Banking on Bankruptcy

Thoughts on Fannie Mae/Freddie Mac, Commodity Spikes, and the "New Stagflation"

By Larry Peterson

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After the stabilization provoked by the government-supported rescue of one of the financial sector's main players, Bear Stearns, in March, the economic focus of most people, including policy makers, immediately turned to the remarkable rise in prices that had been spreading through a worrying extent of the economy for somewhat longer. This trend had been led, of course, by surges in prices of key inputs such as oil and agricultural commodities (and also by gold: though of relatively little industrial use, it retains its traditional popularity as a hedge against inflation—or at least it did until very recently—for many investors). But, despite the clear upward trend, some of these commodities, especially oil, were subject on several occasions during this particular period to huge and rapid—sometimes unprecedentedly so—swings in both directions. And then there was the dollar, which was engaged in a similarly bumpy ride, mainly downwards. But on Friday, July the 11th, the stock of the two major government-sponsored mortgage companies (or Government Sponsored Entities, or GSEs), Fannie Mae and Freddie Mac, fell by more than 50% in the opening minutes of trading in New York; and the focus shifted right back to the specific woes of the financial sector in a twinkling of an eye.

This was ironic in a sense, for it was exactly a year before that interest rate rises, justified at the time by stubbornly increasing prices—especially again, that of oil, but also by rising wages and falling unit labor costs (which corresponds to labor productivity)—precipitated the financial catastrophe that has come to be known as the "subprime crisis." (A quick aside here: just in May, Challenge published the results of a shocking study by Andrew Sum and Paolo Tobar, which indicates that "$32-$37 billion in major Wall Street firms' bonuses in 2006 and 2007 were greater than the annual increases in the wages of 109 million American front-line workers between 2002 and 2007." This suggests that of the feared earnings inflation the Fed is so zealous to combat, the lion's share between 2005-2007 consisted of outsized payouts to movers and shakers on Wall Street—not even in the entire state of New York; and throw in Jersey and Western Connecticut as well. Everyone else was staying above water, if not losing out. So the next time Fed chairman Bernanke or some other such eminent personage starts holding forth about the danger of "inflationary expectations" taking hold, you might wonder why they didn't do what they could to curb executive pay in the financial sector when they had a chance, rather than blaming workers for demanding enough simply to keep up with inflation and rapidly eroding benefits—never mind adequately compensating them for the enormous increases in productivity from 2001-2004, or redistributing some of the ridiculous gains of some of those who, far from contributing to productivity, brought us, and seem to expect us to pay for, the financial crises we're facing now.)

Back to our story, these rate rises considerably decreased the likelihood that borrowers could continue to pay off their mortgages, and the disruption to the flow of income meant that the vast numbers of investors, who had funded the phenomenal growth in the mortgage industry through the kind of securitization that firms like Bear Stearns and others affected, faced potentially dangerous losses as well. Or, the possibility existed that even if the financial firms were left holding the bag, the supply of credit to the whole economy—never mind the grossly oversized housing sector—might dry up. And the likelihood of an unhappy ending was redoubled by the fact that many subprime mortgages were due to reset at much higher interest rates from mid-2007 on. Indeed, prime mortgages are also set to witness a spike in delinquencies, as borrowers who had good credit scores, but no proof of income or assets, join their benighted subprime cousins in falling behind on their payments (which could reset as much as 50% higher for some, and with opportunities to refinance scarce as banks cut back on loans); and many will no doubt decide simply to drop the keys in the mail and send them back to the bank (the famous "jingle-mail" phenomenon), as so many subprime borrowers did. In fact, The International Herald Tribune quoted the president of an investment firm, who went so far as to say: "Subprime was the tip of the iceberg," and that "[p]rime will be far bigger in its impact."

Fannie Mae and Freddie Mac

Fannie Mae and Freddie Mac are private companies that buy mortgages from mortgage originators and banks and securitize them (by aggregating countless numbers of underlying loans, largely on the basis of risk-levels, and selling the bundled loans to investors as bonds), while guaranteeing the payment of the loans to buyers of the bonds for a fee. And it should be noted that Fannie and Freddie were not involved in the sort of subprime shenanigans that other mortgage originators were: Fannie and Freddie require mortgage buyers to provide documentation of ability to pay. However, Fannie and Freddie, following the familiar pattern, bought up a lot of securities that have become tainted by the subprime affair to hold on their books, essentially as cheap collateral for their rapidly expanding loan-books.

