The Wizard of Oz

The following is an excellent excerpt from the book “ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism” by Yves Smith from Chapter 8: “The Wizard of Oz” on page 221 and I quote: “Countries that continue to import more than they sell abroad show falling savings rates.  In the United States, in the 1980s, the mantra was “twin deficits,” namely, the U.S. trade deficit and the burgeoning federal deficit.  In the 1990s, as [Bill] Clinton moved to balance government books but the trade deficit persisted, household savings started to fall rapidly.

Admittedly, there had been some decay even before then.  Personal savings had fallen from roughly 10% in 1980 and averaged 8% through 1994, than plummeted to a 1% level from mid-2000 to mid-2007.  And even that figure is flattering.  In 2001, the Bureau of Economic Advisers changed its method for accounting for personal savings.  Under the old method, the results for that period would have been -0.6%.  By contrast, savings rates in the rest of the world from 1980 to 2001 were higher, with no sharp mid-1990s decay, save in Canada, which is closely integrated with the United States.  For instance: France averaged 15%; Germany, 12%; Japan, 13%.

The rationalizations were impressive.  First was the “wealth effect,” that people were saving less because their appreciating stock portfolios and houses were doing the work for them.  While a logical culprit, it ignored the fact that equities were often held in retirement accounts, and thus for many people, equities were a substitute for corporate pensions, which historically had not shown up on household balance sheets.  And these holdings could not be liquidated prior without paying taxes and sometimes penalties.  Put another way the distinction between “investment,” which are funds deployed with the hope of multiplying, and reserves, which are for times of adversity, was confounded.  If consumers invest all of their savings in risky or illiquid assets, they may take losses if they need to access them on short notice.

Further inspection reveals more holes.  If the increase in consumption was indeed due to a rise in asset values, then the increase in consumption and fall in savings should have been concentrated in the most affluent households.  In fact, the shift was similar across wealth levels and age groups.

Similarly, house equity was now accessible via borrowing against it, which also entailed costs.  In other words, the public was assuming considerably more risk.

Another explanation was that labor productivity had risen, and that households expected the gains to continue.  By implication, they were spending anticipated increases in earnings before they arrived.  Yet as discussed earlier, workers had stopped participating meaningfully in productivity increases starting in the 1970s.  While young workers might assume they would earn more as they gained experience, and could whittle down their debt, for much of the rest of the population, that idea was quite a stretch.

A third assertion was the idea that financial innovation had given consumers more access to credit, allowing them to spend more freely.  This “relaxing liquidity constraints” was code for things like “using credit cards in lieu of savings” and “borrowing before the paycheck arrives.”  Cut to the chase: this was tantamount to “consumers were borrowing more because they could.”  And that unflattering theory was given short shrift.

And the debt side of the ledger was just as sobering.  The Federal Reserve tracks various measures of personal indebtedness, with an explicit warning that it can’t get comprehensive enough information.  Nevertheless, it has two proxies: a debt service obligation ratio, which is computation of debt service relative to disposable income, and a broader measure, the financial obligations ratio, which includes commitments like interest on rental property, auto lease payments, homeowners’ insurance, and property taxes.  Both ratios had increased gradually, with a lot of noise, from 1980 to 1999, and then ramped upward through 2007, with a rise due to an increase in mortgage-related obligations. This was particularly surprising given the fall in long-term interest rates from 2001 onward.  If the level of debt had remained the same, the ratio would have fallen.

No matter which story one believed, they all pointed in the same direction: lenders acting in the way Minsky predicted.  An unusually long period without a serious recession produced more willingness to take financial gambles.

But hollow justifications of growing consumer borrowing and nonexistent savings continued as the new century progressed.  The most remarkable was from Federal Reserve chairman Ben Bernanke in a 2005 speech:

“Some observers have expressed concern about rising levels of household debt. . . .However, concerns about debt growth should be allayed by the fact that household assets (particularly housing wealth) have risen even more quickly than household liabilities.  Indeed, the ratio of household net worth to household income has been rising smartly and currently stands at 5.4, well above its long-run average of about 4.8. . . . One caveat for the future is that the recent rapid escalation in house prices. . . is unlikely to continue. . . . If the increases in house prices begin to moderate as expected, the resulting slowdown in household wealth accumulation should lead ultimately to somewhat slower growth in consumer spending.”

