With the recent passage of the Emergency Economic Stabilization Act of 2008 by the U.S. Congress, the editors of The Lane Report decided to collect a cross sample of past and present quotations and comments about global economics, the U.S. economy and the complex and interrelated public and governmental factors that are causing financial challenges and concerns for investors, business and local governments.
We hope these quotations, assessments, and opinions will be helpful to you in evaluating the issues facing Kentucky and U.S. economic activity in the coming year. Your comments and ideas would be valued. We encourage you to contact us at [email protected].
Markets Will Rebound When Trust Restored
A speech to the Sandra Day O’Connor Project Conference, Oct. 2, 2008
By Alan Greenspan
It’s safe to say that Justice Sandra Day O’Connor’s record of public service tells us who she is, and we commend her for the Western common sense she brought to her career at the Supreme Court. We wish only there was more of it. It’s also a time when we realize that the branch of government she once served seems to be the only one that’s still functioning.
This is especially the case since we are living through the type of wrenching financial crisis that comes along only once in a century. Financial markets freeze up, as an excess of fear displaces a protracted period of what some might call irrational exuberance. Eventually, the market freeze will thaw as frightened investors take tentative steps towards re-engagement with risk.
Broken market ties among banks, pension, and hedge funds and all types of nonfinancial businesses will become re-established, and our complex economy that has the capacity to produce a fifth of the world’s goods and services will re-emerge.
When asked how the U.S. economy in little more than a century achieved the highest standard of living in the world, outpacing all others and then sustaining that lead for another century, my response has always been: It’s the Constitution of the United States.
Critical to economic growth is a rule of law, particularly protection of the rights of individuals and property. While it is true that over the decades the vast majority of investors have come to our shores to participate in a vibrant, open economy, a remarkably large number have simply viewed the United States as a safe haven for their savings that was not available in their home country. Our Constitution accords the rights of U.S. citizens to those who invest here under U.S. law. Short of a few ambiguous incidents, I can think of no circumstances where an expanded rule of law and enhanced property rights have failed to increase material prosperity.
It has been startling over the years to see what even a little private ownership will do. When, three decades ago, China granted highly diluted rights of ownership to the rural residents who tilled vast communal-owned agricultural plots, yields per acre and rural standards of living rose significantly. And it was an embarrassing stain on the Soviet Union’s central planning that a very substantial percentage of its crops came from “privately owned” plots that covered only a small fraction of tilled land.
As living requires physical property – food, clothing, homes – people need the legal protection to own and dispose of such property without the threat of arbitrary confiscation by the state or mobs in the street. To be sure, people have to, and do survive, in totalitarian centrally planned societies where individual property rights are de minimis.
But theirs is a lesser existence.
The ability to own and dispose of property under a rule of law is a notion spawned by the 18th-century’s Enlightenment spread through Europe and North America. It produced new ways to organize society’s pursuit of the industrial means required for people to survive and hopefully prosper. Prior to the Enlightenment, people could barely improve upon their short and miserable lives. Indeed, for generation after generation, people tilled the same plots of land. Material progress was marginal at best. Global life expectancy was 25 years, unchanged for a millennium.
Since the early 18th century, however, the force of the rule of law has fostered standards of living that rose by 20 times in that part of the world that embraced competitive markets. Life expectancy more than doubled. And in the developing countries that have abandoned central planning for markets since the end of the Cold War, hundreds of millions of people have been elevated from subsistence poverty. Other hundreds of millions are now experiencing a level of affluence that people born in developed nations have experienced all their lives.
Regrettably, the notion of rights of ownership of capital and other income-earning assets remains conflicted, especially in societies that still believe that profit seeking is not quite moral. A key purpose of property rights, after all, is to protect assets in order to use them to profit or personally benefit. Such rights are not supportable in a society that holds any significant remnant of the view of property as “theft.”
That notion embraced by Karl Marx rests on the presumption that gained wide acceptance in the first half of the 20th century that wealth created under a division of labor is produced jointly, and hence should be owned collectively. Any rights inhering in an individual, therefore, must be “stolen” from society as a whole.
Classical economists led by Adam Smith, a prominent figure of the Enlightenment, in contrast, developed the notion of the marginal contribution of each individual to the production process as the basis of his or her incomes. Implicitly, Smith’s followers argued that Marx’s view was inconsistent with human nature and therefore could not explain economic development.
