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Mike Whitney

Has Bernanke Pulled the Economy Back From the Brink?


by Mike Whitney

12 May 2009

Fed chief Ben Bernanke’s understanding of financial crises may have kept the country from sliding into another Great Depression. That doesn’t mean that he’s fixed the credit system, removed the non-performing loans from the banks, or stopped housing prices from crashing. It simply means that pumping liquidity into the system — via huge increases in the money supply, zero-percent interest rates, and multi-trillion dollar lending facilities — has either slowed or reversed the rate of decline in many sectors of the economy. Monetary stimulus works. Manufacturing, industrial output, world trade and global stock markets had all been falling faster than during the Great Depression. Bernanke changed that. His aggressive monetary policy helped to stabilize the financial system and pull the economy back from the brink.

In April, retail sales rose slightly as did consumer spending. The service industries contracted less than expected and manufacturing (ISM) showed modest gains. There are also signs that housing prices are flattening out although future price declines are still expected to be somewhere in the range of 10 to 20 per cent. (Housing prices have already slipped 29 per cent since their peak in 2006) The underlying problems in the economy have not been fixed, but green shoots are popping up

Wall Street has taken these first signs of recovery and turned them into an impressive 8 week rally. The S&P 500 has soared 35 per cent in the last two months while the Dow is up nearly 30 per cent. Traders have shrugged off grim earnings reports and myriad other distress signals and joined in the festivities. On CNBC, the financial channel, they’re calling it the TARP Rally. The $700 billion bank bailout bill is now credited with lifting the market out of the doldrums and sending stocks higher. It should be renamed the "Bernanke Rally”; without the Fed chief’s quantitative easing and toxic asset lending programs the Dow would be languishing in the 6,000 range.

On the topic of the the bank stress test results, Bloomberg reports:

"The Federal Reserve determined that 10 U.S. banks need to raise a total of $74.6 billion in capital, a finding that Chairman Ben Bernanke said should reassure investors about the soundness of the financial system.

“The results showed that losses at the banks under ‘more adverse’ economic conditions than most economists anticipate could total $599.2 billion over two years. Mortgage losses present the biggest part of the risk, at $185.5 billion. Trading accounts were the second-largest vulnerability, with potential losses of $99.3 billion.

"Regulators have determined that Bank of America Corp. requires about $34 billion in new capital, the largest need among the 19 biggest U.S. banks subjected to stress tests, said a person with knowledge of the matter. Bank of America fell 9 percent in trading before U.S. exchanges opened.

“Citigroup’s requirement for deeper reserves to offset potential losses over the coming two years is about $5 billion, people with knowledge of that bank’s results said. Wells Fargo requires about $15 billion, while GMAC’s need is $11.5 billion, one person said.”

The stress tests are a public relations ploy designed to build confidence in the banking system and to fend off demands that insolvent banks be taken into conservatorship by the government. The market will decide whether Geithner’s tests are credible or not; the jury is still out. Initial results indicate significantly smaller losses than estimates by the IMF and the vast number of economists. So, who is right; Geithner or the IMF?

If Geithner is right—and the banks are in such great shape — then why is the taxpayer being asked to provide up to $2 trillion through the Term Asset-backed Securities Loan Facility (TALF) and the Public Private Investment Partnership (PPIP) to purchase the banks garbage assets?

Regardless of the stress tests, the banking system is underwater and the problems are not going away. The Treasury has given the failing banks 6 months to submit a plan of action for addressing their capital needs. It’s a "win-win" situation for the banksters who believe that the recession will be over by then and their mortgage-backed securities will have regained much of their lost value. It’s a pipe-dream. More likely, unemployment and foreclosures will continue to rise through 2010, putting greater pressure on banks balance sheets and forcing government intervention. The only alternative is raising capital from private lenders, but that will be a daunting task. The Saudis and China are no longer investing in failing US financial institutions. The capital faucet has been turned off. Obama will have to go to Congress for another multi-billion dollar bailout.

According to author F. William Engdahl:

"Five US banks, according to data in the just-released Federal Office of Comptroller of the Currency’s Quarterly Report on Bank Trading and Derivatives Activity, hold 96 per cent of all US Bank derivatives positions in terms of nominal values, and an eye-popping 81 per cent of the total net credit risk exposure in event of default.

