total of 575,000 federal jobs have been created. But 574,000 of these have been temporary federal census workers, who will be rapidly laid off in the fourth quarter of 2010. In addition, state and local governments have shed 81,000 jobs through May 2010. In the private sector of the economy, of the 495,000 jobs added, a total of 468,000 were involuntary part-time workers. At the same time, hundreds of thousands of full-time permanent jobs have been eliminated. The picture is one of a heavy churning of jobs, from regular full-time to temporary and part-time, the latter of which are paid far less and with few benefits.

The duration of unemployment has continued to rise, on a base that is already the worst since records were first kept of the statistic. There are reportedly six workers for every job opening. One in four workers in the U.S. labor force has experienced some period of unemployment since the crisis began, also an unprecedented figure. The true total jobless, when properly calculated, are between 23-25 million, not the official 15 million. And these don't account for the tens of millions of inner city youth, undocumented, and itinerant workers who are never interviewed by the Labor Dept. in its estimating of unemployment rates. These groups no doubt suffer from an even higher jobless rate. The true level of jobless workers is thus likely in excess of 25 million and the true, effective unemployment rate between 18 to 19 percent. To recover the jobs lost since the current recession began in December 2007 would require hiring more than 300,000 workers every month from now until 2017. Some key conclusions from the second 18 months of the recent crisis are:

  • The Obama administration's bank bailout strategy was in essence no different than Bush's, with the exception that even more money was thrown at the banks on even more generous terms; trillions of dollars of bad assets still remain on bank balance sheets, threatening future instability
  • Despite massive injections of money and liquidity by the Federal Reserve, banks have continued to reduce lending
  • Obama's primary focus on getting credit flowing again has not produced its declared, intended results
  • Bailing out the banks and putting a floor under the banking system collapse is not sufficient to generate a sustained recovery
  • The Obama short term strategy to subsidize banks, state and local governments, and the unemployed and stave off further collapse relied on market forces to generate sustained recovery, but the markets have failed to do so
  • The Obama stimulus package's spending had little to do with the job creation necessary to break out from long-term stagnation

It appears the Obama focus on allowing banks to return to speculative activity to generate capital and profits to offset losses has gone as far as possible, with bank stock prices and profits now flattening once again and more than half of bad assets and losses still remaining on bank balance sheets. Similarly, it appears the strategy of relying ultimately on bank lending to generate sustained GDP and job creation has begun to dissipate as well. Prospects for continued, let alone accelerating, GDP growth appear increasingly limited for the remainder of 2010 and 2011.

Threats to Recovery in 2010 and Beyond

The longer run scenario for the U.S. economy is not particularly positive. Jobs and housing continue to represent a serious problem for the economy, and appear to be heading for further softening rather than recovery. Twenty-five million jobless and seven million foreclosures represent serious consumption fragility in the system.

And those two figures do not tell the full story of jobs' and housing's negative impact on consumption and the economy. The hiring that has occurred has been at lower pay and fewer benefits levels. Higher paid full-time jobs continue to disappear at the rate of tens and hundreds of thousands a month. Mass layoffs will soon hit the public employee sector in 2011, adding still further to the job losses at a time when the 600,000-plus temporary government census workers will have also just been laid off in late 2010.

Wage cutting via furloughs, benefit cuts, shorter work weeks, and lower entry pay have also been reducing the consumption base still further. Housing construction and sales, already off 75 percent from pre-crisis highs in 2006, have begun to weaken once again and home prices are predicted to fall a further 10 to 20 percent in the period ahead. Foreclosures are also forecast to rise further. One in five mortgages will foreclose or default in the current cycle, and between 30 to 40 percent home values are already under water This is not a scenario for positive consumption growth or sustainable economic recovery.

