Washington, D.C. The Stoneleigh Garage at 1707 L Street
Ilargi: The Obama cabal is planning to reform the financial system. As in big time. Biggest since the Great Depression. Not that we're in another depression, mind you, or have -ever had- a chance of one in $14 trillion of hitting one, well, unless you want to talk about how great the cabal is doing in its efforts to save you, because then yes, yes, mais oui, bien sûr, we were so that close to the hell that exists in handbaskets only, but luckily Marshal "Ears" Obama and Sheriff "Fat Larry" Summers headed the posse that rode to the rescue. Looking at it through the eyes of John Wayne, it’s no wonder America falls for that merde.
Let's start with the obvious. The 1930's reforms were not led by a bunch of complete donkeys. As a matter of fact, I'd say they were probably quite competent. And perhaps a bit less on the take than the present bunch of lawmakers and breakers. The one thing they forgot to do is to make it impossible for who came after them to commit the same stupidities and crimes as those who had gone before them.
And when you watch today's Capitol Hill dwellers on TV and read their one-liners in the media they're joined at the waist with, just about the last thing you would trust them with is executing a major overhaul of the US financial system -which as we speak carries debts worth more than everything, all of it combined, that the US has produced ever since the Great Depression-, a major overhaul of the kind that would halt fraud, greed and imbecility for more than the next two months. If that.
But wait, I hear you say! It's not the Dodds and Franks that put the words on paper, they just sign the done deals and insert the pork bills that'll get them re-elected. The ones who choose the laws and the programs and the words are different people. People like Tim Geithner, Larry Summers and Robert Rubin, who know the banking world, and who know how to deal with it, who in fact have all have their closest friends that world, and who have no qualms about taking tens of millions a year away from those friends, who once their public service stint is over and they get back into private finance, are more than willing, would even volunteer, to make one tenth or less of what their friends are making right now. After all, who needs all that dough? What's important is to have good friends, right?
America is in the process of having its biggest banks, which under laws written in the 1930's would either have been bankrupt, or even never have been able in the first place to become so addicted to such highly leveraged wagers -executed with depositors' money- that these could bankrupt them, dictate the terms of the reform of ... banks. It's complete and utter insanity. There is zero chance that the banks - represented in Washington by Rubin, Summers, Geithner and a thousand other revolving door faces - will regulate themselves to the point where their potential of making the highest possible profits will be curtailed or eliminated.
It's worse than nuts that an entire people -and its elected representatives- even considers having this happen to its economy and the personal wealth and happiness of each of its citizens. It's about enough to give up hope altogether for such a people. if you don't see this coming, and you don't do anything to stop it, then what can you possibly expect your futures to look like?
Americans will wind up, unless they stop this charade, which will be labeled a "clamp-down" on Wall Street, with a highly consolidated banking system, and with power over its financial welfare and wellbeing concentrated, and this time deeply engraved in the nation's laws, in the hands of a very few. The new reform laws will be written in such a fashion that hundreds of banks will be helpless victims of takeovers orchestrated by those too big to fail banks that have been saved from zombie bankruptcies only by the use of trillions of dollars in public funds, and who'll use their new hostile acquisitions to write down, at your cost, the tens of trillions of dollars in toxic debt fermenting in their vaults, which they’ve been allowed to keep hidden through policies enacted by the exact same crowd that now claims it will reform the system so as to gallantly protect you from more of the same and worse.
We can spend much time wondering in bewilderment why the last tree was cut down on Easter Island. We can also, however, look at ourselves and recognize that we do indeed know the answer to that question.
Debts Coming Due at Just the Wrong Time
Ten banks slipped out from under the TARP last week, striking deals with the Treasury Department to repay taxpayer money they received last fall. Many bailout-weary investors and taxpayers welcomed this sign that government intervention in the financial sector may finally be receding.
It has been a long slog through the credit morass, and investors are understandably eager to think they are emerging onto higher ground. Still, the bad debt that was amassed by consumers and companies in recent years hasn’t been fully purged, even with the help of the Troubled Asset Relief Program. And the debt on financial companies’ balance sheets must do a lot more shrinking before we can move on from this ugly chapter in financial history.
To get a fix on how much work remains to be done, consider the substantial amount of short-term debt coming due at financial companies in the next year or two. As you absorb these figures, keep in mind that many of the entities that bought this debt when it was issued aren’t around now — they’ve either left the market or are gone, casualties of the crisis. As a result, they’re not around to step up and buy the debt again. So issuers can’t roll it over. They’ll be forced to buy back the debt, at a time when they’re already wallowing in other forms of troublesome debt and short on liquidity.
Barclays Capital has analyzed financial company debt among United States institutions coming due over the next decade. During the rest of the year, for example, roughly $172 billion in debt will mature; in 2010, an additional $245 billion comes due. That amounts to about $25 billion a month in debt rolling into a market with a shortage of buyers willing to invest in it. The size and nature of this financial services debt — and the customers who bought it — are central to the late great credit mania we have just lived through. Banks and other finance companies issued these obligations for relatively short periods — five years or less — and paid investors either variable interest rates or the fixed variety.
Issuance of this financial debt exploded during the mid-2000s. Back in 1999, paper issued by American financial companies made up 30 percent of Barclays’s fixed- and floating-rate corporate debt index. By 2007, this type of debt accounted for almost half of the index. Of the $172 billion coming due by year-end, Barclays says, $123 billion was floating-rate debt. And of the $245 billion maturing next year, some $141 billion pays a variable rate.
As you can see, the bulk of this debt consisted of floating-rate obligations. During the mania, these issues were snapped up by a group of relatively new money managers operating special investment vehicles, or S.I.V.’s. S.I.V.’s raised money from investors by selling commercial paper; then they bought residential and commercial mortgages with it, capturing the spread between their cost of money (what they paid investors for commercial paper) and the yield they earned (on mortgages they bought).
These S.I.V.’s also bought a slug of bank debt, for its perceived safety and relatively high yields. Barclays estimated that 40 percent of the assets held in these vehicles was in floating-rate debt issued by United States banks. The popularity of these special investment vehicles really began to explode in 2004, Barclays reports; that January, they held roughly $125 billion in assets. By 2007, however, some $400 billion sat in S.I.V.’s. Banks were happy to sell their debt to these money machines, but the assembly line broke down in September 2007, when the credit crisis commenced.
And, as we noted, few buyers of short-term bank debt are around now. For example, institutions that generated revenue by lending out securities — their own or their customers’ — took that cash and invested it in these short-term bank obligations. Once again, they captured the spread between their capital costs and interest on the debt they purchased. Now, however, many of these institutions have curtailed the securities lending game.
A result, said Ashish Shah, co-head of credit strategy at Barclays Capital, is a supply-and-demand imbalance that means the institutions whose debt is maturing will have to shrink their balance sheets. Some institutions can do this, he said, but for many it won’t be easy. "Some banks have meaningful cash hoards to deal with some of these maturities," Mr. Shah said last week. "They do have assets on the other side that they can shrink. And the other thing to keep in mind here is institutions are taking in deposits at close to record lengths."
But Mr. Shah said the wave of bank debt coming due could prove problematic if government programs set up to provide liquidity to financial institutions go away. One potent example is the Temporary Liquidity Guarantee Program offered by the Federal Deposit Insurance Corporation; it backs corporate debt issued by bank holding companies in exchange for a fee. The F.D.I.C. has said this program will vanish at the end of October.
"It is a real risk if policy makers sit back and say, ‘Things are fine; we don’t need to do this stuff anymore,’" Mr. Shah said. "Things feel like they are getting better in large part because of the policy response. You take away the policy being administered too soon, and you could cause significant damage to confidence." Policy makers have a tough balancing act to achieve here. On one hand, they want to help financial institutions over a rough patch. But they also have an obligation to taxpayers to withdraw from the business of bank assistance as soon as possible.
It is not clear what decisions will be made, of course. If the economy recovers enough, bank balance sheets will look a lot better next year than they do now. But even as many banks have successfully raised equity capital, how they will finance their maturing debt remains a concern. This much is evident: it is too soon to celebrate the end of the banking crisis. Less debt is the answer, but shrinking balance sheets is hard.
Flying Blind: Risk Management, Bank Debt And The Next Financial Disaster
The news that ten banks were given permission to emerge from under TARP last week, and that several banks may actually do so as early as last week, has many breathing a sigh of relief that the banking crisis is over. Unfortunately, the very measures taken to end our latest crisis all but guarantee that we’ll shortly witness another round of financial catastrophe. This isn’t the kind of news people want to hear these days. When I’m chatting with friends at a saloon or a dinner party, people ask me what fixed the financial sector. They aren’t very interested in hearing that the sector isn’t actually fixed, much less that the apparent fix is actually making things worse.
Let’s begin with the basic fact that no one can quite explain why or how we ended the bank crisis. The financial sector faces almost all the same challenges it did last autumn—uncertainty about profits, outdated business models, heavily leveraged balance sheets, self-dealing short term thinking by bonus hungry executives, ineffective regulation and—perhaps most of all—a huge amount of credit assets of extremely questionable value. Many things have actually gotten worse. It’s not just subprime debt anymore. It’s not even just home mortgages. The entire range of debt products seems shaky—from credit cards, student loans, corporate loans to commercial real estate.
Making matters worse, the banks are still dependent on short-term debt for funding. As Gretchen Morgenson explains in her column today, some $172 billion of debt will mature this year, and $245 billion next year. Still in the midst of a credit crunch, this should be viewed as a ticking time-bomb for the financial sector. But it isn’t. The market seems to have a renewed confidence in financial institutions. Since March, financial stocks have rallied sharply. Several firms once viewed as on their death beds have raised billions of dollars in new debt and equity. Some have had to rely on explicit government guarantees of their debt to issue new bonds but several have issued so called ‘non-guaranteed’ debt at costs that are far from unbearable.
Even the government seems to have confidence in the financial sector. Broad regulatory reforms are being pared back, in favor of minor tweaks that will largely leave the existing structure intact. Banks are being allowed to pay back the TARP, escaping the closest level of scrutiny. Government assistance programs to the financial sector are being allowed to quietly fade into the background. Shelving some of the more ambitious programs—such as Treasury Secretary Tim Geithner’s public private partnerships to buy troubled assets—isn’t seen as the crisis it might have once been.
It’s okay that their unworkable because the work they were meant to do seems already done. What really seems to have happened is not that one policy or another fixed the sector. It’s not even the total effect of them that renewed confidence. Rather, it’s a kind of meta-policy, a shadow program that repaired things. And that policy is that the government will do whatever it takes to prevent the collapse of a major financial institution. There will be no more Lehmans. Failure is not an option.
Obviously, the policy of No Failure helps banks raise debt. Holders of bank debt have been protected in each of the rescues. Unlike the bondholders of Chrysler or General Motors, the government did not fight to upend the traditional structure of payouts in failed financial firms. Quite the contrary, the creditors of banks were made whole in almost every case.
This creates a very strong incentive to allocate capital toward the financial sector and away from less secure sectors. Investors still wary of credit markets find the financial sector more attractive because of the guarantee that the debt is backed by the US government. Importantly, this is true even for debt that is not explicitly backed by the US government. The policy of No Failure means that banks enjoy a cheaper cost of capital the same way Fannie Mae and Freddie Mac did in their heyday. Every major financial institution is now a Government Sponsored Entity.
Beyond access to the credit markets, this implicit guarantee helps the banks do business. Counter-parties on trades can be confident that whichever institution they do business with will be there to make good on the trades. The exogenous risk of modern day bank runs is gone, and the confidence of customers provides new opportunities for profits.
Both of these also drive up the price of banks stocks. The implicit guarantee of bank debt takes away two of the major risks to holders of financial stocks. First, the government backed access to new credit dramatically reduces the liquidity risk that took down both Bear Stearns and Lehman Brothers. Second, the reduced liquidity risk diminishes the risk that government will be forced to take over a financial institution. The rally in financial stocks is partly a result of adding back value that had been discounted to account for these risks. Add to this the fact that the business model risk is diminished, and you have a recipe for a strong rally in bank stocks. Call it the "No More Lehmans" rally.
At first glance, the process just described would appear to be a resounding endorsement of the business of government bank assistance. The usual objections appear either doctrinaire or just churlish. Free marketeers will object that the government is too involved, and taxpayers are still on the hook for bank losses. Profits are being privatized and risk socialized. Moral hazard is increased by the presence of government insurance.
None of these typical objections captures the most important danger created by the implicit guarantees—although the concept of moral hazard comes close. ‘Moral hazard’ is used as short hand for the notion that people and institutions will be tempted to engage in risky behavior if the costs of those risks will be borne by others. When those risks are correlated with rewards that can be held privately, risk taking is even more tempting. A kind of phony, government ‘Alpha’ is created by insurance—excess gains obtained without taking on commensurate levels of risk.
The usual solution to this kind of situation is a combination or risk regulation and profit sharing. Government steps in to make sure the bets made aren’t too risky, and it takes a share of the excess gains made from the government alpha. This profit sharing can reduce risk all by itself, since if done right it takes away the incentives for risky behavior.
But this notion of moral hazard—and this way of ameliorating it—miss an even deeper and more systemic problem created by the implicit guarantee. The problem, to put it in extremely abbreviated way, is that the implicit guarantee and the knock-on effects described above, make risk management and business planning almost impossible. They take away the market signals that could instruct a financial firm about the market’s collective wisdom about the risks it has taken on and the potential for its business model. The executives running banks are essentially left flying blind, guessing about the correct altitude and speed because the market processes that would be their guidance instruments have ceased functioning.
Traditional risk management isn’t quite useless, but it is nearly so. Even somewhat sophisticated measures such as "Value at Risk" that banks employ don’t really work very well. The banks themselves admit this. The problem is that they are too subjective, and involve too much guess work.
The real test of risk management is provided by the financial Darwinism of the markets. By reading market signals about products—pricing of assets, pricing of insurance on those prices—banks develop models that can inform them about risk. By reading market signals about their own financial health—their cost of capital, their borrowing cost, the cost to insure their debt, the willingness of customers to enter into trades—risk managers get a view about the risks of their own portfolios and the strength of the business model.
The "No Failure" rally, however, scrambles these signals. Shareholders, bondholders, counterparties can become indifferent to risk. Business models can seem more effective than they actually are. In this situation, financial executives cannot appeal to the external market to determine whether they have the right business models, asset portfolios or capital structures. They just have to guessitimate.
Students of the history of economics may recognize the similarities between this situation and the old ‘socialist calculation debate.’ That debate centered on the question of whether central planners were able to correctly figure out how much of something should be manufactured in an economy without price signals. Most everyone today agrees that pricing is absolutely central to the ability to make calculations about how to expend limited resources.
With the implicit guarantees in place, the bank executive trying to decide how to change his firm’s business model or what it’s risk portfolio is in the position of a socialist planner. He lacks the ability to calculate risk and reward because his access to the judgment of an external market is cut-off.
This calculational chaos is far worse than simple ‘moral hazard.’ It doesn’t matter what regulations are in place, or how closely supervised a firm might be. After all, the regulators and supervisors suffer from the same blindness of the bank executives. And even if bank executives are well-intentioned and untempted by moral hazard, they still cannot properly decipher the risks in their business. There’s no process for decoding risk except market processes, and we’ve thrown a giant monkey wrench into that process. In short, our implicit guarantees are wrapping the mystery of risk inside the enigma of bailouts.
It was this calculational chaos that brought down Fannie Mae and Freddie Mac. Even when closely supervised by regulators and with well-intentioned executives in place, the mortgage agencies were unable to properly evaluate the size of their balance sheets, the content and quality of their portfolios or the appropriateness of their business models. They were the original ‘flying blind’ financial institutions, operating under the benefits and hazards of ‘No Failure’ even before the collapse of Lehman Brothers.
And there is every reason to believe that this calculational chaos will also bring down financial institutions covered by the government’s implicit guarantee. The question is not, really, whether banks will fail like Fannie and Freddie. The question is how many will fail. Or, perhaps, how many will be able to avoid the fate through some bit of luck. Financial prudence and managerial skill will not be enough.
Policy makers face a tough problem here. In order to restore the health of the financial sector, they need to remove the blinders that the implicit guarantees place on those running these firms. But they never succeeded in doing this with Fannie and Freddie, despite years of denial that any guarantee existed. After the market was proved correct about Fannie and Freddie—there was a guarantee after all—the government simply lacks credibility on this point. No one seriously believes these days that a firm like Morgan Stanley or Goldman Sachs would be allowed to fail, much less a mega-bank like Citi or Bank of America.
