Returning to Charts 9.1, 9.2, and 9.3, we’ll now cover the recovery after 2008 and discuss what remains to be done. Again using references to the numbers on Chart 9.1, we now look at a few of the key events that occurred during the period of recovery and how those affected credit spreads.

BERNANKE SPEECH IN DC (CHART 9.1, EVENT 21)

The fact that the United States and the world somehow made it through 2008 intact is largely the result of the actions taken by the Federal Reserve. As we have discussed, the Treasury under Secretary Paulson was a source of instability and uncertainty during this period, although he now appears to take credit for saving the world. In fact the lion’s share of the credit belongs to the members of the Federal Reserve Board and the thousands of regulators, lawyers, and financial professionals who labored long to save the global financial system. Mistakes were made. Some were unwound and others have been left unresolved for future crisis resolutions.

The following year was also difficult, for a variety of reasons. First and foremost, the peak losses for U.S. banks came during 2009 along with increasing revelations about the scope and magnitude of losses to be taken by investors in all types of securities. It would take several more years before a true picture of the damage done by the latest cycle of fraud on Wall Street was assembled.

Another source of instability came amidst continued questions about the direction to be taken by the Obama administration. Uncertainty arose early in 2009 as some issues with Mr. Geithner’s tax returns and other distractions led people to question his choice as secretary of the Treasury. As president of the Federal Reserve Bank of New York, he had been one of the few people who had successfully challenged the thinking of Alan Greenspan. Rather than confront Greenspan’s belief that “fraud is self-regulating” (a view that reveals an enormous gap in Mr. Greenspan’s understanding of finance and its realities) and that derivatives need no regulation, Mr. Geithner and other regulators undertook a probe of New York banks and found a huge gap in the documentation of derivatives contracts.

Regardless of what one sees as the merits or risks of unregulated derivatives, without documentation of the parties’ rights and obligations it is impossible for anyone to enforce those contracts. Off-balance sheet liabilities had to be discoverable at some point. Mr. Geithner convinced major banks that they needed to catch up on their documentation of trades, thereby beginning the process of creating a regulated central clearing house under the auspices of the Depository Trust and Clearing Corporation (DTCC). This documentation at least provides regulators with the ability to unwind the market when necessary.

What Geithner did proved invaluable as the subprime crisis unfolded, but it was long overdue. The New York derivatives dealers created a market that was deliberately opaque and dragged their feet on making basic changes and reforms to the OTC (over the counter) derivatives markets. Going back to the early 1990s, just when the big banks were preparing the ground work to install their monopoly over the market for mortgage finance, the former head of the New York Fed, E. Gerald Corrigan, joined Goldman Sachs and commenced a decade-long rear guard effort to slow the regulation of the OTC derivatives markets. Corrigan dismantled the dealer surveillance function at the Fed of New York in 1993 before leaving to join Goldman, and since then, has spent time obfuscating the need to bring the deliberately inefficient and murky ghetto called OTC derivatives (including credit default swaps) into the light.

Were Justice Brandeis alive today, he would no doubt condemn much of the OTC derivatives market as “a fraud on its face” because participants purport to sell assets they neither own nor can borrow and deliver.

During the debates over appointing Mr. Geithner, and for a period as he was getting his feet wet as head of the U.S. Treasury, spreads rose nearly 200 basis points, costing investors about $2 trillion of the $7.5 trillion regained between November 20, 2008, and Mr. Obama’s inauguration. As things were beginning to look pretty awful, Chairman Bernanke gave a March 2009 speech that made it clear the Fed would do whatever it took to keep the nation’s financial market operating.

Congress followed with a stimulus plan that Mr. Obama supported and signed. Markets rewarded everyone with a wonderful recovery. Stocks bottomed out in March 2009 and started what is now recognized as one of the most remarkable upswings in history. By June 2009, credit spreads fell another 600 basis points—enhancing the wealth generation capacity of the United States by another $6 trillion per year.

EURO DEBT CRISIS (CHART 9.1, EVENT 23)

Once it became clear that the United States would take the necessary steps to prevent naked short bond trades using CDSs from gaining too-big-to-fail status in American banks, investors specializing in that strategy found a back door to the same game. They began shorting bonds of weaker nations participating in the euro, using CDSs issued by the major U.S. banks.

If the shorts could create havoc in Europe and use the veiled threat of another European war by destroying the euro, they might force the United States to pay up on CDSs backing weak nations’ bonds. Conservative leaders in France and Germany embraced punitive austerity positions that might have permitted the strategy to work.

