Something happened to our economy in this country in September of 2008. Something happened that was so unusual, on such a large scale that it prompted the head of the Federal Reserve and the Secretary of the Treasury of the United States to decide that drastic measures were necessary to avoid an unprecedented economic collapse. I have already established that it wasn’t the housing industry collapse. The numbers just don’t add up. It is beyond argument that the sub-prime mortgage debacle would only directly contribute some 42 billion dollars in bad debt which could not possibly create the need for an emergency injection of federal funds that wound up totaling almost 2 trillion dollars and counting. As I stated before, if it was the sub-prime mortgages that caused the whole problem we could have cleared that off the books by simply paying them all off with a small fraction of what we have already spent. What we are actually talking about here is the difference between a cause and a catalyst. The sub-prime mortgage collapse was a catalyst for the collapse. The cause of the collapse is much more complicated.
The answer to the riddle is not simple. I have already touched upon it briefly in a previous post but want to delve into the subject in a little more detail now. I personally started looking into this issue several years ago because the numbers simply didn’t add up in my own mind. I have spent quite a bit of time since then studying; poring over books and articles that seemed alternately needlessly complex and ruthlessly simple. I would like to try to break it down into terms that are easy to understand but I am aware that may not be possible. Still, I think it is worth the effort to make the attempt.
The first financial instrument one has to understand to make sense of this mess is a Credit Default Swap or CDS. A CDS is simply a way of selling debt by insuring it. CDS’s were basically invented in the early 1990’s as a means of freeing up capital. The germination for the idea for CDS’s came to fruition when JP Morgan Financial Services was in the process of trying to figure out how to loan money to Exxon in 1994. At the time Exxon was facing punitive damages stemming from the crashing of the Valdez in Alaska. Facing large damages and falling stock prices Exxon was in something of a financial bind at the time. Ordinarily, such situations are handled by high interest loans as banks feel they deserve more profit for making riskier loans. Even though Exxon was a huge conglomerate and showed little possibility of financial collapse as a result of the upcoming high fines they were expecting they didn’t have enough cash on hand to handle paying such fines without selling off something which would have only served to drive their stock prices even lower and make the loans riskier. JP Morgan came up with a rather unique solution to the problem. They loaned Exxon the money, some 5 billion in all. However, JP Morgan didn’t want to tie up all of their capital on one loan that may or may not be the last money Exxon needed to weather the storm after the accident so they were interested in selling off portions of the debt to other investors. The problem with this line of thinking was that there were very few financial institutions able to withstand such a large debt on their books.
JP Morgan executives then sold the risk on the loan to the European Bank of Reconstruction and Development which basically cleared the debt off of their books while they made also made a percentage for brokering the transaction. The whole process started a chain reaction of ideas within JP Morgan and the rest of the financial institutions around the world as they studied the feasibility of making loans while at the same time avoiding holding the debts on their books. It seemed eminently profitable to find a way to broker deals for such loans while at the same time avoiding holding long term debts on their books which unavoidably cut into the capital they had available to make the loans to begin with. This is much the same fascination that the middle ages had for alchemy. Just substitute the term “debt” for iron and “asset” for gold and you have the general idea. What could be better to a financial institution than the ability to instantaneously turn a debt into an asset?
It wasn’t long after this that another artificial construct along the same lines began to come into favor in the mortgage industry. Collaterized Debt Obligations are structured credit products that were supposed to increase the availability of credit by leveraging the amount of money available for such loans. In short, a CDO in the context of this discussion is a bundle of home mortgages that is sold as an asset. If you think this seems a little like magic you are not very far from the truth. Lending institutions have always been limited to loaning out a factor of the money they have in reserve (their depositor’s savings) in case the loans go into default. It is really a matter of common business sense that any financial institution can only lend out a finite amount of money because it has to hold a small percentage of these loans in the form of capital to support such loans in the event of defaults. Obviously, there are rules and regulations to this effect and the Federal Deposit Insurance Corporation that guarantees depositor’s money is officially responsible for enforcing such restrictions in this country.
With the advent of CDO’s, lending institutions could bundle up groups of mortgages and sell them as assets to insurance companies, pension funds, hedge funds, and investment banks. While the lending institution thereby only made a percentage of the total value of the loan, it was an instantaneous profit while it simultaneously cleared the loan from their books. This freed up their committed reserves so that they could then lend the same reserve out again and again. It is worth remembering that a mortgage based CDO is actually a bundle of debts. While this bundle of debts certainly has a marketable value it is still a bundle of debts with risk associated with just like the individual loans had as single home mortgages. However, CDO’s are by definition a chain in that each CDO is actually only as strong as the weakest mortgages in the bundle but this is a consideration that seemed to escape the notice of most of those so enamored of the use of CDO’s. In most cases the mortgage company retained the responsibility for servicing the loan and actually collecting the money but they no longer owned the loan and were only working for a fee after the mortgage was actually sold. This was also to play into the collapse of the market once it started but I will get back to that a little later.
Naturally, there had to be some way of valuing CDO’s. If you are holding a group of debts and you want to bundle them up into something you can sell, you must first decide what the value of the bundle will be. Who would be best qualified to ascertain the value of such an instrument? Since no one has the necessary prescience to know for certain about such things it fell to the creators of such instruments to value them as well. This is quite a bit like asking a farmer to tell you how much his cow is worth before you pay for it. In actuality the system for valuing CDO’s turned out to be just as fruitful as my example with the cow with the inevitable result that CDO’s were almost universally overvalued from the very beginning. CDO’s are divided into tranches which is a French word for “slice.” The tranches were rated according to the best estimate of the likelihood of the mortgages bundled to go into default. The highest rated tranches (AAA) were of course worth the most money on the market with the lowest rated tranches following accordingly. You will probably be amazed to know that the vast majority of CDO’s were somehow valued as AAA. Unfortunately, these tranches often contained sub-prime and other alternative mortgages that were well understood to be higher risk loans. When the crunch came and loans started to default it suddenly became clear to everyone that no one really knew how much this would devalue the CDO’s they were holding.
Of course there were people who wanted to be sure that the CDO’s they were buying were worth what they were valued at. As my dad used to say, it is virtually impossible that everyone was born yesterday. Credit Default Swaps or CDS’s became widely used to hedge investors bets against CDO’s. Basically the creator of a CDS agrees to stand good for the amount of the investment. In other words, if a CDO is valued at 10 million dollars you could buy a CDS that would hedge your investment by agreeing to pay you the 10 million in case the CDO itself went into default. This was a good idea but a practical impossibility as the upshot was that if a few loans in the bundle went bad there would have to be a determination of how much the total value of the CDO accordingly dropped. Again, this would call for an estimate of the value by the people who created it in the first place. Going back to the farmer analogy this would be the equivalent of the cow suddenly going blind at which point you would have to go back to the farmer who priced it in the first place to decide how much it is worth now that it is blind. The difference in the value of the blind cow and the healthy cow would be paid by the insurer to the holder of the CDS. Unfortunately, the people who originally bundled the CDO’s and sold them were not as honest as your average farmer and most of the CDO’s were in essence for this analogy full of cows with varying degrees of infirmity and potential collapse.
If all of this seems farfetched and ridiculous you are probably not a financial consultant. However, if you recently lost a large portion of your 401K this is the market you were investing in whether you realize it or not. If this were the end of the story we could all shake our heads in wonder and go about our business a little wiser and less financially able but it gets worse. The creator of the CDS who insured the value of the CDO didn’t do this free of charge. The normal matter of business was for the creator of the CDS to be paid a nominal fee for insuring the CDO. As long as the CDO held its value the fee was clear profit for the creator of the CDS. You may have heard of a company called AIG which was one of the companies that the government had to bail out when the market started to slide. As it turns out, they were the biggest insurer of CDO’s in the world at the time. You may or may not be surprised to know that many of the creators of the actual CDS’s were offshore companies under the management of AIG who actually had virtually no funds in reserve to pay for such defaults should they occur. Getting back to our analogy of the cow, if you bought insurance on the cow when you bought him at the farmer’s price and the cow died a couple of months later you would expect that the money you had been paying for insurance was a safeguard against the death of the cow. This would be true as long as the insurance company didn’t go bankrupt before you could file your claim. In our example, this is exactly what happened. As long as they were collecting money these companies were very profitable. When they started having to pay it out, they went under. There are of course rules and regulations for selling insurance in this country. Unfortunately, since the whole derivatives market is outside of any regulatory oversight these rules were not observed in setting up companies to sell CDS’s. Getting back to our analogy; this simply meant that the same farmer who chose the value of the cow before he sold it to you had his brother in law down the road who grows tomatoes set up a company outside the legal strictures of the United States and sell you insurance on the cow. Never mind that there was no money in the company to cover the loss of the cow, the brother in law made money and you got to feel secure in the mistaken belief that you were covered in the event of the untimely death of your new purchase.
All of this led to a market wherein lenders made money off of volume instead of quality. In other words lending institutions soon learned that the real money in the mortgage industry came from bundling mortgages into CDO’s and selling them, not in slowly over a period of 15-30 years making interest off of the loans themselves. The market for CDO’s boomed fantastically and lending institutions felt the pressure to make more loans. It wasn’t that people were suddenly so stupid that they began buying homes they couldn’t afford; it was the fact that lending institutions were aggressively pushing such loans because it didn’t matter if the loan was sound; all that mattered was that the loans could be sold as CDO’s and the money rolled in.
Unfortunately, this is still not the end of the story. The actual dollar amount of CDO’s in the home mortgage industry at the height of the collapse was estimated to be somewhere in the neighborhood of 6 trillion dollars. While this is a formidable number we must remember that this covers all home mortgages in the US, and only a small percentage of them were ever under the threat of foreclosure so we are still talking about numbers that could not possibly crash the whole economy. However, financial consultants being infinitely clever they managed to leverage this market to numbers as high as 350 trillion according to some estimates.
Mortgage CDO’s were taking over the financial markets of the world. The demand was so great that they had to find a way to create more of them than the housing market could possibly support. This was done by creating credit derivatives based upon CDO’s. In other words, a CDO could be created based upon the profit from an existing CDO. It was strictly an artificial construct in that it was not based upon anything but the profit from something that did exist but it could be created and sold on the market and the market was booming so much that people didn’t seem to care that what they were actually buying. It showed a profit as long as the original CDO it was based upon did and everyone was happy. While this sounds more like sleight of hand than finance it is not unusual in the financial markets. I would give you an accurate farmer analogy here but I don’t know of any farmers that would either buy or sell things based upon cows that don’t actually exist; that seems to be a business that requires a much higher degree of education to get into.
The real magic in the creation of a CDO based upon a CDO is that it only takes a fraction of the actual money to create it while it pays the same amount of profit. One hundred to one leveraging was not out of the norm in such markets by the time it went through a couple of such transformations. In other words such a CDO could be created for 50,000 dollars and sell for 5 million dollars as long as the market was increasing and everyone made a profit. Unfortunately, the leveraging worked just the opposite direction when the market started to go down. The CDO would begin losing money at the same rate that the original one it was based upon had with the noticeable exception that it didn’t have any assets at all that could be sold to get your money back. It was basically worth the cost of its creation, assuming of course that you could find someone stupid enough to buy it. Although there seemed to be plenty of people in that category when things were going good almost no one was interested when things started to go the other direction.
Getting back to the cow analogy let’s attempt to follow this logic. The farmer sells you a cow that he has chosen the value of beforehand. Don’t bother to ask how he valued the cow; this is much too complicated for you to understand. Besides if you are worried that you might be buying a blind or sick cow his brother in law who grows tomatoes and runs an offshore insurance company will sell you insurance that covers your investment for a nominal monthly fee. As long as the cattle market goes well your cattle investment goes well and you get statements every month explaining how much money you are making. Everyone is doing wonderfully in this little arrangement, so much so that the farmer soon sells all the cows he has. Since everything is going so well there is still a large demand for cattle, such a large demand that the farmer hits upon the idea of selling you a virtual cow. It isn’t really a cow, it doesn’t have skin, or hooves, or even meat that you could eat if all else fails but he tells you it is just like having a cow in that you get to make the same profit that people who own real cows make and he doesn’t have to go to the trouble of actually feeding or taking care of the cow. Naturally, the virtual cow business is a vast improvement for the farmer since he makes the same amount of money without all the expenses and sweat associated with actually taking care of a cow. It isn’t long before the money invested in virtual cattle far exceeds the number of real cattle.
