The Next Big Bail Out

The great economic fight of our epoch is being waged by the FIRE sector – Finance, Insurance and Real Estate – against the industrial economy and consumers. Its objective is to maximize property prices and the volume of debt relative to what labor and industry are able to earn.

Rising debts and real estate prices go together, because asset prices depend on how much banks will lend. For creditors, the dream is to obtain an ultimate backup at public expense: government insurance that they will not lose when debtors are unable to pay. The political problem is how to get the government to insure and protect bankers rather than debtors, given that debtors are much more numerous when it comes to the voting booth. In such cases campaign contributions are the balancing factor. Governments are “privatized” and “financialized,” that is, turned from democracies into oligarchies. The banking system aims to make sure that the only losers are the customers it is supposed to serve: debtors, homeowners and employees of companies being “financialized” as the economy is de-industrialized. Indeed, financialization and de-industrialization are becoming almost synonymous. The trick is to get voters to think they are getting rich while actually they are being painted into a debt corner, along with their employers, local government and the federal government too.

For a while the bad-debt overhead can be bailed out by creating yet more debt, backed by public guarantees in what even the Wall Street Journal acknowledges is “socialism for the rich,” that is, privatizing the profit and socializing the losses. But when has government been anything else, for thousands of years before anyone coined the term “socialism”? The so-called July 30 “housing bill” supports the price of mortgages that are the major asset base of most banks and other financial institutions today. What ultimately supports the price of these mortgage packages is the price of the real estate pledged as collateral. And despite Mr. Greenspan’s celebration of soaring housing prices as “wealth creation,” it really was debt creation. As housing prices plunge, the debts remain in place.

The question is, whose balance sheets are to plunge into negative equity territory – those of indebted homeowners, or those of banks that have made the bad loans and the financial institutions (largely pension funds, I’m sorry to say) that have bought “toxic mortgages”?

Financial bubbles in their early phase inflate asset prices more rapidly than debts rise. This helps the financial sector encourage a belief that debt pollution is a quick way to make the economy rich – as long as one looks at financial balance sheets rather than tracing growth in the actual means of production and living standards. Living in the short run, most people do not see the financial war going on, and imagine that finance and industry, labor and capital are fighting for the same kind of economic growth and wealth. The reality is a conflict between financial and industrial growth objectives, subject to the adage that the solution to every problem tends to create yet new, unforeseen problems – ones often are larger in scale, requiring yet new solutions that cause yet larger and even more unforeseen. This is how societies transform themselves for better or for worse, crisis by crisis.

Usually each side fights for its economic interests. But it is best not to crow too loudly over victory. The financial bailout is depicted as a housing bill, not as a giveaway to financial interests. And it is best not to acknowledge that the financial system’s victory now threatens to push the economy further down the road to insolvency, headed by a squeeze on state and local finances, and pension funding public and private. Problems threaten to arise when creditors win too one-sided a victory.

Here’s what has happened so far. Early on the morning of July 30, President Bush signed the law that the Senate had passed at a special session the previous Saturday. Its aim was to restore U.S. housing prices to unaffordably high levels, requiring new buyers to run even deeper into debts to obtain housing. Rather than rolling debts back to more affordable levels, the government now will use its own credit to guarantee payment on whatever portion of the unpayable exponential growth in debt cannot be sustained by the economy at large.

The new “housing law” (a more honest title would have been the “financial bailout and giveaway act of 2008”) authorizes the Treasury and Federal Reserve Board to provide unlimited credit to Fannie Mae and Freddie Mac, and infuse new lending power to the Federal Housing Administration (FHA) and localities to support the “real estate market.” This is a euphemism for saving mortgage lenders from the traditional response to falling property prices – defaults and walk-aways. The idea is for government loans to replace the bad loans that existing mortgage holders are stuck with, and to do so before property prices sink by another 25 percent.

The cover story highlighted in the first line of the press release was that the new act was “intended to provide mortgage relief for 400,000 struggling U.S. homeowners and to stabilize financial markets.” The real aim is to help struggling banks and institutional investors, with little likely aid for homeowners. Mortgage defaults and foreclosures were threatening to wipe out the collateral valuations for the loans packaged and sold to U.S. pension funds, other institutional investors and foreign banks – including the $1 trillion in Fannie Mae and Freddie Mac securities to foreign central banks and sovereign wealth funds.

