posted April 1, 2008
From Financial Crisis to Global Recession, Part 2

From Financial Crisis to Global Recession, Part 2
by Jack Rasmus
copyright 2008

In testimony before the U.S. Congress House Financial Services Committee at the close of February 2008, U.S. Federal Reserve Bank (FED) chairman, Ben Bernanke, acknowledged for the first time what many in finance, banking, and government policy circles have quietly begun to admit to themselves but have been fearful to voice publicly: namely, the current financial crisis is now clearly deepening and spreading rapidly beyond the subprime residential mortgage sector to other credit markets and that monetary policy action by the FED (i.e. lowering interest rates) appears increasingly unable to do much about either the spreading financial crisis or the emerging recession.

As Bernanke admitted to House Committee on February 27, 2008: “The (recent) economic situation has become distinctly less favorable�, with the residential mortgage market decline accelerating, non-residential construction “is likely to decelerate sharply in coming quarters�, consumer spending and the business sector both slowing significantly, and general credit conditions likely to “tighten substantially�. Moreover, “the risks to this outlook remain to the downside�. Bernanke admitted that the FED, despite repeatedly lowering short term interest rates since September 2007, had failed to lower long term interest rates. In fact, long term rates—which have a far greater impact on consumer and business spending and thus on the likelihood of recession—have actually begun to rise ‘across the board’.

Part I of this article last month described the origins of the current financial crisis through year end 2007. It was pointed out that the current financial crisis—now rapidly spreading in 2008 beyond subprime and other housing markets to other U.S. and global credit markets—rests upon a growing ‘mix and weight’ of financial speculation and speculative investment in general that has been building in momentum since the 1980s, resulting in increasing financial instability. Financial booms and busts in the U.S. are consequently growing in magnitude, in frequency, and are leading inevitably to a deep recession in the U.S. that is already well underway, and beginning to spread to leading economies abroad. The longer term outcome may well be a global economic downturn of major dimensions circa 2009-10.

Each time financial crises have erupted in the U.S. since the 1980s they have been only temporarily quelled by a combination of monetary action (i.e. lowering of interest rates) by the U.S. Federal Reserve and fiscal policy action (i.e. tax cuts) by Congress and the President. But fiscal-monetary policy has only succeeded in ‘bottling up’ the forces of financial speculation and their impact on the real economy, ensuring the re-emergence of financial crisis in a more severe and volatile form at a later date. The problem of growing instability is not solved but only put off. Indeed, as will be argued further below, the declining effectiveness of fiscal-monetary policies has actually contributed toward subsequent financial crises erupting more frequently.
Recent speculative excess, volatility and financial crisis in the U.S. is not new or unique. It has occurred before—in the run-up in the 1920s to the great stock market crash of 1929 and the Great Depression that followed. Then—as today—the fundamental forces behind the growing speculation and consequent financial instability lay in the massive redistribution of income in favor of wealthy investors and corporations. That shift and redistribution of income in turn was the result of the various government and corporate policies that created the income inequality that in turn fed the speculative activity of that decade. Accompanying the growth of income inequalityi were further developments enabling and accelerating the speculative activity—i.e. lack of financial regulation, money supply over-expansion by the Federal Reserve, excessive financial ‘leveraging’ (then called margin buying and stock pooling), shady banking practices, severe conflicts of interest, corruption and fraud hidden from the public, and the complicity of private rating agencies and government in covering up all the above—to name but a short list of ‘enablers’ which, while not direct causes of crises, were nonetheless contributing factors to the crisis.

Enabling factors today are essentially similar in content if not in exact form. That is, the ‘forms’ of deregulation, new financial institutions, techniques of over-leveraging, hidden investment dealing and corruption, and so forth may have changed their ‘content’ somewhat but their consequences have been the same. On the other hand, the fundamental driving force—the massive concentration of income in the hands of wealthy individual and corporate investors—has been remarkably similar today compared to the 1920s.

