By Matthew Storey
“The liberty of a democracy is not safe if the people tolerate the growth of private power to a point where it comes stronger than their democratic state itself. That, in its essence, is fascism - ownership of government by an individual, by a group,”
“There are many ways of going forward, but only one way of standing still.”
“Rules are not necessarily sacred, principles are.”
“One thing is sure. We have to do something. We have to do the best we know how at the moment. If it doesn't turn out right, we can modify it as we go along.”
"(the problem)...is not that the system of free private enterprise for profit has failed in this generation, but that it has not yet been tried.''
Franklin D. Roosevelt (32nd President/1933-1945)
“It's a recession when your neighbor loses his job; it's a depression when you lose yours.”
Harry S Truman (33rd President/1945-1953)
Recession?
Depression?
As Harry Truman puts it, the difference is likely to come down to ones own personal situation - but technical indicators define them differently as well. The easy answer for Recessionary definition is two successive quarters of decline in Gross Domestic Product (GDP), but this is imprecise since so many variables outside of GDP impact upon society - GDP can stabilize (and has) while unemployment continues to rise (it is) and create a situation where the recession is technically 'over' at the same time that more and more citizens are feeling its sting and falling away from prosperity. Economists have responded to this reality by defining recession more broadly as lasting from the moment economic activity peaks to the time it hits bottom, but, again, this has little real world correlation, since recessionary forces begin long before they are registered in markets and job rolls and last long after those begin to recover. Depression is typically seen as a more severe (10 to 20% decline that sustains itself beyond the two quarter rule for recession) version of the same phenomena.
Definitions aside, all Americans, regardless of their personal situation, recognize a dramatically different economic reality than we've known has descended upon us.
Ten years ago, our markets were the envy of the World, our currency was robust, our National balance sheet showed a surplus for the first time in nearly three decades of deficits and America was seen as stalwart economic partner by the World. Today the market (Dow, S&P 500) is rebounding from a 50% decline, but still well off levels of two years ago, technology and entrepreneurial indicators (venture capital, NASDAQ, IPO offerings) are at levels 40% of where they were in 1999. The US Dollar, which was pegged to trade at 1.06 to the Euro, actually drove the Euro to .86 of a Dollar a decade ago, today that Euro will fetch you almost $1.50, the Yen is at record levels relative to the dollar and the international trading consortiums who have dealt in dollars since their inception are drafting new plans to shift to a basket of Yen, Yuan and Euro as the dollar underpinnings further erode behind an American balance sheet drowning in red ink. Unemployment is surging past 10%, vast armies of Americans are living on Government subsistence (Michigan, a state of 10 Million plus has 20% of its population on Government relief). 1/6th of Americans have no Health Insurance. American manufacturing, technology, agriculture are all stagnant and surviving on a mixture of government investment and legacy business, not thriving on new markets and profits.
It is a turning point.
How did we get here?
Let's take a look....
Genesis of the Crisis
In the midst of the great boom of the '90s, Markets, consumers, investors and employees were all thriving in part because of a decision to bring Technology directly to consumers and end users rather than shuffling it through DARPA (Defense Advanced Research Projects Agency), who are the guys in Government suits who show up in your middle school Math class to abduct the brainy kid with bad posture and shuffle her off to secret installations all over the world along with the other million smart kids they've nabbed.
In the '90s, the smart kids were left in the light and sold on the market and ideas and dollars flowed. Defense was still on the cutting edge, but the move towards private sector became more seamless. Clinton Administration Treasury Secretary Robert Rubin believed that high earners and business people would pay modestly higher taxes for greatly enhanced growth and that this growth was already in the system, just needing to be allowed to breathe. President Clinton invoked the word 'Digital' at every economic or educational speech and the administration was happy to work towards commoditizing commodities, meaning they viewed commodities from the demand side - wanting to maintain stability of supply and modest prices that would be used to fuel economic growth in knowledge based industries.
While these goals were met, and wildly successful, they were perceived as negative by several constituencies. In Texas and throughout the Oil Patch, the de-emphasis of Oil (a barrel of West Texas crude sold between $12-24 per barrel during the Clinton years), raw materials and extraction industries did not remove profitability from these industries - which would be destructive to industrial goals, but it DID remove windfall profit at precisely the moment huge fortunes were being amassed by Technology entrepreneurs. To a Houston Oil Man, a staunch Conservative, having coin was not sufficient to account for the indignity of seeing some snot nosed twerp getting paid for something as trifling as an idea!
As my Texas uncle told me in 1971, Texas economics hinge on three things.
