ECONOMY
The Causes of the Economic Downturn | Fannie Mae, Freddie Mac, and the Housing Bubble | Approving a Financial Stabilization Bill to Unlock Consumer Credit | Automobile Industry Bailout | Extending Unemployment Insurance | Economic Stimulus Packages | The President’s Housing Fix | The FY2009 and FY2010 Budgets: Unprecedented Spending Sprees
Arizonans are facing serious economic challenges, and many are hurting. The state’s unemployment rate rose to 8.2 percent in May 2009. Chapter 7 bankruptcy filings in the state were up 98.4 percent, while average home values were down 41.9 percent compared to the year before. Arizona ranked second among the states that have been hardest hit by foreclosures.
The federal government can play a role in promoting economic growth and resolving problems in financial markets. The question is, what steps will prove most effective.
The roots of the current economic downturn can be traced back to the decreasing availability of credit brought on, in large part, by overinvestment and speculation in home buying. Plummeting home values have left many homeowners with mortgages that exceed the market value of their homes, making it uneconomical for them to sell and making it impossible to refinance adjustable rate mortgages into more affordable loans. As a result, many people have become delinquent on their mortgages and, in many cases, have entered foreclosure.
The financial institutions holding those troubled mortgages, in turn, found themselves unable to collect on those mortgages or resell them to other investors, even when packaged with mortgages that were being paid in full and on time. Because these assets could not be liquidated, the banks holding them all but stopped lending money to consumers and businesses as they tried to preserve their capital.
Like it or not, our economy runs on credit, and if it’s not available, broad sectors of the economy can grind to a halt. Most families rely on credit to finance major purchases, whether a major appliance, a new car, or, especially, a new home.
By the latter half of 2008, our economy was experiencing a severe credit crunch. The Arizona Republic reported on October 1 that “many small businesses can’t get funding for supplies and in some cases are falling behind on their payrolls.”
In an editorial the following day, the Republic noted that “Arizona business leaders report they are seeing entire lines of credit evaporate.” A USA Today poll in August 2008 found that 67 percent of businesses felt a credit crunch, up from 55 percent in February. The municipal bond market saw rates more than quadruple, thus effectively drying up credit and forcing cities to abandon important projects. The Arizona Mortgage Lenders Association cited examples of consumers losing their home equity lines of credit.
Overinvestment and speculation in home buying can be attributed in part to excessive risk-taking by Fannie Mae and Freddie Mac, the so-called Government Sponsored Enterprises (GSEs) that buy and sell mortgages on the secondary market and help make mortgage credit available to homebuyers throughout the country. According to the Congressional Research Service, Fannie and Freddie had purchased about 80 percent of all new home mortgages in the United States in 2008, and their combined investment portfolios held mortgage assets valued at $1.5 trillion.
The problem is, Fannie Mae and Freddie Mac were subject to less stringent capital requirements than other financial institutions, like banks, so when they took on too many risky mortgages, they were left unprepared to deal with the losses that occurred. The combination of risk and inadequate capital requirements allowed the situation to spiral out of control. Being subject to less stringent capital requirements, Fannie and Freddie made mortgages available to too many people who could not really afford them. That easy credit fueled rapidly rising home prices. As prices rose, so too did the demand for even larger mortgages, so Fannie and Freddie looked for ways to make even more mortgage credit available to borrowers with a questionable ability to repay.
I began sounding the alarm with regard to Fannie and Freddie as far back as 2003, when, as Chairman of the Senate Republican Policy Committee, I provided Senate colleagues with detailed analysis of the institutions’ investment strategies that led them to take on more risk and more debt than they should. My committee also recommended reforms, including improved disclosure requirements and transparency; increased risk-based regulatory oversight; and ways to create a greater separation between the taxpayers and the business operations of these firms. You can review the report by clicking here.
The Bush administration proposed legislation in 2005 to better regulate Fannie and Freddie. Although the initiative was approved by the Senate Banking Committee, it was never considered by the full Senate because of a threatened filibuster.
By 2008, Fannie and Freddie’s business practices had brought it to the brink of bankruptcy. Congress eventually established a new regulator for Fannie and Freddie that placed them into receivership, and committed the federal government to purchase $200 billion in preferred stock that gives the Treasury the option to take an 80 percent ownership stake. The federal government is also allowed to purchase an unlimited amount of mortgage-backed securities.
I opposed this legislation because it provided Fannie Mae and Freddie Mac an open-ended commitment of taxpayer dollars without putting a plan into place that would return the two GSEs to solvency and, eventually, complete privatization.
