Misunderstanding the Great Recession 40 comments
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The proximate cause of the crisis was the turn of the housing cycle in the United States and the associated rise in delinquencies on subprime mortgages, which imposed substantial losses on many financial institutions and shook investor confidence in credit markets. - Fed Chairman Bernanke
Management 101 teaches us the first step in problem solving is accurate definition of the problem. Without accurate definition, the chances of resolution of that problem are diminished.
Was the Housing Cycle the Proximate Cause of the Great Recession?
The first signs of distress in this Great Recession started in mid-2006 when mortgage default levels began growing – and lending institutions began tightening their credit standards. It surely was the obvious indicator of the beginning of the Great Recession – and it does appear to be the epicenter of the series of events which destroyed wealth in historic proportions.
But if we go further back in time, there were signs of duress when we entered the 21st century. We had a recession in 2001/2002, and it is almost as though we never fully recovered.
Gross private domestic investment was growing almost 10% per year through the 90’s, dropped to 3% growth after 2000. We stopped investing in ourselves.
- Employment levels which were running over 62% of the population (aged 16 and over) had fallen below 59% by the end of 2007.
- Over one half of the total GDP growth since 2000 has been on consumer credit. This type of growth is not sustainable.
- Since 2000, $10 trillion dollars of the GDP has been spent on consumer credit (excluding mortgages), the wars in Iraq and Afghanistan, building excess houses for baby boomers, and growth in cost of Government. Using 10% of GDP per year for non-productive economic purposes is a crisis when it is done seven years in a row.
It is how the housing crash started that is the story. It was the giant Ponzi scheme that Goldman Sachs Chase, Citi, B of A, Countrywide, Freddie, Fannie et al pushed on us with the government's compliance that really caused the crash. We went from the dot com bubble, to the housing bubble to the commodities bubble and now the bond bubble. What next? – Jerry Barber
More Likely Proximate Causes
Is the proximate cause of the Great Recession employment? Lower employment started appearing much earlier than the housing crisis. Quite literally 3% of the GDP has been lost because we failed to maintain full employment. Our economic model does not work unless the economy expands. To compensate for the losses due to employment, we used more and more credit based growth to replace the dwindling employment.
And like an addict, America needed more and more credit for the country to function. Credit based expansion easily can create asset value bubbles. At some point, the weight of expanding under credit becomes too onerous, and the house of cards collapses. There is no real solution for this problem except to realize that America’s economy must reset to growth levels sans credit.
click to enlarge
There is another proximate cause which explains the employment drop – failure to expand technologically. At some point we took our eyes off of the ball. We stopped investing in ourselves. Without this investment, new jobs were not created. Companies became obsessed with short term over long term profits. Bonuses based on current stock value caused executives to keep focused on one year horizons. We exported R & D overseas to save costs. Small businesses stopped being created at past rates.
Is the Government blind to the real proximate cause?
The leaders of our economy understand money. They are politicians, bankers, bean counters, businessmen, and economic intellectuals. They are only seeing the part of the crisis which they can see and understand – the flow of money. They understand the concepts of business but not the technology of business.
Few have ever soiled their hands producing a product. The only sweat in their life happens at the gym.
Even fewer have had an original idea on a scientific or engineering subject, and developed that idea into a successful product. They have never had their ass on the line to innovate their way out of any real problems.
You are not an expert on job creation because you can read a data table, can plug numbers into formulas, or have written a paper that some think is great. Because you can critique a movie does not make you a director or producer.
It is obvious that the building block elements of business have been declining since 2000. Yet the measure of our economic engine - GDP - was growing. Either the reporting system is insensitive to problems, the reporting system in miss-targeted, the data is being manipulated, or all of the above.
I see the world differently than the new breed of corporate executives. I was from the old school which required executives to be able to run work (physically able to do the jobs of subordinates including craft tradesmen). This capability allowed for:
visual identification of problems within your span of control and proximate problems outside your span of control;
capability for continuous improvement as parameters change;
outside the box innovation as you understood the process and the goals; and,
development of products which drove profits. Profits naturally follow innovation and well conceived / executed work plans.
