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Obama's Economic Hope Teeters at the Edge of a Chasm of Public Fear

Posted April 20, 2009

President Obama came into office with an agenda of hope. He is confronted by a public with an agenda of fear. The president's speech on the economy Tuesday before leaving for Mexico—another crisis!—was a valiant attempt to justify hope while not disputing that Americans have reasons for fear—an Olympian straddle. Obama's cup of cheer was accompanied by a further dash of hope (tea-bag size) from the chairman of the Federal Reserve Bank, Ben Bernanke. He told students at Atlanta's Morehouse College that he, like the president, sees glimmers of hope and that he remains fundamentally "optimistic" about the prospects for the economy. Bernanke's mildly upbeat remarks came in the face of seven of the 12 regional Fed banks reporting the recession deepening, and all reporting poor prospects for jobs. This on a day when retail sales failed miserably to sustain the advances of January. Meanwhile, industrial production in March fell 1.5 percent despite the "green shoots" perceived by Obama's chief economic adviser, Larry Summers.

Mort Zuckerman

The public is distrustful. It has seen that the public watchdogs like the Securities and Exchange Commission, whose purpose was ostensibly to protect the average investor from predators, perversely protected the financial predators from the investors. People demand a say in their destiny. Yet the nature of this crisis is so utterly unique that it is as hard for the average citizen to comprehend as it is for the policy leaders to find a pathway through the wreckage. This crisis is unprecedented and therefore unpredictable. The once-in-a-century financial earthquake has produced a series of aftershocks in the real economy that we cannot yet be sure are over. Traumatized households and businesses have dramatically cut their spending, causing consumption and investment to plunge and unemployment to soar, putting the country into the worst recessionary spiral since the 1930s. Millions of American families have lost a huge portion of their net worth because of declining home values and falling financial assets; over 5 million Americans have lost their jobs, and millions more are likely to join them by the end of the year. Who could be surprised that there is a deepening mood of pessimism? This mood is a menace in itself, for confidence is critical to recovery.

How can confidence be restored?

Confidence among lenders and borrowers in our banking system—and the creativity that made money work over and over—gave many ordinary citizens, as well as entrepreneurs, unprecedented access to borrowing. In the process, countless lives were improved as families got homes, children got educated, and new enterprises flourished. A dollar in the banking system can create 10 dollars of lending, whereas a dollar in tax cuts is just a dollar. Unfortunately, as we have now learned, the lenders in banks and in the shadow banking system weren't content with 9-to-1 leverage. They got up to 30 to 1 and even 40 to 1 and accumulated a load of debt that, when things turned around, ultimately crushed their capacity to lend. Meanwhile, the regulators looked the other way—be it the Securities and Exchange Commission, which was an enabler to the increased leverage for the investment banks and was fast asleep as Bernie Madoff cheated, or the rating agencies, which handed out triple-A seals like candy. The original idea of the new, relaxed rules was to transfer risk to those who were best able to manage it, but instead, the risk was transferred to those least able to understand it.

The whole world got drunk on excess leverage that coalesced and caused a run on the banks—not in the traditional sense but a run on the capital markets the likes of which we had never experienced. After the bankruptcy of Lehman Brothers in September, many parts of the capital market system simply froze, and the financial panic began. It was too much for the system to bear, especially when it became clear that so many sophisticated financial institutions violated a fundamental rule of sound finance by borrowing short-term funds to invest in long-term, illiquid assets. Many families also became overleveraged, both on their credit cards and by taking on mortgages out of proportion to their incomes. Then there were the sophisticated investors such as hedge funds, private equity funds, and even universities, that took on excess debt. Many of the clever financial muck-a-mucks were spurred on by a distorted bonus structure, which rewarded short-term performance rather than long-term generation of value or profit. The result was that we had a meltdown of financial assets and real estate assets. Some $30 trillion of wealth has evaporated.

The president was mindful of this in his speech when he rightly indicted the short-term mentality. Obama called for us to rise above that mind-set when he invoked the parable of the Sermon on the Mount, envisaging an America that builds its new house on the rock of new, green industries, not on sand blown away in the first big storm. It is a wonderful vision. How do we achieve it?

First, we have the difficult task of saving and reconstructing a financial system in an atmosphere of resentment and deep distrust. The same financiers who preached the necessity of free markets on the way up have come to the public trough to be saved at a cost that will be in the trillions of dollars. Who can blame the average American taxpayer (who earns under $50,000 a year), who has to cope with broken hopes and diminished aspirations, not to speak of shattered expectations of a secure retirement, for becoming angry when he is asked to rescue institutions responsible for the chaos? When forced to fill the begging bowls of financial wizards, who then receive bonuses? But the institutional problems we face will not go away because we are enraged by the malefactors. The inescapable fact is that our financial system is the brains of a market economy that moves money from the people who have it to the people who need it for investment and economic growth.

National economic recovery and Wall Street's health are intertwined. As Federal Reserve Chairman Bernanke stated, "History demonstrates conclusively that a modern economy cannot grow if its financial system is not operating effectively." Former GE Chairman Jack Welch put it well when he said, "Healthy banks are to economies as healthy hearts are to people: They keep them alive with the 'lifeblood' of credit." Given our extreme dependency on credit, the patient is in cardiac arrest.

Not that the analogy will be easier to accept once the full scale of our predicament becomes clear. The estimated volume of bad loans that will have to be written off exceeds $2 trillion—and that is before write-offs estimated at $1.5 trillion from auto, credit card, corporate, and commercial real estate loans yet to be taken. Given that the total capital of the Federal Deposit Insurance Corp. banks is approximately $1.4 trillion, the U.S. banking system is essentially insolvent and may need as much as $2 trillion in new equity to fully resume its role. but we cannot allow the banks to fail. They provide organized, informational capital that understands the credit requirements between a borrower and a lender. Yet today, banks are wary that their capital can't survive most of the worst-case scenarios for the broader economy. This leads them to hoard much of their new capital against future losses rather than use it for loans, since they are unsure how many borrowers will default—or whether there will be more federal money to tap if large numbers do default. Under these circumstances, they simply cannot fulfill the credit-making function once offered by the now discredited securitization markets.

So credit remains very tight, and is even tightening more, in the midst of a harsh recession—the opposite of what is wanted or needed. Private behavior and the lack of confidence are neutralizing public policy. Having once had too little appreciation of risk, lenders now have too much. The willingness of lenders to lend and of borrowers to take on more debt, which is the basis for the creation of credit, is simply not there.

The Fed is basically taking charge of preventing a broad credit collapse. It is finding novel ways to lend to banks and guarantee their assets because the old ways are not working. It has cut the federal funds rate to 1 percent; it has increased dollar loans called "swaps" to other governments; it has made loans and provided credit in the billions and trillions of dollars to prop up financial institutions that may be too big to fail because their collapse would pose a systemic risk to our financial structure.

Understandably, the spectacle of huge amounts of taxpayer money being provided to these very institutions that contributed so much to our current financial difficulties has added to public distrust. The American people don't believe that taxpayer money is being used in ways that will benefit them. They are focused on one main thing: whether the economic measures sponsored by the new administration will halt and reverse job losses and stabilize home prices.

The failing economy will be the dominant political narrative until it turns around. The Obama administration understands that Obama's political standing could tumble by the midterm elections if the voters do not see results of his programs over the next 18 months. But there is one thing that he might do immediately to bolster confidence: renew the term of Chairman Bernanke, which runs out in January of next year. It is fortunate that a student of the Great Depression was in place to react with speed, imagination, and candor. We should not risk another chairman. We have already had too many risks.