Early on the morning of July 30, President Bush signed the act that the Senate had passed at a special session the previous Saturday. The new “housing act” (a more honest title would have been the “Financial Bailout Act of 2008”) authorizes the Treasury and Federal Reserve Board to provide unlimited credit to the mortgage packagers and insurers Fannie Mae and Freddie Mac, and infuse $300 billion of new lending power to the Federal Housing Administration (FHA) and localities to support the “real estate market.” This is a euphemism for saving mortgage lenders from the traditional response to falling property prices – defaults and walk-aways.
The act’s press release claims that its purpose is “to provide mortgage relief for 400,000 struggling U.S. homeowners and to stabilize financial markets.” But its real aim is to help banks and institutional investors get rid of the bad mortgage loans on their books. And mortgages are the major asset base of most banks and other financial institutions today. To support the price at which existing mortgages are traded and can be sold off by their present holders – banks and other financial institutions – the increased funding for Fannie Mae, Freddie Mac and FHA is part of a $1.4 trillion emergency supply of government credit intended to keep housing prices from falling back to more affordable levels, the Federal Reserve and Treasury will act in tandem to inflate asset prices to flood the economy with more and more free credit – that is, expensive debt to borrowers. This funding could have been to save individual debtors from foreclosure and re-set their mortgages at more realistic levels. But homeowners are not the constituency of the Treasury and Federal Reserve. Wall Street is, and its interests simply do not reflect those of the rest of the economy. Rather than rolling debts back to more affordable levels, the aim is to restore housing prices to high levels requiring new buyers to run even deeper into debt to obtain housing.
What ultimately supports the price of packaged mortgages is the market value of the real estate pledged as collateral. Via Fannie Mae, Freddie Mac and the FHA, the government will use its own credit to guarantee payment on whatever portion of the unpayable exponential growth in debt cannot be carried by the economy at large. Public sector loans and guarantees are to replace the bad loans that existing mortgage holders are stuck with. Property prices are threatening to sink by another 25 percent, on top of the 15 percent decline already registered. A price plunge of this magnitude would wipe out much of the collateral backing the loans packaged and sold to U.S. pension funds, other institutional investors and foreign banks. Free markets now mean markets where the government takes responsibility for the financial sector’s losses.
Why isn’t this more widely recognized? The explanation is an economic ideology that lives in the short run. Our society has lost its view of the future – the long-term view on which classical political economists and Progressive Era reformers focused. Most people do not see the financial war going on, and imagine that finance, industry and labor are fighting for the same kind of economic growth and wealth. The reality is a conflict between financial and industrial objectives.
Usually each side votes and acts in its economic interest. At least this is the basic axiom of democratic political theory and the economic theory of efficient markets. But it is best not to crow too loudly over victory. The recent financial bailout of irresponsible mortgage lenders is depicted as a housing bill to promote home ownership (at the price of debt peonage, to be sure), not as a giveaway to financial interests. It is best not to acknowledge that the financial system’s dominance over government debt and real estate policy threatens to push the economy further down the road to insolvency, or how it will squeeze state and local finances, and pension funding public and private. Deception has become a decisive rhetorical tactic. And the most prevalent mode of deception is to narrow the scope of how the public views rising real estate prices and the parallel growth in indebtedness.
The trick is to convince people that the buildup of bad debt can be bailed out by creating yet more debt, backed by public guarantees. Even the Wall Street Journal acknowledges that this is “socialism for the rich,” privatizing the profits of mortgage brokers and lenders while socializing the losses. But when has government been anything else, for thousands of years before anyone coined the term “socialism”?
Debt-financed asset-price inflation
Despite Mr. Greenspan’s now notorious celebration of soaring housing prices as “wealth creation,” it basically was debt creation. This is becoming clear to more people as housing prices plunge while the debts that served to bid up these prices remain in place.
Financial bubbles in their early phase gain popular support by inflating asset prices more rapidly than debts rise. This encourages a belief that debt leveraging – maximizing the use of borrowed funds relative to one’s own money – is a quick and almost effortless way to make the economy rich. This illusion is promoted by diverting attention away from growth in the actual means of production and living standards to focus on financial balance sheets reflecting the pace of asset-price inflation relative to the growth of debt.
