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Commentary on U.S. Economy

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The Financial Market Meltdown: Whatever Happened to Capitalism?
By John Garen and Kenneth Troske

U.S. financial markets are sometimes thought of as a bastion of capitalism, where investors, lenders and borrowers mutually agree to deals ranging from the safe and secure to speculative ones with the potential of huge success but with the risk of failure. All the while, each party accepts the risks and rewards as part and parcel of their agreements in the marketplace. While this characterization may be true of many sectors of financial markets, it is decidedly not true of the mortgage markets that led the way into the present financial market meltdown, nor is it true of the present government policies that lead us in the opposite direction of this type of a marketplace. In our view, this is ill advised and bodes poorly for our economy. Major government interventions are a significant source of the current troubles, and an even heavier hand of government control of financial markets will not promote a strong recovery from these problems. This is not capitalism. How about if we really give it a try?

The path away from capitalism in financial markets can be described by the now familiar phrase “the privatization of profits and the socialization of losses,” which aptly depict Fannie Mae and Freddie Mac. Fannie and Freddie constitute over half of the secondary mortgage market, i.e., they buy and/or insure mortgages from the banks and financial institutions that originate them. They raise the money to do so by selling securities on financial markets. Because they are backed by the full faith and credit of the U.S. government, any losses they suffer are absorbed by the government – this, of course, means taxpayers in our society. Thus the phrase, “the socialization of risk.” Profits were kept by Fannie, Freddie and their stakeholders.

This is a gross deviation from a marketplace where each investor accepts the risk of losses as well as any gain from profits. A serious problem resulting from this deviation is the perverse incentives it generates. From an investor’s perspective, the temptation is to seek higher risk investments: Much of the downside risk is offloaded to the taxpayer while the investors themselves benefit from the upside gain. In the case of Fannie and Freddie, this has played out in ways that have become grim.

Subprime mortgages are such a high-risk investment. These are mortgages made under circumstances that would not normally justify a loan, e.g., the borrower has a poor credit history, unclear earnings potential, and only a minimal down payment. The heightened risk comes from that fact that continually rising housing prices are relied on in order for many of these loans to be repaid. In addition to providing a high-risk investment that the above described incentives proscribe, subprime mortgages offer a decided political benefit – they make politicians look good. They often go to individuals who otherwise would not be a homeowner. Thus, Congress (and sometimes the administration) pushed Fannie and Freddie to promote subprime mortgages as a way to be seen as aiding “affordable housing” and attainment of the “American dream” of homeownership. Since the U.S. government provides Fannie and Freddie with their government sponsored status and position of near monopoly in the secondary mortgage market, the lenders were eager to go along with it.

Politics trumps economics
In the early 2000s, Fannie and Freddie devoted increasing funds for acquiring and insuring subprime mortgages. This required lowering their standards for acceptable mortgages. In addition, there was encouragement and pressure on private-sector lenders to consider “flexible underwriting standards” that would enable many of the previously unqualified borrowers to obtain a mortgage. But flexible standards were, for the most part, a euphemism for lower standards. The private sector had already been engaged in this type of lending, but then with the aid and encouragement of the federal government, the private lenders intensified subprime lending. A large share of these mortgages were sold, sliced up and repackaged into mortgage-backed securities and spread through the economy and onto the balance sheets of many financial institutions.

As is often the case, good politics trumped good economics. Congress and assorted politicians get to look good, Fannie and Freddie maintain their dominant market share and profitability (to be used, in part, to “help out” supporters in Congress), while foisting more risk, little by little, onto millions of unwitting taxpayers. But, as we have seen, this arrangement was a financial time bomb set to go off when housing prices fell, throwing risky loans into default.

Mistakes were made in the private sector as well. Given the emphasis on increasing homeownership and the relatively low interest rates produced by the Federal Reserve’s easy-money policy, many lenders overzealously pushed high-risk loans with little documentation. Loan originators often were paid fees that were not tied to loan performance. Credit rating agencies were lax in rating securities backed by subprime loans. Banks and other financial institutions increased the riskiness of these financial instruments by purchasing them with borrowed money. This risk was then spread to other sectors of the economy and around the world through credit default swaps in which one investor purchases some of the risk held by another investor.

