In this difficult recession, throwing trillions of dollars at the economy seems like administering expensive blood transfusions in the hope of stopping the bleeding. Better to close the wound.
How we got here
For the past two decades, many Americans thought we could have it all. A national policy of easy money (low interest rates and loose underwriting standards) fed our willingness to take on enormous personal debt, often maxing out on multiple, easily-qualified-for credit cards. Irrespective of income, we “deserved” to have multiple cars, the latest electronic gadgetry, and our own homes. Businesses, particularly financial institutions, became overly-leveraged.
The United States pursued what might be called “The American Dream Policy.” Home mortgage lending was liberalized as never before. Congress pressed Fannie-Mae and Freddie-Mac to aggressively purchase home mortgages, of virtually any quality, in the secondary market. (Those government-backed agencies bundle and sell mortgage-backed securities to institutional investors.)
Derivative instruments were expanded by investment banks, slicing and dicing mortgages into securities which rating agencies, based on poor models, often rated AAA. And finally, AIG and others sold credit-default swaps which insured those securities against default.
The resulting voracious appetite for these “high-grade” securities made it attractive for mortgage brokers, banks, and thrift institutions to write mortgages for just about anyone. And why not? After earning origination fees, the bank would sell the mortgages, including the weakest, which would then be packaged and repackaged with others and sold into the capital markets. Everybody won! It was a gravy train for consumers, mortgage brokers, commercial banks, investment banks, and the government. Lax regulation further fanned our collective profligacy.
Congress rebuffed any criticism that this was a dangerous if well-intended course and that tighter oversight was warranted. Spreading risk so opaquely raised the question: if no one effectively owns the risk, how much inappropriate risk will be taken? The sad answer: “An infinite amount.”
Our debt addiction
As easy credit expanded demand for homes, values inflated; 2004 to 2007 saw annual home price increases of over 10% nationally. The increasing property values turned homes into virtual ATM machines; millions of homeowners refinanced their property to repay credit card debt or make big-ticket purchases such as automobiles, vacations, and flat screen TVs. The Federal Reserve estimates that home equity withdrawals exceeded $300 billion annually in recent years.
Total U.S. household debt (mortgages plus revolving credit) reached the equivalent of 100% of Gross Domestic Product by 2007. Twenty-five years earlier, it was less than 50% of GDP. In just one generation, we became debt-addicted. And financial markets were able to camouflage risk. To function properly, free markets require transparency; the new derivative securities were essentially opaque.
With the gains in housing values outstripping gains in income, a burst of the housing bubble was inevitable. The slide in real estate values that began in 2006 led to increasing home foreclosures. That affected the value of mortgage-backed securities. Financial institutions were forced to write down the value of those securities (which embodied poorly understood systemic risk). Balance sheets became impaired. As losses mounted, capital markets froze. And without free flowing capital, economic activity slowed, corporate results weakened, and stock markets dropped.
- Reduced U.S. consumer spending, the engine of the global economy, has led to the worst world-wide slowdown in 75 years.
The role of government
In this crisis, there certainly is an essential role for government. Its intervention last fall, saving financial institutions from implosion, likely averted a devastating global banking collapse. It did not, however, succeed in identifying and auctioning toxic securities, as was promised. The government must focus, as it is now attempting, on plummeting housing values (and resulting foreclosures), along with paralyzed capital markets. That’s the source of the bleeding.
The transfusion
Yet the hastily approved $787 billion “stimulus package,” including in its 1100 pages thousands of programs (hopefully job creating) unrelated to declining home values or constricted capital markets is tantamount to administering expensive blood transfusions rather than closing the wound. Of course, if the blood eventually coagulates–the economy will one day rebound–the transfusions will be credited. But the delayed cure would have come at punishingly high costs to generations of taxpayers. U.S. debt in 2009 is at 69.3% of GDP, the highest level in six decades–and growing at an accelerated rate. This largest-ever debt increase also has security implications; we depend on non-Americans, including foreign governments, to finance at least half of our public debt.