1.) Price of Oil (energy)
2.) Defense Contracts (defense)
3.) Price of Cattle (agriculture)
Texas, and much of the heartland, is a net producer of raw materials, which makes its interests run towards higher prices for those materials and towards industrial utilization of them - drill for Oil, align with Saudis and Venezuelans (at least before Hugo) and get an army moving in the Middle East who will be pump - pump - pumping it up the Kazoo while stomping on some party deemed an enemy by BOTH Texas and Riyadh.
The American economy, on the other hand is a net CONSUMER, what generates profits for raw materials producers cannibalizes growth throughout American industry and dramatically reduces buying power for American consumers while destroying savings for both. Rubin sided with America, believing that the producer states would simply re-jigger their economies to take advantage of the knowledge based gold rush, sans the metal.
Meanwhile, on Wall Street, the Bull Market was perceived as very much a mixed blessing. While burgeoning markets and record trading activity are an unambiguous positive, information technology and the Internet allowed more and more investors to do their own research, trade their own accounts and drive the fee and commission based business models that had sustained profitability, ever downwards. The Rubin market was an INVESTOR market, with day traders flourishing in every small town and low-cost brokerage firms chewing away market share and profitability from the banks. When you hear Business reporters refer to the 'Market' - they mean 'The Investment Banks', in the '90s they became decoupled from that status (as is appropriate) and also faced higher taxes on their fortunes. Like the Oil men, everyone was making money but the spread between Oil/Wall Street wealth and the commoners out there working, inventing, investing was undergoing a dramatic democratizing.
Democratic change was occurring in the workplace as well. Decades removed from the 'Organization man' in the 'Grey Flannel suit' ('Mad Men', if you will), the '90s saw a new generation of geeks, nerds and self-starters move into the workplace and bring their teva sandles, high-top chucks and t-shirts with them. Shiny wing-tips with $5,000 business suits, long the uniform of elitism in business and an important bulwark for the established wealth centers of Houston and Manhattan were suddenly becoming the symbol of anachronism. Meanwhile, on the Left Coast, far from Texas or Morgan Stanley, small armies of young professionals toting laptops and cellphones made their way to Silicon Valley corporate parks - first in a Honda, later a Lexus, but always casually dressed and communally focused. And if the kid in shorts and the rock t-shirt felt his job didn't offer enough playtime or an open enough office culture, he could just pop the clutch over the next rise to a new gig with a handsome raise.
Americans read about the goings on in Silicon Valley and the culture became obsessed with the 'New Economy', but the reality was the 'New' was only happening in a fraction of the overall and the 'Old' were planning a counterattack all along. Ironically, it was the engine behind much of the new growth that would hand them their opportunity and subvert much of the positive change.
On Sand Hill Road in Menlo Park, California, an Artichoke heave from Stanford University sit a group of Venture Capital firms whose early investments in companies like NetScape, Sun, Yahoo generated vast fortunes, added to fortunes built upon earlier generations of Silicon Valley winners (Intel, Apple, Silicon Graphics) and validated the Venture Capital math, which essentially worked like this:
*Hire Technology minds and put them next to financial minds.
*Send them in teams amongst smart kids with ideas.
*Seed the best of these ideas with stages of capital investment, while retaining huge percentages of Equity.
*Sort through the winners and losers, cutting off the flow on dead ends and accelerating the progress of triumphs.
*Remove the impediments to progress of the successes by supplying senior management, accounting, legal, manufacturing and marketing through three types of consortiums modeled on '80s Japan:
Types of Keiretsu:
Kigyō shūdan (企業集団): horizontally diversified business groups
Seisan keiretsu (生産系列): vertical manufacturing networks
Ryūtsū keiretsu (流通系列): vertical distribution networks
A continent away from Wall Street, this model was wresting control of business finance towards the West, empowering a generation of Engineering minds and it was WORKING. America was reaping the benefits of this tension between coasts and between old and new manner of business, the Nations coffers were filling up from tax revenue and nobody was barking because everyone was making money.
But Wall Street always makes money, and bypassed industrial giants began to see that their vast resources could be used to buy up what they could not create. Sand Hill Road, who understood the process best of all subverted their own model out of greed and competitive zeal. Instead of seeding a bevy of companies, waiting patiently to see which ones held promise and nurturing them through the stages necessary to becoming first a going concern and THEN a Public Company, through an IPO (Initial Public Offering) - which is the PAYDAY for the venture capitalist, the investment banking firm handling the transaction and the company founders/employees...the firms saw a ravenous market for new companies and decided to eliminate the staging of the process, believing, correctly, that hungry investors and hungrier East Coast investment bankers would drive up the price of anything they got their hands upon. Whereas earlier offerings were legitimate companies with breakthrough products, the new waves amounted to little more than a marketing effort - patch on a logo, a catchy slogan, some theme music and make some commercials...Engineers built a culture of entitlement in record time to match the ones they were seeking to overthrow. The 'Old Boy Network' became the 'New Boy Network', and then the two networks decided their interests overlapped.