During the real estate bubble homeowners, commercial speculators and corporate raiders were able to borrow the interest charges by refinancing their properties at higher and higher appraisals. But problems occur as finance and real estate extract rising amounts of interest and rent from the rest of the economy. A shrinking economy causes property prices to fall. Speculators (who have made up about 15 percent of the housing market in recent years – one out of every six buyers) stop buying, while an increasing supply of foreclosed and abandoned properties come onto the market. Banks pull back from mortgage lending, and falling prices push debt-leveraged homeowners into negative equity, followed by banks and other hapless mortgage holders. Buyers of packaged mortgages find themselves stuck with paper that is a far cry from the security its AAA bond ratings implied.
The parties being bailed out are the financial institutions that hold the bad mortgages extended, packaged and sold off in recent years. Also on the hook are “monoline” (single-business) insurance companies undercapitalized to sustain the risks of having insured their face value. Now threatened with bankruptcy, their stock prices have plunged to levels too low to raise much more capital to make good on the bonds and loan packages whose value they have insured. This is why Fannie Mae and Freddie Mac are being called on to “save the real estate market,” by which is meant the exponential growth of mortgage debt.
This growth has been achieved by the semi-public Fannie Mae and Freddie Mac providing “liquidity” not just by buying up and packaging mortgages in bulk, but by insuring their income streams. As William Poole, head of the St. Louis Federal Reserve Bank from 1998 to 2008, points out: “Fannie and Freddie exist to provide guarantees for mortgage-backed securities trading in the market. The business is simply insurance.” This insurance against mortgage defaults (and ultimately against banks and mortgage brokers making bad loans beyond the home buyer’s ability to pay) is what has made their sale so irresponsibly liquid. And matters have reached the point where between two and three million U.S. homeowners are still expected to default this year, leading to foreclosures.
Mr. Poole adds that the government’s assumption of the mortgages underwritten and guaranteed by these two public agencies technically doubles the federal debt, from $5 to $10 trillion. The asset side of the government balance sheet also rises, but attempts at real-world accounting quickly become tangled.
From “wealth creation” to debt deflation: Financial wealth as economic overhead
A deeper problem is that Fannie and Freddie underwrote and insured a debt increase whose exponential growth is unsustainable, because it causes domestic debt deflation. As noted above, what Mr. Greenspan called “wealth creation” – pumping up housing and stock market prices on credit – was actually debt creation. Asset prices depend on how much banks will lend. Property prices will soar if they lend more money on easier and easier terms. But carrying the debt that fuels this process diverts more and more income from being spent on consumption and paying taxes. Increasingly enormous charges for interest and amortization leave less available to spend on goods and services or to pay taxes. Paying creditors thus shrinks the domestic market, squeezing business profits and also public finances. Many individuals face default on their credit card debt, auto debt and other debts, obliging banks to set aside higher loan-loss reserves on their bad loans. They pull back from lending, leaving asset prices to spiral downward.
Over at the Treasury, Wall Street investment banker Henry Paulson hopes to solve this problem by providing yet more loans to finance the purchase of homes otherwise destined for foreclosure. The dream is to support the mortgage lenders by keeping housing high-priced, not for prices to fall so that new buyers do not need to run so heavily into debt to afford housing. Supporting real estate prices entails keeping the existing volume of debt on the books, and indeed running up even more. The economy shrinks, leaving it even less able to carry its debt burden. The moral is that the solution to every problem tends to create yet new, unforeseen problems – ones often are larger in scale, requiring yet new solutions that cause yet larger and even more unforeseen. This is how societies transform themselves crisis by crisis, for better or for worse.
Pension obligations as the new weakest link in the financial chain
After real estate, the economy’s largest debts are for pensions and health care. This problem has been growing beneath the view of most public media. Private-sector pensions are insured by the federal Pension Benefit Guarantee Corporation (PBGC), which is substantially undercapitalized in order to save companies from having to pay realistic insurance premiums. This is all part of the network of accounting pretense that has proliferated in recent decades. A much larger problem is state and local pension programs. Not only are they underfunded; they have no insurance at all! The expectation was that public-sector pensions would be paid out of rising property tax revenues and capital gains on financial investments. But taxing property now threatens to cause defaults on mortgage payments, and the stock market has not really risen since Alan Greenspan’s dot.com bubble burst in 2000. This is the corner into which the economy has painted itself by trying to preserve the exponential growth of mortgage debt.
