Pat Chaote in 'Saving Capitalism'

Pat Chaote has published a book titled ‘Saving Capitalism’.  I heartily recommend it as mandatory reading for all Americans.

This is a short history of what has gone wrong over the past decade and also why.  I have already posted that the cause of the financial disaster was outright treason.  This is the first economist to come out and spell out the details.  He adds to my own observations and for exactly the same reasons. 

He also rings the bell on the advent of state sponsored capitalism.  This is not going to go away and must be vigorously regulated.  This is an area that I admit I was aware of but had been happy to largely ignore.  That is not a good idea.  We do not have to wait here for human stupidity to arise before we act.

He outlines several excellent recommendations to remedy the situation that need to be implemented.  It is likely that this will not happen during Obama’s tenure.

He rightly describes the present situation as a depression with a small capital. 

If you want to understand what is presently taking place in the USA, then get this book.

As he clearly points out, the collapse has mirrored the collapse of the Great Depression.  We are now entering the second phase of the collapse cycle, were good business is strangled for cash and a second wave of massive layoffs is in store.  People with good jobs and partially paid for homes will suddenly find themselves forced into liquidation.

That is the present risk that must be averted.  It is now that you want to be scared.  Saving Wall Street cannot save Main Street if the banking industry is unable to lend.

California is on the verge of collapse and must internalize its banking arrangements as soon as possible in the same way as was done by Montana and Alberta during the Depression.  It is the only way in which the political forces in the state can be brought to heel.

Europe is struggling to contain Greece and may not succeed.  In that case, expect the currency arrangements to become at least partially unstuck until it gets sorted out.

Obama's Good Ship America

Obama has been the captain of the good ship America for a good six months now. Most critically, he has done nothing to arrest the collapse in household worth and fair to say, he will do nothing to arrest the collapse in household worth. I could say that he is incompetent, but it is just as clear that all the others at the table share the same fault. Otherwise, they would resign in disgust.

The US consumer is losing a large portion of his net worth and creditworthiness through no fault of his own. And who do you think the average American housewife is going to be blaming for this attack on their home? They are already beginning to wonder who the hell they elected. And somehow, a paean to socialist policies rings pretty hollow when one checks the size of your monthly unemployment payout.

The democrats now face the reality that they elected this man by visibly cocooning the candidate and thoroughly gaming the electoral process in a way to avoid any hard questions ever been answered. If they fail to pull the economy together or infinitely worse, manage to stifle all signs of recovery by allowing the worst aspects of the present foreclosure system to run its course, then they will find themselves blamed for the results.

We have finally done something through the housing business that is able to bring on a real economic depression. To be sure that happens, we merely need only do nothing whatsoever. The housing market has a bottom, but is a bottom with the value of underlying land reduced to zero. There will be ample cash around to buy houses at a fair depreciated replacement cost anywhere.

My son has seen the wisdom of this and has discovered a market in which no appreciation has taken place whatsoever. He is able to purchase modest properties, extract his capital outlay immediately and have enough high quality rental income to pay all finance and carrying costs and leave a couple of hundred bucks in his jeans.

Look around your neighborhood and do the numbers. When that happens there, I assure you, that the housing market has found a bottom. Then ask yourself what will your net worth be? This party is so over.

The global economy is swiftly learning to work with the sharp reduction in US purchasing power and fair to say, they are not expecting or planning for a quick recovery. We can expect the global ecoomy to establish a renewed growth rate somewhat less than formerly but still positive.

There is one other deadly problem brewing up, because of our complete failure to turn around the housing market in its early stages as suggested in my earlier postings on the restructuring of the foreclosure laws. State and Municipal finance is in free fall and will recover at a much lower level of activity. California was hopelessly over exposed thanks to a history of financial imprudence that remained untamed and was likely untamable. At least that is what pundits are saying. This likely means one of the worst results coming over the next three years. Arnie will likely be free of all this just in time and it certainly was not his fault.

This means massive amounts of borrowing at locked in low rates by all government agencies over the next three years until government finance is stabilized and recovering.

The depression spawned incredibly low interest rates on government finance and we are on the way to doing it all over again. In Canada, we even had a 3% perpetual bond that most certainly was the highest rate at the time. I believe some of it is still extant although the only real buyer became the Bank of Canada.

Government finance cannot expand fast enough to make up for the catastrophic loss of household income and wealth. And that sort of finance only provides poverty anyway.

Obama Muddles While Rome Burns

The broad markets have now lost a full sixty percent of their peak values. This is as bad as it should get. The vulnerable will be swept away. The housing market has put all mortgages issued since 2003 underwater to some degree or the other. It faces an overhang of inventory held by folks suddenly unqualified to borrow the sums they have contracted for.