Investors pushed U.S. corporate spreads up about 100 basis points (see Chart 9.1) before leaders in Europe began to figure out they were being played. The impact on bank spreads (see Chart 9.3) was even more noteworthy. Before these events in Europe became major news, trends had returned to the complete market band associated with credit markets at equilibrium (again, see Chart 9.3).

The rise of bank spreads observed on Chart 9.3 reversed when passage of the 2010 Dodd-Frank law made it clear that the U.S. depositor preference rule would limit unsecured CDS holder recoveries to the amount of a U.S. issuer’s capital (whether it was a bank or not) after depositors were paid in full. When the size of the financial and economic problems in Europe became clear, however, the spread for banks rose again. This was primarily over concern that the United States would have to pay if Europe’s financial infrastructure collapsed, despite the prohibition on bank rescues or bailouts of managers and owners of nonbanks by the Orderly Liquidation Authority provision of the Dodd-Frank law.

It looked like short sellers, including those engaging in naked shorts using CDSs, were in the process of creating a classic collision-course problem.

As rhetoric in Europe cooled and reheated in the months and years to follow, those ups and downs spilled back into U.S. credit markets.

GOP WINS HOUSE (CHART 9.1, EVENT 24)

Spreads in the United States fell (see Charts 9.1 and 9.3) during most of 2010 as U.S. markets recovered. Scholars of the U.S. Constitution understand that a majority of the House of Representatives shifting from one party to the other represents a change of government in Washington, DC. Senators have staggered six-year terms and are therefore a bit immune to party rhetoric, but public anger at the behavior of Wall Street and the government bailouts for large banks (e.g., Citibank and Bank of America) reached a high tide in 2010. The House is the people’s chamber. It is where the strongest populist views get expressed. It is also the chamber where, for example, all tax legislation must originate.

The resurrection-recovery phase of the crisis, however, ended in the United States as the Dodd-Frank law passed. With the passage of the legislation, it was less likely that an event similar to the crisis that accompanied the House rejection of TARP would recur. Spreads rose a bit after the election results, but not by an alarming amount. But markets clearly anticipated a political fight now that the House was in Republican hands.

NEW STIMULUS AGREEMENT (CHART 9.1, EVENT 25)

It is not uncommon for politically sensitive matters to be resolved after an upcoming Congress is elected. Reelected members have the longest possible period of time to adjust their pitches for the next election at this point. Lame duck members and carryover senators have their maximum capacity for statesmanship in these postelection sessions. In any event, Congress enacted a stimulus bill. During the next three months corporate bond spreads fell to the bottom of the crisis zone for the first time since October 2007, shortly after Mr. Paulson announced the disastrous Super SIV fund (see Chart 9.1). Meanwhile, the bank spread fell back into the complete market zone (see Chart 9.3).

DEBT CEILING CRISIS (CHART 9.1, EVENT 26)

Just as it looked safe in U.S. financial markets, the relatively new politicians that took office in the new Congress began to make it clear that they did not care if the United States defaulted on its debt—they wanted budget austerity when it was clear that sound economics demanded a more benevolent approach.

The attitude of Republicans is understandable from a certain nineteenth-century perspective, but flies in the face of the needs of a modern society. The fact is that the red states where the GOP is strongest did not experience a housing boom and bust, nor do red states house the large financial institutions that received extraordinary government bailouts. Income levels, home prices, and other measures of economic affluence are lower in Republican red states than in the blue states where Democrats largely predominate. As a result, making arguments against bailouts for big banks and reigning in government have always played well in the red states as a group. Few people, moreover, can distinguish between the essential need to preserve systemic safety by preventing a temporary crisis from destroying debt generally and the bailout of management and shareholders that occurred when Bear Stearns, Citibank, and Bank of America were resolved without forcing the firms into receivership.

With the economy at least stabilized, Wall Street began to look for opportunities. Nonfinancial firms in the United States that produce and export goods were now in a very strong financial position, in part because low interest rates allowed corporations to re-fund liabilities and make investments at an extremely low funding cost. The weaknesses appeared to be lack of recovery in the financial sector and the mortgage hangover that continues even today.

The problems in banks were a logical result of balance sheets with too many bad assets and off-balance sheet liabilities that overhung reported assets and liabilities but were next to impossible to understand. Moreover, the flat labor market meant borrowers were reluctant to generate new loans that would lift the banks. Democrats argued a traditional Keynesian line that new demand for goods, funded with debt, was needed to generate new business loans. But consumers seemed oblivious to such arguments in 2010 and were instead focused on paying down debt and limiting consumption.