For those of us who fervently believe in the virtues of a free-market economy – where businesses succeed and fail based on their appeal to consumers, the soundness of their business practices, and accountability to their shareholders – the idea of government intervention to try to fix the credit crisis is not an appealing one. But the economy is facing a serious emergency, and it was apparent that some kind of bold government action was both necessary and urgent.
Learning from History: The federal government used none of the fiscal or monetary tools available to it to avert the Great Depression early in the 20th Century. In fact, it implemented many policies – raising taxes, imposing steep tariffs, and reducing the money supply – that proved to be exactly the wrong things to do as the country was heading into an economic slowdown. The country suffered through a decade of hardship as a result: the economy contracted by nearly a third, unemployment exceeded 25 percent, business investment declined by 83 percent, and incomes fell by 21 percent.
I believe it is important that we heed the lessons of history, not repeat the serious mistakes that have been made in the past. Unless current credit problems are addressed, economic turbulence will continue to erode our economic well being.
A Plan to Get Credit Flowing Again: By late 2008, the Federal Reserve had taken a number of steps to avert the crisis. The Secretary of the Treasury also promised to use all the tools available to him to protect our financial system, but told Congress “our toolkit is substantial but insufficient.” To bolster the Treasury’s arsenal, he asked Congress to approve legislation to create the Troubled Asset Relief Program (TARP) to pump up to $700 billion into the financial markets to help get credit flowing again.
After being briefed by the nation’s top economic advisors, and after consulting with officials and business and community leaders in Arizona, I concluded that the stakes were simply too great not to support the financial stabilization package recommended by the Treasury Secretary, as well as the Chairmen of the Federal Reserve Board and Securities and Exchange Commission. Too many Arizonans could lose their jobs, too many businesses could be forced to scale back or close, and too many homeowners could be forced into foreclosure.
Broad, bipartisan majorities in Congress came together to approve the financial stabilization bill – the vote was 74 to 25 in the Senate – and Treasury began to make the first half of that funding available within weeks. By the end of January 2009, there was some evidence that liquidity was returning to the financial markets. According to the Federal Reserve, lending had stabilized and had risen – albeit slowly – from the same period the prior year. Given that our economy has gone through a very bad financial shock with the bursting of the housing bubble, it will take time for banks and financial services firms to regain the confidence to lend at sustainable levels.
Congress voted to release the second tranche of TARP funds in January to continue lubricating the credit markets. I supported that action as well. Most of the funding will be used to support additional bank lending and leverage financial markets to finance as much as $1 trillion in student, credit card, small business, auto and commercial real estate loans.
The automobile industry is among those that have been particularly hard hit by the recession. The Arizona Republic reported in October 2008 that automobile sales were down sharply: down 34 percent for Ford, 32 percent for Toyota, and 16 percent for GM. Taxable vehicle sales in Arizona were down 23 percent compared to the year before. Although the credit crunch has hit the automobile industry hard, its problems really go beyond that and have been years in the making.
The Big Three are burdened with tremendous “legacy costs” – the financial burdens resulting from agreements with labor unions, obligations from previous contracts, and the requirements of various state laws – that make it impossible for the companies to compete with foreign-owned automakers. Those obligations raised the average hourly cost of labor for the three domestic auto manufacturers to $73 in 2007, compared to an average of just $48 for the Japanese-owned auto companies operating in the U.S. According to General Motors’ Richard Wagoner, the disparity adds an estimated $1,525 in health-care costs alone to the price of every car and truck the company produces, thereby increasing prices and creating an incentive for consumers to purchase cars manufactured by foreign-owned automakers. A new labor contract was recently negotiated, but many of the costs remain.
Congress considered a proposed bailout of the industry in late 2008. It would have provided the Big Three with a $14 billion taxpayer-financed loan to keep them in operation beyond the end of the year. But it would have done nothing to ensure that the companies engage in sufficient restructuring to resolve the underlying problems that are confronting them, including their legacy costs. And until there are fundamental changes in the way the Big Three do business, simply providing $14 billion in loans will only temporarily keep them afloat. The fact is, no amount of money will solve their problems until they restructure and eliminate extraneous costs.
The bailout failed in the Senate, but President Bush subsequently announced a virtually identical plan later in December that, I believed, would just punt the problem to President Obama after he had taken office, without resolving any of the underlying problems confronting the industry. The plan extended $13.4 billion in short-term loans before the end of 2008, using funds from the Troubled Asset Relief Program (TARP), even though Congress did not intend that the financial stabilization funds be used for that purpose. An additional $4 billion in loans would be made available in 2009 if Congress authorized the further use of TARP money.
