Thursday, July 15, 2010

The State of the US Economy: Part 3 of 5

Tonight I'd like to look at one of the most dangerous aspects of the US financial crisis: politicians and pressure groups. In fact, these may be the single greatest source of problems, past, present and future, affecting our economy.

Politicians and pressure groups are frequently economically illiterate. They have no understanding of the economic impact of their point of view, or proposed legislation, or focus. However, they won't hesitate to manipulate economic affairs to the benefit of their particular hobby-horse, and to hell with the consequences. This is made worse by the culture of corruption endemic in US politics. Businesses, industries and vested interests spend millions every year lobbying Congress and the Senate, contributing to the re-election campaigns of incumbents, and actively seeking to influence any and all legislation affecting their area(s) of operation. In so many words, it's nothing more than bribery. Support our perspective, and the cash will come rolling in. Oppose us, and your opponent at the next election will receive our cash instead. Oh - and we'll be talking to your political party, too, and waving wads of money underneath its collective nose. Your party bosses will be giving you orders to support or oppose certain legislation, because they know what's good for them. If you know what's good for you, you won't argue.

(Oh - in case you're wondering, this is a problem with and for both the Democratic and Republican parties. Both are guilty of this sort of thing, and probably in equal measure. It doesn't seem to matter which one's in power at any particular time - each is as corrupt and self-seeking as the other.)

The current economic mess can be traced back to certain very specific laws that attempted to change the economic landscape in favor of certain vested interests. We don't have space or time to examine them all, but I'd like to highlight a few.

First, in housing, we have the Home Mortgage Disclosure Act of 1975. This was intended to uncover any discrimination (particularly racial in nature) in home lending practices. As Wikipedia points out, the data collected in terms of the Act can be used to target such discrimination.

HMDA data can be used to identify probable housing discrimination in various ways:

* If an institution turns down a disproportionate percentage of applications by certain races (e.g. African Americans), ethnicities (e.g. Hispanics) or genders (typically women) then there is reason to suspect that the institution may be discriminating against these classes of borrowers by unfairly denying them credit. Such discrimination is illegal in the United States.

* If an institution has a disproportionately low percentage of applications by certain races (e.g. African Americans), ethnicities (e.g. Hispanics) or genders (typically women) then there is reason to suspect that the institution may be discriminating against these classes of borrowers by unfairly discouraging them from applying for mortgage loans. Such discrimination is illegal in the United States.

* If an institution has a disproportionately low percentage of applications from certain areas, compared to areas immediately surrounding the area in question, then there is reason to suspect that the institution is engaging in redlining.

* If there is a disproportionate prevalence of high-interest loans to certain classes of borrowers (e.g., Hispanics or women) then there is a reason to suspect that the institution is engaging in discrimination.

The Community Reinvestment Act of 1977 was another attempt to force banks to make loans available to residents of economically disadvantaged areas, prohibiting discrimination in the granting of such loans.

Note that in both cases, the legislation doesn't address good reasons to grant credit (such as creditworthiness, credit history, income, etc.); it merely prescribes what would be bad reasons for refusing it (e.g. race, culture, etc.) Those drafting this legislation weren't interested in what was good or bad from an economic perspective. They were trying to right what they perceived as an institutionalized wrong. Nothing else was important to them. They were, of course, quite right to point out the existence of the institutionalized wrong; but in prescribing these particular remedies, they opened the door to other economic problems that are with us to this day. As a result of these and similar laws, many people obtained loans for which they would not normally have qualified. A disproportionate number of foreclosures and evictions have thus fallen upon such people - and, inevitably, this has led to some politicians and pressure groups alleging that these consequences are due to race rather than economics. That's total nonsense, but those people can only see reality through their race-colored spectacles. They can't understand that economic reality trumps racial theory, every time, in the real world.

The housing problem was made worse during the 1990's, when politicians pressured Fannie Mae and Freddie Mac to underwrite more and more loans to the 'economically disadvantaged'. This, more than any other factor, was to lead to the subprime mortgage crisis of 2007-2008. Kaz Darzinskis sums it up well.

Starting in 1992, a majority-Democratic Congress mandated that Fannie and Freddie increase their purchases of mortgages for low-income and medium-income borrowers. Operating under that requirement, Fannie Mae, in particular, became aggressive and creative in stimulating "minority gains." The Clinton administration investigated Fannie Mae for racial discrimination and proposed that 50 percent of Fannie Mae's and Freddie Mac's portfolio be made up of loans to low- to moderate-income borrowers by the year 2001. The Clinton administration criticized the mortgage industry for looking at "outdated criteria," such as the mortgage applicant's credit history and ability to make a down payment. Threatening lawsuits, Clinton's Federal Reserve demanded that banks treat welfare payments and unemployment benefits as valid income sources to qualify for a mortgage. That isn't a joke -- it's a fact.

