B005HFI0X2 EBOK (52 page)

According to Moody’s, the top 10 percent of American earners accounted for 22 percent of all spending and the top 25 percent for 45 percent of all consumer spending. The bottom 50 percent of Americans accounted for only 29 percent of all American consumer spending. At the same time, however, the top 10 percent of earners received 50 percent of all income, while they accounted for only 22 percent of spending. Where did the rest of their money go?

Much of the money of the American rich went into speculation in the two waves of the bubble economy between the late 1990s and 2008. Had more of that money been in the hands of the bottom 50 percent, more of it would have been spent on consumer goods, including manufactured products, and far less would have gone to gambling on condos in Manhattan and Miami and trendy stocks.
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Just as a ship with a broad base is more stable than a top-heavy boat, so an economy in which well-paid workers create mass markets for goods and services is more stable than a top-heavy plutonomy.

SECURITIZATION: THE WEAK LINK IN THE GLOBAL ECONOMY

Securitization proved to be the weak link in the global economy. This innovative financial practice originated in the 1970s, when the Government National Mortgage Association (GNMA, or Ginnie Mae), began bundling mortgages together and selling them to investors. The larger US quasi-public mortgage agencies, Fannie Mae and Freddie Mac, quickly adopted the practice. With the help of increasingly sophisticated computer programs, the financial industry devised ever more ingenious methods for packaging and selling debt-based securities of various kinds.

Securitization revolutionized the way that banks did business. In the past, banks had been limited in how much they could lend by the debts that they were owed. By permitting them to clear the books, securitization permitted them to engage in a much greater volume of lending. They could not have done so had there not been a market for structured debt products. But China and other countries had an insatiable appetite for dollar-denominated debt, where they could park dollars earned from trade surpluses which, if released into the markets, would have led their currencies to appreciate at the expense of the export industries on which their growth strategies depended.

In these conditions, the business model of American banks and other lenders changed for the worse. The old practice of buy-and-hold was replaced by originate-and-distribute. Because banks and other lenders made a profit on every mortgage, they had less of an incentive to monitor the creditworthiness of borrowers. If the borrower could not repay the loan in the future, that would be somebody else’s problem. In the meantime, they would have collected their fees.

In their search for profits, banks and other lenders offered loans that required low down payments or no down payments at all. People described as NINJAs (no income, no job, no assets) found it easier to take out mortgages. Paperwork suffered, as lenders hired employees known as “robosigners” to approve loan applications as quickly as possible. Confused paper trails would cause problems later, when banks sought to foreclose on properties.

In theory, bundling a number of risky mortgages or other loans into one structured security would lower the risk of default, because all of the borrowers were not likely to default at the same time. That was the theory of the ratings agencies that provided high ratings for increasingly complex structured-debt products, which central banks and other financial institutions bought, believing them to be safe assets.

The flaw in the theory was revealed beginning in 2007, when, as a result of recession in the United States, many American homeowners began to default. In the old days, the losses would have been borne by the lenders who held the mortgages. But now that the mortgages were packaged and distributed widely, nobody could be certain which mortgages were valuable and which were toxic. Paralyzed by uncertainty, the global financial system suffered the equivalent of cardiac arrest.

THE BUBBLE BURSTS

At the beginning of the twenty-first century, global imbalances and skyrocketing inequality in the United States were strikingly similar to trends in the 1920s. Would they be followed by a global economic decline on the scale of the Great Depression? In 2007, the views of the mainstream neoclassical economics profession were summed up by the Nobel Prize–winning economist Robert Lucas, in his presidential address to the American Economic Association: “The problem of depression prevention has been solved.”

Faith in the post–New Deal American model of capitalism was shaken to its foundations when, in August and September 2008, the Federal Reserve and the Treasury mounted the greatest economic rescue effort in world history. Fannie Mae and Freddie Mac, the government-backed corporations that underwrote a majority of America’s home mortgages, were effectively nationalized. Most of the great investment banks on Wall Street, including Bear Stearns, Lehman Brothers, and Merrill Lynch, victims of bad gambles on home-mortgage debt, either vanished or were absorbed by or converted into large commercial banks. In a desperate effort to stop the contagion of bad debt and avert a credit freeze that could cause a new depression, the US government promised a bailout of the financial sector of more than a trillion dollars.

