Our Economic Temple Is Not Structurally Sound

I like reading James Surowiecki, because he's smart, and because I tend to read exactly the same facts he reads and draw precisely the opposite conclusions.

In two recent Surowiecki posts (here and here), Surowiecki points out that during the banking crises of the early eighties and early nineties, banks were arguably as insolvent as our banks are today, but hey, with a little time and without any radical changes, everything turned out great.

The means by which banks recover their rude health, if you give them time, deserves a critical review. I mean to pen some nasty polemic about that, but for the impatient, Yves Smith tells much of the story (with all too little nastiness). See also here, and think about how much poorer people who run credit card balances have paid over the years on loans tied to the "prime rate".

The fundamental difference between my perspective and Surowiecki's is that I don't think those previous recoveries were real. My view is that the crisis that we're in now is precisely the same crisis we've been in since at least the S&L crisis. We've had a cancer, with some superficial remissions, but fundamentally, for the entire period from the 1980s to 2008, our financial system in general and our banks in particular have been broken. They have profited from allocating capital poorly, from funneling both domestic loans and an international deficit into poor investments (current consumption, luxury housing) rather than any objective that might justify arduous promises to repay. We all got a reprieve during the 1990s, because internet enthusiasm persuaded many investors to fund our consumption via equity investment, which we could wash away relatively painlessly in a stock market crash. Debt investors don't go so quietly. Thanks to the cleverness of our banking system, we have a very great many lenders, both domestic and foreign, who've invested in trash but who demand to be made whole at threat of social and political upheaval. That is the failure of our banks. That they are insolvent provides us with an occasion to hold them accountable, and to reshape them, without corroding the rule of law or respect for private property.

(Incidentally, I don't think that the problem is overconsumption or that austerity is the solution. I think we can afford to throw a perfectly good party, but it has been easier to put everything on the credit card than to come up with smart ways to pay for the economy we want in real time.)

Surowiecki seems to believe that if we could resolve the current crisis in pretty much the way we resolved the previous crises, that'd be okay. For me that's the second-worst-case scenario, after a major social collapse. Because I know that a superficially reformed financial system, both in terms of banking and international architecture, will continue to do great harm, permitting imbalances and injustices that will bring a serious collapse or a dangerous war if they are not addressed. We are fortunate, very fortunate, that things have pretty much held together so far, and for that people whom I usually criticize, Messrs Bernanke, Paulson, and Geithner, deserve some credit. But if they manage to "save the world" like that famous committee did during the LTCM crisis, with a lot of empty talk but no real changes once the crisis had passed, we will be here again, and we won't get lucky forever. This is a very serious business.

There are profound economic problems in the United States and elsewhere that our financial system has proved adept at papering over rather than solving. Those of us who've played Cassandra over the years have been regularly ridiculed as just not getting it, as economic illiterates and trade atavists. Unfortunately, as Dean Baker frequently points out, the people who could never see the problems are the only ones invited to the table when the world cries out for solutions. The solutions on that table are those Surowiecki tentatively endorses, weather the storm, take some time to repair, the temple is structurally sound. But the temple is not sound. We either build a decent financial system, or suffer real consequences, in unnecessary toil and lost treasure, in war and conflict over false promises set down in golden ink.

The banking mess and the high unemployment rate are not the crisis, they are symptoms. This is not "dynamo trouble", it is a progressive disease, and what is failing is the morphine. Those of us who believe that financial capitalism is a good idea, that it could be the solution, not the problem, do their cause no favors by resisting radical changes to a corrupt and dysfunctional facsimile of the thing. We need to approach financial capitalism as engineers, and to largely rearchitect a crumbling design. If we don't, we may be so unfortunate as to suffer yet another superficial remission. But error accumulates, and error on the scale now perpetrated by national and international financial institutions is unlikely to be without consequence.

Comments

[RSAAKKS:]

Why don't you point out what the problem is in our financial system, and what you think is the solution. Just saying the system is broken does not say much

Mar 15 03:16 PM

[Crocodilian:]

"The fundamental difference between my perspective and Surowiecki's is that I don't think those previous recoveries were real."
----------------------...

An interesting argument. If you bought a house, worked in a good job, raised a family and paid their bills-- what part of that wasn't "real"?

Our nation has two fundamental problems, neither of which has been addressed:

1) an aging population with guaranteed levels of healthcare and pensions, but in an economy which isn't producing enough wealth for these costs

2) a tendency to skew the GDP toward expenditures which don't increase future wealth (military spending, consumption) in preference to expenditures which do (investment and savings).