Unfortunately, for everyone in this cattle business someone decides to actually eat one of the cows one day and discovers that it is too sickly and weak to eat. This immediately brings into question the original value of the cow and it sends a shock wave all the way through the system. Everyone starts to question the value of their own cattle, more especially the people who suddenly realize their virtual cattle aren’t worth the paper they exist on and they certainly aren’t good to eat because that would require they actually existed in the first place. There is a colossal fire sale on cattle of every description but there are no buyers. After all, everyone knows better than to buy more virtual cattle now and the people who made the money off the original sale of cattle have long since taken their money and gotten out of the business. The farmer’s brother in law has gotten out of the insurance business as well since without reserves he knew with the first sign of trouble in the cattle business he was getting ready to be forced pay out everything he had recently made and he doesn’t want to have to go back to growing tomatoes.
Unfortunately, the virtual cattle business was so profitable and so many banks, investment houses, and mutual funds made up of working people’s 401K’s that it will collapse the whole economy if the government allows the chips to fall. The only thing to do is to throw money at the market in the hopes that the cattle market will return and the magical alchemy of virtual cattle starts to go up again because there isn’t enough money in existence to actually pay for the virtual cattle losses if the market stays down. Meanwhile, the inventors of the virtual cattle industry and the virtual insurance industry that it fostered simply have to bide their time and wait for the market to come back. After all, the billions of dollars that just disappeared from the working people’s 401K’s will be enough to allow them to muddle through the next few years.
All of this sounds a little unbelievable. It does explain why both the Secretary of the Treasury and the head of the Federal Reserve were able to convince Bush that something major had to be done. While our GDP hovers around some 14 trillion dollars a year it is hard to see how we can afford a 350 trillion dollar bill to come due. The fact of the matter is that we have not solved this issue to date. There is no government oversight of the system that created this monstrosity of a problem. While some people are making the first attempts at setting one up one of the first orders of business of the new Republican Congress is to defang the new regulations by pulling the funds necessary to set up a regulation industry for the derivatives market. As long as the housing industry goes up this whole byzantine system works in that everyone makes a profit. The farmer who sold virtual cows made a very large profit and he would like to get back into the business but not if the government is going to regulate it. If you want to find out who these farmers are just watch who supports this new effort to cut away at regulation of the industry.
There is a scene in the Matrix where the hero is offered the choice of taking the red pill or the blue pill. One will open his eyes to the world as it exists, the other will allow him to go back to living in ignorant bliss. I don’t think it is an exaggeration to say that we are facing the same choice right now in this country. Either we will open our eyes and take the time to understand what just happened or we will go through it all over again. The problem with living in ignorant bliss is that it doesn’t last forever and we may not be able to print enough money to pay off the next installment when it comes due.
Wednesday, January 5, 2011
Friday, December 3, 2010
Our economy Part 2
The great collapse of 1907 wasn’t unique in the annals of stock market collapses. It was caused by rampant speculation with borrowed money as are most collapses of this nature. What set the collapse of 1907 apart was the severity of the collapse. As banks and trusts across the nation began to go bankrupt it started a run on even the soundest of banks that threatened to topple the whole banking system of the US. The only thing that kept the whole country from going bankrupt was the determined efforts of one individual; Mr. J. P. Morgan. Morgan spearheaded an effort to get all the largest banks in New York to inject liquidity in the form of capital in the market to stave off further collapses. Without his efforts the whole system would have likely collapsed and politicians took note. When the whole national economy is only saved from a total collapse by the efforts of one banker, even though Morgan was arguably the most powerful banker in the world at the time, people sat up and took notice.
The next year Nelson W. Aldrich, the chairman of the Senate Finance Committee, set up a commission to study the causes of the collapse and come up with recommendations for preventing it from happening again. Aldrich and his committee studied the records of what had happened and also took it upon themselves to study banking systems in more modern financial systems all over the world. What they soon recognized was that a central bank was needed to stabilize the economy and prevent the type of runs on banks that had happened over and over in the US previously. After much political maneuvering the Federal Reserve Act was passed in December of 1913.
The act itself established a national central bank with powers to create money and make discounted loans to member banks. All nationally chartered banks were required to become members of the Federal Reserve and purchase stock in their regional reserve bank as well as hold a certain amount of reserves in their local reserve bank. While this system has been modified and expanded many times since its formation it is still the central bank that controls US financial policy by setting interest rates and managing the money supply. In 1980 it was expanded so that all banking institutions could become members of the Federal Reserve and enjoy the advantages of discount loans and the security of government banking. It is basically a government guarantee for depositor’s money; a state run entity that controls the banking industry and therefore the US economy.
It is worth pausing here to attempt to define one of the basic economic systems that I started this post with. The great bogey man that conservatives like to use to scare the voting base into supporting their agenda with is socialism. Socialism is the first cousin to communism according to most conservatives and the onset of socialist policies is a sure fire path to communism. A basic definition of socialism would be an economic or political theory advocating public or common ownership and cooperative management of the means of production and or capital. It is the favorite stick that conservatives like to use to beat up upon liberals with as they accuse them of fomenting socialism. The Federal Reserve Act is unquestionably a socialist piece of legislation. It put the banking industry under the control of a state run, publicly owned institution; the Federal Reserve. It is THE entity that controls the US economy and has been since 1913 and it is a socialist entity.
In other words, under President Woodrow Wilson, who is widely regarded as one of the most ardent advocates of free markets that ever sat in the White House, the United States adopted a central banking policy that is the very definition of socialism. The stark realities of 1907 and many other cyclical crashes of the US economic system forced our government to adopt a socialist agenda to cope with market fluctuations that threatened to destroy our economy over and over. We have not been a free market since the inception of the Federal Reserve Act and the reason it was adopted was because the free market itself was so volatile and unpredictable that the country simply couldn’t expand with any certainty. Subsequently, the power of the Federal Reserve has been increased many times to cope with emergencies in our economic system because the simple truth is that unfettered free markets are inherently unpredictable and dangerous.
Let’s consider some other facets of the US economy as well. The public school system that fostered the great explosion of literacy in this country from the mid 1930’s onward is a socialist entity. State, local, and Federal governments own the schools and finance the education of almost every child in this country. We can argue whether these institutions are as efficient and productive as they need to be but no one can argue that they are not socialist entities.
The vast electrical grids that power homes, industrial centers, and businesses all over this country are owned by state, local, and federal governments. They were financed, built, and maintained by these same entities and are inherently socialist institutions. Again, we can argue that they have not been maintained and updated as efficiently as they should have been but it cannot be reasonably argued that they are anything other than socialist entities.
The road systems that our economy depends on to get goods to market are owned by state, local, and Federal governments who built and maintain them. The interstate road system that was built during the Eisenhower administration is the key to most all of our national trucking industry and it was built and financed solely by the Federal government. As in my other examples above we are seeing a slow and gradual degradation of this system as funds to maintain it are steadily shunted into other areas of government but it cannot be argued that our road systems are not socialist entities.
Medicare and Medicaid which provide health insurance for our elderly and those without the means to otherwise do so is controlled, administered, and ran by state and federal governments. There are many problems with the system as it stands today, not the least of which is funding but it is entirely a socialist institution.
Much of this country’s industrial might built since WWII comes from US government support and institutional lending from the government controlled banking industry. Almost all necessary and needed research and development breakthroughs in the major industries in this country since WWII were indirectly funded by government research and development programs in the military and NASA. Drug companies’ research and development projects are largely supported by government grants. I will delve more into this tendency in a later post but suffice it to say that much of our industrial strength goes hand in hand with government support of a socialist nature.
The truth is that we our economy is a capitalist/socialist hybrid that is constantly evolving to meet the needs of consumers here and all over the world. The basic flaw in Karl Marx thinking was that he didn’t see that capitalism could evolve. It is a good thing for all of us that it has. I think we need to keep that in mind when the fear mongers of the Tea Party and other right wing movements bring out the socialist stick. If it weren’t for socialism our economy would have collapsed years ago.
As a matter of fact in every facet of American life mentioned above the conservative movement of Reagan and right wing Republicanism away from socialism towards more free markets has led to a universal degradation of our abilities and efficiency.
Reagan had a line he made famous during his run for the presidency. “Are you better off now than you were four year ago?” Can anyone reasonably argue that any facet of our economy is better off now than it was in 1980 when trickle-down economics came in favor?
The next year Nelson W. Aldrich, the chairman of the Senate Finance Committee, set up a commission to study the causes of the collapse and come up with recommendations for preventing it from happening again. Aldrich and his committee studied the records of what had happened and also took it upon themselves to study banking systems in more modern financial systems all over the world. What they soon recognized was that a central bank was needed to stabilize the economy and prevent the type of runs on banks that had happened over and over in the US previously. After much political maneuvering the Federal Reserve Act was passed in December of 1913.
The act itself established a national central bank with powers to create money and make discounted loans to member banks. All nationally chartered banks were required to become members of the Federal Reserve and purchase stock in their regional reserve bank as well as hold a certain amount of reserves in their local reserve bank. While this system has been modified and expanded many times since its formation it is still the central bank that controls US financial policy by setting interest rates and managing the money supply. In 1980 it was expanded so that all banking institutions could become members of the Federal Reserve and enjoy the advantages of discount loans and the security of government banking. It is basically a government guarantee for depositor’s money; a state run entity that controls the banking industry and therefore the US economy.
It is worth pausing here to attempt to define one of the basic economic systems that I started this post with. The great bogey man that conservatives like to use to scare the voting base into supporting their agenda with is socialism. Socialism is the first cousin to communism according to most conservatives and the onset of socialist policies is a sure fire path to communism. A basic definition of socialism would be an economic or political theory advocating public or common ownership and cooperative management of the means of production and or capital. It is the favorite stick that conservatives like to use to beat up upon liberals with as they accuse them of fomenting socialism. The Federal Reserve Act is unquestionably a socialist piece of legislation. It put the banking industry under the control of a state run, publicly owned institution; the Federal Reserve. It is THE entity that controls the US economy and has been since 1913 and it is a socialist entity.
In other words, under President Woodrow Wilson, who is widely regarded as one of the most ardent advocates of free markets that ever sat in the White House, the United States adopted a central banking policy that is the very definition of socialism. The stark realities of 1907 and many other cyclical crashes of the US economic system forced our government to adopt a socialist agenda to cope with market fluctuations that threatened to destroy our economy over and over. We have not been a free market since the inception of the Federal Reserve Act and the reason it was adopted was because the free market itself was so volatile and unpredictable that the country simply couldn’t expand with any certainty. Subsequently, the power of the Federal Reserve has been increased many times to cope with emergencies in our economic system because the simple truth is that unfettered free markets are inherently unpredictable and dangerous.
Let’s consider some other facets of the US economy as well. The public school system that fostered the great explosion of literacy in this country from the mid 1930’s onward is a socialist entity. State, local, and Federal governments own the schools and finance the education of almost every child in this country. We can argue whether these institutions are as efficient and productive as they need to be but no one can argue that they are not socialist entities.
The vast electrical grids that power homes, industrial centers, and businesses all over this country are owned by state, local, and federal governments. They were financed, built, and maintained by these same entities and are inherently socialist institutions. Again, we can argue that they have not been maintained and updated as efficiently as they should have been but it cannot be reasonably argued that they are anything other than socialist entities.
The road systems that our economy depends on to get goods to market are owned by state, local, and Federal governments who built and maintain them. The interstate road system that was built during the Eisenhower administration is the key to most all of our national trucking industry and it was built and financed solely by the Federal government. As in my other examples above we are seeing a slow and gradual degradation of this system as funds to maintain it are steadily shunted into other areas of government but it cannot be argued that our road systems are not socialist entities.
Medicare and Medicaid which provide health insurance for our elderly and those without the means to otherwise do so is controlled, administered, and ran by state and federal governments. There are many problems with the system as it stands today, not the least of which is funding but it is entirely a socialist institution.
Much of this country’s industrial might built since WWII comes from US government support and institutional lending from the government controlled banking industry. Almost all necessary and needed research and development breakthroughs in the major industries in this country since WWII were indirectly funded by government research and development programs in the military and NASA. Drug companies’ research and development projects are largely supported by government grants. I will delve more into this tendency in a later post but suffice it to say that much of our industrial strength goes hand in hand with government support of a socialist nature.
