Plunder and Blunder
America has been badly hit by recession, the worst recession after the Great depression. Dean Baker in this book Plunder and Blunder has discussed the economic bubbles created by the policies of Reagan, Clinton and Bush administrations. The current recession is because the housing bubble of 8 trillion burst sinking valuable dollars belonging to typical America families. Dean Baker has made an effort to save America from future economic calamities. William Greider, author of Come Home, America says
Dean Baker warned us what was coming... the story is intriguing and deeply disturbing
Chapter 1 How We Got Here
From 1947 to 1973, America was having steadily growth with annual increase of 2.8 in real income of typical American families. Despite of social problems like racism etc, Americas promising growth was beneficial for all, at least economically. This chapter gives historical perspectives that how step by step America got to this recession.
After the post war era, stock market grew gradually. By 1970, public and private sector public funds owned 18.5 of the stock market. At this time, home construction expanded and exceeded the overall rate of inflation. U.S economy was different at that time. By 1970, import share of GDP was 7.6 compared to 2007 in which import share exceeded 17. Corporate profits of financial sector rose from 10 in 1960 to 30 in 2004. The sharp increase in the growth of financial sector was due to the technological advancements which provided mechanisms for highly leveraged debts. Through LBOs (leverage buyouts), small firms took over big giants. So companies started focusing on daily stock prices. This caused slow down in productivity growth. By the 1980s, income disparity rose because of three reasons. Firstly because of the Reagans policies regarding labor. Second cause was the trade agreements signed in 1990s and third cause was the immigration policies. All of these hurt average American workers and decreased their wages. On the other hand, CEOs made millions of dollars. This whole virtuous circle broke the productivity growth, consumption, investment and wages. So Americas economy got itself lying on bubbles.
In this chapter, dean baker has very well described that how well America was developing economically in the post war era until 1980, and which policies caused this bubble to grow. Previously America was having steadily growth which ensured secure future of Americans, but short sighted policies to gain quick and big profits for upper level class resulted in big losses for average people. Reagans policies initiated this bubble to grow.
Chapter 2 The Clinton Era and the Origins of the Stock Bubble
In the late 1990s, because of productivity growth, economy showed positive growth until it reached annual growth rate of 2.4 in 2001. This sustainable growth was due to the policies of Clintons administration of reducing federal budget deficit, but this prosperity vanished as Bush office cut taxes and started running deficits. Actually the growth in Clintons era was due to the economic bubbles.
Clinton game plan was based on two agendas. First was public investments and the other was cutting federal deficit. Economists conclude that cutting federal deficit results in slow growth over a long period. Another outcome of lower deficit is a weak dollar. Clinton expected that weaker dollar will increase net exports which was certainly a short term benefit.
Under the leadership of Alan Greenspan fed decided to keep a loose monitory policy, keeping federal funds rate at 3. This gave boost in productivity growth especially in housing construction with an annual rate of more than 25. But when Robert Rubin decided to make dollar stronger in short term, the bubble economy was created. Because of technological advancements, stocks were showing high rate of profits but surprisingly those were not corporate profits. Those who raised the bubble economy issue were excluded from the media. Internet services firm like yahoo had far more capitalization than production based firms. Those who reaped benefit from bubble before its collapse became earned millions.
So investments were diverging towards short term capital. At that time Greenspan intervened and showed concern for the long term capital. Greenspan predicted this bubble and favored long term capital investors. After the reelection of Clinton, once again unemployment lowered. African Americans and Latinos gained real economic benefits. This all became possible because of the upright in productivity growth until 2004. But unfortunately the stock market bubble and high dollar value were unsustainable and were going to burst.
In this chapter, author has drawn a clear line between which elements caused this stock bubble to grow. He clearly stated that productivity growth was beneficial for people at all levels. It decreased unemployment, raised real income of average Americans etc, but the investment in short run capital like stocks and internet companies resulted in bubble stock market which finally had to burst.
Chapter 3 The Collapse of the Stock Bubble
In the spam of 2.5 years from 2000 to 2002, NASDAQ lost 78.4 of it gains and the bubble deflated. Many internet based companies stocks sunk. The total lost is estimated to 10 trillion or 33000 per person in America. Another reason for this fallout was accounting scandal known as EBITDA, which always kept stock holders happy. The accounting scandals showed that companies are meeting their targets. But unfortunately, big companies like WorldCom filed for bankruptcy in 2002. Enron accounting scandal came to face and congress tightened the accounting rules but there was still a basic flaw in it. Companies selected auditors by their own choice.
Moreover, rising stock prices of high tech entrepreneurs shrewd the investments in manufacturing companies. Big foreign investments in NASDAQ also inflated dollar which again caused problem for manufacturers. Defined benefit pension plans of many companies went underfunded because of the bubble collapse.
Economists also failed to predict the burst of stock market in 2000 and 2001 and were expecting economic gains in the coming years. That caused CBO to predict huge tax returns. Early on, Greenspan opposed quick pay off of national debt and the stock market fallout proved his assumption as correct.
The recession hit in 2002 was worst recession after world war. So the fed lowered interest rates. Labor market became weak which affected their wage until 2006. Moreover due to overvalued dollar, trade deficit was 370 billion in 2001. At that time, imports outraged exports. Overvalued dollar made it difficult for America to recover from stock market break down. Rather than lowering dollar value, policies were made to create new financial bubble.
Dean Baker has very precisely discussed the breakdown of stock market from 2000 to 2002. With accurate details and research, he clearly points out what was done right and clarifies the mistakes. He highlights the role of Greenspan who had to play a key role in protecting America by challenging other policy makers. One remarkable thing is this chapter is the caption of how to recognize a stock bubble by which he alerts his readers from committing mistakes in future.