Unfortunately, there's been zero political will to address either of these issues, and great political punishment for anyone who's tried to grapple with them.

So previous leaders mostly "punted" -- to the future. We're living in that "future", where the bills that past leaders said "we'll pay tomorrow, or maybe the day after" have arrived.

Mar 15 04:32 PM

[SeekingTruth:]

The irresponsible and profligate loans by our major banks to So. America in the 70's & 80's in order to seize unsustainable and usurous interest rates very nearly brought down the world's banking sytem at that time when those debtors defaulted on many of the loans.

It also created an inflation inferno when the money we sent them came back to us to compete for our own goods and services. Four administrations felt the brunt of this, Nixon, Ford, Carter, and Reagan. But only Carter was chosen as a scapegoat, because he was politically "odd man out " in this particular group and a very easy and convenient target of the Corporate media and the oligarchies.

Later, when this well ran dry, the banking Ponzi scheme created by the S&L's took over to continue the legalized larceny, and any larcenous hearts with any connections at all of power and wealth profited handsomely , and without any retribution or the slightest accountability..

So their has always been a banking scheme to seize and exploit the public wealth going on, sometimes it's just more stealthy and successful than at other times.

It will be interesting to observe just how long the American citizenry shall remain willing dupes of and for our politicians and bankers.

We need an Andrew Jackson/Thomas Jefferson type personality for leadership very badly right now.
Any volunteers?

Mar 15 05:35 PM

[InnocentsAb...:]

In thinking about Jefferson and Jackson, both ended up being American icons because of their capacity to directly connect with the American common people.

I'd propose Michelle Obama, rather than Barak, to do this. Like Hillary, she is probably not only more upstanding than her husband, but also a more natural connector to the common people.


On Mar 15 05:35 PM SeekingTruth wrote:

> The irresponsible and profligate loans by our major banks to So.
> America in the 70's & 80's in order to seize unsustainable and
> usurous interest rates very nearly brought down the world's banking
> sytem at that time when those debtors defaulted on many of the loans.
>
>
> It also created an inflation inferno when the money we sent them
> came back to us to compete for our own goods and services. Four administrations
> felt the brunt of this, Nixon, Ford, Carter, and Reagan. But only
> Carter was chosen as a scapegoat, because he was politically "odd
> man out " in this particular group and a very easy and convenient
> target of the Corporate media and the oligarchies.
>
> Later, when this well ran dry, the banking Ponzi scheme created by
> the S&L's took over to continue the legalized larceny, and any
> larcenous hearts with any connections at all of power and wealth
> profited handsomely , and without any retribution or the slightest
> accountability..
>
> So their has always been a banking scheme to seize and exploit the
> public wealth going on, sometimes it's just more stealthy and successful
> than at other times.
>
> It will be interesting to observe just how long the American citizenry
> shall remain willing dupes of and for our politicians and bankers.
>
>
> We need an Andrew Jackson/Thomas Jefferson type personality for leadership
> very badly right now.
> Any volunteers?

Mar 15 06:18 PM

[Fred Voetsch:]

On Mar 15 04:32 PM Crocodilian wrote:

> "The fundamental difference between my perspective and Surowiecki's
> is that I don't think those previous recoveries were real."
> ----------------------...
>
> An interesting argument. If you bought a house, worked in a good
> job, raised a family and paid their bills-- what part of that wasn't
> "real"?


They weren't "solid", how about that?

You seem to be arguing that it's okay to pay your credit card off with another credit card as long as it keeps you out of trouble RIGHT NOW, but it's not. The trouble you get into is that the problem is going to be much bigger when you do face it and it may just be too big to deal with. That is where we're at now.

Mar 15 07:54 PM

[Poor Dude:]

I agree that we have a big problem. I also agree that problems created by too much debt can't be solved by simply borrowing more (which seems to be the approach we're taking).


So what's the solution? Should we just declare all prior debt null and void, and have every loan renegotiated between the person who's living in the house or driving the car and the bank that holds the title (at current values, and based on current income levels)? Set legal limits for each borrower that stipulate no more than x percent of their after-tax take-home income can be borrowed for living accomodations, no more than x percent for transportation, no more than x percent for medical treatment, no more than x percent for education, etc.?Immediately cancel all outstanding federal, State, county, and municipal debt, and let them all start over with a clean slate (and a balanced budget amendment to the Constitution, to ensure we don't venture down this path again)?


Those things may sound extreme, but they are do-able. And they might be the only way out of this mess which creates an environment which is sustainable for the long term future.

