http://www.guardian.co.uk/business/2008/mar/17/economics.useconomy
America was conned - who will pay?
The South Sea Bubble ended in riots as trust was lost. Wall Street also
duped the public
* Larry Elliott, economics editor
* The Guardian,
* Monday March 17 2008
* Article history
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This article appeared in the Guardian on Monday March 17 2008 on p30 of
the Financial section. It was last updated at 00:05 on March 17 2008.
Bear Stearns marks the moment when the global financial crisis went
critical. Up until last Friday, it had been possible - just about - to
believe that the worst was over and that things were about to get
better. That pretence was stripped away when JP Morgan, at the behest of
the Federal Reserve, stepped in when the hedge funds pulled the plug on
the fifth-biggest US investment bank.
It is now clear that no end is in sight to the turmoil, and the reason
for that is that the Fed and the US treasury are no closer to solving
the underlying problem than they were eight months ago. The crisis will
only end when house prices stop falling and banks stop racking up huge
losses on their loans. Doing that, however, will require the US
government to intervene directly in the real estate market to end the
wave of foreclosures. Ideologically, it is ill-equipped to take that
step and, as a result, property prices will fall and the financial
meltdown will go on and on.
Ultimately, though, action will be taken because there will be political
pressure for it. Indeed, it is somewhat surprising that there is not
already rioting in the streets, given the gigantic fraud perpetrated by
the financial elite at the expense of ordinary Americans.
The US has just had its weakest period of expansion since the 1950s.
Consumption growth has been poor. Investment growth has been modest.
Exports have been sluggish. But if you are at the top of the tree, the
years since the last recession in 2001 has been a veritable golden age.
Salaries for executives have rocketed and profits have soared, because
the productivity gains from a growing economy have been
disproportionately skewed towards capital.
Patriotic
For ordinary Americans, though, it has been a different story. Real
wages have been growing slowly; at just 1.6% a year on average over the
latest upswing, well down on the experience of earlier decades.
Business, of course, needs consumers to carry on spending in order to
make money, so a way had to be found to persuade households to do their
patriotic duty. The method chosen was simple. Whip up a colossal housing
bubble, convince consumers that it makes sense to borrow money against
the rising value of their homes to supplement their meagre real wage
growth and watch the profits roll in.
As they did - for a while. Now it's payback time and the mood could get
very ugly. Americans, to put it bluntly, have been conned. They have
been duped by a bunch of serpent-tongued hucksters who packed up the
wagon and made it across the county line before a lynch mob could be
formed.
The debate now is not about whether the US is in recession but how deep
and long that recession will be. Super-bears have started to say that
this is perhaps "The Big One", by which they mean the onset of a new
Great Depression. The need to rescue Bear Stearns has done little to
still those voices.
As the economics team at HSBC recently pointed out, there has been a
"catastrophic breakdown" of trust, and when that has happened in the
past - the US in the 1930s, Japan in the 1990s - chucking extra money at
the banks in the hope that they will start lending again proves
ineffective.
It's not hard to see why trust has become such a rare commodity: Wall
Street at the height of the securitisation mania had, in effect, become
London at the time of the South Sea Bubble crisis in 1720. Vast
quantities of funny paper were changing hands even though those involved
in the deals had no idea of their true worth. Nor did they care.
Inevitably, now the bubble has burst and the huge Ponzi securitisation
scam has been exposed, there has been a reaction. The securitisation
market is dead, there is less money sloshing round the system, banks are
hoarding their cash.
Having allowed the housing boom to rage out of control for too long and
then delaying cuts in interest rates until the housing market was
gripped by recessionary forces, the Fed is now trying to make up for
lost time with a burst of hyperactivity. It will cut interest rates on
Wednesday and keep cutting them: financial markets expect the Fed funds
rate to be 1% by the summer, and they are probably right. In most
downturns, easier monetary policy does the trick. Lower interest rates
make it cheaper to borrow and also change the trade-off between saving
and spending. This may not be the usual sort of downturn, however, with
consumers going through a period of debt revulsion after the excesses of
recent years, even so the consensus is that after two or three quarters
of falling output, a slow and sluggish recovery will be under way.
Deflation
These hopes are likely to be dashed, unless there is intervention at
home and internationally to tackle the crisis. Domestically, the
priority should be to stop homes that have been foreclosed being
auctioned on the open market, since by selling them at a 50% discount
property prices are driven down. The US does not seem to have learned
the lessons from Japan, which encouraged a fire sale of property in the
1990s and was sucked into a classic debt deflation trap as a result.
Those who argue, with some force, that it would be counter-productive to
intervene in the market because the US needs to work the rottenness out
of its system must recognise that the cold turkey option will be very
long and painful.
The second form of intervention should be to shore up the dollar, the
collapse of which is worrying countries that rely heavily on exports and
is the main reason for the surge in commodity prices. Co-ordinated
intervention by the major central banks needs to be at the top of the
agenda at next month's G7 meeting in Washington, and there could be
action even sooner if the dollar continues to tank.
In the longer term, lessons must be learnt from the turmoil. One is that
you don't solve the problems of a collapsing bubble by blowing up
another, which is what Alan Greenspan did after the dotcom fiasco in
2001 - the most irresponsible behaviour of any central banker in living
memory.
The second lesson is that there has to be far stricter regulation not
just of the US real estate market but of Wall Street, to prevent the
return of irresponsible lending as soon as the recovery is firmly under
way. If this is, heaven help us, The Big One, one of the only
consolations will be that the repugnance at the orgy of speculation that
has sapped the strength of the US economy will put a new New Deal on the
political agenda.
But for this to happen there has to be a political response and even
though this year's presidential election will be held in the shadow of
recession, there appears not to be a potential FDR among the contenders
for the White House. Yet if this crisis really does get as bad as some
are forecasting, the public will rightly demand more than a slap on the
wrist for Wall Street.
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