What is the cause of the growing turmoil in the housing and financial sectors of the economy, and what is it leading to?
|
On Mar. 14 and 16, the Federal Reserve took new emergency actions to arrange a fire sale of Bear Stearns, the fifth largest investment bank in the United States, which was teetering on the brink of bankruptcy. Still another “extraordinary measure” was announced on Mar. 16: “Acting quickly to prevent a bank run on major global financial firms, the Federal Reserve cut its discount rate by a quarter percentage point … and offered to lend money to a longer list of firms than ever before.” (MarketWatch.com) Further interest rate cuts by the Federal Reserve are expected.
The latest U.S. central bank rescue operations extend to not only the biggest U.S. banks and brokerages but also Fannie Mae and Freddie Mac, the main “government-sponsored enterprises” that have created and guaranteed huge chunks of this increasingly questionable paper.
At the end of 2007, Fannie Mae alone had some $2.8 trillion of mortgages that it either owned in its portfolio or had packaged, guaranteed and sold to investors. That amount corresponds to 23 percent of all U.S. residential mortgage debt outstanding. (Barron’s Online, Mar. 10)
Fannie Mae’s stock price fell 19 percent on Mar. 10 after Barron’s said it might need to be rescued. The Mar. 12 London Telegraph quoted Tim Bond, global strategist at Barclays Capital:
“The agency crisis was a tsunami event. The market was starting to question the solvency of bodies that stand at the top of the credit pile. These agencies together wrap [bundle into bonds] or insure $6 trillion of mortgages. They cannot be allowed to fail because it would cause a financial disaster. The fact that this sector has blown up has caught everybody’s attention in Washington.”
Fed takes bad assets as collateral for massive bailout loans
The new measures by the Federal Reserve include allowing banks and other financial institutions to borrow up to $200 billion (to be expanded if needed) in Treasury securities, which are highly “liquid”—in other words, they can be easily and quickly sold and turned into cash. These financial institutions would in turn provide their highly illiquid mortgage-backed securities as collateral.
Investor’s Business Daily, in its Mar. 12 edition, praised the measure as “innovative” and an example of “thinking outside the box,” since it supposedly provides relief to banks in need without stoking inflation.
Underlining the international scope of the credit crisis, the Fed also arranged “currency swaps” with other countries’ central banks. This effectively provides those countries with dollars to mount rescue operations for their commercial banks, which also face large losses on investments in U.S. mortgage-backed securities. Swapping weak dollars for stronger euros also helped to prop up, briefly, the sinking U.S. currency.
The energetic measures taken by the Federal Reserve to bail out those financial institutions “too big to allow to fail,” amounting to hundreds of billions in loans and swaps, contrast markedly with the tepid “rescues” of homeowners in distress. Most homeowners in trouble are not even being offered short-term help. Even for the minority offered help, in 73 percent of the cases the companies are simply deferring payments or adding them to the loan balance. (Wall Street Journal, Mar. 4)
Fed efforts fail
Previous efforts by the Federal Reserve to stem the credit crunch had aimed at restoring “liquidity” to the huge commercial paper market. Commercial paper is the name for short-term securities issued by corporations to fund routine operating expenses but also, in recent years, by banks and brokerages to finance the purchase of humongous quantities of mortgage-backed securities. That market had almost ceased functioning after the mortgage crisis hit in August 2007.
Put simply, banks and other financial institutions were borrowing short-term to lend long-term. They were profiting hugely from the sizable gap that normally exists between short- and long-term interest rates. Because of the lower risk associated with short-term investments, short-term interest rates tend to be lower.
These operations were carried out with minimum capital, which multiplied the profits. Some banks, such as Citibank, even went so far as to set up separate Enron-style entities to avoid showing on their books the big risks they had incurred.
When the sub-prime crisis hit, the big profits being raked in from investments in mortgage-backed securities turned into huge losses.
Following the August 2007 crisis, the Fed began cutting the federal funds rate, a key interest rate it largely controls for overnight loans between commercial banks. It did so timidly at first, fearing to set off a run on the dollar, and then more aggressively as the crisis worsened. Lowering the federal funds rate is accomplished via open-market purchases of treasury securities, which effectively puts more cash in the hands of commercial banks.
Usually, those banks would quickly seek to lend the extra cash for a profit. This did not work to thaw the frozen commercial paper market, however. The credit-worthiness of the banks had become so eroded that even banks with large excess reserves were afraid to lend.
The Federal Reserve also repeatedly lowered the rate at which it would make short-term loans to banks through its “discount window.” But the banks most in need of cash feared that the stigma associated with such borrowing could set off a panicky run on their deposits. And so that measure failed as well.
Finally, the Federal Reserve created a new “Term Auction Facility” to make it possible for banks to secretly borrow via periodic loan auctions without the stigma associated with the more public discount window. As the housing crisis deepened and foreclosures soared, it became clear that the TAF was not the answer either.