Piles of worthless new stock flooded Wall Street, Sand Hill Road cashed in and sought to propagate the scam for as long as possible. Meanwhile, investors, who had read of the miraculous growth of earlier stage, well tended companies flocked to pour their hard earned into the new paper mache, Earnings never arose because most of these companies had no rationale for being publicly traded companies other than a desire by their founders to get paid, get out, and repeat the process...
It was the death of the boom.
The aggrieved industrials pounced on the cash poor companies left in the wake of the sell-off and the 'New Economy' became a wholly owned subsidiary of the Old one. Innovation left and marketing ruled, the Win-Tel (Microsoft - Intel) cartel swept up the remnants of the best and brightest, tightened the reins on pay packages and lifestyle accommodations and the passed over Houston oil man and Wall Street behemoths planned their return to an exalted perch atop the American economy where they could bleed off dollars and get fatter...but they needed a champion.
Enter George W. Bush, son of the President who Clinton took over from, who had done his best to funnel massive public resources towards Bankers, Energy concerns and Defense contractors during his single term with a nifty war on those pesky Iraqis, a super keen bailout of the Savings and Loans who'd stolen everything they could before failing and a nice, stagnant economy for everyone else, which allowed the exalted status quo to thrive.
Dubya had all of his Father's leanings, but was disdainful of concern for the larger economy, being a Midland, Texas kid who saw the world through the lens my Uncle provided all those decades ago. He got elected despite losing by half a million votes and continued to make war on math, and logic. He declared an interest in generating job growth in 'Energy', hired a commodity guy, Paul O'Neill, CEO of Alcoa (Aluminum) as Treasury Secretary and a Oil/Defense guy, Dick Cheney, CEO of Halliburton as Vice President, while his buddy Ken Lay and the boys at Houston based 'Enron' were deep into scamming the previously haughty state of California out of their cash for bogus energy contracts. Bush got elected in the Heartland and his concerns were theirs.
Knowledge was out, extraction was in.
War, of course, was next on the menu to complete the trifecta.
The next time he uses the word 'Digital' will be the first.
Shifting the largest economy in the World 180 degrees is like turning an Oil Tanker in a bathtub. Grinding on top of the tech selloff was bound to lead to recession, but 9/11 offered political cover to complete the plan.
California made money in the '90s while Texas suffered, and they flipped roles in the '00s. New York gets theirs no matter who is calling the tune.
All of that made the following a foregone conclusion.
On August 8, 2007, more than 70 years after FDR and The New Deal, interbank lending spreads became prohibitively wide as individual banks assessed their internal risk exposure and surmised they were in a heap of trouble if things were allowed to go 'too far'.
For the previous half decade, the golden goose of an economic boomlet built had been built upon;
* Laissez faire regulation of institutional Market players, such as Banks, Investment Banks, Insurance Companies, Multi-National Corporations(which Webster's defines as 'a doctrine opposing governmental interference in economic affairs beyond the minimum necessary for the maintenance of peace and property rights'). This was a system favored by Calvin Coolidge (30th President/1923-1929) ('the business of America is business') and continued, with disastrous results, by his successor, Herbert Hoover (31st President/1929-1933).
It was FDR who came in to clean up their mess in 1933.
It was the Bush White House who resurrected Coolidge's approaches to the economy in 2001.
* An emphasis upon Structured Finance 'products' in OTC (Over The Counter) Derivatives (Financial instrument that derives from another financial instrument). Derivatives are regulated when traded on an Exchange, with clearly defined parameters and available to any willing participant. OTC Derivatives, however, are customized to hedge risk and leverage profit on a case by case basis and traded between market principals themselves, each party choosing to price them according to their own internal standards. These products, by themselves, are not a problem, and are traditionally utilized in underlying asset classes that are regulated and well understood by all parties, there are four principal asset classes typically underlying derivatives:
Equities
Commodities
Interest Rates
Currencies
But, in the Bush years, Banks pushed hard for more liquidity in the OTC markets, where profit (and compensation) would not be restricted by the supply/demand realities of actual asset classes. They looked towards Credit/Debt Markets and found deep oceans of cash that could be bundled into loosely defined instruments and traded amongst market players, with each participant adding a 'market multiple' on their balance sheet, despite the fact the underlying instruments had defined terms and profit particulars.
A mortgage (or any debt instrument - even a 'adjustable rate') has a defined amount of interest income associated with the instrument (variable within interest rate movements for adjustable, but still able to be calculated within historical parameters and finite for a 'fixed' rate mortgage).
