Sharp reductions in investments and low oil prices could curb future supplies by almost eight million barrels a day within the next five years, according to a study scheduled for release Friday, the latest warning that the world could face a new energy shock when the economy picks up.
The price of oil rose to $54.34 a barrel Thursday in trading at the New York Mercantile Exchange, but prices have fallen by 63 percent from their peak of $147 a barrel last summer.
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The report by Cambridge Energy Research Associates, an oil consulting firm, said that the potential drop in production capacity is a “powerful and long-lasting aftershock following the oil price collapse.”
The global slowdown has forced oil companies to slash their investments, postpone or cancel expansion plans, or delay drilling in many corners of the world. While some of the biggest companies, like Exxon Mobil and Royal Dutch Shell, say they will keep their investments unchanged this year, many other producers are curbing investments because of the crisis.
The report says about 7.6 million barrels a day of future supplies are “at risk” of being deferred or canceled, like heavy oil or deepwater projects, and which could bring total supplies to 101.4 million barrels a day by 2014. Last year, the group projected that capacity would rise to 109 million barrels a day by then.
“Seven consecutive years of rising oil prices — unprecedented in the history of the oil industry — have come crashing down, thus burying the notion that the commodity price cycle was a historical relic,” said the report, a field-by-field study of production trends.
Many experts have voiced even darker concerns in recent months. Christophe de Margerie, the chief executive of French oil company Total, recently said that producers would find it challenging to bolster supplies even to 90 million barrels a day by the middle of the next decade as projects get canceled.
Oil prices have fallen by 63 percent from their peak of $147 a barrel last summer. They are now trading around $54 a barrel after OPEC producers curbed supplies to prevent a price collapse.
But even at this level, many producers warn that oil prices remain too low to sustain increased investments.
Global oil demand is headed for its second consecutive drop this year. Over time, as populations grow, most experts expect oil consumption to rebound as emerging economies become richer. Any slowdown in investments now will translate into higher prices.
This month, oil producers meeting in Vienna also warned of a possible price shock when the demand for oil picks up again in coming years. As many as 35 new projects in nations belonging to the Organization of the Petroleum Exporting Countries may be delayed by 2013.
“I have often described unsustainably low oil prices as carrying the seeds of future spikes and volatility. In a low-price environment, the trend is often to focus on survival instead of expansion,” Ali al-Naimi, the Saudi oil minister, said recently. “If we place a low priority on preparing for the future, that lack of action can come back to haunt us through supply shortages and another round of high prices.”
The same concerns are also worrying economic experts from consuming countries, including the International Energy Agency and the International Monetary Fund.
“The lower that oil prices drop now and the longer they stay low, the greater the negative impact on future supply,” John Lipsky, the first deputy managing director of the I.M.F., told an OPEC conference in Vienna this month. “In other words, today’s low prices could be setting the stage for another price run-up in the future.”
Sunday, 29 March 2009
China Slowdown Stunts Entrepreneurs
By JAMES T. AREDDY
SHANGHAI -- Tony Yu grew rich helping build China into the world's factory floor.
Over a decade, his small firm outfitted more than a thousand assembly lines with specialized equipment: pumps and pipes to sluice chemicals through high-tech plants. Business was so good his biggest challenge was keeping up with manufacturers impatient to cut the ribbons on their next plant. Mr. Yu poached engineers from rivals as he grew and acquired a mansion overlooking Shanghai's fanciest golf course.
Now his order book is emptying. China's February exports fell nearly 26% from a year before, the fourth in a series of worsening monthly declines. The building boom in Chinese factories is over, and Mr. Yu is casting about for business ideas. "We have ridden the wave of economic development in the last few years," he says. "We are at a loss as to what to do in the immediate future."
View Slideshow
[SB123797328716236165]
Ryan Pyle for The Wall Street Journal
Tony Yu watches a worker in a "clean room" at his GenTech offices in the suburbs of Shanghai, China.
His fate echoes a broader challenge for China itself. The country has relied heavily for its often double-digit growth on a furious pace of investment in manufacturing. More than 40% of China's gross domestic product traces to factory construction and other kinds of fixed-asset investment.
Contributing to this have been hundreds of thousands of bootstrap entrepreneurs like Mr. Yu who appeared from nowhere, helping the Chinese economy to multiply 14-fold, adjusted for inflation, since 1980. Their bold dives into business -- dubbed xia hai, or "jump into the sea" -- and often unorthodox methods both thrilled and chilled the wider business community. Tiny firms shocked global goliaths with aggressive cost-cutting and sometimes corner-cutting as well.
Speed was everything. "You didn't need to be good," Mr. Yu says. "You needed to be there."
[China investment]
Over a decade these go-getters created five million businesses of at least eight employees each, according to the State Administration for Industry & Commerce. They spawned some 75 million jobs for China's university graduates, workers discarded from state companies and streams of people from the countryside. The output of China's private companies and their investment spending made up half of last year's $4.42 trillion GDP.
Now, with the global customers for Chinese factories in recession, tens of thousands of plants are closed and manufacturers have slashed expansion plans. Beijing has responded with a $585 billion economic-stimulus program, and domestic consumption is picking up some of the slack for the export decline, the head of Industrial & Commercial Bank of China said Thursday. But the stimulus is largely government spending on infrastructure that won't necessarily benefit manufacturers such as Mr. Yu's traditional customers.
"Can they build enough roads to offset the fact that they aren't building as many factories?" asks Ben Simpfendorfer, an economist in Hong Kong for Royal Bank of Scotland. He calculates that a drop of 15%, say, in spending on business equipment would cut 1.6 percentage points off China's 2009 growth rate.
Although China's economy grew a powerful 9% last year, it slowed sharply to a 6.8% pace in the fourth quarter. Industrial production, which has risen an average of 16% annually for five years, slacked off to 3.8% in the first two months of this year. For China's small businesses, it's the first slowdown they've faced, and many are struggling to reinvent themselves.
Mr. Yu, 49 years old, built a business tied to the unrelenting investment spending by his fellow entrepreneurs. His Shanghai GenTech UHP Co. provides containers, pumps and piping that can safely carry the often dangerous gasses and other chemicals that manufacturers use in making semiconductors and other high-tech products. Operated with his wife, Joan Cui Rong, and generating $20 million in revenue last year, the business positioned itself to compete with far larger companies such as Air Products & Chemicals Inc. and Praxair Inc. of the U.S.
Mr. Yu, whose given name is Dong Lei, studied mechanical engineering in Beijing and earned a Ph.D. in agricultural engineering in 1987 at England's Newcastle University. Bored with his professors' directive to research farm equipment, Mr. Yu says, he spent much of his four years writing poetry. Back then, nearly everyone in China worked for the government, but Mr. Yu joined U.S. commodity giant Cargill Inc., which sent him to China to build an oilseed-crushing plant and then to Sioux City, Iowa, to run one.
Working in Iowa in the early 1990s, Mr. Yu sensed that more-dynamic opportunities were opening up back in China. The Chinese "need a lot of stuff from the outside world," he recalls thinking. So he quit Cargill to try his hand at exporting equipment to China from his house in Iowa.
A friend of a friend in China helped him win $1 million of orders from a new computer-chip maker for U.S.-made chemical tubing, an item so specialized that Mr. Yu wasn't entirely sure what he was promising to deliver. He also exported routine items like ambulance equipment and gas-station pumps. After a detour working in Shanghai for a U.S. pork producer that wanted to break into that market, Mr. Yu struck out on his own.
Ever since his early sale to a chip maker, Mr. Yu had kept the semiconductor industry in his sights. So when chip manufacturers began moving to the low-cost Yangtze River delta near Shanghai around 2000, he reached for a piece of the action. Casting himself as a veteran of China's nascent high-tech industry, Mr. Yu began winning contracts to outfit new factories. In 2001 he did a deal that put him at the helm of a business that refit pharmaceutical factories. Mr. Yu refocused it toward the high-tech sector.
Following the semiconductor industry into China were makers of optical fibers and flat-panel television sets, all of them wanting assembly-line equipment and wanting it quickly and cheaply. For Mr. Yu, winning orders was less of a challenge than keeping his engineers from walking out the door to open a competing business.
All of his darting around China to sign deals left him little time to consider where the high-tech industry was going. Indeed, "most of the time we didn't know what the customers were making," he says.
Amid a frenzy of small businesses rushing to be cheapest to supply whatever was needed, Mr. Yu says he decided to build a company with more "professionalism." He moved into an industrial park, wrote an employee handbook and built a "clean room" of the kind chip makers use, to raise the quality of his products. He relaunched the business as GenTech, stitching the name in English on engineers' blue jackets. "Everything we did we wanted to do it professionally," he says.
The company got a chance to show that when a customer had an accidental release of a "pyrophoric" gas that can ignite on contact with air. Mr. Yu and his team worked through the Chinese New Year to prevent a catastrophe.
Battling Giants
Soon, GenTech was nipping at the heels of industry giants. By quoting low prices but maintaining standards, it won subcontracting work from majors like Air Products and Chemicals. With his ambitions growing faster than his expertise, Mr. Yu poached engineers and salesmen, including so many from Air Products that GenTech was nicknamed "Little AP."
After he grabbed one highly regarded manager from Air Products, an executive of that company called to protest, asking in frustration, "Do you really need to have this guy?" say people familiar with the conversation. The poaching ran both ways. Mr. Yu says a headhunter called one desk after another at his business trying to lure people away.
Meanwhile, he was growing wealthy. With his wife and business partner, Ms. Cui, who is also an engineer, he toured Tibet, Europe and South Africa. They bought two peacocks for the yard of their large house. After Ms. Cui won a bet with her husband by closing a difficult deal, he settled the wager by buying her a black Porsche Boxster.
One thing keeping GenTech busy was a burst of investment in the photovoltaics industry, which makes equipment to turn sunlight into electricity. Mr. Yu directed his sales and engineering teams to focus primarily on the sector. Anticipating a windfall, last year he expanded production floor space tenfold and borrowed for the first time, an $880,000 working-capital loan.
But the rise in solar spending disguised a weakening elsewhere in technology, especially semiconductors. One bellwether Shanghai chip maker, Semiconductor Manufacturing International Corp., had multiplied its capacity eightfold over five years, averaging about $1 billion in annual capital spending. But this year, it expects to spend only about $190 million.
Chip demand fell off so much last year that China's industry could sell only 80% of the semiconductors it had the capacity to make, according to Raman Chitkara, head of the technology practice at PricewaterhouseCoopers. As a result, "most of the companies are being extremely selective in [expanding] capacity," Mr. Chitkara says.
The worry for Mr. Yu: "If there's no capital expenditure, there's no business for us."
As he fired up a laptop in his tiny office each morning, he recognized the growing clouds over China's exports. But his focus on the details of his business had left him little time to consider strategic issues that might have made GenTech less vulnerable to a downturn, he acknowledges. Near the middle of 2008 he was taken by surprise when a major company in the solar industry postponed a contract signing, citing a financing snag. In the past, Mr. Yu says, "They didn't need to talk to the banks -- the banks would talk to them."
More contract delays followed. By October, cancellations from solar-equipment customers were flooding in. This year one customer, Suntech Power Holdings Co. of Wuxi, China, slashed its 2009 capital-spending budget to a third of last year's level.
The changes left GenTech more vulnerable than the big multinational suppliers of pipes and pumps that move chemicals. Those companies also supply the chemicals themselves, getting most of their revenue that way. GenTech just makes the equipment -- equivalent to selling only razors when most of the money is in razor blades.
Suddenly, GenTech found its revenue wasn't covering the expenses of its 150-strong team of engineers and salespeople. Then in January Intel Corp. said it would eliminate Shanghai as an assembly base. Though Intel wasn't a GenTech customer, Mr. Yu saw this as a sign tech companies were starting to see the Shanghai area as too expensive.
Humbling Times
Months before turning 50, Mr. Yu faces humbling times. He says GenTech "will have a tough year" but should avoid its first annual loss, thanks to unexpected orders from fiber-optics makers who want to get in on third-generation cellphone service in China. He vows to avoid layoffs or pay cuts this year.
Over coffee in his boardroom, Mr. Yu spoke of his hopes for a new "killer application" to spark a fresh round of high-tech investment in China -- even as, in the next breath, he recited reasons that is unlikely for now.
In an unused half of GenTech's expanded production facility, engineers set up two badminton courts. But Mr. Yu told them to use their idle time to try to invent new kinds of equipment that might make the company more valuable if he decides the best strategy is to sell.
His wife, Ms. Cui, is exploring a way to turn their decade's worth of contacts into a new trading business. Mr. Yu is taking a series of weeklong executive training classes at Beijing's Tsinghua University to "meet new people and hear new ideas."
Having learned the perils of dependence on an ever-growing manufacturing industry, Mr. Yu is determined to find another way. "One hundred percent of our business relies on investment, expansion," he says. "That's what's got us scared. It's not a sustainable business model."
SHANGHAI -- Tony Yu grew rich helping build China into the world's factory floor.
Over a decade, his small firm outfitted more than a thousand assembly lines with specialized equipment: pumps and pipes to sluice chemicals through high-tech plants. Business was so good his biggest challenge was keeping up with manufacturers impatient to cut the ribbons on their next plant. Mr. Yu poached engineers from rivals as he grew and acquired a mansion overlooking Shanghai's fanciest golf course.
Now his order book is emptying. China's February exports fell nearly 26% from a year before, the fourth in a series of worsening monthly declines. The building boom in Chinese factories is over, and Mr. Yu is casting about for business ideas. "We have ridden the wave of economic development in the last few years," he says. "We are at a loss as to what to do in the immediate future."
View Slideshow
[SB123797328716236165]
Ryan Pyle for The Wall Street Journal
Tony Yu watches a worker in a "clean room" at his GenTech offices in the suburbs of Shanghai, China.
His fate echoes a broader challenge for China itself. The country has relied heavily for its often double-digit growth on a furious pace of investment in manufacturing. More than 40% of China's gross domestic product traces to factory construction and other kinds of fixed-asset investment.
Contributing to this have been hundreds of thousands of bootstrap entrepreneurs like Mr. Yu who appeared from nowhere, helping the Chinese economy to multiply 14-fold, adjusted for inflation, since 1980. Their bold dives into business -- dubbed xia hai, or "jump into the sea" -- and often unorthodox methods both thrilled and chilled the wider business community. Tiny firms shocked global goliaths with aggressive cost-cutting and sometimes corner-cutting as well.
Speed was everything. "You didn't need to be good," Mr. Yu says. "You needed to be there."
[China investment]
Over a decade these go-getters created five million businesses of at least eight employees each, according to the State Administration for Industry & Commerce. They spawned some 75 million jobs for China's university graduates, workers discarded from state companies and streams of people from the countryside. The output of China's private companies and their investment spending made up half of last year's $4.42 trillion GDP.
Now, with the global customers for Chinese factories in recession, tens of thousands of plants are closed and manufacturers have slashed expansion plans. Beijing has responded with a $585 billion economic-stimulus program, and domestic consumption is picking up some of the slack for the export decline, the head of Industrial & Commercial Bank of China said Thursday. But the stimulus is largely government spending on infrastructure that won't necessarily benefit manufacturers such as Mr. Yu's traditional customers.
"Can they build enough roads to offset the fact that they aren't building as many factories?" asks Ben Simpfendorfer, an economist in Hong Kong for Royal Bank of Scotland. He calculates that a drop of 15%, say, in spending on business equipment would cut 1.6 percentage points off China's 2009 growth rate.
Although China's economy grew a powerful 9% last year, it slowed sharply to a 6.8% pace in the fourth quarter. Industrial production, which has risen an average of 16% annually for five years, slacked off to 3.8% in the first two months of this year. For China's small businesses, it's the first slowdown they've faced, and many are struggling to reinvent themselves.
Mr. Yu, 49 years old, built a business tied to the unrelenting investment spending by his fellow entrepreneurs. His Shanghai GenTech UHP Co. provides containers, pumps and piping that can safely carry the often dangerous gasses and other chemicals that manufacturers use in making semiconductors and other high-tech products. Operated with his wife, Joan Cui Rong, and generating $20 million in revenue last year, the business positioned itself to compete with far larger companies such as Air Products & Chemicals Inc. and Praxair Inc. of the U.S.
Mr. Yu, whose given name is Dong Lei, studied mechanical engineering in Beijing and earned a Ph.D. in agricultural engineering in 1987 at England's Newcastle University. Bored with his professors' directive to research farm equipment, Mr. Yu says, he spent much of his four years writing poetry. Back then, nearly everyone in China worked for the government, but Mr. Yu joined U.S. commodity giant Cargill Inc., which sent him to China to build an oilseed-crushing plant and then to Sioux City, Iowa, to run one.
Working in Iowa in the early 1990s, Mr. Yu sensed that more-dynamic opportunities were opening up back in China. The Chinese "need a lot of stuff from the outside world," he recalls thinking. So he quit Cargill to try his hand at exporting equipment to China from his house in Iowa.
A friend of a friend in China helped him win $1 million of orders from a new computer-chip maker for U.S.-made chemical tubing, an item so specialized that Mr. Yu wasn't entirely sure what he was promising to deliver. He also exported routine items like ambulance equipment and gas-station pumps. After a detour working in Shanghai for a U.S. pork producer that wanted to break into that market, Mr. Yu struck out on his own.
Ever since his early sale to a chip maker, Mr. Yu had kept the semiconductor industry in his sights. So when chip manufacturers began moving to the low-cost Yangtze River delta near Shanghai around 2000, he reached for a piece of the action. Casting himself as a veteran of China's nascent high-tech industry, Mr. Yu began winning contracts to outfit new factories. In 2001 he did a deal that put him at the helm of a business that refit pharmaceutical factories. Mr. Yu refocused it toward the high-tech sector.
Following the semiconductor industry into China were makers of optical fibers and flat-panel television sets, all of them wanting assembly-line equipment and wanting it quickly and cheaply. For Mr. Yu, winning orders was less of a challenge than keeping his engineers from walking out the door to open a competing business.
All of his darting around China to sign deals left him little time to consider where the high-tech industry was going. Indeed, "most of the time we didn't know what the customers were making," he says.
