Before the rate cut, the FTSE, London's benchmark for stocks, was off by 8%. It rebounded this entire amount, buoyed as well by a part nationalization plan of the banks. The rest of Europe followed a similar track: an opening that was straight down, and then a bounce at the moment of the coordinated rate cut. Germany's stock market bottomed at 4,870.20, down nearly 10% before bouncing back to be down a bit over 1%. In the time it took to enter this diary, the markets have resumed the downward plunge. A depression is when the central bank can't give money away, and we are very nearly at that point.
This has caused Martin Wolf has changed his mind:
As John Maynard Keynes is alleged to have said: “When the facts change, I change my mind. What do you do, sir?” I have changed my mind, as the panic has grown. Investors and lenders have moved from trusting anybody to trusting nobody. The fear driving today’s breakdown in financial markets is as exaggerated as the greed that drove the opposite behaviour a little while ago. But unjustified panic also causes devastation. It must be halted, not next week, but right now.
The panic is not unjustified, it is in fact quite justified. We are discounting the last decade. It is a realization that the global decision to allow Bush to go forward with the war in Iraq was brutally stupid, and that more or less everything that has been invested in in the last decade is of no value. The markets believed, the publics believed, that a war with out consequence would not only be won, but produce a glorious economic explosion. The world may have hated George W. Bush, but they - public, corporate and private - bet very heavily that he would work out.
It is at an end. Clearly we have moved beyond an outsourced bailout backed with threats of martial law.
But the stock markets are not the economy. There is no point to bailing out stock markets as such, they reflect the expectation of earnings. These expectations can only be met by real people doing real things, and being enabled in doing them by companies that make real products. It is not that we have a crisis of confidence on top of a healthy economy, it is that we are having a global market epiphany that we have an unhealthy economy with a vastly over-valued market. As long as elites insist in believing that the economy is basically healthy, rather than basically sick, any and all attempts to print paper, flip bits, or slosh electrons will meet with abject failure. The reality is that the global economy has been running too hot for too long. The reality is that steps were taken to hide this, as leveraged bets piled up, markers and IOUs replaced any connection to real assets, and the various powers that be, from left to right of the political spectrum, refused to act correctly. They were busy fighting over the surplus of a system that was running a chronic real deficit.
The culture of deficits continues to believe that there is no problem that cannot be solved by booking profits you don't earn, paid with borrowing you won't repay, to make things that people don't really need.
The immediate crisis
While I am a believer in free markets as a tool of society, it is clear that the religion of markets, where markets are the master of society, and those who are in a few favored positions accumulate great power and influence - is a religion as discredited as the geocentric model of the solar system. You can make it look as if it works, so long as you ignore most of the data. What needs to be done now is what Bush will not do or allow as long as he is in office, namely, a nationalization of the financial system. The problem, ultimately, is not the financial balance sheets of the banks, but the people running them, and the incentives that they answer too.
This is why each attempt to stimulate fails, because it just means that people will do the wrong things longer. That's why, you guessed it, oil is bouncing off five month lows. If we let it crash, it crashes. If we don't, it means that more money flows into the hands of people who don't have any reason to fix the problem. Both lines lose.
The idea of the old age was that assets should do what they want, and that regulators should look the other way, the stochastic models of the economy sad that asset markets didn't matter. Brad DeLong calls this Greenspanism, and he admits he was an acolyte, but is now thinking anew.
When economic historians look back at this moment, they will see the obvious folly of the Bush tax program, a program the public still nominally supports. By creating a regime of unsustainably low tax rates on the transfer of money from the pool of invested risk, to the pool of personal wealth, it meant that everyone had every incentive to rush the door. They did this by finding ways of booking profits farther and farther into the future, and selling those instruments to those who thought that they were as good as gold. All of the errors of a financial panic were present:
- Allow under-collateralized and under-insured borrowing.
- Allow these to be made against public goods which are believed to be protected by collective action.
- Launder these highly leveraged and risky investments back into the system as if they were solid.
- Pyramid these profits and start over again.
The first usually requires the creation of a new kind of money, a paper that is not restricted in the old way. Paper money, stocks in their early incarnations, insurance, credit, and now derivatives, are all examples of how people who wanted to open a casino did so by moving across the street from a bank. In each case, it was learned how to use the tool correctly, but only after it had been used as a scam. In our case derivatives, which were investing without meeting margin requirements filled the first step. It also generally requires government complicity in loaning money below the real rate of inflation. When a government is giving money away, generally the first people in line are those who have some outrage against the public to spend it on.
The second was done through fraud. Loans were made on fraudulent basis, not because the people could not repay, but because the terms were made it so that it would be nearly impossible for anyone to repay and come out ahead. Home prices were systematically inflated, loan terms systematically lied about, loan quality was systematically debased, and these were sold to Freddie Mac and Fannie Mae, whose privatized stock was sold as a little old lady investment. These mortgage giants continued, for years, to lie about their accounting practices and reserves. But everyone knew that America would not throw millions of people out of their homes, and with the bankruptcy bill, which Vice Presidential nominee Joe Biden still defends, it seemed obvious that they would get their money, because the law had been changed to make sure of it.
The third was done by packaging these mortgage backed securities into Collateralized Debt Obligations, or CDOs. A CDO is not, in itself, strange. Almost everyone here has one, it's called a dollar. The United States Government taxes many different activities, does many different things, has many different assets, and the assertion is that the sum of these is more stable than any of these. The world's monetary system rests on a CDO, we call it the IMF. However, instruments should be no more complex than the activity that they mirror. It is one thing to have a complex financial instrument when writing a bond issue to redevelop an entire city with a hydro-electric plant and industrialization program with housing and infrastructure. It is another thing to turn people's houses into complex financial instruments beyond what is needed.
