What Ails the American Economy?
28 Feb 2009 | By Kevin Phillips, Barry Gewen
What Ails the American Economy?
Everything, and There’s Worse to Come
At a time when the Cassandras of finance are looking like realists, there is no gloomier prophet than Kevin Phillips. The author of 13 previous books including at least one classic, “The Emerging Republican Majority,” Mr. Phillips sees a perfect economic storm coming. The final pages of his bleak new book, “Bad Money,” tell of an “unprecedented” number of Americans planning to leave the country or thinking about it. Readers of “Bad Money” may come away with a similar impulse to flee.
Mr. Phillips begins with an overview of the current debt debacle. The 1980s were the start of “three profligate decades,” when the expansion of mortgage credit and the invention of financial instruments like collateralized debt obligations (C.D.O.’s) led to an orgy of leveraging and irresponsible speculation. The Federal Reserve kept the bubble afloat with easy money, while regulators and ratings agencies looked the other way.
By 2007 total indebtedness was three times the size of the gross domestic product, a ratio that surpassed the record set in the years of the Great Depression. From 2001 to 2007 alone, domestic financial debt grew to $14.5 trillion from $8.5 trillion, and home mortgage debt ballooned to almost $10 trillion from $4.9 trillion, an increase of 102 percent. A crisis in the mortgage market in August 2007 brought the party to an end. Since then we have been living in a twilight zone of what a security analyst quoted in the book calls “one of the slowest-moving train wrecks we’ve seen.”
The second component of the perfect storm is the upheaval in the oil industry. Domestic production peaked in 1971, and there are signs that production worldwide is also peaking. (Mr. Phillips cites experts who believe it already has.) And with the emergence of new economic powers like China and India, demand has risen dramatically and prices have been climbing steadily; by 2004 a rapidly growing China had become the second largest oil consumer, after the United States. Despite the bad news at the gas pump, however, America has actually been getting a cost break, because the major suppliers price their oil in dollars. But with the dollar falling, OPEC has been talking about moving into other currencies. Were that to happen, “the effects,” Mr. Phillips says tersely, “could be painful.”
Finally, Mr. Phillips turns to what he terms America’s “calcified” political system. We may need new regulations to deal with the debt mess, along with an energy policy to address the changing world of oil, but Washington, he says, has become dedicated to “the politics of evasion,” reluctant to pass dramatic reforms or to call for sacrifice from the public. Democrats and Republicans alike are so entrenched, so dependent on campaign money and special interests, that “the notion of a breath of fresh air has become almost a contradiction in terms.” Instead of a “vital center” in Washington, we now have a “venal center.” Mr. Phillips holds out little hope of improvement from a new president; he doubts that any administration could do much, even though “the crisis is no longer in the future, but upon us.”
Is such pessimism justified? Mr. Phillips says he is making no predictions, but that’s not quite true. Throughout his book he tends to lean on the darkest analyses, though others might be less grim. And as readers of his earlier books know, he has a penchant for seeing parallels between the current situation in the United States and the declines of 17th-century Spain, the 18th-century Dutch Republic and early-20th-century Britain.
But historical comparisons are always dangerous playthings (remember all those foreign-policy analogies to Munich?): you necessarily have to cherry-pick eras and evidence from history’s panorama. Perhaps there are similarities in the financial arrangements of monarchical Spain and democratic America, as Mr. Phillips says, but the differences between the two societies are far greater. It’s hard not to feel that Mr. Phillips’s argument has been shaped not only by his facts but also by his temperament.
Still, even if his pessimism doesn’t seem wholly warranted, a sense of foreboding surely is, which is why his warnings have to be taken seriously. Mr. Phillips writes that the inventors and marketers of the new financial instruments didn’t entirely understand them. An executive of Fidelity International says a panicky feeling has set in on Wall Street because no one knows where the risks really are. The finance minister of France observes that investments may have reached such a level of complexity that no one can assess them. And Charles R. Morris, in his own gloomy book, “The Trillion Dollar Meltdown,” reports that even Citigroup’s chief financial officer “did not know how to value his holdings.”
The screenwriter William Goldman once declared that in Hollywood “nobody knows anything.” When Wall Street begins to resemble the American Dream Factory, it’s a safe bet that something has gone terribly wrong.
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Do Paulson and Bernanke Doom McCain’s November Chances?