The new school of thought is to run work through cost analysis and modeling. With this method, you cannot see problems until it appears on a printout. The new executives have spent the majority of their careers on the cost side bean counting. They affect profitability by using innovative accounting techniques, tax loopholes, cost cutting, and short term income pumping. The new school executives have significantly less sensitivity to products, systems, technology, production, sales and distribution than the executives of the past.
The Government and Fed come from the new school. They are seeing low numbers and are trying to fill them. This is not solving the underlying problem which they do not see. The innovation system in America has been damaged by adhering to an economic model which rewards profits before substance.
Wall Street has played a part in this disaster by demanding corporate profits to be consistent quarter after quarter – and punishing the inconsistent companies. This concept transformed innovative companies like General Electric (GE) into financial ones to smooth normal cycles. Few businesses that are growing and innovate can deliver consistent profits. Consistent profits are a sign of a matured company being milked by bean counters with too few new products coming to market.
The majority of large corporations not only in America, but around the world are filled with executive and management layers who understand money – but not the product or service they are producing. They have traded innovation for profits – but in the long term without innovation profits and growth decline.
We need to rebuild the innovative base for our economy. The only promise is in small and possibly medium size business. In small business, product understanding and innovation are necessary elements of growth. We need to build an incubator to accelerate growth in this segment of America as it offers a real promise for a brighter tomorrow with jobs growth driven by innovative new products.
America desperately needs to create jobs. But real long term job growth naturally occurs through innovation – not digging and refilling holes, not changing out windows in government buildings, and not by taking food off of the table to burn in your car. This is GDP filling and it will do little to put America back on its feet.
If the current stimulus works, we will shortly be back into shit because the latent economic defects have not been addressed.
News of the Week
The New York Fed has continued purchasing fixed-rate mortgage-backed securities guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae. Selected private investment managers are acting as agents of the New York Fed in these purchases. They have already purchased $33.4 billion prior to this week, and $19.0 billion this week. By mid-year, the Fed wants to purchase $500 billion worth of these securities.
Bank of Canada lowered its target for the overnight rate by 50bps to 1.00%, taking the rate to the lowest point since Band of Canada's founding in 1934.
The Federal Reserve Bank of New York announced the formation of the AIG Credit Facility Trust. The Trust is being established for the sole benefit of the United States Treasury to hold the 77.9 percent equity interest in American International Group, Inc. (AIG) that will be issued in connection with the previously announced credit facility extended to AIG. Three trustees were appointed. To avoid possible conflicts with the Fed’s supervisory and monetary policy functions, the Trust has been structured so that the Fed cannot exercise any discretion or control over the voting and consent rights associated with the equity interest in AIG. How many months has it been since AIG was bailed out? And the Fed has finally gotten around to this. I hope somebody can explain why this document took so long to form.
Nouriel Roubini and Elisa Parisi-Capone of RGE Monitor estimates $3.6 trillion expected loan losses and writedowns on U.S. originated securitizations. They said:
Loan losses on a total of $12.37 trillion unsecuritized loans are expected to reach $1.6 trillion. Of these, U.S. banks and brokers are expected to incur $1.1 trillion.
Mark-to-market writedowns based on derivatives prices and cash bond indices on a further $10.84 trillion in securities reached about $2 trillion ($1.92 trillion.) About 40% of these securities (and losses) are held abroad according to flow-of-funds data. U.S. banks and broker dealers are assumed to incur a share of 30-35%, or $600-700 billion in securities writedowns.
Total loan losses and securities writedowns on U.S. originated assets are expected to reach about $3.6 trillion. The U.S. banking sector is exposed to half of this figure, or $1.8 trillion (i.e. $1.1 trillion loan losses + $700bn writedowns.)
FDIC-insured banks’ capitalization is $1.3 trillion as of Q3 2008; investment banks had $110bn in equity capital as of Q3 2008. Past recapitalization via TARP 1 funds of $230bn and private capital of $200bn still leaves the U.S. banking system borderline insolvent if our loss estimates materialize.
