Monday, August 3, 2009

Getting to the heart of the economic collapse ...

As pontificators know, it is easy to have an opinion. It is not so easy, however, to have a supposedly educated or even commonsense opinion. That takes a little more effort.
I have had some conversations during the last year or so about the state of the economy and what brought us here. These conversations have been interesting, to say the least. But these are important conversations to have while acknowledging as many of the facts as one can, to the best of our abilities. It is also important to lay blame where blame is due, and not just use our own built in prejudices and political party influence to pigeonhole selected blame.
The economy didn't just collapse because Congress forced banks to lend money to poor or minority folks. The economy didn't just collapse because of the Iraqi invasion or the sustained campaign in Afghanistan, or even the debt incurred by both. The economy didn't just collapse because Bush rolled back taxes on the rich and it won't continue to collapse because Obama and the Democrats will let those tax breaks expire. The economy didn't just collapse because of Bill Clinton's policies either.
It's easy to get caught up in the name-calling because it distracts us from the larger, bigger problems, or the collection of problems, since virtually everything is connected. Blaming poor folks, blacks and Hispanics, liberals, warmongers, and tax cheats is a distraction. It is also hilarious to think that three million mortgages worth a few hundred billion dollars are being blamed for $9 trillion in economic losses that really didn't exist in the first place. These were all smaller symptoms of a larger, longer lingering sickness based on how we treat each other versus how we all live. All kinds of things like greed, fraudulent monetary policy, people who scammed other people, and people who desired better lives and would do just about anything to attain those lives, have all played a role.
It is also important to realize that the economy didn't just crash overnight, even though some folks think it did. As I have said previously, it wasn't just Sept. 15, 2008, that made the economy collapse. It wasn't the entire summer of 2008 or the spring of 2008 either. The economy started sliding way before that for most folks and a lot of us thought the economy would crash years before it actually did, and some of us even wrote about it.
In addition, despite what everyone says, it wasn't BearStearns that started the economic collapse either [Again, read this Vanity Fair piece from a few months back to learn that 1) BearStearns was solvent the week before its collapse, with billions in cash on hand, and 2) was probably brought down by a derivatives speculator betting against the financial powerhouse: "Bringing Down Bear Stearns"].

So what really caused the problems and why did the educated and enlightened - the ones we consistently rely on to guide the nation - not see the collapse coming? I can't say for sure. But here is what I can say. I think that most folks are totally missing the boat when it comes to why this all collectively happened. Obviously, there are many factors. Some are mentioned above. There was the speculative nature of Wall Street or the fact that the Street's police, the SEC, believed the criminals, the speculators, when they were told that things were safe and sound. At the same time, Americans were tempted - even brainwashed, if you consider the bombardment of Ditech ads before the collapse - into making very dangerous financial decisions based on attaining - or holding onto - a certain lifestyle. They were encouraged - or in some cases, literally forced - to put money into Wall Street when they probably had no business being there [if you're in your 40s, ask your parents about the pensions they used to have with their employers instead of the volatile and bankrupt 401k system we're expected to invest in ...]. People purchased homes they couldn't afford with dangerous mortgages and now, the frugal and non-risk-takers are expected to pay to fix everything, as always.
All these combined things played a role. But, as you will see in the data below, the Federal Reserve had a bigger role in the collapse of all of them and no one seems to be calling them on it. In fact, most media outlets are totally looking the other way on the role of the Fed. Politicians clearly are ignoring the problem, including how much power is yielded by the Fed to control monetary policy. Most of us saw the telltale signs on the wall as far back as late 2005, when the Fed started raising interest rates. This chart from gives you a visual idea of what happened:

As this chart shows, for many years, the Fed rate for money was virtually nothing - 1 percent - which allowed banks to get money to lend at very low rates [Admittedly, the thrifty didn't get much bang for their bucks sitting in safe savings accounts or certificates of deposit]. The rate was slowly lowered during the first term of the Bush Administration to get economic growth kicking after the dot-con boom and bust, with the hopes that cheap money would bring our country out of the Clinton recession [Democrats hate this but it is true. The country was in recession in 2000 and it was Clinton's recession. Although, admittedly, Congress - controlled by Republicans under Clinton and Bush, and controlled by Democrats in 2007 and 2008. The larger point is that both major political parties had their hands in the collapse].
After 9-11, the rate continued to drop even more to get the economy pumping after the devastating terrorist attacks on our country's financial and military headquarters, the World Trade Center and the Pentagon. We all clearly remember, don't we, the lack of jobs, the drop in marketing and advertising, the massive layoffs, as companies freaked out over the attacks? It wasn't as worse as today ... but not by much.
The drop in the Fed rate worked - it created growth - but unfortunately, the growth was not sustained or controlled growth - it was fast, speculative growth based around a lot of debt because the money was so cheap. It was basically a very big sugar high. And since Americans weren't actually making much money to begin with there was little real wealth creation for the average American, as statistics have shown. The top 10 percent grew; the bottom 90 percent floundered. And what "wealth" creation there was, was mostly paper - stock market holdings, real estate holdings, etc. - based on the assumption that someone would buy something for a presumed value, or higher value, not an actual value.
This is why the housing boom really kicked in. A developer could take a plot of land, worth basically nothing, and build something on it that was worth something to sell to someone else. If that person bought the house and then someone else was willing to pay more, the value would increase even if it really didn't. It is the same concept as manufacturing, back when we used to manufacture things in this country. Take a tree, for example. A tree has environmental value because it takes CO2 and turns it into oxygen. We need it to breath. But beyond that, it's a tree. It has little economic value. If you cut the tree down though, you can make a table, a chair, fire wood and kindling, toothpicks, paper, whatever, and then sell those items. The sale of those items - nothing to something - creates wealth for the entity that cut down the tree and made the products.

Short sidebar: This is where the horrific state of trade policy kicks in. If you cut the tree down in America and make the items to sell in America, the wealth creation stays in America. If you cut the tree down, ship it overseas, allow the foreigners to make the product, and then bring the product back to sell, the wealth creation stays overseas. All we got was the price of the raw materials and, in fact, the country lost because money circulated here went over there. Throw in the fact that the experts say that two-thirds of the American economy is based on retail spending and you can see where this would become a problem. I have written a lot about this in the past already.

