By The Mogambo Guru
I want to make it perfectly clear that the MoneyWeek.com headline, "China's most toxic export", does not, in any way, refer to any products licensed under the trade name Mogambo Discount Toys And Medicines, Inc that we import from China, as was so cruelly and maliciously maligned in the popular press as "Some kind of murky corporate shell where cheap, nasty people import cheap, nasty things (mostly cat toys and baby pacifiers) that are apparently made with cheap, nasty, toxic industrial by-products of some kind, mostly something that stinks and apparently glows in the dark."
The "toxic export" from China referred to in the title is, instead, inflation, and to save you from the tedium of listening to me expound relentlessly on how growth in the money supply soon means inflation in prices, I will cut right to the meat of the article, as far as I am concerned; things bought from China will cost more, and things that we will be importing from other places will cost more, too, because of all the new demand made possible with more Chinese money.
And how much money? In China, the "Money supply continues to grow at around 18%." Yow! See what I mean?
And what did it buy? From the Technical Market Report by Mike Burk, we read, "In a recent WSJ article a Chinese government official stated that over 70% of publicly traded Chinese companies were worthless." Hahaha! That ought to work out real good! Hahaha!
And speaking of worthless, of all the people invited to rub shoulders with the worthless idiot-savant weenies at the Federal Reserve economics confab at Jackson Hole, Wyoming (which I famously refer to as "A-holes at the J-hole" because it perfectly suits my low opinion of them all), two people were conspicuously missing from the guest list; one is The Mogambo, who is every bit as big an A-hole as any of the other attendees, and William L Anderson, an adjunct scholar of the Mises Institute, who teaches economics at Frostburg State University, who is NOT an A-hole, but was still not invited either! I mean, what are the criteria for inclusion here? How do you predict those guys?
I am pretty sure that I was not invited probably because they know that I hate them all and I have zero respect for any of them or their stupid economic theories, and they probably did not invite Mr Anderson because he wrote the essay, "The Party is Over - Again", where he says things like, "the markets now seem to be catching on to the reality that Austrians and their fellow travelers have recognized for years, and that is that a policy of easy money cannot sustain itself. Someone has to pay the piper, and he has shown up at the door."
That was going to be my cue to suddenly appear at the door, radiant and resplendent in my Mogambo Super Outfit (MSO) with the oversized bejeweled codpiece (with matching tunic and cap), whereupon I was to order the doors locked and bolted and then leap upon Ben Bernanke and the other attendees to deliver the painful face-slapping they all deserve and desperately need.
The reason that I am so desperate to wrest control of the Fed away from these guys is neatly summarized in "It's Different This Time, I Swear" by Charles Zentay of thinkinvestblogspot.com. He writes, "Bernanke, a long-time student of the Great Depression, believes that the cause of the Depression was that the Fed first overlent and then underlent, whipsawing the economy into catastrophe. The solution to prevent a future crisis is to flood the banking system with liquidity during times of instability."
Yow! Perpetually increasing the money supply, meaning perpetually increasing consumer price inflation! Now you see why I am so despondent and suicidal!
And, even worse, they can count on the cooperation of the government, as one can surmise either from long experience, or from the ML-implode.com site (where one can view the on-going carnage in the mortgage market, also caused by the Federal Reserve, via the now-famous Mortgage Lender Implode-O-Meter), which has the subtitle "Tracking the housing finance breakdown: a saga of corruption, stupidity, and government complicity." Hahaha! Perfect!
And even if the Fed and the government can get another fraudulent boom going in stocks, bonds and houses, it will be a hollow victory for the winners, as Jim Willie of the Hat Trick Letter says that, "since the US dollar fell by roughly the same 15% to 20% as the stock market indexes rose", then the "purchasing power of one Dow share or one S&P500 share has been preserved. That is a wash, not a boom."
And while I laugh at market speculators for not actually making a dime but merely breaking even against the ravages of inflation, I notice that nobody is talking about the effect that this "15% to 20%" inflation in prices has on us lowlife workaday bozos and slobs out here who, like me, are not being "made whole" by an investment that is rising, but instead must slave away at our stupid jobs, day after miserable day, up to our freaking necks in debt and overbearing supervisors who correctly suspect that we are incompetent lazy bums, while our stupid kids and hateful families are out wasting all our hard-earned money on things like "back to school supplies", even after you remind them that inflation has made that stuff expensive, and the school will be absolutely lousy with the stuff as all the other students arrive on that first day!
Hell, you could probably outfit a freaking army with the amount of "school supplies" the other kids will drop on the ground ("finders keepers!") when you accidentally bump into them and knock them down! But do they listen to you? NoooOOoooo! They want to buy their own! New! Retail! With tax!
So you silently seethe with anger as you work, and you spend one more dreary day getting that little bit closer to your death while imagining the fun you could have had with the dollars that are flying out of your wallet to pay for all that silly crap, and you grind your teeth in rage and exasperation.
Inflation. It's a killer. Ugh.
Mogambo sez: I'm really, really starting to get really, really freaked out here, as the really, really outrageous mismanagement of economies by the central bankers is getting really, really weird, and the fact that people, the world around, are NOT madly converting everything into gold and silver is even MORE really, really weird, and I can only conclude that sinister mutant spores from outer space have invaded the planet and are eating our brains, making us really, really stupid, which is the really, really weirdest thing of all because it is the only thing that would really, really explain it all. Really.
Richard Daughty is general partner and COO for Smith Consultant Group, serving the financial and medical communities, and the editor of The Mogambo Guru economic newsletter - an avocational exercise to heap disrespect on those who desperately deserve it.
Tuesday, September 18, 2007
Perils of the debt-propelled economy
By Henry C K Liu - Sept 14, 2002
Economics is a complex subject. Any subject, however complex, if looked at in the right way, will become even more complex. This fact baffles many experts who tend to avoid small errors meticulously while sweeping on to grand fallacy.
One of the shortcomings of economics is the inadequate attention paid to it as a behavioral science. The problem can be traced to the neoclassical concept of the economic man who is supposed to act rationally in his own interest which in a money economy is generally defined rather simplistically as financial gain. Economics is obviously more than finance, and economic well-being is not synonymous with financial gain. Modern economics of course deals with the problem of human behavior with some sophistication, albeit always through the back door, and always equating self-interest with rational individual response to pricing. A market economy is coordinated through the price system operating on the principle of marginal utility.
Economists construct indifference curves to show consumer preferences. In economics, the effect on consumption of a pure change in price is shown in an income-compensated demand curve (also known as a Hicksian demand curve after economist John Hicks - 1904-89). A Marshallian demand curve (after economist Alfred Marshall - 1842-1924) is based on the concept of marginal utility. Marginal utility is observed only through choices. Marginal utility in consumption is simply a problem of choosing the bundle of goods that maximizes a buyer's utility, subject to the income constraint - the requirement that the bundle the consumer chooses costs no more than the buyer's disposable income.
Yet the demand for goods is affected by human behavior. A good whose consumption increases when its price goes up is called a Giffen good, after Robert Giffen, a 19th-century English statistician, who noted that Irish peasants bought more potatoes when the price of potatoes rose. This contradicted the law of demand, one of the basic laws of economics. For the poor Irish peasants, potatoes, as the main staple, took up a huge share of their income. If the price of potatoes went up, the share of their income available to purchase other foods would shrink markedly, forcing them to consume more potatoes to make up the difference.
Giffen goods are also necessary for conspicuous consumption. When high-price items go up further in price regularly, such as art objects, more buyers will enter the market, bidding up prices even more. Tulip bulbs during the speculative bubble in Holland in the 17th century were overpriced Giffen goods. The stock market is full of Giffen goods. When a share price goes up, it attracts more buyers. Real estate is often a Giffen good, particularly in places like Hong Kong where the real-estate market is fundamentally controlled by the government through control of the supply of land.
When housing prices rise over long periods, more buyers enter the housing market. The increased demand created by anticipated price appreciation more than offsets the fall in demand caused by price increases. And price deflation in housing creates a downward spiral of shrinking demand, a phenomenon easily observed in recent years all over Asia, from Tokyo to Hong Kong to Singapore. Public health and commercial medicine have characteristics of Giffen goods. When the price of medicine rises, more people tend to get ill due to less preventive use of medicine, causing aggregate demand for medicine to rise.
An inferior good is a good that one buys less of when one's income rises, because one can afford a superior good by comparison, even if the inferior good may also rise in price. During periods of prosperity, when income rises generally faster than prices, inferior goods are separated from Giffen goods. During periods of recession, when income falls generally while prices remain the same or continue to rise, inferior goods and Giffen goods tend to merge. A Giffen good must be an inferior good, but most inferior goods are not Giffen goods.
Credit drives the economy, not debt. Debt is the mirror reflection of credit. Even the most accurate mirror does violence to the symmetry of its reflection. Why does a mirror turn an image right to left and not upside down as the lens of a camera does? The scientific answer is that a mirror image transforms front to back rather than left to right as commonly assumed. Yet we often accept this aberrant mirror distortion as uncolored truth and we unthinkingly consider the flawed reflection in the mirror as a perfect representation.
Similarly, we reflexively accept as exact fidelity the encrypted labels assigned to our thoughts by the distorting mirror of language. Such habitual faulty acceptance is consequential because it is through language that ideas are transmitted and around language that culture develops.
In the language of economics, credit and debt are related but not the same. In fact, credit and debt operate in reverse relations. Credit requires a positive net worth and debt does not. One can have good credit and no debt. Too much debt lowers credit rating. When one understands credit, one understands the main force behind the modern economy, which is driven by credit and stalled by debt. Behaviorally, debt distorts marginal utility calculations and rearranges disposable income. Thus debt turns more commodities into Giffen goods and creates what US Federal Reserve Board chairman Alan Greenspan calls "irrational exuberance", the economic man gone mad.
Human behavior is complex beyond the measurement of price. Price alone is not sufficient to influence market behavior. Karl Marx dealt with the concept of fetish as a factor in demand as expressed in price.
Education is a classic dilemma. Economics literature has never dealt satisfactorily with education, being unable to decide whether it is consumption or investment or both. It has done similarly with health care and environmental preservation. If these endeavors are consumption, the law of scarcity dictates that society cannot afford too much of them. If they are investment, then supply-side theory would conclude the more the better. If they are both consumption and investment, there should be a limitless upward spiraling supply/demand symbiosis. One could not possibly have an over-educated society or over-healthy population or an over-clean environment, if being more educated, more healthy and more clean is deemed economically productive and thus financially profitable.
It is obvious that debt changes human behavior. A little debt reinforces responsibility. The US social system of private property is built on the notion that homeowners with a life-long mortgage are better citizens than renters. People tend to take better care of their homes and plant roots in their communities if they "own" their homes, even though 90 percent of the purchase value is in debt that is not expected to be paid off until three decades later.
On the other hand, it is clear that excessive debt encourages irresponsibility. The borrower may develop an irresistible incentive to walk away from his debt if he perceives the debt to be beyond his ability to repay, or the cost of the debt to exceed its benefits. Even a central bank, which is the domestic lender of last resort, is wary of the problem of moral hazard, that commercial banks within its system would lend irresponsibly if they knew that their lending errors would be bailed out by the central bank.
The US bankruptcy regime is designed to give trapped debtors a fresh start from distressed debt to reestablish credit. Unlike European precedents, one cannot be jailed in the United States for failing to pay one's debt, unless criminal fraud is involved. In fact, there is a legal concept of lender liability, based on which a distressed debtor can sue the lender for damages for lending money irresponsibly that led the debtor into financial trouble.
Lender liability is embodied in common and statutory law covering a broad spectrum of claims surrounding predatory lending. It is a key concept in environmental-cleanup litigation. If a lender knowingly lends to a borrower who is obviously unable to make reasonable beneficial gain from the use of the funds, or causes the borrower to assume responsibilities that are obviously beyond the borrower's capacity, the lender not only risks losing the loan without recourse but is also liable for the financial damage to the borrower caused by such loans. For example, if a bank lends to a trust client who is a minor, or someone who had no business experience, to start a risky business that resulted in the loss not only of the loan but of the client trust account, the bank may well be required by the court to make whole the client.
In the United States, although predatory lending is not defined by federal law, and various states define abusive lending differently, it usually involves practices that strip equity away from a homeowner, or equity from a company, or condemn the debtor into perpetual indenture. Predatory or abusive lending practices can include making a loan to a borrower without regard to the borrower's ability to repay, repeatedly refinancing a loan within a short period of time and charging high points and fees with each refinance, charging excessive rates and fees to a borrower who qualifies for lower rates and/or fees offered by the lender, or imposing new unjustifiably harsh terms for rolling over existing debt. Predation breaks the links between an economy's aggregate resource endowment and aggregate consumption and between the interpersonal distribution of endowments and the interpersonal distribution of consumption.
The choice by some to be predators decreases aggregate consumption, both because the predators' resources are wasted and because producers sacrifice production by allocating resources to guarding against predators. Much of welfare economics is based on the concept of Pareto Optimum, which asserts that resources are optimally distributed when an individual cannot move into a better position without putting someone else into a worse position. In an unjust global society, the Pareto Optimum will perpetuate injustice.
Now, there is a close parallel in most Third World debts and International Monetary Fund (IMF) rescue packages to the above predation examples where sophisticated international bankers knowingly lend to dubious schemes in developing economies merely to get their fees and high interest, knowing that "countries don't go bankrupt", as Walter Wriston of Citibank famously proclaimed. The argument for Third World debt forgiveness contains large measures of lender liability and predatory lending. Debt securitization allows these bankers to pass the risk to the credit markets, socializing the potential damage after skimming off the privatized profits.
Credit is reserved financial resources ready for deployment. Debt basically is unearned money secured with a promise to repay the principal sum plus interest with optimistically anticipated earned money in the future, assuming, for example, that the borrower will not become unemployed through no fault of his own or a business will not be adversely affect by unanticipated shifts in business paradigm, or an economy will not be destroyed by global financial contagion.
Paying down debt with new debt is a Ponzi scheme - the likelihood of its exposure is inversely proportional to its scale of operation. More and more critics are calling the Enron debacle a Ponzi scheme, in that the company filed for bankruptcy even though, for almost a decade up to a few weeks before its bankruptcy filing, many in high places were hailing Enron as the new innovative business model.
Neoliberal economist Paul Krugman publicly hailed Enron as a shining example of free-market entrepreneurship in what he called "a love letter to free markets". He served on its prestigious advisory board for a annual fee of US$50,000. Neoconservative Weekly Standard editor Bill Kristol received $100,000 from the same Enron advisory board, while contributing editor Irwin Stelzer praised Enron for "leading the fight for competition".
On November 13, 2001, two weeks before Enron filed bankruptcy on December 2, the Baker Institute honored Greenspan with its Enron Prize, which the official press release said "gives recognition to outstanding individuals for their contributions to public service. The prize is made possible by a generous gift from the Enron Corp ... one of the world's leading electricity, natural-gas and communications companies. Among the previous recipients of the Enron Prize are Colin Powell, current US secretary of state; Mikhail Gorbachev, former president of the Soviet Union; Nelson Mandela, the first black president of South Africa; and Georgian President Eduard Shevardnadze."
Enron officials have since acknowledged that the company has purposely overstated its profits by billions of dollars since 1997 and has disguised billions in debt as revenue through structured finance via offshore special-purpose vehicles. Top Enron executives cashed out more than $1 billion in company stocks when they were near their peak price of more than $80. In addition, nearly 600 employees deemed critical to Enron's operations received more than $100 million in bonuses in November 2001 while the company was on the brink of bankruptcy. Some commitment to public service.