Piercing the cloud of public relations rhetoric, the actual impact on strapped mortgage debtors is that the increased funding for Fannie Mae, Freddie Mac and FHA are part of a $1.4 trillion emergency supply of government credit intended to keep housing prices from falling back to more affordable levels. An alternative use of this funding would have been to save individual debtors from foreclosure and re-set their mortgages at more realistic levels. But the constituency of the Treasury and Federal Reserve is Wall Street, not homeowners. This is not a constituency whose interests reflect those of the economy as a whole over the long run.

Finance and real estate extract interest and rents from the rest of the economy, shrinking rather than expanding it. This causes property prices to fall. Speculators (who have made up about 15 percent of the housing market in recent years – one out of every six buyers) stop buying, while an over-supply of foreclosed or abandoned properties come onto the market. Falling prices push debt-leveraged homeowners into negative equity, followed by banks and the hapless buyers of the mortgages they have sold off.

During the real estate bubble homeowners, commercial speculators and corporate raiders were able to borrow the interest charges by refinancing their properties at higher and higher appraisals. But banks now are pulling back from mortgage lending, largely because buyers of packaged mortgages find themselves stuck with paper that is a far cry from the security its AAA bond ratings implied. Companies that have insured these mortgages are far undercapitalized to sustain the risks, and themselves are threatened with bankruptcy. So the mortgage packagers and insurers Fannie Mae and Freddie Mac are being kept in business to “save the real estate market,” by which is meant the exponential growth of debt.

The parties being bailed out are the large institutions that hold the bad mortgages extended and packaged in recent years, and companies on the hook for having insured the face value of these mortgages. The growth of real estate debt has been achieved by the semi-public Fannie Mae and Freddie Mac providing “liquidity” not just by buying up and packaging mortgages in bulk, but by insuring their income streams. As William Poole, head of the St. Louis Federal Reserve Bank from 1998 to 2008, points out: “Fannie and Freddie exist to provide guarantees for mortgage-backed securities trading in the market. The business is simply insurance.” This insurance against mortgagees defaulting (and ultimately against banks and mortgage brokers making bad loans beyond the home buyer’s ability to pay) is what has made their sale so irresponsibly liquid. And matters have reached the point where between two and three million U.S. homeowners are still expected to default this year, leading to foreclosures.

Mr. Poole adds that the government’s assumption of the mortgages underwritten and guaranteed by these two public agencies technically doubles the federal debt, from $5 to $10 trillion. The asset side of the government balance sheet also rises, but there may be a substantial shortfall. Private bondholders and stockholders of Fannie and Freddie also have claims on these assets, so any attempt at real-world accounting becomes thoroughly tangled.

A deeper problem is that Fannie and Freddie underwrote and insured a debt increase whose continued exponential growth is unsustainable, because it causes domestic debt deflation. What Mr. Greenspan called “wealth creation” – pumping up housing and stock market prices on credit – was actually debt creation. Asset prices are a function of how much banks will lend. If they lend more money on easier and easier terms, property prices will continue to soar. This is why the economy is facing debt deflation. More and more money will be diverted from being spent on consumption and paying taxes, in order to pay creditors. This will shrink the domestic market, squeezing profits, and also will squeeze state and local finances.

The government will not solve this problem by providing yet more loans for stronger parties to buy the existing supply of homes otherwise in foreclosure. The dream is to keep housing high-priced to support the mortgage lenders, not for prices to fall so that new buyers do not need to run so heavily into debt to afford housing.

Supporting real estate prices thus entails keeping the existing volume of debt on the books, and indeed running up even more debt. This levies an enormous charge on the economy to pay interest and amortization. These payments leave less available to be spent on goods and services or paid in taxes. The economy shrinks, leaving it even less able to carry its debt burden. Many individuals no doubt will default on their credit card debt, auto debt and other debts, but the largest remaining debt consists of pension and health care obligations to the private and public sector work force.