Under normal circumstances, imprudent lending practices and poor investment decisions in the private sector lead to losses and changes in firm behavior, a change in management, or even bankruptcy. Typically though, these consequences are limited to a single firm or sector. The combination of large governmental entities putting an implied government seal of approval on high-risk mortgages, and the private sector belief that this approval reduced the riskiness of these assets, meant that once the engine (rising housing prices) that was driving these markets stopped running, Fannie and Freddie were doomed to failure. Their failure took a large part of the financial market with them.

An implicit mandate
Some claim this fiasco is the result of some kind of deregulation. This is not true. The only major piece of financial market deregulation in the last decade was the Gramm-Leach-Bliley Act of 1999 that enabled commercial and investment banks to merge. This has nothing to do with the present crisis. It is true that new financial instruments, such as credit default swaps, were developed with no new regulation associated with them. However, the biggest and most important regulatory change in the past decade was an implicit one.
It was the implicit mandate from Congress and various administrations for Fannie, Freddie and the private sector to undertake more risk in the form of subprime lending.

This move away from capitalism in financial markets toward the socialization of risk and the subtle politicization of investment is an important source of our present problems. But let’s now consider the policies that are intended to deal with them. Unfortunately, what’s been proposed is a further movement away from capitalism.

The initial policy response was a sporadic set of bailouts of various form, first of Bear Stearns, then of Fannie Mae, Freddie Mac and AIG. This was accompanied by injections of currency into the banking system by the Fed.
More recently, Congress passed and the president signed one of the largest financial bailouts in history. The Targeted Assets Relief Program (TARP) proposes a federal government purchase of poorly performing assets from financial institutions. The Capital Purchase Program (CPP) calls for direct U.S. Treasury purchases of stock in these institutions. These represent one of the largest increases in the government’s role in the private sector since the Great Depression. In our opinion, this legislation has many problems that we fear will lead to much lower long-term growth for the U.S. economy.

Implementation of the asset purchase plan presents many problems. The plan calls for the federal government to buy “nonperforming” assets on the books of financial institutions through a reverse auction. Of course banks are currently free to sell these assets anytime they want. The problem is, given the uncertainty surrounding the value of some of these assets, no investor is willing to pay a price for these assets that banks are willing to accept. Since Treasury officials are no better at valuing these assets than private sector investors, the plan will have the intended effect only if the government pays a higher price for these assets than any other investor. In other words, the government pays more for the assets than they are worth, thereby transferring some of the losses associated with these assets from the owners of financial institutions to taxpayers. This is simply more socialization of risk and rewarding those institutions that took imprudent risk relative to those who played it safe. If Treasury pays the current market value of these assets (less than the book value), this could push the sellers into bankruptcy as easily as would happen in a private-sector transaction.

Changing government’s role
Perhaps in light of these problems, the Treasury has turned to the Capital Purchase Program to provide capital to financial institutions to prevent their bankruptcy. Treasury already has “persuaded” several banks to sell preferred stock to the government.

But either form of bailout changes the government’s role in the economy in a fundamentally negative way. The government becomes the guarantor of last resort for risky investments, either through buying up investments that turned bad or directly owning the losses and covering them with tax dollars. If a company makes a very risky investment and it pays off, they keep the lion’s share of the profits. However, if the investment fails and the company is teetering on bankruptcy, then government dollars are used to salvage the company. This is socialization of risk in spades, with the associated tilt toward ever riskier investments.

The only way to prevent this is for the government to control the investment activity of firms… the ultimate politicization of the use of capital. In such a scenario, taxpayers surely would get many politically correct and feel-good investment projects. But they would be of highly questionable value and we’d consign ourselves to a negligibly growing economy, with stagnant wages and employment. Sadly, this danger seems to grow each day. There are now calls for government investment for broker-dealers, insurance companies and auto manufacturers. And the Office of the Comptroller of the Currency seems to be dictating firm merger activity, with the latest example being the funding of PNC contingent on its purchase of National City Corp. Essentially the government is now picking which banks will succeed and which will fail, which in turn means the government officials are deciding which set of investors will make money and which will lose money.