This wall of inventory is strangling the majority of American consumers and if allowed to continue, it will succeed in destroying all credit and all financial institutions. The reason for this is that the ultimate strike price for buildings is the depreciated cost of the build out and the ultimate strike price for all land is the cost of providing services. All else is an intangible value created by property attractiveness.

With an overhang as we now face, everyone with free capital now owns all the properties they want while their capacity to borrow has disappeared. In short actual demand has collapsed far more than anyone understands and the banks now have to attempt to match the two together to get out from the position they are in and from there to rebuild their balance sheets.

Most consumers also have to rebuild their personal balance sheets. Without been reckless at all, a person with a good job had a mortgage on a property with a hundred thousand in free equity available and a credit card line that totaled $40,000. Now he has a negative equity of $50,000 and his credit card company is no longer revolving his card and is now charging usurious rates of interest for the slightest provocation.

He is highly motivated to force his credit card company into a settlement arrangement and to look carefully at the cost benefit arrangement regarding the house.

The problem is the mortgage portfolio and it must be fixed properly now. This is an emergency. Doing nothing is toying with the economic engine that has driven the world.

This is not a problem that the banks can solve by themselves. All they can do is ask for more money to shore up their balance sheets until the price of all underlying land approaches zero, so that trade becomes impossible. All the banks can do by law and the rules that guide them is to chase the price of property downward.

I have already explained what should be done and what will be done will approach that, but likely in a much more ugly fashion. After all it will be managed by folks driven by greed and stupidity.

President Obama is approaching his Herbert Hoover moment and the signs are not positive. Every investor understands that if his friends are losing their homes that his investments will start losing money.

The other shoe that has not dropped fully yet and it will be crushing, is the pending collapse in all government revenues. We are not talking about a few percentage points. We are talking of a massive revenue shortfall that no tinkering will escape. It also cannot be solved by raising taxes. Hoover tried and it suppressed the economy further.

Quite simply, each day that we fail to act will add several days of pain on the road back. Otherwise, our hope is, and that is a lousy way to run an economy, that there is enough liquidity in hard cash to suck up enough of the inventory to begin the recovery cycle. Once that happens the overhang can disappear quickly.

The last article is a timely reminder of how attempted intervention in the thirties was less than helpful. It also provides background to help understand current government thinking.

Poll: Voters Skeptical About Obama's Recovery Plan

http://us.mg4.mail.yahoo.com/dc/launch?.rand=98adha965nop2

WASHINGTON - Americans are skeptical that President Barack Obama will solve the economic crisis within two years but still overwhelmingly approve his job performance, a new poll found Wednesday.

Most voters also support Obama's mortgage rescue plan unveiled last month in a bid to quell a rising tide of home foreclosures, but they think it is unfair to people who played by the rules and met all their payments.

The large snapshot of more than 2,500 voters reveals deep pessimism among U.S. voters about the state of the economy and prospects for a recovery, according to the Quinnipiac University Polling Institute.

Half of the survey sample was asked whether they believed that the federal government could fix the economic crisis within two years and answered no by a margin of 68 to 26 percent.

The other slice of the survey group was asked whether Obama alone would be able to lead the country out of the economic mire within the same time period, and answered no by a 64 to 28 percent margin.

Yet Obama's approval rating, so far at least, seems immune to the impact of the worst economic crisis in decades: 59 percent of those polled said they approved of the job their new president is doing, compared with 25 percent who did not.

Overall, voters approve of Obama's handling of the economy 57 to 33 percent, and significantly give him much higher marks on the issue - 56 to 26 percent - than Republicans.

"President Barack Obama's approval rating is solid, compared to the historical record of new presidents," said Peter Brown, assistant director of the institute.

"But the lofty numbers he enjoyed after his election are leveling off, largely because of declining support among Republicans," Brown said.

There is also more good news than bad for Obama on three of his key domestic policy priorities, which he has been highlighting in the last two weeks.

By a 55 to 39 percent margin voters believe that he will get healthcare reform, an issue that has bedeviled past Democratic presidents, through the Congress this year.

By a 61 to 35 percent breakdown they also say they believe Obama when he promises not to raise taxes on anyone with a family income under 250,000 dollars a year.

But the president's vow, made last week to cut the ballooning budget deficit in half by the end of his term in 2013, draws more cynicism.

Fifty-five percent of Americans do not believe he can do it, compared to 38 percent who do.

