Electric Politics | A Solution?

By Paul Craig Roberts

The Great Depression sculpture Readers have been pressing for a solution to the financial crisis. But first it is necessary to understand the problem. Here is the problem as I see it. If my diagnosis is correct, the solution below might be appropriate.

Let's begin with the fact that the financial crisis is more or less worldwide. The mechanism that spread the American-made financial crisis abroad was the massive US trade deficit. Every year the countries with which the US has trade deficits end up in the aggregate with hundreds of billions of dollars.

Countries don't put these dollars in a mattress. They invest them. They buy up US companies, real estate, and toll roads. They also purchase US financial assets. They finance the US government budget deficit by purchasing Treasury bonds and bills. They help to finance the US mortgage market by purchasing Fannie Mae and Freddie Mac bonds. They buy financial instruments, such as mortgage-backed securities and other derivatives, from US investment banks, and that is how the US financial crisis was spread abroad. If the US current account was close to balance, the contagion would have lacked a mechanism by which to spread.

One reason the US trade deficit is so large is the practice of US corporations offshoring their production of goods and services for US markets. When these products are brought into the US to be sold, they count as imports.

Thus, economists were wrong to see the trade deficit as a non-problem and to regard offshoring as a plus for the US economy.

The fact that much of the financial world is polluted with US toxic financial instruments could affect the ability of the US Treasury to borrow the money to finance the bailout of the financial institutions. Foreign central banks might need their reserves to bail out their own financial systems. As the US savings rate is approximately zero, the only alternative to foreign borrowing is the printing of money.

Financial deregulation was an important factor in the development of the crisis. The most reckless deregulation occurred in 1999, 2000, and 2004. See Roberts, "The End of American Hegemony."

Lax mortgage lending policies grew out of pressures placed on mortgage lenders during the 1990s by the US Department of Justice and federal regulatory agencies to race-norm their mortgage lending and to provide below-market loans to preferred minorities. Subprime mortgages became a potential systemic threat when issuers ceased to bear any risk by selling the mortgages, which were then amalgamated with other mortgages and became collateral for mortgage-backed securities.

Federal Reserve chairman Alan Greenspan's inexplicable low interest rate policy allowed the systemic threat to develop. Low interest rates push up housing prices by lowering monthly mortgage payments, thus increasing housing demand. Rising home prices created equity to justify 100 percent mortgages. Buyers leveraged themselves to the hilt and lacked the ability to make payments when they lost their jobs or when adjustable rates and interest escalator clauses pushed up monthly payments.

Wall Street analysts pushed financial institutions to increase their earnings, which they did by leveraging their assets and by insuring debt instruments instead of maintaining appropriate reserves. This spread the crisis from banks to insurance companies.

Finance chiefs around the world are dealing with the crisis by bailing out banks and by lowering interest rates. This suggests that the authorities see the problem as a solvency problem for the financial institutions and as a liquidity problem. US Treasury Secretary Paulson's solution, for example, leaves unattended the continuing mortgage defaults and foreclosures. The fall in the US stock market predicts a serious recession, which means rising unemployment and more defaults and foreclosures.

In place of a liquidity problem, I see an over-abundance of debt instruments relative to wealth. A fractional reserve banking system based on fiat money appears to be capable of creating debt instruments faster than an economy can create real wealth. Add in credit card debt, stocks purchased on margin, and leveraged derivatives, and debt is pyramided relative to real assets.

Add in the mark-to-market rule, which forces troubled assets to be under-valued, thus threatening the solvency of institutions, and short-selling, which drives down the shares of troubled institutions, thereby depriving them of credit lines, and you have an outline of the many causes of the current crisis.

If the diagnosis is correct, the solution is multifaceted.

Instead of wasting $700 billion on a bailout of the guilty that does not address the problem, the money should be used to refinance the troubled mortgages, as was done during the Great Depression. If the mortgages were not defaulting, the income flows from the mortgage interest through to the holders of the mortgage-backed securities would be restored. Thus, the solvency problem faced by the holders of these securities would be at an end.

The financial markets must be carefully re-regulated, not over-regulated or wrongly regulated.