Hence, the “extraordinary measure” of offering to swap highly liquid Treasury securities for highly illiquid mortgage-backed bonds came into being.
Housing boom turns into bust
As the U.S. economy recovered from the 2000-2003 recession and subsequently entered a boom centered on housing construction, credit demand soared and interest rates rose sharply. This “boom” is a defining characteristic of the last phase of a capitalist business cycle upswing.
At a certain point, as usually happens at the peak of the cycle, demand for credit—especially, this time, credit to finance the speculative frenzy in housing—surged to such a level that short-term interest rates began to exceed long-term rates.
Such an “inverted yield curve” typically signals that a boom is about to turn into a bust—that an overproduction crisis is imminent, in which more goods (houses, construction materials, cars, and so on) are being produced than can be sold at a profit. When this occurs, industrial capitalists slash production and lay off workers.
The first signs of a credit market meltdown in August 2007 showed that an overproduction crisis was underway and that a recession, or even a depression, was looming.
Layoffs, cutbacks and rising prices
There can be little doubt now that the U.S. economy has turned down. According to the U.S. Labor Department, employers slashed payrolls by 63,000 in February—the largest monthly drop in five years—even deeper than the 22,000 cut in January.
In addition, the government counted hundreds of thousands of workers as having dropped out of the labor force, since they had, according to household surveys, given up actively seeking work. The economy must add at least 150,000 jobs per month just to keep up with people entering the workforce.
No doubt these figures are underestimates, since many thousands of undocumented immigrant workers have lost their jobs, especially in construction, and many have been deported.
Many more layoffs are in the offing. State and local governments have begun to impose draconian cutbacks citing revenue shortfalls brought about by the economic crisis. That means many thousands—probably millions—of public service workers will soon be out of a job, while many more, especially the poor, will be hit with the loss of services. California teachers are organizing to protest pink slip layoff notifications that will result from the governor’s proposed budget cut of $4.8 billion from public education.
On top of all this, workers are facing soaring prices, especially for gasoline and food—the very items left out of the “core inflation” numbers put out each month by the government. The national average price of regular gas jumped to a new record of nearly $3.25 a gallon at the pump as of Mar. 12, according to AAA and the Oil Price Information Service. In Hawaii, it has hit $4.
What happens now?
Gold, the universal measure of value, has spiked above $1,000 an ounce. This reflects a further decline of the dollar, which puts the U.S. central bank in a quandary: Further monetary easing could set off a run on the dollar and result in runaway inflation or even hyperinflation. Tightening credit would stabilize the dollar but most likely guarantee the failures of some of the biggest banks and brokerages, along with many other businesses big and small, and bring about a major stock market crash. It would also bring many more personal bankruptcies, foreclosures and evictions as well as mass layoffs.
Historical experience tells us that any sustained upturn in the capitalist economic cycle is impossible without some currency stabilization. The brief stabilization of the dollar in 1970 made possible the brief upswing of 1971-1973. Likewise, the brief stabilization of the dollar in 1974-75 made possible the short upturn of 1975-1979. And the far more profound stabilization of the dollar following the “Volcker shock” that boosted interest rates sky high in 1979-1980 paved the way for the prolonged 1982-1990 upswing.
Though it is possible that some economic indicators might turn up for a few months, without a stabilization of the currency—essentially a drop of a few hundred dollars in the price of gold—no meaningful upswing is possible.
Nor does stabilization of the dollar mean an immediate upswing; rather, a recessionary liquidation of inventory gets underway, which overcomes the overproduction. Such a liquidation amounts to turning the already overproduced goods or “excess inventories” into cash; in the worst case, those goods are destroyed. Furthermore, current output is slashed and, in more extreme circumstances, factories are permanently closed. This, however, would pave the way for a more or less prolonged upswing.
The Federal Reserve’s policy since the crisis broke out in August has been aimed at preventing the necessary elimination of overproduction—necessary for the capitalist system and the capitalist class, not the working class. Before being appointed Fed chief, Ben Bernanke made his mark as an “expert” on the causes of the 1930s Great Depression. He is now pulling out all the stops to avoid a new slump of similar magnitude—with the profoundly radicalizing effect it could have on the working class. The result is that the overproduction crisis goes on and on.
If the Fed had followed an alternative course, we would be in a much deeper industrial slump, but a sustained recovery might be in sight. No amount of “thinking outside the box” can change this reality.
Whatever policies the Fed and the U.S. government adopt in the weeks and months ahead, we face a future in which the unstable capitalist system and its criminal rulers will continue to inflict grievous pain on millions here at home and throughout the world. Labor and community organizations need to fight for implementing “extraordinary measures” of our own to ease the pain now, and then for abolishing the capitalist profit-driven system altogether and replacing it with one that puts human needs first.