The truth is that we our economy is a capitalist/socialist hybrid that is constantly evolving to meet the needs of consumers here and all over the world. The basic flaw in Karl Marx thinking was that he didn’t see that capitalism could evolve. It is a good thing for all of us that it has. I think we need to keep that in mind when the fear mongers of the Tea Party and other right wing movements bring out the socialist stick. If it weren’t for socialism our economy would have collapsed years ago.
As a matter of fact in every facet of American life mentioned above the conservative movement of Reagan and right wing Republicanism away from socialism towards more free markets has led to a universal degradation of our abilities and efficiency.
Reagan had a line he made famous during his run for the presidency. “Are you better off now than you were four year ago?” Can anyone reasonably argue that any facet of our economy is better off now than it was in 1980 when trickle-down economics came in favor?
Thursday, December 2, 2010
What kind of economy do we have?
The first thing we need to understand in dealing with the economic issues we are facing both individually and as a nation is what kind of economy we are dealing with. There are many descriptions having to do with economic theories or methodologies but there are two basic truths that we need to face in order to understand what is going on:
a) The US economy is, like our country itself, a blended version of many different ideologies; none of which can accurately describe the whole picture alone.
b) The US economy is, at least for the moment, the leading economy in what is actually a world economy comprised of many different national and regional economies more or less cooperating in business.
Let’s start with a) above. There are many terms thrown about these days in debates about economic theory. Capitalism, Socialism, Marxism, Totalitarianism, Fascism, and a fairly long list of other “isms” that are never clearly defined but used commonly to describe our economic system are thrown about in such debates with impunity. The truth of the matter is that no one wants to clearly define these terms when using them in a debate because the system we currently have in place is a combination of all of them. None of them are pure systems in existence anywhere in the world today. To be completely accurate, none of them have ever been pure systems but every economy in recent history has been some combination of them.
The purest forms of any of these systems have without fail been the most brutal. Most Americans are at least conversationally familiar with Fascism in Nazi Germany and Communism in Stalin’s Soviet Union but both were actually more accurately totalitarian governments. In any case, the brutality of these systems is sufficiently well known and documented so that I won’t bother to spend a lot of time discussing them. It is worth noting that the practical applicability of these systems seemed to be the downfall that led to the end results but human nature being what it is, it is hard to argue that such results wouldn’t be the same if we were to somehow decide to give them another try.
What is much less widely understood is the pure capitalism is just as brutal a system. It isn’t exactly a secret to anyone who cares to look into it but the societies in our history that veered closest to pure capitalism were also amongst the most brutal as well. Europe in the middle 1800’s is just one example. As the age of industrialization dawned there was a massive shift from rural to urban areas and working conditions for the vast majority of the population were to say the least brutally oppressive. Widespread use of child labor, 18 hours work days, and living conditions where filth caused disease that lowered life expectancy to ridiculously low numbers were the rule rather than the exception. It was against this backdrop that the formations of ideas in opposition to capitalism were born. Karl Marx, Friedrich Engels, and others wrote in reaction to the human devastation that pure capitalism caused all around them daily.
In this country, capitalism led to other less than stellar repercussions as well. African slavery was in some ways the ultimate expression of capitalist theory in that slave owners owned not only the capital and means of production; they owned the labor force as well. While this was abandoned after a brutal war that cost millions of lives the basic ideas of industrial capitalism practiced in the northeastern states was little better for the working class that it utilized to make profits. The closest this country ever came to a pure capitalist system was probably in the late 1890’s when we had many of the same problems that Marx had seen in Europe some 40 years earlier. Children worked 14 hour days in factories; unemployment cycles ran rampant in that large portions of the population of inner cities that were the labor force routinely faced starvation and death by exposure to the elements. Outbreaks of cholera and typhoid were widespread in many inner cities. The nation as a whole went from boom to depression with great regularity and there were basically only two classes of people, the very rich and the very poor. The very rich lived very well; everyone else struggled to survive. This is exactly why the greatest proponents of capitalism have always been those that profited the most highly from it. It has met with decidedly less satisfaction from everyone else who has ever been exposed to it.
In basic terms Capitalism implies individual ownership of the means of production. The system itself relies upon the laws of supply and demand to regulate the market and theoretically maximizes efficiency by allowing the free market to make all economic decisions. In reality Capitalism in its purest forms leads to a gradual separation of classes. The rich get richer while the poor get poorer. It also leads to the antithesis of free markets; monopoly. As an individual or corporation becomes richer and more successful they gradually gain control of a larger proportion of the market until they eventually own a large enough share to force everyone else out of the market. After this happens, a monopoly results and the rules of supply and demand are manipulated by the owner of the monopoly until there is no longer a free market at all. It is the basic flaw of Capitalist ideology that any unrestrained capitalist entity eventually eliminates competition which is the free market mechanism that the ideology depends upon to work properly. Marx understood this. His idea was that these weaknesses would eventually lead to the collapse of the system itself. If you carry the idea of Capitalism to its logical extreme you can easily see that it is a parasitic system in that it depends on constant growth to survive.
The success of a capitalist system is always measured in its growth. It is in large part the only factor that really matters. This is exactly why the most important measurement of the success of the US economy today is the Gross Domestic Product and whether it has increased or not. Our economy is not built upon the idea of sustaining a level of affluence or sustaining a lifestyle, it is built entirely upon the idea that we have to keep growing. It is in fact a logical reality that this is not possible in the long term as there are limits to everything and uncontained growth can only be supported by unlimited resources.
What happened to change things after 1893 in this country? Was Marx right in thinking that capitalism couldn’t survive, that it would collapse on its own flawed basis? The answer to the first question contains the answer to the second as well. Let’s take a more detailed look at what was going on in 1893. I have already pointed out that the problems in industrialized areas were severe but what I haven’t touched upon yet is that the problems in rural America were just as bad under this pure capitalist system.
Farm prices were in constant flux from the 1860’s on with periodic rises and falls that routinely devastated farmer’s ability to make a living. Almost all farming done at that time was by small independent farmers who were at the mercy of market fluctuations that were basically uncontrollable. To make matters worse, the banking industry was beginning to become more organized as the laws of capitalism led to the inevitable situation where larger banking interests were gobbling up smaller banking interests. This led to a situation of more centralized control of money which essentially meant that large banking interests began to gain a monopoly on the market of lending money. This led to ever increasing interest rates and less available money at the same time that farmers were more dependent on bank loans to get by from year to year as crop prices fell.
The situation got bad enough so that farmers began to organize into cooperatives and form political parties. In an effort to increase the money supply the movement advocated greenbacks based upon silver which was in more plentiful supply. A combination of events occurred to guarantee the movement was unsuccessful in this endeavor but it did serve to push the country towards an understanding that more liquid credit capabilities were needed to smooth out the cyclical nature of the farming industry. The point is that this more pure form of capitalism which existed during the latter half of the 1800’s and the start of the 20th century was undeniably a failure as far as the average American was concerned. Farmers suffered, factory workers suffered, and small business owners suffered. The only people who benefitted from this system were the bankers themselves as Adam Smith had pointed out some 150 years earlier.
It is worth mentioning here that the great fear of inflation which drives the financial markets today is the same fear that kept bankers from increasing the credit supplies that farmers and small business owners so desperately needed in the early part of the 20th century. In reality it is basic common sense that a little bit of inflation is in fact a good thing for the vast majority of consumers. If the value of money goes down while the value of goods go up who is gaining in the market; the person trading money for goods or the person trading goods for money? It is simple really. If you own more money than goods inflation devalues the commodity you own. If you own more goods than money it inflates the value of what you own. This is a nasty little secret that bankers and financial market people go to great lengths to disguise for the simple reason that inflation hurts them where they live even though it actually improves the standard of living of the vast majority of working people. It is also worth noting that every major collapse of our economy has been preceeded by a period of financial speculation by this same class of people.
The final straw the broke the camel’s back came in 1907 as far as pure capitalism in the US is concerned. In 1907 the stock market nosedived some 50% in October. As is usually the case in such collapses there were some very greedy individuals involved in rampant speculation of large amounts of borrowed money which I will go into in more detail a little later but the important point I want to make right now is that this event precipitated a nationwide depression on a vast scale. It was a depression wherein numerous state and local banks collapsed, untold businesses went bankrupt and the US economy itself came very close an actual bankruptcy on the part of the Federal Government. It was in reaction to this depression that American political leaders realized that we HAD to make a basic change from a purely capitalist system and it was a result of this realization that the US government formed the Federal Reserve System.
The Federal Reserve System is a bone of contention for many to this day. Many believe it is the basic flaw in our system but the reality is that it was formed in reaction to the fact that without a central banking system there was no way to control our economy. The Free market had basically collapsed our whole economy and everyone recognized that we simply couldn’t afford to keep going down that path. The Federal Reserve was formed to stave off the absolute collapse of our economic system, yet it was a definitive step in the direction of socialism, a direct admission that Marx was indeed right; a purely capitalist system cannot survive without devouring itself.
To be continued……
a) The US economy is, like our country itself, a blended version of many different ideologies; none of which can accurately describe the whole picture alone.
b) The US economy is, at least for the moment, the leading economy in what is actually a world economy comprised of many different national and regional economies more or less cooperating in business.
Let’s start with a) above. There are many terms thrown about these days in debates about economic theory. Capitalism, Socialism, Marxism, Totalitarianism, Fascism, and a fairly long list of other “isms” that are never clearly defined but used commonly to describe our economic system are thrown about in such debates with impunity. The truth of the matter is that no one wants to clearly define these terms when using them in a debate because the system we currently have in place is a combination of all of them. None of them are pure systems in existence anywhere in the world today. To be completely accurate, none of them have ever been pure systems but every economy in recent history has been some combination of them.
The purest forms of any of these systems have without fail been the most brutal. Most Americans are at least conversationally familiar with Fascism in Nazi Germany and Communism in Stalin’s Soviet Union but both were actually more accurately totalitarian governments. In any case, the brutality of these systems is sufficiently well known and documented so that I won’t bother to spend a lot of time discussing them. It is worth noting that the practical applicability of these systems seemed to be the downfall that led to the end results but human nature being what it is, it is hard to argue that such results wouldn’t be the same if we were to somehow decide to give them another try.
What is much less widely understood is the pure capitalism is just as brutal a system. It isn’t exactly a secret to anyone who cares to look into it but the societies in our history that veered closest to pure capitalism were also amongst the most brutal as well. Europe in the middle 1800’s is just one example. As the age of industrialization dawned there was a massive shift from rural to urban areas and working conditions for the vast majority of the population were to say the least brutally oppressive. Widespread use of child labor, 18 hours work days, and living conditions where filth caused disease that lowered life expectancy to ridiculously low numbers were the rule rather than the exception. It was against this backdrop that the formations of ideas in opposition to capitalism were born. Karl Marx, Friedrich Engels, and others wrote in reaction to the human devastation that pure capitalism caused all around them daily.
In this country, capitalism led to other less than stellar repercussions as well. African slavery was in some ways the ultimate expression of capitalist theory in that slave owners owned not only the capital and means of production; they owned the labor force as well. While this was abandoned after a brutal war that cost millions of lives the basic ideas of industrial capitalism practiced in the northeastern states was little better for the working class that it utilized to make profits. The closest this country ever came to a pure capitalist system was probably in the late 1890’s when we had many of the same problems that Marx had seen in Europe some 40 years earlier. Children worked 14 hour days in factories; unemployment cycles ran rampant in that large portions of the population of inner cities that were the labor force routinely faced starvation and death by exposure to the elements. Outbreaks of cholera and typhoid were widespread in many inner cities. The nation as a whole went from boom to depression with great regularity and there were basically only two classes of people, the very rich and the very poor. The very rich lived very well; everyone else struggled to survive. This is exactly why the greatest proponents of capitalism have always been those that profited the most highly from it. It has met with decidedly less satisfaction from everyone else who has ever been exposed to it.
