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Perils of the debt-propelled
economy
By Henry C K Liu
Economics is a complex subject. Any subject,
however complex, if looked at in the right way, will
become even more complex. This fact baffles many experts
who tend to avoid small errors meticulously while
sweeping on to grand fallacy.
One of the
shortcomings of economics is the inadequate attention
paid to it as a behavioral science. The problem can be
traced to the neoclassical concept of the economic man
who is supposed to act rationally in his own interest
which in a money economy is generally defined rather
simplistically as financial gain. Economics is obviously
more than finance, and economic well-being is not
synonymous with financial gain. Modern economics of
course deals with the problem of human behavior with
some sophistication, albeit always through the back
door, and always equating self-interest with rational
individual response to pricing. A market economy is
coordinated through the price system operating on the
principle of marginal utility.
Economists
construct indifference curves to show consumer
preferences. In economics, the effect on consumption of
a pure change in price is shown in an income-compensated
demand curve (also known as a Hicksian demand curve
after economist John Hicks - 1904-89). A Marshallian
demand curve (after economist Alfred Marshall -
1842-1924) is based on the concept of marginal utility.
Marginal utility is observed only through choices.
Marginal utility in consumption is simply a problem of
choosing the bundle of goods that maximizes a buyer's
utility, subject to the income constraint - the
requirement that the bundle the consumer chooses costs
no more than the buyer's disposable income.
Yet
the demand for goods is affected by human behavior. A
good whose consumption increases when its price goes up
is called a Giffen good, after Robert Giffen, a
19th-century English statistician, who noted that Irish
peasants bought more potatoes when the price of potatoes
rose. This contradicted the law of demand, one of the
basic laws of economics. For the poor Irish peasants,
potatoes, as the main staple, took up a huge share of
their income. If the price of potatoes went up, the
share of their income available to purchase other foods
would shrink markedly, forcing them to consume more
potatoes to make up the difference.
Giffen goods
are also necessary for conspicuous consumption. When
high-price items go up further in price regularly, such
as art objects, more buyers will enter the market,
bidding up prices even more. Tulip bulbs during the
speculative bubble in Holland in the 17th century were
overpriced Giffen goods. The stock market is full of
Giffen goods. When a share price goes up, it attracts
more buyers. Real estate is often a Giffen good,
particularly in places like Hong Kong where the
real-estate market is fundamentally controlled by the
government through control of the supply of land.
When housing prices rise over long periods, more
buyers enter the housing market. The increased demand
created by anticipated price appreciation more than
offsets the fall in demand caused by price increases.
And price deflation in housing creates a downward spiral
of shrinking demand, a phenomenon easily observed in
recent years all over Asia, from Tokyo to Hong Kong to
Singapore. Public health and commercial medicine have
characteristics of Giffen goods. When the price of
medicine rises, more people tend to get ill due to less
preventive use of medicine, causing aggregate demand for
medicine to rise.
An inferior good is a good
that one buys less of when one's income rises, because
one can afford a superior good by comparison, even if
the inferior good may also rise in price. During periods
of prosperity, when income rises generally faster than
prices, inferior goods are separated from Giffen goods.
During periods of recession, when income falls generally
while prices remain the same or continue to rise,
inferior goods and Giffen goods tend to merge. A Giffen
good must be an inferior good, but most inferior goods
are not Giffen goods.
Credit drives the economy,
not debt. Debt is the mirror reflection of credit. Even
the most accurate mirror does violence to the symmetry
of its reflection. Why does a mirror turn an image right
to left and not upside down as the lens of a camera
does? The scientific answer is that a mirror image
transforms front to back rather than left to right as
commonly assumed. Yet we often accept this aberrant
mirror distortion as uncolored truth and we unthinkingly
consider the flawed reflection in the mirror as a
perfect representation.
Similarly, we
reflexively accept as exact fidelity the encrypted
labels assigned to our thoughts by the distorting mirror
of language. Such habitual faulty acceptance is
consequential because it is through language that ideas
are transmitted and around language that culture
develops.
In the language of economics, credit
and debt are related but not the same. In fact, credit
and debt operate in reverse relations. Credit requires a
positive net worth and debt does not. One can have good
credit and no debt. Too much debt lowers credit rating.
When one understands credit, one understands the main
force behind the modern economy, which is driven by
credit and stalled by debt. Behaviorally, debt distorts
marginal utility calculations and rearranges disposable
income. Thus debt turns more commodities into Giffen
goods and creates what US Federal Reserve Board chairman
Alan Greenspan calls "irrational exuberance", the
economic man gone mad.
Human behavior is complex
beyond the measurement of price. Price alone is not
sufficient to influence market behavior. Karl Marx dealt
with the concept of fetish as a factor in demand as
expressed in price.
Education is a classic
dilemma. Economics literature has never dealt
satisfactorily with education, being unable to decide
whether it is consumption or investment or both. It has
done similarly with health care and environmental
preservation. If these endeavors are consumption, the
law of scarcity dictates that society cannot afford too
much of them. If they are investment, then supply-side
theory would conclude the more the better. If they are
both consumption and investment, there should be
a limitless upward spiraling supply/demand symbiosis.