The crisis began the previous year. Home prices rapidly declined as the bubble collapsed. In 2007, the recession led to fear that inability by homeowners to make their payments would trigger defaults throughout the complex tranches of mortgage-based securities. To forestall trouble, in September 2007, the Fed lowered the federal funds interest rate from 6.25 percent to 5.75 percent; by December it had lowered the rate to 5.25 percent. The Fed dropped the rate by a dramatic 0.75 percent on January 22, 2008, and again by another 50 basis points a little more than a week later, for a total reduction of 2.25 percentage points in only three months.
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When the investment bank Bear Stearns, with a capital-to-assets ratio leveraged by 35 to 1, found itself in crisis, the government provided emergency financing so that JPMorgan Chase could purchase Bear Stearns in March 2008. In June, Bank of America took over Countrywide, which had been responsible for a fifth of American mortgages. Concern about the value of the more than $5 trillion in mortgage-backed securities held by Fannie Mae and Freddie Mac led Treasury secretary Henry Paulson to ask Congress for authority to inject billions into the two government-sponsored enterprises (GSEs). Congress passed the American Housing Rescue and Foreclosure Prevention Act in July.

In September, Bank of America absorbed Merrill Lynch, while Treasury and the Fed unsuccessfully tried to find a buyer for Lehman Brothers. Lehman filed for bankruptcy on Monday, September 15, 2008, sending shock waves through the global financial system. On the evening of September 16, the Fed announced a bailout of the American International Group (AIG), fearing that its collapse so quickly after Lehman’s would be devastating. The chair of the House Financial Services Committee, Massachusetts Democrat Barney Frank, joked that September 15 should be called Free Market Day: “The national commitment to the free market lasted one day. It was Monday.”
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The financial system was now in a death spiral. On the evening of September 18, Paulson, Ben Bernanke, chairman of the Federal Reserve, and Christopher Cox, the chairman of the SEC, met with members of Congress, warning that the country faced what Bernanke called “Depression 2.0.” They asked for $700 billion for the Troubled Assets Relief Program (TARP). Their pleas were rejected on September 29, when the House voted down the Emergency Economic Stabilization Act. But the continuing economic collapse led to another vote and on October 3, 2008, a modified version of the act was passed by Congress and signed into law by President Bush. In December 2008, the federal government also allocated more than $17 billion to rescue GM and Chrysler.

To prevent what came to be called the Great Recession from turning into a second Great Depression, both monetary policy (interest rates) and fiscal policy (spending and taxation) were required. By December 16, 2008, the Fed had set the federal funds rate at 0 to 0.25 percent.

The United States was now in the “liquidity trap” described by Keynes, in which normal monetary policy cannot function and expansionary fiscal policy is needed. The economist Dean Baker has calculated that government spending of $1.5 trillion a year beginning in 2009 would have been required to offset the demand lost in the residential housing sector ($600 billion), lost consumption demand ($500 billion), lost demand in nonresidential construction ($250 billion), and lost demand caused by states and local governments that cut spending to balance their budgets ($150 billion). Instead, the stimulus in 2009 and 2010 amounted only to around $300 billion a year.
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Christina Romer, one of President Barack Obama’s economic advisers, argued that to counteract the contraction of the economy the federal government should undertake a $1.2 trillion fiscal stimulus. Instead, Obama proposed a package half that size. On February 13, 2009, Congress passed the American Recovery and Reinvestment Act (ARRA), which spent only $787 billion over several years until September 30, 2011.

In addition to being too small, the stimulus was limited in its effects by the economic contraction imposed by state governments whose constitutions required them to balance their budgets, even in a near-depression, by slashing expenditures, firing employees, and raising taxes. Two economists, Mark Zandi and Alan Blinder, concluded that the ARRA had reduced unemployment only by 1.5 percentage points and created only 2.7 million jobs.
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Meanwhile, the stingy and fragmentary nature of America’s social safety net, in the form of “automatic stabilizers” like unemployment insurance and Social Security, meant that the United States suffered greater unemployment and economic contraction than European democracies with more generous systems of social insurance. Unemployment was far more severe for less educated workers. In 2011, unemployment among college-educated Americans was 4.3 percent, while it was 14.3 percent among workers lacking a high school diploma.
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Having passed an inadequate Keynesian stimulus, the Obama administration and the Democratic majority in Congress turned their attention away from the economic crisis to focus on measures of long-term reform: the Patient Protection and Affordable Care Act of 2010 that sought to provide universal health-insurance coverage, the Dodd-Frank Wall Street Reform and Consumer Protection Act passed in July 2010, and a controversial and ultimately failed attempt to create a cap-and-trade system to reduce greenhouse gas emissions that contribute to global warming. The diversion of attention and energy away from the immediate unemployment crisis that accompanied these other projects brought to mind the warning of Keynes to the Roosevelt administration in its first term that “even wise and necessary Reform may, in some respects, impede and complicate Recovery.”