On the corporate level, debt inevitably alters management behavior. Leverage increases profit margin on successful business plans. As Henry Kravis, king of the leveraged buyout, famously said: "Debt can be an asset. Debt tightens a company." To less creative minds, debt is still a liability, not an asset. But debt also exaggerates losses when business plans fail. In the US financial system, bankruptcy is a legal if not painless way to refute debt. The comfort to lenders is that equity investors are wiped out first before the lenders' various collateralized positions are endangered.
Banks used to be the sole intermediaries of debt. For this reason, a central bank was formed to supervise and provide liquidity to the banking system. Thus a central bank came into existence in the United States in 1913 on the assumption that the existence of a healthy banking system is in the national interest. And to protect the national interest, the central bank, which in the US version is a government institution privately owned by the banks in the Federal Reserve system, is allowed to act as lender of last resort to the nation's commercial banks with public money, or more accurately, through government authority to create fiat money.
Thus regulation on banks is a fair quid pro quo, a social contract. Bank deregulation without corresponding raising of the threshold for central-bank bailout is a direct breach of this social contract. If for the good of the nation banks cannot be allowed to fail, they should also not be allowed to deregulate.
More ominous, the US credit system has broken through the banking system - the bulk of debt now is intermediated through the unregulated credit markets by debt securitization. Securitization acts as more than just providing a vehicle for investment in debt instruments. It restructures simple debt into complex, hybrid instruments sliced infinite ways until the original debt is beyond recognition.
Debt securitization is guerrilla warfare against a sound credit system. Debt proceeds can be disguised as current income, distorting the financial performance of the debtor. In these brave new credit markets, the government is generally only an interested bystander, so far quite unwilling to regulate even over-the-counter (OTC) derivative trading by banks, which are suppose to be regulated, with an "if I don't smoke, someone else will" mentality.
OTC derivatives are traded off exchanges, directly between counterparties, and as such are not subject to disclosure rules. Adding estimated data from the Bank for International Settlements for OTC derivatives to published figures for exchange-traded derivatives, the total notional principal balance of the reported derivatives market in June 2001 was $119 trillion, about four times the gross domestic product (GDP) of the Organization of Economic Cooperation and Development (OECD) countries and twice the value of global trade. The amount unreported remains unknown.
This shows that derivatives performed more than a hedge function, as apologists claim. Derivative trading has become a profit center for banks and non-bank financial institutions. True, the notional principal amount is never at risk, because no principal payments are exchanged. The interest payments that are linked to that notional principal amount are at risk. A loss on a derivative contract becomes possible when (a) interest rates or commodity prices move in a direction that makes the contract more or less valuable, and (b) the counterparty on the other side of the contract defaults. Derivatives credit exposure is the present value of the cost of restoring the economic value of a contract should a counterparty default.
All kinds of street rumors are flying at this very moment that one of the world's biggest banks is exposed to derivative trades that would cause serious counterparty credit problems if the market capitalization of this bank should fall below a triggering level, or the price of commodities or interest rates should move against its derivative positions. Because there is no way to dispel or confirm such rumors, and the bank involved remains tight-lipped about its true financial conditions, the uncertainties weigh down on the economy.
There is ample evidence that the level of interest rates does not always control the aggregate level of debt in an economy, popular expectations notwithstanding. When interest rates are high, they often merely reflect the systemic credit-unworthiness of borrowers as a group or the high risk assumed by lenders collectively. High interest rates in fact create more incentive for both lenders and borrowers to take higher risk to shoot for the higher returns needed to meet higher interest cost. High interest rates also direct money to more desperate borrowers. As William Zeckendorf, the bankrupt real-estate tycoon, once said: "I'd rather be alive at 30 percent interest than be dead at 3 percent."
However, interest rates do affect the distribution of credit in the economy. When rationed by interest rates, debt actually puts money to work for those who need it most desperately, and not necessarily the highest and best use in the economy, or where it is socially needed most. Debts at high interest rates can only be justified by high risk, which tends to destabilize the economy. Debt securitization actually lowers systemic credit quality by socializing risk across the whole system rather than concentrating it on singular, isolatable defaults.
The US Federal Reserve's fixation on interest-rate policy as the sole tool of regulating monetary policy is increasingly taking on the look of shadow boxing, with declining effect on the economy. As chairman Greenspan is fond of saying: "Bad loans are made in good times." As interest rates are artificially raised by Fed action to tighten money supply, distressed borrowers with bad loans made in good times will need to borrow more, thus enlarging the credit pool, defeating the Fed's purpose of a tight monetary policy. As interest rates are artificially lowered by Fed action to stimulate a slowing economy, banks raise their credit threshold to compensate for the narrowing of rate spread, thus reducing the number of qualified borrowers and shrinking aggregate loan volume. This is known as the Fed pushing on a credit string.
Credit rationed by interest rates also discourages economic democracy, since the poor generally find it much harder to obtain or afford credit. The poor also do not have the sophistication to participate in structured finance. There is much truth is the saying that it is not how much you own, it is how much you owe that measures how rich or financially powerful you are.
Debt also encourages carelessness with money, since lending implies faith in the borrower's ability to repay in the future. People tend to be more careful with money they earned in the past in the form of savings because they remember how hard they had to work for it. In contrast, debt is based on future earnings, which is deemed easier money by the existence of debt itself. High interest rates also encourage high risks to justify the high cost of money.
The problem with debt is that it needs to be serviced regularly (except zero coupons, which are discounted from the principal sum at the outset and cost more and are monitored with bond covenants and triggers to activate automatic foreclosure). Unlike a credit-driven economy, a debt-propelled economy will inevitably reach a point where its ability to service the growing debt is exceeded, unless inflation stays ahead of interest charges, in which case the banking system will fail. Thus runaway systemic debt frequently leads to hyperinflation.
Bankruptcy only relieves the debtor, not the economy. If, as economist Hyman Minsky claimed, money is created whenever credit is extended, then the erasure of debt destroys money and shrinks the economy.
There is a circular link among deregulation, debt, overcapacity and bankruptcy. Deregulation has created a havoc of bankruptcy in the airline, health-care, communication, energy and finance sectors. Deregulation permits predatory pricing in the name of competition, which often leads to monopolistic consolidation within industries. The surviving giants then take on massive debt to acquire vanquished competitors and to expand capacity in anticipation of increased demand and soon reach a point where increased sales do not increase net revenue to offset low margin. Once a company is trapped in the whirlpool of debt, a downward spiral of low prices and shrinking revenue will push the cost of debt beyond sustainability, leading to bankruptcy. This is known as the bursting of the debt bubble.
In March 1980, the Depository Institutions Deregulation and Monetary Control Act (DIDMCA) was enacted in the United States. It was a deregulation initiative by the administration of president Jimmy Carter aimed at eliminating many of the distinctions among different types of depository institutions and ultimately removing interest rate ceiling on deposit accounts. Authority for federal savings and loan associations to make risky ADC (acquisition, development, construction) loans was expanded, which ended up with the savings and loan (S&L) crisis five years later. Deregulation of airlines also began under Carter, leading to recurring waves of bankruptcy.
Conventional wisdom suggests that a good credit rating is necessary to borrow. But the financial world works differently in reality. A good credit rating is first necessary to issue credit. Without the ability of some entity to issue credit, no one can borrow. And since no modern financial institution lends its own money, lenders must first secure funds wholesale to lend to retail borrowers. For that, a lender must maintain a good credit rating.
Banks are protected from this requirement by their discount window at the central bank, which is backed by the full faith and credit of the nation, and by Federal Deposit Insurance Corp (FDIC) insurance. Still, central banks and the Bank of International Settlement (BIS) set capital and reserve requirements for commercial banks to assure risk prudence.
GE, the world's largest non-bank financial conglomerate that incidentally also manufactures, issues credit at the retail level through vendor financing, to capture sales for GE products. It gets its funds wholesale from the commercial paper market, which GE dominates because it has a good credit rating. When GE credit rating was downgraded recently, it faced being frozen out of the commercial paper market, and had to revert back to costly bank credit lines that adversely affected its interest rate spread and profitability.
When a government issues currency and circulates money through the banking system, it is in essence issuing credit to the economy that it is entitled to receive back in taxes. Government then spends the tax money on goods and services that the public provides. The surplus money that is not returned by taxes is government credit floating around the economy to keep it operating financially.
It is important to understand that money issued by the government, unlike private money, is not IOUs from the issuer. Money, when issued by government as a legal tender, is a credit from the government good for the payment of taxes, and for settling "all debts, public and private", as printed plainly on all Federal Reserve notes. A US dollar is a Federal Reserve note that entitles its holder to exchange it at any of the six Federal Reserve Banks for another Federal Reserve note of the same face value, no more and no less, at least since 1971 when the late president Richard Nixon took the dollar off the gold standard.
Even before 1971, while an ounce of gold was officially pegged at $35 by president Franklin Roosevelt on January 31, 1931, a domestic holder of a dollar note could only exchange it at a Federal Reserve Bank for another dollar note, since US citizens were forbidden by law to own gold. Only foreigners could demand gold for dollar up to 1971.
A government bond, which on the surface looks like a government debt, is merely a call on government credit previously issued, withdrawing dollars from the money supply by providing a government bond. Government bonds are the living proof that money is not an IOU from the government, otherwise when government sells or redeems bonds, it is perpetrating a Ponzi scheme of paying off old debt with new debt, rather than exchanging debt instruments (bonds) with credit instruments (dollars).
Sovereign debt is fundamentally different from corporate debt. A corporate bond entitles its holder to claim its face value in dollar notes that the bond-issuing corporation cannot create by itself. It must earn dollars with the bond proceeds to pay interest on the bonds. At the time of redemption, if the corporation already spent the bond proceeds, it must then earn back or sell assets or borrow the dollars from somewhere to redeem the bond.
In contrast, a government bond entitles its holder to claim from a Federal Reserve Bank its face value in dollars that the government can print at will, even if it already spent the bond proceeds. The interest on the bond is also paid with dollars of which the government has an unlimited supply. Part of the dollars that the government spends will come back from the public in the form of taxes. The rest will stay in the economy to finance its operations.
So if the government runs a surplus, meaning it takes in more tax money than it spends, it drains money from the economy, forcing the economy to contract. A budget deficit is in essence an injection of more government credit into the economy.
Private citizens can own assets, but whenever such assets are monetized with dollars, one trades those assets for credit from the US government that other market participants in the economy will accept because, aside from its status of legal tender as defined by law, it is good for negotiating tax liabilities.
Technically, a government never borrows. It issues tax credit in the form of money. So when former president Ronald Reagan said the government does not make any money, only the private sector does, he was merely mouthing conventional wisdom, with no clear understanding of the true nature of money and credit. In fact, money is all that government makes. Thus any government that takes on foreign-currency debt or allows its economy to do so is taking unnecessary risk.
The main function of sovereign debt is not to make up for any shortfalls in government funds. Such shortfalls cannot exist by definition. Rather, sovereign debt instruments act as fundamental collateral for the nation's credit market. The Fed Open Market Desk buys and sells government securities to maintain the Fed funds target rate set by the Federal Reserve Board. The repo (repurchase agreement) market, which provides overnight and short-term funds for banks, operates with government securities as collateral.
Thus IMF conditionalities of reducing sovereign debt by imposing budget surpluses and price deflation as a cure for a distressed credit market of excessive foreign debt is merely adding gasoline to fire.
As a sovereign bond is redeemed with cash, it is in essence replacing a call instrument on government credit with government credit. When government securities are withdrawn and cash floods the economy, the debt market shrinks because the amount of collateral shrinks and the amount of cash increases, reducing the need for credit, and the economy contracts with cash inflation, unless the cash is immediately recirculated as private debt or investment.
The reason that the market monitors the Fed funds rate as an indication of Fed policy is that the Fed funds rate closely tracks another rate, the repo rate, that the Fed Open Market Desk actively influences during most market days. Every business-day morning at 11:45 Eastern Standard Time, the Fed announces what it intends to do (buying or selling government securities with an agreement to reverse the transaction later) in the repo market to keep the repo rate close to the Fed funds target rate set by the Fed. Changes in the repo rate are normally quickly followed by changes in the Fed funds rate. Thus, indirectly, the Fed appears to influence the federal funds rate through its impact upon the repo rate.
Non-monetarists subscribe to the view that Fed easing means the Fed lowers interest rates. But they are not specific about how these rates are lowered are how the Fed should go about doing this. There are often periods (such as 1990-91) when interest rates dropped but money growth also fell. Non-monetarists (and market participants) view periods like this as Fed easing episodes, while monetarists argue that these are (implicitly) periods of Fed tightening. Thus it is clear that interest rates by themselves do not always determine the money supply.
Since all private debts in a money economy are anchored by government credit, through what economists called high-power money (money created by the Fed through the increase of the total reserves in the banking system, so called because it would be multiplied manifold through the money-creation power of commercial bank loans), credit in an economic democracy should not be rationed by interest rates to the highest bidder, but by national purposes or social needs.
Credit in fact is a financial public utility, much like air and water, and it should be equally accessible to all, not just the rich. Government loan guarantees for students and house mortgages for low- and moderate-income groups and loans to small business are based on this principle.
For example, the US National Housing Act was enacted on June 27, 1934, as one of several economic-recovery measures of the New Deal. It provided for the establishment of a Federal Housing Administration (FHA). Title II of the Act provided for the insurance of home mortgage loans made by private lenders, taking the risk in lending to low income borrowers off the private lenders. Title III of the Act provided for the chartering of national mortgage associations by the administrator. These associations were to be independent corporations regulated by the administrator, and their chief purpose was to buy and sell the mortgages to be insured by the FHA under Title II.
Only one association was ever formed under this authority on February 10, 1938, as a subsidiary of the Reconstruction Finance Corp, a government corporation. Its name was National Mortgage Association of Washington, and this was changed that same year to Federal National Mortgage Association (Fannie Mae). By amendments made in 1948, Title III became a statutory charter for Fannie Mae.
Before the Great Depression, affording a home was difficult for most people in the United States. At that time, a prospective homeowner had to make a down payment of 40 percent and pay the mortgage off in three to five years. Until the last payment, borrowers paid only interest on the loan. The entire principal was paid in one lump sum as the final "balloon" payment.
During the 1920s boom time in real estate, a rudimentary secondary mortgage market was established. The stock-market crash of 1929 ended the real-estate boom and forced many private guarantee companies into insolvency as home prices collapsed. As economic conditions worsened, more and more people defaulted on mortgages because they couldn't come up with the money for the final balloon payment or to roll over their mortgage because of low market value of their homes.
To help lift the country out of the Depression, Congress created the FHA through the National Housing Act of 1934. The FHA's insurance program protected mortgage lenders from the risk of default on long-term, fixed-rate mortgages. Because this type of mortgage was unpopular with private lenders and investors, Congress in 1938 created Fannie Mae to refinance FHA-insured mortgages.
As soldiers came home from World War II, Congress passed the Serviceman's Readjustment Act of 1944, which gave the Department of Veterans Affairs (VA) authority to guarantee veterans' loans with no down payment or insurance premium requirements. Many financial institutions considered this arrangement a more attractive investment than war bonds.
By revision of Title III in 1954, Fannie Mae was converted into a mixed-ownership corporation, its preferred stock to be held by the government and its common stock to be privately held. It was at this time that Section 312 was first enacted, giving Title III the short title of Federal National Mortgage Association Charter Act.
