Too Much for a Fragile Recovery

Yesterday, Monday, August 8, 2011, the recovery officially died.  True, we are not technically in a recession yet, but yesterday was as good a day as any to draw the line separating our faintest remaining hopes for restoration of economic normalcy from a general sense of foreboding (or for some of us, resignation) about what is to come.

2 numbers are likely to be oft-repeated in news items in the coming days: 634.76 and 1 trillion.  The 1st of those is the number of points by which the Dow Jones Industrial average fell on Monday, which amounts to a 5.6% drop in its total value; the 2nd is the total value of investor assets that were lost in Monday’s domestic market tumble.  The S&P’s downgrade of the United States Federal Government’s credit rating from a perfect AAA to AA+ may have erred on the side of hasty, but even if Monday’s dismal market performance is an overreaction to an overreaction, there’s really nothing to restore the lost value of those investments, because these days there’s just no apparent good news to stamp-out the bad.   The New York Times observed that bank stocks were hit the hardest:

“…Bank of America fell 20 percent. Citigroup fell 16 percent. Morgan Stanley dropped 14 percent. JPMorgan fell 9 percent. And Goldman Sachs fell 6 percent.

“Investors feared that banks could be hit by the economic slowdown and that, with government spending constrained, lenders would be less likely to receive official support in the future should they need it, as they did during the financial crisis.”

Mind you, I’m not with those grumbling about the S&P’s downgrading of our government’s credit rating.  The S&P’s report on its decision gave 2 reasons for the slight but real decline in its confidence–a prognosis of deficits not managed, which I think is as-yet unjustified, and frank doubts about whether our political system and current politics will always provide for the reliable payment of our debt service, which I think is a fair question after House Republicans’ bizarre brinksmanship with the Federal debt limit.

I’m really curious how Wall Street investment bankers and hedge fund managers feel about how the loss of $1 trillion in domestic investments in a single day compares to the aggregate amount by which President Obama has proposed raising their taxes.  The fact that 1 rating agency downgraded the Federal Government’s credit rating from its highest to its next-highest rating and it caused the sharpest drop in the value of the Dow since the 2008 Financial Crash vindicates the President’s dark prognosis about what a “technical default” would have done to the economy.  This demonstrates the truth of the President’s insistence that House Republicans were holding all of us hostage when they held up the vote on increasing the Federal debt limit.  I’m not gloating about this sudden shock to the market, I simply wonder if Wall Street investment bankers and hedge fund managers feel the fools for their massive fundraising rally for the radical Conservatives of the Tea Party movement in 2010.

I also don’t mean to say that the President has exhibited any great insight into this problem.  At this rate the public is likely to blame him for the emergence of the Second Recession during his watch, and this will be a very hard charge to shake.  President Obama’s recriminations at the S&P over its decision to downgrade our government’s credit rating are uncompelling to put it mildly.  A friend of mind was shrugged the grim portents off yesterday: “Taking off my Marxist hat”–Oh, did I mention this friend is a Marxist?–“if you’re living in a market economy, you’re living in a market economy.  If the relevant professionals judge that you aren’t as creditworthy as you used to be, the way you feel about their judgment has no bearing on it.”  The President’s bitterness over the damage to our credit rating is pointless, and unbecoming.  The World has changed a little once again, that’s all.

Maybe President Obama is expressing frustration over a development that will damage his re-election prospects.  If one actually wants to be President, one probably wants to be re-elected President.  The outlook for his re-election has now become dim, and he must suspect that this is owing to the foolhardy actions of others.  This is true–but it isn’t the whole story.  The President of the United States is both the most powerful man in the World and doomed to constant reaction against a kaleidoscopic diversity of crises from all corners.  It’s true that a great many factors beyond his control have undermined our economic recovery from the start.  It’s also true that President Obama predicted that unemployment would peak around 8% by fall 2009 and begin to fall thereafter; with unemployment at 9.8% that September, the President declined to give the most-dismal economy in generations his full attention.

The great irony of the S&P’s downgrade of the government’s credit rating is that it actually drove investors to buy more US Treasury bonds.  With the Dow taking a 634.76 point plunge in 1 day, many investors concluded that stocks aren’t a safe asset in which to keep their money.  They turned instead to the investment they considered the most-reliable–the debt of the US Federal Government, somewhat-diminished from its unblemished reputation as an unshakeable source of sustainable interest, but still a more-stable investment than that of any private company or any other sovereign country.  Effective interest rates for all private-sector borrowers may rise on the news as investor confidence fades, and there simply is nowhere to stow massive financial assets more-securely than in US Treasury bonds.  (Talk of the Euro serving as a replacement currency for the dollar to denominate international financial transactions is dead, as the European Union grapples with the financial bailouts of several less-industrialized members–first Greece, Ireland, and Portugal, and now implausibly, Spain and Italy, 2 of the largest economies in Europe.)  So a market rating agency understandably censured the Federal Government for signaling that it lacked the political will needed to pay its own bills, which pulled the floor out from under many recently-cautious private financial actors, thus leading investors to put their cash in US debt, thus making deficit-spending cheaper for the Federal Government.  Why would the market do this?

