Ignoring America's recession

Back in 2001 the US Fed was considering the very real risk that the US government would be able to pay off their entire national debt. The government had been running a fiscal surplus for five years and was projected to continue with this to 2010. It was this which underpinned George W Bush’s (then recently elected) $1.3 trillion tax cut.

Why worry about paying off all the debt? Well, the Fed controls money supply by using dollars to buy the bonds which the US government issues to cover its debt. No debt, no bonds … and the Fed had to consider new ways of controlling money supply.

At the time then Fed Governor, Alan Greenspan, would rather that additional capital went to prepare the US economy for the pressure to be placed on it through obligations in Social Security and – especially – Medicare.

Squandering the Surplus

As events played out, shortly after the tax cuts were made permanent (for any given value of permanent) events changed dramatically. It turned out that the massive tax bonanza was as a result of short-term capital gains which were being unwound. The surplus turned into a hair-raising deficit overnight.

Bush’s tax cut did have another unintended consequence. The Fed lowered interest rates to counteract the sudden liquidity crunch that came from the tax shortfall (and stock exchange shrink). This made Americans feel richer. They bought property.

Banks had long packaged their debt into what are known as Collateralised Debt Obligations (CDOs). It works like this. If you know the chance of default is 1.5% then you can package a whole bunch of loans together (say $10 million in a single tranche) and sell it as a single package. Banks do this for a simple reason. By international banking law (updated to Basel II in 2008) banks may only carry a certain amount of debt relative to their total deposit base (this keeps them solvent in case of a bank run on their deposits, since they can’t call in their debts immediately). By packaging the debts and selling them, they then remove this debt from their books.

Companies would buy CDOs for some discount rate relative to the expected default (so, perhaps that $10 million tranche would be sold for $9.5 million). However, in case of default the buyer would lose both the capital and the interest in one go. If the risk had been calculated correctly, no problems. If the risk hadn’t been …

This resulted in a moral hazard situation. Since the banks weren’t carrying the actual risk, and the people buying the debt weren’t that familiar with risk profiles, the banks started lending to people who shouldn’t have a hope in hell of getting a loan. Those people (with no jobs, no assets, and no income) are known as the “sub-prime” borrowers.

These loans got packaged in amongst the rest. Because the loans are sold as solid packages, though, the standard risk of default continues but is astonishingly high on sub-prime loans over and above the predicted rate of failure. Companies took out very elaborate insurance on these risks in the form of derivatives and hedges.

Losing the Plot

All of this clever financial packaging had the effect of immeasurably complicating debts until no-one was really sure who had what, or what the impact would be. Hence the slow and erratic declaration of write-downs all across the world that significantly exceed the real value of sub-prime losses (some 1.5% of all home loans issued).

The more amusing thing (for those who find humour in this) is that the hedge funds and insurance companies who bought these CDOs often took out loans from the other banks who were also selling CDOs in order to cover the debts. In other words, the debts never left the bank’s books.

So, this has resulted in a liquidity crunch (exactly what Basel II was supposed to prevent) and the rapid devaluation of US housing stock. All those unfulfilled loans are now not backing all the US dollars in circulation. Rapid devaluation of the US dollar has followed to soak up the excess money supply.

At the same time the US has not reformed either of Social Security or Medicare and fully 76 million people out of the total 150 million of the US employment base are due to retire over the next 10 years as the Baby Boomers hit 65. This will increase consumption while reducing production. Leading to inflation and tax collection shortages which would make Medicare even more unsustainable than it is now.

Dealing with the Morning After

Hence, hoping that the US economy is simply suffering from a bout of investor negativity is a somewhat optimistic given the overhead still to be dealt with.

Both inflation and the obligations facing Medicare are within the ambit of US government control. Neither the current democratic contenders for the presidency (Hillary Clinton or Barack Obama), nor John McCain, have given any indication that they take this seriously. In other words, worries are likely to continue over the medium term.

And, for the rest of the world, a shrinking dollar and recessionary America is continued cause for concern.

In the final analysis, what Americans may consider the lasting legacy of GWB’s administration won’t be the war in Iraq, but the lingering headache of the opportunity to reform Medicare lost for good.

17 replies »

  1. “…fully 76 million people out of the total 150 million of the US employment base are due to retire over the next 10 years as the Baby Boomers hit 65.”

    Yow. This stat puts even more teeth into this.

  2. Medicare will be reformed. The question is not if, but rather when, and our politicians will have to figure out how to do it while getting the most bang for the proverbial buck.

    Unfortunately, I have little faith that our current crop of Congresscritters (or any of the three candidates for President) will it in as timely a manner as is required. Which means the pain will be just that much worse when it finally is changed.

