It's going to get worse

Why the Wall Street bailout—if it ever comes—won’t save America’s economy or ours

It may have been the oddest coalition of dissenters you’ll ever see: hard-core southern conservatives allied with ultra-liberal members of the Congressional Black Caucus, blue-collar Republicans from the Rust Belt, and a couple of dozen conservative Democrats known as the “Blue Dogs.” As a group they likely never agreed on anything before in their lives, and may never again. But they agreed on this—Treasury Secretary Henry Paulson’s US$700-billion plan to rescue Wall Street from a rising tide of toxic debts was a no go. And on Monday afternoon, 228 of them rejected the biggest private sector bailout in history and triggered the sharpest one-day plunge in world stock markets since the 1987 Black Monday crash.

Some said it was morally indefensible that ordinary taxpayers, many of them worried for their jobs, should have to foot the bill to support rich bankers whose idea of hardship is having to sell one of their vacation homes. Others complained the plan failed to address the root of the problem: millions of ordinary people declaring bankruptcy and facing foreclosure. With public opinion firmly against the deal, many simply opted to side with the voters and let the chips fall where they may. On his way out of the House of Representatives after the fateful vote, Rep. Steve Kagen, a Democrat from Wisconsin in the midst of a tough re-election fight, curtly explained his vote against the deal: “The bill does nothing for my constituents.”

The deal itself is not quite dead. Congressional leaders are meeting this week in hopes of reviving Paulson’s rescue plan, and many insist that some kind of bailout will get done, somehow. But with each passing day a more sobering reality is settling in: Washington’s intervention, whenever and however it might come, is already too late. Early Monday morning, Wachovia, the sixth-largest U.S. bank by assets, wilting under the strain of an estimated US$42 billion in bad loans, agreed to an emergency takeover by Citigroup. It is the sixth major American financial institution to crumple under its debt load in two weeks, and this week officials in Britain, Ireland, Iceland, France and Belgium all stepped in to shore up their own crumbling lenders.

Bailout or no bailout, America’s financial system is bucking under stresses that have been building for years, if not decades. The world’s biggest and most dynamic economy has been erected on a mountain of debt from the national government on down to the millions of ordinary families with hefty mortgages and wallets full of maxed-out plastic. America bought its vaunted standard of living on credit, and trading partners around the world profited wildly from its free-spending culture. Now the bill is coming due. Central banks around the world, led by the U.S. Federal Reserve, are pumping hundreds of billions into the system in hopes of keeping it moving. But that, even if it were combined with Paulson’s massive transfer of tax dollars to Wall Street, only buys a temporary deferral, not a solution.

“Everybody keeps saying if we do nothing, there’s going to be a severe recession. Yes. There is. There’s no way around it,” says Peter Schiff, president of Euro Pacific Capital in Connecticut. “We have to take our lumps. We’ve got to pay the price for all our reckless borrowing and spending.”

How painful will that bruising be? Worse than anything we’ve faced in our lifetimes, he says. He describes a depression that would forge a new world economic order, with sharply higher interest rates, a weaker American dollar, surging prices and shortages of consumer basics. These are the strains that can pull a society apart, and while not everyone believes it needs to get that bad, such warnings are fast gaining currency all over the world. There is no easy way out of the economic vice tightening around America, and all the many countries, like Canada, which rely on it for their own prosperity. Last week, with major banks failing, home foreclosures running at a rate of 10,000 a day and unemployment climbing steadily higher, it was clear that something big was happening. Something that is going to change the way we live for decades to come.

For a US$700-billion behemoth, there was a certain elegance to Henry Paulson’s financial rescue plan. A new federal agency called the Office of Financial Stability would buy hundreds of billions in distressed assets (mostly toxic mortgages) from ailing banks and hedge funds in hopes of defusing the spread of panic around the world. In return, taxpayers would receive an ownership stake in the bailed-out companies, along with provisions to discourage excessive executive pay at rescued firms and a promise that, if the program was still losing money after five years, the president would take steps to recover losses through new fees and taxes.

