Why All of Us Have to Keep Spending Like Crazy--Or Else!News at Home
I propose an update in two senses. First, I’ll do some history of crisis management and central banking, and then I’ll offer some, er, speculation on the near term causes and effects of the Fed’s agenda, as interpreted by Martin Wolf and certain lesser lights at FT and the New York Times.
My rewrite of their analysis eventually reaches a bottom line when I claim that the Fed has become the lender of last resort to the consumers who have kept the American economy afloat for the last ten, hell, the last sixty years—it no longer stands apart from the retail level of transactions, I will suggest, and in this sense it has become an emblematic institution of the consumer culture we inhabit.
That is a characterization, not a complaint. It may even be a compliment. For you can’t have socialism without monetary policies that favor consumption over saving and investment.
At the end of the 19th century there were three ways of explaining the onset of economic crisis.
(1) If you were an adherent of Say’s Law (our contemporary George Gilder still is), you saw crisis as a deviation from normality—that is, from equilibrium determined by two facts, or rather theorems. On the one hand, the revenue generated by goods production (wages, salaries, profits) was equal to the value of the goods produced, so there couldn’t be “overproduction” in the absence of financial chicanery. On the other hand, interest rates regulated the distribution of income between saving and consumption. For example, as interest rates on government securities fell—as saving became less lucrative—individuals would consume more, and vice versa.
(2) You could also grasp economic crisis as “disproportionality” (too much capital sunk in, say, railroads), usually created by monetary disturbance, for example by the Sherman Silver Purchase Act of 1890, which mandated the federal government to coin silver even though it had become something less than a precious metal with a stable price relative to gold. Here, too, financial chicanery played the leading role.
(3) Finally, you could see crisis as a function of surplus capital—not in one sector or another, as in disproportionalities induced by monetary disturbance, but across the board. In this view of things, crisis was an inevitable moment in a “business cycle,” but, when managed properly, crisis would become opportunity; for it would puncture bubbles and strip the market system of speculative or imprudent or criminal constituents (they could never be purged altogether, of course, because markets require such crass opportunists).
The Federal Reserve System was invented by people who embraced this last explanation of economic crisis, and who designed the tools of crisis management still in use (emergency lending, interest rate adjustments, mobilization of reserves, all to inject liquidity in times of stress). They thought of the banking system as the “headquarters” of the economy, because the purpose of bankers was to move assets from sector to sector according to their changing prospects. Because they straddled all the intersections between economic sectors, telling their customers where change could lead, they always wanted the big picture.
Even so, it was not bankers who invented the Fed. They played a crucial role, to be sure, but the social movement that created a central banking system here was a cross-class coalition that included merchants, industrialists, journalists, academics, and, yes, trade unionists. Their goal was not to subsidize the profits of bankers; it was to socialize market forces, to bend them to human purposes other than profit. They understood that the anarchy of the financial markets—the absence of a central bank that could coordinate crisis management—was a danger to development, and to democracy.
The “moral hazard” of crisis management (or of guaranteeing bank deposits) is the possibility of rewarding the speculative, imprudent, and criminal constituents of the market system as you go about saving it. If you prop the whole thing up by emergency lending and liquidity—if you resist massive deflation, default, disgrace, and other solutions supplied by free market forces—you may allow the inflation of values to continue, and thus further enable the irrational atrocities associated with speculation, imprudence, and criminality.
Thorstein Veblen, who was not a fan of banking or bankers, got it right in 1904: “This cumulative extension of credit through the enhancement of prices goes on, if otherwise undisturbed, so long as no adverse price phenomenon obtrudes itself with sufficient force to convict the cumulative enhancement of capitalized values of imbecility.” (The Theory of Business Enterprise, p. 55.)
But what if the banking system, under the leadership of the Fed itself, won’t, or rather can’t, allow this adverse price phenomenon to obtrude itself with sufficient force? What if the problem of “moral hazard” has no solution because we—that would be us consumers—are all at risk? What if the central banking system now functions as our lender of last resort because without our increasing debts, our inspired profligacy, the whole thing goes south?
