Crisis? What crisis? Which crisis? Whose crisis?

In the midst of all this panic about a financial meltdown, it is hard to get a sense of how to actually measure if there is a crisis or not. Clearly there are various measures that can be used: the number of houses foreclosed, the number of personal bankruptcies, the number of banks going under, the amount of credit available, the state of the stock market, and so on. While they are all connected in some way, which ones should we be paying most attention to?

Deciding which measures are being used to say there is a crisis is important because that will drive the efforts to resolve it. Clearly what is concerning the political leadership is the state of the financial market, and the current bailout efforts seemed to be aimed at reassuring the banking, insurance, and other financial sectors and propping up the stock market. People are being scared and told that if the stock market declines their retirement savings will go down the tubes.

It is true that there have been fluctuations in the stock market and some recent declines. But whether this is a problem or not depends on whether we know what the “true” level of the stock market should be. If it is declining from an artificially high value to a more realistic one, then there is no crisis, just a return to normalcy.

To get a rough idea of how to see this, you can look at this graph that shows the Gross Domestic Product (GDP), the Consumer Price Index (CPI), and the S&P 500 stock market index since 1970. The GDP is a rough measure of the size of the ‘real’ economy, while the CPI is a rough measure of the rate of inflation.

We see that from around 1970 onwards until now, both the GDP and CPI growth rates have fluctuated around an average annual value of roughly 3.5%. But beginning around 1980, the S&P index started taking off like a rocket, meaning that the size of the ‘virtual’ economy that is measured purely by stock market prices was outstripping the growth of the ‘real’ economy.

This raises the interesting question of what happened after 1980. That was the year that began the great deregulation era, where the corporations and financial institutions markets were steadily freed of the constraints and regulations imposed on them following the Great Depression of 1929. The drive for deregulation started towards the end of the Carter administration, kicked into high gear with Ronald Reagan, and has been on full throttle ever since.

Government regulation was portrayed as this bureaucratic burden that was stifling innovation, so those regulations were removed. The banking and financial sector was delighted because now they could do more things, borrow and lend more money, and take much greater risks than ever before. This was the beginning of the creation of exotic new financial instruments like derivatives, credit default swaps, collateral debt obligations, and securitized mortgages that led to huge debt-based transactions that enabled trillions of dollars to swirl around in an opaque and unregulated manner. All this freely flowing capital drove up stock prices.

There was increased innovation all right, but not all in a good way. The downside of all the dismantling of oversight was not long coming. The massive federal bailout of the savings and loan industry in the late 1980s and the growth and collapse of companies like Enron and WorldCom can be traced to the removal of those regulations that required at least minimally prudent and honest and transparent business practices.

While all those debacles should have been warning signs of underlying problems, the continued rise in the stock market allowed people to ignore the storm clouds. After all, wasn’t the rise in the stock market telling us that we were all getting wealthier, except for those poor saps who lost their jobs in the wake of the collapse of those giant companies?

Below is a graph of the Dow Jones index since its beginning.


Its value on January 2, 1980 was just 786. Like the S&P index, it too started rising rapidly after 1980, reaching a peak of 11,497 on October 1, 1999. It then dropped to 7,592 on July 1, 2002, rose to an even higher peak of 13,896 on July 2, 2007, and ended at 10,831 on October 1 of this year.

The alarmists are pointing to the 3,000 point drop in the last year as a sign of the financial collapse. But if we think the stock market should reflect the value of the ‘real’ economy as measured by the GDP, then it is possible to do a very rough calculation and see what the stock index values should be today based on the growth of the GDP.

If we take the average annual GDP growth rate of 3.5% and add to that the average inflation rate of 3.5% as measured by the CPI, then we can calculate what a 7% growth rate in the Dow, starting with its value in 1980, should give us today. That turns out to be about 5,500, about half today’s value.

If I am more generous and assign a total growth rate of 8%, I still only get a current index value of about 7,200. I need to postulate an astounding rate of 9.5% over the last three decades to get the current value of the Dow index, and would have to ramp it up to 10.5% to get the July 2007 peak value. Such huge growth rates in the real economy over such a long time are, of course, unrealistic.

So is it the case than rather than us currently having “lost” a lot of money, we never should have taken seriously the idea that we had so much money to begin with? Were we living in a dream world of imaginary wealth and living high on borrowed money? Is this financial crisis just telling us that by pumping another trillion dollars we don’t really have into the stock market we are simply postponing the day of reckoning since we are striving to maintain an artificial level of virtual wealth?

