Why the Crisis Isn’t Going Away


Size matters. And it particularly matters when the size of the financial system grossly exceeds the productive capacity of the underlying economy. Then problems arise. Surplus capital flows into paper assets triggering a boom. Then speculators pile in, driving asset prices higher. Margins grow, debts balloon, and bubbles emerge. The frenzy finally ends when the debts can no longer be serviced and the bubble begins to crumple, sometimes violently. As gas escapes, credit tightens, businesses are forced to cut back, asset prices plunge and unemployment soars. Deflation spreads to every sector. Eventually, the government steps in to rescue the financial system while the broader economy slumps into a coma.

The crisis that started two years ago, followed this same pattern. A meltdown in subprime mortgages sent the dominoes tumbling; the secondary market collapsed, and stock markets went into freefall. When Lehman Bros flopped, a sharp correction turned into a full-blown panic.   Lehman tipped-off investors that that the entire multi-trillion dollar market for securitized loans was built on sand. Without price discovery, via conventional market transactions, no one knew what mortgage-backed securities (MBS) and other exotic debt-instruments were really worth. That sparked a global sell-off. Markets crashed. For a while, it looked like the whole system might collapse.
 The Fed’s emergency intervention pulled the system back from the brink, but at great cost. Even now, the true value of the so-called toxic assets remains unknown. The Fed and Treasury have derailed attempts to create a public auction facility–like the Resolution Trust Corporation (RTC)–where prices can be determined and assets can be sold.  Billions in toxic waste now clog the Fed’s balance sheet. Ultimately, the losses will be passed on to the taxpayer.
Now that the economy is no longer on steroids, the financial system needs to be downsized.  The housing/equities bubble was generated by over-consumption that required high levels of debt-spending. That model requires cheap money and easy access to credit, conditions no longer exist. The economy has reset at a lower level of economic activity, so changes need to be made. The financial system needs to shrink.
The problem is, the Fed’s “lending facilities” have removed any incentive for financial institutions to deleverage. Asset prices are propped up by low interest, rotating loans on dodgy collateral. While households have suffered huge losses (of nearly $14 trillion) in home equity and retirement savings; the financial behemoths have muddled through largely unscathed. The Fed handed Wall Street a golden parachute while ordinary working stiffs were kicked to the curb. That’s why household spending has plunged while the big brokerage houses are gearing up. Here’s an excerpt from an article by former Morgan Stanley analyst Andy Xie which explains what’s really going on:

First, let’s look at the most basic objective of deleveraging the financial sector. Top executives on Wall Street talk about having cut leverage by half. That is actually due to an expanding equity capital base rather than shrinking assets. According to the Federal Reserve, total debt for the financial sector was US$ 16.5 trillion in the second quarter 2009 — about the same as the US$ 16.6 trillion reported one year earlier. After the Lehman collapse, financial sector leverage increased due to Fed support. It has come down as the Fed pulled back some support, creating the perception of deleveraging. The basic conclusion is that financial sector debt is the same as it was a year ago, and the reduction in leverage is due to equity base expansion, partly due to government funding. (Andy Xie, “Why One Good Bubble Deserves Another”, Caijing.com)

See? The financial Goliaths are still leveraged to their eyeballs.
Fed chair Ben Bernanke has bent-over-backwards to preserve the system in its present form. That’s why the lending facilities should be viewed with a degree of skepticism. They weren’t set up merely to rescue the system from disaster, but to keep asset prices artificially high so institutions could continue to maximize profits via risky investments. And, it’s worked, too. The S&P 500 is up over 60 percent since March 9. Still, even though Bernanke has succeeded in resuscitating the flagging financial sector, investors remain pessimistic. According to Bloomberg News:

An eight-month, 68 percent rally in global stocks failed to convince investors and analysts that it’s time to take on more risk or dispel their concerns about U.S. economic policies and its banking system.
Only 31 percent of respondents to a poll of investors and analysts who are Bloomberg subscribers in the U.S., Europe and Asia see investment opportunities, down from 35 percent in the previous survey in July. Almost 40 percent in the latest quarterly survey, the Bloomberg Global Poll, say they are still hunkering down. U.S. investors are even more cautious, with more than 50 percent saying they are in a defensive crouch.
The doubt and the pessimism just won’t go away,” says James Paulsen, who helps oversee $375 billion as chief investment strategist at Wells Capital Management in Minneapolis. (Bloomberg News)

Few people seem to believe in the much-ballyhooed economic recovery. And even though the media triumphantly announced the “end of the recession” last week (when GDP came in at 3.5 percent) a closer look at the data leaves room for doubt. Goldman Sachs analysts put it like this:

“How much of the rebound in real GDP was due to the fiscal stimulus, and where do we stand in terms of the effects of stimulus thus far?  Although precise answers are impossible at this juncture, several aspects of the report are consistent with our estimates that the fiscal package enacted in mid-February as the American Recovery and Reinvestment Act (ARRA) would have accounted for virtually all of the growth reported for the third quarter.”