The answer, of course, is the same motivations that drive the market at all times–self-interest in its most-Hobbesian of manifestations, profit and fear.

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4 thoughts on “Too Much for a Fragile Recovery

  1. Steve Giardina

    I think you made a few fundamental failures in assessing both the causes of the debt downgrade and their economic reaction on Wall Street. The majority of traders, investors, bankers said repeatedly yesterday that the credit downgrade of US debt meant very little to them. First, they had already anticipated that eventuality a long time ago and had thus priced it in to their market calculations. But more importantly, as far as the market is concerned, they did not see any evidence that there was an imminent risk of the US government not being able to pay its debt service. The brinksmanship leading up to the debt ceiling revealed an ability by the Treasury to manipulate the books for several months to ensure debt service, even past the Aug 2nd deadline that Geithner laid down. As actors in the market see it, even if our debt skyrockets out of control, they see a government that would first take severe austerity measures like limiting payments for other government services and slashing government programs before allowing a default. The result was that in the opening hours of the market yesterday we only saw a modest drop of somewhere between 150-300 points (modest being relative here, of course). We also saw investors flooding into US treasuries for this reason. In a sea of garbage, US debt is still seen as the best game in town. This is not something to be proud of, of course, but rather as people clinging for dear life moments before they drown.

    I think this is connected to your failure in assessing why S&P downgraded our credit rating. You had said there were two primary factors: our ability to maintain payment of our debt, and the current political climate precipitated by House Republicans. A few important points should be made here. You completely left out an economic assessment of both the US currently and projected into the future. Perhaps you considered that to be a sub-section of our ability to maintain payment of our debt, but it is too important of a factor to be glossed over like that. It’s common sense. When you, individually, receive a credit report, they don’t just look at your personality and past debt payments. They make an assessment of your current economic situation (your employment) and the potential variability of that economic situation in the future (how reliable your employment is and whether you will continue to have it in the future). The same was done by S&P. They saw economic indicators of a double dip recession coupled specifically with a deadlocked political climate. This is not a trivial elaboration. Even with a deadlocked political climate, the US government currently takes in enough in revenues to maintain our debt service. But coupled with a significant decrease in economic output and GDP, we find ourselves in a much more troubling long-term situation. The market reacted to our economic indicators and those of Europe, not our ability to address our debt service.

    There was one piece of news, however, that caused the market to go into free fall. That was the downgrade of Fannie Mae and Freddie Mac by S&P. It was remarkable how fast the market dropped. Almost 200-300 points in a matter of minutes. It indicated two very important factors. One, that the US government is still in the business of bailing out the housing industry and attempting, in vain, to inflate another housing bubble; and two, that the housing industry still has not bottomed out and that mortgage rates are likely to go up. S&P further downgraded a number of credit institutions and placed many insurance agencies on a negative outlook. The DOW did not tank yesterday because of S&P’s downgrade of US debt, but one huge factor was their downgrade of these other institutions.

    You know what else is incredibly interesting that you did not mention? When President Obama spoke to the nation about new stimulus spending and increasing taxes, the stock market went into absolute free fall. As he was talking! It tanked 150-200 points immediately after his speech was over. I watched the whole thing live–it was truly a sight to be seen. After the President of the United States tried to reassure the nation that everything would be ok and that the US is and always will be a AAA nation, the stock market absolutely tanked.

    What does all of this mean? The Austrians argue that Keynesian intervention, when it “works”, only delays the inevitable. It only creates an artificial bubble which is bound to massively fail in the future. What’s incredible about our current situation is how quickly it happened. It appears now that the political will for spending stimulus is completely dead. The market reacted violently to news of Obama’s insistence on tired buzzwords like the infrastructure bank. What’s really going to be interesting about today is that the Dow futures are up about 100-150 points. My guess is not just that they sense a buying opportunity, but that the Fed is meeting today to discuss interest rates (but I’d imagine also to discuss our overall situation and the possibility of a new monetary stimulus). The political will for spending stimulus might be dead, but a lot of people are clamoring for QE3. It’s going to be truly remarkable to see what happens if/when the possibility of QE3 is rejected. The Fed can’t lower interest rates any more than it already has, so I don’t see any other options for them other than QE3. I’m not sure that even the Fed is willing to run the risk of further inflation at this point, so I do not see QE3 coming. I predict a free fall in response to that news.

