Even before the announcement on December 1 by the National Bureau of Economic Research that the US was “officially” in a recession—and has been in one since December 2007—it was apparent that not only was the US in a recession, but the economy was in a downslide of historic proportions. What some are calling “the end” of Wall Street reads like an epic horror novel, with bodies, too many to count, dropping in a freefall—the US dollar, available credit, investment banks and other major financial institutions, jobs, stocks, hedge funds, pensions, and savings. At the root of this crisis is the extreme relaxation of lending regulations that began under the Clinton administration, ballooned under Bush, and made mortgages and equity loans available to just about anyone. In 2002, home prices began to soar. Builders went on a building spree and people—many who simply could not afford them—began to gobble up homes. (Home values historically represent three times the average homeowner’s income, and grow by less than .05 percent annually; this growth skyrocketed to 8.2, topping off at 12.5 percent in certain areas in 2005.) When the bubble began to deflate in the second quarter of 2006, it brought down the super-inflated home prices with it, leaving people with homes they couldn’t sell—the amount owed greater than the current price of their home; and homes they couldn’t afford to live in. For the first time in history, lenders began to see people default on their first payment. Prices are still falling and credit is nowhere to be found.
The NBER announcement certainly wasn’t a surprise to Paul Nawrocki of Beacon. After 36 years working fulltime in the toy industry, he lost his job of four years in February 2007. Faced with a wife recovering from two hip operations and in need of 15 medications, health insurance premiums depleting his savings, and a recently graduated 22-year-old daughter with college debt hanging over her head, he sent out hundreds of resumes to potential employers. When that didn’t snag him a job, Nawrocki took to the streets. Literally. He spends his days on various street corners in midtown Manhattan wearing a sandwich board over his suit and tie that says, “Almost Homeless. Looking for Employment.”
“I am not some freak,” says Nawrocki. “I’m just one of many ‘ghosts’ that happened to bubble up to the surface. More are emerging every day.” In what is becoming a common tale, Nawrocki went to work one day and was told it was his last. “This was a young company putting out great products. Not one you would expect to go out of business. It was my dream job—the one I was headed for my whole career. When my boss let me go he was practically in tears.” The $405 weekly unemployment payments, combined with his wife’s minimal salary as a part-time telephone poll person—work that has slowed down considerably since the election—does not come anywhere near to paying his bills. Recently forced to sell some gold jewelry—his high school, college, and 30th anniversary rings—Nawrocki isn’t lamenting their loss, but instead feels for other people in what he considers “more difficult situations. You can’t get too caught up with ‘things.’ A man passed me on the street with his eight-year-old daughter. He didn’t stop, but as he passed he said, ‘I’m in the same spot. Lost my job months ago.’ It’s Christmas, and people can’t afford to buy gifts. What will this man tell his daughter?”
The financial crisis has a global face as well. Sigridur Hoster is a first-year graduate student in New York University’s Global Affairs program. At 38, she returned to school this past September after working internationally for eight years in the aviation field and saving for graduate school. Barely one month into classes, Hoster watched as one of the richest European economies, that of her Icelandic homeland, tanked. By early December, three of Iceland’s major banks were in receivership; its stock market lost 90 percent of its value, and its central bank broke with liabilities far surpassing assets. The London Times reported, “Icelandic banks have lent hundreds of billions of pounds overseas and their position in the world’s financial system far outweighs the size of the country’s tiny economy, the GDP of which was only $20 billion last year.” As British investors panicked, the British government declared Iceland a terrorist country under its Anti-Terrorism, Crime and Security Act 2001, in order to legally freeze what was left of Iceland’s failing banks’ assets. Not before Hoster saw half of her savings—$15,000—disappear overnight, and the rest devalued to $12,000 as her dream vanished. “By the time they lift the freeze, I’ll be looking at $5,000, maybe,” said Hoster. “Even if I could get financial aid, as a foreign student, the interest rate is 20 percent, which I just can’t afford.”
Closer to home, a brief visit to the emergency food pantry at Family of New Paltz, gives a clear indication of the local extent of the global problem. Phones ring off the hook, boxes of donated food fill the small crowded space, a woman stands at the desk asking for food and clothing for her three children, the youngest 18 months old. As one worker takes down the children’s sizes, telling the woman to fill one bag with whatever food she might want—to which she responds, ”Do you have any baby food?”—a man looking a bit like Santa, complete with snow-white beard, comes in and hands a check to another worker, whose eyes pop at the amount. “Go and buy a lot of turkeys,” he says, slipping out the door.