To answer, I turn to Martin Wolf & Co. at the Financial Times and his counterpart at the NY Times. Let me start with David Leonhardt, who writes the “Economic Scene” column at the NY Times. In his piece of 8/22, he suggests that the Fed “could have tightened financial rules” during the housing boom—or bubble—and thus could have prevented the creative loans that flooded the mortgage market (for example, a third of the mortgages issued in 2005 were interest-only; subprime mortgages were 20% of those issued in 2006).
But there’s a catch. The folks at the Fed had watched the meltdown of Japan’s economy in the 1990s, after the central bank tried to prick a similar bubble by raising interest rates. The long deflation on that economic scene—it ain’t over yet—was not something our guys wanted to reproduce by introducing new constraints on consumer spending. So they waited. Leonhardt thinks they waited too long, but even he hedges his bet on preventive financial medicine: “A crackdown [on creative and subprime lending] wouldn’t have been without complications, given that the expansion of consumer credit in recent decades has been mostly a good thing [do tell!]. ‘It is a fine line to walk between protecting consumers and doing something that has the unintended consequence of preventing responsible lending,’ Sandra Braunstein, who oversees consumer issues at the Fed, told me yesterday. ‘And we’re always walking that fine line.’ ”
The very cranky but always lively Clive Crook over at the FT (8/23) fully agrees that a consumer-oriented Fed was reluctant to go down the Japanese road of deflation. “Regulated banks do little if any such lending [in the mortgage market]. Bank affiliates or independent mortgage companies have built the business—and they are, respectively, lightly regulated or virtually unregulated [on which compare Robert Brent Toplin at HNN, August 20, 2007]. They lent eagerly to borrowers of limited means, often on patently reckless terms . . .. Everything was premised on perpetually rising house prices. The Fed was worried, but mainly on consumer protection not systemic-risk grounds.”
Crook thinks more regulation of “non-bank lenders” is in order. He also thinks that the Fed should avoid the problem of “moral hazard” by supplying liquidity only at a “penalty rate” of interest; here he follows the advice of those who want the market to cleanse itself. But even he hedges his bet by suggesting the Fed should not cut its federal funds rate—it already opened a discount window a week ago to supply emergency funds to banks with clients strapped for cash—“unless there is evidence of harm spreading to the real economy.”
Most sentient observers other than Grover Norquist would agree with this imperative (he’s the village idiot on K Street who wants to abolish the income tax). But how and where do we locate this “real economy”? If growth is driven by consumer expenditures—not by private investment funded through corporate profits—then the Fed’s solicitous stance toward consumer protection during (and after) the housing bubble makes perfect economic sense. The policy-relevant question is, can it sustain this stance if consumption has become so conspicuously dependent on increasing, and increasingly risky, debt? To put it another way, is the Japanese road to deflation the only alternative to the “moral hazard” of continued reflation on behalf of consumers?
As usual, Martin Wolf has the answers. His FT column of 8/22 begins with a prescript from Ben Bernanke on the “global saving glut,” and goes on to explain why consumption financed out of deficits (just like during the Great Depression) is the key to both the Fed’s relative passivity during the housing boom and its frenetic activity in the aftermath. His short answer is that households in the USA—that is, consumers—have offset the lack of private investment by going into debt, and that the Fed validated this offset because it caused growth.
Here is the answer I need: “The recent household deficit more than offset the persistent financial surplus [the “saving glut”] in the business sector. For a period of six years—the longest since the second world war—US business invested less than its retained earnings.” That household deficit, defined as savings minus residential investment, has been the engine of economic growth since 2000, and everybody at the Fed knew it; by comparison, the move from surplus to deficit in the US government budget, from 2001 to 2003, was a blip on the traders’ screens.
And here is the long answer. “Nothing that has happened has been a product of Fed folly alone. Its monetary policy may have been loose too long. The regulators may also have been asleep. But neither point is the heart of the matter. Assume that the US remains a huge net importer of capital. Assume, too, that US business sees no reason to invest more than its retained profits. Assume, finally, that the government pursues a modestly prudent fiscal policy. Then US households must spend more than their incomes [to offset the size of the current account deficit, and to absorb—that is, to buy—the increase of Gross Domestic Product]. If they fail to do so, the economy will plunge into recession unless something else changes elsewhere.”
