Every pundit on Earth is playing the game of picking the various bailouts apart and proposing their own improved bailout schemes. But I think that most of the conversations going on out there miss a critical point: that this bailout and the ones that will in all likelihood follow it fail to address the root cause of the problems.
That root cause, in my opinion, is that the vast majority of political leaders, regulators, and pundits zealously cling to a deeply flawed analytical framework.
To put it more simply: the people and principles that blithely led us into this mess are absolutely the wrong people and principles to lead us out of it.
The problems we are facing have been coming down the pike for a long time. Many, many people saw them coming. Here at VoiceofSanDiego.org, I wrote about the risks posed by credit default swaps (one of the latest credit crisis bogeymen) in January 2007 and collateralized debt obligations (which were at the heart of the subprime crisis) in June of that year. I wrote about the possibility of widespread mortgage defaults as far back as February of 2006 (my second month of writing for Voice) and I have been writing about the risks of the speculative housing bubble at my own website since mid-2004.
I don’t say this to pat myself on the back, but to offer specific examples that these problems were knowable well ahead of time. (This is a necessity, sadly, given the constant historical revisionism practiced by many financial commentators). But it wasn’t just me — a few minutes of Googling will show that many, many analysts identified these problems ahead of time.
So if the problems were knowable to so many people — including me, a regular guy here in San Diego with no letters behind his name or anything — then how is it that the people in charge of running the world’s largest economy were absolutely blindsided by them?
Consider the following quotes:
“[House] price increases largely reflect strong economic fundamentals, including robust growth in jobs and incomes, low mortgage rates, steady rates of household formation, and factors that limit the expansion of housing supply in some areas.” — Fed Chairman Ben Bernanke, Oct. 20, 2005
“[The housing downturn] looks to be a very orderly and moderate kind of cooling.” — Fed Chairman Ben Bernanke, May 18, 2006
“All the signs I look at [show] the housing market is at or near the bottom.” — Treasury Secretary Henry Paulson, April 20, 2007
“I don’t see [subprime mortgage market troubles] imposing a serious problem. I think it’s going to be largely contained.” — Treasury Secretary Henry Paulson, April 20, 2007
“Given the fundamental factors in place that should support the demand for housing, we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited.” — Fed Chairman Ben Bernanke, May 17, 2007
I could dig up enough to fill a book, coming from these two guys and a whole lot more of our leaders, but hopefully the above quotes are enough to give a flavor. These guys had absolutely no idea what was going on. With homes priced in vast excess to any prior relationship they’d had to incomes, Bernanke came out and actually claimed that prices were supported by those same incomes. Paulson then called the bottom in Spring of 2007, with homes still exceedingly overpriced and a huge glut of foreclosures already in the pipeline. And all along they denied that there would be any ill effects outside of homes bought with subprime loans (this after they and their predecessors had for years denied that subprime loans would become a problem at all).
Given the above statements by Paulson and Bernanke, there are only two possibilities: they are incompetent or they are liars. I tend not to think they were lying, because if they really knew what was going on they would have been a lot more non-committal rather than making statements like those above that could later be proven to have been hugely wrong. So that leaves incompetence as the most likely explanation.
I single out Bernanke and Paulson, by the way, because they are spearheading the bailout efforts and because these two unelected men wield phenomenal power over our financial future. But they are absolutely not alone in having had no idea what was underway — they are joined in this honor by the Administration and, as far as I can tell most of Congress and the financial regulatory structure.
Yet all these people are still at the helm. And despite their proven and repeated inability to understand the situation, they are for some reason expected to successfully lead us out of it.
It’s not that any of these people are stupid. Not by any stretch. The issue, as I posited at the outset, is that they are under the sway of an analytical framework that is dangerously misguided.
I don’t want to get too deep into the weeds, here, but by way of providing some justification for the above statement I will outline below a sampling of the misapprehensions that have been at work in guiding us into this morass. The italicized statements below are all core beliefs of what I would contend has been the mainstream view for many years among politicians, regulators, and pundits. They are all, in my opinion, wrong, for reasons explained after each italicized statement.
Financial market prices are always right. Despite having experienced the world’s biggest stock bubble followed by the world’s biggest housing bubble in less than a decade, people still cling to this one. The mainstream view is that market prices reflect the combined knowledge of all market participants and so they must be correct. Whatever prices are, it follows that that some rationalization should be reverse-engineered to explain them. See Bernanke’s laughable attempt to justify home prices in 2005 as an example. But history has proven time and time again, and is once again proving as we speak, that markets get it wrong all the time.
Debt doesn’t matter. The economic boom we just went through was greatly dependent upon people borrowing against rising home prices to increase their consumption spending. Most people only looked at the economic growth side of the equation (such as GDP, or gross domestic product) without seeing that on the other side, our level of indebtedness to foreigners was growing faster than economic activity. This is neither sustainable nor desirable.
There is nothing wrong with borrowing if the proceeds are used to increase future productive capacity by building up infrastructure or the means of production, because these expenditures will lead to an increase in our economic potential and earning power down the road. But when the proceeds are used to buy consumer goods that have no productive capacity — and houses are consumer goods, by the way — that increases the debt we will have to eventually pay without a commensurate increase in our future earning power. This is bad.