One could not possibly have an over-educated society or
over-healthy population or an over-clean environment, if
being more educated, more healthy and more clean is
deemed economically productive and thus financially
profitable.
It is obvious that debt changes
human behavior. A little debt reinforces responsibility.
The US social system of private property is built on the
notion that homeowners with a life-long mortgage are
better citizens than renters. People tend to take better
care of their homes and plant roots in their communities
if they "own" their homes, even though 90 percent of the
purchase value is in debt that is not expected to be
paid off until three decades later.
On the other
hand, it is clear that excessive debt encourages
irresponsibility. The borrower may develop an
irresistible incentive to walk away from his debt if he
perceives the debt to be beyond his ability to repay, or
the cost of the debt to exceed its benefits. Even a
central bank, which is the domestic lender of last
resort, is wary of the problem of moral hazard, that
commercial banks within its system would lend
irresponsibly if they knew that their lending errors
would be bailed out by the central bank.
The US
bankruptcy regime is designed to give trapped debtors a
fresh start from distressed debt to reestablish credit.
Unlike European precedents, one cannot be jailed in the
United States for failing to pay one's debt, unless
criminal fraud is involved. In fact, there is a legal
concept of lender liability, based on which a distressed
debtor can sue the lender for damages for lending money
irresponsibly that led the debtor into financial
trouble.
Lender liability is embodied in common
and statutory law covering a broad spectrum of claims
surrounding predatory lending. It is a key concept in
environmental-cleanup litigation. If a lender knowingly
lends to a borrower who is obviously unable to make
reasonable beneficial gain from the use of the funds, or
causes the borrower to assume responsibilities that are
obviously beyond the borrower's capacity, the lender not
only risks losing the loan without recourse but is also
liable for the financial damage to the borrower caused
by such loans. For example, if a bank lends to a trust
client who is a minor, or someone who had no business
experience, to start a risky business that resulted in
the loss not only of the loan but of the client trust
account, the bank may well be required by the court to
make whole the client.
In the United States,
although predatory lending is not defined by federal
law, and various states define abusive lending
differently, it usually involves practices that strip
equity away from a homeowner, or equity from a company,
or condemn the debtor into perpetual indenture.
Predatory or abusive lending practices can include
making a loan to a borrower without regard to the
borrower's ability to repay, repeatedly refinancing a
loan within a short period of time and charging high
points and fees with each refinance, charging excessive
rates and fees to a borrower who qualifies for lower
rates and/or fees offered by the lender, or imposing new
unjustifiably harsh terms for rolling over existing
debt. Predation breaks the links between an economy's
aggregate resource endowment and aggregate consumption
and between the interpersonal distribution of endowments
and the interpersonal distribution of consumption.
The choice by some to be predators decreases
aggregate consumption, both because the predators'
resources are wasted and because producers sacrifice
production by allocating resources to guarding against
predators. Much of welfare economics is based on the
concept of Pareto Optimum, which asserts that resources
are optimally distributed when an individual cannot move
into a better position without putting someone else into
a worse position. In an unjust global society, the
Pareto Optimum will perpetuate injustice.
Now,
there is a close parallel in most Third World debts and
International Monetary Fund (IMF) rescue packages to the
above predation examples where sophisticated
international bankers knowingly lend to dubious schemes
in developing economies merely to get their fees and
high interest, knowing that "countries don't go
bankrupt", as Walter Wriston of Citibank famously
proclaimed. The argument for Third World debt
forgiveness contains large measures of lender liability
and predatory lending. Debt securitization allows these
bankers to pass the risk to the credit markets,
socializing the potential damage after skimming off the
privatized profits.
Credit is reserved financial
resources ready for deployment. Debt basically is
unearned money secured with a promise to repay the
principal sum plus interest with optimistically
anticipated earned money in the future, assuming, for
example, that the borrower will not become unemployed
through no fault of his own or a business will not be
adversely affect by unanticipated shifts in business
paradigm, or an economy will not be destroyed by global
financial contagion.
Paying down debt with new
debt is a Ponzi scheme - the likelihood of its exposure
is inversely proportional to its scale of operation.
More and more critics are calling the Enron debacle a
Ponzi scheme, in that the company filed for bankruptcy
even though, for almost a decade up to a few weeks
before its bankruptcy filing, many in high places were
hailing Enron as the new innovative business model.
Neoliberal economist Paul Krugman publicly
hailed Enron as a shining example of free-market
entrepreneurship in what he called "a love letter to
free markets". He served on its prestigious advisory
board for a annual fee of US$50,000. Neoconservative
Weekly Standard editor Bill Kristol received $100,000
from the same Enron advisory board, while contributing
editor Irwin Stelzer praised Enron for "leading the
fight for competition".
On November 13, 2001,
two weeks before Enron filed bankruptcy on December 2,
the Baker Institute honored Greenspan with its Enron
Prize, which the official press release said "gives
recognition to outstanding individuals for their
contributions to public service. The prize is made
possible by a generous gift from the Enron Corp ... one
of the world's leading electricity, natural-gas and
communications companies. Among the previous recipients
of the Enron Prize are Colin Powell, current US
secretary of state; Mikhail Gorbachev, former president
of the Soviet Union; Nelson Mandela, the first black
president of South Africa; and Georgian President Eduard
Shevardnadze."