Amid a frenzy of small businesses rushing to be cheapest to supply whatever was needed, Mr. Yu says he decided to build a company with more "professionalism." He moved into an industrial park, wrote an employee handbook and built a "clean room" of the kind chip makers use, to raise the quality of his products. He relaunched the business as GenTech, stitching the name in English on engineers' blue jackets. "Everything we did we wanted to do it professionally," he says.
The company got a chance to show that when a customer had an accidental release of a "pyrophoric" gas that can ignite on contact with air. Mr. Yu and his team worked through the Chinese New Year to prevent a catastrophe.
Battling Giants
Soon, GenTech was nipping at the heels of industry giants. By quoting low prices but maintaining standards, it won subcontracting work from majors like Air Products and Chemicals. With his ambitions growing faster than his expertise, Mr. Yu poached engineers and salesmen, including so many from Air Products that GenTech was nicknamed "Little AP."
After he grabbed one highly regarded manager from Air Products, an executive of that company called to protest, asking in frustration, "Do you really need to have this guy?" say people familiar with the conversation. The poaching ran both ways. Mr. Yu says a headhunter called one desk after another at his business trying to lure people away.
Meanwhile, he was growing wealthy. With his wife and business partner, Ms. Cui, who is also an engineer, he toured Tibet, Europe and South Africa. They bought two peacocks for the yard of their large house. After Ms. Cui won a bet with her husband by closing a difficult deal, he settled the wager by buying her a black Porsche Boxster.
One thing keeping GenTech busy was a burst of investment in the photovoltaics industry, which makes equipment to turn sunlight into electricity. Mr. Yu directed his sales and engineering teams to focus primarily on the sector. Anticipating a windfall, last year he expanded production floor space tenfold and borrowed for the first time, an $880,000 working-capital loan.
But the rise in solar spending disguised a weakening elsewhere in technology, especially semiconductors. One bellwether Shanghai chip maker, Semiconductor Manufacturing International Corp., had multiplied its capacity eightfold over five years, averaging about $1 billion in annual capital spending. But this year, it expects to spend only about $190 million.
Chip demand fell off so much last year that China's industry could sell only 80% of the semiconductors it had the capacity to make, according to Raman Chitkara, head of the technology practice at PricewaterhouseCoopers. As a result, "most of the companies are being extremely selective in [expanding] capacity," Mr. Chitkara says.
The worry for Mr. Yu: "If there's no capital expenditure, there's no business for us."
As he fired up a laptop in his tiny office each morning, he recognized the growing clouds over China's exports. But his focus on the details of his business had left him little time to consider strategic issues that might have made GenTech less vulnerable to a downturn, he acknowledges. Near the middle of 2008 he was taken by surprise when a major company in the solar industry postponed a contract signing, citing a financing snag. In the past, Mr. Yu says, "They didn't need to talk to the banks -- the banks would talk to them."
More contract delays followed. By October, cancellations from solar-equipment customers were flooding in. This year one customer, Suntech Power Holdings Co. of Wuxi, China, slashed its 2009 capital-spending budget to a third of last year's level.
The changes left GenTech more vulnerable than the big multinational suppliers of pipes and pumps that move chemicals. Those companies also supply the chemicals themselves, getting most of their revenue that way. GenTech just makes the equipment -- equivalent to selling only razors when most of the money is in razor blades.
Suddenly, GenTech found its revenue wasn't covering the expenses of its 150-strong team of engineers and salespeople. Then in January Intel Corp. said it would eliminate Shanghai as an assembly base. Though Intel wasn't a GenTech customer, Mr. Yu saw this as a sign tech companies were starting to see the Shanghai area as too expensive.
Humbling Times
Months before turning 50, Mr. Yu faces humbling times. He says GenTech "will have a tough year" but should avoid its first annual loss, thanks to unexpected orders from fiber-optics makers who want to get in on third-generation cellphone service in China. He vows to avoid layoffs or pay cuts this year.
Over coffee in his boardroom, Mr. Yu spoke of his hopes for a new "killer application" to spark a fresh round of high-tech investment in China -- even as, in the next breath, he recited reasons that is unlikely for now.
In an unused half of GenTech's expanded production facility, engineers set up two badminton courts. But Mr. Yu told them to use their idle time to try to invent new kinds of equipment that might make the company more valuable if he decides the best strategy is to sell.
His wife, Ms. Cui, is exploring a way to turn their decade's worth of contacts into a new trading business. Mr. Yu is taking a series of weeklong executive training classes at Beijing's Tsinghua University to "meet new people and hear new ideas."
Having learned the perils of dependence on an ever-growing manufacturing industry, Mr. Yu is determined to find another way. "One hundred percent of our business relies on investment, expansion," he says. "That's what's got us scared. It's not a sustainable business model."
This Crisis Is Way Bigger Than Dead Banks and Wall Street Bailouts
Why the economic crisis, and its solution, are bigger than anyone has so far admitted.
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Barack Obama's presidency began in hope and goodwill, but its test will be its success or failure on the economics. Did the president and his team correctly diagnose the problem? Did they act with sufficient imagination and force? And did they prevail against the political obstacles -- and not only that, but also against the procedures and the habits of thought to which official Washington is addicted?
The president has an economic program. But there is, so far, no clear statement of the thinking behind that program, and there may not be one, until the first report of the new Council of Economic Advisers appears next year. We therefore resort to what we know about the economists: the chair of the National Economic Council, Lawrence Summers; the CEA chair, Christina Romer; the budget director, Peter Orszag; and their titular head, Treasury Secretary Timothy Geithner. This is plainly a capable, close-knit group, acting with energy and commitment. Deficiencies of their program cannot, therefore, be blamed on incompetence. Rather, if deficiencies exist, they probably result from their shared background and creed -- in short, from the limitations of their ideas.
The deepest belief of the modern economist is that the economy is a self-stabilizing system. This means that, even if nothing is done, normal rates of employment and production will someday return. Practically all modern economists believe this, often without thinking much about it. (Federal Reserve Chairman Ben Bernanke said it reflexively in a major speech in London in January: "The global economy will recover." He did not say how he knew.) The difference between conservatives and liberals is over whether policy can usefully speed things up. Conservatives say no, liberals say yes, and on this point Obama's economists lean left. Hence the priority they gave, in their first days, to the stimulus package.
But did they get the scale right? Was the plan big enough? Policies are based on models; in a slump, plans for spending depend on a forecast of how deep and long the slump would otherwise be. The program will only be correctly sized if the forecast is accurate. And the forecast depends on the underlying belief. If recovery is not built into the genes of the system, then the forecast will be too optimistic, and the stimulus based on it will be too small.
Consider the baseline economic forecast of the Congressional Budget Office, the nonpartisan agency lawmakers rely on to evaluate the economy and their budget plans. In its early-January forecast, the CBO measured and projected the difference between actual economic performance and "normal" economic performance -- the so-called GDP gap. The forecast has two astonishing features. First, the CBO did not expect the present recession to be any worse than that of 1981-82, our deepest postwar recession. Second, the CBO expected a turnaround beginning late this year, with the economy returning to normal around 2015, even if Congress had taken no action at all.
With this projection in mind, the recovery bill pours a bit less than 2 percent of GDP into new spending per year, plus some tax cuts, for two years, into a GDP gap estimated to average 6 percent for three years. The stimulus does not need to fill the whole gap, because the CBO expects a "multiplier effect," as first-round spending on bridges and roads, for example, is followed by second-round spending by steelworkers and road crews. The CBO estimates that because of the multiplier effect, two dollars of new public spending produces about three dollars of new output. (For tax cuts the numbers are lower, since some of the cuts will be saved in the first round.) And with this help, the recession becomes fairly mild. After two years, growth would be solidly established and Congress's work would be done. In this way, the duration as well as the scale of action was driven, behind the scenes, by the CBO's baseline forecast.
Why did the CBO reach this conclusion? On depth, CBO's model is based on the postwar experience, and such models cannot predict outcomes more serious than anything already seen. If we are facing a downturn worse than 1982, our computers won't tell us; we will be surprised. And if the slump is destined to drag on, the computers won't tell us that either. Baked into the CBO model we find a "natural rate of unemployment" of 4.8 percent; the model moves the economy back toward that value no matter what. In the real world, however, there is no reason to believe this will happen. Some alternative forecasts, freed of the mystical return to "normal," now project a GDP gap twice as large as the CBO model predicts, and with no near-term recovery at all.
Considerations of timing also influenced the choice of line items. The bill tilted toward "shovel-ready" projects like refurbishing schools and fixing roads, and away from projects requiring planning and long construction lead times, like urban mass transit. The push for speed also influenced the bill in another way. Drafting new legislative authority takes time. In an emergency, it was sensible for Chairman David Obey of the House Appropriations Committee to mine the legislative docket for ideas already commanding broad support (especially within the Democratic caucus). In this way he produced a bill that was a triumph of fast drafting, practical politics, and progressive principle -- a good bill which the Republicans hated. But the scale of action possible by such means is unrelated, except by coincidence, to what the economy needs.
Three further considerations limited the plan. There was, to begin with, the desire for political consensus; President Obama chose to start his administration with a bill that might win bipartisan support and pass in Congress by wide margins. (He was, of course, spurned by the Republicans.) Second, the new team also sought consensus of another type. Christina Romer polled a bipartisan group of professional economists, and Larry Summers told Meet the Press that the final package reflected a "balance" of their views. This procedure guarantees a result near the middle of the professional mind-set. The method would be useful if the errors of economists were unsystematic. But they are not. Economists are a cautious group, and in any extreme situation the midpoint of professional opinion is bound to be wrong.
Third, the initial package was affected by the new team's desire to get past this crisis and to return to the familiar problems of their past lives. For these protgs of Robert Rubin, veterans in several cases of Rubin's Hamilton Project, a key preconception has always been the budget deficit and what they call the "entitlement problem." This is D.C.-speak for rolling back Social Security and Medicare, opening new markets for fund managers and private insurers, behind a wave of budget babble about "long-term deficits" and "unfunded liabilities." To this our new president is not immune. Even before the inauguration Obama was moved to commit to "entitlement reform," and on February 23 he convened what he called a "fiscal responsibility summit." The idea took hold that after two years or so of big spending, the return to normal would be under way, and the costs of fiscal relief and infrastructure improvement might be recouped, in part by taking a pound of flesh from the incomes and health care of the old.
The chance of a return to normal depends, in turn, on the banking strategy. To Obama's economists a "normal" economy is led and guided by private banks. When domestic credit booms are under way, they tend to generate high employment and low inflation; this makes the public budget look good, and spares the president and Congress many hard decisions. For this reason the new team instinctively seeks to return the bankers to their normal position at the top of the economic hill. Secretary Geithner told CNBC, "We have a financial system that is run by private shareholders, managed by private institutions, and we'd like to do our best to preserve that system."
But, is this a realistic hope? Is it even a possibility? The normal mechanics of a credit cycle do involve interludes when asset values crash and credit relations collapse. In 1981, Paul Volcker's campaign against inflation caused such a crash. But, though they came close, the big banks did not fail then. (I learned recently from William Isaac, Ronald Reagan's chair of the FDIC, that the government had contingency plans to nationalize the large banks in 1982, had Mexico, Argentina, or Brazil defaulted outright on their debts.) When monetary policy relaxed and the delayed tax cuts of 1981 kicked in, there was both pent-up demand for credit and the capacity to supply it. The final result was that the economy recovered quickly. Again in 1994, after a long period of credit crunch, banks and households were strong enough, even without a stimulus, to support a vast renewal of lending which propelled the economy forward for six years.
The Bush-era disasters guarantee that these happy patterns will not be repeated. For the first time since the 1930s, millions of American households are financially ruined. Families that two years ago enjoyed wealth in stocks and in their homes now have neither. Their 401(k)s have fallen by half, their mortgages are a burden, and their homes are an albatross. For many the best strategy is to mail the keys to the bank. This practically assures that excess supply and collapsed prices in housing will continue for years. Apart from cash -- protected by deposit insurance and now desperately being conserved -- the American middle class finds today that its major source of wealth is the implicit value of Social Security and Medicare -- illiquid and intangible but real and inalienable in a way that home and equity values are not. And so it will remain, as long as future benefits are not cut.
In addition, some of the biggest banks are bust, almost for certain. Having abandoned prudent risk management in a climate of regulatory negligence and complicity under Bush, these banks participated gleefully in a poisonous game of abusive mortgage originations followed by rounds of pass-the-bad-penny-to-the-greater-fool. But they could not pass them all. And when in August 2007 the music stopped, banks discovered that the markets for their toxic-mortgage-backed securities had collapsed, and found themselves insolvent. Only a dogged political refusal to admit this has since kept the banks from being taken into receivership by the Federal Deposit Insurance Corporation -- something the FDIC has the power to do, and has done as recently as last year with IndyMac in California.
Geithner's banking plan would prolong the state of denial. It involves government guarantees of the bad assets, keeping current management in place and attempting to attract new private capital. (Conversion of preferred shares to equity, which may happen with Citigroup, conveys no powers that the government, as regulator, does not already have.) The idea is that one can fix the banks from the top down, by reestablishing markets for their bad securities. If the idea seems familiar, it is: Henry Paulson also pressed for this, to the point of winning congressional approval. But then he abandoned the idea. Why? He learned it could not work.
Paulson faced two insuperable problems. One was quantity: there were too many bad assets. The project of buying them back could be likened to "filling the Pacific Ocean with basketballs," as one observer said to me at the time. (When I tried to find out where the original request for $700 billion in the Troubled Asset Relief Program came from, a senior Senate aide replied, "Well, it's a number between five hundred billion and one trillion.")
The other problem was price. The only price at which the assets could be disposed of, protecting the taxpayer, was of course the market price. In the collapse of the market for mortgage-backed securities and their associated credit default swaps, this price was too low to save the banks. But any higher price would have amounted to a gift of public funds, justifiable only if there was a good chance that the assets might recover value when "normal" conditions return.
That chance can be assessed, of course, only by doing what any reasonable private investor would do: due diligence, meaning a close inspection of the loan tapes. On the face of it, such inspections will reveal a very high proportion of missing documentation, inflated appraisals, and other evidence of fraud. (In late 2007 the ratings agency Fitch conducted this exercise on a small sample of loan files, and found indications of misrepresentation or fraud present in practically every one.) The reasonable inference would be that many more of the loans will default. Geithner's plan to guarantee these so-called assets, therefore, is almost sure to overstate their value; it is only a way of delaying the ultimate public recognition of loss, while keeping the perpetrators afloat.
Delay is not innocuous. When a bank's insolvency is ignored, the incentives for normal prudent banking collapse. Management has nothing to lose. It may take big new risks, in volatile markets like commodities, in the hope of salvation before the regulators close in. Or it may loot the institution -- nomenklatura privatization, as the Russians would say -- through unjustified bonuses, dividends, and options. It will never fully disclose the extent of insolvency on its own.
The most likely scenario, should the Geithner plan go through, is a combination of looting, fraud, and a renewed speculation in volatile commodity markets such as oil. Ultimately the losses fall on the public anyway, since deposits are largely insured. There is no chance that the banks will simply resume normal long-term lending. To whom would they lend? For what? Against what collateral? And if banks are recapitalized without changing their management, why should we expect them to change the behavior that caused the insolvency in the first place?
The oddest thing about the Geithner program is its failure to act as though the financial crisis is a true crisis -- an integrated, long-term economic threat -- rather than merely a couple of related but temporary problems, one in banking and the other in jobs. In banking, the dominant metaphor is of plumbing: there is a blockage to be cleared. Take a plunger to the toxic assets, it is said, and credit conditions will return to normal. This, then, will make the recession essentially normal, validating the stimulus package. Solve these two problems, and the crisis will end. That's the thinking.
But the plumbing metaphor is misleading. Credit is not a flow. It is not something that can be forced downstream by clearing a pipe. Credit is a contract. It requires a borrower as well as a lender, a customer as well as a bank. And the borrower must meet two conditions. One is creditworthiness, meaning a secure income and, usually, a house with equity in it. Asset prices therefore matter. With a chronic oversupply of houses, prices fall, collateral disappears, and even if borrowers are willing they can't qualify for loans. The other requirement is a willingness to borrow, motivated by what Keynes called the "animal spirits" of entrepreneurial enthusiasm. In a slump, such optimism is scarce. Even if people have collateral, they want the security of cash. And it is precisely because they want cash that they will not deplete their reserves by plunking down a payment on a new car.
The credit flow metaphor implies that people came flocking to the new-car showrooms last November and were turned away because there were no loans to be had. This is not true -- what happened was that people stopped coming in. And they stopped coming in because, suddenly, they felt poor.
Strapped and afraid, people want to be in cash. This is what economists call the liquidity trap. And it gets worse: in these conditions, the normal estimates for multipliers -- the bang for the buck -- may be too high. Government spending on goods and services always increases total spending directly; a dollar of public spending is a dollar of GDP. But if the workers simply save their extra income, or use it to pay debt, that's the end of the line: there is no further effect. For tax cuts (especially for the middle class and up), the new funds are mostly saved or used to pay down debt. Debt reduction may help lay a foundation for better times later on, but it doesn't help now. With smaller multipliers, the public spending package would need to be even larger, in order to fill in all the holes in total demand. Thus financial crisis makes the real crisis worse, and the failure of the bank plan practically assures that the stimulus also will be too small.
In short, if we are in a true collapse of finance, our models will not serve. It is then appropriate to reach back, past the postwar years, to the experience of the Great Depression. And this can only be done by qualitative and historical analysis. Our modern numerical models just don't capture the key feature of that crisis -- which is, precisely, the collapse of the financial system. If the banking system is crippled, then to be effective the public sector must do much, much more. How much more? By how much can spending be raised in a real depression? And does this remedy work? Recent months have seen much debate over the economic effects of the New Deal, and much repetition of the commonplace that the effort was too small to end the Great Depression, something achieved, it is said, only by World War II. A new paper by the economist Marshall Auerback has usefully corrected this record. Auerback plainly illustrates by how much Roosevelt's ambition exceeded anything yet seen in this crisis:
[Roosevelt's] government hired about 60 per cent of the unemployed in public works and conservation projects that planted a billion trees, saved the whooping crane, modernized rural America, and built such diverse projects as the Cathedral of Learning in Pittsburgh, the Montana state capitol, much of the Chicago lakefront, New York's Lincoln Tunnel and Triborough Bridge complex, the Tennessee Valley Authority and the aircraft carriers Enterprise and Yorktown. It also built or renovated 2,500 hospitals, 45,000 schools, 13,000 parks and playgrounds, 7,800 bridges, 700,000 miles of roads, and a thousand airfields. And it employed 50,000 teachers, rebuilt the country's entire rural school system, and hired 3,000 writers, musicians, sculptors and painters, including Willem de Kooning and Jackson Pollock.
