A Fine Mess

The most frustrating aspect of living through the economic woes of the early 2000’s (aside from how badly it messed up my career path in Computer Science) was watching the limp, tepid response of the Bush Administration to it. The “voodoo economics” that had become passe by the time Bush Sr. was elected were back. The Bush tax cuts barely touched the middle class, and instead were driven towards millionaires and big businesses – and the millionaires were investing the money in big business, while the businesses were investing the money in factories and call centers in other countries. The war in Iraq, too, was of little assistance domestically; unlike World War 2, there was no draft to boost the demand for labor nor did the government repurpose idle factories for the war effort. The only useful tool employed by the government were interest rate cuts, which spurred consumer borrow-and-spend habits that drove up the demand for housing. OK, they extended unemployment benefits too, which is always a good idea during a recession, but that just softens the impact, it doesn’t stimulate growth. The other demand-side tool employed by the GOP was their prescription drug plan, which was a disaster of waste and inefficiency, wholly ill-equipped to deliver its benefits to its intended recipients.

Without any meaningful effort towards job creation, interest rate cuts were left to shoulder the burden all alone. Had a blended approach been taken, we’d have considerably more flexibility to use interest rates in treating the current economic flop. Instead, the utility of interest rate cuts was stretched to the breaking point; they provided a mild boost to the economy and mildly increased inflation; however, real wages remained stagnant. The effect was to basically give America a bigger credit card – people spend more but earned the same amount of money, a condition which benefits both big and small businesses in the short term but ultimately leads to a debt burden that chokes off further spending.

The truth is, none of this would have been enough to bring the economy out of the tank in the mid-2000’s if it weren’t for the Mortgage Snowball.

1. Low interest rates lead to more mortgage loans and home equity loans, and a favorable environment for subprime lenders.
2. This leads to more home-buying, home-building, and home improving.
3. This leads to rising home prices.
4. This leads to housing speculation, which pushes prices and profits up further.
5. This drives up the supply of mortgages for use in mortgage-backed securities.
6. Investment banks make a ton of money by carving up subprime mortgage-backed securities and calling the least risky portion (of a very risky porfolio) AAA safe. In other words, they lied to consumers, in the same manner of “light” cigarettes.
7. Alan Greenspan and the GOP champions of deregulation allow this to happen.
8. So do the independent ratings agencies, which are complicit in the scam.
9. Investment banks know they are selling crap, so they sell Credit Default Swaps on these subprime mortgage-backed securities so wise investors can profit when they inevitably fail. This doubles the amount of profit the banks have now, and doubles the amount they’re going to lose when the loans fail. They justify this suicidal route by assuming housing prices will rise forever and demand for mortgages will never ever abate. This is stupid, why do they do it? Likely because people act irrationally when they are making piles of money – they delude themselves into thinking the good times will never end.
10. Thanks to Phil Gramm and the Commodity Futures Modernization Act of 2000 (which also created the Enron loophole that worsened the first recession of the decade), Credit Default Swaps are unregulated, meaning that the investment banks don’t need to back them up with the assets necessary to pay on them when securities default. In fact, they can offer multiple swaps on the same security. Remember how we were just doubling both the current profit and the amount of liability? Multiply that by five.
11. Buckets o’ money – spend some on lobbyists to keep everything deregulated.
12. Inflation increases, and interest rates are increased to combat inflation.
13. High housing prices and high interest rates kill off the demand for new mortgages. And the riskiest subprime loans start going bad.
14. Supply and demand – housing prices fall. Speculators walk away from their souring investments, causing more mortgage loans to fail.
15. Ordinarily, this would require a minor correction. But these loans were being sold as AAA safe investments, which were then purchased by people needing safe investments (such as pension plans). The failure of these investments panics investors, causing the stock market to tank, hurting the economy at large.
16. Ordinarily, this would require a major, but fairly ordinary correction. But the investment banks have multiplied the exposure of these loans tenfold. Billions upon billions of dollars are lost to paying off Credit Default Swaps, and the investment banks weren’t required to have the capital to absorb the loss. Mortgage lenders fail, investment banks fail, and the banks have ruined their credit so badly that the interbank lending interest rates (LIBOR) skyrocket.
17. Banks don’t have money to lend, and no one wants to give them any. Consumers and businesses seeking loans from these banks are out of luck.
18. Consumer spending tanks. Businesses lay people off. The economy enters a recession.

Underlying this cycle is the fact the wages weren’t really growing in the first place, which means in real terms, we never really got out of the first recession. And so, the only way out of this mess is through good old-fashioned Keynesian governmental deficit spending – build bridges, roads, and trains, improve the social safety nets (single-payer healthcare), send more people to college.

Except that the Bush-Cheney Administration spent all our money in Iraq. And they compounded the amount they wasted in Iraq many times over through fraud and sheer incompetence (a subject I’ll have to return to another time). And so now we face an uncertain future – will our nation have enough money to jumpstart the economy?

Only time will tell – but I am glad we have a president-elect who listens, thinks, and persuades people to work together. We’re in for a rough ride.