Economics: Between a Passing Shower and a Looming Hurricane

Economics: Between a Passing Shower and a Looming Hurricane

The first decade of the 201st Century began amidst the notes of an extravagant opera—dramatic, tragic and, above all, loud—. known as the global financial crisis. The global financial crisis While this meltdown appeared to be the Twilight of the Gods, i. It turned out to be simply a routine churning of the U.S. and global business cycles. At the same time, Its greatest significance may well be that it allowed people to ignore the much greater looming crisis that truly will would dominate the next century globally, namely, the intensifying shortage of skilled labor around the worldshortage. The financial crisis was business as usual. The labor crisis will begin changing the entire picture of the world.

The Presidents of the next decade will need have a natural tendency to obsess over the past crisis or to relax with the feeling that the past being past, all is now well. What they need to be doing is preparing for the next crisis.

A challenge every President has is to see past apparent threats, and recognize the real ones, and prepare for them, which is not an easy challenge . That isn’t easy to do, particularly when the public is panicked and transfixed by the sense of a danger. And yet to dismiss our current financialtroubles as business as usual would appear to dismiss public opinion. A President can not talk the people out of their fears. The only way he can only pacify the public is ir fears by showing that he remains steady while believeings what they believe, not by trying to talk them out of their fears. Roosevelt was particularly gifted in reassuring the public that he shared their concerns and was doing something about themit, even though he made little headway against the Ddepression until World War II drove brought the American economy through the roof. back to life.

To dismiss the current crisis as trivial would appear to be dismissing the public. Therefore, Whether or not the current crisis is less than meets the eye—neither unique, a threat to American power, nor frankly, very important.—President Obama had to take action, all the while address the issue. But bearing in mind that past economic crises tend to dim with time. H—how many voters remember clearly the crisis of 1982 1982, or the details of the recession of 1991?—he had to salve fears in full awareness that the crisis would be forgotten. He also had to, if he was to serve the country, develop a strategy for dealing with the real crisis, even though it will only be a distant shadow during his Presidency. Acting on distant dangers is as difficult as ignoring public fears.

The first thing that the President must understand is why, regardless of what is commonly said, this crisis was neither unique, a threat to American power, or frankly, very important. Until he understands that, he can’t remain grounded in reality, but can begin to believe the things he must say to calm public fears. Therefore it is essential, if the President is to weather this storm, that he understand the reality of this crisis and compare it to others. Retaining power demands that the President neither dismiss fears nor believe them himself if they are not valid.

The Financial Panic of 2008

The most dramatic shifts in the international system are caused by wars. The Great Depression that savaged the globe had more to do with World War I, and the destruction it wreaked on Europe, than on any self-contained economic process. The economic system that still dominates the world today was forged in World War II. Retaining power demands that the President neither dismiss fears that are widely accepted, nor believe such fears himself when they are not based on a solid assessment of reality. In order to prepare for the next, truly significant crisis to come, The next change will not be directly defined by war but by demographics and the 2010s will be the time when the world and the United States can prepare for it. But to do that, everyone must understand the relative unimportance of the financial crisis of the last decade. Therefore, any the President must understandbe able to see what happened in 2008, as well as the forces leading up it, in clear perspective. , why it happened, and why it meant much less than it seemed. Then he can begin preparing for the next crisis.

The economic crisis originated in 9-11, oddly enough. To see this, let’s begin with Vietnam. Lyndon Johnson was focused on domestic matters trying to build the Great Society. His involvement in Vietnam was not seen, when it began, as a long term, major military conflict. Everyone knew at the beginning of World War II that the war would be long and enormous. The entire economy was reshaped to fight it. Not so with Vietnam. First, Johnson didn’t know that this would be a long and costly war. He certainly didn’t expect to give up, in the terms of the day, butter for guns. Second, by the time he realized that the war was going to be a massive expense, he did not want to erode his political base by reducing social spending or massively raising taxes to pay for the war. He therefore financed the war by running budget deficits. Richard Nixon responded to the resulting inflation in 1971 with wage and price controls.