In other words, Roosevelt employed Americans on a vast scale, bringing the unemployment rates down to levels that were tolerable, even before the war -- from 25 percent in 1933 to below 10 percent in 1936, if you count those employed by the government as employed, which they surely were. In 1937, Roosevelt tried to balance the budget, the economy relapsed again, and in 1938 the New Deal was relaunched. This again brought unemployment down to about 10 percent, still before the war.
The New Deal rebuilt America physically, providing a foundation (the TVA's power plants, for example) from which the mobilization of World War II could be launched. But it also saved the country politically and morally, providing jobs, hope, and confidence that in the end democracy was worth preserving. There were many, in the 1930s, who did not think so.
What did not recover, under Roosevelt, was the private banking system. Borrowing and lending -- mortgages and home construction -- contributed far less to the growth of output in the 1930s and '40s than they had in the 1920s or would come to do after the war. If they had savings at all, people stayed in Treasuries, and despite huge deficits interest rates for federal debt remained near zero. The liquidity trap wasn't overcome until the war ended.
It was the war, and only the war, that restored (or, more accurately, created for the first time) the financial wealth of the American middle class. During the 1930s public spending was large, but the incomes earned were spent. And while that spending increased consumption, it did not jumpstart a cycle of investment and growth, because the idle factories left over from the 1920s were quite sufficient to meet the demand for new output. Only after 1940 did total demand outstrip the economy's capacity to produce civilian private goods -- in part because private incomes soared, in part because the government ordered the production of some products, like cars, to halt.
All that extra demand would normally have driven up prices. But the federal government prevented this with price controls. (Disclosure: this writer's father, John Kenneth Galbraith, ran the controls during the first year of the war.) And so, with nowhere else for their extra dollars to go, the public bought and held government bonds. These provided claims to postwar purchasing power. After the war, the existence of those claims could, and did, establish creditworthiness for millions, making possible the revival of private banking, and on the broadly based, middle-class foundation that so distinguished the 1950s from the 1920s. But the relaunching of private finance took twenty years, and the war besides.
A brief reflection on this history and present circumstances drives a plain conclusion: the full restoration of private credit will take a long time. It will follow, not precede, the restoration of sound private household finances. There is no way the project of resurrecting the economy by stuffing the banks with cash will work. Effective policy can only work the other way around.
That being so, what must now be done? The first thing we need, in the wake of the recovery bill, is more recovery bills. The next efforts should be larger, reflecting the true scale of the emergency. There should be open-ended support for state and local governments, public utilities, transit authorities, public hospitals, schools, and universities for the duration, and generous support for public capital investment in the short and long term. To the extent possible, all the resources being released from the private residential and commercial construction industries should be absorbed into public building projects. There should be comprehensive foreclosure relief, through a moratorium followed by restructuring or by conversion-to-rental, except in cases of speculative investment and borrower fraud. The president's foreclosure-prevention plan is a useful step to relieve mortgage burdens on at-risk households, but it will not stop the downward spiral of home prices and correct the chronic oversupply of housing that is the cause of that.
Second, we should offset the violent drop in the wealth of the elderly population as a whole. The squeeze on the elderly has been little noted so far, but it hits in three separate ways: through the fall in the stock market; through the collapse of home values; and through the drop in interest rates, which reduces interest income on accumulated cash. For an increasing number of the elderly, Social Security and Medicare wealth are all they have.
That means that the entitlement reformers have it backward: instead of cutting Social Security benefits, we should increase them, especially for those at the bottom of the benefit scale. Indeed, in this crisis, precisely because it is universal and efficient, Social Security is an economic recovery ace in the hole. Increasing benefits is a simple, direct, progressive, and highly efficient way to prevent poverty and sustain purchasing power for this vulnerable population. I would also argue for lowering the age of eligibility for Medicare to (say) fifty-five, to permit workers to retire earlier and to free firms from the burden of managing health plans for older workers.
This suggestion is meant, in part, to call attention to the madness of talk about Social Security and Medicare cuts. The prospect of future cuts in this modest but vital source of retirement security can only prompt worried prime-age workers to spend less and save more today. And that will make the present economic crisis deeper. In reality, there is no Social Security "financing problem" at all. There is a health care problem, but that can be dealt with only by deciding what health services to provide, and how to pay for them, for the whole population. It cannot be dealt with, responsibly or ethically, by cutting care for the old.
Third, we will soon need a jobs program to put the unemployed to work quickly. Infrastructure spending can help, but major building projects can take years to gear up, and they can, for the most part, provide jobs only for those who have the requisite skills. So the federal government should sponsor projects that employ people to do what they do best, including art, letters, drama, dance, music, scientific research, teaching, conservation, and the nonprofit sector, including community organizing -- why not?
Finally, a payroll tax holiday would help restore the purchasing power of working families, as well as make it easier for employers to keep them on the payroll. This is a particularly potent suggestion, because it is large and immediate. And if growth resumes rapidly, it can also be scaled back. There is no error in doing too much that cannot easily be repaired, by doing a bit less.
As these measures take effect, the government must take control of insolvent banks, however large, and get on with the business of reorganizing, re-regulating, decapitating, and recapitalizing them. Depositors should be insured fully to prevent runs, and private risk capital (common and preferred equity and subordinated debt) should take the first loss. Effective compensation limits should be enforced -- it is a good thing that they will encourage those at the top to retire. As Senator Christopher Dodd of Connecticut correctly stated in the brouhaha following the discovery that Senate Democrats had put tough limits into the recovery bill, there are many competent replacements for those who leave.
Ultimately the big banks can be resold as smaller private institutions, run on a scale that permits prudent credit assessment and risk management by people close enough to their client communities to foster an effective revival, among other things, of household credit and of independent small business -- another lost hallmark of the 1950s. No one should imagine that the swaggering, bank-driven world of high finance and credit bubbles should be made to reappear. Big banks should be run largely by men and women with the long-term perspective, outlook, and temperament of middle managers, and not by the transient, self-regarding plutocrats who run them now.
The chorus of deficit hawks and entitlement reformers are certain to regard this program with horror. What about the deficit? What about the debt? These questions are unavoidable, so let's answer them. First, the deficit and the public debt of the U.S. government can, should, must, and will increase in this crisis. They will increase whether the government acts or not. The choice is between an active program, running up debt while creating jobs and rebuilding America, or a passive program, running up debt because revenues collapse, because the population has to be maintained on the dole, and because the Treasury wishes, for no constructive reason, to rescue the big bankers and make them whole.
Second, so long as the economy is placed on a path to recovery, even a massive increase in public debt poses no risk that the U.S. government will find itself in the sort of situation known to Argentines and Indonesians. Why not? Because the rest of the world recognizes that the United States performs certain indispensable functions, including acting as the lynchpin of collective security and a principal source of new science and technology. So long as we meet those responsibilities, the rest of the world is likely to want to hold our debts.
Third, in the debt deflation, liquidity trap, and global crisis we are in, there is no risk of even a massive program generating inflation or higher long-term interest rates. That much is obvious from current financial conditions: interest rates on long-maturity Treasury bonds are amazingly low. Those rates also tell you that the markets are not worried about financing Social Security or Medicare. They are more worried, as I am, that the larger economic outlook will remain very bleak for a long time.
Finally, there is the big problem: How to recapitalize the household sector? How to restore the security and prosperity they've lost? How to build the productive economy for the next generation? Is there anything today that we might do that can compare with the transformation of World War II? Almost surely, there is not: World War II doubled production in five years.
Today the largest problems we face are energy security and climate change -- massive issues because energy underpins everything we do, and because climate change threatens the survival of civilization. And here, obviously, we need a comprehensive national effort. Such a thing, if done right, combining planning and markets, could add 5 or even 10 percent of GDP to net investment. That's not the scale of wartime mobilization. But it probably could return the country to full employment and keep it there, for years.
Moreover, the work does resemble wartime mobilization in important financial respects. Weatherization, conservation, mass transit, renewable power, and the smart grid are public investments. As with the armaments in World War II, work on them would generate incomes not matched by the new production of consumer goods. If handled carefully -- say, with a new program of deferred claims to future purchasing power like war bonds -- the incomes earned by dealing with oil security and climate change have the potential to become a foundation of restored financial wealth for the middle class.
This cannot be made to happen over just three years, as we did in 1942-44. But we could manage it over, say, twenty years or a bit longer. What is required are careful, sustained planning, consistent policy, and the recognition now that there are no quick fixes, no easy return to "normal," no going back to a world run by bankers -- and no alternative to taking the long view.
A paradox of the long view is that the time to embrace it is right now. We need to start down that path before disastrous policy errors, including fatal banker bailouts and cuts in Social Security and Medicare, are put into effect. It is therefore especially important that thought and learning move quickly. Does the Geithner team, forged and trained in normal times, have the range and the flexibility required? If not, everything finally will depend, as it did with Roosevelt, on the imagination and character of President Obama.
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Barack Obama's presidency began in hope and goodwill, but its test will be its success or failure on the economics. Did the president and his team correctly diagnose the problem? Did they act with sufficient imagination and force? And did they prevail against the political obstacles -- and not only that, but also against the procedures and the habits of thought to which official Washington is addicted?
The president has an economic program. But there is, so far, no clear statement of the thinking behind that program, and there may not be one, until the first report of the new Council of Economic Advisers appears next year. We therefore resort to what we know about the economists: the chair of the National Economic Council, Lawrence Summers; the CEA chair, Christina Romer; the budget director, Peter Orszag; and their titular head, Treasury Secretary Timothy Geithner. This is plainly a capable, close-knit group, acting with energy and commitment. Deficiencies of their program cannot, therefore, be blamed on incompetence. Rather, if deficiencies exist, they probably result from their shared background and creed -- in short, from the limitations of their ideas.
The deepest belief of the modern economist is that the economy is a self-stabilizing system. This means that, even if nothing is done, normal rates of employment and production will someday return. Practically all modern economists believe this, often without thinking much about it. (Federal Reserve Chairman Ben Bernanke said it reflexively in a major speech in London in January: "The global economy will recover." He did not say how he knew.) The difference between conservatives and liberals is over whether policy can usefully speed things up. Conservatives say no, liberals say yes, and on this point Obama's economists lean left. Hence the priority they gave, in their first days, to the stimulus package.
But did they get the scale right? Was the plan big enough? Policies are based on models; in a slump, plans for spending depend on a forecast of how deep and long the slump would otherwise be. The program will only be correctly sized if the forecast is accurate. And the forecast depends on the underlying belief. If recovery is not built into the genes of the system, then the forecast will be too optimistic, and the stimulus based on it will be too small.
Consider the baseline economic forecast of the Congressional Budget Office, the nonpartisan agency lawmakers rely on to evaluate the economy and their budget plans. In its early-January forecast, the CBO measured and projected the difference between actual economic performance and "normal" economic performance -- the so-called GDP gap. The forecast has two astonishing features. First, the CBO did not expect the present recession to be any worse than that of 1981-82, our deepest postwar recession. Second, the CBO expected a turnaround beginning late this year, with the economy returning to normal around 2015, even if Congress had taken no action at all.
With this projection in mind, the recovery bill pours a bit less than 2 percent of GDP into new spending per year, plus some tax cuts, for two years, into a GDP gap estimated to average 6 percent for three years. The stimulus does not need to fill the whole gap, because the CBO expects a "multiplier effect," as first-round spending on bridges and roads, for example, is followed by second-round spending by steelworkers and road crews. The CBO estimates that because of the multiplier effect, two dollars of new public spending produces about three dollars of new output. (For tax cuts the numbers are lower, since some of the cuts will be saved in the first round.) And with this help, the recession becomes fairly mild. After two years, growth would be solidly established and Congress's work would be done. In this way, the duration as well as the scale of action was driven, behind the scenes, by the CBO's baseline forecast.
Why did the CBO reach this conclusion? On depth, CBO's model is based on the postwar experience, and such models cannot predict outcomes more serious than anything already seen. If we are facing a downturn worse than 1982, our computers won't tell us; we will be surprised. And if the slump is destined to drag on, the computers won't tell us that either. Baked into the CBO model we find a "natural rate of unemployment" of 4.8 percent; the model moves the economy back toward that value no matter what. In the real world, however, there is no reason to believe this will happen. Some alternative forecasts, freed of the mystical return to "normal," now project a GDP gap twice as large as the CBO model predicts, and with no near-term recovery at all.
Considerations of timing also influenced the choice of line items. The bill tilted toward "shovel-ready" projects like refurbishing schools and fixing roads, and away from projects requiring planning and long construction lead times, like urban mass transit. The push for speed also influenced the bill in another way. Drafting new legislative authority takes time. In an emergency, it was sensible for Chairman David Obey of the House Appropriations Committee to mine the legislative docket for ideas already commanding broad support (especially within the Democratic caucus). In this way he produced a bill that was a triumph of fast drafting, practical politics, and progressive principle -- a good bill which the Republicans hated. But the scale of action possible by such means is unrelated, except by coincidence, to what the economy needs.
Three further considerations limited the plan. There was, to begin with, the desire for political consensus; President Obama chose to start his administration with a bill that might win bipartisan support and pass in Congress by wide margins. (He was, of course, spurned by the Republicans.) Second, the new team also sought consensus of another type. Christina Romer polled a bipartisan group of professional economists, and Larry Summers told Meet the Press that the final package reflected a "balance" of their views. This procedure guarantees a result near the middle of the professional mind-set. The method would be useful if the errors of economists were unsystematic. But they are not. Economists are a cautious group, and in any extreme situation the midpoint of professional opinion is bound to be wrong.
Third, the initial package was affected by the new team's desire to get past this crisis and to return to the familiar problems of their past lives. For these protgs of Robert Rubin, veterans in several cases of Rubin's Hamilton Project, a key preconception has always been the budget deficit and what they call the "entitlement problem." This is D.C.-speak for rolling back Social Security and Medicare, opening new markets for fund managers and private insurers, behind a wave of budget babble about "long-term deficits" and "unfunded liabilities." To this our new president is not immune. Even before the inauguration Obama was moved to commit to "entitlement reform," and on February 23 he convened what he called a "fiscal responsibility summit." The idea took hold that after two years or so of big spending, the return to normal would be under way, and the costs of fiscal relief and infrastructure improvement might be recouped, in part by taking a pound of flesh from the incomes and health care of the old.
The chance of a return to normal depends, in turn, on the banking strategy. To Obama's economists a "normal" economy is led and guided by private banks. When domestic credit booms are under way, they tend to generate high employment and low inflation; this makes the public budget look good, and spares the president and Congress many hard decisions. For this reason the new team instinctively seeks to return the bankers to their normal position at the top of the economic hill. Secretary Geithner told CNBC, "We have a financial system that is run by private shareholders, managed by private institutions, and we'd like to do our best to preserve that system."
But, is this a realistic hope? Is it even a possibility? The normal mechanics of a credit cycle do involve interludes when asset values crash and credit relations collapse. In 1981, Paul Volcker's campaign against inflation caused such a crash. But, though they came close, the big banks did not fail then. (I learned recently from William Isaac, Ronald Reagan's chair of the FDIC, that the government had contingency plans to nationalize the large banks in 1982, had Mexico, Argentina, or Brazil defaulted outright on their debts.) When monetary policy relaxed and the delayed tax cuts of 1981 kicked in, there was both pent-up demand for credit and the capacity to supply it. The final result was that the economy recovered quickly. Again in 1994, after a long period of credit crunch, banks and households were strong enough, even without a stimulus, to support a vast renewal of lending which propelled the economy forward for six years.
The Bush-era disasters guarantee that these happy patterns will not be repeated. For the first time since the 1930s, millions of American households are financially ruined. Families that two years ago enjoyed wealth in stocks and in their homes now have neither. Their 401(k)s have fallen by half, their mortgages are a burden, and their homes are an albatross. For many the best strategy is to mail the keys to the bank. This practically assures that excess supply and collapsed prices in housing will continue for years. Apart from cash -- protected by deposit insurance and now desperately being conserved -- the American middle class finds today that its major source of wealth is the implicit value of Social Security and Medicare -- illiquid and intangible but real and inalienable in a way that home and equity values are not. And so it will remain, as long as future benefits are not cut.
In addition, some of the biggest banks are bust, almost for certain. Having abandoned prudent risk management in a climate of regulatory negligence and complicity under Bush, these banks participated gleefully in a poisonous game of abusive mortgage originations followed by rounds of pass-the-bad-penny-to-the-greater-fool. But they could not pass them all. And when in August 2007 the music stopped, banks discovered that the markets for their toxic-mortgage-backed securities had collapsed, and found themselves insolvent. Only a dogged political refusal to admit this has since kept the banks from being taken into receivership by the Federal Deposit Insurance Corporation -- something the FDIC has the power to do, and has done as recently as last year with IndyMac in California.
Geithner's banking plan would prolong the state of denial. It involves government guarantees of the bad assets, keeping current management in place and attempting to attract new private capital. (Conversion of preferred shares to equity, which may happen with Citigroup, conveys no powers that the government, as regulator, does not already have.) The idea is that one can fix the banks from the top down, by reestablishing markets for their bad securities. If the idea seems familiar, it is: Henry Paulson also pressed for this, to the point of winning congressional approval. But then he abandoned the idea. Why? He learned it could not work.
Paulson faced two insuperable problems. One was quantity: there were too many bad assets. The project of buying them back could be likened to "filling the Pacific Ocean with basketballs," as one observer said to me at the time. (When I tried to find out where the original request for $700 billion in the Troubled Asset Relief Program came from, a senior Senate aide replied, "Well, it's a number between five hundred billion and one trillion.")
The other problem was price. The only price at which the assets could be disposed of, protecting the taxpayer, was of course the market price. In the collapse of the market for mortgage-backed securities and their associated credit default swaps, this price was too low to save the banks. But any higher price would have amounted to a gift of public funds, justifiable only if there was a good chance that the assets might recover value when "normal" conditions return.
