Mort Zuckerman, October 22, 2008-
Nature of the illness:
Everyone is haunted by the fear our
financial crisis might unwind into something like the Great Depression. The world of finance is undergoing a collapse compabable
to that which occurred in during the Great Depression. Federal loose-crdit policies
has produced the greatest destruction of wealth in our history. It is sweeping away giant blue-chip financial firms and will
cause governments around the world to default on their debts. Because of a lack
of industrial foundation and the impoverishment of the working class along with the continuing power of the world of finance
to influence police, this implosion will turn out worse than most pessimistic of us imagine.
Most critically, the financial world
is seized by a collapse of confidence. The uncertainty over the value of the securities they hold has led to an enormous risk
aversion. Customers, creditors, and shareholders of the major financial firms wonder whether they might survive. Once confidence
collapses, there is no telling when the selling will stop. It all brings to mind the story of the economist who walked past
a hundred dollar bill and didn't pick it up. When asked why, he responded, "It can't be a hundred dollar bill for, if it were,
somebody else would have picked it up by now."
All of this has produced an unprecedented
credit squeeze in which banks are refusing to lend to other banks, much less to businesses and individuals. This squeeze has
had a particular impact on the newly unregulated emergent shadow banking system made up of mortgage lenders, investment banks,
broker-dealers, hedge funds, private equity funds, money market funds, structured investment vehicles and conduits. Many of
these names we have never heard of before but cumulatively, they now provide a majority of America's financing. They are not
banks but they act and seem like banks. They borrow short and invest long, mostly in illiquid securities; they have more debt
in relation to equity than banks but have lacked, until recently, both deposit insurance and the support of the Federal Reserve
as the "lender of last resort." They do not have deposits but have relied on roll-over, short-term funding obtained through
borrowing in the money markets that has left these firms vulnerable to disruptions in the money markets. To the extent that
they have bundled these investments into securities that were sold to the markets, they were are also vulnerable to mark to
market losses when these markets, or their securities, start falling.
This quickly wiped out the banks'
capital base and ended their roll-over funding. The functioning of the credit markets was brought to a virtual halt. Even
worse, there is a quiet run on hedge funds and private equity funds ongoing that threatens to bring the shadow banking system
to its knees. Now the question is whether this will produce an economic contraction on Main Street comparable to the Great
Depression.
The inescapable bad news is that
a serious recession is inevitable given the damage to the financial sector, as well as in the degree to which business and
the general public has been traumatized by collapsing stock prices and the daily headlines. But this does not mean we are
bound to have a spiraling recessionary dynamic comparable to the thirties. The unprecedented debt American families and businesses
have assumed will continue to constrain the easing of the credit crunch. But we have avoided some of the mistakes of 1929.
Take monetary policy. This time the
Treasury and the Federal Reserve moved quickly and positively. They understood that when banks lose money they have to shrink
their balance sheets and since bank assets are its loans, this would mean a drastic reduction in credit and worsening business
conditions. The Fed has sought to ease the credit crunch by injecting over $1.5 trillion into the financial system and, most
recently, added another $250 billion directly into the banks to re-liquefy them, plus increasing deposit insurance, extending
it to money market funds, aggressively lowering interest rates and, importantly, doing that in concert with the other major
economic powers.
In the early 1930s, the Fed refused
credit to bankers and forced more and more of them to sell assets in a frantic dash for liquidity. Some 10,000 commercial
banks, or 40%, failed between 1929 and 1933 compared to only 20 this time. Many people back then stopped using checks and
conducted transactions in cash. The money supply declined by more than a third, creating a major contraction of credit.
The contrast in fiscal policy is
equally dramatic. A generation of economists inspired by John Maynard Keynes in the 1930s taught us that the government should
not try to run a balanced budget in a crisis of demand, as both Hoover and Roosevelt did. This time the government is running
a $500 billion deficit to stimulate demand, and next year it will exceed $1 trillion. Orthodox adherence to the gold standard
in the thirties didn't help, compared to a free floating US dollar today that has declined by 16% on a trade weighted basis.
Another critical fiscal difference is that the federal government today has more sway. It makes up 21% of GDP compared to just 3% in 1929. On top of this a
large component of GDP is devoted to health and education that is substantially decoupled from the problems of the
private sector, not to mention that the Social Security program adopted in 1935 today provides unemployment benefits. All
these contribute to maintaining the real economy. By the time FDR took over (1933), the economic entrenchment had begun to
feed on itself and turned a serious recession into the decade of the Great Depression.
We still have in place Social Security
and unemployment to slow the doward spiral. But other things are much worse than
during the Great Depression. Household debt rose from about 50% of a $3 trillion
GDP in 1980 to over 100% of a $13 trillion GDP today. The debts of the financial world, which amounted to 21% of GDP in
1980, soared to 120% of GDP by
2007. The financial world's unprecedented accumulation of debt in relation
to equity sometimes with over $30 of debt for every $1
of equity means that small variations in their asset values, which once produced profits, have now brought them huge losses.
