Cuba Gooding Jr. became an overnight sensation when his character, pro football player Rod Tidwell, pithily directed his high-minded but needy agent Jerry Macguire, played by Tom Cruise, to “Show me the money!” Tidwell’s terse directive is as practical as it is memorable and luckily for Tidwell, Macguire delivers.
Whether out of extraordinary resolve or sheer desperation, a “show me the money” policy is exactly the course Fed Chair Ben Bernancke is pursuing at full throttle. Faced with the unenviable task of reflating a deflating and uncooperative economy, the Fed opted last fall to take the “easy money” quotient a notch higher by formally initiating a second round of quantitative easing, while tacitly acknowledging the possibility of QE3, QE4, and so on into the undefined future. With Fed Fund rates effectively at or very near zero and a trillion dollars already in reserves, the Fed is in other words doing all it can to get the “credit-as-money” spigot flowing.
While hardly a ringing endorsement of the Fed, the truth is that the Fed has few other “money spigot” tools at its disposal.1 So it was that – in an op-ed appearing in the November 4 issue of the Washington Post – the beleaguered Bernancke reminded the nation that the Fed cannot, by itself, solve all the problems rippling through the American economy. That process said Bernancke “will take time and the combined effort of many parties including the central bank, Congress, the administration, regulators and the private sector.”
Although the Fed for its part has shown unusual resolve to go the distance, the stimulative activities of the private sector – disconcertingly led as they are by a handful of big banks – are mostly focused on overseas “opportunities” in the emerging markets and not stimulative activities here at home. This combination of “cheap” dollars and cheap emerging market prices has of course enabled the financial sector to do quite well, despite increased risk. Meanwhile even those regulators not previously captured by special interests find themselves increasingly hobbled by a complex matrix of old, new and proposed regulations interlaced with a variety of deregulation schemes which together dilute the likelihood of effective action – and maintains the regulatory environment for “rogue Wall Street firms to kill small American businesses for profit.”
That leaves Congress and the administration. While both are also arguably captured by special interests, they are clearly feeling the intense pressure of a cash-strapped public. Hence the recent tax-cut bill which will add nearly a trillion dollars to the federal debt but do little to stimulate adequate money (as credit) creation where it is needed most – not in the financial economy headquartered on Wall Street but in the real economy, here on Main Street. Now caught between the proverbial rock and a hard place, the Fed, by its own admission and despite its high minded goals, appears every bit as needy as the erstwhile Jerry Macguire.
Main Street’s Woes Belie Wall Street’s Gains
For the moment, the Fed’s “easy money” goal of raising asset prices seems to be working, albeit not necessarily in sectors – such as real estate – where it would do the home economy the most good. Capitalizing on stockpiles of cash, good credit and “cheap money” secured by uber-low interest loans and back-stopped by TARP, the big banks and large corporations – together with a small army of investment funds – have been having a field day speculating in potentially lucrative but nevertheless risky ventures, inflating as they go various commodity prices such as wheat, corn, hogs and similar commoditized foods, as well as health care, precious metals and oil – and raising the possibility of igniting dangerous currency wars through revved up currency speculation.
Surging prices for necessities such as food, oil, and health care send mixed signals to ordinary Americans because inflation in the U.S. economy (after stripping out volatile food and energy prices) is actually at the lowest level it has been since 1957. Clear evidence of this phenomenon appears in the retail sector where for months retailers have been slashing prices on a seemingly endless supply of goods. While bargain hunters and incurable sentimentalists appear to have responded for the holidays at least, one has to wonder how the slimmest of profit margins can sustain not only retailers but their suppliers – and in turn, the myriad of producers and raw materials providers needed for finished goods, even if these are sourced from cheap-labor countries.
Ominously, job growth (with the exception of part-time jobs) is also going mostly nowhere, a fact which – however contra-indicative of an apparent holiday spending spree – does nothing to reverse the troublesome downward spiral in prices and wages. Consensus also has it that higher-than-normal unemployment will be with us for years to come. All of which affirms Bernancke’s preoccupation with stagflation and deflation – and bodes poorly for the Main Street economy inasmuch as “falling prices often also mean falling wages, as businesses respond to declines by cutting output and jobs.”
Wall Street gains make it clear that the banks and investor class are doing very, VERY well, thank you very much. Another portion of the population, perhaps as much as a third overall, is doing reasonably well – or at least well enough to keep up appearances. We have in other words, two Americas which, if understood, helps us make sense of conflicting economic data. The top 20% of Americans are prospering and spending handsomely despite carrying the major share of the tax burden, while the next 20% represents a fragile middle class that has become “mostly a figment of nostalgia and/or political illusion.” In real terms, the bulk of Main Street, including drop-off portions of the shrinking middle class, is bleeding profusely with one of every six Americans unemployed and countless more chronically “underemployed.”
