– Christopher Swann is a Reuters columnist. The views expressed are his own —

The crusading spirit that at one stage threatened to lead to the nationalization of U.S. banks and the downfall of their top executives now seems like ancient history.

Banks are again flexing their muscles and have turned the tables on America’s politicians. Remarkably, policy makers now seem to be struggling to secure even a modicum of needed change in the regulatory system.

The winter’s paroxysm of public anger has dissipated with astonishing speed. This is in spite of the fact that economic recovery still seems a distant goal and the woes of CIT Group suggest that even the financial system is not out of the woods. As a result there is now a real danger that the administration and Congress will fail to live up to Rahm Emanuel’s famous injunction never to let a crisis go to waste.

The ability of the financial lobby to hold onto its political power has been one of the great mysteries of the crisis. Few special interest groups have shown such  flexibility in their logic.

As profits soared in the 1990s, their strength was taken as proof of their genius and politicians bowed to their every whim. After their crisis their weakness became a trump card. Hurt the banks, they argued, and the economy would go down with them. Now the banks are taking credit for a revival in profits that is almost entirely due to the extraordinary contortions of public policy.

The administration and Congress should not be taken in again. We are entering a crucial phase in the revamping of regulation and there is still little sign that the White House is putting enough political muscle into the process.

And as the self-confidence of the banks increases — along with TARP repayments and climbing profits — the window for reform narrows.

The industry is digging in its heels over efforts to create a credible consumer protection agency and to sanitize credit default swaps. These are debates the Obama administration cannot afford to lose. Keeping anything close to the status quo would expose the United States to a repeat of 2008.

Banks might have less money to throw around. But they do not appear to be skimping on lobbying. Political action committees run by the Independent Community Bankers of America have already raised 40 percent more funds than last year. Overall the finance, insurance and real estate sectors spent $110.7 billion on lobbying in the first three months of the year — second only to healthcare providers.

Financial lobbyists could be forgiven for a certain swagger of late. In May they managed to defeat President Obama’s push for a change in the bankruptcy law that would have allowed judges to cut the principal owed on home loans. They even capped this unlikely victory by extracting a concession that saved banks and credit unions at least $13 billion in fees to top up deposit insurance funds.

Now the industry would dearly like to abort Obama’s new Consumer Financial Protection Agency, which they believe would pay too little attention to the health of banks. Failing this, they want to defang the agency, limiting its powers to vet and approve products.

Given the prominent role played by poorly designed loan products in the financial crisis, this is a hard case to make. There is a pressing public interest in creating a vigilant gatekeeper for consumer products. Not only would it limit much individual misery, it should reduce the chances of bank collapses and public bailouts. It would not, as opponents have misleadingly suggested, seek to monopolize the design of financial products.

On credit default swaps the industry seems determined to stick as close to the status quo as possible, restricting any move towards transparency. If they get their way, the system will still be vulnerable to crises.

The determination of the financial lobby to obstruct moderate regulation on such key components of the recent crisis indicates an alarming lack of humility. Given their recent success, the industry may get much of what it wants.

This makes it especially important that the White House provide a stronger lead to Congress.

Obama appears to have been reluctant to spend his political capital. In fact a defeat of the powerful financial services lobby may actually help him get his way on the rest of his agenda. It would also leave America with a much safer financial system.

– Christopher Swann is a Reuters columnist. The views expressed are his own –

People can be divided into three classes, it has been said: the haves, the have-nots and the have-not-paid-for-what-they-haves. The prevalence of the third category may be the biggest single source of vulnerability for the U.S. recovery.

A stress test of the consumer could reveal more distressing results than the one conducted on the banking system.

Debt is at high levels — 130 percent of disposable income, or more than twice its peak in the late 1980s. A slide in net wealth has reduced the collateral Americans can draw upon for emergency loans. Finally, it is now harder to borrow money for new consumption or to roll over existing debt.

Like a compromised immune system, this weakness makes consumers extremely susceptible to further shocks. Traumatic as the recent bout of retail restraint may have felt, worse may be in store. After all, consumption rose by 18.5 percent in the seven years to 2008. So far it has only fallen back by less than 2 percent.

There are several potential mishaps that could swiftly undermine consumer spending and set the recovery back to square one.

Among the most likely problems would be a continued slide in house prices. Even on the conservative measures used by the Federal Reserve, the value of residential real estate has fallen 18 percent since 2006.