Fannie Mae actually started out during the Depression as a government agency that bought up or guaranteed distressed mortgages, thereby allowing private banks to continue home lending in spite of the ensuing economic catastrophe, secure in the knowledge that they'd be paid back by the government if the mortgages couldn't ultimately be paid off. In 1968, Fannie was privatized by the Democratic Johnson administration, which was eager to offload whatever obligations it could (by this time, the postwar housing boom had stabilized, and it must have seemed unnecessary for the state to directly guarantee the mortgages of increasingly prosperous homeowners) to cover the escalating costs of the Vietnam War in a period of rising inflation and deteriorating government budgets. In 1970, Freddie was established as a private company to provide competition in the mortgage market.

But the two are not your basic, shareholder-owned/liable companies. Over the years they have amassed a lot of special privileges, as well as formidable lobbying and campaign-financing machines to protect those perks, even to increase them (not to mention to shield them, more-or-less-effectively, from the fallout from huge accounting scandals, bloated executive payouts, shortsighted investment strategies, and the like). Among these are: exemption from a host of taxes; lower or less-stringent (regarding the kinds of assets that count to back up loans) capital provisioning requirements than other banks have to observe; ability to borrow from the U.S. Treasury (Fannie and Freddie are essential players in the government bond market); and last, but not least, what is known as the "implicit guarantee" from the U.S. government of Fannie and Freddie's debt. Though never admitted to, and even on occasion denied by government officials as well as persons speaking on behalf of Fannie and Freddie, investors have always assumed the two mortgage giants were too big to fail, and some, particularly foreign ones, were actively encouraged to make this assumption, during a period when such investors (particularly the representatives of foreign central banks, who began to tire of the meager returns generated by the U.S. Treasury bills and notes they had been accumulating to keep their currencies down, and, hence, their export machines humming) were aggressively seeking extra-safe, but higher yielding assets. Accordingly, official foreign holders and even sovereign wealth funds have become pivotal holders of GSE debt. In addition, though, as reported in the International Herald Tribune on August the 5th, the CEOs of Fannie and Freddie were amongst those betting the farm on the government guarantee.

The way the guarantee works is this: because of the assumption that the U.S. government will bail out the GSEs, the GSEs can borrow on the capital markets at artificially low rates (because investors consider the likelihood of not being paid as essentially zero). And though it is arguable how much potential homeowners benefit from this—some say the GSEs pass on virtually none of the their savings in borrowing costs (preferring to pay bigger dividends to stockholders)—it is clear that the guarantee makes home financing available to far, far more people that would otherwise be the case. This is not an entirely positive thing: not only did it contribute to the subprime-mania, as other mortgage firms were pressured to offer easier and easier terms to compete with the GSEs; as Nouriel Roubini has pointed out, investment in housing is perhaps the least productive form of accumulation of capital, and the United States, as a national economy, suffers from the gargantuan, heavily-subsidized amounts channeled into assets which do not contribute nearly as much to increasing productivity—and hence wealth—as, say, health care, education, or investment in a badly neglected infrastructure can, all while affordable housing remains scandalously scarce. And the environmental costs of the housing boom must be impressive, indeed. Still, it was a successful business model: you borrow artificially cheaply, and buy assets that, as long as markets aren't falling, are bound to pay higher yields (as they aren't subsidized in the same way). As the Economist noted, "Had Freddie and Fannie been hedge funds, this strategy would have been known as a "carry trade".

A look at the numbers demonstrates how large the companies are, and how important they are to the United States, and even to the global financial system. Between them, Fannie and Freddie are involved in—either as holders or guarantors of—the financing of about half of all mortgages in the United States, which adds up to about $5 trillion (U.S. annual GDP is some $14 billion, which is, in turn, about a quarter of global GDP). To cover these loans, though, they sit on a cushion of a mere $83 billion, and, as mentioned before, these assets are not required to be of the quality that other financial institutions must provision on their loans. After recording huge losses (they lost about $9 billion in 2007) in their latest quarterly reports, and as house prices continue in free-fall, the threat surrounding the adequacy of their already-vulnerable capital cushions can only increase in size.

