Monday, July 28, 2008

Bad Money by Kevin Phillips

Bad Money: Reckless Finance, Failed Politics, and the Global Crisis of American Capitalism by Kevin Phillips

Most of us look at the economy from an individual perspective. Do we or don’t we have jobs that pay well? Can we make the monthly mortgage payment? How are we holding up under the rising cost of food, heating oil, health insurance, gasoline, and higher education? Kevin Phillips takes our concerns and offers us a broader perspective, regarding the American economy and its place in the global economy. Bad Money is about the insecurity of America’s future as the world’s leading economic power. Phillips’ book discusses the two major components contributing to that insecurity: the rapid and unregulated growth of America’s financial services sector and the vulnerability of America’s oil supremacy, resulting in the embattled dollar.

On the first theme, he begins with some sobering statistics. Manufacturing, which comprised 29.3% of the Gross Domestic Product (GDP), in 1950, shrank to 12% by 2005. Financial services grew from 10.9% to 20.4%, during the same period. In conjunction with the growth of the financial services sector, credit market debt increased from $11 trillion in 1987 to $48 trillion in 2007. In Phillips’ words, we have gone from actually producing things to “moving money around.”

Why is this a problem? The reason is that in order for financial services to have grown to this degree at such a rapid rate, the sector has embraced increasing risk, facilitated by deregulation, as typified by the repeal of the Glass-Steagall Act (1930’s legislation preventing common ownership of banks, investment firms, and insurance companies). In addition, while in previous generations Americans were encouraged to save and those savings were invested in increasing our productive capacity, today Americans are encouraged to borrow. In the past several years, any individual, on any given day, may find in his mailbox, multiple credit card promotions as well as encouragement to borrow against the equity in his home.

In one of the more traditional areas of financial services, home mortgage lending, established lending standards have been relaxed in order to enlarge the pool of borrowers. By 2007, roughly 20% of home mortgages were being made in the “sub-prime” market, to low-income borrowers. Roughly another 20% of home mortgages were being made to borrowers with good incomes, but poor credit histories. These two groups taken together presented considerable risk, particularly because many of these loans were at adjustable rates. A borrower, who could initially make payments on his mortgage, would eventually default and see his home go into foreclosure. As long as home prices continued to rise, this was a problem for the borrower, but not for the lender, who could take the property and resell it to a new buyer, at a similarly high rate of interest. However, with an increasing number of foreclosures, home values dropped, and before long, many people had mortgages that were higher than the current value of their homes. The whole scheme began to fall apart. It is not hard to understand that these trends ended in hardship for a growing number of families. What is less well understood is how they threaten the American economy and its place within the world economy.

In recent years, a trend developed in which mortgage lenders sold off the mortgages they originated to securities firms who would pool them into mortgage backed securities. These securities, because they involved risk, offered a greater rate of return, making them attractive to buyers. The embedded risk came precisely from those less qualified borrowers who were paying higher interest rates. It was only when large numbers of those borrowers could not make their mortgage payments that it became clear that the risk of these mortgage backed securities was too great.

A lot of these securities were being purchased by overseas borrowers. In trading with foreign countries, we purchased their manufactured goods, but we had a declining number of manufactured goods to sell to them. What we did have were these financial instruments, and now there was evidence that they may not be sound. Interest in purchasing them has dropped off. What then will we sell to foreign countries, as we buy their manufactured goods?

Looking at the early history of selling financial instruments to other countries leads us to Phillips’ second major theme: oil. Back in the mid-1970’s, the United States struck a deal with Saudi Arabia and the Persian Gulf states. We agreed to higher oil prices and to arm and protect the monarchies in the region. In return, there was unofficial agreement that oil was to be paid for in dollars. Much of the payment received was recycled back to the United States through investment in Treasury debt, the first financial instrument that we heavily promoted overseas.

The agreement to only accept dollars for oil gave the United States enormous purchasing power, because any country interested in buying oil from the region needed to trade with us to get our currency. Buying and selling in “petrodollars” became the worldwide standard practice.

The first leader of an oil producing nation to rebel against this arrangement was Saddam Hussein. In 2000, chafing after nearly a decade of economic sanctions by the United Nations and periodic bombing attacks by the United States, both of which inflicted great hardship on Iraq, he decided that international oil purchases from Iraq would be paid for in euros and not dollars. He urged members of OPEC to do the same. The 2003 invasion and occupation of Iraq quickly reversed his action. What the United States didn’t count on was the sense of outrage the invasion of Iraq would provoke throughout the world, and particularly among oil exporting nations.

Within a few years, Venezuelan president, Hugo Chavez, instructed the state owned oil company to shift accounts to euros and several Asian currencies. President Ahmadinejad in Iran shifted accounts to euros and yen. Saudi Arabia and several Persian Gulf states didn’t abandon the dollar completely, but significantly reduced the percentage of their oil sales to be paid for in dollars. They, too, were upset with the United States for invading Iraq, but they had a second more practical reason for moving toward other currencies. As the first few countries abandoned the dollar as the currency for oil sales, the value of the dollar began to decline. In that environment, any country which was tied too closely to the dollar would suffer economically.

Phillips believes that these two crises – the one that involves housing and credit and the other involving the end of our domination of world oil -- signal the end of our control of the world economy.

He looks at previous world economic powers – Spain, Holland, and Great Britain – and notes similarities. All three overemphasized the financial sector of the economy above all else. All three developed great wealth disparities between rich and poor. Holland and Great Britain were dominant in the prevailing energy sources of their day – wind and water in the case of Holland and coal in the case of Great Britain. The good news, Phillips reminds us, is that all three are far more prosperous today than they were in the height of their global reach.

But the transition from leading world economic power to a simple nation state among other nation states is not easy. No one prominent in U. S. politics will want to embrace an agenda of managing and minimizing the trajectory of our country’s fall from being the dominant economic power. The same was true in Spain, Holland, and Great Britain. Each experienced a few decades of hardship.

We are already feeling the impact of the transition. The cost of living is skyrocketing, as we pay unprecedented amounts for food, health insurance, heating oil, and gasoline for our cars. At the same time we periodically hear of our low inflation rates. How is this possible? According to Phillips, over time there have been changes in how the Consumer Price Index is calculated. For example, consumer electronics, which have been dropping in price, have been given greater weight in the calculation, and food and energy costs have been given lesser weight.

We need to realize that our entire lifestyle – how we get from place to place, our suburban residential patterns, the products we use – is all predicated on abundant, cheap oil. Within the next few years, the world will reach peak oil production, and it will decline from there. That and our diminishing control over the global oil business, as well as our failure in global credit markets, point to major changes in global economic power.

Recognition that this shift in world economic power is already underway will help us adapt to it. If we can develop high end manufacturing and alternative energy sources sooner rather than later, the transition will be far less painful.