Perhaps something as dramatic as the seizure of Citigroup is necessary to restore the credibility of markets in the financial sector. This, actually, is exactly what the Wall Street Journal’s editorial board recommended last week. But we need to be cautious: the market has already responded to the guarantees in so many ways that if they were effectively removed, the process would be painful to many investors and the ripple effects are unknowable. We might even set off a new round of financial panic, as the markets suddenly tried to work out which institutions were viable on market processes without guarantees.
This much we know: the scheme to save the banks through implicit guarantees is doomed to failure. What we should do about this, and if we can do something about it before it’s too late—well, those should be the questions we’re talking about.
The Fed Might Have Painted Itself into a Corner
A growing concern for Fed policy makers is a weakening in the US dollar against major currencies. The price of the euro in US-dollar terms climbed from a low of $1.27 in November last year to around $1.41 in May and $1.43 in early June – an increase of 12.6% from November. The major currencies dollar index fell to 78.89 in May from 82.3 in April – a fall of 4.1%. If the declining trend in the US dollar were to consolidate, this could cause foreign holders of US-dollar assets to divest into non-dollar-denominated assets and precious metals. This in turn could spark another financial crisis.
For instance, on June 6, 2009, Russia's President Dmitri Medvedev said that American financial policy had made the dollar an undesirable currency for reserves held by central banks. Also China – the largest holder of US-dollar reserves – has voiced its misgivings with the Fed's massive money pumping, which is seen as an important reason behind the recent weakening in the US currency. Note that in March, China's US-dollar reserves stood at $1,953.7 billion – an increase of 2.2% on the month before. The value of the China's holdings of US Treasury securities was $767.9 billion in March against $744.2 in February and $490.6 billion in March last year.
If the US dollar weakens further, Fed policy makers will be forced to slow down monetary pumping in order to placate foreign investors. A visible strengthening in commodity prices is also likely to put pressure on the Fed to slow down the money printer. In May, the CRB commodity price index shot up by 13.8% from the month before. Some harsh critics of the Fed, such as John Taylor (the inventor of the Taylor rule), are of the view that the Fed should already be embracing a tighter stance to prevent the repetition of the interest-rate policy of Greenspan's Fed, which was kept at a very low levels for too long.
According to John Taylor, Greenspan's low-interest-rate policies had been a major contributing factor for the present economic crisis. (Greenspan had lowered the federal-funds rate from 5.5% in January 2001 to 1% by June 2003 and kept the rate at 1% until June 2004. Note that currently the federal-funds rate is between zero and 0.25%.)
There is almost complete agreement among various commentators that the massive monetary pumping by the Fed since September last year was necessary to prevent a plunge in aggregate demand. As a result, it is held, the Fed has prevented the economy from falling into a severe recession. According to this way of thinking, the increase in money supply strengthens the demand for goods and services, which in turn strengthens the economy. A stronger economy in turn feeds back into the demand and this strengthens the economy further.
Following this logic, whenever the economy is starting to gain strength and can stand on its own feet, there is no need any longer for all the pumped money. In fact keeping all the pumped money can be detrimental to the economy's health. (Keeping all the pumped money can only lay the foundation for various distortions and a higher rate of inflation some time in the future – so it is held.) It follows that, once it has been established that the pumped money has managed to place the economy on a healthy growth path, the pumped money can be safely removed without any bad side effects whatsoever. (Again, according to this way of thinking, money pumping is required as long as the economy cannot stand on its own feet.)
Most Fed officials and various economic commentators are of the view that the US economy might be rapidly approaching a stage where it is possible to take out a large chunk of the recently pumped money without causing any harmful side effects in regard to economic activity. Seasonally adjusted construction spending increased by 0.8% in April after rising by 0.4% in March. Pending sales of previously owned homes shot up by 6.7% in April, the biggest monthly gain since October 2001. Manufacturing activity also shows signs of strengthening. The ISM index rose to 42.8 in May from 40.1 in the month before. The new orders component of the ISM jumped to 51.1 in May from 47.2 in April. It seems that the economy is on its way to standing on its own feet.
What most commentators and Fed policy makers don't tell us is that monetary pumping has given rise to various bubble activities. These bubble activities are supported by real savings that have been diverted from wealth generators by means of pumped money. Also note that the pumped money has prevented the removal of various old bubble activities. Hence, contrary to popular thinking, the massive money pumping has actually weakened the economy's bottom line.
If the Fed were to start taking some of the newly pumped money from the economy, i.e., to curb the money-supply rate of growth, this would hurt various old and new bubble activities. It would set in motion an economic bust. (Remember, bubble activities are not self-funded; they require money "out of thin air," which is employed to divert real savings to them from wealth generators.)
A major concern for Fed policy makers is a visible weakening in the US dollar against major currencies. If the Fed were to allow the dollar to fall further, the US central bank runs the risk that major holders of US-dollar assets will divest to nondollar assets. This could push long-term rates and mortgage rates higher, thereby igniting another crisis. If, in order to defend the dollar, the Fed were to start taking some of the newly pumped money from the economy, i.e., to curb the money supply rate of growth, this will hurt various old and new bubble activities and set in motion an economic bust.
Even if the Fed were to decide to tighten its stance just slightly, given the current strengthening in the growth momentum of economic activity, this could visibly weaken the growth momentum of monetary liquidity, thus posing a threat to the stock market. It seems that the Fed might have painted itself into a corner.
Obama eyes tighter controls on banks, Wall Street
President Barack Obama is ready to roll out an overhaul of the intricate rules and systems that govern America's troubled financial institutions, proposing the most ambitious revision since the Great Depression of the 1930s. The goal is to prevent a recurrence of the economic crisis that erupted in the United States and exploded last fall with devastating consequences still reverberating around the world. Unlike the government's temporary ownership stake in automakers and major financial companies, the regulatory changes set to be announced Wednesday are designed to be permanent.
They could result in a major realignment of power and authority among government agencies that set the rules for banking, lending and investing and touch American lives through daily transactions, from credit cards to mortgages and mutual funds. The proposals already are the source of a spirited debate in Congress over whether Obama's measures will prove too timid or place too heavy a hand on the levers of capitalism. At issue is a 21st century system of high-stakes swaps and trades, bets and losses where trillions of dollars worth of investment products have grown too intricate for a 20th century regulatory structure.
Imagine today's financial transactions as an athletic contest where the referees have lost their vantage point. Plays occur out of their sight and fouls go undetected. Some referees halt play while others let it go on. Even the players have had enough. "On a macro-basis, we're very supportive of reform," said Tim Ryan, president and chief executive of the Securities Industry and Financial Markets Association. In devising new regulations and oversight, the administration is looking to address four perceived weaknesses in the current system:
- The lack of an all-seeing federal entity to detect institutional stresses that threaten the financial system, and the government's inability to step in and unwind large institutions before they choke the system. The Federal Deposit Insurance Corp. can do this with banks. But the government lacked the power to do the same with a behemoth such as the insurer American International Group Inc.
- The undercapitalization of large financial institutions. Heading into the financial crisis, too many banks were leveraged with significantly more debt than equity. "If you give people enough leverage, they can lose an unbelievably large amount of their own money and that of their clients," Obama's chief economic adviser, Lawrence Summers, said last week.
- The emergence of large, lightly regulated markets, such as hedge funds, and of big insurers, such as AIG, without a federal overseer. The administration wants large private investment funds to register with the Securities and Exchange Commission and is weighing the creation of a federal charter for insurance firms.
- Consumers and lenders whose unwitting or reckless credit and borrowing decisions placed families under staggering debts and contributed to the instability of the financial system. Obama is likely to recommend creating a financial services consumer protection body with oversight powers over mortgages and credit cards and other consumer financial products.
Internally, the administration has vacillated over whether to streamline the vast array of regulatory agencies. At one point, Treasury and White House officials floated the idea of a single financial services regulator to oversee banks and certain insurers. But it didn't get a warm reception from the chairman of the Senate Banking, Housing and Urban Affairs Committee or the chairman of the House Financial Services Committee. The administration backed away from the idea.
But last week, Democratic Sen. Chuck Schumer of New York, a key player in financial issues, called on Treasury Secretary Timothy Geithner to include a single banking regulator in the administration's overhaul plan. House Republicans want streamlining, too, but would take power away from the Federal Reserve and the FDIC. The administration considered merging the Securities and Exchange Commission, the powerful stock market regulator, and the Commodities Futures Trading Commission, which oversees commodity futures and some options markets. But the move would have meant congressional and regulatory turf battles. At a dinner two weeks ago, Geithner told key lawmakers he would not propose the merger.
"The Obama administration -- because they're working in a more realistic environment -- are into the art of the possible," Ryan said. One way or another, the Fed could be a winner in the administration's plan. The administration and Fed Chairman Ben Bernanke would like the central bank to be the overarching "systemic risk" regulator, lording over the financial system in search of flaws and weak stress points. Such a role would give the Fed exceptional authority as both the manager of monetary policy and the overseer of the enterprises with the biggest financial footprint in the country, if not the world.
Industry officials now expect Obama and Geithner to propose a system that makes the Fed a supervisor of systemic risk assisted by a council of regulators that would advise the central bank about potential dangers. Also in the debate is how to handle failing institutions that pose a threat to the entire financial system. The administration wants a beefed up FDIC to carry out that function provided such intervention is triggered by Fed or Treasury regulators. Republicans prefer that companies be restructured or liquidated in bankruptcy court.
Alabama Rep. Spencer Bachus, the top Republican on the House Financial Services Committee, urged lawmakers to reject a regulatory system "that depends on the infallibility of the government regulators, who have so far shown themselves unable to anticipate crisis, let alone prevent them." In a speech Friday to the Council on Foreign Relations, Summers offered the administration's counterpoint: "Any financial institution that is big enough, interconnected enough or risky enough that its distress necessitates government writing substantial checks, is big enough, risky enough or interconnected enough that it should be some part of the government's responsibility to supervise it on a comprehensive basis."
Regulators Feud as Banking System Overhauled
Two of the nation’s most powerful bank regulators were once again at each other’s throats. At a public meeting three weeks ago, John C. Dugan, the comptroller of the currency, blasted a proposal to impose stiff new insurance fees on banks as unfair to the largest banks, which he regulates. The financial crisis stemmed in part from problems at small banks, he insisted. Sheila C. Bair, chairwoman of the Federal Deposit Insurance Corporation and the regulator for many smaller, community banks, could barely hide her contempt. The large banks, she said, had wreaked havoc on the system, only to be bailed out by "hundreds of billions, if not trillions, in government assistance." She added, "Fairness is always an issue."
Behind the scenes, the two regulators have been clashing over a host of issues, officials said, be it the administration’s coming regulatory overhaul or Ms. Bair’s campaign to shake up the top management at Citigroup. The long-running and deeply personal feud between Mr. Dugan and Ms. Bair, two Republican holdovers with similar career paths in Washington, is now helping to shape President Obama’s attempt to revamp financial regulation aimed at preventing the regulatory lapses that contributed to the economic crisis.
Some of Mr. Obama’s advisers and some senior Democratic lawmakers have suggested creating a single bank regulator. But the administration’s current version, which could be announced as early as this week, would not combine the regulatory agencies. Instead, it would give Mr. Dugan and Ms. Bair significant new powers — and could intensify their turf battles. Ms. Bair and Mr. Dugan declined to comment for this article.
The Treasury secretary, Timothy F. Geithner, the main author of the administration’s plan, in recent weeks has refereed among the competing views of Ms. Bair, Mr. Dugan and Ben S. Bernanke, the Federal Reserve chairman. The four generally agree that, if starting from scratch, they would not create the cumbersome system that has evolved piecemeal over the last 150 years. But with the administration and crucial lawmakers rejecting a single agency, the four officials have often disagreed on just how to streamline and strengthen regulation.
Some points of contention include views on which agencies should play central roles in overseeing financial companies whose troubles could pose problems for the overall system, and whether to create a new agency to protect consumers from abusive mortgages or credit cards. Officials say the latest version of the plan, in large part, is a compromise of various viewpoints. "On an issue like regulatory reform, with so many differing opinions, the expectation is not that all sides will agree on the final product," said Andrew Williams, a Treasury spokesman. "But the administration worked hard to gather information from all parties to prevent a crisis like this from ever happening again."
Mr. Obama’s economic team has often had internecine battles over policy, but the president’s advisers generally fall in line once he makes the final decision. But Mr. Dugan and Ms. Bair are semi-independent regulators whose feuds have multiplied — and at times erupted in public. Most of the banking industry couldn’t be happier with the current system. Bank executives and lobbyists say that the system, while flawed, enables regulators to tailor rules for a variety of financial institutions. They maintain that the policy issues for small banks differ markedly from, and often conflict with, those involving the large banks.
"It’s healthy that the regulators disagree," said Camden R. Fine, head of the Independent Community Bankers of America. "Out of their tension comes good, balanced policy." But the fractured nature of regulation also makes it easier for financial institutions to shop for the friendliest regulator or pit agencies against one another, lawmakers say. To reduce that risk, the administration is expected to propose eliminating one of the weakest agencies, the Office of Thrift Supervision. The agency was faulted for missing problems at some of the largest savings associations, like Washington Mutual and IndyMac, as well as at the American International Group, which it regulated because the company owns a thrift.
Two Democratic senators, Christopher J. Dodd of Connecticut and Charles E. Schumer of New York, have urged Mr. Geithner to combine the four federal bank regulators into one. "With multiple bank regulators, you get the worst of both worlds," Mr. Schumer said. "Some banks get conflicting signals. Other banks get no signals at all." Mr. Dodd said that, despite his support for a single regulator, he favored the F.D.I.C.’s continued role as the manager of the bank insurance fund. He said the plan was intended to reduce regulatory gaps but not discourage healthy debate among officials.
"Despite the fact that I’m an advocate of a single regulator, I like the idea of some tension," Mr. Dodd said. Other Democrats, notably Representative Barney Frank of Massachusetts, have so far succeeded in convincing the administration that such a proposal is more political trouble than it is worth. And some banking experts say that the number of regulators is not the crucial factor. "What’s most important is who the leaders are," said William K. Black, a former senior lawyer for the agency that became the Office of Thrift Supervision, and who brought cases against many savings and loans in the 1990s.
The Obama plan, still being drafted by Mr. Geithner, is likely to give the F.D.I.C. new authority to seize and shut down financial companies in serious trouble. The administration is also expected to propose an agency to oversee financial products sold to consumers, like mortgages and credit cards. Both those ideas were supported by Ms. Bair and challenged by Mr. Dugan. The regulatory plan would also establish the Federal Reserve as a super-regulator to police risk across the financial system, a proposal supported by Mr. Dugan and criticized by Ms. Bair.
The fighting between Mr. Dugan and Ms. Bair reflects the institutional interests of their respective agencies, as well as the differences between big banks and small banks. "The F.D.I.C.’s primary role is as the deposit insurer, so it is inclined to be risk averse," said Brian C. McCormally, a former regulator in the comptroller’s office who is a partner at the Washington law firm Arnold & Porter.
Ms. Bair and Mr. Dugan have fought over many other issues. In recent weeks, Ms. Bair has sought management changes at the large troubled banks, including Citigroup. Mr. Dugan, on the other hand, has advocated giving Citigroup managers more time to put their house in order. The résumés of the two regulators might make it seem as if they would get along. Both began their political careers as aides to Republican senators and both served as assistant Treasury secretaries under Republican presidents, at different times.
Ms. Bair’s approach to policy has evolved significantly from a conservative Republican aide to Senator Bob Dole of Kansas to a top regulator who now derives much of her political clout from her close ties to senior Democrats, notably Mr. Frank and Mr. Dodd. Both lawmakers urged the White House to retain Ms. Bair. "She’s been brilliant," Mr. Frank said in an interview. Mr. Frank said she recognized long before officials in the Bush administration that it was vital for the government to more aggressively support the housing market and reduce foreclosures. He also lauded her for a series of decisions that have helped community banks.
But at the Treasury and the Federal Reserve, Ms. Bair is viewed as someone who pushes her and her agency’s interests rather than someone who finds common ground with other policy makers. Besides Mr. Dugan, she has antagonized many other leaders in Washington. Officials at the Federal Reserve and the comptroller’s office said she exasperated them last fall when she balked at allowing Citigroup to take over Wachovia, a major bank that was about to collapse.
In bruising negotiations that lasted until 4 a.m., Ms. Bair squared off against Mr. Bernanke, Mr. Dugan and the Treasury secretary at the time, Henry M. Paulson Jr. The stand-off left many officials, who thought the broader financial crisis had given them no alternative but to finance the deal, fuming. When Wells Fargo a few weeks later made a more generous offer for Wachovia that required no government aid, Ms. Bair enraged Citigroup executives, some bank officials said, when she backed Wells Fargo and helped scuttle Citi’s deal. Her supporters said she believed that she had a duty to take an active role and could not afford to sit on the sidelines, hoping that the plans of the Fed and Treasury turned out well.
