From Bubble to Bust

Are we already in a recession?

No one knows for sure, and there won’t be official confirmation until after the fact, when several months of economic data come in and show negative economic growth.

But millions of workers and poor people in the U.S. have felt like they’ve been in an economic downturn for months, if not years. That’s because wages for the majority of the population have stagnated, once inflation is taken into account, for much of the 2000s. After finally growing by 2 percent in 2006, average weekly and hourly wages fell by 1 percent last year, according to the Bureau of Labor Statistics.

More recently, inflation in the price of food and fuel — gasoline, heating oil, etc. — has been rising, too. These price rises aren’t considered part of the so-called “core” inflation rate published by the government, so official inflation statistics don’t look as bad. But these price hikes are taking a toll on the working-class living standards.

One big warning sign of recession came in the government’s jobs report for December. While the unemployment rate is still lower than typical recession levels, the number of jobless jumped from 4.7 to 5 percent in one month, indicating a cutback in hiring by employers.

What’s more, the so-called labor-force participation rate, the percentage of working-age people who have dropped out of the job market, is well below the level of the late 1990s, before the last recession hit. And manufacturing jobs — with better pay and benefits than average — have been lost during the 2000s recovery, with 212,000 eliminated in 2007 alone.

Is the housing slump to blame for the crisis?

The crash in the housing market has been a major blow to the U.S. economy in several ways.

Most directly, there has been a big rise in unemployment in construction — the industry jobless rate was 9.4 percent in December. Sales of newly constructed homes dropped 26 percent from 2007 to 2006, the biggest decline since records started being kept in 1963.

Second, the difficulty that homeowners are having with increased payments due to adjustable-rate mortgages — or paying back loans at all — means that consumer spending is dropping.

The housing bubble created $7 trillion in wealth on paper, which was the basis for borrowing that kept consumer spending up even as wages declined and the savings rate went below zero for the first time since the Great Depression of the 1930s. Now the source for that spending is drying up.

If this were the only impact of the housing crisis, it would be bad enough for working people.

The reality, however, is that the collapse in the bubble of housing prices — mainly in the U.S., but also internationally — has badly damaged the ability of the world financial system to function effectively. The resulting “credit squeeze,” with banks unable or unwilling to lend, has in turn spooked the stock markets worldwide, causing the big losses on markets in Hong Kong, Japan, Europe, Brazil, Russia, India and elsewhere.

This financial crisis is coinciding with what mainstream economists call the “end of the business cycle”–that is, the contraction that inevitably follows a period of capitalist expansion. A credit crunch will make new investment more difficult and prolong the slump.

Why are the banks in such bad shape?

If you read the financial press about the reasons for the banks’ crisis, you’ll find a dizzying amount of jargon: SIVs, CDOs, conduits, mortgage-backed securities, credit default swaps.

But if you step back from the details, a pattern emerges. The key to the housing boom was the ability of Wall Street investment banks to buy up mortgages, chop them up into pieces based on their supposed quality, and turn them into giant bonds and other financial paper that was bought up by investors.

The supposed benefit of this arrangement is that it spread the risk of some of those mortgages going bad among many investors, while allowing people who couldn’t qualify for a mortgage in the past to buy a house.

We know now that unscrupulous mortgage brokers knowingly pushed high-interest adjustable-rate loans on low-income people because they got higher fees for doing so. The mortgages were sold off to Wall Street, which then passed them along to all kinds of investors, from East Asian central banks to teachers’ pension funds and to the banks’ own off-the-books subsidiaries.

They could do this because Wall Street ratings agencies like Moody’s and Standard & Poor’s certified that these were perfectly safe investments, and collected big fees from the banks for doing so. This okay from ratings agencies allowed the “securitization” of mortgages on a staggering scale of $7 trillion.

This was part of a much bigger practice in the financial system of trading “derivatives” — financial paper “derived” from underlying financial assets. In housing, however, the value of those underlying assets — the houses themselves — is dropping due to higher default rates on mortgages and falling house prices.

That means the value of the various mortgaged-backed securities is dropping as well, so much so that the big banks have had to write off about $110 billion in bad debt. Big banks big firms like Citigroup, Merrill Lynch and Bear Stearns have had to turn to the Saudi royal family and state-controlled sovereign wealth funds from Dubai and China for bailouts, at high rates of interest.