The flaw in the logic should have been obvious.  Indebtedness was rising and incremental savings had been flirting with zero.  Debt has to be serviced either out of income, liquidating savings, borrowing against other assets (a self-limiting process), or from the proceeds of asset sales.  With real incomes of most Americans stagnant and savings at a low level for a long time, a growing number of consumers were in a position where everything had to work out right for them to make good on their commitments.  Unfortunately, luck is no substitute for prudence.

After the unraveling started, the rationalizations of deteriorating personal finances finally came under scrutiny.  From a paper published in the Review of the Federal Reserve Bank of St. Louis in 2007:

“. . . the recent decline of the personal savings rate to low levels seems to be a real economic phenomenon and may be a cause for concern.  After examining several possible explanations for the trend advanced in recent literature, the authors conclude that none of them provides a compelling explanation for the steep decline and negative levels of the US personal savings rate.” (Emphasis added.)

In other words, the theories advanced at the time were all wet.

A second major contributor to the growth of leverage and risk taking was the market-friendly posture of Federal Reserve chairman Alan Greenspan, embodied in the so-called Greenspan put.  A put is an option that gives an investor the right to sell an instrument at a specified price and is often used as a hedge against losses.  Many investors came to believe that the Federal Reserve would intervene in the event of a serious downdraft, similarly reducing their downside exposure.

Greenspan is a contradictory figure.  A disciple of neoliberal demigoddess and apostle of rampant individualism Ayn Rand, he was a true believer in the virtues of unregulated markets.

Ironically, the Fed chairman rode roughshod over the dictates of another “free markets” stalwart, the monetary economist Milton Friedman, who had urged central banks simply to set a steady but modest rate for growth in money supply.  Indeed, Friedman in his popular writings contended that the Fed had caused the Depression.  Hands off on the financial regulatory front, Greenspan was pretty active as far as interest rate interventions were concerned.

But other followers of “free markets” policies would support Greenspan’s monetary machinations.  Recall that they saw the refusal of workers to accept low enough wages as a factor that made the Great Depression as severe as it was.  One way to contain compensation is for the central bank to raise interest rates when inflation starts to build.  The logic is that increasing unemployment will moderate pay pressures and also discourage businesses from giving employees pay increases in excess of productivity gains.  Ironically, quite a few “freemarkets” supporters endorse this type of intervention to correct a perceived market failure (labor having undue bargaining power) but reject a raft of others.

Greenspan was also famed for poring over reams of economic data.  Wall Street took comfort from his Wizard of Oz act: great and mysterious power, mastery of arcane information, and generally impenetrable pronouncements.

Greenspan’s first major act as Fed chairman helped establish his reputation as a friend of financiers.  Bankers and economists applauded Greenspan’s initial emergency operations during the 1987 crash, only a bit more than two months into his tenure.  He and fellow Fed officials judiciously jawboned market participants into continuing to extend credit to market participants.  The central bank also lowered the Fed funds rate by 50 basis points.

This operation was an expansion of the central bank’s traditional scope.  The Federal Reserve’s charter makes it responsible for the safety and soundness of the banking system.  Subsequent legislation added the duties of promoting growth and price stability.  Aiding in the continued operation of financial markets was a new task.

In the wake of the savings and loan crisis, Greenspan again came to the rescue of the financial services industry, dropping rates and producing and maintaining a steep yield curve, meaning a large differential between short-term interest rates and long-term rates.  But this action was more in keeping with the Fed’s charter.  Bank balance sheets had been battered in the savings and loan crisis in the aftermath of the leveraged buyout boom, and many (Citibank in particular, which was rescued by a large investment from Saudi prince Al-Waleed) were undercapitalized.  Since banks borrow on a short-term basis and make long-term loans, very low short rates and high long rates meant higher profits, enabling banks to earn their way out of their mess.  However, Greenspan had been cautious in making his move.  Both Democratic and Republican observers have commented that had Greenspan lowered rates sooner, George Bush might have won the 1992 election.

