The End of Growth: Adapting to Our New Economic Reality (18 page)
Read The End of Growth: Adapting to Our New Economic Reality Online
Authors: Richard Heinberg
Tags: #BUS072000
Further, the way the Fed at first employed quantitative easing in 2009 was minimally productive. In effect, QE1 (as it has been called) amounted to adding about a trillion dollars to banks’ balance sheets, with the assumption that banks would then use this money as a basis for making loans.
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The “multiplier effect” (in which banks make loans in amounts many times the size of deposits) should theoretically have resulted in the creation of roughly $9 trillion within the economy. However, this did not happen: because there was reduced demand for loans (companies didn’t want to expand in a recession and families didn’t want to take on more debt), the banks just sat on this extra capital. Perhaps a better result could have been obtained if the Fed were somehow to have distributed the same amount of money directly to debtors, rather than to banks, because then at least the money would either have circulated to pay for necessities, or helped to reduce the general debt overhang. But this would require actions far removed from the Fed’s mandate.
In November 2010, the Fed again resorted to quantitative easing (“QE2”). This time, instead of purchasing mortgage securities, thus inflating banks’ balance sheets, the Fed set out to purchase Treasuries — $600 billion worth, in monthly installments lasting through June 2011. While QE1 was essentially about saving the banks, QE2 was about funding Federal government debt interest-free. Because the Federal Reserve rebates its profits (after deducting expenses) to the Treasury, creating money to buy government debt obligations is an effective way of increasing that debt without increasing interest payments. Critics describe this as the government “printing money” and assert that it is highly inflationary; however, given the extremely deflationary context (trillions of dollars’ worth of write-downs in collateral and credit), the Fed would have to “print” far more than it is doing to result in serious inflation. Nevertheless, as we will see in Chapter 5 in a discussion of “currency wars,” other nations view this strategy as a way to drive down the value of the dollar so as to decrease the value of foreign-held dollar-denominated debt — in effect forcing other nations to pay for America’s financial folly.
In any case, the Federal Reserve has effectively become a different institution since the crisis began. It and certain other central banks have taken on most of the financial bailout burden (dealing in trillions rather than mere hundreds of billions of dollars) simply because they have the power to create money with which to guarantee banks against losses and buy government debt. Together, central banks and governments are barely keeping the wheels on the economy, but their actions come with severe long-term costs and risks. And what they can actually accomplish is most likely limited anyway. Perhaps the situation is best summed up in a comment from a participant at the central bankers’ annual gathering in Jackson Hole, Wyoming in August 2010: “We can’t create growth ourselves, all we can do is create the conditions that make growth possible.”
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BOX 2.3
Just a Little Sideshow
The big banks that were involved in securitizing mortgages and trading them in bundles during the past 15 years purposefully evaded local legal requirements for registering mortgages with a county recorder of deeds as they changed hands. Nor did the banks bother to transfer to the buyer a proper document of assignment evidencing the sale. Mortgages were bundled up into trusts for the purpose of securitizing them to investors, but the trusts were also never given proper legal evidence of the assignment of the mortgages.
Then, when the housing market crashed and banks began millions of foreclosure proceedings, they created the assignments after the fact, using “robo-signers” to submit legal documents to the courts (in one such case the signer had been dead for over five years) and falsified notarizations. In thousands of documented cases foreclosures were conducted even though the borrower was not notified in advance, or the borrower was told by the bank to withhold payments in order to qualify for a mortgage modification but then declared in default by the bank, or the bank added thousands of dollars of “late fees” to the borrower’s account, forcing the borrower into default.
In a landmark ruling in January 2011, the Massachusetts Supreme Court held that two banks foreclosed wrongly on two homeowners using suspect paperwork. Attorneys General in 50 states are investigating banks’ foreclosure processes. Many observers are questioning whether the banks actually technically own hundreds of billions of dollars’ worth of securitized mortgage assets on their balance sheets. If further court rulings go against the banks, the result could be fatal for several “too-big-to-fail” institutions.
Investors who bought MBSs are filing fraud claims against the banks, arguing that these securities were never properly collateralized. Their claims against the banks could amount to trillions of dollars.
The Federal government is implicated as well. Fannie Mae and Freddie Mac now face much higher losses on their portfolios of trillions of dollars’ worth of home mortgages, and will therefore likely have to turn to the government for further capital infusions.
L. Randall Wray, a Professor of Economics at the University of Missouri, Kansas City, claims that most mortgage-backed securities are in reality not backed by anything, since the electronic securitization process that most banks used operated illegally. According to Wray, lenders may have the right to foreclose in some instances, but only if they have a clear record of each sale of the mortgage — but electronic securitization in most instances destroyed those records.
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The new Congress is likely to try to find a way for the banks to escape this mess, perhaps by simply writing a law declaring the mortgages in question to be valid even without proper documentation. But it is doubtful whether such a law would hold up to scrutiny by the courts. In the end, it may be up to the Supreme Court to decide on the validity of mortgage claims worth trillions.
Deflation or Inflation?
If the bailouts and stimulus packages are effectively just a way of buying time, then there is further trouble ahead — but trouble of what sort?
Typically, financial crises play out as inflation or deflation. There is considerable controversy among forecasters as to which will ensue. Let’s examine the arguments.
The Inflation Argument
Many economic observers (especially the hard money advocates) point out that the amount of debt that many governments have taken on cannot realistically be repaid, and that the US government in particular will have great difficulty fulfilling its obligations to an aging citizenry via programs like Social Security, Medicare, and Medicaid. The only way out of the dilemma — and it is a time-tested if dangerous strategy — is to inflate the currency. The risk is that inflation undermines the value of the currency and wipes out savings.