    Reply
    1. liberalironist Post author

      It wasn’t clear when Treasury would have a shortfall in its ability to meet current appropriations. The shortfall could have started on August 3rd, it could have started several days later. That was the problem itself: If Congress had waited any longer to raise the debt ceiling, the Federal Government would have an unspecified amount of money to pay an unspecified total amount of its bills–in sum, probably a little more than half. What you are offering as a reassurance that there was more time before a crisis is just a highly-optimistic forecast based upon the fact that so many bills of varying size go through the Federal Government in a given day that no one knew exactly when Treasury would come up short. Again, stalling further to find out whether the fiscal situation was as dire as it initially appeared was a bad idea, and to House Republicans’ minimal credit, they blinked before it came to that.

      I don’t know why you concluded, on the basis of a further decline in stock following the S&P’s downgrade of Fannie Mae and Freddie Mac, that “the US government is…attempting, in vain, to inflate another housing bubble.” We do know that Fannie Mae and Freddie Mac are in Federal receivership–and on that point the Washington Post’s article on that story says simply, “The downgrades of Fannie and Freddie were expected widely.” Regarding the downgrade of the various banks that provide Federal home loans, this also was expected by informed investors to follow as a matter of course. This sounds to me like it necessarily follows, as a lending institution that depends on the Federal Government to provide its specific financial services can’t seriously be said to be more-reliable in the provision of those services than the Federal Government that authorizes and underwrites them. So your theory that the markets reacted with surprise to each of these various downgrades doesn’t really make sense even if it receives circumstantial support from the evidence.

      Your read on the drop in the Dow in the wake of the President’s speech Monday takes an aggregate result for an industry judgment; it is not. The Dow is not a person, let-alone an expert in any field of human endeavor. When President George W. Bush gave his 2-day ultimatum to Saddam Hussein to leave Iraq or else in March 2003, the Dow increased about 300 points, essentially ending a bad run that had lasted since late-summer 2000. The President’s declaration inevitably functioned as a signal: Buy Defense, construction and oil company stocks! When President Obama spoke yesterday, some large investors were hoping for news of…whatever, and they didn’t get it. Getting no indication of specific actions that would help their investments, they sold off uncertain positions en masse, thus creating the impression that “The market thinks the President must be wrong” when the message was simply “A sizeable segment of the market doesn’t expect help to be forthcoming from the President.”

      As for the stimulus, our current unemployment rate hasn’t actually been put into perspective. The unemployment was as high in 1982 and 1983 as it is today, and you haven’t declared supply-side economics a failure as a result. The shock suffered by our economy in 2008 was the worst it has sustained since 1929, and it did so for the same reasons: Insufficient separation of deposit banking from investment banking led to overleveraged malinvestment, which encouraged overproduction (specifically of housing in our recent case), which eventually could not be sustained by consumer spending–particularly not with relatively-high unemployment and relatively-low median income growth. So, with inadequate financial regulation pulling the entire national economy down again, we’re probably stuck in a situation of years-long high unemployment and low domestic production. The stimulus prevented the shock of 2008-2009 from becoming worse, because large companies aren’t hiring due to a desire to be beneficiares of rather than investors in a recovery, while once overly-optimistic investors are now overly-pessimistic, representing the usual reconstitution from profit to fear as the investor’s basic motivation post-bust; meanwhile, with nominal unemployment still over 9% and the rate of underemployment and abandonment of the economy equally high, there aren’t enough consumers to produce short-term profits for companies to hire more workers. The market deals very poorly with this cycle, and that’s what Keynesian stimulus (if adequately-sized and targeted) is for. The problem with critics of the use of stimulus is that they really don’t have any ideas for how to put people to work. Supply-side economics produces the same prescription in a boom as in a bust, which has always suggested to me that it has nothing to do with the particulars of economics.

      I read a Washington Post op-ed (I wish I could remember the author’s name) that pointed out that Conservative critics of Roosevelt argued that the New Deal didn’t end the Great Depression. It’s true that the New Deal only restored modest economic growth–though this only ended in the late-1930s after President Roosevelt shifted from stimulus spending to deficit reduction–but Conservatives preferred to argue that World War II ended the Great Depression. This ultimate end-point for the Depression is accepted by pretty-much everyone. The problem for Conservatives is that this is a fundamentally Keynesian argument, and a strong Keynesian argument at that. Essentially, they are saying that the New Deal didn’t end the Depression, but far greater deficit spending essentially unrelated to the peacetime economy did end the Great Depression. (I also don’t recall any “Defense bust” that Austrian economics supposedly dictates must follow top-down investment on such a large scale; any excuse for this makes the Austrian critique of Keynesian stimulus look forced.)