Enron officials have since
acknowledged that the company has purposely overstated
its profits by billions of dollars since 1997 and has
disguised billions in debt as revenue through structured
finance via offshore special-purpose vehicles. Top Enron
executives cashed out more than $1 billion in company
stocks when they were near their peak price of more than
$80. In addition, nearly 600 employees deemed critical
to Enron's operations received more than $100 million in
bonuses in November 2001 while the company was on the
brink of bankruptcy. Some commitment to public service.
On the corporate level, debt inevitably alters
management behavior. Leverage increases profit margin on
successful business plans. As Henry Kravis, king of the
leveraged buyout, famously said: "Debt can be an asset.
Debt tightens a company." To less creative minds, debt
is still a liability, not an asset. But debt also
exaggerates losses when business plans fail. In the US
financial system, bankruptcy is a legal if not painless
way to refute debt. The comfort to lenders is that
equity investors are wiped out first before the lenders'
various collateralized positions are endangered.
Banks used to be the sole intermediaries of
debt. For this reason, a central bank was formed to
supervise and provide liquidity to the banking system.
Thus a central bank came into existence in the United
States in 1913 on the assumption that the existence of a
healthy banking system is in the national interest. And
to protect the national interest, the central bank,
which in the US version is a government institution
privately owned by the banks in the Federal Reserve
system, is allowed to act as lender of last resort to
the nation's commercial banks with public money, or more
accurately, through government authority to create fiat
money.
Thus regulation on banks is a fair quid
pro quo, a social contract. Bank deregulation without
corresponding raising of the threshold for central-bank
bailout is a direct breach of this social contract. If
for the good of the nation banks cannot be allowed to
fail, they should also not be allowed to deregulate.
More ominous, the US credit system has broken
through the banking system - the bulk of debt now is
intermediated through the unregulated credit markets by
debt securitization. Securitization acts as more than
just providing a vehicle for investment in debt
instruments. It restructures simple debt into complex,
hybrid instruments sliced infinite ways until the
original debt is beyond recognition.
Debt
securitization is guerrilla warfare against a sound
credit system. Debt proceeds can be disguised as current
income, distorting the financial performance of the
debtor. In these brave new credit markets, the
government is generally only an interested bystander, so
far quite unwilling to regulate even over-the-counter
(OTC) derivative trading by banks, which are suppose to
be regulated, with an "if I don't smoke, someone else
will" mentality.
OTC derivatives are traded off
exchanges, directly between counterparties, and as such
are not subject to disclosure rules. Adding estimated
data from the Bank for International Settlements for OTC
derivatives to published figures for exchange-traded
derivatives, the total notional principal balance of the
reported derivatives market in June 2001 was $119
trillion, about four times the gross domestic product
(GDP) of the Organization of Economic Cooperation and
Development (OECD) countries and twice the value of
global trade. The amount unreported remains unknown.
This shows that derivatives performed more than
a hedge function, as apologists claim. Derivative
trading has become a profit center for banks and
non-bank financial institutions. True, the notional
principal amount is never at risk, because no principal
payments are exchanged. The interest payments that are
linked to that notional principal amount are at risk. A
loss on a derivative contract becomes possible when (a)
interest rates or commodity prices move in a direction
that makes the contract more or less valuable, and (b)
the counterparty on the other side of the contract
defaults. Derivatives credit exposure is the present
value of the cost of restoring the economic value of a
contract should a counterparty default.
All
kinds of street rumors are flying at this very moment
that one of the world's biggest banks is exposed to
derivative trades that would cause serious counterparty
credit problems if the market capitalization of this
bank should fall below a triggering level, or the price
of commodities or interest rates should move against its
derivative positions. Because there is no way to dispel
or confirm such rumors, and the bank involved remains
tight-lipped about its true financial conditions, the
uncertainties weigh down on the economy.
There
is ample evidence that the level of interest rates does
not always control the aggregate level of debt in an
economy, popular expectations notwithstanding. When
interest rates are high, they often merely reflect the
systemic credit-unworthiness of borrowers as a group or
the high risk assumed by lenders collectively. High
interest rates in fact create more incentive for both
lenders and borrowers to take higher risk to shoot for
the higher returns needed to meet higher interest cost.
High interest rates also direct money to more desperate
borrowers. As William Zeckendorf, the bankrupt
real-estate tycoon, once said: "I'd rather be alive at
30 percent interest than be dead at 3 percent."
However, interest rates do affect the
distribution of credit in the economy. When rationed by
interest rates, debt actually puts money to work for
those who need it most desperately, and not necessarily
the highest and best use in the economy, or where it is
socially needed most. Debts at high interest rates can
only be justified by high risk, which tends to
destabilize the economy. Debt securitization actually
lowers systemic credit quality by socializing risk
across the whole system rather than concentrating it on
singular, isolatable defaults.