Elegant, yes, but ambitious too. Paulson was asking lawmakers to take unprecedented action, in the face of overwhelming public anger, in the midst of the most convoluted and sprawling financial crisis in modern history. They wanted to spend US$2,300 for every man, woman and child in America to buy assets that nobody else in the world wants, at prices nobody else will pay. And, just like that, a huge swath of bad debt would be cut out of the financial system like a malignant tumour. Banks would be freed to go back to the business of lending, buyers would return to the housing market, consumers would begin spending again and, after a few rocky months, America’s economic miracle would be back on the tracks. True, you’d be saddling the taxpayers with potentially huge losses, but there was a decent chance that once confidence returned, many of those toxic mortgages might actually recover and most, if not all, of the government’s US$700 billion would be recovered. Uncle Sam tried a similar trick with bad loans back in the Great Depression and wound up turning a small profit.

The trouble with that, as dozens of economists were quick to point out this week, is that the U.S. economy isn’t suffering from a single tumour that can be isolated and removed. The problems are systemic and more akin to a virus, rooted in the moribund housing sector but afflicting every corner of the economy, and rapidly spilling across borders to infect other nations as well.

As we all know by now, the spectacular U.S. housing boom, which saw prices rise by 85 per cent in major markets in the decade leading up to 2006, has reversed itself with ferocious consequences. Already, housing prices in the U.S. have fallen by 24 per cent from the peak reached two years ago, and Robert Shiller, a professor of economics at Yale University, is one of many leading observers warning that the declines aren’t nearly done yet. He notes that during the Great Depression, real estate values plunged by 30 per cent. This time, he says, the decline could be worse because prices rose so much more sharply in the past decade than they did in the 1920s. “Even if prices stop falling and just stay at this level, we’d have somewhere around 10 million people whose home’s value is less than their debt,” Shiller said in an interview with CNBC. Indeed, there are few signs that the U.S. real estate market is near a recovery. Last month, foreclosures hit an all-time high of almost 304,000 and new home sales slid to their lowest point in 17 years.

That sudden plunge in credit quality has created a panic in the murky world of derivative investments. Over the past decade or so, banks, hedge funds, insurance companies and pension funds invested untold trillions of dollars in complex derivative investments. They were designed to spread risk, and to allow companies to take on far more debt than they would otherwise be able to handle. Derivatives helped put the real estate market on steroids and, when markets were rising, those derivatives yielded spectacular profits. But as housing prices declined over the past year and a half, those derivatives plunged in value, and left financial institutions in a struggle f
or survival.

The list of victims so far includes Fannie Mae and Freddie Mac, the two giant American mortgage guarantors; American International Group, which a year ago was among the world’s biggest insurance companies; banks like Washington Mutual, Countrywide Financial and Britain’s Northern Rock; and storied Wall Street brokerages Bear Stearns and Lehman Bros. Every one of them was doomed by their outsized portfolios of derivative contracts. And because there is no central clearing house or exchange for such derivative contracts, it is often impossible to know which firms are most at risk. Already, banks around the world have written off more than US$350 billion in bad loans, and Nouriel Roubini, a professor of economics at New York University, projects that number could rise as high as US$1.5 trillion. If Roubini is right, dozens more banks will collapse in the weeks and months ahead. The federal government will cover deposits of up to US$100,000 per person, but the scale of the personal devastation will still be enormous, as will the strain on public finances. “We are now in a generalized panic mode, and back to the risk of a systemic meltdown of the entire financial system,” Roubini said in a note to clients on Monday.

Naturally, banks are suddenly desperate to conserve cash at all costs. In the days following the collapse of Lehman Bros. and the rescue of AIG, many banks even refused to make overnight loans to each other, forcing the U.S. Federal Reserve to make billions in short-term capital available to prevent a wholesale collapse of the credit system. But as banks continue to tighten their lending conditions and increase their demands for collateral, it’s becoming increasingly difficult for anyone to borrow—right from the biggest Wall Street institution to the common homeowner and small businessman. “Think of credit as the oil that keeps the global financial engine running,” explains Mahmoud El-Gamal, chair of Rice University’s economics department. “If you drain the engine of oil, it’s not long before the gears begin to destroy each other.”