Still, given the dire condition of the U.S. mortgage market, the government has been increasing its reliance on Freddie and Fannie to prevent the housing market from falling through the floor altogether as private financing has all but disappeared from that market. Accordingly, new regulations announced earlier this year allowed the GSEs to finance so-called "jumbo" mortgages of up to $750,000 (the earlier ceilings were around $420,000), and actually softened capital provisioning requirements. And in the first quarter of 2008, Fannie and Freddie were responsible for 80% of mortgages, which was double their market share even as short a time ago as 2006.

So how did Fannie and Freddie get into so much trouble? As mentioned in a previous installment of this series, they were coming under intense pressure anyway, and, in early May, as we noted on the Dollars & Sense blog, investors were becoming more and more nervous that the implicit guarantee was going to have to become explicit, inasmuch as Fannie and Freddie were relying on completely unrealistic assumptions concerning recovery in the housing market, and as they were being asked to expand their balance sheets while their capital cushions continued to erode due to deteriorating housing market conditions in the case of the latter, and laxer regulation regarding the former.

But in order to understand how this unstable situation tipped over into a rout that threatened the whole global financial system, we have to focus on a charming investment strategy that is becoming more and more popular every time a major financial firm finds itself under mortal attack. Called "take under," the strategies (which are believed to have been instrumental in the takedown of Bear Stearns) are devised to allow investors to profit from situations in which companies go bankrupt, by betting that the government may allow the share price of the company to fall to virtually nothing, but not, in these days of hyper-complex and ubiquitous debt instruments, the failure to pay off ever-interconnected bondholders. So the investors (especially big, institutional ones and hedge funds) "short" the shares: they borrow them from "market makers" and brokers who are paid fees (and collateral to cover the sale) for transferring shares they hold, often precisely for this purpose, and, expecting the price to decline, sell the shares to other investors. If the price does decline during that period, the "short-sellers" pay the original holders, pocketing the difference between the higher price which held when they did the deal with the second investors, and the lower price at which the short sellers can now buy the declining shares on the open market with the intention of returning them—as many shares as they'd borrowed—to the broker.

But there was a twist: investors who shorted the shares of Fannie and Freddie also piled into their debt, again believing that the government, frightened at the disintegration of the GSE's equity positions, would be all the more pressured to take the nuclear option of explicitly guaranteeing their debts—or watch the dollar go down the tubes, too (remember: China, Russia, the Middle Eastern oil exporters and others who have been financing the U.S. current account and budget deficits have become major buyers of GSE debt). As the explicit guarantee would seemingly ensure that GSE bond prices would rise (the added security would cause demand for the bonds to go up), it seemed a good bet. Almost too good to be true.

In fact, it worked too well: earlier in the week that ended July 11th, take under investors thought it was sufficient to purchase what is known as "junior" debt of the GSEs (meaning holders of these bonds get paid later, if at all, than purchasers of more senior debt, in the case of bankruptcy; and this risk is compensated for by larger interest rate or periodic "coupon" payouts while the firm is viable); but, by the end of the week, the shares were under such pressure that traders now began to move from GSE junior debt to senior debt (that pretty much has to be paid, no matter what), just to be safe. But this movement put even more pressure on the shares, which culminated in the breathtaking 50% drop in the first 30 minutes of Friday's trading. Meanwhile, the larger market was moving away from the junior debt of other threatened firms, like Lehman Brothers. With so much talk of the explicit guarantee amidst all the general market turmoil (the Dow was down more than 250 points—below 11,000, for the first time in two years—at one point that Friday), which seemed to be coming back with redoubled strength after the Bear Stearns rescue interlude, market participants started to fear that even the U.S. government (i.e. already highly-indebted taxpayers) wasn't big enough to bail out everyone, however interconnected they all might be. As one hedge fund group president put it (to the Financial Times), "Everyone is trading the final chapter of the end of the world."

But, for once, officials from the administration anticipated the worst, and spent Thursday night drawing up contingency plans to guarantee funding to the GSEs in case they found themselves shut out of the capital markets like Bear Stearns was. And the gambit worked: Fannie and Freddie never lost their access to funding, and that seemed to reassure investors (some even did some bargain-hunting) as the day wore on Friday (the Dow recovered to close a mere 1.14% down). This gave the authorities the weekend to regroup, and before trading started on Monday (you know you're living in interesting times when the biggest market news days tend to be ones when the markets are closed, as happened in January, March, and, now, July) the U.S. Treasury and Federal Reserve, while not budging on the explicit guarantee, stepped in with a plan of unprecedented scope: they would ask Congress not only for the authority to lend the GSEs unlimited amounts of money; it would also, temporarily at least, buy their shares to prevent their access to funding from becoming threatened.