“People are signing up for food stamps in record numbers,” says program director, Cathy Cartegena. “We used to get one or two applications a month. This week we received four on Monday and three on Tuesday. We used to limit food to one bag of three meals for three days, once per month. One couple with a baby came and applied for food stamps, took their food allotment and came back five or six days later with absolutely no food left in the house.” Unable to say no, Cartegena lessened the time between allotments. “We have a lot of food in this country, people in the community are doubling their donations and I have to trust.” But the agency is getting hit big-time, government grants are not being renewed, her staff has doubled their shifts, and each day “feels like ShopRite on Saturday,” she says. “I don’t know where I’ll be in January.”
Reported as the 11th and longest in the post-WWII period, this recession rivals that of the Great Depression. The housing bubble, while at the root, is just the tip of the iceberg. I spoke with Dimitri B. Papadimitriou, the president of the Levy Economics Institute of Bard College, and executive vice president and Jerome Levy Professor of Economics at Bard College to find out how we got here. Papadimitriou heads the Levy Institute’s macroeconomic modeling team studying and simulating the US and world economies. In addition, he has authored and coauthored studies relating to Federal Reserve policy, fiscal policy, employment growth, and Social Security reform.
For information on how to support human-service agencies in our our area that are struggling to help the swelling ranks of the needy, see the Editor’s Note on page 25.
Lorna Tychostup: How did we get here?
Dimitri Papadimitriou: It used to be that an individual interested in buying a house would go to the bank and provide specific information required: income statements, assets—for the bank to analyze and determine whether the individual or household could service the mortgage. Because of Federal Reserve policy of low interest rates and the encouragement of the President and Congress to increase home ownership, those standards were relaxed. Individuals who could not buy a house because they couldn’t afford it, somehow managed to do so. Approvals were given based on assumptions that since we had a housing boom the prices of houses would keep increasing, and even though the mortgage was very high there would be an equity left that would allow the individual to even get a second mortgage and somehow manage to service it. Most of the mortgages being offered were of an adjustable rate of interest [lower interest rate at first for a period of time followed by an increase based on a benchmark rate at the time of adjustment]. Fixed rate mortgages were passed up. The adjustable mortgages were based on some kind of a benchmark, which was not very clear.
So what happened in cases like this, when you have an inflationary bubble—in this case, a housing bubble—the bubble reaches the point where it cannot go on any longer. When the bubble was realized, housing prices began to experience a downturn. You found individuals who had mortgages where the amount owed was higher than the value of the house. In this case, if I owe a lot more than I could recapture from the value of the home I have, the easiest thing to do is to not pay the mortgage and have it foreclosed. Since the American financial over the world, since markets are global. Individuals had bought derivative securities based on mortgages: some good mortgages, others subprime or Alt-A that were not clearly identified. This made securities all very difficult to unravel, leading the entire financial system to collapse.
These derivatives, these securities, were created as brokers took bundles of mortgages and put them all together in one big pot. Some of these mortgages were what is called “insecure” and some were “secure”—rated triple AAA. Mixed together, they all became “securitized.”
All types of mortgages were securitized even though the risk was not of the same level. Good mortgages were mixed with bad mortgages. The rating agencies gave these mortgage-backed securities a very high rating because they didn’t really know what they were rating. These high-rated securities were bought by many pension funds and investors because of their higher rate of return, which, clearly, investors were looking for.
I understand. What I don’t understand is how these risky BBB
securities went into the same pot with AAA securities, got cooked up and retranched as AAA securities. How did these people, who supposedly knew better, do this so easily? The world is wondering, is this simply a matter of greed?
Oh, absolutely, it was a matter of greed! The point is that you create securities that are so complex and you base the valuations on models that only a few people can understand and determine what that valuation is. When you are in a time of euphoria, the market for these securities showed that they were good buys for investors. So seeking a very high rate of return, if you agree it is a good investment, you will invest in this without realizing there is no free lunch. These investors thought that there was a free lunch. This is what really happened and has had real repercussions, not only in the financial markets, but also in the real economy, because once you realize that your house is no longer valued as you assumed, you stop spending. And this impacts the real economy—we are seeing a decrease in spending, leading to a decrease in economic activity and an increase in the unemployment rate. That is how the recession began last December.
