Galbraith Revisited

John Kenneth Galbraith, preeminent economist and historian, was actually part of history (a Roosevelt appointee), so that he had a bias in his writing about the advisability of government mega-action to effect change in the financial well-being of individuals in the United States. Of the decision to proceed with Social Security Act in 1935, he observed sixty years later: "Those who enjoy good fortune in the economic system, as ever and as now, attribute virtue to themselves and to the system as it stands. All change is thus to be resisted. No plea of personal well-being and possible personal cost can be entered; that would be too crude. Instead, it is said that the larger integrity of the system and its functioning must be protected and furthered. Some things do not change. The comfortable...similarly so contend (today)" (A Journey Through Economic Time, Houghton Mifflin: 1994). His writing sometimes reminds me of a liberal preacher with a background in economics. When national financial messes crop up, the little guy suffers, he seemed to say.

Now we have another national financial mess to clean up. Whereas in Galbraith's young years as an economist, the fiscal excess was the stock market bubble which was pricked in 1929 leading shortly to depression, and in 1980, the savings-and-loan bubble of bad loans followed by government bailout, we have an eerily similar bank bubble now, in the sub-prime loan housing crisis. As in the 1920s (margin accounts to buy stock and investment corporations), and 1980 (lax S&L loans to shaky real estate deals), the financial institutions have again loaned money that should not have been loaned. Rather than to require a sturdy show of earnest money (a downpayment of at least 10% had been traditional for ages), President Bush and Congress together decided that every American who wanted a house should get one, and lenders were happy to oblige (especially if they could sell the loan after they made it). Now, persons who should not have qualified for a loan in the first place are defaulting in droves.

To those who say the subprime mess is contained and restricted to a small percentage of all loans, Bill Gross of PIMCO, a respected bond expert for years, observed on the PIMCO website as early as September 2007, that patches of subprime decay will continue to pop up as the debacle unwinds: regulators have been absent, and this all reminds me of the 1980 S&L fiasco, except that large banks and finance companies are now the endangered institutions. Gross noted that "all assets with the exception of U.S. Treasuries look suspiciously like every other...(Summer and fall 2007) exposed a giant crack in modern financial architecture, created by youthful wizards and endorsed as a diversifying positive by central bankers present and past. ...Nothing within the current marketplace allows for the hedging of liquidity risk and that is the problem at the moment. Only the central banks can solve this puzzle with their own liquidity infusions and perhaps a series of rate cuts. The markets stand by with apprehension." What should we do about the housing market? Gross notes: "Granted a certain dose of market discipline in the form of lower prices might be healthy, but market forecasters currently project over two million defaults before this current cycle is complete. The resultant impact on housing prices is likely to be close to -10%, an asset deflation in the U.S. never seen since the Great Depression...70% of American households are homeowners (the nestegg for most Americans), and now many of those that bought homes in 2005-2007 stand a good chance of resembling passengers on the Poseidon – upside down with negative equity. A 10% “hook” in national home prices is serious business indeed...Housing prices could probably be supported by substantial cuts in short-term interest rates, but even cuts of 200-300 basis points by the Fed would not avert a built-in upward adjustment of ARM interest rates, nor would it guarantee that the private mortgage market – flush with fears of depreciating collateral – would follow the Fed down in terms of 15-30 year mortgage yields and relaxed lending standards. Additionally, cuts of such magnitude would almost guarantee a resurgence of speculative investment via hedge funds and levered conduits which have proved to be the Achilles heel of the current crisis. Secretary Paulson might also have a bone to pick with this “Bernanke housing put” since it more than likely would weaken the dollar – even produce a run – which would threaten the long-term reserve status of greenbacks and the ongoing prosperity of the U.S. hegemon."

Gross suggests that the Presendent consider an intervention "scaling Rooseveltian proportions" : "Why is it possible to rescue corrupt S&L buccaneers in the early 1990s and provide guidance to levered Wall Street investment bankers during the 1998 LTCM crisis, yet throw 2,000,000 homeowners to the wolves in 2007? If we can bail out Chrysler, why can’t we support the American homeowner?...This rescue, which admittedly might bail out speculators who deserve much worse, would support millions of hard working Americans whose recent hours have become ones of frantic desperation. And for those who would still have them eat some Wall Street cake as opposed to Midwest meat & potatoes (The Wall Street Journal editorial page suggested they should get darn good and used to renting once again) look at it this way: your stocks and risk-oriented levered investments will spring to life like the wild flowers in Death Valley after a flash flood. And if you’re a Republican office holder, you’d win a new constituency of voters – “almost homeless homeowners” – for generations to come. Get with it Mr. President and Mr. Treasury Secretary. This is your moment to one-up Barney Frank and the Democrats. Reestablish not the RFC or the RTC, but create an RMC – Reconstruction Mortgage Corporation."

Galbraith would almost certainly agree. I hesitate, because multiple sources of stupidity precipitated this problem; but hesitation may be precisely the wrong thing to do just now.

Which raises an important point: do we have to be confident of either depression or war to implement heavy government subsidization (read: deficit spending) for problems in the banking system, or can we act, in a term recently used for war, "pre-emptively"? One thing is for certain: if nothing gargantuan is done, this could be very bad for all of us Americans, not just the ones with the starter homes.