• May 2015
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Mira Farka, assistant professor of economics, CSUF

Click Here for a Bio of Mira Farka

Atlas shrugged
A half a century later and the title of Ayn Rand’s masterpiece has never rung so true. Atlas, the Greek god who was described in mythology as holding the celestial globe on his shoulders, has literally dropped the ball. The world is on edge, and things are likely to get a lot worse before they get better.

Although governments around the world have taken unprecedented steps to shore up capital markets, there has been very little bang for the buck on that front. Congress approved (after much controversy) the $700 billion bailout package by the end of September, yet financial shares seesawed at a dizzying pace throughout October. As the economists at the Treasury and the Fed are finding on a daily basis, the price tag may be “a few dollars short and a few days late.” There are roughly $11.25 trillion mortgages outstanding. At the same time, the total number of homes in foreclosure is currently at 2.85 percent, and 6.41 percent of all home mortgages are one or more payments overdue. The estimated losses from the foreclosed and at-risk homes are between $1.3 and $1.7 trillion, roughly double the amount of what the Treasury proposes to purchase. The situation may get worse if housing prices continue to decline and there is no indication that a reversal is likely to occur anytime soon.

The most terrifying companion to the current financial crisis is the slump in consumption spending. Consumer expenditure makes up 71 percent of GDP growth. If consumers scale back, U.S. growth will freefall. Consumer spending declined by 3.1 percent in the third quarter of this year – the largest quarterly decline since the recession of the early ’80s. This does not come as a surprise: there is little respite for U.S. consumers these days – massive job losses, negative wealth effect from home and equity price declines, low income growth, large debt service payments, and the list goes on. Even those who are employed and have the money to afford products are holding back, afraid to spend because things may get a lot worse. As credit markets continue to remain problematic, even those few who are willing to purchase goods have found it increasingly difficult to get a loan to finance spending, no matter how good their credit rating is or how solvent their personal accounts are. The end result is a complete erosion of consumer confidence, which will continue to translate in much lower consumer spending and lower GDP growth.

Eventually this crisis will blow over as all others – much worse than the current one – have. In the meantime, let’s hope that Atlas swings the globe back on his shoulders firmly and quickly.   

Red Capitalism?
For a brief moment a couple of weeks back, when Hank Paulson, the Congress and the Fed rushed to the rescue of Fannie Mae and Freddie Mac, I had one of those strange flashbacks of being in a socialist Albania of 20 years ago (that’s my birth country), and the nightmarish slogan of “from each according to his ability to his according to his needs” (which I thought long forgotten), started ringing loud in my ears.

The able ones in this case would be us - the taxpayers – and the needy ones the mortgage semi-independent government-backed mortgage giants Freddie and Fannie. Once again, we would shoulder a massive bail-out (remember Bear Sterns?), carrying the risk and forfeiting the rewards. As the Economist cleverly puts it: “at Fannie and Freddie – and, shockingly, at the investment banks- the profits were privatized, but the risks were socialized.”  The appropriate term for this profit-sharing scheme would be “red capitalism.”

Nonetheless, despite my theoretical objections, I think the steps taken by our policy makers in this case, under these very precarious conditions, were the right ones. Fannie and Freddie back more than half of the outstanding mortgages in the economy; %5.2 trillion on the back of an $83.2 billion core capital. With the recent credit crunch and financial squeeze on other lenders, Fannie and Freddie have become more important than ever, financing around 80% of mortgages in the first quarter of this year. Were they allowed to fail, the entire financial system would collapse with unthinkable damages to the housing market (which would resemble more a house of cards). Sad to admit, but Fannie and Freddie have become “too big to fail.”

But while I can swallow their rescue operations in the name of “financial stability,” I continue to remain concerned with the issue of how we got here. Perhaps the two mortgage companies should have never been allowed to blow to gigantic proportions, perhaps tighter regulation should have been in place, perhaps higher capital requirements should have been demanded.

There are a lot more “perhaps” in the same vein. And perhaps we should start implementing them, slowly and steadily. If Fannie and Freddie are not going to be privatized (this ship seem to have sailed a while back), then let’s put a tighter leash on them, let’s not allow them to borrow cheaply (on the back of the US government guarantee) and sell expensively turning up extraordinary profits in the process, let’s limit them from risky derivative trading (which is around $2.3 trillion). If we are going to bail them out in bad times, let’s lean on them harder during good times. And yes, I realize the irony of my proposition: more government regulation is the very nemesis of free markets. But given the hand we’re dealt, closing the big gates of “red capitalism” and keeping a small window for ventilation seems to be the only solution, at least for the short term.

Ready for the big one?
On Tuesday, for the first time in months perhaps, Southern Californians forgot about the slumping housing market, credit issues, fuel costs, and employment blues and rode out a serious 5.4 earthquake punch. I must confess, having lived here for a total of three years, this ranks pretty high on the list of scary events that I have witnessed.

As I was working in my brand new office in the new building of the Mihaylo College of Business and Economics (a very fine structure with the latest technology and academic facilities), the ground shook and the walls started rocking back and forth with such a ferocity that for a few seconds I seriously doubted if I was going to make it (and while the building is great, I can think of a few more exotic places where to spend the last few seconds of my life).

