As the Obama administration approaches its two-year mark, it finds itself impaled on the horns of a dilemma. The "horns" are the chronic 25 million still unemployed in the U.S. and the 10 million cumulative home foreclosures that have occurred by 2010.
Unemployment has hovered consistently around 16 to 17 percent of the workforce since the summer of 2009, as measured by the Labor Department's more accurate U-6 statistic. That's more than 18 months at that level. Mainstream economists increasingly call it the new normal—meaning little can be done about reducing unemployment and we should all get used to 20 to 25 million unemployed as a permanent feature of the U.S. economy for years to come.
Homeowners have fared even worse. Foreclosures have continued to rise since Obama came into office, from 2.3 million in 2008 to 3.2 million in 2009 to more than 3.4 million in 2010. That's more than 10 million since the recession began in 2007. And that number doesn't include millions more in short sales that are foreclosures by another name. Or the millions more that are 60 days or more delinquent, to whom banks have not yet sent official foreclosure notices.
Obama's most recent answer to the foreclosures, the 75 percent drop in new home sales and housing construction, and the decline in home prices has been to turn over the task of resurrecting the residential housing market to the Federal Reserve. The central bank's most recent policy initiative is called Quantitative Easing 2 (QE2), introduced this past fall to buy up $600 billion in mortgage and other bonds. However, the Fed and QE2 are doomed to fail.
The Administration's answer to the chronic, near depression levels of unemployment promises even less likelihood of success. Now that its $787 billion fiscal stimulus package of early 2009 has dissipated, with virtually no impact on new job creation the past 18 months, the Administration has all but given up on proposals to create jobs. Its policy is simply to continue to try to extend unemployment insurance benefits. But extending unemployment benefits, while necessary, does not create jobs. Moreover, the likelihood of meaningful job creation in 2011 appears increasingly remote, given the incoming Congress and its obsessive focus on deficit reduction and implementing fiscal austerity, as well as the Administration's willingness to join them as indicated by reports issued in November, one by the Obama-appointed Deficit Commission (Bowles-Simpson Report) and the other released almost simultaneously by the Bipartisan Policy Center, called the Rivlin-Domenici Report.
Like the exclusion of all discussion and debate over single-payer healthcare in the recent health reform legislation passed earlier this year, the choices debated will be within the parameters of these two reports. That is, between the draconian and the merely devastating. They will likely call for cuts in Medicare, Medicaid, employer provided health insurance, Social Security benefits, public employees' wages and jobs at all levels of government, pensions, unemployment benefits, and the gutting of previously off-limits middle class tax cuts, like the alternate minimum tax (AMT) and the mortgage deduction in particular.
The QE2 Desperate Gamble
QE2's initial distribution of $600 billion is its low end estimate. The Fed has publicly committed, if needed, to at least a minimum of $1 trillion in direct purchase of bonds via money printing. This $600 to $1,000 billion comes on top of the Fed's QE1 policy, implemented in 2009, when it spent an additional $1.75 trillion. QE1 was designed to resurrect the then moribund housing and commercial property markets. About $1.45 trillion of that $1.75 trillion was directed specifically toward the mortgage markets, with another $300 billion in Fed purchases of long-term treasury bonds from investors. But how might another $600 billion succeed when nearly twice that amount failed 18 months ago?
The official justification for QE is that by directly buying up mortgages the Fed removes bad assets from banks and mortgage lenders' balance sheets, freeing up their reserves to lend to new homeowners. More reserves and lending will mean mortgage interest rates will fall, thereby stimulating demand and home sales and clearing out millions of foreclosed homes. With more demand and less supply, home prices will then rise instead of fall, as is presently happening once more. Rising prices in turn will bring more buyers into the housing market, stimulating price and sales further. And so the process of recovery in the mortgage markets will become self-sustaining. At least that's the official theory.
But it didn't work in 2009 and it has already begun to fail in 2010. Despite the Fed's $600 billion announced injection, mortgage rates began to rise instead of fall in the closing months of 2010. Housing demand and sales have continued to decline—not rise. And expectations that home prices will fall are growing, producing a self-fulfilling condition. So what's going on? What's QE2 really about?
There are several possible explanations. First, QE2 is really designed to bail out many of the 7,700 or so regional-community banks that continue to lose billions in the mortgage markets, as well as the big 5 banks that service most of the mortgage payments. In other words, it's a bank subsidy and bailout with a new name. If growing numbers of these 7,700 second-tier banks go under, the government will have to put up hundreds of billions more in direct bailouts. The agency handling the wind-down of these 7,700 banks, the Federal Deposit Insurance Corporation (FDIC), does not have sufficient funds to insure depositors money from its current sources of funding. About 300 of these banks failed by year-end 2010, with another 900 on the FDIC's endangered list—a list that is growing weekly.
