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Financial Markets Turmoil Is Just The Beginning

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The break-up of Lehman Brothers, the fire sale of Merrill-Lynch, and the woes of AIG are, sadly, not fundamentally symptoms of corporate malfeasance, or the sad lot of an unlucky few, but, rather, signs of a worsening storm. The storm has several fronts:

1. Inflation - rising commodity prices slowly spreading to wages and consumer goods will suppress long-run growth prospects, decrease investment and increase long-term interest rates.

2. Over-levered consumers – low savings rates, cheap credit (cards and mortgages) and a culture of profligacy has run its course. The US consumer has no more money to spend; their houses are underwater and their bank accounts are empty. All that's left are mounds of debt than will take years to pay back.

3. Over-levered companies – cheap debt used to finance LBOs and other acquisitions has left corporate America struggling to generate enough cash to operate in a declining economy while still servicing its debt.

4. Under-financed municipalities – local and state governments face sharply declining revenues from declining property taxes and years of mismanagement.

5. Wasteful federal government – deficit spending for the foreseeable future may continue to drive down the dollar and drive up long-term interest rates, while making additional fiscal stimulus risky.

6. Slowing growth overseas – Europe, the UK in particular, is suffering economically as well. China and India have to deal with issues of inflation, internal instability and other growing pains which may limit their ability to support the US in attempting to export its way out of its economic mire.

Am I being overly gloomy? Perhaps. Smart government policy could go a long ways to help things. For example, offering more H1Bs to skilled overseas workers who are willing to work in the US and invest in US real estate could help stabilize the housing market. Reducing spending on Iraq and using the funds to rebuild America's crumbling infrastructure could help create jobs and stir growth. Cut taxes on small businesses and start-ups.

All should be done. But, alas, too little, too late. I am not going to be the one to put lipstick on this pig. Batten down the hatches. We are in for the storm of a lifetime.

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About Jeremy Berman

  • cuervodeluna

    Yep, you ARE in for the storm of a lifetime.

    But, all in all, I have to say that nobody deserves that storm more than the peppy people of Gringolandia.

    As the Good Ship Lollipop is flushed into the abyss of history, remember that a little bird warned you about all this quite some time ago.

    And it was not Chicken Little.

  • http://www.sitejabber.com Nick First

    Nothing wrong with a little schadenfreude, but the real danger is the contagion spreads to the rest of the world. This is looking increasingly likely.

  • Lisa Solod Warren

    If only it was just the greedy bloodsuckers who would suffer the consequences, but that is never the way, is it?

    Whatever happened to real Crime and Punishment????

  • http://www.sitejabber.com Nick First

    I believe a cynical man once said, “American capitalism is unique because we privatize the profits and socialize the losses.”

  • http://www.futonreport.net/ Matthew T. Sussman

    This story does fit into the political spectrum. And that’s the problem.

  • http://www.sitejabber.com Nick First

    Yes, this is the problem in the US. We have partisan politics, but we have bipartisan disasters.

  • Baronius

    Matt – What do you mean?

  • Baronius

    cuervodeluna, weren’t you banned from this site for personal attacks?

  • bliffle

    I’ve been bringing up the “privatize the profits and socialize the risks” mantra of modern US business for a long time. I’ve watched it developing for 30 years.

    At this point I think we have to admit that our attempts at “privatizing” various activities is a total flop. Whether it’s Municipal Water Departments, the Blackwater oafs in Iraq, or health care, they’ve all failed. All they did was increase costs and restrict supply!

  • bliffle

    Contrast the bankruptcy situation of the officers of AIG with that of the poor guy who goes broke because of their machinations.

    The exec takes his golden parachute and retires to his luxurious digs. No problem.

    The victim of his crimes finds it almost impossible to qualify for bankruptcy help because of the strict new rules.

  • http://www.sitejabber.com Nick First

    But in times like these, I think we have to be careful not to throw the baby out with the bathwater. Private markets are often much more effective than government for providing many goods and services. The trouble is, many markets need some form of helpful regulation to ensure well-functioning markets. The current situation has arisen from decades of poor regulation. So going forward, hopefully we will have better regulation, but that need not necessarily be more regulation.

  • Mooja

    There is no better regulation than a good, large failure every now and then. I can assure there are real shock waves propagating throughout the financial industry. Increased government regulation is a costly, bureaucratic whack-a-mole game. When will we shed this notion that the government must be every citizens financial nanny? Failure is not a dirty word. It is natural and it this too shall pass.

  • http://www.republicofdave.com Dave Nalle

    Bliffle, could you explain to me how AIG makes people go bankrupt? I’m not clear on how that works, exactly. Is it just the loss on stock investments or something more nefarious?

