Monday, September 8, 2008

Trickle Up or Trickle Down?

Now that I got the details of the GSE takeovers out of the way with my last post, I wanted to write a more controversial opinion piece about this socialization of the mortgage market. As with many opinion pieces the topic is overly simplified in order to get the opinion across, but that's where all the fun is!

First let me note that although it is socialization now, the plan is to wind down the GSEs to approximately one quarter of their current size so ultimately this is a mortgage market privatization plan as much as it is a socialization plan. What has caused all of this turmoil? How did we get to this point? Here is one perspective for your consideration.

First, lets put a few factors into play. The divide between rich and poor has gotten very wide – the GINI coefficient has risen from under 40 in 1967 to 47 in 2006 (from Second, we have seen falling or flat real wages as globalization has put pressure on labor’s ability to negotiate increases at the same time labor has become more productive by leaps and bounds. Third, corporate profits have been excellent over the past several years prior to the “credit crunch”. Finally, we have witnessed a huge increase in the level of debt owed by the average American household. Are all of these things related? I think they are, and my conclusion may not sit well with free marketeers.

At the heart of a capitalist system is the drive for profits. This drive, in an environment of free market competition, should result in innovation and, in turn, a rising standard of living. I agree with this concept and believe that there should be competition in markets. But does this system always work without unacceptable excesses? Of course not, and the current fallout is just one example. I believe that the imbalance of power between capital and labor has had a lot to do with our current situation, and if that sounds Marxist so be it.

Capital seeks profit. This is what drives a capitalist system. It gets profits by taking some of the value created by labor and keeping it for the owners of capital rather than sharing it with the producers – labor. Whether you believe this is good or bad is irrelevant for my purposes, so I will dispense with value judgment here. In order to maximize profits owners of capital seek to compensate labor at lower levels, and modern globalization together with governmental trade policies have enabled owners to take the upper hand in labor/wage negotiations. This is clearly evident in the fall of unionization and falling real wages, and is currently playing out at Boeing as labor seeks to limit management’s ability to outsource production. By successfully seeking lower labor costs owners created increased profits (lower labor costs net of increased transportation expenses). The higher levels of profit meant more new capital seeking profit. That means more investment in productive capacity. If the system gets out of balance, there is too much capital seeking profit and we get over-production. The problem is, who will purchase the surplus production, especially when real wages are falling? In theory this would result in declining prices and capital would be allocated away from production because profits would fall. So what got in the way of this process? Where is the invisible hand?

Enter leverage, the elixir. All of the excess capital was turned into even more excess capital through leverage in the financial industry. This leverage is evident in all of our financial institutions, from the failure of Bear Stearns to the liquidity crisis to the socialization of the GSEs. Leverage was enabled by our government through regulatory steps that opened the door for massive levels of debt relative to the existing pool of capital. This partnership between Wall Street and Congress is, I believe, bi-partisan and well entrenched. The result – consumers had the capacity to borrow and purchase even though they did not have the income to support the ongoing cost of ownership. Therein lies the imbalance between capital and labor that has resulted in our current situation. Too much capital allocated to production and lending for consumption, not enough wages to support ownership. The signs are there – rising inequality between rich and poor, outstanding corporate profits (until recently), consumption exceeding production, and stagnant or falling real wages. Now, as losses mount in the capital and money markets from all of the foolish extensions of credit (capital seeking profit), the process goes into reverse. Credit is difficult to come by and only allocated to the most worthy of borrowers. Consumers can no longer consume above their incomes and the price adjustment process that should have occurred a long time ago arrives with ferocity. Welcome to the credit crunch! What was the cause? Unrestrained and under-regulated capital.