Because the immediate cause of financial market disarray stems from declining house prices and defaults on mortgages, some have suggested a government bailout for homeowners to enable mortgages to be paid and defaults avoided. Of course, this has a problem similar to that outlined above: The imprudent are rewarded with the consequent encouragement of excessive risk taking.

The right medicine
There has also been a growing call from politicians in both major political parties for “more regulation.” This is a little like going to your doctor when you are sick and having the doctor tell you to “take more medicine.” This advice is obviously silly because, while some medicine can cure you, other medicine will make you even sicker and may kill you. The trick is choosing the right medicine. At its basics, financial markets work by investors providing money to financial intermediaries that, in turn, lend the money to the ultimate borrowers. Investors, to a significant extent, rely on the good reputation of the intermediaries to identify solid borrowers and make sound investments. And, under normal conditions, lenders rely on the reputation of borrowers to repay.

So the trick now is choosing regulation that can restore investor trust and confidence in markets. Regulation that increases the amount of information available to borrowers and investors, that produces more transparency in transactions, that increases penalties for fraudulent lending practices, that ensures that rating agencies are conducting independent evaluations of the riskiness of assets, are all regulations that will help restore confidence in the market and lead us back to a path of long-term financial growth. Regulations that limit the ability of market participants from contracting with each other, such as limitations on executive salaries, or regulating the types of assets financial intermediaries are allowed to sell, or that investors are allowed to buy, will not help restore confidence in the market. Nor will additional bailouts on the part of the government.

If there is one lesson to be learned from this financial crisis it is that unintended and often disastrous outcomes occur when we have large government entities transacting in private markets and making decisions based on political rather than economic considerations. Long-term economic growth results from governments creating rules that are designed to enhance market efficiency and then allowing private sector entities to transact based on these rules. In other words, the best solution to the current problem is a return to capitalism.

New President’s Administration Must Stimulate Recovery
Increasing capital investment, employment, stock prices
and consumer spending necessary for a turnaround
By Dr. Charles F. Haywood

Kentucky’s unemployment rate broached the 7 percent level in September 2008, a level not seen since the 1991-1992 recession. Of concern, too, is the swiftness of the increase. A year earlier, September 2007, unemployment was only 5.4 percent of Kentucky’s labor force, and in January 2008 even dipped to 5.2 percent. The unemployment rate shot up to 7.1 percent in only eight months.

The number of jobless persons seeking employment in September was 145,843. That was 38,149 greater than the number of jobless in January. Total employment in Kentucky declined from 1,945,703 in January to 1,901,763 in September, a loss of 43,940 jobs. The fact that the job loss was greater than the increase in number of unemployed persons indicates that some 5,781 persons withdrew from the labor force, i.e., stopped seeking employment
Nationally, the unemployment rate was 6.1 percent in September, up significantly from 4.7 percent in September 2007 and 4.9 percent in January 2008. From September 2007 to September 2008, the number of jobless persons increased from 7,246,000 to 9,477,000, a jump of 2,231,000. During the same period, total employment fell from 154.73 million to 153.18 million, a loss of 1.55 million jobs. That the number of jobless increased by 681,000 more than the decline in total employment reflects continuing growth, nationally, in the size of the labor force, i.e., the number of persons looking for work.

The hardest part of economic forecasting is predicting the “turning points:” (1) the point at which expansion ends and recession begins, and (2) the point at which recession ends and recovery begins. Once recession (the “downswing”) begins, the course of the downswing is ordinarily not too difficult to predict. The current economic situation, however, is anything but ordinary. All that can be said at present, with some degree of certainty, is that unemployment in Kentucky and nationally will continue to increase through at least the first several months of 2009. Contrary to the ordinary, there is very little, if any, basis to say how deep and how long the downswing will be.

The outlook depends profoundly on how quickly and effectively the new administration coming to Washington can act to halt the economic downswing and get a recovery underway. The past several months have been reminiscent of the closing months of the Hoover administration in 1932-33. The Roosevelt administration did not take office until March 4, 1933, though elected in November 1932. The nation’s economic and financial situation worsened while awaiting the transfer of power in Washington. The 20th Amendment, ratified in 1933, changed the Presidential Inauguration Date from March 4 to January 20, thus shortening the time during which the nation may suffer from a power vacuum in Washington.

