Friday, November 07, 2008

Who is spilling on who?

Is the financial crisis spilling out into the economy or is it economic weakness spilling into the financial system, or both? In his first press conference, Barack Obama said that "We have a current financial crisis that is spilling out into the rest of the economy." Yes, that is what we all have been saying, but when I actually read it like that, it immediately occurs to me that the direction of spillage is a little more complicated, so that simply fixing the financial system does not automatically fix the economy.

The basic problem is that the economy, for example GM and the airlines, was actually not in great shape when the financial crisis was taking root. In fact, GM and significant portions of the so-called "old economy" were really in rather sad shape back in the 1990's and basically got a free pass as a result of the rise of the "new economy" and the tech boom in the late 1990's. The dot-com boom gave the car companies and airlines the mistaken impression that "old economy" companies were doing just fine, if not great.

Then the technology and dot-com boom ended. And then 9/11 came along. Then all of the old problems with the "old economy" resurfaced.

In response, the Federal Reserve lowered interest rates in 1.00%.

That caused four problems: 1) the creation of the housing bubble (and we know how that movie ended), 2) the creation of a credit bubble that left Wall Street (especially hedge funds) thinking that they were on the top of the world, 3) the creation of a commodities bubble, and 4) the "old economy" companies got another reprieve from their structural problems and misguidedly acted as if they were in good shape rather than on the edge of a precipice.

We have been seeing the effects of the collapse of those three bubbles, but now we are on the verge of re-opening the storage vault where we had hidden all of those "old economy" structural problems for over a decade. A few billion dollars won't put very much financial "lipstick" on those "old economy" skeletons and pigs.

The car companies. The airlines. The companies that support construction. The list goes on.

Sure, we can and should have fiscal stimulus for transportation and other infrastructure construction projects, but that will not result in sustainable job creation.

After lowering interest rates to 1.00% and then watching the three bubbles grow and grow, eventually the Federal Reserve decided that inflation was a looming issue and began to raise rates.

Wall Street does not like rising interest rates.

But, I am not convinced that rising rates alone triggered the current problems, at least directly.

Rather, the housing bubble was so extreme and Wall Street's credit bubble (and the rise of the so-called "shadow banking system" was so extreme that people were willing and permitted to buy houses at any price and at any interest rate. Wall Street (and not Fannie Mae and Freddie Mac) had gotten addicted to securitization and even preferred the riskier debt due to the higher fees. And rising housing prices alone was also fueling further demand.

Then the housing market essentially hit what is known as "buying exhaustion" -- everybody who wanted to buy a house had done so. Not every last person, but the volume of demand rapidly fell off. Even though the Fed was raising its short-term target rate, mortgage rates remained quite low. The shadow banking system and Wall Street securitization were interfering with the effect of the Fed trying to raise rates.

Roughly at the same time, the demand for securitized debt rapidly fell off. This was at least partially due to rising rates (the Fed) which quickly made a lot of other investments relatively more attractive than securitized debt.

Wall Street was screwed. They were dependent on securitization for fees, but the somewhat out of sync bizarre combination of falling demand for mortgages by consumers and falling demand for securitized mortgages by investors left Wall Street holding the "bag", in particular, structured investment vehicles (SIV) holding mortgages and mortgage-backed securities, while buyers of those securities were suddenly becoming scarce.

Now the "old economy" companies were screwed. Rising interest rates were directly impacting them, and suddenly Wall Street and the so-called "shadow banking system" were unable to supply the copious amounts of super-cheap credit that the "old economy" companies were addicted to, such as GMAC and zero-percent car loans.

And once the "old economy" companies are screwed, their workers are screwed.

The result is a significant recession.

In short, a non-recessionary cooling of the economy (deflation of the housing bubble) led to a financial crisis on Wall Street. That is not the fault of the Fed for raising rates, but the fault of Wall Street for misguidedly structuring itself to be critically dependent on low rates and no longer able to cope with rising rates. Then, the financial crisis on Wall Street led to a credit crunch, which crippled both the "old economy" and even the "new economy" (venture capital is suddenly scarce.)

We can and should blame Wall Street for becoming addicted to the housing bubble, but it was in fact a slowing in at least one sector of the economy that triggered the Wall Street financial crisis.

The point is that merely putting the Wall Street Humpty Dumpty back together again does not resolve the longstanding structural problems in the "old economy."

Simply throwing money at the "old economy" companies does not magically restructure their inherent problems away.

And simply throwing money at consumers (who may be out of work) to in turn throw at the "old economy" companies does not automatically create new and sustainable jobs.

Interestingly, two of the key structural problems in the "old economy" are pension liabilities and health care costs. With the new administration having a high priority on both retirement and health care, it seems rather obvious to me that we really do need to move both retirement and health care out of the corporate structure.

In summary, we need to do a bunch of things and they need to be done in parallel. For awhile the banking system was clearly the top priority, but I do think that Ben and Hank have that firmly in hand. Now, we have two "spill" effects to deal with, the structural problems of the "old economy" and consumers and "new economy" businesses that are feeling under significant pressure due to unemployment, tight credit, and spending cuts at the "old economy" companies.

-- Jack Krupansky


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