The economy is in the toilet and the President is begging for $700 billion to bailout the investment banking industry. I have some questions about all this and I hope to find the answers to them.
- What is really going on?
- Are we in a depression now?
- Is it a Wall Street bailout for $700 billion or something else?
- Will taxpayers actually be stuck with the bill for this mess?
- Do we really need to move quickly to “save” the economy?
- Didn’t we already bail out Fannie Mae and Freddie Mac?
- Didn’t we already bail out AIG?
Definition of an Economic Depression
In economics, a depression is a term commonly used for a sustained downturn in the economy. It is more severe than a recession (which is seen as a normal downturn in the business cycle). Considered a rare but extreme form of recession, a depression is characterized by unusual increases in unemployment, restriction of credit, shrinking output and investment, price deflation or hyperinflation, numerous bankruptcies, reduced amounts of trade and commerce, as well as violent currency devaluations.
There is no official definition for a depression, even though some have been proposed. In the United States the National Bureau of Economic Research determines contractions and expansions in the business cycle, but does not declare depressions. A common rule of thumb for depression is a 10 percent decline in gross domestic product (GDP). The corresponding rule of thumb for recession is two quarters of negative GDP growth. Hence using these figures, the threshold for depression is vastly more severe than that for recession. A GDP decline of such magnitude has not happened in the United States since the 1930s.
Generally periods labeled depressions are marked by a substantial and sustained shortfall of the ability to purchase goods relative to the amount that could be produced given current resources and technology (potential output). One could say that while a recession refers to the economy “falling down,” a depression is a matter of “not being able to get up.”
Source: Wikipedia
What is really going on?
Basically, lots of money has been loaned in a lot of areas to people and businesses who cannot repay the money. The supply of money available to loan (liquidity) is drying up as more businesses and people can’t make the payments on the money they borrowed. They can’t sell the assets they bought with borrowed money because the asset values have gone down, often below the amount they owe. More is owed than the stuff is worth.
This loss of liquidity is beginning to affect daily business activities because companies who make things or sell things have to have cash to buy inventory and raw materials before the products can be made and sold. They have to have cash to pay employees. They have to have cash to pay for supplies, maintenance, repairs, etc. to keep their businesses going. Assets don’t pay the bills, cash does. This cash is obtained through short-term loans. Money generated by these loans evens out the cash flow during the time between the purchase of inventory, raw materials, the labor of employees (paychecks) and the sale of the final products which generates the cash to repay the short-term loans.
Credit, in the form of commercial paper, which is what businesses trade in to get the short-term cash they need, is what makes our economy tick. Without it, the economy will slow down significantly and only those with the cash to buy what they need and pay their employees will be able to continue to operate.
This is why the credit crisis must be solved. If we do not inject cash into the economy and free up credit it may cause a Great Depression that may make the 1930’s look like a party. Our economy is bigger and much more global than it ever has been in the past. When we have liquidity problems, we cause liquidity problems in other parts of the world. If we dive into a depression, we will likely take the world economy with us.
Are we in a depression now?
We’re certainly on the brink of a recession. The GDP declined 4.3% in Q4 2007 to a growth rate of only +0.6%. GDP increased 0.4% during Q1 2008 to a growth rate of +1%. GDP increased 1.8% during Q2 2008 to a growth rate of +2.8%. Q3 2008 is likely to have a very low or negative growth rate. This is not a 10% decline in the GDP as has been the relevant benchmark for a depression.
We are not in a recession, let alone a depression, according to the GDP numbers, but there are many worrisome actions occurring now that may cause a fast nose-dive into a depression. We’re not in a depression in the 1930’s sense of the word yet, but we’re heading that way as fast as Thelma and Louise headed for that cliff at the end of the movie.
Let’s look at the other indicators that signal an economic depression.
Restriction of Credit and Reduced Amounts of Trade and Commerce
This is the major problem right now and it is a credit market crisis. Companies, like Sonic and AT&T, haven’t been able to borrow the money they need to keep operating, and some community colleges have had entire blocks of student loans unfunded. Boston College had to halt a construction project because of a lack of available cash to borrow.
Credit is becoming unavailable to those who should be able to borrow and who will most certainly pay the money back. Trade and commerce are declining because there is not enough cash to fund normal business operations.
Because of a lack of cash, companies may not be able to make payroll and people may lose their jobs temporarily or permanently. Job losses may start as early as this week if the credit market doesn’t open back up soon. Lost jobs means higher unemployment and people have less money to spend on basic necessities, let alone any kind of luxury. Unemployed people are more likely to default on credit cards and loans, including their home mortgages.
