The Political Discourse of a Wall Street/Main Street Dichotomy, the Senate Finance Bill, Financial Turbulence and the Global Debt/Financial Crisis

The Political Discourse of a Wall Street/Main Street Dichotomy, the Senate Finance Bill, Financial Turbulence and the Global Debt/Financial Crisis

Carlos M Pelaez

A prevailing wisdom in political discourse postulates that government policy can impose costs and regulatory constraints on banks and financial systems, or “Wall Street,” proposing legislation which would promote progress in the only important productive sector, or “Main Street.” The error in this approach is that the financial system, production, investment and government are equally important parts in different ways of the stability and prosperity of an indivisible whole or general economy. Legislative shocks on any of the sectors can disrupt the general economy and social wellbeing. Overhaul legislation focuses on restructuring business models by alleged superior wellbeing in the long term on the basis of this fake distinction of Wall and Main streets while ignoring the critical needed reform of government. There is high risk that overregulation of the financial sector may further complicate the ongoing crisis of unsustainable government budget deficits and debt that may erase in another global downturn the alleged prosperity claimed for restructurings. The sections below consider the true causes of the credit crisis and global recession of 2007-2009 by analysis of the indivisible (I) general economy, the instability and prosperity constraints added by (II) the Senate finance bill, the closer interrelation of (III) financial turbulence and the global debt/financial crisis, (IV) economic indicators and brief (V) conclusions.
I The General Economy. The conventional dichotomy of a financial sector or Wall Street and a productive sector or Main Street acting in conflict of interest is used to propose regulation: “Today the economy is growing. In fact, we’ve seen the fastest turnaround in growth in nearly three decades. Until this progress is felt not just on Wall Street but on Main Street we cannot be satisfied”(http://www.whitehouse.gov/the-press-office/remarks-president-wall-street-reform ). The noted economist Joseph Schumpeter postulated that the social process is an indivisible whole and that the economist abstracts economic principles for purposes of simplifying analysis (cited in Pelaez and Pelaez, Government Intervention in Globalization, 1-12, 131). The “economy” is in itself an abstract conceptualization in economics but it is also an indivisible process. Financial markets are considered in isolation to apply conventional tools of partial equilibrium or analyzed within general economy models. Economists are fully aware that all these markets interact in multiple ways into an aggregate called the economy. Thus, there is only a general economy and not separate compartments called “Wall Street” and “Main Street.” There is high risk in this dichotomy that punishing “Wall Street” can be accomplished without risking another even worst recession. Two competing explanations of the origins of the credit/dollar crisis and global recession illustrate this point and help to demystify the fake Wall Street and Main Street dichotomy.
First, official prudential and systemic regulation (OPSR) postulates that the credit crisis originated in inadequate regulation and excessive risk taking by financial entities. The system of originate to distribute of mortgages relaxed credit evaluation with resulting trillions of dollars of subprime mortgages bundled in mortgage-backed securities (MBS) sold to investors. Regulation failed to create and enforce standards of mortgage origination and securitization. Financial entities were reckless in risk management with excessive leverage, low liquidity, short-term financing in sales and repurchase agreements (SRP) or repos and complex financial products such as collateralized mortgage obligations (CDO) and credit default swaps (CDS). Reckless risk management was encouraged by remuneration of finance professionals mostly in cash without relation to “long-term” performance. While Main Street worked without excessive risks and low remuneration, Wall Street allegedly engaged in casino-style capitalism to appropriate cash windfalls. Eventually, Main Street paid for the excesses of Wall Street in the form of bailouts with taxpayer funds, economic contraction and loss of employment.
Second, the alternative view does not consider the fake Wall Street and Main Street dichotomy but actual interrelations in an indivisible general economy of sectors that only exist for purposes of abstract analysis. A stream of theory considers the relations of the financial sector and the rest of the economy by analysis of balance sheets. Consider a primary shock in the form of higher inventories than required in the productive sector. The reduction in inventories would be attained by reducing production that would require lower hours worked or even layoffs. Balance sheets of producers, wholesale distributors, retailers and families of workers would be weakened. The weakening of balance sheets of borrowers would weaken the balance sheets of banks and other financial entities by erosion of the credit quality of loan portfolios. Lending would be curtailed, reducing the ability of families and business to bridge their situation to the future by means of borrowing. The indivisible general economy could enter in recession.