Each player in the chain must have known something was amiss. Real estate agents knowingly taking clients to look at homes they couldn’t afford. Potential homeowners thinking, “Wow, all I have to do is provide my name and income to the mortgage broker and I can be a homeowner.” Commission-driven mortgage brokers knowing they would not lose if a loan defaulted because by then it would have been bundled, resold, and someone else’s problem. Insatiable Wall Street traders with clients with lots of money in their hands looking for investments who told brokers to send them lots more of this extraordinarily lucrative product and regulations were loosened. Is this a correct picture?
This is exactly what happened. You are wondering why, right? Of course, with hindsight we say, “Who was that fool to believe that these kind of returns can be sustained?” Because, it was basically a scheme—the expectation was that houses would continue to increase in value. But as you know, nothing increases forever. In financial markets we call it the “Greater Fool Theory.” There is always another fool after you—until there is no other fool. And then the unraveling begins.
But you have to understand the sub-prime mortgages are only five percent of the total markets and are not the only cause of this calamity. It has to do with what we call the “slicing and dicing” of these mortgages—mixing them in with good mortgages. The problem is that investors believe that all the mortgage-backed securities are bad, because you cannot distinguish bad from good. Also we should not think that everyone who bought a house could not afford it. The traditional business of banks is to make loans and keep them on their books. In this case they did not keep them on their books. They sold them by way of securitization in the market. Some of them were given to Fannie Mae and Freddie Mac, who also got their fees and sold them in the market. People bought them thinking, “Well, Freddie Mac and Fannie Mae are semi-public companies, so the government is really behind them.” You know you can interpret these things in any way you want to justify a very high return.
At present, we are experiencing a global reverberation. Looking at recent Organization for Economic Co-operation and Development (OECD) reports, England had its own bubble that has crashed…
Spain…Iceland…If we look at the major countries, Germany, the European Union, the US, Canada—the world is involved.
It’s an integrated world. The US was the importer of last resort, but, when there is a dramatic fall in US spending, the whole world is affected. Some people thought the world economy was decoupled from the US and that assumption was proven false, because as we see now, as the US is in a downturn the global economy is affected. Not for the same reasons, but [due to] codependency with the US. As you correctly pointed out, England had its own problems, and the same thing with Spain and some other countries. But Germany, dependent on exports to the US and other countries, has been affected dramatically. With the decline of economic activity and lower interest rates in the US, investors moved their positions from the US dollar to the euro as an alternative reserve currency, which created a big problem because the exports from Germany became more expensive. In a coordinated and integrated world one is never immune to a system that is collapsing, especially if it hits the most advanced country in the world, the United States.
How long will this downturn last?
It all depends on the coordinated effort of the leaders of the industrialized countries to actually begin to spend money. That is why you see that in the US the President-elect has suggested that he will spend and authorize a significant fiscal stimulus, whatever it takes to move the economy. And that, I suspect, will be dependent on what the new Congress does, because our current Congress isn’t going to enact anything. So in a way, recovery is dependent on what the fiscal policy stance will be to move us out of this deep recession—because this is a deep recession. Whatever it takes, whatever is spent, it will still be a bargain if we are to avoid a new Great Depression.
Economist Robert Reich wrote an entry in his blog on December 5 titled “Should We Call It a Great Depression Now?” Should we be calling it a Great Depression? Or are we not calling it a Great Depression simply because once this naming gets into the media, and into people’s hearts and minds it would cause more—
Absolutely. However, it really is not a Great Depression, because during the Great Depression we had dramatic decreases in growth, much deeper than what we are experiencing today. And the unemployment rate reached 25 percent. We are not there. But if we don’t do anything, we will get there.
The unemployment numbers were at 6.7 percent as of December 5. You’ve said that during the Great Depression they were at 25 percent. The 6.7 figure doesn’t speak to the underemployment numbers.