Importantly, the new administration will not be confronted with a collapsed banking system as was the case in March 1933. Cash infusions under the emergency enacted Troubled Assets Relief Program and other actions by the Federal Reserve and Treasury appear to have halted what could have been a total meltdown of our major financial institutions. The vast amount of mortgage-backed bonds, credit-swaps and other derivative securities as well as just plain old debt (e.g., commercial paper) posed a “linkage of risks” far beyond anything ever seen in our financial system or could have even been imagined seven or eight years ago. An impressive example of “linkage of risks” was that the failure of the Lehman Brothers investment banking firm also collapsed a major money-market mutual fund holding some of Lehman’s commercial paper. The commercial-paper market, in general, assumed the posture of “a deer in the headlights,” which adversely affected large finance companies relying on such paper to raise funds to make loans to businesses and households, which, in turn, adversely affected sales of equipment, vehicles, appliances, and so on, and so on.

The Herculean task awaiting the new administration goes far beyond assuring the stability of the financial system and the availability of credit. Increases in unemployment must be halted by stimulating demand for equipment, vehicles, appliances and, yes, housing.

The potential for further increases in unemployment is scaring. In Kentucky, the highest unemployment rate since before World War II came in December 1982: 12.1 percent. The number of jobless persons at that time was 207,293 with a total labor force of 1,711,658. Now with Kentucky’s labor force at close to 2,050,000, an unemployment rate of 12.1 percent would represent 248,050 jobless persons, or about 102,500 more unemployed than in September. How likely is such an increase? Some forecasters have opined that the national unemployment rate may go as high as 8 percent by mid-2009. That would add about 3 million Americans to the approximately 9.5 million already jobless in September 2008. The impact in Kentucky would probably be an increase of about 50,000 in the number of unemployed, i.e., raising the total from 145,683 jobless in September 2008 to 195,000 or so in mid-2009, which would be a little less than 10 percent of Kentucky’s labor force. A national unemployment rate of 10 percent, which some forecasters regard as possible but not likely, would boost Kentucky’s rate close to the December 1982 peak of 12.1 percent, with a 250,000 persons unemployed.

Clearly, Kentuckians have a lot riding on the speed and effectiveness of the new administration in stimulating a recovery in effective demand for goods and services. One possible source of help is recovery in the stock market. At least $3 trillion of wealth, including pension and 401(k) plans as well as private portfolios, has disappeared with the decline in stock prices since August 2008. Consumer spending is dependent not only on income currently received but also on past income accumulated in savings and investments.
Recovery of stock prices, if it were to occur quickly, could have a strong stimulating effect on business and consumer spending.

What, then, are the prospects for quick recovery in stock prices? A recent publication (“Leading the Way,” 3rd quarter, 2008) of The Hartford Financial Services Group Inc. presented data on the “one-year rebound” rates from stock-market bottoms in 10 recessions since the end of World War II. The “one-year rebound” rates average 39 percent. Of course, printed conspicuously in a number of places in the publication was the caveat: “past performance is no guarantee of future results.” Nevertheless, the analysis by The Hartford makes for at least a glimmer of hope stock prices will rebound sooner than later and thus help to shorten the economic downswing in which we find ourselves.

Historically, stock prices have been a “leading indicator.” That is, stock prices have usually turned down at least several months before the beginning of a recession is evidenced by a decline in our nation’s GDP (total spending for goods and services). Further, stock prices usually find a bottom at least several months before GDP stops decreasing. Employment (nonagricultural payrolls) has historically been a “coincident indicator,” declining at about the same time as GDP begins to fall and rising at about the same time as GDP recovers an upward tilt. The implication is that the stock market bottoms out before employment does. A view that employment will stop declining by mid-2009 would imply the bottom of the stock market is nearby. But, as said above, calling the “turning points” is the hardest part of economic forecasting.