The credit/dollar crisis and global recession can be explained by means of the balance sheet approach (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4). The Fed lowered the fed funds rate to 1 percent in Jun 2003 and kept it at that level, with a forward guidance that it would not be changed indefinitely, until Jun 2004 when it began to increase it by 25 basis points (bps) during 17 consecutive meetings of the Federal Open Market Committee (FOMC) until it reached 5.25 per cent in Jun 2006. Prior to that Treasury eliminated the 30-year Treasury between 2001 and 2005 to encourage purchases of mortgages to lower their rates in order to stimulate the economy perceived to be in a jobless recovery. The long-term policy of affordable housing resulted in a yearly subsidy of $221 billion per year. Fannie Mae and Freddie Mac operated with leverage of 70:1, faking their balance sheets to obtain higher remuneration of executives, effectively lobbying against their oversight supervisor and purchasing or guaranteeing $1.6 trillion of nonprime mortgages. In the first period of near-zero interest rates and housing subsidies the government created the artificial impression that housing prices would increase forever, which was equivalent to making everybody feel richer. For the borrower there was an opportunity of living in a house beyond the borrower’s income levels because of lower monthly payments caused by near zero interest rates with the minor downside risk of selling the house at a small profit in the future and repaying the mortgage. For the lender the only perceived risk was to sell the house after foreclosure to recover principal and interest owed and perhaps even some profit. The adjustable-rate mortgage (ARM) converted the borrower into something similar to a financial entity: the borrower took a 15-year loan on a house perceived as appreciating in price forever and financed the mortgage at short-term rates close to near-zero percent fed funds; the financial entity acquired a 10-year Treasury appreciating in price and financed it with near zero percent SRPs or repos. Borrowers and financial entities were induced by Fed policy to position houses and bonds, respectively, with near zero percent short-term interest rates. At the time of the policy before the recession policymakers and regulators deliberately induced borrowers and bankers to buy houses and position bonds. The complaint of policymakers and regulators with hindsight after the recession is that borrowers and bankers should have been omniscient and know that they were induced into a fatal error. The easy credit policy of the Fed encouraged both “Main Street” and “Wall Street” into taking high risks with borrowed liquidity at very low interest costs. Homeowners were caught in increasing monthly payments with declining house prices when the Fed increased the fed funds rate from 1 percent to 5.25 percent. The financial innovations in MBS and CDOs worked without problems in the past but collapsed in value because they were not intended to function with underlying nonprime mortgages. Fannie and Freddie purchased or guaranteed the subprime and liar mortgages with credit ultimately paid by the United States taxpayer. The deterioration of family balance sheets with the increase in monthly mortgage payments and loss of credit because of late payments resulted in erosion in the quality of loan portfolios of banks. Weakening balance sheets of banks and financial entities resulted in contraction of credit that affected balance sheets of producers. The end result was a rare global recession that would not have occurred if there had not been flooding of cheap liquidity and guarantees of liar mortgages. Neither “Wall Street” nor “Main Street” created this crisis. The government through low interest rate policy, housing policy, Fannie and Freddie created the crisis. Government is indispensable in modern societies and an essential part of the general economy (Pelaez and Pelaez, Government Intervention in Globalization, 1-12) but created the excessive leverage, low liquidity and false perception of increasing wealth that eventually caused the recession and 26.9 million people in job stress.
II The Senate Finance Bill. The objective of policy is not to punish the government or the financial system but to improve their functioning in inducing prosperity of the general economy. The Senate Finance Bill (http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=111_cong_bills&docid=f:s3217as.txt.pdf http://banking.senate.gov/public/_files/FinancialReformSummaryAsFiled.pdf http://blogs.wsj.com/dispatch/2010/05/20/major-provisions-in-senate-financial-overhaul-bill/ ) is not the product of rigorous analysis of regulation that improves policy with individual provisions that are consistent in overall objectives. There are at least six categories of adverse consequences of this rush to regulation. (1) Credit volume and interest rates. The creation of a politicized consumer protection agency will reduce credit volumes and increase interest rates with rules similar in effects to the Credit CARD Act of May 22, 2009 ((http://www.whitehouse.gov/the_press_office/Fact-Sheet-Reforms-to-Protect-American-Credit-Card-Holders ). Nearly all credit in the US is raised by securitization of loans into bonds that are rated for credit by rating agencies. One of the low points in recent legislation is the amendment creating a Credit Rating Agency Board at the Securities and Exchange Commission (SEC) that would allocate thousands of bonds to rating companies (http://professional.wsj.com/article/TPMRKWC00020100517e65h003ea.html ). This board has an impossible technical task, reproducing at high cost the staff and knowledge of rating companies and even then would slow or even impede securitization, reducing credit and