      If quantitative easing is the only kind of stimulus still left to us, that would be suboptimal because all those dollars may simply go to wealthy investors who have no intention of creating jobs or boosting aggregate consumption with it. (The idea that the Bush tax cuts for the rich must be maintained because they will ostensibly create jobs with it some day is made, unselfconsciously, in the face of 2 years of evidence to the contrary.) That said, flooding the market with dollars couldn’t hurt, in part because inflation would be good for exporters (whose products would become commercially-competitive if the dollar were weaker), businesses that cater to international tourists (as more distance travelers would decide to visit the United States if their own money were to rise against the dollar, and thus against our prices), and debtors (as their debt is in nominal terms). Take those 3 groups together, and another round of quantitative easing would probably be beneficial; all it would take (and this may indeed be too much to hope for) would be for the Federal Reserve to commit to a long-term plan that envisioned a given rate of inflation.

      Reply
  2. Steve Giardina

    My basic point about the purchasing of US treasuries despite the credit downgrade was that you were reversing cause and effect. You noted the purchase of treasuries as a strange irony that seemed to defy the logical consequences of the credit downgrade. But you just have your causes and effects mixed up. Market actors look at economic indicators which, in the short-term, seem to show the likelihood of a double-dip recession. They see the potential for collapse in Europe, terrible jobs numbers here in the US, and near-stagnant GDP growth. They see a lack of political will for spending stimulus and the Fed showing a reluctance for significant fiscal stimulus in the vein of another round of quantitative easing. Thus, market actors are fleeing the short-term stock market for long-term investments which happen to be safer only because the short-term picture is so bleak. They are betting on a long-term strategy which will see inevitable economic improvement from the bleak short-term picture.

    S&P made a judgment based on a different calculus. They see very negative economic indicators in the short-term, AND they see the government continuing to put off addressing our significant debt problem to the long-term. In other words, they see an individual that not only has asked for an increase in their credit limit, but is also at serious risk of losing their job. The very behavior that the market is engaging in is indicative of why they believe the US debt deserved to be downgraded. They see a problem that has to be addressed now being kicked off to the short-term, they see a market that agrees with that analysis, and they see a political climate that is not only deadlocked, but has agreed to put off the majority of its cost-cutting measures to long in the future. There’s no irony here. S&P deliberately rejected the long-standing US faith that everything will get better in the future, somehow. They rejected Obama’s fantasy that the US has always and will always be a AAA country. The market is in complete lock-step with that fantasy.

    Financial stocks took an absolute pounding in early trading yesterday, on news that Bank of America was having trouble managing its assets. There was a rumor circulating that they would soon need an injection of capital to stay afloat. The news of Fannie and Freddie’s downgrade, while not unexpected, threw fuel onto the fire. Also, there was news that AIG is suing Bank of America for selling them mortgage securities that were junk.

    I don’t particularly have an interest in getting into a larger economic argument with you from this point, as I just don’t find that it would be beneficial for me. I’ll only make a few key points to the rest of what you said.

    – We have already talked, at long length, about the causes of the 2008 financial crash. You understand part of the mechanism behind it, but your analysis misses key factors and motivations which change the picture significantly. You paint the crash as the inevitable result of a market left to its own devices and insufficiently regulated while completely ignoring how specific government action and fiscal policy incentivized incredibly risky behavior.

    – I cannot speak to supply-side economics, but the Austrians fundamentally reject the notion that it is possible for a stimulus to be “adequately targeted.” The very idea that “the market deals very poorly with this cycle” is the essence of the problem. Any kind of Keynesian stimulus, no matter the size or direction, inevitably yields malinvestment because there is no consideration of profit or loss. The targets of stimulus are usually chosen in small pieces based on the political gains received by those who pull in pork projects for their local constituencies. In other words, economic considerations of what would make a good investment and what would not are largely ignored in favor of what projects yield political points for those who propose them. But the further, and deeper problem is that even the few spending projects that could potential yield a return on investment are managed so poorly and inefficiently that it is inevitable the government will run a massive loss in its construction and maintenance. The reason is that the government faces no pressure to go out of business should it not be able to yield a return on their investment. Five, ten, fifteen, twenty years, it doesn’t matter–the government is handing out free money so get in while the getting is good. The boom and bust cycle is made utterly inevitable by Keynesian economics. After each stimulus it is only a matter of time before the bubble of malinvestment bursts and the Keynesians are yelling for a new round.

