Common Cents Read online

  The political danger with a WTA society is that celebrity fame and economic mega-fortunes can translate into power to influence the democratic process, creating a plutocracy, a word of Greek origin meaning “rule by the wealthy.” Thus, we see professional actors and celebrities advising us on politics and public policy and influencing election campaigns.[38] We can observe Wall Street banking elites dominating our policy institutions and we suffer professional politicians winning Oscars and Nobel Prizes for dubious achievements. Winner-take-all dynamics aggravate wealth and income inequalities and also feed back into political policies that reinforce the basic inequities.[39] Most recently we’ve seen how bankers have influenced the political class over financial regulation, then with the taxpayer-funded bailouts after the financial crash.

  While we may not be able to blunt the economic power of fame or wealth, we can certainly change the policies that institutionalize the problem. A plutocracy should concern us gravely. The siphoning of wealth from savers, homeowners, and middle-class wage earners to wealthy bankers, creditors and an elite political class is the first step down the road to a plutocracy. The endpoint is a banana republic characterized by crony capitalism. I would suggest that the reversal of this trend towards crony capitalism lies less in attacking the machinations of the rich and powerful than in understanding how risk is shared, borne, and compensated in our political economy. With this knowledge we can transform our capitalism with the true powers of our free and democratic society: sheer magnitude of voters and consumers, networked coordination, market openness, transparency, and free competition.

  Chapter Four

  Applying the Model to Policy

  4.1 The Great Moderation, The Credit Bubble and Financial Crises

  In order to understand how we got where we are today, we need to familiarize ourselves with some recent economic history and U.S. policy responses. The period from 1982 to 2007 is often referred to as “The Great Moderation,” a time when economists and policymakers had thought they had solved the problems of unemployment, inflation, and recessionary cycles while promoting steady economic growth. The financial crisis of 2008 exploded that myth, but we must go back a bit further in history to understand the full context of the past three decades.

  In the post-World War II period, the international monetary system was based on a fixed exchange rate regime established under the Bretton Woods Agreements of 1948. This regime established the U.S. dollar as the international reserve currency, anchored by a fixed exchange rate into gold. This meant that foreign banks could exchange their dollars for gold at the rate of $35 per ounce. This worked fine as long as there was a steady trade demand for dollars that was not outstripped by the supply. By the late 1960s, the excessive debt-driven spending of the Vietnam War and the Great Society social programs created an oversupply of dollars as the U.S. government spent in excess of tax receipts. Foreign banks, fearing the eventual depreciation of the dollar, demanded to exchange their dollar holdings for gold. [40] As U.S. gold reserves rapidly depleted, policymakers realized that the exchange system could not survive. In 1971, President Nixon abrogated the Bretton Woods Agreements, refusing to allow the U.S. Treasury to exchange dollars for gold at the $35 rate. In effect, he "closed the gold window," to preserve the gold reserves of the U.S.

  Immediately, the price of gold rose to reflect this de facto depreciation of the dollar. As we discussed previously, the value of a currency is determined by what it can be exchanged for. If the sum of all the goods and services in the U.S. grows slower than the supply of the currency, the value of the currency will decline as each good or service will demand more of that currency to trade. This is inflation. In other words, prices of U.S. goods and services will rise in dollar terms (a haircut or restaurant meal will cost more), while dollar exchange rates against other currencies will fall (a trip to Paris will cost a lot more, while Europeans will flock to our shores to enjoy cheaper vacations in the States). By the early 1970s the dollar had become nominally overvalued and was then, by Nixon’s policy change, losing value to bring prices back into equilibrium. It is important to understand that with the breakdown of Bretton Woods, the value of the U.S. dollar became untethered to anything of fixed real value, such as an ounce of gold. This meant that the dollar would become entirely subject to the policies that determine their supply and demand. Dollar supply is controlled by the private U.S. Federal Reserve system with Congressional oversight. We discussed this previously in the section, The Mystique of Money. Dollar demand is a function of real economic forces influenced by both monetary and fiscal policies.

  The Nixon administration, in effect, transformed the international monetary system from a fixed exchange rate system, where currency values are fixed to each other, to a floating rate, fiat currency system where exchange markets determine the relative value of a currency on a daily basis based upon supply and demand. The U.S. dollar could no longer be converted into gold at $35 per ounce and could only be exchanged for whatever the markets determined its exchange value to be on any day.[41] The exchange value of the U.S. dollar began to "float" relative to all other currencies. This created the conditions for a market in competitive currencies—such as the British pound, the various European currencies (now replaced by the euro), the Japanese yen, the Swiss franc, and now the Chinese yuan—to trade against the dollar.

  It is often said that controlling the supply of dollars to keep the U.S. economy on a steady growth path is like driving a car by using the rearview mirror. We never know when to step on the accelerator or the brake until it's too late. In other words, we don’t know how many dollars is “right” until after we’ve veered off the road. (Not surprising, there have been a few crashes.) Why is the supply of dollars and their value important? Because the value or 'price' of the dollar affects every other price signal in the economy. In its role as the international reserve currency (central banks around the world hold dollar reserves and reconcile their trade payments accounts in dollars rather than in hundreds of various national currencies), the value of the U.S. dollar affects every other price signal in the world. If price signals are not accurate, there is little chance that our millions of individual economic decisions will be optimal.

