Maybe there’s a New Economy after all

by Eric Janszen


Let’s put to rest the myth that the Fed is blind to asset bubbles and never intentionally acts to prick them. The truth can be obtained by anyone with an internet browser and a few hours on their hands to read the voluminous Fed Open Market Committee (FOMC) meeting minutes. In the FOMC meeting minutes from March 22, 1994 (pdf), Greenspan says (my emphasis in italics):

    "When we moved on February 4th, I think our expectation was that we would prick the bubble in the equity markets. What in fact occurred is that, as evidence of the dramatic shift in the economic outlook began to emerge after we moved and long-term rates began to move up, we were also clearly getting a major upward increase in expectations of corporate earnings. While the stock market went down after our actions on February 4th, it has gone down really quite marginally on net over this period. So what has occurred is that while this capital gains bubble in all financial assets had to come down, instead of the decline being concentrated in the stock area, it shifted over into the bond area. But the effects are the same. These are major capital losses, which have required very dramatic changes in the actions and activities on the part of individuals and institutions."

    "So the question is, having very consciously and purposely tried to break the bubble and upset the markets in order to sort of break the cocoon of capital gains speculation, we are now in a position—having done that and in a sense succeeded perhaps more than we had intended—to try to restore some degree of confidence in the System."

To try to restore some degree of confidence in "the System," as Greenspan calls it, the Fed injected liquidity in 1994 that restored function to a dysfunctional banking system and rescued the bond market. But what cures one bubble sows the seeds of new ones. As Martin Mayer said in his book The Fed: "The truth is that liquidity, the only significant weapon remaining in the central bank’s arsenal as decision making moves to the markets, will not necessarily go where you want it to go when you need it to go there."

The 1994 liquidity injection kicked off the largest and longest period of real estate appreciation in US history and launched the late 1990s stock market bubble in the bargain. Five years later, in June 1999, the Fed appears to have moved to prick the new stock market bubble in the same purposeful manner as in 1994, except you won’t find the same explicit discussion about pricking bubbles in the minutes of the June 30 FOMC meeting notes. The only reference to asset bubbles comes from the President of the Federal Reserve Banks of Boston, Cathy E. Minehan, during the previous month’s meeting (emphasis added):

"We recently held a meeting of the Bank’s Academic Advisory Council which, as you all know, includes two or three Nobel Prize winners and people from Harvard, MIT, Yale, and so forth. The discussion focused on issues related to productivity growth, labor market tightness, and asset market bubbles. The group was lively, to say the least. But some consensus was reached on the need for action that might take the wind out of asset markets, even in the absence of tighter monetary policy, perhaps through increased margin requirements or increased supervisory oversight on credit extended, particularly in the day trading operations."




She also commented on "excesses and imbalances" in the "stock markets, real estate markets, corporate and personal debt." If there was concern around the FOMC in 1999 about real estate excesses, you have to wonder what the FOMC thinks today. The median home price in California is up 123 percent since then. That’s close to the median home price increase for the US in the previous 20 years, from 1980 to 1999.

We won’t know for a while what committee members think because the full minutes of FOMC meetings are released after a five-year lag, but two things appear to have changed since 1994. First, there has been an apparent shift in the policy of talking about bubbles openly in committee meetings. Second, the Fed now appears to wait until the latest bubble has become considerably more egregious than the previous one. But otherwise the responses and results are the same.

Nine months after the Fed began to withdraw liquidity from the markets (starting in June 1999), the bubble popped in March 2000. The Fed then beat the previous post-bubble Fed rate cut record of 4% in 14 months, from 6% to 2%, that followed the 1929 crash. Between January 2001 and June 2003, the Fed flushed the System with liquidity once again as the Fed Funds Rate target was cut from 6.5% to 1%.

After more than four years of post stock market bubble collapse reflation, with short term interest rates kept below the rate of inflation, it appears that liquidity once again did "not necessarily go where you want it to go," resulting in the creation of bubbles in several asset classes. Unique to this bubble period, several asset classes that have historically been counter-cyclical, such as bonds and equities, are all rising in tandem. Now we have:

A Housing Bubble

A Bond Bubble

A Private Equity Bubble

A Hedge Fund Bubble

A Commodities Bubble

An Art Bubble

All asset classes can’t rise together forever. These bubbles too will eventually collapse. Then it’s reflation time again.

