Annals of the Great Recession XVI, Legacies.

In theory, the American economy is doing well.  Unemployment is at the lowest level in this century; corporations are investing, and there are signs of increasing consumer spending.  Fine.  However, there are also reasons to be concerned.  One is the “flattening of the yield curve.”[1]

The United States government borrows money by selling bonds (Treasury notes).  Basically, bonds are IOUs + Interest.  These Treasury notes run for different periods of time and pay different rates of interest.  Long-term bonds run for like 10 years, while short-term bonds run for like 2 years.  The long-term bonds pay higher interest (called “yield”) than do short-term bonds to account for inflation.  When the economy is growing strongly, prices will tend to rise.  The gap between the yield for long-term bonds and the yield for short-term bonds is called the “yield curve.”

If people think the economy will grow, then they will put their money in stocks and the Treasury will have to pay higher interest on its long-term bonds.  If a lot of people want the security of long-term bonds, rather than the risk of stocks and don’t fear inflation, then the Treasury won’t have to pay as much interest.

Then there are the banks.  They borrow money at low short-term rates and lend it at higher long-term rates.  That’s how they make a profit.  If short-term rate approach long-term rates, it pinches their profits.  If short-term rates exceed long-term rates, they actually lose money.  So, they stop borrowing and lending.

Here’s the thing.  The gap between long-term and short-term bonds has been closing.  This is called “the yield curve flattening.”  A year ago the gap was 1 percent; three months ago it was 0.5 percent; in early July it fell below 0.3 percent.  Interest rates for long-term bonds has not been rising much, while the rates for short-term bonds has continued to rise.  This suggests that bond-traders do not expect a lot of inflation, which suggests that they have doubts about future economic growth.  At some point, the yield for short-term bonds could rise above the yield for long-term bonds.  When this happens, the yield curve is said to be “inverted.”  Economists interpret an inverted yield curve as “a powerful signal of recession.”  Inversions have come before every recession and one near-recession since 1955.  However, the time lag between an inversion and a recession can stretch from six months to two years.  So, we aren’t there yet.

The huge number of bonds that central banks acquired to push down long-term rates during the period of “quantitative easing” are continuing to weigh on the long-term rates.  Now the Federal Reserve Bank is raising short-term rates to prevent excessive price rises in a strong economy.  There is mounting concern that policies being pursued by the Federal Reserve Bank could harm the economy by pinching off lending or by pushing banks to pursue riskier strategies.[2]    On the other hand, there is evidence that, in the wake of the “Great Recession,” the yield curve has lost some of its predictive power.  Moreover, a strong American economy coupled with a slowing world economy could push foreigners to buy long-term bonds.  The issue at hand is whether the Fed should continue to raise short-term interest rates as planned.  The stakes are high.

[1] Matt Philips, “A Recession Signal Is Flashing Yellow,” NYT, 27 June 2018.

[2] Nick Timiraos, “Fed Debates Signal From Yield Curve,” WSJ, 9 July 2018.

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The current explanation.

Back in 2000, the Clinton Administration held a conference to congratulate itself on its skillful economic management.[1]  The participants foresaw the opening of a new era of rapid economic growth.  Low inflation would run in tandem with stable growth in what some saw as a “Great Moderation.”  Markets behaved rationally most of the time.  Technological innovation increased labor productivity.  Increasing international trade through agreements like the North American Free Trade Agreement expanded high-end American exports while providing American consumers with low-cost imports and stimulating the shift of factors of production (capital, labor) out of low-end industries.  China, in particular, tantalized businessmen and economists alike.  More education and geographic mobility offered the best means for displaced workers to adapt.  Investors faced a host of “staggering high-quality investment opportunities.”  Central bankers could manage the economy with relatively small changes in interest rates.

Like many another rosy dawn, this one failed to arrive.   The host of “staggering high-quality investment opportunities” turned out to be the “tech bubble” that collapsed almost as soon as Bill Clinton handed the White House keys to George W. Bush.  “The China Market” turned out to be just as much of an illusion now as in the past.[2]  Indeed, China’s enormous labor force multiplied by rising productivity multiplied by low wages created an export giant unlike anything ever seen before.  (A 2016 paper by three economists calculated that between 1999 and 2011, Chinese competition ate up 2.4 million American jobs.)  The financial crisis at the end of the Bush administration showed that at least some markets were far from rational and self-correcting.  More education has not guaranteed a better adaptation to a changing economy, while fewer start-ups are creating new businesses and many displaced workers have been reluctant to relocate toward growth areas.  Technological innovation has destroyed far more jobs than it has created.  Indeed, one economist argues that there is a shortage of investment opportunities to provide either an outlet for savings or new jobs.