“The top three are, in declining order of importance: JPMorgan Chase, which holds a staggering $88 trillion in derivatives; Bank of America with $38 trillion, and Citibank with $32 trillion. Number four in the derivatives sweepstakes is Goldman Sachs, with a mere $30 trillion in derivatives; number five, the merged Wells Fargo-Wachovia Bank, drops dramatically in size to $5 trillion. Number six, Britain’s HSBC Bank USA, has $3.7 trillion." (Geithner’s Dirty Little Secret, F. William Engdahl, Asia Times)

The derivatives meltdown could have been avoided if Glass Steagall had not been repealed. Instead, the biggest banks have become the most reckless speculators creating trillions of dollars in poison assets which will eventually be dumped the taxpayer. Even worse, the banks have used their political influence to transform the FDIC (the agency which guarantees bank deposits) into the primary funding-mechanism for the purchase of toxic assets through the Treasury’s Public Private Investment Program (PPIP) Bernanke helped Geithner launch the PPIP and was part of the Greenspan-led deregulatory movement which created the very problems he’s now trying to resolve. Neither Bernanke nor Geithner have made any effort to restore the regulatory regime that preceded the crisis.

Bernanke made this gloomy statement to Congress on May 5:

"The U.S. economy has contracted sharply since last autumn, with real gross domestic product (GDP) having dropped at an annual rate of more than 6 per cent in the fourth quarter of 2008 and the first quarter of this year. Among the enormous costs of the downturn is the loss of some 5 million payroll jobs over the past 15 months.... we are likely to see further sizable job losses and increased unemployment in coming months.

“... A number of factors are likely to continue to weigh on consumer spending, among them the weak labor market and the declines in equity and housing wealth that households have experienced over the past two years. In addition, credit conditions for consumers remain tight.

“... The available indicators of business investment remain extremely weak. Spending for equipment and software fell at an annual rate of about 30 per cent in both the fourth and first quarters, and the level of new orders remains below the level of shipments, suggesting further near-term softness in business equipment spending. ... surveyed firms are still reporting net declines in new orders and restrained capital spending plans. Our recent survey of bank loan officers reported further weakening of demand for commercial and industrial loans. The survey also showed that the net fraction of banks that tightened their business lending policies stayed elevated, although it has come down in the past two surveys.

“Conditions in the commercial real estate sector are poor. Vacancy rates for existing office, industrial, and retail properties have been rising, prices of these properties have been falling, and, consequently, the number of new projects in the pipeline has been shrinking.

“We continue to expect economic activity to bottom out, then to turn up later this year....An important caveat is that our forecast assumes continuing gradual repair of the financial system; a relapse in financial conditions would be a significant drag on economic activity and could cause the incipient recovery to stall.

“Even after a recovery gets under way, the rate of growth of real economic activity is likely to remain below its longer-run potential for a while, implying that the current slack in resource utilization will increase further. We expect that the recovery will only gradually gain momentum and that economic slack will diminish slowly. In particular, businesses are likely to be cautious about hiring, implying that the unemployment rate could remain high for a time, even after economic growth resumes.

In this environment, we anticipate that inflation will remain low."

In other words, “the economy stinks and unemployment is going up. People have lost a bundle on their homes and they can count on losing even more. Business is slow, the banks aren’t lending and demand has fallen off a cliff. Things might get better, but if we have another Lehman-type blow up, all bets are off. The recovery will be weak and high-unemployment will persist into the foreseeable future, but at least inflation won’t be a problem. We think. If there’s a problem we hadn’t anticipated; please call. Yours, Ben B.”

The economy is now in a downward spiral. Tightening in the credit markets has made it harder for consumers to borrow or businesses to expand. Overextended financial institutions are forced to shed assets at firesale prices to meet margin calls from the banks. Asset deflation is ongoing with no end in sight. Price declines in housing have reached 30 per cent already and are accelerating on the downside. Unemployment is at a 40 year high and headed higher. There are no jobs; home equity and retirement funds are shrinking and prospects for a quick recovery are nil.

The stock market surge doesn’t help working people who get paid by the hour and don’t have the extra money to bet on equities. They can’t move numbers from one ledger to another and magically show a profit. They have to balance their check books, show up on time. For these people — the bulk of working Americans — the future has never been grimmer and less certain. They’re afraid for their jobs, their standard of living and their kids. They aren’t covered under the bailout, don’t have a powerful constituency, and the recovery probably won’t include them. There are no green shoots for working stiffs.

Personal debt-to-income has skyrocketed in the last decade. The average American has never been so underwater. Troubles in the credit markets have forced banks to cut credit lines and tightened lending standards are further exacerbating the problem. Consumers have cut back on spending fearing that the recession will deepen or they’ll lose their job. At the same time, homeowner equity is vanishing at a record pace, leaving millions on the brink of bankruptcy. An article in Barron’s sums it up like this::

“The complacent reaction among the investment cognoscenti is that the credit markets are wildly oversold. More likely... it has something to do with the fact that “an overwhelming portion of some $8 trillion in mortgage debt (or 80 per cent of the total) is teetering on the edge of, or in some state of, negative equity.