  What happened as a result of this new dollar policy? Because of the oversupply of dollars, inflationary forces buffeted the U.S. and world economy. This inflation was ineffectually, and temporarily, addressed by price and wage controls in the U.S. and international capital controls overseas. Then the world economy was hit by two unforeseen OPEC oil embargoes. While these embargoes were politically motivated to draw attention to the Arab-Israeli conflict, they were not unrelated to the declining value of the dollar. Oil is the major world commodity actually priced in U.S. dollars, so when oil exporters received less valuable dollars for their products, they had to raise their prices to compensate for the depreciation. Cutting the oil supply helped support the price increase.

  By the end of the 1970s the U.S. economy had been in the doldrums for more than a decade. The so-called misery index, which added the inflation rate to the unemployment rate, reached a high of just over 20% as the election of 1980 approached. This led to a dramatic shift in monetary policy with President Carter's appointment of inflation hawk Paul Volcker as Chairman of the Federal Reserve. Under Carter and then Reagan, Volcker's mission was to break the back of inflationary expectations. He did this effectively in the early 1980s by shrinking the U.S. money supply, sending interest rates to 20% and spiking unemployment into double-digit levels. By 1984, inflation was broken and the U.S. economy bounced back as interest rates and unemployment receded.

  Using the logic of our economic model, what was happening in the 1970s and 80s? How did the economy get out of equilibrium and what was required to get it back into balance? Before the breakdown of Bretton Woods, the world economy had gotten out of balance, as had the U.S. economy. U.S. government borrowing to spend on both the Vietnam War and Great Society welfare programs boosted consumption more than in
vestment, while increasing the overall level of U.S. debt. Neither spending priority—military or welfare expenditures—did enough to increase the productive capacity of the U.S. economy. Thus, consumption demand outstripped production and, with accommodative monetary policy increasing the supply of dollars, prices rose.

  How does inflation affect our simple model?[42] Inflation has the pernicious effect of creating uncertainty over future prices and future values. This raises nominal interest rates, which should cause people to consume less as they produce more. Inflation also erodes the value of savings and incomes, further causing people to save more and consume less. However, because prices are not stable and uncertain, the real interest rate (the nominal or actual interest rate minus the inflation rate) may actually be negative.[43] Negative real interest rates encourage borrowing and spending because the interest cost is negative, but the uncertain price environment will favor speculation in real assets, not investment in new production. So real estate prices rise, precious metal prices rise, art and other collectibles prices rise, but none of this hard asset speculation increases the productive capacity of the economy. What we end up with is the infamous "stagflation" of the late 1970s: slow growth, high unemployment, and rising prices. Inflation distorts economic incentives and impedes the reallocation of resources that would get a stalled economy back onto a stable growth path. Volcker's policy to reduce the money supply with high real interest rates sharply corrected this inflationary price distortion, but at considerable cost in unemployment and productive capacity underutilization. In other words, Volcker and the central bank engineered a steep recession.

  Once inflationary expectations were eliminated and prices stabilized, interest rates gradually declined as they lost the uncertainty premium tacked onto lending rates to compensate for inflation. Asset bubbles in gold and silver burst and investment was channeled back into productive activities. Reagan enacted tax reductions as part of his supply-side economic policy, arguing that lower taxes on productive activity would increase the returns to investment. The twin effect of eliminating inflation and lowering taxes on production meant that risks were reduced while returns increased, so the risk-adjusted rate of return to investment got a double boost. The results were highly favorable, but were perhaps less due to the immutable logic of supply-side economic policy and more to the fact that the misguided policies of the 1970s had severely depressed productive capacity. My point is that the debates between the competing theories of Keynesian demand and supply-side economic policies often ignore the context of whether the problem is inadequate demand, disincentives to production, or both.[44]

  The limits to the success of the Volcker-Reagan supply-side corrective became apparent by the end of the 1980s as the economy slowed. The economy’s saving grace was probably the technological innovation wave in microchips, computers, and networked communications during the 1990s. The new Federal Reserve Chairman Alan Greenspan was dubbed "The Maestro" for his benign monetary policy that helped finance this technological and economic revolution. This was the high point of The Great Moderation. The only hiccups were a series of international financial crises that engulfed Mexico, Thailand, Korea, Argentina, and Russia (not mere hiccups to those living in these countries). These crises were mostly due to the massive financial flows on international capital markets that accompanied the explosion of exchange rate trading in the new floating rate monetary regime after 1971. Developing countries that liberalized their economies could attract massive inflows of capital that could and did reverse when financial circumstances changed. This capital was often loaned and invested in a developing country's growing economy, but then the capital that financed these investments could be withdrawn at a moment's notice, forcing the country to the brink of bankruptcy. Often the loans were priced in U.S. dollars, while the country's local investment returns were received in local currencies. A financial crisis meant a crash in the domestic currency and almost certain bankruptcy with the inability to pay off the loans in U.S. dollars. This was the case in Russia, which defaulted on its debts in 1998. But the Federal Reserve rescued the world financial system from the Russian crisis with liquidity (i.e. lots of cheap credit in the U.S. to shore up U.S. credit markets), while the International Monetary Fund (mostly funded by U.S. taxpayer funds) came to the rescue with conditional bailouts for the beleaguered countries. This all seemed to work at the time and the U.S. economy, together with the world economy, marched on. Unfortunately, all the dollar liquidity sloshing around in the economy meant we were just heading off another precipice.