With an average of 14.3% of disposable income being spent on credit card payments, what happens when income declines rapidly? More defaults on debt payments and less cash in the market.
Shrinking Output and Reduced Investment
With the credit market drying up and insufficient cash available to do business, output is shrinking or it will start shrinking soon.
Investment banks have lost their trust in the customers who borrow from them. They fear any money lent won’t be paid back. They are not lending as much so they are not investing as much.
Nearly $1 trillion has evaporated from the value of the stock market. The stock market closed down over 500 points on September 15, rallied a bit over the following 2 weeks, but dropped like a rock again on September 29 by nearly 800 points. On October 1, 2007 the Dow Jones Industrial Average closed at 14,088 points. The DJIA closed on October 1, 2008 at 10,851 points, a 23% drop in value. This steep of a drop hasn’t been seen in the market since the terrorist attacks of September 11, 2001.
If you are retired and need your investments to make ends meet, I hope the market rallies quickly. If you are still saving and investing for retirement, it’s time to buy.
Price Deflation or Hyperinflation
We have both going on.
Can you say $4/gal for gasoline, $5/gal for diesel, and $6/gal for milk? Fuel and energy prices are much higher than they were just one year ago. Everything that depends on fuel or energy has gone up proportionately, and energy or fuel is intertwined with nearly everything I can think of.
Forty-six million Americans as of 2004 do not have any type of health insurance, and the number of people losing their insurance is growing each week. The majority of insurance losses is in the 18-64 age group. The cost for employers to provide insurance for employees is too high. Many uninsured people not only cannot afford health insurance, they cannot get insurance at any price because of pre-existing medical conditions. Many who have medical insurance find themselves in a position where their insurance does not cover enough of the cost of treatment for a serious illness, like cancer, and they are left with huge medical expenses they simply cannot pay. Those without insurance must either use the public health system for treatment or decide not to treat an illness at all.
Some investment banks are buying assets of other investment banks at extremely deflated prices. JPMorgan Chase & Co. bought Washington Mutual (a savings and loan) for the bargain basement price of $1.9 billion. At the time, WaMu’s market capitalization was $3.5 billion. At the end of 2006, Washington Mutual was worth $43 billion.
Bank of America bought Merrill Lynch in September for $29 per share. Merrill Lynch shares were only worth $8.70 per share at the time. Since Merrill Lynch hadn’t gone bust, Bank of America must think they’re worth the premium.
Lehman Brothers failed. Lehman Brothers is an investment bank that predates the Civil War and weathered the Great Depression. It filed the largest bankruptcy in American history in September.
Currency Devaluation
The Canadian dollar and U.S. dollar are now equal in value. That hasn’t happened since 1976. The Canadian dollar is usually of less value than the U.S. dollar. The euro is now worth $1.40 U.S.
Why is the dollar weaker against other important currencies? When the U.S. Federal Reserve drops its interest rate, the rest of the world’s central banks don’t have to do the same. This devalues the USD against other countries’ currencies. The Fed has kept interest rates artificially low since the terrorist attacks on 9/11/2001.
Central banks around the world used to buy and hold U.S. dollars. Now they diversify into euros, USDs, CDs, British pounds, German Deutchmarks, Japanese Yen, etc. The net result is there are more USDs out there to purchase and more availability means cheaper prices.
Oil-producing nations can sell their oil for USDs, euros, etc. We pay higher prices for the same amount of oil because our dollars are worth less. Those same oil producing countries sell USDs to buy euros and British pounds putting even more dollars out on the currency markets for sale, deflating their value.
A devalued dollar is bad for our economy because it causes inflation here at home. We import a lot of what we buy, and if our dollar is devalued, imported goods cost more. We get the same amount of goods, but we have to pay more for them. Oil is a good example. A barrel of oil cost over $120 a couple of months ago. Today, oil prices closed at $98 per barrel. It’s the first time in a long time that oil has cost less than $100 per barrel. When oil used to cost under $50 per barrel, pumping it out of the ground here wasn’t profitable, so we imported oil and left oil we still have sitting untouched under our own soil. Now it’s worth the trouble to go and get it.
There are some good things about a devalued dollar. We can sell more goods produced here overseas since our goods are cheaper because our dollar is worth less. Foreign companies, like Toyota and Honda, bring their manufacturing plants and jobs here because it costs less to pay our workers, the cars can be sold for less and they don’t have to be imported into the U.S. These companies make a profit doing this. It’s what our companies have done by sending manufacturing jobs to Mexico, Latin America and China.