By amendments made in 1968, the Federal National Mortgage Association was partitioned into two separate entities, one to be known as the Government National Mortgage Association (Ginnie Mae), the other to retain the name Federal National Mortgage Association (Fannie Mae). Ginnie Mae remained in the government, and Fannie Mae became privately owned by retiring the government-held stock. Ginnie Mae has operated as a wholly owned government association since the 1968 amendments. Fannie Mae, as a private company operating with private capital on a self-sustaining basis, expanded to buy mortgages beyond traditional government loan limits, reaching out to a broader income cross-section.
By the early '70s, inflation and interest rates rose drastically. Many investors drifted away from mortgages. Ginnie Mae eased economic tension by issuing its first mortgage-backed security (MBS) guarantee in 1970. Investors found these guaranteed MBSs highly attractive. Also in 1970, under the Emergency Home Finance Act, Congress chartered the Federal Home Loan Mortgage Corp (Freddie Mac) to buy conventional mortgages from federally insured financial institutions. The legislation also authorized Fannie Mae to purchase conventional mortgages. Freddie Mac introduced its own MBS program in 1971.
In the early 1980s, the US economy spiraled into deep recession. Interest rates and housing prices were high, while income growth was stagnant. The US economy faced a dual problem of income deficiency and money devaluation. In this poor housing environment, Ginnie Mae, Fannie Mae and Freddie Mac all created programs to handle adjustable-rate mortgages. The Ginnie Mae guaranty is backed by the full faith and credit of the United States. Today, Ginnie Mae guaranteed securities are one of the most widely held and traded MBSs in the world. Ginnie Mae has guaranteed more than $1.7 trillion in MBSs. Historically, 95 percent of all FHA and VA mortgages have been securitized through Ginnie Mae. Ginnie Mae is a guarantor, a surety. Ginnie Mae does not issue, sell, or buy MBSs, or purchase mortgage loans.
Fannie Mae operates under a congressional charter that directs it to channel its efforts into increasing the availability and affordability of home ownership for low-, moderate- and middle-income Americans. Yet Fannie Mae receives no government funding or backing, and it is one of the nation's largest taxpayers as well as one of the most consistently profitable corporations in America. The company has evolved to become a shareholder-owned, privately managed corporation supporting the secondary market for conventional loans. It continues to operate under a congressional charter with oversight from the US Department of Housing and Urban Development and the US Treasury.
Fannie Mae has two primary lines of business: Portfolio Investment, in which the company buys mortgages and MBSs as investments, and funds those purchases with debt, and Credit Guaranty, which involves guaranteeing the credit performance of single-family and multi-family loans for a fee.
Its Portfolio Investment business includes mortgage loans purchased throughout the US from approved mortgage lending institutions. It also purchases MBSs, structured mortgage products and other assets in the open market. The corporation derives income from the difference between the yield on these investments and the costs to fund these investments, usually from issuing debt in the domestic and international markets. Fannie Mae has $3.46 trillion in MBSs outstanding today.
The corporation accomplishes its mission to provide products and services that increase the availability and the affordability of housing for low-, moderate- and middle-income Americans by operating in the secondary rather than the primary mortgage market. Fannie Mae purchases mortgage loans from mortgage lenders such as mortgage companies, savings institutions, credit unions and commercial banks, thereby replenishing those institutions' supply of mortgage funds. Fannie Mae either packages these loans into MBSs, which it guarantees for full and timely payment of principal and interest, or purchases these loans for cash and retains the mortgages in its portfolio.
Fannie Mae is one of the world's largest issuers of debt securities, the leader in the $5 trillion US home-mortgage market. Fannie Mae's debt obligations are treated as US agency securities in the marketplace, which is just below US Treasuries and above AAA corporate debt. This agency status is due in part to the creation and existence of the corporation pursuant to a federal law, the public mission that it serves, and the corporation's continuing ties to the US government. It benefits from the appearance, though not the essence, of being backed by government credit.
Fannie Mae debt obligations receive favorable treatment from a regulatory perspective. Fannie Mae securities are "exempted securities" under the laws administered by the US Securities and Exchange Commission to the same extent as US government obligations. Also, Fannie Mae debt qualifies for more liberal treatment than corporate debt under US federal statutes and regulations and, to a limited extent, foreign overseas statutes and regulations.
Some of these statutes and regulations make it possible for deposit-taking institutions to invest in Fannie Mae debt more liberally than in corporate debt and mortgage-backed and asset-backed securities. Others enable certain institutions to invest in Fannie Mae debt on par with obligations of the United States and in unlimited amounts. Fannie Mae uses a variety of funding vehicles to provide investors with debt securities that meet their investment, trading, hedging, and financing needs. Fannie Mae is able to issue different debt structures at various points on the yield curve because of its large and consistent funding needs. As the Treasury retires 30-year bonds, agencies have stepped in to fill the void.
The privatization of Fannie Mae and Freddie Mac was an ideological move. It was financially unnecessary and government credit could have funded the entire low-, moderate- and middle-income housing-mortgage needs with no profit siphoned off to private investors. These agency debt instruments played a crucial role in developing and sustaining the credit markets in the US.
In fact, the funding risk of both agencies was questioned by the Wall Street Journal last February 20 in an editorial about Fannie Mae's and Freddie Mac's safety, soundness and financial management, characterizing both agencies as risky, fast-growing companies that "look like poorly run hedge funds", "unduly exposed to credit risk with large derivative positions", and that they "use all manner of derivatives" and "are exposed to unquantified counterparty risk on these positions". Such concerns would have been avoided if both agencies had been funded with government credit, and the cost of housing to low-, moderate- and middle-income Americans would have been lower.
A government credit economy is different from a private debt economy in its sustainability. The Japanese economy stagnated for more than a decade primarily because it shifted from a government credit economy to a private debt economy in the name of financial liberalization and market fundamentalism. The Japanese version of London's Big Bang started the Japanese private debt bubble that subsequently infected all Asian economies.
The Big Bang in London refers to deregulation on October 27, 1986, of London-based securities markets, an event comparable to May Day in the US, marking a major step toward a single global financial market. May Day refers to May 1, 1975, when fixed minimum brokerage commissions ended in the US, ushering in the era of discount brokerage firms and the beginning of diversification by the brokerage industry into a wide range of financial services using computerization and advanced communication systems. This started the offering of new genres of financial products and the emergence of structured finance that made possible a new private-debt economy that turned quickly into a global debt bubble. As the US reaped the fleeting benefits of dollar hegemony, a budget surplus accompanied with sovereign debt reduction merely pushed more debt on to the private sector to feed the debt bubble.
The most fundamental aspect of a private-debt economy is that it cannot sustain a slowdown, even a soft landing. If Greenspan had been better versed in debt economics, he would have understood that a debt bubble, unlike the conventional business cycle, cannot survive the slightest deflation. Inflation is the oxygen for a debt bubble.
Greenspan's attempt to engineer a soft landing by raising interest rates to fight pending inflation pre-emptively only accelerated the debt bubble's burst. His only option was to prevent the debt bubble from forming by tightening credit quality years ago, but he chose to rely on the market to exercise its discipline. He rejected the suggestion of such Wall Street gurus as Henry Kaufman to raise margin requirements. Instead of discipline, the market gave him an insatiable appetite for addictive debt, which he had previously called "irrational exuberance".
Once the bubble was on its way, Greenspan was on top of a debt tiger that he could not get off without being devoured by the beast. It was not the New Economy, it was not the unprecedented productivity that gave the US its decade-long boom. It was debt. Without debt, there would have been no New Economy, no dotcom industry, no telecom explosion, no structured finance, no budget surplus and no current account deficit or its flip side, capital account surplus.
The 1990s was the debt decade. Much of the technology was invented prior to the beginning of the decade of finance capitalism and became widely applied through debt in the form of vendor finance. The communication revolution was built on debt that had been accumulated in the last decade. The greatest invention of the 1990s was more and more sophisticated debt instruments.
Greenspan warned in December 1996 about "irrational exuberance" when the Dow Jones Industrial Average (DJIA) was at 7,000, that inflation down the road was inevitable unless the Fed started to raise Fed funds rate pre-emptively. Yet as rates rose, the DJIA rose to 12,000 by 2000, because inflation as measured by the government failed take into account the wealth effect.
The reason for this was twofold. Inflation was kept low by imports and inflation was measured mostly by rising wages but not by rising asset value. Stock prices doubled and real-estate prices tripled, but the economy officially did not register inflation because of low wages and cheap imports. As stock prices rose, the price to earnings ratio skyrocketed. As the economy inched toward technical full employment with 4 percent unemployed, Greenspan reflexively raised the interest rate to cut off anticipated wage-pushed inflation. The high interest rate adversely affected the earnings of debt-ridden companies. To boost earnings, companies cut employees, which started the downward spiral.
Since July 1997, the risks of protracted global asset deflation caused by the aftermath of excessive private debt have become reality, first in the emerging markets and now in the United States. Neither the IMF nor the Group of Seven (G-7) have been able to deal effectively with the twin problems of the artificially strong but debt-driven dollar and the spreading manipulated devaluation of other national currencies around the globe.
For the affected nations, the combination of mountains of foreign-currency debt and massive short-term capital flight through stock-market collapses, exacerbated by IMF conditionalities of high interest rates, austerity measures that insisted on reduced government deficits and sharp currency devaluations coupled with asset deflation, have led to tragic destruction of hard-earned wealth and a severe drop of living standards.
Certainly market forces in a runaway-debt economy have not created Adam Smith's "universal opulence which extends itself to the lowest ranks of the people". The only trickling down has been poverty and misery. In a world of 6 billion people, only about 1,000 currency traders and a small circle of rich investors in their hedge funds seem to enrich themselves further through the unbridled manipulation of the free financial market. Even in advanced economies, workers are misled to accept low wages as a trade-off for stock options that become worthless when the debt bubble bursts.
Corporations seduce share owners with fantasy capital gains based on debt to replace regular dividend payouts. When market capitalization of major corporations inflated by debt can fall by 90 percent within a matter of months while top executives can cash out at peak prices and resign with severance packages worth tens of millions of dollars, there is no other way to describe the situation than reversed Robin Hood: robbing the poor to help the dishonest rich.
This view is now shared by increasing numbers across ideological spectrums. Economist John Kenneth Galbraith's famous description of trickling down prosperity was if you feed the horse enough oats, the sparrows will some day benefit from its droppings. In finance capitalism, the poor sparrows are crushed by the wheels of the carriage of debt that the horse pulls.
If debt is dilapidating, foreign-currency debt, mostly dollar debt, is deadly. Thus those governments that had been misled by neoliberals to borrow massive amounts of foreign currency unnecessarily and subsequently dutifully implemented IMF prescriptions, such as Brazil, Argentina, Turkey, South Korea and Indonesia, saw their economies destroyed to the point where recovery may now take decades, if ever, and only if the poisonous IMF medicine is quickly rejected.
The IMF has now admitted that it made a "slight mistake" in dealing with the Asian financial crisis of 1997. It might have been slight for the IMF, but the cost to the economies of Asia was horrendous. Trillions of dollars of hard-earned assets and economic capacities have been destroyed, lost forever. In fact, lives have been lost, children malnourished, families ruined, governments fallen and ethnic animosities intensified. The cooperative partnership among neighboring countries has been undermined and regions destabilized. This is the direct result of predatory lending followed by predatory IMF rescues. The operations were technically successful but the patients died.
Since World War II, the term "capitalism" has been gradually displaced by the more benign label of the free market. Capitalism ceased to be mentioned in most economic literature. In the process, economists also squeezed out of official dialogues the word "capitalism", the once-traditional name for the market system, with its subjective connotation of class struggle between owners, through their professional managers, and workers, through their trade and industrial unions, and with its legitimization of the privileges that go with various levels of wealth.
The word "capitalism" no longer appears in textbooks for Economics 101. A Harvard economist, N Gregory Mankiw, author of a popular new textbook, Principles of Economics, told the New York Times: "We make a distinction now between positive or descriptive statements that are scientifically verifiable and normative statements that reflect values and judgments." A whole new generation of economists have grown up thinking of "capitalism" only as a historical term like "slavery", unreal in the modern world of market fundamentalism.
Capital, when monetized in dollars, is in essence credit from government. Capitalism in a money economy is a system of government credits. Thus a case can be made that in a capitalistic democracy, access to capital and credit should be available equally to all in accordance with national purpose and social needs. The anti-statist posture of neoliberalism is not only logically flawed, but its glorification of a private-debt economy will inevitably lead to self-destruction.
Economics is a complex subject. Any subject, however complex, if looked at in the right way, will become even more complex. This fact baffles many experts who tend to avoid small errors meticulously while sweeping on to grand fallacy.
One of the shortcomings of economics is the inadequate attention paid to it as a behavioral science. The problem can be traced to the neoclassical concept of the economic man who is supposed to act rationally in his own interest which in a money economy is generally defined rather simplistically as financial gain. Economics is obviously more than finance, and economic well-being is not synonymous with financial gain. Modern economics of course deals with the problem of human behavior with some sophistication, albeit always through the back door, and always equating self-interest with rational individual response to pricing. A market economy is coordinated through the price system operating on the principle of marginal utility.
Economists construct indifference curves to show consumer preferences. In economics, the effect on consumption of a pure change in price is shown in an income-compensated demand curve (also known as a Hicksian demand curve after economist John Hicks - 1904-89). A Marshallian demand curve (after economist Alfred Marshall - 1842-1924) is based on the concept of marginal utility. Marginal utility is observed only through choices. Marginal utility in consumption is simply a problem of choosing the bundle of goods that maximizes a buyer's utility, subject to the income constraint - the requirement that the bundle the consumer chooses costs no more than the buyer's disposable income.
Yet the demand for goods is affected by human behavior. A good whose consumption increases when its price goes up is called a Giffen good, after Robert Giffen, a 19th-century English statistician, who noted that Irish peasants bought more potatoes when the price of potatoes rose. This contradicted the law of demand, one of the basic laws of economics. For the poor Irish peasants, potatoes, as the main staple, took up a huge share of their income. If the price of potatoes went up, the share of their income available to purchase other foods would shrink markedly, forcing them to consume more potatoes to make up the difference.
Giffen goods are also necessary for conspicuous consumption. When high-price items go up further in price regularly, such as art objects, more buyers will enter the market, bidding up prices even more. Tulip bulbs during the speculative bubble in Holland in the 17th century were overpriced Giffen goods. The stock market is full of Giffen goods. When a share price goes up, it attracts more buyers. Real estate is often a Giffen good, particularly in places like Hong Kong where the real-estate market is fundamentally controlled by the government through control of the supply of land.
When housing prices rise over long periods, more buyers enter the housing market. The increased demand created by anticipated price appreciation more than offsets the fall in demand caused by price increases. And price deflation in housing creates a downward spiral of shrinking demand, a phenomenon easily observed in recent years all over Asia, from Tokyo to Hong Kong to Singapore. Public health and commercial medicine have characteristics of Giffen goods. When the price of medicine rises, more people tend to get ill due to less preventive use of medicine, causing aggregate demand for medicine to rise.
An inferior good is a good that one buys less of when one's income rises, because one can afford a superior good by comparison, even if the inferior good may also rise in price. During periods of prosperity, when income rises generally faster than prices, inferior goods are separated from Giffen goods. During periods of recession, when income falls generally while prices remain the same or continue to rise, inferior goods and Giffen goods tend to merge. A Giffen good must be an inferior good, but most inferior goods are not Giffen goods.
Credit drives the economy, not debt. Debt is the mirror reflection of credit. Even the most accurate mirror does violence to the symmetry of its reflection. Why does a mirror turn an image right to left and not upside down as the lens of a camera does? The scientific answer is that a mirror image transforms front to back rather than left to right as commonly assumed. Yet we often accept this aberrant mirror distortion as uncolored truth and we unthinkingly consider the flawed reflection in the mirror as a perfect representation.