That chance can be assessed, of course, only by doing what any reasonable private investor would do: due diligence, meaning a close inspection of the loan tapes. On the face of it, such inspections will reveal a very high proportion of missing documentation, inflated appraisals, and other evidence of fraud. (In late 2007 the ratings agency Fitch conducted this exercise on a small sample of loan files, and found indications of misrepresentation or fraud present in practically every one.) The reasonable inference would be that many more of the loans will default. Geithner's plan to guarantee these so-called assets, therefore, is almost sure to overstate their value; it is only a way of delaying the ultimate public recognition of loss, while keeping the perpetrators afloat.
Delay is not innocuous. When a bank's insolvency is ignored, the incentives for normal prudent banking collapse. Management has nothing to lose. It may take big new risks, in volatile markets like commodities, in the hope of salvation before the regulators close in. Or it may loot the institution -- nomenklatura privatization, as the Russians would say -- through unjustified bonuses, dividends, and options. It will never fully disclose the extent of insolvency on its own.
The most likely scenario, should the Geithner plan go through, is a combination of looting, fraud, and a renewed speculation in volatile commodity markets such as oil. Ultimately the losses fall on the public anyway, since deposits are largely insured. There is no chance that the banks will simply resume normal long-term lending. To whom would they lend? For what? Against what collateral? And if banks are recapitalized without changing their management, why should we expect them to change the behavior that caused the insolvency in the first place?
The oddest thing about the Geithner program is its failure to act as though the financial crisis is a true crisis -- an integrated, long-term economic threat -- rather than merely a couple of related but temporary problems, one in banking and the other in jobs. In banking, the dominant metaphor is of plumbing: there is a blockage to be cleared. Take a plunger to the toxic assets, it is said, and credit conditions will return to normal. This, then, will make the recession essentially normal, validating the stimulus package. Solve these two problems, and the crisis will end. That's the thinking.
But the plumbing metaphor is misleading. Credit is not a flow. It is not something that can be forced downstream by clearing a pipe. Credit is a contract. It requires a borrower as well as a lender, a customer as well as a bank. And the borrower must meet two conditions. One is creditworthiness, meaning a secure income and, usually, a house with equity in it. Asset prices therefore matter. With a chronic oversupply of houses, prices fall, collateral disappears, and even if borrowers are willing they can't qualify for loans. The other requirement is a willingness to borrow, motivated by what Keynes called the "animal spirits" of entrepreneurial enthusiasm. In a slump, such optimism is scarce. Even if people have collateral, they want the security of cash. And it is precisely because they want cash that they will not deplete their reserves by plunking down a payment on a new car.
The credit flow metaphor implies that people came flocking to the new-car showrooms last November and were turned away because there were no loans to be had. This is not true -- what happened was that people stopped coming in. And they stopped coming in because, suddenly, they felt poor.
Strapped and afraid, people want to be in cash. This is what economists call the liquidity trap. And it gets worse: in these conditions, the normal estimates for multipliers -- the bang for the buck -- may be too high. Government spending on goods and services always increases total spending directly; a dollar of public spending is a dollar of GDP. But if the workers simply save their extra income, or use it to pay debt, that's the end of the line: there is no further effect. For tax cuts (especially for the middle class and up), the new funds are mostly saved or used to pay down debt. Debt reduction may help lay a foundation for better times later on, but it doesn't help now. With smaller multipliers, the public spending package would need to be even larger, in order to fill in all the holes in total demand. Thus financial crisis makes the real crisis worse, and the failure of the bank plan practically assures that the stimulus also will be too small.
In short, if we are in a true collapse of finance, our models will not serve. It is then appropriate to reach back, past the postwar years, to the experience of the Great Depression. And this can only be done by qualitative and historical analysis. Our modern numerical models just don't capture the key feature of that crisis -- which is, precisely, the collapse of the financial system. If the banking system is crippled, then to be effective the public sector must do much, much more. How much more? By how much can spending be raised in a real depression? And does this remedy work? Recent months have seen much debate over the economic effects of the New Deal, and much repetition of the commonplace that the effort was too small to end the Great Depression, something achieved, it is said, only by World War II. A new paper by the economist Marshall Auerback has usefully corrected this record. Auerback plainly illustrates by how much Roosevelt's ambition exceeded anything yet seen in this crisis:
[Roosevelt's] government hired about 60 per cent of the unemployed in public works and conservation projects that planted a billion trees, saved the whooping crane, modernized rural America, and built such diverse projects as the Cathedral of Learning in Pittsburgh, the Montana state capitol, much of the Chicago lakefront, New York's Lincoln Tunnel and Triborough Bridge complex, the Tennessee Valley Authority and the aircraft carriers Enterprise and Yorktown. It also built or renovated 2,500 hospitals, 45,000 schools, 13,000 parks and playgrounds, 7,800 bridges, 700,000 miles of roads, and a thousand airfields. And it employed 50,000 teachers, rebuilt the country's entire rural school system, and hired 3,000 writers, musicians, sculptors and painters, including Willem de Kooning and Jackson Pollock.
In other words, Roosevelt employed Americans on a vast scale, bringing the unemployment rates down to levels that were tolerable, even before the war -- from 25 percent in 1933 to below 10 percent in 1936, if you count those employed by the government as employed, which they surely were. In 1937, Roosevelt tried to balance the budget, the economy relapsed again, and in 1938 the New Deal was relaunched. This again brought unemployment down to about 10 percent, still before the war.
The New Deal rebuilt America physically, providing a foundation (the TVA's power plants, for example) from which the mobilization of World War II could be launched. But it also saved the country politically and morally, providing jobs, hope, and confidence that in the end democracy was worth preserving. There were many, in the 1930s, who did not think so.
What did not recover, under Roosevelt, was the private banking system. Borrowing and lending -- mortgages and home construction -- contributed far less to the growth of output in the 1930s and '40s than they had in the 1920s or would come to do after the war. If they had savings at all, people stayed in Treasuries, and despite huge deficits interest rates for federal debt remained near zero. The liquidity trap wasn't overcome until the war ended.
It was the war, and only the war, that restored (or, more accurately, created for the first time) the financial wealth of the American middle class. During the 1930s public spending was large, but the incomes earned were spent. And while that spending increased consumption, it did not jumpstart a cycle of investment and growth, because the idle factories left over from the 1920s were quite sufficient to meet the demand for new output. Only after 1940 did total demand outstrip the economy's capacity to produce civilian private goods -- in part because private incomes soared, in part because the government ordered the production of some products, like cars, to halt.
All that extra demand would normally have driven up prices. But the federal government prevented this with price controls. (Disclosure: this writer's father, John Kenneth Galbraith, ran the controls during the first year of the war.) And so, with nowhere else for their extra dollars to go, the public bought and held government bonds. These provided claims to postwar purchasing power. After the war, the existence of those claims could, and did, establish creditworthiness for millions, making possible the revival of private banking, and on the broadly based, middle-class foundation that so distinguished the 1950s from the 1920s. But the relaunching of private finance took twenty years, and the war besides.
A brief reflection on this history and present circumstances drives a plain conclusion: the full restoration of private credit will take a long time. It will follow, not precede, the restoration of sound private household finances. There is no way the project of resurrecting the economy by stuffing the banks with cash will work. Effective policy can only work the other way around.
That being so, what must now be done? The first thing we need, in the wake of the recovery bill, is more recovery bills. The next efforts should be larger, reflecting the true scale of the emergency. There should be open-ended support for state and local governments, public utilities, transit authorities, public hospitals, schools, and universities for the duration, and generous support for public capital investment in the short and long term. To the extent possible, all the resources being released from the private residential and commercial construction industries should be absorbed into public building projects. There should be comprehensive foreclosure relief, through a moratorium followed by restructuring or by conversion-to-rental, except in cases of speculative investment and borrower fraud. The president's foreclosure-prevention plan is a useful step to relieve mortgage burdens on at-risk households, but it will not stop the downward spiral of home prices and correct the chronic oversupply of housing that is the cause of that.
Second, we should offset the violent drop in the wealth of the elderly population as a whole. The squeeze on the elderly has been little noted so far, but it hits in three separate ways: through the fall in the stock market; through the collapse of home values; and through the drop in interest rates, which reduces interest income on accumulated cash. For an increasing number of the elderly, Social Security and Medicare wealth are all they have.
That means that the entitlement reformers have it backward: instead of cutting Social Security benefits, we should increase them, especially for those at the bottom of the benefit scale. Indeed, in this crisis, precisely because it is universal and efficient, Social Security is an economic recovery ace in the hole. Increasing benefits is a simple, direct, progressive, and highly efficient way to prevent poverty and sustain purchasing power for this vulnerable population. I would also argue for lowering the age of eligibility for Medicare to (say) fifty-five, to permit workers to retire earlier and to free firms from the burden of managing health plans for older workers.
This suggestion is meant, in part, to call attention to the madness of talk about Social Security and Medicare cuts. The prospect of future cuts in this modest but vital source of retirement security can only prompt worried prime-age workers to spend less and save more today. And that will make the present economic crisis deeper. In reality, there is no Social Security "financing problem" at all. There is a health care problem, but that can be dealt with only by deciding what health services to provide, and how to pay for them, for the whole population. It cannot be dealt with, responsibly or ethically, by cutting care for the old.
Third, we will soon need a jobs program to put the unemployed to work quickly. Infrastructure spending can help, but major building projects can take years to gear up, and they can, for the most part, provide jobs only for those who have the requisite skills. So the federal government should sponsor projects that employ people to do what they do best, including art, letters, drama, dance, music, scientific research, teaching, conservation, and the nonprofit sector, including community organizing -- why not?
Finally, a payroll tax holiday would help restore the purchasing power of working families, as well as make it easier for employers to keep them on the payroll. This is a particularly potent suggestion, because it is large and immediate. And if growth resumes rapidly, it can also be scaled back. There is no error in doing too much that cannot easily be repaired, by doing a bit less.
As these measures take effect, the government must take control of insolvent banks, however large, and get on with the business of reorganizing, re-regulating, decapitating, and recapitalizing them. Depositors should be insured fully to prevent runs, and private risk capital (common and preferred equity and subordinated debt) should take the first loss. Effective compensation limits should be enforced -- it is a good thing that they will encourage those at the top to retire. As Senator Christopher Dodd of Connecticut correctly stated in the brouhaha following the discovery that Senate Democrats had put tough limits into the recovery bill, there are many competent replacements for those who leave.
Ultimately the big banks can be resold as smaller private institutions, run on a scale that permits prudent credit assessment and risk management by people close enough to their client communities to foster an effective revival, among other things, of household credit and of independent small business -- another lost hallmark of the 1950s. No one should imagine that the swaggering, bank-driven world of high finance and credit bubbles should be made to reappear. Big banks should be run largely by men and women with the long-term perspective, outlook, and temperament of middle managers, and not by the transient, self-regarding plutocrats who run them now.
The chorus of deficit hawks and entitlement reformers are certain to regard this program with horror. What about the deficit? What about the debt? These questions are unavoidable, so let's answer them. First, the deficit and the public debt of the U.S. government can, should, must, and will increase in this crisis. They will increase whether the government acts or not. The choice is between an active program, running up debt while creating jobs and rebuilding America, or a passive program, running up debt because revenues collapse, because the population has to be maintained on the dole, and because the Treasury wishes, for no constructive reason, to rescue the big bankers and make them whole.
Second, so long as the economy is placed on a path to recovery, even a massive increase in public debt poses no risk that the U.S. government will find itself in the sort of situation known to Argentines and Indonesians. Why not? Because the rest of the world recognizes that the United States performs certain indispensable functions, including acting as the lynchpin of collective security and a principal source of new science and technology. So long as we meet those responsibilities, the rest of the world is likely to want to hold our debts.
Third, in the debt deflation, liquidity trap, and global crisis we are in, there is no risk of even a massive program generating inflation or higher long-term interest rates. That much is obvious from current financial conditions: interest rates on long-maturity Treasury bonds are amazingly low. Those rates also tell you that the markets are not worried about financing Social Security or Medicare. They are more worried, as I am, that the larger economic outlook will remain very bleak for a long time.
Finally, there is the big problem: How to recapitalize the household sector? How to restore the security and prosperity they've lost? How to build the productive economy for the next generation? Is there anything today that we might do that can compare with the transformation of World War II? Almost surely, there is not: World War II doubled production in five years.
Today the largest problems we face are energy security and climate change -- massive issues because energy underpins everything we do, and because climate change threatens the survival of civilization. And here, obviously, we need a comprehensive national effort. Such a thing, if done right, combining planning and markets, could add 5 or even 10 percent of GDP to net investment. That's not the scale of wartime mobilization. But it probably could return the country to full employment and keep it there, for years.
Moreover, the work does resemble wartime mobilization in important financial respects. Weatherization, conservation, mass transit, renewable power, and the smart grid are public investments. As with the armaments in World War II, work on them would generate incomes not matched by the new production of consumer goods. If handled carefully -- say, with a new program of deferred claims to future purchasing power like war bonds -- the incomes earned by dealing with oil security and climate change have the potential to become a foundation of restored financial wealth for the middle class.
This cannot be made to happen over just three years, as we did in 1942-44. But we could manage it over, say, twenty years or a bit longer. What is required are careful, sustained planning, consistent policy, and the recognition now that there are no quick fixes, no easy return to "normal," no going back to a world run by bankers -- and no alternative to taking the long view.
A paradox of the long view is that the time to embrace it is right now. We need to start down that path before disastrous policy errors, including fatal banker bailouts and cuts in Social Security and Medicare, are put into effect. It is therefore especially important that thought and learning move quickly. Does the Geithner team, forged and trained in normal times, have the range and the flexibility required? If not, everything finally will depend, as it did with Roosevelt, on the imagination and character of President Obama.
Why Suburbs May Become the Next Slums
The poor are fleeing our cities, but life is not always greener in the suburbs, even when affordable housing comes with a two-car garage.
The financial meltdown has produced a vast patchwork of foreclosed and abandoned single-family homes across America, accelerating the decades-long migration of our nation's poor from cities to the suburban fringe. In 2005, as rising property values reduced affordable-housing stock in inner-city neighborhoods, suburban poverty, in raw numbers, topped urban poverty for the first time.
The trend will continue. By 2025, predicts planning expert Arthur C. Nelson, America will face a market surplus of 22 million large-lot homes (a sixth of an acre or more), attracting millions of low-income residents deeper into suburbia where decay and social and geographic isolation will pose challenges few see coming.
"As a society, we have fundamentally failed to address our housing policy," said Nelson, director of metropolitan research at the University of Utah. "Suburbia is overbuilt and yet we will keep on building there. Most policymakers don't see the consequences, and those who do are denying reality."
Nelson and others warn that suburbia's least desirable neighborhoods - aging, middle-class tract-home developments far from city centers and mass transit lines — are America's emerging slums, characterized by poverty, crime and other social ills. Treating those ills is complicated by the same qualities that once defined suburbia's appeal — seclusion, homogeneity and low population density. "We built too much of the suburban dream, and now it's coming back to haunt us," Nelson said.
To be sure, the low-income drift to suburbia has less to do with bucolic appeal and more to do with economics. Over the past two decades, the gospel of urbanism has spread though the American mainstream, Nelson and others argue. The young, the affluent, the professional class and empty-nesters are reclaiming the urban living experience — dense, walkable, diverse, mixed-use neighborhoods in and around city centers — while the poor disperse outward in search of cheap rent. Low-income residents often subdivide suburban homes, sharing them with multiple families. Studies reveal that population densities in suburban neighborhoods increase two to four times when low-income families replace the middle-class, Nelson said.
Meanwhile, layoffs and other effects of the economic crisis are contributing to higher poverty levels in once-solidly middle-class communities.
Most experts believe the market-driven migration of the poor to suburbs and the affluent to urban zones — sometimes called "demographic inversion" — will continue for decades.
"Americans are disillusioned with sprawl, they're tired of driving, they recognize the soullessness of suburban life, and yet we keep on adding more suburban communities," said Christopher B. Leinberger, a land-use expert at the University of Michigan. He said consumer preference is reflected by Hollywood: "People identify with Sex and the City and Seinfeld. So why are we still building like Leave it to Beaver?"
Leinberger is an unabashed urbanist who preaches the gospel of dense, mixed-use communities like a missionary saving souls in the jungle. As a visiting fellow this year at the Brookings Institution in Washington, D.C., he walks to his office and to appointments around the city. He argues, with few dissenters, that suburbs are losing favor because they make little sense, forcing people into their cars, limiting social interaction and discouraging racial and socio-economic diversity. Enlightened planners across the country are promoting compact "24/7" urban centers were people live, work and play in close proximity. Virtually every major U.S. city is targeting once-gritty urban neighborhoods for revitalization and, inevitably, gentrification.
The displaced poor find value in the aging, outer-ring tract-home developments that once promised easy living far from the city's hustle and bustle. And housing officials, resolved to breaking up pockets of concentrated poverty (where at least 40 percent of the families are living below the poverty line), are thrilled. The federal Section 8 housing program, which allows recipients to negotiate government-subsidized rentals anywhere, is grounded in the belief that a safe, stable neighborhood can help unbuckle the straps of poverty.
But the positive benefits of moving to a neighborhood of less poverty diminish as the number of poor relocating there increases, new research suggests. In other words, families are far less likely to pull themselves out of poverty when their exposure to other poor families reaches a kind of tipping point. George C. Galster, a professor of urban affairs at Wayne State University, has quantified this poverty threshold as roughly 15 to 20 percent of a neighborhood. If the poverty rate exceeds that, Galster said, "All hell breaks loose" in the form of crime, drop-out rates, teen pregnancies, drug use and, in turn, declining property values.
Galster's working paper for the National Poverty Center, Consequences from the Redistribution of Urban Poverty During the 1990s: A Cautionary Tale, warns that polices to break up concentrated poverty may be backfiring. While the number of Americans living in the poorest neighborhoods has notably declined since 1990, by about 25 percent, poverty elsewhere has inched up. Galster worries that the rush to relocate the urban poor, through Section 8 and other poverty redistribution programs, has pushed many less-desirable suburban neighborhoods to this tipping point.
And when they tip, he added, neighborhoods tend to spiral deeper into poverty: Declining property values attract more poor residents, gradually displacing the middle-class families that provide stability, further depressing prices.
