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Friday, September 26, 2008

The Strengths and Vulnerabilities of the US Economy in 2008

Today's Buggy Topic

Read the title above, and you get a pretty good working-idea of today's bugged-out analysis . . . with one exception.  The lengthy buggy comments, posted yesterday in a thread at Carpe Diem --- the impressive data-driven web site of Professor Mark Perry of the University of Michigan --- also set out a fast, top-skimming analysis of where the US economy went wrong in the last 29 years of de-regulated markets: in effect, since the start of the Reagan era (with some deregulation carried out near the very end of the Carter presidency).

Deregulation of Industry and Services vs. Financial Institutions

Prof bug has always regarded the financial side of capitalism as its major destabilizing influence --- mainly because of the boom-bust nature of financial investments since the end of the 18th century.  Yes, even more so than external disruptions like wars or supply-side problems like surging oil prices in the 1970s and in this decade . . . at any rate, in American history.  More important yet have been the waves of excessive enthusiasm and then --- sooner or later --- excessive pessimism that have marked major financial investors in the stock market or bond market, whether the financial institutions involved are commercial banks, investment banks, brokerage houses, insurance companies, and (a real odd-ball innovation of this decade), independent real-estate brokers.  

A Period of Semi-Tamed Financial Markets 

In the 1930s era of FDR, all sorts of regulations were put in on the existing financial institutions.  The result? 

Though recessions continued after WWII, the financial causes were limited and more restrained, and so the recessions that disrupted American economic growth in the 1950s and 1960s were fairly frequent, but generally shallow . . . thanks in large part to government regulators and the Federal Reserve doing what they were supposed to do.  That changed in the late 1970s.  A period of sudden rising unemployment and rising inflation --- caused on the supply side of the economy by the huge burst in oil prices in that decade --- badly dislocated the US economy. 

Lacking a macro-economic theoretical guide how to deal with the rise of both --- until then, the Phillips curve followed by mainstream economists postulated a trade-off between the two --- the Carter administration started a new wave of deregulation, especially in service industries like trucking and air service and telephone-communications, with a limited de-regulation of financial markets.

Then Came the Reaganite Economic Revolution 

Guided by new classical free-market theories, a wholesale deregulation of more service industries and above all financial ones was implemented in the 1980s Republican era that, it's important to note, were furthered by the Clinton era in the 1990s . . . in ways discussed in the buggy comments that appeared in prof bug's posts at Carpe Diem.   

The wider consequence? 

Add in the big tax cuts on the income of the rich and super-rich in the George W. Bush decade.  Add further the tremendous sums of footloose capital in the hands of utterly corrupt gangster regimes in oil-rich countries and the huge sums of US dollars in the hands of the utterly corrupt Communist-controlled Chinese economy . . . sums that they didn't invest in domestic economic development such as improved infrastructure, better education, better environmental policies, better health-care for their people (or in the Chinese case, where 50% of GDP is saved! --- in more consumption power for the average Chinese household), or sums that couldn't be absorbed in the tiny Persian Gulf oil-glut countries even with better economic policies.  Add these together with the financial deregulations and innovative fancified financial derivatives and house-mortgage repackaging in this decade, and what do you have?

Yikes!  We all know now, nicht wahr? .

No Need to Say More: The Linked Buggy Commentary Deals with All These Points

Well, maybe one more thing is worth tossing in. 

Until the 1980s, an average investor in financial instruments --- say, the stock market or the corporate bond market --- could make sense of what he was investing in, even if, as with all investments, there was risk attached.

Suppose you were interested in investing in a big manufacturing company like GE.  You'd look at its profits over recent years; examine whether it was committed a decent slice of those to R&D and to training their employees; look at their own projections for future profits; and decide whether --- given what its stock prices were compared to its profits and its recent stock market performance --- it was a good investment with acceptable risk. 

Nowadays, it's all different.  We're in a of financial world of Alice-in-Wonderland investment instruments that few, if any, average investors can even make sense of, and --- worse --- that few so-called investment experts or advisers can explain clearly in simple-to-understand English.  And who knows?  Quite possibly, the vast majority of these experts have only a half-garbled idea of what they're touting.

An Example:

Consider, by way of illustration, what one knowledgeable investment adviser says apropos of the new-fangled allurements :

"... But try explaining a credit default swap -- the financial instruments now collapsing -- to your neighbor. Here is how one popular website defines the strategy:

"A credit default swap is a credit derivative contract between two counterparties, whereby the 'buyer' or 'fixed rate payer' pays periodic payments to the 'seller' or 'floating rate payer' in exchange for the right to a payoff if there is a default or 'credit event' in respect of a third party or 'reference entity.' " At what point in this elaborate series of maneuvers is the economy enhanced and American workers' standard of living increased?..."

Nor Is That All. 

Because, you see . . . even GE, which was a model company in the 1980s and 1990s, became partly a financial company as well.  And yes, in all sorts of financial areas, such as complex credit-loans in Europe that, in effect, act as surrogate mortgage-loans for house buyers as in France who --- staying in a house for only 7 years or so on an average --- want a shorter-term way of becoming the (highly indebted) house-owners. 

These substitute, half-disguised mortgages have a variable interest rate too --- like variable real mortgages.  Such financing has its advantages.  For GE, it brings a steady flow of credit-payments . . . as with GE financed refrigerators in this country, only for $200,000 and not $1000.  And since the French house, say, is lien-free, GE has a housing asset behind its loans to (half-disguised) house-buyers.  For the takers of these loans, they get a bargain --- or so they hope: possible full home ownership (if they can complete the credit payments over time) or, so they probably hope even more, the ability to reap capital gains from a housing price increase, sell off, and buy a new house . . . maybe financed in the same way. 

Of course, as with real variable 15- or 20- or 30-year mortgages, GE can hike the interest payments at will.  From the little prof bug knows about this system in France, it may not hike the interest due from, say, 4.0% in 2004 to 6.3% in 2007, but GE will try to keep ahead of general price-inflation and will hope --- as banks, insurance companies, and others stuck with huge packages of good and bad mortgages, amid following house prices --- that their asset-based gamble will still pay off.

Will it? 

And Believe Me, There Are Even Harder-To-Understand New Instruments

Click here for the Buggy commentaries on US economic strengths and vulnerabilities, with an effort (dashed off very rapidly, and touching on some highlight-causes --- nothing more), along with the initial post by Prof. Perry to which prof bug was responding.

The key point to keep in mind:

Time was, to put it tersely, financial institutions in this country --- commercial banks, investment banks, brokerage houses, and insurance companies --- were able to allocate capital with a fair amount of efficiently and manage risk decently over the entire business cycle.  That was in the era of effective regulation, roughly from the middle of the 1930s until the early part of the 1970s.