For example, the share of income concentrating among ‘the top’ wealthiest 1% households and corporations since 1980 is virtually the same today as it was then. Over the past three decades in the U.S. the share of total U.S. income has fundamentally shifted to the wealthiest 1% households from the general U.S. working population, having risen from 9% in 1979 to approximately 22% today—i.e. the same percent level it was in 1929. Meanwhile, corporations in the past five years have experienced the greatest rates and levels of profits and retained earnings gains since records were first kept by the U.S. government. Moreover, the preceding percent shares of total income are low estimates. Neither the above 22% of total income earned by the wealthiest 1% of households today, nor record profits and earnings by corporations, reflects the increase in ‘hidden income’ shuffled to offshore tax shelters by wealthy and corporate investors. That unaccounted (and untaxed) income which has risen from $250 billion in 1983 to more than $6 trillion today. The extreme concentration of incomes in the hands of wealthy and corporate investors has fed the speculative investment boom, in particular that part of the boom diverted into speculative financial investment. Without the income concentration there would likely be no excessive speculative boom, at least not of today’s dimensions. There might be speculation but likely of dimensions controllable by traditional fiscal-monetary policy means.

In short, it is not merely coincidental that the growing tendency today toward financial instability, and successive financial crises of growing severity, has paralleled the growing concentration and inequality of income distribution in the U.S., reported and hidden, since 1980. And in that regard the current financial crisis is very much like that of the 1920s.

What follows is a description of how the financial crisis has been spreading at a rapid rate in the U.S., from the subprime mortgage to other credit markets, and how that contagion is beginning to penetrate the real (non-financial) economy, causing the deep recession now emerging in the U.S. The transmission mechanism from financial crisis to deepening recession will be described. What follows will also address current efforts by the Federal Reserve to contain the financial crisis and stave off recession by lowering interest rates and propping up sagging bank balance sheets. However, the Federal Reserve’s efforts will not only fail but will actually worsen the financial crisis. Already FED policies, it will be noted, are leading to a collapse of the U.S. dollar in world currency markets and producing the next ‘financial speculation boom’ in commodities (food, oil, metals, etc.) and thus in turn rapidly raising inflation in the U.S. On the fiscal side, it will also be shown how recent attempts by the Congress and Bush to inject $168 billion into the economy via tax cuts will prove no less ineffective as monetary policy by the FED.

From Subprimes to Generalized Credit Crisis: July-December 2007

The subprime mortgage crisis that erupted publicly in July-August 2007 did not cause the current financial crisis, but was just one of several (and now growing) symptoms of a deeper more fundamental financial instability. Speculation in subprime mortgages—fueled by the new ‘securitization and derivatives revolutions’ in finance, virtual deregulation of finance capital since the late 1990s, new technological forces, and widespread corruption and fraud on numerous fronts—produced a housing asset price bubble of epic dimensions between 2003-2006. Mortgage borrowing rose more than $4 trillion between 2003-6 with $2 trillion of that issued in subprime mortgages. That’s approximately $1 trillion a year for four consecutive years. Today, 2008, the subprime mortgage market has virtually evaporated, with much of the non-subprime market in turn rapidly coming to a standstill.

With the evaporation of the subprime market came a collapse in prices and value for subprime mortgage securities (bonds). Because of the magnitude of the speculation ($2 trillion) in subprime mortgages, the magnitude of losses by banks and financial institutions was correspondingly immense as well. According to rating agencies, Moody’s and Standard & Poor’s, by early 2008 totaled a minimum of $400 billion. Other foreign bank sources estimate the potential losses from subprimes in the U.S. at $600 billion. Banks and finance institutions have thus far written off only $120 billion. That leaves $280-$480 billion yet to go.

The massive nature of the losses quickly led to the collapse of other credit markets most closely related to the subprime market. Subprimes were often ‘bundled’ with other securities before being sold as repackaged deals by banks and hedge funds to investors. Subprimes were often bundled with Commercial Paper called Asset Backed Commercial Paper (ABCP). As subprimes collapsed by $600 billion in 2007, the ABCP market plummeted by about $500 billion along with it within a matter of a few months. Contagion from the subprime market also simultaneously infected the non-subprime mortgage market (called ‘Alt-A’ mortgages). Similarly, the ABCP market infected the non-asset backed ‘Broad Commercial Paper’ market. In turn, the Commercial Property mortgage market began to plummet by several hundred billion $ by year end 2007, with projections for its likely ‘shut down’ to occur by mid-2008.

