Has the economy gone over the edge?

March 10, 2009

Lee Sustar explains why the soaring unemployment rate is one aspect of a new phase in the economic crisis.

THE GREAT American jobs wipeout continues with no end in sight, as the financial meltdown continues and the entire world economy unravels.

The 651,000 jobs eliminated in February pushed the unemployment rate to its highest point in a quarter of a century--8.1 percent. That's the number that the Obama administration estimated would be the average for the rest of the year. Now it looks like a mere stopping point on the way to a much higher figure.

Total U.S. job losses since the recession began in December 2007 has hit 4.4 million--already overwhelming President Obama's promise to "create or save" some 3.5 million jobs by next year through the $787 billion economic stimulus spending plan. Certainly the terrible jobs report lent credence to those who argued that the package will be too small to kick-start the economy.

Bad as that figure is, the headline jobless rate of 8.1 percent understates the scale of the jobs crisis. According to the Bureau of Labor Statistics, the broadest measure of unemployment and underemployment--those involuntarily working part time--has now reached 16 percent of the population.

The New York Stock Exchange trading floor, where stocks have continued to plunge this week

This mass loss of jobs--or full-time jobs with benefits--is causing a cascade of social problems.

"Losing your job is a much worse disaster for Americans than it is for people in Europe or Canada," Gary Burtless, a former economist at the U.S. Department of Labor, told Canada's Globe and Mail newspaper. "Unlike most of the Western world, when we lose our jobs in the United States, most of us lose our health insurance."

All this adds up to even more misery than the higher jobless rate would suggest. And the recession appears to be driving a long-term transformation of the U.S. labor market for the worse. "In key industries--manufacturing, financial services and retail--layoffs have accelerated so quickly in recent months as to suggest that many companies are abandoning whole areas of business," the New York Times reported.

BAD AS the unemployment rate is, it's likely to get much worse as the world economy keeps crumbling. A quick scan of recent news gives a sense of the deepening crisis: economic collapse in much of Eastern Europe, which in turn is dragging down the already crippled Western European banks that loaned money to them; plummeting industrial production worldwide as credit evaporates and customers disappear; a collapse in foreign direct investment and a sharp drop in world trade.

The epicenter of the crisis remains the U.S. financial system, where "zombie" banks--that is, insolvent ones like Citigroup--continue to swallow hundreds of billions in government funds, even as they are unable or unwilling to make new loans themselves.

According to a recent news report, even the institution that was considered to be healthiest among the giant banks, JPMorgan Chase, is facing potential losses of $241.2 billion on complex investments known as derivatives, far above its $144 billion in capital reserves. The bank faces future exposure of $299 billion. The reason: with housing prices still tumbling, the value of securities tied to mortgages has gone down, too.

One of the most destabilizing kinds of derivatives has been credit default swaps (CDS), a form of insurance on underlying bonds and other securities. That's because much of the CDS market is tied to mortgages that have declined in value. As a result, banks that sold the CDSs have to pay out huge amounts--something that the programmers of their supposedly sophisticated computer models said could never happen.

In fact, rather than provide insurance against losses--which sounds like a prudent thing--the CDS market has become the black hole of the world financial system. In 2007, the CDS market was estimated at $45 trillion (by way of comparison, the entire U.S. annual economic output in that year was worth $13.8 trillion).

Banks bought and sold CDSs and similar derivatives not to play it safe, but rather to take enormous risks. In Europe, for example, banks used CDSs to game regulations specifying minimum capital reserves. Since investments in mortgage-related securities were insured by CDSs, the banks could claim they had far higher capital reserves than they really had. So their balance sheets looked great--until the housing bubble finally burst, and the value of mortgage-related assets plunged during last September's panic.

As Western financial institutions staggered into the arms of their respective governments for bailouts, the CDS dominoes started to fall. The collapse of Lehman Brothers last September raised fears that banks with CDSs tied to Lehman would be dragged down, too.

But it was imminent crash of the huge insurance company, American International Group (AIG) that really set off alarms in Washington. Federal Reserve Chair Ben Bernanke and the then-Treasury Secretary Henry Paulson teamed up with Tim Geithner--now Obama's Treasury Secretary, then the president of the Federal Reserve Bank of New York--to organize an overnight nationalization of the company.

It seemed bizarre that the U.S. government would take over an insurance company just days after it allowed Lehman to go under. But the reason was fear that AIG's central role in another derivatives market--collateralized debt obligations, or CDOs--would lead to a complete seizure of world financial markets. The initial terms of the bailout seemed fairly stern for a Republican administration: AIG would receive $85 billion in government money in return for control of 80 percent of the company's stock.

Bernanke was scathing about the company at recent testimony before Congress, calling it a "a hedge fund basically that was attached to a large and stable insurance company." But rather than punish AIG for nearly wrecking the global financial system, the government has been shoveling money into the company and easing the terms of its takeover. After AIG announced the biggest quarterly loss in U.S. history--$62 billion--it got another $30 billion in government money, bringing the total amount the Feds have given to the company so far to $160 billion.

The reason given for this latest bailout is that failure to do so would threaten an already fragile financial system. "What no one is saying--the Bush folks wouldn't, and the Obama team seems to have taken the same vow of Wall Street omertà--is which firms would be most threatened by an AIG collapse," a New York Times editorial stated. "That means that by enabling AIG to avert bankruptcy proceedings, the taxpayer is also bailing out--whom exactly?"