Marx did recognize that acquisitive human nature was not compatible with a collectivized state. But he postulated a change of human nature fostered by communism. It took many generations to prove him wrong. With the exception of a few diehards, none of today’s communist leaders hold to that orthodoxy.
In the West, the moral validity of property rights is accepted, or at least acquiesced, by virtually the whole of the population. This is true even in societies that are disdainful of competition. Attitudes toward property ownership are passed from one generation to the next through family values and education. These attitudes derive from the deepest values governing social interaction that people hold.
Even in non-democratic societies where property rights are embraced, standards of living improve. But democracies with a free press and protection of minority rights have proved the most effective form to safeguard property rights, largely because democracies rarely allow discontent to rise to a point that leads to explosive changes in economic regimes. Capitalism under authoritarian rule, on the other hand, is inherently unstable because it forces aggrieved citizens to seek redress outside the law.
Protection of property has always been a moving target as the law continually tries to keep up with the nature of economic change. It’s not surprising that different cultures have different views as to whether and to what extent property should be protected. This issue is becoming pronounced as property is becoming increasingly intellectual.
How appropriate is our current system of intellectual property protection – developed for a world in which physical assets predominated – for an economy in which value increasingly is embodied in ideas rather than tangible capital? Arguably, one of the single most important economic decisions our lawmakers and courts will face in the next 25 years is to clarify the rules of intellectual property.
The demonstrable driver of economic progress is competition. I cannot improve on Adam Smith’s identification in his “Wealth of Nations,” “the natural effort of every individual to better his own condition, when suffered to exert itself with freedom and security is so powerful a principle, that it is alone, and without any assistance… capable of carrying on the society to wealth and prosperity.” People generally do not exert the effort to accumulate the capital necessary for economic growth unless they can own it.
Clearly the increased concentrations of income that have emerged under technological advance and global competition, have rekindled the battle between the cultures of socialism and of capitalism – a battle some thought had ended once and for all with the disgrace of central planning. But over the past year, some of the critical pillars underlying market competition arguably have failed. A worldwide debate on the future of globalization and capitalism is being intensified by the current crisis. Its resolution will define the world marketplace and the way we live for decades to come.
Another important requirement for the proper functioning of market competition is also not often, if ever, covered in lists of factors contributing to economic growth and standards of living: trust in the word of others. Where the rule of law prevails, despite everyone’s right to legal redress of a perceived grievance, if there is more than a small fraction of outstanding contracts that require adjudication, court systems would be overwhelmed, as would society’s ability to be governed by the rule of law.
This implies that in a free society governed by the rights and responsibilities of its citizens, the vast majority of transactions must be voluntary, which, of necessity, presupposes trust in the word of those with whom we do business – in almost all cases, strangers. It is remarkable that large numbers of contracts, especially in financial markets, until recent advances in information technology, were initially oral, confirmed by a written document only at a later time, even after much price movement. It is remarkable how much trust we have in the pharmacist who fills the prescription ordered by our physician. Or the trust we grant to automakers that their motor vehicles will run as certified. We are not fools. We bank on the self-interest of our counterparties with whom we trade to foster and protect their reputation for producing quality goods and services. Just contemplate how little division of labor and wealth creation would be engendered if that were not the prevailing culture in which we lived.
Wealth creation requires people to take risks, and thus we cannot be sure our actions to enhance our material well being will succeed. But the greater our ability to trust in the people with whom we trade, that is, the more enhanced their reputation, the greater the accumulation of wealth. In a market system based on trust, reputation has a significant economic value. I am therefore distressed at how far we have let concerns for reputation slip in recent years.
Reputation and the trust it fosters have always appeared to me to be the core attributes required of competitive markets. Laws at best can prescribe only a small fraction of the day-by-day activities in the marketplace. When trust is lost, a nation’s ability to transact business is palpably undermined. In the marketplace, uncertainties created by not-always-truthful counterparties raise credit risk and thereby increase real interest rates and weaker economies.
During the past year, lack of trust in the validity of accounting records of banks and other financial institutions in the context of inadequate capital led to a massive hesitancy in lending to them. The result has been a freezing up of credit.
As I noted in my opening remarks, trust will eventually re-emerge as investors dip hesitantly back into the marketplace. From that point, history tells us, financial and economic revival sets in. I suspect it will be sooner rather than later. In either event, human nature being what it is, revival will come. It always has in this society governed by that remarkable document we call the Constitution of the United States.