The rewards of economic change have flowed disproportionately to the upper levels of American society.  In 1990, the top 20 percent of families earned 44.3 percent of total income.  In 2014, the top 20 percent of families earned 48.9 percent of income.  In 2000, wages, salaries, and benefits accounted for 66 percent of Gross Domestic Product (GDP), while business profits accounted for 8 percent.  By 2010, wages, salaries, and benefits accounted for 61 percent of GDP, while business profits have now risen to 12 percent.  Between 2000 and 2015, median family income fell by 7 percent.  One recent poll reported that 91 percent of Bernie Sanders supporters and 61 percent of Donald Trump supporters think that the economy favors powerful interests.   (More likely it favors certain skills and behaviors, but no one is buying that line.)

Those job losses and income shifts now are having a political effect.  Of the 100 counties with industries worst hit by Chinese competition, 89 voted for Trump in the primaries.  Of the 100 counties with industries least hit by Chinese competition, only 28 went for Trump.   Faced with losing their own jobs, many Republican leaders are re-thinking their positions.  A former Treasury official in the Bush II administration reflected that “Washington and we in the establishment spent too much time celebrating the efficiency gains of trade and not enough time thinking about the people who were impacted.”

[1] John Hilsenrath and Bob Davis, “Unkept Economic Promises Drive Stormy Election,” WSJ, 8 July 2016.

[2] “If every Chinaman would add eight inches to the length of his shirt it would take all of the cotton cloth that we have in America, because they all wear them on the outside.”  Proceedings of the … Annual Convention of the Investment Bankers (1919), p. 71.

Annals of the Great Recession XIII.

A couple of polls from back in late 2015 may give some indication of fundamental beliefs that will play out in the general election in November 2016.

Back in September 2015, almost half (49 percent) of Americans saw the free-market as the best escalator out of poverty, while a mere 18 percent disagreed.[1]  That still leaves a disturbing 33 percent “not sure.”  Similarly, when asked if the American economic system gave everyone an equal chance to succeed, 52 percent said that it did, while 45 percent said that it did not.[2]  This second report is bizarre.  Do most Americans really believe that the children of upper middle class suburban whites have an equal chance to succeed as a fifteen year-old black girl living with her mother or grandmother in North Philadelphia?  Perhaps it depends on the meaning of “success.”  No two people have an equal chance to end up in the same place, but perhaps they have an equal chance to improve on their starting position.  Perhaps it reflects a belief that people don’t have an equal chance, but that if you admit that there is a problem, then the Democrats or Republicans will come up with some new scheme that doesn’t work any better than the previous ones.  In any event, faith in capitalism has been undermined—by capitalists.

Just under half saw the economy as good, but a plurality saw it as stagnating.  That is, the country had recovered from the “Great Recession,” but it wasn’t moving forward to new heights.  Why was it stagnating?  Not for the reasons that Bernie Sanders might think.  On the issue of government regulation’s impact on the economy, 54 percent said that it posed a more urgent danger than did economic inequality, while 38 percent said that too little regulation posed a more urgent problem.  Republicans and a majority of Independents believed that the Republicans would do a better job managing the economy and creating jobs.[3]  This in the wake of the financial crisis, the “Great Recession,” and Republican opposition to a big stimulus bill!  How is this possible?  Well, perhaps things like the roll-out of Healthcare,gov have made lots of people go “even those idiot Republicans would be better than these clowns.”  Democrats and a minority of Independents beg to differ.  On the question of priorities, the vast majority (61 percent) saw unemployment as a greater problem than inequality (12 percent).[4]  Since the “Great Recession,” Democratic politicians and their favorite economists have been talking about the injustices and economic problems created by income inequality.  Broadly, Americans weren’t buying it.  Get the economy growing again and the inequality stuff will go away.