Mr. Dugan, a more low-key regulator, has also worked as a lawyer representing some of the largest banks. He derives much of his influence from his close relationship with Mr. Geithner, reinforced when they worked on the banking crisis last year under the Bush administration. The proposal to overhaul financial regulation must be approved by Congress, where it could be reshaped drastically. "This is the kind of thing that reminds me of the anecdote about the old man and the sea," said Mr. Dodd, the Senate Banking Committee chairman. "It’s going to take so long to drag it in that by the time it gets to the boat, it could come in as a set of bones."
'Light-touch' reforms raise fears of new bank disaster
Controversial reforms of major companies' accounts threaten to unleash a new wave of financial calamity, experts have warned. Proposals by the Financial Reporting Council, the regulator responsible for promoting confidence in corporate governance and reporting, have raised the possibility that the accounts of wholly owned subsidiaries of major banks need not be audited. The plans appear to indicate that the financial community is intent on returning to the days of light-touch regulation. The City is also resisting demands to create a European financial regulator.
The FRC is asking the financial industry whether subsidiaries should be required to file audited accounts with full disclosures. "Is a more simplified reporting regime more appropriate? Would it be desirable to eliminate the UK requirement to prepare, have audited, and file wholly-owned subsidiary accounts in the case of a parent company guarantee?" it asks. Critics point out that it was a subsidiary of Northern Rock, Granite, that contained the liabilities that led to the collapse of the bank: Granite owned £49bn of mortgages that were sold by Northern Rock and moved offshore to the tax haven of Jersey. Likewise, a series of banks crashed last year because their subsidiaries loaded up on asset-backed securities that plummeted in value.
Richard Murphy, an influential forensic accountant, said: "We have seen how subsidiaries have led parent companies into liquidation. HMRC and the public should have a right to get high quality audited information on every company. If this goes through, it will mean complex financial transactions will become harder to detect, so tax avoidance will increase." A senior City figure said: "On the one hand, we're aware of the size and complexity of report and accounts. But on the other, if we abandon audits of wholly owned subsidiaries we are potentially not getting access to important information. We need investors to think carefully which side of the argument we're on, but I don't think we've reached a view."
The proposals are contained in a 16-page document from the FRC entitled, "Louder than Words - principles and actions for making corporate reports less complex and more relevant". An FRC spokesman said, if adopted, the proposals would require government legislation. He said the FRC was attempting to reform company accounts to make them simpler and easier to understand. Meanwhile, there are many in the City who are taking comfort from the recent declaration by a leading thinktank, the National Institute for Economic and Social Research, that the recession is over. This, combined with banks paying billions of pounds of bailout money back to governments, and rising equity markets, has buoyed confidence.
Earlier this week, US treasury secretary Tim Geithner rowed back on limiting bankers' pay after he was persuaded that the initiative would see an exodus of Wall Street financiers to Dubai. A senior fund manager said: "Entrenched vested interests are putting up a sufficiently good rearguard action that they're forestalling any significant changes in the regulatory environment. The general improvement in financial markets is possibly covering up the cracks."
IMF bond plan shows US woes
The IMF’s plan to issue bonds for the first time has attracted several large emerging countries looking to diversify investments to the detriment of the dollar, whose luster is dimming under the mushrooming US budget deficit. After the G20 major developed and emerging market countries pledged in April to boost the IMF’s resources by US$500 billion, each country must determine just how to deliver.
To help gather such a colossal sum, the 185-nation IMF has decided to take the unprecedented step of issuing bonds. "IMF staff will present the necessary documentation to the fund’s executive board to allow the issuance of notes as early as possible," Dominique Strauss-Kahn, the managing director of the IMF, said on Wednesday. Three countries lined up for the notes in the space of two weeks: Russia, China, then Brazil. Both Russia and Brazil are in the market for US$10 billion in bonds, while China is aiming for US$50 billion. Other G20 members could follow, such as India or Saudi Arabia.
The new bonds will be offered in the IMF accounting unit, Special Drawing Right (SDR), whose value is based on a basket of currencies, rebalanced daily, in which the dollar represents only a 41 percent share. It is the dollar’s relative weakness in SDRs that has raised market concerns that some countries are seeking to distance themselves from the greenback, the world’s reserve currency. Those concerns materialized in a spike in bond interest rates when, on Wednesday, the Russian central bank clearly said it wanted to sell US Treasury bonds to buy IMF bonds.
In an extreme scenario, "if countries use this issuance as a way to diversify reserve holdings out of dollars, these sales will prompt liquidation of Treasuries or other dollar-denominated securities held by central banks," Carl Weinberg of High Frequency Economics said. But for Weinberg, the market "is overestimating the importance of this," given the small volume that IMF bonds would represent in the face of dozens of billions of dollars the US borrows each day.
Ted Truman, an expert on the IMF who advised the US Treasury Department before the G20 summit in London on April 2, also downplayed the impact of the IMF bonds. "These will not be bonds that will be traded in the market. They are the type of instrument that countries will receive in connection with their short-term lending to the IMF ... I see no symbol in connection with reserve diversification," he said. Rather, the economist said demand for the multilateral institution’s bonds was an "indication of the relative external strength of these countries at a time of global economic crisis when in previous global crises their economies would have been severely affected." Eleven years ago Russia, for example, defaulted on sovereign loan obligations amid a financial crisis.
For some, the announcements by Russia, China and Brazil are troubling rumbles for the US. "It is a clear sign that these countries are not comfortable with their large dollar holdings and should be read by the US as an additional signal of market unease about their large budget deficit," said Desmond Lachman of the American Enterprise Institute, a Washington think tank. The US, meanwhile, has not yet contributed the US$108 billion it pledged to the IMF. The funding is tied to legislation in Congress that is still being debated.
De-Dollarization: Dismantling America’s Financial-Military Empire
by Michael Hudson
The city of Yakaterinburg, Russia’s largest east of the Urals, may become known not only as the death place of the tsars but of American hegemony too – and not only where US U-2 pilot Gary Powers was shot down in 1960, but where the US-centered international financial order was brought to ground.
Challenging America will be the prime focus of extended meetings in Yekaterinburg, Russia (formerly Sverdlovsk) today and tomorrow (June 15-16) for Chinese President Hu Jintao, Russian President Dmitry Medvedev and other top officials of the six-nation Shanghai Cooperation Organization (SCO). The alliance is comprised of Russia, China, Kazakhstan, Tajikistan, Kyrghyzstan and Uzbekistan, with observer status for Iran, India, Pakistan and Mongolia. It will be joined on Tuesday by Brazil for trade discussions among the BRIC nations (Brazil, Russia, India and China).
The attendees have assured American diplomats that dismantling the US financial and military empire is not their aim. They simply want to discuss mutual aid – but in a way that has no role for the United States, NATO or the US dollar as a vehicle for trade. US diplomats may well ask what this really means, if not a move to make US hegemony obsolete. That is what a multipolar world means, after all. For starters, in 2005 the SCO asked Washington to set a timeline to withdraw from its military bases in Central Asia. Two years later the SCO countries formally aligned themselves with the former CIS republics belonging to the Collective Security Treaty Organization (CSTO), established in 2002 as a counterweight to NATO.
Yet the meeting has elicited only a collective yawn from the US and even European press despite its agenda is to replace the global dollar standard with a new financial and military defense system. A Council on Foreign Relations spokesman has said he hardly can imagine that Russia and China can overcome their geopolitical rivalry,1 suggesting that America can use the divide-and-conquer that Britain used so deftly for many centuries in fragmenting foreign opposition to its own empire. But George W. Bush ("I’m a uniter, not a divider") built on the Clinton administration’s legacy in driving Russia, China and their neighbors to find a common ground when it comes to finding an alternative to the dollar and hence to the US ability to run balance-of-payments deficits ad infinitum.
What may prove to be the last rites of American hegemony began already in April at the G-20 conference, and became even more explicit at the St. Petersburg International Economic Forum on June 5, when Mr. Medvedev called for China, Russia and India to "build an increasingly multipolar world order." What this means in plain English is: We have reached our limit in subsidizing the United States’ military encirclement of Eurasia while also allowing the US to appropriate our exports, companies, stocks and real estate in exchange for paper money of questionable worth.
"The artificially maintained unipolar system," Mr. Medvedev spelled out, is based on "one big centre of consumption, financed by a growing deficit, and thus growing debts, one formerly strong reserve currency, and one dominant system of assessing assets and risks."2 At the root of the global financial crisis, he concluded, is that the United States makes too little and spends too much. Especially upsetting is its military spending, such as the stepped-up US military aid to Georgia announced just last week, the NATO missile shield in Eastern Europe and the US buildup in the oil-rich Middle East and Central Asia.
The sticking point with all these countries is the US ability to print unlimited amounts of dollars. Overspending by US consumers on imports in excess of exports, US buy-outs of foreign companies and real estate, and the dollars that the Pentagon spends abroad all end up in foreign central banks. These agencies then face a hard choice: either to recycle these dollars back to the United States by purchasing US Treasury bills, or to let the "free market" force up their currency relative to the dollar – thereby pricing their exports out of world markets and hence creating domestic unemployment and business insolvency.
When China and other countries recycle their dollar inflows by buying US Treasury bills to "invest" in the United States, this buildup is not really voluntary. It does not reflect faith in the U.S. economy enriching foreign central banks for their savings, or any calculated investment preference, but simply a lack of alternatives. "Free markets" US-style hook countries into a system that forces them to accept dollars without limit. Now they want out.
This means creating a new alternative. Rather than making merely "cosmetic changes as some countries and perhaps the international financial organisations themselves might want," Mr. Medvedev ended his St. Petersburg speech, "what we need are financial institutions of a completely new type, where particular political issues and motives, and particular countries will not dominate."
When foreign military spending forced the US balance of payments into deficit and drove the United States off gold in 1971, central banks were left without the traditional asset used to settle payments imbalances. The alternative by default was to invest their subsequent payments inflows in US Treasury bonds, as if these still were "as good as gold." Central banks now hold $4 trillion of these bonds in their international reserves – land these loans have financed most of the US Government’s domestic budget deficits for over three decades now!
Given the fact that about half of US Government discretionary spending is for military operations – including more than 750 foreign military bases and increasingly expensive operations in the oil-producing and transporting countries – the international financial system is organized in a way that finances the Pentagon, along with US buyouts of foreign assets expected to yield much more than the Treasury bonds that foreign central banks hold. The main political issue confronting the world’s central banks is therefore how to avoid adding yet more dollars to their reserves and thereby financing yet further US deficit spending – including military spending on their borders?
For starters, the six SCO countries and BRIC countries intend to trade in their own currencies so as to get the benefit of mutual credit that the United States until now has monopolized for itself. Toward this end, China has struck bilateral deals with Argentina and Brazil to denominate their trade in renminbi rather than the dollar, sterling or euros,3 and two weeks ago China reached an agreement with Malaysia to denominate trade between the two countries in renminbi.
Former Prime Minister Tun Dr. Mahathir Mohamad explained to me in January that as a Muslim country, Malaysia wants to avoid doing anything that would facilitate US military action against Islamic countries, including Palestine. The nation has too many dollar assets as it is, his colleagues explained. Central bank governor Zhou Xiaochuan of the People's Bank of China wrote an official statement on its website that the goal is now to create a reserve currency "that is disconnected from individual nations."5 This is the aim of the discussions in Yekaterinburg.
In addition to avoiding financing the US buyout of their own industry and the US military encirclement of the globe, China, Russia and other countries no doubt would like to get the same kind of free ride that America has been getting. As matters stand, they see the United States as a lawless nation, financially as well as militarily. How else to characterize a nation that holds out a set of laws for others – on war, debt repayment and treatment of prisoners – but ignores them itself? The United States is now the world’s largest debtor yet has avoided the pain of "structural adjustments" imposed on other debtor economies. US interest-rate and tax reductions in the face of exploding trade and budget deficits are seen as the height of hypocrisy in view of the austerity programs that Washington forces on other countries via the IMF and other Washington vehicles.
The United States tells debtor economies to sell off their public utilities and natural resources, raise their interest rates and increase taxes while gutting their social safety nets to squeeze out money to pay creditors. And at home, Congress blocked China’s CNOOK from buying Unocal on grounds of national security, much as it blocked Dubai from buying US ports and other sovereign wealth funds from buying into key infrastructure. Foreigners are invited to emulate the Japanese purchase of white elephant trophies such as Rockefeller Center, on which investors quickly lost a billion dollars and ended up walking away.
In this respect the US has not really given China and other payments-surplus nations much alternative but to find a way to avoid further dollar buildups. To date, China’s attempts to diversify its dollar holdings beyond Treasury bonds have not proved very successful. For starters, Hank Paulson of Goldman Sachs steered its central bank into higher-yielding Fannie Mae and Freddie Mac securities, explaining that these were de facto public obligations. They collapsed in 2008, but at least the US Government took these two mortgage-lending agencies over, formally adding their $5.2 trillion in obligations onto the national debt. In fact, it was largely foreign official investment that prompted the bailout.
Imposing a loss for foreign official agencies would have broken the Treasury-bill standard then and there, not only by utterly destroying US credibility but because there simply are too few Government bonds to absorb the dollars being flooded into the world economy by the soaring US balance-of-payments deficits.
Seeking more of an equity position to protect the value of their dollar holdings as the Federal Reserve’s credit bubble drove interest rates down China’s sovereign wealth funds sought to diversify in late 2007. China bought stakes in the well-connected Blackstone equity fund and Morgan Stanley on Wall Street, Barclays in Britain South Africa’s Standard Bank (once affiliated with Chase Manhattan back in the apartheid 1960s) and in the soon-to-collapse Belgian financial conglomerate Fortis. But the US financial sector was collapsing under the weight of its debt pyramiding, and prices for shares plunged for banks and investment firms across the globe.
Foreigners see the IMF, World Bank and World Trade Organization as Washington surrogates in a financial system backed by American military bases and aircraft carriers encircling the globe. But this military domination is a vestige of an American empire no longer able to rule by economic strength. US military power is muscle-bound, based more on atomic weaponry and long-distance air strikes than on ground operations, which have become too politically unpopular to mount on any large scale.
On the economic front there is no foreseeable way in which the United States can work off the $4 trillion it owes foreign governments, their central banks and the sovereign wealth funds set up to dispose of the global dollar glut. America has become a deadbeat – and indeed, a militarily aggressive one as it seeks to hold onto the unique power it once earned by economic means. The problem is how to constrain its behavior. Yu Yongding, a former Chinese central bank advisor now with China’s Academy of Sciences, suggested that US Treasury Secretary Tim Geithner be advised that the United States should "save" first and foremost by cutting back its military budget. "U.S. tax revenue is not likely to increase in the short term because of low economic growth, inflexible expenditures and the cost of ‘fighting two wars.’"6
At present it is foreign savings, not those of Americans that are financing the US budget deficit by buying most Treasury bonds. The effect is taxation without representation for foreign voters as to how the US Government uses their forced savings. It therefore is necessary for financial diplomats to broaden the scope of their policy-making beyond the private-sector marketplace. Exchange rates are determined by many factors besides "consumers wielding credit cards," the usual euphemism that the US media cite for America’s balance-of-payments deficit. Since the 13th century, war has been a dominating factor in the balance of payments of leading nations – and of their national debts. Government bond financing consists mainly of war debts, as normal peacetime budgets tend to be balanced. This links the war budget directly to the balance of payments and exchange rates.
Foreign nations see themselves stuck with unpayable IOUs – under conditions where, if they move to stop the US free lunch, the dollar will plunge and their dollar holdings will fall in value relative to their own domestic currencies and other currencies. If China’s currency rises by 10% against the dollar, its central bank will show the equivalent of a $200 million loss on its $2 trillion of dollar holdings as denominated in yuan.
This explains why, when bond ratings agencies talk of the US Treasury securities losing their AAA rating, they don’t mean that the government cannot simply print the paper dollars to "make good" on these bonds. They mean that dollars will depreciate in international value. And that is just what is now occurring. When Mr. Geithner put on his serious face and told an audience at Peking University in early June that he believed in a "strong dollar" and China’s US investments therefore were safe and sound, he was greeted with derisive laughter.7
Anticipation of a rise in China’s exchange rate provides an incentive for speculators to seek to borrow in dollars to buy renminbi and benefit from the appreciation. For China, the problem is that this speculative inflow would become a self-fulfilling prophecy by forcing up its currency. So the problem of international reserves is inherently linked to that of capital controls. Why should China see its profitable companies sold for yet more freely-created US dollars, which the central bank must use to buy low-yielding US Treasury bills or lose yet further money on Wall Street?
