This Sucker Could Go Down

"This sucker could go down,” declared President Bush, after the White House leadership summit failed to reach agreement on a bailout plan for the financial services sector. The President is one of the last to recognize how bad the economic situation really is. But the U.S. economy has been tiptoeing on quicksand for years, and the current problems will not be solved quickly, even with an infusion of $700 billion, as the President proposes.

The root of the problem is this: the U.S. has been living on borrowed money for an entire generation; this debt has been serviced internally by a mushrooming but shaky financial services sector, and externally by foreign governments (especially the Chinese); and now both of these sources are evaporating. Whether or not the bailout package is approved, the U.S. economy and American consumers are going to take a bit hit.

First--the borrowed money. Both government and consumers have been spending beyond their means, almost continuously, for two decades. The federal government has had huge budget deficits every year since 1980, except for a few years during the Clinton presidency. The deficits have built the federal debt up to some $10 trillion, accounting for two-thirds of GDP, compared to only one-third in the 1970s. Next year’s budget deficit will add almost $500 billion to that debt. The bailout package will probably add another trillion dollars. Just the interest on the federal debt is one of the largest items in the federal budget, draining over $400 billion annually.

Government profligacy is matched by consumers: the household savings rate in the U.S. has been declining for two decades, is the lowest among all developed countries, and in 2005 fell below zero for the first time ever. Credit card and mortgage debt are both at record levels, as are bankruptcies and mortgage foreclosures. Most Americans, even those near retirement age, have almost no retirement savings. The Social Security and Medicare “trust funds” are actually unfunded, to the tune of some $41 trillion. The government is unlikely to find resources to meet these liabilities, which will put further strains on seniors.

Consumer spending now accounts for two-thirds of all economic activity in the U.S. This growth in spending has been possible only by borrowing. The consumer spending and borrowing binge has been fueled by the growth of the financial services industry, which has increasingly replaced manufacturing as the mainstay of the U.S. economy. Banks, mortgage companies, loan agencies and credit card companies make their money by making loans, and they are constantly seeking new customers and encouraging existing ones to borrow more. It is this symbiotic relationship between binging consumers and profit seeking financial companies that has created the piles of consumer debt and subprime mortgages.

All of this is starting to unravel now. People borrowed more than they could afford; the mortgage crisis undercut their ability to repay loans and mortgages; the banks and loan agencies faced mounting defaults and declining profits and stock prices. Banks are increasingly unable or unwilling to extend loans to businesses or individuals, which will crimp both consumer spending and economic growth, accelerating the economic downturn.

The U.S. government is not really in a position to rescue bankrupt companies, because it is itself bankrupt. And just as the financial industry has been an enabler of consumer deficit spending, foreign governments have enabled the U.S. government to spend more than it brings in, by buying up U.S. debt. Over half of U.S. debt is now owned by foreigners—compared to just 5 percent that was owned by foreigners twenty years ago. The biggest outside holder of U.S. debt is the government of China. Holding such debt only makes sense if you are sure you can redeem the funds when you need to. As you can imagine, foreign governments and banks are increasingly worried about this, and have already started shifting such investments to other countries, and other currencies, especially the euro. This is one of the reasons for the sharp drop in the value of the dollar, to record low levels against the euro and other currencies.

So this $700 billion bailout, as large as it is, will only scratch the surface of these multiple dimensions of debt and economic weakness. We cannot continue to grow, based on borrowing against the future. The domestic financial pot is empty, and our foreign enablers are wising up. The economy will contract, our standard of living will decline, and more people will join the ranks of the poor and unemployed. This sucker could go down. The U.S. is in for tough times.

CEO Pay and the Bailout

Even in Congress, a lot of people are concerned that President Bush’s proposed $700 billion bailout for the financial sector will unduly benefit the superrich CEOs who contributed so much to this mess in the first place. Most Americans are appalled by the bloated CEO compensations that we occasionally hear about.

But maybe you didn’t hear about the CEO pay for the very firms that are most in the news these days.Last year, for example, AIG’s Martin Sullivan received compensation of $13.9 million, including a performance based bonus of $5.6 million. And this was after a 50% cut in his compensation from 2006! Who topped the list of CEO compensation in 2007? John Thain of Merrill Lynch, another failed enterprise. His compensation in 2007 was $83.1 million.

These amounts are breathtaking, but most people don’t realize, I think, how much this has changed over the last twenty years, and how out of line US CEO salaries are with those in other countries. I raise this in my book, in Chapter 2 on “The End of Affluence and Equality,” which I excerpt here:

In the 1950s, big-company CEOs in the U.S. earned about fifty times the pay of an average worker. Even then, that ratio was very high compared to other countries. But since then, CEO pay in the U.S. has skyrocketed in comparison to average salaries. By 1990, average CEO pay was about 100 times the average worker’s salary, and by 2000, it was more than 500 times that of the average worker.

These benefit packages are far out of line with those in other wealthy countries.