Positive growth is an illusion created by government spending. In fact, the economy is still flat on its back. Consumer spending and credit are in sharp decline. Unemployment is steadily rising (although at a slower pace) and wages are flatlining with a chance of falling for the first time in 30 years. Deflationary pressures are building. The talk of a “jobless recovery” is intentionally misleading. Jobs ARE recovery; therefore a jobless recovery merely points to asset-inflation brought on by erratic monetary policy. Surging stocks shouldn’t be confused with a real recovery.
Bernanke is a scholar of the Great Depression. He is familiar with Hyman Minsky and Minsky’s “Financial Instability Hypothesis”, which states that, “A fundamental characteristic of our economy is that the financial system swings between robustness and fragility and these swings are an integral part of the process that generates business cycles.”
Boston Globe correspondent, Stephen Mihm, summarized Minsky’s theory in his article “When Capitalism Fails”:  

“In the wake of a depression,” he noted, “financial institutions are extraordinarily conservative, as are businesses.” With the borrowers and the lenders who fuel the economy all steering clear of high-risk deals, things go smoothly: loans are almost always paid on time, businesses generally succeed, and everyone does well. That success, however, inevitably encourages borrowers and lenders to take on more risk in the reasonable hope of making more money. As Minsky observed, “Success breeds a disregard of the possibility of failure.”

As people forget that failure is a possibility, a “euphoric economy” eventually develops, fueled by the rise of far riskier borrowers – what he called speculative borrowers, those whose income would cover interest payments but not the principal; and those he called “Ponzi borrowers,” those whose income could cover neither, and could only pay their bills by borrowing still further. As these latter categories grew, the overall economy would shift from a conservative but profitable environment to a much more freewheeling system dominated by players whose survival depended not on sound business plans, but on borrowed money and freely available credit.
Once that kind of economy had developed, any panic could wreck the market. The failure of a single firm, for example, or the revelation of a staggering fraud could trigger fear and a sudden, economy-wide attempt to shed debt. This watershed moment – what was later dubbed the “Minsky moment” – would create an environment deeply inhospitable to all borrowers.
The speculators and Ponzi borrowers would collapse first, as they lost access to the credit they needed to survive. Even the more stable players might find themselves unable to pay their debt without selling off assets; their forced sales would send asset prices spiraling downward, and inevitably, the entire rickety financial edifice would start to collapse. Businesses would falter, and the crisis would spill over to the “real” economy that depended on the now-collapsing financial system.
Stability leads to instability.  By zeroing in on capitalism’s genetic flaws, Minsky countered the prevailing orthodoxy that markets are fundamentally efficient and rational. He not only showed that capitalism was inherently crisis-prone, but also, that it was most vulnerable during those periods which seemed to be most stable. (Like during Greenspan’s “Great Moderation”.) Stability invites speculation and risk-taking. Investors are buoyed by market euphoria and fat returns; borrowing to purchase dodgy equities turns into a mania which distorts prices and leads to massive credit bubbles. Eventually, the foundation cracks and debts cannot be rolled over. Then markets tumble.
The point is, Bernanke knows that a bloated financial system poses unnecessary risks to the  economy; just as he knows he should wind-down existing lending programs (which just encourage more speculation) and focus on rebuilding household balance sheets. The only way to put the economy back on a solid foundation is by helping struggling workers get back on their feet so they can create more demand. The objective should be full employment and broad, sustained wage growth, which is precisely what Minsky’s recommended.
Stephen Mihm again:  

The government – or what Minsky liked to call ‘Big Government’ – should become the ’employer of last resort,’ he said, offering a job to anyone who wanted one at a set minimum wage. It would be paid to workers who would supply child care, clean streets, and provide services that would give taxpayers a visible return on their dollars. In being available to everyone, it would be even more ambitious than the New Deal, sharply reducing the welfare rolls by guaranteeing a job for anyone who was able to work. Such a program would not only help the poor and unskilled, he believed, but would put a floor beneath everyone else’s wages too, preventing salaries of more skilled workers from falling too precipitously, and sending benefits up the socioeconomic ladder.  (“Why Capitalism Fails, by Stephen Mihm, Boston Globe)

Minsky’s analysis not only sheds light on the causes of the current crisis, but also provides a practical way to fix the system. Too bad Bernanke’s not paying attention.
Mike Whitney lives in Washington state, He can be reached at