This was extraordinary, perhaps even more so than if the explicit guarantee had finally been invoked: the government of the United States, far-and-away the most powerful promoter of the more aggressive strain of capitalism on earth, was committing itself not only to extending a potentially infinite debt lifeline to a private company in distress; it was also promising to go so far as actually buying an equity stake in it to prevent it from failing of its own accord. This from a government that had spent the last several decades warning others against the dangers of a state-led "industrial policy" (even Alan Greenspan had opposed some proposals regarding Social Security privatization on the grounds that it would involve the government—however many times removed—in the purchase of shares in private companies)." But before jumping to the ludicrous conclusion, as the moronic Senator Jim Bunning of Kentucky did, that he'd woken up in (presumably "socialist"—under Sarkozy, no less!) France, remember that the GSEs are strictly private entities where profits are concerned, while being a tad more egalitarian when it comes to spreading of risk.

As for the GSEs, no one knows how bad the situation will get. Like the monoline bond insurers, they have been extended a series of frayed lifelines (many of the monolines' previous customers are seeking insurance elsewhere, while counterparties to credit default swaps backed by the monolines are being lobbied to tear them up), keeping them above water for a while (especially inasmuch as other financial firms, which hold assets insured by the failing monolines, try to sell the assets off at huge discounts: Merrill Lynch's recent sale of collateralized debt obligations originated by monoline insurer XL Capital Assurance Inc. to an affiliate of Lone Star Funds at $ .22 on the dollar is a good case in point, with the promise of big, cheap loans to aid in the purchase). But as Fannie and Freddie stabilized, pressure began to build on regional banks, which are even more exposed to property-related losses (residential and commercial), in the sense that, due to their smaller size, there is more of a threat—particularly in over-built parts of the country, especially California—that they will not be able to withstand the sort of onslaught their mightily-capitalized multinational brethren can. This is all the more the case insofar as these banks are also more sensitive to downswings in credit card (and even the richest credit card customers are starting to cut back on purchases), student loan and home-equity loans. Indeed, recent reports indicate that even payment delinquencies amongst the wealthiest (i.e. "superprime") consumers (whose lines of credit can be many times that offered to a normal customer) are beginning to rise at a worrying rate. Many now doubt that the banks have sufficient reserves to fall back upon if prime level consumer debt falls next. Accordingly, Wachovia and some of the other regionals have been reporting horrific results since Fannie and Freddie "stablilized." But one bank, IndyMac, went bankrupt, in one of the biggest bankruptcies in American history. Given the other events of the last few weeks, that major bankruptcy was considered something of an afterthought.

Commodity Price Spikes and the Dollar

Rewind the tape to late May. On May 21st, oil futures contracts for 2016—almost a decade from now—rose by $9 a barrel on a single day, to $139.30. A fortnight later, on June 6th, prices went up by $10 a barrel, settling again at close to $140.00/bbl, and setting yet another record. During this period and even before, there was much speculation about, well, speculators, and their role in our super liberalized and globalized financial markets. But something else was happening here, something that bore a distinct—if inverted—resemblance to the Fannie/Freddie story we've just heard.

On Friday, June 6th, the Department of Labor issued its monthly employment report, and the numbers were appalling: the unemployment rate went up .5% from the month before, constituting the largest monthly rise in 22 years. And though these figures were affected by a couple of one-off occurrences, like large numbers of students leaving their studies in May, the message to traders seemed clear: the economy was slowing considerably. But traders had been, a mere three weeks earlier, factoring in interest rate rises by the Federal Reserve beginning in October at the latest, and continuing through much of 2008. Here they were taking their cue from hefty price rises, especially for oil and important foodstuffs, and concluding that economic growth was too fast (led by surging exports), and that the Fed would have to act quickly to subdue inflation that seemed to be spiraling out of control.