The survey was conducted between February 25 and March 2 among 2,573 voters with a margin of error of plus or minus 1.9 percentage points.

The Government and the Great Depression

by Chris Edwards, Director of Tax Policy, Cato Institute


The economic policies of the 1930s are a continuing source of myth and confusion. Many people believe that capitalism caused the Great Depression and that President Franklin Roosevelt helped to end it. A recent History Channel special on Roosevelt said that his New Deal resulted in “recovery and reform” while creating “millions of jobs.”


1 Such often-stated claims are incorrect. Misguided federal policies caused the downturn that began in 1929, and they prevented the economy from fully recovering for a decade. Policy blunders by the Federal Reserve, Congress, and Presidents Herbert Hoover and Roosevelt battered the economy on many fronts. The events of the 1930s influence economic policymaking today. Many people think that we need a big government to prevent, or to reverse, recessions. But the 1930s illustrate that activist policies increase, not decrease, economic instability. Government interventions reduce the flexibility that markets need to adjust to shocks and return to growth. This bulletin looks at the 1930s economy and highlights the worst policy failures.


2 Policy Failures Lead to a Long and Deep Downturn


The Depression was a uniquely severe contraction. Real gross domestic product fell for four years before finally beginning to recover.


3 Real output only regained its 1929 level in 1936, but then output plunged again in 1938. The unemployment rate stayed persistently high at more than 14 percent for 10 years (1931 to 1940).


4 By contrast, the economy recovered rapidly after a sharp contraction in 1921. Real output fell 9 percent in 1921 and unemployment rose to 11.7 percent.


5 But the economy bounced back with output recovering all its lost ground in 1922. Unemployment fell to 6.7 percent in 1922 and 2.4 percent in 1923. The secret to the quick recovery was that the government generally stood aside and let the market recover by itself—wages and prices adjusted, resources shifted to new areas of growth, profits recovered, business optimism returned, and investment rose. By contrast, government policies in the 1930s prevented the U.S. economy from recovering. The following are some of the key policy mistakes:


6 Monetary Contraction. The Depression was precipitated by a one-third drop in the money supply from 1929 to 1933, which was mainly the fault of the Federal Reserve. The Fed made further errors that helped put the economy back into recession in 1938. Meanwhile, a flood of bank failures in the early 1930s compounded the money supply shrinkage and heightened economic fears. A key problem was that most states restricted bank branching, which prevented banks from diversifying their portfolios across jurisdictions. By contrast, Canada allowed nationwide branching and did not suffer a single bank failure during the Depression.


Tax Hikes. In the early 1920s, Treasury Secretary Andrew Mellon ushered in an economic boom by championing income tax cuts that reduced the top individual rate from 73 to 25 percent. But the lessons of these successful tax cuts were forgotten as the economy headed downwards after 1929. President Hoover signed into law the Revenue Act of 1932, which was the largest peacetime tax increase in U.S. history. The act increased the top individual tax rate from 25 to 63 percent. After his election in 1932, Roosevelt imposed further individual and corporate tax increases. The highest individual rate was increased to 79 percent. State and local governments also increased taxes during the 1930s, with many imposing individual income taxes for the first time. All these tax increases killed incentives for work, investment, and entrepreneurship at a time when they were sorely needed.


International Trade Restrictions. In 1930, President Hoover signed into law the infamous Smoot-Hawley trade act, which raised import tariffs to an average of 59 percent on more than 25,000 products. More than 60 countries retaliated by slapping new restrictions on imports of U.S. products. As new trade restrictions were imposed around the world, trade plummeted. By 1933, world trade was down to just one-third of the 1929 level.


Keeping Prices High. The centerpiece of the New Deal was the National Industrial Recovery Act of 1933. It created “codes” or cartels in more than 500 industries in order to limit competition. Businesses were told to cut output and maintain high prices and wages. Businessmen who cut prices were cajoled, fined, and sometimes arrested. Fortunately, NIRA was struck down by the Supreme Court in 1935. The Agricultural Adjustment Act of 1933 similarly restricted production to keep prices high. “Excess” output was destroyed or dumped abroad. While millions of Americans were going hungry, the government plowed under 10 million acres of crops, slaughtered 6 million pigs, and left fruit to rot. Production of milk, fruits, and other products was cartelized to boost prices under “marketing orders” begun in 1937. These policies reduced employment and burdened families with higher prices. At a May 1935 press conference, Roosevelt read letters from businessmen thanking him for keeping prices high.


7 With millions out of work and short of money, Roosevelt thought that his job was to shield high-cost producers from entrepreneurs wanting to offer lower prices to hard-pressed families.