    I wish I knew whether to blame the people, the corporations, or the government for our national inability to focus beyond next quarter or next year. Short term gain usually comes at the cost of long term performance, a fact that doesn’t seem to be taught anymore.

  3. This isn’t a solely US problem. How is any politician anywhere in the world going to get re-elected when the reform process will only pay off in a decade, but re-election is up for grabs in two years?

    Ultimately it is up to voters to stop robbing their children and grandchildren of a future.

    As Alan Greenspan so eloquently put it when Bill Clinton asked him where the Social Security debt came from, “Well, Ronald Reagan borrowed it from you.”

  4. Whythehawk just wrote an excellent post describing the events that occurred. The real thing to ponder is that while we know what happened, what is one personally going to do to react to events and protect themselves and their families. There are ways to personally avoid going down the tube.


  5. Thanks for an explanation of the liquidity crisis even I can understand. NYT and BizWeek didn’t do as good a job as you did.

  6. I thought that both Obama and Clinton did address the potential shortfall in medicare and social security funding by proposing to raise the cap on the social security tax. As it is the payment to the social security fund falls diproportionally on those in the lowest income brackets.

  7. Carol – Social Security is the (much) lesser of the dual Medicare/Social Security problem, so it’s not as pressing. I personally think that fact makes it easier to fix, and gives all the parties a practice run, so to speak, before they try to fix Medicare, but that’s just my personal opinion. If it takes 10 years to fix Social Security, then that’s probably too long to wait before fixing Medicare.

    Whythawk – I realize that this isn’t necessarily a U.S.- only problem, but I’m not tied well enough into the detailed workings of other governments (election cycles, for example) or the economic workings of other economies to feel confident that they all suffer from the same short-sightedness problem. In fact, there are a few European economies that seem to have avoided this problem, but I haven’t looked deep enough to know for sure.

    I’d never heard that Greenspan quote, but I like it. I just wish that Clinton hadn’t borrowed it from Bush, and that Bush hadn’t borrowed it again from whoever happens to succeed him. We can only do that for so long before the repo man comes to collect.

  8. Brian, Wouldn’t a health care program (any of the three that have been on the table–Bush, Obama, or my favorite by Edwards) also include setting up oversight on the drug companies. ONe of the features that is screwing up medicare, as I understand it, is the refusal to let the government bargain directly with the drug companies on prices.

  9. There’s a great section of the book “Undercover Economist” that puts the problem with the US health system very clearly into focus. It suffers from selection bias.

    As an entirely market-driven system only those who know that they are ill (or likely to become ill) will join a medical insurance scheme. Healthy people (especially the young) tend to stay out until they, in turn, become unhealthy.

    Since the insurance companies know less than their clients, they tend to get stuck with people making a few payments and then demanding huge claims. They get defensive, and you wind up with the system you have.

    Unfortunately, Europe has the complete opposite problem. In the US people probably go see doctors infrequently, and get less care than they need, all to reduce the cost.

    In Europe patients don’t pay directly (everyone is taxed) and so they tend to clog the system with every little ailment they can think of. Plus, instead of you deciding that you want eye surgery, some government bureaucrat gets to decide on your behalf. Which means you wind up queuing.

    And universal health cover is fiendishly expensive. In many ways, they US system has a lot further to go before it hits a wall than the European version. European baby-boomers retire earlier and receive more benefits than in the US. Plus, many European countries have serious population decline. I.e. fewer taxpayers covering ever greater benefits for every more people.

    It’s a little complex, but a recent suggestion is a mix of both public and private. Regular, tax deductible, mandatory, savings schemes for each person – with top-ups from the taxpayer for those who cannot afford them – to cover basic medical needs (like colds, broken bones, etc.) and then catastrophe insurance for everything larger.

    So far the only country in the world with something like this is Singapore. And their cost of care per head (and return on that investment) is amongst the highest in the world.

  10. Whythawk, Taking account of what you wrote in answer to mine, I wonder what you think about a reform that is really important to a lot of us. People with pre-existing conditions are frequently refused insurance or it is priced so high that it is very difficult to sustain the payment. I doagree that if their is going to be a national health plan it should cover everyone so that healthy people do not opt out until they are sick and then expect to get coverage.

  11. While it is accepted among most in the non-financial community that we are in a recession, here’s some hard data that might suggest otherwise. There is, for certain, a major credit crunch which is the market’s way of digesting all of the irrational exuberance of the past couple of years. The unwinding of the leverage, the transfer of the risk, combined with investor jitters has contributed to the recession fears. However, it takes two quarters of negative GDP growth to meet the definition of recession.