Reagan + Friedman + Keynes
We need all the help we can get
By Lawrence Kudlow
Back in early 1981, when I went to Washington to work for President Reagan, one of the architects of supply-side economics, Columbia University’s Robert Mundell, visited my OMB budget-bureau office inside the White House complex. At the time we were suffering from double-digit inflation, sky-high interest rates, a long economic downturn and a near 15-year bear market in stocks.

So I asked Prof. Mundell, who later won a Nobel Prize in economics, if President Reagan’s supply-side tax cuts would be sufficient to cure the economy. The professor answered that during periods of crisis, sometimes you have to be a supply-sider (tax rates), sometimes a monetarist (Fed money supply), and sometimes a Keynesian (federal deficits).

I’ve never forgotten that advice. Mundell was saying: Choose the best policies as put forth by the great economic philosophers without being too rigid.

Of course, John Maynard Keynes was a deficit spender during the Depression. Milton Friedman warned of printing too much or too little money. And Mundell, along with Art Laffer, Jack Kemp and others, revived the importance of reducing high marginal tax rates to reward work, investment and risk. The idea was to make each of these activities pay more after tax, and in the process boost asset values across-the-board. This incentive model of economic growth was used effectively by President John F. Kennedy and the great 1920s Treasury man, Andrew Mellon.

During the 1980s, Reagan enacted Mundell’s three-legged approach. He slashed tax rates on the supply side and was not afraid to run budget deficits in the Keynesian mold. At the same time, Reagan gave Paul Volcker carte blanche to practice the tough-minded monetarism that curbed excess money and vanquished inflation. This eclectic policy mix reignited economic growth, and it ushered in a three-decade prosperity boom that revived free-market capitalism.

Today, however, the economic naysayers are ignoring the advice of Prof. Mundell. Looking at our financial crisis, with its deflationary sweep from stock markets to home prices to energy, they want to lurch leftward to a big-government tax-and-spend regulatory approach. Instead, we need to put all three legs of the Mundell hypothesis in place. And we’re already two-thirds of the way there.

Treasury man Henry Paulson is using a $700 billion rescue package to prop up banks with new capital, purchase distressed assets and backstop interbank lending. Keynesian deficits will finance it. But it’s working. While ankle biters on the left and right have dissed Paulson’s plan, important credit-market spreads have declined significantly beginning in mid-October.

Fed head Ben Bernanke, meanwhile, is combating deflation with a Friedmanite monetarist approach — the second leg of the Mundell mix. Over the past two months the Fed has doubled its balance sheet and spurred a major increase in the basic money supply in order to meet the enormous liquidity demands that always accompany deflation. The Fed should keep this up in the coming months until stocks, commodities and credit show life-signs of recovery.

But what’s missing is Mundell’s third policy leg: supply-side tax cuts. And here we find the partisan debate of the closing days of the presidential and congressional elections.

Democrats want to tax the rich, redistribute the wealth and spend our way out of the economic doldrums. It won’t work. Sens. Barack Obama and Harry Reid, along with Speaker Nancy Pelosi, disdain supply-side tax incentives. Sen. John McCain continues to advocate to reemploy them as a recovery tool. McCain is right, and now is the time for the Republican Party to call for sweeping tax cuts that would reduce marginal rates by half for businesses, individuals and investors. Yes, it would be bold. But no bolder than Reagan in the 1980s, Kennedy in the 1960s, or Mellon in the 1920s.

The corporate tax rate should be slashed from 35 percent to less than 25 percent, including capital-gains. (Corporations, let’s not forget, don’t pay taxes. Only individuals do, since business costs are passed along to consumers.) The top individual rate should similarly be lowered, with fewer income brackets to clutter up the tax code. And investment taxes on capital-gains and dividends should be cut from 15 percent to 7.5 percent to revive the dormant animal spirits of investors.

These tax cuts would mean all three legs of Robert Mundell’s pragmatic approach to policy are in place. Use the money supply to combat deflation (inflation is not the problem), employ deficits to rescue and stabilize the banking and credit system, and slash tax rates to reignite economic growth.
In effect, a successful rescue plan requires a drawdown of all the major economic schools of thought. Given the current economic emergency, we need all the help we can get. For a change, how about a little pragmatism in the policy mix? That just might do the trick.