The most dramatic shifts in the global economy are usually caused by major wars, when the cost outstrips the government’s income. The Great Depression that savaged the globe had more to do with World War I, and the destruction it wreaked on Europe, than on any self-contained economic process. Today’s economic system was forged in World War II. The cost of major war outstrips the current income of governments. Everyone knew at the beginning of the conflict that this war would be long and enormous, so During World War II, the government launched incessant bond drives were designed to achieve two ends:. First, it was designed to raise money, and s. Second, it was designed to raise money siphon off earnings from the public in order to increase savings and reduce the amount of money in circulation. As employment soared in war and related industries, the government was fueling personal wealth in the hands of the public. Left unchecked, this would increase the money supply while decreasing consumer products, leading to sky rocketing inflation. The bonds were sold in an attempt to While reducinge the amount of money in circulation, the bonds would also and to allow the war debt to be paid off over a generation, rather than as expenses were incurred.

Lyndon Johnson understood the lesson of what it meant to finance a major waris, but when he began his escalation in Vietnam, he did not see that conflict in those terms. by the time he realized he was fighting a major war, the situation had gotten away from him. Focused on the domestic aims of his Great Society, certainly he had no intention of giving up, in the terms of the day, butter for guns. By the time he realized that the war was going to be a massive expense, he did not want to erode his political base by reducing social spending or massively raising taxes. So he financed the war by running budget deficits. The resulting inflation led Richard Nixon to respond in 1971 with wage and price controls.

Similarly, George W. Bush also didn’t realize he was fighting a major war. He thought that the invasion of Iraq war would be quick and easy, and by and then he thought the insurgency could be handled at a limited cost. By the time he realized the full cost of fighting a protracted insurgencythe war he had limited options. His constraints were intensified options were limited by the fact that he something that Johnson didn’t do—Bush cut taxes in 2002 and 2003, something no one had ever done during a major war.

Under normal circumstances this might well have been a rational strategy, but war is not a normal circumstance. When Bush got Congress to agree to tax cuts in 2002 and 2003, he did something that no one had ever done during a major war. But the key is to understand that Bush didn’t think he was in a major war. He saw Afghanistan as a low cost enterprise, which it was, and he saw Iraq as something that would be over quickly. When it wasn’t, he didn’t reverse his economic policy, both for ideological and political purposes. He cut revenues while increasing expenditures.

The theoryBush was acting on the theory —not a bad one—is that tax cuts generate increased tax revenues by increasing money in the hands of the public and corporations, and particularly particularly in the hands of the wealthy, who tend to invest rather than consume. But for this to work, the investment has to be in the private sector. Whenith government borrowing soarsing, the government would be sucksing up a huge amount of the tax cut as investors bought uy government debt. Theatusual could create a situation called “ result is that crowding out” where government debt crowds out private borrowing, driving up consumer and corporate interest rates,, and triggering a recession.

During Bush’s term of office, tTwo factors kept interest rates down while keeping and inflation under control. The first was that a vast amount of money that was being pumped into the economy went overseas, particularly to China, as Americans purchased , whose low cost consumer products. attracted vast amounts of money. The Chinese in turn, Mmaking more money than their own small economy could absorb, the Chinese, in turn, —chose to invest this money in the safety of U.S. Treasury debt. This is where the “supply side” theory broke donw. Instead other words, instead of circulating within the U.S. economy to fuel real growth and increased tax revenues, the money loosened up by low taxes was pumped overseas, then and came back into the United States mainly to finance as purchases of the debt the government had to issue incurred in order to cover the war and the tax cuts in the first place. That meant that the theory wasn’t holding up, it wasn’t the U.S. economy growing rapidly and increasing tax revenues, although the U.S. economy did grow. Rather it was the U.S.-Chinese tango—as well as other foreign exporters who reinvested their money in U.S. federal debt—that soaked up the debt and helped keep interest rates low.

At the same time as this was going on, the The Federal Reserve Board’s support for low interest rates actually encouraged the US-China tango, did everything to encourage this while doing what they could to keep interest rates low. That increasinged consumer spending even more, especially spending on credit cards as we gobbled up low cost Chinese products. now shifting from tax cut spending and spending of increased earnings, but spending into their credit card available credit as well—buying imported goods on credit that was recycled by exporting countries back into U.S. credit markets.