Mar 15 08:53 PM

[THofler:]

"Debt investors don't go so quietly."

"That they are insolvent provides us with an occasion to hold them accountable, and to reshape them, without corroding the rule of law or respect for private property." This is nonsense. We've already been taking the wrecking ball to the rule of law and property rights. What do you think a mortgage cram down is? It is a complete violation of the personal bankruptcy law that was passed only a few years ago.

Debt investors don't go quietly because the rule of law says that they are supposed to control the whole shooting match when things go bad.

I have to laugh that now the U.S needs to take lessons in capitalism from China, France, and Sweden.

In the Swedish bank nationalization ALL preferred and bond holders were made whole.

The Continental Bank of Chicago take-over was resolved with the preferred and bond holder made 100% whole. The chief of that take-over said he tried to get some value for the common shareholders but didn't quite achieve it.

Now we have any number of nitwits saying of our banks, "Let's zero out all of the investors." It's almost as though I can hear them think "Maybe we don't need to trash the debt holders, but it sounds like too much fun to pass up the opportunity."

What could be more fun than taking a couple million elderly folks who worked hard all of their lives & saved up a big nest egg and throwing them into poverty and the mercy of the state?

Mar 15 11:07 PM

[Crocodilian:]

@freddyv

On Mar 15 07:54 PM freddyv wrote:

"They weren't "solid", how about that?

You seem to be arguing that it's okay to pay your credit card off with another credit card as long as it keeps you out of trouble RIGHT NOW, but it's not. The trouble you get into is that the problem is going to be much bigger when you do face it and it may just be too big to deal with. That is where we're at now."
----------------------...

Except I didn't say that at all.

Debt as a % of GDP was at manageable levels in 2001, when W took office. He chose to fight a war, and cut taxes, which, predictably, has been disastrous.

Obviously, we're going to have to pay for W's party, and its going to be painful, but the author's contention that our problems go back to the 1980s is what I'm questioning.

The US economy produced extraordinary numbers of good jobs through the 1990s, together with economic growth that certainly seemed "solid". There certainly was a painful deflation of the Internet bubble, but its worth noting that many of the high flyers of the 1990s are still around, and while the share price of Cisco, for example, may not be what it was in 2000, it is, nonetheless a very "real" contributor to the wealth of the nation.

Mar 15 11:53 PM

[PastTense:]

We have the solutions: they are called bankruptcy and foreclosure laws.

Unfortunately the Republicans and Democrats both believe that certain classes of losers (bank investors, house buyers who overpaid for houses they couldn't afford anyway...) deserve to be bailed out.

Mar 16 12:11 AM

[Dirk McCoy:]

We live in a credit economy where debt service, due to the high levels of leverage most entities were encouraged by the market to take on as margins shrank due to global competition, was a key component of cash flow. With inflation targeting of 1.5-2%, some assets inflated higher (houses) than others (electronics) and created a sense of ever-increasing asset values. When the Fed increased interest rates, the resulting impacts to debt service (remember, not just interest payment but profit coverage and the threat of increased interest and profit coverage requirements) created a drop in spending- corporate and personal.

That this then put the entire financial system, and much of the consumer economy, into near collapse says alot about the leverage and underpricing of risk- but raised the spectre of "you break it, you fix it"- and so the Fed and Treasury have tried to step in and mitigate some of the bankruptcies and foreclosures. Without them, you well could have seen 50% of everthing in bankruptcy.

But if central banks don't create enough money/credit, deflation will continue to destroy our economy (price stickiness will act as a price control, and we all know what happens with that- reduced supply). When US purchasing power is double or more of the rest of the world, further devaluing our currency makes absolute sense going forward- it's just a matter of how quickly.

Mar 16 01:33 AM

[donzelion:]

Bravo, and a strong concurrence across the board. To extend the thinking...
----
We need to approach financial capitalism as engineers, and to largely rearchitect a crumbling design.
----
We need to approach financial capitalism as engineers, and also as "doctors" and "soldiers." For too long, the only party with any say has been sales teams - they're important, but should not be permitted to dominate, since one salesman isn't necessarily the best candidate to review another.

In product design, engineers play key roles designing, testing, and validating their products before they are ever marketed. In financial product design, all those functions are "dead weight" - far better to simply start selling the stuff at a profit, and let someone else bear the burdens if something goes wrong.

In medical care, doctors play key roles diagnosing, treating, and adjusting treatment to result in a favorable outcome for a patient/client. Putting a patient on "life support" is occasionally necessary, but never desirable. However, in financial care, the goal is to put the retiree's nest egg on "life support" - which lets the wealth manager extract management fees every year.