To avoid this quandary it is necessary to reverse the philosophy of open capital markets that the world has held ever since Bretton Woods in 1944. On the occasion of Mr. Geithner’s visit to China, "Zhou Xiaochuan, minister of the Peoples Bank of China, the country’s central bank, said pointedly that this was the first time since the semiannual talks began in 2006 that China needed to learn from American mistakes as well as its successes" when it came to deregulating capital markets and dismantling controls.
An era therefore is coming to an end. In the face of continued US overspending, de-dollarization threatens to force countries to return to the kind of dual exchange rates common between World Wars I and II: one exchange rate for commodity trade, another for capital movements and investments, at least from dollar-area economies. Even without capital controls, the nations meeting at Yekaterinburg are taking steps to avoid being the unwilling recipients of yet more dollars.
Seeing that US global hegemony cannot continue without spending power that they themselves supply, governments are attempting to hasten what Chalmers Johnson has called "the sorrows of empire" in his book by that name – the bankruptcy of the US financial-military world order. If China, Russia and their non-aligned allies have their way, the United States will no longer live off the savings of others (in the form of its own recycled dollars) nor have the money for unlimited military expenditures and adventures. US officials wanted to attend the Yekaterinburg meeting as observers. They were told No. It is a word that Americans will hear much more in the future.
BRIC summit watched for signals on dollar
When the leaders of Brazil, Russia, India and China gather for their first full-fledged summit, they will be closely watched for signs of policy shifts that could affect the global role and strength of the U.S. dollar. During the summit Tuesday in the Ural Mountains city of Yekaterinburg, Russian President Dmitry Medvedev is likely to reprise Russia's call for a new global reserve currency to augment the dollar. The Russian proposal reflects both the Kremlin's push for greater international clout and a concern shared by other so-called BRIC members that soaring U.S. budget deficits could spur inflation and weaken the dollar.
Russia, China and Brazil recently announced their intention to invest in International Monetary Fund bonds to diversify their dollar-heavy currency reserves. IMF bonds are denominated in Special Drawing Rights, of SDRs, an artificial currency used by the IMF. While this has raised fears that the greenback could be further weakened, analysts say BRIC nations can offer no viable alternative to the dollar. "This should be a currency with some liquidity to it. SDRs won't work in this respect," said Nataliya Orlova, chief economist at Moscow-based Alfa Bank. "The United States is the IMF's chief investor, so one can hardly think that you can invest in the IMF and get rid of the dollar altogether."
Some say the main aim behind the reserve currency talk is to send a signal to the U.S. administration to step aside from its policy of printing money. "They want to show the United States that there are forces that can influence U.S. policy," said Alexander Konovalov, head of the Moscow-based Institute of Strategic Assessment. The foreign ministers of the four countries met last year in Yekaterinburg, and the presidents have met on the sidelines of other meetings, but Tuesday's summit will be their first.
China is Washington's biggest foreign creditor, holding an estimated $1 trillion in U.S. government debt. Chinese officials have been considerably more careful than their Russian counterparts in talking about potential alternatives to the dollar, apparently fearing that such comments could undermine the value of their dollar assets. Russia's finance minister also took a markedly less bullish line recently, saying that the creation of a new reserve currency would require much greater integration of economic policies. The summit is unlikely to produce any specific results because of deep differences among BRIC countries, which were initially linked together solely because of their fast-developing economies.
While they share a desire to play a bigger role in creating a new global financial order and counterbalancing the West and Japan, their often contradictory interests would make forging a common policy a difficult task. "BRIC nations are united by their desire to take a more visible role in global affairs," Konovalov said. "They represent a growing part of the global economic potential, but they have different priorities and lack a common economic basis for closer integration." China and India have sizable labor resources, while Russia and Brazil are rich in natural resources. China is a major consumer of natural resources, unlike Russia and Brazil, which are top producers. While China wants lower oil prices, Russia and Brazil would seek higher oil prices.
"On the one hand they need to cooperate because buyers and sellers need to cooperate, but on the other, their interests at times are set against one another," said Ron Smith, chief strategist at Alfa Bank. There is also a huge competition among the BRIC nations for foreign capital and investment. "BRIC is like a reduced model of the world, rich in all its diversity," said Fyodor Lukyanov, editor of Russia in Global Affairs magazine. "They have few coinciding interests, except their striving for a more just economic order."
Analysts have been pondering for years whether BRIC nations could join efforts and replace the United States as the driver of global economic growth. Most agree that however fast growing the BRICs are, their influence is still limited. "Even together, BRIC is smaller than the U.S. economy," said Yelena Sharipova, economist with the Renaissance Capital investment bank. "They are growing very fast and getting closer to the United States. The developing nations will be biting more and more from the developed economy's pie, but it will take at least 20 years for them to reach the level of the U.S. economy."
A Tale of Two Diverging Economic Worlds
Increasingly a deep divide within the world of globalization is emerging which will have the most profound significance for the future of G7 nations’ economic and political stability. The divide is between those nations which are still embedded within the dollar system, including countries in the Eurozone, versus those emerging economies—especially the BRIC—Brazil, Russia, India, China—where new economic markets and regions are rapidly replacing their over-dependence on the United States as prime export market and prime source for investment finance.
The long-term consequences will be an aggravation of the trend of the United States as a political and economic superpower in terminal decline, while dynamic new economic zones, initially mainly of regional importance, will arise. The one great asset which nations like China, Indonesia, India and Brazil bring to the emerging divide is the one greatest long-term economic deficit or liability of the older industrialized world, USA, UK, Germany and the EU generally. That is their demographic advantage.
With the exception of Russia, all the growth economies possess young, dynamic and growing populations. Interesting to recall is that the hidden story of the pre-1914 German ‘economic miracle’ was based on a similar ‘secret’—rapid and dynamic young and growing population, while that of Great Britain and France was stagnant or in decline after the British Great Depression of 1873 which led to huge emigration of population to the USA.
It’s no accident that the leading political elites of the G7 argue that the greatest threat globally is the rapid birth rate in developing countries. Translated from their euphemism, they really mean the greatest threat to their continued dominance of world affairs is population expansion in emerging economies, as new contenders inevitably rise.
Almost naturally in the past eighteen months, once the initial shock of the worst financial and economic shock since the 1930’s began to subside, China and its immediate trading partners along with the other high-growth emerging economies, began looking for new alternatives to the dying dollar system.
The present crisis is no short-term epiphenomenon as Ben Bernanke, Treasury Secretary Tim Geithner or Barack Obama would wish us to believe. It is the reflection of more than 65 years of defective US economic policy, a defect which reached epidemic proportions after the decision to abandon the gold exchange standard in 1971. Let’s be clear , that gold standard as well as its predecessors was no magic economic panacea. But the break by Nixon in August 1971 allowed Washington to embark on a de facto financial imperialist policy which ruined much of the world economy in its ravages of the past thirty eight years.
Today the contrast between declining G7 economies and emerging dynamic high-population growth economies could not be clearer. The G7 nations from USA to Germany to Italy are choking in public debt, ranging from 80% of GDP in the United States to well over 100% in Italy and a staggering 199% in Japan. Only Zimbabwe with 218% debt to GDP tops that. Germany has a ratio of 77%.
By contrast, of the emerging dynamic high-growth countries, only India has significant public debt, a legacy of the British colonial era, of 58% GDP. Brazil, despite a severe debt crisis in the 1980’s, today has a public debt to GDP level of a very manageable 45%, while Indonesia, one of the fast-growing newly emerging economies, has 34%. South Korea with a high domestic savings culture has a mere 28% debt ratio and China a mere 18% debt to GDP level. Russia, which used the recent boom in oil and gas revenues to pay down its foreign and IMF debts, while the country has severe demographic problems, has a public debt to GDP as of 2008 data of 6%. It has also slowly rebuilt foreign exchange reserves after the crisis last year to a level of $404 billion this month, making its reserves the third largest in the world.
So, with the economies of the USA and EU caught in the jaws of a twin scissors-like crises between growing public debt and declining population growth rates to service that debt long-term, the emerging economies of Asia and Eurasia as well as Brazil in South America are booming, precisely because they enjoy the twin assets of low public debt to GDP ratios combined with dynamic growing populations.
In China, India, Indonesia, Brazil economic growth continues to advance significantly. Governments are not buried under a mountain of debt and citizens remain optimistic about their future. This divergence, between the once rich and the once poor, will mark a geopolitical shift in the pivot of world history when viewed retrospectively by future economic historians.
The most notable aspect of the crisis is the thorough discrediting of western academic economists, including every single winner of the Economics Nobel Prize. Their grandiose theories justifying their laissez faire ‘free market’ economic model of globalization has been proven fatally wrong, in effect a transparent promotion gimmick to justify the process of one-sided globalization, little more. They have been exposed, to use the terms of one of my favourite children’s stories by the Danish writer H.C. Andersen, like the Emperor with no clothes.
The dollar system their world had been based on since Bretton Woods in 1944, is undergoing a death agony. Every measure advocated to date by two US Administrations—Bush and now Obama—as well as the other G7 governments has amounted to giving heavy and even heavier doses of financial chemotherapy to a dying patient. The ever higher doses of taxpayer bailout to maintain a failed financial and banking model on artificial life support is merely worsening the underlying health of the US economy.
The record US financial bailouts since September 2008, a span of a mere ten months, have brought the US Federal debt from some 60% to a whopping 80% of GDP. Private US household debt is now above a record 100% of GDP, significantly worse than in the bad recession year 1974 when it was a mere 40%.
More alarming, for any prospect of growing out of the US economic downturn, the long-awaited phenomenon of demographics has slowly begun to impact. In the coming 1-3 years the impact of Baby Boom generation retirees in record numbers will hit. They will be forced to draw down their public Social Security retirement from the Government as well as selling their private 401k and similar stock and bond investments in order to live in retirement. In economic terms they will become a net drain on the US pubic finances whereas rising unemployment among younger workers whose taxed earnings are needed to pay into the Social Security fund, will aggravate the US public debt level rapidly to Italy or even Japan or Zimbabwe levels in coming years. Unemployed workers do not pay taxes. They draw on state benefits instead.
In April, India's car sales were 4.2 percent higher than they were a year prior. Retail sales rose 15 percent in China in the first quarter of 2009. China is likely to grow at 7 or 8 percent this year, India at 6 percent and Indonesia at 4 percent. By contrast, even using badly flawed official data, the US economy contracted at an annual rate of 6.1 percent last quarter, Europe by 9.6 percent and Japan by a frightening 15 percent, something that rivals the 1930s.
In the West, plus G7 member Japan, banks are overleveraged and thus dysfunctional, governments paralyzed with debt, and consumers are rebuilding their huge debt burdens. America is having trouble selling its public debt at attractive prices. The last three Treasury auctions have gone badly. Its largest state, California, is veering toward total fiscal collapse. The current fiscal year US budget deficit is going to surpass 13 percent of GDP, a level last seen during World War II.
By contrast emerging-market banks are largely healthy and profitable. Every Indian bank, government and private, posted profits in the last quarter of 2008. The governments are in good fiscal shape. China has the world’s largest foreign currency reserves, $2 trillion in reserves, and a budget deficit less than 3 percent of GDP. Brazil is now posting a current account surplus. Indonesia has reduced its debt from 100 percent of GDP nine years ago to 34 percent today.
Unlike in the West - where governments have run out of money or creative new ideas and are now praying that their medicine will work - these countries still have options. Only a year ago, their chief concern was an overheated economy and inflation. Brazil has cut its interest rate substantially, but only to 10.25 percent, which means it can drop it further if things deteriorate even more.
The mood in many of these countries remains surprisingly upbeat. Their currencies are appreciating against the dollar because the markets see them as having better fiscal discipline as well as better long-term growth prospects than the United States. Their bonds are rising. This combination of indicators, all pointing in the same direction, is unprecedented.
The United States remains the richest and most powerful country in the world. Its military spans the globe. Even if its leaders prefer not to call it such it represents the most powerful informal empire in history to date. But just as previous global hegemons went into irreversible decline--the Spanish Empire of the 16th century to the British Empire in the 20th century--great global powers sink into terminal decline once they become overburdened with debt and stuck in slow growth.
California imposes 90-day foreclosure moratorium
California is imposing a 90-day moratorium on housing foreclosures under a new law that takes effect Monday. The law is expected to make lenders try harder to keep borrowers in their homes. Loan companies must prove they tried to modify the delinquent loans before they can begin foreclosing. But supporters acknowledge the California Foreclosure Prevention Act won't stop thousands of foreclosures from eventually happening.
There have been more than 365,000 foreclosures in California since early 2007, with many more already scheduled. The bill passed in February is similar to the Obama administration's Making Home Affordable Program that began in March. Both encourages lenders to cut interest rates or rewrite loans to affordable levels.
Schwarzenegger: A bad time to sell state assets
Gov. Arnold Schwarzenegger says it's the wrong time to consider putting California landmarks up for sale -- less than a month after he proposed doing just that. He acknowledged Friday it was not "the best time right now" to sell state assets such as the San Quentin State Prison, the Los Angeles Memorial Coliseum and the California State Fairgrounds. Schwarzenegger originally announced the proposal in May as part of his revised plan to address a $24.3 billion budget deficit. The Republican governor said California, which has the world's eighth-largest economy, could generate $3 billion from selling seven landmarks and 11 office buildings scattered around the state.
The commercial real estate market is just one part of California's economy that has been pummeled by the recession. Real estate experts told The Associated Press last week that many of the properties would be undervalued if placed on the market now because the commercial real estate market is so poor. Many potential buyers also might have trouble obtaining credit. Even if the properties were put up for sale this year, California would not realize proceeds for perhaps two to five years -- and in some cases even longer. That would do nothing for the current budget crisis.
Who Can We Bank On, Who Can We Trust, As Crisis Sharpens?
Can it possibly be true that Congress can’t walk and chew gum at the same time? This question is prompted by the announcement that financial reform is being pushed back as health care becomes the priority.
This makes me nervous for two reasons. First, it portends a long drawn out legislative battle on health care reform with more time for industry lobbyists and the Congresspersons and Senate persons on their payrolls to compromise away or wreck the change we so deeply need.
Second, it confirms that the lobbyists for financial institutions — the people responsible for the collapse of our economy — have been scheming and wrangling to gut the reforms that could stop anther economic breakdown. Reviving this industry without restructuring and re-regulating it just guarantees another disaster down the line.
Bear in mind, that disaster is already underway despite what you may be reading about "green shoots" and signs that a turnaround is coming because unemployment didn’t go down as much as expected - only 500,000 plus a month.
In fact, many observers see a deeper crash still coming with a depression quietly deepening, even if most us cling to our perennial optimism and trust in the change-maker we can believe in. The Telegraph’s Ambrose Evan-Pritchard, who unfortunately has been more prescient than wrong, whines:
"Those of us who still question whether the world has purged its toxins are reduced to the same tiny band of moaning Druids from early 2007, when we shook our heads in disbelief as the carry trade swept Iceland to fresh madness and bankers laughed off sub-prime rot at Bear Stearns.
We learned then to thicken our skins with walnut juice, lie down in dark rooms, and dissent from Goldman Sachs."
You may recall Dennis Kucinich asking his colleagues aloud if he was in the Congress of the United States or the "board room of Goldman Sachs," as if the former is a wholly owned subsisidiary of the latter. Or perhaps, there was a merger between the two in the sense that Wall Street may be down but by no means out. It is "clawing back" its influence with a new lobbying surge which is allowing Goldman and the big banks to pay back their TARP Money and get out from under the spectre of new regulations, compensation limits and the like.
The Empire inside the Empire is striking back.
Meanwhile, we still live with a fog of misinformation, disinformation and no information. Basic information about monies from the Federal Reserve to banks and financial institutions have not been disclosed. Bear in mind, the Banks control the Fed - and free marketers run the economy, not the government.
Writes Bob Chapman of International Forecaster:
"Not one banking or Wall Street executive owned up to what really happened to cause the crisis. They are totally lacking in honesty, integrity and decency. As it now stands we’ll never know the true inside story of what really went on. We have seen no civil or criminal charges against any of these crooks. Not even investigations. Whatever happened to RICO. Over the past 25 years our financial industry has descended into darkness and corruption and the people who caused it are getting away scott free"
Wow, what an indictment! Example: do we really know the purpose or the TARP program that gave money to banks that apparently didn’t need it, but didn’t say no. (The other side of giving loans to borrowers who couldn’t afford them?)
The Ritholtz blog suggests: http://www.ritholtz.com/blog/2009/06/repayments-confirm-tarp-ruse/
"It was $700 billion dollar pile of money in search of a justification for its existence.