Wall Street’s reputation hadn’t recovered from the financial crisis.  A large majority (61 percent) expressed Not Much (29 percent) or No (32 percent) confidence in Wall Street bankers and brokers.  Almost a third (31 percent) expressed only Some confidence.  Related to this lack of confidence in Wall Street itself, a majority (58 percent) expressed Not Much (34 percent) or No (24 percent) confidence in the ability of the federal government to regulate financial institutions.  Again, almost a third (31 percent) expressed only Some confidence.  Perhaps this is one source of the distrust and unpopularity of Hillary Clinton?  We know that the Republicans are sold to the big money, but it’s disconcerting to see the guardian of Main Street “walking hand in hand with the one I love.”[5]

[1] Tim Montgomerie, “A Fading Faith in Capitalism,” WSJ, 7-8 November 2015.

[2] Andrew Ross Sorkin and Megan Thee-Brenan, “Many Feel American Dream Is Out of Reach, Poll Shows,” NYT, 11 December 2015.

[3] Then how come Romney didn’t win?  Because, although a very nice and accomplished man, he was an incredible bust as a national level politician?

[4] Montgomerie, “A Fading Faith.”

[5] See—if you can bear it– https://www.youtube.com/watch?v=iVpqtsy1o_4

Annals of the Great Recession VIII.

When we say “investors” we naturally think of Thurston Howell III from “Gilligan’s Island.” Nothing could be further from the truth in contemporary America. Now “investors” means banks, insurance companies, hedge funds, and pension funds. Many of these investors are, in turn, owned by mutual funds. These investors had a lot of money to throw around and they wanted safe investments.[1] The banks addressed this dual problem by creating Collateralized Debt Obligations (CDO). Essentially, a CDO is a super-bond that groups together many smaller loans. So, a CDO is a big financial instrument appropriate for a big investor. At the same time, the CDO addressed the safety problem by bundling the few loans anticipated to default with the many that were expected to not default. These CDOs proved to be wildly popular with investors: $550 billion worth of CDOs were issued in 2006 alone.

For a combination of reasons, the risky, or “sub-prime,” share of mortgages greatly expanded. Rather than trying to rein-in the “sub-prime” risk, lenders relied on safety features of the CDO (many presumably sound mortgages bundled together with a handful of presumably bad mortgages). Furthermore, other companies sold insurance for the derivatives, so they seemed very safe. The market in these “financial derivatives” just exploded. Less noticed, many of the loans were also adjustable rate mortgages (ARMs) which allowed the lender to increase the interest rate charged the borrower if interest rates in general began to rise.

Then, in the second half of the 2000s the whole process went into reverse.[2] The Federal Reserve Bank raised the Federal Funds Rate from 1 percent in Summer 2004 to 5.25 percent in 2006, then left it there until Summer 2007.[3] Interest rates began to rise and housing prices began to drop. The adjustable rate mortgages followed the track of interest rates in general, squeezing many marginal home owners to the point where they could not service the mortgage at all. Defaults suddenly began to mount, leading to foreclosures, leading to a glut of homes on an already falling market, leading to a further decline in the value of all homes.

The trouble here finally appeared in the opacity of the CDOs. Once the defaults started to mount, it proved impossible to tell with any certainty how solid any one CDO was. It might be made up of mostly good loans with a few dogs mixed in. It might be a veritable animal rescue society with a few good loans mixed in. As Peter Peterson put it, “you’ve got ten bottles of water and one of them is poisoned; which one do you drink?” There was no way to tell, so people did the safe thing by distrusting all of them.

As the number of worthless mortgages inside the “bundles” of mortgages bought by investors rose sharply, the value of the securities plunged. Banks that had bought these securities as part of their capital, suddenly found their balance sheets showing huge losses. Worse still, the companies which had sold insurance on the derivatives found that they had misunderstood the degree of risk of default and did not have the resources necessary to cover their own losses. Banks started refusing to lend to other banks out of a fear that the loans would not be repaid. Suddenly, the whole financial system seemed to be on the verge of collapse.

The United States had been through this once before, in the early stages of the Great Depression of the Thirties. Inadequate government action then had led to more than a decade of hardship, misery, and political upheaval. This time would be different. Sort of.

[1] “The ‘toxic debt’ tsunami,” The Week, 20 March 2009, p. 13.

[2] “Wall Street’s hidden time bombs,” The Week, 10 October 2008, p. 11.

[3] http://fpc.state.gov/documents/organization/112465.pdf

Annals of the Great Recession VII.

All business decisions are bets on an unknowable future.[1] Faced with uncertainty about the future and the risk that some bets will go bad, businessmen have long sought to build in certainty through contracts and off-set possible losses through hedging. Commodities futures—promises to deliver a set amount and a set price at some future point—have been contracted for and traded for a long time. Commodities futures guarantee sellers a buyer and an income, while guaranteeing purchasers a product at a fixed price.

