Setting Thine House of Cards in Order

For those of us who grew up in the boom years of the 1990s, the idea of an economic depression was something for the history books, not the newspapers. From the collapse of the Soviet Union to 9/11, America was an island of relative peace and prosperity, even as much of the world was falling into chaos. Wealth flowed from indefatigable Wall Street; a feeling of stasis set in. Like cigar-smoking socialites in Jazz Age Manhattan, we never recognized the maelstrom that was developing just over the horizon.

The economic storm that's been quietly generating strength for years is now coming ashore, and it's official: last week was a Category 5 disaster for the American (and global) financial sector. Reputable, highly respected economists went on the record using the word "depression"; suddenly and irrevocably, the whole fragile network of our economy seemed on the verge of falling to pieces for a few tense days. The failures are by now well-known. Fannie Mae and Freddie Mac, mortgage giants with total loan obligations of 4 trillion dollars (making it the biggest company in human history and second only to the United States itself in total assets) were brought in under the umbrella of the US Treasury (read: taxpayer). Lehman Bros., a company with a hallowed 158 year history, went under, erasing much of their $600 billion investment pool as well as 20,000 employees. AIG, the world's biggest insurance company, followed in the path of government takeover. In a far less bloody but in many ways more real way than 9/11, American capitalism was placed under existential red alert, where it remains now.

It's stunning how quickly the events of the last two weeks have transpired. We have just witnessed the biggest government socialization of a private financial sector ever, yet most of us are too shocked and awed to question the profound ramifications of the continuing crisis. The fear is so palpable on both Wall St. and Main St. that we've essentially ceded huge powers to Hank Paulson at Treasury and Ben Bernanke at the Fed - investors have whisked their money away into the safest possible investments (CDs, gold, bonds) and handed these two men the sword with which to go off and kill the dragon. They'll open their eyes when the battle is over.

Over the weekend, our two beleagured and desperate saviors met with congressional leaders to hash out a far more radical and comprehensive approach to the widening crisis. The plan: throw $700 billion at bad mortgages, effectively taking the yoke of bad loans off the financial service sector's shoulders and placing them on those of the American taxpayer. Paulson expressed great grief over this prospect in interview after interview as he made his Sunday morning talk show rounds just like a presidential candidate: "It pains me that the taxpayer had to get involved in this, but it's better than the alternative." This notion has widespread bipartisan support: something must be done, and congress is prepared to act. But, as Paul Krugman points out, the new plans raises many more questions than it answers: are we going to buy these mortgages at a fair, real price or are we going to buy them up for inflated prices just to get some liquidity back into the credit markets? If we get them for fair, market prices, we leave much of the financial sector in dire trouble; if we overpay, we're essentially throwing money back into the hands of the institutions that so stupidly and greedily led us into this disaster to begin with ("cash for trash"). There is no win-win endgame here. If these pieces of paper are valueless - and nobody really knows how much they're worth - then we'll be throwing our money into a black hole. (And, by the way, $700 billion comes out to around $2,000 for each American.)

Like the earlier buyouts, this is a palliative measure. Injecting some liquidity into markets might have the desired short-term effect of freeing up credit so the economic juggernaut can keep churning away to face our crises another day. But will it solve the problem? Many people talk about the concomitant reforms that must accompany the bailout: in the future, we must have stricter regulations to ensure that "irrational exuberance" (or, in layman terms, avarice leading to idiocy) is kept at bay. This is indeed true - twenty plus years of hands-off, neo-liberal economic policy have knocked all regulation and accountability from the dark corners of the so-called "shadow economy" (all these complicated new financial instruments that have been developed to help rich firms get something for nothing). However, this isn't going to be enough. Even the vast sums of (borrowed) money, even the reforms - there is a systemic problem here. I'm no economist (although I do read the magazine), but I'm aware enough to understand that there's an elephant in the room here. Lately, more and more of us have started to address the pachyderm, however inconvenient a truth it may be.

Let's ignore all the smoke and mirrors of complex derivatives, credit-default swaps, bundled securities, and all the other arcane products of the finance world for a second here. Here's the fundamental question: What in an economy creates real value? This is something right out of a high school Econ text, but I feel our Masters of the Universe on Wall Street need to take a step back and contemplate this question for a moment. Real value, of course, comes in the form of real things: products, technologies, innovative ideas, houses, services, etc. At one point in the 20th century, America was the undisputed world leader in all of these things: we produced the world's cars, its electronics, its cutting edge concepts, etc. We CREATED value, in other words.