Like lights going out in a regional ‘brownout’, the subprime and directly related credit markets began to go out one by one; that is, began literally to ‘freeze up’, freefall, and even shut down. Such was the scenario by late 2007. The cumulative credit contraction for just these five inter-related markets amounted to more than $1.6 trillion, occurring in less than six months, with associated bank losses and write downs estimate around $600-$800 billion.

The Deepening Financial Crisis: January-February 2008

Enter 2008, and the above scenario deteriorated further, more broadly and rapidly.
The construction (housing-commercial) and closely related Commercial Paper markets’ decline almost immediately began to spill over to the corporate bond markets, in particular the so-called ‘High Yield Corporate’ or ‘Junk Bond’ market which contracted by 90% by January 2008 compared to January 2007 and dropping by more than $900 billion. Like the ABCP market, the Junk Bond market is where already economically shaky corporations go to raise funds by issuing and selling their equally unsecure bonds. However, with ABCP and Junk Bond credit markets collapsing, corporations that previously relied on them are predicted now to default in record numbers. Default rates are predicted to surge from 1% to more than 10%, according to both Moody’s and Standard & Poor’s. That in turn means massive further losses for banks on top of subprime and commercial property mortgage losses already occurring. It also means that as those corporations default, many going bankrupt and out of business, the result will be widespread layoffs over the next 18 months.

Rising corporate defaults and anticipated subsequent bank losses translate into rising interest rate costs for otherwise stable companies. From the corporate junk bond market, the credit contraction has thus begun to spread to more mainstream business credit markets, like the Commercial and Industrial Bank Loan and short term Commercial paper markets. Together, these two represent credit markets that most medium and smaller sized corporations most heavily rely upon to finance business operations. The two markets had a combined total of $3.3 trillion in outstanding credit issued to business in August 2007; however, by early 2008 that amount had declined by more than $300 billion.

Another credit market taking a dive by early 2008 was the Leveraged Buyout, or LBO market. This was a hot speculative investment area up to 2008, in which companies arranged loans and other financing through investment banks in order to ‘buy out’ other companies or to go private in order to avoid government oversight of speculative and other even more shady business practices. By early 2008 more than $200 billion in loans for leveraged buyouts were ‘left hanging’ without interested buyers. This meant banks and original investors would eventually have to absorb the losses themselves.

But the even bigger news of early 2008 was the growing likelihood of Bond Insurer companies like MBIA, Ambac, and others (called ‘Monolines’) facing downgrading and perhaps default themselves. These companies insured other companies’ bonds and loans, promising to pay investors for corporate and other bond defaults should they occur. But with combined reserves only in the $20-$30 billion on hand, the half dozen bond insurers are themselves grossly under-funded. Their combined liabilities (i.e. insurance commitments) amount to more than $1.9 trillion. Moreover, they too speculated in subprimes as well as other derivative investments in the amount of $572 billion. In other words, it became increasingly clear to investors and markets that the reserves ‘Monolines’ themselves had on hand were woefully inadequate. Rating agencies like Moody’s and S&P had conveniently overlooked their condition during the speculative run-up. But the Moody’s and S&P now threatened to downgrade the bond insurers. Should that occur, countless corporations and banks that purchased their insurance would face severe downgrades in turn as well—resulting in still further losses and potential defaults.

The precarious position, and potentially huge losses, of the Monolines prompted global financier, George Soros, recently to comment, “there is a growing concern about the monolines…there is also a potential problem with money market funds which could be holding doubtful assets�. Soros’s concern was echoed by JP Morgan CEO, Jamie Dimon, who added “if one of these entities (bond insurers) doesn’t make it, the secondary effect could be terrible� That ‘secondary effect’ would be the downgrading and consequent default of hundreds of billions in corporate bonds—on top of the already projected 10x increase in corporate defaults in 2008.