This problem has been growing beneath the view of most public media. Private-sector pensions are insured by the federal Pension Benefit Guarantee Corporation (PBGC), which is substantially undercapitalized. A much larger problem is state and local pension programs. not only are underfunded; they have no insurance at all. The expectation was that public-sector pensions would be paid out of rising property tax revenues and capital gains. But taxing property now threatens to cause defaults on mortgage payments. This is the corner into which the economy has painted itself by trying to preserve the exponential growth of mortgage debt.

To cap matters, this threatens to push state and local budgets into deficit at a time when their pension and medical insurance payments are soaring. On the expense side of their balance sheet, localities must spend more money to cope with the consequences of empty houses being stripped of building materials, occupied by squatters, burned down and generally becoming a source of blight. On the fiscal income side, states and localities are facing populist political pressure crafted by large real estate interests and promoted with the usual flow of crocodile tears on behalf of retirees and other homeowners whose debt squeeze prompts them to support politicians promising to reduce property taxes.

At first glance the connection between bailing out Fannie Mae and, behind it, the real estate market to keep prices high for American homeowners might not seem closely linked to corporate, state and local pension plans. So let us trace the linkage. Bailing out mortgage lenders ultimately must be achieved at the expense of state and local property tax revenues. Revenue that is used to pay interest is not available to pay taxes. If debts are to continue to grow exponentially and extract more carrying charges, this forces a tax shift onto labor and industry.

For the past century the financial sector has made steady incursions to take over what used to be the role of government. Today’s libertarian anti-tax “free market” rhetoric is simply a cover for the financial sector’s replacement of elected democratic government. Forward planning is being distorted to serve the financial sector, not aiming to promote long-term growth and raise living standards, and certainly not to protect the public sector’s fiscal position.

One of the lesser-known features of this week’s real estate bailout is the endorsement of “negative mortgages.” These debt agreements add the accrual of interest onto the principal. The cover story is that this enables low-income homeowners to keep their houses with a lower carrying charge, borrowing the interest rather than paying it. But this means that what used to accrue to homeowners or their heirs as a “capital” (land-price) gain henceforth will accrue to the mortgage lender. For over a century, the main way that most American families have become rich has been by the free lunch of exponentially rising land prices. What is to rise exponentially in years to come is now their debt overhead. It is the financial sector that will get the free lunch of land-price gains.

Adding the interest charge onto the principal is how Ponzi schemes work. They cannot work for long, because no real economy can keep up with “the magic of compound interest.” The Bush-Paulson bailout plan calls for mortgages to become larger and larger, regardless of whether property prices keep pace. The interest is to accrue to the federal government as mortgagee at first, but this innovation is really a test run. It is the path of least resistance for private banks to start making mortgage loans that give them a return in the form of “capital” gains as well as interest.

These gains consist of the inflation of land prices in cases where state, local and federal government fails to capture this gain for the economy at large. So the scheme obliged the public sector to turn elsewhere than property for its revenues – namely, to consumers and industry.

Who is not going to get paid: bankers and bondholders, or pensioners?

From corporate balance sheets to today’s state and municipal fiscal crises, what appears at first glance to be a pension and Social Security problem turns out to be a financialization (debt) problem. In an attempt to maximize dividend payouts, companies in the auto, steel airlines and other industries made a bargain with labor to take its wages in the form of deferred pension and health-care payments. And labor – being much more farsighted than corporate financial managers – chose to defer the latter.

In the case of public sector pensions, the problem is the anti-tax ideology promoted by the financial sector, which prefers government to borrow from the wealthy rather than tax them. Cities from New York to San Diego chose not to raise taxes but to promise public sector employees future retirement income and health care. Also like companies, they chose to finance their budgets by borrowing, by issuing bonds rather than by taxing their traditional real estate tax base. In a nutshell, they chose to borrow from the rich rather than tax them.

Corporate and public bond issuers point out that there is not enough revenue to pay all claimants. But rather than blaming the lenders for making loans to be paid by carving up and selling off assets rather than by producing more, financial lobbies are taking a neo-Malthusian position. They are blaming the corporate and public sector cost squeeze on pension obligations stemming from the fact that people are living longer. The number of retirees per employee or taxpayer is rising – and the much-vaunted rise of science, technology and productivity is not supposed to be able to carry this extra load.

