[Dialogue] A good analysis of the situation and the options

[KroegerD at aol.com]

The  Political Nature of the Economic Crisis

September  30, 2008
 
 


 



 (http://www.stratfor.com/) By George Friedman 
Classical economists like Adam Smith and David Ricardo referred to their  
discipline as “political economy.” Smith’s great work, “The Wealth of Nations,” 
 was written by the man who held the chair in moral philosophy at the 
University  of Glasgow. This did not seem odd at the time and is not odd now. 
Economics is  not a freestanding discipline, regardless of how it is regarded today. 
It is a  discipline that can only be understood when linked to politics, since 
the wealth  of a nation rests on both these foundations, and it can best be 
understood by  someone who approaches it from a moral standpoint, since 
economics makes  significant assumptions about both human nature and proper behavior. 
 
The modern penchant to regard economics as a discrete science parallels the  
belief that economics is a distinct sphere of existence — at its best when it 
is  divorced from political and even moral considerations. Our view has always 
been  that the economy can only be understood and forecast in the context of 
politics,  and that the desire to separate the two derives from a moral 
teaching that Smith  would not embrace. Smith understood that the word “economy” 
without the  adjective “political” did not describe reality. We need to bear 
Smith in mind  when we try to understand the current crisis. 
Societies have two sorts of financial crises. The first sort is so large it  
overwhelms a society’s ability to overcome it, and the society sinks deeper 
into  dysfunction and poverty. In the second sort, the society has the resources 
to  manage the situation — albeit at a collective price. Societies that can 
manage  the crisis have two broad strategies. The first strategy is to allow 
the market  to solve the problem over time. The second strategy is to have the 
state  organize the resources of society to speed up the resolution. The market 
 solution is more efficient over time, producing better outcomes and 
disciplining  financial decision-making in the long run. But the market solution can 
create  massive collateral damage, such as high unemployment, on the way to the 
superior  resolution. The state-organized resolution creates inequities by 
not  sufficiently punishing poor economic decisions, and creates long-term  
inefficiencies that are costly. But it has the virtue of being quicker and  
mitigating collateral damage.  
Three Views of the Financial Crisis
There is a first group that argues _the current financial crisis_ 
(http://www.stratfor.com/analysis/20080926_intelligence_guidance_week_sept_28_2008)  
already has outstripped available  social resources, so that there is no market or 
state solution. This group  asserts that the imbalances created in the 
financial markets are so vast that  the market solution must consist of an extended 
period of depression. Any  attempt by the state to appropriate social 
resources to solve the financial  imbalance not only will be ineffective, it will 
prolong the crisis even further,  although perhaps buying some minor alleviation 
up front. The thinking goes that  the financial crisis has been building for 
years and the economy can no longer  be protected from it, and that therefore an 
extended period of discipline and  austerity — beginning with severe economic 
dislocations — is inevitable. This is  not a majority view, but it is 
widespread; it opposes government action on the  grounds that the government will 
make a terrible situation worse. 
A second group argues that the financial crisis has not outstripped the  
ability of society — organized by the state — to manage, but that it has  
outstripped the market’s ability to manage it. The financial markets have been  the 
problem, according to this view, and have created a massive liquidity  crisis. 
The economy — as distinct from the financial markets — is relatively  sound, 
but if the liquidity crisis is left unsolved, it will begin to affect the  
economy as a whole. Since the financial markets are unable to solve the problem  
in a time frame that will not dramatically affect the economy, the state must  
mobilize resources to impose a solution on the financial markets, introducing 
 liquidity as the preface to any further solutions. This group believes, like 
the  first group, that the financial crisis could have profound economic  
ramifications. But the second group also believes it is possible to contain the  
consequences. This is the view of the Bush administration, _the congressional 
leadership_ 