Some analysts predict that the bankruptcy or even major downgrade one or more bond insurers could easily spill over to the $3.3 trillion Money Market Fund market or the $2.5 trillion Municipal Bond Market, precipitating an institutional ‘run on the banks’ that would be an historic first (and quite unlike individual depositors’ ‘bank runs’ in the 1930s and before). Early indications of just such a possible scenario in fact began to emerge in February 2008, as key sectors of the Muni Bond Market began to dry up. With about half of Municipal Bonds ‘insured’ by the bond insurers the ‘safety’ of Muni bonds began to be questioned. Two key segments of the ‘Muni Market’ began to contract sharply—i.e. ‘Auction Rate’ and ‘Variable Rate’ municipal bonds, which finance around $330 billion and $500 billion, respectively. Strategically critical for state and local government funding, shrinking trades at ‘muni markets’ threatened significant cost increase and funding problems for local governments. Many state and local government authorities now face excessive borrowing costs at a time of accelerating recession and lower tax revenues.

Another ‘insurer’ avenue also began to come under pressure by early 2008. This was the derivatives-based “Credit Default Swaps� market. Virtually nonexistent prior to 2002, outstanding credit default swaps now total more than $45 trillion, bigger than the total U.S. government bond and housing markets combined. Most of securities in this market reside in a ‘shadow banking system’, itself largely a product of the post-2001 period, set up by banks to park risky assets ‘off balance sheet’ and hidden from investors and government oversight agencies alike. (An arrangement, by the way, not dissimilar to that at the now defunct ENRON Corp., for which that company’s senior management were indicted and jailed). Like the monolines, Credit Default Swap derivatives are designed to ‘insure’ against defaults. But if corporate bond defaults approach just historical normal levels of 1.25%, Bill Gross, managing director of the world’s largest bond fund, Pimco, publicly pointed out that $500 billion in credit derivative contracts would result in losses of at least $250 billion.

Perhaps an early ‘red flag’ of the beginning of just such a fracturing of the $45 trillion credit derivatives market was the dramatic losses announced in January by the major French bank, Societe General, which raised the possibility that the ‘derivatives’ problem was perhaps not limited to subprimes and asset backed paper but was actually far more widespread, just as Pimco head, Bill Gross, had predicted.

Sings of major problems in the Insurance Industry also began to emerge in early 2008, as AIG Inc., the largest insurance company by assets, announced record losses of $11.5 billion due to credit default swaps (derivatives) trading. Still to come perhaps are Hedge Funds, where early signs of problems have also begun to arise as more go bankrupt and are beginning to close.

In summary, the picture by end of February 2008 was one of a rapidly spreading credit contraction, in part the product of accelerating write downs and losses. The following Tables 1 and 2 represent a partial, select list of credit markets’ contraction and estimated losses, as announced or predicted by rating agencies and various sources in the business press:

TABLE 1

ESTIMATED SELECT FINANCIAL MARKET LOSSES
Actual & Predicted 2007-09

Subprime Residential Mortgages $400 billion
Commercial Property Mortgages $212 billion
Junk Bonds $230 billion
Leverage Buyout Loans $200 billion
Monolines downgrades $150 billion
Credit Default Swap Derivatives $250 billion
Leveraged/Collateralized Loans $110 billion

TOTALS $1.552 trillion

TABLE 2

ESTIMATED GENERAL CREDIT CONTRACTION
SELECT MARKETS
Actual & Predicted, 2007-2009

Subprime Mortgage Market $600 billion
Commercial Property Market $175 billion
Junk Bonds $900 billion
Commercial & Industry Loans
& Short Term Paper $300 billion
Asset Backed Commercial Paper $500 billion
Broad Commercial Paper $400 billion
Auction Rate Muni Bonds $330 billion
Variable Rate Muni Bonds $500 billion
Leveraged/Collateralized Loans $500 billion
Leverage Buy Out Loans $200 billion

TOTALS $4.405 trillion

The above losses and credit contraction do noyet include additional potential losses and contraction in ‘consumer’ credit—in particular in areas of auto loans, credit card debt, and student loans. Evidence now appearing suggests significant losses are anticipated in these markets as well. Major credit card companies like American Express and others have announced record level loss provisioning and ‘set asides’ in anticipation of consumer defaults. A growing list of public universities have begun to announce shutting down student loan programs due to sharply rising borrowing costs. And General Electric Corp.announced intent to exit the consumer credit markets altogether. Thus, the accelerating mortgage, bank and corporate ‘debt’ problem appears by early 2008 to be infecting consumer markets.