With signs of recovery still tentative, a further 10 percent slide is well within the realm of possibility — inflicting a further blow on the balance sheet and sense of well-being of American households. (If nervousness over swelling government debt pushes up bond yields, the outcome could be still worse.)

Homeowner’s equity, already down to 40 percent from close to 60 percent, would plunge to 35 percent. This would send household wealth down to its lowest level since the mid-1980s. While Americans can’t immediately rebuild the $12 billion of net worth lost over the past 2 years — equivalent to more than a year’s worth of consumption — further losses will heighten their sense of caution.

A second threat is also looking increasingly likely — wage cuts. Fifteen percent of employers surveyed by the Society for Human Resource Management reduced pay in the past six months, a threefold increase from earlier this year. It is no longer implausible to imagine nominal wages starting to decline on a nationwide basis.

The Employment Cost Index is already rising at its slowest rate since the early 1980s. Wage deflation would make it even harder for Americans to repay the $10.5 trillion of mortgage debt they hold or the $2.5 trillion of consumer credit.

Martha Olney, a professor at Berkeley, envisages disproportionate cuts in spending if wages dip. “For households that are paying 60 percent of their income in mortgage and credit payments a 10 percent pay cut does not mean a 10 percent fall in disposable income,” she says. “It’s a 25 percent fall.” This is the danger of leverage.

Even under a rosy scenario it could take years for American consumers to repair their finances. If the savings rate rises to 8 percent of disposable income — about $860 billion a year — it will now take four years for debt to return to its 2002 level. This steady drain alone is equivalent to almost 10 percent of consumer spending.

After such a substantial loss of wealth, Americans will be pressed to be even more frugal. Along the way American will be hyper-sensitive to any jolts from weaker than expected employment, house prices or financial markets.

Consumer spending may not merely stagnate as most economists expect. It could yet decline more sharply. And like the banks, consumers will almost certainly need more support from the central bank and government before this economic malaise is over.

– Christopher Swann is a Reuters columnist. The views expressed are his own –

Optimism has been all but extinguished from the U.S. housing market.

The number of Americans lining up for new home loans is shrinking again, according to Wednesday’s release from the Mortgage Bankers Association, and the best that can be said of homebuilding is that it has stabilized at almost 80 percent below its peak.

With no end in sight to falling prices, perhaps we should look on the bright side. Indeed, there are three good reasons why sliding prices are not such a bad thing.

Falling house prices are usually seen as wealth destruction. But they can also be seen as wealth transfer. The next generation of homebuyers will benefit from our loss. Those young homebuyers who have been able to cling onto their jobs are already reaping the advantage. The American dream of home ownership can now be achieved at bargain basement prices.

Take San Francisco. If you earned the median wage in San Francisco at the peak of the housing market in 2006, you would have needed to devote 75 percent of your income to meet mortgage payments on the average home. Now people will pay just 35 percent of their income, according to Ian Morris, chief U.S. economist at HSBC.

It would no longer be any surprise if prices remained stagnant for a decade - spreading the benefit of cheap housing for at least 13 million new households.

Americans may also reflect that much of their temporary housing wealth was illusory anyway. Since house prices in a given area tend to rise in tandem, the only way to cash out was to borrow against equity, or move to a cheaper area or smaller space, or die.

A second consolation is political. Tumbling prices have exposed the flaws in the American government’s efforts to subsidize housing.

It is now clear that these efforts did more harm than good. More thoughtful U.S. politicians must now question the mortgage interest tax deduction. The benefit of this tax was heavily skewed towards high earners since they paid a stiffer tax rate. Instead of fostering broad home ownership, the deduction encouraged rich Americans to borrow more and build bigger homes.

This is bad financial and even worse environmental policy. At the very least, Congress should now cap this deduction at $500,000.

The third source of solace is macroeconomic. For several years America borrowed money from abroad to make an investment that did nothing to expand its productive capacity or its ability to export. Residential construction in 2005 reached 6.3 percent of US national income — its highest level since 1951.

A more sober level can be gauged from the average since 1980, which is 4.5 percent. Rampant home building went far beyond the actual housing needs of Americans. Over the past five years around 8.9 million housing units were built and just 6.7 million new households were created, according to Harvard economics professor Edward Glaeser. The number of vacation homes jumped from 3.6 million in 2002 up to 4.8 million now.