That is, up until about June 6th: after the employment report, traders started selling dollars. As the Fed seemed more likely at this point not to raise interest rates, the dollar appeared likely to weaken (higher rates on dollar-denominated assets attract investors). But oil, gold and other commodity sales worldwide are denominated in U.S. dollars, and as the dollar goes down in value, the prices of these commodities tend to go up to compensate for the loss. And here's where the story gets interesting. Before the employment report, many traders were selling oil short (you can sell commodities short, just as you can shares or bonds), expecting Fed interest rate rises to increase the strength of the dollar, and, hence, lower the real cost of oil. But now, as the Financial Times put it, "an unexpectedly bad U.S. employment report upset the calculations of energy traders and triggered frenzied buying."

Why such frenzied buying, you might ask? After all, the outlook for inflation and interest rates was hardly clear; it was more contradictory than anything else, with persistent deflationary indicators sitting uneasily beside explosively inflationary ones for long periods of time. In fact, this may be the most characteristic feature of the current economic crisis. Why did traders buy oil at a frenzied pace if the outlook, if altered significantly by the employment report, still admitted of so much uncertainty? Well, it was precisely because traders had shorted oil in such great numbers; when you short and lose, you have to "cover your position," and buy up the asset you need to return to the broker you borrowed the asset from, even if its trading at a much steeper price. And that price will rise even higher if more and more short-sellers are piling into the market to cover bets gone bad.

So is this story evidence of the dreaded—and much maligned by most mainstream economists— influence of speculators on the commodities markets? Not really: this is an extremely complicated issue (partially because, as Michael Gordon noted in the Financial Times, many pronouncing on the issue don't even seem to be talking about the same thing), but I think, for reasons to be developed later, that the focus on speculation, warranted or not, is somewhat misguided, and that we miss the forest for the trees if we focus too much on it. But it is worthwhile to review some of the extraordinary developments that have taken place in the commodities markets—particularly those for oil and agricultural produce—recently.

In the year to May, 2008, the price of food rose 5.1%, outstripping the overall inflation rate by about a percentage point (the so-called "core" rate, which strips out energy and food, advanced at a much more moderate rate, around 2%, showing that wage demands continue to lag far higher costs, even for necessities: and, as Max Fraad Wolff has pointed out, the focus on food and energy is misleading inasmuch as healthcare and housing costs, which demand a larger share of workers' paypackets than food or energy do, continue to stay at elevated levels, especially compared to incomes). As for oil, it has doubled in eighteen months, from $62/bbl at the beginning of 2007, to $117.40 as I write this piece (and, as mentioned earlier, was over 20% higher, at more than $147.00/bbl, just a few weeks ago). This is truly noteworthy, particularly in light of the fact that these price increases are offset by tax policies and subsidies (which tend to benefit the well-to-do and middle classes, not so much the poor) in much of the world, including the United States. In the developing world, whole classes of people are finding themselves shut out of markets for essential staples; and many of the belated rewards of decades of economic development and hard-won (especially again, on the part of the working and lower classes) price stability may have been wiped away in just a few months.

Now it is true that some historic influences have been exerted on commodity prices in the last few years: the rise of China and India, especially, but of other huge (population-wise) and extremely rapidly growing economies like Brazil and Vietnam (not to mention the revival of formerly middle-income countries like Russia), has had multiple effects on global demand for primary goods. Many commentators tend to focus on the increased demand for meat in such countries (meat requires far more by way of primary inputs than poultry, fish or, of course, cereals and vegetables) that has accompanied increases in incomes, not to mention the huge increase in oil use to fuel unprecedented industrial growth, but this is only part of the story. Needless to say, agriculture is heavily petroleum-dependent (in fertilizers and as fuel for tractors, machinery and transport to markets which now, in a more globalized market, stretch across oceans); it is also dependent on depleting stores of water. And both of these influences will put serious upward pressure on both agricultural commodities and petroleum.

But there are more subtle influences stacked on top of these giant ones. For one, both agriculture and petroleum production have witnessed a drop off in investment in the last few decades, largely because of the depression in all commodity prices that characterized the generation from 1980 to 2005. And just as oil producers considered it uneconomical to retool in order to exploit older fields more fully under such conditions, many agricultural concerns did little to improve yields by doing things like enhancing the longevity of soils. And then there is the problem of refineries and grain elevators: despite rapid ramp-ups in production, bottlenecks will form because it takes far longer to outfit this essential infrastructure than it takes to produce the commodity itself. Even the weather isn't cooperating: epic droughts in Australia and Ukraine, flooding in the Midwest of the United States and in China. Finally, there's ethanol: according to a World Bank report, the diversion of agricultural production to ethanol for biofuels (of an extremely inefficient sort) has pushed up food prices worldwide by 75%; and even if you don't buy that, the figure far outstrips the 3% one admitted to by the U.S. government.

