Toward a New Economy

We are told that an investment by the long-suffering taxpayer and his grandchildren are needed to keep the economy going. It is agreed that current troubles trace back to the housing market. According to the Economist Magazine, the initiation of new mortgages in the US in 2002 came to $2.8T (for Trillion); in 2003, it was $3.9T. Then it was around $2.9T again for each of 2004, 2005, and 2006. It was still over $2.3T in 2007, and in the first quarter of 2008 it was $0.4T. Collectively, then, the American housing bubble was blown up by an investment of over $18 trillion and counting. All this came out of the private economy. Now it is argued that with housing prices on the decline, an infusion of $700B from the reluctant taxpayer will stanch the bleeding. Somehow that does not seem likely.

Even if that effort were to be successful, what kind of an economy would we be supporting? Was the nation well-served by the economic developments of the last six years? The implicit assumption of the bailout is that the engine of progress is at the top of the pyramid, and its name is finance. Indeed, the financial sphere has gone from amounting to ten percent of gross corporate profits decades ago to 40% currently. But there has been no net contribution to jobs for Americans by the Fortune 500 since President Clinton came into office. So just what is this glorious future that Americans are willing to pay tax dollars to assure? What is going to give the American worker a better deal in the future?

After all, the $700B is not the first installment on the robber baron economy. Bush’s tax cuts for the rich came first, and cumulatively amount to even more than $1T over eight years. The additional Federal deficit was incurred mainly because of the promised growth that would ensue, ostensibly for the benefit of our whole population. But instead family income has gone down in real terms over the Bush years. And the middle class has shrunk. So when might we expect trickle-down to start trickling?

If there is any doubt that our faith in Wall Street is misplaced, that doubt is removed by one single data point. Last year corporations gave back one trillion dollars to shareholders through stock buybacks. That’s up from $600B a few years ago, so we’re dealing with a long-term pattern. This means that the best use of money our top corporate managers could think of was to repurchase their own stock. The stockholders, in turn, built mansions…

The sobering reality is that societal innovation does not start at the top. America was so innovative throughout its history because it did not have overweening concentration of power and wealth. Now that it does so, stagnation has set in at the bottom, and malfeasance has crept in at the top. We need to get back to a real economy, not one based on financial gimmickry.

The success of micro-lending in the developing countries shows the enormous innovative potential that is available in the nation at large. And China’s growth illustrates the value of infrastructure spending by the government. Some two-thirds of our economy is composed of services. Most of the service industries don’t require huge dollops of finance from Wall Street. The government is in a position to undertake the necessary infrastructure investments, provided that self-serving Republican ideologues are not in charge. Right now, the US is committing some 2% of GNP toward infrastructure, whereas China is committing 13%. There is room for growth here, which can make up for the fall-off in housing. 

We’re told the bailout is needed because capital is freezing up in Wall Street and around the world. Capital is fundamentally risk-averse, and follows collateral. With valuations shrinking, capital commitments will indeed shrink. But bailouts of the size envisioned will not keep valuations from shrinking.

The much bigger problem is that the manner in which Wall Street has attempted to insulate itself from risk, namely through Credit Default Swaps, is now suspect. This 62 trillion dollar market has distributed the risk over the entire system, with the perverse consequence that localized risk can no longer be assessed. We have on our hands a modern Tower of Babel, one in which words can still be understood but no longer necessarily trusted.

The gnomes of Wall Street have thus far managed to avoid a thorough test of the CDS market. There is little doubt in their minds that such a test would expose a fundamental flaw: With high leverage everywhere, the risk is in fact not covered anywhere. And this exposes the most basic flaw that has gnawed away at our financial system: the unregulated growth of leverage.

This should have been recognized at the time that Long Term Capital Management needed rescuing a few years ago. That outfit leveraged a mere $4B into an investment of $1.25T, a leverage factor of over 300. What was a $1.25T problem then is a $62T problem now. It is difficult to see how this can end well. One has to hope that the viability of that edifice will never be tested, which is increasingly unlikely. In time, Alan Greenspan and Phil Gramm will come to be recognized as the key architects of the debacle, if one ensues. But there have been many fellow travelers along the way.

There is indeed a part of me that relishes the image of the chickens finally coming home to roost on Wall Street. But whatever good feelings derive from that is overwhelmed by anticipation of misery that will be spread in our country with a shrinking economy as it enters this transition phase. So let there be no doubt---there is unanimity in the wish that this financial crisis could be avoided. Unfortunately, it’s only too likely that these emergency measures will not be enough to stabilize the system. And then we will have wasted our precious resources on maintaining the status quo rather than on building our future economy. Therein lies the tragedy.

It must be recognized that we have only a few silver bullets left before the dollar is completely trashed. Are these crucial social “investments” to be made in salvaging the status quo or in building the future? To the average American citizen who has not particularly benefited from past policies, the choice should be clear. But no real choice is being presented. Even so, there is an unease throughout the land about what we are undertaking, and well there should be. There is the general sense that the country is heading in the wrong direction, and the bailout plan is part of that wrong direction.

To steer away from the present path we have to have an alternative in view. Unfortunately, with Wall Street controlling not only Washington but also the principal media, it is taking all the oxygen in the room, and alternatives are not getting a hearing. With finance being such an overweening presence in our economy, the focus would inevitably be on those few big ticket items that can generate large cash flows and profits in the future.