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Why the economy is cratering: a guide for reporters

COMMENTARY | January 24, 2008

Martin Lobel and D. Jeffrey Hirschberg break down and examine the components of the economy’s plunge and urge the press to take a hard look at how Congress and the Administration plan to deal with it.

By Martin Lobel and D. Jeffrey Hirschberg

As the nation focuses on presidential candidates and the horse race, the economy is cratering. Congress and the Administration are under increasing pressure to act quickly to stimulate the economy and demonstrate to the voters that they are trying to help. The media have a vital role in analyzing and explaining what these various proposals mean. Although it’s easy to be cynical about what politicians promise, this is one of those rare situations in which Congress and the Administration will be forced to fulfill their promises. [Congress and the President reach a tentative agreement.]

Stating the problem is easy. Enacting effective solutions will not be easy because of competing entrenched interests. Here are some guidelines to evaluate some of the more significant proposals. Keep in mind though that these are, by and large, not the long-term solutions to the underlying economic problems. Also keep in mind that most of the economic gurus on TV are encouraging people who can to save, rather than spend, which is the purpose of most of the stimuli proposals.

Housing prices are down 12 percent in some areas of the country and could go down another 20 percent or so to fall in line with historical values. Spending and consumer confidence are down because consumers cannot borrow against the declining value of their homes to keep spending. Unemployment is up. Credit card debt is increasing, as are defaults. Major financial institutions like Citibank are desperately seeking capital infusions from Saudi Arabia and elsewhere. Middle class income has declined even though productivity has increased, while the top 1 percent of the population has increased its income significantly. In fact, according to the Congressional Budget Office, between 2002 and 2005 the increase in income of the top 1percent exceeded the total income of the bottom 20 percent of the population.

All the presidential candidates and President Bush have put forth various temporary, targeted proposals to ease the economic pain. Although Congress and the Administration have been stalemated on economic issues, under pressure from the voters both will be forced to act. This is the kind of issue that is so large and so public that lobbyists will be forced to operate under the spotlight. Members of Congress who hope to be re-elected will have to justify their actions. What they do will have dramatic implications for their future and the country’s. Unfortunately, none of the proposals discussed so far deal with the fundamental reforms we need to enact, such as simplifying the tax code and cutting the deficit.

Here are some of the more important issues that have been raised:

Housing: Millions of people were encouraged to buy homes they could not afford which means, as prices decline, defaults will increase. The mortgage companies should be encouraged to extend the teaser rates they extended to subprime home owners who can afford those rates, but not the increases. This will avoid expensive legal problems and cost the mortgage industry less than foreclosing while encouraging homeowners to maintain their homes. It will require modifying the bankruptcy code and lending rules. Although it will be difficult, those subprime homeowners who cannot afford even the teaser rate should be allowed some time to find other housing that makes more economic sense or allow lenders to cut their rates without adverse tax consequences. Bailing some of them out with government subsidies by, for example, extending the 8(a) housing voucher program to them would be expensive but may be cost effective. In any case, speculators should be allowed to fail unless we have decided to repeal the moral risk inherent in the capitalist system.

Derivatives[*]: Wall Street and the Federal Reserve Board loved derivatives because they generated huge fees and spread the risk of investing. Unfortunately, valuing derivatives, like collateralized debt obligations (CDOs), was an impossible task because there was no transparency. The industry argued that investors in these derivatives were “too sophisticated” to need the information that every shareholder receives. This meant that when real estate prices started declining and they had to sell their “best” CDOs to meet cash calls, the rest were unsaleable except at fire sale prices because they could not be valued with any confidence. Clearly some regulation is required. Transparency needs to be enforced so that the market can value these derivatives. Also the Federal Reserve Board and other regulatory agencies need to require that all assets and liabilities including derivatives (CDOs, CDSs, etc) are reported on the books of the financial institutions under their jurisdiction. Apparently, they didn’t learn the Enron lesson that special purpose entities which allow businesses to keep potential liabilities off their books are invitations to disaster. There are about $43 trillion worth of CDS (credit default swaps) in the market. And the financial industry is acutely aware that all it would take is one major default to create a panic.

Energy: Forget energy independence. It’s not going to happen. Any politician who claims to have a plan for energy independence doesn’t understand economics. However, Congress needs to help lower oil prices. Now hovering around $100 a barrel, they act as a tax on the public that will offset the impact of any likely tax relief. If we don’t do something, we will continue to recycle petrodollars through the Middle East and elsewhere which are then used to buy increasing shares of our largest financial institutions.  Does the oil industry still need over $13 billion of tax subsidies? Obviously not and, now that the public’s attention is focused on Congress, perhaps Congress will be willing to eliminate them to fund some anti-recessionary activity, like creating jobs. Congress should also take steps to lower speculative pressures on oil prices by requiring all commodity trades be reported to the CFTC to insure transparency, by encouraging sales of oil from the strategic petroleum reserve in return for future shipments of oil as a way to create uncertainty for the speculators and by suspending purchases of sweet crude which are artificially inflating prices. Finally, we need to consider whether the ethanol subsidy accomplishes anything except raising the price of food.