Similarly, we reflexively accept as exact fidelity the encrypted labels assigned to our thoughts by the distorting mirror of language. Such habitual faulty acceptance is consequential because it is through language that ideas are transmitted and around language that culture develops.
In the language of economics, credit and debt are related but not the same. In fact, credit and debt operate in reverse relations. Credit requires a positive net worth and debt does not. One can have good credit and no debt. Too much debt lowers credit rating. When one understands credit, one understands the main force behind the modern economy, which is driven by credit and stalled by debt. Behaviorally, debt distorts marginal utility calculations and rearranges disposable income. Thus debt turns more commodities into Giffen goods and creates what US Federal Reserve Board chairman Alan Greenspan calls "irrational exuberance", the economic man gone mad.
Human behavior is complex beyond the measurement of price. Price alone is not sufficient to influence market behavior. Karl Marx dealt with the concept of fetish as a factor in demand as expressed in price.
Education is a classic dilemma. Economics literature has never dealt satisfactorily with education, being unable to decide whether it is consumption or investment or both. It has done similarly with health care and environmental preservation. If these endeavors are consumption, the law of scarcity dictates that society cannot afford too much of them. If they are investment, then supply-side theory would conclude the more the better. If they are both consumption and investment, there should be a limitless upward spiraling supply/demand symbiosis. One could not possibly have an over-educated society or over-healthy population or an over-clean environment, if being more educated, more healthy and more clean is deemed economically productive and thus financially profitable.
It is obvious that debt changes human behavior. A little debt reinforces responsibility. The US social system of private property is built on the notion that homeowners with a life-long mortgage are better citizens than renters. People tend to take better care of their homes and plant roots in their communities if they "own" their homes, even though 90 percent of the purchase value is in debt that is not expected to be paid off until three decades later.
On the other hand, it is clear that excessive debt encourages irresponsibility. The borrower may develop an irresistible incentive to walk away from his debt if he perceives the debt to be beyond his ability to repay, or the cost of the debt to exceed its benefits. Even a central bank, which is the domestic lender of last resort, is wary of the problem of moral hazard, that commercial banks within its system would lend irresponsibly if they knew that their lending errors would be bailed out by the central bank.
The US bankruptcy regime is designed to give trapped debtors a fresh start from distressed debt to reestablish credit. Unlike European precedents, one cannot be jailed in the United States for failing to pay one's debt, unless criminal fraud is involved. In fact, there is a legal concept of lender liability, based on which a distressed debtor can sue the lender for damages for lending money irresponsibly that led the debtor into financial trouble.
Lender liability is embodied in common and statutory law covering a broad spectrum of claims surrounding predatory lending. It is a key concept in environmental-cleanup litigation. If a lender knowingly lends to a borrower who is obviously unable to make reasonable beneficial gain from the use of the funds, or causes the borrower to assume responsibilities that are obviously beyond the borrower's capacity, the lender not only risks losing the loan without recourse but is also liable for the financial damage to the borrower caused by such loans. For example, if a bank lends to a trust client who is a minor, or someone who had no business experience, to start a risky business that resulted in the loss not only of the loan but of the client trust account, the bank may well be required by the court to make whole the client.
In the United States, although predatory lending is not defined by federal law, and various states define abusive lending differently, it usually involves practices that strip equity away from a homeowner, or equity from a company, or condemn the debtor into perpetual indenture. Predatory or abusive lending practices can include making a loan to a borrower without regard to the borrower's ability to repay, repeatedly refinancing a loan within a short period of time and charging high points and fees with each refinance, charging excessive rates and fees to a borrower who qualifies for lower rates and/or fees offered by the lender, or imposing new unjustifiably harsh terms for rolling over existing debt. Predation breaks the links between an economy's aggregate resource endowment and aggregate consumption and between the interpersonal distribution of endowments and the interpersonal distribution of consumption.
The choice by some to be predators decreases aggregate consumption, both because the predators' resources are wasted and because producers sacrifice production by allocating resources to guarding against predators. Much of welfare economics is based on the concept of Pareto Optimum, which asserts that resources are optimally distributed when an individual cannot move into a better position without putting someone else into a worse position. In an unjust global society, the Pareto Optimum will perpetuate injustice.
Now, there is a close parallel in most Third World debts and International Monetary Fund (IMF) rescue packages to the above predation examples where sophisticated international bankers knowingly lend to dubious schemes in developing economies merely to get their fees and high interest, knowing that "countries don't go bankrupt", as Walter Wriston of Citibank famously proclaimed. The argument for Third World debt forgiveness contains large measures of lender liability and predatory lending. Debt securitization allows these bankers to pass the risk to the credit markets, socializing the potential damage after skimming off the privatized profits.
Credit is reserved financial resources ready for deployment. Debt basically is unearned money secured with a promise to repay the principal sum plus interest with optimistically anticipated earned money in the future, assuming, for example, that the borrower will not become unemployed through no fault of his own or a business will not be adversely affect by unanticipated shifts in business paradigm, or an economy will not be destroyed by global financial contagion.
Paying down debt with new debt is a Ponzi scheme - the likelihood of its exposure is inversely proportional to its scale of operation. More and more critics are calling the Enron debacle a Ponzi scheme, in that the company filed for bankruptcy even though, for almost a decade up to a few weeks before its bankruptcy filing, many in high places were hailing Enron as the new innovative business model.
Neoliberal economist Paul Krugman publicly hailed Enron as a shining example of free-market entrepreneurship in what he called "a love letter to free markets". He served on its prestigious advisory board for a annual fee of US$50,000. Neoconservative Weekly Standard editor Bill Kristol received $100,000 from the same Enron advisory board, while contributing editor Irwin Stelzer praised Enron for "leading the fight for competition".
On November 13, 2001, two weeks before Enron filed bankruptcy on December 2, the Baker Institute honored Greenspan with its Enron Prize, which the official press release said "gives recognition to outstanding individuals for their contributions to public service. The prize is made possible by a generous gift from the Enron Corp ... one of the world's leading electricity, natural-gas and communications companies. Among the previous recipients of the Enron Prize are Colin Powell, current US secretary of state; Mikhail Gorbachev, former president of the Soviet Union; Nelson Mandela, the first black president of South Africa; and Georgian President Eduard Shevardnadze."
Enron officials have since acknowledged that the company has purposely overstated its profits by billions of dollars since 1997 and has disguised billions in debt as revenue through structured finance via offshore special-purpose vehicles. Top Enron executives cashed out more than $1 billion in company stocks when they were near their peak price of more than $80. In addition, nearly 600 employees deemed critical to Enron's operations received more than $100 million in bonuses in November 2001 while the company was on the brink of bankruptcy. Some commitment to public service.
On the corporate level, debt inevitably alters management behavior. Leverage increases profit margin on successful business plans. As Henry Kravis, king of the leveraged buyout, famously said: "Debt can be an asset. Debt tightens a company." To less creative minds, debt is still a liability, not an asset. But debt also exaggerates losses when business plans fail. In the US financial system, bankruptcy is a legal if not painless way to refute debt. The comfort to lenders is that equity investors are wiped out first before the lenders' various collateralized positions are endangered.
Banks used to be the sole intermediaries of debt. For this reason, a central bank was formed to supervise and provide liquidity to the banking system. Thus a central bank came into existence in the United States in 1913 on the assumption that the existence of a healthy banking system is in the national interest. And to protect the national interest, the central bank, which in the US version is a government institution privately owned by the banks in the Federal Reserve system, is allowed to act as lender of last resort to the nation's commercial banks with public money, or more accurately, through government authority to create fiat money.
Thus regulation on banks is a fair quid pro quo, a social contract. Bank deregulation without corresponding raising of the threshold for central-bank bailout is a direct breach of this social contract. If for the good of the nation banks cannot be allowed to fail, they should also not be allowed to deregulate.
More ominous, the US credit system has broken through the banking system - the bulk of debt now is intermediated through the unregulated credit markets by debt securitization. Securitization acts as more than just providing a vehicle for investment in debt instruments. It restructures simple debt into complex, hybrid instruments sliced infinite ways until the original debt is beyond recognition.
Debt securitization is guerrilla warfare against a sound credit system. Debt proceeds can be disguised as current income, distorting the financial performance of the debtor. In these brave new credit markets, the government is generally only an interested bystander, so far quite unwilling to regulate even over-the-counter (OTC) derivative trading by banks, which are suppose to be regulated, with an "if I don't smoke, someone else will" mentality.
OTC derivatives are traded off exchanges, directly between counterparties, and as such are not subject to disclosure rules. Adding estimated data from the Bank for International Settlements for OTC derivatives to published figures for exchange-traded derivatives, the total notional principal balance of the reported derivatives market in June 2001 was $119 trillion, about four times the gross domestic product (GDP) of the Organization of Economic Cooperation and Development (OECD) countries and twice the value of global trade. The amount unreported remains unknown.
This shows that derivatives performed more than a hedge function, as apologists claim. Derivative trading has become a profit center for banks and non-bank financial institutions. True, the notional principal amount is never at risk, because no principal payments are exchanged. The interest payments that are linked to that notional principal amount are at risk. A loss on a derivative contract becomes possible when (a) interest rates or commodity prices move in a direction that makes the contract more or less valuable, and (b) the counterparty on the other side of the contract defaults. Derivatives credit exposure is the present value of the cost of restoring the economic value of a contract should a counterparty default.
All kinds of street rumors are flying at this very moment that one of the world's biggest banks is exposed to derivative trades that would cause serious counterparty credit problems if the market capitalization of this bank should fall below a triggering level, or the price of commodities or interest rates should move against its derivative positions. Because there is no way to dispel or confirm such rumors, and the bank involved remains tight-lipped about its true financial conditions, the uncertainties weigh down on the economy.
There is ample evidence that the level of interest rates does not always control the aggregate level of debt in an economy, popular expectations notwithstanding. When interest rates are high, they often merely reflect the systemic credit-unworthiness of borrowers as a group or the high risk assumed by lenders collectively. High interest rates in fact create more incentive for both lenders and borrowers to take higher risk to shoot for the higher returns needed to meet higher interest cost. High interest rates also direct money to more desperate borrowers. As William Zeckendorf, the bankrupt real-estate tycoon, once said: "I'd rather be alive at 30 percent interest than be dead at 3 percent."
However, interest rates do affect the distribution of credit in the economy. When rationed by interest rates, debt actually puts money to work for those who need it most desperately, and not necessarily the highest and best use in the economy, or where it is socially needed most. Debts at high interest rates can only be justified by high risk, which tends to destabilize the economy. Debt securitization actually lowers systemic credit quality by socializing risk across the whole system rather than concentrating it on singular, isolatable defaults.
The US Federal Reserve's fixation on interest-rate policy as the sole tool of regulating monetary policy is increasingly taking on the look of shadow boxing, with declining effect on the economy. As chairman Greenspan is fond of saying: "Bad loans are made in good times." As interest rates are artificially raised by Fed action to tighten money supply, distressed borrowers with bad loans made in good times will need to borrow more, thus enlarging the credit pool, defeating the Fed's purpose of a tight monetary policy. As interest rates are artificially lowered by Fed action to stimulate a slowing economy, banks raise their credit threshold to compensate for the narrowing of rate spread, thus reducing the number of qualified borrowers and shrinking aggregate loan volume. This is known as the Fed pushing on a credit string.
Credit rationed by interest rates also discourages economic democracy, since the poor generally find it much harder to obtain or afford credit. The poor also do not have the sophistication to participate in structured finance. There is much truth is the saying that it is not how much you own, it is how much you owe that measures how rich or financially powerful you are.
Debt also encourages carelessness with money, since lending implies faith in the borrower's ability to repay in the future. People tend to be more careful with money they earned in the past in the form of savings because they remember how hard they had to work for it. In contrast, debt is based on future earnings, which is deemed easier money by the existence of debt itself. High interest rates also encourage high risks to justify the high cost of money.
The problem with debt is that it needs to be serviced regularly (except zero coupons, which are discounted from the principal sum at the outset and cost more and are monitored with bond covenants and triggers to activate automatic foreclosure). Unlike a credit-driven economy, a debt-propelled economy will inevitably reach a point where its ability to service the growing debt is exceeded, unless inflation stays ahead of interest charges, in which case the banking system will fail. Thus runaway systemic debt frequently leads to hyperinflation.
Bankruptcy only relieves the debtor, not the economy. If, as economist Hyman Minsky claimed, money is created whenever credit is extended, then the erasure of debt destroys money and shrinks the economy.
There is a circular link among deregulation, debt, overcapacity and bankruptcy. Deregulation has created a havoc of bankruptcy in the airline, health-care, communication, energy and finance sectors. Deregulation permits predatory pricing in the name of competition, which often leads to monopolistic consolidation within industries. The surviving giants then take on massive debt to acquire vanquished competitors and to expand capacity in anticipation of increased demand and soon reach a point where increased sales do not increase net revenue to offset low margin. Once a company is trapped in the whirlpool of debt, a downward spiral of low prices and shrinking revenue will push the cost of debt beyond sustainability, leading to bankruptcy. This is known as the bursting of the debt bubble.
In March 1980, the Depository Institutions Deregulation and Monetary Control Act (DIDMCA) was enacted in the United States. It was a deregulation initiative by the administration of president Jimmy Carter aimed at eliminating many of the distinctions among different types of depository institutions and ultimately removing interest rate ceiling on deposit accounts. Authority for federal savings and loan associations to make risky ADC (acquisition, development, construction) loans was expanded, which ended up with the savings and loan (S&L) crisis five years later. Deregulation of airlines also began under Carter, leading to recurring waves of bankruptcy.
Conventional wisdom suggests that a good credit rating is necessary to borrow. But the financial world works differently in reality. A good credit rating is first necessary to issue credit. Without the ability of some entity to issue credit, no one can borrow. And since no modern financial institution lends its own money, lenders must first secure funds wholesale to lend to retail borrowers. For that, a lender must maintain a good credit rating.
Banks are protected from this requirement by their discount window at the central bank, which is backed by the full faith and credit of the nation, and by Federal Deposit Insurance Corp (FDIC) insurance. Still, central banks and the Bank of International Settlement (BIS) set capital and reserve requirements for commercial banks to assure risk prudence.
GE, the world's largest non-bank financial conglomerate that incidentally also manufactures, issues credit at the retail level through vendor financing, to capture sales for GE products. It gets its funds wholesale from the commercial paper market, which GE dominates because it has a good credit rating. When GE credit rating was downgraded recently, it faced being frozen out of the commercial paper market, and had to revert back to costly bank credit lines that adversely affected its interest rate spread and profitability.
When a government issues currency and circulates money through the banking system, it is in essence issuing credit to the economy that it is entitled to receive back in taxes. Government then spends the tax money on goods and services that the public provides. The surplus money that is not returned by taxes is government credit floating around the economy to keep it operating financially.
It is important to understand that money issued by the government, unlike private money, is not IOUs from the issuer. Money, when issued by government as a legal tender, is a credit from the government good for the payment of taxes, and for settling "all debts, public and private", as printed plainly on all Federal Reserve notes. A US dollar is a Federal Reserve note that entitles its holder to exchange it at any of the six Federal Reserve Banks for another Federal Reserve note of the same face value, no more and no less, at least since 1971 when the late president Richard Nixon took the dollar off the gold standard.
Even before 1971, while an ounce of gold was officially pegged at $35 by president Franklin Roosevelt on January 31, 1931, a domestic holder of a dollar note could only exchange it at a Federal Reserve Bank for another dollar note, since US citizens were forbidden by law to own gold. Only foreigners could demand gold for dollar up to 1971.