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There are many fairly recent historic examples, as well as ancient ones going back to the very earliest days of money. The Romans generated inflation by debasing their coinage — gradually reducing the precious-metal content until coins were almost entirely made of base metals. With the advent of paper money, currency inflation became much easier and more tempting: Germany famously inflated away its onerous World War I reparations burdens during the early 1920s. Between June and December 1922, Germans’ cost of living increased approximately 1,600 percent, and citizens resorted to carrying bundles of banknotes in wheelbarrows merely to purchase daily necessities; some even used currency as wallpaper. In the United States, hyperinflation occurred during the Revolutionary War and the Civil War. Hungary inflated its currency at the end of World War II, as did Yugoslavia in the late 1980s just before breakup of the country. During the 2000s, Zimbabwe inflated its currency so dramatically that eventually banknotes were being circulated with a face value of 100 trillion Zimbabwe dollars. In each case the result has been the same: a complete gutting of savings and an eventual re-valuation of the currency — in effect, re-setting the value of money from scratch.
How does a nation inflate its currency? There are two primary routes: maintaining very low interest rates encourages borrowing (which, with fractional reserve banking, results in the creation of more money); or direct injection by government or central banks of new money into the economy. This in turn can happen via the central bank creating money with which to buy government debt, or by government creating money and distributing it either to financial institutions (so they can make more loans) or directly to businesses and citizens.
Those who say we are heading toward hyperinflation argue either that existing bailouts and stimulus actions by governments and central banks are inherently inflationary; or that, if the economy relapses, the Federal Reserve will create fresh money not only to buy government debt, but to bail out financial institutions once again. The addition of all this new money, chasing after a limited pool of goods and services, will inevitably cause the currency to lose value.
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The Deflation Argument
Others say the most likely course for the world economy is toward continued deleveraging by businesses and households, and this ongoing shedding of debt (mostly through defaults and bankruptcies) will exceed either the ability or willingness of governments and central banks to inflate the currency, at least over the near-term (the next few years). In this view, those who see government actions so far as inflationary fail to see that all that the expansion of public debt has accomplished is to replace a portion of the amount of private debt that has vanished through deleveraging; total debt has actually declined, even in the face of massive government borrowing.
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If a bubble consists of lots of people simultaneously taking advantage of what looks like a once-in-a-lifetime opportunity to get rich quick, deflation is lots of people simultaneously doing what appears to be perfectly sensible (under a different set of circumstances) — saving, paying off debts, walking away from underwater homes, and pulling back on borrowing and spending. The net effect of deflation is the destruction of businesses, the layoff of millions of workers, a drop in consumption levels, and consequently further bankruptcies of businesses due to insufficient purchases of overabundant goods and services.
Deflation represents a disappearance of credit and money, so that whatever money remains has increased purchasing power. Once the bubble began to burst back in 2007–2008, say the deflationists, a process of contraction began that inevitably must continue to the point where debt service is manageable and prices for assets such as homes and stocks are compelling based on long-term historical trends.
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Many deflationists tend to agree that the inflationists are probably right in the long run: At some point, perhaps several years from now, some future US administration will resort to truly extraordinary means to avoid defaulting on interest payments on its ballooning debt, as well as to avert social disintegration and restart economic activity.
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The Bridge to Nowhere
In general, what we are actually seeing so far is neither dramatic deflation nor hyperinflation. Despite the evaporation of trillions of dollars in wealth during the past four years, and despite government and central bank interventions with a potential nameplate value also running in the trillions of dollars, prices (which most economists regard as the signal of inflation or deflation) have remained fairly stable. (While at the time of this writing food and oil prices are soaring, this is due not to monetary policy but to weather events on one hand, and political turmoil in petroleum exporting nations on the other.) That is not to say that the economy is doing well: the ongoing problems of unemployment, declining tax revenues, and business and bank failures are obvious to everyone (see Box I.1 in the Introduction, “But Isn’t the US Economy Recovering?”). Rather, what seems to be happening is that the efforts of the US Federal government and the Federal Reserve have temporarily more or less succeeded in balancing out the otherwise massively deflationary impacts of defaults, bankruptcies, and falling property values. With its new functions, the Fed is acting as the commercial bank of last resort, transferring debt (mostly in the form of MBSs and Treasuries) from the private sector to the public sector. The Fed’s zero-interest-rate policy has given a huge hidden subsidy to banks by allowing them to borrow Fed money for nothing and then lend it to the government at a 3 percent interest rate. But this is still not inflationary, because the Federal Reserve is merely picking up the slack left by the collapse of credit in the private sector. In effect, the nation’s government and its central bank are together becoming the lender of last resort and the borrower of last resort — and (via the military) increasingly also both the consumer of last resort and the employer of last resort.
How can the US continue to run up deficits at a sizeable proportion of GDP? If other nations did the same, the result would be currency devaluation and inflation. America can get away with it for now because the dollar is the reserve currency of the world, and so if the dollar entirely failed most or all of the global economy would go down with it. Other nations are willing to continue holding dollar-denominated debt obligations simply because they see no better alternative. Meanwhile some currency devaluation actually works to America’s advantage by making its exports more attractively priced.
Over the short to medium term, then, the US — and, by extension, most of the rest of the world — appears to have achieved a kind of tentative and painful balance. The means used will prove unsustainable, and in any case this period will be characterized by high unemployment, declining wages, and political unease. While leaders will make every effort to portray this as a gradual return to growth, in fact the economy will remain fragile, highly vulnerable to upsetting events that could take any of a hundred forms — including international conflict, popular unrest and dissent, terrorism, the bankruptcy of a large corporation or megabank, a sovereign debt event (such as a default by one of the European countries now lined up for bailouts), a food crisis, an energy shortage, an environmental disaster, a curtailment of government intervention based on the political shift in the makeup of Congress, or a currency war (again, more on that in Chapter 5).