Or rather, economies cannot carry this load and also pay exponentially rising debt service and money-management fees. But this blame-the-victim logic ignores the fact that today’s debts – and property prices – are growing at compound interest, beyond the ability of economies to produce a net economic surplus to pay. Something has to give. For the financial sector, what gives is supposed to be labor’s wages, industry’s profits and the government’s taxing power.

We got into this mess by giving special tax breaks to real estate and finance at the expense of labor and industry, and warping the tax system to favor debt over equity. Financial managers and politicians conformed to type by living in the short-run. Labor did not demand that government take responsibility for what is commonly provided to employees and retirees in most civilized countries: a living income and health care. Instead, both labor and its employers took this responsibility on the private sector itself. It was a cost that other countries are spared from having to bear – and from having to “financialize” by pre-saving in the form of financial speculation, to pay pensions and health care out of capital gains that are to be ensured by the government cutting taxes to leave more profits and other revenue to capitalize into yet higher loans to bid up asset prices. The entire detour of financialization has added a vast non-production cost to the expense of doing business and hiring labor in America. To put matters bluntly, we have taken a wrong path – yet hardly anyone in authority is explaining how to retrace our steps to get out of the present dilemma.

As long as one believes that government can only add to overhead waste – and that the financial sector can only “economize” and make the economy more efficient – there will be little motivation to seek an alternative. Without doubt, one can point to exorbitant retirement giveaways such as New York City’s pension arrangements for public transport workers, policemen and firemen. Their craft unions obtained pension and health care rights substantially above those of the labor force in general. But such deviations from the norm are inevitable in a system where pensions and health care are left to company-by-company, city-by-city and state-by-state negotiations rather than negotiated nationally as is the case in social democracies. The situation is the same with taxes negotiated at the local level. Companies and real estate investors play states and cities against each other to extract special tax breaks for locating in their areas. Political lobbying and insider dealing become rife under such conditions.

At the root of America’s pension and health care problems is an ideological opposition to public services and taxation at the national level. In the aftermath of World War II, corporations opposed “socialized medicine.” This left companies to pay for health care out of their earnings rather than leaving it to government to organize and pay out of the general tax base. This probably made sense to the vested interests when they bore the brunt of progressive taxation. But they seem not to have noted that this attitude has ceased to be self-serving now that the richest families have shifted the taxes onto the lower brackets. General Motors recently has protested that health care costs more money per auto than steel. Yet someone must pay for health care and retirement. If not the government, then who – besides one’s employer? So one wonders just what General Motors wants more: the luxury of an obsolete anti-Bolshevist rhetoric, or to make consumers pay for their health care and Social Security as “user fees” without the upper tax brackets taking the responsibility that they take in countries with more progressive tax systems.

In retrospect it would seem that companies did not act in their self-interest when they insisted on taking responsibility on themselves for providing medical care whose price has soared, largely because the medical profession itself has been taken over by financialized health management organizations (HMOs) in the insurance sector (an increasingly prosperous element of the FIRE sector). They have put doctors as well as patients on rations – fee-for-service in the case of physicians, and rationed care for the hapless insured. And this is supposed to be the free market alternative to centralized planning!

The explanation for companies acting this way is to be found in the era of progressive taxation. More than two centuries of classical economic analysis had shown the logic of taxing predatory wealth (land ownership, monopoly rights and financial claims on the economy) rather than labor and industry. The objective was to tax all forms of income that were not necessary for production to take place. Above all were rights to land, which is provided by nature, for the purpose of charging an access fee, and other extractive property rights and financial charges loaded on top of what actually is needed to be spent on production.

The early income tax captured such “unearned income.” The wealthy classes thus opposed public provision of services, including medical care as well as basic infrastructure, in an epoch when they were the major parties being taxed. But being sclerotic and rigid, the rentier classes failed to shift their attitudes toward public service as they moved to free themselves from taxation. Ever since the United States enacted its first modern income tax in 1913, finance and its major clients – real estate and monopolies – have lobbied to distort the tax code to make their gains tax-exempt. Rather than declaring taxable income, they count as a cost of production interest and over-depreciation for real estate, as well as payments to corporate shells in offshore tax-avoidance centers. The finance and property sectors also take their returns in the form of capital gains rather than as profits, trading through financial hedge funds whose revenue is taxed at only half the rate of normal income.