An ever-growing number of U.S. homes were also vacant, as investors waited for tenants or buyers. Not only did houses become more numerous, they also got bigger. The average square footage of a U.S. family home expanded from 2,200 to 2,500 over the past eight years. “Mistaken beliefs about housing may have crowded out more productive investments,” argues Glaeser.

Since two-thirds of Americans own their homes, falling prices are never likely to inspire street parades. The economic loss has certainly outweighed the gains and the banking system may take years to fully recover. Even so, our loss is a hidden accounting gain for the next swath of homeowners. A more balanced economy and housing policy may now emerge. For more philosophically minded Americans, this is a cloud with a silver lining.

– Christopher Swann is a Reuters columnist. The views expressed are his own –

The Federal Reserve is putting on a brave face about the rise in Treasury yields.

At the moment, the Fed can afford to put off bringing out the big cannons for a little while. If market optimism is overdone, a few weak economic releases would soon send interest rates plunging again. If the market is right, then higher rates are justified and the economy will cope.

But Fed policymakers, who next meet in two weeks, should be getting the artillery ready. They have already promised to buy as much as $300 billion of Treasuries before September.

Unless rates come down swiftly, this limit should be increased substantially.

So far, the Fed has managed to confound the skeptics of their unconventional monetary policy.

Fed intervention breathed life back into the commercial paper market and the program appears to be winding down. The purchase of mortgage securities has driven the spread between 30-year mortgages and Treasury yields down to pre-Lehman levels. The result was a spurt of mortgage refinancing.

Thursday’s rally in Treasuries notwithstanding, the recent run-up in yields is now threatening this great achievement.

Refinancing of home loans has already halved over the last two months and may grind to a halt. Around $3 trillion of Fannie and Freddie debt has a coupon of more than 5 percent.

With rates on a 30-year mortgage rising above 5.5 percent, it no longer makes sense to refinance. Mark Zandi of Moody’s Economy.com had expected Americans to save up to $30 billion in 2009 by locking in lower rates. This would require the fixed-rate mortgage to stay under 5 percent.

The rise in rates will also damage several federal programs aimed at kick-starting the housing market. The Homeowners Affordability and Stability Plan was created to allow those with very limited home equity to refinance. There will be few takers at current rates.

Similarly, the $8,000 tax credit for new homeowners expires on December 1 and will be largely wasted unless rates decline.

Against these possible outcomes, an additional round of Treasury purchases by the Fed poses relatively modest risks. The threat of an adverse market reaction — with nervous creditors dumping Treasuries and the dollar — is overdone as is the fear of inflation.

So far the Treasury Inflation Protected Securities suggest that investors have confidence in the Fed’s ability to keep inflation in check.

Even if the Fed buys its full quota of $300 billion in Treasuries it will still own less than 5 percent of the $6.6 trillion of outstanding market.

It can afford to buy much more before suggestions that it is monetizing the debt are to be taken seriously. After all the Fed is planning to buy $1.25 trillion in mortgage-backed securities by the end of the year — leaving it with up to a quarter of the total, according to Louis Crandall, chief economist at Wrightson.

The Fed still has great credibility, accumulated in the decades since it vanquished inflation under Paul Volcker. Now is the time to spend some of this credibility.

– Christopher Swann is a Reuters columnist. The views expressed are his own –

Obama’s tax cuts were meant to be the first strike force of the stimulus package. The main selling point — other than political popularity — was speed.

Higher take-home pay in April and May would be the first evidence many Americans would see of their government’s broad effort to rescue the economy. The hope was that this would prop up spending long before lumbering public work projects could get under way.

Yet the financial impact already looks set to be swept away. The recent run-up in gasoline prices and a surge in personal savings have provided an uncomfortable reminder of the diminutive size of the tax cuts.

The cuts are just part of a broad government campaign to revive the U.S. economy — along with fresh infrastructure projects, help to the states and bank bailouts.

Even so, boosting take home pay has been an important part of the White House strategy to prop up spending.

But the “Making Work Pay” deduction in withholding tax will amount to an estimated $116 billion spread over two years.

In April — the first month in which Americans would have noticed the extra take-home pay — the annual infusion was just shy of $50 billion. Even if you add a one-time payment to Social Security recipients and extra unemployment benefits, you still only reach about $80 billion over the year.

Compare this with the impact of rising prices at the pump. Americans have been spending roughly $240 billion a year to fill up their cars. A 38 percent increase in retail gasoline prices since the first quarter — if sustained — will increase their yearly bill by more than $90 billion.

This alone would be enough to swamp the tax element of the stimulus.