By 1999, liberals were bragging about extending affirmative action to the financial sector. A Los Angeles Times reporter hailed the Clinton administration's affirmative action lending policies as one of the "hidden success stories" of the Clinton administration, saying that "black and Latino homeownership has surged to the highest level ever recorded." After 2001, a major new market was found for these loans-illegal immigrants.

Meanwhile, a few economists (but no politicians) were screaming that the Democrats were forcing mortgage lenders to issue loans that would fail as soon as the housing market slowed and overly-stretched borrowers couldn't get out of their loans by refinancing or selling their houses. In Bush's first year in office, the White House chief economist, N. Gregory Mankiw, warned that the government's "implicit subsidy" of Fannie Mae and Freddie Mac, combined with loans to unqualified borrowers, was creating a huge risk for the entire financial system. Rep. Barney Frank denounced Mankiw, saying he had no "concern about housing". The New York Times reported that Fannie Mae and Freddie Mac were "under heavy assault by the Republicans," but these entities still had "important political allies" in the Democrats.

During the 2004 presidential campaign, George Bush bragged about the fact that a greater percentage of Americans owned their own homes than ever before, but (except for praising low interest rates) he did not explain how or why this happened. President Bush pushed even farther; he asked lawmakers to eliminate the down payment normally required for FHA loans. So Republicans have dirty hands too.

Nevertheless, in 2005 after Fannie and Freddie were investigated and heavily fined for accounting fraud, Republicans in Congress wanted to take away Fannie and Freddie's privileged status, but by a strict party line vote Democrats won, and Fannie and Freddie were allowed to continue their businesses largely unchanged, but with one condition...they had to increase their support of loans for challenged borrowers. By this time, those working in the mortgage industry were calling such loans, "liars' loans".

By the end of 2006, 30% of new mortgages in the USA were subprime mortgages, up from 2% in 2002.

. . .

Lax standards for borrowers and low interest rates after 9/11/2001 expanded the demand for houses which, in turn, inflated prices. Seemingly reliable price increases attracted flippers and people who figured that owning a second or third house would be a good investment, further adding to the demand. Total demand drove housing far beyond any sustainable price level. Confidence in ever-increasing housing prices tempted many to cash in their "profits" by taking home equity loans.

When the housing bubble finally burst in 2005, the huge inventory of dubious first mortgages along with accumulated second mortgages piled on many properties caused the mortgage loan default rate to spike. This caused the market for mortgage-backed securities to soon collapse. Those who bet against these securities collectively made billions, but others like Merrill Lynch and AIG were stuck. Because no one would buy them, these securities had to be recognized on the books as essentially having no value, as per one of the new regulations ("mark to market") adopted after the Enron debacle. Per accounting standards, financial institutions that owned these securities had to write down these assets against their equity, leading to huge decreases in the equity of a few of the largest banks. These banks no longer had enough equity to meet the loan/equity ratios required by banking regulations, so they had to virtually stop making loans of any kind, thus triggering the present credit crisis.

. . .

As some economists predicted, the affirmative action loan time-bomb has exploded.

. . .

While government intervention caused the problem, the fix, ironically, is supposedly greater government involvement (regulation) in the future. Politicians are participating in this cover-up, because nearly all of them are on record supporting easier-to-get mortgages, and they want people to believe they had little to do with causing the problem.

There's more at the link. Recommended reading. My only disagreement with Darzinskis is that he places more emphasis on the sins of the Democratic Party than on the Republican, whereas I regard them as equally culpable. I can name half a dozen politicians on each side of the aisle who are primarily responsible for this mess . . . and I'd happily participate in their tarring and feathering, irrespective of their party.

The subprime mortgage crisis is so large a subject that I can't possibly address it all in a short blog article like this. I refer those interested to the link, where you can find much more information and links to other sites.

Another aspect of political interference in the economic process is taxation. Politicians usually impose tax policies that reflect their political and social agendas, rather than economic reality. A statist party will tax at higher rates, to take more of the 'wealth' into Government hands and 'redistribute' it according to their particular priorities. A less statist, more individualist party will usually lower tax rates, cutting the Government's share of the economy and leaving more of the 'wealth' in private hands. Usually, neither side will ask whether or not this is going to give a good return on their 'investment'. Politics trumps economics in both cases.