In order to restore safe lending, additional private and/or public capital in the order of $1 – 1.4 trillion is needed. This magnitude calls for a comprehensive solution along the lines of a ‘bad bank’ as proposed by policy makers or an outright restructuring through a new RTC.
I have been requesting a good figure on the toxic assets in the banks. I am not sure if this number is correct – but at least there is some quantification of the problem and can realize now that the banking system will shortly be owned by the taxpayers either through bailouts or nationalization.
Based on international economic news, this was a terrible week. China released its 4Q2008 GDP of 6.8% YoY growth. Nouriel Roubini points out that if you convert this to a normal quarter-over-quarter method, 4Q2008 growth in China was zero or negative. As Q12009 appears to be much worse, China is in a recession. Singapore also revised its 2009 GDP growth estimate to -2% to -5%. Japan’s exports fell 35% in December 2008, the third straight month of decline. South Korea’s economy shrank 5.6% in 4Q2008.
The EU has released a report saying that the economy in the UK will contract by 2.8% and Italy by 2.0% in 2009. The IMF believes the German economy will contract by 2.5%. Russia has revised its 2009 growth to -0.2% based on lower oil prices, a revalued ruble, and lower industrial output.
Freddie Mac (FRE) needs an additional $30 billion to $35 billion in government aid. It comes on top of the $13.8 billion the company received last year after it was seized by the government. Any stimulus package will be dwarfed by the size of backfilling necessary to keep the system afloat. I continue to recommend that the stimulus be restrained until the size of the wealth destruction can be accurately accessed.
New bankruptcy filings this week: Qimonda AG (QI)
Summary of the Week’s Economic Fundamentals
The indicators continue to show a moderate to severe economic contraction. Below is a list of news which happened this week.
Interesting but Not Indicating Anything
Home loan applications decreased 10.3 percent compared with the previous week and increased 23.1 percent compared with the same week one year earlier. This Mortgage Bankers Association index covers 50% of all loan applications. Over 83% of all loan applications were for refinancing existing loans.
Positive Leading Indicators
None this week
Negative Leading Indicators
ECRI’s Weekly Leading Index continues to demonstrate recessionary market conditions six months from now.
The futures price for oil has risen above $40 per barrel this week. However, development needs prices above $50 to $60 a barrel.
Positive Coincident Indicators
None
Negative Coincident indicators
The Department of Labor released their weekly Unemployment Insurance Claims. The non-seasonally adjusted initial claims continue to be very large.
Positive Trailing Indicators
None
Negative Trailing Indicators
New residential construction was down in December 2008 – and this was a fitting climax to 2008 being the worst year on record:
Building Permits: down 10.7% over November, 50.6% YoY
Housing Starts: down 15.5% over November, 45% YoY
Housing completions: down 5.2% over November, 23.6% YoY
Going through the data, it was interesting the uniformity throughout the country.
If you would like a summary of all government financial indicators, click here.
The Problem with Data
When I finish articles, I always ask myself how the information I have presented is slanted or biased. A slant or bias can occur by misrepresentation, leaving out relevant facts, or simply by cherry-picking the points you present.
Even though I have opinions on most subjects (ask my wife), I try to present things balanced and objective so that an informed decision can be drawn. I honestly believe that for most issues there is not a totally right or totally wrong answer – just the better of many bad options.
It is easy for a writer to select data points to reflect their beliefs. Be careful what you accept as the truth.
Disclosures: None
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"The new school of thought is to run work through cost analysis and modeling. With this method, you cannot see problems until it appears on a printout. The new executives have spent the majority of their careers on the cost side bean counting. They affect profitability by using innovative accounting techniques, tax loopholes, cost cutting, and short term income pumping. The new school executives have significantly less sensitivity to products, systems, technology, production, sales and distribution than the executives of the past.
The Government and Fed come from the new school. They are seeing low numbers and are trying to fill them. This is not solving the underlying problem which they do not see. The innovation system in America has been damaged by adhering to an economic model which rewards profits before substance."
and adapted much more slowly back then(1873.). I'd say 6 years by the standards of the time was quick. It that guide is useful, we are near
the end of this downturn !
