The Political Economy of Last Week

Yes, once again, Mr. and Ms. Taxpayer, you may be about to hold the bag for a failing financial institution, infusing these firms with the money they need to keep buying and selling mortgage debt.
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It's been an intense week for political economics. Here's a rundown and one beltway denizen's view of what it all means.

McCain's Pain, Gramm version: Phil Gramm's economic policies from his days in the Senate are making life hard for millions of people right now. But it was his gum-flapping last week that was particularly tough for McCain. Gramm is McCain's top economic advisor, so when he described the current economic downturn as existing in people's heads ("a mental recession") and called us a "nation of whiners" -- well, I guess he gets points for calling it like he sees it. From McCain's perspective though, he's a bit off message.

One policy note caught my eye re Gramm's role in the current meltdown in financial markets, especially in a week where the problems at Fannie and Freddie came into light (more on that later). As I discuss in the link above, many believe that a bill Gramm championed -- Gramm-Leach-Bliley, which open up investment banks and insurers to commercial lending, but without the oversight of commercial banks--helped pave the way to the housing bubble, the credit crunch, and the current downturn.

But check out Dr. Phil's response from this obsequious interview with Gramm by Steve Moore of the Wall St. Journal's editorial page, itself a cauldron of crazed economics. When Moore "delicately" broaches the subject of Gramm's bill in today's crisis, he responds, "There's every evidence that the markets were made more stable by the diversification. J.P. Morgan could not have bought Bear Stearns and prevented a meltdown without Gramm-Leach-Bliley."

Markets more stable!? If they were any less stable, Wall St. would fall into the Hudson Bay. And how about the comment re Morgan buying Bear? It's like saying, "don't you get it? If I hadn't gotten rid of the cops, then one street gang couldn't have beat up the other street gang." The fact that Morgan had to bail out Bear is a bad thing, Phil. Shareholders and employees lost millions in equity and the deal has exposed the taxpayer to huge potential liabilities.

What kind of person thinks like that? Or perhaps the better question is: what kind of person hires that kind of person to be their top economic advisor?

McCain's Pain, self-inflicted version: McCain also hit us with some straight talk re Social Security this week, calling the program a disgrace. What he specifically found disgraceful was the fact that today's young workers sacrifice a portion of their paychecks to finance the guaranteed pensions of today's retirees. But that's the program.

To me, the quote sounded like he just discovered that this is how it works. But Social Security is the biggest single program we fund; at $600 billion, it's one-fifth of the damn budget. And he's been up there for almost 30 years. I'm not saying I want a policy wonk for president. But this betrays a scary lack of understanding of basic government functioning.

It also betrays something deeper. The intergenerational dimension of Social Security is one the wonderful things about it...sorry if I sound sentimental, but this part just always chokes me up. When they were younger, today's retirees worked to create the economy we have today. They produced the capital, the infrastructure, they taught us in our schools, and treated us in our hospitals. We've inherited these goods, public and private, and we're using them to create the growth that our families enjoy today. Under Social Security, we shave off a portion of that growth to help provide for those who came before us, while creating a new economy for our progeny, who will do the same for us ("Circle of Life" music swells up here...).

To the extent that McCain's thinks about stuff like this, he's a YOYO economist (you're on your own), which is why he wants to drain the risk pool that makes Social Security work, and introduce private accounts. Further evidence that the YOYOs are congenitally unable to appreciate anything that smacks of WITT (we're in this together).

The Ballad of Fannie and Freddie: The nation's largest secondary mortgage insurers are on the ropes. Fannie Mae and Freddie Mac are government sponsored institutions -- the feds created them, but they operate in the private market and the government does not guarantee their investments -- that buy mortgages from primary lenders (the people who lend them to you and me). This makes for a more liquid system of lending for home buyers--banks that make the loans are quickly recapitalized when they sell those loans to Fannie or Freddie.

But like so many of the institutions out there right now, the bursting housing bubble is wreaking havoc on the solvency of these two companies, as some of the debt they're holding starts to go bad. They're even less capitalized than Bear Stearns was -- they borrow a lot, take on lots of debt, and don't keep a lot of money lying around -- in part because they've always been able to borrow freely at very favorable rates. And the reason for this is that most lenders assume the government will backstop them.

And most lenders are almost certainly right. Treasury Sec'y Hank Paulson stresses that the feds are not planning a bailout, by which I suspect he means the feds are planning a bailout. Because if anybody's TBTF (too big to fail), it's this guy and gal (Fred and Fan).

Yes, once again, Mr. and Ms. Taxpayer, you may well be about to hold the bag for a failing financial institution, infusing these firms with the money they need to keep buying and selling mortgage debt, while any sorry souls with stock in the companies will find themselves facing an "equity wipe," as they quaintly call it on the street.

So what can we learn from this, Dorothy? Here are a few random observations, all of which have bearing on the actions of the next administration.

-- Bubbles are much worse than we like to think, and we should work much harder to identify and prevent them. By "we" I mean, among others, the Federal Reserve, who, under Greenspan, had a fairly explicitly stated policy of waiting by the sidelines as the bubbles inflated, mops at the ready.

-- Overleveraging means undercapitalizing. See Fannie/Freddie/Bear Stearns and pretty much every hedge fund and investment bank that borrows short and lends long. It's one thing if big banks want to play with fire. It's quite another if I'm going to be called upon to put the fire out. If you're TBTF, then we must provide you with the necessary oversight to avoid charging a costly bailout to US taxpayers.

-- When derivatives are worth multiples more than the underlying value of the equity or bond from which their value is derived, that's not a hedge. It's a big, speculative bet and a recipe for greater volatility and risk ... risk which will typically be under-priced.

-- Speaking of pricing risk, yes, moral hazard is a big problem that contributes to the underpricing of risk (which, at some level, is the main factor behind all the bad stuff that's happening now). But the time to worry about moral hazard is not the weekend when the big bank is failing. It's years before, when you're setting up the regulations under which the financial system can flourish without going off the rails.

These are tough challenges, and deep-pocketed, powerful forces will fight reform every step of the way. It's going to take equally tough, persistent focus by the next administration and Congress to craft the regulations that truly promote greater stability in the financial system. Enough already with the shampoo approach to economic growth: bubble, bust, repeat.

Maybe it's me, but I don't think the McCain/Gramm team is up to the challenge.

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