To shore up the credibility of the US Treasury's own credit rating and the US dollar as world reserve currency, the US budget and trade deficits must be addressed. The US budget deficit can be eliminated by halting the Bush Regime's gratuitous wars and by cutting the extravagant US military budget. The US spends more on military than the rest of the world combined. This is insane and unaffordable. A balanced budget is a signal to the world that the US government is serious and is taking measures to reduce its demand on the supply of world savings.

The trade deficit is more difficult to reduce as the US has stupidly permitted itself to become dependent not merely on imports of foreign energy, but also on imports of foreign manufactured goods including advanced technology products. Steps can be taken to bring home the offshored production of US goods for US markets. This would substantially reduce the trade deficit and, thus, restore credibility to the US dollar as world reserve currency. Follow-up measures would be required to insure that US imports do not greatly exceed exports.

The US will have to set aside the racial privileges that federal bureaucrats pulled out of the Civil Rights Act and restore sound lending practices. It the US government itself wishes to subsidize at taxpayer expense home purchases by non-qualified buyers, that is a political decision subject to electoral ratification. But the US government must cease to force private lenders to breech the standards of prudence.

The issuance of credit cards must be brought back to prudent standards, with checks on credit history, employment, and income. Balances that grow over time must be seen as a problem against which reserves must be provided, instead of a source of rising interest income to the credit card companies.

Fractional reserve banking must be reined in by higher reserve requirements, rising over time perhaps to 100 percent. If banks were true financial intermediaries, they would not have money creating power, and the proliferation of debt relative to wealth would be reduced.

Does the US have the leadership to realize the problem and to deal with it?

Not if Bush, Cheney, Paulson, Bernanke, McCain and Obama are the best leadership that America can produce.

The Great Depression lasted a decade because the authorities were unable to comprehend that the Federal Reserve had allowed the supply of money to shrink. The shrunken money supply could not employ the same number of workers at the same wages, and it could not purchase the same amount of goods and service at the same prices. Thus, prices and employment fell.

The explanation of the Great Depression was not known until the 1960s when Milton Friedman and Anna Schwartz published their A Monetary History of the United States. Given the stupidity of our leadership and the stupidity of so many of our economists, we may learn what happened to us this year in 2038, three decades from now.

Paul Craig Roberts was Assistant Secretary of the Treasury in the Reagan administration. He was Associate Editor of the Wall Street Journal editorial page and Contributing Editor of National Review.

Comments

I like PCR's work, but there has been a lot of criticism of assertions like this, as inaccurate and racist:

"Lax mortgage lending policies grew out of pressures placed on mortgage lenders during the 1990s by the US Department of Justice and federal regulatory agencies to race-norm their mortgage lending and to provide below-market loans to preferred minorities."

What do you think about this?

[I don't know the details but suppose one must look at the record. Nevertheless, I'm sure that there's something to what PCR argues — my own preference is for a color-blind system though I do acknowledge that in some circumstances (perhaps not these or perhaps not in this particular way) minority quotas may be a good thing. g.]

Posted by: Dwight | October 10, 2008 12:39 AM

Meanwhile, we are running another larger and larger debt every year. Last year we started consuming unsustainably on October 5, 2007. This year it was September 23, 2008.

We are consuming 140% of the resources the ecosystem can offer us this year. The financial debt can be repaid, rescheduled, bargained with. Can we do it with the ecological one? We need to lower our consumption fast and go back to 100% or below. How do we do that? Will it be easier after a meltdown? Or will the meltdown make us even more reckless? Could we do drastic changes on the economic, energy, and production fronts at the same time, quickly?
The way I see us live tells me "no", but I wish the answer was "yes".

People have been talking about this debt since the 70s, and not much has been done about it. Like for the Great Depression, it seems we are good at analyzing failure after it has destroyed many of us, but desperately bad at preventing it.

