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Richard Christopher Whalen, a Senior Vice President and a Managing Director of Institutional Risk Analytics, has worked as an investment banker and research analyst for more than two decades. Whalen, who has appeared before the U.S. Congress and Securities and Exchange Commission to testify on financial issues, edits The Institutional Risk Analyst and contributes regularly to publications such as American Banker, The International Economy and The Washington Times. I recently spoke to him by phone about the weak state of the American economy and whether any of the presidential candidates, or Congress, have any good ideas about how to address it.
1. What’s wrong with the economy?
The productive economy is withering and the speculative economy is growing. We’ve been through several speculative cycles, first in tech and then in real estate, which has led to mini slowdowns and recessions, and now threatens an old fashioned financial crisis. Real estate was traditionally a very solid industry–we had a 65 percent rate of home ownership among adults for decades since WWII. You had to put down twenty percent cash to get a mortgage. Then along came the affordable housing mafia–HUD, the realtors, the mortgage bankers–to promote home ownership. With the help of the Congress, the “partnership for affordable housing” increased home ownership by six to seven percent. But many of the new buyers didn’t have any real credit, but got loans because of “innovative financing.”
Overall, we’ve got the most speculative economy in more than 100 years. Americans have embraced a culture where a cash settlement derivative contract is considered to be a solid investment vehicle and where opaque complex structured assets are sold to public pension funds. There’s been a complete abandonment of prudential rules and guidelines, a process led by the Congress and aided by federal regulators. As a nation, we’ve come full circle since the financial crises of a century ago. Today we have a financial system that has little personal financial discipline and massive moral hazard, where the taxpayer is picking up the messes created via private speculation. Bank failures and tens of billions in losses to investors and homeowners are the legacy of the financial innovations of the Alan Greenspan era. Never forget that the Fed in Washington has always been the cheerleader for expanded dealing by the largest banks in derivatives and complex structured assets like CDOs and asset conduits.
2. Is that situation likely to improve?
Not for a long while in financial terms. The competitive position of the U.S. economy and our ability to employ people is eroding fast. The growth prospects of the U.S. will be hampered because our people are less and less able to afford basic necessities like housing. We’ll see growth in the Southeast, which has benefited from industrial relocation by Japanese carmakers, and in the Southwest, because of the growth of trade with Asia. But look at Ohio and Michigan–we’re going to see large areas of the US being depopulated. The industrial heartland is going to be a sad place to be. American corporations will do fine, profits will be good. But it’s going to be a very tough environment for consumers and the average American.
3. How tough?
Look at how high energy prices are rippling through an economy that used to be based on cheap transportation and, hence, distribution. This is going to have a profound impact. There’s already been serious price creep for basic consumer goods–just go to the supermarket and look at the price of milk. But energy prices are not reflected in policy in Washington, partly because no one’s sure what to do. Over time the U.S. economy will adjust–and I suspect energy prices will come down in 2008 since twenty to thirty percent of the market is speculative, every other hedge fund on the planet is playing long commodities–but in the near term energy prices are going to squeeze any disposable income out of American families, even ones with two wage-earners. Every extra dollar is going to be spent on heat and transportation.
4. What is the economy going to look like during the upcoming election year, and how will that impact the political environment?
By the end of the primaries and heading into the summer, we could be looking at the collapse of the real estate market, which will have an impact upon homebuilders and suppliers, like Home Depot and Lowe’s. That’s going to put up red flags even for the Bush Administration, which is pretty much brain-dead. Whoever gets the nomination is going to be staring at a recession and a financial market running scared with safety and soundness issues. Citibank and J.P. Morgan could be facing insolvency, and Fannie Mae and Freddie Mac as well. In the early 1990s, Fannie and Freddie were basically insolvent because they had to buy back a lot of mortgages that were on their books or that they had guaranteed. Today, those two agencies own or guarantee $4.6 trillion in mortgages and they don’t have the capital to underwrite that scale of risk. Look at the Fed’s projections for 2008–they’re talking about a 20 to 25 percent retreat in real estate prices. [New York Senator] Chuck Schumer says Fannie and Freddie will ride to the rescue but they don’t have the capital to do that, and banks are going to be tested too. The next president, whoever it is, may be dealing with a 1930s-style financial crisis from the first day in office.
5. Do any of the presidential candidates, or anyone in Congress, have strong ideas about what policies are needed to address all this?
No, because the political class doesn’t understand the scope of the mess, or their role in creating it. First thing, we need to figure out what a “normal” growth rate is, without all the stimulation from excessive monetary expansion by the Fed and real estate speculation. That growth rate is going to be lower than we want, in part because Americans refuse to acknowledge that we have an economy that doesn’t produce wealth. We no longer extract or manufacture in America. We produce consumer goods and services, mostly for one another.
The big question now to ask politicians is: how do we get America focused again on being a productive economy, and focus less on the manic, speculative economy that’s led by the financial sector and equally inane groups like the realtors? But the Chuck Schumers of the world, from both parties, get a lot of money from the finance industry, which is why the Democrats and Republicans stopped talking pretty quickly about equalizing the taxation of carried interest by private equity funds. Both the Republicans and Democrats have given the financial services industry everything it wanted. The finance sector has endless amounts of money to influence politics and can outgun the bank regulators every time.
6. What should the next president do, on the economic front, during his or her first 100 days in office?
First thing we need to make a serious effort to attack federal spending and eliminate the federal budget deficit. If we do not get our public sector finances under control quickly, the dollar will collapse and we could see much higher interest rates, capital controls and tariffs imposed in the U.S., incredible as that may sound. We are not very far away from a time when foreigners will be explicitly dictating terms to the U.S. Treasury and private companies when we need to borrow money. Our future as a sovereign nation depends upon our ability to govern our financial behavior, both in the public arena and in private financial markets. This means avoiding costly adventures like the war in Iraq and probably maintaining a much smaller U.S. military in the future, but fiscal sobriety will also require painful domestic spending cuts.
Second, we need to appoint some seasoned bankers to the Federal Reserve board and other key fiscal and regulatory positions in the US government. For the past two decades, both monetary policy and financial regulation in the U.S. has been dominated by academic economists who think that gaming instruments like derivatives are good for the economy and for the safety and soundness of our banking system. This is madness. We need to restrict bank dealing in unregistered securities like CDOs, require the registration of all securities sold to public pension funds and force Wall Street to trade all derivatives on exchanges, with proper oversight and disclosure. We don’t need more regulation, but we do need to enforce existing laws and impose greater personal and market discipline and transparency on private banks and bankers. Selling a security that is designed to be misleading and defraud investors is a felony and those responsible for such acts should do prison time.
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"It is an interesting and somewhat macabre parlor game to play at a large gathering of one’s acquaintances: to speculate who in a showdown would go Nazi. By now, I think I know. I have gone through the experience many times—in Germany, in Austria, and in France. I have come to know the types: the born Nazis, the Nazis whom democracy itself has created, the certain-to-be fellow-travelers. And I also know those who never, under any conceivable circumstances, would become Nazis."