So the Fed clearly has no choice except to risk the “moral hazard” of propping up a mortgage market saturated by speculation, imprudence, and criminality. In the historical moment when net private investment became almost irrelevant as a source of economic growth—the moment named the “disaccumulation of capital” by the historian Martin J. Sklar—the Fed clearly had no choice except to validate consumer preferences, even when they’re financed out of household deficits.
The question that remains is what to do about those deficits. For my purposes, for my part, the answer is pretty simple. If you know that consumer expenditures are the engine of economic growth, then you try to synchronize supply and demand by raising wages instead of forcing people to go into debt as a way of financing such growth. Or you detach income from work, so that the lack of jobs that pay a living wage won’t constrain consumer spending. Whatever. It all spells socialism, Grover.
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Marc Craig Chandler - 8/30/2007
While there is a large overlap in views, the key difference between Jim's analysis and mine is the role of the sub-prime market and what is happening in the markets now.
Livingston places the consumer at the center of his narrative and the policy the Fed needs to puruse to protect this key engine of growth.
My analysis places the circuit of capital at the center, the disintermediation process and the securitization strategy of enlongated and flattening the credit cycle.
The widespread nature of the fallout speaks more to the state of the financial markets prior to the subprime eruption. The business cycle and the bull market in equities had extended much longer than average. The easy access to credit/leverage had produced a situation in which the risk premium that investors historically demanded for higher risk assets, like high yield bonds, emerging market debt, subprime mortgages (and packages of them bundled up), was at historically speaking low, if not unprecedented levels.
Indeed the problem began as a re-pricing of risk--completely encouraged by officials--. Later the problem spilled over to the short-end of the money market because that was where many of these investors had financed themselves (classic borrowing short and lending long. Often the borrowing was secured by the financial assets that were being purchased.
From a quantitative point of view, volatility had broken down and correlations were high. Every thing become in essence one trade.
That is what is going on in the last few days. As the nerves calm, the yen weakens, the stock market goes up,the emerging markets strengthen. And on days that the fickle market psychology gets worried or more bad news, the opposite takes place.
After several quarters in which the US consumer carried the economy, it pulled back in Q2. However, the key to the US consumer as demonstrated by its track record is not housing prices, but jobs and income and both measures are holding up into mid-Q3 by the government's measure.
An interest rate cut by the Fed or more accomodative monetary policy, which Jim seems to think is consistent with supporting the consumer would do no such thing.
First there is not evidence that the real economy has been hit hard by the unsettled capital markets. In fact, the decline in gasoline prices and new discounts on autos is likely to see a rebound in US consumption as this quarter winds down.
Second, Wall Street has been clamoring for a rate cut since June 2006 when the Fed ended its sequence of rate cuts.
Third,this is the most inexperienced Federal Reserve Board in history. The vice chairman Kohn has more experience at the Fed than all the other board members combined.
As is often the case with new Fed chairman, Bernanke has yet to anchor his anti-inflation credentials to the extent that satisfies the markets. In the past Bernanke has seemed sympathetic to the so-called Greenspan put and in some press he is satirized by reference to Helicopter Be, when he indicated during the deflation scare several years ago, that officials could always drop curreny from a helicopter to induce inflation.
A rate cut now would be Bernanke and the Fed will have to fight all the harder to establish those credentials or resign to higher yields (and a steeper yield curve.
Third, to the extent that a rate cut will help any one, it may be of some consolation to imprudent lenders and to speculative forces in the capital markets.
Wall Street is cognizant of the moral hazard of the welfare state and yet because of the power it wields, officials like Greenspan and now Bernannke, when protectors of the financial system as a whole, feel compelled rescue Wall Street from itself.
My reference to fascism in my initial comment meant to imply a political configuration in which a purposely-designed body that is insulated from the vagaries of democracy or accountability (outside of testifying before its representatives)controls the important levels of monetary policy(to the extent any one does)and does so in favor of the house of finance does not sound like the concept of socialism that Jim and I agree on.
Richard Schneirov - 8/29/2007
Thanks for a very thought-provoking, historically-situated analysis of the present financial crisis. As one who is a student of Martin Sklar, like yourself, I have for some time now found the theory of "the mix" useful and insightful. I do have one caveat to your discussion of the decline of net investment. As you note in your Aug. 20 piece, that decline has been documented in goods production. But as you well know, goods production is less than 20% of the current economy. Does disaccumulation exist in the service sector which comprises the large majority of business activity? Or rather, to what extent? It seems to me that accumulation of capital must and does go on, otherwise there would be no way of employing additional human labor within the confines of the capitalist economy. As I see it, disaccumulation is a tendency that the managers of the mix must compensate for; otherwise the capitalist system goes out of business. But, it does not characterize the entire economy.