The property-tax squeeze threatens to push state and local budgets into deficit at a time when their pension and medical insurance payments are soaring. On the expense side of their balance sheet, localities must spend more money to cope with the consequences of empty houses being stripped of building materials, occupied by squatters, burned down and generally becoming a source of blight. On the income side, states and localities are facing populist pressure to support politicians promising to reduce property taxes. This campaign is crafted by large real estate interests and promoted with the usual flow of crocodile tears on behalf of retirees and other homeowners suffering from the mortgage-debt squeeze.
At first glance the connection between bailing out Fannie Mae and, behind it, the real estate market to keep prices high for American homeowners might not seem closely linked to corporate, state and local pension plans. But bailing out mortgage lenders ultimately must be achieved at the expense of state and local property tax revenues. Revenue earmarked to pay interest is not available to pay taxes. Debts growing exponentially and extracting more carrying charges force a tax shift onto labor and industry.
For the past century the financial sector has made steady incursions to take over the role and power of government. The power of allocating credit has allowed banks and Wall Street to centralize the economy’s resource-planning power in their own hands. Today’s libertarian anti-tax “free market” rhetoric is simply a cover for the financial sector’s replacement of elected democratic government. Forward planning is being distorted to serve the financial sector rather than aiming to promote long-term growth and raise living standards.
This is exemplified by one of the lesser-known features of this week’s real estate bailout: the promotion of “negative mortgages.” These add the accrual of interest onto the principal so that they grow larger and larger rather than being self-amortizing. The cover story is that this innovative way of systematically running up more and more credit enables low-income homeowners to keep their houses with a minimum current carrying charge, borrowing the interest rather than paying it out of current income or resources.
The result is that the “capital” (land-price) gain that formerly accrued to homeowners or their heirs henceforth will accrue to the mortgage lender. For over a century, the main way that most American families have built up their wealth has been by the free lunch of exponentially rising land prices. What is to rise exponentially is now their debt overhead. It is the financial sector that will get the free lunch of land-price gains. For the past decade or so it has done this by refinancing mortgages at higher prices each time around. Henceforth the mortgage balance will rise automatically to loan the debtor more and more interest accruals.
Adding the interest charge onto the principal is how Ponzi schemes work. They cannot work for long, because no real economy can keep up with “the magic of compound interest.” The Bush-Paulson bailout plan calls for mortgages to become larger and larger, regardless of whether property prices keep pace. The interest is to accrue to the federal government as mortgage lender at first, but this innovation is really a test run for commercial banks to start making mortgage loans that give them the property’s “capital” gain as well as interest. In this way the loan volume never gets aid off. It keeps growing, accruing more and more interest for the banking sector – an automatic market-increasing sales strategy!
These gains consist of the inflation of land prices in cases where state, local and federal government fails to capture this gain for the economy at large. So the scheme obliges the public sector to turn elsewhere than property for its revenues – namely, to consumers and industry.
Who is not going to get paid: bankers and bondholders, or pensioners?
From corporate balance sheets to today’s state and municipal fiscal crisis, what appears at first glance to be a pension and Social Security problem turns out to be a financialization (debt) problem. In an attempt to maximize dividend payouts, companies in the auto, steel airlines and other industries made a bargain with labor to take its wages in the form of deferred pension and health-care payments. And labor – being more farsighted than corporate financial managers – chose to take deferred income so as to obtain greater security over the long run.
Public sector pension under-funding is he result of the anti-tax ideology promoted by the financial sector. Their politicians have repaid their major campaign contributors from the real estate and financial sectors by financing their budgets by borrowing from the wealthy, issuing bonds rather than taxing the traditional real estate tax base.
Corporate and public bond issuers point out that there is not enough revenue to pay all claimants. Their lobbyists have pressed cities from New York to San Diego not to raise taxes. This leads to a cutback in spending – and the path of least resistance is to ignore funding for retirement income and health care that public sector employees have negotiated. To pave the way for panicking voters into approving defaults and “renegotiation” of these promises, financial lobbyists are taking a neo-Malthusian position. They blame the corporate and public sector’s pension obligations, and the fact that people are living longer, increasing the number of retirees per employee or taxpayer.