Miami real estate broker Adrian Salgado said he's witnessing the spiral, even within newer tract-home development in the region's southern and western fringes. With many areas overbuilt, and foreclosure rates high, Section 8 tenants and other low-income renters are finding deals too good to pass up. "I know everybody needs a place to live, but we're creating a social disaster," said Salgado, noting that many early middle-class buyers in these transition neighborhoods are desperate to sell but can't.
Although national data is thin, local officials across the country are reporting an increase in violent crime, gang activity, drug use and other social breakdowns within suburban neighborhoods. In places like New York City, Atlanta and Chicago, urban crime rates are dropping while rising on the outskirts of town. Crime is also rising in the fast-growing sunbelt communities hit hard with foreclosures. Leinberger noted that in Lee County Fla., where nearly 25 percent of the homes stand empty, robberies were up nearly 50 percent last year.
Indeed, police in some cities are monitoring suburban foreclosures to identify neighborhoods at risk for increased crime, while others look at Section 8 relocations, arguing that a sudden rise in low-income rental densities is among their most reliable indicators of a coming crime spike.
Such tactics rankle some anti-poverty advocates, but a growing body of research is challenging suburban relocation as a remedy for poverty. Ed Goetz, a housing policy specialist at the University of Minnesota, said the suburban dream often fades for poor families because old support systems are severed, and access to programs and services — day care, after-school programs, job training, drug treatment and counseling — are greatly hampered by shear distance.
"The isolation can be both physical and emotional," Goetz said. "The frequency of interaction with neighbors declines, social networks break down. We haven't considered that carefully enough." Goetz said studies show a surprising willingness among the suburban poor to return to urban, high-poverty neighborhoods where services are more accessible and mass transit more convenient.
But the suburban diaspora of America's poor is unlikely to subside, most experts agree, posing complex challenges for policymakers. If anything, added Alan Berube, a housing expert at the Brookings Institution, suburban poverty will grow not just from in-migration of the poor but from within as the financial crisis "pushes middle-class families down the economic ladder."
With that in mind, Galster recommends strict monitoring of suburban poverty rates to prevent neighborhoods from reaching the so-called tipping point. Such data would allow housing officials to push for laws requiring property owners in low-poverty neighborhoods to accept Section 8 tenants (the existing program is voluntary), something he recommends. Conversely, he argued, laws should prevent landlords from accepting low-income tenants when neighborhood poverty rates exceed designated levels. He also supports "inclusionary zoning" rules that mandate a small number of low-income housing units in new single-family developments.
But Nelson, whose research predicts the vast oversupply of large-lot homes in the coming decades — and the growing "suburbanization of poverty" — said much can be done today to reshape the residential landscape. Most of the homes he expects to exist in 2025 have yet to be built. He said planners can reduce that oversupply by crafting long-term growth policies that reflect a careful assessment of regional demands for all housing types over a generation or more. What they will find, he said, is a preference among all income groups for denser, mixed-use communities with access to mass transit.
Leinberger agreed, arguing that planners should acknowledge that the suburban experiment has failed. "I wouldn't add another new road in American today," he said. "The changing geography of poverty is another reminder that our housing policies today will be felt for years to come, and in ways nobody ever imagined."
The financial meltdown has produced a vast patchwork of foreclosed and abandoned single-family homes across America, accelerating the decades-long migration of our nation's poor from cities to the suburban fringe. In 2005, as rising property values reduced affordable-housing stock in inner-city neighborhoods, suburban poverty, in raw numbers, topped urban poverty for the first time.
The trend will continue. By 2025, predicts planning expert Arthur C. Nelson, America will face a market surplus of 22 million large-lot homes (a sixth of an acre or more), attracting millions of low-income residents deeper into suburbia where decay and social and geographic isolation will pose challenges few see coming.
"As a society, we have fundamentally failed to address our housing policy," said Nelson, director of metropolitan research at the University of Utah. "Suburbia is overbuilt and yet we will keep on building there. Most policymakers don't see the consequences, and those who do are denying reality."
Nelson and others warn that suburbia's least desirable neighborhoods - aging, middle-class tract-home developments far from city centers and mass transit lines — are America's emerging slums, characterized by poverty, crime and other social ills. Treating those ills is complicated by the same qualities that once defined suburbia's appeal — seclusion, homogeneity and low population density. "We built too much of the suburban dream, and now it's coming back to haunt us," Nelson said.
To be sure, the low-income drift to suburbia has less to do with bucolic appeal and more to do with economics. Over the past two decades, the gospel of urbanism has spread though the American mainstream, Nelson and others argue. The young, the affluent, the professional class and empty-nesters are reclaiming the urban living experience — dense, walkable, diverse, mixed-use neighborhoods in and around city centers — while the poor disperse outward in search of cheap rent. Low-income residents often subdivide suburban homes, sharing them with multiple families. Studies reveal that population densities in suburban neighborhoods increase two to four times when low-income families replace the middle-class, Nelson said.
Meanwhile, layoffs and other effects of the economic crisis are contributing to higher poverty levels in once-solidly middle-class communities.
Most experts believe the market-driven migration of the poor to suburbs and the affluent to urban zones — sometimes called "demographic inversion" — will continue for decades.
"Americans are disillusioned with sprawl, they're tired of driving, they recognize the soullessness of suburban life, and yet we keep on adding more suburban communities," said Christopher B. Leinberger, a land-use expert at the University of Michigan. He said consumer preference is reflected by Hollywood: "People identify with Sex and the City and Seinfeld. So why are we still building like Leave it to Beaver?"
Leinberger is an unabashed urbanist who preaches the gospel of dense, mixed-use communities like a missionary saving souls in the jungle. As a visiting fellow this year at the Brookings Institution in Washington, D.C., he walks to his office and to appointments around the city. He argues, with few dissenters, that suburbs are losing favor because they make little sense, forcing people into their cars, limiting social interaction and discouraging racial and socio-economic diversity. Enlightened planners across the country are promoting compact "24/7" urban centers were people live, work and play in close proximity. Virtually every major U.S. city is targeting once-gritty urban neighborhoods for revitalization and, inevitably, gentrification.
The displaced poor find value in the aging, outer-ring tract-home developments that once promised easy living far from the city's hustle and bustle. And housing officials, resolved to breaking up pockets of concentrated poverty (where at least 40 percent of the families are living below the poverty line), are thrilled. The federal Section 8 housing program, which allows recipients to negotiate government-subsidized rentals anywhere, is grounded in the belief that a safe, stable neighborhood can help unbuckle the straps of poverty.
But the positive benefits of moving to a neighborhood of less poverty diminish as the number of poor relocating there increases, new research suggests. In other words, families are far less likely to pull themselves out of poverty when their exposure to other poor families reaches a kind of tipping point. George C. Galster, a professor of urban affairs at Wayne State University, has quantified this poverty threshold as roughly 15 to 20 percent of a neighborhood. If the poverty rate exceeds that, Galster said, "All hell breaks loose" in the form of crime, drop-out rates, teen pregnancies, drug use and, in turn, declining property values.
Galster's working paper for the National Poverty Center, Consequences from the Redistribution of Urban Poverty During the 1990s: A Cautionary Tale, warns that polices to break up concentrated poverty may be backfiring. While the number of Americans living in the poorest neighborhoods has notably declined since 1990, by about 25 percent, poverty elsewhere has inched up. Galster worries that the rush to relocate the urban poor, through Section 8 and other poverty redistribution programs, has pushed many less-desirable suburban neighborhoods to this tipping point.
And when they tip, he added, neighborhoods tend to spiral deeper into poverty: Declining property values attract more poor residents, gradually displacing the middle-class families that provide stability, further depressing prices.
Miami real estate broker Adrian Salgado said he's witnessing the spiral, even within newer tract-home development in the region's southern and western fringes. With many areas overbuilt, and foreclosure rates high, Section 8 tenants and other low-income renters are finding deals too good to pass up. "I know everybody needs a place to live, but we're creating a social disaster," said Salgado, noting that many early middle-class buyers in these transition neighborhoods are desperate to sell but can't.
Although national data is thin, local officials across the country are reporting an increase in violent crime, gang activity, drug use and other social breakdowns within suburban neighborhoods. In places like New York City, Atlanta and Chicago, urban crime rates are dropping while rising on the outskirts of town. Crime is also rising in the fast-growing sunbelt communities hit hard with foreclosures. Leinberger noted that in Lee County Fla., where nearly 25 percent of the homes stand empty, robberies were up nearly 50 percent last year.
Indeed, police in some cities are monitoring suburban foreclosures to identify neighborhoods at risk for increased crime, while others look at Section 8 relocations, arguing that a sudden rise in low-income rental densities is among their most reliable indicators of a coming crime spike.
Such tactics rankle some anti-poverty advocates, but a growing body of research is challenging suburban relocation as a remedy for poverty. Ed Goetz, a housing policy specialist at the University of Minnesota, said the suburban dream often fades for poor families because old support systems are severed, and access to programs and services — day care, after-school programs, job training, drug treatment and counseling — are greatly hampered by shear distance.
"The isolation can be both physical and emotional," Goetz said. "The frequency of interaction with neighbors declines, social networks break down. We haven't considered that carefully enough." Goetz said studies show a surprising willingness among the suburban poor to return to urban, high-poverty neighborhoods where services are more accessible and mass transit more convenient.
But the suburban diaspora of America's poor is unlikely to subside, most experts agree, posing complex challenges for policymakers. If anything, added Alan Berube, a housing expert at the Brookings Institution, suburban poverty will grow not just from in-migration of the poor but from within as the financial crisis "pushes middle-class families down the economic ladder."
With that in mind, Galster recommends strict monitoring of suburban poverty rates to prevent neighborhoods from reaching the so-called tipping point. Such data would allow housing officials to push for laws requiring property owners in low-poverty neighborhoods to accept Section 8 tenants (the existing program is voluntary), something he recommends. Conversely, he argued, laws should prevent landlords from accepting low-income tenants when neighborhood poverty rates exceed designated levels. He also supports "inclusionary zoning" rules that mandate a small number of low-income housing units in new single-family developments.
But Nelson, whose research predicts the vast oversupply of large-lot homes in the coming decades — and the growing "suburbanization of poverty" — said much can be done today to reshape the residential landscape. Most of the homes he expects to exist in 2025 have yet to be built. He said planners can reduce that oversupply by crafting long-term growth policies that reflect a careful assessment of regional demands for all housing types over a generation or more. What they will find, he said, is a preference among all income groups for denser, mixed-use communities with access to mass transit.
Leinberger agreed, arguing that planners should acknowledge that the suburban experiment has failed. "I wouldn't add another new road in American today," he said. "The changing geography of poverty is another reminder that our housing policies today will be felt for years to come, and in ways nobody ever imagined."
Tax Time Covert Ops
Catherine, Daily Musings and Financial Permaculture,
March 19, 2009 at 5:03 pm
I just got back from town where I listened to the latest rumors - the local African-American gang is rumored to be planning a gang initiation. Initiates are required, or so it goes, to kill three women and three men at the local big box store.
Two years ago, two kids went on a “wilding,” breaking into a series of homes and businesses in my town. This was followed by presentations from local law enforcement about wildings and various violent gang initiations.
Now, having grown up in an urban community taken over by drug dealing and having spent a fair amount of time learning how secret societies, law firms, banks and government agencies manage the narcotics business and $500 billion - $1 trillion of US money laundering, when you say “local gang” what I hear is “local CIA distributor.” So when a local drug gang does something or is rumored to do something, what I hear is that covert ops is on the move and the orders are coming top down.
Think back to the race riots. My sources have convinced me that they were started by covert ops shutting off the drug supply and seeding violent behavior. Or the school shootings. My bet is that people unwillingly put through mind control are being manipulated to help do shootings that make it easier to pass gun control laws. Sound far fetched? Spend some time studying how covert operations have been used and implemented historically and I think you will be surprised. If you have not read my online book yet, I would recommend reading it and the resource documentation provided as a good place to begin. Then watch the movies that illuminate mind control operations, including the new Manchurian Candidate, Bourne Identity, Telefon, Conspiracy Theory, Long Kiss Goodnight and La Femme Nikita.
When I heard the rumor today, I was not surprised. I have been expecting these kinds of rumors and ops. With bailouts up to $12-14 trillion, the Fed announcing another $1 trillion plus monetization and AIG bailing out Wall Street and paying out large bonuses, men and women on Main Street are frustrated. This is tax preparation time. When you are scrimping to come up with money to pay your taxes, the reminders that it will be liberally spent to make the rich richer runs the risk of setting off a class war or increased tax resistance.
How do you prevent a class war? How do you stop people from starting or joining tax resistance movements? Well, believe it or not, you start a race war. You target people who understand their rights and are working to build self sufficiency. If people are afraid, they will want more law and order. So they will pay their taxes. They will worry about the gangs next door instead of the gangs in the City of London. They will not realize the two are intimately connected.
Hate. Divide and conquer. It’s a business. The media is pushing it. The people directing it are the same people who brought you the AIG bonuses. Indeed, AIG is my vote for one of the top three financial institutions involved in financing domestic covert operations.
We have nothing to fear from teenagers of any color. They are our future. We have nothing to fear from patriots. They are our conscience. If we have anything to fear, it is the IRS.
Make sure you file your taxes on April 15th. The government needs our money. They need to give it to rich traders in London and secretive banks who are laundering the profits from the drugs and gangs that plague our neighborhoods.
God forbid everyone who owed the IRS money this year should file tax extensions in protest. God forbid Wall Street should have to wait until October 15 for more bailout money.
March 19, 2009 at 5:03 pm
I just got back from town where I listened to the latest rumors - the local African-American gang is rumored to be planning a gang initiation. Initiates are required, or so it goes, to kill three women and three men at the local big box store.
Two years ago, two kids went on a “wilding,” breaking into a series of homes and businesses in my town. This was followed by presentations from local law enforcement about wildings and various violent gang initiations.
Now, having grown up in an urban community taken over by drug dealing and having spent a fair amount of time learning how secret societies, law firms, banks and government agencies manage the narcotics business and $500 billion - $1 trillion of US money laundering, when you say “local gang” what I hear is “local CIA distributor.” So when a local drug gang does something or is rumored to do something, what I hear is that covert ops is on the move and the orders are coming top down.
Think back to the race riots. My sources have convinced me that they were started by covert ops shutting off the drug supply and seeding violent behavior. Or the school shootings. My bet is that people unwillingly put through mind control are being manipulated to help do shootings that make it easier to pass gun control laws. Sound far fetched? Spend some time studying how covert operations have been used and implemented historically and I think you will be surprised. If you have not read my online book yet, I would recommend reading it and the resource documentation provided as a good place to begin. Then watch the movies that illuminate mind control operations, including the new Manchurian Candidate, Bourne Identity, Telefon, Conspiracy Theory, Long Kiss Goodnight and La Femme Nikita.
When I heard the rumor today, I was not surprised. I have been expecting these kinds of rumors and ops. With bailouts up to $12-14 trillion, the Fed announcing another $1 trillion plus monetization and AIG bailing out Wall Street and paying out large bonuses, men and women on Main Street are frustrated. This is tax preparation time. When you are scrimping to come up with money to pay your taxes, the reminders that it will be liberally spent to make the rich richer runs the risk of setting off a class war or increased tax resistance.
How do you prevent a class war? How do you stop people from starting or joining tax resistance movements? Well, believe it or not, you start a race war. You target people who understand their rights and are working to build self sufficiency. If people are afraid, they will want more law and order. So they will pay their taxes. They will worry about the gangs next door instead of the gangs in the City of London. They will not realize the two are intimately connected.
Hate. Divide and conquer. It’s a business. The media is pushing it. The people directing it are the same people who brought you the AIG bonuses. Indeed, AIG is my vote for one of the top three financial institutions involved in financing domestic covert operations.
We have nothing to fear from teenagers of any color. They are our future. We have nothing to fear from patriots. They are our conscience. If we have anything to fear, it is the IRS.
Make sure you file your taxes on April 15th. The government needs our money. They need to give it to rich traders in London and secretive banks who are laundering the profits from the drugs and gangs that plague our neighborhoods.
God forbid everyone who owed the IRS money this year should file tax extensions in protest. God forbid Wall Street should have to wait until October 15 for more bailout money.
U.S. seizes top credit union clearinghouse
* U.S. Central has $34 billion in assets
* Settles for all other wholesale credit unions
* Western Corporate also seized
* Action comes as three small banks closed by FDIC (Adds NCUA spokesman, moves to bolster insurance fund)
By Karey Wutkowski
WASHINGTON, March 20 (Reuters) - Regulators seized the top clearinghouse for U.S. credit unions, citing a critical deterioration in the finances of the provider of services to thousands of retail credit unions.
The National Credit Union Administration (NCUA) took control of U.S. Central Federal Credit Union, a huge wholesale credit union with about $34 billion in assets based in Lenexa, Kansas.
It also seized Western Corporate (WesCorp) Federal Credit Union of San Dimas, California, another corporate credit union with $23 billion in assets.
Stress tests of corporate credit unions had uncovered an "unacceptably high concentration of risk" at these two institutions, the regulator said in a statement.
The immediate costs of the takeover are coming out of a $7 billion industry-maintained insurance fund, but will mean higher premiums levied on retail credit unions.
The action highlighted strains in the nonprofit banking sector that has recently been touted as a source of new lending, even as many for-profit banks limit their lending and receive billions of dollars of taxpayer-funded capital injections.
U.S. regulators also seized another three small banks on Friday, bringing the total to 20 so far this year.
U.S. Central and WesCorp were carrying the bulk of the soured mortgage-backed securities that have been causing woes to the corporate credit union industry, said NCUA spokesman John McKechnie.
"We've been intervening in the corporate networks... for several months now and it just got to a critical stage," McKechnie said. "In the last couple of months the problems have moved from liquidity to be more capital and asset-based."
In January the NCUA injected $1 billion into U.S. Central after the corporate credit union suffered dramatic declines in the value of mortgage-backed securities it had bought.
Corporate credit unions are the retail credit union's credit union, providing services including lending, and check and payment clearance services.
The NCUA also moved in January to guarantee the $80 billion that regular credit unions have on deposit in the corporate network. The moves were considered a bailout of the U.S. credit union network.