The US Federal
Reserve's fixation on interest-rate policy as the sole
tool of regulating monetary policy is increasingly
taking on the look of shadow boxing, with declining
effect on the economy. As chairman Greenspan is fond of
saying: "Bad loans are made in good times." As interest
rates are artificially raised by Fed action to tighten
money supply, distressed borrowers with bad loans made
in good times will need to borrow more, thus enlarging
the credit pool, defeating the Fed's purpose of a tight
monetary policy. As interest rates are artificially
lowered by Fed action to stimulate a slowing economy,
banks raise their credit threshold to compensate for the
narrowing of rate spread, thus reducing the number of
qualified borrowers and shrinking aggregate loan volume.
This is known as the Fed pushing on a credit string.
Credit rationed by interest rates also
discourages economic democracy, since the poor generally
find it much harder to obtain or afford credit. The poor
also do not have the sophistication to participate in
structured finance. There is much truth is the saying
that it is not how much you own, it is how much you owe
that measures how rich or financially powerful you are.
Debt also encourages carelessness with money,
since lending implies faith in the borrower's ability to
repay in the future. People tend to be more careful with
money they earned in the past in the form of savings
because they remember how hard they had to work for it.
In contrast, debt is based on future earnings, which is
deemed easier money by the existence of debt itself.
High interest rates also encourage high risks to justify
the high cost of money.
The problem with debt is
that it needs to be serviced regularly (except zero
coupons, which are discounted from the principal sum at
the outset and cost more and are monitored with bond
covenants and triggers to activate automatic
foreclosure). Unlike a credit-driven economy, a
debt-propelled economy will inevitably reach a point
where its ability to service the growing debt is
exceeded, unless inflation stays ahead of interest
charges, in which case the banking system will fail.
Thus runaway systemic debt frequently leads to
hyperinflation.
Bankruptcy only relieves the
debtor, not the economy. If, as economist Hyman Minsky
claimed, money is created whenever credit is extended,
then the erasure of debt destroys money and shrinks the
economy.
There is a circular link among
deregulation, debt, overcapacity and bankruptcy.
Deregulation has created a havoc of bankruptcy in the
airline, health-care, communication, energy and finance
sectors. Deregulation permits predatory pricing in the
name of competition, which often leads to monopolistic
consolidation within industries. The surviving giants
then take on massive debt to acquire vanquished
competitors and to expand capacity in anticipation of
increased demand and soon reach a point where increased
sales do not increase net revenue to offset low margin.
Once a company is trapped in the whirlpool of debt, a
downward spiral of low prices and shrinking revenue will
push the cost of debt beyond sustainability, leading to
bankruptcy. This is known as the bursting of the debt
bubble.
In March 1980, the Depository
Institutions Deregulation and Monetary Control Act
(DIDMCA) was enacted in the United States. It was a
deregulation initiative by the administration of
president Jimmy Carter aimed at eliminating many of the
distinctions among different types of depository
institutions and ultimately removing interest rate
ceiling on deposit accounts. Authority for federal
savings and loan associations to make risky ADC
(acquisition, development, construction) loans was
expanded, which ended up with the savings and loan
(S&L) crisis five years later. Deregulation of
airlines also began under Carter, leading to recurring
waves of bankruptcy.
Conventional wisdom
suggests that a good credit rating is necessary to
borrow. But the financial world works differently in
reality. A good credit rating is first necessary to
issue credit. Without the ability of some entity to
issue credit, no one can borrow. And since no modern
financial institution lends its own money, lenders must
first secure funds wholesale to lend to retail
borrowers. For that, a lender must maintain a good
credit rating.
Banks are protected from this
requirement by their discount window at the central
bank, which is backed by the full faith and credit of
the nation, and by Federal Deposit Insurance Corp (FDIC)
insurance. Still, central banks and the Bank of
International Settlement (BIS) set capital and reserve
requirements for commercial banks to assure risk
prudence.
GE, the world's largest non-bank
financial conglomerate that incidentally also
manufactures, issues credit at the retail level through
vendor financing, to capture sales for GE products. It
gets its funds wholesale from the commercial paper
market, which GE dominates because it has a good credit
rating. When GE credit rating was downgraded recently,
it faced being frozen out of the commercial paper
market, and had to revert back to costly bank credit
lines that adversely affected its interest rate spread
and profitability.
When a government issues
currency and circulates money through the banking
system, it is in essence issuing credit to the economy
that it is entitled to receive back in taxes. Government
then spends the tax money on goods and services that the
public provides. The surplus money that is not returned
by taxes is government credit floating around the
economy to keep it operating financially.
It is
important to understand that money issued by the
government, unlike private money, is not IOUs from the
issuer. Money, when issued by government as a legal
tender, is a credit from the government good for the
payment of taxes, and for settling "all debts, public
and private", as printed plainly on all Federal Reserve
notes. A US dollar is a Federal Reserve note that
entitles its holder to exchange it at any of the six
Federal Reserve Banks for another Federal Reserve note
of the same face value, no more and no less, at least
since 1971 when the late president Richard Nixon took
the dollar off the gold standard.
Even before
1971, while an ounce of gold was officially pegged at
$35 by president Franklin Roosevelt on January 31, 1931,
a domestic holder of a dollar note could only exchange
it at a Federal Reserve Bank for another dollar note,
since US citizens were forbidden by law to own gold.
