Given that the stimulus package will affect not only our immediate lives but those of future generations, I thought I would focus this week’s column on explaining what is unique about this economic recession. It seems to me that until we understand this, we cannot consider subsequent questions including:
1) Should we support the stimulus package or oppose it?
2) Should we support government spending or should we let private markets regulate themselves?
I asked a colleague who is expert in financing and risk management to explain the current economic collapse in laymen’s terms. Here’s my attempt to translate what is a complex process into basic ideas. We all know that the collapse of the subprime mortgage market is universally acknowledged to be the primary cause of the economic recession and virtual stall on credit lending. How did this happen?
Imagine that you go to the bank and get a mortgage loan. Traditionally, if you defaulted on your loan, the bank would seize your property. About twenty years ago, banks began selling mortgage loans to private investors in bundles. This is called “securitizing” mortgages. The bundles were rated according to the risk they carried. For example, mortgage securities that were considered very risky were rated as “subprime,” while those that were considered low-risk received “AAA” or “good” ratings. The banks therefore transferred the risk associated with the mortgage loans to private investors. In essence, if I defaulted on my loan now, the investors rather than the bank would have to seize my property.
Things got bad when banks, among other things, made deals with rating agencies to falsify “subprime” securities as “good” securities. In essence, investors thought they were buying low-risk securities when in fact they were buying high-risk, toxic securities. Because investors were buying in bundles, when people started defaulting on their mortgage loans en masse, investors’ assets essentially lost value very quickly. This led to the collapse of Lehman Brothers, Bear Stearns and other investment companies.
Now we’re in a situation where banks are not lending because of all the toxic securities they have on the books. The Bush Administration’s stimulus package to the banks has been used to essentially shore up the banks’ capital rather than to initiate lending. It is in the interest of the banks to reinforce their capital value than to lend, because nobody wants to invest in a bank that is on the verge of bankruptcy.
So, here is the ripple effect this has caused: When banks don’t lend, businesses and individuals don’t spend. When people and corporations don’t spend, demand for products and services declines, causing companies to cut jobs. When people lose jobs or face the potential of losing jobs, they don’t feel confident to spend. And so the whole cycle perpetuates itself into a downward spiral.
An additional problem occurs when individuals and corporations don’t spend. Federal, state and local tax revenues decline. Several state and local governments are currently facing bankruptcy. This might cause federal, state and local entities to be unable to pay public employees such as school teachers, health and human services personnel, law enforcement officers, firemen, civic employees, public defenders, etc. We’re already seeing signs of this. DMV employees in California were recently told to stay home of Fridays because the state cannot pay them.
So, banks are not lending, individuals and corporations are not spending. The last resort is for the federal government to borrow and spend. This is why the question of “should the government pass a stimulus package or shouldn’t it?” is the wrong question. To do nothing amounts to accepting the downward spiral I’ve just described above. The underlying logic on which the downward spiral operates is that everyone acts according to his/her interests. Banks are going to hoard what capital assets they can; individuals are going to do the same and limit their spending; corporations are going to continue to cut jobs in order to reduce costs, etc.
Those Republicans who oppose the stimulus package entirely have done so on the pretense that they want to limit government spending. The irony of this argument is not only that the Bush Administration has done the most government spending in recent world history. Let us be clear. Opposition to the stimulus package is tantamount to saying “it is okay to let everyone sink and lose their livelihood so that we can learn a lesson about the consequences of greed and the absence of personal responsibility.”
The key contestation between Republicans and Democrats has centered on tax-cuts as an incentive to spend vs. borrowing to invest in projects that create jobs. Presumably, Republicans would be happy to have a stimulus package that simply involved tax cuts to individuals, small businesses, and corporations. (Currently, about 40% of the proposed stimulus package consists of tax cuts or tax incentives). The problem with this strategy is that it would be difficult to imagine in the current economic climate that tax cuts or refunds will necessarily trigger spending. Because the forecast is so bleak for individual, small businesses and corporations, it may very well be that people are going to opt for holding on to that money instead of spending it (at least in the near future).
This is why the Democrats have been arguing for spending on job creation, even if this means increasing the national debt. Without restoring some sort of confidence in job stability and demand for products and services, the argument goes, people and corporations will still hesitate to spend.
These basic realities have been masked in political rhetoric that more often than not confuses rather than clarifies. This is also intentional insofar as a lot of political careers are on the line (most politicians will come up for re-election before the economic crisis is projected to turn around). Nobody knows the outcome of the stimulus package. There is a lot of playing in the dark because the scope of the crisis has no historical precedent. But political figures are hedging their bets. If the stimulus package works over time, constituents will favor those politicians who supported it. If it fails, those politicians who opposed can gleefully declare, “I told you so.” In any case, it will be difficult to tell whether job creation or tax cuts were the source of economic restoration, making the ideological battles between Republicans and Democrats moot. What’s certain is this: greed and individualist interests are still the order of the day. It remains to be seen how low we have to sink before we consider the possibility that individual well-being is linked to the well-being of all others.