When a stock is issued, it can be traded in regulated markets for whatever price can be agreed upon between buyer and seller. The stock has a price which is defined by its market multiple, meaning price of the traded security can be a multiple of the underlying companies intrinsic earnings or 'book value'. Buyer and seller have access to the information relating to earnings and book value and can determine for themselves what multiple they are willing to accept for the stock.
The purchaser of a stock selling at a P/E (price divided by earnings = multiple);
Ex: XYZ Corporation has earnings of $1 per share and the stock is trading at $15, that is a P/E of 15 times earnings.
...is willing to pay a multiple because he/she believes the earnings will go UP, which will increase the price of the stock if the market continues to assess a multiple of 15 and the market may also note these increased earnings and assess an even higher multiple, which means the stock has no finite upside limit. Many stocks DO trade without earnings or underlying 'book value', as well, but in all cases, the corporation is a going concern that operates a business, it CAN and often does, generate profits that justify the speculation, and in all cases, the limit of risk exposure is built into the share price (if you pay $5 for a share and the company goes belly up, you are out $5).
A Fund is a bundle of stocks, most of which trades at a multiple of its underlying value, which can contract or expand depending upon market sentiment, but the avenue for increased prices (profit) EXISTS and is well understood.
A CDO or MBS is a bundle of mortgages or debt instruments for which the underlying instruments have a FINITE level of income/profit within tight parameters of interest rate movements. Every time these instruments are sold at a higher price, the purchaser is applying equity-like expectations where they do NOT apply. The mortgage will not earn a dime more than as written, bundling has no impact upon this. The multiple, applied and agreed to between unregulated parties who price it on their balance sheets according to their private determinations of ability to resell the instrument at an even higher multiple has no underlying basis in reality. Add in the fact that the underlying economy was experiencing contractions in employment and compensation, which impacts upon the ability of debtors to make payments and increases the possibility of default.
So you have a finite instrument, multiplied, sold and resold with phantom assumptions and then massive defaults against even the initial finite profit potential of the instrument.
Gee, what could go wrong?
*Real estate gains built upon loose credit, low interest rates and those structured finance products (MBS - Mortgage Backed Securities, CDO - Collateralized Debt Obligations). In this construction, the Federal Reserve, concerned about the collapse of the Technology driven Equity markets in 2000 and the 9/11 attacks of 2001 and prompted by an administration seeking to move away from Technology and knowledge based industry towards a commodity/real estate driven economy, lowered Interest Rates (which is known as 'accommodative'). Realtors were flooded with new brokers (many of whom had made money as stock brokers in the previous decade) who were anxious to cash in on what President Bush called 'an ownership society'. With low interest rates and easy loans for developers leading to increased supply, brokers could push mortgages and with lower regulation and oversight, these mortgages could be extended to lower credit worthy customers and, since the mortgages were then bundled and sold off to investment banks as MBS - you had a Ponzi Scheme to make Bernie Madoff look like a piker!
Inevitably, Banks who built balance sheets on whispy fantasies while draining off the actual C-A-S-H in compensation, threw up their arms in dismay and asked their buds in the White House for a patriotic salvage.
Bear Stearns, Lehman, AIG...you know the rest.
How did it start? You've just read how, the same way it always has. Capitalists have no conception of how much is 'too much' and that is why Government regulates business and re-distributes the gain, to keep the wheels of society properly greased. Since Teddy Roosevelt took on the Gilded Age Robber Barons, the entrenched wealth has bickered and blustered about this arrangement, but John D. Rockefeller, the Wealthiest American of his time, Bill Gates and Warren Buffett, the richie-riches of OUR time all understood that for them to continue flourishing they would have to SPEND their gains and inject capital back into the system - through foundations dedicated to progress, through taxes on property and holdings and through inheritance taxes. It is not the the having of wealth that makes one seek to chisel out, many of the wealthiest are eager to contribute - they understand the model American economics depends upon. It is those with feudal designs on America who are the scourge, the ones who FDR rightly condemned for subverting 'free' enterprise with nefarious constructs greased with mythologizing so intrusive that poor people who lack health insurance, cash, jobs or a future parade around spouting feudal slogans that only serve to further denigrate their OWN lives at the nourishment of those who mean them the most harm.
America's economy, culture and political discourse are broken. We cannot begin to fix that until we restore accountability for the events we have discussed here and create a path that rewards innovation, retires stagnancy and holds back resources for the next wave, the next generation, the next ideas.
Next week, we will discuss how that can work...we know how we got INTO Recession, now we have to discover how we get OUT.
