Save the Economy, Hike the Deficit!

May 27 - 29, 2011
Careening Toward a Third Depression

By MIKE WHITNEY
http://www.counterpunch.org/whitney05272011.html
How do you light a fire under Congress? How do you get these guys to do what they're paid to do?

We're 5 years into this slump, millions of people have lost their homes and jobs, 44 million people are on food stamps, the economy is in the tank, and congress won't lift a finger to help. What's that all about? You'd think that the revision in GDP and the uptick in unemployment claims would set off alarms on Capitol Hill. But it hasn't. They just shrug it off and move on. What do they care? They get their fat paycheck one way or another, so what difference does it make to them? Besides, if they play their cards right, they'll nab a 6-figure lobbying job as soon as they retire and spend the rest of their lives working on their chip-shot and swilling single-malt at the club with their moneybags friends. Doesn't that piss you off?

Congress just doesn't seem to "get it". They don't understand what people are going through; how maxed out they are. We're in the middle of a Depression and all they want to do is score points playing political circlejerk by stonewalling the debt ceiling or jacking-around with Medicare. Meanwhile, unemployment is on the rise (Initial claims rose to 424,000 on Thursday), GDP is falling (1Q GDP revised to 1.8%), durable goods are down 3.6 percent in April, the market is topping out, business investment is flat, Europe's on the ropes, Japan is in a historic slump, China is overheating, the output gap is as wide as it was 6 quarters ago, bank balance sheets are bleeding red from falling home prices and non-performing loans, and the housing market is crashing.

Did I miss something?

Oh yeah, and the Fed's goofy QE2 program is winding down, which means that the last drop of monetary stimulus will be wrung-out by the end of June. That ought to be good for stocks.

So, excuse me for asking, Mr. Bigshot Congressman, but would you mind lending a hand? A little stimulus would be nice. You know, just enough so we can get a job and feed the kids. And if you're worried about the deficits; don't be. They're not a problem. That's just more GOP scaremongering. Here's how economics professor Bradford DeLong sums it up:

"The biggest problem generated by this right now is that Washington DC's focus on the Dingbat Kabuki theater of the long-run fiscal stability of America is keeping it from taking any effective steps to use government to boost employment and output now. And things aren't helped by the fact that the way the rescue of the banking system was carried out convinced a lot of people that stimulus policies exist to enrich the top 1% of Americans at the expense of everybody else.

This means that our hopes for economic recovery right now rest not on any government boost to aggregate demand--whether through fiscal, monetary, or banking policy--but rather on the natural equilibrium-restoring full-employment achieving market forces of the economy, especially in the labor market.

And so we are in trouble: right now there are no signs that the economy is crawling up back to anything like full employment on its own. ... The economy will grow, but we won't close the gap between actual and potential output. We will not for a long time to come get back to the 62 to 64% of the adult population having jobs that we thought was normal back in the decades of the 2000.

And that is the depressing overall macroeconomic picture. I wish I could paint a better one....("DeLong: The Economic Outlook as of May 2011", Economist's View)

Deficits aren't the problem, they're the solution. The government needs to increase spending to make up for the loss of activity in the private sector, otherwise, we're back in the soup. But, here's the good part; the government can borrow at rates that are lower than ever. Just look at the bond market. The 10-year is stuck at 3.12. That means that money is cheap because no one is borrowing, because, well, because the economy is dead-in-the-water. It's like Treasuries are yelling, "Wake up, you idiots, we're in a Depression!"

