[Oe List ...] Fwd: Stratfor on economic crisis

[Jack Gilles]

>
Dear Colleagues,

If you can stand another article on the current crisis I think you'll  
find the following one quite fair and balanced (with due  
acknowledgement to FOX News!).  I found it quite helpful to understand  
the situation and options before Congress.  I won't add any editorial,  
just enjoy.

G&P,

Jack
> The Political Nature of the Economic Crisis
>
> Stratfor Today »-- September 30, 2008
>
> 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 penchan t 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  
> 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, 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 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  
> wou ld 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, 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.
> 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. Ever since the collapse of Bear Stearns, 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. 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.  
> 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. 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 irrationally, 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 somethin g 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 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. 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 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 happe n 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 redef ine 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 will emerge.  
> The question is how much time remains before mass ive damage is done  
> to the economy.
>
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