Yes, underemployment and people who have given up looking for a job are not accounted for. The Bureau of Labor statistics has a much more detailed and expanded unemployment rate, presently for the US to be at 12.5 percent; it includes part-time people, who are working part-time for economic reasons, would like to have a full-time job but cannot find one. It includes individuals who have been discouraged, individuals who no longer receive unemployment insurance benefits and therefore are not counted [in the 6.7 percent tally]. There are also people who are not in the labor force but would like to have a job if one were available to them. If you include all these categories the unemployment rate becomes 12.5 percent. The 6.7 percent rate is comparable to the 25-percent rate of the Great Depression era. During the Great Depression, the more detailed unemployment rate was close to 40 percent (comparable to today’s 12.5 percent rate). I don’t believe we will reach 25 percent. I do believe that by the end of next year we might be looking at an unemployment rate of close to nine percent. Then, perhaps, after the stimulus packages taking hold you might see a decrease, and, ultimately, perhaps, get out of the recession.
The current bailout plan that has been put forward seems to keep morphing. They keep changing their minds about where this money will be spent. We have one more month to go before the new administration takes office. Is this lag time between administrations detrimental?
I think it is detrimental for the markets. For example: the expectation is that something will happen with the automobile industry—so people will see that, in fact, the government is concerned with what will happen to two million people, not only to the three automobile companies, but to their suppliers as well. Everyone is waiting to see what will happen. We hear announcements, for instance, from China, showing leadership in approving a $600 billion fiscal stimulus plan. That’s China—$600 billion. For the US to have a $600 billion package it would take a huge amount of blood being spilled in Congress to actually have a fiscal plan of that level enacted. If they don’t enact a fiscal plan we are looking at really turbulent times.
Please explain.
In China, $600 billion represents a very big fraction of their Gross Domestic Product (GDP). Six hundred billion dollars for us represents only four percent of GDP. For China, $600 billion is closer to 20 percent. This I call strong leadership. The same thing with French President Sarkozy, who is trying to show leadership in seizing the moment and Gordon Brown in Great Britain thinking along the same lines.
The stimulus money on the table right now in the US, what do you think should be done with it?
What is in the package right now, we don’t really know. What we know is that the President-elect has indicated that he is willing to spend amounts of money close to $600 to $700 billion over two years. There are many things that can be done. There is infrastructure to be developed, providing stability to homeowners, increasing employment, and energy efficiency, healthcare reform. We have so many immediate needs that the government can play a pivotal role to get this economy to the place where it ought to be that has been neglected—not only during Mr. Bush, but also during the presidency of Mr. Clinton.
What about localism? Investing locally, shopping locally, investing in local businesses run by people that you know and trust, as a way to fortify the American economy?
I think you are absolutely right. If you don’t shop locally, and don’t promote the local business sector, the stability of the community is going to be eroded. You need to maintain jobs in the community, to do business in the community. We know that some of the local banks are not in trouble. The big money-center banks are in trouble because they are the ones involved in highly speculative practices. Nobody talks about the community banks being insolvent because they are doing quite all right.
Economist and New York University professor, Nouriel Roubini, known as Dr. Doom in economic circles, predicted two years ago all that has happened, would. According to Roubini, even if the economy comes out of the recession by the end of 2009, due to the damage done we will not feel any relief until sometime in 2010.
In general he is right. We have been predicting this at the Levy Institute before him. It all depends on what the new US administration will do, how Congress will respond, and what the coordinated efforts will be from other countries. If there is an understanding that massive fiscal stimulus packages are necessary [and they are implemented], I believe that by the end of 2009 we will see some dramatic improvement. However, if none of these things happen, I think that the recession will be deeper and longer than 2010. If we believe what the President-elect says, that he expects to sign a package on January 20 when he takes office, I think we will see an improvement by the end of 2009.
Define massive.
More than $600 billion.
William J. McDonough, vice chairman and special advisor to the chairman of Merrill Lynch & Co., Inc. and former president and CEO of the Federal Reserve Bank of New York, recently told an audience, “There is something about the American people that is different from all other people in the world. We are by nature, or by our history, given to be able to have hope.” After the election, a lot of hope was injected into the American psyche and a lot of hope is riding on President-elect Obama and his team. People expect some magic to occur.
You know, people have to latch onto hope. On the basis of what the President-elect has said and what he has been saying every Saturday in his radio addresses and with every press release, there is a hopeful sound that comes out of his mouth. It is in concert with his choices of cabinet appointments. They are all experienced people and know what is happening. The only issue here is if Congress will realize, especially the Republican aisle of Congress, that, unfortunately, big government is here to stay.
This article appears in January 2009.