Posted by: iSoph | October 10, 2008 3:49 AM

The collapse of the mortgage market was the match and the initial fuel. This has created a wider credit crisis that is cascading. Lehman goes down and takes more with it than just its bad mortgage investments. There is a massive loss of confidence. Nobody wants to lend any money to anyone. The banks will not even lend to each other right now because they do not know if the other bank will go down because it does not know what the other bank is still hiding (Libor is telling us this). The loss of confidence is driving the financial markets down, which is resulting in massive redemptions at hedge funds and other investment funds creating forced selling, which is making things worse and its continues to spiral down. This is now creating an economic crisis tsunami that is coming straight at Americans right now at a 100 miles an hour and nobody is really seeing it coming. All companies are not able to get financing and the banks are being quicker at pulling the plug. Many companies are going to go bankrupt. This is and will continue to break consumer confidence which will result in more bad earnings from companies and causing banks to pull the plug. Very ugly situation right now. It makes the election an actual afterthought. Whoever wins will just have to worry about stopping the bleeding. I think healthcare reform, tax cuts, the environment or whatever the next President wants to do can now be throw out the window. The stock market in the U.S. is down almost 50%, meaning that the value of all companies in the U.S. are now worth half of what they were 1 year ago. That is remarkable and will have huge implications. The market really is not reacting and does not care about what governments are doing. Fed rate cuts or rescue packages are having no impact right now. Governments have no idea what to do. It is a wild fire being whipped up by the winds with the governments trying to dose the flames with a single helicopter.

A lot of blame to go around on the initial mortgage problem:

1) home buyers who bought more than they could handle or where not smart enough to read the fine print in a con job....

2) mortgage brokers who just piled in anyone with a pulse or in a dishonest way.. egged on by the banks who needed as many mortgage as could be found of any quality to put in their mortgage backed securities.

3) the banks who created these mortgage backed securities who mispriced the risk or purposely did not care about the risk because they sold them to investors who had no idea what they were buying.

4) institutional investors who bought mortgage backed securities with no idea what they were buying

5) the rating agencies who said these securities were "A" rated. they terribly misjudged the risk

6) the Federal Reserve and Greenspan who raised interest rates too fast, so people with variable rates got hit very hard very fast when their mortgage payments went up

7) the government and its regulatory agencies that had no idea what was going on or felt the pressure to keep things deregulated, especially in a Republican deregulation environment.

8) the Bush administration who push a freewheeling atmosphere.. a house for everyone... and no regulation... you have to ask yourself why there was no subprime market in Canada or in other countries... why in the U.S. only...

Posted by: Phillip | October 10, 2008 9:17 PM

I do not see racism in the comment "Lax mortgage lending policies grew out of pressures placed on mortgage lenders during the 1990s by the US Department of Justice and federal regulatory agencies to race-norm their mortgage lending and to provide below-market loans to preferred minorities." The word "Lax" is a little derogatory but racist is not accurate as this is more of a class issue, not race. The following sentence is the real conclusion to the how subprime lending contributed to the current crisis; "Subprime mortgages became a potential systemic threat when issuers ceased to bear any risk by selling the mortgages, which were then amalgamated with other mortgages and became collateral for mortgage-backed securities." This is exactly what happened when I bought my first house in California in 1999. I got a mortgage from a broker with Countrywide and it was sold in a week to another bank. That bank sold it to Chase six months later. Chase had no real clue what my level of risk was and probably purchased my mortgage with a bunch of others in a packaged deal. That's what I call "unsound" lending practices!! Anybody want to buy a pig in a poke?

In my unqualified estimation, subprime mortgages could have been managed with a level of risk commensurate to their actual risk and no financial crisis would have ensued. However, when they were amalgamated or "bundled" with "good" mortgagees and sold for profit, this is where the crisis began. Cause? Good old greed. I have not read this stated anywhere but it seems to me that the current crisis is caused by an utter lack of trust within the financial community due to a lack of reporting and accounting of how much of the mortgage-backed securities are comprised of subprime loans. Essentially, everyone knows that everyone else's mortgage backed securities are crap but no one knows what they are worth so the credit market ground to a halt since everyone knew that the securities were overvalued. Oops.

I do think the following statement smacks of racism "The US will have to set aside the racial privileges that federal bureaucrats pulled out of the Civil Rights Act and restore sound lending practices" and I offer as a counterpoint my assertion that "high risk" lending can be properly managed without usurious rates and without leading to "unsound" lending practices as long as those higher risk loans are not bundled and passed off as low risk loans.

I agree that refinancing the current troubled mortgages is the most effective solution to the problem as it will restore the trust in the current mortgage backed securities.

I still think the staggering national debt presents a greater threat to our national security than any aspect of the current crisis.