Much of this debt takes the form
of securities and derivatives that remain on their balance sheets. In fact, another systemic risk and one that cannot be measured
is based on the opacity and complexity of these exotic securities, mainly credit default swaps and derivatives
that remain mainly on financial balance sheets exceed
$50 trillion. Debt requires payment of interest, the fainancial institutions act as a great vacccum cleaner. As long as debt rose, prices on stocks and and properties rose. Now the combination of falling property and stock prices, reduced consumer demand, rising unemployment,
tightening credit, falling wages, and a lack of confidence by the consumer, the banker, and the business community, all these
entail that a major correction is under way, one which will likely rival the Great Depression.
Then there is the housing bust. The
current crisis in housing has an important history. When the Fed tried to respond to the dot.com bust in the year 2000 and
2001, that is when the Internet bubble burst, littering the country with bankruptcies and layoffs -- not to speak of investor
losses of more than $1 trillion -- the Fed rapidly increased the money supply to offset these losses and slashed short-term
interest rates to 1%, the lowest in 45 years. The result was the greatest housing boom this country had ever encountered.
From 2002 to 2006 housing values appreciated at the astonishing rate of 16% per year compared to only 3% for the 55 years between 1945 and the year 2000. We finally came to the point
where it was impossible for the typical American family to buy an average priced house using a conventional 30-year mortgage.
Then the housing bubble burst. Housing
prices have dropped roughly 30% and the decline is continuing. Plummeting house prices mean more foreclosures, more homes
on the glutted marketplace and a further house-price slump. There are 15 million homes today with negative equity where the
mortgage exceeds the home's value and it may rise to 20 million over the next few months. Most of them have mortgages that
now exceed the value of the homes by over 20%. If half these people drop the keys in a box and walk away, the losses will
be in the trillions and may well destroy the equity in our banking system. That is why it is critical to find ways to keep
foreclosures to a minimum. The entire attempt to re-liquefy the financial system could be undermined by this collapse in housing
prices.
These are substantial threats and
for all the measures (belatedly taken) distrust remains. American policymakers have seemed to be responding at an ad hoc,
unfocused fashion, not fully taking into account the looming insolvency issues and the frightening complexity of the bundles
of exotic securities. It is fair to acknowledge that they've been dealing with a crisis on a scale not seen before, and one
that unfolded with terrifying speed. But the fact remains that by the time they acted, measures that might have re-stabilized
the markets were ineffective. Robert Brusca of FAO Economics, captured it well when he said, "There is sense that if policymakers
were surfers, they would have missed every wave." {Inaction is the mantra of neocons, who believe that the free market is a self-correcting system, and that intervention
in the long term makes things worse.}
Lehman's bankruptcy is a case study
in government ineptitude. It was the $785 million of losses on Lehman's securities that pushed the value of the assets of
a major money market firm below their $1 per share paid value, described as "breaking the buck." This caused $400 billion
to be taken out of money market funds in a matter of days, while the rest of the funds were frozen in anticipation of further
withdrawals. Banks were relying heavily on these funds for their commercial paper and the result was a spiral of illiquidity.
The Lehman decision prompted the following from the French Minister of Finance, "Horrendous!" an assessment echoed by many
others. It remains puzzling that our Treasury officials did not foresee that the Lehman failure would not be just another
failure, but a catastrophic failure undermining faith in the system. After Lehman, all remaining trust vanished in the financial
world. Money market and interbank lending froze virtually completely. The spread on credit default swaps rose to levels that
caused fear and speculation.
What next?
Here are some proposals:
1. We must have a quick and efficient
way to sustain more banks with capital injections, not just the major banks, using appropriate information gathered by bank
supervisors.
2. We need to expand the definition
of banks to extend appropriate regulatory regimes to the shadow banking system.
3. We will have to oblige the newly
defined banking system to build up equity capital when their lending is expanding, for financial busts too often follow credit
booms.
4. We must establish a standard for
risk management and risk assessment covering mortgages, derivatives, debt, and even equity and especially on new financial
instruments.
5. The Fed will have to continue
to guarantee interbank borrowing by banks eligible for recapitalization to reactivate the interbank lending market and reduce
abnormally high rates of interest on loans that float above the LIBOR interbank rate.
6. If there is to be a fiscal stimulus
program, it should be primarily in infrastructure and not on tax cuts: these tend to be saved and not spent (and Obama's are
more of a new entitlement program to people who don't pay any tax at all)
The danger is that politicians, who
have little understanding of the financial world, may draw the wrong conclusions from Wall Street follies and make the wrong
decisions, as they try to revive our financial system.
We must get this right. The new administration
must draft the best of our national talent into shaping and administering these new policies. Otherwise the recession will
not be U-shaped and relatively short. It will be L-shaped and extend for many unnecessary years