Michael Lewitt of Hegemony Capital Management (a hedge fund) gives his perspective. Given his position as a market insider, trading in the very kinds of things that are at the heart of the current mess, his critiques carry particular weight. He concludes that:

There is a point when free enterprise tips over into a degree of economic and social inequality that is politically unacceptable, and the United States has reached that point. HCM is well aware that its views on this topic genuinely anger many of its readers, but this is an issue that must be addressed as an essential component of any program that will return confidence to the financial system. Free market economic policies, in particular tax policies, have led to the creation of an American oligarchy whose wealth and power is excessive. While not as pernicious as the oligarchy that rose from the ruins of the Soviet Union and now lords over Russia and spends its money garishly over the world, an American oligarchy has unduly benefitted from ill-advised tax and economic policies and must be reigned in as a sign to Main Street that the game will no longer be rigged against it. (my italics)

His analysis of the causes of the current situation is similar to what I have been saying:

Financial busts are preceded by financial bubbles. The current bust was preceded by a debt bubble whose unique manifestations were debt securitization and credit derivatives. Underlying these novel debt structures were the human emotions of greed and fear that led to abuses by even the most sophisticated individuals and most highly respected institutions in the market. While these human attributes are the most difficult to legislate, their ability to wreak havoc is clear evidence that they must be regulated in a thoughtful way.
. . .
The profits that Wall Street generated over the past few years were not the result of some new-found genius in the executive suites, but were merely the product of adding unprecedented amounts of leverage to balance sheets.

He points out that all the current panic talk is being driven by short-term thinking.

It is a certainty that America, and then the rest of the world behind it, is going to experience a severe recession the likes of which it hasn’t seen for decades. . . One of the problems plaguing America is that we have become so frightened of short-term pain that we are willing to risk incalculable long-term suffering. Any plan that treats the symptom (the loss of confidence) and not the disease (the underlying problems that caused the loss of confidence) will not solve the real problem.
. . .
Despite the cries of pain from the credit markets, HCM has never believed that the world would spin off its axis if a deal is not rushed to completion in the next few days. A bad deal would be worse than no deal at all. (my italics)
. . .
In order to be successful, the Paulson Plan needs to be followed up by comprehensive regulatory reform that accomplishes the goals of convincing the public that the financial system will be fairer in the future than it has been in the past (i.e. that the gains will be spread more equitably and that failure will not be rewarded) and that strong steps will be taken to prevent the oversights that led to the current instability from being repeated.

He also points out that the heads of these financial institutions, while asking for the taxpayers to bail them out, are brazen in their demands, acting like they are doing us a favor by taking our money! And Paulson and Bernanke go along with that.

While trying to help rebuild confidence in American capitalism, Mssrs. Paulson and Bernanke tried to convince Congress that bank executives would prevent their institutions from participating in the bailout if it meant that their compensation would be capped. One would think, as the financial system teeters on the brink of collapse, that the Secretary of the Treasury and the Chairman of the Federal Reserve could make a more persuasive argument than one that poses the likelihood that corporate executives would knowingly violate their fiduciary duty and refuse to participate in a plan to rescue the financial system because it might limit their compensation.

Meanwhile, Pam Martens, who worked on Wall Street for 21 years, reads the fine print in the bailout plan and discovers what Wall Street hopes to win from it. It is an inside job in which the Treasury, the Fed, and Wall Street are using their agents in Congress to pick our pockets.

The more I think about it, the more this bailout plan looks like a swindle. I hope the members of the House of Representatives defeat it in its current form and instead demand a full and careful examination of the problem and what is needed to solve it.

POST SCRIPT: The Vice-Presidential debate

Well, the debate went pretty much as I expected. Sarah Palin was fairly coherent in her answers most of the time though I thought she overdid the folksy, down-home manner. By the way, did you know that she and John McCain are mavericks? And that Palin likes to talk about energy issues whatever the question?

Those who are not political junkies may have been surprised by the solid performance by Joe Biden, who has been pretty much ignored so far in the media coverage, overshadowed by the other three candidates. This may explain why early polls suggest that he ‘won’ the debate, though declaring winners and losers for such events is a largely meaningless exercise.

What was really surprising was the way Palin was flirting with me.

Sarah, give me a call and let’s get together for coffee sometime.

Sarah Palin, a river of babble-on*

Tonight the nation finally gets to see Sarah Palin live and unplugged, presumably speaking unscripted.

The last three weeks have been mixed for her. On the one hand, she has drawn large and adoring crowds to rallies and meetings, being a bigger attraction than John McCain or Joe Biden. But despite this, her campaign has gone to extraordinary lengths to shield her from reporters. The two interviews she gave to Charles Gibson of ABC News and Katie Couric of CBS News were excruciatingly painful to watch, as you can judge for yourself from these excerpts from the latter.
[Read more…]

Gambling John McCain

John McCain is known as a lifelong gambler relishing visits to casinos. I have written before that I thought John McCain is also hot-headed and reckless. All these are not signs of the temperament required for a head of state. But his performance last week was extraordinary, even by his own standards.

His week started poorly when the headlines were blaring about a financial crisis and he had to backtrack from his earlier statement that the fundamentals of the economy are strong. He may actually be correct (I am not one who equates the health of Wall Street financial institutions and the stock market with the general economy, although the two are undoubtedly linked) but it was a poor choice of words and timing and he had to immediately retract and explain away, not a good thing to have to do for someone already being portrayed as being out of touch and ignorant on the economy.