If uncertainty is one fixture of business, so is innovation. In the 1990s lenders developed a new form of betting on the future. Housing prices had risen steadily in the United States since the 1970s. Believing that housing prices were on a long-term or even permanent upward track, some lenders perceived mortgages issued today as a promise of secure returns tomorrow. Large numbers of newly-issued mortgages were bundled together into securities which were then sold to investors seeking the promise of above-market rates of return. In all lending there is the danger that the borrower cannot or will not repay the loan. The theory appears to have been that a few bad mortgages in any one bundle would not impair the value of all the other sound mortgages in the security.

Democrats wanted to bring these new financial instruments and markets under federal regulation in the same way that the Securities and Exchange Commission over-sees the stock market. Republicans defeated this effort. Indeed, Senator Phil Gramm pushed through a law which exempted such “financial derivatives” from federal regulation. Potentially, the derivative market had become the Wild West. On the other hand, it was a pretty small market in the later 1990s. What’s the worst that could happen?

The “dot.com boom” was one of the hall-marks of the late 1990s.[2] It turned out to be a bubble and the bubble popped in 2001. Then the 9/11 attacks administered a second shock to the system. Rather than put the United States through a financial crisis and recession, the Federal Reserve Bank pumped a lot of money into the economy and cut the short-term interest rate from 6.5 percent to 1 percent. Banks borrowed money cheaply, then re-lent it to others at a somewhat higher rate of interest. Pretty soon all the reasonable loans had been made, but there was still a lot of money to lend. What to do?

Make unreasonable loans, that’s what. Mathematical risk models for these loans, based on an extremely shallow historical record, predicted only a few defaults and constantly rising house prices. The usual standards for making a loan to someone were diluted. This allowed banks to lend to people and for purposes that normally would not have been acceptable. Some of it went to home loans that were labeled “sub-prime”; some of it went for auto loans, credit card debt, student loans, and commercial mortgages. In short, it financed a lot of consumption by ordinary Americans that otherwise would not have been possible.

So, the banks and non-bank financial institutions (mortgage originators) made all these loans. What to do with them? One answer would be “sit on them and collect the interest and principle until the loan is repaid, then make another loan.” Another answer would be “sell the loans (i.e. the right to be repaid by the original borrower) to investors looking for a steady income stream.” Mostly the banks chose the latter course. Selling the loans brought in cash immediately and earned fees for the banks. It transferred the assets to the “investors.”

[1] “Wall Street’s hidden time bombs,” The Week, 10 October 2008, p. 11.

[2] “The ‘toxic debt’ tsunami,” The Week, 20 March 2009, p. 13.

Annals of the Great Recession VI.

The “Great Recession” led to much head-scratching. How could this disaster have come about? Who or what was responsible? How should we proceed going forward. Many books have poured forth in an attempt to answer these questions. Four of them take a critical look at the the materialism that drives modern life. The books raise more questions than they answer. The questions are worth some thought.

People used to live with scarcity we can’t imagine.  They had to work very hard just to have enough to survive on.  Then industrialization and the agricultural revolution created abundance.  People had to work very hard to have enough, then later to have a lot of stuff.  Now people ask what to do with this abundance.  Consideration of this question can lead people into areas that will be unfamiliar to most people.

The philosopher Michael Sandel argues that people start to think of money as the solution to everything, instead of just as a situationally-appropriate tool.[1]  Moreover, “the more things that money can buy, the more the lack of it hurts.”  Economic inequality leads to experiential inequality.

The writers Robert and Edward Skidelsky identify certain “basic goods”: health, security, respect, “personality,” harmony with nature, and leisure.[2]  How much is “enough”?  Should people continue to produce and consume ever more?  What do people get out of having more stuff or more activities?  Should they make do with less to have more time?  What would they do with more time?   Among their solutions: tax consumption, not income; tax spending on advertising.  What if the prescription for the good life offered by the Skidelskys conflicts with what most people want?

Luigi Zingales argues that Americans used to think that capitalism was a “fair enough” system, even if it wasn’t perfectly fair.[3]  The economist Alan Meltzer argues that Capitalism is the only system that produces freedom and prosperity.[4]  It makes no claim to produce virtue or stability.  This means that freedom and prosperity have an ugly reverse face.  However, “corruption, fraud, and greed” are common in all other systems, and less likely to be corrected than under capitalism.  What concerns Meltzer and Zingales is the government response.