Editor’s Note: Dr. Greenspan’s comments were edited for length
Unwinding the Biggest Pyramid Scheme in the History of the World
By John Farris
Most successful pyramid schemes are able to grow based on their ability to blur the line between a legitimate business and a moneymaking scam. In a counter-intuitive manner, it is often the confusing and complicated nature of the business model for the pyramid scheme that allows it to attract more and more followers. As long as the scheme continues to recruit more followers, the people at the top reap significant personal benefit. Eventually, when the scheme is unable to recruit any new followers, the people in the worst situation are the ones at the bottom of the pyramid.
Before their collapse in September, few people could explain exactly what legitimate business function Fannie Mae and Freddie Mac served. To oversimplify their function, Fannie Mae and Freddie Mac used an implicit guarantee from the federal government to lower their borrowing costs and create a secondary market for mortgage loans. This secondary market allowed banks and mortgage companies to get the loans off their books so the banks and mortgage companies could make more loans. Some economists estimated that the secondary market created by Fannie Mae and Freddie Mac allowed mortgage rates to be one-quarter of a percentage point lower than they would have otherwise been. However, even this benefit is debated among economists, especially in light of their recent collapse.
Although Freddie Mac and Fannie Mae were privately owned, they were known as government-sponsored enterprises (GSEs). The GSEs did not have to follow many of the rules that applied to other private companies who were also borrowing money to buy mortgages in the secondary mortgage. For example, they didn’t have to register their securities with the government. In addition, they did not have to pay federal or state taxes.
But Fannie Mae and Freddie Mac’s largest perk came in the form of an “implicit” backing of the United States government for their debt. This meant the interest rate at which they borrowed funds from investors was lower than it otherwise would have been without the guarantee. In addition, it also meant the amount they could borrow from willing investors was almost limitless.
It is estimated their lower rate created by this implicit guarantee saved the GSEs approximately $2 billion a year in borrowing costs. With these cheap funds, Fannie Mae and Freddie Mac bought and held mortgages and mortgage-backed securities with considerably higher yields than they paid for them. In turn, Fannie and Freddie used these savings to make “paper” profits, which enriched management, shareholders, government officials, lobbyists and others at the top of the pyramid. For example, the former CEO of Fannie Mae, Franklin Raines, received total compensation from 1998 through 2004 of $91.1 million, including some $52.6 million in bonuses.
As a result of the implicit guarantee of the United States government, they attracted more and more investors willing to lend them money. At the end of 2007, Fannie and Freddie held or guaranteed mortgages worth about $5.2 trillion. In fact, some of the biggest “suckers” were foreign governments. In total foreign governments and investors hold over $1.4 trillion in Fannie Mae and Freddie Mac bonds. China alone holds an estimated $300 billion of this debt and reportedly made it very clear that it had no taste for accounting schemes.
After all, these foreign governments, like the other bondholders for Fannie and Freddie debt obligations, had always assumed that the bonds were implicitly backed by the United States government. This is the only reason they bought into the scheme.
In September, as investors and foreign governments became skeptical of the GSEs’ ability to pay back their obligations, they became increasingly unwilling to buy Fannie and Freddie debt on the secondary market. The pyramid was beginning to unravel quickly. The only question was who was going to be left holding the bag.
Luckily, at the last minute, Secretary of the Treasury Henry Paulson came up with an ingenious method to keep the scheme going. He was able to create one more layer to the pyramid by placing the two entities in “conservatorship.” In other words, congratulations! You, the U.S. taxpayer, are now the proud “conservator” of all Fannie Mae and Freddie Mac debt obligations. Doesn’t it feel great to be the one holding the bag in a pyramid scheme you did not even know you were participating in?
De-Leveraging Could Take Years
A gloomy assessment of our economic future
By David A. Dubofsky
If you listen to the news from any source, you know that the U.S. economy is not in good shape. The financial sector … just about anything connected with mortgage lending, commercial banks and investment banks (now extinct) … is in particular distress.
Unfortunately, many statistics indicate that the situation is going to get worse before it gets better. The good news is that no one, particularly me, knows exactly what the future holds. So, maybe I’ll be wrong. But many figures suggest that we are in the early stages of a long recession. We may be in for a five-year period of little-to-no-to-negative economic growth.
The purpose of this article is to present some reasons for this assessment, and present some conjectures about what it might mean for Kentucky businesses and individuals.
There are two forces that can turn around a recession: government actions and the natural forces of markets as supply and demand reach a new equilibrium that permits the economy to start growing again.
