Sunday, September 28, 2008
News, In this Issue...

Highjacked

Just five weeks before the presidential election, America’s worried about high finance, which most of us don’t understand. So how will we vote?

Federal Reserve Board Chairman Ben Bernanke appears on a television above the heads of Congressional staffers last week.
Chip Somodevilla/Getty Images

By Stephanie Ramage

Marc Hetherington is afraid of flying. He knows it’s an irrational fear.

“One reason I have this fear is that there are no news stories about planes landing safely,” he says. “Even though many more of them do land safely.”

Hetherington, a political scientist at Vanderbilt University, compares his fear with Americans’ present economic jitters.

“I’m not an economist, but the Wall Street developments, it’s not as if they are having a profound effect on us,” he says. “I go to the grocery store and prices have gone up, but it’s not profound.”

A proposed $700 billion bailout of Wall Street, which is being debated by members of Congress as The Sunday Paper goes to press, is, however, having a profound effect on politics.

Beginning last March, when the Federal Reserve and the U.S. Treasury brokered a deal for JP Morgan Chase & Co. to purchase failing Bear Stearns and took the unusual step of guaranteeing $29 billion in Bear Stearns assets to make the deal more appealing to JP Morgan, America’s political leadership has increasingly been drawn into a discussion of high finance, a topic that most Americans don’t understand and traditionally don’t feel very good about. Main Street has been suspicious of Wall Street since the stock market crash of 1929, even despite a slew of regulations to keep that kind of crash from ever happening again.

And there’s good reason not to feel good, with one financial powerhouse after another failing or begging for federal rescue. There have been six in as many months: Bear Stearns, Indymac, Freddie Mac, Fannie Mae, Lehman Brothers and AIG. There will almost certainly be repercussions for the general election on Nov. 4, when Americans choose their next president, even though most voters probably wouldn’t know a mortgage-backed security from a restaurant receipt.

Why should we care? Most experts say that mortgage-backed securities have been the major factor in Wall Street’s downward spiral.

David Colander, an economist at Middlebury College, explains that in the past decade, credit was loosened and “that brought about an illusion that times were good. People were getting rich simply by owning houses. As the belief that the way to get rich is to own a house became built into the American psyche, people who had never before owned a home dove in. The party continued and more people wanted in. Credit and mortgage requirements became even looser, and more and more people found that they qualified for home loans that previously they never would have gotten, and that they too could join the wealth-making machine.”

Buoyed by the new demand, the housing industry grew, cranking out more new homes than ever. That’s the good news. The bad news is that many of those new homeowners had taken a gamble they couldn’t cover unless home prices kept rising. Some had lost their jobs, others had crushing medical expenses, but a lot of them simply should never have been given loans in the first place. The banks who gave them the mortgages didn’t worry about it, because they had sold their mortgages to Freddie Mac and Fannie Mae, who in turn sold them to others. Investment banks such as Bear Stearns and Lehman Brothers made billions buying and selling these securities—which is kind of a funny word for it, when you think about it, since it was pretty clear to anyone that they were not very secure. Because Freddie and Fannie were started by the U.S. government, the assumption by many, even on Wall Street, was that they couldn’t possibly fail; the government would stand behind the mortgages.

But as more people defaulted on their loans and went into foreclosure, it became clear that the securities were in trouble. In selling them, the investment banks had packaged and repackaged them into other securities, so good and bad mortgage-backed securities were grouped together.

“No one knew how secure any of these securities were, and so no one wanted to hold them,” says Colander. “Banks stopped being willing to accept them, and the entire U.S. credit market was grinding to a halt.”
     
By the time an ailing AIG got treated with an $85 billion loan in the federal infirmary on Sept. 23, the economic unrest was already affecting the political arena. Results of an ABC/Washington Post poll released that same day showed that Obama had widened his lead over McCain the previous week. The poll, conducted from Sept. 19-22, asked the question, “If the 2008 presidential election were being held today and the candidates were Barack Obama and Joe Biden, the Democrats, John McCain and Sarah Palin, the Republicans … for whom would you vote?” Fifty-two percent responded “Obama” and 43 percent said “McCain.” The numbers represent a three-point gain by Obama over the same poll’s results in late August, and a four-point drop by McCain.
   
Vanderbilt’s Hetherington says that’s to be expected. When the economy sours, the sitting president’s party takes the hit.

“People tend to think more in terms of the president than they do about the Congress that passes the laws,” he says. “Right now, by a margin of two to one, the public is assigning blame to Bush and the Republican administration, not the Democratic Congress.”

Congress is narrowly controlled by Democrats—“by one vote in the House and a couple in the Senate”—but Hetherington points out that it’s only been that way for the past two years, whereas the Republicans’ guiding philosophy is one of deregulation, which makes them easy targets in an environment in which lack of oversight is blamed for a downturn.

What’s real vs. what we feel

Hetherington’s work focuses on the effect of “objective versus subjective economies” on elections—which mirrors the difference between the actual safety of flying and Hetherington’s irrational fear of it. The objective economy consists of actual economic indicators like inflation, unemployment and gross domestic product. The subjective economy is how people feel about the economy. It used to be, he says, that the way people felt about the economy pretty much reflected what was going on with it. But since at least 1992, the way people feel hasn’t necessarily reflected the conditions of the economy. That year, Bill Clinton campaigned on what he described as President George H.W. Bush’s bad economy.
   
“At the end of the H.W. Bush years, things were getting better, but peoples’ assessment of the economy was very bleak,” says Hetherington. “Clinton had driven the agenda to the point that people thought the economy was really horrible.”
   