In war, soldiers play key roles attacking and defending key positions from enemy threats. In finance, 'enemy threats' include scams, abuses, exploitations, secretive double dealing, and the like. However, instead of empowering regulators, we engaged private armies of mercenaries to serve these risk control functions - AIG, Fannie Mae/Freddie Mac, the bond insurers, and the mega-banks.

Today's mess is a product of having blocked out "irrelevant fringes" - the doctors, engineers, and soldiers - and given all such roles and functions to the sales teams to perform.

Mar 16 05:38 AM

[Ferdinand E...:]

Let's take a look at what we've got here. The bad news didn't come last year, or when George Bush lost his mind after defeating Iraq and Afghanistan,and decided to keep the show on the road, but in the l980s. Hmm. It's a good thing that I gave up teaching macro, because if one of my students had written something like that, he would have received a failing grade on the spot. Notice that I said he, because I don't remember a female student in Sweden who ever came up with such a crank idea.

Mar 16 08:20 AM

[John Lounsbury:]

Steve Waldman - - -

Excellent article which challenges the reader to think.

User 50674 - - -

You wrote: "Why don't you point out what the problem is in our financial system, and what you think is the solution. Just saying the system is broken does not say much "

I think you are missing an important point: We are still in a process of trying to define what the problem is. The article and the comment stream make that clear. Until there is clear definition of the problem (separating cuases from symptoms) there can not be credible discussion of solutions.

As the problem becomes more clearly defined (especially causes of the problem), a box will be defined. At that point in time, we can start thinking outside the box. That's when the engineering, doctoring and soldiering (suggested by donzelion) can be really effective.

Personally, I found this article and comment stream to be intellectually stimulating. Now, we should just figure out how to make it pragmatically stimulationg.

Mar 16 11:33 AM

[Raution:]

"I don't think that the problem is overconsumption or that austerity is the solution"
I think that the issue has been somewhere in this line and like most of financial wizards, you have tried to read it quick. This statement needs more attention.
We all know that the source of this flood(credit crisis/recession)begin... in US and its because of the polices and culture that has encouraged us to spend more and bank on the future cash flows to repay it. Most of the time we forget that it is not certain that we will have a a future cash flow. Then what ? How will I pay my bills ? Any contingencies play ? And the answer is NO. And if many people answer in chorus then the situation becomes a financial mess. So we need to understand that we can spend to a limit and certainly more than we make but to an extent that if needed we can manage the leverage and do not turn belly up.
So, heed more attention to this issue and make your readers aware of it in your next article. thank you.

Mar 16 12:23 PM

[henarl:]

Crocodilian is correct in that past businesses, consumers, and mostly the government, have been kicking the can down the road and it has now come to rest again at our feet.

Unfortunately, short term gratification has always trumped long term consequences and the government is still kicking the can down the road with it's excessive spending. But the road is getting steeper and it's harder and harder to keep that can out in front of us. Eventually that road may end in a vertical wall and the kick the can game will end.

Mar 16 01:49 PM

[mr freddo:]

This is a very thought provoking article. As Mr. Lounsbury mentions, the point may be to sit and think about it for a while so we can start to focus on the cause rather than the symptom.

It reminds me of Churchill's quote: " A lie gets half way around the world before the truth has a chance to get its pants on."

We get excited into a lather about bailouts and bonuses without really getting to the core of the problem. But what is the core of the problem? Greed? Capitalism? Core values?

Before this meltdown, we were prodded to spend, consume, and borrow in pursuit of the good life. Just in light of the environmental damage that our consumption was and is exacting on the planet, this system was not sustainable over the long run even without a financial crisis.

Another quote this time from the Rolling Stones: "You can't always get what you want, but if you try sometime, you might find, you get what you need."

Communism was essentially an effort to get to the core of human society's problems and fix them. The cause of human suffering was determined to be the capitalist philosophy with its inherent exploitation of the worker. As we know, that experiment did not work out so well. I guess what that lesson teaches us is, be careful, things can always get worse.

Do we all need a dose of Zen? Is it time to question our core values? We put the wealth holders on a pedestal. The rich, the famous, the celebrities are worshipped. We overlook the shoe cobbler, the vacuum repair man, the grocer, the farmer, the priest. the teacher, the engineer.

Make things, grow things, invent things. Work. Save. Raise children with values. Reduce consumption. Read, learn. grow.

On that note, it's time to go for a nice long walk on a beautiful day. Thanks again for the article.

Mar 18 04:31 PM