(http://www.stratfor.com/geopolitical_diary/20080928_geopolitical_diary_congress_plan_u_s_financial_sector) , the Federal Reserve Board and  
most economic leaders. 
There is a third group that argues that _the state mobilization of resources 
to save the financial  system_ 
(http://www.stratfor.com/analysis/global_market_brief_mortgage_bailout_plan_and_u_s_economy)  is in fact an attempt to save 
financial institutions, including many  of those whose imprudence and avarice 
caused the current crisis. This group  divides in two. The first subgroup 
agrees the current financial crisis could  have profound economic consequences, but 
believes a solution exists that would  bring liquidity to the financial 
markets without rescuing the culpable. The  second subgroup argues that the threat 
to the economic system is overblown, and  that the financial crisis will 
correct itself without major state intervention  but with some limited 
implementation of new regulations.  
The first group thus views the situation as beyond salvation, and certainly  
rejects any political solution as incapable of addressing the issues from the  
standpoint of magnitude or competence. This group is out of the political 
game  by its own rules, since for it the situation is beyond the ability of 
politics  to make a difference — except perhaps to make the situation worse.  
The second group represents the establishment consensus, which is that the  
markets cannot solve the problem but the federal government can — provided it  
acts quickly and decisively enough.  
_The third group spoke Sept. 29_ 
(http://www.stratfor.com/podcast/20080930_congressmen_began_count_cost_their_decision_markets_head_south) , when a 
coalition of Democrats  and Republicans defeated the establishment proposal. For a 
myriad of reasons,  some contradictory, this group opposed the bailout. The 
reasons ranged from  moral outrage at protecting the interests of the perpetrators 
of this crisis to  distrust of a plan implemented by this presidential 
administration, from  distrust of the amount of power ceded the Treasury Department 
of any  administration to a feeling the problem could be managed. It was a 
diverse group  that focused on one premise — namely, that _delay would not lead 
to economic catastrophe_ 
(http://www.stratfor.com/geopolitical_diary/20080915_geopolitical_diary_measuring_danger) . 
>From Economic to Political Problem
The problem ceased to be an economic problem months ago. More precisely, _the 
economic problem has transformed into a political problem_ 
(http://www.stratfor.com/geopolitical_diary/20080929_geopolitical_diary_crises_washington_wall_st
reet) .  Ever since _the collapse of Bear Stearns_ 
(http://www.stratfor.com/analysis/global_market_brief_bear_stearns_bailout_and_calls_oversight) , the 
primary actor in the drama  has been the federal government and the Federal 
Reserve, with its powers  increasing as the nature of potential market outcomes 
became more and more  unsettling. At a certain point, the size of the problem 
outstripped the  legislated resources of the Treasury and the Fed, so they went 
to Congress for  more power and money. This time, they were blocked.  
It is useful to _reflect on the  nature of the crisis_ 
(http://www.stratfor.com/subprime_geopolitics) . It is a tale that can be as complicated as you wish 
to  make it, but it is in essence simple and elegant. As interest rates 
declined in  recent years, investors — particularly conservative ones — sought to 
increase  their return without giving up safety and liquidity. They wanted 
something for  nothing, and the market obliged. They were given instruments 
_ultimately based on mortgages on private homes_ 
(http://www.stratfor.com/u_s_subprime_mortgages_and_markets_update) . They therefore  had a very real asset base 
— a house — and therefore had collateral. The value  of homes historically 
had risen, and therefore the value of the assets appeared  secured. Financial 
instruments of increasing complexity eventually were devised,  which were 
bought by conservative investors. In due course, these instruments  were bought by 
less conservative investors, who used them as collateral for  borrowing money. 
They used this money to buy other instruments in a pyramiding  scheme that 
rested on one premise: the existence of houses whose value remained  stable or 
grew. 
Unfortunately, _housing prices declined_ 
(http://www.stratfor.com/geopolitical_diary/20080915_geopolitical_diary_measuring_danger) . A period of 
uncertainty about the  value of the paper based on home mortgages followed. People 
claimed to be  confused as to what the real value of the paper was. In fact, they 
were not so  much confused as deceptive. They didn’t want to reveal that the 
value of the  paper had declined dramatically. At a certain point, the facts 