Posted by: AES | November 4, 2008 10:47 PM

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Home FAQ Contact Archive EP Store EP Alerts © 2008 ElectricPolitics	A Solution? By Paul Craig Roberts Readers have been pressing for a solution to the financial crisis. But first it is necessary to understand the problem. Here is the problem as I see it. If my diagnosis is correct, the solution below might be appropriate. Let's begin with the fact that the financial crisis is more or less worldwide. The mechanism that spread the American-made financial crisis abroad was the massive US trade deficit. Every year the countries with which the US has trade deficits end up in the aggregate with hundreds of billions of dollars. Countries don't put these dollars in a mattress. They invest them. They buy up US companies, real estate, and toll roads. They also purchase US financial assets. They finance the US government budget deficit by purchasing Treasury bonds and bills. They help to finance the US mortgage market by purchasing Fannie Mae and Freddie Mac bonds. They buy financial instruments, such as mortgage-backed securities and other derivatives, from US investment banks, and that is how the US financial crisis was spread abroad. If the US current account was close to balance, the contagion would have lacked a mechanism by which to spread. One reason the US trade deficit is so large is the practice of US corporations offshoring their production of goods and services for US markets. When these products are brought into the US to be sold, they count as imports. Thus, economists were wrong to see the trade deficit as a non-problem and to regard offshoring as a plus for the US economy. The fact that much of the financial world is polluted with US toxic financial instruments could affect the ability of the US Treasury to borrow the money to finance the bailout of the financial institutions. Foreign central banks might need their reserves to bail out their own financial systems. As the US savings rate is approximately zero, the only alternative to foreign borrowing is the printing of money. Financial deregulation was an important factor in the development of the crisis. The most reckless deregulation occurred in 1999, 2000, and 2004. See Roberts, "The End of American Hegemony." Lax mortgage lending policies grew out of pressures placed on mortgage lenders during the 1990s by the US Department of Justice and federal regulatory agencies to race-norm their mortgage lending and to provide below-market loans to preferred minorities. Subprime mortgages became a potential systemic threat when issuers ceased to bear any risk by selling the mortgages, which were then amalgamated with other mortgages and became collateral for mortgage-backed securities. Federal Reserve chairman Alan Greenspan's inexplicable low interest rate policy allowed the systemic threat to develop. Low interest rates push up housing prices by lowering monthly mortgage payments, thus increasing housing demand. Rising home prices created equity to justify 100 percent mortgages. Buyers leveraged themselves to the hilt and lacked the ability to make payments when they lost their jobs or when adjustable rates and interest escalator clauses pushed up monthly payments. Wall Street analysts pushed financial institutions to increase their earnings, which they did by leveraging their assets and by insuring debt instruments instead of maintaining appropriate reserves. This spread the crisis from banks to insurance companies. Finance chiefs around the world are dealing with the crisis by bailing out banks and by lowering interest rates. This suggests that the authorities see the problem as a solvency problem for the financial institutions and as a liquidity problem. US Treasury Secretary Paulson's solution, for example, leaves unattended the continuing mortgage defaults and foreclosures. The fall in the US stock market predicts a serious recession, which means rising unemployment and more defaults and foreclosures. In place of a liquidity problem, I see an over-abundance of debt instruments relative to wealth. A fractional reserve banking system based on fiat money appears to be capable of creating debt instruments faster than an economy can create real wealth. Add in credit card debt, stocks purchased on margin, and leveraged derivatives, and debt is pyramided relative to real assets. Add in the mark-to-market rule, which forces troubled assets to be under-valued, thus threatening the solvency of institutions, and short-selling, which drives down the shares of troubled institutions, thereby depriving them of credit lines, and you have an outline of the many causes of the current crisis. If the diagnosis is correct, the solution is multifaceted. Instead of wasting $700 billion on a bailout of the guilty that does not address the problem, the money should be used to refinance the troubled mortgages, as was done during the Great Depression. If the mortgages were not defaulting, the income flows from the mortgage interest through to the holders of the mortgage-backed securities would be restored. Thus, the solvency problem faced by the holders of these securities would be at an end. The financial markets must be carefully re-regulated, not over-regulated or wrongly regulated. To shore up the credibility of the US Treasury's own credit rating and the US dollar as world reserve currency, the US budget and trade deficits must be addressed. The US budget deficit can be eliminated by halting the Bush Regime's gratuitous wars