On Jan 26 12:06 PM John McLeod wrote:
> It is clear now that the present crisis was caused by hedonic shock
> resulting from a disruptive cornucopia. That is, East Asia sented
> sending Europe and North America massive amounts of cheap cars and
> manufactured goods, clothes, etc. I think it was pre-Xmas 2006 when
> LA & Long Beach were backed up 6-weeks deep in Bratz dolls and
> radio controlled cars. This destroyed the competing domestic suppliers,
> but caused consumers to (temporarily) feel about twice as wealthy
> and confident. Thus banks-gone-wild, the re-fi boom and so on.<br/>
>
> As Professor Scott Nelson of William & Mary recently pointed
> out in the Chronicle of Higher Education, of all places, exactly
> the same thing happened in the run-up to the Crisis of 1873. Then
> it was American grains and manufactured goods flooding Western Europe.
> First the economies of their traditional bread basket (Russia &
> Ukraine) collapsed, while at the same time financial innovation and
> hedonic shock caused exuberant consumerism and a monumental building
> boom (that's where all those touristy piles in Vienna, Berlin, Paris
> and so on came from). It took about 6 years to clear.
are we following in the path of all successful civilizations, failing by our own success and subsequent decay of "what got us here"?
no stimulus package help there!
regards POLS and BANKERS, history is replete with those bad tales[always bad bedfellows].
maybe "...past is prologue..." be true.
Bernanke:
" A substantial body of research demonstrates that investments in education and training pay high rates of return to individuals and to society as a whole. Importantly, workforce skills can be improved not only through K-12 education, college, and graduate work but also through a variety of expeditious, market-based channels such as on-the-job training, coursework at community colleges and vocational schools, extension courses, and online training. An eclectic, market-responsive approach to increasing workforce skills is the most likely to be successful"
"From a macroeconomic standpoint, education is important because it is so directly linked to productivity, which, in turn, is the critical determinant of the overall standard of living"
"If we are to successfully navigate such challenges as the retirement of the baby-boom generation, advancing technology, and increasing globalization, we must work diligently to maintain the quality of our educational system where it is strong and strive to improve it where it is not"
All elected politicians lose power if they lose the re-election bid. Once elected and enjoyed the power, they will do anything to get re-elected. All politicians in the congress and in the whitehouse do their best to spend, spend, and spend to get re-elected.
So, politicians force GSE to lower rates to make the american dreams available to anyone without considering the ability to pay back, to deficit spending like there is no tomorrow, etc., etc., etc.,
If Ben Bubble Bailout Bernanke cannot create another bubble to delay the inevitable and the politicians cannot learn the lesson and change the course dramtically during whatever the time Bernanke bought, then the survival of the Republics is in question. It could just collapse like the former Soviet due to mounting debts sometime in the future. (Former Soviet collapse due to less production, the coming collapse of the Republics will be over consumption.)
To eradicate the mother of all root causes in our democracy system, two things must be added to the Constitution: one is term limit for those elected politicians: A 6 year one-term limit for all politicians, congressman, senator and the president. Another is the balance budget. The Federal Government must be forced to live within its means.
Or else, watch the demise of this Republic some time in the not-so-distant future.
The access to large amounts of easy credit has to end. The American Consumer can not be the only driving engine for other countries economy.
We must ask why debt grew so out of control. Fed low interest rate policies, government deficit spending, and Fannie Mae and Freddie Mac abusing their government backed policy to consume the whole mortgage market were very big factors. The funny thing is, we still have all these factors here today. So what exactly have we fixed to deserve to come out of this recession.... 0.
On to the next point, so all of these things led to banks asking for the revocation of Glass Stegal to compete with Fannie Mae and Freddie Mac on the mortgage front using derivatives to back them. This way they too could issue ton's of bad mortgage bonds without fear of reprisal (defaults) to grow their marketshare.