Only foreigners could demand gold for dollar up to 1971.
A government bond, which on the surface looks
like a government debt, is merely a call on government
credit previously issued, withdrawing dollars from the
money supply by providing a government bond. Government
bonds are the living proof that money is not an IOU from
the government, otherwise when government sells or
redeems bonds, it is perpetrating a Ponzi scheme of
paying off old debt with new debt, rather than
exchanging debt instruments (bonds) with credit
instruments (dollars).
Sovereign debt is
fundamentally different from corporate debt. A corporate
bond entitles its holder to claim its face value in
dollar notes that the bond-issuing corporation cannot
create by itself. It must earn dollars with the bond
proceeds to pay interest on the bonds. At the time of
redemption, if the corporation already spent the bond
proceeds, it must then earn back or sell assets or
borrow the dollars from somewhere to redeem the bond.
In contrast, a government bond entitles its
holder to claim from a Federal Reserve Bank its face
value in dollars that the government can print at will,
even if it already spent the bond proceeds. The interest
on the bond is also paid with dollars of which the
government has an unlimited supply. Part of the dollars
that the government spends will come back from the
public in the form of taxes. The rest will stay in the
economy to finance its operations.
So if the
government runs a surplus, meaning it takes in more tax
money than it spends, it drains money from the economy,
forcing the economy to contract. A budget deficit is in
essence an injection of more government credit into the
economy.
Private citizens can own assets, but
whenever such assets are monetized with dollars, one
trades those assets for credit from the US government
that other market participants in the economy will
accept because, aside from its status of legal tender as
defined by law, it is good for negotiating tax
liabilities.
Technically, a government never
borrows. It issues tax credit in the form of money. So
when former president Ronald Reagan said the government
does not make any money, only the private sector does,
he was merely mouthing conventional wisdom, with no
clear understanding of the true nature of money and
credit. In fact, money is all that government makes.
Thus any government that takes on foreign-currency debt
or allows its economy to do so is taking unnecessary
risk.
The main function of sovereign debt is not
to make up for any shortfalls in government funds. Such
shortfalls cannot exist by definition. Rather, sovereign
debt instruments act as fundamental collateral for the
nation's credit market. The Fed Open Market Desk buys
and sells government securities to maintain the Fed
funds target rate set by the Federal Reserve Board. The
repo (repurchase agreement) market, which provides
overnight and short-term funds for banks, operates with
government securities as collateral.
Thus IMF
conditionalities of reducing sovereign debt by imposing
budget surpluses and price deflation as a cure for a
distressed credit market of excessive foreign debt is
merely adding gasoline to fire.
As a sovereign
bond is redeemed with cash, it is in essence replacing a
call instrument on government credit with government
credit. When government securities are withdrawn and
cash floods the economy, the debt market shrinks because
the amount of collateral shrinks and the amount of cash
increases, reducing the need for credit, and the economy
contracts with cash inflation, unless the cash is
immediately recirculated as private debt or investment.
The reason that the market monitors the Fed
funds rate as an indication of Fed policy is that the
Fed funds rate closely tracks another rate, the repo
rate, that the Fed Open Market Desk actively influences
during most market days. Every business-day morning at
11:45 Eastern Standard Time, the Fed announces what it
intends to do (buying or selling government securities
with an agreement to reverse the transaction later) in
the repo market to keep the repo rate close to the Fed
funds target rate set by the Fed. Changes in the repo
rate are normally quickly followed by changes in the Fed
funds rate. Thus, indirectly, the Fed appears to
influence the federal funds rate through its impact upon
the repo rate.
Non-monetarists subscribe to the
view that Fed easing means the Fed lowers interest
rates. But they are not specific about how these rates
are lowered are how the Fed should go about doing this.
There are often periods (such as 1990-91) when interest
rates dropped but money growth also fell.
Non-monetarists (and market participants) view periods
like this as Fed easing episodes, while monetarists
argue that these are (implicitly) periods of Fed
tightening. Thus it is clear that interest rates by
themselves do not always determine the money supply.
Since all private debts in a money economy are
anchored by government credit, through what economists
called high-power money (money created by the Fed
through the increase of the total reserves in the
banking system, so called because it would be multiplied
manifold through the money-creation power of commercial
bank loans), credit in an economic democracy should not
be rationed by interest rates to the highest bidder, but
by national purposes or social needs.
Credit in
fact is a financial public utility, much like air and
water, and it should be equally accessible to all, not
just the rich. Government loan guarantees for students
and house mortgages for low- and moderate-income groups
and loans to small business are based on this principle.
For example, the US National Housing Act was
enacted on June 27, 1934, as one of several
economic-recovery measures of the New Deal. It provided
for the establishment of a Federal Housing
Administration (FHA). Title II of the Act provided for
the insurance of home mortgage loans made by private
lenders, taking the risk in lending to low income
borrowers off the private lenders. Title III of the Act
provided for the chartering of national mortgage
associations by the administrator. These associations
were to be independent corporations regulated by the
administrator, and their chief purpose was to buy and
sell the mortgages to be insured by the FHA under Title
II.