Besides, deficit spending isn't always a bad thing anyway. Just ask a guy who's been out of work for 99 weeks how much he cares about deficits. Not much, I'll bet. All he cares about is getting a job and paying the bills. Here's a clip from economist Mark Thoma who explains how deficits can actually rev up the economy:

"When the economy goes into recession, deficit spending through tax cuts or the purchase of goods and services by the government can stop the downward spiral and help to turn the economy back around. Thus, deficits can help us to stabilize the economy. In addition, as the economy improves due to the deficit spending the outlook for businesses also improves, and this can lead to increased investment, an effect known as crowding in. Deficits also allow us to purchase infrastructure and spread the bills across time similar to the way households finance the purchase of a car or house, or the way local governments finance schools with bond issues." (Government Deficits: The Good, the Bad, and the Ugly, Mark Thoma, CBS Moneywatch)

Deficits are just a way of investing in the future, like student loans. You don't hear anyone crybabying about paying for college, do you? No, because it improves their chances for making more money in the future. Sometimes you have to take on a little debt to create better opportunities for yourself. That's just the way it is. It's the same with the economy, the deficits are a bridge to the next credit expansion. But once things are up-and-running and revenues increase, then the government can throttle-back on spending and balance the budget. That's how we've always done it in the past, until we started listening to the Voodoo crackpots, that is. Besides, if we don't increase the deficits now and put people back to work fast, we're going to be stuck in this "underperforming" funk for a very long time. So, we're just shooting ourselves in the foot.

How did we get to where we are today?

Well, when the financial system crashed, the economy plunged and then reset at a lower level of output. So--while we're no longer in freefall--we're still no where near where we should be. And, guess what, we can't get back to trend when 9% of the workforce (16.5% underemployed) is on the sidelines. We have to put people back to work and get them spending. That's the only way to boost demand and kickstart the economy. Of course, big business doesn't mind the current policy, because more of the profits from productivity go to them during a sluggish recovery. So, they're just fine with the way things are right now. They also like the fact that high unemployment puts more pressure on wages. CEO's love that part.

So, how dire is the situation right now?

Well, consider this: QE2 ends on June 30, right? But according to economist David Rosenberg, there's a "89% correlation between the Fed's balance sheet and the movements in the S&P 500 over the past two years." So when the Fed stops purchasing US Treasuries, then stocks will retreat.

Add that to the fact that the states are cutting costs and laying off state workers at record pace to balance their budgets. That just increases deflationary pressures. When money is drained from the system, activity slows, demand weakens, revenues shrink, deficits bulge, and more people are laid off. It's a vicious circle.

Here's how Paul Krugman breaks it down on his blog this week:

"Last year I warned that we seemed to be heading into the "Third Depression" — by which I meant a prolonged period of economic weakness:

' Neither the Long Depression of the 19th century nor the Great Depression of the 20th was an era of nonstop decline — on the contrary, both included periods when the economy grew. But these episodes of improvement were never enough to undo the damage from the initial slump, and were followed by relapses.

We are now, I fear, in the early stages of a third depression. It will probably look more like the Long Depression than the much more severe Great Depression. But the cost — to the world economy and, above all, to the millions of lives blighted by the absence of jobs — will nonetheless be immense.'.....

And nobody in power cares! (Third Depression Watch, Paul Krugman, New York Times)

And that's what makes this political burlesque on Capitoll Hill so excruciating to watch, because it's such a waste. Peoples lives are being ruined for nothing, just because Congress doesn't have the courage to do the right thing. Do you think they'd hesitate if they had to pony-up for another multi-billion dollar weapons system, or another bailout for Wall Street, or more tax cuts for their tycoon friends? Of course not. The only time congress worries about red ink is when it might help working people. Then they throw a major hissyfit, waving their hands overhead and babbling hysterically about the free market. Give me a break. The world's not going to end. The truth is, the rest of the world WANTS us to borrow more because they want to maintain strong demand for their exports and keep their workers busy. That's why they're willing to lend us money so cheap.

So, why don't we oblige them? Why don't we borrow enough money to whittle down unemployment to 4 or 5% and get back on track? After all, we know that fiscal stimulus works, because the non-partisan Congressional Budget Office (CBO) released another report on Wednesday saying that Obama's American Recovery and Reinvestment Act (ARRA) was a booming success.

Here's a clip from the report:

"The economic stimulus package passed by Congress in 2009 raised gross domestic product, created jobs and helped lower the country's unemployment rate this year..... the Congressional Budget Office said Wednesday.