Of course, unfortunate for them, their derivative bets weren't as fullproof as a government backed guarantee.
Likewise, in 2001 during the dot com crash banks asked to deal with a basket of items off balance sheet so they could keep lending and pay off losses over time. To help grease the economic wheels they were allowed this indulgence called Base I accounting which let them hide all their derivatives losses from the world. This monster didn't get paid off like they said they intended to do (who would have guessed) but instead grew to the size of the entire assets of the US (an estimated $55+ trillion CDS and 5-10 trillion CDO contracts).
Of course Bush and Greenspan were in power so to help things along we got very low inflation, even wilder government spending, and no regulation.
When people say no one saw this recession coming I just laugh. I mean, how much more could you poison the US economy without having it get sick.
Steve, you do great work and thanks for another good article.
"The innovation system in America has been damaged by adhering to an economic model which rewards profits before substance."
I think this is the core of the problem. When you set up an economy where people can 'earn' money without producing anything that other people are willing to pay you for, you have effectively replaced the rewards-structure of a natural productive "substance" economy with the rewards structure of an arbitrary socialized "profit" economy; a politicized economy.
The further a person's work is from direct production, the more abstract that job becomes and the more arbitrary the determination of the income that job should pay. At its extreme we see CEO's collecting millions of dollars in income in the same year the business they are supposedly managing goes bankrupt. You cannot say they 'earned' that money. Putting in time on the job is not equal to performing the job you're supposed to be doing.
In small-medium business if you lose money it comes straight out of your pocket, and if you earn money it goes straight in. There is a direct relation between how much you 'earned' and how much you actually get to put in your pocket.
Bureaucrats 'earn' as much money as their union can extract from the other bureaucrats who the politicians hire to negotiate public sector wages. Taxpayers are happy to pay for pothole filling and snowplowing, but where is the taxpayer value in 'equity consultant'? No business in their right mind would hire an equity consultant unless the threat of some government law or policy forced them to. Too much bureaucracy is definitely part of the problem, both in Big Business and Big Government, and too many people get the wrong idea about how to 'earn' money.
In small-medium business the owner is directly involved. You spend all your time trying to minimize your costs and maximize your profits; or to minimize your effort and maximize your production. It's these mentally engaged on-the-ground owners and workers who think up new technologies that make their line of work more efficient. In Alberta where I live there are lots of rich guys with very little formal education who figured out an ideal solution to some problem relating to drilling and producing oil and gas. They got some money together, built and perfected a prototype of their idea, patented it, and now it's what the world uses. You don't get that by sitting in the office.
Economies of scale maybe apply to production with existing technologies, but it is individuals who think up the new technologies. Maybe part of the problem is that since WWII companies have become global behemoths generating profits only because their industry is an oligopoly and everyone else charges the same high prices to mask their economic inefficiency. In this way Big Business is able to 'tax' the consumer and pay their employees and management higher incomes than the free enterprise sector is able to earn and pay.
Bigger is not necessarily better. Small is often far more economically efficient. But you won't see this by looking at the financials, as Steven points out.
Absolutely brilliant article!!!!
There is so much quality substance in the comment stream that I can not just single out individuals.
The bean counters vs the design, build and market/sales people is very key. Not many people remember that IBM almost went belly up in the early 1990s because bean counters got control and the company assumed the hubris that IBM drove the market, and not that the market (customer) drove IBM. Today, IBM is operated on a business model that defines their services and products on what the customer wants and great success and stability has resulted.
I am e-mailing links for this article to some people I think ought to read it, people who do not often frequent SA.
Thanks again, Steve.
The "proximate cause" is not the same as the "root cause" -- its the "what tipped the cart over" question, and not "how did we ever load such a poorly balanced cart" question.
Essay author Hansen lists lots of factors which may have contributed to the current difficulty: its certainly reasonable to cite "failure to invest in technology", debt, and employment as factors which contribute to the severity of this crisis -- but not as a "proximate cause"
"Proximate" means the "nearest". If you fall down a flight of stairs and break your hip, the fall is the "proximate cause" of your broken hip. Your osteoporosis, and balance disorder certainly are factors-- but they're not the "proximate cause".
