Summary: this series speculates about the consequences of a deep and long recession over the next few years. How might we react? How might this change America? The first post examined our alternatives. This post discusses possible changes in our financial system. The last chapter looks at the effect on Americans, and America. Our next President will face these challenges, so your vote in November is important! This series is an expanded version of my post of 12 February.
Politics
All large-scale economic events have a decisive political component. Edward Carter Glass, Robert Taft, and Mellon will have their modern equivalents in this down cycle — advocating the hard path that leads to long-term prosperity. We already hear similar recommendations. Are they correct? Ask God, 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.
The stars seem to align now for bold political action.
a) Federal Reserve Chairman Bernanke is an interventionist and Statist. His reading of the Great Depression means he will fail because of insufficiently large and bold actions.
b) With the Democrats probably sweeping the 2008 elections, the activist-statist view will have veto-proof Congressional Support.
c) Not that vetoes will be needed. McCain’s record suggests a man who loves bold actions, with near-zero understanding of economics or history to restrain or guide him. The more likely IMO winner, Obama, has the record and writings of a doctrinaire leftist. We can expect bold actions from him to remold us to a form more suited for his visions.
d) The Supreme Court will also change composition in the next 8 years, with 3 judges expected to retire quickly — giving the activists a strong majority to act in the majestic manner of priest-kings
A Scenario
Many economists forecasting a serious recession, like that of 1973-75 or 1980-82, warn that it might have calamitous consequences. The most likely and serious would be large-scale collapse of the US residential and commercial mortgage systems. Massive foreclosures, bankruptcies. Deep price declines in financial and real assets. Massive capital losses at financial institutions, leading to bank failures.
It is easy to say that this will not happen. It will not. Determining what would stop these things is more difficult. Here are few guesses.
We will nationalize the banking system
The US is already moving towards de facto nationalization of banks, as loans by the Fed (and foreign governments) become their primary source of new capital. A broad recession will accelerate the deterioration in both households and businesses, so that this nationalization process must continue. The large scale state interventions advocated by several of the leading Presidential candidates (e.g. Clinton) indicate what we could then expect.
Nationalization can be done in many ways. We cannot predict the details, as they depend on choices we do not yet understand.
a) Open, direct action — welcome to the “First And Only Federal Bank of Hometown.”
b) De facto, making the government-sponsored (e.g., FNMA) and government agencies (e.g., GNMA, FHA) foundational elements of the system — but keeping the private banks as “fronts” — collecting deposits, processing checks, originating and servicing loans.
c) Light but firm control, as Japan did: prop up the banks with lightly hidden government help and wait for natural forces to “heal” the economy over time.
If you listen carefully, you will hear the whispers about what is to come. Here is an excerpt from the American Securitization Forum conference (4 February 2008):
“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.
There are many ways this could be done. The Fed could expand its loans to banks in both size and duration, as Japan did when they re-capitalized their banks via convertible preferred stock. Or this could be done through the government-sponsored mortgage agencies, or even by direct Federal action.
For example, by allowing exchanging existing mortgages for a 30-year low interest fixed mortgage. In turn these could be government guaranteed and swapped to institutions for their existing MBS. Done well this might require relatively little cash outlays (hence minimal adverse fiscal impact), but would have severe impact on the government’s balance sheet (but of course as yet few care about such things).
Other aspects of nationalization
a) It would require severe legislative action, of dubious constitutionality. Both have become commonplace during the past seventy years.
b) The cost would be great, but doable. The Iraq War has cost something in excess of $1 trillion, and counting — yet nobody cares or notices.
c) Combined with nationalization of the health care sector, this would represent a massive expansion of scope for the US government. This would be a major change in US public policy change, a repudiation of the post-1980 dominance of private-sector solutions. I doubt health care and finance would be the only sectors affected.
Will the rich, powerful financial sector allow this to happen?
Can the government take action against the interests of financial sector? Easily; look at our history. During a long, deep recession government policy makers might care little about Wall Street magnates. Andrew Mellon was a major guru in the 1920’s and early 1930’s. Then FDR waged a long, dirty battle to put him in jail. Waged from 1932 – 1937, Mellon was acquitted in December 1937, after his death. “Malefactors of great wealth” might again become election year fodder. Seldom have so many made so much so fast and so easily — speaking of CEO’s and Wall Street tycoons and speculators.
If the downturn is severe, financial institutions might beg for nationalization. As we see here: “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.
Please share your comments by posting below (brief and relevant, please), or email me at fabmaximus at hotmail dot com (note the spam-protected spelling).
For more information about this subject
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A brief note on the US Dollar. Is this like August 1914? (8 November 2007) — How the current situation is as unstable financially as was Europe geopolitically in early 1914.
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The post-WWII geopolitical regime is dying. Chapter One (21 November 2007) — Why the current geopolitical order is unstable, describing the policy choices that brought us here.
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We have been warned. Death of the post-WWII geopolitical regime, Chapter II (28 November 2007) — A long list of the warnings we have ignored, from individual experts and major financial institutions (links included).
