There have been a lot of dire predictions about our economy. To believe the most dire, worthless credit default swaps now equal at least half of the entire world's GDP and we're about to see a complete collapse of civilization as we know it, perhaps even a third world war fought with nuclear weapons as desperate nations fight for the last scraps of wealth. We've heard a lot of doom-mongering lately, including here on DKos.
President Obama's proposals so far certainly don't add up to the total measure of the problem. But how far short are they? And the political limitations of what he can get through Congress aside, might his team have a diagnostic purpose in proceeding incrementally?
Note: the solution to this week's Kossaku is in today's tip jar.
More below the fold....
Where is the bottom?
Google "economy in free fall" and you'll get 91,000 hits. From the Washington Times to the National Journal to National Public Radio, "free fall" has become the nom du jour for the world economy. And it's not pure hype. Unemployment, bankruptcies, home foreclosures, and consumer interest rates are rising. Businesses are closing, cutting jobs, or cutting employees' hours. States and cities are cutting services. The stock market is still soft, and the financial markets are still choking on toxic assets.
To believe the direst predictions, this heralds the end of civilization as we know it. Markets will continue to fall, the European Union will come apart, and wars will erupt as countries and people fight over the last few scraps of wealth. Revolutions will erupt, perhaps even here in the U.S., as either the hungry and homeless revolt against their overlords on Wall Street, or arch-conservatives revolt against socialism government in Washington, or both.
Resourceful doom-mongers can even cite statistics to back their claims. Credit default swaps (CDSs) are estimated to total $33 trillion, against a world GDP of about $60 trillion. If they all fail at once, that's half the entire world's annual economic activity ... gone. It sounds very dire indeed.
Confidence is not enough.
Some have argued that President Obama needs to sound a more confident tone. If people just believe things will get better, things will, or apparently so the notion goes. But as Paul Krugman said last night on Countdown, that's not true:
Unless fundamental flaws in the economy are fixed, merely boosting our confidence won't suffice. And Krugman believes Obama is suffering from "a failure of nerve" in not nationalizing the failing banks.
Krugman may be right, but there's another possibility as well. Setting aside the political realities of having to move legislation through the Senate over likely GOP filibusters, there may be another reason Obama's economic team are proceeding slowly. They may be trying to use market signals to find out how deep this well goes.
The birth of a storm.
There is fairly widespread agreement that our economic crisis began with an over-leveraged, hyper-inflated housing market. Mortgage companies were pushing novel products on homeowners, who were using those products to either buy houses above the traditional income-to-price range, or to extract and spend the speculative equity in the house they owned. I say "speculative equity" because home equity is a guess: you don't know how much your house is really worth until you sell it.
Banks and bond rating agencies were assuming a perpetual 7% annual rise in home values, and leveraging Collateralized Debt Obligations (CDOs) and other derivatives against that assumed equity growth, with everyone - homeowners, mortgage companies, banks, and the purchasers of CDOs - assuming the vast majority of homeowners would either pay their mortgages, refinance if the payments were too steep, or sell the home on that perpetually rising housing market.
But median family incomes were not keeping pace with the rising home prices. Indeed, median family incomes had been stagnant for years, and it was only a matter of time before the gravy train of debt ran dry and people began to default on mortgages. Foreclosure sales usually yield below-market prices. A wave of foreclosures thus both fails the holders of securities backed by those mortgages, and deflates the housing values on which other mortgage-backed securities rely to show a profit.
Simply, when housing prices did not continue to rise fast enough, CDOs keyed to 7% annual growth lost their expected value. Other instruments like CDSs that hedged against failures had to pay off claims at higher-than-projected rates, driving down their values as well. Because too many of those speculative instruments had been over-rated by agencies like Moody and Standard & Poor, many institutional investors like pension funds and municipalities were holding very risky paper they'd thought to be safe, investment-grade bonds. A hiccup became a hurricane.
Economic sonar.
Simplistic answers like writing off all CDOs and CDSs aren't practical. First, most Americans are still paying their mortgages, so most of those securities will still show some return over time. But more important, those securities are not all held by financial fat cats who can afford to take the loss. Most were marketed as AAA-rated bonds and sold to pension funds and municipalities, here in the U.S. and around the world. The securities' complete failure would leave workers and retirees without pensions, and cities and towns bankrupt and unable to provide for their citizens. Those are ordinary working people who can't afford to "just write it off."
Those securities are not worth the highly-inflated returns they were touted to provide. But they're not entirely worthless either. They reflect a lot of pseudo-wealth - gambling on others' activity - but they reflect some real wealth as well. Most are backed by homes that people can and do live in, in communities that could and probably will provide jobs and real economic activity once this crisis is resolved. And many of the CDSs are bets against each other; like a bookmaker's betting list, the winners pay off the losers, less the bookie's (in this case bankers') vigorish for managing the bets.
In that perspective, President Obama's housing plan may be an attempt to use market signals to figure out the true value of homes, mortgages, and the mortgage-backed securities. By slowing foreclosures and encouraging mortgage companies to negotiate terms homeowners can pay, the market gets valuable information. How much is an 1800 square foot home in a given community really worth? What can the average homeowner really afford to pay for it? How many of the homeowners in that community were flippers or buying above their income levels, versus good-faith buyers who can and will keep their homes?
Because the unregulated mortgage industry was so rife with fraud - the new FBI report is staggering - it's impossible to know the answers to these questions from examining the existing paperwork. An estimated 80% of that fraud was initiated by mortgage brokers who inflated applicants' incomes and/or under-reported their debts, in order to get the mortgage fees. With that much disinformation in the market, the only way to tell what's real and what isn't is to encourage mortgage companies and homeowners to work out new, fully-documented agreements. The money the government is investing to subsidize those agreements is money spent to gain information: to use those negotiations as economic sonar to see where the bottom is.
A light hand may be better.
The Republican mantra of relying on the "invisible hand" of capitalism to gain that information carries grave risks. No hand on the wheel, at this point, lets the markets careen and hurt people that needn't be hurt. But there is some wisdom to the notion that government intervention can skew the market. Doing too much too fast - more than ultimately was necessary - can be as bad as doing nothing at all. And it comes at the expense of public debt that inhibits future government acts.
It may be that President Obama and his economic team are trying to strike a careful balance, using a light hand to get better information on scope of the problem - to see where the bottom is - and find out how much more intervention will be needed to soften the landing. This can also lessen the risk of reinflating the bubble, only to see it burst again. Knowing just how much American homes are worth, then estimating price changes based on historical factors like median family income, migration for new jobs, etc. can help peg a more reasonable value to CDOs and the other mortgage-backed securities. Knowing the real worth of those securities lets banks, pension funds, municipalities, and investors know how much real wealth they've lost and plan accordingly.
And quieting the doom-mongers benefits us all. Panic and reason are not good colleagues. We need more of the latter and less of the former.
Happy Thursday!