The wealthiest 1% take their returns in the form of bonuses, not wages, and enjoy a cut-off point of only $102,000 for FICA Social Security and Medicare wage withholding. When Wall Street Journal editorials assert that the richest 1% earn “only” a small portion of taxable income, all this really means is that a shrinking portion of their economic returns are deemed subject to the income tax. Their buildup of wealth takes a form not classified as “income.” Inherited wealth meanwhile is the great loophole for avoiding ever having to pay capital gains that have accrued on real estate and other assets rising in price.

If the rentier classes act flexibly, they will see that as they shed their national, state and local fiscal burden, it is time to “socialize of the risks” as a travesty of true socialism by passing the costs of pensions and health care off of companies and localities onto the federal government. After all, now that labor and consumers are paying the lion’s share of taxes, is it not all right to extend public spending to take over areas of cost hitherto borne by corporate business and other private-sector employers? This promises to be the next big political fight.

But ideological sloganeering dies slowly, and corporate business and the financial sector continue to oppose “big government” even as they are un-taxed. That is the problem with the vested interests: they live only for themselves in the short run. The financial mentality is opportunistic (“after me, the deluge”), caring little about the future. Labor cannot enjoy this luxury. It needs to look to how it will live after its working years end and health care becomes a rising expense. This perspective involves a more far-sighted economic and social contract.

Meanwhile, property taxes continue to be phased out as the basis for state and local finance. The tax burden is being shifted onto income and sales levies that fall on consumers, not on the preferred tax status of high finance and property. For many years now, the political drive to un-tax real estate led cities such as San Diego and entire states such as New Jersey to pay their work force in the form of retirement and health care obligations rather than current wages, while borrowing from the rich rather than taxing them. The income hitherto paid as property tax was available either to pledge to bankers for loans to buy property rising in price as it was untaxed.

All this was fiscal and economic madness from a long-term vantage point – not the madness of crowds, but that of self-serving lobbying by the financial sector. The result has been a trend that cannot go on for long. But having managed to free themselves from progressive wealth and income taxation, the vested financial and property interests evidently believe that they can pull the same trick again and free themselves from the obligation to live up to the pension and health care promises that corporate and public-sector employers have made to their work force.

Such evasion requires a populist rhetoric. Malthusian doctrine worked well two centuries ago, so why not try it once again? Blame population growth – in this case, not the tendency of the poor to have more children, but the ability of employees to live beyond the retirement age at which they were supposed to die if they had conformed to the models used so hopefully by their employers in explaining their financial position. The claim is being made that paying business and public-sector commitments to labor will bankrupt both. There is no mention of debt payments to bondholders for funds borrowed to cut progressive taxes on the rich. Nor is the burden of high housing and other real estate prices that the July 30 bailout of mortgage lenders aims to create.

Something has to give, but it is this old worldview. No doubt when the next financial crisis hits we will see all the usual journalistic adjectives: “unexpected,” “surprising everyone by the depth of the problem,” etc. Give me a break! Can no major media see the obvious trends at work?

MICHAEL HUDSON is a former Wall Street economist specializing in the balance of payments and real estate at the Chase Manhattan Bank (now JPMorgan Chase & Co.), Arthur Anderson, and later at the Hudson Institute (no relation). In 1990 he helped established the world’s first sovereign debt fund for Scudder Stevens & Clark. Dr. Hudson was Dennis Kucinich’s Chief Economic Advisor in the recent Democratic primary presidential campaign, and has advised the U.S., Canadian, Mexican and Latvian governments, as well as the United Nations Institute for Training and Research (UNITAR). A Distinguished Research Professor at University of Missouri, Kansas City (UMKC), he is the author of many books, including Super Imperialism: The Economic Strategy of American Empire (new ed., Pluto Press, 2002) He can be reached via his website,





Michael Hudson’s new book, The Destiny of Civilization, will be published by CounterPunch Books next month.