The problem is, once a Government program has been established, it's extremely difficult - if not practically impossible - to curtail it, even when its performance can be measured and be shown to be abysmally poor. A classic example is the US Department of Education. It was established under President Carter in 1979. Since then, it's received literally hundreds of billions of dollars in taxpayers' money - for virtually no return on that investment. In 2000, Citizens Against Government Waste pointed out:

Scholastic Aptitude Test (SAT) and ACT Assessment scores are significantly lower today than they were 30 years ago – before the creation of DoEd. In addition, the average amount spent on each public school student has skyrocketed. In 1965, the average SAT score was 980 and slightly less than $3,000 was spent per student. More than 30 years later, the average SAT score is 910 and about $6,500 is spent per pupil.

DoEd's first budget was $14 billion and the department employed 450 people. By fiscal 2000, the budget had ballooned to more than $32 billion. The fiscal 2001 budget estimate is more than $43 billion, a 33 percent increase from the previous year. The department now employs more than 4,800 people, a 966 percent increase from 1979, yet DoEd spending for public schools accounts for less than 6 percent of total education spending. There are currently 780 education programs spread throughout 39 federal agencies, costing taxpayers $100 billion annually.

Despite the federal government's well-intentioned intervention, Americans are losing the education race. National Assessment of Education Progress (NAEP) tests show that average reading scores for high school students over 20 years have improved only one point, from 286 to 287 out of a possible 500. Writing scores during the same period, on the same scale, fell seven points from 290 to 283. On a standard percentile scale (where students answering 60 percent of the questions correctly receive passing grades) these reading and writing scores would receive failing grades. The scores have real-life consequences. Only 40 percent of American 12th graders are reading proficient. The other 60 percent of American students will find it difficult to hold jobs or attend college after graduation.

A recent study showed that although DoEd spent $15 billion in 1996 on elementary and secondary education, $3 billion went for purposes other than the needs of school districts. Various audits across the country have estimated that as little as 26 percent of DoEd funds are spent in the classroom. In a 1993 survey of small schools in Ohio, then-Governor George Voinovich (R) noted that as many as 170 federal reports totaling more than 700 pages must be filed by school officials each year. These reports comprise 55 percent of all school district paperwork. The Ohio survey illustrates the excessive spending for administrative activities required by DoEd.

There's more at the link.

Matters haven't improved any since that report came out a decade ago. By any rational economic analysis, money spent on the US Department of Education is wasted, every single penny of it: yet the Department continues to receive tens of billions of dollars every single year. Why? Because pressure groups - particularly the National Education Association - work to keep it that way, and would scream blue murder if that expenditure were cut. They have many politicians in their pocket, and spend millions every year on lobbying fees and political contributions to keep it that way. Neither they, nor their 'tame' politicians, are concerned about the waste of taxpayers' money. That money directly benefits them; so they'll move heaven and earth to keep milking the taxpayer for everything they can.

Another classic example of political interference by pressure groups is the fate of the Glass-Steagall Act of 1933. It was introduced to correct some of the malpractices that led to the Great Depression, and functioned pretty much as designed until the 1990's. However, the restrictions it imposed were 'inconvenient' for those who wanted to make a great deal of money out of marketing derivatives and other financial instruments. The arguments for and against repeal were set out by the Congressional Research Service in 1987. It was eventually repealed in 1999, and this time the Republican Party must carry the major share of the blame. However, in the more lax regulatory environment thus permitted, many financial institutions 'went overboard' in speculative maneuvers, contributing in large measure to the global financial crisis of 2008/09. Many of the provisions of the Glass-Steagall Act have been incorporated and renewed in the currently-proposed financial reform legislation, due to come up for a vote in the Senate within days.

(The new legislation for financial reform is itself a nightmare. It entrenches many of the special interests that have plagued our economy in the past, and adds new considerations that have nothing whatsoever to do with economics, but everything to do with satisfying lobbyists and pressure groups. Read about it for yourself at the links provided.)

The Department of Education and financial reform legislation are only two examples out of many that could be highlighted. Again, in a short blog article like this, there's neither space nor time to point out all of them. Do your own investigating, and you'll find plenty of food for thought. The point is, in order to support these worthless and futile institutions and programs, taxes have to be raised. I think if we cut out all of the worthless departments in the Federal Government, we could reduce our overall tax bill by hundreds of billions of dollars, putting that money back into economic circulation to achieve a more worthwhile result. However, to do that, we'd have to get rid of the 'career politicians' who take their orders from lobbyists and pressure groups, and replace them with others who are genuinely representatives of 'we, the people'. Is that likely? Well . . . for the first time, I think many Americans are so fed up with Washington that it may be getting that way. We'll have to see what happens in the November 2010 elections.