Bankruptcy Rates
- 300,000 filings in 1980
- 750,000 filings in 1990
- 1.2 million filings in 2000
- 2.0 million filings in 2005 (the law changed in October 2005)
- 600,000 filings in 2006
- 800,000 filings in 2007
The law change in 2005 certainly curtailed the number of bankruptcy filings, but the rate is on the rise despite the new law, and the number of bankruptcy filings in 2006 only went down to 1990 levels before increasing to the 1993 level in one year. It will be interesting to see what the 2008 level will be.
Unemployment
- 6.1% during the month of August
- 5.7% during the month of July
- 5.5% during the month of June
- 5.3% during the second quarter of 2008
- 4.9% during the first quarter of 2008
Unemployment has risen steadily since the beginning of 2008. If the money supply doesn’t loosen up, unemployment could jump drastically, not because there isn’t work to do, but because there won’t be enough cash to pay workers.
Work Hours
Work hours stayed steady in all private employment (33.7 hr/wk), but manufacturing jobs declined 0.2 hr/wk and overtime declined 0.3 hr/wk since the beginning of 2008. The average hourly wage is up $0.33 since the beginning of 2008.
Percent of Debt to Disposable Income
- 11.0% in 1980
- 12.0% in 1990
- 12.8% in 2000
- 14.0% in 2005
- 14.4% in 2006
- 14.3% in 2007
This statistic is more distressing than the bankruptcy rate. It shows that 3.3% more of our disposable income is going to pay our debts than in 1980. It may not seem like much, but couple that with the average U.S. savings rate of -2% and we have a nation of people spending more than we are making and saving nothing.
Homelessness
This isn’t an official economic indicator, but we have an ever-increasing number of homeless people. As more people are living paycheck-to-paycheck, a job loss is causing families to fall through the cracks. The homeless are no longer drug abusers and bums. They are regular folks who faced an income crisis and lost. They are us.
On average, the homeless rate increased 19% from 2001 to 2002. 41% of the homeless are families with children. In New York city, the homeless rate increased 40% between 1999 and 2002. In Boston, the homeless rate increased 8.3% between 2001 and 2002.
Experts find the homelessness rate is directly proportional to the dismal job market. Jobs are harder to find, and many don’t pay enough to meet a family’s financial needs. Things cost more and people are earning less.
But 20% of the homeless are employed and most of the rest are actively seeking full-time work. They have more needs than the historic homeless person. They need a place to shower, shave and change into suits and ties to go to job interviews or to continue going to work if they land a job requiring such a dress code. Families have children, some as young as babies so shelters for families must provide cribs, diapers and formula. Children need to attend school if possible and must be clean and usually dressed in a uniform even to attend public school.
Another reason for the increase in homelessness of families is the welfare safety net is limited to 5 years. If you haven’t pulled out of your slump by then you stop receiving benefits even if it means you will be put out on the streets with your family. Philanthropic donations to homeless shelters and other services have declined along with a general decline in charitable giving. Some of the safety nets of the Roosevelt administration are gone again.
Are we in a depression? The GDP says no, but most of the other indicators are saying maybe to a definite yes. We’re at the brink of a depression if something isn’t done to prevent it.
$700 Billion Investment in the Financial Infrastructure, Not a Bailout
Many people are very angry about the idea that taxpayers are being put in the position where we have to bail out Wall Street and its rich, greedy CEOs and other company executives. When I think of the many middle class and working class families that are barely getting by, including myself, and then think of all these rich guys whining because their company might go under if they don’t get the money, I get extremely angry.
If we can bail them out, why not just pay off all the bad debts that are causing the problem in the first place? It would not cost as much as $700 billion to pay off subprime mortgages for every middle or working class family who is stuck with one. Unfortunately, it’s not that simple and the subprime mortgages are only the tip of the iceberg. They only account for 10% of the bad debts in the credit market. The other 90% is bad investment debt.
And it won’t be a bailout. It’s an investment in the economic infrastructure of the country and the world. What will happen is the government will pay $700 billion cash in exchange for artificially deflated assets that are causing the credit crunch right now. The cash will free up the credit market and allow businesses to get back to operating normally again, stabilizing the economy, providing goods and services and keeping unemployment from skyrocketing. The assets are shares of stock or percentage ownership in the companies that get some of the money. The government would actually be investing in the investment banks and holding the deflated assets as collateral until the market evens back out. The government then sells the assets it is holding slowly over time as they appreciate to pre-crisis levels or more, and recoup the money they invested in the economic infrastructure. This will not cost the taxpayers anything in the long run. It is a short-term socialization of the market to help the market work its way out of a mess.
