December surprise: is the GOP cooking the books to avoid recession till after Election Day?

Mother Jones, July-August, 2008 by James K. Galbraith

The mechanisms of mortgage finance and home-equity drawdown haven't simply been damaged. That well has been poisoned. Having largely outsourced mortgage originations to companies like Countrywide who didn't care whether the borrowers had good credit, the banking system cannot easily go back to its old method of making loans to creditworthy people and contenting itself with the interest paid back over many years. And who would trust them, anyway, if that's what they claimed they wanted to do?

Then there's another problem: The banks no longer trust each other. Last August, as mortgage-backed securities unraveled, finances froze up worldwide. Why? Because banks knew how much undisclosed junk they had on their own books. Who could say what the next fellow had? Overnight lending between banks--the process that ensures that every bank has funds when it needs them--fell apart. This is a very big deal. If banks will not lend money to each other, why (except for the blessings of federal insurance) should anyone else leave their money to them? Economists like me wait entire careers to study events such as these-which should provide no comfort to anyone else.

Since August, America's big banks have been wards of the Fed, and those in Europe equally so of the Bank of England and the European Central Bank. The system survives because central banks keep the lending windows open, and the result is that--except for one instance in Britain--the public has not pulled out of the banks. Let's be clear. The private financial markets did actually fail. It's only the fact that the public trusts government that keeps the system from dissolving in panic. But even if the Fed and its counterparts can hold the line, the problem of mistrust among the big bankers won't go away soon. And that means we're at the end of the age of credit expansions, for now.

As for next year, good luck. No matter who becomes president, there probably won't be another tax cut. Instead, cries for "fiscal responsibility" will be heard. States and localities, hit in 2008 on their property taxes, will cut their spending. Consumers, hit hard on their home equity, will cut back on new borrowing (which they probably couldn't get anyway) and pinch pennies however they can. Businesses won't even think about new investments.

In this situation, more cuts to interest rates--the only applicable tool the Fed has--don't work well. And they weaken the dollar, which raises inflation. What is gained by cheaper money will be lost in higher gas and food prices. But if the Fed reverses field and defends the dollar, exports will slump and the housing crisis will get worse. There's no easy way out.

Thus far the dollar has fallen, but it hasn't collapsed. Will it? There are two big threats. The first is the financial crisis itself, which is a problem of trust not only in the ordinary borrower, and not only in the banks, but in the American dollar. Why is the rest of the world nervous? Because the fundamental trust that they have always had--that the United States was a safe place to put your money--has come into question.