The plan set a series of conditions that the automakers must meet, but they are the same conditions that the Senate deemed insufficient when it refused to pass the bill earlier in the month. Additional conditions that would seemingly address some of the underlying problems – like the cost of the Jobs Bank, and the large disparity between the cost of labor borne by the Big Three and that of foreign-owned manufacturers – were included in the President’s plan only as non-binding goals.
The problem is, without binding conditions, the companies will never be able to reduce those crushing costs because of labor union and other contractual obligations. The unions will never voluntarily make the concessions necessary to enable the companies to reduce costs and become competitive. In fact, it was because the United Auto Workers balked that the bailout failed in the Senate last December.
A better alternative: In my view and the view of many leading economists, the only way for the automobile industry to address its problems is under an existing section of our bankruptcy laws, known as Chapter 11.
In announcing his plan, President Bush justified his action with a false choice between his plan and abrupt liquidation. However, Chapter 11 allows the automobile companies an opportunity to reorganize, rather than liquidate. Under Chapter 11, the companies could obtain an immediate stay, suspending debt payments and giving them breathing room to plan for the future. A company in Chapter 11 would have to negotiate new labor agreements with employees and restructure debt with other creditors. This orderly process would allow the car companies to get out from under crushing obligations, but only after negotiations with unions and other creditors and approval by a judge. It would allow the companies to start fresh – probably a little slimmer and with fewer employees and facilities – and emerge more competitive.
President Bush also argued that consumers wouldn’t purchase automobiles from companies in Chapter 11, despite assurances that Members of Congress would support federal backing of car company warranties. If the companies, unions, bondholders, dealers, and others demonstrate sufficient good faith to resolve the problems in Chapter 11, I would support other federal aid as well, including a certain amount of debtor-in-possession financing, which would allow the companies to pay their workers and vendors for ongoing operations while making their business more competitive.
The Bush administration seemed to think that the automakers hadn’t seen these financial difficulties developing or had the time begin making plans for an orderly bankruptcy. Nothing could be further from the truth. The automakers have had ample time but have failed to make the tough decisions necessary to become more competitive, and President Bush’s plan allows them to defer those decisions even longer.
President Bush’s action meant that the Big Three received short-term financing to carry them through the first part of 2009, but it did nothing to resolve the serious financial problems that will continue to confront the automakers. It also sets a terrible precedent for other ailing industries with political clout to seek taxpayer bailouts of their own, rather than restructure their operations to remain viable in a competitive marketplace.
As long as the economy continues to struggle, people in Arizona and the rest of the country who have lost their jobs will need some help. With that in mind, I supported an extension of unemployment benefits in 2008.
Although an unemployment benefits extension will help some people, it will not stimulate the economy or solve the underlying problems facing our economy. Congress must still quickly approve pro-growth economic policies that will get the economy moving again, creating new jobs and opportunities for all Americans. After all, most people want the long-term security of a good job, rather than the short-term benefit of unemployment compensation.
The Bush Plan: At the beginning of 2008, Congress approved President Bush’s plan to try to stimulate the economy by sending out tax rebate checks amounting to $600 for individuals and $1,200 for couples. Proponents of the plan, which cost the Treasury more than $115 billion, argued that people would spend the money and help prevent the economy from spiraling into recession. I opposed the plan, believing that previous experience with such rebates indicated they would not have the desired effect, and indeed they did not.
Renowned economist Martin Feldstein initially supported the Bush tax rebate, but subsequently wrote “[t]he evidence is now in and that optimism was unwarranted. Recent government statistics show that only between 10 [percent] and 20 [percent] of the rebate dollars were spent. The rebates added nearly $80 billion to the permanent national debt but less than $20 billion to consumer spending. This experience confirms earlier studies showing that one-time tax rebates are not a cost-effective way to increase economic activity.”
The Obama-Pelosi Plan: Despite the failure of the Bush tax rebate, President Obama called on Congress to pass a new economic stimulus bill, which was drafted by House Speaker Nancy Pelosi and included tax rebates nearly identical to the ineffective rebate pushed by President Bush. Most Americans will get an extra $7.69 a week under the Obama-Pelosi plan, hardly enough to provide much help for struggling taxpayers or effectively stimulate the economy.
Unlike the Bush package, the new stimulus bill, which I opposed, also included massive amounts of new debt-financed spending. When interest costs are added, the cost of the bill rises from an already astounding $787 billion to nearly $1 trillion. The Associated Press described it this way in a January 31 news story: “They call it ‘stimulus’ legislation, but the economic measures racing through Congress would devote tens of billions of dollars to causes that have little to do with jolting the country out of recession.”