Most people still look at TARP the wrong way. When trying to discern what the true basis of it was, we eliminated what made no sense whatsoever, and what was left were a few strange ideas. When you eliminate the impossible, what’s left, no matter how improbable, becomes the best explanation.
What was that explanation? In Bailout Nation, we discuss the possibility that The TARP was all a giant ruse, a Hank Paulson engineered scam to cover up the simple fact that CitiGroup (C) was teetering on the brink of implosion. A loan just to Citi alone would have been problematic, went this line of brilliant reasoning, so instead, we gave money to all the big banks"
Oh, that explains it.
Shamus Cooke writes on Global Research:
"History will likely show that these bailouts involved the largest transfer of wealth ever - from the working class to that small group of billionaires who own the corporations. This fact is recognized by most people now and is such common knowledge that even the mainstream media feels comfortable discussing it… matter-of-factly.
These corporations have also exerted tremendous influence in other realms of politics, working towards destroying Obama’s campaign promises of health care, job creation, civil liberties, the Employee Free Choice Act, peace, etc.
In each case, the promised reform was gutted of its essence, and “compromise” versions of the bills are now being discussed: instead of universal health care, we will likely be universally mandated to purchase health insurance; instead of ‘job creation’ we are told that the stimulus has “saved jobs” (contrary to the evidence); while troops are “drawing down” from Iraq, the war in Afghanistan/Pakistan is being escalated; instead of allowing workers to organize unions easier, a compromise version of ‘Employee Free Choice Act,’ minus card check - seems more politically ‘pragmatic,’ etc."
At the heart of the crisis is the plight of homeowners who we know were defrauded in large numbers, victims like the Madoff investors. Yet the former are getting reimbursed to some degree, the latter are not. Bills to help them have been killed with Matt Renner on Truthout reporting:
"A new analysis from a government watchdog group shows senators who killed off a consumer-friendly change in law aimed at addressing the foreclosure crisis received more money in campaign contributions from the industries their vote aided. Senators who voted against the consumer-friendly amendment received $3.98 million from the financial industry during the 2008 election cycle, while proponents of the bill received $2.65 million.”
Could this be more corruption? Of course, but they call it politics as usual. And, that’s not the worst of it, foreclosures are still rising and now affecting non-subprime lenders with little relief in sight.
Back to the banks: I have been reading complex web posts showing how the stress tests of banks were rigged and more may be needed. I have been reading about how the unemployment figures undercount folks out of work with the real numbers probably doubled, with minorities possibly tripled. I have been reading essays arguing that the notion that the government is "saving jobs" is not quantifiable with any statistical back up. I have been following the campaign to get the Federal Reserve Bank to disclose its showering of money on financial institutions - something it refuses to do.
Who can we trust and bank on? The President wants to give us confidence but seems to be playing a confidence game. The Banks are dissembling when they are not lying. The most trenchant critics - may they be wrong - believe a total collapse is in the offing.
And the rest of us, mostly puzzled and paralyzed, unable to comprehend the severity of the situation, the billions, no make that trillions, gone. How do we make sense of the game playing in State Governments like those in California and New York which lead to a caricature of responsibility? The jobs are going and the Banksters are still going for it, sucking up what they can in a race to the bottom.
Who Can We Trust? Who Can We Bank On? You tell me.
Paul Krugman's fear for lost decade
As analysts and media hailed the tentative emergence of green shoots last week, Nobel Prize-winning economist Paul Krugman caused international shock with a prediction that the world economy would stagnate just as badly, and for just as long, as Japan's did in the 1990s. In an exclusive interview, he talks to Will Hutton about his anxiety for the future - and how Gordon Brown might have saved Britain from the blight that hangs over the West
Will Hutton: You are warning that what happened to Japan could happen to the whole world. Japan's GDP at the end of this year will be no higher than it was in 1992 - 17 lost years. You are saying that this is an ongoing risk, certainly for the North Atlantic economy - maybe the world economy.
Paul Krugman: Yes. It's not that the risk of the Japan syndrome has receded very much. The risk of a full, all-out Great Depression - utter collapse of everything - has receded a lot in the past few months. But this first year of crisis has been far worse than anything that happened in Japan during the last decade, so in some sense we already have much worse than anything the Japanese went through. The risk for long stagnation is really high.
WH: So what is the heart of your pessimism? The bust banking system? A critic would say: "Hold on, Paul Krugman. Japan is a special case. It had an overblown export sector that had become too large for an American market it had saturated. The yen was very, very overvalued. And this interacted with a credit crunch and bust banking system. Its policy response was consistently behind the curve. That's not the story of the United States or the United Kingdom."
PK: The thing about Japan, as with all of these cases, is how much people claim to know what happened, without having any evidence. What we do know is that recessions normally end everywhere because the monetary authority cuts interest rates a lot, and that gets things moving. And what we know in Japan was that eventually they cut their interest rates to zero and that wasn't enough. And, so far, although we made the cuts faster than they did and cut them all the way to zero, it isn't enough. We've hit that lower bound the same as they did. Now, everything after that is more or less speculation.
For example, were the problems with the Japanese banks the core problem? There are some stories about credit rationing, but they are not overwhelming. Certainly, when we look at the Japanese recovery, there was not a great surge of business investment. There was primarily a surge of exports. But was fixing the banks central to export growth?
In their case, the problems had a lot to do with demography. That made them a natural capital exporter, from older savers, and also made it harder for them to have enough demand. They also had one hell of a bubble in the 1980s and the wreckage left behind by that bubble - in their case a highly leveraged corporate sector - was and is a drag on the economy.
The size of the shock to our systems is going to be much bigger than what happened to Japan in the 1990s. They never had a freefall in their economy - a period when GDP declined by 3%, 4%. It is by no means clear that the underlying differences in the structure of the situation are significant. What we do know is that the zero bound is real. We know that there are situations in which ordinary monetary policy loses all traction. And we know that we're in one now.
WH: So your point is that the crisis in Japan was about excess debt, excess leverage and lack of demand - reinforced by the fallout from the asset bubble collapsing. They didn't have credit contraction on anything like our scale, but even so, zero interest rates were just unable to turn the economy around.
PK: That's right, that's right.
WH: But an optimist would say that there are signs all around of the traction that you say doesn't exist is working. The stockmarkets in London and Wall Street - along with most world markets - are up a solid 20% to 25%. You've got all these improving business confidence indicators. You've got the first signs of the housing market bottoming in both the UK and the United States. This is what the optimists would tell you.
PK: But all of that points to levelling off, rather than an actual recovery. Britain's looking the best among the major European economies because it's got a PMI [purchasing managers' index, a key measure of economic sentiment] that's just above 50. In other words, Britain actually may have stopped contracting - that's the most positive thing one can say.
Who knows if the stockmarket makes sense or not? It was pricing in the possibility of an apocalypse a few months ago. That possibility seems to have receded, so it makes sense for the markets to come up, but that's not saying that the economy is going to be great. If you do the comparison not with where they were three months ago, but where they were two years ago, then the markets still seem awfully depressed.
I hope I'm wrong but the question you always have to ask is: where do we think that this recovery's going to come from? It's not an easy story to tell.
WH: In your lectures, you drew attention to the importance of stressed balance sheets holding back consumers and business alike in their likely spending ambitions - and thus dragging back economic activity. Is this going to be a balance-sheet-constrained recovery?
PK: It's probably true that households have been impoverished a lot by the fall of the housing and stock prices. And that it's likely that households, with all of this debt, are going to have trouble spending. And yes, the North Atlantic economy was supported quite a lot by gigantic housing booms. Here in the UK you have had the house price surge without very much construction. Economists have a well-developed theory about how balance-sheet problems can cause financial and economic crises, but we thought of it in terms of third world countries with foreign-currency debt. We didn't realise that there were lots of other ways in which that can happen.
WH: So, one way to think about it is that self-reinforcing financial crises rooted in overstretched, overborrowed companies and governments in less developed countries - like those in Argentina and Indonesia, which were amazingly destructive in the 1990s and 2000s, but localised - are now playing out in the developed world?
PK: There are really two stories. One is the Japan-type story where you run out of room to cut interest rates. And the other is the Indonesia- and Argentina-type story where everything falls apart because of balance-sheet problems.
WH: So in a nutshell your story is ...
PK: The "Nipponisation" of the world economy with a bunch of "Argentinafications" playing a role in the acute crisis. But even after those are over, we have the Nipponisation of the world economy. And that's really something.
WH: What was the heart of the Japanese problem? What was at the heart of their 17 years of going nowhere?
PK: Well, my guess is that it was that the balance-sheet problems took a very long time to resolve. And it is difficult to get enough demand in an economy where you have really very adverse demography ...
WH: So, which countries look closest to being Nipponised - combining balance-sheet problems and ageing populations?
PK: Well, the US doesn't have the same combination. But in Europe, Germany and Italy look comparable. France is better and Europe as a whole is considerably better.
WH: Germany matches Japan to an uncanny degree. You talk about the Nipponisation of the world economy: I'm not so sure. But I would talk about the Nipponisation of Europe via a German economy at its centre in the grip of the same problem - and that starts to be a global problem.
PK: Germany has huge inadequacy of domestic demand. Their economic recovery in the first seven years of this decade rested on the emergence of gigantic current account surplus.
How is it possible that Germany, which did not have a house price bubble, is having a steeper GDP fall than anyone else in the major economies?
The answer is that they depended upon exporting to the bubble regions of Europe, so they actually got side-swiped by the loss of those exports worse than the bubble regions themselves got hit.
It's Germany on a global scale that is the concern. We worry about the drag on world demand from the global savings coming out of east Asia and the Middle East, but within Europe there's a European savings glut which is coming out of Germany. And it's much bigger relative to the size of the economy.
WH: And on top there is an unique and unaddressed huge potential banking crisis. The Germans pride themselves on their three-legged banking system, but it is incredibly interlinked. The IMF warns that Germany could have to take at least $500bn of writedowns, which its banks have not begun to recognise. German banks hold a trillion dollars - maybe more - of maturing collateralised debt obligations that can only be refinanced by crystallising the losses. We've had RBS and you've had Citigroup. Germany's GDP will fall 6% this year - before the banking crisis has hit it.
PK: Yeah, that's the financial view. Its important to keep track of the financial state of the banks. But one always has to keep track of the real side of the economy, too. It is a hypothesis that the problem is essentially financial. But it is by no means a hypothesis that we know is true.
WH: So even after what we've gone through, you say it's just a hypothesis that the cause of the crisis is financial?
PK: That the cause is primarily financial. Certainly, Lehman and all of that alerted us all. And it did trigger an immediate drop in demand. But the housing bust was going to happen regardless.
The fall in business investment is at least to a large degree a response to excess capacity, which is the result of falling consumer demand and the housing bust. So we don't know.
WH: I think we know more than that. The links between bank capital, loan losses, credit availability and economic activity and asset prices have never been clearer. That was why there was a threat of Depression.
PK: Clearly, re-establishing stability in the financial markets is a necessary condition for recovery. But we're not sure it's sufficient.
WH: That's very scary.
PK: Well, that is part of the reason why I am so depressed.
WH: In one of your lecture charts you seemed to be suggesting that we're 12 months into what you think could be a 36-month period of downturn, albeit at a slower rate.
WH: It's quite shocking that you think it will be that severe.
PK: If we measure the 2001 US recession by when the labour market finally started to turn around, it was a 30-month recession. It was really 30 months in before you started to see the unemployment rate come down.
WH: In Britain, there is now a new consensus forming that the government's economic forecasts, which were roundly mocked at the time of the April budget for being wildly optimistic, could be right - that is, growth will start to resume in 2010, albeit at a very low rate.
PK: Well, the UK has achieved a lot of monetary traction in the way that no one else has through the depreciation of the pound. In effect, you've carried out a successful beggar-my-neighbour devaluation.
WH: So, the United Kingdom might actually get through this in reasonably good shape?
PK: Yeah. That's why I've been watching with an outsider's slight puzzlement, your bizarre political circus.
WH: Darling and Brown deserve more credit than they're given?
PK: If the government can hold off having an election until next year, Labour might well be able to run as "we're the people who brought Britain out of the slump".
WH: So your advice to the Labour Party is: hold steady.
PK: I don't know enough about the other aspects of politics, but I would guess that the option value is quite high that the economy might actually have turned a corner. That's unique. That's a uniquely British thing. None of the other G7 countries has anything like that.
WH: And that's a combination of our big beggar-our-neighbour devaluation, aggressive monetary policy, successfully recapitalising our banks and our fiscal policy.
PK: There hasn't been very much discretionary fiscal expansion when all's said and done.
WH: Well, there was a £20bn temporary cut in VAT.
WH: Which is non-trivial.
PK: Non-trivial. But not much [other spending], as I understand.
WH: Well, there was bringing forward £3-4bn of capital spending. Perhaps together in a full year the stimulus was 1.5% GDP. Maybe 2% at the outside.
PK: Monetary policy has been more aggressive - though maybe less than the Fed - and the depreciation of the pound is a nice thing from a UK point of view.
WH: So you remain committed to the key role of fiscal policy?
PK: Yeah. Fiscal policies are best; certainly something to do to mitigate recession. People say that the Japanese fiscal policy on all that infrastructure was wasted. But it did help sustain the economy and avoid a collapse. Fiscal policy can certainly do that: it gives the credit sector time to rebuild its balance sheets. There's every reason to be expansive around the fiscal side now because even if you're not sure that it provides a long-term solution, avoiding catastrophe is a big thing to do.
WH: If you believe that, is Obama doing enough on fiscal policy?
PK: Well we have a stimulus which is a little over 5% of one year's GDP but some of it is not real - something that was going to happen anyway and not very stimulative. So it's really about 4% of GDP of genuine stimulus, but spread over two and a half years. So, it's actually quite a lot less than what I was arguing for.
WH: So, will it be sufficient?
PK: Well, sufficient to actually restore full employment would probably have to be 5% or more. More than we have would certainly be a good thing. It actually might happen. You know, the buzz I'm getting is that a second-round stimulus might well come on the agenda.
WH: Really? When you say "the buzz you're getting", have you been asked?
PK: Well, it's what you hear from people who talk to people who talk to people.
WH: Who would argue for that? Would it be Larry Summers [director of the US National Economic Council]?
PK: I think Larry. I'm not sure Tim Geithner [US treasury secretary] would be opposed to it. Nor would Chrissie [Christine Romer, director of the Council of Economic Advisers] I'm sure they would be making similar judgements. It is actually a little spooky.
WH: They're all people you know pretty well, who look at the world the same way, use the same tools and framework ...
PK: Yeah. They may be sitting where they are, having some differences. Larry's always more conventional than I am. Sometimes rightly. Sometimes wrongly. But they do operate in the same framework.
WH: How seriously do you take the argument that the growth of public debt on this scale will crowd out the spontaneous amount of growth of corporate and private debt? Is this already happening with the rise in long-term interest rates in the US?
PK: The thing about long-term interest rates is that they are a weighted average of future expected short-term interest rates. Movements in long-term rates are mostly about what people think the short rates are going to be. Look, real rates are barely up at all. What seems to have moved up is the expected rate of inflation, which is still below the Fed target. So it's more like what the markets are doing is reducing their discounting of deflationary catastrophe.
WH: how do you see the politics working out in the States and in the UK now? Your praise of Gordon Brown after the banks in October were recapitalised was front-page news. Are you still as well disposed?
PK: I still think his economic policies have been pretty good. They really kind of lost their nerve on fiscal policy, but I do understand it's harder to do it here. I think the UK economy looks the best in Europe at the moment. I have no position on all of the crazy stuff. But I think the policies are intelligent. The fact of the matter is that Britain did manage to stabilise the banking situation. I'm not ecstatic, but I'm not sure I know what I could have done better.
WH: So where are you on the debate about various shape recoveries? V-shaped? L-shaped ? A W-shaped recovery?
PK: There is a possibility that we get some perk-up as the stimulus dollars start to flow and an almost mechanical bounceback in industrial production as inventories are built up. But then we slide down again. The idea that we sort of bounce along the bottom is all too easy to imagine.
WH: Is it just a story about the right dose of fiscal policy? What structural change would you advocate in the economy, to support recovery?
PK: Financial regulation. Rein in that monster. The huge increase in general private-sector leverage is at the core of how we got so vulnerable. We went for 50 years after the Great Depression without any major financial crises, and that, I think, was because we had a financial sector that didn't let people get as deeply into debt as they have now.
WH: So rein in the financial monster and give a fiscal stimulus. So you would leave the American way of doing capitalism untouched?
PK: I'm not that cosmic in this stuff. But it is true that Gordon Gekko [the anti-hero of Oliver Stone's film Wall Street, motto: Greed is Good] went hand in hand with the wave of financialisation. Corporations got more brutal and fiercer.
