The Game is over: There Won't be a Rebound

June 20, 2008
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An Interview by Mike Whitney with Michael Hudson on the Economy – Counterpunch

1–Fed chairman Bernanke has been on a spree lately, delivering three speeches in the last two weeks. Every chance he gets, he talks tough about the strong dollar and “holding the line” against inflation. Treasury Secretary Henry Paulson even said that “intervention” in the currency markets was still an option. Is all of this jawboning just saber rattling to keep the dollar from plummeting, or is there a chance that Bernanke actually will raise rates at the Fed’s August meeting?

MH: The United States steers its monetary policy almost exclusively with domestic objectives in mind. This means ignoring the balance of payments. From the U.S. vantage point, supporting the dollar’s exchange rate by the traditional method of raising interest rates would have a very negative effect on the stock and bond markets – and on the mortgage market. These markets fall whenever there’s serious talk of an interest rate increase, because it discourages speculation – and that’s what the Bubble Economy is still based on these days. Higher rates and a stock-market downturn would lead foreign investors to sell U.S. securities, and likely would end up hurting more than helping the U.S. balance of payments and hence the dollar’s exchange rate.

So Mr. Bernanke’s statements are merely being polite in not rubbing the faces of European and Asian governments in the fact that U.S. officials are not at all unhappy to see the dollar’s exchange rate plunge. U.S. officials believe that dollar depreciation will help their exporters, especially in the aircraft and other military-industrial sector. It’s foreign investors and central banks who must absorb the loss in their dollar holdings as valued in their own domestic currencies.

Like the domestic U.S. economy itself, the global financial system is all about getting a free lunch. When Europe and Asia receive excess dollars, these are turned over to their central banks. Until the recent decision to create sovereign wealth funds, these government bodies had little alternative but to recycle these dollar inflows back to the United States by buying U.S. Treasury bonds. This financed the domestic U.S. federal budget deficit, which stems largely from the war in Iraq that most foreign voters oppose. Unless foreign governments are willing to make a structural break to change the world monetary system, they will remain powerless to avoid giving the United States a free ride – including a free ride for its military spending and war in the Near East.

2–How do you explain the soaring price of oil? Is it mainly a supply/demand issue or are speculators driving the prices up?

MH: It’s true that enormous amounts of speculative credit are going into commodity index funds. Forward purchases increase the demand for deliveries of oil and other raw materials. But bear in mind also that as the dollar depreciates, OPEC countries have sought to stabilize their receipts in euros, and to offset their losses they are suffering on the dollar-denominated securities they have bought with past export proceeds. For over 30 years they have been pressured to recycle their oil earnings into the U.S. stock market and make loans to U.S. financial institutions. They have taken large losses on these investments (such as last year’s contributions to bail out Citibank), and are trying to recoup them via the oil market.

OPEC officials also point to a political motive: They resent America’s military intrusion in the Middle East, especially in view of how much it contributes to the nation’s balance-of-payments deficit and federal budget deficit.

Look at it from their point of view. They see that the U.S. invasion of Iraq was a win-win situation as far as the oil industry is concerned. If America conquers Iraq and forces the Oil Agreement through, U.S. companies will be able to grab the world’s largest available pool of oil for a generation, and U.S. officials can use the oil weapon against oil-deficit countries. Last week the U.S. oil firms managed to bump Russia’s oil industry out of the Iraq picture, reversing the trend that had been developing under Saddam.

And if the war continues to be a military and economic disaster, the price of oil will skyrocket, providing a price umbrella for domestic U.S. producers – as you can see from how the stock market is raising its valuation of Exxon and other oil majors. So the question is by no means just an economic one.

The U.S. press prefers to blame Chinese, Indian and other foreign growth in demand for oil and raw materials. This demand has contributed to the price rise, no doubt about it. But the U.S. oil majors are receiving a windfall “economic rent” on the price run-up, and are not at all unhappy to see it continue. By not building more refining and shipping capacity, they have created bottlenecks so that even if foreign countries did supply more crude oil, it would not be reflected in refined gasoline, kerosene or other downstream product prices.

3–The Fed has traded over $200 billion in US Treasuries with the big investment banks for a wide variety of dodgy collateral (mostly mortgage-backed securities). How can the banks hope to repay the Fed when their main sources of revenue (structured investments) have been cut off? Are the banks secretly using the money they borrow via repos from the Fed to dabble in the carry trade or speculate in the futures markets?

