Monday, November 5, 2012

The Election: Did It and Does It Matter?

This is a guest blogger -- Buck Klemkosky

As election day 2012 approaches, an interesting question is: Did it matter for the economy who won the 2008 presidential election, Obama or McCain? And a more relevant question today is: Does it matter in 2012 in terms of the economy whether Obama gets reelected or Mitt Romney? A case could be made that it didn’t matter in 2008 and may not matter in 2012 for the economy anyway.

While Obama and Romney differ on many major issues, the compelling fact is that the Great Recession of 2008-2009 was caused by a financial crisis. Empirical evidence shows that recovery from a financial crisis takes not only good economic policy decisions but more importantly, time – time for the economic excesses that caused the financial crisis and recession to adjust back to some level of normalcy.

The root causes of a financial crisis don’t materialize overnight or even over a few years. It may take a decade or longer; in the case of the U.S. financial crisis, the excesses started several decades earlier. Some of you are old enough to remember the 1970s slow-growth economy and high inflation, referred to as stagflation. Treasury long-term interest rates approached 15 percent, and short-term rates 20 percent – some of the highest interest rates in U.S. history.

Paul Volcker was selected as head of the Fed in 1979 and immediately decided to wring inflation and inflationary expectations out of the U.S. economic system. In what became known as “Volcker’s Massacre,” in October 1979 he decided to tightly control the money supply and let interest rates go where they may. And they did go up further. It took a while, but by August 1982, inflationary expectations started to cool and interest rates started their secular downtrend to today’s historically low interest rates.

One consequence of lower interest rates and inflation was massive amounts of wealth created from 1982 to 2007. As interest rates came down, bond prices went up dramatically and trillions of dollars of wealth were created in the bond markets. Likewise, lower interest rates were reflected in lower mortgage rates, and home prices began to rise again – although not out of line with historical trends until 1996 when the housing bubble started. Stocks also don’t do well in high inflation environments, so stock prices were depressed in 1982. The total valuation of publicly traded U.S. stocks was only $2 trillion in mid-1982. By March 2000, they were worth $16 trillion.

The trillions of dollars of wealth created from 1982-2007 and an economy that grew and only experienced two short recessions in 1991 and 2001, resulted in a consumption bubble in the U.S. Consumption increased from 66 percent of GDP to more than 70 percent over this time period. Much of the increased consumption was funded by the increased financial wealth as well as by credit. Increasing home equity also fueled consumption as consumers used home equity like an ATM machine. The end result was a credit bubble of massive proportions. Consumer debt relative to GDP reached an all-time high in 2007.

Another consequence of the wealth creation and associated credit bubble was a financial system bubble.  The repeal of the Glass-Steagall Act by the Clinton administration in 1999 allowed commercial banks to move into investment banking. There was also dramatic growth in the “shadow banking” system, which included non-commercial bank institutions such as hedge funds, private equity funds, mutual funds, money market funds and a multitude of others.

In addition to the financial system bubble, the long period of moderation in terms of steady economic growth, declining interest rates and inflation, and increasing wealth from 1982-2007 created other problems, such as aggressive risk taking by consumers, corporations (remember Enron, WorldCom and others), and financial institutions. Credit standards became lax, the complexity of the system increased – especially as the derivatives market grew from nothing in 1982 to $600 trillion in 2007 – and transparency declined as overconfidence increased.

All of this credit expansion and wealth creation began to impact home prices in 1996 when they began to increase above historical trend lines; from 1996 to 2006 median home prices more than doubled. Both the Clinton and George W. Bush administrations promoted the home ownership society. They and Congress pressured the government-sponsored agencies, Fannie Mae and Freddie Mac, to not only provide mortgage financing but also to provide financing to lower-income individuals and families. Thus the advent of the sub-prime mortgages, which grew from nothing in 1996 to more than $1 trillion by 2006.

Not even the bursting of the stock bubble and subsequent bear market from March 2000 to October 2002, when U.S. stocks lost approximately half their value ($8 trillion), could dampen the real estate enthusiasm, speculation and the increase in home prices. Home ownership increased from 64 percent to 68 percent of those eligible during this period, something most thought was stabilizing for the economy. The basis assumption was that home prices would not decline, which they had not since 1930s.

So 2007 found home prices inflated, consumers with too much debt, financial institutions that were too complex and too big to fail, and a financial system that had become not only innovative, but also complex and interrelated. Nobody knew where the risks were in the financial system. The long period of credit expansion, excess leverage, and aggressive risk taking was about to end in dramatic fashion.

The first cracks in the system came from the sub-prime mortgage market in 2007 as default rates increased and mortgage prices decreased. Most thought the problem was controllable, as the sub-prime mortgage market was less than 10 percent of the total mortgage market. But home prices in general began to decline, and problems spread to other markets and to most financial institutions – especially the large investment and commercial banks. What started out as a small credit crisis became a liquidity crisis, then a financial crisis and then the Great Recession.

