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.
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.