In many instances, corporate borrowers had so much cash that accessing new debt was not a priority. As a result, business lending languished, in sync with reduced consumer lending.

DEATH OF OSAMA BIN LADEN (CHART 9.1, EVENT 27)

Some events affect markets by generating a collective sigh of relief among investors. Successfully ending the threat this man posed to everyone’s freedom caused a short-term recovery in U.S. credit markets, lowering credit spreads to a point below the crisis zone on Chart 9.1.

GREEK BUDGET RESTRAINTS (CHART 9.1, EVENT 28)

Bin Laden’s death was soon trumped by new events in Europe. Pushing austerity on Greece generated disturbances and a Greek political crisis. That round of the euro crisis ended with the adoption of Greek budget restraints—but the resulting calm would not last.

In the summer of 2011, events combined to raise the corporate bond spread (see Chart 9.1) about 100 basis points. The same events pushed the spread for banks above the top of the crisis zone on Chart 9.3, highlighting the need for more action on both sides of the Atlantic Ocean.

TEA PARTY UPRISING (CHART 9.1, EVENT 29)

The Tea Party represents a political reaction against the perceived dominance of a center-left, corporate statism that they see as having controlled American politics since the Great Depression. The components of the Tea Party agenda includes devotion to small government and civil liberties, neither of which is bad in and of itself. But their thinking on fiscal matters is decidedly angry and self-destructive. It echoes the sort of selfishness and narrow-mindedness that we have discussed with respect to the likes of J. P. Morgan and Henry Ford. As with several proposals made by Treasury Secretary Paulson in 2008, the agenda of the Tea Party in the U.S. House of Representatives confirms a simple observation by German theologian Dietrich Bonhoeffer:

Folly is a greater enemy of the good than evil.

Why would a rising group in American politics think that it could succeed by defaulting on U.S. obligations, thereby destroying the fabric of America’s rule of law? The United States makes humorous movies about blundering nations that think that they can succeed by doing demonstrably dumb things so others (generally the United States) will pay money to save them. In this case, however, a group convinced the Republican House majority that sabotage was the only way to prevent the continued and uncontrolled growth of government. Unable to succeed at the ballot box, they decided to embrace political terrorism by holding financial markets hostage.

For several decades, active lobbyists like Grover Norquist, founder of Americans for Tax Reform, have become personally successful advancing an idea that the government should be starved of revenue in order to limit its growth. The science of macroeconomics, however, shows that taxing, spending, borrowing, and repaying debt are of little concern to a reserve currency sovereign, as long as it demonstrates continuing respect for its obligations. That’s because, absent a total waste of men and materials (as in a war), for each person harmed by changing a nation’s fiscal patterns, someone else benefits.

Thus economists recognize the far greater economic significance of changes in credit spreads. High spreads unnecessarily weigh down the great wheel of circulation. The payment of spreads produces no offsetting macro- economic benefit at any level that exceeds the cost of keeping the wheel turning.

Debate over taxation divides a nation and leads to less effective governance, but since one group will benefit by any change, all such groups lobby, and that benefits politicians and lobbyists. So we will never stop debating fiscal policy. All people naturally like to receive more government benefits or less of a tax burden.

By reaching the point at which their only argument was whether to pay government debt, however, the Tea Party strategy failed miserably. That point was reached in July and August of 2011. Credit spreads widened by roughly 100 basis points as the end result of GOP strategy, national default, became clear. Apparently nobody told the Tea Party that a 100 basis-point rise in spreads represents a near-certain loss of roughly $1 trillion per year in accumulated wealth in the United States. The nation’s $15 trillion national debt looms much larger against $50 trillion of U.S. wealth than against $100 trillion.

For a while, the Tea Party, with support of the second-ranking Republican in the U.S. House of Representatives, stood firm. They threatened to force the United States to default on its debt rather than do what every sane investor in the world was begging the country to do—spend its way out of a recession. One of many reasons money was flowing into U.S. debt securities at the time, despite in some cases a negative effective yield, was because of the belief that the United States would follow past practice and spend until the financial crisis went away. After that, investors assumed, its ability to repay would be assured by economic growth.

When any nation’s investors are begging it to borrow money and spend it (indeed, paying the nation to take the money) at zero cost, only fools ask questions. When rates begin to rise above 0 percent (after inflation is taken into account), there is plenty of time to return intermediation levers back to the private sector. When interest rates are below the rate of inflation (going back to the work of Irving Fisher) it is time to borrow and spend until that changes and the crisis that led to negative interest rates in the first place fades from memory.