A government bond, which on the surface looks like a government debt, is merely a call on government credit previously issued, withdrawing dollars from the money supply by providing a government bond. Government bonds are the living proof that money is not an IOU from the government, otherwise when government sells or redeems bonds, it is perpetrating a Ponzi scheme of paying off old debt with new debt, rather than exchanging debt instruments (bonds) with credit instruments (dollars).
Sovereign debt is fundamentally different from corporate debt. A corporate bond entitles its holder to claim its face value in dollar notes that the bond-issuing corporation cannot create by itself. It must earn dollars with the bond proceeds to pay interest on the bonds. At the time of redemption, if the corporation already spent the bond proceeds, it must then earn back or sell assets or borrow the dollars from somewhere to redeem the bond.
In contrast, a government bond entitles its holder to claim from a Federal Reserve Bank its face value in dollars that the government can print at will, even if it already spent the bond proceeds. The interest on the bond is also paid with dollars of which the government has an unlimited supply. Part of the dollars that the government spends will come back from the public in the form of taxes. The rest will stay in the economy to finance its operations.
So if the government runs a surplus, meaning it takes in more tax money than it spends, it drains money from the economy, forcing the economy to contract. A budget deficit is in essence an injection of more government credit into the economy.
Private citizens can own assets, but whenever such assets are monetized with dollars, one trades those assets for credit from the US government that other market participants in the economy will accept because, aside from its status of legal tender as defined by law, it is good for negotiating tax liabilities.
Technically, a government never borrows. It issues tax credit in the form of money. So when former president Ronald Reagan said the government does not make any money, only the private sector does, he was merely mouthing conventional wisdom, with no clear understanding of the true nature of money and credit. In fact, money is all that government makes. Thus any government that takes on foreign-currency debt or allows its economy to do so is taking unnecessary risk.
The main function of sovereign debt is not to make up for any shortfalls in government funds. Such shortfalls cannot exist by definition. Rather, sovereign debt instruments act as fundamental collateral for the nation's credit market. The Fed Open Market Desk buys and sells government securities to maintain the Fed funds target rate set by the Federal Reserve Board. The repo (repurchase agreement) market, which provides overnight and short-term funds for banks, operates with government securities as collateral.
Thus IMF conditionalities of reducing sovereign debt by imposing budget surpluses and price deflation as a cure for a distressed credit market of excessive foreign debt is merely adding gasoline to fire.
As a sovereign bond is redeemed with cash, it is in essence replacing a call instrument on government credit with government credit. When government securities are withdrawn and cash floods the economy, the debt market shrinks because the amount of collateral shrinks and the amount of cash increases, reducing the need for credit, and the economy contracts with cash inflation, unless the cash is immediately recirculated as private debt or investment.
The reason that the market monitors the Fed funds rate as an indication of Fed policy is that the Fed funds rate closely tracks another rate, the repo rate, that the Fed Open Market Desk actively influences during most market days. Every business-day morning at 11:45 Eastern Standard Time, the Fed announces what it intends to do (buying or selling government securities with an agreement to reverse the transaction later) in the repo market to keep the repo rate close to the Fed funds target rate set by the Fed. Changes in the repo rate are normally quickly followed by changes in the Fed funds rate. Thus, indirectly, the Fed appears to influence the federal funds rate through its impact upon the repo rate.
Non-monetarists subscribe to the view that Fed easing means the Fed lowers interest rates. But they are not specific about how these rates are lowered are how the Fed should go about doing this. There are often periods (such as 1990-91) when interest rates dropped but money growth also fell. Non-monetarists (and market participants) view periods like this as Fed easing episodes, while monetarists argue that these are (implicitly) periods of Fed tightening. Thus it is clear that interest rates by themselves do not always determine the money supply.
Since all private debts in a money economy are anchored by government credit, through what economists called high-power money (money created by the Fed through the increase of the total reserves in the banking system, so called because it would be multiplied manifold through the money-creation power of commercial bank loans), credit in an economic democracy should not be rationed by interest rates to the highest bidder, but by national purposes or social needs.
Credit in fact is a financial public utility, much like air and water, and it should be equally accessible to all, not just the rich. Government loan guarantees for students and house mortgages for low- and moderate-income groups and loans to small business are based on this principle.
For example, the US National Housing Act was enacted on June 27, 1934, as one of several economic-recovery measures of the New Deal. It provided for the establishment of a Federal Housing Administration (FHA). Title II of the Act provided for the insurance of home mortgage loans made by private lenders, taking the risk in lending to low income borrowers off the private lenders. Title III of the Act provided for the chartering of national mortgage associations by the administrator. These associations were to be independent corporations regulated by the administrator, and their chief purpose was to buy and sell the mortgages to be insured by the FHA under Title II.
Only one association was ever formed under this authority on February 10, 1938, as a subsidiary of the Reconstruction Finance Corp, a government corporation. Its name was National Mortgage Association of Washington, and this was changed that same year to Federal National Mortgage Association (Fannie Mae). By amendments made in 1948, Title III became a statutory charter for Fannie Mae.
Before the Great Depression, affording a home was difficult for most people in the United States. At that time, a prospective homeowner had to make a down payment of 40 percent and pay the mortgage off in three to five years. Until the last payment, borrowers paid only interest on the loan. The entire principal was paid in one lump sum as the final "balloon" payment.
During the 1920s boom time in real estate, a rudimentary secondary mortgage market was established. The stock-market crash of 1929 ended the real-estate boom and forced many private guarantee companies into insolvency as home prices collapsed. As economic conditions worsened, more and more people defaulted on mortgages because they couldn't come up with the money for the final balloon payment or to roll over their mortgage because of low market value of their homes.
To help lift the country out of the Depression, Congress created the FHA through the National Housing Act of 1934. The FHA's insurance program protected mortgage lenders from the risk of default on long-term, fixed-rate mortgages. Because this type of mortgage was unpopular with private lenders and investors, Congress in 1938 created Fannie Mae to refinance FHA-insured mortgages.
As soldiers came home from World War II, Congress passed the Serviceman's Readjustment Act of 1944, which gave the Department of Veterans Affairs (VA) authority to guarantee veterans' loans with no down payment or insurance premium requirements. Many financial institutions considered this arrangement a more attractive investment than war bonds.
By revision of Title III in 1954, Fannie Mae was converted into a mixed-ownership corporation, its preferred stock to be held by the government and its common stock to be privately held. It was at this time that Section 312 was first enacted, giving Title III the short title of Federal National Mortgage Association Charter Act.
By amendments made in 1968, the Federal National Mortgage Association was partitioned into two separate entities, one to be known as the Government National Mortgage Association (Ginnie Mae), the other to retain the name Federal National Mortgage Association (Fannie Mae). Ginnie Mae remained in the government, and Fannie Mae became privately owned by retiring the government-held stock. Ginnie Mae has operated as a wholly owned government association since the 1968 amendments. Fannie Mae, as a private company operating with private capital on a self-sustaining basis, expanded to buy mortgages beyond traditional government loan limits, reaching out to a broader income cross-section.
By the early '70s, inflation and interest rates rose drastically. Many investors drifted away from mortgages. Ginnie Mae eased economic tension by issuing its first mortgage-backed security (MBS) guarantee in 1970. Investors found these guaranteed MBSs highly attractive. Also in 1970, under the Emergency Home Finance Act, Congress chartered the Federal Home Loan Mortgage Corp (Freddie Mac) to buy conventional mortgages from federally insured financial institutions. The legislation also authorized Fannie Mae to purchase conventional mortgages. Freddie Mac introduced its own MBS program in 1971.
In the early 1980s, the US economy spiraled into deep recession. Interest rates and housing prices were high, while income growth was stagnant. The US economy faced a dual problem of income deficiency and money devaluation. In this poor housing environment, Ginnie Mae, Fannie Mae and Freddie Mac all created programs to handle adjustable-rate mortgages. The Ginnie Mae guaranty is backed by the full faith and credit of the United States. Today, Ginnie Mae guaranteed securities are one of the most widely held and traded MBSs in the world. Ginnie Mae has guaranteed more than $1.7 trillion in MBSs. Historically, 95 percent of all FHA and VA mortgages have been securitized through Ginnie Mae. Ginnie Mae is a guarantor, a surety. Ginnie Mae does not issue, sell, or buy MBSs, or purchase mortgage loans.
Fannie Mae operates under a congressional charter that directs it to channel its efforts into increasing the availability and affordability of home ownership for low-, moderate- and middle-income Americans. Yet Fannie Mae receives no government funding or backing, and it is one of the nation's largest taxpayers as well as one of the most consistently profitable corporations in America. The company has evolved to become a shareholder-owned, privately managed corporation supporting the secondary market for conventional loans. It continues to operate under a congressional charter with oversight from the US Department of Housing and Urban Development and the US Treasury.
Fannie Mae has two primary lines of business: Portfolio Investment, in which the company buys mortgages and MBSs as investments, and funds those purchases with debt, and Credit Guaranty, which involves guaranteeing the credit performance of single-family and multi-family loans for a fee.
Its Portfolio Investment business includes mortgage loans purchased throughout the US from approved mortgage lending institutions. It also purchases MBSs, structured mortgage products and other assets in the open market. The corporation derives income from the difference between the yield on these investments and the costs to fund these investments, usually from issuing debt in the domestic and international markets. Fannie Mae has $3.46 trillion in MBSs outstanding today.
The corporation accomplishes its mission to provide products and services that increase the availability and the affordability of housing for low-, moderate- and middle-income Americans by operating in the secondary rather than the primary mortgage market. Fannie Mae purchases mortgage loans from mortgage lenders such as mortgage companies, savings institutions, credit unions and commercial banks, thereby replenishing those institutions' supply of mortgage funds. Fannie Mae either packages these loans into MBSs, which it guarantees for full and timely payment of principal and interest, or purchases these loans for cash and retains the mortgages in its portfolio.
Fannie Mae is one of the world's largest issuers of debt securities, the leader in the $5 trillion US home-mortgage market. Fannie Mae's debt obligations are treated as US agency securities in the marketplace, which is just below US Treasuries and above AAA corporate debt. This agency status is due in part to the creation and existence of the corporation pursuant to a federal law, the public mission that it serves, and the corporation's continuing ties to the US government. It benefits from the appearance, though not the essence, of being backed by government credit.
Fannie Mae debt obligations receive favorable treatment from a regulatory perspective. Fannie Mae securities are "exempted securities" under the laws administered by the US Securities and Exchange Commission to the same extent as US government obligations. Also, Fannie Mae debt qualifies for more liberal treatment than corporate debt under US federal statutes and regulations and, to a limited extent, foreign overseas statutes and regulations.
Some of these statutes and regulations make it possible for deposit-taking institutions to invest in Fannie Mae debt more liberally than in corporate debt and mortgage-backed and asset-backed securities. Others enable certain institutions to invest in Fannie Mae debt on par with obligations of the United States and in unlimited amounts. Fannie Mae uses a variety of funding vehicles to provide investors with debt securities that meet their investment, trading, hedging, and financing needs. Fannie Mae is able to issue different debt structures at various points on the yield curve because of its large and consistent funding needs. As the Treasury retires 30-year bonds, agencies have stepped in to fill the void.
The privatization of Fannie Mae and Freddie Mac was an ideological move. It was financially unnecessary and government credit could have funded the entire low-, moderate- and middle-income housing-mortgage needs with no profit siphoned off to private investors. These agency debt instruments played a crucial role in developing and sustaining the credit markets in the US.
In fact, the funding risk of both agencies was questioned by the Wall Street Journal last February 20 in an editorial about Fannie Mae's and Freddie Mac's safety, soundness and financial management, characterizing both agencies as risky, fast-growing companies that "look like poorly run hedge funds", "unduly exposed to credit risk with large derivative positions", and that they "use all manner of derivatives" and "are exposed to unquantified counterparty risk on these positions". Such concerns would have been avoided if both agencies had been funded with government credit, and the cost of housing to low-, moderate- and middle-income Americans would have been lower.
A government credit economy is different from a private debt economy in its sustainability. The Japanese economy stagnated for more than a decade primarily because it shifted from a government credit economy to a private debt economy in the name of financial liberalization and market fundamentalism. The Japanese version of London's Big Bang started the Japanese private debt bubble that subsequently infected all Asian economies.
The Big Bang in London refers to deregulation on October 27, 1986, of London-based securities markets, an event comparable to May Day in the US, marking a major step toward a single global financial market. May Day refers to May 1, 1975, when fixed minimum brokerage commissions ended in the US, ushering in the era of discount brokerage firms and the beginning of diversification by the brokerage industry into a wide range of financial services using computerization and advanced communication systems. This started the offering of new genres of financial products and the emergence of structured finance that made possible a new private-debt economy that turned quickly into a global debt bubble. As the US reaped the fleeting benefits of dollar hegemony, a budget surplus accompanied with sovereign debt reduction merely pushed more debt on to the private sector to feed the debt bubble.
The most fundamental aspect of a private-debt economy is that it cannot sustain a slowdown, even a soft landing. If Greenspan had been better versed in debt economics, he would have understood that a debt bubble, unlike the conventional business cycle, cannot survive the slightest deflation. Inflation is the oxygen for a debt bubble.
Greenspan's attempt to engineer a soft landing by raising interest rates to fight pending inflation pre-emptively only accelerated the debt bubble's burst. His only option was to prevent the debt bubble from forming by tightening credit quality years ago, but he chose to rely on the market to exercise its discipline. He rejected the suggestion of such Wall Street gurus as Henry Kaufman to raise margin requirements. Instead of discipline, the market gave him an insatiable appetite for addictive debt, which he had previously called "irrational exuberance".
Once the bubble was on its way, Greenspan was on top of a debt tiger that he could not get off without being devoured by the beast. It was not the New Economy, it was not the unprecedented productivity that gave the US its decade-long boom. It was debt. Without debt, there would have been no New Economy, no dotcom industry, no telecom explosion, no structured finance, no budget surplus and no current account deficit or its flip side, capital account surplus.
The 1990s was the debt decade. Much of the technology was invented prior to the beginning of the decade of finance capitalism and became widely applied through debt in the form of vendor finance. The communication revolution was built on debt that had been accumulated in the last decade. The greatest invention of the 1990s was more and more sophisticated debt instruments.
Greenspan warned in December 1996 about "irrational exuberance" when the Dow Jones Industrial Average (DJIA) was at 7,000, that inflation down the road was inevitable unless the Fed started to raise Fed funds rate pre-emptively. Yet as rates rose, the DJIA rose to 12,000 by 2000, because inflation as measured by the government failed take into account the wealth effect.
The reason for this was twofold. Inflation was kept low by imports and inflation was measured mostly by rising wages but not by rising asset value. Stock prices doubled and real-estate prices tripled, but the economy officially did not register inflation because of low wages and cheap imports. As stock prices rose, the price to earnings ratio skyrocketed. As the economy inched toward technical full employment with 4 percent unemployed, Greenspan reflexively raised the interest rate to cut off anticipated wage-pushed inflation. The high interest rate adversely affected the earnings of debt-ridden companies. To boost earnings, companies cut employees, which started the downward spiral.
Since July 1997, the risks of protracted global asset deflation caused by the aftermath of excessive private debt have become reality, first in the emerging markets and now in the United States. Neither the IMF nor the Group of Seven (G-7) have been able to deal effectively with the twin problems of the artificially strong but debt-driven dollar and the spreading manipulated devaluation of other national currencies around the globe.
For the affected nations, the combination of mountains of foreign-currency debt and massive short-term capital flight through stock-market collapses, exacerbated by IMF conditionalities of high interest rates, austerity measures that insisted on reduced government deficits and sharp currency devaluations coupled with asset deflation, have led to tragic destruction of hard-earned wealth and a severe drop of living standards.