Chapter 4 The Beginning of the Housing Bubble
The housing bubble began with the increasing price gap between renting and owning. Rising real estate prices reached its peak in 2005. The expectations from soaring prices pushed everyone to buy. Huge profits were made within days and even published in media. Housing bubble roots are found in stock bubble. Because houses are tangible, investors had more believe in it. Though in 2002, Greenspan told congress that there is no bubble in the economy, the extraordinary high prices without any changes in supply and demand ensures presence of bubble. Greenspan avoided questionable house lending practices across the country. In 2004, fed issued a report supporting Greenspan claim that housing bubble doesnt exist. A skeptical look over the trend in rising housing prices highlights the flaws of policy makers. Even big economists assumed that housing bubble was a false idea.
Another big reason in increasing house prices was governments push to make average people homeowners. Private sectors also played a key role in mortgage housing along with government. The decline in home ownership in 2008 indicated a further decline in the coming future. The housing boom lifted the economy from the stock slum bit it was for short run. They were not aware that they are leading to even worse condition.
Dean Baker starts this chapter with a practical example of his own to show the rate of increase in housing. While talking about the failure of Greenspan to predict housing bubble, he comes up with ample of rationales to clear that many factors suggested presence of a bubble which should have been addressed by the fed. Indirectly he says that might be many economists were aware of this boom, but for the short term benefit, they kept it hidden until they emptied the pockets of common people. He has even mentioned their names.
Chapter 5 The Final Collapse
It is difficult to predict when the bubble will actually burst. As the bubble grew, financial institutions came up with innovations like nonstandard mortgages and ARM to support bubble. Subprime loans were given at very high interest rate which reached 25 in 2002. The authenticity of loans was also questionable. Moreover higher interest rates resulted in high payments. Excess lending put financial institutions in problem. Homes purchased from 100 percent financing rose form 3 percent in 2003 to 33 percent in 2006.
The wrong appraisers certainly pushed mortgagers to mortgage as much as they can, without reviewing the holding power. These mortgages were further sold in the secondary market. Banks were issuing these mortgages on mortgage-backed securities to keep themselves protected. Again new and complex innovations in financial institutions made it more complex. Once wrong strategy, like issuing bonds, was backed by another wrong strategy such as credit default swaps. Banks made millions of dollars by producing what neither they, nor buyers wanted. Short term incentives forced top executives to reach their targets by any means.
When house prices began to drop in 2006, home owners were left with no equity. So in 2007 mortgagers came up with refinancing. When stock markets were hit internationally in 2007, U.S treasury ensured congress that mortgages are going well. But the financial problems arose. LIBOR gap jumped to more than 1 percent. In august 2007 fed clearly announced the financial problems. Banks borrowed money from fed on discount window and kept it secret. Their secrecy points out that something has gone wrong.
By mid 2007, house prices decreased by 30 percent. Need for the stimulus was been observed by economists. Fed started supporting many investment banks like Bear Stearnss which were collapsing. But these majors taken in March 2007 didnt last long. Banking sector was collapsing and Americas leadership was shocked. A bill of 700 billion was passed for bail out after that Paulson received some resistance from congress. By October 2008, the bubble of 8 trillion finally collapsed.
This chapter is an eye opening for its readers. It gradually takes us from the beginning when economy started melting till the final and most crucial days of September 2008 when major decisions were taken for bail outs. At some stages, it becomes hard to understand what baker is concluding but the last pages, when baker wraps up the whole story, are very important to understand that how the housing bubble collapsed.
Chapter 6 Beyond the Bubble Economy
After facing two bubbles, it becomes important for policy makers to closely monitor bubble creation in the economy. One measure is to talk with congress and with people about the policies and appreciate their feedback. Another measure is that fed should use substantial regulatory authority to stop bubbles from developing. In stocks, fed can use margin requirement if stocks are bought on loan. Fed should even intervene in housing market. High interest rate will settle the bubble if it shows signs of growth. Fed should be given the political influence to take major steps in the economy.
Dean further suggests that dollar should be devalued to lower trade deficit. Tux cuts and over valued dollar doesnt provide sustainable growth. An overvalued dollar is beneficial for those who dont compete internationally, but overall it has negative effect.
Financial sector should be restructured with new incentives to work for. Auditors should either be assigned by government or stock exchange. In the same manner, appraisers should not be chosen by the banks for lending purposes. To conclude, financial institutions should be independent in their workings and should not have preserve incentives. Most importantly, fed should clear it to financial institutions that it will not help them in crisis if they entertain high risks. Moreover taxes should be implemented on buying and selling of stocks. Workings of highly paid economists and analysts should also be monitored. For compensation of top executives, laws of corporate governance should be rewritten to ensure them from pocketing millions of dollars.
Dean Baker has provided solutions and suggestions to government officials, policy makers, decision makers etc that how we should prevent our economy from further collapses. The 8 trillion dollar loss has certainly caused big damages for average people and the responsible people should be held accountable. So he suggests some reforms within the system to create more open, rigid and secured system.
Chapter 7 Learning From the Bubbles
Bubbles started to be created after 1973. Prior to that, America was having sustainable growth. Bubble wasnt a problem when income was equally distributed. Dean considers Greenspan as the main culprit. In 1999 and 2000, those who used buy and hold strategy were surely losers.
This recession might have caused because we solely rely on few economists who got everything wrong. The reality of bubbles was not publicly announced at the right time and so it grew larger and larger. There werent any hidden policy or invisible hands which lead us to recession. Even a person with common sense could figure out the bubble.
In the last chapter, baker comes up with some logical errors and shows his concern that why fund managers couldnt interpret this threat. He named Greenspan as villain. He reminds some basic concept of demand and supply and says that irregularities in supply and demand show that something is going wrong. In the end, he questions all the leaders about what they did and indirectly held them accountable for these losses.