Economist Martin Feldstein agreed, saying, “on the spending side, the stimulus package is full of well-intended items that, unfortunately, are not likely to do much for employment.” Citing a number of other economists, the Associated Press reported that “the big stimulus plan won’t ‘save or create 3.5 million jobs,’ as the President and Congressional Democrats claim, at least not this year.”
The American people want Members of Congress to work together and with the President in a bipartisan way, but they don’t want us to work together to waste a lot of their money.
Consider that the bill included funding for such things as:
- $198 million for new benefits for Filipino veterans of World War II (who still live in the Philippines);
- $300 million for a new fleet of cars for federal employees and government agencies;
- $8 billion for a high-speed rail corridor between Las Vegas and Disneyland;
- $1 billion to subsidize rides on Amtrak;
- $165 million for wildlife management;
- $2 billion for a Neighborhood Stabilization Program, with the funds expected to go primarily to groups, like the Association of Community Organizations for Reform Now, better known as ACORN (ACORN is under investigation for allegedly engaging in voter fraud around the country);
- $50 million for the National Endowment for the Arts; and
- $650 million for the purchase of digital television converter boxes.
The bill also included $15 billion to increase the maximum Pell Grant to needy college students, a worthy cause, but even Nebraska’s Democratic Senator commented, “You don’t want to be against Pell Grants . . . But the question is: How many people go to work on Pell Grants.”
Less than five percent of the spending is devoted to rebuilding the nation’s infrastructure, even though the original goal of the bill that was articulated by President Obama was to “put people to work rebuilding our crumbling roads and bridges.”
In fact, the grab bag of spending included in the bill even fails the President’s test of being “timely, targeted, and temporary.” It isn’t timely because over half of the money in it won’t be spent until 2011 or later. It’s not targeted because it spends billions on things that have nothing to do with job creation. It’s not temporary because many of the most popular programs in the spending bill will become permanent. Moreover, in a couple of years those who try to scale back the spending to pre-stimulus levels will be accused of substantially cutting funding, when in fact we would simply be returning it to the level everyone claims it should be at today.
As is often the case in politics, government programs sometimes gain political support because they are perceived as attempts by the government to “do something,” regardless of the merit or effect. President Franklin Delano Roosevelt was an articulate and decisive leader who was seen as trying to “do something” to try to bring the Great Depression to an end. As a result, both he and his policies enjoyed popular support from 1933 until 1938. But when the economy continued to lag, people began to recognize that the policies were ineffective, and they became disillusioned and then registered their frustration at the polls during the 1938 midterm elections.
In retrospect, some of the programs that were quite popular during the early part of Roosevelt’s administration proved to be harmful to the economy and actually prolonged the Great Depression. What we learned from history was that the industrial buildup for World War II, not New Deal spending and regulatory policies, was what finally got the country out of a period of high unemployment and terrible depression.
A False Choice: The Obama-Pelosi Bill or No Bill at All: Proponents of this year’s stimulus bill argued that the trillion dollar spending package had to pass, because “doing nothing was not an option.”
Of course, no one suggested that Congress should “do nothing.” There were plenty of good ideas – and some bad ones – from both sides of the aisle. With the amount of unprecedented amount of spending being proposed, the least Members of Congress owed to their constituents was fair and thorough consideration of the range of options available to spur the economy back to health.
The theory that underpins the Obama-Pelosi stimulus bill is that the massive amount of government spending showered on the economy will eventually find its way into people’s pockets and they will spend it, thereby creating – or “saving” – jobs. But in an open letter to the President published in newspapers around the country, 250 leading economists (including Arizona’s own Nobel Laureate, Dr. Edward Prescott) disputed that such massive increases in government spending will lead to improved economic performance. They argued instead for removing “impediments to work, saving, investment and production” and said that “lower tax rates and a reduction in the burden of government are the best ways of using fiscal policy to boost growth.”
A Better Approach: President Obama called for bipartisan cooperation in drafting an economic stimulus bill, so during consideration of the measure in the Senate, a number of Senators on my side of the aisle offered many good ideas in good faith.
For example, an amendment by Senator Graham would have addressed the root cause of the credit crisis by targeting homeowners, allowing them to refinance into mortgages guaranteed by the federal government at a rate of about 4.2 percent and thereby save hundreds of dollars a month. Another amendment would have provided a new $15,000 tax credit for home buyers in an effort to reenergize the housing market.
Using an economic model developed by one of President Obama’s own economic advisors, Senator John Thune of South Dakota offered an amendment that could have created almost twice the number of jobs, but at half the cost of taxpayers. Senator McCain offered an amendment that would have cut workers’ payroll taxes and specifically targeted working families.