And it is yet another thing still to create complexity for the sake of complexity.
These complex objects then needed to be insured. The way to insure them was by issuing what are called "Credit Default Swaps." A CDS is an insurance policy for a bond or other interest bearing instrument. The idea is that if the borrower does not pay, then the entity that sold the CDS would. But under-collateralization and fraud are here too. Who said who could issue a CDS? No one. It would be like setting up a lemonade stand and selling medical insurance policies.
The last then was to then turn around, have investment banks buy and sell these, and book the profits. Many of the CDS's out there will never see another payment made on them. Imagine you are a insurance company, and you want to buy the value of an insurance policy that another company issued. You would look at the risk of paying out, and the stream of payments that are yet to be made. Yet many CDS were made as one off payments, they are never going to be paid on again. This is why they are referred to as "toxic waste," because the best that can happen is that they don't default.
In our case, the repeal of Glass-Steagall was the crazy plunge into the matrix of fake money being mixed with real money.
But the last key step is that they were recycled back to petrodollar investors and the money used to buy oil, and this to build another round of houses, starting the cycle all over again.
This cycle, an accelerated version of the paper for oil economy, is the root problem. This cycle is not merely a paper cycle, and cannot be fixed by paper means. It is rooted in the basing of value on hard assets, which therefore means that buying hard resources drives the financial incentives. To fix the problem is to break the cycle. Financial regulation can be put in place to block the pyramiding and the profiteering, but that means we will drive over the cliff slowly and wearing our seat belts.
This means that in the short term, financial fixes without restrictions on economic activity and redirection of economic activity, will fail. This is because each attempt to stimulate the economy and restore confidence will make it so that people go back to doing what created the problem in the first place. The problem is that there is not enough oil on the planet to keep everyone happy, and there is not enough money on the planet to pay back the promises made in the form they were made. Thus a financial fix uncoupled with rationing of bottleneck resources, will fail, since we will be back in this position shortly, with more bets made than money in the casino's vaults.
America had a war time boom without a war time regime of economic direction of effort. Since we were not serious about winning the two wars we were fighting, we lost them both.
This situation, where a war created the incentive for cheap money, to finance the war, was exactly what was seen in World War II. Interest rates were kept low, because the government was borrowing more than GDP. Essentially, the government was the economy during the war. This is how we churned out aircraft carriers the way other nations could make planes. We won that war. But as John Kenneth Galbraith notes, interest and activity were heavily regulated, so that really only the government could make use of those low rates.
The failure to ration then, combined with the failure to regulate, or even enforce such few regulations as were present, created the acute crisis.
The immediate action required is a raising of top marginal income tax rates, a large insurance fee on mutual fund deposits, and a large financial transfer tax to prevent a flight to the mattress. Only once this is done will the ability of large players to withhold liquidity in hopes that stock prices will fall farther, be broken.
The Greening of the American Spirit
However, while austerity to counteract inflation, and dropping interest rates to nominal levels is the first step, it must be met with a second one, namely expansion.
We read a great deal about Energy Independence. This will mean "Drill, Dig and Burn." There is no way to get to energy independence in the current economy without burning coal, drilling for non-conventional hydrocarbons, and burning all of them.
But this looks at the problem through the wrong end of the telescope. The reason we have the economy we have, is because it follows the path of least resistance of the hydrocarbon and analog electrical tools. If the great technological win is an internal combustion engine, then the way to riches is to harness one to do something. We have motors stuck on toothbrushes now.
The reason creating clean energy will not work as the first line of attack on the problem is that clean energy is simply a more expensive way doing what we are doing now. But what we are doing now isn't making us that happy. Americans can slice a huge fraction of what they do, but as importantly, we are not making ourselves happy. America does not need another McDonald's.
To green the American economy means starting at the other end: to change the things that people can buy, and the ways that they achieve happiness. This means that many shibboleths of the past must fall. It does no good to "cut taxes" if people will just go back to buying what they did before. In fact, the reality is that taxes must be dramatically increased, because the government is already bleeding money, and does not command a sufficiently large share of the national effort. If we wait for a World War II to do this, then it will come with the price tag of millions of dead. If we allow people to believe that they can go back to burning oil to make hamburgers, and then sell paper backed by the idea that a century from now they will still be eating hamburgers, then the only result will be a war for the dwindling sources of oil, and then facing the catastrophic effects of global warming.
It must be this that will be the direct project, not "alternative energy," but a new happiness and new goal for economic activity itself. We must remember that money exists in the real world. Money means what we say it means, and it exists because of its utility, not it's God given certainty.
In a few weeks the election will usher the Pillsbury dough boy and his all moose orchestra from the stage, despite their appeals to naked racism and bigotry that are falling flat, and quite possibly deliver the Democratic Party the constitutional super-majority of 60 seats. It will be a vast coalition from Bernie Sanders on the left, to senators that will have to come from Mississippi, Kentucky, and Georgia. But in a very real sense this coalition's first fact to face, is that they are all far too far to the right. The era of Thatcherite "TINA" - there is no alternative to unrestrained markets - is over, and we are now faced not with the short term problem of avoiding this financial meltdown, but the long term problem that the paper for oil economy is dead, because the oil for happiness economy is no longer the future in America, or much of the developed world.
We cannot want black things by green means, and get a green economy.