In basic terms Capitalism implies individual ownership of the means of production. The system itself relies upon the laws of supply and demand to regulate the market and theoretically maximizes efficiency by allowing the free market to make all economic decisions. In reality Capitalism in its purest forms leads to a gradual separation of classes. The rich get richer while the poor get poorer. It also leads to the antithesis of free markets; monopoly. As an individual or corporation becomes richer and more successful they gradually gain control of a larger proportion of the market until they eventually own a large enough share to force everyone else out of the market. After this happens, a monopoly results and the rules of supply and demand are manipulated by the owner of the monopoly until there is no longer a free market at all. It is the basic flaw of Capitalist ideology that any unrestrained capitalist entity eventually eliminates competition which is the free market mechanism that the ideology depends upon to work properly. Marx understood this. His idea was that these weaknesses would eventually lead to the collapse of the system itself. If you carry the idea of Capitalism to its logical extreme you can easily see that it is a parasitic system in that it depends on constant growth to survive.
The success of a capitalist system is always measured in its growth. It is in large part the only factor that really matters. This is exactly why the most important measurement of the success of the US economy today is the Gross Domestic Product and whether it has increased or not. Our economy is not built upon the idea of sustaining a level of affluence or sustaining a lifestyle, it is built entirely upon the idea that we have to keep growing. It is in fact a logical reality that this is not possible in the long term as there are limits to everything and uncontained growth can only be supported by unlimited resources.
What happened to change things after 1893 in this country? Was Marx right in thinking that capitalism couldn’t survive, that it would collapse on its own flawed basis? The answer to the first question contains the answer to the second as well. Let’s take a more detailed look at what was going on in 1893. I have already pointed out that the problems in industrialized areas were severe but what I haven’t touched upon yet is that the problems in rural America were just as bad under this pure capitalist system.
Farm prices were in constant flux from the 1860’s on with periodic rises and falls that routinely devastated farmer’s ability to make a living. Almost all farming done at that time was by small independent farmers who were at the mercy of market fluctuations that were basically uncontrollable. To make matters worse, the banking industry was beginning to become more organized as the laws of capitalism led to the inevitable situation where larger banking interests were gobbling up smaller banking interests. This led to a situation of more centralized control of money which essentially meant that large banking interests began to gain a monopoly on the market of lending money. This led to ever increasing interest rates and less available money at the same time that farmers were more dependent on bank loans to get by from year to year as crop prices fell.
The situation got bad enough so that farmers began to organize into cooperatives and form political parties. In an effort to increase the money supply the movement advocated greenbacks based upon silver which was in more plentiful supply. A combination of events occurred to guarantee the movement was unsuccessful in this endeavor but it did serve to push the country towards an understanding that more liquid credit capabilities were needed to smooth out the cyclical nature of the farming industry. The point is that this more pure form of capitalism which existed during the latter half of the 1800’s and the start of the 20th century was undeniably a failure as far as the average American was concerned. Farmers suffered, factory workers suffered, and small business owners suffered. The only people who benefitted from this system were the bankers themselves as Adam Smith had pointed out some 150 years earlier.
It is worth mentioning here that the great fear of inflation which drives the financial markets today is the same fear that kept bankers from increasing the credit supplies that farmers and small business owners so desperately needed in the early part of the 20th century. In reality it is basic common sense that a little bit of inflation is in fact a good thing for the vast majority of consumers. If the value of money goes down while the value of goods go up who is gaining in the market; the person trading money for goods or the person trading goods for money? It is simple really. If you own more money than goods inflation devalues the commodity you own. If you own more goods than money it inflates the value of what you own. This is a nasty little secret that bankers and financial market people go to great lengths to disguise for the simple reason that inflation hurts them where they live even though it actually improves the standard of living of the vast majority of working people. It is also worth noting that every major collapse of our economy has been preceeded by a period of financial speculation by this same class of people.
The final straw the broke the camel’s back came in 1907 as far as pure capitalism in the US is concerned. In 1907 the stock market nosedived some 50% in October. As is usually the case in such collapses there were some very greedy individuals involved in rampant speculation of large amounts of borrowed money which I will go into in more detail a little later but the important point I want to make right now is that this event precipitated a nationwide depression on a vast scale. It was a depression wherein numerous state and local banks collapsed, untold businesses went bankrupt and the US economy itself came very close an actual bankruptcy on the part of the Federal Government. It was in reaction to this depression that American political leaders realized that we HAD to make a basic change from a purely capitalist system and it was a result of this realization that the US government formed the Federal Reserve System.
The Federal Reserve System is a bone of contention for many to this day. Many believe it is the basic flaw in our system but the reality is that it was formed in reaction to the fact that without a central banking system there was no way to control our economy. The Free market had basically collapsed our whole economy and everyone recognized that we simply couldn’t afford to keep going down that path. The Federal Reserve was formed to stave off the absolute collapse of our economic system, yet it was a definitive step in the direction of socialism, a direct admission that Marx was indeed right; a purely capitalist system cannot survive without devouring itself.
To be continued……
Monday, November 29, 2010
CRA and the Collapse Part 2
The Community Reinvestment Act of 1977 is often tossed around these days as the source of the economic collapse we are still experiencing in this country. If you think it sounds a little strange that an act passed in 1977 caused an economic collapse in 2008 you are correct. It would be strange if that is what happened but the truth of the matter is that it isn’t that strange because that is not what caused the recent collapse no matter what Sean Hannity and Rush Limbaugh would have you to believe. In my last post, I pointed out that the actual numbers concerning the real estate mortgage industry didn’t add up to the collapse we experienced and I will go further into what actually happened in later posts on this subject but I thought it would be worthwhile to look at what actually did happen to the real estate market first.
The Community Reinvestment Act was passed with the express intent of eliminating unfair lending practices in inner cities. As far back as the thirties when the government became involved in assistance for home mortgages the mortgage industry has discriminated against one factor, perceived risk. In the early years of government involvement there were maps drawn up wherein were lined off with colored lines based upon the projected amount of risk associated with mortgages in different areas. Historically, the inner cities which were largely populated by minorities were “redlined” or outlined in red as the highest risk areas to loan money. Up until the early sixties such maps were the rule in the industry and it was very hard to convince mortgage companies and banks to loan money in these areas for the simple reason that there were plenty of other areas considered less risky in which to loan their money.
In 1968 the Fair Housing Act was passed to fight this problem. This act prohibited the policy of redlining areas based upon race, religion, gender, familial status, or ethnic origin. While the act was aimed at specifically limiting the ability of lending institutions to discriminate based upon these criteria the industry continued to be slanted away from lending in these areas because of perceived risk. While the Fair Housing Act specifically made it illegal to discriminate based upon these factors the lending institutions simply had to avoid having it proved that their bias was based upon these factors to fall outside of the control of this act.
The Community Reinvestment Act was passed to encourage investment in these areas. What the act does in effect is to require banks under the FDIC to maintain equal opportunity for loans in all areas where they are chartered to do business including lower income areas. In other words, if a bank has depositors in low income areas it is required to offer equal opportunity for loans in these same areas. There were no specific requirements to how this was to be effected but it was to be enforced by the same FDIC auditors who take care of making sure that such banks do safe and legal business under the protection of the FDIC. The Act specifically states that all such banks are to maintain due diligence and follow accepted criteria for determining that loans made under this act are fiscally sound. As with the other constraints in the act, these decisions are to be audited and enforced by the FDIC auditors.
The teeth of the enforcement of the act came from the FDIC’s recommendations as to how member institutions were graded according to their compliance with the provisions of the act. In other words, the FDIC would either give thumbs up or thumbs down to member institutions who applied for mergers and acquisitions with other banks based upon their compliance with the CRA. A good rating for compliance was the carrot on the end of the stick and member banks were to respond accordingly. The specific regulatory agencies who made these judgments were the Office of the Comptroller of Currency, the Office of Thrift Supervision, and the FDIC. The Federal Financial Institution Examinations Council was charged with coordinating these reports and publishing the findings for a bank’s compliance with CRA regulations.
While that Act itself was aimed at increasing the ability of people in lower income areas to attain financing for buying homes in these areas it was not very successful in changing the status quo. The Act itself was continuously modified to make it more effective. Changes in 1989, 1992, 1994, 1995, 1999, and 2005 were made to the Act to make it more effective in increasing this ability by giving the regulatory agencies more teeth in enforcing the act. Still, as late as 2007 there were conversations in government about further strengthening the Act to increase the amount of access to such loans for the simple reason that it never successfully impacted the markets in large numbers.
According to independent studies by the Cato Institute, and the Competitive Enterprise Institute the Act itself could never be shown to improve home ownership in low income areas. There are those who disagree of course but the reality is that the Act itself played a very small part in the growth of loans in low income areas. The overwhelming consensus of such studies is that the loans that were made under the CRA were loans that to a large extent held to term and were much less likely to threats of foreclosure than those made by private entities which were not under the jurisdiction of the CRA. As a matter of fact, some 80% of the loans that came into foreclosure during the 2007 crisis and later were made by private mortgage companies that were not in any way associated with the Community Reinvestment Act because they were not under its jurisdiction in any form.
Sub Prime Mortgages and other exotic entities that actually led to the housing bubble collapse were the overwhelmingly the creation of private enterprise mortgage companies. Why? For the same reason that all such schemes are hatched; PROFIT.
In the recent past in this country the overwhelming majority of home mortgages that were made were simple financial agreements wherein one party made a loan and the other party held onto the loan as an investment. The profit was in collecting the interest rate over a long term and it was a pretty handsome profit at that. The standard rule of thumb for such mortgages is that a 30 year note usually pays off some 300% over the term of the loan. As most homeowners understand this means that a $50,000 dollar mortgage usually costs some $150,000 by the time it is paid off if it goes the full term of the loan. Obviously, a loan that defaulted was bad business for everyone. The homeowner lost his home and the money he had invested up to the point of foreclosure and the mortgage holder lost the projected profits of the long term interest payments so it was in no one’s best interest to make bad loans.
Securitization changed the whole industry in a drastic way in the late 1990’s. Just as the Dot Com collapse of the late 90’s started to crash the financial markets securitization of mortgages began to take over these markets which is basically the way we avoided an economic collapse at that time. I will go more into the details of Securitization and how it works in a later post but for now I will give the short version explanation.
Basically, Securitization involves bundling groups of mortgages into bond type instruments that are traded on the market as assets. In other words, it is a little bit of hocus pocus magic whereby a Debt in the form of a mortgage is changed into an Asset in the form of a Collaterized Mortgage Obligation (CMO). Of course the rules and regulations for this little bit of magic are hazy and open ended which is exactly why such regulations are needed but for now it is worth noting that this industry grew at an astronomical rate in the late 1990’s and early 2000’s.
Securitization instantaneously created a market for mortgages, lots of mortgages. The people producing the mortgages sold them immediately after creating them to a group who would bundle them into CMO’s and sell them again. Each transaction created a profit margin so that such mortgage bundles often actually increased in value with each trade, sometimes in margins that ended up being in the range of 50 to 100 times over the initial value. It was magic. A debt instantaneously becomes an asset and then multiplies in value and everyone was making lots of money. Of course there is really no such thing as magic. A debt is still a debt, no matter how you bundle it or what you name it but that is something we still don’t seem to recognize as a nation and another point for another post later on.
As Securitization grew mortgage companies became more and more creative with the types of loans they created. They also pushed harder for approval of higher risk loans. After all, the mortgage company wasn’t going to hold the loan to maturity and the next person in line who was doing the securitization wasn’t either. Instead of long term profit on sound loans the real money was now in short term profits on large volumes of loans and no one really cared how safe the loans themselves were. After all, as the market boomed the home values increased so that a person could always just refinance if they couldn’t pay the mortgage. It was the classic case of paying the piper later and the US economy boomed.
The Housing industry became a pyramid scheme and as long as the home values kept increasing there was no end in sight. As in most such schemes the jig is eventually up. Someone notices that the emperor isn’t actually wearing any clothes and reality starts to set in. As in all pyramid schemes that inevitably collapse the people on the bottom lose and we are seeing the effects of this one now. It wasn’t the fact that the government forced banks to make bad loans it was the fact that banks found a way to make it profitable to make bad loans. Through control of Congress and the gradual dismantling of the regulations put in effect after the last great collapse in 1929 from rampant speculation greed found a way to create even more rampant speculation in the last 15 years.