By Kevin Phillips
If his new plan remains afloat, Treasury Secretary Hank Paulson, from the Wall Street wing of the GOP, may well have doomed the November chances of John McCain, the presidential nominee of this month’s Main Street-oriented Republican national convention. By promoting the mother of all financial bail-outs, Paulson has all but mocked McCain’s recent anti-bail-out rhetoric, as well as whetting the Arizona Senator’s slowly growing awareness that Wall Street misbehavior and greed and the year-long Paulson-Bernanke string of botched policy and rescue missions have been a disaster for 1) the United States and 2) what’s left of Bush and Republican credibility.
McCain has never been much on economics, but Paulson’s indicated arrangement with the Democrats—financial firms will get to turn in the toxic debt and financial instruments they can’t peddle for reimbursement by an American taxpayer-funded entity—is so bad that if the former Navy pilot grins and accepts it he will look like a wobbler and a Grade A sap. He’s already lost the edge he had coming out of the Republican convention. Barack Obama, by contrast, can get away with being evasive because the Democrats look like they’re accepting a measure principally authored and promoted by Paulson and Federal Reserve Chairman Ben Bernanke.
Now for a little bit of background. We’re not just looking at a real estate mess. Over the last quarter century, the total of public and private credit market debt in the United States—most of it, in fact, is private—has more than quintupled from $8 to $48 trillion, the biggest such orgy in world history. Over that period, domestic financial debt - the money borrowed by the financial sector for expansion, consolidation, empire-building, leverage, exotic mortgages, gambling, you name it - swelled from just $1 trillion to some $14 trillion. Employing these economic steroids, the financial sector ballooned itself from 14-15% of what back in the mid-1980s was the Gross National Product to 20-21% in 2004 of the newer Gross Domestic Product calculation. In the meantime, the once-dominant manufacturing sector fell far behind, dropping to just 12% of GDP. In a nutshell, the economy has been hijacked in recent decades by the very groups who now purport to have remedies - Wall Street, from whence Paulson emerged, and the money-bubbling, don’t regulate the dangerous practices Federal Reserve Board, from whence Bernanke comes.
The public is finally starting to understand what’s been going on in this perverse milieu of Wall Street socialism where private individuals get the profits and the taxpayers underwrite the bail-outs. It has a long history; in Bad Money I have a chart that lists fifteen or so rescues over some 25 years. Finance has now grown into an octopus, with dozens of debt, speculative, credit card, mortgage, interest group and Washington lobby tentacles that will lock onto any new bail-out proposal and turn it into another food supply. Even as the new “legislation” is being drafted, you can bet all the lawyers, lobbyists and big donors are already on the phone to key people in Congress, the White House, the Treasury and the Federal Reserve. Anybody with a good nose can almost smell the fixes and corruption, and of course, political critics and the public will be told that there’s just no time for debate, no time to go over the details. Don’t pass it tomorrow, pass it yesterday. We can assume that George W. Bush will sign it, possibly with a fleeting smirk.
Will this bail-out solve the current mess? Of course not. For the last year, Paulson and Bernanke have been Fumble and Bumble. They won’t strike at the roots of the problem - indeed, one could almost say the two men represent those roots - so their rescue gimmicks fail and the crisis extends and deepens.
Ironically, the best hope for resistance comes not from the left but from free-market elements of the Republican Party. I have not had much good to say about the GOP for years, but recent events may hint at their political and ideological renewal. Sometime back, when Congress passed the Fannie Mae and Freddie Mac bail-out program, Senator Charles Grassley of Iowa, the ranking Republican on the Senate Finance Committee, ultimately voted against it. He had worked on its early stage, but ultimately voted no because seeing a pay-off to “Wall Street and K Street (the Washington lobbyist corridor)”. Then the Republican National Convention, in a rejection of Bush, Paulson and Bernanke, put an anti-bailout section in its 2008 platform. A few days ago, the ranking Republican on the Senate Banking Committee, Richard Shelby of Alabama, called on the Fed to reject bail-outs and allow the markets to work even if the consequences are “brutal.” And on September 18, a hundred Republican members of the House of Representatives sent a letter to Paulson and Bernanke requesting that the two men “refrain from conducting any additional government-financed bail-outs for large financial firms.”
I suppose there’s a chance that McCain could decide to oppose the administration and truly fight this latest round of Wall Street socialism. Maybe instead of asking George W. Bush to fire SEC Chairman Cox, McCain could come out against Paulson and Bernanke. But the odds are much greater than an embarrassed McCain will flounder toward November defeat.
