Ruin and recovery

By Peter Golden
Guest columnist, MetroWest Daily News
Posted Dec 14, 2008 @ 12:29 AM

I’ve never owned a crystal ball, nor am I in the market for one today. But given the current disarray in global financial markets, the broad-ranging loss of confidence by consumers, and all-around bad business conditions, it would seem some comment as to what lies ahead is in order, here.

First, an observation: No matter how bad things look, it's worse than you think. Basically, the whole government and financial establishment have disgraced themselves. The banking industry, the mortgage lenders, Wall Street, federal agencies, credit rating agencies and a large number of industrial corporations - all are disgraced.

The Office of the President and Congress, along with the Federal Reserve, are all disgraced as well, saved from being mobbed and sacked only by the integrity of the United States Constitution and the generous spirit of the American people. Our instinct for self-preservation is only slightly stronger than our capacity for self-delusion. Basically, we have been subjected to a failure of governance emanating from both the executive and legislative branches.

Yet, we are a civil people, and the dissolution in value of our homes and retirement accounts, the difficulties of educating our children (especially in light of horrific losses in college endowments) have all been received with a quotient of polite resignation.

Among other utter transgressions, our political leaders and the agency heads that report to them built a house of cards in the mortgage lending industry. That allowed millions of unqualified people to buy homes from untrained and unprincipled mortgage brokers who then turned around and sold those mortgages to federally guaranteed agencies.

"Fannie and Freddie" then "packaged" those mortgages as "securities" and sold them on the open market. With 10 percent of American homes currently in foreclosure or delinquent, the result speaks for itself. Basically, these two federally chartered organizations served as lenders of last resort for every flim-flam artist on the street, including over 600,000 itinerant "mortgage brokers" in California, alone - leaving you and me holding the Bag.

But that was only the beginning. The Federal Reserve and Securities and Exchange Commission allowed a shadow market to develop alongside the stock market. Similar government agencies in other countries played the same tune. A new class of "securities derivatives" known as "collateralized debt obligations" or "credit default swaps" was allowed to develop over the last 15 years.

No legal requirements for reporting or valuation were attached to their trading. It was a shell game, pure and simple, and its full effects are yet to be felt, as companies like AIG, currently enjoying $150 billion in public support—read your tax dollars and mine—unreel multi-billion dollar losses devoid of any offsetting capital value whatsoever.

Some estimates give the ostensible total net value of securities derivatives at issuance at $60 trillion dollars. Folks, that's four or five times the gross national product of the United States of America. Or to cast a brighter light on an obscure term, that's quadruple every penny earned or produced by every person in this country for half a decade.

And just when you were feeling really lousy, here's even worse news: Since the derivatives market was (and for all I know, still is) unregulated, no one knows who has them and what they are really worth, even today.

The result of all these failures of oversight and moral will is that the world of today is suddenly worth about half of what it was a year ago. All the major stock indexes are cut in half, as are oil and most industrial commodities. Tin, as good a proxy for the commodities market as any, has traded recently at less than $10 a ton, down from $327 at its high.

Please, don't jump if you are near a window. While the losses we have all incurred in the value of our homes and retirement accounts have been soul searing, the federal government, mother of us all, is pouring hundreds of billions if not trillions into rescue and stimulus packages.

"Full faith and credit" are powerful words and the U.S. government has a virtually unlimited supply, but one must wonder how we can escape the twin burdens of continuing deflation and an unprecedented mountain of new public debt. The "Q Factor," Nobel laureate James Tobin's notion that when assets fall below a certain value ("Q"), then it no longer makes sense to replace them, would then come into play.

This suggests current pump priming (bailouts, public works and related federal spending) will eventually drive tangible assets and equities even lower as the dollar degrades and inflation kicks in after an initial burst of stock market optimism. Note the recent Japanese experience, for example.

Given the ability of the new administration to spend its way out of recession with infrastructure programs, cheap mortgage money and an auto industry bailout, markets should stabilize in the near term. A new regulatory regime that lends transparency to derivatives markets should also calm down investors.

Once industry begins to spend on capital goods and new hires, assuming credit markets take their cue from federal initiatives, growth should begin again. By mid-2010, we might be back in business. Which is when a whole new set of problems linked to the Q Factor will emerge.

How to dodge the inflation/replacement cost bullet? It all comes down to one word: productivity. Bailing out the auto industry (too big to fail, too many jobs at stake) is one thing, but simply building more fuel efficient cars with consumer appeal doesn't solve the commuting problem faced by millions of Americans in trying to get to work every day.

A whole new transportation paradigm is needed, as is also the case in energy generation and distribution, environmental management (including food and water) and education.

In short, America has somewhere between 700 and 1,800 days to reinvent itself as the dynamics of the world economy manifest themselves in the actions of investors, producers and consumers. It's all about confidence in our future, folks, about living in hope of something better.

My hope is that the new administration and Congress will have the wisdom to invest in the "Economy of Innovation" by building the schools, funding research programs and developing the tax incentives required for us to capitalize on the brains, imagination and sheer guts that are the true products of the American experience.

A wry old Yankee farmer, when once asked for directions by a baffled traveler, responded by saying, "You can't get there from here."

I'm betting we can, but on the road to recovery we all need to keep a sharp eye on what lies ahead.

Peter Golden writes about public affairs from Natick, Massachusetts.

See earlier Blog articles by Peter Golden.

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