On a different level, there's the geopolitical environment: most of the world's oil is produced by national oil companies, whose governments rely on them to finance super-rapid development (not to mention huge payouts to cronies and elites, which often finds its way immediately offshore) for often restive and frustrated populations on the one hand, and to subsidize consumer and industrial energy consumption on the other, with the aid of those very proceeds. Disregarding the mere profitability of the oil monopoly model, many such producers are certainly not going to be overly sympathetic to Western countries that, as in the case of Russia in the 'nineties, stood back and watched the country nearly implode, or, in the case of Saudi Arabia, saw a generation of Islamic militants grow up alongside something like a 40% decline in living standards while oil prices were depressed. Even within these countries, as Amartya Sen has shown, inflation often flows from the top down, and from the cities to rural areas; and while the urban poor, with higher earnings, can pay more for food, rural producers, who often do not share in the increased prosperity at all, often due to government policies which favor urban industry, cannot keep up, and are also, for obvious reasons, unable to ramp up production, which makes the situation worse. And though talk of an attack on Iran has significantly abated in the last few weeks—this has had an unappreciated impact on the slide in oil prices—a whole host of political standoffs and even open conflicts exist worldwide, the outbreak of any one of which could send oil prices spiraling at the drop of a hat: the Palestinian/Israeli conflict, Lebanon, Pakistan and India, Iraq and Afghanistan, Russia and Ukraine or the other Eastern European countries, the ex-Soviet Central Asian producers, the Niger Delta, Venezuela, Bolivia and Ecuador (by inclusion in this category please don't think I'm expressing any judgment considering the political experiments going on in these countries; the classification relates exclusively to the impact strife in these countries has on potential oil supply) , even Mexico and the Arctic.

So even given this brief survey we have a lot here to account for extraordinary, nay, historic price hikes. But why now, and why so, so fast and so volatile (and, one might ask, without any hint of compensating wage pressure, which marks a clear difference with the stagflation of the 'seventies)?

Well, one factor is the inverted relation between key commodities and the dollar, mentioned before, in which commodities rise in price as the dollar falls. As a fall in the dollar means higher inflation, commodities have long been considered a hedge in times of inflationary outbreaks. But this hedging has been taken to another, rather self-destructive level with the liberalization of asset and currency markets worldwide. Nowadays, it's not merely hot-shot investors who invest in these assets, but managers of huge pension and index (funds which are pegged to the performance of asset indices, rather than chosen by a fund manager) funds; and where highly-leveraged hedge funds go, plain-vanilla pension and index funds are, these days, almost certain to follow. But unlike old-fashioned speculators, these purchasers are, as British economist Meghnad Desai has noted, passive, not hoping to make profits by taking hot commodities off the markets and then selling (as speculators in the normal sense of the word would), but merely in the hope that expectations that the price will rise will become reinforced—in markets drawing more and more investors, many of whom are passive, and follow the trends. As Desai puts it, "this extra layer of price rise…is driving money into even the farther futures contracts. There are futures contracts being bought and sold for 2016 at $138-only astrologers can pretend that they can forecast that far ahead."

So, far from remaining a hedge, commodities are purchased as an asset class, to aid in the diversification of portfolios that are already under intense pressure from huge losses in hitherto popular, core investments, like financial firms' stock, asset-backed securities and homebuilders' stock. In this way, what was considered a hedge has turned into a self-fulfilling prophecy: with this switch, prices of commodities inevitably go up, at least until the central bankers start worrying about inflation again (and even as ever-harder economic times guarantee a solid hold on wages); and then it becomes favorable to buy dollars on the expectation that the Federal Reserve will have to raise interest rates; but that strategy works only until another financial firm fails and threatens to take the whole economy with it, or another horrible economic number presages even harder economic times ahead; which causes another sharp reversal as large numbers of investors have to cover their positions, on the assumption that the Fed will have to cut instead; which then makes commodities more valuable once again; and so on.