WH: But it is all connected. Without the leverage, there would have been no Gordon Gekkos. And leverage meant that predator companies had the firepower to launch contested hostile takeovers. The only way to fend off attack, or to make the sums work after an attack, was for companies to be more brutal and fierce - often breaking the promises to staff and suppliers that kept commitment and trust.
PK: All of that is true. I have a more mundane view about what we do. I just want a stronger welfare state and a little bit more social democracy. And some restoration of the labour movement as a counterweight.
I'm not sure - maybe I'm just not thinking about it deeply enough. I guess I've got the same attitude Keynes had, which was he was looking for almost technical fixes. You're looking for ways to fix the parts that have gone wrong rather than replace the whole thing.
You know the human cost of this crisis is vastly worse in America than it is on this side of the Atlantic. So this is a good time to push for a better US social safety net too.
WH: And lastly - you've been critical about Obama. Your view now?
PK: I'm increasingly happy with him. I was unhappy; I think they could have gotten a bigger stimulus coming out the gate. But they've become more forceful. I would have been more aggressive on the banks; we'll see if we need to re-fight that battle later on.
Healthcare is looking really good. I'm getting increasingly optimistic on healthcare reform. Climate change looks like it's going to happen. So my odds that this will in fact be the kind of New Deal I was hoping for are rising. I had my scepticism, but he is smart. He's impressive. And it is such a relief to have somebody whom you can respect in the White House.
Dead Banks Walking
It's widely acknowledged that hundreds if not thousands of banks are on the ropes and just waiting for regulators to wrap them in yellow tape some Friday evening. However, fewer than forty US banks have been seized this year. The Federal Deposit Insurance Corporation (FDIC) list of problem banks grew to 305 in the first quarter, the highest number since 1994, but of course the names of those banks are not released so that depositors can be forewarned.
The assets of those troubled banks total $220 billion, while the FDIC's deposit-insurance fund has fallen to $13 billion. Not to fear: the Treasury Department tripled the FDIC's line of credit to $100 billion in preparation for more losses. So, including the line of credit from taxpayers, the FDIC has just over two cents of reserves to cover each dollar it is insuring. Sure, the FDIC is not yet staffed up to close down the sick banks as fast as they would like to, but how do these banks remain liquid enough to keep operating?
After all, savvy customers surely must study bank balance sheets and income statements to know where to safely place their funds. Doesn't the average bank depositor know the loan portfolio concentrations and past-due loan balances of their friendly neighborhood bank, only placing their funds in the safest of banks, leaving the worst banks to quickly run out of money and fail? Perhaps the most naive believe that.
Bernard Condon's "The Reverse Bank Run" article on Forbes.com explains that with increased FDIC deposit-insurance limits in place (up to $250,000 for interest-bearing deposit accounts), Americans seeking high yields on their money are causing deposits at struggling banks to mount in seeming lockstep with their troubles. The result is that banks that should fail are sticking around longer, making the cleanup when they do more costly.
There is no incentive for bank depositors to go to the trouble of determining a bank's soundness if the government is going to guarantee deposits. Not to mention that most folks aren't equipped for the job anyway. On the other hand, if a legitimate banking system were in place, it would be based upon honoring property rights. Customers making a deposit in a bank expect the bank to guard, protect, and return their money — at a moment's notice in the case of demand deposits. After all, that person has not traded a present good for a future good. The depositors believe the bank is warehousing the money for them and that it is available to them at any time. This deposit is not a loan — there is no fixed term, which would be required in the case of a loan — and availability hasn't transferred.
However, we don't have legitimate deposit banking but a fractionalized banking system that combines deposit banking with loan banking. Those that sympathize with fractionalized banking will contend that time certificate of deposit accounts are in essence loans from depositors, entitling the bankers to use the funds at their discretion for the term of the CD — just as long as the banker has the money ready when the CD matures. But if the money is lent secured by illiquid assets such as real estate, the banker is clearly not counting on those loans to satisfy expiring CDs and must count on attracting new CD money to pay off the old.
Bankers, pressured to earn returns for shareholders and protected from bank runs by FDIC insurance, have over time lent not only more of their deposits but advanced the money for riskier projects. James Grant in a recent Grant's Interest Rate Observer reminisced about National City Bank, which back in 1954 had only lent out 41 percent of its deposits, with less than one percent of the portfolio being real-estate loans. By the end of last year, the total loan-to-deposit ratio for all US banks and thrifts was 87 percent, and 60 percent of all loans were classified as real-estate secured.
Instead of guarding the safety of deposits, banks embezzle the deposits and lend them out. The recently failed Silverton Bank in Atlanta lent its deposits on construction projects that turned out to be duds. Yet, as the bank was spiraling toward failure, its brokered deposits, described by Forbes's Condon as "money pooled from rich folks then shopped around for higher rates," quadrupled. The Forbes article cites three banks whose brokered deposits doubled or tripled in the months leading up to their seizure by banking authorities.
Problem banks desperately need deposits to stay afloat and thus they pay the highest rates, "and many people apparently either don't know about the [bank's] troubles or, more likely, don't care," Condon writes, because the FDIC has committed to covering deposits within its insurance limits. RBC Capital's Gerald Cassidy, who is predicting that there will be over 1,000 bank failures, half-jokingly says that he scans Bankrate.com to identify the highest rate payers to determine which banks will fail next, according to Condon.
High on this list is Chicago-based Corus Bankshares, which is paying a half a percentage point higher for deposits than its competitors. During the boom, Corus was an aggressive high-rise-condo-construction lender and reportedly nearly half its loan portfolio is now nonperforming. Condon also mentions the Federal Home Loan Banks that have provided funding during the property mania, when deposits were scarce or expensive. "The FHLB is a welfare-state institution to the bone," wrote John Paul Koning in his Mises Daily article entitled "The Federal Home Loan Banks to the Rescue!" in late 2007. As Koning explained, the FHL Banks raise money by issuing bonds at low rates because "investors assume the FHLBank debt has a federal government guaranty," as was the case with Fannie Mae and Freddie Mac.
This cheap money is then lent to the banks, providing banks and thrifts "with a steady and hassle-free flow of credit at subsidized rates." So while an aggressive FHLB helped fuel the real-estate boom, Koning puts his finger on another factor that's making current bank failures costly to the FDIC fund: when FHL Banks make loans to banks, they take a lien on many of the banks' loans. Thus, when a bank fails, the FHLB will take possession of those loans that collateralized their advance, making them unavailable to the FDIC to sell in order to make depositors whole when it liquidates a failed bank. "This makes it more likely that, in the case of multiple bank failures, FDIC will not get a large enough slice of the pie to pay off insured depositors," Koning explains.
It is no wonder that the losses from recently failed banks equal a third of seized assets, which Condon points out is double the level from the 1990s banking crises. These losses lead Bud Conrad with Casey Research to the conclusion that the FDIC is in trouble. And that the deposit insurer and bank regulator will be bailed out with hundreds of billions in new funding from the taxpayer or the central bank. "Another bale of straw on the camel's back," Conrad writes, "and another reason to be concerned about holding paper dollars for the long term."
To keep today's zombie banks alive, massive amounts of government intervention have been required. In last fall's panic, the Fed wheeled out the Money Market Investor Funding Facility and the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility. It raised the ceiling on insured deposits from $100,000 to $250,000; guaranteed new debt issuance of banks, thrifts, and holding companies, providing full insurance for any and all noninterest bearing deposits; and the Treasury issued a blanket guarantee of money-market fund liabilities. Ultimately the government took equity stakes in a number of larger banks.
Jesus Huerta de Soto explains in his book Money, Bank Credit, and Economic Cycles that, ultimately, fractional reserves cannot survive economically on their own and must be supported by government force in the form of a central bank that institutes the regulations and supplies the liquidity necessary at all times to prevent the entire apparatus from collapsing. Although ostensibly it is dodgy real-estate loans that are bringing the banks down, it is really the fraudulent nature of the fractionalized banking system, described by Murray Rothbard in The Mystery of Banking as "the pernicious and inflationary domination of the state," that is the real culprit.
When loans without the backing of real savings "foster the foolish investment of resources and give rise to unwisely invested business assets which are either worthless or of limited value and therefore incapable of balancing the corresponding deposit accounts on bank balance sheets," Huerta de Soto writes, bank insolvencies tend to occur. Bank regulators accuse failing banks of operating in an "unsafe and unsound" manner. But what is "unsafe and unsound" is fractionalized banking, the lending out of embezzled deposits with the state's permission.
Too Poor to Make the News
The human side of the recession, in the new media genre that’s been called "recession porn," is the story of an incremental descent from excess to frugality, from ease to austerity. The super-rich give up their personal jets; the upper middle class cut back on private Pilates classes; the merely middle class forgo vacations and evenings at Applebee’s. In some accounts, the recession is even described as the "great leveler," smudging the dizzying levels of inequality that characterized the last couple of decades and squeezing everyone into a single great class, the Nouveau Poor, in which we will all drive tiny fuel-efficient cars and grow tomatoes on our porches.
But the outlook is not so cozy when we look at the effects of the recession on a group generally omitted from all the vivid narratives of downward mobility — the already poor, the estimated 20 percent to 30 percent of the population who struggle to get by in the best of times. This demographic, the working poor, have already been living in an economic depression of their own. From their point of view "the economy," as a shared condition, is a fiction.
This spring, I tracked down a couple of the people I had met while working on my 2001 book, "Nickel and Dimed," in which I worked in low-wage jobs like waitressing and housecleaning, and I found them no more gripped by the recession than by "American Idol"; things were pretty much "same old." The woman I called Melissa in the book was still working at Wal-Mart, though in nine years, her wages had risen to $10 an hour from $7. "Caroline," who is increasingly disabled by diabetes and heart disease, now lives with a grown son and subsists on occasional cleaning and catering jobs. We chatted about grandchildren and church, without any mention of exceptional hardship.
As with Denise Smith, whom I recently met through the Virginia Organizing Project and whose bachelor’s degree in history qualifies her for seasonal $10-an-hour work at a tourist site, the recession is largely an abstraction. "We were poor," Ms. Smith told me cheerfully, "and we’re still poor." But then, at least if you inhabit a large, multiclass extended family like my own, there comes that e-mail message with the subject line "Need your help," and you realize that bad is often just the stage before worse. The note was from one of my nephews, and it reported that his mother-in-law, Peg, was, like several million other Americans, about to lose her home to foreclosure.
It was the back story that got to me: Peg, who is 55 and lives in rural Missouri, had been working three part-time jobs to support her disabled daughter and two grandchildren, who had moved in with her. Then, last winter, she had a heart attack, missed work and fell behind in her mortgage payments. If I couldn’t help, all four would have to move into the cramped apartment in Minneapolis already occupied by my nephew and his wife. Only after I’d sent the money did I learn that the mortgage was not a subprime one and the home was not a house but a dilapidated single-wide trailer that, as a "used vehicle," commands a 12-percent mortgage interest rate. You could argue, without any shortage of compassion, that "Low-Wage Worker Loses Job, Home" is nobody’s idea of news.
In late May I traveled to Los Angeles — where the real unemployment rate, including underemployed people and those who have given up on looking for a job, is estimated at 20 percent — to meet with a half-dozen community organizers. They are members of a profession, derided last summer by Sarah Palin, that helps low-income people renegotiate mortgages, deal with eviction when their landlords are foreclosed and, when necessary, organize to confront landlords and bosses.
The question I put to this rainbow group was: "Has the recession made a significant difference in the low-income communities where you work, or are things pretty much the same?" My informants — from Koreatown, South Central, Maywood, Artesia and the area around Skid Row — took pains to explain that things were already bad before the recession, and in ways that are disconnected from the larger economy. One of them told me, for example, that the boom of the ’90s and early 2000s had been "basically devastating" for the urban poor. Rents skyrocketed; public housing disappeared to make way for gentrification.
But yes, the recession has made things palpably worse, largely because of job losses. With no paychecks coming in, people fall behind on their rent and, since there can be as long as a six-year wait for federal housing subsidies, they often have no alternative but to move in with relatives. "People are calling me all the time," said Preeti Sharma of the South Asian Network, "They think I have some sort of magic."
The organizers even expressed a certain impatience with the Nouveau Poor, once I introduced the phrase. If there’s a symbol for the recession in Los Angeles, Davin Corona of Strategic Actions for a Just Economy said, it’s "the policeman facing foreclosure in the suburbs." The already poor, he said — the undocumented immigrants, the sweatshop workers, the janitors, maids and security guards — had all but "disappeared" from both the news media and public policy discussions.
Disappearing with them is what may be the most distinctive and compelling story of this recession. When I got back home, I started calling up experts, like Sharon Parrott, a policy analyst at the Center on Budget and Policy Priorities, who told me, "There’s rising unemployment among all demographic groups, but vastly more among the so-called unskilled."
How much more? Larry Mishel, the president of the Economic Policy Institute, offers data showing that blue-collar unemployment is increasing three times as fast as white-collar unemployment. The last two recessions — in the early ’90s and in 2001 — produced mass white-collar layoffs, and while the current one has seen plenty of downsized real-estate agents and financial analysts, the brunt is being borne by the blue-collar working class, which has been sliding downward since deindustrialization began in the ’80s.
When I called food banks and homeless shelters around the country, most staff members and directors seemed poised to offer press-pleasing tales of formerly middle-class families brought low. But some, like Toni Muhammad at Gateway Homeless Services in St. Louis, admitted that mostly they see "the long-term poor," who become even poorer when they lose the kind of low-wage jobs that had been so easy for me to find from 1998 to 2000. As Candy Hill, a vice president of Catholic Charities U.S.A., put it, "All the focus is on the middle class — on Wall Street and Main Street — but it’s the people on the back streets who are really suffering."
What are the stations between poverty and destitution? Like the Nouveau Poor, the already poor descend through a series of deprivations, though these are less likely to involve forgone vacations than missed meals and medications. The Times reported earlier this month that one-third of Americans can no longer afford to comply with their prescriptions. There are other, less life-threatening, ways to try to make ends meet. The Associated Press has reported that more women from all social classes are resorting to stripping, although "gentlemen’s clubs," too, have been hard-hit by the recession. The rural poor are turning increasingly to "food auctions," which offer items that may be past their sell-by dates.
And for those who like their meat fresh, there’s the option of urban hunting. In Racine, Wis., a 51-year-old laid-off mechanic told me he’s supplementing his diet by "shooting squirrels and rabbits and eating them stewed, baked and grilled." In Detroit, where the wildlife population has mounted as the human population ebbs, a retired truck driver is doing a brisk business in raccoon carcasses, which he recommends marinating with vinegar and spices.
The most common coping strategy, though, is simply to increase the number of paying people per square foot of dwelling space — by doubling up or renting to couch-surfers. It’s hard to get firm numbers on overcrowding, because no one likes to acknowledge it to census-takers, journalists or anyone else who might be remotely connected to the authorities. At the legal level, this includes Peg taking in her daughter and two grandchildren in a trailer with barely room for two, or my nephew and his wife preparing to squeeze all four of them into what is essentially a one-bedroom apartment. But stories of Dickensian living arrangements abound.
In Los Angeles, Prof. Peter Dreier, a housing policy expert at Occidental College, says that "people who’ve lost their jobs, or at least their second jobs, cope by doubling or tripling up in overcrowded apartments, or by paying 50 or 60 or even 70 percent of their incomes in rent." Thelmy Perez, an organizer with Strategic Actions for a Just Economy, is trying to help an elderly couple who could no longer afford the $600 a month rent on their two-bedroom apartment, so they took in six unrelated subtenants and are now facing eviction. According to a community organizer in my own city, Alexandria, Va., the standard apartment in a complex occupied largely by day laborers contains two bedrooms, each housing a family of up to five people, plus an additional person laying claim to the couch.
Overcrowding — rural, suburban and urban — renders the mounting numbers of the poor invisible, especially when the perpetrators have no telltale cars to park on the street. But if this is sometimes a crime against zoning laws, it’s not exactly a victimless one. At best, it leads to interrupted sleep and long waits for the bathroom; at worst, to explosions of violence. Catholic Charities is reporting a spike in domestic violence in many parts of the country, which Candy Hill attributes to the combination of unemployment and overcrowding.
And doubling up is seldom a stable solution. According to Toni Muhammad, about 70 percent of the people seeking emergency shelter in St. Louis report they had been living with relatives "but the place was too small." When I asked Peg what it was like to share her trailer with her daughter’s family, she said bleakly, "I just stay in my bedroom." The deprivations of the formerly affluent Nouveau Poor are real enough, but the situation of the already poor suggests that they do not necessarily presage a greener, more harmonious future with a flatter distribution of wealth. There are no data yet on the effects of the recession on measures of inequality, but historically the effect of downturns is to increase, not decrease, class polarization.