In 2004, the New York Times reported comparative ratios of CEO pay to employee averages. In Japan, CEOs earned about ten times that of the average employee. In Germany, the ratio was 11 to 1, in the UK 25 to 1, and in the United States, 531 to 1! It is difficult to see how American companies can justify these huge executive compensations when these other countries, which much smaller CEO pay, have generally managed faster economic growth, greater productivity increases, and greater gains in their stock markets.

CEO pay is another glaring example of how far out of kilter the U.S. economy is, how eroded is the sense of fairness in this country, and how out of sync the U.S. is with the rest of the world. It is yet another example of The End of the American Century.

Are We Smart Enough to Manage These Problems? An Engineer's Perspective

My friend Charlie Yokomoto, a Professor Electrical and Computer Engineering, and a savvy observer of the political scene, has read this blog and offered the following thoughts on the difficulties of managing complex systems. Maybe we human beings aren't smart enough to deal with these devilishly complicated systems (think financial markets!) that we have created!

Here are some thoughts in engineering terms about the difficulty of decision making in modern society. One of the things that engineers do is to model a system with mathematics so that they can predict behavior to different inputs and find ways to control the system. The system can be a rocket to the moon, a car's transmission, a car's engine, etc. These are fairly basic systems to model because they can be treated as systems whose parameters don't change, or if they change, they change in easily describable ways.

When the system is more complex, like the stock market, the human mind, the atmosphere, a tornado, etc, the modeling becomes far more complicated. When society was much simpler (all white, mostly all middle class, mostly traditional families, mostly church going, low crime, low poverty), then the modeling becomes simpler, and making rules to control the society was simpler than today.

Now for complex systems. A semi-trailer truck sliding on an icy road can also be modeled, but it is more difficult. Mathematics profs are now modeling economic systems, where parameters are always changing. Probabilistic methods have to be used, and time varying dynamic equations have to be used. The atmosphere has been modeled with time varying parameters for years. These equations are more difficult to solve, making it more difficult to use them to predict things, and to control it.

OK, now about controls. Then a system can be accurately modeled, then mathematical methods can be used to determine if the system is observable from the outside (can you observe all of the changes, or will some changes be hidden from the observer?). Methods can be used to determine if the system is controllable (are there ways to push the system in a direction you want it to go?) Sometimes, you find out that you can't--the system will go where it wants to go.

As systems become more complex, you then find out that your mathematics is not equal to the task of modeling it--you need more complexity. Example. If you have a groups of points on a graph, and they all line up in a straight line, you can easily model it with a straight line. If there is a slight curvature, you can try modeling it with a second order equation. But if it is fluctuating wildly, then you need a very high order equation to model it.

I believe that society is getting to the point where it is getting so complex that the human brain cannot intuitively, through experience, fully understand develop a heuristic model of society--how creation of jobs, curbing crime, helping the needy, paying for roads and schools, keeping the food supply safe, etc.--can be done using the same decision making processes that were used successfully when the system was much simpler (fewer parameters, slower changing, and more homogeneous). If the system become more highly complex at rates faster than the human mind becomes smarter (not necessarily in IQ, but in terms of ability, tools, and know-how), how can they solve problems in a system whose complexity if more that their brains can handle?

Take crime. If you have 100 cops and 1 person breaking the law, they can handle it. If you have two people breaking the law, they can handle it. What if there are 10 people breaking the law? Twenty? At what point, will the system of people breaking the law become too complex for 100 cops to handle? Some say that you can't have a perfect law enforcement system and that you have to tolerate a certain level of crime going on at any time. Well, people in charge were ok with that as long as the crime was kept in particular neighborhoods.

Anyway, that's how an engineer looks a society, which is just another system--a very complex one at that, that becomes more and more difficult to model and influenced as the complexity increases, possibly to levels that cannot be understood or influence with legislation and rules.

Niall Ferguson Sees American Century Continuing

Niall Ferguson, the British historian and author of Colossus: The Rise and Fall of the American Empire (2005), has written a column for The Washington Post, "Rough Week, But America's Era Goes On," in which he contends that despite the country's economic weaknesses, "it is much too early to conclude that the American century is over."

As usual with Professor Ferguson's writings, his ideas are well-informed and thought-provoking. (In Colossus, for example, he argued that the U.S. should be an empire, but doesn't have the rights mental stuff for it--we are "an empire in denial.") However, as might be expected from the title of my book, I can't agree with his assessment.

He rightly calls attention to the economic weakness of the United States, and our dependence on others, especially the Chinese, for the underwriting of our huge debts. But he underestimates the broad-based nature of U.S. decline, which stretches far beyond the economic realm. He cites the British journalist who wonders why the U.S. should now be the world's model for economic development, and indeed, polls around the world show that America has already lost that reputation. Furthermore, even the U.S. political system and its very political ideals are being questioned around the world, as revealed in polls by the Pew Center, among others.

The U.S. no longer compares favorably with other developed countries on measures of health care, education, poverty, inequality, violence, corruption, and political participation. We have lost not only lost our ability to dictate global politics, but lost the "soft power" influence that led other countries to admire and emulate us.

