Rant on the Economy

The collapse of the economy is the result of many different causes. There is plenty of blame to go around. For all too long, the government, under the spell of the mantra that “the government is the problem, the free market is the solution,” let much of the financial industry escape any real regulation by morphing into new forms of business that did not fall within the conventional regulatory schemes. As the Madoff and Stanford scandals show, the regulators gradually deregulated, through lack of vigorous enforcement, even in areas that are within their authority to regulate. As Judge Posner admitted recently, in that environment of rampant non-regulation, the Wall Street “Masters of the Universe” acted as he would expect, as “rational profit maximizers”: Unrestrained short term greed simply drove all good sense out of the market.

For example, most of the “credit default swaps,” and it appears much of the world of “derivatives,” is in fact gambling. Neither party to the swap has any connection to any actual economic activity. They are simply betting on the outcome of the actual economic activity undertaken by others.  In a world of rational regulation, no honest business would propose such a scheme because regulators would be expected to swoop in and determine these swaps to be what they are — unenforceable gambling contracts. Where was the accountability for those in the financial industry, the regulators and those in charge of the regulators who all acted so irresponsibly? A new structure of regulation and new regulators need to be put in place so that those with basic good sense have the reinforcement of prudent regulation.

Some of the blame seems wrongheaded.

Sure, some potential homeowners bid on homes way over their heads under any economic scenario. But many were induced by the mortgage marketers to do it. It is bizarrely American that some have tried to point the finger of blame at minority group members when they were specifically targeted for shabby treatment by some in the mortgage business.

Why blame the auto workers for the mismanagement of their industry? Blind to the inevitable long term pressure on the supply of oil and therefore the cost of gas, the automobile executives bet their companies on a single strategy to make more profits in the short term: Build large, heavy, low-tech, clumsy, and dangerous gashogs to satisfy the atavistic desires of American consumers to have their grandpas’ Buick though in slightly disguised form. Then, as with the minivan market the American companies created earlier, they failed to stay competitive with foreign makers of SUVs. American corporate laws create incentives for enterprise to focus on short term profits, not the long term development of the enterprise. The Detroit automakers have not had a culture that made sure each new car model advanced the state-of-the-art; they have not even tried to keep up with the competition. The only thing that has mattered is the profit and loss statement for the next quarter.

The mortgage crisis, the credit crisis, the banking crisis are all, I fear, symptoms of an underlying problem that has not been brought to the fore. That is that our middle class no longer earns an income sufficient to maintain a middle class life-style. The problem is not that the U.S. autoworkers make too much, it is that all too few workers earn what the UAW workers earn.

Almost all of the economic gains in this country in the last thirty years have flowed to the very highest income groups. While it is easy to understand outrage at the AIG bonuses, there seems to be too much focus on the claim that those on the top get too much and not enough on the consequences of the vast majority of workers who fall far below the top and who do not earn enough.

Male wages have been stagnant since the 1970s. American families nevertheless were able to cope because family income gained ground because of the tremendous influx of women into the paid workforce. But, family income, even with two wage earners, then topped out. And so, to try to maintain a middle-class lifestyle, American families turned to credit, starting with taking equity out of their homes. The financial industry was all too accommodating, throwing out all the old rules that evaluated risk on the belief that housing values would always continue to rise. But, like any bubble, it burst. So, the problem is not that the autoworkers in Detroit make too much money, it is that most American families need to be able to earn substantially more than they have been earning for a long time. For the future, what a middle-class lifestyle will mean is likely to be a lot less in terms of consumption than it has been. That is not all bad. But, what is bad, is that the implementers of the “government is the problem, the free market the solution” have left our economy and our nation very much weakened.  But they still manage to be entitled to tremendous bonuses.

Historically, this country had many things going for it to become great. But, one of the best was the decision, starting with the Northwest Ordinance in 1789, to devote public lands to develop broad public education. It is our leadership in education, not our under-regulated free market system, that has underwritten the development of our economy. And, given the “free market” rhetoric that has captured public discussion for all too long and has resulted in an increasing underinvestment in education, we are falling behind other countries. Worse than losing competitive advantage, we are wasting a tremendous amount of human potential by not providing both basic and advanced educational opportunity to all of our people. It is not clear that expanding and deepening educational opportunity for all will necessarily help us recapture our past strengths: If we build a much more robust educational infrastructure, will new jobs, new opportunities be there to utilize it?  There is a strong historical correlation between the extent of quality education and expanding economic strength. That suggests that when we produce better educated people, economic development does follow. Educational infrastructure development, unfortunately, takes a long time and so we cannot expect results tomorrow. I am sure there are other social investments that are necessary to rebuild America for this century and beyond. But betting big on education is necessary for the long run.