increasing interest rates. (2) Bank capital. Excessive regulation increases transaction costs of banks, reducing profits that constrain the banks’ ability to raise equity capital needed for Basel Tier 1 capital requirements. The Senate approved by unanimous vote (http://professional.wsj.com/article/SB10001424052748703691804575254433629763888.html?mod=wsjproe_hps_MIDDLESecondNews ) an amendment prohibiting the use of trust-preferred securities (TPS) that the Board of Governors of the Federal Reserve System had authorized bank holding companies to use as Tier 1 capital in Oct 1996 (Pelaez and Pelaez, Regulation of Banks and Finance, 68-9). This amendment is another of the low points in legislation within the same bill because it forces banks to raise more expensive capital without any gains in stability. The proposed change in reconciliation is to apply the amendment only to large banks, which would magnify the reduction of loans required for the general economy to recover and create jobs, distorting the optimum banking structure in the US. Imposing more costly capital for no sound reason prevents the US from negotiating international bank capital requirements. (3) Innovation and risk management. The bill frustrates innovation and risk management techniques by virtually eliminating the over-the-counter derivatives market, replacing it with inflexible trading in public exchanges. The objective is to prohibit what cannot be understood, which is similar to banning air transportation because the passengers do not understand aviation technology. If this law had existed decades ago there would not have been commercial paper, high-yield bonds and funding for credit cards, mortgages, auto loans and nearly all credit that financed the US at cheaper costs, promoting the prosperity of the general economy. The Senate Finance Bill is an act of prohibiting progress for all. (4) Bank and financial system instability. Frustration of innovative risk management techniques will create more unstable financial institutions, depending on pure lending. The financial stability oversight council will not have sound theory and measurements, amputating lines of business of banks, making whatever survives more unstable. The over financial system could become more unstable because of the combination of various banks subject to riskier activities caused by concentration on lending without risk-reducing diversification of activities. Congress is legislating systemic risk. The council could provoke a costly crisis by making banks and the financial system unstable after arbitrarily breaking up financial entities. Banks could not transfer fully risk by securitization of loans and mortgages becoming more vulnerable to credit risk by the requirement of holding part of the loans in their balance sheets. (5) Too politically important to liquidate. The bill sanctions a new doctrine of perpetuating with unlimited taxpayer funds zombie financial entities that are politically useful, beginning with Fannie and Freddie that contributed critically to the crisis and were saved from bankruptcy with taxpayers funds that will never be repaid. Fannie, Freddie and other similar politically important entities will be resuscitated with taxpayer funds, creating new risks in the future. The bill also prevents market exit of companies through M&As, forcing liquidations of the not politically important to liquidate that could have been restructured in private arrangements. (6) International competitiveness. The Senate Finance Bill makes US international banks uncompetitive and by anticipating global regulation allows other jurisdictions to adapt their statues to encourage the migration overseas of the US financial industry, which is a key component of the indivisible general economy.
III Financial Turbulence and the Global Debt Financial Crisis. Financial turbulence continues because of the fears of the growing global debt crisis that is being exacerbated by the overall financial system through both the cross-border and domestic exposures of banks. There were sharp percentage declines of equity indexes from highs in Apr to the closing of markets on May 21: Global Dow -15.2, Dax Germany -7.9, Shanghai Composite China -18.4 and S&P 500
-10.6 (http://online.wsj.com/mdc/public/page/mdc_international.html?mod=topnav_2_3002 ). The announcement by Germany of bans on naked short sales of equities and bonds caused an event of global financial market fright that was exacerbated by the procyclical Senate Finance Bill (http://www.ft.com/cms/s/0/d3fa8864-6436-11df-8618-00144feab49a.html ). Bloomberg informs that the fixing of LIBOR, to which $350 trillion of financial assets such as mortgages and student loans are indexed, increased for the ninth consecutive day to 0.497, which is the highest level since Jul 24 while the LIBOR/OIS spread rose to 26.7 basis points (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aAIJD5G5GME4 ). The LIBOR/OIS spread is three times higher than a month ago (http://www.ft.com/cms/s/0/857a3a1c-651d-11df-b648-00144feab49a.html ).VIX, the index of implied volatility of S&P options at the CBOE (http://www.cboe.com/micro/vix/introduction.aspx ), rose in intraday trading to 48.20, the highest level since Mar 9, 2009 and just below 48.46 after the Sep 11, 2001 attack (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a8qdvLtcM1oc ). VIX was at 15.23 six weeks ago, which was a three-year low (http://www.ft.com/cms/s/0/857a3a1c-651d-11df-b648-00144feab49a.html ).The most threatening fiscal situation could be that of the United States as revealed by the President’s budget (http://www.whitehouse.gov/omb/budget/fy2011/assets/hist.pdf ). The highest deficit as percent of GDP since World War II occurred in 1983, -6, but no past budget is comparable to the estimated deficits as