One other point. As a labor historian, I've been looking at the lack of real wage increases these past seven years (and the very slight increase in real wages these past thirty five years) with amazement. How long can consumer debt keep filling the gap? David Harvey in his stimulating "Brief History of Neoliberalism" argues that the major contradiction of neoliberalism is the one between sustaining capitalism (insert "the mix" here) and restoring and reconstituting ruling class power. Consumer debt seems to me the major factor in allowing the mix to be sustained under conditions of reconstituting a capitalist class (in brief, my own understanding of the term "reconstituting" is that a neo-capitalist class may now be ruling our corporations these days, one that no longer lacks ownership of the firm's assets and operates on that basis, but like the nineteenth century variety, combines ownership with control). In his last chapter Harvey speculates that the increase in international and domestic debt to finance working-class consent to the present system cannot be sustained forever. I wonder too.
James Livingston - 8/29/2007
I agree with almost everything Chandler says, including the incendiary conclusion regarding fascism (to which I return below).
But if the subprime bust is such a minor piece of the puzzle, why are the markets--all of them--so unsettled? I don't think it is possible, at this late stage of capitalism, to underestimate the role of consumers in driving economic growth and development; perhaps that is our main difference, although Chandler's own analysis of the Wal-Mart phenomenon as an adjunct of China's ascendence would suggest that we are in agreement here, too.
As for fascism. The unstable isotope of capitalism and socialism has many variants, in the 20th century and after. The imbrication of these two modes of production happened to almost every developed country after 1920.
Where a liberal political inheritance--a firm belief in both the supremacy of society over the state and in the value of individualism--remained resilient, the mix of capitalism and socialism allowed for development and democracy. Where that inheritance was disavowed, from the Left and/or the Right, the mix of capitalism and socialism led toward a totalitarian state, whether fascist or communist.
So fascism ain't on the agenda just yet. To summon this specter as we try to think through the general unsettlement of markets seems premature at best.
Jerry Jenks - 8/28/2007
What you’ve written is stimulating but how can you talk about “socialism” in contemporary America where social and economic inequalities have become more and pronounced? While you show that risks are socialized so that the whole system doesn’t collapse, doesn’t the little guy get screwed under this “socialism” with foreclosures, debt burdens, stagnant wages, and the like? You do talk about raising wages as the alternative to debt and I’m for that, but isn’t the system rigged (e.g., pro-employer NRLB) so that won’t happen? If this is socialism, then it is a highly deformed version.
Jeffrey Sklansky - 8/28/2007
What a marvelous piece! I found Livingston's history lesson as well as his analysis of the current crunch/crisis extraordinarily sharp and illuminating. However, I wasn't sure what to make of the opening and closing salvos on the coming of socialism--or, more specifically, how to interpret who the "you" is in the last paragraph, striving somehow to raise wages or "detach income from work," and what Livingston is implicitly proposing there. Raising wages sounds good, but wouldn't that be more like attaching income to work? Detaching income from work sounds closer to a description of what's actually occurred in the debt-driven, stock-inflated growth of the last fifteen years, as evidenced by growing income inequality and the widening gap between productivity and paychecks. So I'm hung up on how a description of the problem morphs, rather too seamlessly for me, into a prescription for transcending it. But this is really quibbling with the edges of the piece rather than arguing with its central claims, which I greatly appreciated.
Marc Craig Chandler - 8/28/2007
Does the Fed really have no choice but to "risk moral hazard" of propping up the mortgage market saturated with speculation, imprudence, and criminality, as Livingston says? Is this how the Fed "validates" consumer preferences ? And does this have anything to do with curbing, re-directing or in other ways mitigating the exercise of power than emanates from the control or ownership of property, i.e.does it say anything about the socialist project in America ?