Casinos make a lot of money off of people’s belief that they can beat statistical certainty but at least most people who play in Casinos have to use their own money. The banking industry in the US has created their own Casino but they are using our money to gamble with. As long as the general public doesn’t understand what just happened to our economy we have no way to prevent it from happening again. It doesn’t really matter if the economy comes back or not if we don’t fix the problems that caused it to collapse in the first place and we simply have not done that so far.
We have allowed a system to be created where it was profitable to make bad loans and it was the pursuit of these profits that crashed the economy. Don’t expect the people who made all the money to abandon the system that was so profitable for them any time soon. It is fairly easy to just buy media outlets if you have a lot of money and spread propaganda that blames everyone but the people who created the problem. After all, most Americans are so stupid that they can be convinced that poor people buying homes they couldn’t afford crashed the world economy. Oh how those poor bankers must have anguished over being forced to make loans to people they knew couldn’t pay them back by the big bad government. As my dad used to say, “they must have cried all the way to the bank.”
The Community Reinvestment Act was passed with the express intent of eliminating unfair lending practices in inner cities. As far back as the thirties when the government became involved in assistance for home mortgages the mortgage industry has discriminated against one factor, perceived risk. In the early years of government involvement there were maps drawn up wherein were lined off with colored lines based upon the projected amount of risk associated with mortgages in different areas. Historically, the inner cities which were largely populated by minorities were “redlined” or outlined in red as the highest risk areas to loan money. Up until the early sixties such maps were the rule in the industry and it was very hard to convince mortgage companies and banks to loan money in these areas for the simple reason that there were plenty of other areas considered less risky in which to loan their money.
In 1968 the Fair Housing Act was passed to fight this problem. This act prohibited the policy of redlining areas based upon race, religion, gender, familial status, or ethnic origin. While the act was aimed at specifically limiting the ability of lending institutions to discriminate based upon these criteria the industry continued to be slanted away from lending in these areas because of perceived risk. While the Fair Housing Act specifically made it illegal to discriminate based upon these factors the lending institutions simply had to avoid having it proved that their bias was based upon these factors to fall outside of the control of this act.
The Community Reinvestment Act was passed to encourage investment in these areas. What the act does in effect is to require banks under the FDIC to maintain equal opportunity for loans in all areas where they are chartered to do business including lower income areas. In other words, if a bank has depositors in low income areas it is required to offer equal opportunity for loans in these same areas. There were no specific requirements to how this was to be effected but it was to be enforced by the same FDIC auditors who take care of making sure that such banks do safe and legal business under the protection of the FDIC. The Act specifically states that all such banks are to maintain due diligence and follow accepted criteria for determining that loans made under this act are fiscally sound. As with the other constraints in the act, these decisions are to be audited and enforced by the FDIC auditors.
The teeth of the enforcement of the act came from the FDIC’s recommendations as to how member institutions were graded according to their compliance with the provisions of the act. In other words, the FDIC would either give thumbs up or thumbs down to member institutions who applied for mergers and acquisitions with other banks based upon their compliance with the CRA. A good rating for compliance was the carrot on the end of the stick and member banks were to respond accordingly. The specific regulatory agencies who made these judgments were the Office of the Comptroller of Currency, the Office of Thrift Supervision, and the FDIC. The Federal Financial Institution Examinations Council was charged with coordinating these reports and publishing the findings for a bank’s compliance with CRA regulations.
While that Act itself was aimed at increasing the ability of people in lower income areas to attain financing for buying homes in these areas it was not very successful in changing the status quo. The Act itself was continuously modified to make it more effective. Changes in 1989, 1992, 1994, 1995, 1999, and 2005 were made to the Act to make it more effective in increasing this ability by giving the regulatory agencies more teeth in enforcing the act. Still, as late as 2007 there were conversations in government about further strengthening the Act to increase the amount of access to such loans for the simple reason that it never successfully impacted the markets in large numbers.
According to independent studies by the Cato Institute, and the Competitive Enterprise Institute the Act itself could never be shown to improve home ownership in low income areas. There are those who disagree of course but the reality is that the Act itself played a very small part in the growth of loans in low income areas. The overwhelming consensus of such studies is that the loans that were made under the CRA were loans that to a large extent held to term and were much less likely to threats of foreclosure than those made by private entities which were not under the jurisdiction of the CRA. As a matter of fact, some 80% of the loans that came into foreclosure during the 2007 crisis and later were made by private mortgage companies that were not in any way associated with the Community Reinvestment Act because they were not under its jurisdiction in any form.
Sub Prime Mortgages and other exotic entities that actually led to the housing bubble collapse were the overwhelmingly the creation of private enterprise mortgage companies. Why? For the same reason that all such schemes are hatched; PROFIT.
In the recent past in this country the overwhelming majority of home mortgages that were made were simple financial agreements wherein one party made a loan and the other party held onto the loan as an investment. The profit was in collecting the interest rate over a long term and it was a pretty handsome profit at that. The standard rule of thumb for such mortgages is that a 30 year note usually pays off some 300% over the term of the loan. As most homeowners understand this means that a $50,000 dollar mortgage usually costs some $150,000 by the time it is paid off if it goes the full term of the loan. Obviously, a loan that defaulted was bad business for everyone. The homeowner lost his home and the money he had invested up to the point of foreclosure and the mortgage holder lost the projected profits of the long term interest payments so it was in no one’s best interest to make bad loans.
Securitization changed the whole industry in a drastic way in the late 1990’s. Just as the Dot Com collapse of the late 90’s started to crash the financial markets securitization of mortgages began to take over these markets which is basically the way we avoided an economic collapse at that time. I will go more into the details of Securitization and how it works in a later post but for now I will give the short version explanation.
Basically, Securitization involves bundling groups of mortgages into bond type instruments that are traded on the market as assets. In other words, it is a little bit of hocus pocus magic whereby a Debt in the form of a mortgage is changed into an Asset in the form of a Collaterized Mortgage Obligation (CMO). Of course the rules and regulations for this little bit of magic are hazy and open ended which is exactly why such regulations are needed but for now it is worth noting that this industry grew at an astronomical rate in the late 1990’s and early 2000’s.
Securitization instantaneously created a market for mortgages, lots of mortgages. The people producing the mortgages sold them immediately after creating them to a group who would bundle them into CMO’s and sell them again. Each transaction created a profit margin so that such mortgage bundles often actually increased in value with each trade, sometimes in margins that ended up being in the range of 50 to 100 times over the initial value. It was magic. A debt instantaneously becomes an asset and then multiplies in value and everyone was making lots of money. Of course there is really no such thing as magic. A debt is still a debt, no matter how you bundle it or what you name it but that is something we still don’t seem to recognize as a nation and another point for another post later on.
As Securitization grew mortgage companies became more and more creative with the types of loans they created. They also pushed harder for approval of higher risk loans. After all, the mortgage company wasn’t going to hold the loan to maturity and the next person in line who was doing the securitization wasn’t either. Instead of long term profit on sound loans the real money was now in short term profits on large volumes of loans and no one really cared how safe the loans themselves were. After all, as the market boomed the home values increased so that a person could always just refinance if they couldn’t pay the mortgage. It was the classic case of paying the piper later and the US economy boomed.
The Housing industry became a pyramid scheme and as long as the home values kept increasing there was no end in sight. As in most such schemes the jig is eventually up. Someone notices that the emperor isn’t actually wearing any clothes and reality starts to set in. As in all pyramid schemes that inevitably collapse the people on the bottom lose and we are seeing the effects of this one now. It wasn’t the fact that the government forced banks to make bad loans it was the fact that banks found a way to make it profitable to make bad loans. Through control of Congress and the gradual dismantling of the regulations put in effect after the last great collapse in 1929 from rampant speculation greed found a way to create even more rampant speculation in the last 15 years.
Casinos make a lot of money off of people’s belief that they can beat statistical certainty but at least most people who play in Casinos have to use their own money. The banking industry in the US has created their own Casino but they are using our money to gamble with. As long as the general public doesn’t understand what just happened to our economy we have no way to prevent it from happening again. It doesn’t really matter if the economy comes back or not if we don’t fix the problems that caused it to collapse in the first place and we simply have not done that so far.
We have allowed a system to be created where it was profitable to make bad loans and it was the pursuit of these profits that crashed the economy. Don’t expect the people who made all the money to abandon the system that was so profitable for them any time soon. It is fairly easy to just buy media outlets if you have a lot of money and spread propaganda that blames everyone but the people who created the problem. After all, most Americans are so stupid that they can be convinced that poor people buying homes they couldn’t afford crashed the world economy. Oh how those poor bankers must have anguished over being forced to make loans to people they knew couldn’t pay them back by the big bad government. As my dad used to say, “they must have cried all the way to the bank.”
Monday, November 15, 2010
Economic Collapse Part I
What happened to the economy in 2008? Obviously, we went into a recession or maybe even a depression but what happened to cause this to happen? Lots of people want to know the answer to that but I am afraid that for the most part we are listening to the wrong sources to figure it out. What we really need to do is understand what kind of economy we actually have in the US today to be able to understand what just went wrong with it. Unfortunately, I don’t see a lot of people taking this approach as it is always easier to continue a bad policy than to understand what is wrong with it in the first place.
Maybe we should start with some of the currently accepted ideas as to what went wrong with the economy. If you listen to Rush Limbaugh or Sean Hannity or any of their carefully cloned copies currently filling the talk radio airwaves you will hear that government is at fault. In their view, the government began to interfere with the free market and this caused a lot of loans to be made that were not secure loans. When these loans inevitably went into default, the market began to collapse and voila; we have a recession on our hands. Big government, in its infinite ignorance of the free market, basically caused the whole thing. To be even more explicit, liberal politicians in their effort to take care of their entitled voter base began to force the free market to loan money to people who couldn’t afford to pay it back.
If this sounds familiar, it is because we have heard it before. Ronald Reagan used similar logic to get himself elected in 1980. We had a recession during that time too. Jimmy Carter, the incumbent president went on TV and began asking Americans to cut back, to conserve, to consider the possibility that we might all have to do things differently to continue to lead the free world in economic growth. Self sacrifice and a calling to a greater good were his solution to the problems we were facing at the time. Reagan took the opposite tact and began excoriating government as the source of the problem. In Reagan’s view it was the government and its entitlements programs to those undeserving that were dragging the economy down. Welfare queens who lived better than the average working man were the topic he continually wanted to dote upon whether it actually had anything to do with the problems we were facing or not.
Reagan knew what we really needed. A scapegoat to blame all our problems on; especially one that would resonate so thoroughly with working class Americans and he found it in the welfare queens and the liberals in government who fostered them. Unfortunately, this recipe for fixing the problem didn’t work then and it won’t work this time either. In point of fact, the government might have been part of the problem in that it has blindly supported the corporate entities that have been feeding it money for the last half of the 20th century but that is like blaming the cow for giving bad milk when you feed it onions all day.
Let’s take a look at the actual numbers of what was going on in 2008 when the government publicly admitted that it was going to have to bail out the private banking concerns in this country. On September 18, 2008 Ben Bernanke (head of the Federal Reserve) and Treasury Secretary Henry Paulsen met with key Congressional legislators with the message that they needed 700 Billion dollars to avoid a financial catastrophe. This wasn’t some cry in the wilderness from a lunatic fringe; this was the head of the Federal Reserve and the head of the US Treasury telling US congressmen that they had to do something quick. In Bernanke’s words,
“If we don’t do this, we may not have an economy on Monday.”
In order to understand the magnitude of this statement it is necessary to look back a little bit. The George W. Bush administration, the Bill Clinton administration, the George H. W. Bush administration, and the Ronald Reagan administration have been in power in Washington since 1980. There is little doubt that they have been the most business friendly, corporate sponsored administrations in the history of this country. With the exception of the first term of the Clinton presidency we had seen 28 years of pro business government without respite. They have gradually dismantled or defanged every financial regulatory agency, every economic control that was put in place after the Great Depression. These agencies and laws were put in place after the Great Depression for the express reason that some very bright men took a look at what happened then and decided they needed regulations to keep from having a repeat performance. Not surprisingly, we are now getting that repeat performance and for many of the same reasons that the last collapse happened.