and by cutting the extravagant US military budget. The US spends more on military than the rest of the world combined. This is insane and unaffordable. A balanced budget is a signal to the world that the US government is serious and is taking measures to reduce its demand on the supply of world savings. The trade deficit is more difficult to reduce as the US has stupidly permitted itself to become dependent not merely on imports of foreign energy, but also on imports of foreign manufactured goods including advanced technology products. Steps can be taken to bring home the offshored production of US goods for US markets. This would substantially reduce the trade deficit and, thus, restore credibility to the US dollar as world reserve currency. Follow-up measures would be required to insure that US imports do not greatly exceed exports. The US will have to set aside the racial privileges that federal bureaucrats pulled out of the Civil Rights Act and restore sound lending practices. It the US government itself wishes to subsidize at taxpayer expense home purchases by non-qualified buyers, that is a political decision subject to electoral ratification. But the US government must cease to force private lenders to breech the standards of prudence. The issuance of credit cards must be brought back to prudent standards, with checks on credit history, employment, and income. Balances that grow over time must be seen as a problem against which reserves must be provided, instead of a source of rising interest income to the credit card companies. Fractional reserve banking must be reined in by higher reserve requirements, rising over time perhaps to 100 percent. If banks were true financial intermediaries, they would not have money creating power, and the proliferation of debt relative to wealth would be reduced. Does the US have the leadership to realize the problem and to deal with it? Not if Bush, Cheney, Paulson, Bernanke, McCain and Obama are the best leadership that America can produce. The Great Depression lasted a decade because the authorities were unable to comprehend that the Federal Reserve had allowed the supply of money to shrink. The shrunken money supply could not employ the same number of workers at the same wages, and it could not purchase the same amount of goods and service at the same prices. Thus, prices and employment fell. The explanation of the Great Depression was not known until the 1960s when Milton Friedman and Anna Schwartz published their A Monetary History of the United States. Given the stupidity of our leadership and the stupidity of so many of our economists, we may learn what happened to us this year in 2038, three decades from now. Paul Craig Roberts was Assistant Secretary of the Treasury in the Reagan administration. He was Associate Editor of the Wall Street Journal editorial page and Contributing Editor of National Review. Posted by George Kenney on October 9, 2008 10:39 PM « A Letter to Harper's \| Main \| EP a Finalist for Podcast Awards ⊕ Please Vote Again! » Share this post: Comments I like PCR's work, but there has been a lot of criticism of assertions like this, as inaccurate and racist: "Lax mortgage lending policies grew out of pressures placed on mortgage lenders during the 1990s by the US Department of Justice and federal regulatory agencies to race-norm their mortgage lending and to provide below-market loans to preferred minorities." What do you think about this? [I don't know the details but suppose one must look at the record. Nevertheless, I'm sure that there's something to what PCR argues — my own preference is for a color-blind system though I do acknowledge that in some circumstances (perhaps not these or perhaps not in this particular way) minority quotas may be a good thing. g.] Posted by: Dwight \| October 10, 2008 12:39 AM Meanwhile, we are running another larger and larger debt every year. Last year we started consuming unsustainably on October 5, 2007. This year it was September 23, 2008. We are consuming 140% of the resources the ecosystem can offer us this year. The financial debt can be repaid, rescheduled, bargained with. Can we do it with the ecological one? We need to lower our consumption fast and go back to 100% or below. How do we do that? Will it be easier after a meltdown? Or will the meltdown make us even more reckless? Could we do drastic changes on the economic, energy, and production fronts at the same time, quickly? The way I see us live tells me "no", but I wish the answer was "yes". People have been talking about this debt since the 70s, and not much has been done about it. Like for the Great Depression, it seems we are good at analyzing failure after it has destroyed many of us, but desperately bad at preventing it. Posted by: iSoph \| October 10, 2008 3:49 AM The collapse of the mortgage market was the match and the initial fuel. This has created a wider credit crisis that is cascading. Lehman goes down and takes more with it than just its bad mortgage investments. There is a massive loss of confidence. Nobody wants to lend any money to anyone. The banks will not even lend to each other right now because they do not know if the other bank will go down because it does not know what the other bank is still hiding (Libor is telling us this). The loss of confidence is driving the financial markets down, which is resulting in massive redemptions at hedge funds and other investment funds creating forced selling, which is making things worse and its continues to spiral down. This is now