  The excess liquidity in the U.S. economy became apparent with the Internet bubble of 2000. The mania of this period saw stock fortunes made and lost in matters of days and weeks, with new companies selling for incomprehensible values just because they had a .com in their names. This is the nature of financial euphoria—it causes investors to chase ever higher prices of financial assets until these collapse like a party balloon meeting a pin. We will experience these types of bubbles and busts again and again. But it is important to note that all financial asset bubbles must be financed with credit. This is where the Federal Reserve went seriously wrong in the first decade of the 21st century.

  When the Internet bubble burst, the real economy was not seriously affected because most of the money lost was "funny money" anyway. Unemployment was barely effected and the recession of 2001-2 that followed was notable for the 2000 presidential election that was decided by the Supreme Court, a slew of corporate scandals that often accompany financial manias, and the terrorist attacks of 9/11 that occurred before the economy had found its footing. There is a good case to be made that the recession was aggravated by poor Federal Reserve policy, which first raised interest rates too high in late 2000 and then pushed them too low for too long after the economy stalled in 2002. Recall from our model that manipulating the interest rate distorts the signals that govern our decisions to consume or save, borrow, or invest. In late 2002, the economic policymakers were faced with a moribund stock market, businesses that were retrenching and neither borrowing nor investing, banks had no corporate borrowers, and investors who were jaded by corporate scandals and the deflated tech bubble. Nevertheless, Federal Reserve policy found a new belle to take to the ball: the housing market.

  4.1.1 A House is Not Just a Home?

  Starting in 2002, the Federal Reserve helped push interest rates down to 1% and held them there for almost three years to encourage credit creation. I say 'helped' because there was also a world savings glut caused by the high savings rates in rapidly growing economies, such as India’s and China’s, which also put downward pressure on interest rates. These excess Asian savings found their way to U.S. and European consumers mostly by refinancing and expanding the world housing stock. A lower interest rate allows a buyer to purchase more house with the same income, or refinance at a lower rate and withdraw equity from his or her existing home. U.S. policymakers such as Greenspan, who believed that the world had attained a new, stable plateau of low inflation, balanced GDP growth, and reduced risk, welcomed this new ‘stimulus’ strategy. These new conditions engendered a rising confidence in the future that justified permanently low interest rates and higher valuations of capital. Greenspan argued that additional consumption demand from refinancing and home equity withdrawals would keep the economy humming along until the corporate sector started expanding. If only we had reached such a Nirvana.

  To understand what was happening we need to examine the process in greater detail. First, when banks create credit through lending, they control the risks of nonpayment by several methods. If you’ve ever applied for a bank loan, you are familiar with these. Most obvious is the past credit history of the borrower, but most important for the lender is securing loan collateral that can be claimed in case of default. This, ironically, is why banks are happy to lend money to people who don’t need it. Collateral value can be represented by liquid financial assets, like savings or Treasury bonds in the bank, or real assets, such as a hou
se. When we secure a home mortgage from a lender, the lender holds a lien on our house. If the bank fails to receive mortgage payments, it can exercise this lien by foreclosing on the mortgage and repossessing the house. Then it sells the house to recapture its loan investment.

  All loans created by the banking and the shadow banking systems were backed by some form of collateral. In the residential mortgage market, the collateral was represented by rising home values. In the shadow banking system, collateral was represented by complex financial derivatives, mostly collateralized loans based on these same home values. In the last twenty years, banks’ careful monitoring of the collateral value of their loans has been weakened by a financial innovation known as securitization. Securitization is an effective risk management technique whereby many different loans with different characteristics can be pooled together to reduce credit risk through diversification. This asset pool of loans can be packaged into a new financial security for resale to investors. In this manner, the payments on the loan go to the new investor/owners together with the credit risk of default. If the home owner defaults, the issuing bank is out of the picture and the investors lose. The bank no longer bears that risk of default so it has less incentive to care about the quality of the loans it originates. Through securitization, banks were able to ramp up credit creation with little concern for the risks of borrower creditworthiness or the value of the collateral. (This is the first hint that all is not going to end well with this story.) For financial markets in general, securitized pools of mortgages and other collateralized debt obligations created a vast new market for tradable credit instruments.