Unfortunately, the U.S. government will be limited in its efforts to fight a recession.
The U.S. government has two weapons to fight a recession: monetary policy and fiscal policy. The Federal Reserve Bank has already lowered its fed funds loan rate to 2 percent. To further try to stimulate the economy, it can only go to zero; there is not much room to maneuver. Moreover, the effectiveness of lower rates disappears if other interest rates don’t follow suit.
The ability to use fiscal policy, tax cuts and/or increased government spending may be even more restricted. Even before the recent acquisitions of Freddie Mac, Fannie Mae and AIG, and the likely acquisition of another $700 billion of troubled assets, the government would have been handicapped in its ability to increase spending. Prior to its recent acquisitions – which also resulted in the acquisitions of assets (good), the values of which we do not know (bad) – the U.S. government was forecasting a $600 billion deficit for fiscal 2009, a figure that includes the off-balance-sheet costs of the Iraq war. But that figure assumed the economy would grow at a 2.2 percent rate. With zero growth, the deficit would likely be closer to $1 trillion. Now, with all of the recent troubled asset adoptions, the deficit may be closer to $1.5 trillion.
It seems that the government’s two weapons may be exhausted, even at this early stage of a recession.
That leaves us to rely on market forces to work their magic and turn things around. The good news is that they will work … eventually. The unknown is how long it will take them to work. I am thinking five years for two reasons. First, the process of the de-leveraging of America has a long way to go.
Second, the maximum impact of failed option ARM mortgages will be felt between 2009 and 2012. This means that more foreclosed houses will be on the market for the next four years, impeding any housing market recovery.
Like the U.S. government, state governments, banks and other financial institutions, many corporations and households are also over-leveraged.
Financial institutions are in the process of shedding assets (depressing prices), becoming smaller and reducing the amount of credit they make available. This will slow the economy down, because a growing economy depends on the expansion of credit. In a slowing economy with less credit, many debts will not be able to be repaid. The original loans were made on assumptions of asset value growth and or income/profitability/revenue growth. Many of these assumptions have already been proven false, and many other assumptions are likely to be proven false. There may be many more failures, foreclosures, defaults and bankruptcies in the near future.
Let me offer just a few figures about the current state of the U.S. consumer. Household debt as a percentage of GDP rose from 25 percent in 1953 to 45 percent in 1965-1977, then to 65 percent in 2001 and to 90 percent in January 2007. Credit card debt rose by a factor of four between 1989 and 2006. Total consumer credit exceeds $2 trillion. However, 9.2 percent of all mortgages are currently delinquent or in foreclosure. Sixteen percent of all homeowners are now living in homes whose values are less then their mortgage balances; in a year, one forecast predicts it will be 25 percent.
Consumers, particularly the tens of millions of marginal borrowers, are going to have difficulty renewing loans, getting new loans and repaying loans. They will almost surely cut back their spending.
In general, credit and capital is likely to be scarcer and more expensive for almost everyone in the next few years.
Some businesses that cannot get credit, or can only get less credit at higher prices, will not be able to pay off existing loans. Others will be forced to slow their growth and slow their hiring. More than 600,000 jobs have already been lost this year and there are currently over 9.3 million people looking for work in our country. More jobs are likely to be lost in the next few years.
Investors and savers will have to accept lower rates of returns on their investments. I don’t think that investors should chase high rates of return in the next few years because high returns only come with high risks. This is not a time to be risk tolerant.
On the other hand, it is well known that markets turn before the economy turns. On average, the stock market starts rising about five months before the bottom of a recession.
State governments will be squeezed the next few years. Thirty states (including Kentucky) have now revealed budget shortfalls for fiscal 2009. Combined deficits are $52 billion. More than 40 percent of all state and local pension funds are underfunded, in the estimated amount of $750 billion (including Kentucky’s $25 billion pension deficit). States can deal with these problems in three ways: use their “rainy day funds,” raise taxes, and/or cut spending. The last two solutions will only further the country’s economic downturn.
My five-year recession forecast is not based on any econometric forecast. It is based on just reading the numbers that reveal the degree of extreme leverage that has existed around the world, which is now in the process of de-levering. This leverage stimulated our economy. This source of economic growth is finished in the near term, and it will have a severe impact on our economy. I see de-leveraging occurring for several years.
Penny-Wise Politics
by Thomas Sowell
Congress is never more ridiculous than when it tries to look like it is serious.