In the November 2010 midterm elections, the Republicans regained the House. The activists of the conservative Tea Party movement were reminiscent of the anti–New Deal Liberty League in their denunciations of the supposed “fascism” and “socialism” of the Obama administration. As it had done since the Reagan years, the Republican Party asserted without evidence that further tax cuts for the rich and corporations were the solution to all problems. On the left, the Occupy Wall Street movement, spreading from downtown Manhattan to cities throughout the nation in the fall of 2011, gave voice to the frustration of many Americans with the financial industry.

Having originated in America, the crisis dragged the entire global economy down. The major industrial countries protected their own banks and industries and responded according to their national traditions and interests. China shoveled more state-controlled credit at its overbuilt export sector and infrastructure. “Euroland,” the European area that shared the euro as a common currency, was crippled by disputes between Germany and debtor nations like Greece.

THE PREDATORS BALL

Even before the Great Recession began in the crash of September 2008, the first decade of the twenty-first century was a Japanese-style “lost decade” in the United States. Compared to the 24 percent overall growth of the 1990s, the US economy grew by only 6 percent in the 2000s.
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What little growth there was went to a tiny plutocratic minority. During the Bush years, two-thirds of the income growth in the United States went to the top 1 percent of the US population.
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Over a longer period, 82 percent of all gains in US wealth between 1983 and 2009 went to the richest 5 percent of American households.
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By the early twenty-first century, the Gini coefficient, a measurement of economic inequality, showed that the United States was radically different from other developed nations and resembled other highly unequal nations including Rwanda, Ecuador, and the Philippines.

In 1985, junk-bond king Michael Milken threw a party he called “the Predators Ball.” By the second decade of the twenty-first century, it was clear that the party was over.

The history of the productive apparatus is a history of revolutions. So is the history of transportation from the mailcoach to the airplane. . . . This process of Creative Destruction is the essential fact about capitalism.

—Joseph A. Schumpeter, 1942
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We believe that this country will not be a permanently good place for any of us to live in unless we make it a reasonably good place for all of us to live in.

—Theodore Roosevelt, 1912
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n the early twenty-first century, Paterson, New Jersey, is a troubled city in a troubled country. The city that traces its origins back to Alexander Hamilton’s Society for Establishing Useful Manufactures (SUM) has lost most of its manufacturing businesses to other countries. Like other cities in America’s deindustrialized Rust Belt, Paterson has been plagued for decades by poverty, crime, and urban decay. Like other northern industrial cities, Paterson became a home of black migrants from the South just as many manufacturing jobs that provided ladders to middle-class status were disappearing. National shifts in demography are reflected in Paterson, where a majority in the city now consists of Latino immigrants and their descendants. Immigration has helped to revitalize the city, to some degree. But levels of poverty, illiteracy, and illegitimacy are high.

About twenty miles south of Paterson in Elizabeth, New Jersey, is something called Foreign Trade Zone 49. FTZ 49, established in 1979, is one of hundreds of special business districts created in recent years in the United States that provide special customs treatment for companies engaged in international trade. Operated by the Port Authority of New York and New Jersey, FTZ 49 is one of the largest contiguous foreign trade zones in the country. Its 3,587 acres include 2,075 acres in the Port Newark/Elizabeth Port Authority Marine Terminal; 41-acre Global Marine Terminal and 145-acre Port Authority Auto Marine Terminal, both in Jersey City/Bayonne; 125-acre Industrial Park at Elizabeth; 53-acre Greenville Industrial Park in Jersey City; a 23-acre site in Bayonne; a 40-acre tank farm and fuel-distribution system at Newark Liberty International Airport; a 407-acre industrial site in South Kearny; 316 acres in Port Reading Business Park in Woodbridge and Carteret; 115 acres in the I-Port 12 industrial park in Carteret; 72 acres in Port Elizabeth Business Park in Elizabeth; and 176 acres in the I-Port 440 industrial park in Perth Amboy.