Like excessive corporate debt, total household debt over the four year period, 2003-07, roughly doubled, rising by nearly $7 trillion. It too now appears to be ‘unwinding’ as of early 2008. And all this before widespread foreclosures, mass layoffs, and deepening recession even begin to have an additional impact on consumer credit, markets, and defaults.

How Financial Crisis Is Creating Recession

How does such a magnitude of financial losses translate to a deepening recession in the general U.S. economy? The short answer is that such epic financial losses have two immediate consequences. First, losses on financial institutions’ balance sheets mean losses must be restored by raising additional real capital. If not, the institutions themselves may ‘default’. They can borrow from other banks, borrow from the Federal Reserve, or, as has recently been the case, from what are called ‘Sovereign Wealth Funds’, which are foreign government owned investment funds. The first option is a problem when banks are suspicious of each other’s financial viability and uncertain if the bank that requests to borrow funds may eventually default, leaving them with the losses. Interbank borrowing thus dries up, as it almost did in late 2007. Borrowing from the Federal Reserve is the second option, and has been occuring since late 2007 under especially favorable terms by the FED. But FED loans have thus far proved insufficient to cover the anticipated magnitude of future losses by the banks. Similarly, Sovereign Wealth Funds located in Dubai, Singapore and elsewhere have injected funding into the banks by purchasing partial ownership of Merrill Lynch, Citicorp and others. But the amounts are measured in the low tens of billions, nowhere near the high hundreds of billions of losses to date and anticipated.

Given the still massive anticipated losses and likely insufficient available funding, banks turn reluctant to ‘loan out’ the funds they do have. So they raise interest rates to record levels. These interest rates are not the ‘short term’ interest rates of 3%-4% at which the FED loans money to the banks. The banks’ rates offered to customers are ‘long term’ interest rates—which are essentially bonds and long term loans of 10 to 30 years duration—which are loaned out at 7%, 10%, or more. Rising long term rates raise the cost of borrowing by non-bank, corporate customers and to consumers’ buying durable products like cars, furniture, homes, etc.

Some corporate customers may be desperate for funding and must take on the long term debt borrowing even at record high rates, thus raising their costs significantly and increasing the possibility of losses, default and bankruptcy in recession. Other corporate customers simply decide not to borrow at the high long term rates and instead focus on cutting operating costs, which means mass layoffs across industries at some point.

In short, in an accelerating recession, banks are reluctant to lend and corporations equally reluctant to borrow. Only the most exposed companies are willing to borrow at the high rates, which means in many cases they will eventually go under—thus Moody’s and S&P’s predictions of a 10x increase in corporate default rates over the next 18 months. Lower investment and business spending translates into layoffs eventually, more defaults in auto, credit card and student loans, and thus further momentum in the direction of recession.

The above process then takes on psychological dimensions at some point, which worsens the economic decline. Fear and uncertainty over still unannounced, further bank losses leads to lack of confidence in the banking system itself, and even further reluctant to loan or to borrow. This in fact has been growing over the past several months. Ever-deepening crises of confidence in the banking system itself is a particular hallmark of transitions from recessions to depressions.

Another ‘psychological scenario’, for example, is when fear of losses in the subprime mortgage market led to concerns of losses as well in non-subprime residential mortgage, commercial property markets, and closely associated markets like Asset Backed Commercial Paper. Borrowing rates rise and investors turn away from borrowing not only in subprime and related markets, but other mortgage markets. Prices of property then nose dive across the board. This kind of ‘debt price deflation’, when spreading from an isolated to associated credit markets, is a further event that is also historically closely associated with depressions rather than recessions.

