A run on the banks? Where is this all headed? Are we on the brink of another big one? The Great Depression of the 1930s was first kicked off by a particularly bad day on the stock market. There have had some other days even worse than Black Thursday October 24th 1929 with stock values falling 17% in one day. But in the plunge continued and stocks continued downward well into the next week with a Black Monday and a Black Tuesday. Stock values never fully recovering until the mid 1950's. As we know it was so bad that stockbrokers jumped out of windows. But the real problem manifested itself a little later when there was a run on the banks. Sound familiar? Back in 1929 as the pessimism spread people lost confidence in those granite pillars of respectability, the banks, and wanted their money out immediately if not sooner.
Banks always have more outstanding claims on their assets than they have as real cash in their vaults. That is there function; banks not only hold money they create money. Amazingly enough they are allowed to generate money out of thin air by simply making loans. It’s all a confidence game in a way. So when the depositors all want their money on the same day or week, there is, hey, not enough there to go around. This because banks are legally allowed to create money by loaning amounts based on a percentage of their deposits. It’s called their Reserve Requirement. This is set by the Federal Reserve Board. This along with several other mechanisms for controlling the money supply, the most important being the Prime Rate are the way the money supply is managed, and in turn the entire economy -theoretically anyway. But unlike the 1930s today we have have a safety net, something called the Federal Deposit Insurance Corporation (FDIC) which exists as a direct result of the problems causing by previous bank runs. This government funded corporate entity allows depositors to rest assured that their saving and checking accounts are safe, at least the first $100,000.
However, banks again are starting to experience ‘the runs’ even with the FDIC in place. As we have seen last week IndyMac Bankcorp had to be rescued by the FDIC. This rescue took a big bite out of the FDIC’s total reserves, as much as 10% of their $53 billion cache. And that's just one bank. IndyMac is the fifth US bank to fail this year - and its only July. It's classified as a ‘retail bank’. There probably won’t be a run on retail banks. IndyMac bank was big into subprime mortgages and has been under scrutiny for some time. But the real problem is with the next level up, the so-called investment banks. These banks create “money” for the big boys – corporations, hedge funds, pension funds. They do this by creating financial instruments like equities and securities that can be traded internationally. These include the recently nearly bankrupted Bear Stearns investment bank. Since they are investment banks, not regular commercial or retail banks, there is no FDIC and very little regulation – ah yes, the benefits of deregulation. Besides FDIC's 100K safeguard is chump change in this crowd. In fact to them millions are small potatoes. They wheel and deal in billions. And what has everyone concerned is that other investment banks are also on the ropes. Bear Sterns, which was recently taken over, that is eaten by a bigger fish, JP Morgan Chase, with government support. This happened with the unprecedented event of the Federal Reserve, that is the US government, "guaranteeing" the massive $32B buyout of Bear Stearns by JP Morgan. It was entirely necessary as Bear Sterns could have easily been the first domino in a long ugly chain of collapses. No one gains from a worldwide financial meltdown.
Why are Bear Sterns and other investment banks failing? Is it because they became too greedy and irresponsible during the gravy years of “free market” deregulatory madness? Were they like all compulsive gamblers unable to know when to 'cash in their chips'? Did they think they could permanently engineer all risk out of loaning to poor people at high interest rates (like the credit card companies have done?) They sliced and diced risky low grade ‘subprime mortgages’ and embedded them into financial instruments known as CDOs (Collateralized Debt Obligations.) The subprime loans were supposed to remain safely buried deep inside a mix of solid and not so solid mortgages, using high interest subprimes to pump up the returns but offset by the safer mortgages. These things were then sold to big players like hedge funds, insurance companies, pension funds, etc. Cool idea for making quadzillions. One hedge fund manager made over three billion dollars last year (and paid income tax on it at a rate far lower than your mailman pays.) Until the housing market went south these buried subprime mortgages pumped up the CDOs taking advantage of the high interest rates the poor saps eventually would get stuck with once their Adjustable Rate Mortgages (ARM) reset. But, alas, as the everything imploded and home values slid below mortgage value, these new homeowners began 'to walk'. So the subprime mortgages instead of bolstering eventually contaminated the CDOs in which they were embedded.
When an investment becomes questionable it gets dumped first by the sharpies, the Warren Buffets of the world, then as word gets around, survival instinct takes over and there is a mad rush to the exits. So now the mighty investment banks are in the toilet, a credit crisis threatens and the US economy slides inexorably into recession - and it might be a really bad one. This is because the standard counter cyclical tools, monetary and fiscal policy, in a downturn require expanding the already looming federal deficit. This will in turn weakens the dollar, which (alas) pushes up the price of oil thus more inflation and less money for consumer durables and so it goes. Inventories accrue leading to layoffs (maybe in China, too) resulting in even less disposable income available for consumption, and so on. Feedbacks loop r us. Stagflation, anyone? Runaway inflation, anyone?
Of course the overheated US housing sector had been in a near bubble bursting state for some time now. So its actual puncture was no surprise to anyone. But the problem is that it has been propping up the whole US economy for years. What now? Even Fannie Mae and Freddie Mac, the privately owned but government backed holder of mortgages, are now both in trouble and need rescue. They were indirectly burned by the subprime crisis. They hold trillions, yes trillions, in regular mortgages, much of it in Southern California where home values are sinking like rocks. Consequently Fannie Mae and Freddie Mac, normally solid as rock (again that tired simile,) have seen their stock hit the skids as their profitability goes into the red. They will need an injection of liquidly from Uncle Sam or all hell will break loose.