Certainly market forces in a runaway-debt economy have not created Adam Smith's "universal opulence which extends itself to the lowest ranks of the people". The only trickling down has been poverty and misery. In a world of 6 billion people, only about 1,000 currency traders and a small circle of rich investors in their hedge funds seem to enrich themselves further through the unbridled manipulation of the free financial market. Even in advanced economies, workers are misled to accept low wages as a trade-off for stock options that become worthless when the debt bubble bursts.
Corporations seduce share owners with fantasy capital gains based on debt to replace regular dividend payouts. When market capitalization of major corporations inflated by debt can fall by 90 percent within a matter of months while top executives can cash out at peak prices and resign with severance packages worth tens of millions of dollars, there is no other way to describe the situation than reversed Robin Hood: robbing the poor to help the dishonest rich.
This view is now shared by increasing numbers across ideological spectrums. Economist John Kenneth Galbraith's famous description of trickling down prosperity was if you feed the horse enough oats, the sparrows will some day benefit from its droppings. In finance capitalism, the poor sparrows are crushed by the wheels of the carriage of debt that the horse pulls.
If debt is dilapidating, foreign-currency debt, mostly dollar debt, is deadly. Thus those governments that had been misled by neoliberals to borrow massive amounts of foreign currency unnecessarily and subsequently dutifully implemented IMF prescriptions, such as Brazil, Argentina, Turkey, South Korea and Indonesia, saw their economies destroyed to the point where recovery may now take decades, if ever, and only if the poisonous IMF medicine is quickly rejected.
The IMF has now admitted that it made a "slight mistake" in dealing with the Asian financial crisis of 1997. It might have been slight for the IMF, but the cost to the economies of Asia was horrendous. Trillions of dollars of hard-earned assets and economic capacities have been destroyed, lost forever. In fact, lives have been lost, children malnourished, families ruined, governments fallen and ethnic animosities intensified. The cooperative partnership among neighboring countries has been undermined and regions destabilized. This is the direct result of predatory lending followed by predatory IMF rescues. The operations were technically successful but the patients died.
Since World War II, the term "capitalism" has been gradually displaced by the more benign label of the free market. Capitalism ceased to be mentioned in most economic literature. In the process, economists also squeezed out of official dialogues the word "capitalism", the once-traditional name for the market system, with its subjective connotation of class struggle between owners, through their professional managers, and workers, through their trade and industrial unions, and with its legitimization of the privileges that go with various levels of wealth.
The word "capitalism" no longer appears in textbooks for Economics 101. A Harvard economist, N Gregory Mankiw, author of a popular new textbook, Principles of Economics, told the New York Times: "We make a distinction now between positive or descriptive statements that are scientifically verifiable and normative statements that reflect values and judgments." A whole new generation of economists have grown up thinking of "capitalism" only as a historical term like "slavery", unreal in the modern world of market fundamentalism.
Capital, when monetized in dollars, is in essence credit from government. Capitalism in a money economy is a system of government credits. Thus a case can be made that in a capitalistic democracy, access to capital and credit should be available equally to all in accordance with national purpose and social needs. The anti-statist posture of neoliberalism is not only logically flawed, but its glorification of a private-debt economy will inevitably lead to self-destruction.
Either way, it could be an unkind cut
By Henry C K Liu
Strong employment had been a key benefit of the liquidity boom in the United States even though wages had not been rising enough to keep up with asset prices. But news on slow growth of employment for July was an ominous sign that the liquidity boom was ending.
Economists know that employment data are a lagging indictor, showing only the effects of previous periods. Yet official unemployment in the US for July was only 4.6%, or 7.1 million workers, still "uncomfortably" near the bottom of the structural range (4-6%) of what neo-classical economists call a non-accelerating inflation rate of unemployment (NAIRU).
The low structural unemployment rate presented a lingering inflation threat. It will continue to do so until unemployment rises past the 6% NAIRU limit to stall the economy with deflation.
The voodoo theory
Central banks operate on the theory that NAIRU is the cardinal rule to keep inflation in check, using current unemployment to fight future unemployment, keeping some people out of work now in hope of enabling more people to work later.
The rationale is that excessively low unemployment is undesirable because it pushes up wages, in turn pushing inflation, which will require central banks to raise interest rates, which will in turn slow the economy, which will increase unemployment down the road. This necessary unemployment is called structural or natural unemployment, and up to 6% of it must be tolerated to maintain a non-accelerating inflation rate. In other words, there is no case for central-bank intervention as long as unemployment stays below 6%.
The problem with the concept of NAIRU is that when wages have persistently failed to rise as fast as the astronomical rate of asset appreciation, any talk of wage-pushed inflation is perverse and does not need 6% unemployment to contain. This is particularly true when outsourcing of jobs to low-wage countries has kept inflation abnormally low. In fact, full employment with rising wages is an effective way to close the wide gap between stagnant personal incomes and runaway asset prices buoyed by debt.
Not only is NAIRU a dubious theory, particularly in a debt bubble, it is also decidedly a perverse moral posture of neo-liberalism. NAIRU condones a policy of making a helpless minority pay heavily now for maximizing future marginal job opportunities that may benefit the majority, instead of forgoing future maximization to ensure that all can have jobs now to share the benefits of full employment equitably. The equity issue is exacerbated when structural unemployment consistently falls on the same segment of the labor force that is least able to fend for itself.
Credit crisis aggravated by stagnant wages
The credit crisis that has been ongoing since last month was obviously caused by years of systemic credit abuse, but it is aggravated by stagnant wages that have been out of step with runaway debt-pushed asset inflation for almost a decade. Throughout the United States, workers have been forced to live in homes priced at levels their wages cannot support because wages have persistently fallen behind home prices.
The resilience of US equity markets, buoyed by robust employment and strong corporate earnings fueled by cheap debt, has been frequently cited by irrational yet unyielding optimists as proof that the credit crisis in the money markets is merely a passing shower in otherwise fair economic weather. The reality is that the robust employment and strong corporate earnings have been the unsustainable result of systemic credit abuse. This illusion, formed by mistaking debt-pushed exuberance in the stock market as a sign of health in the economy, was shattered recently by news of the first US job contraction in four years, which many market participants regard as the first sign of a financial perfect storm.
Having bought into the myth of a benign decoupling of the credit squeeze from the real economy, analysts had expected a gain of 110,000 new US jobs for August. The unwarranted expectation caused market shock, sparking sharply lower stock prices, when the ugly reality showed a loss of 4,000 jobs. Normally, central banks, driven by an institutional bias bordering on phobia toward inflation threats, would consider unemployment rising toward 6% positive news, since it removes inflationary pressure. But the news of a reverse in employment in August spooked the jittery market, even though the overall US unemployment rate stayed at a benign 4.6%. The market surmises that when the credit market collapses even with low structural unemployment, the economy is heading for serious trouble.
Talk of recession immediately proliferated in the media as it finally dawned on even the most doggedly wishful-thinking analysts that August was the month that economic reality set in to dispel doctrinaire myths that assert that economic fundamentals can remain strong in finance capitalism even when financial markets seize up. Waves of layoffs had been anticipated in all sectors related to housing and financial services in recent months, but unemployment was still expected to stay below the 6% NAIRU threshold, posing no serious threat to the economy except inflation. This is the reason the US Federal Reserve has been reluctant to lower the Fed Funds rate target.
Then suddenly, in August, like the subprime-mortgage crisis spreading to the entire financial system, contagion began spreading unemployment to all sectors. The market fears that unemployment might shoot above 6% within a few short months, because layoffs have been made easy and swift for corporate management by government policy in the past decade. Whether the Fed will lower the Fed Funds rate target in the Federal Open Market Committee (FOMC) meeting on Tuesday depends on whether the Fed sees 6% unemployment is on the horizon.
Poor employment data tilt sentiment
Despite reports of massive bank exposure - approaching $1 trillion - to the systemwide credit squeeze from a 13.4% contraction of the commercial-paper market in the past four weeks, the mood among equity investors had still been one of cautious optimism sustained by silly pep talks from giddy analysts. That unwarranted optimism evaporated with the US jobs report for August.
Share prices fell and both corporate bonds and Treasuries rallied to push yields down sharply on the very day of the bad news on jobs, as traders fled to safety on the realization that many more homeowners will have difficulty meeting higher adjusted interest payments in their floating-rate mortgages this year and next when unemployment rises further. Recession risks are overshadowing rate-cut hopes as market participants begin to understand that rates cuts can be neutralized by a liquidity trap in which banks cannot find enough creditworthy borrowers at any rate.
The interest-rate futures market was already pricing in a Fed Funds rate of 4.57% by the end of October, a 68-basis-point drop from current the Fed Funds target of 5.25%. Fear remains that a rate cut not only may not help alleviate the present credit squeeze in the non-bank financial system, it could also be a psychological trigger that would destroy the Fed's already dwindling credibility. A market that catches on to the impotence of central-bank intervention can go into a free fall.
In fact, a program of sharp rate cuts will render risk-averse investment unattractive and revive the insatiable risk appetite for abnormally high returns that landed the US economy in its current sorry state in the first place. A case can be made that what is needed under current conditions is not more cheap money from the Fed, but full employment with rising wages by government fiscal stimulants to boost consumer demand.
The US government should make use of the money that the banks cannot find worthy borrowers to lend to, with money-cautious investors seeking to lend to the government, creating jobs for infrastructure rehabilitation and upgrading education to get the economy moving again off the destructive track of privatized systemic financial manipulation.
Credit-market seizure causes more unemployment
The scurry by banks to shore up their deteriorating balance sheets as the commercial-paper market dries up as a source of funding for many of their highly leveraged borrowers could slow down bank funding for consumer credit further, to cause a downward spiral of more layoffs in the already anemic US economy. Also, as recently completed private-equity deals structured with cheap money turn distressed with a credit squeeze, massive layoffs in the target companies will follow, adding to a further sharp rise in unemployment.
More ominous, the wide anticipation for a rate cut by the Fed at its September 18 FOMC meeting has already pressured the exchange rate of the US dollar, pushing up gold prices. By September 12, the GLD exchange-traded fund (ETF) for gold set a 52-week high of $70, with gold prices rising above $700 per ounce from $610 in January. Oil has risen above $80 per barrel. Food prices are rising. A further weakening of the dollar combined with faster-growing economies in emerging markets means foreign investors would invest in non-dollar zones or in US companies that have non-dollar revenue, further weakening the US domestic market.
All 10 major sectors in the S&P fell lower on September 7, and for the week, the US consumer discretionary sector fell 3.2% amid fears over lower consumer spending. Home-builders lost 6.8% for the week, taking their fall for the year to 50%. Financials declined 2.6% for the week, while the S&P Investment Bank Index fell 0.8% on the day of the discouraging jobs report, taking its loss for the year to 16.5%.
Investors are still waiting nervously to see whether the market can clear a backlog of $300 billion in unsold debt paper and bonds associated with this year's record private-equity buyout deals. In the midst of all the negative news, it is sometime forgotten that the Dow Jones Industrial Average is still above 13,000, a level substantially higher than economic fundamentals would justify. Left alone, a truly free market would adjust downward by as much as 40% before all the liquidity fluff is removed. The pleasure of excess in the market is never restrained by the excess of pleasure, which unfortunately must be paid for at some point by pain in the economy.
Still, structural disparity in job opportunities persists in the faltering US economy. In August, white unemployment was at 4.2%, below the overall rate of 4.6%; black unemployment at 8.0%; Hispanic at 5.9%; and Asian at 3%. The last two categories did not include illegal immigrants, which could alter data on underemployment substantially. Teenage (16-19) unemployment was at 15.2%, while black teen unemployment was 26.5%. The pain of NAIRU has not been equitably shared even in the liquidity boom. The rising tide failed to lift all boats.
Hidden US unemployment was 16.2 million or 10.3% of the labor force. They included 4.3 million who had part-time jobs because they could not find full-time employment and 4.8 million who wanted jobs but were not counted in official statistics because they were not looking, of whom about 1.4 million searched for work during the prior 12 months and were available for work during the reference week.
In addition, millions more were working full-time, year-around, yet earned less than the official poverty level for a family of four. In 2005, the latest year for which data were available, that number was 17.0 million, 16.2% of full-time workers. In June 2007, the latest month available, the number of job openings was only 4.3 million, nearly four job-seekers for each job opening, while corporate earnings continued to rise from job outsourcing and financial manipulation such as share buybacks made possible by a liquidity boom.
Phantom 'strong economic fundamentals'
With the liquidity boom abruptly halted, residual robust employment and corporate earnings were misidentified as the alleged remaining "strong" economic fundamentals to which high US government officials and Wall Street cheerleaders misleadingly referred, in defiance of facts even weeks after the subprime-mortgage crisis broke out. Even honest fools would know that a collapse of credit markets would lead quickly to rising unemployment and falling corporate profits, and high government officials and high-paid analysts are surely not fools. The issue then must be one of honesty.
Non-farm US payroll employment dropped by 4,000 in August to 138 million, and the unemployment rate remained at 4.6% or 7.1 million workers, more than the total population of any US city except New York. Still, 4.6% is uncomfortably on the low end of NAIRU (4-6%), and that means an interest-rate cut now would risk inflation down the road in a faltering economy, ie, stagflation, as in the 1977-81 period under Fed chairman Paul Volcker and president Jimmy Carter. This is the dilemma faced by the Fed: a cut in short-term rates may do more harm than good by not helping to sustain a liquidity boom yet fueling accelerated inflation, not to mention leading to a loss of confidence of the part of the market in the Fed's ability to manage a monetary and financial crisis.
As with their flawed attitude toward risk, the authorities in charge of regulating financial markets and the US economy apparently think that inflation-fighting structural unemployment spread over the whole economic system is not damaging to the economy as long as the resultant profit is privatized and concentrated on a preferred selection of financial institutions, even if the privatized profit is achieved by externalizing the cost of risk to the entire financial system through structured finance. Free-market capitalists obviously think that socializing risk or unemployment is not dreaded evil socialism, only socializing profit is.
Over the third quarter of 2007, total US payroll employment changes have averaged 44,000 new jobs per month, well below the monthly average of 147,000 new jobs between January and May. In August, employment in manufacturing, construction, and local government education declined, while job growth continued in health care and food services. The civilian labor force edged down to 152.9 million, and the labor-force participation rate decreased to 65.8%. The declines were largely due to a drop in labor-force participation among teenagers; their participation rate fell to 39.7%. Total employment in August was 145.8 million.
Part-time and temporary workers
The number of Americans working part-time for economic reasons, at 4.5 million in August, was 359,000 higher than a year earlier. This category includes people who indicated that they would like to work full-time but were working part-time because their hours had been cut back or because they were unable to find full-time jobs.
Nearly 1.4 million Americans (not seasonally adjusted) were only marginally attached to the labor force in August, down by 227,000 from a year earlier. These individuals wanted and were available to work and had looked for a job some time during the prior 12 months. They were not counted as unemployed because they had not searched for work in the four weeks preceding the survey.
Among the marginally attached, there were 392,000 discouraged workers in August, little different from a year earlier. Discouraged workers are those not currently looking for work specifically because they believe no jobs are available for them even if they try. The nearly 1 million remaining persons marginally attached to the labor force in August had not searched for work in the four weeks preceding the survey for reasons such as school attendance and family responsibilities.
Drop in employment in August
The overall drop in employment in August was preceded by negligible job growth in June (+69,000) and July (+68,000), as revised. In August, employment continued to fall in manufacturing and construction; local government education also lost jobs. Job gains continued in health care and in food services and drinking places.