Another example: concerns that the bond insurers (monolines) and credit default swaps deals will not be able to cover anticipated defaults leads investors to withdraw in growing numbers from even ‘safe’ credit markets like Muni Bonds, about half of which outstanding are ‘insured’. Local governments’ borrowing costs shoot up, at a time their revenues are falling sharply due to recession. In turn state and local governments reduce spending, layoff workers in large numbers, reduce benefits for others, raise property taxes and various fees, etc.—all which translate into further recessionary pressures.

A third example: rising financial institution losses translate into rising rates and to a tightening of credit terms for consumers as well as business borrowers. Credit card rates rise, terms become more onerous, banks start dinging consumer customers with more fees, auto loan rates rise, student loans become harder to get with higher rates, state and local governments must spend more to borrow and in turn pass on the costs to citizens in higher local fees, property taxes, and lower spending (resulting in less hiring or layoffs). Like the recent phenomenon of homeowners starting to simply ‘walk away’ from homes they recently bought, consumers begin to default on auto and student loans and credit cards—which is increasingly occurring.

Psychological expectations of downturn thus feed the downturn. It starts with falling confidence in the banking system, which spreads to the general financial system, then spreads throughout various credit markets to the real economy. The growing lack of confidence is not linear but occurs somewhat exponentially. The rate of spread of a crisis of confidence gathers momentum, and consequently so too does the magnitude of the financial crisis itself.

The rate of spread, magnitude, and momentum also means efforts to check the crisis (and its penetration of the real economy) by traditional fiscal-monetary means becomes increasingly difficult. What people think, feel, and believe will happen becomes a material, and even perhaps at times determining, force. And it is not easy to shift the general psychology when it takes hold—whether by ‘fine tuneing’ short term interest rates (FED action) or by providing paltry injections of tax cuts (recent Congressional legislation). When the magnitude and rate of spread of the financial crisis reaches a certain threshold, like a jet aircraft moving through the sound barrier, the controls operate in reverse.

Contradictions of Monetary and Fiscal Policy

Both FED monetary policy and the recent $168 billion Congressional tax cut package will prove grossly insufficient in dealing with the current financial crisis and the recession.

The FED is on a roller coaster ride, attempting to skirt both inflation and deflation, as it desperately lowers short term interest rates to buttress bank balance sheets and attempts with decreasing success to check the widespread and growing credit contraction.

Rapid deflation (i.e. price collapse) is now occurring in the general housing and commercial property markets and may soon spread to other non-construction markets as corporate defaults rise and additional bank losses are reported. Debt deflation in housing and property markets is the inevitable consequence of prior (housing and property) asset price inflation, which was produced by excessive speculation. Excessive speculation breeds extraordinary inflation and eventually just as extraordinary deflation. But deflation is the greater danger.

When debt deflation spreads from housing to other sectors of the economy, the real crisis begins. Companies facing rising costs and unavailability of funds to finance day to day business, turn to raising revenue on an emergency basis by selling their products below market prices. This raises immediate cash necessary to operate or even stay in business, but sets in motion a downward price spiral—i.e. deflation—that ultimately accelerates losses and the need for still further price cuts. This is what especially distinguishes Depression from Recession. Efforts to raise revenue by price cutting, moreover, is often accompanied by cutting costs by mass layoffs. Thus rising unemployment accompanies the deflation in parallel. The U.S. economy is approaching the cusp, heading in that direction.

FED interest rate reductions of more than 3% points by March 2008 has assisted banks’ sagging profitability, but has not succeeded in heading off the general credit crisis and recession. The crisis has continued to outrun FED actions as long term interest rates have risen and thus pushed the economy further into recession. In short, the FED has thus underestimated the depth and magnitude of the current financial crisis, its particularly rapid rate of spread (compared to prior financial crises in the 1980s-1990s), and its equally deepening impact on the economy.

The FED may in fact have even assisted the momentum toward recession by its recent lowering of short term interest rates. For example, lower rates has resulted in an accelerating decline of the U.S. dollar and a growing shift from the dollar to the Euro and other currencies as the preferred medium of global trade and financial transactions. The financial crisis, in other words, is rapidly translating into a parallel currency crisis—which is also a characteristic of Depressions as compared to Recessions.