The Obama administration and Congressional Democrats said the American Recovery and Reinvestment Act, passed while the U.S. struggled to emerge from a severe recession, would save or create 3.5 million jobs while cutting taxes, investing in roads, bridges and other infrastructure, extending unemployment benefits and expanding aid to states....

The CBO report out Wednesday said the plan increased the number of people employed by between 1.2 million and 3.3 million, and lowered the unemployment rate by between 0.6 and 1.8 percentage points in the first quarter of 2011.

The stimulus package also raised gross domestic product, the broadest measure of economic output, by between 1.1% and 3.1% in the same period...." ("CBO Says Stimulus Boosted Growth, Will Add More to Deficit", Wall Street Journal)

Okay, so ARRA boosted growth by roughly 2% and added about 2 million new jobs to the workforce just like the administration predicted. So, that settles it, right? We now have solid proof that the program worked, so what are we waiting for? Congress needs to push through a second round of stimulus, put people back to work and get the economy firing on all 6 cylinders. No more foot dragging.

Mike Whitney lives in Washington state. He can be reached at fergiewhitney@msn.com

Everything you always wanted to know about Fannie Mae and Freddie Mac

Adhip Chaudhuri, Al Jazeera - Both Fannie Mae and Freddie Mac are US government "sponsored" home loan banks. Each of them have formal names, but are primarily known by their nicknames. In fact, both these institutions prefer to go by their nicknames rather than their official names. That's like the US government going by "Uncle Sam" all the time.

Fannie Mae was created by the government in 1938 to guarantee mortgage loans made by private banks.
After the Great Depression, which was characterised by bank failures on the one hand, and substantial losses of income on the part of large number of households on the other, the private mortgage market was providing mortgage loans to too few households.

The objective of the Roosevelt Administration was to restore widespread homeownership, which had become almost an ideology in the United States from early on in the twentieth century.

Thirty years later, in 1968, the government freed Fannie Mae from its control and privatized it with a Congressional charter. It became just like any other bank, except that it still did not make mortgage loans directly to the public. Instead, it bought up what is called the "secondary" market - the mortgages which had already been made by the private banks.

Two years later, in 1970, the US government created Freddie Mac, an exact duplicate of Fannie Mae. The reason behind a second institution was that high economic growth of the 1960s had led to rising incomes and the resulting widespread homeownership made just one government sponsored mortgage institution, namely Fannie Mae, unappealingly, if not scarily, large.

Both Fannie Mae and Freddie Mac have been private enterprises since then, up until September 7, 2008.
They have stockholders who provide the equity capital, they both sell bonds to raise funds, and they both pay for their operations out of their profits. There has been no money paid by the American taxpayers to these two institutions.

The two were "sponsored" banks, meaning that there was an implicit guarantee from the US government that it would not allow these two institutions to fail.

The principal act that Fannie Mae and Freddie Mac are mandated to do is to buy mortgages from private banks. The private banks, meanwhile, make mortgage loans with the comfort of knowing that they will be able turn around and sell those loans to Fannie Mae and Freddie Mac.

This comfort has two aspects. First, the banks which make the initial loans in the primary market get their liquidity back when they sell off their mortgages in the secondary market to Fannie Mae and Freddie Mac.

They can, therefore, make fresh mortgages to new customers with the funds they received from selling the previous mortgages, thereby making it possible for greater homeownership.

The second benefit that private banks get from the existence of Fannie Mae and Freddie Mac is that they can offer mortgages to middle class and low income households at affordable interest rates with the sure knowledge that Fannie Mae and Freddie Mac will take those mortgages over.

Where do Fannie Mae and Freddie Mac . . . raise funds first by issuing bonds on Wall Street just like any private company.

Then, in addition, they sell some of their mortgage holdings in the tertiary markets. They pool together a lot of mortgages and create a marketable security. These are called mortgage backed securities. If any household, whose mortgage is part of a MBS, fails to pay its mortgage obligation for, say, a month, then Fannie Mae or Freddie Mac, whoever is the relevant party, will make good the payment to the MBS holder.

