History shows the difficulty of predicting the short-term path of economic or political events. However, we can often see the medium-term with greater clarity. In January 1942 none could forecast the events of the next 44 months, but it did not take an expert to see that the US would defeat Japan. So it is with the current economic down cycle in America.
This series describes (see the list at the end) how we have begun to reduce the massive debts the US private sector has accumulated over the past two generations. As I said here, there are only four ways to get rid of one’s excess debt (that, debt that cannot be repaid):
1. Growth: given time and rapid wage growth, the debt burden becomes manageable. We pay it off ever more easily as incomes grow. That was the dream solution to America’s high levels of household debt and large long-term government obligations. It burst in 2000, and will not return in time to help us.
2. Inflation, reducing the real weight of our debt. This requires two things. First, real growth in wages (no signs of this). Second, either the cooperation or blindness of bond investors — they must either accept negative real after-tax yields, or remain oblivious to rising inflation. The consequences are severe if our creditors (domestic and foreign) rebel.
3. Debt can burn off the hard way as debtors default on their loans. Both recessions and declining home prices drive defaults (involuntary and voluntary, respectively). This is equivalent of surgery without anesthesia, resulting in bankruptcies, homelessness, decaying neighborhoods, and bank failures.
4. Socialization of the debt. The government can spread the burden of debt, in many different ways (that so many of our creditors are foreigners makes this more attractive).
- They can legislate to change contracts (e.g., mortgages): reducing interest rates and payment terms, preventing or slowing foreclosures. This spreads the debt burden from debtors to creditors.
- They can change the rules of the bankruptcy courts, with the same result as above – spreading the debt burden from debtors to creditors.
- They can directly intervene in the markets, extending loans (absorbing the resulting losses) or buying property from debtors or creditors (e.g., as the Resolution Trust Company did after the commercial real estate bust in the early 1990’s.)
Socialization is the seemingly easy path. Done well, we have reforms like those Solon instituted for Athens — laying the foundation for its future greatness. Done poorly, we have increased moral hazard leading to another cycle of rising debt and speculation – except that the next crash will imperil a larger part of the society, or even all of it.
It’s all about choice. Every downturn gives us the opportunity to determine what America will become. We weigh our fidelity to our principles, our history, our forefathers — vs. our ability to collectively withstand pain (financial, social, political). These are collective decisions, because all large-scale economic events have a decisive political component.
Speculation about the future
Inflation is impractical (for reasons too complex to discuss in this post). Large-scale defaults would likely lead to a deflationary collapse of our financial system. The government will not allow that to happen as the consequences would be apocalyptic. I believe that instead we will socialize the debt, the least-painful and most operationally feasible alternative.
Not all will agree. Robert Taft, and Andrew Mellon will have their modern equivalents, advocating the hard path that leads to long-term prosperity. President Hoover wrote in his Memoirs that Mellon, as Secretary of the Treasury, had
… only one formula: liquidate labor, liquidate stocks, liquidate the farmers, and liquidate real estate…. It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people.
We already hear similar recommendations. Are they correct? Ask God for when you see him, for the question is irrelevant in this world. Politicos adopting such views will find themselves unemployed after the elections of 2008 and 2010, in the dustbin of history alongside the Republican politicos defeated in 1932.
Nor will find allies at the Federal Reserve. Chairman Bernanke is an interventionist and Statist. He see these things through the prism of the Fed’s failures during the Great Depression. If he fails, it will NOT be for lack of large bold actions. Since I believe the Democrats will sweep the 2008 elections, those calling for strong solutions will have both Executive and Congressional Support. The Supreme Court will also change composition during the next eight years, with at least three Justices expected to retire quickly — giving the activists a strong majority on the Bench.
A Scenario (just a sketch due to keep the length tolerable)
The US is already moving towards #4 through de facto nationalization of the banks, as loans by the Fed (and foreign governments) become the primary source of new capital. The large scale government interventions advocated by several of the leading Presidential candidates (e.g. Clinton) indicate what we can expect if conditions continue to deteriorate.
A recession – especially if long and deep — will accelerate deterioration of both households and businesses, forcing this nationalization process to continue. The “Japan solution” is the course of least political resistance: prop up the banks with lightly hidden government help and wait for natural forces to “heal” the economy over time.
There are many ways to socialize the debt. The government (via the Fed or the Treasury) could expand its loans to banks in both size and duration, similar to what Japan did when they re-capitalized their banks with convertible preferred stock. Or government-sponsored mortgage agencies could be the hidden hand providing support. Either way, the mechanics are conceptually simple. For example, a government program could allow you to exchange your existing mortgage for a 30-year, low interest, fixed rate mortgage (non-refinancable, with recourse, principle and interest “government guaranteed” to the creditor). Done well this might require small cash outlays (hence minimal adverse fiscal impact), but would have severe impact on the government’s balance sheet (although few care about such things, yet).
