Discredited

In the last act of Martin McDonagh’s The Lieutenant of Inishmore, one character, sitting amid gore and dead bodies, moans, “Worse and worse and worse this story gets!” And so it seems with the credit crisis.

It’s hard to believe that it has barely been two years since Federal Reserve chairman Ben S. Bernanke, a fine economist, reassured Congress:

The U.S. economy appears to be making a transition...to a more sustainable average pace of growth. The principal source of the ongoing moderation has been a substantial cooling in the housing market.... However, the weakness in housing-market activity and the slower appreciation of house prices do not seem to have spilled over to any significant extent to other sectors of the economy.

He was a little off. In the last quarter of 2008, real (after inflation) growth fell at an annual rate of about 6 percent in the United States, 6 percent in the Euro countries, 8 in Germany, 12 in Japan, 16 in Singapore, and 20 in South Korea. The first quarter of 2009 looks as if it could be considerably worse. Even China, which needs 8 percent growth just to keep pace with population growth, is now hoping for 5 to 6 percent real growth in 2009. In other words, they’re in recession, too.

The word “recession” doesn’t quite capture what’s going on. In February the slide in American industrial production was the worst in fifty-one years, which is as far back as data go. In the four months through February, nonfarm payroll employment fell by 2.6 million. If we tracked unemployment the way we used to—when “discouraged” workers and involuntary part-timers counted as unemployed—the unemployment rate would be well over 15 percent. The home-price debacle has become self-amplifying. Falling prices have closed the home-equity borrowing spigot, which supplied the equivalent of 6 percent of gross disposable personal income from 2000 through 2007. That loss of spending power is killing businesses and jobs, which just increases the downward pressure on home prices.

How could Bernanke not have seen this coming? The fact is that almost the entire economics profession missed it. A survey of fifty-one leading economists by the Wall Street Journal shows that, as of early 2008, well after the credit crisis had gotten underway, the consensus outlook for 2008 was decidedly cheery. Most expected some rough patches in the first half of the year, but with solid growth in the second half, and a fine 2009 and 2010. (Bernanke, by the way, expects the recovery to start in the second half of this year. You can take it to the bank.)

What’s scary about the current crisis is that it doesn’t fit mainstream economic models. This is not your father’s recession. “Normal” recessions usually start with overproduction and inventory buildups followed by a cooling-off period to work through the excess. Those are relatively rare now because of computerized inventory management and the long-term shift of economic activity toward services. What’s going on now is something that economists, for all their bravado, really don’t understand.

A Credit Crisis

A little recent history. Corporate cash flows were very strong in the 2000s, but the rate of corporate investment fell from the robust 1990s, so free corporate cash flows grew mightily. Conveniently, Congress changed the tax code to encourage cash distribution to shareholders. The companies that make up the S&P 500, from the last quarter of 2004 through the third quarter of 2008, earned a total of $2.1 trillion, but distributed more than that to shareholders. And shareholder distributions far exceeded company investment.

Those huge streams of free cash went mostly to institutions and wealthy investors, and were invested primarily in financial instruments. The powerful surge of money into stock and bond markets raised asset prices and drove a steep drop in yields. Falling yields encourage risky behavior. Banks built up huge trading books of highly leveraged assets, and they started chasing the riskiest loans, like subprime mortgages, because they had the highest yields. The Federal Reserve did nothing to stop the asset boom; indeed, by keeping interest rates inordinately low for an extended period, it greatly encouraged it. The financial sector quickly became the primary driver of the economy, accounting for 40 percent of all corporate profits by 2007.

Disquietingly, something similar happened in the 1920s. Corporate cash flows grew much faster than investment or wages, and the excess flowed into financial instruments. There was a burst of inventive consumer lending, both through residential mortgages and installment purchase debt, including some of the same instruments, like interest-only mortgages, which got banks like Countrywide in such trouble. And when banks got worried about their shaky loans, they bundled them up—or “securitized” them—into highly leveraged “investment trusts” that they floated on the stock market. It has a familiar ring.