Similarly, Geithner's kid-gloves treatment of Citigroup is intended to reassure bondholders that U.S. government intervention--even nationalization--won't squeeze them. To date, the U.S. has invested $45 billion directly into Citigroup, and now controls 38 percent of its voting stock. It's also guaranteed $300 billion of Citigroup's debt.

Yet even after Alan Greenspan and former Reagan administration Treasury Secretary James Baker called for nationalizing the banks, Geithner is bending over backwards to avoid an outright government takeover of Citi or other sickly banks.

THIS SEMI-, quasi-, sort-of-, yet anything-but nationalization strategy pursued by Geithner raises the question: Is Geithner's so-called "stress test" review of bank balance sheets designed to justify a creeping government takeover of the banks? Or is he stumbling along from crisis to crisis, Paulson style, making it up as he goes along? In either case, government policy appears confused and contradictory, and contributes to the ongoing financial meltdown.

What's more, the will-they-or-won't-they speculation about bank nationalization misses the larger point: the Obama administration's policy so far will lead to an even more colossal transfer of wealth from workers to the banks than Paulson's discredited Troubled Asset Relief Program (TARP) scheme to buy up the banks' bad assets.

Even if the banks were nationalized, the aim wouldn't be to place them under democratic control, but to stick taxpayers with the losses while paying off the companies and wealthy individuals who own those bonds.

Essentially, Geithner is attempting to pull off what Henry Paulson found politically impossible: use the $700 billion TARP funding appropriated by Congress to simply buy the banks' devalued mortgage-backed securities at inflated prices. Instead, Paulson's Treasury Department announced in October that he would put $250 billion of capital directly into the nation's largest banks in exchange for preferred shares of stock. That partial nationalization could, at least, give the government some say over the banks in exchange for their money.

But now comes Geithner with a warmed-over version of Paulson's original TARP. The only difference is that instead of handing over taxpayer dollars directly to the banks to purchase their toxic assets, the government plans to loan between $500 billion to $1 trillion to private equity firms and hedge funds, which will use the money to buy up those assets.

If, for example, these proposed "public-private partnerships" buy a bank's mortgage-backed securities for 50 cents on the dollar and sell them later for 75 cents, the investors can make big money. And under Geithner's plan, the government would insure investors against losses. So if those 50-cents-on-the-dollar securities turned out to be worth just a quarter each, working people will eat the losses through higher taxes.

This amounts to heads, the wealthy investors win; tails, the taxpayers lose--which is just what Paulson, a former CEO of the Wall Street giant Goldman Sachs, had in mind.

As New York Times columnist and economist Paul Krugman put it on his blog:

The insistence on offering the same plan over and over again, with only cosmetic changes, is itself deeply disturbing. Does Treasury not realize that all these proposals amount to the same thing? Or does it realize that, but hope that the rest of us won't notice? That is, are they stupid, or do they think we're stupid? I don't know which possibility is worse.

ANOTHER ELEMENT of the Treasury bank bailout strategy--the Term Asset-Backed Securities Loan Facility, or TALF--reflects the same soak-the-taxpayers strategy. Under the terms of TALF, the government will again lend big money--starting with $200 billion, with the aim of expanding to $1 trillion--to financial institutions that own asset-backed securities tied to student loans, auto loans, credit card debt and loans to small businesses.

TALF is being presented as an effort by the Treasury and the Federal Reserve Bank to provide liquidity to consumer credit markets. In reality, it's a backdoor means to buy up more toxic assets from financial institutions.

It's set to work like this: the Treasury Department will loan money to financial institutions--including shadowy hedge funds and private equity firms--in exchange for collateral comprised of asset-backed securities. In case the borrows don't repay the loans, Treasury will create a company known as a special purpose vehicle to purchase the assets that were put up as collateral, much as a bank takes over a house in a foreclosure.

This may appear to be tough terms: "If you don't repay your TALF loan, the government will seize your collateral."

But if the market values your collateral at only a fraction of what you claim it is worth, letting the government grab it isn't so bad after all. In fact, it's a great deal. You keep the money, and the government gets a bunch of bad paper. And because it's a so-called "non-recourse" loan, the government has no legal claim on any of your other assets.

Writing on the Credit Writedowns blog, Edward Harrison put it this way:

Seized toxic assets will be put into a special purpose vehicle controlled by the U.S. government. Translation: please dump your toxic assets with us. We will take them off your hands and have no recourse to any other assets you own.

In short, the TALF is a way for any and all comers, domestic and foreign, with toxic U.S. asset-backed securities, to dump those assets on to the U.S. government at taxpayers' expense. This is happening right now right under your noses, and it smacks of crony capitalism. At least the Fed has the transparency to spell it out. But has anyone noticed?

But all this is just a partial list of the transfer for wealth to the banks. It doesn't include the $200 billion of government funds used to take over Fannie Mae and Freddie Mac or the $29 billion of federal money used to finance JPMorgan Chase's takeover of Bear Stearns a year ago, a figure that was shocking at the time but sounds like peanuts today. Then there's the expansion of the Federal Reserve's balance sheet from $900 billion in September to about $2 trillion today, as the central bank pumps money into the banking system in exchange for dodgy assets as collateral.

The big unemployment numbers for February rightly stirred fear over the impact of the recession and anger at the big banks that caused it. But the Fed's and Treasury's ongoing surreptitious shift of wealth from labor to capital should also be cause for outrage--and protest.

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