    Dave

  • http://www.sitejabber.com Nick First

    It’s true occasional failures can improve market function by making other firms re-evaluate their risk exposure. However, so many of these financial companies are “too big to fail,” which means tax payers are subsidizing their risk taking, and they therefore need to be regulated in the risks the take.

  • Franco

    Nick, this is an outstanding opinion pieces and I concur with most all of it. Well-crafted outline with solid resoning in clear terms.

    In your post #11 you add the following.

    But in times like these, I think we have to be careful not to throw the baby out with the bathwater. Excellent follow up statement!

    I would like to make the following correction to your next statement.

    ”Private markets are often predominately much more effective than government for providing many most all goods and services..

    And then this is another excellent follow up statment.

    ”The current situation has arisen from decades of poor regulation. So going forward, hopefully we will have better regulation, but that need not necessarily be more regulation.

    I would also like to add that America it too diversified and creative not to survive, and will come through it better and stronger in areas it has been weak in. It needs the pain for the gain, this is good for us, its just that it is going to take much of the free western world with it on this ride. But then again, other countires too will need to make many of their own corrections.

    Question: AIG was really the biggest surprise to me. Can you elaborate on what this means and what effects the markets an which markets we feel from this. Aren’t they not the largest insurance company in the world and didn’t they loose 60% in value?

  • http://www.sitejabber.com Nick First

    Franco: thank you for the compliments and clarifications. I agree that America will survive this, but I think it will be a long time before we can return to business as usual.

    Re: AIG – because the US Government essentially nationalized the company and assumed its liabilities, markets should be sheltered from much of the direct fallout from AIG (and AIG insurance policy holders will still be covered) which I believe was part of the Government’s intention behind the intervention. However, it seems equity and credit markets will remain skittish as they speculate on which other companies have toxic assets on their books (the Government would likely let smaller companies fail). Also, the Government will need to begin to sell off AIG’s non-impaired assets to pay down its debts, which could put another form of downward pressure on asset markets. The Economist wrote a good piece on this today

  • bliffle

    The US investment problem is not because people save little money (in fact, savings are the enemy of growth as they inhibit money velocity), the problem is disinvestment, which is the result of redistributing income from the low-income to the high-income, thus diminishing the economic multiplier. cf. “The Thrift Paradox” as it was known before macro economics.

    Also, we have developed a peculiarly American mode of disinvestment in the common LBOs and holding companies that liquidate company assets for personal wealth and exhaust capital and retained earnings.

  • cuervodeluna

    bliffle, Let me save you all those words.

    The problem was and IS: gringo greed.

  • bliffle

    Actually, I think it’s human greed, as I haven’t noticed that greed is restricted to people in any particular geographic location.

  • Don Jarrett

    This video on the subprime problem was recorded in 2007.

    Comical — but tragic.

  • http://www.sitejabber.com Nick First
  • cuervodeluna

    bliffle,

    I prefer to hope that there are some cultural groups less flagrantly promoting greed.

    Where I live it’s Mexican greed.

  • bliffle

    Seems like utter folly to expect Paulson, Bernanke and co. to bail us out of the crisis they’ve contributed to with such enthusiasm.

    In fact, it seems like folly to prop up the institutions that are proven failures. There’s no reason to expect they will do better if we give them a trillion dollars to cover their embarrassment.

    In fact, it would be a lot cheaper to pump the money in at the bottom of the economy rather than the top. Maybe 12 times cheaper.

    There’s about $550trillion of money paper riding on $45trillion of real assets in the US, so that entire facade of paper is 12 times bigger than the underlying intrinsic value. We’re operating on the same margin as in 1929.

    So, instead of wasting the money on the paper facade it should be applied to protecting and enhancing the intrinsic value.

    Instead of bailing out false front institutions we should be bailing out people who have lost, and are losing, their homes thru foreclosure. Every dollar we spend on our intrinsic value is like $12 spent on the paper facade.

    Looks like a better deal, to me.

    But then Paulson and Bernanke would be deprived of the pleasure of coppering their friends investments in paper. How sad.

    Just think, instead of $1trillion we could do it with a mere $80billion or so. Thats just 6 months of Iraq warfare. Hell, that’s not much. Chump change, as they say.

    But maybe we’d be sending the Wrong Message. That intrinsic value, like real property, real work (you know, building and fixing things, etc.) is more valuable than being a Hedge Fund operator, and that might upset our whole aspirational system.

  • http://www.sitejabber.com Nick First

    The trouble is, credit markets are locked up. That means banks won’t lend to each other (because the fear they won’t get their money back). And if banks won’t lend to each other they won’t lend to consumers or other businesses. That means business will have less money to invest and consumers will have less money to consume. This could bring our economy to a halt.