Manufacturing employment declined by 46,000 in August, losing 215,000 jobs over the past year. In August, declines were widespread among component industries: for durable goods, job losses in motor vehicles and parts were 11,000, machinery 7,000, wood products 7,000, furniture and related products 4,000, and semiconductors and electronic components 4,000. For non-durable goods, manufacturing job loss continued with 4,000 in apparel and 2,000 in textile mills. Construction employment declined in August by 22,000, with most of the loss occurring among residential specialty trade contractors. Since its most recent peak in September 2006, construction employment has fallen by 96,000. Employment in local government education fell by 32,000 in August, as seasonal hiring was less than usual.
Health care employment continued to grow in August (+35,000); the industry added 396,000 jobs over the year. In August, the good news was that employment continued to grow in all the components of health care: ambulatory care services (+18,000), hospitals (+11,000), and nursing and residential care (+6,000). The bad news was that this was the sector with the highest inflation rates. Employment in social assistance rose by 14,000 and was 83,000 above its year-ago level, showing that the economic cancer of income disparity was growing faster than the economy as a whole.
Within leisure and hospitality, food services and drinking places, employment continued to expand in August (+24,000). The industry has added 350,000 jobs over the year, showing that the rich are still enjoying the good life, albeit employment in the accommodation industry has trended down over the past three months due to a drop in business traveling and middle income family vacationing.
Employment in retail trade was little changed in August because of back-to-school shopping. A job gain in building material and garden supply stores was partially offset by a decline in general merchandise stores. Wholesale trade employment changed little in August because unemployment in these sectors tends to have longer lag time.
Employment in financial activities was flat in August, following a large increase in July. Within the industry, employment in credit intermediation edged down over the month and was 19,000 below its most recent peak in February. The trend is expected to rise sharply in coming months to reflect turmoil in the credit market. One company, Countrywide, alone announced a job-cut program of 12,000 in the next three months. The mortgage brokerage industry is expected to lose 100,000 jobs this year. A sharp shift in employment from deal-making to distress restructuring is expected.
In professional and business services, management and technical consulting services added 7,000 jobs in August, and temporary help employment continued to trend down. Temporary help has lost 72,000 jobs thus far in 2007 as companies downsize by first shedding temporary workers with no severance cost and pension liabilities.
Average hourly earnings of production and non-supervisory workers on private non-farm payrolls increased by five cents, or 0.3%, in August to $17.50, seasonally adjusted. Average weekly earnings grew by 0.3% over the month to $591.50. The CPI (consumer price index) in July was 2.4% higher than in July 2006. August 2007 CPI data are scheduled to be released on Wednesday at 8.30am Eastern Standard Time, one day after the scheduled FOMC meeting that decides on Fed Funds rate targets. The employment situation for September is scheduled to be released on Friday, October 5, three weeks before the scheduled two-day meeting of the FOMC on October 30-31.
The honest services issue
On Friday, September 7, the disappointingly bad news on August employment was released to the public at 8.30am Eastern Standard Time by the Bureau of Labor Statistics (BLS). Although the data had been embargoed until official release time, surely both the Fed and the Treasury had advanced knowledge of BLS data as they were collected. It is inexplicable why those in charge of maintaining the sustainability of a healthy economy and open and transparent markets would knowingly pronounce misleading prognosis on economic trends that they know to be false and that would be refuted by pending public release of official data in a matter of days. Do these officials not realize that by not coming clean before the sun rises on what they know to be false, they damage rather than promote market confidence in their ability to manage the economy?
By any measure, the employment data for August were discouraging. Yet on Thursday evening, September 6, some 12 hours before the public release of the dismal BLS August employment data, Treasury Secretary Henry Paulson said in an interview on Nightly Business Report on Public Broadcasting Service (PBS)that turmoil in credit markets will only exact a price on the US economy but would not stall its growth. "There will be a penalty to our economic growth and I'm quite comfortable that we're going to continue to grow, create jobs," said Paulson. "We have a very strong economy against the backdrop of these stresses and strains in the capital markets," the US Treasury chief added confidently.
His bravado was not echoed by market confidence the next day. Mortgage defaults continue to soar to seize up credit markets as lenders grow increasingly reluctant to lend and investors to invest in commercial paper amid uncertainty about the true conditions of portfolios with risky mortgages that have been packaged into synthetic tranches of securities, given investment-grade ratings by rating agencies and sold in credit markets to unidentified investors around the world, leaving the market scrambling to determine which institutions are left holding the unsold toxic commercial papers.
When asked how long he thought it would take to sort out the stress in capital/debt markets and determine how serious the contagion problems actually are in subprime mortgage loans, Paulson, having repeatedly declared that the problem had been contained in previous weeks, now said: "It's certainly going to be into the weeks, maybe a matter of months. I have a difficult time making projections, but it will be a while."
It is not clear if Paulson, the nation's highest finance official, was making a political statement or deliberately false market analysis by someone in the position to know about the true state of finance in the economy. The US Treasury for over a decade under both Democrat and Republican administrations has been the branch of the government most responsible for pushing financial globalization to produce a strong US-dominated global economy at the expense of a weak US domestic economy held up by debt.
The situation makes it very difficult for the Fed to use monetary ease, ie, lowing dollar interest rates, to stimulate the US economy without pushing the exchange rate of the dollar down, which will further weaken the US domestic economy. A collapse of the dollar will make a recession seem like a tea dance by comparison.
Enron executive not guilty?
It should be recalled that top Enron executives who made similar, knowingly false statements about their company to calm markets were convicted of fraud and sent to prison. The conviction was based on the so-called "honest services" theory of which the defendants had conspired to deprive the company.
On September 11, Paulson finally came clean on the seriousness of the crisis of confidence in credit markets and admitted that it would take longer to work out than previous financial shocks of the past two decades, such as the 1982 Latin American debt crisis, the 1997 Asian financial crisis and the 1998 Russian bond default that sank Long Term Capital Management, a big, highly-leveraged hedge fund. The uncertainty over the distribution of holdings and the complexity of valuing structured finance instruments based on subprime mortgages could last for up to two years, as many such loans reset to higher rates over time. Still, he assures the market that the US economy is fundamentally strong, a position that instead of calming markets only makes him seem disconnected to reality.
Paulson spoke in Washington as Jean-Claude Trichet, the European Central Bank president, warned that it was time for global financial authorities to tackle unregulated entities whose activities had contributed to the latest upheavals. Ratings agencies were called to a special meeting for questioning by regulators on the way they rated structured financial products based on mortgage collaterals.
As Treasury secretary, Paulson of course enjoys legal immunity on misleading political statements that technically stay clear of perjury or other impeachable offenses. And no suggestion is made here that Paulson is not an honorable man. Yet moral immunity from robbing society of "honest services" by the Treasury secretary of the world's most powerful economy is a different matter in the court of public opinion and in the judgment of history.
Interestingly, the day after the Paulson interview on PBS, former Enron chief executive officer Jeff Skilling filed an appeal before the Fifth Circuit Appeals Court in New Orleans more than 15 months after he was convicted and nearly nine months after he began serving a 24-year, four-month prison term in southern Minnesota.
Skilling's top-rated legal team, led by Daniel M Petrocelli, who also famously won a wrongful death civil suit against O J Simpson on behalf of Fred Goldman, surviving father of murdered victim Ron Goldman, argues that errors by prosecutors and US District Judge Sim Lake, who presided over Skilling's first trial in Houston, require the appeals court to overturn all 19 of his convictions of conspiracy, securities fraud, insider-trading and lying to auditors. "They were in search of crimes knowing this wasn't a clear-cut case, and in particular, that Jeff Skilling hadn't done anything wrong," said Petrocelli in an interview, whose firm, O'Melveny & Meyer, reportedly was owed $30 million in legal fees by Skilling from the first trial.
The appeal said the government sought to criminalize normal business activities in its zeal to ensure someone paid for Enron's failure. "That someone was Jeff Skilling - the last man standing when the court meted out its punishment," the appeal said. Former Enron chairman Ken Lay, Skilling's co-defendant in their fraud and conspiracy trial last year, died six weeks after the pair was convicted, vacating his criminal liability.
The major arguments presented by the appeal include:
1. Prosecutors used a flawed theory that Skilling robbed Enron of his "honest services" to prove the overarching count of conspiracy to commit securities and wire fraud. A Fifth Circuit panel rejected that prosecution theory in a shareholder class action suit against Enron two months after Skilling's conviction.
2. Judge Lake gave flawed jury instructions, most notably allowing jurors to find Skilling guilty of deliberately ignoring fraud when his defense was that no fraud existed. Lake refused to move the trial from Houston, where the defense contends anger about those hurt by Enron's collapse poisoned the jury pool. Skilling never asserted an "ostrich" defense, a usual prerequisite to issuing the "deliberate ignorance" instruction.
3. Skilling's prison term is excessive and unconstitutional, being four times longer than any other convicted Enron executive, two to three times longer than comparable white-collar defendants and six years longer than the average federal sentence for murder, albeit slightly less than the record-breaking 25 years in prison being served by Bernie Ebbers, the former boss of bankrupt WorldCom.
Judge Patrick Higginbotham of the Fifth Circuit signaled last December that Skilling's legal argument could be well received regarding 14 of the 19 counts. In a ruling denying Skilling's request to remain free on bond during appeal, Higginbotham pointed to "serious frailties" in those counts, noting "difficulties brought by a decision of this court handed down after the jury's verdict". Higginbotham did not sit on the panel that issued the honest services decision, but he also wrote that Skilling had not raised issues likely to lead to reversal of all his convictions.
Skilling's appeal argues, however, that the prosecution's "honest services" theory taints all the other counts and that Skilling should get a new trial. The theory took a judicial hit in August 2006 when the appeals panel threw out convictions of four former Merrill Lynch & Co executives in the Enron case. The judges said prosecutors improperly argued that the defendants robbed Enron of their "honest services" when they helped push through a loan on Nigerian barges disguised as an asset sale in late 1999 to help the energy company meet its missed earnings targets.
The appeals panel ruled that the "honest services" theory did not apply because the Merrill Lynch defendants acted in Enron's corporate interests and did not take money or property from the energy company, even though their firm profited financially from the arrangement. There was no criminality because the money came from society, an entity that apparently has no court-recognized legal rights or advocate of legal standing in the legal system of market capitalism.
Prosecutors in the Skilling case had argued that he "robbed" Enron of his "honest services" by breaching his duty to make sure financial statements correctly reflected the state of the company.
Skilling argues in his appeal that he did not steal anything. Yet he was unjustly convicted of one count of conspiracy, a dozen counts of securities fraud, one count of insider trading and five counts of making false statements to auditors, while he was acquitted of nine counts of insider trading. The "honest services" theory was presented by the prosecution only with the conspiracy count, but the appeal argues an instruction Judge Lake gave the jury links it to the other counts as well. Oral arguments in the appeals case are expected to be scheduled for 2008.
Conflict between systemic guilt and individual guilt
The issue raised by the Skilling appeal, beyond the legal technicalities, was a conflict between systemic failure and individual responsibility. The court found Skilling guilty personally to absolve the system from guilt. The Appeals Court has ruled in related cases that convicted defendants were acting within the laws and regulations then governing their behavior. The court's decision implies that criminality rests with the system, not the individuals involved. However, logic would suggest that Skilling, by participating in a guilty system, cannot escape personal criminality even though he did not violate any laws of the system. That logic has been firmly established by the historic Nuremburg trials for war criminals.
Over the years of the liquidity boom, some people have profited very handsomely securitizing and selling subprime mortgages. These people were not even required to pay their fair share of taxes. Now in the consequential liquidity bust, these same people are home free because they have passed the risk onto unsuspecting money market and pension funds that hold the savings of middle income citizens. The structured financiers are keeping their ill-earned profit while the massive loss will be borne by millions of others who innocently thought they were investing in risk-averse instruments created by the same financiers. Even the former chairman of the Federal Reserve had been on record for having said publicly that systemic risk is a good trade-off for unprecedented economic expansion. There is a high probability that individuals responsible for the credit melt-down that will hurt millions will be brought to justice before the end of the day. The uncertainty is who they will be.
Strong employment had been a key benefit of the liquidity boom in the United States even though wages had not been rising enough to keep up with asset prices. But news on slow growth of employment for July was an ominous sign that the liquidity boom was ending.
Economists know that employment data are a lagging indictor, showing only the effects of previous periods. Yet official unemployment in the US for July was only 4.6%, or 7.1 million workers, still "uncomfortably" near the bottom of the structural range (4-6%) of what neo-classical economists call a non-accelerating inflation rate of unemployment (NAIRU).
The low structural unemployment rate presented a lingering inflation threat. It will continue to do so until unemployment rises past the 6% NAIRU limit to stall the economy with deflation.
The voodoo theory
Central banks operate on the theory that NAIRU is the cardinal rule to keep inflation in check, using current unemployment to fight future unemployment, keeping some people out of work now in hope of enabling more people to work later.
The rationale is that excessively low unemployment is undesirable because it pushes up wages, in turn pushing inflation, which will require central banks to raise interest rates, which will in turn slow the economy, which will increase unemployment down the road. This necessary unemployment is called structural or natural unemployment, and up to 6% of it must be tolerated to maintain a non-accelerating inflation rate. In other words, there is no case for central-bank intervention as long as unemployment stays below 6%.
The problem with the concept of NAIRU is that when wages have persistently failed to rise as fast as the astronomical rate of asset appreciation, any talk of wage-pushed inflation is perverse and does not need 6% unemployment to contain. This is particularly true when outsourcing of jobs to low-wage countries has kept inflation abnormally low. In fact, full employment with rising wages is an effective way to close the wide gap between stagnant personal incomes and runaway asset prices buoyed by debt.
Not only is NAIRU a dubious theory, particularly in a debt bubble, it is also decidedly a perverse moral posture of neo-liberalism. NAIRU condones a policy of making a helpless minority pay heavily now for maximizing future marginal job opportunities that may benefit the majority, instead of forgoing future maximization to ensure that all can have jobs now to share the benefits of full employment equitably. The equity issue is exacerbated when structural unemployment consistently falls on the same segment of the labor force that is least able to fend for itself.
Credit crisis aggravated by stagnant wages
The credit crisis that has been ongoing since last month was obviously caused by years of systemic credit abuse, but it is aggravated by stagnant wages that have been out of step with runaway debt-pushed asset inflation for almost a decade. Throughout the United States, workers have been forced to live in homes priced at levels their wages cannot support because wages have persistently fallen behind home prices.
The resilience of US equity markets, buoyed by robust employment and strong corporate earnings fueled by cheap debt, has been frequently cited by irrational yet unyielding optimists as proof that the credit crisis in the money markets is merely a passing shower in otherwise fair economic weather. The reality is that the robust employment and strong corporate earnings have been the unsustainable result of systemic credit abuse. This illusion, formed by mistaking debt-pushed exuberance in the stock market as a sign of health in the economy, was shattered recently by news of the first US job contraction in four years, which many market participants regard as the first sign of a financial perfect storm.
Having bought into the myth of a benign decoupling of the credit squeeze from the real economy, analysts had expected a gain of 110,000 new US jobs for August. The unwarranted expectation caused market shock, sparking sharply lower stock prices, when the ugly reality showed a loss of 4,000 jobs. Normally, central banks, driven by an institutional bias bordering on phobia toward inflation threats, would consider unemployment rising toward 6% positive news, since it removes inflationary pressure. But the news of a reverse in employment in August spooked the jittery market, even though the overall US unemployment rate stayed at a benign 4.6%. The market surmises that when the credit market collapses even with low structural unemployment, the economy is heading for serious trouble.