The George W. Bush administration was arguably the friendliest to corporate interests and de-regulation of the industry. Imagine what it took to convince a president extraordinarily concerned with his public image and how he would be viewed by history to completely reverse his field on how free markets are supposed to work in his last 4 months in office. I would like to have been a fly on the wall in the meeting when Bernanke and Paulsen proposed to him that in order to stave off total economic collapse; he was going to have to nationalize the US banking system by doing a government bailout. I wonder what it took to convince him that his whole laissez-faire approach to economics was wrong; that he was going to have to socialize the US financial system to avoid a worldwide economic collapse. Everyone seems to miss that this occurred; that a notoriously stubborn and self serving US President who had built his whole career around the idea that we need less government suddenly decided the government was the only solution. What did they actually show him in that meeting?
Let’s look at some numbers to see if the current ideas about home mortgage defaults explain the problem. In September of 2008 there were some 760,000 homes in danger of foreclosure according to data released by the US Foreclosure Market report. While this is a high number it doesn’t explain the collapse. In 2008 the average home mortgage total value was 167,000 dollars. If you multiply 760,000 by 167,000 which is the worst possible scenario because it assumes that each and every house in danger of foreclosure instantly becomes a total loss you come up with a little less than 127 billion dollars. Keep in mind that this is the worst possible case in that most home foreclosures actually result in much lower losses after all the paperwork is done and the lawyers are paid. According to most estimates I have found the highest average is quote by Freddie Mac officials as 60,000 dollars. Using this number which is actually quite a bit higher than most estimates and multiplying it by 760,000 we come up with somewhat less than 46 billion dollars. In other words, if worse came to worse and every single home that was in danger of foreclosure in September of 2008 actually occurred all at once the industry would be looking at a 45.6 billion dollar loss. Remember, this is the worst case scenario and assumes that all these homes were foreclosed upon at once. Where did the 700 Billion dollar numbers that Paulsen and Bernanke were talking about come from? Clearly, there is something else going on that we aren’t discussing on a public level and I will get back to that in a later post but for now I just wanted to point out that if the foreclosure market was the problem we could have completely solved that with a 46 billion dollar injection into the market and I heard no one in power making that suggestion.
In my next post on this subject I will begin to explore the Community Reinvestment Act and how it supposedly led to the collapse of the housing bubble.
Maybe we should start with some of the currently accepted ideas as to what went wrong with the economy. If you listen to Rush Limbaugh or Sean Hannity or any of their carefully cloned copies currently filling the talk radio airwaves you will hear that government is at fault. In their view, the government began to interfere with the free market and this caused a lot of loans to be made that were not secure loans. When these loans inevitably went into default, the market began to collapse and voila; we have a recession on our hands. Big government, in its infinite ignorance of the free market, basically caused the whole thing. To be even more explicit, liberal politicians in their effort to take care of their entitled voter base began to force the free market to loan money to people who couldn’t afford to pay it back.
If this sounds familiar, it is because we have heard it before. Ronald Reagan used similar logic to get himself elected in 1980. We had a recession during that time too. Jimmy Carter, the incumbent president went on TV and began asking Americans to cut back, to conserve, to consider the possibility that we might all have to do things differently to continue to lead the free world in economic growth. Self sacrifice and a calling to a greater good were his solution to the problems we were facing at the time. Reagan took the opposite tact and began excoriating government as the source of the problem. In Reagan’s view it was the government and its entitlements programs to those undeserving that were dragging the economy down. Welfare queens who lived better than the average working man were the topic he continually wanted to dote upon whether it actually had anything to do with the problems we were facing or not.
Reagan knew what we really needed. A scapegoat to blame all our problems on; especially one that would resonate so thoroughly with working class Americans and he found it in the welfare queens and the liberals in government who fostered them. Unfortunately, this recipe for fixing the problem didn’t work then and it won’t work this time either. In point of fact, the government might have been part of the problem in that it has blindly supported the corporate entities that have been feeding it money for the last half of the 20th century but that is like blaming the cow for giving bad milk when you feed it onions all day.
Let’s take a look at the actual numbers of what was going on in 2008 when the government publicly admitted that it was going to have to bail out the private banking concerns in this country. On September 18, 2008 Ben Bernanke (head of the Federal Reserve) and Treasury Secretary Henry Paulsen met with key Congressional legislators with the message that they needed 700 Billion dollars to avoid a financial catastrophe. This wasn’t some cry in the wilderness from a lunatic fringe; this was the head of the Federal Reserve and the head of the US Treasury telling US congressmen that they had to do something quick. In Bernanke’s words,
“If we don’t do this, we may not have an economy on Monday.”
In order to understand the magnitude of this statement it is necessary to look back a little bit. The George W. Bush administration, the Bill Clinton administration, the George H. W. Bush administration, and the Ronald Reagan administration have been in power in Washington since 1980. There is little doubt that they have been the most business friendly, corporate sponsored administrations in the history of this country. With the exception of the first term of the Clinton presidency we had seen 28 years of pro business government without respite. They have gradually dismantled or defanged every financial regulatory agency, every economic control that was put in place after the Great Depression. These agencies and laws were put in place after the Great Depression for the express reason that some very bright men took a look at what happened then and decided they needed regulations to keep from having a repeat performance. Not surprisingly, we are now getting that repeat performance and for many of the same reasons that the last collapse happened.
The George W. Bush administration was arguably the friendliest to corporate interests and de-regulation of the industry. Imagine what it took to convince a president extraordinarily concerned with his public image and how he would be viewed by history to completely reverse his field on how free markets are supposed to work in his last 4 months in office. I would like to have been a fly on the wall in the meeting when Bernanke and Paulsen proposed to him that in order to stave off total economic collapse; he was going to have to nationalize the US banking system by doing a government bailout. I wonder what it took to convince him that his whole laissez-faire approach to economics was wrong; that he was going to have to socialize the US financial system to avoid a worldwide economic collapse. Everyone seems to miss that this occurred; that a notoriously stubborn and self serving US President who had built his whole career around the idea that we need less government suddenly decided the government was the only solution. What did they actually show him in that meeting?
Let’s look at some numbers to see if the current ideas about home mortgage defaults explain the problem. In September of 2008 there were some 760,000 homes in danger of foreclosure according to data released by the US Foreclosure Market report. While this is a high number it doesn’t explain the collapse. In 2008 the average home mortgage total value was 167,000 dollars. If you multiply 760,000 by 167,000 which is the worst possible scenario because it assumes that each and every house in danger of foreclosure instantly becomes a total loss you come up with a little less than 127 billion dollars. Keep in mind that this is the worst possible case in that most home foreclosures actually result in much lower losses after all the paperwork is done and the lawyers are paid. According to most estimates I have found the highest average is quote by Freddie Mac officials as 60,000 dollars. Using this number which is actually quite a bit higher than most estimates and multiplying it by 760,000 we come up with somewhat less than 46 billion dollars. In other words, if worse came to worse and every single home that was in danger of foreclosure in September of 2008 actually occurred all at once the industry would be looking at a 45.6 billion dollar loss. Remember, this is the worst case scenario and assumes that all these homes were foreclosed upon at once. Where did the 700 Billion dollar numbers that Paulsen and Bernanke were talking about come from? Clearly, there is something else going on that we aren’t discussing on a public level and I will get back to that in a later post but for now I just wanted to point out that if the foreclosure market was the problem we could have completely solved that with a 46 billion dollar injection into the market and I heard no one in power making that suggestion.
In my next post on this subject I will begin to explore the Community Reinvestment Act and how it supposedly led to the collapse of the housing bubble.
Friday, November 5, 2010
Drill baby, Drill!
Drill baby drill! The last presidential election this was one of the mantras of the imbecilic Sarah Palin who somehow managed to get on the ballet as the Republican Vice Presidential candidate. While hardly anyone mistakes Palin for an intelligent politician with actual ideas for how to solve some of our problems as a nation she is from Alaska where some of the biggest oil reserves that the US owns exist. Unfortunately, this reserve is now past its peak production and the supply curve on the way down is pretty steep. However, Alaska as a state has done very well with oil as a source of income with Alaskan citizens receiving a rebate check from the state every year from the profits that the State sees from oil drilling. Unfortunately, the rest of the nation doesn’t get one of those checks so the idea that more oil drilling in Alaska will somehow help the rest of us requires a suspension of the fact that oil reserves there are dwindling as well.
Behind Palin’s rhetoric is a growing number of conservative talk show hosts and politicians who seem to think that we can remove our dependence on foreign oil by simply drilling enough of it here to make up for it. Similar to most cures for our ills that the far right comes up with, it makes some sense in a very simple minded way. After all, if we own oil reserves why should we be buying oil from overseas? Let’s take a look at this in a little more detail and see if it actually makes any sense.
Oil, like any other commodity, is bought and sold in the market place according to the laws of supply and demand with few exceptions. In other words, the cost of finding, harvesting, and transporting the oil to the market all combine to make up the expense required in selling it. As long as all of these costs can be met and the product is sold a little higher than these costs a profit is made. These are the basic rules of any such market and since oil is bought and sold all over the world any oil that is harvested here is in direct competition with oil that is harvested anywhere else. The US is a large producer of oil but the fact of the matter is that we passed our peak production levels in the late 1960’s for the simple reason that oil reserves are not unlimited and we had by that time depleted the amount of oil in the existing wells. It isn’t a matter of simply drilling more wells as the oil reserves themselves are depleted. In other words, the oil we have remaining is harder to find, in smaller fields, and much more expensive to get out of the ground.
In the oil industry there is a term for the costs associated with oil production. “Lifting costs” include all of the costs associated with harvesting oil. These include buying the property the oil reserve is situated underneath, the exploration costs expended locating the oil in the first place, and the actual production costs of removing the oil from its reserve. As our supplies grow smaller and smaller the exploration costs grow in the opposite direction at roughly the same rate and oil in smaller fields is less economical to harvest. Since we have depleted all the reserves that are easily removed from the ground first, we are left with oil reserves that are technically more expensive to harvest. This has been the reality for many years in this country and it is not a picture that is getting rosier as time passes. The largest reserves the US has left are in offshore deposits. Over the last 20 years the US has been forced to turn to more expensive drilling projects on the ocean floor because it is where the vast majority of our remaining oil reserves are.
The world average for lifting costs is around 25 dollars a barrel. In the largest and most available oil reserves in the world in the middle east this number drops even more; to around 14 dollars a barrel. In the US in shallow water oil drilling the price is somewhere in the neighborhood of 40 dollars a barrel depending on the field, where it is and what kind of weather and climate conditions prevail. It isn’t hard to figure out that when we are spending 40 dollars a barrel it precludes the possibility of competing with someone who is spending 14 dollars a barrel unless they are taking a very large markup due to market conditions such as a shortage. This is the position that US oil companies have been in for quite a few years now which is exactly why they are not drilling enough wells to meet our demand; they can simply buy the oil cheaper than they can harvest it. This sounds bad but the situation is actually worse than what I have covered so far. Most of the shallow water offshore reservoirs have already peaked in production; they are now on the steep downside of the supply curve. This means that we are now looking at even steeper lifting costs to tap into the remaining reserves in deeper waters. Most estimates put these numbers in the 65-75 dollar a barrel range. This is the little secret that never enters into the political discussions wherein conservatives respond to alternate energy requests by insisting that we just need to release the oil companies to tap into our reserves. It is economically unfeasible and the oil companies know it.
Let’s look at the economical reality of the situation. The only way US oil companies can invest the large amounts of capital in specialized rigs and new technology drilling equipment needed to do more deep water drilling they have to either know the oil prices are going to stay at ranges around 90-100 dollars a barrel or else they are spending money harvesting a product they can’t make a profit selling. Any time the owners of larger and therefore cheaper oil reserves to harvest decide to flood the market with this oil the US companies heavily invested in expensive technologies to harvest deep water oil will take a huge loss and oil companies are fond of profit. Since the whole thing is an economic pariah it is worth taking notice who is pushing the argument that we should simply drill more and why.
Oil companies are like any other large bureaucratic entity; they are mainly interested in their own survival. Presently, the oil companies own the distribution of the energy source our country depends on. I won’t bother to explain why cornering the market on any commodity is profitable but I will point out that US oil companies have owned the energy market in this country for much of this century and they are not anxious to give it up now. Since they own or are leasing these deep water reservoirs which they bought with the understanding that their monopoly would continue, they are not willing to see it threatened from any quarter; whether it makes economic sense or not. Every time the government starts making noises about alternate energy and subsidizing infrastructure to make such ideas feasible the oil companies see this as a direct threat to these investments. Oil company lobbyist in Washington are pushing very hard for increased government support to subsidize the costs of deep water drilling, shale oil removal projects and other economically unfeasible ideas because any other alternative is a threat to their control of energy policy in this country.