Economic Stimulation: Every politician and interest group in town has proposals about how to stimulate the economy in the short term. Three things should be kept in mind when evaluating them: how quickly can they get more money into the hands of those who will spend it, how many jobs will they create and how can it be done through temporary appropriations or tax rebates. Jobs, not welfare, should be the goal. Something is very wrong with the economy when 95 percent of the population is working harder, productivity is increasing, but their incomes are declining. Even very conservative economists agree that most tax subsidies cost more than any benefit they generate. The IRS is a tax collection agency, not a social service agency, although Congress keeps trying to dump those programs on the IRS. So whatever relief Congress provides should go directly to those who are going to spend now, not sometime in the future. Even President Bush recognized that making his tax cuts for the wealthy permanent is a non-starter. Unfortunately, because of our growing deficit and declining dollar we don’t have a lot of cash to spend unless we revamp the tax code, and few are thinking about the long term reforms we need.

Tax reform: The Chairman of the House Ways & Means Committee has promised a long overdue major tax reform proposal similar to the 1986 tax reform which, by eliminating many special interest tax provisions, simplified the tax code and lowered tax rates. Although it is impossible to determine the specifics of whatever tax reform legislation may emerge from Congress, it is clear that it will have to deal with the inequities of wealth and taxes. Obvious examples are taxing “carried interest” from hedge funds at ordinary tax rates when earned, not when repatriated and the appropriate tax rate for Publicly Traded Partnerships (PTP). Globalization has increased the opportunities for multinational companies to “earn” money in tax havens. We have to treat these multinational companies as unitary companies, which is how they report themselves to their stockholders. This would level the playing field between multinational and domestic corporations because both would then pay the same percentage of their income in taxes.  How quickly this can be accomplished is open to question.

Regulatory reform: It’s time for a major shakeup of our financial regulatory agencies. The Federal Reserve Board is flooding the market with money and cutting interest rates to keep the banks functioning and diminish the chance of a credit crunch, but it has done an inadequate job of regulating the banks it supervises. What possible justification did it have for not requiring Citibank and others to report its Structured Investment Vehicle (SIV) assets and liabilities on its books? Didn’t Enron with its special purpose entities teach us anything? In the short term, Congress needs to reemphasize that these regulatory agencies are supposed to represent the public, not the industries they supervise.  In the long term, we need to rethink whether we ought to concentrate supervision of our financial institutions in a fewer agencies with a more global view. After all, when Fannie Mae and Freddie Mac buy mortgages and sell securities what is the functional difference between them and investment banks?

State needs: Washington has been imposing unfunded mandates on the states for years, but most states are facing large budget deficits. Those mandates which benefit the middle and lower income individuals are going to have to be funded by Washington or the economic problems will get worse. Indeed, when underfunded state pension plans are included, the deficit problem is even worse than it first appears. Too many of the state pension funds face the same kind of risk that the big banks face because too many institutions invested in hedge funds they know little or nothing about to try to fully fund their pensions. The risk reward ratio is out of whack and is likely to cause serious damage. States are going to need help and should get it because they are closest to the problems of their residents and state spending for education and health tend to have the most beneficial impact on the economy. Unfortunately, finding that money is going to be very difficult, given the need to keep the federal deficit under control to moderate the decline in the value in the dollar.

Most of the “experts” agree that Congress and the Administration need to act now to stimulate the economy. Unfortunately, most of these proposals are like putting a band aid on a spurting artery. Recovery is likely only when the price of housing and stocks have declined to more realistic values and consumers have regained the confidence and the income to begin investing again. The question remains, however, whether Congress can enact bills that will really help the economy or will it merely act to benefit a bunch of special interests with access. The answer depends on how well the media analyze these proposals and explain them to the voters now that everyone’s attention is focused on the issue.

[*] Derivatives are financial instruments which derive their value from other assets. The classic example is the bundling of say 1000 mortgages into three bundles (or tranches, as they like to call them, also known as CDOs -- collateralized debt obligations) by a bank or mortgage banker which sells them to investors. The first group has mortgages with the lowest risk of default -- they pay the lowest rate. The second group is more risky and pay a higher rate. And the third consists of the mortgages most at risk of default which pay the highest interest rate. Theoretically, the investors choose the amount of risk they want to take on and buy either the first, second or third tranche. Simple so far, but then Wall Street discovered (because they got fees every time they created and sold a new derivative) that they could convert the second tranche into three more tranches and sell them too. Unfortunately, because most of the derivatives were not transparent and really couldn't be valued they needed something to convince investors the risk was small so another derivative was used called a collateralized debt swap (CDS), essentially an insurance policy against loss, which were sold by a few insurance companies. Regretfully, these companies don't have enough assets to pay off the kind of defaults that are occurring because there are $43 trillion worth of them in the market and, if just one of the companies defaulted, the whole market would likely explode. Of course that explains why Warren Buffet got into the market because he could cherry pick it and make another fortune.

It's time to stop hoping...
Posted by Neal Fitzgerald -
03/05/2008, 04:20 PM

I'm a self-employed graphics person, struggling to pay the bills, and far from rich.

Why does anyone assume I don't have a care in the world just because I understand how the government is screwing us?

Americans complain a lot, but they don't spend the time or energy to figure out why they can't get ahead.

Instead, they listen to feel-good politicians telling them what they want to hear, then they elect them to office based on a whole lot of nothing.

When nothing changes, they complain some more.

We need to educate ourselves and stop believing what we're told by politicians and mainstream media, who are both corrupted to the core.

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