How Fast Does It Have To Happen?
This bill has to pass as quickly as possible to open the credit market back up and get cash flowing to businesses again. When companies as big as AT&T and Sonic can’t borrow money short-term for operations, it spells big trouble and layoffs could start immediately if they don’t have enough cash to meet payroll and keep people producing.
The Senate voted on the bill on October 1. There were 74 votes yea and 25 votes nae. The bill passed the Senate with a 3/4 majority. Now the House of Representatives has to get off its collective butt and pass the bill. They already voted on their version once this week and it failed. Republicans voted against the bill 2 to 1 over Democrats. The committee thought it had a plan worked out that everyone would accept well enough to pass on Monday, but it didn’t pass. The current feeling is the House will vote on the Senate version of the bill again on Friday, October 3, but only if they are sure it will pass. If they feel it won’t pass the negotiations will continue over the weekend and the vote will come sometime next week.
The longer it takes Congress to pass this legislation, the worse off we the people will be and the more dire the consequences will be. If the credit market dries up at the end of the week but the House doesn’t pass the bill until Tuesday of next week, thousands of people could lose their jobs if payroll can’t be met.
Didn’t The Government Already Invest in (Bailout) Fannie Mae, Freddie Mac and AIG?
Yes.
Fannie Mae was actually a government agency created by President Roosevelt as part of the New Deal. Fannie Mae and Freddie Mac hold roughly $1.5 trillion in direct debt mortgages, guarantees on what could be as large as $5 trillion and possibly off-balance sheet obligations that could reach $3 trillion, according to recent estimates from Ladenburg Thalmann & Co.
The Treasury Department took over the two companies and the government will make periodic injections of funds by buying either convertible preferred shares or warrants in the two companies as needed, as opposed to a large, up-front cost.
During the third week of September, the Treasury Department and the Federal Reserve Bank bought 80% of the shares of AIG (American Insurance Group) for $85 billion. This came at the same time the government refused to bail out Lehman Brothers. The reason is the plan had to protect the families that count on insurance from AIG. Lehman Brothers bankruptcy isn’t directly entangled with the financial security of most Americans and didn’t deserve government help.
Conclusion
All these federal government investments come to several trillions of dollars.
The government will demand that company executives don’t receive golden parachutes or other excessive compensation for their bad decisions, there will be much more active oversight of these companies and the FDIC will now insure deposits up to $250,000 per person per institution instead of only $100,000. That needed to increase anyway and this is as good a place to make it happen as any. The reason for this increase in deposit insurance is people have lost confidence in the banking system and some are withdrawing amounts over $100,000 that they have deposited. This shortens the money supply even more and causes the credit market to have even less cash to use for lending.
The Federal Reserve may also find itself under more scrutiny. At present the Fed Chairman (Ben Bernanke, previously Alan Greenspan) testifies before the House Financial Services Committee. Other than that, it makes monetary policy as its bankers see fit with no other oversight by any branch of government. The Fed should seriously consider selling at least some of its 47 Lear jets.
In the long run, the economy will stabilize, taxpayers won’t actually pay for these investments in our financial infrastructure, and we may be able to avoid an economic depression. Taxpayers made a profit as a result of the New Deal in the 1930’s. It’s our money, but we won’t get dividend checks. We’ll get our money back in the form of lower taxes as the appreciated assets are sold at cost or at a profit.
The regulations that were stripped away over the past several decades that came out of the Great Depression will have to be reviewed and some will have to be put back in place. Others will only require funding and/or real watchdogs to enforce regulations already on the books. One way to deregulate is to put people in charge who are friendly to the industry they are regulating and allow them to look the other way when shady dealings are afoot.
An administration who takes a hard line against circumventing regulations is also vital to the success of this investment and to the long-term health of the free market system. People seem to be inherently greedy, and these regulations and watchdogs are necessary to keep the greedy from robbing the treasury while the President and Attorney General look the other way.
Technorati Tags: $700 billion bailout, AIG bailout, economic depression 2008, Fannie Mae bailout, Freddie Mac bailout
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October 2nd, 2008
Posted by
joubess |
Economy |
4 comments
