MHC’s Moseley on U.S. Economic Crisis

Questioning Authority recently tapped economics professor Fred Moseley, an expert on Marxian economic theory and U.S. economic history, for some cogent analysis of the present U.S. economic crisis.

QA: Some commentators have suggested that the current economic crisis is the worst the U.S. has seen since the Great Depression of the 1930s. Is this assessment too dire?

FM: It is certainly the worst financial crisis since the Great Depression, but it is not yet the worst crisis in the U.S. economy as a whole. The rate of unemployment for August was 6.1 percent, which is considerably less than the peak of 10 percent in the “Great Recession” of 1981-1982. But the current crisis is far from over; I would say it is just beginning. The potential is there for the current crisis to become much worse and for unemployment to reach 10 percent.

A lot depends on the rest of the world. The main strength of the U.S. economy today is exports to foreign markets. If exports decline significantly in the months ahead, then the U.S. economy would be in serious trouble.

And the recovery from this recession will be slower than usual. It is going to take awhile to work off the excess supply of houses for sale and the excess debt of households.

QA: Have other factors besides the mortgage crisis contributed to the present situation? Do you fault the Bush administration’s regulatory slackness?

FM: Bush’s “regulatory slackness” certainly contributed to the mortgage crisis, but Bush was not the only “deregulator.” Financial deregulation started back in the 1980s in the Reagan administration, and continued during the first Bush and Clinton administrations.

All this deregulation was the main cause of the current mortgage crisis. The mortgage crisis never would have happened without it. Without deregulation, there would not have been the securitization of mortgages, the increased risk taking associated with subprime mortgages, and the perverse incentives of the originators of mortgages (commercial banks and mortgage companies, who made their money from “processing fees” and thus had an incentive to ignore the creditworthiness of the borrowers, because they soon sold these mortgages to other investors, and “the more mortgages, the more fees”).

Many economists advocated or supported the deregulation of financial markets, arguing that “financial markets are efficient.” Financial markets may be efficient in some respects, but they are also crisis prone. And when a financial crisis happens, it does a great deal of damage to the rest of the economy, so tight regulation is necessary in order to ensure that these crises do not happen.

U.S. economic history is filled with financial crises. The powers that be finally learned that painful lesson in the Great Depression and created significant regulations of financial institutions. But as the decades passed, they forgot that lesson and deregulated, and now they have to learn that painful lesson all over again. I hope they don’t forget it this time.

QA: Is the federal government doing the right thing to bail out Fannie Mae, Freddie Mac, and AIG?

FM: I think it was the right thing to do to take over Fannie and Freddie, because they own or guarantee almost half of all the home mortgages in the U.S., and over the last year have accounted for over 80 percent of all new mortgages. Without the government takeover, Fannie and Freddie would have gone bankrupt soon, which would have dealt a severe blow to the U.S. mortgage market, the housing construction industry, and the U.S. economy as a whole.

The most controversial issue in the months ahead will be the future of Fannie and Freddie--should they become permanent public enterprises, or should they be re-privatized, or should they be sold off in pieces and cease to exist? Treasury Secretary Paulson made it clear that the “conservatorship” of Fannie and Freddie is a holding action, and that the final decisions about their future status will be made by the next administration and the next Congress. He said that their current structure was not working because of its dual and conflicting goals of affordable housing and maximum profit for shareholders. And he suggested either that Fannie and Freddie should be fully public enterprises or they should be fully private enterprises without any government backing. So it looks like there will be a debate in the coming months about the fundamental issue of the role of the government in the home mortgage market.

I think Fannie and Freddie should be merged and should remain a government enterprise whose single purpose is affordable housing, without the conflicting purpose of maximum profit, for two main reasons: (1) to stabilize the home mortgage market and avoid the boom/bust instability of private mortgage markets that has brought on the current crisis; and (2) decent affordable housing should be considered a basic economic right. Providing credit for home purchases should be a function of the government, rather than private businesses (whose primary goal is maximum profit, not affordable housing). There should not be enormous profit made on the provision of credit for housing, as has been the case in recent years. Without this huge profit, mortgages would be cheaper and houses more affordable. There was also a lot of fraudulent activity in the housing industry in the recent boom, and this fraud would be eliminated. Therefore, the government should be responsible for this important economic function of providing credit for housing.

AIG is different. AIG is an insurance company, not a bank or a mortgage company. It is not even clear if the Fed has the legal authority to loan money to an insurance company. It certainly has never happened before. But it is the largest insurance company in the world, and is also the largest insurer of mortgage-based securities, in the form of financial instruments called “credit default swaps” (another “financial innovation” of the last 20 years and another result of deregulation). The reason why the Fed intervened is that AIG was about to lose its AAA rating from the credit-rating agencies, and if that had happened, then the default insurance that banks had purchased from AIG would have been worth much less, resulting in losses for these banks and worsening the credit crisis.

So a case can be made that it was necessary to loan AIG $85 billion in order to avoid this worsening of the crisis. But one could also argue that this default insurance market should have been much more tightly regulated (it has not been regulated at all), so that this danger never would have arisen.

QA: What about the “comprehensive bailout” of the financial system that Treasury Secretary Paulson announced at the end of last week?

FM: Even the unprecedented government interventions described above did not succeed in reassuring investors. Last Wednesday, September 17, the credit crisis entered a new and more dangerous phase, in which credit markets almost froze up completely. No one would lend money to anyone, except the U.S. Treasury. Banks would not lend to each other; investors withdrew almost $100 billion in one day (!) from money market funds (which are supposed to be super-safe, but were now being questioned); and there was a massive “flight to safety” of Treasury bonds, which reduced the interest rate on three-month Treasury bills to O.2 percent! (Shades of Japan.)

Then on Thursday, Secretary Paulson announced that he would seek authorization from Congress to purchase $700 billion (!) worth of mortgage-based securities (“toxic waste”) from U.S. banks. $700 billion is a lot of money; it is $2,000 for every man, woman, and child in the U.S., and is roughly equivalent to what the U.S. government spends on social security in a year. The justification for this mega-bailout is that if these toxic securities are not taken off the books of the banks, then the banks will continue to cut back on their lending, which will continue to do serious damage to the rest of the economy.

As I write, the details of this mega-bailout have not yet been worked out (the staff of the Treasury, the Fed, and Congress supposedly worked all weekend in crisis mode to iron out the details). The most important question to be decided is: what prices will the Treasury pay for these securities and how will these prices be determined? The higher the price, the more this will be a bailout of the shareholders of these banks, a bailout that taxpayers will have to pay for. Another important question is whether there will be write-downs of the money owed by homeowners on their mortgages as part of this package.

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