American government tends to provide benefits to selected businesses without thinking about actually helping society as a whole.  For example, the mortgage interest deduction helps the construction industry, but amounts to a tax on renting that makes it less reasonable. Similarly, subsidies for ethanol amount to a tax on regular gasoline.  Zingales thinks that both education and health-care are “protected” industries.  They need to be exposed to competition.

It also tries to control the flaws.  Very often these efforts at “reform” miscarry.  For example, government seeks to correct for inequality of result by means of paying benefits funded by debt (the obligation of future generations to pay for benefits enjoyed by the present generation) or by regulatory systems that favor present established interests over newcomers.

Similarly, people who behave immorally need to be publically shamed even when they cannot be prosecuted. Bankers have taken their share of this, but someone needs to go after the “jingle-mail” borrowers.  They decided “enough is enough” and abandoned their obligations and assets. Probably not the answer the Skidelskys and Sandel had in mind.

[1] Michael Sandel, What Money Can’t Buy: The Moral Limits of Markets (2012).

[2] Robert Skidelsky and Edward Skidelsky, How Much Is Enough?  Money and the Good Life (2012).

[3] Luigi Zingales, A Capitalism for the People: Recapturing the Lost Genius of American Prosperity (2012).

[4] Alan Meltzer, Why Capitalism?  (2012). A

Annals of the Great Recession V.

From the late 19th Century “Gilded Age” to the early 20th Century “New Era,” America lived with a lot of income inequality.[1] The Great Depression of the 1930s and the policies of the New Deal closed that range of incomes. This new order continued from the 1930s through the 1970s. From the 1980s to the financial crisis income inequality rose sharply once again.   The financial crisis and the subsequent Great Recession dented this inequality, but did not reverse it. Nor does it seem likely that it will be substantially reduced under foreseeable conditions.

The low and middle-income groups suffered limited losses from the recession in comparison to upper income groups. The financial crisis and subsequent recession hit upper income group harder than other groups; federal government responses helped lower income groups more than upper income groups, the wealthy still haven’t made up their losses, and inequality has decreased.

The one-percent suffered the largest fall in pre-tax income during the Great Recession. Between 2007 and 2012-2013, the income of the top one ten-thousandth of earners fell 26 percent; the income of the “one-percent” fell 21 percent; the income of the top five percent fell 15 percent; and the bottom 90 percent fell 13 percent. For most poor and middle-class groups, the average income decline was about 10 percent.

In 2007, the pre-tax income of the highest one ten-thousandth of earners peaked at $39.4 million. In 2009 it fell to $21 million. That’s a 46.6 percent drop in income. Most of these losses came on falling stock-prices, so the run-up of the stock market in recent years has done much to restore the income of this group. In 2012 and 2013, it reached $29.2 million. This group is back at about 74 percent of its pre-recession income. Overall, the income of the “one percent” is still about 20 percent below its pre-recession peak.

Long-standing federal government counter-cyclical policies—unemployment payments, food stamps—helped off-set the effects of the Great Recession for low-income groups. The stimulus bill helped as well. After-tax and after-transfer incomes for the middle quintile of income earners fell by 2 percent in comparison to pre-recession levels. After tax and after transfer incomes for the lowest quintile income group actually rose 2.6 percent.

These facts run against the common perception. “Maybe [people haven’t perceived this truth] because many liberals are tempted to believe inequality is always getting worse,…”

Leonhardt sees middle-class incomes as having been “damaged” by income inequality. This, in turn, “has caused wide-spread frustration.” The implications for American politics should be obvious.

It’s hard to sympathize with people whose incomes dropped from almost $40 million a year to barely $20 million a year. They’ll get by, somehow.

Nevertheless, there are issues that are worth some thought.

First, is inequality as such a durable political issue or would most people be satisfied if they experienced a moderate rise in income each year?

Second, why have upper-incomes grown so much since the 1980s while most incomes have stagnated? The answers here are likely to be more complex and the problems less tractable than the political ideologies of left and right would lead us to believe. Increasing inequality has coincided with globalization, two recessions, the aging of the “Baby Boom” generation, problems in adapting the American labor force, and political near-paralysis. What to do?

[1] David Leonhardt, “Since the Financial Crisis, A Little Less Inequality,” NYT, 17 February 2015.