In the midst of a major national financial crisis, what was one of the first things Congress zeroed in on? The pay of chief executive officers of financial institutions.
If all those CEOs agreed to work for nothing, that would not be enough to lower the bailout money by 1 percent. Anyone who was really serious would start with the 99 percent and let the 1 percent come later, if at all.
But however insignificant the pay of CEOs is economically, it is big stuff politically. Whatever the shortcomings of the Democrats, they are consistent in their message, and class envy is a great part of that message.
People who say that they cannot understand how CEOs in general get so many millions of dollars seem not to realize what a trivial thing they are saying. Most people do not understand most things. But that is no reason to have national policy guided by their ignorance.
I do not understand 1 percent of what there is to understand about the very computer on which these words are being written — nor about the Internet on which these words will be transmitted to the syndicate that distributes this column. I don’t have a clue about how a syndicate is run, much less how much someone should be paid for running it.
What really sets some people off is the fact that a CEO who has mismanaged some corporation into losing billions of dollars is rewarded with a severance package worth millions.
Think about it. If the CEO’s decisions are costing the company billions, it is a bargain to get him out the door immediately for millions, rather than having his departure delayed by either internal struggles or battles in the courts.
It is the same principle if you are married to someone who is impossible to live with. The divorce may cost far more than the marriage — and still be worth every cent of it.
But what about the “social justice” of it all?
Such questions seem to carry great weight with people who act as if they are God on Judgment Day. But one of the little overlooked differences between themselves and God on Judgment Day is that God does not have to worry about what is going to happen the day after Judgment Day.
Rewarding someone for being impossible to live with may offend our feelings, just as rewarding someone for mismanaging a company does. But the real question is — what is the alternative and how will that alternative affect the future?
Politically imposed limits on the pay of CEOs is one of the most penny-wise and pound-foolish things that can be done. The difference between a top-notch CEO and a second-rate CEO can be billions of dollars on the bottom line.
That is what drives up the pay of CEOs. If you want someone who will be top-notch in running organizations as huge and complex as Fannie Mae or Freddie Mac, there is no point offering $5 million a year if similar enterprises elsewhere are paying $20 million for people with the kind of ability required.
Who is going to take a $15 million pay cut to go run these enterprises, in addition to having to put up with politicians? The money that can be saved by limiting CEO pay is chump change compared to the money that can be lost because you cannot attract top-notch talent.
Congress itself is a classic example of what can happen when penny-wise policies restrict the caliber of people who can be attracted. No top-level doctor, lawyer, economist, engineer or CEO can become a member of Congress without taking a big pay cut, perhaps costing that person’s family millions of dollars over a lifetime.
On the other hand, if you paid every member of Congress $1 million a year, it would cost less than the cost of even a small government boondoggle, much less a whole agency.
It is not that the turkeys in Congress today deserve a raise. They don’t even deserve their current pay. But that is the very reason for attracting different people. Cheap politicians are actually very expensive, and the same principle applies to CEOs.
Why Government Planning Always Fails
Special interest groups ensure plans do not change – no matter how costly
By Randal O’Toole
Government officials claim their plans will help us live happier lives. But planners’ predictions of the future are no better than anyone else’s, so their plans will always be flawed.
Everybody plans. We plan our workdays, we plan our careers, we plan for retirement. But private plans are flexible, and we happily change them when new information arises. In contrast, as soon as a government plan is written, people who benefit from the plan form special interest groups to ensure the plan does not change, no matter how costly to society as a whole.
New Deal planning did more to prolong the Depression than it did to end it. Urban-renewal planning in the 1950s and 1960s displaced more than a million low-income families from their homes and turned some inner city neighborhoods into bombed-out landscapes. And President Nixon’s wage-and-price controls didn’t stop inflation.
Despite these failures, governments continue to plan. Almost every city and county in the country has a planning department. More than a dozen states have passed laws requiring local governments to write comprehensive land-use plans that place strict limits on how people can use their property. Congress has passed numerous laws requiring federal agencies to plan, including the National Environmental Policy Act of 1969 (which requires agencies to write detailed plans for any action affecting the environment).
32,000 professional planners
Who writes these plans? The Bureau of Labor Statistics says the United States has about 32,000 professional planners. About 30,000 of them belong to the American Planning Association, which says two out of three of its members work for government agencies.
Most professional planners graduated from a planning school that is closely affiliated with an architecture school. This gives them faith in what is known as the “physical fallacy,” the idea that urban design has a huge influence on human behavior.
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