Only one association was ever formed under
this authority on February 10, 1938, as a subsidiary of
the Reconstruction Finance Corp, a government
corporation. Its name was National Mortgage Association
of Washington, and this was changed that same year to
Federal National Mortgage Association (Fannie Mae). By
amendments made in 1948, Title III became a statutory
charter for Fannie Mae.
Before the Great
Depression, affording a home was difficult for most
people in the United States. At that time, a prospective
homeowner had to make a down payment of 40 percent and
pay the mortgage off in three to five years. Until the
last payment, borrowers paid only interest on the loan.
The entire principal was paid in one lump sum as the
final "balloon" payment.
During the 1920s boom
time in real estate, a rudimentary secondary mortgage
market was established. The stock-market crash of 1929
ended the real-estate boom and forced many private
guarantee companies into insolvency as home prices
collapsed. As economic conditions worsened, more and
more people defaulted on mortgages because they couldn't
come up with the money for the final balloon payment or
to roll over their mortgage because of low market value
of their homes.
To help lift the country out of
the Depression, Congress created the FHA through the
National Housing Act of 1934. The FHA's insurance
program protected mortgage lenders from the risk of
default on long-term, fixed-rate mortgages. Because this
type of mortgage was unpopular with private lenders and
investors, Congress in 1938 created Fannie Mae to
refinance FHA-insured mortgages.
As soldiers
came home from World War II, Congress passed the
Serviceman's Readjustment Act of 1944, which gave the
Department of Veterans Affairs (VA) authority to
guarantee veterans' loans with no down payment or
insurance premium requirements. Many financial
institutions considered this arrangement a more
attractive investment than war bonds.
By
revision of Title III in 1954, Fannie Mae was converted
into a mixed-ownership corporation, its preferred stock
to be held by the government and its common stock to be
privately held. It was at this time that Section 312 was
first enacted, giving Title III the short title of
Federal National Mortgage Association Charter Act.
By amendments made in 1968, the Federal National
Mortgage Association was partitioned into two separate
entities, one to be known as the Government National
Mortgage Association (Ginnie Mae), the other to retain
the name Federal National Mortgage Association (Fannie
Mae). Ginnie Mae remained in the government, and Fannie
Mae became privately owned by retiring the
government-held stock. Ginnie Mae has operated as a
wholly owned government association since the 1968
amendments. Fannie Mae, as a private company operating
with private capital on a self-sustaining basis,
expanded to buy mortgages beyond traditional government
loan limits, reaching out to a broader income
cross-section.
By the early '70s, inflation and
interest rates rose drastically. Many investors drifted
away from mortgages. Ginnie Mae eased economic tension
by issuing its first mortgage-backed security (MBS)
guarantee in 1970. Investors found these guaranteed MBSs
highly attractive. Also in 1970, under the Emergency
Home Finance Act, Congress chartered the Federal Home
Loan Mortgage Corp (Freddie Mac) to buy conventional
mortgages from federally insured financial institutions.
The legislation also authorized Fannie Mae to purchase
conventional mortgages. Freddie Mac introduced its own
MBS program in 1971.
In the early 1980s, the US
economy spiraled into deep recession. Interest rates and
housing prices were high, while income growth was
stagnant. The US economy faced a dual problem of income
deficiency and money devaluation. In this poor housing
environment, Ginnie Mae, Fannie Mae and Freddie Mac all
created programs to handle adjustable-rate mortgages.
The Ginnie Mae guaranty is backed by the full faith and
credit of the United States. Today, Ginnie Mae
guaranteed securities are one of the most widely held
and traded MBSs in the world. Ginnie Mae has guaranteed
more than $1.7 trillion in MBSs. Historically, 95
percent of all FHA and VA mortgages have been
securitized through Ginnie Mae. Ginnie Mae is a
guarantor, a surety. Ginnie Mae does not issue, sell, or
buy MBSs, or purchase mortgage loans.
Fannie Mae
operates under a congressional charter that directs it
to channel its efforts into increasing the availability
and affordability of home ownership for low-, moderate-
and middle-income Americans. Yet Fannie Mae receives no
government funding or backing, and it is one of the
nation's largest taxpayers as well as one of the most
consistently profitable corporations in America. The
company has evolved to become a shareholder-owned,
privately managed corporation supporting the secondary
market for conventional loans. It continues to operate
under a congressional charter with oversight from the US
Department of Housing and Urban Development and the US
Treasury.
Fannie Mae has two primary lines of
business: Portfolio Investment, in which the company
buys mortgages and MBSs as investments, and funds those
purchases with debt, and Credit Guaranty, which involves
guaranteeing the credit performance of single-family and
multi-family loans for a fee.
Its Portfolio
Investment business includes mortgage loans purchased
throughout the US from approved mortgage lending
institutions. It also purchases MBSs, structured
mortgage products and other assets in the open market.
The corporation derives income from the difference
between the yield on these investments and the costs to
fund these investments, usually from issuing debt in the
domestic and international markets. Fannie Mae has $3.46
trillion in MBSs outstanding today.