Government and/or central banks are, of course, not necessarily the best actors to address economic problems. A South African report highlights the difficulties faced by legislators and fiscal administrators.

There are many practical economic and political difficulties encountered in discretionary fiscal stabilisation policy. Governments find it easier to increase spending in times of low growth than to reduce expenditure and tighten fiscal policy during economic upturns. According to the European Central Bank ... this induces a tendency for continuous increases in deficits and the tax burden. Furthermore, it is difficult to determine the appropriate size of the annual deficit, while fiscal adjustments and their effects are also subject to variable and unpredictable time lags. As a result, governments' well-intended efforts to stabilise the economy often end up destabilising it, "booming the boom" or "depressing the depression". Proper timing of discretionary policy is both extremely difficult to achieve and extremely crucial if it is to help the economy.

There is also the growing realisation that high budget deficits could directly or indirectly crowd out relatively more productive private sector activity such as investment. Moreover, discretionary policy presents a dilemma when low levels of economic activity coincide with high inflation and balance of payments deficits. According to the European Commission ... efforts to support the economy during downturns in EU countries have often been made through expenditure commitments that have subsequently proven de facto irreversible. This resulted in an upward "ratchet" effect on the size of the public sector in the economy, on both the tax and the expenditure side.

The attempts of discretionary fiscal policy to stabilise the economy therefore run into some technical problems. The ability to measure and analyse the economy is imperfect; gauging how far the economy is from full employment at any particular time is difficult. Furthermore, the amount that output will increase in response to a fiscal expansion is not known exactly, making it difficult to assess how much of a fiscal change is needed to restore full employment. Because macroeconomic policies take time to implement and more time to affect the economy, their optimal use requires knowledge of where the economy will be in six or twelve months from now. Such knowledge is, at best, very imprecise.

Against this background, most economists have become highly sceptical about the potential benefits of "fine tuning" the economy. ... The combined problems of lags, crowding out effects, political constraints, inflexibility and practical problems in measuring and forecasting the state of the economy and determining how much fiscal stimulus is needed at any particular point in time all present very serious challenges for discretionary fiscal policy to have the desired effect on stabilisation.

There's more at the link. Heavy reading, and not all applicable to the present situation, but worthwhile for those with a deeper interest in the subject.

I've mentioned the impact of taxation on the economy. Statist parties want to take in as much tax money as possible to benefit their centralist policies. More individualist parties and politicians want to leave as much money as possible in the private sector, where they believe it will be more efficiently and effectively used. I tend to agree with the latter perspective, although there are certain areas where I think a centralized approach might be more effective in the longer term. (I'm a rational centrist, not operating at either extreme, you see.)

The Heritage Foundation points out the dangers of increasing taxes, rather than reducing spending, in the current economic climate.

If you earn income, your taxes are about to go up. If Congress does not act to preserve current law, even the lowest 10 percent bracket will rise to 15 percent. Throw in tax hikes on capital gains, dividends and other tax code fixes, and the American economy is staring straight down the barrel of $3.2 trillion tax hike over the next ten years.

. . .

The tax raising culprit here is the expiration of the 2001 and 2003 tax cuts set to take effect on January 1, 2011. The leftist majority in Congress is refusing to extend current law because they believe that these tax cuts are the cause of our trillion dollar deficits. They are wrong. Heritage Foundation research fellow Brian Riedl explains why in today’s Wall Street Journal: With Washington set to tax $33 trillion and spend $46 trillion over the next decade, how does one determine which policies “caused” the $13 trillion deficit? [President] Obama could have just as easily singled out Social Security ($9.2 trillion over 10 years), antipoverty programs ($7 trillion), other Medicare spending ($5.4 trillion), net interest on the debt ($6.1 trillion), or nondefense discretionary spending ($7.5 trillion).”

The real cause of our nation’s debt problem is spending. According to the Congressional Budget Office (CBO), extending all the 2001 and 2003 tax cuts will place revenues at 18.2% of gross domestic product (GDP), which is actually above the 18% average over the past 50 years. Meanwhile, spending, which has averaged 20.3% of GDP over the past 50 years, is set to explode to 26.5% of GDP by 2020. These spending increases are being driven by our entitlement programs (Social Security, Medicare and Medicaid), which along with net interest payments are projected to rise by 5.4% of GDP between 2008 and 2020.