Two things are key part to the oil company’s strategy; maintaining high demand and maintaining high prices. Without the high demand they can’t maintain the high prices and without the high prices they can’t even make the argument that higher lifting costs are in any way economically feasible. It is a little amazing that such supposed supporters of free markets don’t understand the logical fallacy of the position they are in. As prices go up demand decreases; it is one of the basic laws of economics. This has happened several times in the last few years in this country. When supposed shortages raised prices so high in 2008 people cut back on their consumption which is why the prices came back down. The oil companies can’t make the argument that more expensive technologies to harvest oil make any sense whatsoever if the demand for oil starts to dip which is why they are so adamantly opposed to alternative energy of any kind; it will necessarily lessen demand.
In short, energy policy in this country like most everything else is built around money. I won’t bother to go into environmental costs associated with these more expensive harvesting methods but as we saw this last summer in the Gulf they are not minor. The people who have the money set the policy and right now that is oil companies. Never mind that the reality of the situation is that an oil based energy policy is completely unsustainable. Never mind that this is true not only in the US but all over the world as well. Demand for energy is outpacing the world’s supply of oil and all signs are that the emergence of industrialization all over the world promises to increase this demand in the next century.
We are faced with a clear cut choice in this country. We can continue to support an industry that is doomed to inevitable failure because we simply don’t own the oil that we need for energy and it is getting more expensive in every possible way to get it; or we can use our resources to get ahead of the curve and be the leader in finding an alternative.
The US has been the leader in innovation for much of this century. It is amongst our greatest strengths as a nation, both technological and intellectual innovation. We are now faced with a clear cut choice as to whether we will squander everything we have worked for maintaining an industry doomed to inevitable collapse or find a better way. Reality is knocking at the door and no matter how many oil company lobbyists funnel money into congressmen’s pockets in Washington the message it has for us about our dependence on oil will be delivered.
Behind Palin’s rhetoric is a growing number of conservative talk show hosts and politicians who seem to think that we can remove our dependence on foreign oil by simply drilling enough of it here to make up for it. Similar to most cures for our ills that the far right comes up with, it makes some sense in a very simple minded way. After all, if we own oil reserves why should we be buying oil from overseas? Let’s take a look at this in a little more detail and see if it actually makes any sense.
Oil, like any other commodity, is bought and sold in the market place according to the laws of supply and demand with few exceptions. In other words, the cost of finding, harvesting, and transporting the oil to the market all combine to make up the expense required in selling it. As long as all of these costs can be met and the product is sold a little higher than these costs a profit is made. These are the basic rules of any such market and since oil is bought and sold all over the world any oil that is harvested here is in direct competition with oil that is harvested anywhere else. The US is a large producer of oil but the fact of the matter is that we passed our peak production levels in the late 1960’s for the simple reason that oil reserves are not unlimited and we had by that time depleted the amount of oil in the existing wells. It isn’t a matter of simply drilling more wells as the oil reserves themselves are depleted. In other words, the oil we have remaining is harder to find, in smaller fields, and much more expensive to get out of the ground.
In the oil industry there is a term for the costs associated with oil production. “Lifting costs” include all of the costs associated with harvesting oil. These include buying the property the oil reserve is situated underneath, the exploration costs expended locating the oil in the first place, and the actual production costs of removing the oil from its reserve. As our supplies grow smaller and smaller the exploration costs grow in the opposite direction at roughly the same rate and oil in smaller fields is less economical to harvest. Since we have depleted all the reserves that are easily removed from the ground first, we are left with oil reserves that are technically more expensive to harvest. This has been the reality for many years in this country and it is not a picture that is getting rosier as time passes. The largest reserves the US has left are in offshore deposits. Over the last 20 years the US has been forced to turn to more expensive drilling projects on the ocean floor because it is where the vast majority of our remaining oil reserves are.
The world average for lifting costs is around 25 dollars a barrel. In the largest and most available oil reserves in the world in the middle east this number drops even more; to around 14 dollars a barrel. In the US in shallow water oil drilling the price is somewhere in the neighborhood of 40 dollars a barrel depending on the field, where it is and what kind of weather and climate conditions prevail. It isn’t hard to figure out that when we are spending 40 dollars a barrel it precludes the possibility of competing with someone who is spending 14 dollars a barrel unless they are taking a very large markup due to market conditions such as a shortage. This is the position that US oil companies have been in for quite a few years now which is exactly why they are not drilling enough wells to meet our demand; they can simply buy the oil cheaper than they can harvest it. This sounds bad but the situation is actually worse than what I have covered so far. Most of the shallow water offshore reservoirs have already peaked in production; they are now on the steep downside of the supply curve. This means that we are now looking at even steeper lifting costs to tap into the remaining reserves in deeper waters. Most estimates put these numbers in the 65-75 dollar a barrel range. This is the little secret that never enters into the political discussions wherein conservatives respond to alternate energy requests by insisting that we just need to release the oil companies to tap into our reserves. It is economically unfeasible and the oil companies know it.
Let’s look at the economical reality of the situation. The only way US oil companies can invest the large amounts of capital in specialized rigs and new technology drilling equipment needed to do more deep water drilling they have to either know the oil prices are going to stay at ranges around 90-100 dollars a barrel or else they are spending money harvesting a product they can’t make a profit selling. Any time the owners of larger and therefore cheaper oil reserves to harvest decide to flood the market with this oil the US companies heavily invested in expensive technologies to harvest deep water oil will take a huge loss and oil companies are fond of profit. Since the whole thing is an economic pariah it is worth taking notice who is pushing the argument that we should simply drill more and why.
Oil companies are like any other large bureaucratic entity; they are mainly interested in their own survival. Presently, the oil companies own the distribution of the energy source our country depends on. I won’t bother to explain why cornering the market on any commodity is profitable but I will point out that US oil companies have owned the energy market in this country for much of this century and they are not anxious to give it up now. Since they own or are leasing these deep water reservoirs which they bought with the understanding that their monopoly would continue, they are not willing to see it threatened from any quarter; whether it makes economic sense or not. Every time the government starts making noises about alternate energy and subsidizing infrastructure to make such ideas feasible the oil companies see this as a direct threat to these investments. Oil company lobbyist in Washington are pushing very hard for increased government support to subsidize the costs of deep water drilling, shale oil removal projects and other economically unfeasible ideas because any other alternative is a threat to their control of energy policy in this country.
Two things are key part to the oil company’s strategy; maintaining high demand and maintaining high prices. Without the high demand they can’t maintain the high prices and without the high prices they can’t even make the argument that higher lifting costs are in any way economically feasible. It is a little amazing that such supposed supporters of free markets don’t understand the logical fallacy of the position they are in. As prices go up demand decreases; it is one of the basic laws of economics. This has happened several times in the last few years in this country. When supposed shortages raised prices so high in 2008 people cut back on their consumption which is why the prices came back down. The oil companies can’t make the argument that more expensive technologies to harvest oil make any sense whatsoever if the demand for oil starts to dip which is why they are so adamantly opposed to alternative energy of any kind; it will necessarily lessen demand.
In short, energy policy in this country like most everything else is built around money. I won’t bother to go into environmental costs associated with these more expensive harvesting methods but as we saw this last summer in the Gulf they are not minor. The people who have the money set the policy and right now that is oil companies. Never mind that the reality of the situation is that an oil based energy policy is completely unsustainable. Never mind that this is true not only in the US but all over the world as well. Demand for energy is outpacing the world’s supply of oil and all signs are that the emergence of industrialization all over the world promises to increase this demand in the next century.
We are faced with a clear cut choice in this country. We can continue to support an industry that is doomed to inevitable failure because we simply don’t own the oil that we need for energy and it is getting more expensive in every possible way to get it; or we can use our resources to get ahead of the curve and be the leader in finding an alternative.
The US has been the leader in innovation for much of this century. It is amongst our greatest strengths as a nation, both technological and intellectual innovation. We are now faced with a clear cut choice as to whether we will squander everything we have worked for maintaining an industry doomed to inevitable collapse or find a better way. Reality is knocking at the door and no matter how many oil company lobbyists funnel money into congressmen’s pockets in Washington the message it has for us about our dependence on oil will be delivered.
Wednesday, November 3, 2010
The Energy Policy of Oil
It is always a little amazing to me to realize how little Americans understand about energy policy and how it is orchestrated in this country. The fact of the matter is that our country is in danger of becoming a third world country in terms of economic development and much of the reason for this fall can be traced to our energy policy. The rise of American power during and after WWII is closely related to the fact that we utilized and owned the most efficient energy source in the world at the time; Oil. It is worth remembering that our actual involvement in the war itself came about as a direct result of our energy policy.
In the early months of 1941 the United States was trying to steer clear of conflicts in Europe while at the same time keeping a wary eye on developments. At the same time Japan, still incensed over what it considered to be slights at the end of WWI, was steadily striving to increase its security in the Far East and the Pacific Rim. Japan had been one of the Allies during WWI but at the end of the war had initially been denied the gains that it had made in China and other areas of the Pacific Rim. When Japan threatened to walk out of talks with the Allies as they were dividing up the spoils of the war, Britain had intervened on her behalf. Still, the American contingent under Wilson was not happy with the whole scenario and steadily pressured Britain after the war to drop support for Japan as a partner. Japan saw American opposition as very threatening, more especially since Japan had earned the enmity of some powerful enemies in supporting the Allies in WWI. China and the Soviet Union were very close and very powerful in Japan’s eyes and without allied support as trading partners and suppliers of raw materials needed to keep building up their defensive powers Japan felt ever more exposed with each effort by Americans to isolate them.
Unlike the United States, Japan was wholly without the raw materials of steel and iron needed to build a navy or an army. It was also completely without the oil that it needed to keep its basic economy going without importing it from outside sources. American efforts to isolate Japan were seen by the Japanese as threats to its very existence and it reacted accordingly. As the rest of the world became enthralled with watching the exploits of Nazi Germany in Europe, Japan began expanding her borders and subsidizing her military buildup by colonizing the far east just as Western powers had done for much of the preceding century. Japan saw it not in the light of economic development but in the light of survival of their nation. As Japan began to invade Manchuria and then later China itself, the western powers became more concerned with Japanese ambitions. These concerns were sharpened further by the abject brutality of Japanese invasions which often included the wholesale slaughter of civilians.
By early 1941 relations with Japan had reached a crucial stage with Roosevelt and the American government determined to discourage further Japanese military expansion and Japan just as determined to continue what it considered to be tactics necessary for its survival as a nation. The American government decided to set up an embargo on industrial products that Japanese needed to continue their expansion. These included steel and other raw materials but even more critically, they included oil. The Japanese were dependent on foreign sources for fully 80% of their oil supply. This oil supply not only powered the Japanese military but also the whole Japanese economy. Without this critical oil supply the whole economy would collapse internally and Japan would no longer be able to feed or clothe its people.
Naturally, the Japanese reacted to this oil embargo with great alarm. They first tried to cut a deal with the American government. Japan offered to give up part of its expansion plans in return for American support of many of it conquests already achieved. With publicity of Japanese atrocities in the Pacific Rim and China getting more exposure daily these requests for compromise fell on deaf ears with the United State government insisting that all expansion activities cease as well as the return of lands the Japanese had already conquered. Facing the prospect of a total collapse and realizing that there was no compromise position that the US would agree to that would be palatable to the Japanese public the war hawks in Japan took over the government and began making plans of how to neutralize American power in the Pacific Rim until Japan could seize control of the supplies that it needed from the region.
Pearl Harbor was the almost inevitable result of this oil embargo. Japan had no delusion of being able to conquer the United States but it did believe it could cripple American power in the Pacific Rim long enough to seize control of the area and assure Japan’s access to oil and other raw materials it needed to survive. With the choice between collapse and war, Japan chose war and the United States was involuntarily dragged into the middle of WWII. With hindsight it is easy to see the chain of events that led to Japan attacking Pearl Harbor. In 1941 of course, this chain of events was much harder to see and very few people believed that events would lead to such an attack. However, it is without question that it was the Japanese need for oil that was at the core of the reasons for the attack. Japanese sources within the government at the time point this out repeatedly in their explanations for the attack. A country dependent upon foreign oil for its very survival will often be forced to make decisions that are antithetical to its basic moral views and the United States is no exception.