The
corporation accomplishes its mission to provide products
and services that increase the availability and the
affordability of housing for low-, moderate- and
middle-income Americans by operating in the secondary
rather than the primary mortgage market. Fannie Mae
purchases mortgage loans from mortgage lenders such as
mortgage companies, savings institutions, credit unions
and commercial banks, thereby replenishing those
institutions' supply of mortgage funds. Fannie Mae
either packages these loans into MBSs, which it
guarantees for full and timely payment of principal and
interest, or purchases these loans for cash and retains
the mortgages in its portfolio.
Fannie Mae is
one of the world's largest issuers of debt securities,
the leader in the $5 trillion US home-mortgage market.
Fannie Mae's debt obligations are treated as US agency
securities in the marketplace, which is just below US
Treasuries and above AAA corporate debt. This agency
status is due in part to the creation and existence of
the corporation pursuant to a federal law, the public
mission that it serves, and the corporation's continuing
ties to the US government. It benefits from the
appearance, though not the essence, of being backed by
government credit.
Fannie Mae debt obligations
receive favorable treatment from a regulatory
perspective. Fannie Mae securities are "exempted
securities" under the laws administered by the US
Securities and Exchange Commission to the same extent as
US government obligations. Also, Fannie Mae debt
qualifies for more liberal treatment than corporate debt
under US federal statutes and regulations and, to a
limited extent, foreign overseas statutes and
regulations.
Some of these statutes and
regulations make it possible for deposit-taking
institutions to invest in Fannie Mae debt more liberally
than in corporate debt and mortgage-backed and
asset-backed securities. Others enable certain
institutions to invest in Fannie Mae debt on par with
obligations of the United States and in unlimited
amounts. Fannie Mae uses a variety of funding vehicles
to provide investors with debt securities that meet
their investment, trading, hedging, and financing needs.
Fannie Mae is able to issue different debt structures at
various points on the yield curve because of its large
and consistent funding needs. As the Treasury retires
30-year bonds, agencies have stepped in to fill the
void.
The privatization of Fannie Mae and
Freddie Mac was an ideological move. It was financially
unnecessary and government credit could have funded the
entire low-, moderate- and middle-income
housing-mortgage needs with no profit siphoned off to
private investors. These agency debt instruments played
a crucial role in developing and sustaining the credit
markets in the US.
In fact, the funding risk of
both agencies was questioned by the Wall Street Journal
last February 20 in an editorial about Fannie Mae's and
Freddie Mac's safety, soundness and financial
management, characterizing both agencies as risky,
fast-growing companies that "look like poorly run hedge
funds", "unduly exposed to credit risk with large
derivative positions", and that they "use all manner of
derivatives" and "are exposed to unquantified
counterparty risk on these positions". Such concerns
would have been avoided if both agencies had been funded
with government credit, and the cost of housing to low-,
moderate- and middle-income Americans would have been
lower.
A government credit economy is different
from a private debt economy in its sustainability. The
Japanese economy stagnated for more than a decade
primarily because it shifted from a government credit
economy to a private debt economy in the name of
financial liberalization and market fundamentalism. The
Japanese version of London's Big Bang started the
Japanese private debt bubble that subsequently infected
all Asian economies.
The Big Bang in London
refers to deregulation on October 27, 1986, of
London-based securities markets, an event comparable to
May Day in the US, marking a major step toward a single
global financial market. May Day refers to May 1, 1975,
when fixed minimum brokerage commissions ended in the
US, ushering in the era of discount brokerage firms and
the beginning of diversification by the brokerage
industry into a wide range of financial services using
computerization and advanced communication systems. This
started the offering of new genres of financial products
and the emergence of structured finance that made
possible a new private-debt economy that turned quickly
into a global debt bubble. As the US reaped the fleeting
benefits of dollar hegemony, a budget surplus
accompanied with sovereign debt reduction merely pushed
more debt on to the private sector to feed the debt
bubble.
The most fundamental aspect of a
private-debt economy is that it cannot sustain a
slowdown, even a soft landing. If Greenspan had been
better versed in debt economics, he would have
understood that a debt bubble, unlike the conventional
business cycle, cannot survive the slightest deflation.
Inflation is the oxygen for a debt bubble.
Greenspan's attempt to engineer a soft landing
by raising interest rates to fight pending inflation
pre-emptively only accelerated the debt bubble's burst.
His only option was to prevent the debt bubble from
forming by tightening credit quality years ago, but he
chose to rely on the market to exercise its discipline.
He rejected the suggestion of such Wall Street gurus as
Henry Kaufman to raise margin requirements. Instead of
discipline, the market gave him an insatiable appetite
for addictive debt, which he had previously called
"irrational exuberance".
Once the bubble was on
its way, Greenspan was on top of a debt tiger that he
could not get off without being devoured by the beast.
It was not the New Economy, it was not the unprecedented
productivity that gave the US its decade-long boom. It
was debt. Without debt, there would have been no New
Economy, no dotcom industry, no telecom explosion, no
structured finance, no budget surplus and no current
account deficit or its flip side, capital account
surplus.
The 1990s was the debt decade. Much of
the technology was invented prior to the beginning of
the decade of finance capitalism and became widely
applied through debt in the form of vendor finance. The
communication revolution was built on debt that had been
accumulated in the last decade. The greatest invention
of the 1990s was more and more sophisticated debt
instruments.
