What Obama Left out of His Economic Recovery Plan: Higher Wages and Debt Relief

By Mike Whitney, Dissident Voice. Posted January 28, 2009.

Barack Obama and Co. are planning to launch their own version of economic "shock and awe" in the opening weeks of the new administration. Aside from the $825 billion stimulus package, which will be used to create three million new jobs and make up for flagging consumer demand, Obama is planning a financial rescue operation for banks that are buried under hundreds of billions of dollars of troubled assets. Spearheaded by Treasury Secretary Timothy Geithner and White House economics chief Lawrence Summers, the new program will create a government-backed "aggregator" bank that will purchase mortgage-backed securities (MBS) and other problem assets for which there is currently no active market. The proposed "bad bank" will do what the TARP program was supposed to do: wipe clean the banks’ balance sheets so they resume lending to consumers and businesses. Until the credit mechanism is fixed, the economy will continue to slip deeper and deeper into recession.

This is not a normal recession where the mismatch between supply and demand will work itself out over time. The banking system is clogged and dysfunctional, the Wall Street funding-model (securitization) has broken down, global markets are in disarray and falling, and unemployment is steadily rising. The system is broken and can’t be fixed without intervention. The question is, what parts of the present system are salvageable and which parts should be scrapped altogether. So far, too much attention has been devoted to re-inflating the credit bubble and not enough to off-balance sheets operations, over-leveraged assets, SIVs, opaque hedge funds, unregulated derivatives contracts and a financial system that operates without guardrails or oversight. The Obama team is more focused on treating the symptoms than curing the disease. That suggests that their ties to Wall Street make them unsuitable for the task at hand. The job requires competent people who are free from the institutional and class bias that prevents them from acting in the public interest.

While it is true that the banks need emergency triage, the underlying problem is falling demand brought on by stagnant wages. This can’t be solved by making credit more easily available. In fact, credit expansion is what led to the present crisis. There needs to be a rethinking of wealth-distribution so that future crises can be avoided. The only way to maintain a healthy economy, without producing destructive speculative bubbles, is by strengthening the middle class via higher wages. That’s the key to sustained consumer demand. The recent attempt to bust the automakers union indicates that many members of Congress believe that the economy can thrive even though a disproportionate amount of the nation’s wealth goes to the upper 5 percent. The current economic crisis illustrates the flaws in this argument.

Presently, the banks are sinking faster than the government’s efforts to bail them out. That’s why Obama asked Congress for the remaining $350 billion of the TARP funds. He knows that he’ll need to be ready to provide emergency funding for capital-starved financial institutions (like Bank of America) as soon as he is sworn in. The market for mortgage-backed securities, credit card debt, car loans and student loans is frozen. The Fed has started to purchase large amounts of these toxic assets, but to no effect. Bernanke’s purchase of agency debt -- Freddie Mac and Fannie Mae -- has pushed the 30-year fixed mortgage below five percent for the first time, but housing prices continue to tumble and sales are at record lows. The Fed’s monetarist lifeline has done nothing to slow the pace of defaults, foreclosures or bankruptcies. Money supply alone cannot reverse the effects of a collapsing credit bubble.

Economists are finally making realistic projections of the costs of the meltdown. According to the Wall Street Journal: "Estimates from Goldman Sachs: $1.1 trillion from residential mortgages, $390 billion from corporate loans and bonds, $234 billion from commercial real estate, $226 billion from credit cards, and $133 billion from auto loans."

Roughly $2 trillion in losses for financial institutions. Originally, experts thought the losses would be no more than $200 billion, a small sum considering that 65 percent of mortgages were securitized between 2003 to 2007, representing roughly $4 trillion in additional mortgage debt. Clearly, with housing prices plummeting, foreclosures skyrocketing and millions of mortgages under pressure from negative equity, losses were bound to be significantly larger than originally predicted. The banks have no way of making up the $2 trillion of lost capital, which is why economist Nouriel Roubini says, "the banking system is basically insolvent."

Up to this point, Secretary of the Treasury Henry Paulson has tried to keep critical banks functioning through capital injections. In theory, this allows the bank to lend even though it may be holding billions in toxic assets that are downgraded with every reporting period. As it happens, the injections have not increased bank lending at all. According to a recent report, the banks increased their reserves by over $600 billion in a matter of months. In other words, the banks are taking money from the Fed’s lending facilities and hoarding it for the tough times ahead. Naturally, this has angered Congress, which feels that it was duped into giving away $350 billion with no guarantees about how it was to be used.

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