Bad as these numbers are, the worst is probably still to come, with bank losses expected to reach as high as $300 or $400 billion. A warning sign came recently when companies that insure bonds for Wall Street went to the brink of bankruptcy. And if bond insurance becomes more expensive and difficult to get, bonds can’t be easily bought and sold, which further disrupts the credit machinery of the system.

Lower interest rates can ease the situation for the banks, but they won’t prevent further big losses in housing-related investments. Those losses mean that banks must increase their capital reserves, which in turn means they’ll be less able or willing to make loans.

By one estimate, the banks will have $2 trillion less to lend as the result of the housing meltdown. So lower interest rates aren’t a magic bullet, not so long as the banks are unable to finance new investments needed for the economy to recover.

Then there’s the wider threat that the U.S. crisis poses to the global economy. U.S. borrowing fueled demand internationally, which stimulated China’s great industrial revolution and double-digit annual growth rates. That, in turn, boosted industrial exports from Europe to China, and increased food and commodity prices worldwide, extending the boom to Latin America.

The result by 2006-07 was the strongest period of economic growth outside the U.S. in 30 years — even as the U.S. economy slowed down. There was talk that the world economy had “uncoupled” from the U.S. But one of the reasons for the international panic on stock markets in January was a recognition that a recession in the U.S. would cause overcapacity and lower growth rates for China and other exporters.

Will the interest rate cuts by the Federal Reserve solve the crisis?

The Fed’s job is to keep banks solvent and profitable, not to help workers get through hard times.

And the Fed’s emergency interest rate cut of 0.75 percent did keep the U.S. stock market from following the rest of the world into a meltdown — at least initially. That’s because lower interest rates push investors to shift to the stock market in search of better returns on their money. Another interest rate cut is expected soon.

But lower interest rates don’t automatically prevent an economic slump. That’s the lesson from Japan, where a real estate bubble collapsed in the early 1990s. The economy was stagnant for years even though interest rates dropped to near zero, because there were still too few profitable investments to spur an expansion.

The other risk of lower interest rates is higher inflation. Also, lower rates tend to lower the value of the dollar relative to other currencies. Already, the dollar has declined 30 percent compared to other major currencies over the past five years.

While this has made U.S. exports more competitive, it hasn’t made much of dent in the huge U.S. current account deficit, the gap between what the U.S. sells and loans abroad and what it buys and borrows. In the last three years, the U.S. borrowed $2.5 trillion from abroad. This has given China and other countries huge dollar reserves and underpinned China’s rise as an economic competitor to the U.S.

U.S. policymakers often have worried that low interest rates and a weak dollar would lead foreign investors to dump their dollar-based investments and cause a currency crisis. Instead, however, foreign companies and sovereign wealth funds are taking advantage of the weak dollar to buy up U.S. assets at bargain-basement prices, a trend which diminishes U.S. capitalists’ control over their own fate.

A couple of years ago, Congress sounded the alarm about a proposed Chinese takeover of the Unocal oil company and Dubai’s attempted purchase of U.S. ports. Now, the politicians are silent, because the U.S. banks desperately need the cash.

What about the proposed economic stimulus package that the Bush White House and Democrats in Congress have agreed on?

This won’t stop a recession, either. The stimulus package is basically another Democratic Party capitulation to George W. Bush’s ideologically driven tax-cut agenda.

If passed, it package would give money to households through tax rebates — $600 for individuals, $1,200 for couples, and $300 credits per child, with low-income workers who don’t pay taxes getting $300 to $600.

While this money will be welcome to people scrambling to get by, it won’t boost consumption nearly as much as increasing funding for food stamps or extending unemployment benefits would — by putting money directly in the hands of people who need it most, and who must spend it immediately.

The tax incentives for greater business investment won’t make a difference, either, since investment, already historically low during the economic expansion, isn’t likely to pick up until market conditions improve anyway.

Finally, the proposed $150 billion package is paltry in view of what’s needed to kick-start the U.S. economy, with a gross domestic product of $13.9 trillion. What neither Bush nor the Democrats will acknowledge is that the money that could be used for economic stimulus is being spent on wars and occupations in Iraq and Afghanistan.

Author Chalmers Johnson wrote recently that combined U.S. war-related spending will top $1 trillion in 2008. Thus, the demand for money for jobs, education and health care, not war and occupation, will be politically central no matter who is elected president in November.

Lee Sustar writes for Socialist Worker. Read other articles by Lee, or visit Lee's website.