Similarly, if there is a foreclosure and the sale price of the distress sale ends up being less than the value of the mortgage, then Fannie Mae and Freddie Mac will make up the difference.

A lot of these MBS are sold in foreign markets, especially to central banks with large US dollar holdings. The central bank of China is reputed to be holding $340 billion worth of MBS. . .

The overly aggressive primary mortgage lenders knew full well that Fannie Mae and Freddie Mac would have to buy up all the mortgages below the congressional cap of $417,000.

The primary mortgage companies get their profits from commissions and fees per mortgage that they make, and not from the repayments of principal plus interest from the mortgage borrowers, that is, the homeowner. That is why they were so reckless in their lending - it is a classic case of "moral hazard".

As the housing prices have plummeted, there have been two problems that have hurt Fannie Mae and Freddie Mac very badly. First, they have had to make increasing payments to cover the defaults in the MBS which the two institutions have sold.

Second, they have had to set aside reserves for those mortgages in their own portfolios which are "non-performing", meaning that the borrower cannot keep up with their payments. These set-aside reserves do not earn any income for the two mortgage institutions and hence, contribute to losses.

As the profitability of Fannie Mae and Freddie Mac decreased, their borrowing costs went up, squeezing the interest rate differential between what they earn from the mortgages they hold and the rate they have to pay on the bonds that they issue.

Fannie Mae and Freddie Mac did not help themselves during the crisis much either. They did not implement the guidelines they normally impose on the primary mortgage lenders, but instead they accepted many bad mortgages including "sub-prime" mortgages.

"Sub-prime" mortgages refer to those loans which were made without the necessary information on the borrowers. For example, a "sub-prime" mortgage may not require borrowers to disclose their incomes.

In addition the two institutions followed highly spurious accounting concepts to overstate their capital base. And lastly, they continued paying their top executives obscenely high salaries, even when their stock values fell by 80 per cent.

Legally speaking, the US government has put the two institutions under its "conservatorship". It's not clear what exactly does that mean.

The following is what we know now: The US government will immediately take hold of $1 billion worth of equity in each of the institutions. These will be in the form of preferred stocks with a guaranteed 10 per cent rate of return. These $1 billion infusions are however, not real cash infusions but rather, just compensation for the privilege of being expropriated by the US government.

The government has allowed itself to infuse as much as $100 billion to each of the institutions, and thus the American tax payers could be out $200 billion by the time the housing crisis plays itself out. The savings and loan crisis cost the tax payers $120 billion. Presumably, this bail-out will be less expensive.

In addition, all cash infusions by the US government will be more like an investment because they will receive a 10 per cent return. . .

Bush Crash Hurting Many Local Governments

WASH POST In Illinois' Cook County, women in poor neighborhoods no longer have access to free mammograms from two mobile vans testing for breast cancer. In Michigan, hikers will find about 20 campgrounds closed, and scientists are ending their studies of fish populations in the Great Lakes. In New Jersey, state workers are being laid off, and at least one town is canceling its traditional Fourth of July fireworks. And in California's San Fernando Valley, Everardo Orozco, 53, who has AIDS, exhausted his medical benefits and can no longer afford the drugs that are keeping him alive. . .

State budgets have been hit hard by a worsening national economy, including rising costs for energy and health care. In addition, fallout from the subprime mortgage crisis -- declining home sales, deflated property values and mounting foreclosures -- has caused a slide in states' anticipated tax receipts. Revenue from property taxes, sales taxes and real estate transfer taxes is affected.

At least half of the nation's states are facing budget shortfalls, some of them severe, and policymakers in most of the states affected are proposing and passing often-painful measures to trim costs and close the gaps. Spending on schools is being slashed, after- school programs are being curtailed and teachers are being notified of potential layoffs. Health-care assistance is being cut for the elderly, the disabled and the poor. Some government offices, such as motor vehicle department locations, will start closing on weekends, and some state workers are receiving pink slips.