Credit union retail customer deposits are insured up to $250,000 per account, in line with bank deposits, a step taken last year as part of a wider effort to increase consumer confidence in banking.
The NCUA said service will continue uninterrupted at U.S. Central and WesCorp, and said member accounts are guaranteed through Dec. 31, 2010.
"When a credit union or a corporate credit union is taken into conservatorship... it remains business as usual, all insured deposits are protected," said Henry Kertman, spokesman for the California Credit Union League.
A HIT TO INDUSTRY EARNINGS
U.S. Central has 26 corporate credit union members and says it provides settlement services to 100 percent of corporate credit unions and 93 percent of all U.S. credit unions.
WesCorp based in San Dimas, California, has approximately 1,100 retail credit union members, the NCUA said.
McKechnie said the industry will have to pay an additional $1.2 billion to cover the resolution of the the two institutions, on top of a $4.7 billion assessment the NCUA announced earlier this year for its actions in January.
"The direct impact is going to be to the earnings of credit unions as they pay to replenish the fund," McKechnie said.
He said the NCUA does not anticipate having to tap into its $100 million line of credit with the U.S. Treasury Department, meaning taxpayers will not be on the hook for the latest dramatic financial rescue.
Legislation moving through Congress would increase the credit union industry's borrowing authority to $6 billion, and give it more time to replenish its insurance fund.
McKechnie said he would not speculate about any future actions the NCUA might have to take to stabilize the credit union industry, which he said is "very well capitalized at this point."
"I do think that we have taken whatever steps are necessary to maintain a well-functioning, safe and sound credit union industry," McKechnie said.
Separately, the U.S. Federal Deposit Insurance Corp said it had found other banks to acquire the deposits of TeamBank (TFIN.O) of Paola, Kansas, and Colorado National Bank of Colorado Springs, Colorado. But the FDIC became receiver of FirstCity Bank of Stockbridge, Georgia, and approved the payout of its insured deposits. (Reporting by Karey Wutkowski, Helen Chernikoff and Elinor Comlay; Editing by Tim Dobbyn)
* Settles for all other wholesale credit unions
* Western Corporate also seized
* Action comes as three small banks closed by FDIC (Adds NCUA spokesman, moves to bolster insurance fund)
By Karey Wutkowski
WASHINGTON, March 20 (Reuters) - Regulators seized the top clearinghouse for U.S. credit unions, citing a critical deterioration in the finances of the provider of services to thousands of retail credit unions.
The National Credit Union Administration (NCUA) took control of U.S. Central Federal Credit Union, a huge wholesale credit union with about $34 billion in assets based in Lenexa, Kansas.
It also seized Western Corporate (WesCorp) Federal Credit Union of San Dimas, California, another corporate credit union with $23 billion in assets.
Stress tests of corporate credit unions had uncovered an "unacceptably high concentration of risk" at these two institutions, the regulator said in a statement.
The immediate costs of the takeover are coming out of a $7 billion industry-maintained insurance fund, but will mean higher premiums levied on retail credit unions.
The action highlighted strains in the nonprofit banking sector that has recently been touted as a source of new lending, even as many for-profit banks limit their lending and receive billions of dollars of taxpayer-funded capital injections.
U.S. regulators also seized another three small banks on Friday, bringing the total to 20 so far this year.
U.S. Central and WesCorp were carrying the bulk of the soured mortgage-backed securities that have been causing woes to the corporate credit union industry, said NCUA spokesman John McKechnie.
"We've been intervening in the corporate networks... for several months now and it just got to a critical stage," McKechnie said. "In the last couple of months the problems have moved from liquidity to be more capital and asset-based."
In January the NCUA injected $1 billion into U.S. Central after the corporate credit union suffered dramatic declines in the value of mortgage-backed securities it had bought.
Corporate credit unions are the retail credit union's credit union, providing services including lending, and check and payment clearance services.
The NCUA also moved in January to guarantee the $80 billion that regular credit unions have on deposit in the corporate network. The moves were considered a bailout of the U.S. credit union network.
Credit union retail customer deposits are insured up to $250,000 per account, in line with bank deposits, a step taken last year as part of a wider effort to increase consumer confidence in banking.
The NCUA said service will continue uninterrupted at U.S. Central and WesCorp, and said member accounts are guaranteed through Dec. 31, 2010.
"When a credit union or a corporate credit union is taken into conservatorship... it remains business as usual, all insured deposits are protected," said Henry Kertman, spokesman for the California Credit Union League.
A HIT TO INDUSTRY EARNINGS
U.S. Central has 26 corporate credit union members and says it provides settlement services to 100 percent of corporate credit unions and 93 percent of all U.S. credit unions.
WesCorp based in San Dimas, California, has approximately 1,100 retail credit union members, the NCUA said.
McKechnie said the industry will have to pay an additional $1.2 billion to cover the resolution of the the two institutions, on top of a $4.7 billion assessment the NCUA announced earlier this year for its actions in January.
"The direct impact is going to be to the earnings of credit unions as they pay to replenish the fund," McKechnie said.
He said the NCUA does not anticipate having to tap into its $100 million line of credit with the U.S. Treasury Department, meaning taxpayers will not be on the hook for the latest dramatic financial rescue.
Legislation moving through Congress would increase the credit union industry's borrowing authority to $6 billion, and give it more time to replenish its insurance fund.
McKechnie said he would not speculate about any future actions the NCUA might have to take to stabilize the credit union industry, which he said is "very well capitalized at this point."
"I do think that we have taken whatever steps are necessary to maintain a well-functioning, safe and sound credit union industry," McKechnie said.
Separately, the U.S. Federal Deposit Insurance Corp said it had found other banks to acquire the deposits of TeamBank (TFIN.O) of Paola, Kansas, and Colorado National Bank of Colorado Springs, Colorado. But the FDIC became receiver of FirstCity Bank of Stockbridge, Georgia, and approved the payout of its insured deposits. (Reporting by Karey Wutkowski, Helen Chernikoff and Elinor Comlay; Editing by Tim Dobbyn)
More on robbing the US tax payer and debauching the FDIC and the Fed
The US authorities have no money to fulfil their ambition of stopping large US banks from failing without taking them into public ownership. The $300 bn left in the TARP kitty is all that is available for recapitalising banks, purchasing toxic assets and providing other financial support. Congress has thrown its toys out of the pram and is unwilling to appropriate more funds for the rescue of the banking sector.
As an aside: it is astonishing that Congress and much of the US populace are apoplectic about $165 mn (perhaps $182 mn) of bonuses paid to AIG executives and employees, when $170 billion or so of public money is at risk (and tens of billions probably already gone out of the window) in the rescue of this most undeserving of companies. Perhaps you can only get indignant about what you can comprehend… .
The US authorities are reduced to begging, stealing and borrowing the rest of the funds they believe they will need. The two main proximate sources of funds are the FDIC and the Fed. The ultimate sources of funds will be (1) the US tax payer and the beneficiaries of future US spending programs that will have to be cut, (2) the holders of nominally denominated liabilities of the US state, including the monetary liabilities of the Fed and US Treasury bills and bonds.
Owners of dollar-denominated debt instruments will see the real value of their claims on the government eroded by future inflation if, as I expect, the recent and prospective future increases in the US monetary base (driven by credit easing and, in the future also be quantitative easing) cannot be reversed in the future. The main obstacle to such a reversal will be the US fiscal authorities, who are unlikely to let the Fed dump large amounts of US Treasury debt, acquired by the Fed as part of its quantitative easing program, into the markets.
I believe that the raids by the US Treasury on the FDIC and on the Fed are illegitimate and, in the case of the FDIC, quite possibly illegal.
The FDIC
The FDIC is supposed to be an independent agency of the US federal government. Its website tells us that “The FDIC receives no Congressional appropriations - it is funded by premiums that banks and thrift institutions pay for deposit insurance coverage and from earnings on investments in U.S. Treasury securities” . The FDIC also has no borrowing capacity except that granted it by the US Treasury.
The operating budget of the FDIC for 2009 is $2.24 billion, a big increase from the $ 1 billion set in 2008, but still a tiny number. Its current Treasury borrowing limit is $30 bn, again nowhere near enough to make an impact on the black hole that is the asset side of the balance sheet of the US cross-border banking system. With an insurance fund of just over $45 billion, the FDIC insures more than $5 trillion of deposits in U.S. banks and thrifts. The insurance fund is therefore less than one percent of the amount of insured deposits.
The near-demise of the US banking system means that, should even a single large deposit-taking bank go bust, there is not enough money in the kitty to pay off all insured depositors. The FDIC would have to borrow - hence the usefulness of the increase in the borrowing limit. It is both unwise and illegitimate to use that borrowing limit instead to subsidise potentially non-viable banks (likely to still be non-viable even after the subsidy) as well as the private investors who plan to purchase these banks’ bad loans through the Legacy Loans Program.
The FDIC’s Mission Statement is clear: “The Federal Deposit Insurance Corporation (FDIC) is an independent agency created by the Congress that maintains the stability and public confidence in the nation’s financial system by insuring deposits, examining and supervising financial institutions, and managing receiverships.” I don’t see anything there about guaranteeing debt from or loans to private entities wanting to buy bad loans from bad banks. The Federal Deposit Insurance Corporation Improvement Act of 1991 also does not, as far as i can see, authorise the FDIC to engage in the kind of quasi-fiscal activities it is engaging in through the Temporary Liquidity Guarantee Program (see below) and is about to engage in under the Legacy Loans Program.
But help is on the way! Senate Banking Committee Chairman Chris Dodd of Connecticut is proposing, in a bill submitted on March 5 2009 (the Depositor Protection Act of 2009) to increase the FDIC’s Treasury borrowing limit from $30 billion to $500 billion. With the deposit insurance limit now at $250,000 at least until the end of 2009 (up from $100,000) and so many large deposit-taking banks in the US insolvent but for past, present and anticipate future hand-outs from the tax payer, the increased borrowing limit of $500 bn may come in handy to make whole the insured depositors if and when one or more large banks keel over.
But this does not appear to be the use (the proper use) that the US authorities have in mind for it. Instead the increase in the FDIC’s Treasury borrowing limit to $500 billion is likely to be diverted to the entirely improper use of providing debt guarantees for debt used to co-finance the purchase bad loans from the banks under the Legacy Loans leg of the Private-Public Investment Program (PPIP). This quasi-fiscal role of the FDIC is on top of the earlier prima-facie illegitimate use of FDIC resources under the FDIC’s Temporary Liquidity Guarantee Program (TLGP), under which the FDIC guarantees newly issued senior unsecured debt of banks, thrifts, and certain holding companies.
The FDIC, under the TLGP also provides full coverage of non-interest bearing deposit transaction accounts, regardless of dollar amount. This is a legitimate use of its resources, albeit an unwise one. As of February 28, 2009 the amount of debt insured under the TLGP was more than $268 billion. After debauching the Fed to pay for the bail-out of insolvent US banks, the US administration is now subverting the purpose of another so-called independent government agency.
The debauching of the FDIC is, however, different in one respect from that of the Fed. The Fed has an independent source of revenue - seigniorage, that is, the revenue from issuing base money, part of which is non-interest-bearing (bank notes) and part of which (commercial bank deposits with the Fed) earns an interest below what the Fed earns on its assets.
The FDIC has no independent source of revenue (ignoring the premia charged for the deposit insurance, which is chicken feed). Getting the FDIC to guarantee loans is therefore just a cute and non-transparent way of having the US Treasury guarantee those loans. But it’s off the books, off-budget and off-balance sheet as far as the US Treasury is concerned. With a bit of luck the guarantees will not be called. And if they are called - well, that will be then and this is now. If the FDIC can insure $ 5 trillion worth of deposits with a mere $45 bn fund, think of what amount of lending the FDIC can guarantee when it borrows its full allotment of $500 bn! The bill will be presented to the tax payers later.
How large could the bill be, that is, how much money could be transferred from the US tax payers to the banks or the investment funds bidding for toxic assets?
The potential for subsidies to the private parties involved in the PPIP’s Legacy Loans and Legacy Securities Programs is truly astonishing. Jeff Sachs, in a recent Financial Times column, provides a representative calculation for the Legacy Loans Program. Note that this is targeted not at toxic assets (assets whose value is unknown) but on bad loans, whose (low) fundamental value can be ascertained without too much effort.
What follows paraphrases Jeff Sach’s argument and calculation. I put all of it in quotation marks, even though a few words have been changed.
“For every $1 of bad assets that an investment fund authorised under the PPIP buys from the banks, the FDIC will lend up to 85.7 cents (six-sevenths of $1), and the Treasury and private investors will each put in 7.15 cents in equity to cover the balance. The Federal Deposit Insurance Corporation (FDIC) loans will be non-recourse, meaning that if the bad assets purchased by the investment fund fall in value below the amount of the FDIC loans, the investment funds will default on the loans, and the FDIC will end up holding the bad assets. The investment fund is not responsible for part of the FDIC loan not covered by the liquidation value of the bad assets. At most it loses the equity it put in.
Consider a portfolio of bad assets with a face value of $1 trillion. Assume that these assets have a 20 percent chance of paying out their full face value ($1 trillion) and an 80 percent chance of paying out only $200 billion. The fair value of these assets is given by their expected payout, which is 20 percent of $1 trillion plus 80 percent of $200 billion, i.e. $360 billion.
Investment funds will bid for these assets. It might seem at first that the investment funds would bid $360 billion for these toxic assets, but this is not correct. The investors will bid substantially more than $360 billion because of the massive subsidy implicit in the FDIC non-recourse loan. The FDIC makes a “heads you win, tails the taxpayer loses” offer to the private investors.
With a little arithmetic, we can calculate the size of the transfer from the tax payer to the banks and the investment funds. In this example, the private investment fund will actually be willing to bid $636 billion for the $360 billion of fair value of the bad assets, in effect transferring excess $276 billion from the FDIC (taxpayers) to the bank shareholders.
Under the rule of the Geithner-Summers Plan, private equity investors and the TARP each put in 7.15 percent of the purchase price of $636 billion, equal to $45 billion each. The FDIC will loan $546 billion. (All numbers are rounded). If the bad assets actually pay out the full $1 trillion (which happens with 20 percent probability), there will be a profit of $454 billion, equal to $1 trillion payout minus the repayment of the FDIC loan of $546 billion. The private investors and the TARP will each get half of the profit, or $227 billion.
Since this outcome occurs only 20 percent of the time, the expected profits to the private investors are 20 percent of $227 billion, or $45 billion, exactly what they invested. Similarly, the TARP’s expected profits are also equal to the TARP investment of $45 billion. Thus, both the TARP and the private investors break even. As competitive bidders, they have bid the maximum price that allows them to break even.
The bank shareholders, however, come out $276 billion ahead of the game, while the FDIC bears $276 billion in expected losses! This transfer occurs because the investment fund defaults on the FDIC loan when the bad assets in fact pay only $200 billion, an outcome that occurs 80 percent of the time. When that happens, the investment fund is “underwater” (holding more in FDIC debt than it gets in payouts on the bad assets). The investment fund then defaults on its debt to the FDIC. The FDIC gets $200 billion instead of repayment of $546 billion, for a net loss of $346 billion. Since this outcome occurs 80 percent of the time, the expected loss to the taxpayers is 80 percent of $346 billion, or $276 billion. This is exactly equal to the overpayment to the banks in the first place.”
The problem of collusive behaviour between the private investment funds and the banks for whose assets they bid will undoubtedly rear its ugly head. Indeed, the banks could set up their own investment funds (through SPVs registered in places where information is even harder to obtain than in Liechtenstein) and so make sure the underpriced put provided by the FDIC through its non-recourse loan can indeed be exercised.
This is a very bad deal for the tax payer indeed. And the Legacy Securities Program works on the same principles, although the non-recourse leverage provided by the Fed will be less than that provided by the FDIC for the Legacy Loans Program.
The Fed
I have written at length before about the ever-expanding quasi-fiscal role of the Fed. This began as soon as the Fed began to take private credit risk (default risk) onto its balance sheet by accepting private securities as collateral in repos, at the discount window and at one of the myriad facilities it has created since August 2008. It is possible - I would say likely - that the terms on which the Fed accepted this often illiquid collateral implied even an ex-ante subsidy to the borrower. But the Fed is refusing to provide the necessary information on the valuation of the illiquid collateral, interest rates, fees and other key dimensions of the terms granted those who access its facilities, for outsiders, including Congress, to find out what if any element of subsidy is involved.
Should the borrowing bank default and should the collateral offered also turn out to be impaired, the Fed will suffer an ex-post capital loss on its repos and other collateralised lending operations against private collateral. It does not have an indemnity from the Treasury for such capital losses.
The Fed also created the Maiden Lane I (for Bear Stearns toxic assets), Maiden Lane II (for AIG’s secured loans and Maiden Lane III (for AIG’s credit default swaps) special purpose vehicles in Delaware. The losses made by Maiden lane II and III when the Fed paid off the investors (counterparties) of AIG at par, were, however, not booked on the balance sheets of the two Maidens, but were booked on AIG’s balance sheet, keeping Maiden Lane I and II, and the Fed, clean for the time being. The financial shenanigans used by the Fed (in cahoots with the US Treasury) to limit accountability for these capital losses are quite unacceptable in a democratic society. Clearly, the US authorities are using the financial engineering tricks and legal constructions whose abuse by the private financial sector led to our current predicament, to engage in Congressional- and tax payer accountability avoidance/evasion. To watch the regulators engage in regulatory arbitrage is astonishing.
With the onset of credit easing, the Fed now also takes private credit risk onto its balance sheet through outright purchases of private securities (including commercial paper and possibly corporate bonds) and by making non-recourse loans through the TALF (that is, though unsecured lending). There is no full (100 percent) Treasury guarantee for this credit risk taken by the Fed. In fact, the $1 trillion TALF has at most $100 billion of Treasury funds to back it up.
I don’t envy Ben Bernanke the extremely uncomfortable position he finds himself in. He can insists on minimizing the quasi-fiscal role of the Fed by insisting on a 100% US Treasury guarantee for any credit risk, other than the credit risk of the US sovereign, that the Fed assumes. In that case the amount of financial ammunition that the US state, broadly defined to include the US Treasury, the FDIC and the Fed, have at their disposal to deal with financial sector reconstruction is inadequate. Or he can compromise the independence of the Fed and let the central bank be used as an off-balance sheet and off-budget special purpose vehicle of the US Treasury, reducing transparency and undermining democratic accountability. Talk about a rock and a hard place.