Greenspan developed an unseemly interest in equity prices, which had never been part of the Fed’s job description.  Indeed a May 2000 Wall Street Journal story called it an “obsession” that dated to at least 1991.  1994 Federal Open Market Committee records show the chairman pleased at “[breaking] the back of an emerging bubble in equities.”  December 1996 witnessed his famous “irrational exuberance” remark, widely seen as a comment on stock valuations.  Foreign equities swooned overnight, with major indices falling 2% to 4% and the Dow dropping 145 points in its first half hour of trading.  Similarly, he voiced skepticism toward the “new era” thinking driving levitating equity prices, in Congressional testimony in February 1997 and July 1998.

Despite seeing signs of frothiness, Greenspan failed to connect other data.  The Fed chairman in the mid-to late 1990s would occasionally remark that imports were helping keep inflation tame, and by extension, he could keep interest rates at their current level without risk of stroking price gains.  But this was a flawed view.  The price of imports did not reflect the actions of the Fed.  A better metric would have been prices excluding imports.  A former Federal Reserve economist, Richard Alford, set forth the problem:

“One of the interesting aspects of economic policy in the US is a belief that we exist independent of the rest of the world. . . . most US economists pretend that the rest of the world does not exist, is stable, or that the dollar will quickly adjust so as to maintain US external balances. . . .

If you look at the difference between gross domestic purchases and potential output, by US consumers, businesses, and government–all are above potential output.  The only time in recent memory when the difference between these two measures started to narrow was in 2001 when we were in a recession. . . .

The policy goal has been to generate sufficient levels of demand to support full employment. . . . That would be fine if we did not have a net trade sector or at least had a stable net trade sector.  But. . . we’ve had a flood of imports which have depressed prices in tradable goods.  Fed Governor Don Kohn. . . said imported deflation knocked 50-100 basis points off measured per annum inflation.  At the same time, rising imports have hurt American workers. . . . the underlying problem is not deficient US demand, but a structural external increase in supply (globalization).  Given the inability of the dollar to serve as an adjustment mechanism, we are consuming too many imports, but instead of US policymakers addressing this global development, we created a number of unsustainable domestic imbalances to keep employment at politically acceptable levels.  Higher levels of debt and asset bubbles have been the result of policy responses to external imbalances.”

The nub of argument is that since the mid-1990s, domestic demand in the United States was in excess of potential output, a claim many economists would find surprising.  The most widely used estimates for potential output come from the Congressional Budget Office and for aggregate demand, from the Bureau of Economic Analysis.  Those data series, which had seemed reliable for most of the postwar period indeed showed demand was running below potential output.  Based on that, stimulus, such as low interest rates, would be warranted.

But Alford contends that globalization rendered those measures invalid.  In the new world of “free markets,” the United States has made no effort since the time of the failed Plaza Accord to rein in trade deficits.  If we could rely on the trade imbalance correcting itself, we could indeed ignore the export-import sector, which the prevailing approach does.  But in these circumstances, another measure of demand, gross domestic purchases, give a more accurate picture, and it shows that demand ran ahead of potential output by roughly 2% to 6% through 2006.”


LaVern Isely, Progressive, Overtaxed, Independent Middle Class Taxpayer and Public Citizen Member and USAF Veteran


About tim074

I'm a retired dairy farmer that was a member of the National Farmer's Organization (NFO). Before going farming, I spent 4 years in the United States Air Force where I saved up enough money to get my down payment to go farming. I also enjoy writing and reading biographies and I write about myself as well as articles and excerpts I find interesting. I'm specifically interested in finances, particularly in the banking industry because if it wasn't for help from my local Community Bank, I never could have started farming which I was successful at. So, I'm real interested in the Small Business Administration and I know they are the ones creating jobs. I have been a member of Common Cause and am now a member of Public Citizen as well as AARP. I have, in the past, written over 150 articles on the Obama Blog ( and I'd like to tie these two sites together. I'm also on Twitter, MySpace and Facebook and find these outlets terrifically interesting particularly what many of these people did concerning the uprising in the Arab world. I believe this is a smaller world than we think it is and my goal is to try to bring people together to live in peace because management needs labor like labor needs management. Up to now, that hasn't been so easy to find.
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