There was nothing inherently wrong in this process. If Americans were addicted to Chinese goodproducts, the Chinese were addicted to American debt. Having built the factories, they now had to sell the products, and they couldn’t sell them domestically because their own people were too poor. Once they had earned the money, tThey had nowhere else to put their moneyit, and a decline in American consumption would have been disastrous for them. Keeping , so they kept the pump primed by investing in the U.S. credit markets, particularly government debt. , not only made sense, but they really had no choice. Having built the factories they had to sell the products. They couldn’t sell them in China since, as we shall see later, China was too poor to buy these products. They had to sell and the U.S. market was vast and essential to China. So it was all a self-sustaining processcycle that . It also solved the political problem of the Bush administration—how to finance the war and the tax cuts without surging interest rates or inflation.

The problem was that flaw in thise system was the flood of awash in cheap money—a problem that arises . But in a sense, that’s what happens during the climax of all economic expansions, when r. Rational cycles become irrational, and the system hits a wall. The usual culminationdenouement is that some asset on which wealth is based goes down in value, as in the late 1990s when the value of the .The dot.comsera saw massive expansion in the value of these companies, until they reached irrational heights and collapsed. This led to a loss of assets and in many cases, the inability to repay debts ,which had been based around predicated on these inflated asset values. That led to a contraction in credit, and a recession, but after the . The recession cleaned out the excesses, and the economy resumed its growth. SuchThese cycles occur on average every 4-5 years, with the time between recessions increasing since 1982.

In this case
During the Bush years, the asset class that had risen rose in price was residential housing. With interest rates low, more people than ever had been were able to buy houses. And with excess cash—cheap money— in the system, banks and others wanted to put their money it to work in what was traditionally regarded as a conservative investment: real estate.. The price of homes had risen for the past generation, but as the chart below shows, that success story is ’s a bit deceptive:

If you adjust home prices for inflation, home prices went did go up and down in a narrow band since 1970. But mortgages don’t rise with inflation. So if you borrowed $20,000 to buy a $25,000 house in 1970, by 2000 that house would be worth around $125,000, and you’d have paid off your mortgage. But $125,000 was not much more than $25,000 in real terms. You felt richer because the numbers were higher and you had paid off your mortgages, but the truth was that home ownership was not a great way to make money.

On the other hand, the record showed that you were not unlikely to lose money either, and that . That gave lenders confidence. in home mortgages. Given that housing prices never really fell, mortgages were deemed to be always safe investment. If wWorse comes to worse, they lender could always seize the house and sell it, getting back his their money back. So lenders became more aggressive in lending money. Given that prices didn’t fall, lending to people who might default wasn’t dangerous to the lender.

That meant thatWith cheap money enabling more people were able to buy houses, and as demand rose, which meant that the price of housing prices es broke out of its historic patterns. In terms of dollars adjusted for inflation, home prices broke out of their historic pattern about 2001, and took off like a rocket in 2001, increasing the rate of then accelerated further growth after 2004. Lenders kept looking for more and more borrowers for their cheap money, which meant that was available. They kept lending to people who were less and less likely to repay these now “subprime” loans. The ultimate moment climax came with the invention of the 5 year variable rate mortgage, which . This allowed people to buy houses for monthly payments frequently lower than what they were paying for rent on an apartments. These rates would explodesoar in five years, but if the buyery lost the house, they had at least had enjoyedlived in one for five good years , and were back where they started. No loss. If housing prices stayed steady, they could remortgage again, so, all in all, t. They didn’t seem to be weren’t taking much of a risk.

Nor did the lenders appear to betake much of a risking much, especially given that they made their money on closing costs and other transaction fees, then . First, housing prices wouldn’t fall. Second, the lenders sold the mortgages (and passed along the risk) to secondaryother investors. They made their money on closing costs and other transaction fees, while passing the risk off to conservative investors who were the real villains of the piece. Conservative investors aren’t looking to make a killing. They just want a little higher interest at no higher risks. Lenders took the mortgage loans and packaged them to give them higher interest.

In packaging these loans for the secondary market, lenders emphasized What they actually did was create complex processes for looking at the lifetime income from the loan, which made the sub-prime loans appear to be the perfect investment.really attractive, and put these together in order to give the conservative investor a bit more interest, with no further risk. How could there be risk in residential mortgages? Had the conservative investor understood that higher interest always means higher risk, he might have looked twice. But by definition, financial crashes happen when sure things turn out not to be sure.