Even faced with this kind of dilemma, however, certain practices are clearly improper and unacceptable. The (ab)use of the Maiden Lane SPVs to hide some of the losses made by the Fed and the US Treasury and to channel money non-transparently to AIG counterparties (in the case of Maiden Lane II and III is just plain wrong. So is the refusal to make public the information required to judge the appropriateness of the terms and conditions attached by the Fed to the use of its facilities.
Conclusion: we need banking; we don’t need these banks
The raiding by the US Treasury of the financial resources of the FDIC and the Fed is not just unwise, illegitimate and possibly illegal, it is also unnecessary. For some reason, perhaps an example of cognitive capture of the Treasury and White House policy makers by the spin doctors and skilled persuaders of Wall Street, Tim Geithner, Larry Summers, Ben Bernanke and Sheila Bair all appear to believe that to save the banking sector you have to save the existing banks as going concerns. Indeed, in view of the astonishing survival rate of CEOs and other top managers in the zombie banks, they may even believe that to save the banking system you have to rely on the continued contribution of those whose past best efforts brought us this crisis and debacle.
All that matters is banking as a function and activity, that is, new lending and borrowing by banks. When a massive disaster strikes the existing banks, it is essential to decouple the stocks of existing assets and liabilities from the flows of new lending and borrowing. The good bank model does that.
Both Fed Chairman Bernanke and US Treasury Secretary Geithner have called for the creation of a special resolution regime (SRR) with prompt corrective action (PCA) for non-bank systemically important institutions. Bernanke clearly had AIG in mind when he told the US Congress on March 20, that there was a need for a special insolvency regime that “permits the orderly resolution of a systemically important nonbank financial firm”. With a proper federal resolution authority, AIG could have been put into conservatorship or receivership and could have been unwound slowly, with not just the shareholders but also the unsecured creditors taking the haircuts (losses) justified by the financial condition of AIG. Bernanke’s words that a proper special resolution regime for non-banks would permit the Conservator or Administrator to “unwind it slowly, protect policymakers, and impose haircuts on creditors and counterparties as appropriate,” truly are music to my ears.
I also agree with Chairman Bernanke’s statement that “given the interconnected nature of our financial system and the potentially devastating effects on confidence, financial markets and the broader economy that would likely arise from the disorderly failure of a major financial firm in the current environment, I do not think we have had a realistic alternative to preventing such failures.”
But with a proper SRR, there can be orderly failures of major financial firms, banks and well as non-banks. The US has a proper SRR for FDIC-insured banks. That now includes all Wall Street banks. The orderly failure and resolution of one of more Wall Street banks need therefore pose no threat to financial stability. Indeed, with the limited resources the US authorities have at their disposal, the failure and orderly resolution of all dodgy Wall Street banks may well be the best way to stabilise the financial sector and to get financial intermediation - new lending and borrowing between banks and the non-financial sectors - going again. With the information the authorities now are acquiring (I hope) about the soundness of the large banks (whose balance sheets and financial fitness are being scrutinised as part of the Treasury’s Capital Assistance Program), the authorities will soon know which banks should be allowed to survive and which ones should be put out of their and our misery.
Why hasn’t the FDIC’s special resolution regime been used to resolve the large Wall Street zombie banks, but just the tiddlers in the boonies (OK, add WAMU)?
Any large, deposit-taking Wall Street bank (the old bad bank or OBB) with a significant amount of non-insured deposit liabilities on its balance sheet and a survival-threatening amount of toxic assets, can be split into a new good bank and a new bad fund virtually with the stroke of a pen, using the proposal by Bulow and Klemperer and Hall and Woodward (see also Buiter (1) and (2)). The new good bank gets the insured deposits and the non-toxic assets. If liabilities net of insured deposits of the OBB exceed toxic assets, the new good bank will have positive equity. Give that equity in the new good bank to the new bad fund. The new bad fund does not have a banking license and cannot make new loans or acquire any new assets. It simply manages down its portfolio of existing assets in the interests of its owners. It gets no further government financial support of any kind. If it fails, it goes into Chapter 11 or Chapter 7. Both the shareholders and the unsecured creditors can be expected to take a hit. That is as it should be.
If the new good banks needs additional capital, it can go to the market or obtain it from the government. Government guarantees (just from the Treasury, please) are only granted to new bank borrowing or bank lending.
Save banking. Allow the zombie banks to die.
As an aside: it is astonishing that Congress and much of the US populace are apoplectic about $165 mn (perhaps $182 mn) of bonuses paid to AIG executives and employees, when $170 billion or so of public money is at risk (and tens of billions probably already gone out of the window) in the rescue of this most undeserving of companies. Perhaps you can only get indignant about what you can comprehend… .
The US authorities are reduced to begging, stealing and borrowing the rest of the funds they believe they will need. The two main proximate sources of funds are the FDIC and the Fed. The ultimate sources of funds will be (1) the US tax payer and the beneficiaries of future US spending programs that will have to be cut, (2) the holders of nominally denominated liabilities of the US state, including the monetary liabilities of the Fed and US Treasury bills and bonds.
Owners of dollar-denominated debt instruments will see the real value of their claims on the government eroded by future inflation if, as I expect, the recent and prospective future increases in the US monetary base (driven by credit easing and, in the future also be quantitative easing) cannot be reversed in the future. The main obstacle to such a reversal will be the US fiscal authorities, who are unlikely to let the Fed dump large amounts of US Treasury debt, acquired by the Fed as part of its quantitative easing program, into the markets.
I believe that the raids by the US Treasury on the FDIC and on the Fed are illegitimate and, in the case of the FDIC, quite possibly illegal.
The FDIC
The FDIC is supposed to be an independent agency of the US federal government. Its website tells us that “The FDIC receives no Congressional appropriations - it is funded by premiums that banks and thrift institutions pay for deposit insurance coverage and from earnings on investments in U.S. Treasury securities” . The FDIC also has no borrowing capacity except that granted it by the US Treasury.
The operating budget of the FDIC for 2009 is $2.24 billion, a big increase from the $ 1 billion set in 2008, but still a tiny number. Its current Treasury borrowing limit is $30 bn, again nowhere near enough to make an impact on the black hole that is the asset side of the balance sheet of the US cross-border banking system. With an insurance fund of just over $45 billion, the FDIC insures more than $5 trillion of deposits in U.S. banks and thrifts. The insurance fund is therefore less than one percent of the amount of insured deposits.
The near-demise of the US banking system means that, should even a single large deposit-taking bank go bust, there is not enough money in the kitty to pay off all insured depositors. The FDIC would have to borrow - hence the usefulness of the increase in the borrowing limit. It is both unwise and illegitimate to use that borrowing limit instead to subsidise potentially non-viable banks (likely to still be non-viable even after the subsidy) as well as the private investors who plan to purchase these banks’ bad loans through the Legacy Loans Program.
The FDIC’s Mission Statement is clear: “The Federal Deposit Insurance Corporation (FDIC) is an independent agency created by the Congress that maintains the stability and public confidence in the nation’s financial system by insuring deposits, examining and supervising financial institutions, and managing receiverships.” I don’t see anything there about guaranteeing debt from or loans to private entities wanting to buy bad loans from bad banks. The Federal Deposit Insurance Corporation Improvement Act of 1991 also does not, as far as i can see, authorise the FDIC to engage in the kind of quasi-fiscal activities it is engaging in through the Temporary Liquidity Guarantee Program (see below) and is about to engage in under the Legacy Loans Program.
But help is on the way! Senate Banking Committee Chairman Chris Dodd of Connecticut is proposing, in a bill submitted on March 5 2009 (the Depositor Protection Act of 2009) to increase the FDIC’s Treasury borrowing limit from $30 billion to $500 billion. With the deposit insurance limit now at $250,000 at least until the end of 2009 (up from $100,000) and so many large deposit-taking banks in the US insolvent but for past, present and anticipate future hand-outs from the tax payer, the increased borrowing limit of $500 bn may come in handy to make whole the insured depositors if and when one or more large banks keel over.
But this does not appear to be the use (the proper use) that the US authorities have in mind for it. Instead the increase in the FDIC’s Treasury borrowing limit to $500 billion is likely to be diverted to the entirely improper use of providing debt guarantees for debt used to co-finance the purchase bad loans from the banks under the Legacy Loans leg of the Private-Public Investment Program (PPIP). This quasi-fiscal role of the FDIC is on top of the earlier prima-facie illegitimate use of FDIC resources under the FDIC’s Temporary Liquidity Guarantee Program (TLGP), under which the FDIC guarantees newly issued senior unsecured debt of banks, thrifts, and certain holding companies.
The FDIC, under the TLGP also provides full coverage of non-interest bearing deposit transaction accounts, regardless of dollar amount. This is a legitimate use of its resources, albeit an unwise one. As of February 28, 2009 the amount of debt insured under the TLGP was more than $268 billion. After debauching the Fed to pay for the bail-out of insolvent US banks, the US administration is now subverting the purpose of another so-called independent government agency.
The debauching of the FDIC is, however, different in one respect from that of the Fed. The Fed has an independent source of revenue - seigniorage, that is, the revenue from issuing base money, part of which is non-interest-bearing (bank notes) and part of which (commercial bank deposits with the Fed) earns an interest below what the Fed earns on its assets.
The FDIC has no independent source of revenue (ignoring the premia charged for the deposit insurance, which is chicken feed). Getting the FDIC to guarantee loans is therefore just a cute and non-transparent way of having the US Treasury guarantee those loans. But it’s off the books, off-budget and off-balance sheet as far as the US Treasury is concerned. With a bit of luck the guarantees will not be called. And if they are called - well, that will be then and this is now. If the FDIC can insure $ 5 trillion worth of deposits with a mere $45 bn fund, think of what amount of lending the FDIC can guarantee when it borrows its full allotment of $500 bn! The bill will be presented to the tax payers later.
How large could the bill be, that is, how much money could be transferred from the US tax payers to the banks or the investment funds bidding for toxic assets?
The potential for subsidies to the private parties involved in the PPIP’s Legacy Loans and Legacy Securities Programs is truly astonishing. Jeff Sachs, in a recent Financial Times column, provides a representative calculation for the Legacy Loans Program. Note that this is targeted not at toxic assets (assets whose value is unknown) but on bad loans, whose (low) fundamental value can be ascertained without too much effort.
What follows paraphrases Jeff Sach’s argument and calculation. I put all of it in quotation marks, even though a few words have been changed.
“For every $1 of bad assets that an investment fund authorised under the PPIP buys from the banks, the FDIC will lend up to 85.7 cents (six-sevenths of $1), and the Treasury and private investors will each put in 7.15 cents in equity to cover the balance. The Federal Deposit Insurance Corporation (FDIC) loans will be non-recourse, meaning that if the bad assets purchased by the investment fund fall in value below the amount of the FDIC loans, the investment funds will default on the loans, and the FDIC will end up holding the bad assets. The investment fund is not responsible for part of the FDIC loan not covered by the liquidation value of the bad assets. At most it loses the equity it put in.
Consider a portfolio of bad assets with a face value of $1 trillion. Assume that these assets have a 20 percent chance of paying out their full face value ($1 trillion) and an 80 percent chance of paying out only $200 billion. The fair value of these assets is given by their expected payout, which is 20 percent of $1 trillion plus 80 percent of $200 billion, i.e. $360 billion.
Investment funds will bid for these assets. It might seem at first that the investment funds would bid $360 billion for these toxic assets, but this is not correct. The investors will bid substantially more than $360 billion because of the massive subsidy implicit in the FDIC non-recourse loan. The FDIC makes a “heads you win, tails the taxpayer loses” offer to the private investors.
With a little arithmetic, we can calculate the size of the transfer from the tax payer to the banks and the investment funds. In this example, the private investment fund will actually be willing to bid $636 billion for the $360 billion of fair value of the bad assets, in effect transferring excess $276 billion from the FDIC (taxpayers) to the bank shareholders.
Under the rule of the Geithner-Summers Plan, private equity investors and the TARP each put in 7.15 percent of the purchase price of $636 billion, equal to $45 billion each. The FDIC will loan $546 billion. (All numbers are rounded). If the bad assets actually pay out the full $1 trillion (which happens with 20 percent probability), there will be a profit of $454 billion, equal to $1 trillion payout minus the repayment of the FDIC loan of $546 billion. The private investors and the TARP will each get half of the profit, or $227 billion.
Since this outcome occurs only 20 percent of the time, the expected profits to the private investors are 20 percent of $227 billion, or $45 billion, exactly what they invested. Similarly, the TARP’s expected profits are also equal to the TARP investment of $45 billion. Thus, both the TARP and the private investors break even. As competitive bidders, they have bid the maximum price that allows them to break even.
The bank shareholders, however, come out $276 billion ahead of the game, while the FDIC bears $276 billion in expected losses! This transfer occurs because the investment fund defaults on the FDIC loan when the bad assets in fact pay only $200 billion, an outcome that occurs 80 percent of the time. When that happens, the investment fund is “underwater” (holding more in FDIC debt than it gets in payouts on the bad assets). The investment fund then defaults on its debt to the FDIC. The FDIC gets $200 billion instead of repayment of $546 billion, for a net loss of $346 billion. Since this outcome occurs 80 percent of the time, the expected loss to the taxpayers is 80 percent of $346 billion, or $276 billion. This is exactly equal to the overpayment to the banks in the first place.”
The problem of collusive behaviour between the private investment funds and the banks for whose assets they bid will undoubtedly rear its ugly head. Indeed, the banks could set up their own investment funds (through SPVs registered in places where information is even harder to obtain than in Liechtenstein) and so make sure the underpriced put provided by the FDIC through its non-recourse loan can indeed be exercised.
This is a very bad deal for the tax payer indeed. And the Legacy Securities Program works on the same principles, although the non-recourse leverage provided by the Fed will be less than that provided by the FDIC for the Legacy Loans Program.
The Fed
I have written at length before about the ever-expanding quasi-fiscal role of the Fed. This began as soon as the Fed began to take private credit risk (default risk) onto its balance sheet by accepting private securities as collateral in repos, at the discount window and at one of the myriad facilities it has created since August 2008. It is possible - I would say likely - that the terms on which the Fed accepted this often illiquid collateral implied even an ex-ante subsidy to the borrower. But the Fed is refusing to provide the necessary information on the valuation of the illiquid collateral, interest rates, fees and other key dimensions of the terms granted those who access its facilities, for outsiders, including Congress, to find out what if any element of subsidy is involved.
Should the borrowing bank default and should the collateral offered also turn out to be impaired, the Fed will suffer an ex-post capital loss on its repos and other collateralised lending operations against private collateral. It does not have an indemnity from the Treasury for such capital losses.
The Fed also created the Maiden Lane I (for Bear Stearns toxic assets), Maiden Lane II (for AIG’s secured loans and Maiden Lane III (for AIG’s credit default swaps) special purpose vehicles in Delaware. The losses made by Maiden lane II and III when the Fed paid off the investors (counterparties) of AIG at par, were, however, not booked on the balance sheets of the two Maidens, but were booked on AIG’s balance sheet, keeping Maiden Lane I and II, and the Fed, clean for the time being. The financial shenanigans used by the Fed (in cahoots with the US Treasury) to limit accountability for these capital losses are quite unacceptable in a democratic society. Clearly, the US authorities are using the financial engineering tricks and legal constructions whose abuse by the private financial sector led to our current predicament, to engage in Congressional- and tax payer accountability avoidance/evasion. To watch the regulators engage in regulatory arbitrage is astonishing.
With the onset of credit easing, the Fed now also takes private credit risk onto its balance sheet through outright purchases of private securities (including commercial paper and possibly corporate bonds) and by making non-recourse loans through the TALF (that is, though unsecured lending). There is no full (100 percent) Treasury guarantee for this credit risk taken by the Fed. In fact, the $1 trillion TALF has at most $100 billion of Treasury funds to back it up.
I don’t envy Ben Bernanke the extremely uncomfortable position he finds himself in. He can insists on minimizing the quasi-fiscal role of the Fed by insisting on a 100% US Treasury guarantee for any credit risk, other than the credit risk of the US sovereign, that the Fed assumes. In that case the amount of financial ammunition that the US state, broadly defined to include the US Treasury, the FDIC and the Fed, have at their disposal to deal with financial sector reconstruction is inadequate. Or he can compromise the independence of the Fed and let the central bank be used as an off-balance sheet and off-budget special purpose vehicle of the US Treasury, reducing transparency and undermining democratic accountability. Talk about a rock and a hard place.
Even faced with this kind of dilemma, however, certain practices are clearly improper and unacceptable. The (ab)use of the Maiden Lane SPVs to hide some of the losses made by the Fed and the US Treasury and to channel money non-transparently to AIG counterparties (in the case of Maiden Lane II and III is just plain wrong. So is the refusal to make public the information required to judge the appropriateness of the terms and conditions attached by the Fed to the use of its facilities.
Conclusion: we need banking; we don’t need these banks
The raiding by the US Treasury of the financial resources of the FDIC and the Fed is not just unwise, illegitimate and possibly illegal, it is also unnecessary. For some reason, perhaps an example of cognitive capture of the Treasury and White House policy makers by the spin doctors and skilled persuaders of Wall Street, Tim Geithner, Larry Summers, Ben Bernanke and Sheila Bair all appear to believe that to save the banking sector you have to save the existing banks as going concerns. Indeed, in view of the astonishing survival rate of CEOs and other top managers in the zombie banks, they may even believe that to save the banking system you have to rely on the continued contribution of those whose past best efforts brought us this crisis and debacle.
All that matters is banking as a function and activity, that is, new lending and borrowing by banks. When a massive disaster strikes the existing banks, it is essential to decouple the stocks of existing assets and liabilities from the flows of new lending and borrowing. The good bank model does that.