Then on Tuesday there was the release of damaging news that his campaign chief Rick Davis’s company had received millions of dollars from Fannie Mae and Freddie Mac to provide access to McCain. Davis’s company was receiving a hefty retainer as late as August 2008 even though both Davis and McCain had said that Davis had no links to the two companies for over two years. So either Davis was lying to McCain or both were lying to the nation. The previously highly visible and voluble Davis who used to be interviewed all the time suddenly disappeared from sight, not talking to reporters

Then came Wednesday. First there was the release of the Washington Post-ABC News poll showing Obama surging ahead with a whopping 52-43 point lead, suggesting that McCain’s campaign was tanking and the Palin bounce was gone. Then there was the taping during the day of the interview that Sarah Palin had with CBS News’s Katie Couric. Apparently the Palin entourage who watched the interview realized that it was an unmitigated disaster (more on this tomorrow) and that it would dominate the news that evening.

McCain may have felt the need to make a dramatic move to obliterate all this bad news and put the focus back on himself, playing the role he loves of someone who does not play by the normal conventions. So he declared that he was ‘suspending his campaign’, flying back to Washington to solve the financial situation, and would even skip the much anticipated debate on Friday until and unless there was agreement on the bailout plan. This headline-grabbing move was reminiscent of his dramatic selection of Sarah Palin when it was becoming clear that Obama would have a rousing finale to the Democratic convention.

In tactical terms, both moves worked. They definitely overshadowed the other news, though the Palin-Couric interview still created waves. But just as the Palin selection rapidly declined in effect over the subsequent few weeks, the campaign ‘suspension’ move had an even shorter life, blowing up in just a few days.

For one thing it was pointed out that McCain’s ‘suspension’ had little meaningful content. He was still giving numerous interviews, his ads were running all over the country, and his surrogates were out in full force putting out his message.

Second, it proved embarrassing when it was revealed that McCain had not even read the Paulson plan, even though it was only three pages long.

Third, it came out that after all his dramatic statements about wanting to solve the problem, McCain was silent at the White House meeting on the plan. It was Obama who was active in the discussions, asking a lot of questions, some of them directly to McCain and not getting any response. McCain seemed disengaged.

Fourth, many lawmakers in Washington were not pleased with injecting presidential politics into the negotiations and openly said that the candidates’ presence was not helpful, since neither of them were members of the committees that were responsible for the matters involved in the negotiations.

Finally, the impression arose that the House Republicans had scuttled a tentative agreement at McCain’s request after he arrived in DC, so he was now portrayed as part of the problem, not the solution.

McCain was back in the spotlight but not in a good way. Speculations ran rampant as to the reasons for his erratic behavior. Did McCain scuttle the tentative agreement? If so, why? Some suggested that he wanted to ride to the rescue and solve the crisis single-handedly and was disappointed that an agreement seemed to have been reached before he arrived, so he sabotaged it even though he did not have a ready alternative.

Another suggested reason was that what he and his campaign actually wanted was to postpone or even cancel the Biden-Palin debate because of fears that she would be revealed live on national TV to be out of her depth. His campaign’s suggestion that his September 26 debate with Obama be postponed to October 2nd (the original date of the vice-presidential debate) and that the VP debate be vaguely rescheduled for a later date seemed to suggest that they were either trying to run out the clock completely or at least stall for more time to help her prepare.

Whatever the reasons, the tactic did not work. Instead attention became focused on his penchant for stunts and what it said about him and his campaign. Slate even ran a list of his next ten possible stunts to grab attention. (#1: Returns to Vietnam and jails himself.)

Faced with mounting criticism and even ridicule, McCain was forced to go to Mississippi for the debate with his tail between his legs, even though there was no bailout deal. During the debate he even weakly conceded that he would vote for the deal that would be worked out in Washington, even though he did not know at that time what eventual plan would be proposed. It is likely that this will be regarded as his worst week in his campaign, one misstep following another.

Oddly enough, I think McCain could have come out of this as a very big winner. There is huge public opposition to the bailout. It was a foregone conclusion that Obama, a good friend of Wall Street, would support the bailout plan in its essential outlines. If McCain had come out strongly opposing the bailout and openly led the efforts to scuttle it, he may have been able to accurately portray Obama, the Bush administration, and the Congressional leadership of both parties as serving only Wall Street interests, and ride a huge surge of public support as the only true champion of ordinary people, all the way to November.

But the gambler lost his nerve and folded. Wall Street enmeshes the political leadership of both parties in a tight embrace. To defy them now would be to defy all the people who have supported him all these years: his financial contributors, his own party’s leadership, George Bush, all his close advisors and confidantes, and those with whom he socializes. He would have been turning his back on his own class and he just could not bring himself to do it.

Although McCain rails against Washington elites and praises his own alleged maverickiness, when an occasion came along that provided an ideal vehicle to show his independence in a concrete way and not just as rhetoric, he capitulated. Such is the power of ruling class allegiance.

In the end, he did what he and Palin repeatedly keep saying you must never do. He blinked.

POST SCRIPT: McCain’s stunts

Jon Stewart gives his take on McCain’s erratic behavior.