The system as usual was gamed. Irresponsible abuse of credit ran rampant. Everybody played, big boys and little fellas. Wall Street's investment bankers went wild as we have seen. But the middle class also participated in this hog wallow. Those who owned houses with plenty of equity used them to leverage themselves into ever bigger, newer, fancier ones. Or they simply felt wealthier (known as the "wealth effect") and spent profusely. Other more entrepreneurial types made big bucks 'flipping house' - buying and selling them in short succession as they rapidly appreciated, and then buying others. Those lower the down food chain or merely less enterprising simply refinanced often drawing out equity each time for SUVs, plasma HD TVs or vacations in Mexico, or else they irresponsibly took out ‘equity loans’ (once known derisively as 'second mortgages') foolishly consuming their hyper inflated home equity (for many their main asset) and adding it to ever heftier mortgages. This process was fine for a while especially when it involved solid mortgages on ever appreciating real estate. It was a avarice-driven phenomena typical of finance capitalism and it worked to pull us out of the downturn following the last bubble popping, the Dot Com bust.
All this was cooking along with no end in sight. But what about all the lower income working class types who also wanted to participate in the American Dream, home ownership and the realization something for nothing - real estate created wealth? With real income flat for blue collar and service sector jobs and the once unionized manufacturing jobs having been globalized to 'low wage platform' countries, many full time families with both parties working simply could not afford a home. They could neither come up with the traditional 20% down nor the stiff monthly payments on a multi hundred thousand mortgage. The inflated value of the housing, old and new, sent the value of even older tract homes into the stratosphere at least those near jobs. But not to worry, the banks had an answer - “creative financing” . All sorts of new loan packages were conjured up - adjustable rate, no interest, negative amortization and all without that annoying, intrusive documentation.
These new fangled mortgages were marketed like hamburgers or Fords. Amazingly enough hundreds of thousand dollar loans were floated without even verifying the info on the loan apps like actual employment. It all worked because the value of owner occupied homes kept zooming up. The sky was the limit. If people were worried about ballooning payments when the ARM reset or their ever-growing mortgage on interest only deals, they were told “when that happens, just refinance dude.” Of course, all of this irresponsibility pumped up the bubble ever more - and kept the US economy cooking right along. But it had to pop. And it now has. But so much else was going on – an unpopular inept President involving us not one but two wars, global warming actually happening, torture as official US policy, Constitutional shredding by a power mad administration and so on. How to could we be concerned about merely a possible real estate meltdown?
In any case, economists right, left and center agree we are in big trouble. We have definitely stepped into some serious shit. Generally in these situations by the time there is enough political support to do something drastic and steadfastly move away from what is obviously not working, more damage is done than was necessary. The dithering is dangerous. Yet moving resolutely in the wrong direction using superannuated ideologies as did the Hoover administration did in the early years of the Depression can be even worse. They did dumb stuff like plowing under crops to drive up ag prices up while people went hungry. An recent example of this was the pathetic attempt to goose the economy back ion track by luring consumers into going 'back to the mall' by giving everybody a measly $600 “tax rebate”. Like that is going to turn around a trillion dollar economy.
The problem we have now is that the tools that worked to get us out of the 1930s Depression (eventually), deficit spending on a grand scale (WW II) have been abused, misused and dulled for over 60 years. We have used it rain or shine, on the upside and or downside of the business cycle. We have used it like heroin and our tolerance as ever increased. The irony is that the Republicans who resisted such methods during the Depression and restrained Roosevelt from full application of counter-cyclical deficit spend in the 1930s, went hog wild with them in 1980s under Ronald Reagan and in the 2000’s and under George W. Bush went absolutely insane – pushing the deficit into the trillion dollar stratosphere. Since the positive effects of Keynesian deficit spending only came about only as a result of massive armament spending during WW II, it became acceptable by the Republicans and the libertarian right - but never acknowledged. They made it article of faith that social spending was "liberal tax and spend" apostasy and bad for everyone. Yet in the economic theory of John Maynard Keynes, that underpinned liberalism got us of out the Great Depression. The theory is that the business cycle endemic to capitalism, can be countered by deficit spending in downturns and recessions and recouped during upturns and booms (as Bill Clinton managed to do.) However the deficit, pump priming, spending that Keynes envisioned was to be for domestic needs ) – infrastructure, health care, welfare for the poor, education, etc. Yet WW II was no sooner over than we engaged in an arms race, the Cold War, with the Soviet Union and to a lesser extent the Peoples Republic of China. "Warfare Keynesianism" become the underlying mechanism that drove the fiscal policy but was never acknowledged. In fact as the Republican right took over from Reagan onwards, it continued to function but for guns not butter, even as 'liberalism" went out fashion and right wing, neoliberal, 'free market', deregulatory mania reigned supreme.
What next? It will probably take a major crash in one or more of the following -the US economy and/or the world economy, the biosphere, the USA as a superpower, confidence in monopoly capitalism, a belief in reactionary fundamentalist religion ideologies (we wish) and other hoary institutions of modern life to turn this mess around.