Keeping Employment Costs High. Many New Deal policies raised employer costs, contributing to the extraordinarily high unemployment of the 1930s. NIRA industry codes required high wages. The new Social Security tax increased compensation costs. New minimum wage rules reduced demand for low-skilled workers. The Davis-Bacon Act required the payment of excessively high wages on federal contracts. Compulsory unionism and militant union tactics were encouraged under a series of laws. One result was that U.S. work stoppages soared from an average 980 annually between 1922 and 1932 to a peak of 4,740 in 1937.


8 While “millions of jobs” were created in the government during the 1930s, private-sector jobs were destroyed. Total U.S. private employment was lower in 1940 than it had been in 1929.


9 Harassment of Businesses. Investment stagnated in the 1930s as a result of uncertainties in the economy and the new risks of adverse federal actions.


10 Roosevelt and members of his administration demonized business leaders and investors in their speeches. FDR called them “economic royalists” and “privileged princes” seeking a “new despotism” and “industrial dictatorship.” Laws and regulations poured forth from Washington like never before. Roosevelt issued more executive orders than all presidents from Harry Truman through Bill Clinton combined. Presidents typically issue just a few hundred executive orders, but Roosevelt issued 3,723.


11 Roosevelt’s antitrust crusade was typical of his antimarket approach. The Justice Department hired hundreds of new attorneys and began a lawsuit blitzkrieg in 1938 against dozens of industries for conspiring to keep prices high. The irony was that Roosevelt had spent his first term encouraging cartels, monopoly unionism, and other policies designed to boost prices and production costs.


Conclusion


New Deal interventions were not only bad for the economy, but favored fat cats over average families. Most farm subsidies went to major land owners, not small-time farmers. Required reductions in farm acreage devastated poor sharecroppers. Efforts to keep farm prices high led to the destruction of food while millions of families went hungry. Compulsory unionism led to discrimination against blacks because it gave monopoly power to union bosses who often didn’t want them hired. NIRA cartels prevented entrepreneurs from cutting prices for consumers. Roosevelt’s strategies of handouts, federal jobs, subsidized loans, demonizing businesses, and public works projects in swing states worked well politically. But economically, Roosevelt and his “brains trust” had no idea what they were doing. They attempted one failed intervention after another. The Great Depression was a disaster, and sadly an avoidable one.

1 The History Channel, “America’s Man of Steel,” advertisement, Washington Post, April 17, 2005, p. R2.

2 See Chris Edwards, Downsizing the Federal Government (Washington: Cato Institute, November 2005), Appendix 1.

3 U.S. Bureau of Economic Analysis, Survey of Current Business, April 2000, p. 15.

4 U.S. Bureau of the Census, Historical Statistics of the United States, 1975, Part 1, p. 135.

5 For the change in output during the 1920s, see U.S. Bureau of the Census, Part 1, p. 224. For unemployment, see p. 135.

6 Most facts are from Jim Powell, FDR’s Folly: How Roosevelt and His New Deal Prolonged the Great Depression (New York: Crown Forum, 2003). See also Alan Reynolds, “What Do We Know About the Great Crash,” National Review, November 9, 1979.

7 http://newdeal.feri.org/court/fdr5_31_35.htm.

8 Powell, p. 204. Powell cites data from Morgan O. Reynolds.

9 www.bea.doc.gov/bea/dn/nipaweb. See Table 6.4A.

10 Real gross private domestic investment did not recover to its 1929 level until 1936. Investment fell again in 1938. U.S. Bureau of Economic Analysis, p. 15.

11 William J. Olson and Alan Woll, “Executive Orders and National Emergencies: How Presidents Have Come to ‘Run the Country’ by Usurping Legislative Power,” Cato Policy Analysis no. 358, October 28, 1999, p. 13

Halting the Mortgage Collapse

A short comment of the current condition of our securities markets appears to be in order.

A run on a major bank with Freddie Mae and Fannie Mae coming to the table cap in hand is not business as usual. In fact it is a reprise of the worst days of the onset of the Great Depression. That is the bad news.

The good news is that volatility has increased in the oil market and a major commodity price crash is now brewing up. Expect oil to break below a $100 very soon. The economy cannot sustain the higher prices at all. The other commodities can be expected to follow suit right away.

The problem we have is that the real estate market has been marked down and is now taking all boats with it. Your fifty percent mortgage in the Hamptons can go under water. And underwater debt cannot be resolved easily until all that inventory is worked off a generation from now.

Any attempt to actually solve the problem by liquidation is impossible because the incoming supply is outstripping the supply of any likely buyers. It cannot be done.