FTZ 49 sponsors industries involved in manufacturing, pharmaceuticals, petroleum products, and special chemicals and hosts companies that include motor-vehicle importers and an importer of frozen-orange-juice concentrate. The industrial park is connected to world commerce by Newark Liberty International Airport and the ExpressRail Intermodal Rail System, with dedicated facilities at major container terminals in Elizabeth and Staten Island. Nearly ten thousand workers are directly employed at FTZ 49, while the multiplier effects of its economic activity create a far greater amount of indirect employment in the area and the nation.
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FTZ 49 is Alexander Hamilton’s SUM reborn. Power is provided by electricity rather than by water, and the products include many that did not exist when the United States was founded. Ingredients are brought in and products taken out by trucks, trains, and planes, not by boats and wagons. The purpose of American economic policy in the twenty-first century is no longer to catch up with industrial Britain, but to allow the United States to participate in high-value-added global supply chains in a world of transnational production, without sacrificing strategic industries. But the project of creative collaboration between government and private enterprise to ensure that America remains a land of promise is no different today than it was on that fateful day of July 10, 1778, when General Washington and Colonel Hamilton, enjoying a respite from war, admired the thundering falls of the Passaic and imagined what America might be.

The story of the American economy that has been told in this book can be summarized in a paragraph. When the United States won its independence and organized its Constitution, the world’s economy was still the preindustrial economy that had existed for millennia since the invention of agriculture—an economy in which human and animal muscle provided most of the power, supplemented where possible by the force of windmills and water mills, in which the burning of wood and other biomass provided heat and light, and in which passengers and freight were most efficiently moved by water. Within decades of the Founding, America began to be transformed by the industrial revolution, which has radiated outward from workshops and laboratories in three waves—the first industrial revolution based on steam and telegraphy, the second industrial revolution based on electric and oil motors, and the third industrial revolution based on computers. Each wave of technological innovation has destabilized existing economic, social, and political arrangements, forcing Americans to adapt by creating, in effect, a series of new republics while keeping, for the sake of continuity, the old name of the United States of America and the old federal Constitution of 1787, with formal and much more important informal amendments.

American history shows a recurrent pattern: a thirty- to forty-year time lag between technology-driven economic change and the modernization of political and legal structures to deal with its consequences. During this period of misalignment, such as the 1830s through the 1860s, the 1890s through the 1930s, and the 1970s through the 2000s, the institutions of the economy and the polity drift further and further apart. Nostalgic Jeffersonian politicians like Andrew Jackson, William Jennings Bryan, and Ronald Reagan who idealize a smaller-scale past often win wide support in these eras of drift and stagnation. Finally, after three or four decades of misalignment between economy and polity, there is a crisis—the Civil War, the Great Depression, the Great Recession. The crisis provides an opportunity for reformers to reconstruct the economy and political system in an attempt to realize perennial American democratic and liberal ideals in forms adapted to the new technological era. The Hamiltonian tradition enjoys a revival, in light of the urgent need for large-scale, ambitious programs of national development based on collaboration rather than conflict between government and private enterprise.

If American history is any guide, the cycle of Jeffersonian nostalgia and partial regression that began with Carter and Reagan will give way at some point to a neo-Hamiltonian era of nation building—or, to be more precise, nation rebuilding. Eventually, however, the next political-economic order will be obsolete. As long as technological progress continues to transform the way we work and live, the economy and the polity inevitably will become misaligned again, challenging new generations of reformers.

THE GREAT RECESSION AND BEYOND

The Great Recession that followed the global financial crisis of 2008 is best thought of as a depression whose worst effects have been contained by governments that learned the lessons of the 1930s. Stimulus programs funded by deficit spending in countries from the United States to China have sought to compensate in part for the collapse of private consumer and business demand. Systems of social insurance like unemployment insurance have ameliorated the effects of unemployment. And from the failures of the 1930s, governments in the 2000s learned the importance of the state as a lender of last resort during an economic collapse.

However, by ameliorating the effects of the Great Recession, the policies and institutions put into place after the 1930s may have disguised the severity of the present crisis from political classes, if not members of the public, in the United States and other nations. That, along with a mistaken understanding of the crisis as a severe but normal recession rather than a near-depression, may explain why in the United States and Europe the focus of elites turned almost immediately, in the years after 2008, to the long-term problem of deficit reduction, away from the short-term crises of mass unemployment and the household-debt overhang.

In the United States, the unwillingness of federal leaders to engage in much greater stimulus spending and much more energetic restructuring of home-mortgage debt resulted from an irrational fear of “big government,” stoked by a Republican Party that had abandoned its northern Hamiltonian roots for the right-wing Jeffersonianism of its new regional base, the former Confederacy. It is difficult for the United States to have a rational response to the Great Recession when the opinion leaders of one of the two national parties believe that Herbert Hoover was too progressive. All too many of America’s leaders have learned nothing from the mistakes of Hoover and Franklin D. Roosevelt in their premature attempts to balance the budget during the Great Depression, which backfired by contracting demand and plunging the economy back into crisis. In Europe, the misguided attachment to austerity policies on the part of Germany, the largest economy, has harmed both Europe and the world.

