The Bubble Economy

[marmar]

from The American Prospect:


The Bubble Economy

The financial meltdown is the logical consequence of deregulation. Will we reverse field in time to prevent another 1929?

Robert Kuttner | September 24, 2007



We have all been here before. -- Crosby, Stills, Nash, and Young


The federal reserve is still struggling to contain what is already the most severe credit contraction since the Great Depression. Yet in all of the press coverage, commentators have scarcely acknowledged that this old-fashioned panic is a child of deregulation. During the past decade, the financial economy has repeated the excesses of the 1920s -- too much borrowing to underwrite too many speculative bets with other people's money, too far beyond the reach of regulators, setting up the entire economy for a crash.

The sub-prime mess, the huge risks taken by hedge funds, and the conflicts of interest that led to Enron and kindred scandals, are all the consequences of serial bouts of financial deregulation. Since the 1970s, in the name of free-market efficiency, Congress and presidents of both parties repealed key protections put in place by the New Deal. But the main effect has been to engineer windfall profits for financial insiders, replace real productive innovation with financial engineering, shift wealth from families to corporations, and put the entire American economy at ever greater risk.

As a result, the economy has increasingly come to depend on asset bubbles -- overvalued stocks, overpriced real estate, and dubious financial instruments like derivatives. The bubbles have been pumped up by speculative borrowing. The borrowing feeds on itself, as it did in the 1920s, since an inflated asset is handy collateral for still more borrowing. Alarmingly, these bubbles turn out to be interconnected -- hedge-fund profits reliant on high-yield sub-prime mortgages, and a soaring stock market bid up by risky private equity deals -- so if the air goes out of one bubble, it goes out of others. That's why the crisis is so hard to manage, even by a very aggressive Federal Reserve.

Supposedly, we can't have depressions anymore, for three reasons. First, the Fed has gotten far more sophisticated about containing financial panics. In recent weeks, the Fed's and the world's other central banks have poured hundreds of billions of dollars into credit markets so that risk-averse banks keep lending against shaky collateral. This in turn keeps the price of that collateral -- bonds, stocks, real estate -- from sinking still farther in a 1929-style meltdown. However, once a bubble bursts, low interest rates can't necessarily revive it; the Fed can cheapen money, but it can't make anxious creditors put it at risk.

The other story we all learn in Economics 101 is that ever since Franklin D. Roosevelt, the volatility of a market economy has been steadied both by regulations and by the ballast of "automatic stabilizers" -- unemployment insurance, public spending, Social Security, and so on. Meanwhile, the regulation contains financial bubbles before they start. But both the regulations and the automatic stabilizers have been seriously weakened, leaving only the Fed, to whose limitations we will return shortly.

Meanwhile, back in the real economy, most people are working longer hours for flat or declining incomes. Since 2000, productivity is up 19 percent, but median earnings are down. Ordinary people, and the larger economy, have come to depend on inflated prices of both real estate and stocks and on increasing debts against those assets as a substitute for rising incomes. Household savings rates are currently negative, meaning that new debt exceeds new savings. Home equity as a percentage of the value of the house is at a record low as people borrow against their homes for living expenses, while credit-card and tuition debt are at record highs. In short, the increasing financial insecurity and inequality for ordinary people, and the increasing risk of collapse now afflicting financial markets, are two sides of the same coin. And that coin is the willful dismantling of managed capitalism. .....(more)

The complete piece is at: http://www.prospect.org/cs/articles?article=the_bubble_economy

[Igel]

1. I assume that there's little alternative to bubbles.

Why?

Retirement savings. Baby boomers will be starting to retire in the next few months. The number of people dumping money into pensions and retirement funds will continue to increase for a while. They all want decent returns. I think of it as investment inflation: Too many dollars chasing too few goods.

Question is, Where do you get decent returns when investment funds are probably at an all-time high? Land? Great, $20 billion chasing what used to be worth $5 billion. Stocks? Bonds?

Government securities?

Overseas investments?

Or do you tell people that, well, they were counting on 6% interest over the next 20 years, but instead they'll ge 2% and should be happy with it?