Who is to blame for the financial crisis? There is plenty of blame to go around and plenty to blame. You could start with the borrower who took on too much debt, real estate speculators, mortgage lenders with lax or no credit standards, bankers who lent and then securitized mortgages, ratings agencies that gave a AAA rating to low-quality mortgages, investors in mortgage-backed securities who relied on the ratings agencies and didn’t perform due diligence, bank regulators who were clueless, the Federal Reserve for keeping interest rates too low in the latter part of the housing bubble, and two U.S. presidents and the U.S. Congress for promoting home ownership to those that couldn’t afford it. But certainly the leverage in the system exacerbated the problem once housing prices started to fall and collateral prices declined. Calls for more collateral forced margin selling, and the downward spiral began.

If the sub-prime mortgage market was the trigger that started the financial crisis, then financial innovation and derivatives also can be blamed. Sub-prime mortgages were pooled into mortgage-backed securities, which were then pooled into collateralized debt obligations (CDOs), each of which was subdivided into tranches – with the highest tranche rated AAA by the ratings agencies.  In hindsight, we now know that you can’t create quality from junk. If the CDO had not existed and credit default swaps (CDSs) not available to insure CDOs, the sub-prime mortgage market would not have developed. Would this have prevented a financial crisis? Probably not, as the housing bubble was pervasive and leverage as well.

The peak of the financial crisis was probably the collapse of Lehman Brothers in September 2008. This prompted Congress to pass TARP, which bailed out the financial system as well as GM and Chrysler. In addition, Congress and the Fed threw many things against the wall. Some stuck, some didn’t.

Back to the basic question: Did it matter for the economy who was elected president in 2008? Probably not. The Fed still would have pumped massive amounts of liquidity into the system and lowered interest rates to historical lows. The U.S. Congress would have still approved of a stimulus package, and the U.S. government would still have had deficits of $5 trillion for the last four fiscal years. As Reinhart and Rogoff point out in their book, “This Time Is Different: Eight Centuries of Financial Folly,” it usually takes an economy seven to eight years to recover from a financial crisis. Consumers have to reduce debt, which they have done to the tune of $1.3 trillion since 2008. The financial system, especially the banks, has to be stabilized and recapitalized. And confidence has to be restored so consumers can spend and corporations can invest and hire. Lately U.S. consumers are spending more than U.S. corporations are investing, even though median family income in the U.S. has fallen five consecutive years.

If the U.S. economy follows the norm, it may take another three to four years to get out of the slow-growth environment and back to normal growth of 3.5 percent annually. The next president, the Fed and Congress have little ammunition left, given the magnitude of our debt and deficits. Given that world GDP growth has fallen, the problems in Europe, and the slowdown in the emerging economies (especially China), the next U.S. president faces challenging economic problems with few options. But good luck to him, whoever it may be.


  1. Excellent Presentation

    Along with the financial crisis was the movement from the industrial age to the information age. Education did not follow do to the ease of earning a living in all of the fields and related service that cropped up during the bubble years. Now those people are unemployed or underemployed without the training be part of what is driving the economy and will continue to do so for the foreseeable future.

    Unfortunately, our leaders neither understand what has happened and what will probably happen. So they kick the can. This is not the time to kick the can. It is time for new solutions not verbiage.

  2. Good job, but no matter who is elected, the man won't be able to fix a problem which has been in manufacture since at least William Howard Taft. $16 trillion is too big a hole to fill in 4 or even 8 years, and the American people are not willing to accept the pain that will be required to fix it, therefore, kicking cans will continue to be the modus operandi.

    This election is important because the next president will get to appoint at least 2 new Supreme Court justices. That act will make all the difference in the ethical, moral, and financial direction of the country.

  3. Part One. Good stuff, Buck; clear as a bell on what happened, and to some degree why. I cannot disagree with your proposition that POTUS can’t really remedy an economy in the short-term. However, I have some asides to your commentary, particularly that there is a lot of blame for the financial crises—namely the housing collapse—to go around. The long view in the rearview mirror would affirm that, but the granular view gives a different slant.

    Underlying all the promotion by legislators of both parties for universal home ownership, Fannie/Freddie pushing money, irresponsible (ignorant?) borrowers and aggressive lenders incented by bonuses, intended low interest rates, creative “innovative” financial products to grease the flow of and availability of funds, feckless regulators, et al is—tada-a-a-a, the Federal Reserve. Sold as a regulatory cop to endure the flow of funds and to prevent banking collapses, it has failed repeatedly in that role and the primary reason is that it is “the lender of last resort”—code for taxpayer. Because it controls the world’s largest ATM, it prints money at the drop of a hat and through the various agencies reporting to it—FSLC, FSLIC, FDLC, RTC, FFLB, etc.—it “guarantees” loans which permits bankers and lenders, mortgage brokers, Fanny/Freddie, et al to engage in reckless risky lending leading to bank failures/collapses that the taxpayer ultimately must pay for via inflation and taxes. It is the world’s biggest Ponzi scheme followed by Social Security. Therein is the playing field on which all the aforementioned players play without fear of losing the game because the good old taxpayer is the backstop, the catcher—there is no risk of losing. Get rid of the Fed, allow risk to come back, and let bad credit/lending behaviors suffer the loss—not the taxpayer. There is no financial free market nor should there be a free ride.