Ever since markets overran the Fed in the creation of money and credit in the late 1970s, the Fed has overseen a series of bubble booms and bubble busts. Market professionals, especially hedge fund managers, have learned how to position themselves to profit from these boom and bust cycles. Speculators are now well-trained and will be standing by; ready, willing, and able to turn the next post-bust liquidity flow of money their way.

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President George W. Bush’s "ownership society" is a seductive idea: who wouldn’t want to become the owner of their home, health care, retirement, and destiny? From the "home on the range" to the adulation heaped on high-tech entrepreneurs, the concept is rooted in the American experience. No other nation places more value on the importance of individual autonomy. Ultimately, however, Bush’s promise of an ownership society is an empty one. In exchange for ownership, we receive increased risk while the wealthy and corporate interests benefit, as in his Social Security privatization plan. In Bush’s world, everyone gets a little piece of the pie, but at the cost of giving the wealthy extremely large helpings. Bush has, in fact, exacerbated a long-running trend: not only is income inequality greater in the United States than in any other advanced society, but the ownership of wealth is literally feudal in nature–and getting more so. The top 1 percent garners more income than the bottom 100 million Americans taken together. A mere 1 percent of wealth-holders, however, own just under half of all financial assets. A slightly larger group, the top 5 percent, own roughly 70 percent of all business assets. In 2003, the top 1 percent alone received 57.5 percent of all capital gains, rent, interest, and dividend income.

With recent rollbacks of the estate tax, incentives for retirement savings from which the well-off disproportionately benefit, and tax cuts that reward wealth, these inequities will only deepen. Morally, this is offensive to progressives and anyone with even a semi-serious conception of justice. Practically, this is troubling–and should be–to people across the political spectrum, because societies in which wealth disparities are so great are unstable societies. Divisions are magnified. The bonds of citizenship and brotherhood are weakened. The social fabric is frayed. A nation that begins down this path ends up with a country that begins to look more like a developing nation in Latin America and Africa: high walls keeping a restless and poor population out of sight and out of mind.

Decrying such inequities is nothing new. Yet, unfortunately, the progressive response of the twentieth century–redistributive tax structures and public assistance–no longer has the capacity to alter the dominant trends. Not only has income inequality continued to expand despite large-scale entitlement programs like Medicaid and Social Security, but there is little prospect that significant new programs will come into being any time soon. In a world of deepening deficits, an aging population, global competitive pressure, and persistent public skepticism of government, the appetite for the tax hikes and entitlement programs needed to rebalance these inequities is weaker than ever.

Although the redistributive door is largely closed, the ownership door is, in fact, open. Not ownership in Bush’s skewed sense, but rather ownership in a democratic sense through the possibility of community-based investment in, and control over, wealth creation. Employees, companies, non-profits, cities, and states are using diverse and innovative strategies to create community wealth. It is wealth that improves the ability of communities and individuals to increase asset ownership, anchor jobs locally, expand the provision of public services, and ensure local economic stability, rather than just boost corporate profits and shareholder fortunes. A common thread runs through the employee-owned firms, community development corporations, and even the traditional co-ops: the idea that real wealth equality can only be built by communal involvement in the means by which that wealth is produced. Such approaches provide ownership for millions of Americans–in many cases, through a tangible asset that can appreciate and be passed on to subsequent generations. Others create community wealth by enabling businesses and jobs to stay in the United States.

But more than that, these ownership strategies give people a real stake in their community, strengthening the bonds of citizenship and the connections between people, institutions, and places. These are not incidental by-products of a progressive ownership society; they lie at its core. A country where more people have a tangible stake and believe they can create better lives for themselves and their children is a strong society–and a strong democracy. "Necessitous men are not free men," Franklin Roosevelt urged. Or as an earlier President, John Adams, reminded a young nation: "The balance of power in a society accompanies the balance of property."