MH: The Fed’s idea was to buy enough time for the banks to sell their junk mortgages to the proverbial “greater fool.” But foreign investors no longer are playing this role, nor are domestic U.S. pension funds. So the most likely result will be for the Fed simply to roll over its loans – as if the problem can be cured by yet more time.

When a bubble bursts, time makes things worse. The financial sector has been living in the short run for quite a while now, and I suspect that a lot of money managers are planning to get out or be fired now that the game is over. And it really is over. The Treasury’s attempt to reflate the real estate market can’t work, but can only cut losses for the financial institutions who have become the nation’s major political campaign contributors. Mortgage arrears, defaults and foreclosures are rising, and much property has become unsaleable except at distress prices that leave homeowners with negative equity.

This prompts them to do what Donald Trump would do in such a situation: to walk away from their property. The banks will be left holding the bag, just as they were in Japan after 1990. In Japan’s case, real estate prices declined steadily every quarter for 17 years! That should give you a flavor of how serious the U.S. problem is today.

The banks are trying to win back their losses by arbitrage operations, borrowing from the Fed at a low interest rate and lending at a higher one, and gambling on options and derivatives. But this is a zero-sum game: one party’s gain is another’s loss. So the banks collectively are simply painting themselves into a deeper corner. They hope they can tell the Fed and Treasury that if it doesn’t keep bailing them out, they’ll fail and cost the FDIC even more money to make good on insuring the “bad savings” that have been steered into these bad debts and bad gambles.

The Fed and Treasury are following the traditional “Big fish eat little fish” principle of favoring the vested interests. They are more willing to bail out the big financial institutions than to bail out savers, pensioners, Social Security recipients and other small fry.

4–According to most estimates, the Fed has already gone through half or more of its $900 billion balance sheet. Also, according to the latest H.4.1 data “the current holdings of Treasury bills is $25 billion. This is down from some $250 billion a year ago, or a net reduction of 90%.” (figures from Market Ticker) Doesn’t this suggest that the Fed is just about out of firepower when it comes to bailing out the struggling banking system? Where do we go from here? Will some of the larger banks be allowed to fail or will they be nationalized?

MH: You need to look at what the Treasury as well as the Fed is doing. The Fed can monetize whatever it wants. And as you just pointed out in the preceding question, it’s been buying junk securities, leaving sound Treasury securities on the banking system’s balance sheet. Meanwhile, false reporting will help financial institutions avoid the appearance of insolvency.

Government bailout credit will keep the big banks alive. But many small regional banks will go under and be merged into larger money-center banks – just as many brokerage firms in recent decades have been merged into larger conglomerates. They will seek more and more government guarantees, ostensibly to help middle-class depositors but actually favoring the big speculators who are their major clients. What we are seeing is the creation of a concentrated financial oligarchy – precisely the power that the Glass-Steagall Act was designed to prevent. A combination of deregulation and “moral hazard” bailouts – for the top of the economic pyramid, not the bottom – will polarize the economy all the more.

Cities and states will preserve their credit ratings by annulling their pension obligations to public-sector workers, and raising excise and sales taxes – but not property taxes. These already have fallen from about two-thirds of local budgets in 1930 to only about one-sixth today – that is, a decline of 75 percent, proportionally. While the debt burden and the squeeze in disposable personal income is pressuring workers, finance and property are using the crisis to get a bonanza of tax relief. Democrats in Congress are as far to the right as George Bush on this, as their base is local politics and real estate.

5–According to the Financial Times: “Analysts at Citigroup said a planned tightening of the rules regarding off-balance sheet vehicles would force banks to reconsider arrangements and could result in up to $5,000bn of assets coming back on to the books. The off-balance sheet vehicles have been used by financial institutions to keep some assets off their balance sheets, thereby avoiding the need to hold regulatory capital against them.” Is there any way the banks can find investors with “deep enough pockets” to provide the capital they need to meet the requirements on $5 trillion dollars? Are most of these off-balance sheets assets mortgage backed securities and other hard-to-value bonds?

MH: It looks like the practice of off-balance-sheet accounting has become obsolete, because nearly all the banks have abused it in a fraudulent way. The United States is going to adopt Europe’s normal “covered bond” practice of bank head-office liability for mortgages and other loans. The Wall Street Journal had a good article on this on June 17, anticipating that the U.S. covered bond market might rise quickly to $1 trillion as early as next year. This coverage is what traditionally has protected European investors. But the United States put its faith in “self-regulation,” by banks – in a sector where financial crime always has been rife. We’ve already seen criminal charges brought against Bear Stearns, and the FBI has announced that it’s in the middle of a far-reaching fraud investigation. I hope they get Countrywide and the other crooked institutions – but nearly all the big banks and companies have been involved.