Consumer spending is the basis of our economy. People panic whenever consumer spending drops and many bailouts, specifically the government “stimulus checks,” are directly aimed at increasing consumer spending. But long-term economic strength is based on what a society produces, not what it consumes. Seems like common sense, doesn’t it? Yet our economic policies are overwhelming geared towards stimulating consumption.
As a nation we have consumed more than we produced for so long that people think that this pattern can be sustained forever. It cannot. Someday we will have not only to produce the same amount as we consume, but to produce even more than we consume in order to pay back all the debt we’ve racked up. But as we’ve seen so many times recently, unsustainable trends like these are often ignored and rationalized until they become crises.
This misunderstanding is tied in closely to the above idea that debt doesn’t matter. When the debt starts to matter — as it inevitably will when our creditors eventually come calling — it will be clear that it would have been much better to encourage the development of more productive capacity and earning potential rather than to stimulate consumer spending.
A rise in home prices is the same as saving. During the boom we constantly heard that it didn’t matter that Americans spent more than they earned. Their home prices were going up, we were told, so the country was getting wealthier. This reasoning is very flawed.
An individual who owns a home that goes up in price can indeed become wealthier if he sells the house. But in that case, the person to whom he sells has to come up with the money to buy the house. There is no increase in overall wealth — just a transfer of wealth from buyer to seller. If on the other hand the owner keeps the house and takes out some equity, he has to borrow money from someone else in order to do so. Again, there is no net increase in wealth — just a temporary transfer of money from lender to borrower.
Saving is the act of foregoing current consumption in order to use your capital (money, in this case) at a future date. From an overall standpoint, rising home prices (or any asset prices, for that matter) do not lead to any increase in society’s accumulation of saved capital.
High asset prices are good for the economy. Over the long haul, society’s prosperity is dependent largely on how effectively it utilizes its resources, including its people, its natural resources, its existing means of production, and its saved money. The purpose of the investment markets is to foster the most efficient allocation of saved money. To this end, neither high asset (specifically stock and bond) prices nor low asset prices are desirable.
When asset prices are too high, it is too easy for businesses to gain access to capital (again, money) and many inefficient business ventures will be funded, thus wasting society’s resources. Good examples of this phenomenon from recent times include the free-spending yet profitless dot-com companies during the tech stock bubble and the glut of McMansions in the Inland Empire more recently. In both cases, society’s resources were squandered because asset prices were too high.
If asset prices are too low, on the other hand, it is hard even for viable businesses to gain access to capital. Society’s resources will not be used to their full potential. It’s tougher to find recent examples of this phenomenon, given that so much money was until recently chasing financial assets, but it certainly has happened in times past.
If asset prices are too low, it’s better for them to go higher. Everyone can probably agree to that. But if asset prices are too high, such that they are encouraging a wasteful use of resources, it’s better for society’s long-term prosperity that they go lower. A big part of the current (and future, I surmise) bailouts entails propping up asset prices. This is bad for the economy in the long haul.
Inflation isn’t inflation unless it shows up in the CPI. A sensible definition of inflation, I would think, would be: “your dollars buy less.” As such it makes sense that inflation can occur in anything that can be bought with dollars. Anything can become more expensive, after all. This includes consumer goods as well as producer goods and even financial assets. (What we saw with the tech stock bubble and then the mortgage-backed securities bubble was rampant inflation in financial assets in which prices of those assets rose in great excess to their capacity to generate future earnings.)
But the government has this inflation measure called the Consumer Price Index, or CPI, which measures changes to consumer goods and services prices. There is nothing wrong with this, but the problem is that if inflation doesn’t happen to show up in the CPI, it is ignored.
Here’s one recent and significant example of why this matters. The CPI happens to measure rents instead of home prices. So when home price inflation raged here in San Diego during the housing boom, it never registered in the CPI. And thus, as far as mainstream economists were concerned, those 25 percent per year home price increases weren’t “inflation” — even though by any common sense definition, inflation is exactly what they were.
Money supply growth does not matter. OK, despite earlier promises I’ve long since entered the weeds. Last one. It’s pretty widely acknowledged that over the long term, inflation is a function of how much money is created. But per the above item, if the money supply increases and the resulting inflation happens to take place in items not measured by the CPI, it’s deemed to be a non-issue.
Rampant home price inflation, to continue with the above example, was deemed to have nothing to do with the breakneck pace of money creation that took place earlier in the decade. That was just a coincidence, we were implicitly told. Instead, the home prices were deemed by the establishment to be fundamentally sound despite the fact that prices were far higher than those fundamentals would have dictated. After all, market prices must be right, no?
And with that we’ve looped around to the first misconception. I’ll stop now. I realize that I’ve blazed through some pretty complex topics here, but I believe that most of what I’m saying aligns with common sense. Hopefully this provides at least an idea as to some of the the flawed, unrealistic, and often nonsensical ideas that infest mainstream economic thought.
The vast majority of policymakers, and Bernanke and Paulson in specific, cling to a dangerously misguided analytical framework. That is a huge problem. The best fix we could put in place for the long-term health of the economy would be to forsake the wrong and now-disproven framework and to embrace a view of the world that, while surely less appealing to quick-fix oriented politicians, is both more realistic and more focused on sustainable long-term prosperity.
Unless and until this happens, I don’t expect any of the bailouts to do much good in the long run.
— RICH TOSCANO