The fall of the dollar is also provoking another speculative price bubble, in the form of rapidly rising commodity prices—e.g. food grains, food commodities, raw material commodities, metals, and, of course, the king of commodities: oil. As the dollar falls, OPEC and middle eastern oil producers have been raising their prices to offset the fall of their investments held in dollars. Oil prices have shot up over $100 a barrel. Rising commodity prices translate into U.S. consumers’ reduced spending power, which in turn reduces consumption dramatically, and feeds the recession. Oil and other commodity speculators may also push up the prices of oil and food even further before it reaches the U.S. consumer, but the FED action initiates and feeds the whole process. Thus, FED efforts to stave off recession actually provide more impetus for recession. The FED is thus between a ‘rock and a hard place’—the ‘rock’ of inflation and the ‘hard place’ of deflation. At some point it will likely give up on lowering interest rates as a consequence. When that happens, yet another ‘psychological effect’ will occur and the impact will be immense. By that action the FED will in effect admit it cannot do anything about the financial crisis. That will most certainly accelerate the crisis further.

On the fiscal side, the recent $168 billion Congressional (and Bush) package to stimulate the economy will also prove ineffective. First, a good portion of the tax cut package are business tax cuts that will largely have no effect in a recessionary downturn. In a period of accelerating recession, lower tax cuts for business do not stimulate net investment. Business may absorb the tax cuts, but delay decisions to invest, while actually reducing employment. A good part of the business tax cuts will also likely be shuffled to offshore expansion by corporations that will have no effect on U.S. economic conditions, a trend that has been occurring for several years now. Finally, what business spending does occur as a direct consequence of tax cuts will more than offset by mass industry layoffs coming later this year.

Little of the consumer tax rebate will translate into new spending. Many consumers, now deeply in debt, will use rebates to pay off record debt. Perhaps only a third of the $168 billion will constitute actual new consumer spending. And that consumer spending will be largely offset by reductions in spending and higher fees by state and local government, as tax revenues plummet due to recession while costs of borrowing rise significantly. Before the November 2008 election it will become increasingly clear that the recent Congress-Bush fiscal package was a classic example of ‘too little too late’. Like the FED, Congress and politicians have an inadequate understanding of the dynamic and magnitude of the current financial crisis. They are seeing it in light of past financial crises of the 1980s and 1990s, which were eventually ‘contained’ by traditional monetary-fiscal policy. But those policies are far less effective today and the crisis far deeper. Like the well-known metaphor of aged generals, they are fighting the last war.

Should the crisis and recession continue to accelerate, new solutions will be required. As during the Depression of the 1930s, new solutions may require a major overhaul of the Federal Reserve System, the return of something like the Reconstruction Finance Corp. government agency of that period, and a fundamental re-regulation of the financial sector in the U.S., and reversal of policies since the 1980s that have resulted in a massive redistribution of income that has fed the speculative excesses of recent decades—to name just a few.

Scenario 2008-09

Fundamental structural and in some cases radical reform of the U.S. political economy will be necessary to deal with the crisis in 2009 and beyond, which may include some of the following features:
Widespread corporate defaults and mass layoffs occurring later in 2008 and into 2009. Continuing revelations of further losses by banks and financial institutions. The collapse of one or more of the mainstream banks in the U.S., setting off a major stock market correction of an additional 20%-30%. A further decline of 10%-20% of the dollar in international currency markets. Continued rise in oil and commodity prices as offshore speculators continue to take advantage of the U.S.’s worsening dual financial-devaluation crisis. Deflation spreading from housing and other asset investments in the U.S. to goods and services. Record U.S. (unified) budget deficits of $700 billion plus. And a growing general awareness that traditional monetary and fiscal policies are increasingly ineffective in addressing financial crisis and recession.

Whomever is President in 2009 will also almost certainly have to confront the growing fact and reality that the rest of the global economy is not ‘decoupled’ from the U.S., but that it too is slipping, along with the U.S., into a synchronized downturn. But the topic of the transmission of the U.S. crisis to the greater global economy (and the feedback of the global on the U.S. economy in turn) is a subject for a subsequent article.

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