Secondly, QE2 is an indirect way of bailing out the government agencies Fannie Mae, Freddie Mac, as well as the Federal Housing Authority (FHA), all of which are continuing to experience growing losses. Initially bailed out in August 2008 at a cost of at least $200 billion, losses have continued to exceed that amount for both Fannie and Freddie and the FHA as well. Hundreds of billions more will be needed before the end of 2012. Congress won't put up the tab for political reasons. Thus, the Federal Reserve, the only remaining bailout game in town, is once again printing money to buy more of the bad debt of Fannie and Freddie.
But by purchasing bad mortgage debt via QE, the Fed is weakening the economy and recovery in other ways. First, pumping up to a trillion dollars more into the economy will cause the value of the dollar to decline relative to other key currencies. This will raise the cost of imports for American consumers and thereby reduce their real incomes further in 2011. They will have less to spend on goods and services produced by U.S.-based employers, in turn slowing the recovery. Food and oil-gasoline prices can be expected to rise noticeably in 2011. With less consumption, U.S.-based businesses will have less incentive to hire.
Employment will be negatively affected due to QE2 in yet another way. QE2 has already set off a currency war between the U.S. and other key countries, in particular the Eurozone, Canada, Australia, Japan, Brazil, and elsewhere. A declining dollar means the U.S. hopes to divert export sales from these countries to exports from the U.S. QE2 is thus designed to stimulate the export manufacturing sector of the U.S. economy, as well as housing. The U.S. manufacturing sector was growing and adding jobs in early 2010, but has since weakened with manufacturing jobs disappearing once again. The problem is other countries can also take action to reduce their currencies in response to the Fed and QE2 and that has begun as well. The situation globally is becoming reminiscent of the 1930s when each country, experiencing trouble getting their domestic economy going, started "beggaring their neighbor," by stealing their exports by devaluing their own currencies. QE2 has precipitated a currency war that may deteriorate into a full blown general trade war as countries become more desperate. The outcome is a general slowing of the entire global economy.
Deficit Cutting and Fiscal Austerity
The single greatest contributing cause of deficits is the collapse of tax revenues due to recession. By not taking aggressive action in 2009 to generate sustained recovery, the Obama administration doomed itself to lagging tax revenues and growing deficits. Of course, declining tax revenues are not the sole cause of deficits. A trillion dollar annual bill for defense spending contributes significantly as well. So does the hundreds of billions in Bush tax cuts, the benefits of which almost all accrued in 2010 to the wealthiest 5 percent households and multinational corporations. As does the bailouts of banks and non-bank corporations like the auto (GM, Chrysler) and insurance companies (AIG). In other words, the cause of the deficits is not Social Security benefits, public employee wages and pensions, education, and other social program costs. In fact, Social Security alone has produced a surplus of more than $2 trillion over the past two decades—a surplus used to subsidize and reduce the general budget deficit by that amount. Social Security has carried the federal budget, not contributed to the budget deficits.
Nevertheless, the focus in 2011 will be on cutting the federal government deficit through fiscal austerity, the outlines of which are only beginning to emerge. Proposals to extend the Bush tax cuts for another two years are the first phase of a broader strategy. It appears the consensus among the political elites of both parties is to pass the Bush tax cuts extension before moving on to deficit cutting. Addressing both simultaneously would prove more difficult. Moreover, extending the tax cuts, and thus raising the deficit by hundreds of billions more in the process, provides even further justification for reducing social spending.
Subsequent deficit cutting will include raising the retirement age for Social Security to 69 years (or even 70) for full retirement and increasing early retirement at reduced benefits to 65 years. Cost of living adjustments will also be reduced. For Medicare, contributions and other out of pocket payments will increase significantly and some benefits will be capped. Public employee retirement ages will also rise, and employees will have to contribute more while benefits are simultaneously reduced. Many states, cities, and school districts will cut wages and benefits—a move already announced for federal workers. Housing, education, and public transport will be reduced, as will federal contributions to Medicaid. In contrast, defense spending cuts will occur mostly as a result of attrition and by outsourcing non-combatant activities. Cuts in spending on military equipment will be minimal.