The tax relief in the bill could have been better targeted to small businesses, which create 80 percent of the jobs in the country. (The Obama-Pelosi plan actually penalizes small businesses, which have done the most in our economy to create new jobs.) Current low tax rates, which are set to expire after 2010, should have been extended or made permanent, something that would encourage capital formation and permit businesses to grow and hire more workers.
Our suggested improvements were all rejected, usually on party-line votes.
President Obama outlined a $250 billion plan in February that he contends will help stem the tide of home foreclosures without “help[ing] speculators or that neighbor down the street who bought a house he could never hope to afford.”
But an analysis of the President’s claim by the Associated Press (AP) indicates that “if the administration has come up with a way to ensure money does not go to home buyers who used bad judgment, it hasn’t announced it.” The AP further reported that the head of the Federal Deposit Insurance Corporation said it’s unlikely that aid will be denied to homeowners who overstated their income or assets to get a mortgage they couldn’t afford.
Moreover, the Arizona Republic reported on February 27 that as the details of the Obama plan have come out, they’ve “rais[ed] early doubts about the program’s ability to help homeowners in Arizona.”
The President’s plan includes provisions that will not only bail out some who bought more house than they could afford, it includes a provision that will raise interest rates for everyone else. Known as “cramdown,” the provision would allow bankruptcy judges to reduce mortgage payments or alter the terms of mortgages, something that supporters and opponents alike agree would increase mortgage interest rates. The Mortgage Bankers Association estimates an increase of 1.5 percentage points.
One of the reasons a loan for a primary residence is more affordable than for a second residence is because bankruptcy judges do not have the ability to modify the terms of a primary residence mortgage. Adopting a cramdown provision would make it more difficult for everyone to secure a mortgage because lenders would be more wary about lending money when there is the possibility that bankruptcy courts could modify the terms of a mortgage. Lenders would have to price the heightened risk into the cost of all mortgages in the form of higher interest rates.
A better approach to resolving the problems plaguing the housing market is represented in some of the amendments that were referred to earlier, but were rejected, including a proposal to allow homeowners to refinance into mortgages guaranteed by the federal government at a rate of about 4.2 percent. The latter proposal could help people’s mortgage payments by several hundred dollars a month.
Fiscal Year 2009
Congress completed work on only three of the 12 regular appropriations bills for FY2009 before President Bush left office, so it approved a stop-gap spending bill to fund government operations covered by the remaining nine bills through March 6, 2009. The stop-gap bill was intended to give Congress time to reconvene in January and work with the new President on a budget for the remainder of the year.
However, instead of writing a new spending package that takes into account the state of the economy and the flurry of other massive spending initiatives that had been approved, the House Speaker moved last year’s bloated bill unchanged. And the Obama administration simply went along, with the President’s representatives dismissing the bill as “last year’s business.”
The bill that passed the House of Representatives and Senate spends $410 billion, which is $32 billion – or eight percent – more than was provided last year, and it comes on top of the spending authorized by the $700 billion financial stabilization bill, President Obama’s $787 billion stimulus bill (which provided $269 billion to many of the same agencies as the omnibus bill), and his $275 billion housing fix.
The so-called omnibus bill includes 8,570 so-called “spending earmarks” that cost $7.7 billion, notwithstanding President Obama’s call to foreswear such projects. It embarks on a virtual spending spree, providing increases amounting to 21 percent for a popular food program, 10 percent for Section 8 housing vouchers, 13 percent for the Agriculture Department, and 11 percent for Amtrak. The State Department and foreign aid programs would get a 12 percent boost.
I opposed this bloated spending package and supported an alternative which would have continued funding at the levels in place last year.
Fiscal Year 2010
Before the Congress had even completed action on the FY2009 spending bill, President Obama submitted a budget for FY2010, proposing a jaw-dropping $1.75 trillion deficit for just the next year alone. As a percentage of Gross Domestic Product, next year’s deficit would amount to 12.3 percent – a level not seen since World War II. The one-year deficit proposed in the Obama budget would be three times greater than the previous record set under President George W. Bush, and it would lead to additional $1 trillion deficits for each of the next two years, before declining to just $533 billion in FY2013.
There are huge long-term consequences to such vast, unprecedented deficits – all of which will have to be financed by borrowing. In fact, it is likely that the recovery could take longer because this massive amount of borrowing will crowd out private investment, which is critical to job creation. Economists generally predict that for every $1 the government spends, it takes away $1 away from real people and business, leaving $1 less for private investment and consumption.
President Obama’s budget grows the government, not the economy. The new programs and policies it would establish also mean the government will have much more control over our health care, education, and other aspects of our everyday lives. The increased debt burden that will result from the plan will substantially affect our quality of life long after this recession is over.