States and cities in the U.S. are simultaneously facing a growing fiscal crisis. Over the past year, reductions in state and local government spending more than offset the amount of the Obama fiscal stimulus. Little attention has been given to that fact or the full dimension of the local government fiscal crisis. And that crisis will further worsen in the year ahead, as it appears that federal subsidies to the states will not continue as deficit cutting becomes the mantra of politicians at the federal level. Local government will be forced to raise taxes still further, as it lays off hundreds of thousands at minimum and reduces pay and benefits for millions more. To complicate local government financial stress further, signs of trouble have begun to reappear anew in the municipal bond markets. Should a crisis re-emerge here, the fiscal crisis, layoffs, and tax hikes by state and local government will intensify several fold.

The slowdown in government spending at all levels, within a context of further housing deterioration, job losses, and wage decline is not a scenario for robust recovery. It is impossible to imagine a V-shape trajectory with just these three—jobs, housing, government spending—thus deteriorating further.

The private sector shows additional signs of growing weakness as well. Most notable, the U.S. manufacturing-export sector's recent modest revival will likely fade as well in the coming months, due to China and other Asian economies' slowing as policymakers try to cool off growing bubbles in real estate and stocks, which will slow demand for U.S. exports. Also, the falling Euro against the U.S. dollar will make U.S. exports more expensive, leading to Germany and other economies displacing U.S. export sales.

Despite the multi-trillion dollar bailout of the banks, there remain serious points of stress on the financial side as well as a growing risk of further financial instability in the future. As of mid-2010, bank stocks are falling and bank profits leveling off. Should recently passed financial regulation in Congress limit banks' trading with hedge funds and other conduits to speculative markets globally, then bank profits and stock prices will decline further in the year ahead. Banks' diverting of funds to speculative markets has resulted in a serious decline in bank lending to small-medium businesses in the U.S. over the past year and this will likely continue. Although the big banks are sitting on and hoarding more than a trillion in cash, they will continue to restrict lending to U.S. businesses due to uncertainty about bank regulation, bank taxes, and increased capital requirements mandated by recent financial legislation.

The second tier of 7,800 regional-community banks is in even worse shape. Close to 300 have already failed or been merged by the FDIC, whose funds for future consolidation of local banks will require hundreds of billions of dollars. The commercial property market, on which these banks depend heavily, shows few signs of recovery. Almost 800 tier-two banks remain on the FDIC's trouble list and at risk of collapse or merger.

The Fed has been unable to revive the securitized markets for commercial and residential mortgages, which only a few years ago amounted to nearly $2 trillion and today account for less than $100 billion in loans. To complicate the mortgage picture further, the quasi-government agencies, Fannie Mae and Freddie Mac, which are required to buy up bad mortgages by law, are themselves moving toward a further financial crisis. Already having been subsidized by $200 billion from the U.S. government, they will soon need another $200 billion to keep going. Even hedge funds and other shadow banks, that had enjoyed a significant recovery in 2009, are showing signs of difficulty. Having lost $700 billion during the 2008-09 financial implosion, the funds recovered more than half of that loss last year. In 2010, however, losses have once again returned. Financial instability is growing as well in the municipal bond market and among pension funds, both public and private.

But the biggest risk to financial fragility and instability is the potential impact of government debt crises beginning to appear in Europe at mid-year, and the likely impact on Euro bank losses and on U.S. banks in the months ahead. Globally, bank exposures to potential losses in the European periphery countries of Greece, Spain, Portugal, and Ireland at mid-year amount to $2.6 trillion, according to data released in June by the Bank for International Settlements—i.e. the bank for central banks—located in Switzerland. European banks are exposed to $1.7 of the $2.6 trillion. It is likely that U.S. banks account for at least $500 billion of the remaining amount. French and German banks alone are exposed to more than $950 billion of the debt of those four countries. And that does not include other countries in trouble, like Italy, Hungary, and elsewhere in Europe. The potential risk is likely even much higher than reported. Given this pending financial instability, in a repeat of the U.S. in 2007-08, European banks have begun to stop lending to each other. Should a chain reaction implosion occur in Europe, sovereign debt losses promise to cascade to Euro bank losses and to U.S. banks as well. A third global financial implosion would consequently follow. The effects of that on the real economy globally, and in the U.S., would be significant.

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