What do you do with your last dollar when
you are flat broke? You might as well buy a
lottery ticket. Putting your last silver dollar
into the slot machine with a million-dollar payout
is a rational decision after you've gambled away
your whole stake. Absent a miracle, you're going
to walk home anyway.
Two great upheavals
took place in the past week. One occurred in
American politics, when the voters of South
Carolina crushed the predictions of the political
professionals. The other occurred on the world's
stock exchanges, where the value of the world
economy swung in a 20% range.
Senator
Barak Obama's surprise landslide victory in the
South Carolina primary demarcates a turning point
in modern American
politics. Can it be a
coincidence that it occurred in the same week that
financial markets showed their wildest gyrations
in post-war history? Days ago, every poll
indicated that economic weakness gave the edge to
Senator Hillary Clinton, whom voters regarded as a
superior manager. But the Democrats of South
Carolina chose a miracle over a manager, for the
same rational reasons that a down-and-outer spends
his last dollar on the lottery.
Obama's
South Carolina victory speech was the economic
equivalent of a carnival snake-oil pitch. He
promised to "stop giving tax breaks to rich
companies and instead put the money in the pockets
of struggling homeowners who can't pay their
mortgages", and at the same time stop the export
of American jobs overseas, while raising
everyone's wages.
The crowd chanted, "Yes
we can! Yes we can!" Excuse me: No, you can't. You
can't keep inefficient American factories open
without massive tax breaks to corporations, in the
form of tariffs or otherwise. In 1992, voters
rejected the same message from Ross Perot, who
warned that free trade with Mexico would create a
"giant sucking sound" as American jobs
disappeared, and chose the free-trader Bill
Clinton. But that was then: this is now.
Polls projected a close race, but Obama
crushed Clinton by a two-to-one margin. The
inability of the pollsters to gauge the opinions
of voters is one of the most important
observations, for uncertainty itself has become a
decisive variable. Can it be coincidence that
investors also suffer from the same degree of
uncertainty in valuing economic outcomes? During
2008 to date, the Nasdaq 100 Index of American
stocks swung in a 26% range. Citicorp , America's
largest bank, gyrated in a 30% range - and therein
lies a tale to which I will return momentarily.
If markets cannot make sense of economic
outcomes, all the less can individuals at the
bottom of the economic pyramid make sense of their
own prospects. Americans face a degree of economic
uncertainty not seen since the Clinton years, and
in some ways much worse, for more Americans than
ever will retire during the next decade with
slimmer means than they ever expected to have.
People of modest means do not understand
the stock market, but they are sly: they can read
the panic in the eyes of their leaders. After
assuring them for months that all was well,
Washington last week offered an emergency interest
rate cut for the first time since September 11,
2001, and an emergency economic package which will
send a small check to every American family
earning less than a certain threshold. Both
President George W Bush and Clinton proposed
essentially the same program. If that is
"managerial ability", thought the voters of South
Carolina , we might as well buy the lottery
ticket.
America faces not a dip in the
business cycle, but the end of a 25-year run of
wealth creation. Rising home prices were supposed
to provide America's retirement nest egg, the
substitute for the savings that Americans never
amassed. Home prices have fallen by a third in
markets like California, Arizona, Nevada and
Florida where the bubble rose fastest. During
2007, the price of American homes fell overall for
the first time since the Great Depression. Yet
Americans still expect home price appreciation of
5% a year over the long term, according to polls
conducted by economist Robert Shiller.
Americans, as I wrote on January 8 (Putin for President ... of the
United States) mistook the one-time
windfall from the Ronald Reagan boom of the 1980s
for the enduring right to get something for
nothing. Despite massive evidence to the contrary,
they still cling to the delusion that twenty years
from now, everyone will retire by selling his home
to his neighbor at double the price. It is like
the passengers on the Titanic selling each other
annuities.
Writing about the impending
retirement of the Baby Boomers in the January
Atlantic Monthly, Megan McArdle observes that
prospective retirees evince a preternatural
optimism about their prospects. But this
confidence "seems to rely on some mystical alchemy
of strong stock gains, housing value increases,
and government largesse. The first, as we've seen,
may disappoint. The second seems outright
fantastic".