Fortunately, there was no damage (except a few books flying off shelves), the building is still standing, grand and magnificent as ever. Given the proximity of our campus to the epicenter of the quake, this is indeed remarkable. Much credit should be given to modern technology, its precise execution, and the strict building codes adopted in California in 1997 in response to the ’94 Northridge earthquake. More impressively, after the excitement of the first few hours, most people went back to work, shops opened and business continued as usual.

This infuses me with new optimism. Yes, we are all riding the harsh waves of a very sharp economic downturn. Perhaps, in a perverse way, the collective amnesia we all developed for a short time on Tuesday to our economic troubles may help place things in perspective. More importantly, the reassurance that we are today better prepared to deal with these types of natural disaster can certainly serve as a confidence booster.

Tuesday’s quake did bring up yet again the perennial question: Are we ready to face the “Big One” which, depending on sources, is supposed to happen over the course of the next 20, 30 or maybe 100 years. My knowledge on seismic events is extremely limited so I will leave it to the experts to weigh in on the this issue while adding simply that we have seen considerable improvements on that front. As an economist, however, the catchy phrase “the Big One,” served as a reminder that the current economic environment has been described by many as “worse than the big depression.”

If we accept this prognosis (and I don’t), then the economic storm we are facing can be viewed as the “Big One.” While current economic pains are far from over and we might have to face them for another 4-6 quarters, much like Tuesday’s quake, we have the capability to ride out this storm. Our financial infrastructure is overall fundamentally sound (Congress and the Fed are patching a few holes), oil prices have retreated from their record-highs, and global economy continues to remain relatively strong.

Is this big economic storm going to cause more collateral damage? Without a doubt. Can we survive it? You bet.

Out of ammo
Despite the posturing, the hawkish tone, the never-ending warnings about inflationary pressures, much like we anticipated, the Fed did not raise interest rates in its June meeting. Being buffeted by a series of negative shocks, a continued house price decline, a rapidly slowing economy, and an excessively volatile financial sector, the Fed decided to maintain its accommodative bias. I, for one, concur with this decision, at least for now.

There are however, dangers associated with this scenario. Inflationary pressures have escalated and oil prices continue to set record daily highs. It won’t be long before the current high energy costs filter through the economy placing further upward pressure on other prices. The excess liquidity provided by the Fed over the past nine months will certainly add to the current build-up of inflationary pressures.
Ironically, it seems that the Fed has run out of ammo this time.

It lowered its target rate by 350 basis points in a span of seven months – the most aggressive move in history. It designed conventional and unconventional tools to bail out the financial sector (remember Bear Stearns). In maneuvering and imagination, the Bernanke Fed has vastly surpassed its predecessor – the Greenspan Fed. The irony comes from the fact that Bernanke’s Fed was supposed to be the more hawkish, more willing to fight inflation, and less concerned with financial market developments than Greenspan’s Fed. But Wall Street jitters of late last summer seem to have spiked a high fever in the Fed, followed by an unprecedented overreaction. 

Where does this leave us now? With an ammo tank almost empty, and a Fed that jumped the gun a few months too soon, and a few hundred basis points too low, we’re pretty much on hold. The Fed is unlikely to tighten over the next few months given that housing market blues are far from over (an optimistic scenario would put it half-way through) and we have yet to see a bottom to the current economic slowdown. In the meantime, I see little hope of a drop in oil prices.  Against this backdrop, I cannot help but feel that the only bullets left for the Fed, at least for the time being, are hawkish words and a concerted effort to anchor the ever-increasing inflationary expectations without taking any drastic policy actions in the near future. 
Will the real Fed please stand up!
The Fed is in a “pickle”. In its upcoming June 27-28 meeting it will have to decide which battle to fight first: the soaring inflation or the slump in economic activity.  Unfortunately, the wiggle-room for maneuvering is particularly tight. Much like Eminem’s alter ego Slim Shady (earlier in the decade), high oil prices “are back” and this time, with a vengeance. The Fed cannot take on both villains simultaneously: it needs to pick its spot, fight one battle at a time and tackle the remaining issue sequentially. Strategically, this is tantamount to playing the Lakers early in the millennium and deciding whether you should contain Shaq or Kobe since you can’t do both (as a Spurs fan, that analogy cuts me to the quick but it seemed particularly fitting here).

The question then, is: which fight should the Fed take on? In my opinion, the Fed will be less effective in combating inflation and should concentrate on jump-staring the economy. Here is why:

•    Although inflation is on the rise, wages have remained subdued and at 2.3 percent, core inflation is only a tad above a year ago.

•    Domestic and global economic slowdown will continue to put downward pressure on prices, thus partially self-correcting the inflation problem.

•    For the first time, America is importing inflation: high commodity and food prices are largely due to high demand from emerging economies.

•    Thanks to large budget surpluses, emerging markets have ample room to subsidize oil prices which means that not all countries are paying the same price at the pump.

•    The Fed can coordinate policy with emerging countries so that their governments take steps towards reigning in high levels of inflation.

•    More importantly, the Fed can anchor inflation expectations without having to raise interest rates by issuing statements which reiterate its commitment to fight inflation.

It remains to be seen what the Fed will do. I can only hope that it does not reverse its recent rate cuts too soon since that would be disastrous for the economy. Besides, swinging the interest rate pendulum from one extreme end to the other can be rather confusing, at which point, we will all have to demand for the real Fed to stand up!!

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