First, there is extremely little about the US consumer that is at the center of the current crisis. The credit crunch is not about consumers in the first instance. It is about banks and hedge funds and other financial institutions that issued loans to some households on incredible terms (no documentation of income, employment, or assets and sometimes interest only repayment schemes), But the sub-prime market is relatively small compared with the US overall mortgage market. Moody's estimate that some 3.2mln households acquired homes under such liberal loan provisions. If 1.7 mln households lose their homes now due to foreclosure or default, we are talking about a minor hit on the overall $12 trillion US GDP. Federal Reserve Chairman Bernanke quoted a $50-$100 bln cost. When the problem was defined as such, officials hardly batted an eye lash.
What lit the match under the collective hide of policy makers was when the problem of the sub-prime mortgage market spilled overand began impacting the overall credit conditions of the economy. When large institutions appeared vulnerable not the consumer.
In essence, what happened was that the subprime loans were packaged with some other subprime and other credits and sold, deconstructed, reconstituted and resold. They were purchased by a wide range of financial institutions. There were some financial vehicles set up that issued asset backed commericial paper and used the proceeds to buy some of those subprime debt products.
Not only did those subprime debt instruments go south but the commerical paper market dried up as there was a capital strike or a buyer boycott because it was not clear what was behind them in terms of credit. Pension funds and money market funds, typical buyers of commercial paper, flocked to the US Treasury T-bill market.
At the samer time, many financial institutions overseas also participated in this market. They had bought long-term bonds of suspect quality and financed their purchases in the the dollar commericial paper market or other short-term instruments.
As the big margin call came, they had to scramble to secure dollars and hence the US dollar appreciated against the euro, sterling and most other currencies when the credit crunch become evident.
I see nothing in the Fed'sdeclaratory policy or operational policy that says they are validting US consumers or bailing out the mortgage market. The Fed made liquidty provisions for the financial institutions that draw on it--not to consumers. It has accepted as collateral for its operations asset backed commerical paper and mortgage backed securities, but this was to most efficient address the credit crunch and scramble for liquidity.
Some Fed officials have joined other officials froma number of different countries warning for several months that the markets were mis-pricing risk. The adjustment in credit spreads was and is largely desired and welcomed by officials.
I would suggest two other important aspects of the curernt crisis that seem to more more relevant.
First, we are engaged in a transgenerational attempt to smooth out the business cycle. Consider thathalf of the 35 years from 1865-1900 were marked by panics, depressions, crisis. In the last quarter of a century the US has experienced just seven quarters of contracting growth. After the 1997-98 financial crisis, there was a greater realization of the importance of flattening out and enlongating the credit cycle. The curernt crisis grows out of the derivatives in part designed to help managed risk and extend the credit cycle for businesses as well as households.
Second, we are also engaged in a transgenerational process of disintermediation. The role of banks is transforming. Banks, the head of capitalism, no longer have a monopoly on credit. They incresaingly rely on other income streams besides interest. This is in part about the democratization of access to capital. Banks givea thumbs up or down on loans. The markets have capital for anyone: bankrupt businesses, defaulted sovereigns, an artist who wants his money for future sales of DVDs up front (David Bowie), and all that is dickered about is the price.
Capitalism, especially as it has been developed in the Anglo-American economies has been transformed from a bank centric capital distribution model to a market-centric capital distribution model.
In summary my argument is: 1) the current crisis has little to do with the US consumer. The subprime problem impacts a relatively small number of households and a small share of GDP. It does pose systemic risk to the US economy and the Fed was not inclinedto move based on it. 2) When the crisis spread to a generalized credit crunch, the Fed acted as it perceived systemic risks. 3) The Bernanke Fed has tried to distance itself from perceptions of a "Greenspan put) that would seem to bailout imprudent lenders and investors. 4) Lengthening and flattening the business cycle and credit cycle is underlying chanllenge for policy makers. 5) of the 3..2 mln American households that acquired homes through the sub-prime conduit, estimates suggest 1.7 mln may lose their homes. This is a tragedy. But 1.5 mln will likely be able to keep them. The onwership-based society will be extended, beyond what banks and traditional finance would allow. 6) Capitalism/markets work in lurches and are prone to excess. It is always entertaining to see who gets singled out as a culprit. There has been much literature penned in recent years about the rationality of some asset bubbles. It is not clear that recongizing those excesses will lead to limits on the power than comes from the ownership and control of private property. Socializing the costs of investments that go sour might not be socialism, but fascism.