Right now, two of the three objective economic indicators are not great. Unemployment is up and prices have risen. Those have been worse in the past, though, like at the end of the Carter Administration. 
   
“If you go back to the 1970s, we had much higher unemployment, and we had inflation of around 10 percent,” he says.

But now there’s this whole scary thing about the government taking over businesses. Isn’t that regulation to the point of, well, nationalizing the financial sector?
   
“The issue is the right mixture of regulation,” says Brown University economist Ross Levine. “We have deposit insurance, and that creates incentives for banks to take on lots of risk,” he continues. “So we need to limit the risk that banks take through regulation. We don’t want the government to choose each and every investment for banks. We want the government to establish sound incentives for banks and transparent accounting systems so that investors can gauge the riskiness of banks. The issue is getting regulation right. We got it very wrong.”

    Hetherington describes a pendulum swing among Americans regarding financial regulation. “After the crash of 1929, Americans loved regulation,” he says. It wasn’t until the 1950s, when we’d recovered from the Great Depression, that we started really rejecting regulation. But the American market has become significantly globalized since the ’50s, and that means that we might consider things we haven’t considered before.

 “I agree that we don’t want government to have a say running the companies, but firewalls—blind trusts—can be set up to solve the problem,” says Middlebury’s Colander. “Currently, foreign governments own shares in U.S. companies—why can’t the U.S.?” SP

---

McCain vs. Obama on the economy

Alexander Barinov, an assistant professor of banking and finance at the University of Georgia, and Ivo Welch, a professor of finance and economics at Brown University, share some insights into the presidential candidates' stands on the economy.

Q Democratic presidential candidate Barack Obama says the Wall Stret crisis is the result of a lack of regulation. Would you agree with that?

Barinov: It’s true to some extent, but overall, more regulation would be worse. At best, we’d have less catastrophic events at the expense of doing worse on average. At the worst, we’d have the same or greater number of financial disasters (probably of different nature) and would do worse on average.

Welch: This is not an easy statement, and for many reasons. First, many people will think Obama's statement is about bank regulation. However, it is not [investment] bank regulation that had gone missing in action, but the more general regulation of corporate governance. Second, Obama is correct that good regulation could have reduced the magnitude of these problems. However, we also know that government regulation often starts out well-intended, and eventually deteriorates into a system that is rigid, discourages innovation, and protects the incumbents. We need to find an appropriate balance, and this is not easy to do. All in all, Obama is correct that we need to think about how we can create sensible regulation to reduce such occurrences. I don't think McCain would disagree with this.


Republican presidential candidate John McCain says regardless of what’s happening right now, he plans to move forward with his tax cut plans (and so does Obama), although he does promise to cut spending. Does this make sense? 

Barinov: Apparently, we should cut spending even more. Pulling the troops out of Iraq would be one idea. Tax cuts are usually good for the economy, though not so good for the budget.

Welch: We need to cut government spending. In the medium run, neither [McCain nor Obama] can cut taxes too much. We already have too many unavoidable obligations heading toward us. We already are suffering capital flights [investment capital not being invested in the U.S.], and our total tax rates on young professionals are now over 50 percent of their income. At some point, it strangles them.


Obama told the New York Times that despite the huge new government obligation, he would press ahead with his plans to overhaul the health-care system to insure more people, make college tuition more affordable, give a tax cut to the middle class and raise taxes on those making more than $250,000 a year. How exactly do we do that?

Barinov: I don’t think we should raise the income tax for the rich. More income equality means slower growth in the long term. Countries like France and the U.K. lag behind the U.S. on GDP per capita by about 25 percent. Ireland taxes the rich less than we do, and it is catching up with us. The U.S. made it to the top by letting the most creative and hardworking people reap their rewards. This is what attracts so many talented foreigners to the U.S. As for making health care and education more available, it may sound good, but given that the budget is running a deficit for several years in a row and the economy is doing badly, it is clearly a bad time for doing that. If we had a booming economy and a state budget with surplus, it could be one of the uses for the surplus.

Welch: We definitely need a health care overhaul. Universal basic, not advanced, health care is a human right. The most important economic part in any health-care reform will be to cut the cost in the process. It is interesting that no one has proposed the most simple solution: expand Medicare as an opt-in system for everyone. The public does not complain about Medicare, as far as I can tell, so aversion to government health programs is manageable. Of course, Medicare is still too expensive to administer, and awful procurement rules have driven up the cost, but it is working and enjoys the public's support.


Is either candidate really presenting a cogent plan for dealing with the economy?

Barinov: I favor McCain’s plan because it is more free-market and talks more about cutting government spending. Obama’s plan is a bit dangerous, because he is not backing off on all his increased federal spending proposals, and I doubt we will have enough money to pay for all that during the probable recession we are facing.


Welch: We have had very poor economic management by Congress and the president—especially the current one—for a very long time now. No matter what the candidates' plans are, they will have far fewer options in the future. In the best of all worlds, I would probably want to pick different aspects from the candidates' platforms, and add some of my own. Obama's intent to pull out of Iraq sooner could save a lot of money. A good health care plan, if it cuts administrative costs, could save a lot of money. McCain's intent to cut the government budget could save a lot of money.

Unfortunately, neither party is talking much about tax simplification. Unfortunately, neither party really offers a program that focuses on shifting the tax burden from income and work to wealth and consumption. Unfortunately, neither party really offers a program to induce foreign companies to settle in the U.S., while at the same time stopping non-productive corporate subsidies to existing companies. Unfortunately, neither party can talk about retiring Baby Boomers—it would be political suicide. SP