There were certainly many worthwhile projects that the United States could have funded to improve infrastructure that would have added value at a rate above the cost of the funds investors offered to provide. But sadly, it appears that most members of Congress do not understand the previous several sentences (or, do not think their constituents would reelect them if they admitted such knowledge).

Part of the rise in U.S. spreads certainly related to the difficulty Europe seemed to be having with default by smaller nations in the eurozone. Why would leaders of France and Germany announce that the eurozone project, the best hope for long-term peace in history, should be weakened by demanding that people in some nations that overspent buying German goods should be starved into understanding the need to be more frugal? Did France forget the World War I lesson about demanding reparations? Did Germany forget what happened when the United States and its allies forgave Germany’s prewar debts, squelched demands for reparations after World War II, and actually gave Germany enough in loans and trade benefits to fully recover?

In any event, the combined follies of Europe and Republican efforts to achieve austerity by a debt default pushed the bank spread above the crisis zone until calm returned to Europe in 2012 (see Chart 9.3). Probably by virtue of the extraordinary recovery in financial conditions within the productive sectors of the U.S. economy, the impact of events in Europe on U.S. business borrowers was not nearly as alarming as it was for banks (see Chart 9.1).

BERNANKE SPEECH AT JACKSON HOLE (CHART 9.1, EVENT 32)

Mr. Bernanke used the occasion of a speech at Jackson Hole, Wyoming, to make clear the Fed’s intent to keep on buying securities until its dual mandate was achieved—price stability and full employment that is consistent with price stability. While nobody actually believes that the Fed can print jobs with the same ease and facility that it prints money, the statement was reassuring. By leaving that commitment open-ended, Mr. Bernanke told the shorts to buzz off. If the group in charge of a reserve currency that is perceived as infinitely elastic is willing to do whatever is needed to bring economic recovery, shorting that position is utter folly.

FED ACTS DESPITE GOP THREATS (CHART 9.1, EVENT 33)

Some GOP leaders tried to intimidate the Fed into a less active position, believing as they do that the Fed is facilitating the growth of government in Washington, DC. While the Fed has been concerned (and at times obsessed) with preserving the ability of the Treasury to borrow, the view of many Washington politicians about the role of the central bank sometimes hovers at about a second-grade level.

Failing to stand up to a bully is always a mistake. When that happens between Congress (or the president) and the Fed, we know from past experience that the Fed’s credibility as an institution is undermined. The negative ramifications of such interference can last a long time.

When the Fed made clear its intention not to cower to GOP threats, short-sellers of debt realized they had almost no chance to succeed. From and after October 2012, several more skirmishes resulted from disagreements in Europe. Once the ECB (European Central Bank) took a firm position that it would similarly defend the euro from attacks, spreads all moved below the crisis zone shown on Charts 9.1, 9.2, and 9.3.

All three charts have shown a spread at (or even below) the complete market equilibrium level since the end of 2012. We will certainly see spreads rise as future events impact investors, but we now have all the precedents needed to instruct fiscal and monetary policy leaders on steps to reverse and prevent any recurrence of the horrific events of 2007–2008.

As is customary when credit spreads are low and stable, equity markets have risen strongly. Since low and stable credit spreads are the ideal conditions for productive sector growth, rising equity prices are both logical and beneficial. When the productive side of the economy’s private sector expands, cash flow increases. When cash flow rises at a rate that exceeds the effect of increasing interest rates, total wealth (shown on Table 9.1) will expand, allowing debt and/or equity to rise even as interest rates must rise to preclude inflation. Rising values are what will permit policy makers to take additional steps to assure a balanced and brighter economic future. The only question is how long it will take for policy makers to actually turn these hopes into concrete reality.

While monetary policy has proven itself, U.S. market policy still has a long way to go. We need continuing reforms to be in a position where private-sector participants will be able to pick up the slack in terms of credit creation, much less to reabsorb the Fed’s investments without generating a new crisis.

TEA PARTY EXTORTION (CHART 9.1, EVENT 34)

After the U.S. government’s fiscal year came to a close in September 2013, Republicans in Congress again aligned themselves with the Tea Party and demanded that the U.S. government be shut down. Worse yet, at least for a while, it appeared the Tea Party might actually push the GOP into committing political suicide by forcing the United States to default on its financial obligations. The target of this extortion was at first the Affordable Health Care Act, which Mr. Obama and the Democrats passed in March 2010 over unanimous Republican opposition. Later targets arose, but the whole concept of using default as a political tool proved to be a farce.