The "New" Stagflation

What can break this cycle? One place to begin looking is the aftermath of the crash of 2000, the effects of which were redoubled by the terrorist attacks of September, 2001. In an excellent piece in the current Review of Radical Political Economics, University of Massachusetts economist David Kotz makes the point that after the recession year of 2001, "consumer spending grew by 2.5 percent, and spending on consumer durables by 4.3 percent, despite the fact that disposable income grew that year by only 1.9 percent." This was highly unusual; usually, after a recession, spending—especially for durables, purchases of which can usually be postponed—falls. This spending pattern more-or-less held through the next few years, as tax cuts, low interest rates, ever higher debt-levels and rapidly increasing house prices (which many homeowners borrowed against) enabled purchases in spite of stagnating wages. Now, with debt levels and the percentage of consumption in overall GDP at all-time highs, and savings and labor participation rates languishing, it is clear that the economy will require something beyond the technology-based investment along the lines of the late 'nineties (this was largely lacking in the productivity explosion of 2002-2004, which was based mainly on squeezing more work out of workers with longer hours for less pay and benefits) to become sustainable; what is needed even more than increases in productivity is a far more equitable means of distributing the fruits of productivity increases, one that will allow consumers to decrease their reliance on debt, and which can, in turn, allow the economy to begin to realign investment with real savings rather than securitized debt. Such a realignment would also have to involve the full readjustment of housing prices to affordable, non debt-enabled levels, something that many commentators and policymakers tend to forget or downplay when speaking of the present crisis.

This is important because, in the absence of such a shift (which seems exceedingly unlikely, given present political and institutional realities), the economy may be in real danger of being caught in the kind of vice I've sketched above, fluctuating aimlessly between outbursts of inflation increasingly based on the emergence of bottlenecks of all sorts, and financial crises which force the monetary authorities to socialize more and more losses, which could be profoundly deflationary (not only will taxpayers foot the bill, but bailed out financial companies will have to take money out of the economy to recapitalize). Under such conditions, investors may increasingly bet on whether the authorities rob a highly indebted Peter to pay a likewise distressed Paul, or vice-versa, rather as they bet against Fannie Mae and Freddie Mac's equity versus their "guaranteed" debt in July, or against oil rising against the hapless dollar in May and June. And here it's important to realize that this sort of thing is happening throughout the world. In China, which has come to depend on indebted U.S. consumers almost as much as U.S. consumers have come to expect lower prices for Chinese goods to offset their stagnating wages (with a little help from the Bank of China, which has bought unprecedented amounts of dollars—a jaw-dropping $393 billion in the first five months of 2008 alone—in an attempt to keep its currency down versus the dollar), a similar game of chicken is being played between speculators who throw vast sums of "hot money"—often-times disguised as the proceeds from overinvoiced goods—into the country betting that the central bank will have to keep raising interest rates. For, as these flows are absorbed by Chinese banks, more money is made available for lending, which increases inflation, unless the authorities "sterilize" the inflows by selling bonds to the banks, which becomes increasingly expensive, and leads to, you guessed it, inflation—and which requires yet higher interest rates to combat. But, again, this is a dangerous game: and if inflation gets too high, and economic growth becomes threatened—either within China, by inflation, or in its chief export markets, for whatever combination of reasons, the danger exists of massive capital flight, though its difficult to believe the authorities would allow this. But if they don't allow it, its equally difficult to believe that investors in China will be continue to be quite as forthcoming with their money, and this at a time when increasing protectionist pressures may put further pressure on China's export machine.

This scenario may be excessively bleak; still, the persistence of massive and politically irresolvable macroeconomic imbalances, and the increasing likelihood that financiers will try to arbitrage them in the absence of profitable productive ventures, will almost certainly lead to further volatility on global markets, which may impede the development of productive investment alternatives all the more. Recently, commentators have been warning of the danger of a new "stagflation," or period characterized by slow growth, high inflation and high unemployment. And it was this kind of stagflation that led to the imposition of austerity measures on the working classes of the West, and offshoring of financial crises to developing countries (many of which were commodity producers) that resulted in the revival of economic growth in the last two decades (though, again, at great cost). But it's difficult to see how workers in the West or in the developing countries can be played off against each other in the same sort of way that allowed for the growth spurt of the last twenty-five years; both groups are already being pressed too hard, even given the fact that hundreds of millions of Chinese and Indian workers have emerged from abject poverty in a remarkably short time; as the Chinese authorities, if not Indian, know all too well, such workers leave behind vast numbers who remain to be integrated into a modern economy, and these authorities are willing to defy all the laws of conventional economics where exchange rates are concerned in an attempt to do this. To them, it's a matter of sheer survival. Meanwhile, in the West, various forms of protectionism will almost certainly be put into effect (in fact, the recent ban on short selling of the shares of nineteen U.S. financial firms in precarious financial condition has come to be known as "protectionism of the 19"), and this will diminish the likelihood of the kind of productive investment boom that might be able to result in sustainable recovery. If this turns out to be the case, rather than another period of stagflation, I fear we may be facing a time of "alterflation," if you'll permit the neologism, in which attempts by the authorities to prevent financial meltdowns lead to the formation of speculative bubbles, which the authorities must then deflate, thereby increasing the likelihood of financial failures, the losses of which the authorities much socialize at the cost of further deflationary effects, and so on. Much depends on what policymakers will do; but the last thirty years gives us little scope for optimism on this score.