    My understanding of the administration’s proposal is that they plan to buy up the illiquid assets from the banks to help strengthen the banks’ balance sheets, so they can start lending again, which is vital to the entire US economy.

  • http://www.sitejabber.com Nick First

    For those looking for an articulate argument against the administration’s proposal you might want to read this.

  • Don Jarrett

    The path of least resistance in a financial crisis such as the current one is for the government to print more paper money.

    A government in financial free-fall finds the easiest path is to print more and more money until the money loses its value. What will happen is the government will inflate the dollar up to the point where the national debt is wiped out, and a fresh start can be made. Of course, this will be at the expense of all those who lose their savings. The process is accompanied by explanations, propaganda and new regulations which hide the truth from the people until they have lost almost everything.

    The day of reckoning can’t be far away.

    Those in the know will buy gold — but most will not understand what the politicians have done to them until it too late.

    But settle back, keep watching Britney, Paris and NASCAR and enjoy your six-pack of Bud as long as you can afford it.

  • bliffle

    Credit markets will unlock immediately with an injection of cash at the bottom of the income scale because that’s where we have the largest Propensity To Spend, which, in addition to some cash, is what we need. All the rest will follow.

    Why give more money to the idiots who caused the problem? When you find yourself in a hole the first thing to do is stop digging.

    How could cash given to dolts possibly improve their performance? The banking business is exactly the wrong thing to rescue.

  • http://intersportswire.com alessandro

    #4. So true. How do you feel about that, Nick?

    And yes, cuervodeluna does sound a lot like moonraven, eh?

  • http://intersportswire.com alessandro

    I wonder what the “storm of a lifetime” would be like if there was no government intervention.

  • Franco

    #25 —Nick First

    “For those looking for an articulate argument against the administration’s proposal you might want to read this.”

    Nick, the University of Chicago economist Luigi Zingales that your link takes us to makes a very stronge logical argument against the federial bailout and as it states, this is the arugments bottom liine.

    —————————–

    The decisions that will be made this weekend matter not just to the prospects of the U.S. economy in the year to come; they will shape the type of capitalism we will live in for the next fifty years.

    Do we want to live in a system where profits are private, but losses are socialized? Where taxpayer money is used to prop up failed firms?

    Or do we want to live in a system where people are held responsible for their decisions, where imprudent behavior is penalized and prudent behavior rewarded?

    For somebody like me who believes strongly in the free market system, the most serious risk of the current situation is that the interest of few financiers will undermine the fundamental workings of the capitalist system. The time has come to save capitalism from the capitalists.

    ——————————–

    What are your thought son this?

    Start with this. Shouldn’t these federal rescue ballouts have unbreakable strings obligating full repayment to taxpayers over time?

  • http://intersportswire.com alessandro

    Franco, I’m with you.

    I once took a von Mises test. Apparently I would fit right in with the Austrian school.

  • Franco

    Funny you would say that alessandro, I also took a similer test and feel right in with the Austrian school of thought as well.

  • Franco

    alessandro,

    It came about for me when reading “The Law” written by Frederic Bastiat in 1850. He is credited with being the forerunner in thought leading to the Austrian school.

    You probably already know this but…

    Frederic Bastint, was a French classical liberal theorist, political economist, and member of the French assembly in the first half of the 19th century who wrote extensively on liberty.

    Bastiat asserted that the only purpose of government is to defend the right of an individual to life, liberty, and property. (Sounds like something I once read in the Declaration of Independence if I’m not mistaken)

    As Bastiat maintained, government control of private individuals and regulation of private industry was inefficient, economically damaging, and morally wrong.

    From this definition, Bastiat concluded that the law cannot defend life, liberty and property if it promotes socialist policies inherently opposed to these very things. In this way, he asserts, the law is perverted and turned against the thing it is supposed to defend.

    Selected quotations from “The Law”

    “Government is the great fiction through which everybody endeavors to live at the expense of everybody else.”

    “Life, faculties, production — in other words, individuality, liberty, property — this is man. And in spite of the cunning of artful political leaders, these three gifts from God precede all human legislation, and are superior to it. Life, liberty, and property do not exist because men have made laws. On the contrary, it was the fact that life, liberty, and property existed beforehand that caused men to make laws in the first place.” — from The Law

    “If the natural tendencies of mankind are so bad that it is not safe to permit people to be free, how is it that the tendencies of these organizers are always good? Do not the legislators and their appointed agents also belong to the human race? Or do they believe that they themselves are made of a finer clay than the rest of mankind?” — from The Law

    “When under the pretext of fraternity, the legal code imposes mutual sacrifices on the citizens, human nature is not thereby abrogated. Everyone will then direct his efforts toward contributing little to, and taking much from, the common fund of sacrifices. Now, is it the most unfortunate who gains from this struggle? Certainly not, but rather the most influential and calculating.” — from The Law

    “But how is this legal plunder to be identified? Quite simply. See if the law takes from some persons what belongs to them, and gives it to other persons to whom it does not belong. See if the law benefits one citizen at the expense of another by doing what the citizen himself cannot do without committing a crime. Then abolish this law without delay … If such a law is not abolished immediately it will spread, multiply and develop into a system.” — from The Law

    Bastiat is commemorated by a road bearing his name in Pairs, France. Maybe with all of Frances real social economic troubles they’ll start taking more of his logic to heart.