The leftist majority in Congress has had years to address this impending economic disaster but have refused to act. Last month, the House leadership announced that for the first time in the history of the budgeting process, they would not set a budget this year. And not only are they refusing to set any limits on their own spending, but now they are even talking about punting the tax issue into December so that they can raise our taxes without having to answer to the American voter. Sen. Tom Harkin (D-IA) told The Hill earlier this month: “It’s not going to get done before the election. The lame-duck session is when all of this is going to get resolved.”

There's more at the link. I tend to read the Heritage Foundation's articles with care, because they can go overboard on the conservative side of the equation; but in this case I think they're spot on. The spending figures they quote are accurate. Draining a further three-billion-dollars-plus out of the economy by means of a tax hike, on top of such already ruinous (and frequently fruitless) spending, is a recipe for disaster.

The matter is made more complicated by built-in delays in unpopular legislation, designed to ensure that benefits are front-loaded (for immediate voter gratification) and expenses are delayed as long as possible (so that those who voted for them are out of office, and no longer have to answer to the voters, when the real costs of their votes become clear). Politico recently published a good analysis of this problem.

Some of Obama’s biggest promises won’t go into effect until long after his first term — and in some cases, well past a second. In fact, buried deep within some of the Democrats’ most significant reform bills are dozens of policy time bombs set to blow at more politically convenient times.

The Democratic reform triumvirate — health care, Wall Street and energy — is filled with provisions designed to front-load policy benefits and delay political pain.

Health care reform cracks down on insurers right away but won’t force people to buy insurance until 2014. A new consumer financial protection agency kicks in almost immediately under the Wall Street reform bill, but banks won’t feel its full force for more than 10 years. And even Democrats’ nascent immigration reforms include at least an eight-year wait before illegal immigrants can apply for permanent residency — after Obama leaves office.

The delicate balance aims to gradually get a skittish public accustomed to the enormous changes, while insulating lawmakers from potential backlash.

“You always delay anything that might be disruptive or difficult,” said Frances Lee, professor of political science at the University of Maryland. “The goal is to do it in a way that no one feels it and no one writes news stories about it — minimize the blowback.”

. . .

Perhaps most famously, House Democrats practically demanded that their leaders load the health care bill with goodies that take effect before November’s election, giving them something to sell on the campaign trail.

. . .

Obama certainly isn’t the first president to work the calendar to keep costs down, Lee noted. In 2001, President George W. Bush’s tax cuts front-loaded relief for poor and middle-class taxpayers and gradually phased in tax cuts for the wealthy. In fact, the full repeal of the estate tax just took effect this year, Lee said.

And in 1983, when Congress raised the Social Security retirement age, the first people the change affected were those who turned 65 in 2003 — giving most lawmakers who voted for it plenty of time to retire, Lee said.

Again, there's more at the link - and again, it's clear that the problem lies with both past and present Administrations, involving both major parties. Neither side can claim to be innocent of such tricks.

I guess, at the root of it all, our politicians and pressure groups are gambling with other people's money, as Russell Roberts put it in his excellent monograph on the subject. (It's worth clicking on that link and reading it for yourself). Unfortunately for us, it's our money they're gambling with - and we have to live with the consequences. Given what we see around us right now, I think it's time we changed politicians . . . but whether Americans are sufficiently angry and energized to do that this year remains to be seen.



Anonymous said...

I'm glad there are people who can put this information together in an easy to read way.

I like this series so far. However I hope you talk more about government rules and regulation of businesses.

Two years ago I was all set to start my own business. However the more I looked into the Byzantine rules that govern how I did business and how I handled employees, I decided to throw in the towel before I started.

I figured I'd spend at least 5% of my profits on accounting services and another 5% on legal serves. That was only if everything went well and we didn't have to defend ourselves against some bureaucrat's charge that we forgot to dot an i or cross a t.

So instead of spending that start up money and helping to employ several people, I socked it away (and I'm very glad I bought gold when I did).

Dad29 said...

It's also important to know that the lobbying game works in reverse.

Congresslime A floats a proposal to increase the regulation on Business B.

Biz B (and all in that business) go to DC and persuade Congresslime A not to go ahead. Money may change hands...

Slimer gets campaign cash, BizB goes 2 (or so) years without any more threats.

Rinse, repeat, whenever fundraising is going badly.