    –Yearly Percent Change–
    Jan. Dec. Nov.
    2008 2007 2007

    Total new orders 7.2% 6.4% 5.2%
    Ex-transportation 7.7% 5.6% 7.2%
    Excluding defense 7.2% 5.5% 6.7%
    With Unfilled Orders 5.0% 7.8% -1.1%
    Capital goods 12.9% 12.6% -1.0%
    Nondefense 14.3% 7.8% 5.6%
    Ex-aircraft 5.3% 2.3% -2.6%
    Defense 3.5% 48.1% -43.1%
    Consumer goods 11.1% 8.1% 11.8%


    Feb. Jan. Dec.
    2008 2008 2007

    Composite Index 49.3 44.6 53.2
    Business Activity 50.8 41.9 54.4
    Prices Paid 67.9 70.7 71.5
    New Orders 49.6 43.5 53.9
    Backlog of Orders * 49.5 46.0 49.0
    Supplier Deliveries* 50.0 49.0 52.5
    Inventory Change * 50.0 44.5 50.5
    Inventory Sentiment* 60.5 57.0 64.5
    Employment 46.9 43.9 51.8
    New Export Orders * 46.5 52.0 50.0
    Imports* 49.0 41.5 50.5

    *NOT seasonally adjusted

    This will either turn out to be the biggest head fake in the history of economics, i.e., no recession, or the most well advertised one with the longest advance notice.

    Note….I do agree with y’all that Medicare and Medicaid needs reform, major reform.


  12. Jeff, Ronald Reagan’s quote: “A recession is when your neighbour loses his job, a depression is when you lose yours.” It doesn’t have to be technically a recession to feel like one.

    Carol, as regards covering people with existing conditions. Difficult one. Lung cancer as a result of life-long smoking? Failed suicide? Child got hit by a bus? Easy to agree to finance the latter, but why pay for the results of other people’s self-imposed foolishness?

    However, this won’t be my decision. It will be an elected official promising to spend other people’s money. Go figure.

  13. Decisions, decisions? There is certainly culpability on the tobacco industry side, for example deliberately increasing the addictiveness of cigarettes. Spuriously targetting filtered and “lite” brands as less dangerous. Using psychological gimmicks to hook kids on cigarettes at a young age–remember how all the coolest actors and actresses on TV and film used to smoke, not to speak of the provcative models and sexy scenes displayed in TV advertisements. And then there are folks like me with two parents who were big-time smokers plus work environments that allowed heavy smokers to pollute the atmosphere. Suicide–I dunno–but it doesnt’ fall under a pre-existing condition.

    You know a big saver in medical costs, in my opinion, would be stop over-prescribing drugs such as statins and anti-depressants, and perhaps not doing every conceivable diagnostic test when there are good ones available at a lower cost like a sigmoidoscopy versus a colinoscopy.

  14. Whythehawk:
    Does it feel like a recession to you, personally? If it does, I’d be interested in how it’s affecting you.

    I merely offered some hard data courtesy of the US government, suggesting that things aren’t as bad as the media portrays. If there is a recession, it will be an election year media driven one, like the one in 91-92. However, we won’t know if there is a recession until the end of next quarter.

    If we’re indeed in a recession, then it’s a good time to buy stocks. It’s a good time to buy mortgages right now, as the discounted prices and yields are outstanding. The old axiom “Buy on the cannons and sell on the trumpets” has been time tested for over 600 years.


  15. Carol, I’d argue that anyone who still doesn’t know – after 20 years of the Surgeon General’s Warning – that cigarette smoking is unhealthy is to stupid to survive unaided anyway. However, perhaps we could discuss drug addiction (cocaine, methadone, prescription drugs, your poison). That wasn’t the point. My point is simply that if it is difficult to decide how to help people who have messed themselves up, how much easier is it to help people whose parents made unfounded genetic choices for their children (by, for instance, breeding when there was a high statistical chance of passing on muscular dystrophy or whatever to their kids). And while these choices, in and of themselves, are not a problem, they do become a problem when people unassociated with those choices are asked to pay for their consequences.

    Jeff, difficult for me to comment on direct US experiences since I’m down here in sunny South Africa. Inflation is running at 9%, interest rates are 14.5%, food price inflation (which isn’t included in CPI) is running at 20%, and we have 40% unemployment. The rand (our currency) can’t even keep up with the collapsing dollar, having lost 15% in the last 3 weeks against the greenback. Yet GDP growth is still 4.5%. We don’t have a recession, but try telling that to the poor and unemployed majority.

    And I’m fairly sure that, as the US runs into an election year, it doesn’t much matter what the headline figures say. Blue-collar workers are being paid relatively less than they have in the past five years, inflation is high, their house values are shrinking (and it’s their only capital asset) and they’re uncomfortable about the future.

    This makes it rather unlikely that any politician hoping for future election is going to tell those same people, “Listen, I know it’s tough, but I have to tighten up on your benefits a little.”