A second imposing obstacle has been the increasing desire of Americans to save. Early estimates suggested that jittery consumers stashed away two thirds of Bush’s 2008 tax rebate, turning a bazooka for spending into a pea-shooter.

Obama’s package was drafted with precisely this danger in mind. Behavioral economists, like Richard Thaler, believe that one-off bonanzas are more likely to be hoarded, while consumers will spend inconspicuous monthly sums.

Again, this clever policy making may be overwhelmed by the sheer scale of the problem. Americans are scrambling to pay down debt. In April consumers paid down around $15.7 billion — once again more than double the monthly impact of personal tax cuts.

People with any ability to replenish their savings seem keen to do so. Americans squirreled away an extra $130 billion in April compared with March — a total of $620 billion.

To be sure, the outlook would be even grimmer were it not for this well-timed help to the consumer. An increase in take-home pay may also have a psychological effect that outweighs its financial impact. But little should be expected from the tax cut portion of the “stimulus package”.

Indeed, it might more accurately be called a “damage limitation” package.

– Christopher Swann is a Reuters columnist. The views expressed are his own –

This recession is introducing many Americans to a novel experience — the pay cut.

Fifteen percent of employers surveyed by the Society of Human Resource Management reduced pay in the past six months — a threefold increase from earlier this year. Companies like Hewlett-Packard, Caterpillar and the New York Times have taken the pruning shears to wages.

Real pay cuts — when wages fail to keep pace with inflation — are commonplace in recessions, but you would have to look back to the 1930s for the last example of widespread cuts in nominal wages in the United States.

Since Keynes, many economists have treated nominal wage cuts as a virtual impossibility. In 1999, Yale economist Truman Bewley wrote the optimistically titled “Why Wages Don’t Fall During a Recession.”

Wage cuts cause huge resentment, damage moral and raise the risk of losing star employees. Bewley found American firms prefer to lay people off to “get the misery out the door”.

The notion that pay is rigid on the downside has been a cornerstone of much post-war economics. This assumption is now proving about as true for wages as it was for houses.

Pay cuts are threatening to make the leap from anecdote to generalization. The Employment Cost Index is already showing wages growing more sluggishly than at any time since 1983.

Downward pressure on salaries is intensifying. While job losses slowed in May, the unemployment rate jumped to 9.4 percent — the highest since July 1983.

Even this may not fully capture the current oversupply of labor. The U6 unemployment rate — which includes people working part time because they can’t find permanent positions — climbed to 16.4 percent.

With so many workers waiting in the wings, wages nationwide may start to fall over the next couple of years.

The United States would be following the path of Japan in the 1990s — the most recent example of absolute pay cuts in a modern economy. The impact on consumers could be worse than focused layoffs — spreading the pessimism over a broader base.

The Conference Board’s measure of consumers’ income expectations has dipped to the lowest level in its 21-year history.

Alpine levels of household debt — which has doubled to 134 percent of disposable income since 1985 — put consumers in a particularly vulnerable position. Lower wages make it harder to service loans and increase the incentive to defer spending.

As demand ebbs, companies cut headcounts and remuneration further. If companies use the money saved to grab market share by reducing prices the final piece of the deflationary jigsaw slots into place.

Pay cuts, far from averting layoffs, could increase them.

If the trend toward pay cuts increases, the economic consequences will be profound. The damage may be deeper than merely the erosion of spending power. Breaking the taboo on wage cuts greatly heightens the threat of a deflation mentality.

– Christopher Swann is a Reuters columnist. The views expressed are his own –

It’s not just California that threatens to sabotage the Obama stimulus. State and local governments across the nation are gradually unravelling federal efforts to revive growth.

The states have been inveterate stimulus eaters in the past. For most of the 1930s the expansionary policies of the federal government were just sufficient to offset the shrinking of state and local governments. Click here for PDF.

States also raised taxes in the recession of the early 1990s and in 2001. It was a problem that Obama — his team stocked up with renowned  scholars of the Great Depression — was determined to avoid.

Sadly, the financial woes of the states and cities — many of them self inflicted — are overwhelming these good intentions. The maths now looks distinctly unpromising.

The Obama administration has pledged around $140 billion in fiscal assistance to the states with the express goal of saving them from tax increases, layoffs and painful cuts in services. But as state tax revenues have tanked, they now appear to be heading for a $370 billion shortfall over the next few years. Federal largesse will cover just 40 percent of the gap.