The real question that needs to be asked is why the much-vaunted rise of science, technology and productivity is not able to carry this load. The explanation is that economies cannot carry this load and also pay exponentially rising debt service and money-management fees. Something has to give – and for the financial sector, this should be labor’s wages, industry’s profits and public taxes. This doctrinaire position overlooks the fact that productivity gains have created an enormous economic surplus over and above costs of production and basic living costs. The national income and product accounts show that labor is not receiving this surplus in the form of rising consumption and living standards. Rather, debt service and related financial charges, monopoly pricing and a proliferation of tax concessions to finance, insurance and real estate are absorbing the fruits of economic growth.
The financial sector’s insistence that labor is over-paid and over-pensioned turns out to be a smokescreen to divert attention from the degree to which lenders have made loans that can be paid off only by carving up and selling off assets and downsizing and outsourcing the labor force. Today’s debts – and property prices – are growing at compound interest, beyond the ability of economies to pay.
We got into this mess in the first place by giving special tax breaks to real estate and finance at the expense of labor and industry. Labor did not demand that government take responsibility for what most civilized countries provide employees and retirees: a living income and health care. Instead, this responsibility fell on the private sector. This burdened U.S. labor and its employers with a cost that their counterparts in most other countries are spared from having to bear. Corporate pension funds are obliged to pre-save via financial speculation to pay pensions and health care out of capital gains.
These asset-price gains are to be ensured by the government cutting taxes to leave more profits and other revenue to capitalize into yet higher loans to bid up asset prices, out of which to pay pensions and other costs of doing business, living and governing. The detour of financialization adds a non-production cost to the expense of doing business and hiring labor in America. Yet hardly anyone in authority is willing to disturb today’s financialized world-view to explain how to retrace our steps to get out of the wrong path we have taken.
There will be little motivation to seek an alternative as long as one believes that government can only add wastefully to overhead– and that the financial sector can only “economize” and make the economy more efficient. Without doubt, one can point to exorbitant retirement giveaways such as New York City’s pension arrangements for public transport workers, policemen and firemen. Their craft unions obtained pension and health care rights substantially above those of the labor force in general. But such deviations from the norm are inevitable in a system where pensions and health care are left to company-by-company, city-by-city and state-by-state negotiations rather than determined nationally as is the case in social democracies.
The situation is the same with taxes negotiated at the local level. Companies and real estate investors play states and cities against each other to extract special tax breaks for locating (or simply staying) in their areas. Political lobbying and insider dealing become rife under such conditions.
At the root of America’s pension and health care overhead is an ideological opposition to public services and taxation. In the aftermath of World War II, corporations opposed “socialized medicine.” This left companies to pay for health care out of their earnings rather than leaving it to government to organize and pay out of the general tax base. This probably made sense to the vested interests when they bore the brunt of progressive taxation. But they seem not to have noted that this attitude has ceased to be self-serving now that the richest families have succeeded in shifting the taxburden onto the lower brackets. General Motors recently has protested that health care costs more money per auto than steel. Yet someone must pay for health care and retirement. If not the government, then who – besides one’s employer? One wonders what General Motors wants more: the luxury of an obsolete anti-Bolshevist rhetoric, or to make consumers pay for their health care and Social Security as “user fees” without the upper tax brackets taking the responsibility they have borne in countries with more progressive tax systems.
In retrospect it would seem that companies did not act in their self-interest when they take responsibility on themselves for providing medical care whose price was soaring. The medical profession itself has been taken over by financialized health management organizations (HMOs) in the insurance sector, which is becoming an increasingly prosperous element of the FIRE sector (Finance, Insurance and Real Estate). It has put doctors as well as patients on rations – fee-for-service in the case of physicians, and rationed care for the hapless insured. Amazingly, this is depicted as a free-market alternative to centralized planning!
The explanation for companies acting so seemingly self-destructive a way is to be found in the era of progressive taxation. More than two centuries of classical economic analysis had shown the logic of taxing predatory wealth (land ownership, monopoly rights and financial claims on the economy) rather than labor and industry. The objective was to tax all forms of income not necessary for production to take place. Above all were rights to land, which is provided by nature, for the purpose of charging an access fee, and other extractive property rights and financial charges loaded on top of what actually needs to be spent on production.