El-Gamal describes a devastating chain reaction: frightened banks refuse to lend; soon even stable consumers and businesses are unable to get loans needed to make major purchases and fund day-to-day operations; companies are forced to scale back, putting more people out of work; the slowing economy drags more and more people into financial distress, which leads to more debt defaults, which forces the banks to be even stingier with credit. Eventually, desperate financial institutions try to shore up their capital by indiscriminately selling whatever stocks and bonds they can, leading to a simultaneous stock market crash that only adds to the panic as people see the value of their retirement funds decimated. Once it starts, that spiral is extremely difficult to reverse.

Unless the U.S. Federal Reserve and Congress can somehow untie the knotted credit system, analysts say the impacts will begin to be felt within days. “We’re already seeing a weak economy and if we don’t see the credit markets improve within the next week or two, we’ll start to see some businesses having difficulty,” Gary Thayer, chief economist at Wachovia Securities in St. Louis, told Reuters. “This could lead to increased layoffs within the next month.”

There are already many signs that the stress is grinding consumers down. In August, U.S. consumer spending was unchanged from a year earlier, this despite the fact that the government has sent US$92 billion in cash to taxpayers in 2008 in an effort to bolster spending, and several economists now believe that overall spending may have declined during the summer months—the first time that has happened since 1991. One look at consumer finances explains why so many are so afraid to go shopping. In the past decade, U.S. credit card debt has risen by about 80 per cent, to more than US$900 billion. Last week, analysts at Innovest Strategic Value Advisors in New York warned that American lenders could be hit by as much as US$96 billion in delinquent credit card debts next year.

Already, banks and retailers are scrambling to cover themselves. Citibank is offering to match its customers’ payments, up to US$550, if they agree to pay off a large chunk of their balances and stop using their plastic. Retail giant Target said last week that a growing number of its credit card customers aren’t paying their bills, and that those customers who are are paying less. The retailer wrote off US$8.7 billion of its credit card accounts in August, and analysts fear the charge-off rate could rise even further in the coming months. In recent weeks Wells Fargo, HSBC and Bank of America each notified customers that they were unilaterally cutting back the credit limit on millions of accounts.

“This is a 100-year flood for the financial industry, we’ve never seen this level of risk in lending before,” says Brian Bethune, director of financial economics at Global Insight. “We’re in uncharted territory in terms of how to deal with it, but the bottom line is we should not underestimate the problem. That is how we got into trouble.”

Needless to say, the plunging stock markets have put people into a state of shock, watching the value of their retirement savings dwindle with each passing month. Canada’s S&P/TSX composite has tumbled 22 per cent since June, and in the U.S. the Dow has been falling for a year—a decline of over 25 per cent so far. The financial squeeze on consumers will get even worse if the job market continues to sour, as expected. The U.S. economy has shed 605,000 jobs this year and the unemployment rate hit a five-year high of 6.1 per cent in August. But many analysts believe the worst effects of a slowing economy are still ahead. Chris Low, chief economist with FTN Financial Group in New York, said this week that 10 per cent unemployment is “almost inevitable.” “I think it’s going to get real ugly,” Low said. “We’re looking at economic pain for two or three years.”

It was John McCain, of all people, who sounded the alarm. Ironic, considering just nine months ago the Republican presidential candidate from Arizona acknowledged that “economics is not something I’ve understood as well as I should.” On Sunday morning, just hours after Treasury Secretary Henry Paulson and various congressional leaders hammered out the framework of a market rescue plan, McCain appeared on ABC’s This Week, with George Stephanopoulos, where he was handed opportunity after opportunity to trumpet the deal and even to claim credit for helping calm market turmoil. Instead, he urged caution and expressed deep concern. “All we know is we’re in the most serious crisis in our lifetime,” he told Stephanopoulos. “We’re working on a solution that will bring some stabilization, at best. Even if this plan works perfectly, there’s still enormous economic challenges out there.”

McCain may not be a crack economist, but he can read, and he knows that the U.S. government can’t run up astronomical debts forever, any more than you or I can. And for most of the past decade, Washington has run every kind of deficit it could.