could no longer  be hidden, and vast amounts of value evaporated — taking with 
them not only the  vast pyramids of those who first created the instruments and 
then borrowed  heavily against them, but also the more conservative investors 
trying to put  their money in a secure space while squeezing out a few extra 
points of  interest. The decline in housing prices triggered massive losses of 
money in the  financial markets, as well as reluctance to lend based on 
uncertainty of values.  The result was a liquidity crisis, which simply meant that a 
lot of people had  gone broke and that those who still had money weren’t 
lending it — certainly not  to financial institutions. 
The S&L Precedent
Such financial meltdowns based on shifts in real estate prices are not new.  
In the 1970s, regulations on savings and loans (S&Ls) had changed.  
Previously, S&Ls had been limited to lending in the consumer market,  primarily in 
mortgages for homes. But the regulations shifted, and they became  allowed to 
invest more broadly. The assets of these small banks, of which there  were 
thousands, were attractive in that they were a pool of cash available for  investment. 
The S&Ls subsequently went into commercial real estate,  sometimes with their 
old management, sometimes with new management who had  bought them, as their 
depositors no longer held them.  
The infusion of money from the S&Ls drove up the price of commercial real  
estate, which the institutions regarded as stable and conservative investments,  
not unlike private homes. They did not take into account that their presence 
in  the market was driving up the price of commercial real estate i
rrationally,  however, or that commercial real estate prices fluctuate dramatically. As  
commercial real estate values started to fall, the assets of the S&Ls  
contracted until most failed. An entire sector of the financial system simply  
imploded, crushing shareholders and threatening a massive liquidity crisis. By  the 
late 1980s, the entire sector had melted down, and in 1989 the federal  
government intervened. 
The federal government intervened in that crisis as it had in several crises  
large and small since 1929. Using the resources at its disposal, the federal  
government took over failed S&Ls and their real estate investments, creating  
the Resolution Trust Corp. (RTC). The amount of assets acquired was about 
$394  billion dollars in 1989 — or 6.7 percent of gross domestic product (GDP) — 
 making it larger than the $700 billion dollars — or 5 percent of GDP — 
being  discussed now. Rather than flooding the markets with foreclosed commercial  
property, creating havoc in the market and further destroying assets, the RTC 
 held the commercial properties off the market, maintaining their price  
artificially. They then sold off the foreclosed properties in a multiyear  
sequence that recovered much of what had been spent acquiring the properties.  More 
important, it prevented the decline in commercial real estate from  
accelerating and creating liquidity crises throughout the entire economy. 
Many of those involved in S&Ls were ruined. Others managed to use the RTC  
system to recover real estate and to profit. Still others came in from the  
outside and used the RTC system to build fortunes. The RTC is not something to  
use as moral lesson for your children. But the RTC managed to prevent the  
transformation of a financial crisis into an economic meltdown. It disrupted  
market operations by introducing large amounts of federal money to bring  liquidity 
to the system, then used the ability of the federal government — not  shared 
by individuals — to hold on to properties. The disruption of the market’s  
normal operations was designed to avoid a market outcome. By holding on to the  
assets, the federal government was able to create an artificial market in real 
 estate, one in which supply was constrained by the government to manage the  
value of commercial real estate. It did not work perfectly — far from it. But 
it  managed to avoid the most feared outcome, which was a depression. 
There have been many other federal interventions in the markets, such as the  
bailout of Chrysler in the 1970s or the intervention into failed Third World  
bonds in the 1980s. _Political interventions in the American (or global)  
marketplace_ 
(http://www.stratfor.com/analysis/20080919_u_s_market_intervention_far_unprecedented_move)  are hardly novel. They are used to control the 
consequences of  bad decisions in the marketplace. Though they introduce 
inefficiencies and  frequently reward foolish decisions, they achieve a single end: 
limiting the  economic consequences of these decisions on the economy as a whole. 