percent of GDP of -9.9 in 2009, -10.6 in 2010 and -8.3 in 2011. The deficits are staggering in trillions of current dollars: -1.4 in 2009, -1.6 in 2010 and -1.3 in 2011. Estimated outlays or expenditures increase in current dollars by 28.5 percent from 2008 to 2011 while revenues increase 1.7 percent after declining by 14.2 percent between 2008 and 2010. As percent of GDP the estimated expenditures are the highest since 24.8 in 1946: 24.7 in 2009, 25.4 in 2010 and 25.1 in 2011. The federal debt held by the public as percent of GDP peaked at 108.7 in 1946, declining to 52.0 in 1956 and never exceeding 50 until the current estimates: 53.0 in 2009, 63.6 in 2011, 70.8 in 2012 and above 70 during the remainder of the decade but likely surpassing 100. David Ranson measures a ceiling of the ratio of government revenues to GDP of 20 percent calculated since 1929 (http://professional.wsj.com/article/SB30001424052748704608104575217870728420184.html ). Federal government expenditure has risen above 25 percent of GDP. Tax increases will not increase above 20 percent according to past experience. Increases in taxes such as the federal value added tax and the energy tax will slow economic growth, reducing tax revenue. US government debt may reach 100 percent of GDP faster than in forecasts that always underestimate the realized debt. The US is moving toward a government debt event consisting of expenditure reduction, tax increases and implicit default in dollar devaluation. Financial assets will increasingly incorporate in current prices the global debt event. The crowding out effect is defined as follows: “Economists have long agreed that, if the supply of goods and services is fixed and resources fully employed, the government can claim more of the economy’s output only by depriving the private sector of its use” (Benjamin M. Friedman, Brookings Papers on Economic Activity, 3 (1978), 596). With the economy moving toward full employment, historically high budget deficits at the economy’s limit of taxation will add to the federal debt replacing private economic activity with government economic activity likely flattening the expansion path of the economy. The rise of interest rates will be magnified by the unwinding of the Fed’s portfolio of $1.99 trillion of long-term securities (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ). The economic cost of the restructurings is in terms of economic activity or percentage points of GDP and jobs that could be created by the private sector but that will be foregone because of the restructurings.
IV Economic Indicators. There is continuing recovery in manufacturing in the US with some doubts about employment and housing. The Empire State Manufacturing Survey by the New York Fed registers a tenth consecutive monthly improvement of conditions in manufacturing in May (http://www.ny.frb.org/survey/empire/empiresurvey_overview.html ). The Philadelphia Fed’s diffusion index of current activity increased for the fourth consecutive month in May and has been positive for the ninth consecutive month (http://www.phil.frb.org/research-and-data/regional-economy/business-outlook-survey/2010/bos0510.cfm ). Manufacturing was facing difficulties before the recession and recovered earlier and stronger. Housing starts increased in Apr to the seasonally annualized rate of 672,000, which is 5.8 percent higher relative to Mar and 40.9 percent above the Apr 2009 rate of 477,000. Housing permits in Apr declined to 606,000, which is 11.5 percent below Mar but 15.9 percent above 523,000 in Apr 2009 (http://www.census.gov/const/newresconst.pdf ). In Jan 2006, housing starts in the US were at an annual rate of 2265 thousand (http://www.census.gov/const/newresconst_200701.pdf ). Housing starts declined by 70.3 percent from Jan 2006 to Apr 2010. The increase in housing starts in Apr was part of a rush to receive the expiring tax credit and the decline in permits may signal decline in starts ahead. Price indexes are fluctuating with energy prices but without immediate threats of inflation. The producer price index declined 0.1 percent in Apr after increasing 0.7 percent in March and decreasing 0.6 percent in Feb. Prices for finished goods increased by 5.5 percent in the 12 months ending in Apr 2010 (http://www.bls.gov/news.release/pdf/ppi.pdf ). The consumer price index declined by 0.1 percent in Apr and increased by 2.2 percent over the past 12 months (http://www.bls.gov/news.release/pdf/ppi.pdf ). Initial jobless claims in the week ending May 15 increased by 25,000 to 471,000 (http://www.dol.gov/opa/media/press/eta/ui/current.htm ).
V Interest Rates. Funds abandoning risk exposures partly flowed to Treasuries. The Treasury yield curve continued its downward shift with the 10 year declining to 3.24 percent from 3.44 percent a week earlier and 3.82 percent a month earlier (http://markets.ft.com/markets/bonds.asp ). This decline in yields of Treasuries will be reversed as the continuing increase in government debt and the unwinding of the Fed’s balance sheet become incorporated in measuring the rate/price risk of US debt. There was similar flow of funds into German bonds because of the lower deficit of Germany with the 10-year yield at 2.67 percent corresponding to a negative spread of 57 bps relative to the 10-year Treasury.
VI Conclusions. The combined crowding out effects on capital markets of the historically high budget deficits, government debt and unwinding of the Fed’s $1.99 trillion balance sheet will flatten the expansion path of the economy. Legislative restructurings of business models may hinder growth of the overall economy and job creation. There is no alleviation for the drama of the 26.9 million persons in job stress who have lost their priority in the agenda. Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10