    Now, to the political players. Yes, pols of both parties have enjoyed playing on the field, but there are always a few who play a little differently, a small maneuver here, there—that the refs don’t see; not the feckless regulators reporting to the Fed and SEC, but the taxpayer who is lulled to sleep because the rules of the game have been surreptitiously hidden—they don’t have a clue because the pols have executed the perfect misdirection play—they say it’s all for the general welfare and everyone will be happy with the game’s outcome. You mentioned Clinton and GWB and Congress as pol players who greased the financial wheels—promoted universal home ownership to those who couldn’t afford it. Ya gotta add Jimmy Carter to that list as signer of the anti-redlining Community Reinvestment Act, 1978—what I consider the spark that lit the flame of the housing meltdown because it effectively compelled the home mortgage industry to relax prudent lending standards that previously withheld credit to those considered unable to repay. Thank you, J. Carter.

    Along comes sweet talk’n, Bill. Yes he signed the repeal of Glass-Steagall, which is the Gramm-Leach-Bliley Act, 1999. To get that bill through the Senate financial committee (can we say Chris Dodd? . . and Barney Frank in the House) Gramm, Leach, and Bliley (all Republican) had to agree to language to strengthen the CRA, giving it authority over any merger involving the financial holding industry, and to Clinton’s position that he "would veto any legislation that would scale back minority-lending requirements"(thus putting the CRA on steroids)—a quintessential Slick Willy maneuver that the oblivious and lulled-to-sleep taxpayer didn’t see. Onto Carter’s spark Slick Willy poured a little kerosene.

  4. Part Two. Can’t fergit GWB. I cannot find any legislation he signed that would augment Carter’s spark and Slick Willy’s liquid smoke although he did promote universal homeownership—a head fake maybe? His attempts to shore up Fanny/Freddie—the unraveling of which started under Slick Willy’s deregulation—were defeated by none other than Dodd and Frank. He proposed—simply explained—to reset the capital reserves for Fan/Fred and to exercise some oversight with a new regulatory board and other government recipients for the express purpose of addressing bad loan practices—and Democrats blocked it. It was the Bush administration that wanted to rein in the madness in the credit markets, and the Democrats who wanted to extend the policies that created the crisis. Additionally, the Federal Housing Enterprise Regulatory Reform Act of 2005, cosponsored by McCain, Hagel, Dole, and Sununu (all Republican) died in committee due priorities of the Iraq war and impending action for re-appropriation. Ergo, Republican efforts to head-off the crisis.

    Here’s my granular point. Yes, the field upon which the players of both parties play is rigged to guarantee the outcome so that the taxpayer will have to keep maintaining the stadium and might even have to build a new one. So much for metaphors. While some succumb to the siren of spreading the blame so that no one’s feeling are hurt, there must be root causes and unless those are addresses the players will continue to play and the taxpayers will continue to pay.

    Gov’t action needed = pull the plug on the Fed.

    Let free market forces tighten financial and monetary policy so that prudent credit/lending practices return—which is now occurring but almost too tight. The lesson learned should be that Liberal philosophy to avoid the consequences of free markets, individual responsibility, and self-reliance does not work. My granular view is there’s NOT a lot of blame to go around—it lies squarely at the base of Liberal philosophy.

  5. Chuck, you're a man after my own heart!

  6. So here we are about to repeat the same thing again but worse with 4 more years of the Obama Administration. But wait...there is the fiscal cliff and then there is the Bush Era Tax break repeal. If the government has the :balls" to address the cliff then there will be some short term pain but long term benefit. If not, then the can goes to the next president in 2016. The government's only option is to increase regulations and to kick the can...or continue to print more money...just like Greece.

  7. Obama has a chance to show real leadership. Our problems are so severe that he could get a lot of credit if he finds ways to lead Congress. All eyes will be watching.

  8. The market is tanking with their opinion of what his leadership ability will bring. He invited Romney to come to the White House and share his thoughts on improving the economy. We would hope Obama realizes or knows what he does not know and knows when to call liberal fixes BS and take good advise.

  9. Unfortunately his #1 issue is redistribution of income. I just don't see him changing that. He has raised too many hopes. He has a great chance now but I am not sure he has the honest inclination to do what is necessary.