Unfortunately for those most severely affected, the level of suffering is masked by the fact that there are “wide variations of hardship in the 50 largest metropolitan areas” – and official estimates do not always paint accurate pictures. As but one example, Detroit’s mayor and local leaders maintain that Detroit’s unemployment rate actually hovers near 50%, a figure far above official estimates of 30%.
Contributing to the probability of an increase in Main Street woes is the likelihood of a second dip in the housing recession – meaning home prices have yet to hit bottom. This translates into progressively fewer Americans who will be able to tap into home equity as a means of getting themselves through tough times – and it could bring about another tsunami of foreclosures. In turn, local real estate and other tax revenues will continue to decline even as demand for social services increases. This spells additional trouble for state and local governments, with states themselves collectively facing a $140 billion dollar operating budget shortfall next year alone.
Big Trouble Ahead for State and Local Budgets?
Indeed, state and local operational budgetary problems are becoming serious enough to threaten the inviolability of once “super safe” municipal bonds – which heretofore have been considered an attractive investment that comes with the added benefit of providing state and local government with funds for community improvements. Because bonds are essentially loans which the issuer (be it corporate or governmental entity) must pay back with interest, income streams of the issuer must be adequate enough to satisfy the terms of the loan. Unfortunately, low tax revenues and weak economic outlook are now compromising the bond issuer’s (borrower’s) ability to meet the terms of the loan – so much so that municipal bond defaults have been running triple the usual rate.
Economic forecasts that are tepid at best lead anaylsts to “fear that at some point, investors could balk at lending to the weakest states, setting off a crisis that could spread to the stronger ones.” Big name financial analysts such as Meridith Whitney and bond experts such as Marilyn Cohen go so far as to pose the possibility of widespread muni bond defaults.
While not everyone believes state and local budget problems are severe enough to create a ripple effect of bankruptcies, it is nevertheless unsettling to recall that the Great Depression actually began – and was prolonged – as various municipalities, mostly in the South and Midwest, began cutting services and defaulting on bond debt. A re-play of the Great Depression notwithstanding, the one thing most agree on is that states and communities with high levels of debt and poor revenue prospects will at the very least see the cost of borrowing head skyward, as investors head for cover.
Compounding muni market fears is the fact that, while investors of muni bonds may at one time have been lucky enough to have ended up with the equivalent of a piece of Central Park in satisfaction of debt defaults, today many such investors may not fair so well. This is in part because the states themselves are ill-prepared to help themselves much less troubled municipalities, and in part because, in the words of SEC Commissioner Elisse Walter, “investors in municipal securities [have become] in many ways ‘second-class citizens’ who [do] not receive the protections customary in many other sectors of the U.S. capital markets.”
Although states themselves cannot declare bankruptcy and typically look to other ways to satisfy their debt obligations including recasting pension contracts, increasing taxes and slashing programs, they can, at their discretion, help municipalities in trouble. States are, however, much less likely to provide such help when they themselves are in financial trouble. So what happens when a state refuses to rescue a troubled municipality? The municipality can potentially be forced into bankruptcy, leaving bond holders holding the bag.
As fiscal pressures have mounted, states seem to be turning to unorthodox methods in order to remain operational. This is verified by new evidence – emerging as a result of SEC investigations of New Jersey, Florida, California and elsewhere – which suggests that many states may be papering over their fiscal troubles by providing fraudulent information about their finances to muni bond investors. The states do this in a variety of ways, including keeping liabilities under wrap through delayed filings or by burying them in opaque documents. They also may resort to deferring payments of obligations and re-characterizing bond debt as revenues.
In the case of Illinois, for example, heavy borrowing and a history of deferring bill payments has led three major credit-rating agencies to rank Illinois as one of the two riskiest states for bond investors, California being the other. In his final quarterly report, published January 7 (2011), former Illinois Comptroller Dan Hynes warned that “the state could face $7 billion to $10 billion in unpaid bills by the end of the current fiscal year… Any use of bonds to deal with the state’s fiscal condition will continue to impact the state’s cash management practices in the future, as the state must adjust to those higher debt service obligations.”
Despite such warnings, “Illinois plans to borrow more than $3 billion to pay the bills for FY2011 and in June 2010, the legislature permitted the university systems to borrow millions more to make up for the fact that the state has not made the payments it had promised them.” In other words, Illinois is not only borrowing more to pay its own bills (by floating bonds) but it also has begun allowing other entities within its purview the new privilege of borrowing as a means of helping that entity to meet the state’s portion of obligations to it. This according to the non-profit Sunshine Review, which is a collaborative research organization dedicated to state and local government transparency.