There is not much to be gained
from giving up the illusion that rising home
prices will fund the retirement of Americans, for
the alternative is to reduce consumption
drastically in order to save. It is hard to
imagine how Americans can avoid such a shift away
from the spending habits of grasshoppers to the
thrift of ants during the next several years. But
even a very large increase in the savings rate
will not match the decline in household wealth due
to falling home and stock prices.
It is an
ominous sign for the American economy that banks
already have taken US$120 billion in charges due
to the collapse in the value of securities backed
by mortgages of poor ("subprime") credit quality,
before the onset of an actual recession. A number
of banks, including Citicorp, America's largest,
are short of capital and have gone hat in hand to
sovereign wealth funds in the Middle East and Asia
to raise more. To date banks have suffered almost
no defaults from corporate borrowers, after the
most aggressive round of lending to
speculative-grade companies in American history.
As defaults pile up during 2008 and 2009, pressure
on banks' capital will become extreme.
Bank capital is the Achilles' heel of the
world economy. Last Monday, stock markets crashed
in Asia around one pm local time, when an e-mail
from Hong Kong and Shanghai Bank told investors
that two of the sovereign wealth funds had pulled
out of agreements to investment in Citicorp and
other major financial institutions. Whether that
is true or not remains unconfirmed, but the rumor
alone was sufficient to send world stock markets
into a tailspin. Compounding the crisis was
concern that insurance companies who have
guaranteed $1.6 trillion of securities would not
meet their obligations. Investors had assumed that
the banks would bail out the bond insurers, but if
the banks themselves could not raise capital from
the sovereign funds, they themselves would need a
bailout before they could bail out anyone else.
No, Obama, you can't. You can't blame
America's trading partners for the loss of
manufacturing jobs, and at the same time persuade
them to replace the misspent capital of the
American banking system. You can't persuade the
world to fund hundreds of billions of dollars a
year of American home mortgages, and protect the
employment of a few hundred workers at Maytag.
Obama well may win the presidency
notwithstanding. Some of the decisive electoral
battles of 2000 and 2004 were won in the so-called
exurbs, the newer and more distant suburbs that
mushroomed during the home-building boom of the
past decade. Republicans no longer dominate the
upwardly-mobile middle class of the exurbs, where
the most devastating home-price declines are
registered. Earlier this month a large
home-builder, Lennar, sold tracts of unoccupied
homes in exurban Florida to speculators at 40
cents on the dollar. That does not bode well for
the shoddily-wrought McMansions in recently built
exurban tracts.
Obama is the "Democratic
Reagan", observes one of my favorite bloggers,
Beliefnet's Rod Dreher. In terms of political
punch, the comparison is apt; it is now
conceivable that Obama will sweep the November
election and bring a Democratic Congress on his
coattails. In content, though Obama is the
anti-Reagan, promising that the government will
come to everyone's rescue. In his South Carolina
victory speech, he proclaimed, "We cannot afford
another year without decent wages because our
leaders could not come together and get it done."
What precisely does that mean? "The
teacher who works another shift at Dunkin' Donuts
needs us to reform the educational system to raise
her pay." Is the Federal government planning to
subsidize teachers' salaries, which in America are
paid by local school boards with city and state
taxes? Is he really planning to raise corporate
taxes and subsidize mortgage payments?
If
Reagan offered "voodoo economics", as his
opponents charged, Obama is selling Cargo Cult
economics. After World War II, New Guinea
aborigines build model airfields to entice the
gods to bring them "cargo". They watched American
soldiers build airstrips and land cargo planes,
and sought to accomplish the same through
sympathetic magic. Given the culture of the
aborigines and their observations, anthropologists
aver, making radios and observation towers out of
straw and coconuts was a rational response.
Something similar might be said of the position of
the American middle class.
Waves of
uncertainty are whipsawing through both the
financial markets and the primary elections. The
danger in coming days is that a kind of harmonic
resonance will amplify both of them. The Bush
administration will cower before Obama's growing
shadow as it struggles to prevent the unraveling
of the financial system. Every action to buttress
the banks and insurers the administration might
take will be vulnerable to the charge that the
Republicans are bailing out out Wall Street rather
than distressed homeowners or insecure workers.
The danger is that election-year politics will
paralyze crisis management.
It has been a
very long week, and it is going to be a very, very
long year.
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