I think Bernancke's statement is accurate. The turn of the housing cycle and associated delinquencies is the "proximate cause" of the crisis. All of the other factors cited were present before housing turned down, but without causing a collapse-- once house prices began to decline, their impact was significant.
Invest in industries where you know you can make a diffrence to be globally competitive, so you can bring back wealth and growth by generating a self standing economy instead of borrowing money to pay for exports that you could make at home.
Aiiiiiiiiiiii this so called anglo-saxon market economy....its a little extreme if you dont control it a little thats why keynes theory is coming into play to fill the gaps of neglagence.
-Invest in a range of Energy, you dont want to drive up demand espeically when your economy is weak. (Nuclear, Wind, Solar, Liquified Natural Gas, Bio Fuels)
-Give subsidies for products that invest in these
-You got to end or negotiate stricter terms with this UAW union for the car companies, teachers, and healthcare facilitators, also im gonna out on a limb and admit the american brand has been damaged thanks to bush.I think it will get stronger due to the dream that America is the righteous leader, and to once again inspire hope to find a new road for the next generation.
-Also with infrastructure, im looking at the asian continent and noticing their flair for their cities while american cities and sub-urbs all look the same, subsidize people for going the extra mile to make building and contruction actually pleasing to the eye espeically in the mega cities, it brings confidence in the people. That we do contribute to somthing.
-Invest in social housing
-Invest in UI and tag along good educational training like at home self study or online.
I think some of those would bring a kick start, and some for the future just to sustain confidence, that when we did it we did it for others and not just for that moment when we invested dire wealth to the hungry giant few.
On Jan 26 10:48 PM Cameron Mitchell wrote:
> I feel the USA has to work on thier trade deficeit #1 you cant export
> wealth to import goods, its economically retarded. (excuse my langauge,
> i just dont get how they let it spin out of control)
>
> Invest in industries where you know you can make a diffrence to be
> globally competitive, so you can bring back wealth and growth by
> generating a self standing economy instead of borrowing money to
> pay for exports that you could make at home.
> Aiiiiiiiiiiii this so called anglo-saxon market economy....its a
> little extreme if you dont control it a little thats why keynes theory
> is coming into play to fill the gaps of neglagence.
As for the economy, there are a few intersecting events. For the first time in world history, the entire world could compete with the U.S. and demographic decline reduced the growth rate of the domestic workforce. Finally, consider the creative destruction of Internet and communication technologies.At first, new technologies earn a high profit and boost the economy, but it is the second stage of technological acceptance that wipes out the old order and causes losses throughout business, with the benefits passing to consumers. We are experiencing the wake of the tech boom. There are still investments taking place, but we are learning how to cut costs using recent inventions now, not making capital investments in new technology, because there is more money to be earned through cost cutting.
I would challenge readers to probe even deeper to look for root cause...if we believe that many years of Bank funded lobbying lawyers finally prompted (and incented) congress enough to cave, perhaps the real issue is we need term limits for all branches of the government (i.e. Congress and Judicial) as well as the Executive branch. If there was no "Tenure" in Congress, lobbying would certainly not be as successful and hence unproductive to our society...
On Jan 26 07:22 AM apppro wrote:
> The 4 Golden Rules
>
> 1. Reinstate the Up-tick rule
>
> 2. Crack down on naked short selling
>
> 3. Institute some rules on what should be said on National TV to
> prevent rumor-mongering
>
> 4. Pass a Wind-Fall Capital Gains Tax of 65% on ALL short sales retroactive
> to 01/01/08.
On Jan 26 06:39 PM Stark Naked wrote:
> My company is a prime example of one being run by bean counters.
> Of the top 10 executives not one has a background other than finance.
> over the past five years profits are generated by cutting cost rather
> than incresing reveues. I am sure that at least 50% of the S&P
> 500 companies have a similar management makeup. All those Harvard
> MBAs (like Mr. Bush) will run you into the ground filling their own
> coffers!