    – Conservatives tend to argue that WWII ended the Great Depression, but they are simply wrong. Furthermore, Austrian economists do not argue that. I think the Austrians would be the first ones to tell you that conservatives “got religion” along with their fellow liberals a long time ago. As far as arguing that war ended the Great Depression I’d like to point you to the Keynes vs. Hayek Round Two video. Severe austerity was implemented through rationing and unemployment tends to plummet when there’s a Draft and a significant portion of the working population is sent out of the country. Also, a bust would not follow the influx of money into war spending because the flow is one-way. The money flows into tanks, weapons, and machines that are deployed and largely destroyed in the process of war. War spending is deliberately short-term investment, while infrastructure and housing are deliberately long-term investments. They are much easier bubble-formers. If conservatives want to argue that defense spending led to an economic boom, I’ll just point to the window-smashing argument. I can create 100 jobs right now by walking down my block smashing every window that I see and then hiring contractors to fix them.

    – Your last paragraph is almost too much to bear. I’m not going to touch it. It would take me too much time to dissect all of the problems with that paragraph. All I’ll say is that Q3 will just further delay the inevitable and make the next crash all the worse. In one breath you argue that the 2008 financial crash was caused by overleveraged malinvestment, and in another breath you suggest another round of quantitative easing to alleviate the consequences of that malinvestment. What precisely do you think that will encourage? When you bailout the losers there’s no end to the cost.

    Reply
    1. liberalironist Post author

      I never said investors turning to finance Federal debt as a shelter from the volatility of the private sector was illogical. I said it was simple, and logical: Investment is driven by a handoff between the motives of profit and fear, and investors concluded that the Treasury remains one of the most reliable sources of an interest yield. This is definitely ironic, as the S&P’s warning about the full faith and credit of the United States left many investors more-reliant upon it.

      As for blaming the boom and bust cycle on Keynesian economics, this has been the preferred means of dealing with a collapse of investment and production for almost 70 years, so the evidence doesn’t really sustain the Austrian critique of its essential role in the boom and bust cycle. Booms and busts long preceeded this, and even Milton Friedman blamed the Federal Reserve for the Depression *for not acting correctly and fast-enough.*

      Since you mentioned infrastructure as a supposed source of malinvestment, I’ll say something about that. The current political climate is crippling investment in our basic infrastructure, which is beset by breaking water mains, crumbling streets, and collapsing bridges. (Governor Tim Pawlenty may be happy that more people haven’t brought up the collapse of the bridge that carried Interstate 35 over the Mississippi River in Minneapolis back in summer 2007, as it suggests more-diligent stress-testing may have been 1 of the capital items that should have found their way into his “lean” budgets.) Taking care of infrastructure isn’t profitable for the operator of a highway; only collecting fees is profitable. A poor state of repair causes traffic congestion, damage to cars and accidents even without bridges collapsing. This doesn’t represent a failure of government but of political will: The drive to keep taxes low compels budgeters to put off necessary capital spending that doesn’t provide obvious and immediate benefits. Our infrastructure used to be the best in the World; today it is little-expanded since the 1970s because the Federal Government doesn’t make adequate capital investments. The Republican solution is public-private partnerships, which are well and good but which have been an option much longer than people realize. A few years ago Acting Governor Richard Cody tried to privatize the New Jersey Turnpike (which should be a rather attractive proposition as the only limited access highway directly connecting New York and Philadelphia through the Northeast Corridor), but a serious investor was not forthcoming. Apparently the profits wouldn’t come quick and easy-enough. Amtrak’s Northeast Corridor, meanwhile, is owned by the Federal Government and operates at a profit. All this private sector efficiency/government inefficiency talk is a myth, a simplistic distinction that assumes needed services can be provided effectively at-profit. When they can’t, the sound course of action is the old one: Tax people and spend the revenues on the relevant capital projects. We’ve essentially been trying to dodge paying for the quality of infrastructure and public services we want for 30 years now because we’ve been told we don’t have to, and now the results are all around us. Much as with the deterioration of investment regulations, Conservatives have had their way with capital spending since the late-1970s, and with an odd air of self-assurance they now essentially insist that the problem is that we haven’t been sufficiently inattentive for the problem to fix itself. Having found that no skepticism is more narrowly-bounded than that of strict free marketers, I propose we bite the bullet now and start actually paying for our infrastructure again.

      Reply

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