The recession of the ’80s transformed the working class into the working poor, as manufacturing jobs fled to the third world, forcing American workers into the low-paying service and retail sector. The current recession is knocking the working poor down another notch — from low-wage employment and inadequate housing toward erratic employment and no housing at all. Comfortable people have long imagined that American poverty is far more luxurious than the third world variety, but the difference is rapidly narrowing.
Maybe "the economy," as depicted on CNBC, will revive again, restoring the kinds of jobs that sustained the working poor, however inadequately, before the recession. Chances are, though, that they still won’t pay enough to live on, at least not at any level of safety and dignity. In fact, hourly wage growth, which had been running at about 4 percent a year, has undergone what the Economic Policy Institute calls a "dramatic collapse" in the last six months alone. In good times and grim ones, the misery at the bottom just keeps piling up, like a bad debt that will eventually come due.
Awaiting a Rebound, Back With the Folks
I’ve been a mortgage broker in the Phoenix area for 15 years. In April 2007, the company I had been with for a year went out of business. That was the latest of four companies I’ve worked for since 2000. They all either went under or let most of the staff go, including me. In December 2007, the bank foreclosed on my house, and I had no choice but to move in with my parents, five miles away. My sister has three children, and she had no room. My fiancée, Brandi Wetch, and I have been living in my parents’ house for about a year and a half now.
When I asked my mother if we could move in, she said, "Of course." My father left for a job in the Marshall Islands a few months ago and will be gone for two years. Still, my house was 5,000 square feet and my parents’ house is 1,100, so even with one less person it’s crowded. I also brought my two dogs with me. I worked on a 1099 instead of a W-2, so I wasn’t eligible for unemployment, but I have health insurance through a state program. I’m trying to be patient about finding a new job, but it’s been tough.
I’m beyond bored at this point. I check the Internet for jobs every morning, but I apply and never get a response. It’s frustrating. I have no idea how many other people are applying for the same job. I take the dogs for a lot of walks, too. I can’t do much socially because money is tight, so I’ve been somewhat isolated, like a monk. I like golf, but I haven’t been able to play this whole time. I do the housework and the laundry, and I maintain the lawn. My mother, Sue, who is retired, works part-time at a Bible school library. Brandi got a job at Home Depot for now. She was a mortgage processor before being laid off in 2007.
I’m not above taking a job that pays $10 an hour, but I’m focused on finding one that will allow us to have a house again, even if we just rent one. I want a job that will get us out of this situation. It may come down to applying for a $10-an-hour job, but I’m putting it off. Working at a job like that takes time away from hunting for a better one. I’d rather have the time so I can keep looking. I’ve even tried new fields. I was accepted into a training program for the Postal Service last year, but it didn’t work out. On the last day of the driving test, I hit a parking cone and was fired on the spot. I can try again, but I have to wait a year to retake the written test and then hope I’m chosen for the driving test.
I also tried an insurance company but that didn’t work out, either. It’s very discouraging. Life seems smaller living day-to-day like this. Sometimes it feels like the best part of my life is over. The worst part of the day is when I wake up to the same old thing. Some people might like the lack of structure, but it gets old. Having a job gives you a purpose; not having one makes me feel like I’m not part of the world. I miss the interaction with other people.
I joined Facebook about a month ago and have reconnected with friends from high school and college, which has lifted my spirits. Some people have left their phone numbers, and I’ve started calling. I’ve talked to about 10 old friends and acquaintances. The first thing they usually ask is what I’m doing now. I just say I’m still kind of in the mortgage business. I’ve told one person that I’m not working and I’ve moved back in with my parents, but I try to skip over that fact with everyone else. I just want to get past the subject and move on. It’s not something people need to know. If someone else is out of work, I tell them to hang in there.
I’m still hoping that the mortgage business will take off again. I’m talking to a couple of mortgage companies about working for them. F.H.A. loans were my bread and butter, and people seem interested in refinancing their homes lately, so I’m optimistic. Our elected officials are trying to fix this mess, and Congress may come through with some helpful programs. It’s scary, but it’s out of my control. I’m trying to be philosophical.
I never saw this recession coming. I made great money when times were good, but I spent a lot. I helped my family buy the house I’m living in, and I wasn’t a good investor. When the economy comes back, I’m going to be a smarter investor. My mother, who is in her 60s, has been so patient and supportive. She acts like she’s happy to have us, not like we’re crowding her or that she minds the dogs. We have learned what’s important since I’ve been living here.
Where Are We Now? Five Point Summary
1. Financial markets have stabilized – largely because people believe that the government will not allow Citigroup to fail. We have effectively nationalized any banking system losses, but we’ll let bank executives enjoy the full benefits of the upside. How much shareholders participate remains to be seen; there will be no effective reining in of insider compensation.
2. The real economy begins to bottom out, although unemployment will not peak for a while and could stay high for several years. Longer term growth prospects remain uncertain – has consumer behavior really changed; if finance doesn’t drive growth, what will; is the budget deficit under control or not (note: most of the guarantees extended to banks and other financial institutions are not scored in the budget)?
3. More broadly, there is sophisticated window dressing in the pipeline but no real reform on any issue central to (a) how the banking system operates, or (b) more broadly, how hubris in finance led us into this crisis. The financial sector lobbies appear stronger than ever. The administration ducked the early fights that set the tone (credit cards, bankruptcy, even cap and trade); it’s hard to see them making much progress on anything – with the possible exception of healthcare.
4. The consensus from conventional macroeconomics is that there can’t be significant inflation with unemployment so high, and the Fed will not tighten before late 2010. The financial markets beg to differ – presumably worrying, in part, about easy credit leading to dollar depreciation, higher import prices, and potential commodity price inflation worldwide. In all recent showdowns with standard macro models recently, the markets’ view of reality has prevailed. My advice: pay close attention to oil prices.
5. Emerging markets are increasingly viewed as having "decoupled" from the US/European malaise. This idea was wrong in early 2008, when it gained consensus status; this time around, it is probably setting us up for a new bubble – based on a "carry trade" that now runs out of the US. The "appetite for risk" among investors is up sharply. The G7/G8/G20 is back to being irrelevant or merely cheerleaders for the financial sector.
The Bubble Next Time
Ben Bernanke gave a great speech in 2002, mapping out exactly what the Fed should do if the United States faced a deflationary price spiral — falling wages and prices — that could wreak havoc on the economy. He outlined a series of steps: starting with lowering short-term interest rates to zero, then making purchases of longer-dated Treasury securities, then purchasing securities issued by Fannie Mae and Freddie Mac. All of this is has come to pass since mid-2007. Surely, Mr. Bernanke was well prepared for the crisis, and is a shoo-in to be reappointed as chairman of the Fed early in 2010.
But is this the right version of history? Mr. Bernanke’s speech focused on how to resolve Japan’s deflation — the aftermath of Japan’s rapid credit expansion in the 1980s. During the 1990s, Japan was saddled with lower real estate prices, banks had many toxic assets, and consumers and companies wanted to save rather than spend. The United States did not have those problems in 2002, but it did by 2007. Why? In part because of our great 2001-02 fear of deflation, articulated by Mr. Bernanke and acted on by Mr. Greenspan. The Fed lowered rates to 1 percent for almost two years — to universal acclaim from our financial sector, which made great profits under such conditions. Those low rates ignited a new credit bubble to replace the old dot-com bubble, and from 2002 to 2007 the American consumer and home builder pulled us out of a downturn and up to the edge of a new cliff.
The next global bubble is already under way. What happens when the most powerful nation in the world, with a reserve currency everyone trusts and holds, decides to push a big credit expansion — again, at the instigation of our financial sector? The creditworthy borrowers this time are not in the United States — they are in Asia, Latin America, and even Africa. They have little debt and great prospects; for a mere 1 percent per year they can borrow American dollars, spend the funds at home, and turn paper money into real assets. Every great bubble begins with a truly convincing shift in fundamentals.
In the 1990s this was called the "carry trade." You borrowed from the Japanese at 1 percent and bought anything outside Japan that yielded a bit more (including United States subprime mortgages). The coming American carry trade is the same thing: it weakens the dollar, lifts the economy out of recession through exports, and creates inflation that reduces the real value of our debts. This can last quite a while — both the Treasury and the Fed are sure that early attempts to tighten policy prevented serious recoveries in Japan in the mid-1990s and in the United States toward the end of the 1930s.
The balance of global power is shifting. Japan was perceived as a great powerhouse until 1990 — deflation, the lost decade, and demographic decline have ended that. America and Europe both have years ahead of low interest rates, balance-sheet problems, and sluggish growth. Brazil, China, South Korea, Russia and the like used to be called emerging markets; now they’ll be known simply as the New Rich. Perhaps this is the greatest foreign-aid package of all time. But are we re-establishing our global leadership, albeit in a strange way, or just throwing all pretense to strategic leadership out the window? And are we laying the foundation for a truly massive international debt crisis?
It'll be years before jobs return to much of U.S.
Unlike the labor market collapse that killed millions of U.S. jobs in a matter of months, the nation's return to peak employment will not be nearly as uniform nor as swift. While signs indicate that the worst of the recession may be over, only six metropolitan areas across the country are expected to regain their pre-recession employment levels by the end of 2009, according to projections from IHS Global Insight, a leading economic forecaster.
The areas poised for a jobs rebound later this year are: Anchorage, Alaska; Champaign-Urbana, Ill.; Coeur d'Alene, Idaho; Columbia, Mo.; Laredo, Texas; and the Houma-Bayou Cane-Thibodaux areas of Louisiana. Only five areas are expected to see a similar jobs recovery in 2010: Las Cruces, N.M. and El Paso, San Antonio and the McAllen-Edinburg-Pharr and Austin-Round Rock areas of Texas. Most of the country — 286 of 325 metro areas covered in the IHS analysis_ aren't likely to regain their pre-recession employment levels until at least 2012.
Of these areas, 112 probably won't return to their recent peaks until 2014 or later. These include Rust Belt towns such as Cleveland, Dayton and Akron, Ohio; Detroit, Warren and Flint, Mich.; the hurricane-ravaged Gulfport-Biloxi, Miss., area and the greater Los Angeles region, where the housing bubble and high unemployment have strangled the local economy. The bleak jobs picture underscores the long, tough road ahead in rebuilding the U.S. economy after the worst recession since the Great Depression.
Of the 6 million jobs lost since the recession began 18 months ago, nearly 4 million were eliminated between November and April. The six-month freefall included a record four straight months with more than 600,000 job losses. "This recession is unique because of the way it leveled the playing field," said James Diffley, IHS managing director of U.S. regional services. "The precipitating factor, after housing, was the finance industry, and that affected everybody. Now everybody's cutting back on debt, and the banks are being more cautious about lending, so there's less spending. All those things mitigate against a quick turnaround."
The IHS analysis covers 325 of 363 U.S. metropolitan areas, or population centers, as defined by the Census Bureau. Thirty-eight metro areas weren't included because of a lack of government data, said Jeannine Cataldi, an IHS senior economist. Diffley said the projections reflect a local economy's response to various economic factors based on a statistical analysis of recent history. IHS expects Texas, Oklahoma and Alaska to be among the first to match their previous employment peaks because their economies never fell as far as those in the rest of the country.
All three states are dominated by the energy industry and are benefitting from rising oil prices. They also have lower unemployment rates than the national average and have weathered only light-to-moderate job losses compared to the rest of the country. In April, Alaska was one of two states that had more people employed than it had in the previous year. In addition, none of the states has suffered through the kind of major housing bubble that has sapped housing wealth nationwide. In fact, Alaska has one of the nation's lowest foreclosure rates.
Michigan, Ohio and Indiana, on the other hand, will take years to recover from manufacturing job losses, particularly in the troubled automobile industry. President Barack Obama this week said that he expects the economic stimulus bill to create 600,000 jobs over the next 100 days, but most economists expect the economy to continue bleeding jobs for the foreseeable future. "Although we expect the economy to bottom out in GDP terms during the second half of the year, job losses should continue throughout 2009, with the unemployment rate peaking just above 10 percent," said IHS chief U.S. economist Nigel Gault in a recent letter to investors. "We still expect total job losses to exceed 7 million. But the worst news is behind us, and employment declines should progressively soften as the year proceeds."
In fact, by the end of the year, the economy is expected to begin adding jobs. "We'll start to have an uptick, but it won't be very strong," Diffley said. At least not until mid-2010, when a majority of states are likely to be adding jobs, Diffley said. Expect much of the new job growth to occur in areas where the population is growing, Cataldi said. Many of the new jobs will be in the areas of professional and business services. "We expect that to be a large growth sector going forward," Cataldi said.
Britain's young people 'giving up on the property dream'
Young people are increasingly falling out of love with the idea of owning their own home, new research shows, as prices remain too high for most to afford. A study of 2,000 people by the Chartered Institute for Housing, to be released tomorrow, shows that only a third of 18-to-24-year-olds now think owning a home is right for them. Over the past 12 months an estimated 2.4 million people, most of them young, have changed their opinion about home ownership, when asked their ideal living situation before the credit crunch compared with their ideal living situation now.
The biggest change in attitudes has come in the 25-to-34 age range, with a fall from 83% to 69% of respondents wanting to own their home. CIH chief executive Sarah Webb said: "A generation has grown up believing it has to own at any cost - in part because we haven't provided them with decent information about the alternatives. We can't repeat this mistake with future young people." Webb believes Britain not only needs to build many more flats and houses, but to come up with more viable and affordable forms of tenure such as shared equity. She also wants the government to consider using the tax system to prevent house prices from booming again.
Corrupt, Amoral Politicians. An Economy Sinking in Terrifying Debt. And a People Enraged. Britain Has Been Here Before... and the Lesson Should Chill Us All
A corrupt parliament; an unprincipled government; an economy sinking under a mountain of debt - and a people enraged. Not a bad description of Britain in 2009. Also not a bad description of Britain nearly two centuries ago, in the dismal decade of distress and discontent that followed the Napoleonic Wars. Yes, we've been in this mess before. The question is: How did we get out of it? And can we do it again?
In his Rural Rides, which he began writing in 1822 and published in 1830, the radical journalist William Cobbett portrayed a country groaning under the twin burdens of debt and sleaze. The 1820s were a time of acute financial crisis - of deflation, a crashing stock market and soaring unemployment - and Cobbett expressed better than anyone the bitter national mood. Unlike the economists of his time, he dismissed the idea that the crisis was the result of a natural business cycle. For Cobbett, it was clearly a consequence of political corruption.
'A national debt,' he wrote, 'and all the taxation and gambling belonging to it, have a natural tendency to draw wealth into great masses - for the gain of a few.' Now, Cobbett lamented, 'the Debt, the blessed Debt' was 'hanging round the neck of this nation like a millstone'. Ring a bell? It should. Under Gordon Brown's stewardship of the nation's finances, we have witnessed both an explosion of public debt and a marked increase in inequality.
We can already feel the millstone growing as taxes rise to pay the interest on the money borrowed to bail out the greedy incompetents who blew up the big banks. The UK Debt Management Office estimates that the Government will have to sell a record £147.9 billion of new bonds in the 2009-10 financial year. But that understates the magnitude of the debt mountain. According to one estimate, the various guarantees, asset purchases, capital injections and stimulus measures introduced by the Government since this crisis began amount to 59 per cent of gross domestic product.
A doubling of the national debt might end up being the ironic legacy of Gordon 'Prudence' Brown's premiership. Nor is the debt explosion the only thing we have in common with Cobbett's time. The entire political system, he argued, had become a kind of 'vortex', sucking money from the poor to a new plutocracy - and to an ever-growing bureaucracy. The country was in the hands of a 'monster of a system', declared Cobbett, that was run for the benefit of a 'tribe of tax-eaters'. That, too, has a familiar ring. Under Gordon Brown and his more charismatic predecessor there has been a steady expansion of public sector employment.
From 1998, the public payroll grew with every passing year to reach a total of 5,846,000 in June 2005. That was 680,000 higher than in June 1998. Private sector employment rose by 1,241,000 in the same period. In other words, more than a third of new jobs created under New Labour in those seven years were in the public sector. And we can expect a further expansion of government employment relative to private sector employment as a consequence of this crisis.
Like other Radicals of the period, Cobbett saw electoral reform rather than revolution as the necessary remedy. After all, he argued, 'the House [of Commons] made all the loans which constitute the debt'. It was Parliament that was the heart of the system of 'Old Corruption', whereby the government doled out wellpaid sinecures and handouts to 'placemen' who could be relied on to vote the right way as and when required. Now, that really does sound familiar, doesn't it?