Interestingly, the idea of using investment strategies to benefit non-elites has been difficult for some progressives to grasp–it sounds too much like the other side’s programs. However, properly structured, such strategies can be a practical and effective way to combat wealth inequalities. Indeed, at the grassroots level, a progressive ownership society is already quietly taking shape–one that enables the poor, blue- and white-collar workers, and the middle class in general (broadly, the vast majority of perhaps the bottom 95 percent of American society) to create and gain the benefits of wealth ownership. These various strategies, and they are indeed very diverse, are beginning to change who gains from wealth ownership and investment. Some do it directly, helping low-income individuals increase savings and asset-holding. Others do it indirectly, but nonetheless importantly, by increasing the numbers of non-profit corporations that have established businesses to help finance neighborhood development or various social missions. Still others use municipal and state strategies to build community wealth. And all of these efforts are found throughout the country, in states "red" and "blue."

Community Wealth Strategies

Several proposals have emerged in recent years that move government policy beyond conventional redistribution and toward wealth creation. For example, prompted by the Clinton Administration, a bipartisan coalition came together in the late ’90s to provide federal backing for Individual Development Accounts (IDAs). In the typical IDA, the government directly matches the savings of poor families or individuals up to a certain level, thereby doubling their efforts and allowing them to benefit from the ownership of capital. Although IDAs are still very much in the experimental stage, roughly 400 community-based organizations currently administer some 20,000 individual accounts; in the San Francisco Bay Area, participants have consistently saved 5 percent or more of gross income despite averaging less than $20,000 per year in household income.

Bush has committed only modest federal funding to the initiative, but it has nevertheless spawned a number of proposed variations in recent years, many with bipartisan backing. In 2005, for instance, the America Saving for Personal Investment, Retirement, and Education, or ASPIRE Act, was jointly introduced by two Republicans and two Democrats: Senators Rick Santorum, Jim DeMint, Jon Corzine, and Charles Schumer. ASPIRE would provide every child with a starter deposit of $500, with children from households below the national median income eligible for an additional $500. In Great Britain, a similar "baby-bond" measure is now law, with the first "Child Trust Funds" opened last year.

The most far-reaching effort so far proposed, however, is that of Yale Professors Bruce Ackerman and Anne Alstott. This would provide every young person a "capital stake" of $80,000 on reaching adulthood, to be used for any purpose they chose. An interesting wrinkle here challenges existing wealth inequality directly: the program would be financed through a 2 percent wealth tax. Bill Gates, Sr. and Chuck Collins of United for a Fair Economy have suggested an additional angle of attack that, like the Ackerman-Alstott approach, also simultaneously challenges existing wealth inequality through the tax code. They propose a revised estate tax to begin at $2.5 million in assets, with the proceeds used to support a "wealth-building" fund to finance a variety of individual and community-benefiting strategies.

These programs and proposals, while noteworthy, are in some ways old wine in new bottles: they focus on wealth creation, but still mainly rely on the redistribution of funds through government policy as their means of doing so. But beyond Washington, in the "laboratories of democracy" that are the states, leaders in the private, public, and non-profit sectors are exploring even more creative ways to build community assets for broader groups and for communities.

Employee-Owned Firms

The most intriguing and instructive approach in the new mix is the employee-owned firm. "Worker ownership of the means of production" used to be a hoary radical demand; today it is increasingly an accepted reality. Few realize that roughly 11,500 U.S. businesses are now wholly or substantially owned by their employees–up from fewer than 300 a generation ago. The 10 million individuals involved in employee-owned firms include more people than the entire membership of private-sector labor unions.

Take, for example, the 7,500 employee-owners of W. L. Gore and Associates, manufacturer of Gore-Tex fabric, who control facilities in 45 locations around the world. Management is both sophisticated and participatory: workers may lead one task one week and follow other leaders the next week; teams disband after projects are completed, with team members moving on to other teams. The firm, which regularly ranks on Fortune’s "Best Companies to Work For" list, enjoyed revenues of $1.84 billion last fiscal year.

Other enterprises range in size and impact. Appleton Co. in Appleton, Wisconsin, is a world leader in specialty-paper production and is owned by roughly 3,300 employees. Reflexite is an optics company with approximately 420 employee-owners in Avon, Connecticut. In Harrisonburg, Virginia, ComSonics–owned by its 200 employees–makes cable television (CATV) test and analysis devices and boasts the largest CATV repair facility in the United States. These companies were not birthed from some sort of commune or communal movement. Rather, the typical employee-owned company is established when a retiring owner of a medium-sized business decides to sell to his workers, taking advantage of special tax incentives for firms organized through employee stock option plans (ESOPs).