The early income tax captured such “unearned income.” To minimize their tax liability in an epoch when they were the major parties being taxed, the FIRE sector opposed government spending as such, including public services, medical care and even basic infrastructure. This set financial and property interests in opposition to those of industry and labor. But being sclerotic and rigid, industrial companies failed to shift their attitudes toward public service as they moved to free themselves from taxation. Ever since the United States enacted its first modern income tax in 1913, finance and its major clients – real estate and monopolies – have lobbied to distort the tax code to make their gains tax-exempt. Rather than declaring taxable income, they count as a cost of production interest and over-depreciation for real estate, as well as payments to corporate shells in offshore tax-avoidance centers. The finance and property sectors also take their returns in the form of capital gains rather than as profits, trading through financial hedge funds whose revenue is taxed at only half the rate of normal income.
The wealthiest 1% take their returns in the form of bonuses, not wages, and enjoy a cut-off point of only $102,000 for FICA Social Security and Medicare wage withholding. When Wall Street Journal editorials assert that the richest 1% earn “only” a small portion of taxable income, all this really means is that a shrinking portion of their economic returns are deemed subject to the income tax. Their buildup of wealth takes a form not classified as “income.” Inherited wealth meanwhile is the great loophole for avoiding ever having to pay capital gains that have accrued on real estate and other assets rising in price.
If industrial companies act in an enlightened way, they will see that as they shed their fiscal burden at the national, state and local levels, their economic interest lies in “socializing” overhead costs such as labor’s pensions and health care. To be sure, this shift of expenses off corporate balance sheets onto the public sector – at the same time that business, finance and real estate is being un-taxed – is a travesty of real socialism. It simply passes the costs of pensions and health care off companies and localities onto the federal government, to be paid by the lower tax brackets – preferably as “user fees” such as Social Security has been since the Greenspan Commission’s notorious 1982 tax shift off business onto labor. Now that labor and consumers are paying the lion’s share of taxes, it is deemed permissible to extend public spending into areas of cost hitherto borne by corporate business and other private-sector employers.
But ideological sloganeering tends to rigidify thought and limit political policy choices. Corporate business and the financial sector continue to oppose “big government” even as they are un-taxed. That is the problem with the vested interests. They live only for themselves in the short run. The financial mentality is opportunistic (“after me, the deluge”), caring little about the future and not even understanding it very well. Labor cannot enjoy this luxury. It needs to look to how it will live after its working years end and health care becomes a rising expense. This perspective involves a more far-sighted economic and social contract.
Meanwhile, property taxes continue to be phased out as the basis for state and local finance. The tax burden is being shifted onto income and sales levies that fall on consumers, not on high finance and property. For many years the drive to un-tax real estate led cities such as San Diego and entire states such as New Jersey to pay their work force in the form of retirement and health care obligations rather than current wages, while borrowing from the rich rather than taxing them. The income hitherto paid as property tax was available either to pledge to bankers for loans to buy property rising in price as it was untaxed.
All this has been fiscal and economic madness from a long-term vantage point – a madness not of crowds but of self-serving lobbying by the financial sector. The result is a trend that cannot go on for long. But it can be bandaged over, as has just occurred with the July 30 bailout. Having managed to free themselves from progressive wealth and income taxation, the vested financial and property interests hope to pull the same trick again, to free themselves from the obligation to honor the pension and health care debts owed by corporate and public-sector employers to their work force.
Such evasion requires a populist rhetoric. Malthusian doctrine worked well two centuries ago, so why not try it once again? Blame population growth – in this case not the tendency of the poor to have more children, but the ability of employees to live beyond the retirement age at which they were supposed to die if they had conformed to the models used so hopefully by their employers in making their financial position appear more positive than it really was. The claim is being made that paying business and public-sector commitments to labor will bankrupt the economy. There is no mention of debt payments to bondholders for public funds borrowed as a result of cutting progressive taxes on the rich. Nor is there mention of the burden of high real estate prices and hence the home mortgage burden that the July 30 bailout of mortgage lenders aims to create and even increase. Rising real estate prices still seem to be “creating wealth,” not driving homebuyers into debt.
Something has to give. Will it be this financialized worldview? If not, then we will see all the usual journalistic adjectives when the next financial crisis hits: “unexpected,” “surprising everyone by the depth of the problem,” etc. Give me a break! Can no major media see the obvious trends at work as the financial sector careens along its collision course with the rest of the economy? “The Price of Fannie Mae,” Wall Street Journal editorial, July 10, 2008.
 William Poole, “Too Big to Fail, or to Survive,” The New York Times op-ed, July 27, 2008.