Who - apart from our shameless MPs themselves - has not felt a surge of indignation at reading each day of the antics of our elected representatives, merrily fiddling their expenses while the City of London burned? Even on the other side of the Atlantic, where political corruption is hardly unknown, there has been amazement at the bare-faced nature of the frauds perpetrated by some of those we elected to make, rather than break, our laws. Only in dear old England, the Washingtonians joke, could you put a moat on expenses. To be a Brit abroad these days, dear reader, is to be a laughing stock. It would take a Cobbett to do full justice to my sense of indignation.
So what can we learn from Cobbett's time? The answer is that there can be redemption through reform - and indeed, without reform we risk revolution: the popular repudiation of the parliamentary system itself. That was certainly the risk Britain was running by 1830. When revolutions broke out in Paris and elsewhere on the European continent, there were many who feared barricades and bloodshed in the streets of London. Yet it didn't happen. Why not?
First, because a change of government paved the way for electoral reform, culminating in the passage of the 1832 Reform Act. It was, of course, very far from a complete overhaul of the old, corrupt system, since many of the abuses of aristocratic patronage persisted into the 1860s and beyond (as any reader of Trollope can confirm). But it was a start - and a signal that the political class was in earnest about mending its ways. Under Gordon Brown's, we have witnessed both an explosion of public debt and an increase in inequality
Second, and more important, both the major political parties underwent a transformation both in leadership and in ideology. 'Old Corruption' had been an 18th-century system in which Tories and Whigs took it in turns to harvest the fruits of office. (Whigs were more sympathetic to the American and French Revolutions. Tories put King and Country first.) The political crisis of 1829-1832 - which began with the decision to give Roman Catholics the vote and culminated in the passage of the Reform Act - dealt a deathblow to the old Toryism personified by Lord Liverpool, who had clamped down vigorously on all forms of popular protest.
In its place there gradually emerged a new Liberal Toryism, under the leadership of Sir Robert Peel, which identified itself with free trade, balanced budgets and sound money. Peel ended up splitting his party over free trade (removing tariffs on imported grain that hurt Tory landowners, but benefited urban consumers). But his legacy lived on in the person of William Ewart Gladstone, who emerged as the dominant figure of a new Liberal Party - essentially Whigs plus Radicals - in the second half of the century.
The rump Tories also received a makeover under the very unlikely leadership of Benjamin Disraeli who, despite his Jewish origins, colourful literary career and chronic money problems, somehow succeeded in casting himself as the spokesman for a new kind of compassionate Conservatism. Disraeli insisted that the pillars of the English constitution - monarchy, Church and aristocracy - were sacrosanct. Yet he also spoke out against the social division of the country into 'two nations' as a consequence of the unfettered free market.
And it was Disraeli who grasped that 'jingoism' - a potent cocktail of popular patriotism and imperial expansionism - could win new voters among newly enfranchised groups such as artisans, skilled workers and shopkeepers: the Essex Men of the Victorian era. The big question for our time is whether the two major parties are capable of similar regeneration. The good news is that I think the Conservatives are already there. Under David Cameron's leadership, great strides forward have been taken to reconcile the principles of the Thatcherite Right - Euroscepticism, in particular - with the need to attract new supporters from the political centre.
Cameron may be a committed opponent of European federalism, but he is also - like many younger voters - distinctly green on the issue of climate change. I am a convinced Cameroon, not least because I see him as a conservative mailed fist in a velvet glove. In their recent speeches, he and Shadow Chancellor George Osborne have made it clear they will not shirk the tough choices that will have to be made in the new era of austerity we are entering. The days of 'jobs for the boys' are coming to an end in British politics, as are the days of 'get rich quick' by borrowing to the hilt and speculating in property.
Yet the Tories under Cameron and Osborne understand that 'progressive Conservatism' cannot merely attempt to rerun the 1980s. That's why they are laying so much emphasis on the need for greater accountability and decentralisation throughout the public sector. 'Active citizenship' was never much more than a slogan in the Thatcher years. Under Cameron I hope it will become a reality as state schools, in particular, become more responsive to local needs, and our health service breaks decisively with half-a-century of Soviet-style central planning.
But what of Labour? Here the picture is altogether more bleak. After a dozen years in power, the members of the parliamentary party resemble nothing more closely than the nomenklatura of the old Eastern Bloc - the communist party cronies who were handed all the plum administrative jobs. Most are party hacks whose sole qualification for a seat in our national legislature was a tour of duty in local government. Bullied mercilessly by hard-boiled Scotsmen who learned their politics in the student unions and regional authorities of the drizzly North, these greyapparatchiks must make Lord Mandelson wince on the (mercifully few) occasions when he has to socialise with them.
In the U.S. a charismatic new President, Barack Obama was elected just as the financial crisis reached a crescendo My worry about the next General Election is not that Labour could somehow win. The probability of such an outcome must be close to zero. My worry is that Labour will perform so badly that it will be unable to constitute an effective Opposition in future - and that a substantial proportion of traditional Labour voters in the English working class will turn elsewhere for political representation.
The big political challenge we face is one that the Victorians did not have to reckon with: Populism. This was the inchoate political movement that arose on both sides of the Atlantic in the wake of the depression that followed the 1873 financial crisis - another fine mess caused by real estate speculation and badly managed banks. In the U.S., the populists were predominantly disgruntled farmers who blamed crooked politicians and cosmopolitan bankers for the falling prices of the 1870s and 1880s. In Germany and Austria they were peasants, craftsmen and small businessmen, who more often pinned the blame for their economic troubles on Jews.
To be sure, populism was neither so vicious nor so successful as fascism in the 1930s. But since the economic crisis we are living through is much more like a 19th-century crisis than the Great Depression of the Thirties, it is populism rather than fascism we should look out for. Populists reject all established political parties. They heap scorn on high finance. They are hostile to immigration and to globalisation generally. It would be hard to think of a more classically populist slogan than 'British jobs for British workers'.
When he used this phrase last year, the Prime Minister inadvertently lit the populist touchpaper. If xenophobic fringe parties such as the British National Party are going to make major gains anywhere at the next election, I suspect it will be from disillusioned Labour voters in places like Dagenham. If that happens, it will not be unique to Britain. In America, by sheer good luck, a charismatic new President was elected just as the financial crisis reached a crescendo, allowing all the blame to be heaped on George W. Bush - though in reality much more responsibility lies with Congress, Democrats as much as Republicans.
Elsewhere, as in Britain, the financial crisis is destroying the credibility not just of incumbent governments, but entire political establishments. Four governments have fallen in Eastern Europe so far (in Latvia, Hungary, the Czech Republic and Estonia). More will surely follow. It is too early to say for sure if this current crisis will lead to a backlash against parliamentary democracy itself. That seems unlikely, considering it was only 20 years ago that these countries escaped from communist tyranny.
But it would be very surprising if we did not see a backlash of some kind against the politicians who have led Eastern Europe since the fall of the Berlin Wall. The BNP has its counterparts all over central and Eastern Europe. This is their moment. William Cobbett, after all, was not above anti-Semitism in his broadsides against the financiers of his day. We should not be surprised to hear echoes of that kind of populism in our day, too. The challenge for today's mainstream politicians is to convince an angry public that our parliamentary system is capable of reforming itself, as it was in the 19th century. The alternative, should they fail to do so, is a populist backlash that will not be pretty to behold.
In the midst of the current economic cycle, corporations have been meaningfully pulling back on their financial engineering activities (stock buybacks) that have positively influenced both reported earnings per share as well as acted as a demand support for equity prices in relatively cyclical fashion over time. The fact is that the S&P has experienced its best performance periods really over the last thirty years whenever corporate retirement of equities has been the strongest at any point in time. Not surprising. But as we look over the truly long term, another meaningful secular support for equity prices has been demand from pension funds, with very much special emphasis on the public pension funds of this world. What have been massive demographic tailwinds for US financial assets of really all types over the prior three-plus decades are set to become modest headwinds as we move forward. It’s already starting. This is not some huge negative that these rhythmic headwinds are now starting to blow. What this set of circumstances suggests is that investment selection, asset allocation and individual investment decision making need to be thoughtful and focused. After all, one need only look at the ten year performance of the S&P to know change is already upon us and broad exposure to equities as an asset class being an investment strategy, with little sector or geographic focus, may not be the key to the magic kingdom.
Let’s quickly review some numbers that set the stage for this issue of pension tension in terms of demographic circumstances. The following table shows us the point-to-point growth rate of various age specific demographics over the last sixty years, from the dawn of 1950 through March of 2009. Have a look.
Clear enough for you? The numbers are simple and completely reflective of a baby boom generation that has been a key driving force of both domestic economic and financial market outcomes for decades now. Nothing new really. As a quick tangent, and although the focus is on financial assets in this portion of the discussion, think about what this means for US residential real estate. Investor after investor have chased foreclosures in the last year or two, all hoping to become real estate kingpins when real estate “comes back”. But these numbers tell us directly and unequivocally that residential real estate price appreciation indeed also faces these same clearly delineated demographic headwind or future demand issues as does the demand for financial assets. When the US is not reproducing its internal population, as has clearly been the case, immigration must take up the slack in terms of forward demand. And what the table above tells us is that as the baby boom generation dies off in the next twenty to thirty years, slack there will be.
So as of right now, we’re looking at 37.8 million folks in the US over the age of 65.
Of course what you see above has been brought to us by the miracles of modern health care, better diets, more awareness of wellness, etc. But it also represents a lot of mouths to feed in terms of currently unfunded SSI and Medicare liabilities. As we add up the numbers, about 12 months back the US had national debt of roughly $12 trillion. The current stimulus/bailout spending will add near another $13 trillion to the money printing/debt accumulation hole if enacted fully. Add in maybe $50 trillion in unfunded NPV of SSI and Medicare promises and the US is looking at something like $75 trillion in forward liabilities to be covered over the decades ahead. There are only two ways this will be accomplished as is clear – default or with “cheaper” dollars. And you already know which choice politicians will make, so we can frame our investment decision making with this constantly in mind.
Very quickly, back to the pension issues. Let's start with the public funds. Why? First, as you may have seen, Moody’s placed the bulk of US municipal specific bonds on negative watch a while back. This is a first, but understandable in terms of a bond rating company trying desperately to make up for past sins. In fact, none other than Barney Frank stood up and declared the action reckless in that it could materially hurt municipal specific cost of capital ahead. Hey Barney, where were you when these folks were putting AAA ratings on mortgage related CDO’s, etc. Oh that’s right, you were distracted while cashing their campaign contribution checks. Whoops, forgot you were “busy”. Just think, bond rating agencies actually trying to tell the truth. At least according to Frank, we can’t have that! But the fiscal issues facing the municipalities are severe. Declining property tax revenues and retail sales tax overrides are meeting up with increased benefit and general obligation costs for these folks. We need to add in the time bomb of pension costs escalating meaningfully at the exact time many a fund is seriously under funded due to financial market losses of the last few years.
As you look at the chart below, it’s absolutely clear that public funds got religion about owning common stocks in the early 1980’s. And from there it has been a straight up shot in terms of increased asset allocation to equities over time. In like manner the near 100% allocation of public pension funds to bonds half a century back (when memories of the stock crash during the depression were still fresh scars), “changed places” with their equity allocations in almost mirror image fashion. In hindsight, this was absolutely the correct allocation shift to undertake, but in recent years this excess weighting has cost these funds dearly.
But as we look ahead, THE big question becomes, are we looking at a multi-decade buyer of US equities that is now set to go into more of a distributory mode as per the character of in place plans? You bet we are. Again, not Armageddon for equities immediately or looking forward by any means, but simply the lessened impact of what has been a meaningful buyer of equities for the last three decades. It’s a generic support to the equity market that will not be as forceful and as important a buyer ahead based solely on the demographics you saw in the table. Simple enough.
One other issue of the moment complicates life just a bit and says something about the forward ability of public pension plans to shoulder risk. The following table documents total public pension fund assets dating back to 1990. THE key issue is that as of the close of 2008, public pension fund assets in nominal dollars stood just a bit below where they had been in 1999. And despite the equity rally since March, it seems a very good bet that YTD 2009 what you see below has not gotten better at all.
Unfortunately, accrued pension benefit costs today are well above where they stood for these funds in 1999. And that means the public funds are facing meaningful under funding issues. It's estimated that public funds lost 30% of their value last year, a huge number in the world of actuarial pension accounting. Just huge. Do you think Moody’s was taking this into account when it decided to put the individual municipalities on negative credit watch? You better believe they were. And quite unfortunately for municipal employees, unlike private sector funds that participate in PBGC insurance (and we use that term very loosely), public funds have no Federal guarantee. You can count on the fact that before it’s all over there will indeed be a Federal bailout of public sector pension fund obligations. C’mon, what’s another bailout at this point, right? Your grandchildren will be thrilled. Most State and municipal pension fund promises are fixed in nature (defined benefit), unlike so many private sector funds that have gone to defined contribution (with no payout guarantee - think 401(k)) plans. This puts municipalities in a particular bind as they look at these rising costs over time in shock relative to the values that have just been erased from their plan assets. Just for laughs, the NBER (yes, the same folks responsible for calling official US recessions) estimates that within 15 years time, the value of pension promises already made by US public pension funds will approach $8 trillion. You know, that's just a wee bit more than you see in the chart above, made more noticeable by the fact that the last ten years is truly the "lost decade" for public pension plan assets. Assets would have to increase 250% in the next decade and one half to reach projected needs.
So, given these facts the question stands, can public pension funds afford to shoulder more investment risk ahead now that their net funding status has deteriorated meaningfully? Do they go for broke in the hopes of regaining lost ground? Yes or no? And just what does this mean for what has been their multi-decade support of equity prices specifically?
Let’s move on and quickly take a peek at the private pension funds in the US. In broad concept what applied to the public funds above also applies to the private pension fund world. The advantage the private fund sector has is that so many in this space shut down their defined benefit pension vehicles years back and converted to defined contribution plans. No defined obligations as the individual participants in these plans are in many cases in control of their own investment choices and ultimate retirement destiny. It’s simply a good thing these folks have investment guidance counselors like Jim Cramer and Larry Kudlow from which to receive investment wisdom. But we do need to remember that there exist a fair amount of shuttered corporate defined benefit plans in this mix whose current charter and objective is one thing and one thing only – they want to pay out the last nickel in fund assets about five seconds before the last participant departs planet Earth. And that means the key goal is to match fund forward liabilities so the least amount of additional contributions to these plans need to be made over time. And that absolutely implies these vehicles will be net distributory over the decades ahead, selling every month to fund promised benefits. As the boomers age and begin collecting from these vehicles, accepting additional investment risk will not be on the agenda of trustees of these plans, quite the opposite. Their risk profiles will shift markedly with time. So in much the same manner as their public fund counterparts, the support these funds have been in terms of equity demand ahead will dissipate.
You can see below that current private fund equity allocation is already as low as anything experienced in this space since the late 1950’s. Of course current values reflect the significant losses in equity values that have occurred over the last year and one half. The private funds never increased their allocations to equities over the last few decades as had the public funds as the much more adventuresome and progressive private pension sector diversified into alternatives such as commercial real estate, private equity and hedge funds (of course all of which have also been hit pretty hard over the last few years). And at least as of year end 2007, there was very little allocation to fixed income in private funds with which to cushion the asset decline blow we’ve now experienced.
As of year end 2008, the private folks were very much in the same place as their public fund compadres – nominal total asset values rested at a level slightly below what was seen in 1999.
In short, there you have it. In quick summary, pension plan under funding after the financial market debacle of the last few years is meaningful and serious, particularly serious at the public fund level given the pressure on State and municipal budgets of the moment, something that’s not going to change any time soon. Secondly, the ability of these plans to shoulder longer term investment risk is dissipating quickly due increased payout needs that are accelerating right now and will only grow as the boomer generation ages. The risk profile of shuttered defined benefit plans will only become much more conservative ahead as they move into net distributory mode. Undoubtedly unless financial market asset values zoom to the sky very quickly, we will be looking at public pension fund bailouts before it’s over. It’s also a good bet that on the private side of the equation the very meagerly funded PBGC (Pension Benefit Guarantee Corp.) will need many an additional shot in the arm from the Federal Government, and that’s exclusive of the negative influence of corporate bankruptcy possibilities in the current economic down cycle.
What has been a secular tailwind to equity prices due to the accumulation of pension assets over time will turn into a mild headwind in the decades ahead on two important fronts. First, many of these plans will become net distributory and be scheduled sellers by which you could almost set your watch. Secondly the investment risk profile of these funds will shift to become decidedly less aggressive and more risk averse as payouts accelerate. Again, not monumental to equity market outcomes tomorrow, but an issue we need to keep in mind in terms of global and sector specific asset allocation over time. All part of the longer cycle ebb and flow of the influence of the baby boom generation on the real economy and financial markets.