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A priest near Orlando, Fla., borrows $9,000 for home repairs at an annual rate of 17.75%. A second-year Harvard Business School student wants $15,000 for foreign travel and gets a loan at 8%. A stepmother in suburban Sacramento needs $4,000 to cover the legal expenses of adopting her stepson and gets a loan at 23.75%.

These three borrowers have one thing in common. They’re part of a loan portfolio that I’ve built, sitting at my computer in New York, with the help of Prosper.com, a new San Francisco-based Web site that facilitates peer-to-peer microlending — that is, individuals lending money to one another directly.

For those needing a small loan, Prosper represents an alternative to credit cards or the credit union. And for those with a few dollars to spare, it can be a more entertaining option than savings accounts and bonds. Though there are a few other sites that provide similar services — and at least one, Zopa.com, that plans to launch in the U.S. later this year — Prosper, for now, is the most popular.

Prosper operates like both an auction site and an online dating service. It provides an eBay-like forum where lenders can evaluate hundreds of prospective borrowers, each seeking loans of $1,000 to $25,000, repayable over three years. The borrowers explain why they want the loan, Prosper provides information on homeownership, credit history and debt-to-income ratio, and the loan gets put up for bid at the maximum interest rate the borrower is willing to pay.

The loan requests read a lot like personal ads, complete with head shots of the borrowers, or cute pictures of their children and pets, enabling borrowers to find the lenders of their dreams. It’s hard to read them and not get hooked. Though some borrowers have prosaic needs, like trying to consolidate their loans or to fund home improvements, there are people facing eviction, medical bills to be paid and even a "Christian wife" trying to reverse her new husband’s vasectomy. The largely male lender community seemed eager to fund one woman’s breast-augmentation surgery, giving her a rate several percentage points below what her surgeon was offering.

Lenders also have the opportunity to offer microloans to offbeat small businesses — cat breeders, doll makers, ticket brokers. When I bid, it often feels like I’m voting on the soundness of a business plan.

Lenders can bid in increments as small as $50. One particularly enticing loan request for $6,000 garnered 95 bids. The borrower, who had excellent credit, began the bidding at 9.75%. Toward the end, eager lenders competed to lend money at increasingly modest rates. The loan was shared by 39 different people at a final annual rate of 8.43%. So long as she doesn’t default, the woman’s lenders will receive 7%.

Prosper was started by Chris Larsen, the co-founder of online mortgage broker E-Loan. Mr. Larsen says he wants to take on the credit-card companies who promote revolving, no-end-in-sight debt and the "payday" lenders whose annualized interest charges can easily exceed 400%. Although the level of involvement has been growing since Prosper opened to the public in February, the volume remains low, with only about 1,000 loans funded so far.

To participate, borrowers and lenders must submit to a credit check and then link their bank accounts to their Prosper account. All money transfers are automated, simplifying the repayment process. When a payment is due, Prosper withdraws the money from the borrower’s bank account and deposits it, on a pro-rata basis, into the various lenders’ Prosper accounts. The site, which imposes a 24% cap on interest rates, charges borrowers a 1% fee and lenders an annual half-percentage-point fee.

There’s always the risk of default, and in the event a borrower fails to pay the loan, it is turned over to one of the three collection agencies Prosper has contracts with. Prosper also encourages its borrowers to form "groups," which serve as mini credit unions. Should a member miss a payment, the group’s leader is contacted before the collection agency.

For every loan request that gets funded, there are many that fail, often because the borrower doesn’t offer a high enough interest rate to match his or her credit grade. All borrowers are assigned a grade based on their credit score with Experian, a credit-rating service. The highest is "AA," which the site says has a historical risk of default of 0.20% for a normal debt-to-income loan. The lowest is "HR," for high risk, which the site says has a historical risk of default of 19.1% for a similar loan. The "NC" designation signifies no credit history.

There are many HR borrowers who want loans at less than 10%, when they should be offering more than 20% — and these requests are systematically ignored. Wedding loans where a prospective bride or groom seeks help to pay for their forthcoming nuptials seem to have limited appeal as well.