Greenspan warned in December 1996
about "irrational exuberance" when the Dow Jones
Industrial Average (DJIA) was at 7,000, that inflation
down the road was inevitable unless the Fed started to
raise Fed funds rate pre-emptively. Yet as rates rose,
the DJIA rose to 12,000 by 2000, because inflation as
measured by the government failed take into account the
wealth effect.
The reason for this was twofold.
Inflation was kept low by imports and inflation was
measured mostly by rising wages but not by rising asset
value. Stock prices doubled and real-estate prices
tripled, but the economy officially did not register
inflation because of low wages and cheap imports. As
stock prices rose, the price to earnings ratio
skyrocketed. As the economy inched toward technical full
employment with 4 percent unemployed, Greenspan
reflexively raised the interest rate to cut off
anticipated wage-pushed inflation. The high interest
rate adversely affected the earnings of debt-ridden
companies. To boost earnings, companies cut employees,
which started the downward spiral.
Since July
1997, the risks of protracted global asset deflation
caused by the aftermath of excessive private debt have
become reality, first in the emerging markets and now in
the United States. Neither the IMF nor the Group of
Seven (G-7) have been able to deal effectively with the
twin problems of the artificially strong but debt-driven
dollar and the spreading manipulated devaluation of
other national currencies around the globe.
For
the affected nations, the combination of mountains of
foreign-currency debt and massive short-term capital
flight through stock-market collapses, exacerbated by
IMF conditionalities of high interest rates, austerity
measures that insisted on reduced government deficits
and sharp currency devaluations coupled with asset
deflation, have led to tragic destruction of hard-earned
wealth and a severe drop of living standards.
Certainly market forces in a runaway-debt
economy have not created Adam Smith's "universal
opulence which extends itself to the lowest ranks of the
people". The only trickling down has been poverty and
misery. In a world of 6 billion people, only about 1,000
currency traders and a small circle of rich investors in
their hedge funds seem to enrich themselves further
through the unbridled manipulation of the free financial
market. Even in advanced economies, workers are misled
to accept low wages as a trade-off for stock options
that become worthless when the debt bubble bursts.
Corporations seduce share owners with fantasy
capital gains based on debt to replace regular dividend
payouts. When market capitalization of major
corporations inflated by debt can fall by 90 percent
within a matter of months while top executives can cash
out at peak prices and resign with severance packages
worth tens of millions of dollars, there is no other way
to describe the situation than reversed Robin Hood:
robbing the poor to help the dishonest rich.
This view is now shared by increasing numbers
across ideological spectrums. Economist John Kenneth
Galbraith's famous description of trickling down
prosperity was if you feed the horse enough oats, the
sparrows will some day benefit from its droppings. In
finance capitalism, the poor sparrows are crushed by the
wheels of the carriage of debt that the horse pulls.
If debt is dilapidating, foreign-currency debt,
mostly dollar debt, is deadly. Thus those governments
that had been misled by neoliberals to borrow massive
amounts of foreign currency unnecessarily and
subsequently dutifully implemented IMF prescriptions,
such as Brazil, Argentina, Turkey, South Korea and
Indonesia, saw their economies destroyed to the point
where recovery may now take decades, if ever, and only
if the poisonous IMF medicine is quickly rejected.
The IMF has now admitted that it made a "slight
mistake" in dealing with the Asian financial crisis of
1997. It might have been slight for the IMF, but the
cost to the economies of Asia was horrendous. Trillions
of dollars of hard-earned assets and economic capacities
have been destroyed, lost forever. In fact, lives have
been lost, children malnourished, families ruined,
governments fallen and ethnic animosities intensified.
The cooperative partnership among neighboring countries
has been undermined and regions destabilized. This is
the direct result of predatory lending followed by
predatory IMF rescues. The operations were technically
successful but the patients died.
Since World
War II, the term "capitalism" has been gradually
displaced by the more benign label of the free market.
Capitalism ceased to be mentioned in most economic
literature. In the process, economists also squeezed out
of official dialogues the word "capitalism", the
once-traditional name for the market system, with its
subjective connotation of class struggle between owners,
through their professional managers, and workers,
through their trade and industrial unions, and with its
legitimization of the privileges that go with various
levels of wealth.
The word "capitalism" no
longer appears in textbooks for Economics 101. A Harvard
economist, N Gregory Mankiw, author of a popular new
textbook, Principles of Economics, told the New
York Times: "We make a distinction now between positive
or descriptive statements that are scientifically
verifiable and normative statements that reflect values
and judgments." A whole new generation of economists
have grown up thinking of "capitalism" only as a
historical term like "slavery", unreal in the modern
world of market fundamentalism.
Capital, when
monetized in dollars, is in essence credit from
government. Capitalism in a money economy is a system of
government credits. Thus a case can be made that in a
capitalistic democracy, access to capital and credit
should be available equally to all in accordance with
national purpose and social needs. The anti-statist
posture of neoliberalism is not only logically flawed,
but its glorification of a private-debt economy will
inevitably lead to self-destruction.
Henry
C K Liu is chairman of the New York-based Liu
Investment Group
(©2002 Asia Times Online
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