Both Fed Chairman Bernanke and US Treasury Secretary Geithner have called for the creation of a special resolution regime (SRR) with prompt corrective action (PCA) for non-bank systemically important institutions. Bernanke clearly had AIG in mind when he told the US Congress on March 20, that there was a need for a special insolvency regime that “permits the orderly resolution of a systemically important nonbank financial firm”. With a proper federal resolution authority, AIG could have been put into conservatorship or receivership and could have been unwound slowly, with not just the shareholders but also the unsecured creditors taking the haircuts (losses) justified by the financial condition of AIG. Bernanke’s words that a proper special resolution regime for non-banks would permit the Conservator or Administrator to “unwind it slowly, protect policymakers, and impose haircuts on creditors and counterparties as appropriate,” truly are music to my ears.
I also agree with Chairman Bernanke’s statement that “given the interconnected nature of our financial system and the potentially devastating effects on confidence, financial markets and the broader economy that would likely arise from the disorderly failure of a major financial firm in the current environment, I do not think we have had a realistic alternative to preventing such failures.”
But with a proper SRR, there can be orderly failures of major financial firms, banks and well as non-banks. The US has a proper SRR for FDIC-insured banks. That now includes all Wall Street banks. The orderly failure and resolution of one of more Wall Street banks need therefore pose no threat to financial stability. Indeed, with the limited resources the US authorities have at their disposal, the failure and orderly resolution of all dodgy Wall Street banks may well be the best way to stabilise the financial sector and to get financial intermediation - new lending and borrowing between banks and the non-financial sectors - going again. With the information the authorities now are acquiring (I hope) about the soundness of the large banks (whose balance sheets and financial fitness are being scrutinised as part of the Treasury’s Capital Assistance Program), the authorities will soon know which banks should be allowed to survive and which ones should be put out of their and our misery.
Why hasn’t the FDIC’s special resolution regime been used to resolve the large Wall Street zombie banks, but just the tiddlers in the boonies (OK, add WAMU)?
Any large, deposit-taking Wall Street bank (the old bad bank or OBB) with a significant amount of non-insured deposit liabilities on its balance sheet and a survival-threatening amount of toxic assets, can be split into a new good bank and a new bad fund virtually with the stroke of a pen, using the proposal by Bulow and Klemperer and Hall and Woodward (see also Buiter (1) and (2)). The new good bank gets the insured deposits and the non-toxic assets. If liabilities net of insured deposits of the OBB exceed toxic assets, the new good bank will have positive equity. Give that equity in the new good bank to the new bad fund. The new bad fund does not have a banking license and cannot make new loans or acquire any new assets. It simply manages down its portfolio of existing assets in the interests of its owners. It gets no further government financial support of any kind. If it fails, it goes into Chapter 11 or Chapter 7. Both the shareholders and the unsecured creditors can be expected to take a hit. That is as it should be.
If the new good banks needs additional capital, it can go to the market or obtain it from the government. Government guarantees (just from the Treasury, please) are only granted to new bank borrowing or bank lending.
Save banking. Allow the zombie banks to die.
Soros Says Commercial Property Values Will Fall 30%
By Michael Forsythe
March 26 (Bloomberg) -- Billionaire investor George Soros said U.S. commercial real estate will probably drop at least 30 percent in value, causing further strains on banks.
“Commercial real estate has not yet fallen in value,” Soros, speaking at a forum in Washington, said. “It is inevitable, it is written, everybody knows it, there are already some transactions which reflect and anticipate it, so we know, they will drop at least 30 percent.”
U.S. commercial real estate values have fallen 30 percent from the 2007 peak as cheap financing disappeared and the recession reduced occupancies, RREFF, the real estate investment unit of Deutsche Bank AG, said yesterday in its 2009 forecast. Total returns in a commercial property index used by pension funds may decline as much as 11 percent this year, the group said.
Soros, 78, said the risk of further declines in property prices is reason for the administration of President Barack Obama to move quickly to recapitalize banks. Soros said Obama acted too slowly on a banking overhaul and should have moved immediately upon taking office.
“At that moment of enthusiasm, fresh out of the gate, he would have gotten that money, and then we could have recapitalized the banks the right way, which would be to draw a line over the existing past accumulated bad assets and create new banks on top of these old banks,” Soros said.
‘New Bank, Old Bank’
“Instead of good bank, bad bank, have new bank, old bank and keep the old capital to cover the old assets which are still deteriorating and will continue to deteriorate for several years” because of the coming decline of commercial real estate values, Soros said.
Soros also said that the U.S. may face a new round of inflation should the flow of credit recover because of the large increase in the money supply stemming from the Federal Reserve’s purchases of Treasury securities.
U.S. central bankers decided last week to buy as much as $300 billion of long-term Treasuries and more than double mortgage-debt purchases to $1.45 trillion, aiming to lower home-loan and other interest rates.
“In order to make up for the collapse of credit, we are effectively creating money,” Soros said. “If and when credit is restarted, you would then have an incredibly swollen monetary base, which, if it were leveraged, you would have an explosion of inflation.”
“Right now we are in a period of deflation, but it could easily tip over, where you are facing inflation,” Soros said. “You are then faced with the prospect of draining money supply as fast as credit is created.”
March 26 (Bloomberg) -- Billionaire investor George Soros said U.S. commercial real estate will probably drop at least 30 percent in value, causing further strains on banks.
“Commercial real estate has not yet fallen in value,” Soros, speaking at a forum in Washington, said. “It is inevitable, it is written, everybody knows it, there are already some transactions which reflect and anticipate it, so we know, they will drop at least 30 percent.”
U.S. commercial real estate values have fallen 30 percent from the 2007 peak as cheap financing disappeared and the recession reduced occupancies, RREFF, the real estate investment unit of Deutsche Bank AG, said yesterday in its 2009 forecast. Total returns in a commercial property index used by pension funds may decline as much as 11 percent this year, the group said.
Soros, 78, said the risk of further declines in property prices is reason for the administration of President Barack Obama to move quickly to recapitalize banks. Soros said Obama acted too slowly on a banking overhaul and should have moved immediately upon taking office.
“At that moment of enthusiasm, fresh out of the gate, he would have gotten that money, and then we could have recapitalized the banks the right way, which would be to draw a line over the existing past accumulated bad assets and create new banks on top of these old banks,” Soros said.
‘New Bank, Old Bank’
“Instead of good bank, bad bank, have new bank, old bank and keep the old capital to cover the old assets which are still deteriorating and will continue to deteriorate for several years” because of the coming decline of commercial real estate values, Soros said.
Soros also said that the U.S. may face a new round of inflation should the flow of credit recover because of the large increase in the money supply stemming from the Federal Reserve’s purchases of Treasury securities.
U.S. central bankers decided last week to buy as much as $300 billion of long-term Treasuries and more than double mortgage-debt purchases to $1.45 trillion, aiming to lower home-loan and other interest rates.
“In order to make up for the collapse of credit, we are effectively creating money,” Soros said. “If and when credit is restarted, you would then have an incredibly swollen monetary base, which, if it were leveraged, you would have an explosion of inflation.”
“Right now we are in a period of deflation, but it could easily tip over, where you are facing inflation,” Soros said. “You are then faced with the prospect of draining money supply as fast as credit is created.”
Tim Geithner’s toxic-asset scheme will not work unless banks are forced to sell their problem loans
Reuters
IT WAS a measure of the desperation for a plan—any plan—to tackle the paralysis in the American banking system that stockmarkets soared on March 23rd when Tim Geithner, the treasury secretary, detailed his proposals to purge toxic debt from the banks’ balance-sheets. In fact, the effort to recruit private investors into a government-led campaign to buy bad assets from the banks is still, at best, half a plan. It is better than Mr Geithner’s woeful false start in February and may one day even prove to be inspired. But it will work only if the Obama administration accompanies it with a cast-iron determination to get to the bottom of America’s banking mess. So far the president has shown little stomach for going the whole way.
As it stands, Mr Geithner’s Public-Private Investment Programme looks like an ungainly political and financial fudge and far from the market solution the government claims it is (see article). It aims to buy $500 billion-$1 trillion of the loans and hard-to-value securities that have swamped the banks’ balance-sheets since the collapse of America’s mortgage market in 2007. Ideally, the government would have raised that money from Congress and parked the toxic assets in a discrete “bad bank”, or offered to guarantee them. But Congress has bail-out fatigue. Bonus-bashing scores immeasurably higher with voters than adding to the $700 billion earmarked to buy bank assets last October. Of what is left, Mr Geithner has a relatively thin $100 billion for his Augean clean-up. Beyond that there is less than $100 billion in the kitty.
Hence the need to conjure money out of thin air, or rather the government’s off-balance-sheet equivalents—the Federal Reserve and the Federal Deposit Insurance Corp, which may provide loans and guarantees without a word from Congress. To show that this is not wasted, there is the figleaf of market discipline: a slug of private money is supposed to ensure that hard-nosed capitalists have enough of a stake to stop the government overpaying. But this is capitalism of the “Heads I win, tails you lose” variety. The government bears almost all the risks, while private investors pocket half the rewards. If there are big pay-offs, Congress could decide to claw back the benefits. Forget bail-out fatigue; the risk is class war.
Hold your nose, however. Mr Geithner’s proposal is worth a try, not least because, as any leader at the Group of 20 summit in London next week will tell you, fixing American banks is one of America’s—and hence the world’s—most urgent economic priorities. However unpalatable it is to shower public largesse on big vulture funds, one of the few ways to see if there is any residual value in all the toxic waste left on the banks’ books is to induce someone to buy it. Without a subsidy, there are many reasons for private investors to hold back. Above all, they do not have the same information advantages as the seller, which is only too keen to offload the worst assets on its balance-sheet while hanging on to the good stuff. The trouble is, the proposal barely has a hope unless banks agree to sell assets, and therein lies Mr Geithner’s unfinished task: arm-twisting them to do so. Many banks value their assets well above the prices they would fetch in an open (albeit illiquid) market. They have incentives to keep them there: the lower the price, the more capital they need to raise; in these capital-constrained times, that means the closer banks are to insolvency.
Come on, Tim
But if America wants to avoid the fate of Japan in the 1990s—a lost decade of zombie banks—it is vital that its banks face reality. Mr Geithner has a ready-made tool for that, about which he has been mysteriously quiet of late: his “stress tests” to determine whether America’s biggest banks have enough capital. Done rigorously, the stress tests could force the banks to come clean about their balance-sheets and lead to the forced sale of assets into the government’s toxic-asset programme. If a bank cannot raise the capital to offset its losses, it should be deemed insolvent and temporarily nationalised. Mr Geithner’s proposal is part of a process that could lead to more certainty—even healing—in America’s banking system. But only if he has the gumption to turn his half-plan into a whole one.
IT WAS a measure of the desperation for a plan—any plan—to tackle the paralysis in the American banking system that stockmarkets soared on March 23rd when Tim Geithner, the treasury secretary, detailed his proposals to purge toxic debt from the banks’ balance-sheets. In fact, the effort to recruit private investors into a government-led campaign to buy bad assets from the banks is still, at best, half a plan. It is better than Mr Geithner’s woeful false start in February and may one day even prove to be inspired. But it will work only if the Obama administration accompanies it with a cast-iron determination to get to the bottom of America’s banking mess. So far the president has shown little stomach for going the whole way.
As it stands, Mr Geithner’s Public-Private Investment Programme looks like an ungainly political and financial fudge and far from the market solution the government claims it is (see article). It aims to buy $500 billion-$1 trillion of the loans and hard-to-value securities that have swamped the banks’ balance-sheets since the collapse of America’s mortgage market in 2007. Ideally, the government would have raised that money from Congress and parked the toxic assets in a discrete “bad bank”, or offered to guarantee them. But Congress has bail-out fatigue. Bonus-bashing scores immeasurably higher with voters than adding to the $700 billion earmarked to buy bank assets last October. Of what is left, Mr Geithner has a relatively thin $100 billion for his Augean clean-up. Beyond that there is less than $100 billion in the kitty.
Hence the need to conjure money out of thin air, or rather the government’s off-balance-sheet equivalents—the Federal Reserve and the Federal Deposit Insurance Corp, which may provide loans and guarantees without a word from Congress. To show that this is not wasted, there is the figleaf of market discipline: a slug of private money is supposed to ensure that hard-nosed capitalists have enough of a stake to stop the government overpaying. But this is capitalism of the “Heads I win, tails you lose” variety. The government bears almost all the risks, while private investors pocket half the rewards. If there are big pay-offs, Congress could decide to claw back the benefits. Forget bail-out fatigue; the risk is class war.
Hold your nose, however. Mr Geithner’s proposal is worth a try, not least because, as any leader at the Group of 20 summit in London next week will tell you, fixing American banks is one of America’s—and hence the world’s—most urgent economic priorities. However unpalatable it is to shower public largesse on big vulture funds, one of the few ways to see if there is any residual value in all the toxic waste left on the banks’ books is to induce someone to buy it. Without a subsidy, there are many reasons for private investors to hold back. Above all, they do not have the same information advantages as the seller, which is only too keen to offload the worst assets on its balance-sheet while hanging on to the good stuff. The trouble is, the proposal barely has a hope unless banks agree to sell assets, and therein lies Mr Geithner’s unfinished task: arm-twisting them to do so. Many banks value their assets well above the prices they would fetch in an open (albeit illiquid) market. They have incentives to keep them there: the lower the price, the more capital they need to raise; in these capital-constrained times, that means the closer banks are to insolvency.
Come on, Tim
But if America wants to avoid the fate of Japan in the 1990s—a lost decade of zombie banks—it is vital that its banks face reality. Mr Geithner has a ready-made tool for that, about which he has been mysteriously quiet of late: his “stress tests” to determine whether America’s biggest banks have enough capital. Done rigorously, the stress tests could force the banks to come clean about their balance-sheets and lead to the forced sale of assets into the government’s toxic-asset programme. If a bank cannot raise the capital to offset its losses, it should be deemed insolvent and temporarily nationalised. Mr Geithner’s proposal is part of a process that could lead to more certainty—even healing—in America’s banking system. But only if he has the gumption to turn his half-plan into a whole one.
Our correspondent in Silicon Valley looks back before moving on to a new beat
IN 2003, when your correspondent arrived in Silicon Valley, a common response to “How is the Valley?” was “In a nuclear winter.” The dotcom bust had incinerated an entire generation of start-ups. A much-debated essay argued that “IT [information technology] doesn’t matter.” The Valley itself seemed to matter less.
Its geeks were desperately looking for their “next big thing” and minting neologisms (“utility computing”, “the digital home”) in the hope that one might stick. But ordinary people outside the Valley were no longer paying attention. Valley geeks were already hopping onto Wi-Fi hotspots and playing with “smart” phones, but most people were still dialling up to connect to the internet and using mobile phones only for talking. There was some excitement about a fairly new gadget, Apple’s iPod, but nobody suspected that its progeny, in the form of a phone, might one day make the internet “mobile”. Nor did a popular search engine, Google, show signs that it might be a lucrative business, much less a new technology superpower. It was still a world of personal computers, dominated by Microsoft through its Windows operating system.But towards the end of 2003 two conference organisers, Dale Dougherty and Tim O’Reilly, were brainstorming when Mr Dougherty used the words “Web 2.0”. They immediately realised that the phrase—with its software connotation of a newly released, better and more stable version—had enormous appeal as a rallying cry for the Valley. The Web 2.0 Conference was born, and the first one, in San Francisco in October 2004, created a stir.
It took place shortly after the first big initial public offering (IPO) of a technology firm since the dotcom boom. Google’s IPO did not just announce the Valley’s return to Wall Street. It also unveiled a new business model. When Google at last revealed how much money it was making by placing small, targeted text advertisements next to search results, jaws dropped. Overnight, every entrepreneur had a new one-word pitch to venture capitalists: advertising.
Google became the Valley’s new champion. Its share price soared, it entered new areas almost weekly—from e-mail to maps, from radio to newspaper advertising—and it started buying start-ups, thus replacing the stockmarket as the preferred “exit strategy” for entrepreneurs. Yahoo!, Microsoft and other rivals could not keep up.
Having popularised the term “Web 2.0”, meanwhile, Mr O’Reilly started fretting that it had become a cliché, and was being applied to so many things that it was in danger of becoming meaningless. He tried hard to give it a definition. And so Web 2.0 came to encapsulate several trends that had been going on all along. One was the shift from individual computers as the “platform” for applications to the web as a whole. Residing on the web, these new applications and services inherently lend themselves to collaboration, sharing and participation.
A new boom began, with telltale signs of frivolous start-ups but also the long-hoped-for succession of next-big-things. Each year saw at least one: MySpace, an online social network soon bought by News Corp, a media giant; Flickr, a photo-sharing site snapped up by Yahoo!; YouTube, a site for sharing amateur videos, quickly bought by Google; Facebook, the most innovative social network yet and so far fiercely independent; and now Twitter, a social-messaging service.
People began adopting new habits very fast. Wi-Fi became widespread in homes, offices and universities, and hotspots popped up in cafés, hotels and airports, allowing nomadic workers to go online many times a day, in many different places. Apple launched the iPhone, which upstaged even the BlackBerry in bringing the web, and Web 2.0 applications, to mobile phones, accessible all the time and everywhere. As social animals, people began expecting permanent “connectivity”.
Gadflies began pointing to excesses. Jaron Lanier, a Valley pioneer, saw behind the Web 2.0 totem of “collective intelligence” an insidious “digital Maoism” that suppressed individuality. Linda Stone, a former Apple and Microsoft executive, observed an unhealthy trend towards “continuous partial attention”, as people spent less time focusing on a single thing or person because they were constantly scanning so many other things—from Facebook to e-mail and their phones—for fear of missing out on some social opportunity.
Perhaps most dangerously, Web 2.0 still had only one business model, advertising, and the Valley was refusing to admit that only one company (Google) with only one of its products (search advertising) had proved that the model really worked. The older internet firms, Yahoo! and AOL, were doing their best to grab a piece of the action. But the “next big things” were selling negligible advertising, often on one another’s sites. Not one of them has become an advertising success in its own right.
And so, as this correspondent prepares to leave, the Valley again finds itself in a curious position. It has been a boon to the world, helping people keep abreast of acquaintances on their social networks, wherever they go, and record and share much more of their own lives. But the Valley stands on ground that is as unstable, seismically and metaphorically, as it was in the earlier bust. Another bubble—this time, not of the Valley’s making—has burst. The world economy is in crisis, advertising is collapsing and start-ups are once again vanishing into thin air. Silicon Valley may be entering another nuclear winter.
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