Nor is the roughly $200 billion fiscal drag from the states Obama’s only problem. America’s towns present a fiscal headwind as well, with an expected funding gap of  nearly $100 billion, according to the National League of Cities. Taken together these could cancel out up to 40 percent of the federal stimulus.

Balanced budget rules put the states in the same position as crisis-ridden emerging markets — a pro-cyclical fiscal policy is their only option. Yet they do have the ability to minimize the damage to consumption.

It is an opportunity many states do not appear to be taking. Indeed some are going about their economizing in ways that would make a good Keynesian blanch. The lesser of evils in the current circumstances would be to focus revenue-raising on those unlikely to cut back spending — the rich.

Instead, all too many of the measures so far have been regressive, putting most of the burden on people who have little option but to tighten their belts. Earlier this month Massachusetts lawmakers voted to increase sales tax by 25 percent with a view to raising $900 million a year. Six other states are considering following suit.

So far 36 states have cut spending — mostly on education, health and programs for the poor. Arizona is cutting cash grants to 38,500 low-income families, while Rhode Island is slashing funds for affordable housing.

Again, these are exactly the kind of payments a Keynesian would normally recommend increasing in a recession — since low-income groups have a low savings rate and hence a high multiplier. At least 39 states have made cuts in state workforce.

More radical still, some towns are simply shutting-up shop and “disincorporating,” according to the Wall Street Journal.

Rio Vista and Vallejo could soon be the first Californian towns to do so since 1972.

There are plenty of improvements that could be made to state finances. Lawmakers could economize on expensive mandatory criminal sentencing rules and trim generous pensions. Ditching the supermajority requirement for tax increases would allow them to build up larger rainy day funds in the future. But none of this would help now.

The hard fiscal logic offers few ways out. Going back to Congress for more money is not politically viable. Aid to the states was a hard-sell last time and had to be watered down.

Damage limitation is now the only option. At the very least states should seek to balance their budgets in such a way that minimizes the drain on personal consumption.

This may mean following the lead of Delaware, where the governor has proposed increasing the top income tax rate by a percentage point to 6.95 percent. Minnesota lawmakers are also attracted to this idea.

Extracting more from the wealthy won’t fully plug the gap. But as the centrepiece of state revenue-raising, it may be the least economically harmful choice.

– Christopher Swann is a Reuters columnist. The views expressed are his own –

There is nothing like a home-grown financial crisis to undermine a superpower’s sense of superiority. The United States is finding it has something to learn from some of the world’s lowest profile countries.

Among those that are now being held up as role models are Denmark, Canada and Sweden.

This brings to mind the old joke about the European heaven and hell. In a financial heaven you would have Danish mortgages, Canadian regulators and bank rescues would be orchestrated by the Swedes. In a financial hell the mortgages would be Hungarian, the bank regulators would be from Iceland and the Americans would manage bank rescues.

Imitation is the sincerest form of flattery, yet there has been precious little of this. This is probably a result of the continued political influence of the financial oligopoly.

The common thread linking Danish mortgages, Canadian bank regulation and Swedish bank rescues is that they are all less favourable to the financial services sector.

The Danish mortgage system has huge appeal to everybody but entrenched interests. Emulating it in the United states would involve finally putting Fannie Mae and Freddie Mac out of their misery. It would also force mortgage originators to retain the full credit risk of loans, allowing them to palm off only interest rate risk.

For the public, the system offers considerable benefits since the way mortgages are securitized would greatly reduce the threat of negative equity. Similarly the Swedish bank rescue in the 1990s enabled the taxpayer to recoup almost all of its bailout investment.

Obviously it was less good news for shareholders of the hapless Nordbanken and Gota, who were wiped out.

It is not hard to understand why the Swedish model might not have appealed to the financial services sector, even though the International Monetary Fund ranked it as one of history’s most successful bank rescues.

Although it is not universally accepted, Canada’s more old-fashioned banking regulation almost certainly helped prevent a U.S.-style collapse. Canadian bankers and regulators even achieved a touch of celebrity after the World Economic Forum ranked their system as the most stable in the world in 2008.

Here at least, U.S. policy makers seem inclined to follow the example set by their less glamorous northern neighbour. But as banking profits recover, they are likely to encounter some push-back.

Obviously no foreign system can be incorporated wholesale into the United States. But if policy makers in Washington are to be free to learn from the world’s best practices in the future, they need to break the political power of the banks.