In our own day, the flood of finance pushed consumer spending to 72 percent of GDP, the highest rate ever, anywhere, while personal savings rates dropped to virtually zero. Very quickly, Americans became grossly overinvested in items that Wall Street was good at financing—bigger houses, SUVs, electronic toys from Asia. Secondary booms duly followed—in new shopping malls; in the shiny new office buildings and the luxury hotels and restaurants that bankers like; and in highly leveraged buyouts of companies riding the same waves, such as hotel chains, retailers, casinos, furniture stores, and home builders.

And when there were no good assets to lend against, and a dearth of creditworthy borrowers, the financial sector just kept on lending, inventing “ninja” mortgages (“no income, no job or assets”), “no covenant” company takeover loans (if you can’t pay, the lender can’t make you), and other corruptions. All that easy credit allowed Americans-consumers, businesses, and government together—to spend 5 percent more than we produced, for an overrun of $4.5 trillion over the entire period from 2000 through 2007.

The bankers have long since taken their fake profits and real bonuses, bought their second and third vacation homes, and acquired new trophy wives. Most of the “innovative” assets created over the past three or four years are now worth half or less of their face value. And now we’re left with the cleanup. How are we doing?

A Shaky Start for the Obama Team

The whining on Wall Street about the “Obama Bear Market” is, of course, grossly unfair. It took years for Wall Streeters to blow up the world, so there was no way that a new team could put it back together in just months.

But after the silky-smooth campaign, the administration’s performance has not been impressive, often seeming both irresolute and fumbling. It’s still early, and the public seems well disposed, but it’s past time to finish filling the key jobs, and to stop getting rolled by the bankers.

It would also be nice to see some conviction around a few central points:

• Almost all the “innovation” of the past decade has been destructive. The derivative inventions that enable irresponsible mortgage brokers in Nevada to destroy banks in Switzerland are very dangerous, and the industry has proved that it can’t be trusted with them.

• The financial sector has to shrink. The merger of commercial and investment banking, which put federally guaranteed deposit money at the disposal of high-rolling wheeler-dealers, was an accident waiting to happen. It has duly happened, and has been worse than anyone thought. It’s time to make banking dull again.

• At this late date, it is no longer excusable for key players like Bernanke and Treasury Secretary Tim Geithner to keep on being surprised. There needs to be a standard playbook for intervening; clear guidelines for who fails and who doesn’t; and a quasi-independent corporate structure to hold and manage the government’s security holdings. Drive-by policymaking by Treasury officials and random congressmen will surely end in tears. The current process (which the administration inherited) seems to be: Pay whatever AIG, or Merrill (or whoever) asks for, and hope against hope that it’s the last. It never is, and we have to do better.

• It will take some months to learn whether the recently announced federal toxic asset purchase program will be effective in repairing bank balance sheets. The smart money seems roughly split on whether it’s a useful first step or just another rape of the taxpayer. While the administration seems determined to avoid outright nationalization of the bigger failing banks, it may find itself driven to that solution even if the new asset purchase plan succeeds. Some banks, like Citi, may be just too deep in the hole. Citi is already into the government for some $300 billion in capital and guarantees. If its balance sheet continues to implode, about the only course of action will be to take it all onto the government books, then spin out a simple deposit-taking bank with the current Citi deposits and performing standard loans. Citi investors would recover what they could as the warehoused assets were gradually sold or written off—after the government recovered its costs, to be sure.

The truth is that everybody is flying blind. More banks will fail. The economy will be on a knife’s edge between deflation and inflation. And there is no way that a galumphing bank rescue in America is going to put an early stop to the worldwide collapse in jobs and assets that is still gathering speed.

In short, there are no winners here. It’s time for the Obama team to pluck up their courage, stop talking up the stock market, and get much more aggressive about downsizing the industry. Another presidential election will be upon them, and much too soon, so better to get the dirty work over now. The public should just avert their eyes, then take another look in a year or so and decide whether these guys are up to it.

Related: Too Bad to Forget by the Editors
The Wall Street Meltdown by John W. Weiser
Northern Light by Marc I. Seltzer & Leslie Schreiber
After the Meltdown by Charles R. Morris
Greed 101 by Mark A. Sargent