Good idea or  not, these interventions are institutionalized in American 
economic life and  culture. The ability of Americans to be shocked at the thought of 
bailouts is  interesting, since they are not all that rare, as judged 
historically. 
The RTC showed the ability of federal resources — using taxpayer dollars — 
_to control financial processes_ 
(http://www.stratfor.com/analysis/global_market_brief_takeover_twins) . In the end, the S&L story  was simply one of bad 
decisions resulting in a shortage of dollars. On top of a  vast economy, the U.S. 
government can mobilize large amounts of dollars as  needed. It therefore can 
redefine the market for money. It did so in 1989 during  the S&L crisis, and 
there was a general acceptance it would do so again  Sept. 29. 
The RTC Model and the Road Ahead
As discussed above, the first group argues the current crisis is so large  
that it is beyond the federal government’s ability to redefine. More precisely,  
it would argue that the attempt at intervention would unleash other 
consequences  — such as _weakening dollars_ 
(http://www.stratfor.com/weekly/china_and_arabian_peninsula_market_stabilizers)  and inflation — meaning the cure would 
be  worse than the disease. That may be the case this time, but it is difficult 
to  see why the consequences of this bailout would be profoundly different 
from the  RTC bailout — namely, a normal recession that would probably happen 
anyway. 
The debate between the political leadership and those opposing its plan is  
more interesting. The fundamental difference between the RTC and the current  
bailout was institutional. Congress created a semi-independent agency operating 
 under guidelines to administer the S&L bailout. The proposal that was  
defeated Sept. 29 would have given the secretary of the Treasury extraordinary  
personal powers to dispense the money. Some also argued that the return on the  
federal investment was unclear, whereas in the RTC case it was fairly clear. In 
 the end, all of this turned on the question of urgency. The establishment 
group  argued that time was running out and the financial crisis was about to 
morph  into an economic crisis. Those voting against the proposal argued there 
was  enough time to have a more defined solution.  
There was obviously a more direct political dimension to all this. Elections  
are just more than a month a way, and the seat of every U.S. representative 
is  in contest. The public is deeply distrustful of the establishment, and  
particularly of the idea that the people who caused the crisis might benefit  
from the bailout. The congressional opponents of the plan needed to demonstrate  
sensitivity to public opinion. Having done so, if they force a redefinition of 
 the bailout plan, an additional 13 votes can likely be found to pass the  
measure. 
But the key issue is this: Are the resources of the United States sufficient  
to redefine financial markets in such a way as to manage the outcome of this  
crisis, or has the crisis become so large that even the resources of a $14  
trillion economy mobilized by the state can’t do the job? If the latter is 
true,  then all other discussions are irrelevant. Events will take their course, 
and  nothing can be done. But if that is not true, that means that politics 
defines  the crisis, as it has other crisis. In that case, the federal government 
can  marshal the resources needed to redefine the markets and the key 
decision-makers  are not on Wall Street, but in Washington. Thus, when the chips are 
down, the  state trumps the markets. 
All of this may not be desirable, efficient or wise, but as an empirical  
fact, it is the way American society works and has worked for a long time. We  
are seeing a case study in it — including the possibility the state will refuse  
to act, creating an interesting and profound situation. This would allow the  
market alone to define the outcome of the crisis. This has not been allowed 
in  extreme crises in 75 years, and we suspect this tradition of intervention 
will  not be broken now. The federal government will act in due course, and an  
institutional resolution taking power from the Treasury and placing it in 
_the equivalent of the RTC_ 
(http://www.stratfor.com/analysis/20080919_global_market_brief_biggest_piece_plan)  will emerge. The question is how  much time 
remains before massive damage is done to the economy. 
_Tell  Stratfor What You Think_ (http://www.stratfor.com/cont
act?type=responses&subject=RE:+The+Political+Nature+of+the+Economic+Crisis)  
This report may be forwarded or republished on your website with attribution  
to _www.stratfor.com_ (http://www.stratfor.com/) 





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