This Post Has 12 Comments

  1. Tom Kamenick

    I see both the consumer and business as equally culpable for all of this. What it all comes down to in both groups is that people wanted to overachieve, either living a life beyond what was sustainable for the long term or running a business with no eye for planning for downturns and slow times.

    Individuals getting houses at the outermost limit of what they could afford if the future had no hiccups, getting cars with five- or six-year loan terms to bring the monthly payments of a $35,000 car down to a level they thought they could afford.

    Businesses assuming that all trends would continue without changing direction, failing to consolidate and buttress their gains against future dangers.

    Life runs in cycles. Anybody who lives his or her life assuming (whether knowingly or in ignorance) that no hard times will come, whether an individual or business, deserves what’s happened. They should fail, and suffer, and not be propped back up, so that those who come next honestly face the true consequences of their actions.

    Before I came to law school, I bought a house (2005). I was offered ARMs and was prequalified to spend nearly $100,000 more than we decided would be prudent to spend on a house. We also turned down the ARMs and got a higher fixed rate. I’m already being punished in the drop in property values from all this unwise borrowing (and lending) and foreclosing. Why should I be punished further by being forced to subsidize the horrible decisions of others?

  2. Mike Zimmer

    Hi, Tom,

    Thanks for your comment. Two things:

    1. You leave out the culpability of the government — letting the rascals in business escape all regulation by creating new ways of doing financial business just in order to escape regulation and not enforcing regulations even where they continued to apply.

    2. As to you being “punished further,” I guess it is a question of what is worse — a Greatest Depression So Far — or bailing out the business, government, and consumer rascals.

  3. Tom Kamenick

    #1 – You ascribe the sins of inaction to the government. My problem is that the government took action to encourage this mindset, largely through the advantages given borrowing over saving and debt over equity, and also through its own spending policies. Government borrowing isn’t problematic… so long as it’s safe to assume that GDP and tax revenues will continue to increase. Now that both of those are decreasing, drastic spending increases is just digging a deeper hole. Look at the way the financial experts and politicians are talking – “We need to free up the financial market so people can start borrowing again.” We need to solve the problem created by excessive debt by… encouraging everyone to go into more debt?

    #2 – That’s a false dichotomy of choices. Letting the poorly-run businesses fail will not destroy the economy, it can remove the impediments standing in the way of smaller, more efficient, better-run businesses. Bailing out the rascals will only perpetuate the problems – they are too entrenched, they are too large and have too much inertia to change the way we need. Government can regulate (force) them into change, but that is less efficient, less effective, and less permanent than allowing it to happen naturally.

  4. Nick Toman

    I think Tom’s cyclical business cycle misses that the financial dealings that led to the meltdown were unsustainable in any environment. The risk of lending was (supposedly) seperated from the benefits — those who originated and profited from the loans underlying the CDO’s bore no risk of those loans busting. Therefore, the financial incentives for everyone up until the very end was to push for absurdly large, expensive loans.

    So the finanical industry would have collaped with or without a downturn in the market. In fact, the lack of regulation that allowed the risk to go unheeded is what caused the downturn, not some sort of natural business cycle.

    Unless all the players in the market have some skin in the game, the government has to step in so that the markets don’t reward short term gain over the wellbeing of the long term sustainability.

  5. Vince Heine

    Professor, you are incorrect (but also correct in some ways), and there are many other factors of consideration that are not mentioned, mostly I fear as a result of political correctness.

    Unions do deserve a a great deal of blame. It was their bargaining power that led to an absurd cost structure for the auto manufacturers, both in hourly wages and in legacy costs. The auto manufacturers had no choice but to focus on the SUV market because the profit margin was higher and if they couple it with their financing arm they actually could turn a profit. If they try to make cheap, fuel efficient cars their margins would go down, and so would the amount of principal being financed. Admittedly though, better management would have been nice.

    You are correct that the middle class is the victim, buy your analysis as to why seems to exclude other factors. For example, low-skilled laborers still make up a large part of the country. Immigration has brought an oversupply of low-skilled workers into the country and as a result wages have not only been stagnant, in many cases they have declined. That is a result of simple supply and demand, but in today’s PC age one can’t dare say immigration may be a problem, lest they be considered racist or xenophobic. I have blue collar friends from high school who started out making $20/hour in construction. Some 10+ years later they make slightly less. This is a direst result of immigration patterns.

    What is also hurting the middle class is education costs and health care costs. When Zilber went here back in the late 40s (I think that was when he was here) I believe he said his tuition was $25/semester. If I index that to the historical average of inflation, would that equal the 16k/semester I pay? I have my doubts. No other university seems to be capable of this either. This is not mentioned in your discussion about the education. Perhaps we must admit that higher taxes are necessary for this as only greater government funding will bring tuition costs down.