In 1940 the US was one of the main producers of oil in the industrial world. US oil companies operated in the world market with great freedom and the US still owned a large portion of the world’s known supply of oil. However, since that time with the exponential growth of the usage of oil for agricultural production and an industrial sector that was the envy of the rest of the world the US gradually used up its own supply of oil and began being more dependent on other sources of oil. Along with this change, smaller third world countries that had up to this point welcomed US expertise and US oil companies into partnerships to produce oil in their countries began taking over ownership of their own oil reserves. This is a pattern that repeated itself in South America, Indochina, and the Middle East with unerring accuracy.
By the late 1960’s the US found itself in the unenviable position of being the biggest consumer of oil while its own reserves were steadily being used up. By 1970 most US sources of oil were peaking in production with a sharp downside to the supply curve that spelled major economic problems for an economy completely dependent on oil for survival. While this was not unpredictable and the US had foreseen the necessity of maintaining a presence in the largest oil reserve area of the world after WWII, it soon became obvious that even minor disruptions in this supply would cause major upheavals in the US economy. The Oil Embargo of OPEC nations of the Middle East in the early seventies were a precursor to what the US government understood to be a deadly source of destruction for US economic concerns.
After WWII the Allied powers basically split up and reordered the landscape in the Middle East based upon their own individual needs for oil and the fact that this area of the world happened to be the largest known supply of the commodity. Almost all political decisions in the Middle East since that time have been based upon the underlying fact that western economies are dependent on a steady supply of these reserves of oil. The US found itself forced to deal with governments in the region that were both antithetical to our moral values and some of the worst violators of their own people that the world has ever seen. How else can one justify America’s undeniable support of regimes in Saudi Arabia, Iran, Iraq, Afghanistan, Jordan, Syria, and Egypt that were both brutal violators of basic human rights and at different times dangerous and tribal based aggressors in both internal and external wars that have consumed the area for much of the last seventy years. We have installed dictators, fomented wars, and supported brutality in the area since WWII that is as bad as has ever been seen on the planet. Even today, we lament the brutality of Saddam Hussein while forgetting that we helped put him in power to act as a buffer against radical Islamic groups in Iran. We support brutal dictatorships in Kuwait and Saudi Arabia who regularly fund terrorist organizations that mindlessly attack innocents all over the world. We rage against Iran for her own abuses while at the same time that we support governments in Jordan, Pakistan, and Egypt with equally appalling records of human right violations against their own people.
Any real accounting of the cost of this oil dependency has to include the military costs that we have expended in the region in 3 separate wars in the last 20 years. If we add the cost of these wars to the cost in dollars per gallon in oil that we import; is oil still the most efficient energy? I don’t understand why Americans would continue to insist that we have no energy alternative when faced with the real costs in military incursions and increased national security measures that became necessary after 9-11. We must remember that it was our need for oil that got us involved in the area to begin with. It is our need for oil that keeps us embroiled in political issues in the area that should be reprehensible to every American. Without oil we have no need to have a presence in Saudi Arabia, Iraq, Iran, or Afghanistan. Since we are the biggest consumer of oil in the world we have the ability to bring about the collapse of these regimes. We can easily remove their ability to afford war by simply removing ourselves from the equation. We cannot do away with demand for oil in the rest of the world but we can devastate the demand markets by simply finding other sources of energy; sources that don’t force us to support brutal dictatorships or tribal based hatreds.
All of this leads us to the place where I started this post. We are now in the same position that Japan found itself in previous to WWII. We are completely dependent on oil from foreign sources. The only difference is that we are dependent not upon the United States or Great Britain, we are dependent upon brutal regimes that we would not otherwise do business with for any amount of money. While we don’t import 80% of the oil that we use, we do import 55% of the oil that we use from outside sources. What that means of course is that we are extremely dependent on outside sources for the well being of our economy and that in itself should be enough to convince Americans that we need to find a better solution without even bringing up the fact that many of these outside sources are diametrically opposed to our moral viewpoints. There was a commercial on TV when the government was trying to drum up support for the war against terrorism that suggested that Americans buying drugs were inadvertently and indirectly supporting terrorism. A more accurate statement would be that Americans support terrorism by directly funding its sponsors every time we fill up our SUV at the gas pump.
In the early months of 1941 the United States was trying to steer clear of conflicts in Europe while at the same time keeping a wary eye on developments. At the same time Japan, still incensed over what it considered to be slights at the end of WWI, was steadily striving to increase its security in the Far East and the Pacific Rim. Japan had been one of the Allies during WWI but at the end of the war had initially been denied the gains that it had made in China and other areas of the Pacific Rim. When Japan threatened to walk out of talks with the Allies as they were dividing up the spoils of the war, Britain had intervened on her behalf. Still, the American contingent under Wilson was not happy with the whole scenario and steadily pressured Britain after the war to drop support for Japan as a partner. Japan saw American opposition as very threatening, more especially since Japan had earned the enmity of some powerful enemies in supporting the Allies in WWI. China and the Soviet Union were very close and very powerful in Japan’s eyes and without allied support as trading partners and suppliers of raw materials needed to keep building up their defensive powers Japan felt ever more exposed with each effort by Americans to isolate them.
Unlike the United States, Japan was wholly without the raw materials of steel and iron needed to build a navy or an army. It was also completely without the oil that it needed to keep its basic economy going without importing it from outside sources. American efforts to isolate Japan were seen by the Japanese as threats to its very existence and it reacted accordingly. As the rest of the world became enthralled with watching the exploits of Nazi Germany in Europe, Japan began expanding her borders and subsidizing her military buildup by colonizing the far east just as Western powers had done for much of the preceding century. Japan saw it not in the light of economic development but in the light of survival of their nation. As Japan began to invade Manchuria and then later China itself, the western powers became more concerned with Japanese ambitions. These concerns were sharpened further by the abject brutality of Japanese invasions which often included the wholesale slaughter of civilians.
By early 1941 relations with Japan had reached a crucial stage with Roosevelt and the American government determined to discourage further Japanese military expansion and Japan just as determined to continue what it considered to be tactics necessary for its survival as a nation. The American government decided to set up an embargo on industrial products that Japanese needed to continue their expansion. These included steel and other raw materials but even more critically, they included oil. The Japanese were dependent on foreign sources for fully 80% of their oil supply. This oil supply not only powered the Japanese military but also the whole Japanese economy. Without this critical oil supply the whole economy would collapse internally and Japan would no longer be able to feed or clothe its people.
Naturally, the Japanese reacted to this oil embargo with great alarm. They first tried to cut a deal with the American government. Japan offered to give up part of its expansion plans in return for American support of many of it conquests already achieved. With publicity of Japanese atrocities in the Pacific Rim and China getting more exposure daily these requests for compromise fell on deaf ears with the United State government insisting that all expansion activities cease as well as the return of lands the Japanese had already conquered. Facing the prospect of a total collapse and realizing that there was no compromise position that the US would agree to that would be palatable to the Japanese public the war hawks in Japan took over the government and began making plans of how to neutralize American power in the Pacific Rim until Japan could seize control of the supplies that it needed from the region.
Pearl Harbor was the almost inevitable result of this oil embargo. Japan had no delusion of being able to conquer the United States but it did believe it could cripple American power in the Pacific Rim long enough to seize control of the area and assure Japan’s access to oil and other raw materials it needed to survive. With the choice between collapse and war, Japan chose war and the United States was involuntarily dragged into the middle of WWII. With hindsight it is easy to see the chain of events that led to Japan attacking Pearl Harbor. In 1941 of course, this chain of events was much harder to see and very few people believed that events would lead to such an attack. However, it is without question that it was the Japanese need for oil that was at the core of the reasons for the attack. Japanese sources within the government at the time point this out repeatedly in their explanations for the attack. A country dependent upon foreign oil for its very survival will often be forced to make decisions that are antithetical to its basic moral views and the United States is no exception.
In 1940 the US was one of the main producers of oil in the industrial world. US oil companies operated in the world market with great freedom and the US still owned a large portion of the world’s known supply of oil. However, since that time with the exponential growth of the usage of oil for agricultural production and an industrial sector that was the envy of the rest of the world the US gradually used up its own supply of oil and began being more dependent on other sources of oil. Along with this change, smaller third world countries that had up to this point welcomed US expertise and US oil companies into partnerships to produce oil in their countries began taking over ownership of their own oil reserves. This is a pattern that repeated itself in South America, Indochina, and the Middle East with unerring accuracy.
By the late 1960’s the US found itself in the unenviable position of being the biggest consumer of oil while its own reserves were steadily being used up. By 1970 most US sources of oil were peaking in production with a sharp downside to the supply curve that spelled major economic problems for an economy completely dependent on oil for survival. While this was not unpredictable and the US had foreseen the necessity of maintaining a presence in the largest oil reserve area of the world after WWII, it soon became obvious that even minor disruptions in this supply would cause major upheavals in the US economy. The Oil Embargo of OPEC nations of the Middle East in the early seventies were a precursor to what the US government understood to be a deadly source of destruction for US economic concerns.
After WWII the Allied powers basically split up and reordered the landscape in the Middle East based upon their own individual needs for oil and the fact that this area of the world happened to be the largest known supply of the commodity. Almost all political decisions in the Middle East since that time have been based upon the underlying fact that western economies are dependent on a steady supply of these reserves of oil. The US found itself forced to deal with governments in the region that were both antithetical to our moral values and some of the worst violators of their own people that the world has ever seen. How else can one justify America’s undeniable support of regimes in Saudi Arabia, Iran, Iraq, Afghanistan, Jordan, Syria, and Egypt that were both brutal violators of basic human rights and at different times dangerous and tribal based aggressors in both internal and external wars that have consumed the area for much of the last seventy years. We have installed dictators, fomented wars, and supported brutality in the area since WWII that is as bad as has ever been seen on the planet. Even today, we lament the brutality of Saddam Hussein while forgetting that we helped put him in power to act as a buffer against radical Islamic groups in Iran. We support brutal dictatorships in Kuwait and Saudi Arabia who regularly fund terrorist organizations that mindlessly attack innocents all over the world. We rage against Iran for her own abuses while at the same time that we support governments in Jordan, Pakistan, and Egypt with equally appalling records of human right violations against their own people.
Any real accounting of the cost of this oil dependency has to include the military costs that we have expended in the region in 3 separate wars in the last 20 years. If we add the cost of these wars to the cost in dollars per gallon in oil that we import; is oil still the most efficient energy? I don’t understand why Americans would continue to insist that we have no energy alternative when faced with the real costs in military incursions and increased national security measures that became necessary after 9-11. We must remember that it was our need for oil that got us involved in the area to begin with. It is our need for oil that keeps us embroiled in political issues in the area that should be reprehensible to every American. Without oil we have no need to have a presence in Saudi Arabia, Iraq, Iran, or Afghanistan. Since we are the biggest consumer of oil in the world we have the ability to bring about the collapse of these regimes. We can easily remove their ability to afford war by simply removing ourselves from the equation. We cannot do away with demand for oil in the rest of the world but we can devastate the demand markets by simply finding other sources of energy; sources that don’t force us to support brutal dictatorships or tribal based hatreds.
All of this leads us to the place where I started this post. We are now in the same position that Japan found itself in previous to WWII. We are completely dependent on oil from foreign sources. The only difference is that we are dependent not upon the United States or Great Britain, we are dependent upon brutal regimes that we would not otherwise do business with for any amount of money. While we don’t import 80% of the oil that we use, we do import 55% of the oil that we use from outside sources. What that means of course is that we are extremely dependent on outside sources for the well being of our economy and that in itself should be enough to convince Americans that we need to find a better solution without even bringing up the fact that many of these outside sources are diametrically opposed to our moral viewpoints. There was a commercial on TV when the government was trying to drum up support for the war against terrorism that suggested that Americans buying drugs were inadvertently and indirectly supporting terrorism. A more accurate statement would be that Americans support terrorism by directly funding its sponsors every time we fill up our SUV at the gas pump.
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