creating an economic crisis tsunami that is coming straight at Americans right now at a 100 miles an hour and nobody is really seeing it coming. All companies are not able to get financing and the banks are being quicker at pulling the plug. Many companies are going to go bankrupt. This is and will continue to break consumer confidence which will result in more bad earnings from companies and causing banks to pull the plug. Very ugly situation right now. It makes the election an actual afterthought. Whoever wins will just have to worry about stopping the bleeding. I think healthcare reform, tax cuts, the environment or whatever the next President wants to do can now be throw out the window. The stock market in the U.S. is down almost 50%, meaning that the value of all companies in the U.S. are now worth half of what they were 1 year ago. That is remarkable and will have huge implications. The market really is not reacting and does not care about what governments are doing. Fed rate cuts or rescue packages are having no impact right now. Governments have no idea what to do. It is a wild fire being whipped up by the winds with the governments trying to dose the flames with a single helicopter. A lot of blame to go around on the initial mortgage problem: 1) home buyers who bought more than they could handle or where not smart enough to read the fine print in a con job.... 2) mortgage brokers who just piled in anyone with a pulse or in a dishonest way.. egged on by the banks who needed as many mortgage as could be found of any quality to put in their mortgage backed securities. 3) the banks who created these mortgage backed securities who mispriced the risk or purposely did not care about the risk because they sold them to investors who had no idea what they were buying. 4) institutional investors who bought mortgage backed securities with no idea what they were buying 5) the rating agencies who said these securities were "A" rated. they terribly misjudged the risk 6) the Federal Reserve and Greenspan who raised interest rates too fast, so people with variable rates got hit very hard very fast when their mortgage payments went up 7) the government and its regulatory agencies that had no idea what was going on or felt the pressure to keep things deregulated, especially in a Republican deregulation environment. 8) the Bush administration who push a freewheeling atmosphere.. a house for everyone... and no regulation... you have to ask yourself why there was no subprime market in Canada or in other countries... why in the U.S. only... Posted by: Phillip \| October 10, 2008 9:17 PM I do not see racism in the comment "Lax mortgage lending policies grew out of pressures placed on mortgage lenders during the 1990s by the US Department of Justice and federal regulatory agencies to race-norm their mortgage lending and to provide below-market loans to preferred minorities." The word "Lax" is a little derogatory but racist is not accurate as this is more of a class issue, not race. The following sentence is the real conclusion to the how subprime lending contributed to the current crisis; "Subprime mortgages became a potential systemic threat when issuers ceased to bear any risk by selling the mortgages, which were then amalgamated with other mortgages and became collateral for mortgage-backed securities." This is exactly what happened when I bought my first house in California in 1999. I got a mortgage from a broker with Countrywide and it was sold in a week to another bank. That bank sold it to Chase six months later. Chase had no real clue what my level of risk was and probably purchased my mortgage with a bunch of others in a packaged deal. That's what I call "unsound" lending practices!! Anybody want to buy a pig in a poke? In my unqualified estimation, subprime mortgages could have been managed with a level of risk commensurate to their actual risk and no financial crisis would have ensued. However, when they were amalgamated or "bundled" with "good" mortgagees and sold for profit, this is where the crisis began. Cause? Good old greed. I have not read this stated anywhere but it seems to me that the current crisis is caused by an utter lack of trust within the financial community due to a lack of reporting and accounting of how much of the mortgage-backed securities are comprised of subprime loans. Essentially, everyone knows that everyone else's mortgage backed securities are crap but no one knows what they are worth so the credit market ground to a halt since everyone knew that the securities were overvalued. Oops. I do think the following statement smacks of racism "The US will have to set aside the racial privileges that federal bureaucrats pulled out of the Civil Rights Act and restore sound lending practices" and I offer as a counterpoint my assertion that "high risk" lending can be properly managed without usurious rates and without leading to "unsound" lending practices as long as those higher risk loans are not bundled and passed off as low risk loans. I agree that refinancing the current troubled mortgages is the most effective solution to the problem as it will restore the trust in the current mortgage backed securities. I still think the staggering national debt presents a greater threat to our national security than any aspect of the current crisis. Posted by: AES \| November 4, 2008 10:47 PM Leave a comment Name Email Address URL Remember personal info? Comments (You may use HTML tags for style)

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