A’s and AA’s, however, can get funding for almost anything, if they offer enough interest. Accountants taking flying lessons, small businesses buying point-of-sale systems and board-game makers seeking to expand were all able to acquire the funds they wanted. Many of these borrowers are simply trying to shave a few points off their car and credit-card payments or to leverage their excellent score to acquire a piece of equipment for their small businesses at rates that beat the local bank’s and without reams of paperwork. Depending on the size of the loan, the most creditworthy borrowers have received loans for 7% to 15%.

Though we all want to make money, there’s a surprising element of altruism. I like women in small business and single mothers. Another lender, an investment adviser by day, is partial to borrowers with medical issues, while another professional investor is keen on people seeking educational advancement.

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DALLAS — To earn his pay, Mike Mitchel collects boarding passes and helps passengers onto airplanes. At age 56, he lives with his mother, takes a yearly vacation to Las Vegas when the room rates are cheapest, and counts movies and music CD’s as extravagances. “I like to save,” Mr. Mitchel said. “I’ll pick up a penny.” Mr. Mitchel, though, could readily afford to walk past any dropped change. As one of the 17 remaining active employees who helped start Southwest Airlines 35 years ago, he is rich. Quite rich. A beneficiary of Southwest’s profit-sharing program — like all the airline’s regular employees — he owns about 50,000 shares of Southwest stock, valued at roughly $800,000. And that is just a quarter of a portfolio that makes Mr. Mitchel a multimillionaire. “I could retire tomorrow,” he said. So why doesn’t he? After all, very few long-tenured workers in the airline industry even have that option, given that the pensions and wages of most have been sharply reduced in recent years in bankruptcies and other cutbacks. But for Mr. Mitchel and his Southwest colleagues from the first days — eight flight attendants, five operations workers and four executives, each a millionaire — it is not about the money. Ask them why they stick around and they mention frugality and pride in earning their keep. And they say they simply like to work. That is not all. Bound together by Southwest’s initial struggle to survive, they are reluctant to end careers that for many of the 17 have defined their lives. “My friends who left early at Southwest regret it so much,” said Deborah Stembridge, who began as a flight attendant when the airline was just getting off the ground. Accustomed only to success, it is as if they do not want to miss out on the rest of the story. They helped Southwest send big-name airlines like Pan Am and Eastern to the junk heap, and more recently helped bring United and Delta to their knees. Sure, it is hard work. But, they wonder, what might be next? “This place has pushed employees to the breaking point,” said Dan Johnson, 55, who started in 1971 as a Southwest ramp worker and now works in air traffic control. “It’s part of why we’re successful.” “I don’t need to work,” Mr. Johnson added at a recent reunion. “In fact, I paid off the house two weeks ago.” The original workers were lucky to be hired on to what at the time seemed a long-shot business proposition. And they had to show some grit to stick it out. Sandra Force, an elementary school teacher and one-time beauty pageant winner from Memphis, was floating on a raft in the swimming pool of her Dallas apartment building one summer day in 1971, she said, hoping to attract the attention of a fellow tenant. Rather than ask her out, however, he told her that a new local airline was hiring flight attendants. ” ‘And you wear hot pants,’ ” he told her. “I got up off my raft, dried off and went into my apartment and called Southwest,” Ms. Force said. “They said, ‘Please wear a dress,’ because they wanted to see my legs.” She was hired on the spot. “My mother was devastated: ‘Sandra, if you were going to quit your teaching job, why didn’t you go with a well-known airline like Braniff?’ ” Braniff, which competed directly with Southwest in Texas, later failed. Along with her fellow flight attendants, clad in orange hot pants and white vinyl go-go boots to attract attention to the new airline, Ms. Force initially flew between Dallas, Houston and San Antonio. “One time I did 12 trips back and forth to Houston in one day,” she said. “My feet were killing me.” When Southwest’s zany service and skimpy flight attendant outfits drew national attention, Ms. Force ended up on the February 1974 cover of Esquire magazine, a not altogether happy experience for the graduate of a Baptist college. The photo made her appear shapelier than she was. “They airbrushed,” she said. “They didn’t tell me they were going to do that.”