The Sunshine Review further reports that: “As of the end of August 2010, Illinois had borrowed $9.6 billion in the prior 12 months.” For Illinois residents this means that as much as $551.3 million extra will have to be shelled out for the state’s borrowing over the last year alone. In addition, “more than half the state’s additional borrowing costs, amounting to approximately $301.2 million, will come due in the next five years.” And adding still more salt to taxpayer wounds, “the cost of insuring five-year Illinois bonds to protect $10 million of debt against default in June 2010 rose to $370,000, a record, from a low of $155,000 in January, 2010. The price fell back to $281,000 at the end of July 2010.”
In addition to the myriad problems associated with borrowing to pay obligations (about which we have only touched upon here), there is another problem connected to the budgetary process – and it lies in current accounting practices which rely on the cash basis method (also referred to as modified accrual basis). This according to the Institute for Truth in Accounting, a professional group of financial and public policy experts dedicated to reform of the GAAP accounting practices now used under the Comprehensive Annual Financial Reports (or CAFRs). For example, “the state of Illinois routinely delays Medicaid payments to healthcare providers. Each year the budget appears balanced on a cash basis even though the state does not provide sufficient funding for the Medicaid program.”
While arguing that “objectively better” accounting systems are universally employed in the private sector, the IFTA said that its research found that the current accounting system “does not give all stakeholders an accurate diagnosis of the financial health of state governments because the accounting principles recommended are biased towards the interests of government officials. The current structure and funding mechanism of the GASB make it difficult for members of this board to not be influenced by constituency groups that represent governmental officials and their staff.”
Thus, says former SEC Chairman Arthur Levitt, “At the core of the [muni] problem are questions about how governments manage pension funds, what investors know, and when they know it. The case against New Jersey revealed that the state has made unfunded pension fund promises to its employees, and compounded the problem by not being forthright with bond investors.”
In ideal circumstances, pension funds are supposed to keep up with benefit promises through a combination of employer and worker contributions, together with market returns from a fund’s investment portfolio. But, says Levitt, those revenue streams have slowed to a trickle as states have cut back on their own contributions, employees have contributed too little, and hoped-for investment gains have shriveled up. If investors discover that the muni market has instead become a way to paper over irresponsible promises, they will flee it, and that could spell disaster.
Investor anxiety has become significant enough that “some analysts have suggested that the Fed could ease muni market worries by purchasing muni debt or lending to struggling borrowers.” But on January 7, Fed Chair Ben Bernancke nixed the idea on legal, political, and practical grounds, saying “that if municipal defaults did become a problem, it would be in Congress’s hands, not his.”
But assuming that Congress will bail out any state in terminal trouble is itself a very risky gamble. Why? Because “[a]nything that the feds do for one state they’d have to do for others, which would turn into a bottomless and politicized spending pit.” With balance sheet problems of its own to contend with, the federal government is hardly in a position to bail out a string of troubled states, this fact being reinforced by growing taxpayer objections.
All of which brings us back to the unchartered waters of quantitative easing. Will QE2 and beyond be able to provide the kind of economic relief so desperately needed by Main Street? This is likely to remain an open question for some time to come because the money spigot used by the Fed can only create money as bank credit – and credit becomes far more expensive, indeed sometimes altogether unobtainable, for those in financial distress. Which of course translates to a “tight” money (as credit) supply – right where it is needed most, here on Main Street.
Should QE2 (or maybe 3 or 4) somehow ultimately work well enough to satisfy squeaky wheels, there’s still that pesky question forever lurking in the background: Can we REALLY keep borrowing our way into prosperity – or is there a better way? 2,3
- While Fed tools may be limited, its options within that framework of tools are less so. In this video presentation prepared for the American Monetary Institute, ex-marine and long time AMI board member Dick Distelhorst explains that the Fed actually has the ability to issue “money,” based on reserves, directly to the American people instead of to the banks as it has been doing, thereby bailing out the people instead of the banks. While this interesting option would still be based on debt (that is to say, creating money at interest based on bonds held in reserves), it does nevertheless raise the important question as to why the Fed chose to support the errant banks instead of the people who are forced to pay for the bailout. Answers to that question may potentially be found in 13 Bankers by Simon Johnson and James Kwak and similar books along with articles such as this, this, and this. But particularly for the purposes of this article, the present author has charitably conjectured that the Fed unwittingly over-looked this option in favor of fractional reserve monetary (that is, credit/debt) expansion – which of course can only be done by the banks, but which could potentially get more money (as credit) into the system. [↩]
- Monetary expert Will Abrams explains Canada’s experience under two types of monetary systems, one built on debt – the other on the creative and consumptive activities of the people. [↩]
- For an abbreviated, step-by-step explanation of our current monetary system see “Money Owed and Owned.” Or see this more technical description. [↩]