It can take years or decades for countries to recover from the aftermath of asset bubbles in housing or stocks that burst, leaving financial systems burdened with worthless debts that will never be repaid.
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The long stagnation of the Japanese economy shows that policies that are too timid or too favorable to creditors who refuse to write off worthless debt can cause a nation to keep sliding back into the hole before it manages to crawl out. Moreover, previous financial crises since the Depression have been national, like late-twentieth-century crises in Japan and Sweden, or regional, like the Asian financial crisis. Those countries and regions recovered, but it is not clear that they provide precedents when the crisis is global and all countries are trying to recover at the same time, using the same methods, such as expanding exports while moving toward budgetary balance. The historians of the future will probably render a judgment on today’s policymakers similar to that rendered on those of the 1930s: excessive fears of deficits and national debt, along with excessive optimism about the self-healing powers of the market, led governments to do too little, not too much.

GLOBAL REBALANCING

Whatever lies beyond the Great Recession, it will not resemble the bubble economy that caused the crisis. It is doubtful that chastened American consumers would engage in another multidecade spending spree, and even if they did the public debt overhang built up during the Great Recession would severely limit the ability of the federal government to respond to another, perhaps even greater, crisis.

Both the Great Depression and the Great Recession were preceded by periods characterized by global imbalances in trade and finance and by the maldistribution of wealth. During the Golden Age that followed World War II, both of these problems were corrected. After World War II the United States, which had worsened global imbalances by becoming the world’s lender while refusing to import goods from its debtors, abandoned protectionism for reciprocal trade (which, because of Cold War considerations, mutated into a quite different system of unilateral free trade). At home, the extreme inequality of the 1920s was replaced by a compression of incomes, with incomes at the top limited by customary norms and taxation and with minimum-wage laws, unionization, and restricted immigration putting a floor on wages at the bottom. A similar combination of global rebalancing and a more equitable distribution of the gains from economic growth will be required, if America and the world are to move beyond the bubble-economy pattern of asset bubbles followed by collapses and rising inequality of income and wealth.

As we have seen, the fable that following the Cold War the world repudiated statism and embraced free-market capitalism and moved toward a borderless global market bears little resemblance to reality. What really happened is that, following the fall of the Berlin Wall, the United States sought to extend the Pax Americana system beyond its allies to incorporate formerly hostile and neutral powers, including giants like China and India. During the Cold War, the United States had offered to provide the public goods of security, the dollar as a reserve currency, and one-way access to American consumer markets to its former enemies Japan and Germany, on the condition that they accept the military leadership of the United States and concentrate on civilian industrial production. The United States turned a blind eye to their mercantilist export-promotion policies, sacrificing its own industries in the interest of alliance unity and specializing in military spending and finance.

Already by the 1970s, with the recovery of Japan and Germany, this bargain no longer benefited the United States. As it wound down the Vietnam War, the Nixon administration engaged in a policy of strategic retrenchment, while retaliating against Japanese mercantilism and abandoning the Bretton Woods fixed-exchange-rate system in an effort to help American industry. But first Jimmy Carter and then Ronald Reagan denounced Nixonian Realpolitik in favor of a vision of American foreign policy based on human-rights idealism or crusading anticommunism. The abandonment of the Bretton Woods system allowed the United States to borrow vast sums from abroad, even as its merchandise trade deficit swelled. Public borrowing enabled Reagan and George W. Bush to build up the military while cutting taxes, while private borrowing allowed Americans to live better even though their wages stagnated for a generation.

Having been strained by Japanese and German export-oriented mercantilism, the economic order of the Pax Americana was finally shattered by the attempt to admit post-Communist China to the system on terms similar to those that had been offered to the defeated Axis powers. The form that globalization took severed the link within the United States and other nation-states between domestic mass consumption, domestic investment, and domestic economic growth. On both sides of the Pacific Ocean, wages failed to rise to track productivity growth. Wage-led growth in the United States was sacrificed to debt-led growth, while in China, wage-led growth was sacrificed to investment-led growth. When debt and investment dramatically outstripped wage-based aggregate demand, a painful readjustment became inevitable.