The problem with financial institutions is that they live in the short run. This actually has paid them. They declared large profits on fraudulent loans, and paid out an amount equal to their entire capital on wages and salaries for upper management, and dividends. So their managers have stripped them dry, leaving them today with Negative Equity. This is the same situation they were in back in 1980, but at that time the reason was that interest rates had soared to 20% in the Carter-Volcker inflation. Today, interest rates are low, and the banks already are broke. If this really were a “free market” economy, their shareholders would be wiped out – and the government would demand return of the exorbitant bonuses and salaries.

Instead, it looks like the government will bail out the banks. But I think it’s wrong to lend money to a bank today without getting preferential treatment over its stockholders and bondholders, plus secure collateral. In view of the heavy losses of German banks in Saxony and Düsseldorf in the U.S. subprime market last summer, and the heavy losses by Arab sheiks in Citibank stock last summer, it’s unlikely that investors will buy mortgages that no major bank or government agency stands behind. So something has to give.

6–Many of the TV financial gurus –as well as Henry Paulson–keep assuring us that the worst is behind us, but I don’t see it. Foreclosures are increasing, the dollar is falling, unemployment is rising, manufacturing is sluggish, food and fuel are soaring, and consumers are backed up on their credit cards, student loans and house payments. Where would you say we are in the present cycle? What will it take to rebound from the current slump? Will the stock market take a beating before all this is over? What do you think the greatest problem facing the economy is; inflation or deflation?

MH: The idea that we’re even in a business “cycle” is whistling in the dark. To think of the economy being in a cycle is to imply an automatic recovery is in store. This free-market idea was developed at the National Bureau of Economic Research by opponents of government regulatory policy. The fantasy is that the economy oscillates in a fairly smooth and regular sine curve. But this always has been a fiction. 19th-century writers didn’t speak of economic cycles, but rather of periodic financial crises. There is a slow buildup, and a sudden plunge, so the shape is ratchet-shaped.

Today’s plunging real estate and stock market prices are not a self-correcting ebb and flow in which downturns set in motion automatic stabilizers that produce recovery. Each U.S. recovery since World War II has started out from a higher level of debt. The result is like driving a car with the brakes pressed more and more tightly. Alan Greenspan at the Federal Reserve flooded the banking system with enough credit to enable debts to be carried by borrowing against the rising price of homes and office buildings, corporate stocks and bonds. In effect, the interest charge was simply added onto the debt balance. But now prices are falling, leaving families, companies and many Wall Street firms with negative equity. Asset-price inflation fueled by the Federal Reserve – is giving way to debt deflation.

Today, the prospects are dim for paying off debts out of further price gains for homes and real estate. Speculators have pulled out of the market – and as late as 2006 they accounted for about a sixth of new purchases. The United States and other countries have reached the point where interest and amortization payments are absorbing the entire economic surplus of so many individuals, so many companies and so many government bodies that new construction, investment and employment are grinding to a halt. Families, real estate investors and companies are obliged to use their disposable income to pay their creditors. This leaves them without enough money to sustain the living standards of recent years – and they no longer can wipe out their debts by declaring bankruptcy as in times past, because Congress has passed the harsh bankruptcy law that credit-card and bank lobbies paid them to pass.

This means that there won’t be a rebound, and it will take longer than 2009 to recover.

7–I read about 8 or 9 articles every day about the meltdown in housing. I always tell my wife that its like reading a Tom Clancy novel except the ending is less certain. As Yale economist Robert Schiller pointed out last month; the decline in prices is now greater than it was during the Great Depression. Will prices find a bottom in 2009 or will it take longer? If prices keep falling then how are the banks going to sell the hundreds of billions of dollars of mortgage-backed securities that they are presently holding?

MH: Prices will keep going back down, because they no longer can be bolstered by interest rates plunging further. The zero-amortization mortgages and low or zero (or even negative) down payments in recent years are as low as can be achieved mathematically. This means the end of the Bubble Economy.

The actual real estate market is much worse even than the present price statistics show, because many people are frozen in with negative equity. So instead of price declines, we’ll simply see many more foreclosures. This means that the banks can’t sell their mortgage-backed securities without taking big losses – except to the government at prices way above what the market will pay. The Fed already has let them borrow against collateral at way, way more than it is worth – in sharp contrast to how it treats middle-class debtors.