This would require strong legislative action of dubious constitutionality. Neither is unprecedented in American history; both are commonplace in the past fifty years.
And for our second trick
Rescuing the financial system would not distract the Democratic Party from its major public policy goal: nationalization of the health care sector (like that of other western nations). Together these would represent a massive expansion in the scope of the US government, a repudiation of the post-1980 bias towards private-sector solutions.
Are banks are too powerful, so that this could never happen?
The major financial institutions probably will not object, as seen in this quote from the American Securitization Forum conference (4 February):
Merrill Lynch senior director Sarbashis Ghosh, in a session on RMBS research: “It’s not a subprime problem, it’s a housing leverage problem … we have people with a mortgage who simply cannot afford to make their payments.” Ghosh suggested the solution was “to address the question of leverage,” and went so far as to suggest something like a food stamp program to help borrowers with payments.
From “Wall Street Embraces Government to Avoid Recession, Bloomberg (1 Feb 2008) — Excerpt:
Alex Pollock, former president of the Federal Home Loan Bank of Chicago, urges the creation of a federal lending agency based on the Home Owners Loan Corp., or HOLC, created by Congress during the Great Depression. Robert Kuttner, co-founder of the Washington-based Economic Policy Institute, Senate Banking Committee Chairman Christopher Dodd and others have proposed similar ideas.
Many who are calling for action point to the 1930s, the last time the U.S. national median home price fell, as an example of what government should do. During the worst economic slump of the 20th century, HOLC issued tax-exempt bonds and used the proceeds for below-market- rate mortgages. It refinanced one-fifth of U.S. homes between 1933 and 1936 after negotiating with the original lenders to accept less than the amount owed on the defaulted mortgage.
… In the 1930s, lenders were seizing homes at an average rate of 3,000 a day, adjusted for today’s housing stock size. In the fourth quarter of 2007, new foreclosures averaged 2,939 a day, double the pace of a year earlier, according to RealtyTrac Inc., an Irvine, California-based real estate data company.
And if the banks resist? During a deep recession politicos might care little about Wall Street’s views. Andrew Mellon was a respected financial Titan in the early 20th century, America’s longest serving Treasury Secretary (1921 – 1932). The Great Depression made him a “malefactor of great wealth.” From 1932 – 1937 FDR waged a dirty battle to put him in jail. Mellon was acquitted in December 1937, only after his death.
But people who took on too much debt should suffer the consequences!
As a democracy, American values are determined by mass behavior. Divorce and abortions are bad, until lots of folks get them. Then they become empowering and life-affirming. Likewise the moral stigma of illegitimacy and bankruptcy have largely faded away. This may be happening now with bankruptcy and even voluntary mortgage defaults.
Consider the politics. Are legislators likely to miss an opportunity to help voters in the 50 million American households with mortgages? This is not just speculation. During the Depression several states (e.g., Minnesota) passed foreclosure moratoriums. There were also widespread “penny auctions” of farmers’ land and equipment at which his neighbors forcibly prevented competing bids.
That was generations ago, before the maturation of 4GW — of which mass popular action is an essential part (e.g., US civil rights and anti-Vietnam War protests). Mass action might appear much faster and with more impact than in the 1930’s.
Will these drastic measures work?
How do you define “success”? These measures will slow the decline, allowing natural forces to heal the economy (which did not work during the 1930’s) — albeit with large scale and unpredictable side-effects. The steps forecast here are only illustrative in nature, the first phase in the end of the post-WWII economic and geopolitical regime. Looking beyond these early steps takes us far into the unknown.
If you are new to this site, please glance at the archives below. You may find answers to your questions in these.
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For more information from the FM site
To read other articles about these things, see the FM reference page on the right side menu bar. Of esp relevance to this topic:
- about the Financial crisis – what’s happening? how will this end?
- about the America – how can we reform it?
- some Good News about America!
Posts about solutions to this economic downturn:
- How should we respond to the crisis?, 24 September 2008
- A solution to our financial crisis, 25 September 2008
- The last opportunity for effective action before disaster strikes, 3 October 2008 — How to stabilize the financial system.
- Effective treatment for this crisis will come with “The Master Settlement of 2009″, 5 October 2008
- Dr. Bush, stabilize the economy – stat!, 7 October 2008
- The new President will need new solutions for the economic crisis, 9 October 2008
- A brief note about our financial system: Intermediation, disintermediation, and soon re-intermediation, 16 October 2008
- New recommendations to solve our financial crisis (and I admit that I was wrong), 23 October 2008
- A look ahead to the end of this financial crisis, 30 October 2008
- Everything you need to know about government stimulus programs (read this – it’s about your money), 30 January 2009