As we de-leverage business profits will suffer from falling demand, asset prices will fall, and unemployment will rise. For the less well off there is the struggle to maintain the household, obtain food, and keep up with payments. For those with capital there is the struggle to preserve and grow it in an environment where prices are unstable. The current struggle is also playing out in the context of the political contest for President. Whether both parties are actually shills for the wealthy interests is a matter for debate and many believe this to be the case. Taking the candidates at face value, however, the Democratic party is calling for a redistribution from wealth to wage, while the Republican party is calling for a reduction of social benefits for wage earners to pay for ongoing tax cuts that benefit high income earners and owners of capital. Trickle up or trickle down. That is the question.

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Anonymous said...

"Whether both parties are actually shills for the wealthy interests is a matter for debate"

I vote shills.

The question is which shill wants to correct the problems mentioned in favor of the group that is stuck in the middle of the "less well off" and "those with capital"

Perhaps my situation is unique, maybe its not, as a professional late twenty something I don't identify with either the "less well off" or "those with capital". I'm stuck in the middle with the widening divide between rich and pore shrinking around me the fear of falling into the category of "Less well off" coming up from behind and unable to find the foot holds to climb into the category of "those with capital"

Trickle down or trickle up doesn’t look to much different from my standpoint in both cases wealth is not coming to me directly; yet some form of wealth surly will be taken away.

So I vote for note adopting either Reaganonmics or the newly coined Obamonmics; instead the government should stay out of the business of creating trickles and leave the markets to decide what happens. If I lose then I loss because I didn’t move fast enough my self, not because the government decided to stack the deck for a group that I don’t belong to. If the "less well off" lose because they are over leveraged, so be it they only have them selves to blame no one told them to debt them selves into oblivion. And if "those with capital" lose because they where overly ambitious (a nice euphemism for greed and unintentional greed), so be it they to only have them selves to blame as well. If we all lose, then at least where all doing something together for once.

Palermo's Blog said...

I love your last sentence:-) I think those in the middle are often ignored. They get no sympathy from the bottom or the top and policy makers don’t worry about them because they are usually not a threat. I think this is beginning to change as many people in your situation are feeling a bit unnerved. I’m a bit older, and I am feeling very insecure about social security and health care – things I have been paying into my entire working life and at rates high enough that we are supposed to be saving excess for retirement.

You bring out another good point – that the American population has blame in the creation of this mess because we as a whole got carried away with consumption and leverage. You don’t hear that as much as you hear complaints against Wall Street and the politicians, but I think a lot of that comes from the fact that lots of people didn’t get carried away and now they have to pay for the cleanup – they relied on politicians and regulators to steer the ship and they sailed it into an iceberg.

CD Rates Blog said...

And today the problem became even more frustrating. The Gov't wants $700BB to save the system, but none of that is going to actually help people in the lower or middle brackets. But the middle is probably going to bear the brunt of the cost.

I made a comment on my blog that true Capitalism assumes people are able to control themselves. Unfortunately we know they can not.

I also comment about companies being allowed to get so big, that the Gov't feels they can't be allowed to fail. A company should never be allowed to have such power and control.

Palermo's Blog said...

Hi CD Rates! I don't know, I think that was Treasuries out-of-the box proposal and the democrats will get some provisions in. The one I think they will fight the most is getting bailout beneficiaries to pony up some taxpayer benefit, such as dividends or warrants for equity. After all, that would be uncapitalistic of them:-)

Anonymous said...

"I made a comment on my blog that true Capitalism assumes people are able to control themselves. Unfortunately we know they can not." ~ CD Rates

That is an interesting thought; I have often heard and I have even used the argument my self– That Capitalism is a better system than Socialism and Communism in part because does not expect people to have control or discipline; two things we humans find hard to adhere to.

Socialism and Communism expect a certain altruism from the populous so that everyone lives up to their potential with out the incentive of cumulated wealth.

But it seems quite evident now that Capitalism requires a certain kind altruism itself.

Palermo's Blog said...

"Socialism and Communism expect a certain altruism from the populous so that everyone lives up to their potential with out the incentive of cumulated wealth." Thanks for the comments about the behavioral side - really good food for thought.