This year, Washington’s budget shortfall is projected to come in at a record, just shy of US$500 billion, and is expected to remain near that level until at least 2010. As of July, the trade deficit was running at more than US$700 billion annually. The current accounts deficit, which takes into account the flow of investment dollars, stood at US$183 billion in the second quarter. What all of these staggering numbers have in common is that they rely on foreign debt to be funded. When the U.S. government spends more than it collects in tax revenue, it issues bonds to cover the shortfall. Since 1997, the total consolidated public debt in the U.S. has risen from just over US$5 trillion to almost US$11 trillion—a staggering, historic escalation, most of which has come in the past five years.

The single biggest foreign holder of U.S. debt is China, which has gladly bought up as much debt as Washington wants to issue, because Americans keep buying Chinese-made products with all that easy money. The problem is the same as it is for anyone running up a massive credit card debt with no clear plan of how to pay. At some point, and nobody knows exactly when, foreign investors like the Chinese will become concerned about America’s ability to service its mounting debt payments and will look to protect themselves against a default—cutting back on the amount of debt they will finance. If and when that happens, it would trigger a sudden plunge in the value of the U.S. dollar, and unleash a set of consequences that make the current market turmoil seem paltry by comparison.

“Eventually, somewhere along the way, the dollar is going to break, the foreigners will say enough, and we’re going to have a much bigger crisis,” Schiff says. “America won’t be able to sell any of its debt, interest rates are going to skyrocket, the dollar will plunge, and prices for everything in the United States will go through the roof. We’re going to see government instituting price controls on food items, price controls on energy, which is going to lead to shortages, rioting in the streets and civil unrest. We’re going to have massive inflation, nobody is going to be able to borrow money to do anything, businesses won’t be able to borrow money. We are headed for a real, complete disaster.”

To be sure, not everyone is quite so apocalyptic in their outlook as Schiff. Mahmoud El-Gamal uses more measured terms, but he agrees that the U.S. is now in the early stages of a historic adjustment. He says the value of the greenback, which has already fallen by a quarter against other world currencies, must continue to decline. That will make U.S. exports more competitive, but it will also massively increase the price of imported goods—everything from food to electronics to commodities like oil. But even a managed decline in the value of the U.S. dollar brings with it the threat of inflation, which means interest rates will have to rise significantly to keep price increases in check and to encourage Americans to save and to rebuild their nest eggs.

It all adds up to a downscaling of the American dream and a ratcheting down of the Western standard of living, with huge ripple effects for trading nations like Canada that rely heavily on the spending of ordinary Americans to prop up our economies. As all Canadians know, this country’s economy is heavily tied to the health of the American consumer, with 76 per cent of Canada’s exports flowing south of the border in 2007. Every one per cent decline in cross-border trade with the U.S. pulls about $3.5 billion out of Canada’s economy. Already, manufacturers in Ontario and Quebec are hurting from the slowdown, as are forestry firms in the West. Any deep economic decline in the U.S. would cut demand for oil and other commodities that have been driving the western boom for the past several years. This week, economists Douglas Porter at BMO Nesbitt Burns and Benjamin Tal at CIBC World Markets warned separately that a deep U.S. recession will almost certainly drag down Canadian real estate prices—a market previously thought to be impervious to the turmoil.

This is the disaster scenario that the federal leaders weren’t discussing on the campaign trail this week. Nor was Congress. As politicians batted around the merits and deficiencies of Paulson’s rescue mission, the underlying realities of America’s crumbling economy were lost in the bickering. El-Gamal, for one, supports the bailout because it might buy some precious time, but he is quick to temper expectations—not just for Americans, but for everyone who has grown affluent and comfortable in the shadow of the American commercial juggernaut. “Right now it’s like we’re in the middle of a hurricane, and they’re using duct tape to repair a cracked window and ensure that it doesn’t blow open and destroy your entire property,” El-Gamal says from his office in Houston. “Eventually the structural problems with the system have to be addressed. But, every time the immediate crisis passes, there is no political will to make the painful changes. You can’t continue to live on credit. You can put it off to the next generation, but at some point you get close to Ponzi finance in which you’re borrowing to pay the interest on your debts. Then the real crash happens.”

That is, if the real crash isn’t already upon us.

With Jason Kirby

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