Again, outmaneuvered at the ballot box and even on the floor of the House, the Republicans decided to try political terrorism. The results were appalling for the GOP and could have been even worse for the markets.

The United States pays some 80 million separate obligations each month. When Richard Nixon sought to unilaterally sequester some payments to whip inflation, Congress wrote a law making that illegal. As a result, the U.S. Treasury created the equivalent of a massive automated teller machine. Anyone seeking payment must prove eligibility and, if proved, the machine automatically pays each and every bill that comes in. The only thing that stops the process is if the ATM runs out of money.

This process is appropriate because discretion is simply not feasible. It would take an army of people to decide which of 80 million monthly U.S. payment obligations to pay and which to ignore. If the ATM suddenly stopped, about 4 million bugs (obligations to pay) would slam (full speed) against the inside of the machine’s windshield on that day and on each workday thereafter. One day’s accumulation of bugs could gum up the process for months. Every bank and investor in the world that made commitments to buy or invest in reliance on payment by the United States would suddenly be without those funds.

How many members of Congress would be retired at the next election if social security payments froze for a few days? Just as Hank Paulson eventually learned to get out of the way and let the Federal Reserve do its job by acting positively to avoid a deflationary death spiral, Republicans in Congress need to recall the advice of New York Congressman Jack Kemp and tell voters how they propose to improve the economy rather than destroy it.

Never in modern financial history has any responsible person or group suggested such a disastrous course for this (or any other developed) nation. In 2011, the economies of Europe and other areas of the world were still teetering on edge after the subprime financial crisis when Congress threatened a debt ceiling crisis. That made the 2011 Tea Party uprising pretty scary for U.S. investors. The 2013 extortion was so absurd, however, that markets reacted by generating less than 8 percent of the credit spread spike that was observed in 2011. In simple terms, the market dismissed the 2013 Tea Party extortion for what it was, a ridiculous and petulant display.

The 2011 battle proved that the disruption of responsible governance can generate a large, negative, and instantly demonstrable impact on markets. The 2013 battle proved that investors and responsible leaders recognize political lunacy. They rose above the clamor of competing talking heads and ignored the ravings of the Tea Party. The crisis ended October 16, 2013, when GOP House leaders wisely agreed with a Senate proposal to end the shutdown and continue paying obligations that Congress had already approved. The final tally showed that 80 GOP representatives and more than 40 GOP senators joined with the Democrats to remove the threat of a new financial crisis.

That leaves less than 10 GOP senators and about 65 percent of House Republicans to be educated about the need for (and the process to achieve) financial stability by assured fiscal responsibility. That education is easy. Charts 9.1, 9.2, and 9.3 provide unmistakable and unimpeachable proof for what is, and is not, responsible fiscal policy. Table 9.1 puts the benefit/cost in dollar terms.

To show the calamity of causing a crisis, contemplate Chart 9.2. On that chart, up is bad and down is good. The gigantic mountain centered on November 20, 2008, is, in fact, the abyss into which the economy of the entire world fell, and would likely fall again if the United States actually defaulted on its obligations. That mountain is twice as high as the one that led to the Great Depression. To repeat that blunder would combine political suicide for the GOP with worldwide economic catastrophe.

On Table 9.2, each basis point by which credit spreads exceed those of a complete market equilibrium represents a $10 billion annual drain on the production of U.S. national wealth. Since most of the world’s corporate bond intermediation is done in the United States, moreover, whatever harms U.S. bond markets similarly impacts the rest of the world, roughly doubling the total damage. At the depth of the recent abyss—November 20, 2008—that means U.S. wealth was shrinking at the rate of roughly $17 trillion per year ($34 trillion globally). No person with intelligence and/or compassion would knowingly use a threat of such decimation to support any political or personal agenda. The weapon of default must be banned.

If Republicans want to reduce the size of government or repeal the Affordable Health Care Act, then they need to make that case to the voters and win the mandate for change on election day. If they win, there is nothing wrong with adjusting the size of the federal government in line with voters’ wishes. In that case, investors’ daily responses to each new policy will also equally instruct the victors as to how to implement change constructively.

The only thing proven by these Tea Party struggles is that utter stupidity is not good policy. If that lesson sinks in, the skirmishes of 2011 and 2013 will not have been a total waste. Talk constructively about creating jobs, cutting taxes, and reducing the size of government, and Republicans will attract more voters and greater approval from the financial markets. The same simple test applies for Republicans as for Democrats: If your proposals make stock prices rise and keep bond spreads low and stable, then you know that you are on the right track.