So far the fed and congress has thrown cash at the institutions in an effort to keep it all afloat. The problem with this scheme is that it is not creating new buyers and not halting the downward pressure on prices.

This may not end until a full blown decadal depression is in full swing with a major deflation of value across the board. However, there is a simple fix that can be implemented if someone had the balls and vision.

Every property is marked to market on a set day. Each property is mortgaged to a maximum of 75% of value. The owner surrenders a fifty percent equity share in the property for the balance of the old mortgage not so covered to the mortgage company. The balance sheets of the mortgage companies are then refinanced by the takedown of equity by the fed or other government agency. (this going to otherwise happen the hard way)

The next day all the customers are whole and are in rebuilding mode. The banks have a major new shareholder(s) and a shrunken mortgage portfolio of high quality as well a huge portfolio of property equity that it can expect to dispose of profitably over the next several years as their new partners will want to buy them out.

The customers emerge largely whole and the banks emerge chastened but with excellent prospects to recoup all their capital in the medium term as prices now begin to rise as fresh demand is created. And we can get on with solving the energy problem.

Credit Stabilization

I try not to write often on the condition of the global markets as it is rather off topic for this blog. Of course, being a student of the markets for decades, I do have opinions and ideas that sometimes need to be shared.

Friday saw our first true bank run since the depression. It appears to be essentially averted and stabilized. More importantly, the institution will not liquidate. In the depression, institutions failed and this destruction of infrastructure aborted an early recovery.

Several years ago when a number of new debt instruments came into vogue, I was very disturbed. I know that there is no set of rules and ironclad guidelines able to resist a rising market and the enthusiastic participants. And so we have the sub prime collapse and other related inventories of debt instruments reeling into the market.

What few folks realize is that mortgage contracts are long term contracts between the borrower and the lender. They simply cannot be either unwound or liquidated on a whim or for that matter dire necessity. They are also very difficult to resell.

Over the past several years, a vast amount of fresh debt was promoted and created that with falling property prices are under water already, with worse to come. The good news is that this type of dodgey lending has ended. The bad news is that the bulk of the outstanding inventory needs to be refinanced as good paper. This is not going to happen with current lending rules and products.

However, if we fail to in fact refinance this idiotic disaster, we will have an unavoidable shrinkage in the money supply, to say nothing of a restructuring of equity. It will be a real depression. That is why the fed is jumping through hoops these days trying to keep the system turning over. Almost certainly, the velocity of the money supply is declining.

The one sector that will and is having a massive effect on the citizenry is the housing market. It is already a disaster and can slide into free fall. I can suggest a fix or at least a patch that could restore confidence and speed the turn around.

That is to unilaterally mark maturing mortgages to market and impose a new contract structured as follows:

A 75% to current value forty year mortgage provided the borrower qualifies (it gets real easy with dropping prices).

A swap of the remaining old loan principal in exchange for a fifty percent participation in the equity of the house over the current mortgage value established for lending.

Lenders have been statute barred from equity participation in such housing equity. Unfortunately, their own folly has made them the only buyers for the time been. So we must make a temporary fix.

The benefits are obvious. The borrower has a mortgage that is feasible in the current lending environment based on the present value of the property. His credit is also healed or soon will be. Disruption is largely avoided.

The lender swaps a current write down against capital for a fifty percent equity interest that could and should at a later date recover part or all the loss. What the lender loses is the cash that they were not going to get anyway, while restoring a customer to good standing.

The lenders will still have to recapitalize to make up the inevitable shortfall, but they will be able to do this in a stable environment in which everyone knows the rules. And millions of Americans will have a new lease on life.

Of course, some will argue that the reckless are been rewarded in some manner. That will not be true, but that is still preferable to a massive reduction in pension payouts. A true lasting depression will reduce and stifle everyone. On the current road, millions of Americans are having their credit wiped out for years. That is not healthy for the economy, particularly when the root of their failure lies in the recklessness of the lenders.

Example:

1 Original $400,000 property carrying a current principal mortgage of $375,000

2 Current market value of $240,000

3 75% mortgage granted at $180,000

4 $195,000 losses exchanged for a fifty percent equity stake in the property over the $180,000 level.

Thus by paying off the mortgage the borrower rebuilds his own equity and becomes a solid partner of the lender. At some point the borrower should be strong enough to buy out the lender at current market value.

The real point of this exercise is that the borrower now has no reason to abandon the property and the lender has no reason to add the property to a disastrous housing market. This stabilizes the situation and makes it very attractive for new buyers to enter the housing market since inventory will quickly dry up at current depressed prices.