Larry Peterson is a member of the D&S collective. He writes a series of postings entitled "The Dull Compulsion of the Economic" on the D&S blog.

Sources: David M. Kotz, "Contradictions of Economic Growth in the Neoliberal Era: Accumulation and Crisis in the Contemporary U.S. Economy," Review of Radical Political Economics 40:2, Spring, 2008; Andrew Sum, Paolo Tobar, et al, "The Great Divergence: Real-Wage Growth of All Workers Versus Finance Workers," Challenge, May/June, 2008; Charles Duhhig, "New Price Drop Could Imperil Mortgage Agencies," New York Times, May 6, 2008; Carola Hoyod, Javier Blas and Geoff Dwyer, "Oil Futures Near $140 Amid Fears of Shortage, Financial Times, May 21st, 2008; Amartya Sen, "The Rich Get Hungrier," New York Times, May 28, 2008; Javier Blas, "The End of Abundance: Food Panic Brings Call for a Second 'Green Revolution,'" Financial Times, June 1st, 2008; Meghnad Desai, "Act Now To Prick the Bubble of a High Oil Price," Financial Times, June 6th, 2008; "Oil Stages Its Biggest Single-Day Advance," Financial Times, June 7th-8th, 2008; Javier Blas, "Oil Jump Catches Speculators Off-Guard," Financial Times, June 10th, 2008; Max Fraad Wolff, "Our Love, Hate Relation to Inflation," Huffington Post, June 24th, 2008; "Hot and Bothered," Economist, June 28th, 2008; John Bellamy Foster, "Peak Oil and Energy Imperialism," Monthly Review, July/August, 2008; Aditya Chakrabortty, "Secret Report: Biofuel Caused Food Crisis," Guardian, July 4th, 2008; Stephen Labaton, "Worst Fears Ease, for Now, On Mortgage Giants' Fate," New York Times, July 12th, 2008; Michael Pettis and Logan Wright, "Hot Money Poses Risks to Chinese Stability," Financial Times, July 13th, 2008; Krishna Guha, "Bleak Choices for Fannie and Freddie," Financial Times, July 14th, 2008 Henry Sender and Nicole Bullock, "Investor Strategy Signals Fears for Big Two," Financial Times, July 14th, 2008; Michael Mackenzie and Francisco Guerrera, "Fate of Dollar Depends on Swift Solution," Financial Times, July 14th, 2008; Henry Sender, "Pressure Eases on Big Two But Others Feel The Heat," Financial Times, July 15, 2008; Anatole Kaletsky, "The Real Reason Why Bankers Feel So Gloomy," Times (London), July 17th. 2008; Peter Wilby, "Fannie and Freddie Go Broke," New Statesman, July 17th, 2008; "End of Illusions," Economist, July 19th, 2008; Mark Weintraub, "Oil Prices, Weak Dollar Caused Food Price Rally: Study," Reuters, July 23d, 2008; "Superprime Slime," Economist, July 26th, 2008; "Am Devisenmarkt drehen etablierte Trends," Frankfurter Allgemeine Zeitung, August 1st, 2008; Peter L. Bernstein, Three Strikes against Consumers," New York Times, August 3d, 2008; Vikas Bajaj, A Second, Far Larger Wave of U.S. Mortgage Defaults Is Building," International Herald Tribune, August 4th, 2008; "Hundreds of banks will fail, Roubini tells Barron's," Reuters, August 3rd, 2008; Charles Duhhig, "At Freddie Mac, Chief Discarded Warning Signs," International Herald Tribune, August 5th, 2008.
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