    As for regulation versus deregulation, this has become a broad argument used by many, but devoid of the necessary nuance to lend itself to a meaningful discussion. At times, regulation may in fact be harmful. In the last State of the Nation’s Housing published by the Joint Center for Housing Studies at Harvard, one of the main problems with housing — which in turn also injures the middle class — is affordability. They concluded that the greatest “culprit” with respect to affordability was federal, state, and local regulations. That’s the problem with regulations, they make everything more expensive. This is not to suggest that no regulation is preferred. The answer with respect to regulation versus non-regulation is, like many law school answers, “it depends.” To suggest that deregulation led to this mess is inaccurate (though it certainly was an important factor), as the government itself nudged the market many times through its beloved GSEs like Fannie and Freddy, etc. Thus, the market was not a “free” one.

    With respect to minorities, I have actually never heard anyone blame minorities directly, but rather the government’s push for minority home ownership. This is partly to blame as well because, to put it all too simply, if people can’t afford a home then they can’t afford a home, and banks should not be forced to lend to risky homeowners simply because a local nonprofit strong-armed them with the Community Reinvestment Act, threatening to ensure they would not expand as a result of perceived non-compliance.

    Just my two cents.

  6. Tom Kamenick

    Well, they were sustainable… just for a very short time.

    I think the problem is that the markets AREN’T rewarding short term gain over the wellbeing of long term sustainability. Do you call what’s been happening a reward? The market is doing what it’s supposed to do – coming crashing down bringing utter ruin to the institutions that made horrible choices (choosing short term over long term to an extreme degree).

    Government regulation is reactive – it can’t stop “the next crazy idea”. The people coming up with these crazy ideas have NO INCENTIVE to stop unless they are allowed to suffer the full consequences of them, which the government seems hell bent on shielding those “innovators” from.

    Why should these people stop trying to get around the system when they aren’t allowed to suffer fully for their mistakes?

  7. Mike Zimmer

    As I said, there is a lot of blame to go around. I know that macroeconomics has been downgraded in the intellectual world because of the dominance achieved by Milton Friedman’s microeconomic perspective. But we do face a tremendous macroeconomic challenge. Saying that individual enterprises should be allowed to fail when they make bad decisions seems to assume that there is no larger impact when those failures become quite general.

    I do find it hard to blame the UAW for bargaining to establish decent wages, hours, and conditions of employment for auto workers. One of its failures, of course, is not being successful at organizing the workers at the assembly plants of the foreign automakers. Also, it is hard to blame the union for operating within a society that ties health insurance to employment.

  8. Tom Kamenick

    “Saying that individual enterprises should be allowed to fail when they make bad decisions seems to assume that there is no larger impact when those failures become quite general.”

    No, I agree that such failures can and do have negative impacts on “innocent” third parties. My contention is that the broad, general impact is much worse in the long run where failures aren’t allowed to happen.

    It’s like venting gas out of a system to prevent the buildup of pressure that could lead to a catastrophic explosion. The government seems intent on trying to build ever stronger containment systems rather than simply venting out the bad elements by letting them dissipate.

    When large companies fold, they leave a vacuum. Nature abhors a vacuum – it will be filled, so the failure of a large business won’t lead to a permanent hole in the economy.

  9. Vince Heine

    Unions aren’t to blame if there is no blame to give to a group that was essentially successful in accomplishing its goals. However, if their goals are incompatible with the long-term success of the company, then they deserve some blame.

    I don’t believe unions are the right approach to helping the middle class; health care reform from the Feds/States would be better, coupled with education reform, i.e., price decreases.

    As for the too big to fail argument, I would simply note that Chrysler was bailed out in 1981 and now again, despite being owned by a private equity firm now. This seems of dubious social utility. The idea that not a single car maker can fail seems as if it will bite us once again in the future, and the taxpayer will essentially be perpetually subsidizing auto makers but getting little, if anything, in return.

  10. Mike Zimmer

    Hi, Tom,

    In your first comment you said you had played by the rules in buying your house and wonder why anybody who didn’t should be bailed out. And, even so, you have suffered because the value of your house has declined.

    When a macroeconomic crisis happens and deep deflation occurs, almost everyone (including innocent individuals and enterprises who always did the right thing) suffers catastrophically. President Hoover thought the system would right itself. But it didn’t. Keynesian economics says that drastic government action is necessary to revive an economy that has collapsed.

  11. Doug Hoffer

    In contrast to Hoover, FDR took dramatic government action and the depression still didn’t end for many years. Many Keynesian economists argue that the federal government didn’t spend enough to get out of the depression.

    Since the current government has committed to spending more, I hope the Keynesians are right. However, I worry that this spending spree may have unintended consequences.

  12. Spencer Larche

    Okay, so I’ve been loosely following this thread and deciding not to get involved here, but when people start saying Hoover was not an interventionist and “did nothing,” and that the Great Depression was only ended upon FDR’s wonderfully fantastic New Deal, I changed my mind…sort of.

    Before commenting on Hoover and worshipping FDR, please at least read the following.


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