Following the next budget, a general revision of the tax code will occur. As part of this revision, the Bush tax cuts will be extended beyond 2012. Personal income tax brackets will almost certainly be reduced from the current six to no more than three, representing a return to the Reagan years. Fewer brackets always mean tax cuts for those at the highest end. Almost certainly the top rate currently of 35 percent will be reduced over time to something less. For corporations, depreciation write-offs (a de facto investment tax cut) will be accelerated to full deductions in the first year, replicating what has already been introduced for small businesses. For multinational corporations, the foreign profits tax will be restructured to their advantage. The corporate tax rate will be reduced to offset the phasing out for businesses of their current tax deduction for employee health care contributions. This latter measure will significantly raise health care costs, where monthly premiums have already begun to rise 10 to15 percent annually once again. Health-care price increases will thus join with food and oil-gas oline price hikes to depress consumer spending in other areas, where prices will continue to deflate. Revision of the tax code may not prove as beneficial to the middle classes, however. Once sacrosanct tax deductions such as the mortgage interest payment deduction and the middle class exemption from the Alternative Minimum Tax (AMT) are likely to be eliminated. To make it palatable, these tax hikes on the middle class would be delayed until after the 2012 election and phased in after 2012 in stages.
Those advocating deficit reduction and austerity for middle and working class America have as their true objective ensuring, first and foremost, the continuation of Bush tax cuts for wealthy households, investors, and corporations. The deficit (cutting) hawks clearly have the upper hand. Liberal mainstream economists like Paul Krugman and Joseph Stiglitz have played a role in enabling the rise of the deficit hawks and their growing policy hegemony. They have proposed over the past two years that the Administration spend a great deal more than it has. Their argument is that the recovery has faltered because the Administration spent too little. This is only partly correct. The liberals have not focused enough on the composition of that spending. It is not a matter of just more spending, but a matter of what kind of spending that explains why Obama's programs did not reduce unemployment, rescue homeowners, and result in a sustained economic recovery. Spending should have focused on direct job creation and on reducing homeowners' mortgages and payments, instead of subsidizing the handful of mortgage lenders and mortgage servicing banks.
This analysis of the global economy is based on a theory of what is called epic recession. Past predictions have included that Obama would turn to austerity policies and programs; that major banks would fail in the U.S. in 2008; there would be layoffs and unemployment on a massive scale before year end 2008; more than 25 million would become jobless in 2009; and the euro financial system would be shaken in 2010 by one or more debt defaults on its periphery. Predictions for 2011-2012 are:
The Eurozone sovereign debt crisis will spread beyond the current four economies (Ireland, Portugal, Spain, Greece) and engulf Italy, Belgium, and potentially (though less likely) France.
The euro currency will decline from its current $1.3 to one euro to roughly parity between the dollar and euro.
A restructuring of the EU currency system will result in a kind of two-tier euro currency.
The Fed's QE2 policy will not succeed in generating a recovery of either housing or manufacturing sectors, nor will it stop the drift toward deflation for the core consumer price index.
Currency wars will intensify between the U.S., Eurozone, Brazil-China, and others.
The Eurozone's diverging stability problem between North (Germany, France) vs. Periphery (Portugal, Ireland, Greece, Spain) will be replicated in Asia. China-India will grow as Japan, Singapore, Thailand, Philippines, etc. will experience double-dip recession.
A new phenomenon of "def-inflation" will emerge in the U.S. as select goods rise in price (food, gasoline, healthcare) while other products and services enter a deflationary phase.
U.S. home prices will fall another 10 to 15 percent and home construction and sales continue to decline.
Both Japan and the eurozone economies will weaken faster than the U.S.
State and local governments and school districts will continue to face a deepening fiscal crisis, resulting in still further budget cutting, more layoffs, program reductions, and wage and benefit cuts. No further subsidies from the Federal government will be forthcoming to bail out this sector.
The $2.8 trillion U.S. municipal bond market will experience financial crisis, further exacerbating state and local governments' fiscal crises. A more general crisis in U.S. and Euro bond markets is also possible.
Fannie Mae, Freddie Mac, and the FHA will require a further bailout of $200 billion.
A minimum of 200 more regional-community banks will fail in 2011, bringing the total to more than 500 by year-end 2011.
The health-care sector will experience a deepening crisis on multiple fronts: physicians will increasingly abandon Medicare patients; States will increasingly opt out from the Medicaid system; health insurance premiums will resume double-digit annual increases; and employers will accelerate dropping health insurance.
- Several provisions of the Dodd-Frank financial regulation law passed in June 2010 will be repealed.
Jack Rasmus is author of Epic Recession: Prelude to Global Depression (Pluto Press). His website is www.kyklosproductions.com.