That would mean that the anti-bail-out forces in Congress and at the grassroots will take over the national party helm in 2009, and it’s not too late to start right now. If they strike a tough stance in the next few days, they could expose, delay, amend and even block—by any available means—what amounts to a massive mutation and even perversion of the U.S. economy. The leader of the hundred House Republican conservatives, Congressman Jeb Hensarling of Texas, summed it up quite neatly: “Enough is enough. It’s time to bail out the American taxpayers from bail-out mania.” Hopefully, we’re looking at a September battle cry.
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Why Wall Street Socialism Will Fail
By Kevin Phillips
Socialism, we are told, is the naiveté of youth, and a fallacious economics the United States has luckily spurned. The late Seymour Lipset, an well-known academician, penned a book in 2001 entitled It Didn’t Happen Here: Why Socialism Failed in the United States.
Alas, nobody ever told the leaders of American finance. Whereas the old style of socialism elected no more than a handful of mayors and congressmen, Washington has now embraced a new variety that could not be more different in its class consciousness and privileged sponsorship.
I am talking, of course, about the collectivization of financial risk being promulgated by the Federal Reserve Board and the U.S. Treasury Department and applauded in pin-striped precincts from Park Avenue to Pacific Heights. Described as Wall Street Socialism by the gauche and more precisely identified as the “socialization of risk” by sophisticates, the new fashion leaves the profits of finance in private hands as of yore. It is only the “risk”—of collapsed currencies, flawed speculation, busted hedge funds or the greedy misjudgments of large banks or brokerage firms—that is quietly taken up by government entities and all too often shifted to taxpayers who do not understand the pompous phraseology but know full well that Washington will never bail out their hardware store or the widget plant where their son works.
This has been going on for decades—a major reason why finance has grown and prospered so much compared with most other industries. But it’s only been so boldly and shamelessly embraced in the last few weeks. The Federal Reserve insists that “inter-connections” require rescuing large institutions that might knock down other entangled financial dominoes. However, these would not have been so cocky or so inter-connected in their web-spinning if the Fed had not allowed so much greed and gamesmanship for so long. Ex-Fed Chairman Alan Greenspan is often singled out as a culprit, but most of what he did was what most of the financial sector wanted. They, too, loved making 4th of July speeches about the glories of free enterprise and free—market profits while counting on the government to collectivize the perils of risk. Big, fat and dumb financial institutions could count on being big, fat and bailed-out.
There was a time in the annals of American finance when this kind of practice would have been unacceptable—indeed, serious economists like Joseph Schumpeter recognized that “creative destruction” was part of a vital capitalism. Painful as the depression of the early 1930s was, its creative destruction so revitalized U.S. finance and enterprise that by 1950, the U.S. economy was the kingpin of the post-World War Two world, vital and vibrant.
Even the sharp 30% Wall Street correction in 1969-1970 turned out to be a financial purge that refreshed. In the period between 1969 and 1970, the twenty-eight largest hedge funds saw 70 percent of their assets disappear, and roughly one hundred brokerage firms were acquired or disappeared. Then came the 1980-82 period, when Federal Reserve Board chairman Paul Volcker broke the back of runaway inflation by putting the stock market and the U.S. financial system through the wringer with interest rates that hit a brutal 18 percent. Adjusted for inflation, the Dow-Jones Industrial Average lost some nearly half of its value between 1978 and its bottom in the summer of 1982. Business Week even ran a famous cover story on “the death of equities.” However, far from falling into a grave, equities rose for two decades in what became the biggest bull market in American history.
But this is where Risk Socialism began to rear its head. The dangers of creative destruction in the marketplace were rejected. Bail-outs and government intervention became the norm. Big investors were upheld through everything from foreign currency bail-outs to the rescue of major banks. In 1998, the Federal Reserve arranged a bail-out of a well-connected hedge fund and now in 2008 it’s katy-bar-the-door in Washington aid for the financially undeserving. And hardly anyone stops to figure out that the quarter-century suspension of anything resembling creative destruction or traditional market forces is the culprit. The inevitable chimera of economic collectivization is coming undone.
Will ordinary Americans pay much of the price? Almost certainly. Should they blame what happens on marketplace forces? No, because the historical operation of such forces has been stymied and suspended. Should they blame the political and financial proponents of Risk Socialism? Yes, because the longtime genius of American capitalism may be on its 21st century deathbed.