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Death of the post-WWII geopolitical regime, III – death by debt (8 January 2008) – Origins of the long economic expansion from 1982 to 2006; why the down cycle will be so severe.
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Geopolitical implications of the current economic downturn (24 January 2008) – How will this recession end? With re-balancing of the global economy, so that the US goods and services are again competitive. No more trade deficit, and we can pay out debts.
- A happy ending to the current economic recession (12 February 2008) – The political actions which might end this downturn, and their long-term implications.
- What will America look like after this recession? (18 March 208) — More forecasts. The recession might change so many things, from the distribution of wealth within the US to the ranking of global powers.
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The most important story in this week’s newspapers (22 May 2008) — How solvent is the US government? They report the facts to us every year.
To see the all posts on this subject, go to the archive for The End of the Post-WWII Geopolitical Regime.
Fabius posted:
Other aspects of nationalization
a) It would require severe legislative action, of dubious constitutionality. Both have become commonplace during the past seventy years.
Well, good to know that we are following our founding father’s precepts.
What’s the nicest part about nationalization of the banking system?
1. No need to have any illusions about banking privacy – it simply won’t exist (not that it does, but there is at least somewhat of a polite facade).
2. A static, european distribution of wealth, where there is great wealth at the top of pyramid and little opportunity for those who are not in that category to ever achieve anything near it. Infinite opportunity for those who are in the wealthy category to legislate themselves into perpetual wealth as they will have effectively infinite resources to purchase influence and create entrenched interests.
Taxation burdens shifted further onto the population and deflationary effects inherent in such a scenario further entrenching monied interests into an aristocracy of wealth, rather than our current ‘meritocracy’ (loosely stated). Perhaps we should rename the Senate the “House of Lords”? Hardly a recipe for a dynamic nation but rather death by eurosclerosis until we lose our national identity to whichever ethnic, religious, or immigrant group reproduces sufficiently to replace those who currently consider themselves Americans who could not do so due to poverty or limited resources.
We fear Schumpterian destruction so much that we fail to allow ourselves to create. No birth without death. No boom without bust. No great edifices without dirt.
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Fabius Maximus replies: Nicely said! Esp #1 — not so much a polite facade as ignorance by their unsophisticated customers. Folks have no idea what the Patriot Act did to our financial system, and might riot in the streets if they knew.
I am just curious what it is going to take to turn around the falling dollar.
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Fabius Maximus replies: My answer is given here:
“Geopolitical implications of the current economic downturn” (24 January 2008) – How will this recession end? With re-balancing of the global economy, and a decline of the US dollar so that the our goods and services are again competitive. No more trade deficit, we can pay our debts, and little outflow of jobs.
Dollar devaluation is the main alternative to nationalization, and why I doubt that the extreme nationalization steps you foresee will occur. Instead, to avoid the deep recession, the interest rates will remain low and the dollar will continue to sink until the trade deficit is reduced. Recall that prior trade deficits were “balanced” by foreign investment into the US, as well as the build up of USD reserves in foreign national banks.
The key moral hazard is that fat cat bankers took high risks, looking for a receiving high, private returns as long as the housing market went up. Now that their assumed housing increases have stopped, they want the taxpayer/ USD user to reduce their losses.
Unfortunately, the elite have a point about the need to help the elite bankers continue to lend money for new businesses, even if those bankers lost a ton of cash on bad housing loans.
On the privacy issue, there won’t be riots until there are actual abuses that are publicized, not merely potential abuses. The IRS has long had so much info that claims of true privacy were a bit laughable. Huckabee’s Fair Tax is the only semi-realistic way to increase privacy, which is a (secret?) reason it will never eliminate the IRS — although we might get stuck with higher retail taxes AND the IRS (only to tax the rich!).
The Iraq War costs … yet nobody cares or notices This is a silly delusion. Obama’s chance at the presidency is precisely because so many DO care and DO notice — but if he loses it will be because folks like me, who care and notice, actually think the cost is worth the benefit.
There’s a LOT less caring or noticing about slo-mo genocide in Darfur, Zimbabwe non-democracy, Nl. Korean near starvation of its people, continued Chinese occupation of Tibet, Burmese dictators — all of which are far worse global problems.
Similarly US Social Security and expanding Medicare have received less care or notice, but are hugely more expensive. If the USA is to fight, it’s clear that the US military should do it — there is no good substitute for gov’t. Retirement and health insurance should both be provided by middle class individuals themselves, and NOT the gov’t.
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Fabius Maximus replies: I agree that a devaluation is the most likely eventual path to resolve the extraordinary global imbalances. This scenario is described in “Geopolitical implications of the current economic downturn.” “How will this recession end? My guess: with re-balancing of the global economy and a decline of the US dollar so that the our goods and services are again competitive. No more trade deficit, we can pay our debts, and there will be no serious outflow of jobs.”
We are already seeing incerased exports due to the dollar’s fall over the past few years. This has been the major support for our economy this year. But recovering lost markets and building export capacity (e.g., trained workers, build factories and transportation systems) is a long, slow process.
De-leveraging — defaults in household and business loans, which slow the economy, which leads to more default — runs much faster.