If one is to believe the non-partisan Congressional Budget Office, the transfusion will hurt more in the long run than if we did nothing. The “crowding-out” effect of the huge national debt will reduce availability of productive private capital—with attendant inflation and dollar devaluation.
The reaction
In fact, most of the government’s costly initiatives have been viewed skeptically thus far by global financial markets. So the U.S. Treasury Department has worked for months to identify and deal with the toxic securities. If effective, its new “Public-Private Investment Program” should help banks shore up capital and normalize the credit markets. Repeated transfusions–trillions in new government spending–are not seen as closing the wound. In the first two months following passage of the stimulus, the stock market stagnated (after a 40% one-year drop, a loss of $5.5 trillion for the two-thirds of U.S. households who own stock). And consumer sentiment surveys reflect continuing skepticism about the “transfusion” strategy.
Closing the wound
- That would be seen as an attempt to actually stop the hemorrhage.
In a New York Times essay, Professor Susan Koniak of Boston University’s School of Law and economics Professor John Geanakoplos of Yale, a partner in a hedge fund that trades mortgage securities, estimate that for $3 to $5 billion, the government could help banks (and other bondholders) and at-risk homeowners with the costs of appraisals and the assessment of default risks. Their point was to minimize bank losses (often 75% ofthe loan valuein foreclosure) and to arrange more manageable payment terms for at-risk homeowners. Banks/bondholders would lose less than through wholesale foreclosures. The government would have assisted but taxpayers would not have had to underwrite those losses with the $75 billion of mortgage-assistance included in the stimulus bill. Finally, strengthening values in this way would make mortgage-backed securities less toxic and would lower subsequent “bailout” costs.
Just as direct action to stabilize the housing market targets the root problem, the Treasury’s program to deal with mortgage-backed securities, if it works, could restore confidence and credit. Both steps would stanch the bleeding. But the country should avoid more “transfusions” (i.e. stimuli), whose benefit is uncertain but whose deficit burden and inflation effect are certain.
Related thoughts
Two related observations: First, no industry is more fundamental to the U.S. economy than automobiles, accounting for more than 10% of American jobs. “Detroit” is not without fault, but it has been dealt a lethal blow by a credit crunch it did not create. At the current 9+ million vehicle annual selling rate, 3 million below the vehicle scrappage rate, the survival of all auto companies, domestic and foreign, is threatened.
If the federal government would spend trillions to right the economy, then it should have served as lender of last resort, granting domestic auto companies 18-month bridge loans contingent upon UAW, bondholder, and management concessions. The pent-up auto demand in 2010-2013 will be enormous. The companies would then be required to begin repaying the loans with interest.
The alternative, namely operating Detroit from Washington, is folly. And, in this economy, permitting an auto company bankruptcy, pre-packaged or otherwise (perhaps a fact by the time this appears) will either deepen the recession, because already-weakened suppliers will choke the entire industry, or it will require expensive, government-backed (and potentially anti-competitive) purchase incentives and warranties to offset the perceived risk of buying a vehicle from a “bankrupt” manufacturer.
Secondly (again about jobs): The U.S. Small Business Administration reports that 75% of all jobs created over the past two decades are in companies of fewer than 500 employees. Increasing taxes on those making $250,000, fully two-thirds of whom are small business owners, is self defeating. Reinvestment creates jobs. If we seek job creation, we shouldn’t penalize job creators.
Conclusion
We can hope that struggling stock markets and a bailout-weary/spending-weary public will keep Washington focused on collapsed housing values and damaged credit markets. Debt-deepening “transfusions,” unrelated to the root problem, will cripple future growth. Instead we should close the wound. The economy will then right itself, as it has historically.
The era of excessive leverage and poor risk management has ended for individuals and financial institutions now forced to be more responsible borrowers, spenders and savers. Will we expect the same of government?
Louis E. Lataif
Allen Questrom Professor and Dean
Boston UniversitySchool of Management
Former President, Ford of Europe (1988-1991)