What's the difference now? Well, starting in the late 1960s and leading to the present, our economy underwent a profound transformation. The "Empire of Production" (historian Charles Maier's term) made way for the "Empire of Consumption." Our economy shifted to services, manufacturing jobs fled to China - this is all well known and it continues to be a major political bugbear. But what is often overlooked, however, is the rise of the financial services sector during this period, especially in the last 25 years or so. As value-creating areas of the American economy disappeared, investment banks and hedge funds moved in to take their place at the table of American wealth.

But are Goldman Sachs and AIG really the same as Apple and GM? They all produce billions in profits, have a global reach, trade publically. In ways, both industries are productive: Apple and GM produce things, and the financial sector lubes up the economy and gets them the funds they need to make significant investments. Some financial industries - I think we all can agree - are a good thing for the American economy. But the finance sector has become bloated and obese as a result of its own excesses (much like the American people - see last post). Today, the finance sector (money management, insurance, etc.) is bigger than health care, bigger than energy, bigger than manufacturing. Currently, this area of the economy accounts for over 20% of US GDP: that's right, 1 in every 5 dollars in the American economy is generated here. And what takes place on the computer screens and trading floors of these behemoths? Money and assets are transfered around, and the Masters of the Universe in the firms (what a telling term from the good ol' Reagan years) take a generous cut off the top. They are fundamentally middlemen, yet they account for a whopping percetage of our national economy.

Many analysts go much further in their damning assessment of finance's role in the US economy. More than being the unnecessary but ultimately benign middlemen, it can easily be argued that finance actually subtracts value from the economy. John Bogle (Vanguard Group CEO) estimates that finance takes a stunning $560 billion from the economy every year, money that could be going into research and development, new products, and other value-creating activities. Instead, these funds are going into the padded wallets of major investment firms. In the midst of the mortgage crisis, when Americans were losing their homes, we learned last winter that hedge fund manager John Paulson took home $3.7 billion as a result of betting against the housing sector. Without creating a thing, utilizing a system that completely lacks transparency, Paulson and his ilk fleeced the productive economy of vast fortunes while millions of people were getting booted onto the street. This is perverse and despicable, and it illustrates precisely what's wrong today. As economist Catherine Austin Fitts says, we have a "tapeworm economy."

Now, getting back to the bailout. We can toss all the taxpayer money we want at the problem, but it's not going to create value where there fundamentally is none. In a telling moment, we learned recently that Bear Stearns' biggest real asset at this point is their high-rise headquarters in Manhattan. At the end of the day, when all the smoke cleared, all they really owned was their building. All the files on the computers telling them they had hundred of billions in assets; all the pieces of stock paper - it was all just a house of cards. So what happens if Treasury tosses a lot of money back into this colossal shell game? Does it suddenly, magically make it so that the coin will appear under any of the shells when they are overturned, in essence creating something out of nothing?

The answer, of course, is no. We've been hearing a lot about the "crisis of confidence" lately. This fear is extending far beyond mortgages, even though that's what sparked this whole thing. So why is the entire sector all of a sudden dangerous and unsure of itself?

We are a debter nation - with the addition of all these buyouts, our total federal debt comes to over $14 trillion. Like the government, American people are proligate with their purses, and the average household now saves less than 0% a year: we officially borrow more than we earn. We let foreign countries, particularly China, subsidize our reckless culture of insolvency and living beyond our means. We let others subsidize our disasterous wars. Our trade deficit accounts for 5% of GDP, which essentially means that we consume far more than we create.

On an individual and a collective level, we are a culture living on borrowed time. And perhaps our time has finally run out. America's economic chickens are coming home to roost.


[In addition to the daily paper, information for this post was drawn from the following sources: Andrew Bacevich ("The Limits of Power: The End of American Exceptionalism"); Kevin Phillips ("Bad Money: Reckless Finance, Failed Politics, and the Global Crisis of American Capitalism"); John Bogle ("The Battle for the Soul of Capitalism"); Catherine Austin Fitts (see web citation); the following great interviews here and here; and NPR's new Planet Money podcast - all of these have been invaluable resources in helping me understand this grave situation.]