Back to the housing boom and subsequent bust. There wasn't much else to put the money into but there was plenty of land to sell and plenty of people to build homes. In fact, there is a gold rush of land to build on. Even though many of our centers are populated, many hundreds of millions of acres are not. And any developer could grab a section of land and start building a community. There were even plenty of people to buy homes and populate these communities, if the rates were right and the down payments low. Remember, depending on the price, it almost costs as much to rent as it does to buy [not figuring in property taxes, which, again, rose substantially as government grew along with the economy]. Why wouldn't you want to own a home? It's the American dream.
So things were churning along until the summer of 2004, when the Fed started slowly kicking the rate up again on some perceived notion that there was inflation even though inflation was non-existent. In 2003, the annual inflation rate was 2.3 percent, according to the Bureau of Labor Statistics, which is quite measly when you think about it [There is a perceived 3 percent inflation rate which is considered normal]. By the end of 2004, the annual rate was 2.7 percent. Again, relatively normal. In May 2004, the inflation rate was 3.05 percent. It would go up in June but drop in July, August, and September. And yet the Fed would raise the rate to 1.25 percent on July 1, 2004, 1.5 percent on Sept. 1, 2004, and 1.75 percent on Oct. 1, 2004 - while the inflation rate was dropping! By the end of 2004, the rate was up to 2 percent and inflation had risen from 2.5 percent in September to 3.26 percent in December 2004. The Fed raising rates had the exact opposite affect the experts said it would have.
At the same time, the increase in the Fed rate started to hit consumers.
People who had credit cards and were using the credit to buy things like computers, HDTVs, and other items were getting nailed as the rate for the debt went up. Most people don't read the back of the statements that note that the rate of the credit card is based on X amount percent over the prime rate. Say the card is 9 percent over the prime rate and the prime is 1 percent. Then the percentage on your purchases is 10 percent. But if the prime rate is 5 percent, you're paying 14 percent, or literally 50 percent more on products than you would have if the prime rate was 1 percent. Add in the fact that many people live paycheck to paycheck and must use credit cards and revolving unsecured debt to make ends meet and you have a serious problem.
People also purchased homes with adjustable rate mortgages and saw their rates rise, which made their mortgages more expensive since their rates were based on a markup of Fed rate. For example, if your ARM mortgage was 7 percent and based on the prime rate, each time the Fed raised the rate, the bank would raise the rate, and then the mortgage company that lent the homeowner the ARM would also raise the rate. Most people, so eager to become homeowners, didn't read the fine print and didn't realize the rates could rise, not unlike consumer debt. The difference is that consumer debt might only be $10,000 or $20,000 ... but housing debt is 15 or 20 times that! At 1 or 2 percent, this wasn't a huge problem. But during the next two years, the Fed raised the rate even higher and the collapse would come.
The rate reached a peak of 5.25 percent in July 2006 and remained there until September 2007. For more than a year, the rate that money was lent out at by the Fed was more than five times what it was just a couple of years before. This created an atmosphere where money was more expensive than before.
Think about that for a second: Money was being lent out at five times what it was being lent out in previous years. Of course there was a credit crunch. Americans could afford the lifestyle at 1 percent being marked up but not 5-plus percent! In many ways, the raising of the rates which was done to curb non-existent inflation CAUSED inflation and subsequently, the economic crisis. Between 2004 and 2005, the annual inflation rose from 2.7 percent to 3.4 percent. It was as high as 4.7 percent in September 2005. The next year, it went down slightly, to 3.2 percent, but was still higher than previous years when the rate was lower and within the year, there were monthly spikes as high as 4.3 percent in June 2006.
Even though the inflation rate continued to drop, the Fed kept the rate at 5.25 percent. The Fed should have seen the economic slowdowns and tempered the rate accordingly. But it didn't. It kept the rate artificially high, strangling credit markets, consumer debt, and ARMs until October 2007, which the rate dropped to 4.75 percent.

Some of us speculated that the economy was going to crash because we saw economic indicators that were worrisome. I wrote about it in August 2007: ["Is an economic collapse coming?"]. I saw some of the potential effects of the collapse much earlier, when I started reading the WSJ in 2005 and started seriously looking at some of the numbers.
Some people, like Peter Schiff, were literally laughed at when they told people on television the collapse was coming back in August 2006: ["Peter Schiff was right ..."].
I mean, we didn't know there was going to be a collapse. We were guessing. But, it was a pretty accurate guess, wasn't it?

Back to trade policy for a second: This all doesn't address a large component of the problem - globalization, trade policy, and the free trade cultists stranglehold on the debate - and the effects those things have had on the American family. That is a bigger mess that is an underlying contributor to the reason why Americans cannot keep up with the lifestyles they would like to have, the debt they hold, the hours they work, and in some ways, the media they consume. I've often wondered how many people would still subscribe to a daily newspaper if they could afford it and had the time to read it instead of always running around at 110 miles per hour. Trade policy and globalization have had a major role in the decline of economic growth in the United States during the last 30 years, while poverty, desperation, and revolution remain in other countries that have benefitted from the transfer of wealth from America.

What is the solution or what are the solutions? To be honest, I don't know. I have some ideas and tinkering isn't one of them. Sweeping reforms, competent regulation, open and honest government, thorough oversight, are just a few things that should but will never get done. In many ways, the American people were hopeful, almost too hopeful, that Obama would sweep in and fix these things. The Obama administration has made some things better but some things worse while other, extremely important things languish. In addition, many of the same people who caused the problems, or at least had a role in causing the problems, are in the White House today, influencing public policy.

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