“As to the Fed’s claim that the equity of homeowners as a group stands at 43 per cent, she (Stephanie Pomboy) points out that what the Fed neglects to tell you is that roughly a third of them have their houses free and clear. Lo and behold, some basic arithmetic reveals that 67 per cent of homeowners with mortgages have equity of less than 15%. That, Stephanie comments dryly, suggests the ‘destruction priced into the credit markets hardly seems out of whack with potential reality.’

“And while, thanks to ‘ transfer of toxic assets to taxpayers’ and the magic of accounting legerdemain, the scarred financials to some significant extent may be spared further pain, the same can’t be said for the nonfinancial sector. Little recognized, she insists, is how much the extraordinary gains in domestic nonfinancial profits from the low in 2001 to the peak in 2006 - a stunning rise of 388 per cent - owed to the housing bubble." (Shotgun Wedding, Alan Abelson, Barrons)

Those gigantic gains have been wiped out leaving the average homeowner with a mere 15 per cent equity stake in his home. If prices continue to fall, the vast majority of homeowners will be at or near destitution. If the Fed’s plan was to shift the nation’s wealth from homeowners to the investor class via the housing bubble; they may have achieved their goal.

The Obama administration has done little to help struggling homeowners even though the incidents of predatory lending are widespread and overwhelmingly directed at poor people of color. The New York Times lashed out at Obama for not pushing cram-down legislation through congress even though he gave the bill lip-service during his presidential campaign. From the New York Times editorial:

“The Obama administration sat by last week as 12 Senate Democrats joined 39 Senate Republicans to block a vote on an amendment that would have allowed bankruptcy judges to modify troubled mortgages.

Senator Obama campaigned on the provision. And President Obama made its passage part of his antiforeclosure plan. It would have been a very useful prod to get lenders to rework bad loans rather than leaving the modification to a judge.

But when the time came to stand up to the banking lobbies and cajole yes votes from reluctant senators - the White House didn’t. When the measure failed, there wasn’t even a statement of regret. " (New York Times)

It would have been easy for Obama to twist a few arms in the Senate and push through the legislation, but he didn’t lift a finger. Instead, he’s focused on expanding the war in Pakistan and pushing through his pay-your-own-way health care boondoggle. Obama’s pattern of backing-away from his campaign promises suggests that he’ll cave in when the critical union organizing bill, The Employee Free Choice Act (EFCA) comes up for a vote. Obama, no friend of labor, will be AWOL once again.

Bernanke may have saved the country from another Great Depression, but he’ll have a tough time putting the economy back on track. The Fed’s ideological bias keeps it from addressing the root problem of flagging demand. What’s needed are policymakers who understand that the endless debt-expansion is not sustainable, and that maintaining a healthy economy requires higher wages and a narrowing of the income gap. Inequality leads to falling demand and boom-and-bust cycles. Fiscal stimulus can take up the slack in demand on a temporary basis, but eventually, wages and compensation need to be increased to rebalance the system. The economist James K. Galbraith made these observations on the state of affairs in a recent interview with The Texas Observer:

"As a matter of economics, public spending substitutes for private spending. It provides jobs, motivates useful activity, staves off despair. But it is not self-sustaining in the absence of a viable private credit system. The idea that we will be on the road to full recovery and returning to high employment in a year or so therefore seems to me to be an illusion. And for this reason, the emphasis on short-term, ‘shovel-ready’ projects in the expansion package, while understandable, was a mistake. As in the New Deal, we need both the Works Progress Administration, headed by Harry Hopkins, to provide employment, and the Public Works Administration, headed by Harold Ickes, to rebuild the country.

“The desire for a return to normal is very powerful. It motivates both the ritual confidence of public officials and the dry numerical optimism of business economists, who always see prosperity just around the corner. The forecasts of these people, like those of official agencies such as the Congressional Budget Office, always see a turnaround within a year and a return to high employment within four or five years. In a strict sense, the belief is without foundation. Liquidation of excessive debt is now, and will remain for a time, the highest priority of American households. That is in part because for the moment they want to hold on to cash, and therefore they do not wish to borrow, and in part because with the collapse of house values, they no longer have collateral to borrow against. And so long as that is the case, there can be no strong recovery of private spending or business investment. ("Causes of the Crisis", James K. Galbraith: The Texas Observer)

Digging out of the current recession won’t be easy. The wholesale credit system will have to be rebuilt, just as the financial system will have to be re-regulated and reset at a lower level of economic activity. That means higher unemployment, smaller GDP, and falling demand. Debts will have to be written-down or paid off. Deleveraging takes time. The fireworks in the stock market are premature. Recovery is still a long way off.

Published in Counterpunch


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