Overview and interview about my book

Marc Allan of Butler University's public relations department taped an interview with me about The End of the American Century. An overview of the book, and the transcript of the interview, appear on the Butler website. Click here to see the whole thing.

Is The U.S. Becoming Third World?

Rosa Brooks, writing in the Los Angeles Times, has a clever but sobering column entitled "Hey, U.S., Welcome to the Third World!":

It's not every day that a superpower makes a bid to transform itself into a Third World nation, and we here at the World Bank and the International Monetary Fund want to be among the first to welcome you to the community of states in desperate need of international economic assistance.

She also points out the many aspects of domestic decline in the U.S.:

Now you are facing the consequences. Income inequality has increased, as the rich have gotten windfalls while the middle class has seen incomes stagnate. Fewer and fewer of your citizens have access to affordable housing, healthcare or security in retirement. Even life expectancy has dropped.

Partly tongue-in-cheek, she offers World Bank and IMF assistance to help bail out the U.S. economy.

But this is not so far-fetched after all. In fact, in 2004, the International Monetary Fund issued a report (see p. 17 of my book) raising concern, even then, about the consequences of the U.S. debt for the stability of the world economy. It fretted about the potential insolvency of the U.S., warning that "large U.S. fiscal deficits posed a significant risk for the rest of the world." The IMF economists calculated that closing the deficit gap in the U.S. would require a permanent 60 percent hike in taxes, or a 50 percent cut in Social Security and Medicare benefits.

So while the U.S. is far from Third World status, it's fiscal and economic problems pose serious problems for the whole world.

(Thanks to my Butler colleague Vivian Deno for calling my attention to the column by Rosa Brooks).

The Unraveling of the U.S. Economy

Since I posted “Bankrupt America” here ten days ago, major pillars of America’s financial edifice have come crashing down. First, the federal government had to take control of Fannie Mae and Freddie Mac, the nation’s two largest mortgage finance companies. Then the prominent securities firm Lehman Brothers declared bankruptcy, and the even more venerable Wall Street firm, Merrill Lynch avoided the same by selling itself to Bank of America. Today the Federal Reserve announced that it was taking over the insurance giant, A.I.G., in a bailout that will cost taxpayers $85 billion.

These are all huge companies—mainstays of the U.S. economy. It is difficult to make much sense of Senator John McCain’s assertion that “the fundamentals of our economy are strong.” These companies were the fundamentals, and they are all bankrupt. Most people, even most financial analysts, I think, do not quite grasp how elemental these developments are. They signal a shift that is as fundamental for the United States as global warming is for the planet.

The collapse of these financial institutions are part of the bigger picture of economic weakness that I describe in The End of the American Century. The United States has been overspending and under saving for a generation or more, and this has led to borrowing, deficit spending, and debt inside and outside the government. As I write near the end of Chapter One of the book, “where the U.S. once drove the world economy through economic growth, invention, and productivity, now it is doing so almost entirely by consumption but at levels it cannot pay for.”

The consumer spending and borrowing binge has been fueled by the growth of the financial services industry, which has increasingly replaced manufacturing as the mainstay of the U.S. economy. The shrinking manufacturing sector now accounts for only about 10 percent of corporate profits in the U.S., compared to 44% of such profits from the financial sector. Banks, mortgage companies, loan agencies and credit card companies make their money by making loans, and they are constantly seeking new customers and encouraging existing ones to borrow more.

It is this symbiotic relationship between binging consumers and profit seeking financial companies that has created the piles of consumer debt—the largest in U.S. history. All of this is starting to unravel now. People borrowed more than they could afford; the mortgage crisis undercut their ability to repay loans and mortgages; the banks and loan agencies faced mounting defaults and declining profits and stock prices. And as goes the financial sector, so goes the rest of the economy.

This is not some episodic financial downturn. The chickens are coming home to roost, and they have nowhere to land. The U.S. government has record budget deficits and is deeply in debt; Social Security is unfunded; households have zero savings (literally); the dollar is at record lows; energy at record highs; and now the stock market is taking a bashing. Former Fed chief Alan Greenspan told ABC that this is a “once-in-a-century type of event.” And former Commerce Secretary Peter Peterson, who I invoke in my “Bankrupt America” post, admitted that “these are the most extraordinary events I’ve ever seen.” (NYT 9/15/08).

In The End of the American Century, first written a year ago, and appearing next month, I wrote this at the conclusion of my Chapter One on “Imperial Overstretch and Economic Decline”:

A serious recession, perhaps even a depression, is the probable outcome. Such a recession will actually be necessary, however, for the long-term viability of the American economy. It will cause unemployment in the short run and declining wages and incomes in the long run, but this is inevitable if balance is to be restored. The U.S. economy will shrink, as will the country’s standard of living. This will simply reflect the actual economic situation in the U.S., which for so many years has been obscured by mortgaging the future with deficits and debt. The U.S. will no longer be the dominant economic power in the world, and with economic decline will come military, diplomatic, and political decline.”

What does all this mean for us? Stay tuned. (And your comments and thoughts are welcomed).