8–How serious is the current crisis in the financial markets and housing and what steps do you think Obama or McCain should take to stabilize the markets, reduce the deficits, strengthen the dollar, increase employment, and put the economy on solid footing? Is it possible to have a strong economy without policies that distribute the nation’s wealth more equitably? As chief economic advisor to Rep Dennis Kucinich, what one bit of advice would you give to Obama to restore America’s economic vitality and put the country on the right path again?

MH: In economic terms America today is in as “optimum” a position as it is can be. That’s actually bad news, because an optimum position is, mathematically speaking, one in which you can’t move without making your situation worse. This is the position we’re in now, and it’s already as good as it can get. There’s nowhere to move, at least within the existing structure. “The market” can’t be stabilized, because it was based on fictitious prices to begin with. It’s hard to impose fiction on reality for very long. The rest of the world has woken up – although not Congress, it seems.

In times past, bankruptcy would have wiped out the bad debts. The problem with such write-offs is that bad the savings that have been steered into bad loans must follow suit and go by the boards. But today, the very wealthy hold most of the savings, so the government doesn’t want to let them take a loss. It would rather wipe out pensioners, consumers, workers, industrial companies and foreign investors. So debts will be kept on the books and the economy will slowly be strangled by debt deflation.

The U.S. can’t reduce its balance-of-payments deficit without scaling back its military spending. Meanwhile, Congress is refusing to let foreign governments invest in much besides overpriced junk here, so central banks are treating the dollar like a hot potato, trying to buy foreign assets that can play a role in their own future economic development. At a point these actions threaten to leave the United States economically isolated as foreign economies protect themselves from U.S. credit creation out of thin air to buy their exports and companies.

The questio is, will Obama and other politicians be willing to tell the public the bad news – that restoring vitality will take radical measures? The way to do this is to present it as good news. There ARE reforms that can help matters, and they are reforms that Americans have endorsed for a century, ever since the Progressive Era.

One problem is that lobbyists for the vested interests are so powerful that they probably can get Congress to water down any real so much that the economic situation will to keep on getting worse and worse before the needed reforms can be enacted. On the other hand, only in such a situation CAN they be enacted.

I think that Mr. Obama would be wise to explain this before taking office. As president, he will have to do what FDR did, and challenge the financial oligarchy with new regulatory agencies, staffed with real regulators, not deregulators as under the Bush-Clinton-Bush regime. His political hope to avoid being blamed for the economic problems in which 16 years of Clinton and Bush policies have pushed the United States is to come out in the fall – probably after the election – and blame the Republicans for their regressive tax policies. This would help bring pressure on the new Democratic Congress to back a return to progressive taxation and serious financial restructuring.

For starters, Mr. Obama should repeal the Clinton repeal of Glass Steagall. And he should make large depositors and “savers” take the losses on their bad bets. Most of all, he will have to make the tax system back progressive again if the domestic market is to recover. Also, a good tax code should encourage equity financing instead of debt pyramiding as is now the case, thanks to the banking lobby. This winding down of U.S. debt can best be achieved by removing the tax-deductibility of interest payments, and do what the original 1913 income tax did: tax capital gains at normal income rates rather than subsidizing speculation. The great majority of such gains accrue to real estate speculators, not to industrial entrepreneurs.

Mr. Obama can help revive the middle class by paying Social Security and medical care out of the general budget, not as user fees borne by the lowest wealth brackets as at present. Until this change is made, FICA withholding should be levied on total income, without any upper cutoff point. If there is a cut-off point, it should be to exempt people who earn LESS than $60,000 a year. This would end up being fairly revenue-neutral. Pres. Obama should explain that his policy is not to “soak the rich.” It is to make them pay their way once again, by favoring a strong middle class as the tax code was meant to do prior to the 1980s.

Unless Mr. Obama does this, what used to be a democracy will be turned into an oligarchy. The problem with oligarchies is that historically they are so shortsighted that they stifle the domestic economy, driving enterprise and emigration abroad. This threatens to reverse America’s long-term affluence. The word means literally a flowing-in – an inflow of capital, of skilled immigrants and other labor, of technology, and of foreign support. All this has now been put in danger by the policies pursued since the 1980s. Industry and savings already have begun to flow abroad. Skilled labor and technology is next, while domestic infrastructure is sold off to foreigners. Free roads will be turned into toll-roads, and the fees, interest and profits sent abroad.

If this trend cannot be reversed in the present economic squeeze, U.S. living standards and the domestic market will be subject to IMF-style austerity and shrink.

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