  • http://intersportswire.com alessandro

    Thanks for that Franco. I must profess I’ve only heard of him before and not more. But will endeavor to learn more.

    He certainly hit a chord with regards to government I always held close to me:

    “Or do they believe that they themselves are made of a finer clay than the rest of mankind?”

  • http://www.sitejabber.com Jeremy Gin (Nick First)

    Franco: honestly, I don’t know if the bailout is the right thing to do. But, frighteningly, I don’t think anyone else does either. Let’s consider the alternatives:

    Bailout-

    pros: get credit markets working again, which could prevent a deeper recession/depression by freeing up capital that can be borrowed by businesses and individuals. a new regulatory structure, if done properly, could actually make markets more efficient and protect the financial system in the future. also, a bailout may not have to cost a lot of money bc just the mere presence of an approved proposal may get markets working again – also if the federal gov’t were to buy the mortgages, they could potentially turn a profit on some of them in the long-run.

    cons: potentially costs a lot of money that could be used for more useful things like paying down the deficit. creates moral hazard – people who took risks get bailed out, could take more risks like this in the future (unless proper regulation is put in place). we don’t know the long-term market distortions that may be caused and we don’t know what precise regulatory framework will be used… could be worse for the economy and country in long-run.

    No bailout-

    pros: risk-takers are punished and perhaps will learn their lesson and not take so many risks in the future. no risk of a poorer regulatory structure (the current structure may work fine now that big losses have been made). no big price tag.

    cons: financial markets grind to a halt. all lending dries up, banks collapse. economy enters a long and deep depression. Rome falls.

    —————————-

    in my view, the underlying problem is uncertainty. as i see it, no one really knows:

    (1) what the “right” regulatory structure is to ensure well functioning markets and economic prosperity in the future. historically, when politicians mettle in these things they make them worse, not better.

    (2) how bad things would get if the bailout did not happen now.

    but like it or not, a bailout will probably occur – it is too politically risky for our weak-willed politicians to do nothing (if things get worse, at least they can tell their constituents they tried). let’s just hope they do this right….our economic future depends on it.

    from the economist.

  • http://intersportswire.com alessandro

    I think you summarized it perfectly and succinctly Jeremy. There are no easy answers.

  • bliffle

    Jeremy didn’t even mention the third alternative: apply the bailout elsewhere in the economy.

    As I’ve shown in another thread, it is best to apply the bailout to individual citizens, such as those who’ve had their homes foreclosed. It’s only 8% as costly to apply the money where the intrinsic value is, rather than to the extrinsic value, i.e., the paper facade of our potemkin capitalism.

    We could do the same thing with $80billion instead of $1trillion. Isn’t that a better deal?

  • http://www.sitejabber.com Jeremy Gin (Nick First)

    bliffle: I sympathize with your desire to directly aid citizens, but in practice, it is very difficult to do well. Historically, boosting the economy using fiscal stimulus targeted at consumers has had a poor record. I wrote blog post on this in August.

  • bliffle

    But that was a sham, designed to achieve political, not economic, goals.

    Yes, it will take work to figure out how to distribute the money. Yes, it will take struggle and arbitration among contending supplicants to figure out who gets what.

    Maybe that’s a burden, but that it’s the burden we have fated ourselves to by not regulating the untamed use of Frankenstein Capitalism by pirates.

    How many times have we listened to the enablers on the BC right contriving reasons why some criminal businessman should not be prosecuted? That Greed is Good? That all an exec owes is to return the highest profit to shareholders?

    Yes, it’s WORK to do it, but it’s what we owe to our society. We have to make up for GWBs laziness and no-work attitude for the past 8 years. And for his cowardice.

    If we don’t a storm of economic and societal war awaits us.

    The Paulson/Boehner bailout of wallstreet will NOT solve the problem that US citizens have in front of them. It will only result in further indebtedness of US citizens to slavemasters in distant lands.

  • cuervodeluna

    alessandro,

    Since cuervodeluna MEANS moonraven, wouldn’t it be logical?

    Duh.

  • Cindy D

    hee hee

  • http://intersportswire.com alessandro

    I wasn’t talking about your name, Moonraven.

    Duh.

    Heh, heh.