Talk of recession immediately proliferated in the media as it finally dawned on even the most doggedly wishful-thinking analysts that August was the month that economic reality set in to dispel doctrinaire myths that assert that economic fundamentals can remain strong in finance capitalism even when financial markets seize up. Waves of layoffs had been anticipated in all sectors related to housing and financial services in recent months, but unemployment was still expected to stay below the 6% NAIRU threshold, posing no serious threat to the economy except inflation. This is the reason the US Federal Reserve has been reluctant to lower the Fed Funds rate target.
Then suddenly, in August, like the subprime-mortgage crisis spreading to the entire financial system, contagion began spreading unemployment to all sectors. The market fears that unemployment might shoot above 6% within a few short months, because layoffs have been made easy and swift for corporate management by government policy in the past decade. Whether the Fed will lower the Fed Funds rate target in the Federal Open Market Committee (FOMC) meeting on Tuesday depends on whether the Fed sees 6% unemployment is on the horizon.
Poor employment data tilt sentiment
Despite reports of massive bank exposure - approaching $1 trillion - to the systemwide credit squeeze from a 13.4% contraction of the commercial-paper market in the past four weeks, the mood among equity investors had still been one of cautious optimism sustained by silly pep talks from giddy analysts. That unwarranted optimism evaporated with the US jobs report for August.
Share prices fell and both corporate bonds and Treasuries rallied to push yields down sharply on the very day of the bad news on jobs, as traders fled to safety on the realization that many more homeowners will have difficulty meeting higher adjusted interest payments in their floating-rate mortgages this year and next when unemployment rises further. Recession risks are overshadowing rate-cut hopes as market participants begin to understand that rates cuts can be neutralized by a liquidity trap in which banks cannot find enough creditworthy borrowers at any rate.
The interest-rate futures market was already pricing in a Fed Funds rate of 4.57% by the end of October, a 68-basis-point drop from current the Fed Funds target of 5.25%. Fear remains that a rate cut not only may not help alleviate the present credit squeeze in the non-bank financial system, it could also be a psychological trigger that would destroy the Fed's already dwindling credibility. A market that catches on to the impotence of central-bank intervention can go into a free fall.
In fact, a program of sharp rate cuts will render risk-averse investment unattractive and revive the insatiable risk appetite for abnormally high returns that landed the US economy in its current sorry state in the first place. A case can be made that what is needed under current conditions is not more cheap money from the Fed, but full employment with rising wages by government fiscal stimulants to boost consumer demand.
The US government should make use of the money that the banks cannot find worthy borrowers to lend to, with money-cautious investors seeking to lend to the government, creating jobs for infrastructure rehabilitation and upgrading education to get the economy moving again off the destructive track of privatized systemic financial manipulation.
Credit-market seizure causes more unemployment
The scurry by banks to shore up their deteriorating balance sheets as the commercial-paper market dries up as a source of funding for many of their highly leveraged borrowers could slow down bank funding for consumer credit further, to cause a downward spiral of more layoffs in the already anemic US economy. Also, as recently completed private-equity deals structured with cheap money turn distressed with a credit squeeze, massive layoffs in the target companies will follow, adding to a further sharp rise in unemployment.
More ominous, the wide anticipation for a rate cut by the Fed at its September 18 FOMC meeting has already pressured the exchange rate of the US dollar, pushing up gold prices. By September 12, the GLD exchange-traded fund (ETF) for gold set a 52-week high of $70, with gold prices rising above $700 per ounce from $610 in January. Oil has risen above $80 per barrel. Food prices are rising. A further weakening of the dollar combined with faster-growing economies in emerging markets means foreign investors would invest in non-dollar zones or in US companies that have non-dollar revenue, further weakening the US domestic market.
All 10 major sectors in the S&P fell lower on September 7, and for the week, the US consumer discretionary sector fell 3.2% amid fears over lower consumer spending. Home-builders lost 6.8% for the week, taking their fall for the year to 50%. Financials declined 2.6% for the week, while the S&P Investment Bank Index fell 0.8% on the day of the discouraging jobs report, taking its loss for the year to 16.5%.
Investors are still waiting nervously to see whether the market can clear a backlog of $300 billion in unsold debt paper and bonds associated with this year's record private-equity buyout deals. In the midst of all the negative news, it is sometime forgotten that the Dow Jones Industrial Average is still above 13,000, a level substantially higher than economic fundamentals would justify. Left alone, a truly free market would adjust downward by as much as 40% before all the liquidity fluff is removed. The pleasure of excess in the market is never restrained by the excess of pleasure, which unfortunately must be paid for at some point by pain in the economy.
Still, structural disparity in job opportunities persists in the faltering US economy. In August, white unemployment was at 4.2%, below the overall rate of 4.6%; black unemployment at 8.0%; Hispanic at 5.9%; and Asian at 3%. The last two categories did not include illegal immigrants, which could alter data on underemployment substantially. Teenage (16-19) unemployment was at 15.2%, while black teen unemployment was 26.5%. The pain of NAIRU has not been equitably shared even in the liquidity boom. The rising tide failed to lift all boats.
Hidden US unemployment was 16.2 million or 10.3% of the labor force. They included 4.3 million who had part-time jobs because they could not find full-time employment and 4.8 million who wanted jobs but were not counted in official statistics because they were not looking, of whom about 1.4 million searched for work during the prior 12 months and were available for work during the reference week.
In addition, millions more were working full-time, year-around, yet earned less than the official poverty level for a family of four. In 2005, the latest year for which data were available, that number was 17.0 million, 16.2% of full-time workers. In June 2007, the latest month available, the number of job openings was only 4.3 million, nearly four job-seekers for each job opening, while corporate earnings continued to rise from job outsourcing and financial manipulation such as share buybacks made possible by a liquidity boom.
Phantom 'strong economic fundamentals'
With the liquidity boom abruptly halted, residual robust employment and corporate earnings were misidentified as the alleged remaining "strong" economic fundamentals to which high US government officials and Wall Street cheerleaders misleadingly referred, in defiance of facts even weeks after the subprime-mortgage crisis broke out. Even honest fools would know that a collapse of credit markets would lead quickly to rising unemployment and falling corporate profits, and high government officials and high-paid analysts are surely not fools. The issue then must be one of honesty.
Non-farm US payroll employment dropped by 4,000 in August to 138 million, and the unemployment rate remained at 4.6% or 7.1 million workers, more than the total population of any US city except New York. Still, 4.6% is uncomfortably on the low end of NAIRU (4-6%), and that means an interest-rate cut now would risk inflation down the road in a faltering economy, ie, stagflation, as in the 1977-81 period under Fed chairman Paul Volcker and president Jimmy Carter. This is the dilemma faced by the Fed: a cut in short-term rates may do more harm than good by not helping to sustain a liquidity boom yet fueling accelerated inflation, not to mention leading to a loss of confidence of the part of the market in the Fed's ability to manage a monetary and financial crisis.
As with their flawed attitude toward risk, the authorities in charge of regulating financial markets and the US economy apparently think that inflation-fighting structural unemployment spread over the whole economic system is not damaging to the economy as long as the resultant profit is privatized and concentrated on a preferred selection of financial institutions, even if the privatized profit is achieved by externalizing the cost of risk to the entire financial system through structured finance. Free-market capitalists obviously think that socializing risk or unemployment is not dreaded evil socialism, only socializing profit is.
Over the third quarter of 2007, total US payroll employment changes have averaged 44,000 new jobs per month, well below the monthly average of 147,000 new jobs between January and May. In August, employment in manufacturing, construction, and local government education declined, while job growth continued in health care and food services. The civilian labor force edged down to 152.9 million, and the labor-force participation rate decreased to 65.8%. The declines were largely due to a drop in labor-force participation among teenagers; their participation rate fell to 39.7%. Total employment in August was 145.8 million.
Part-time and temporary workers
The number of Americans working part-time for economic reasons, at 4.5 million in August, was 359,000 higher than a year earlier. This category includes people who indicated that they would like to work full-time but were working part-time because their hours had been cut back or because they were unable to find full-time jobs.
Nearly 1.4 million Americans (not seasonally adjusted) were only marginally attached to the labor force in August, down by 227,000 from a year earlier. These individuals wanted and were available to work and had looked for a job some time during the prior 12 months. They were not counted as unemployed because they had not searched for work in the four weeks preceding the survey.
Among the marginally attached, there were 392,000 discouraged workers in August, little different from a year earlier. Discouraged workers are those not currently looking for work specifically because they believe no jobs are available for them even if they try. The nearly 1 million remaining persons marginally attached to the labor force in August had not searched for work in the four weeks preceding the survey for reasons such as school attendance and family responsibilities.
Drop in employment in August
The overall drop in employment in August was preceded by negligible job growth in June (+69,000) and July (+68,000), as revised. In August, employment continued to fall in manufacturing and construction; local government education also lost jobs. Job gains continued in health care and in food services and drinking places.
Manufacturing employment declined by 46,000 in August, losing 215,000 jobs over the past year. In August, declines were widespread among component industries: for durable goods, job losses in motor vehicles and parts were 11,000, machinery 7,000, wood products 7,000, furniture and related products 4,000, and semiconductors and electronic components 4,000. For non-durable goods, manufacturing job loss continued with 4,000 in apparel and 2,000 in textile mills. Construction employment declined in August by 22,000, with most of the loss occurring among residential specialty trade contractors. Since its most recent peak in September 2006, construction employment has fallen by 96,000. Employment in local government education fell by 32,000 in August, as seasonal hiring was less than usual.
Health care employment continued to grow in August (+35,000); the industry added 396,000 jobs over the year. In August, the good news was that employment continued to grow in all the components of health care: ambulatory care services (+18,000), hospitals (+11,000), and nursing and residential care (+6,000). The bad news was that this was the sector with the highest inflation rates. Employment in social assistance rose by 14,000 and was 83,000 above its year-ago level, showing that the economic cancer of income disparity was growing faster than the economy as a whole.
Within leisure and hospitality, food services and drinking places, employment continued to expand in August (+24,000). The industry has added 350,000 jobs over the year, showing that the rich are still enjoying the good life, albeit employment in the accommodation industry has trended down over the past three months due to a drop in business traveling and middle income family vacationing.
Employment in retail trade was little changed in August because of back-to-school shopping. A job gain in building material and garden supply stores was partially offset by a decline in general merchandise stores. Wholesale trade employment changed little in August because unemployment in these sectors tends to have longer lag time.
Employment in financial activities was flat in August, following a large increase in July. Within the industry, employment in credit intermediation edged down over the month and was 19,000 below its most recent peak in February. The trend is expected to rise sharply in coming months to reflect turmoil in the credit market. One company, Countrywide, alone announced a job-cut program of 12,000 in the next three months. The mortgage brokerage industry is expected to lose 100,000 jobs this year. A sharp shift in employment from deal-making to distress restructuring is expected.
In professional and business services, management and technical consulting services added 7,000 jobs in August, and temporary help employment continued to trend down. Temporary help has lost 72,000 jobs thus far in 2007 as companies downsize by first shedding temporary workers with no severance cost and pension liabilities.
Average hourly earnings of production and non-supervisory workers on private non-farm payrolls increased by five cents, or 0.3%, in August to $17.50, seasonally adjusted. Average weekly earnings grew by 0.3% over the month to $591.50. The CPI (consumer price index) in July was 2.4% higher than in July 2006. August 2007 CPI data are scheduled to be released on Wednesday at 8.30am Eastern Standard Time, one day after the scheduled FOMC meeting that decides on Fed Funds rate targets. The employment situation for September is scheduled to be released on Friday, October 5, three weeks before the scheduled two-day meeting of the FOMC on October 30-31.
The honest services issue
On Friday, September 7, the disappointingly bad news on August employment was released to the public at 8.30am Eastern Standard Time by the Bureau of Labor Statistics (BLS). Although the data had been embargoed until official release time, surely both the Fed and the Treasury had advanced knowledge of BLS data as they were collected. It is inexplicable why those in charge of maintaining the sustainability of a healthy economy and open and transparent markets would knowingly pronounce misleading prognosis on economic trends that they know to be false and that would be refuted by pending public release of official data in a matter of days. Do these officials not realize that by not coming clean before the sun rises on what they know to be false, they damage rather than promote market confidence in their ability to manage the economy?
By any measure, the employment data for August were discouraging. Yet on Thursday evening, September 6, some 12 hours before the public release of the dismal BLS August employment data, Treasury Secretary Henry Paulson said in an interview on Nightly Business Report on Public Broadcasting Service (PBS)that turmoil in credit markets will only exact a price on the US economy but would not stall its growth. "There will be a penalty to our economic growth and I'm quite comfortable that we're going to continue to grow, create jobs," said Paulson. "We have a very strong economy against the backdrop of these stresses and strains in the capital markets," the US Treasury chief added confidently.
His bravado was not echoed by market confidence the next day. Mortgage defaults continue to soar to seize up credit markets as lenders grow increasingly reluctant to lend and investors to invest in commercial paper amid uncertainty about the true conditions of portfolios with risky mortgages that have been packaged into synthetic tranches of securities, given investment-grade ratings by rating agencies and sold in credit markets to unidentified investors around the world, leaving the market scrambling to determine which institutions are left holding the unsold toxic commercial papers.
When asked how long he thought it would take to sort out the stress in capital/debt markets and determine how serious the contagion problems actually are in subprime mortgage loans, Paulson, having repeatedly declared that the problem had been contained in previous weeks, now said: "It's certainly going to be into the weeks, maybe a matter of months. I have a difficult time making projections, but it will be a while."
It is not clear if Paulson, the nation's highest finance official, was making a political statement or deliberately false market analysis by someone in the position to know about the true state of finance in the economy. The US Treasury for over a decade under both Democrat and Republican administrations has been the branch of the government most responsible for pushing financial globalization to produce a strong US-dominated global economy at the expense of a weak US domestic economy held up by debt.
The situation makes it very difficult for the Fed to use monetary ease, ie, lowing dollar interest rates, to stimulate the US economy without pushing the exchange rate of the dollar down, which will further weaken the US domestic economy. A collapse of the dollar will make a recession seem like a tea dance by comparison.
Enron executive not guilty?
It should be recalled that top Enron executives who made similar, knowingly false statements about their company to calm markets were convicted of fraud and sent to prison. The conviction was based on the so-called "honest services" theory of which the defendants had conspired to deprive the company.
On September 11, Paulson finally came clean on the seriousness of the crisis of confidence in credit markets and admitted that it would take longer to work out than previous financial shocks of the past two decades, such as the 1982 Latin American debt crisis, the 1997 Asian financial crisis and the 1998 Russian bond default that sank Long Term Capital Management, a big, highly-leveraged hedge fund. The uncertainty over the distribution of holdings and the complexity of valuing structured finance instruments based on subprime mortgages could last for up to two years, as many such loans reset to higher rates over time. Still, he assures the market that the US economy is fundamentally strong, a position that instead of calming markets only makes him seem disconnected to reality.
Paulson spoke in Washington as Jean-Claude Trichet, the European Central Bank president, warned that it was time for global financial authorities to tackle unregulated entities whose activities had contributed to the latest upheavals. Ratings agencies were called to a special meeting for questioning by regulators on the way they rated structured financial products based on mortgage collaterals.
As Treasury secretary, Paulson of course enjoys legal immunity on misleading political statements that technically stay clear of perjury or other impeachable offenses. And no suggestion is made here that Paulson is not an honorable man. Yet moral immunity from robbing society of "honest services" by the Treasury secretary of the world's most powerful economy is a different matter in the court of public opinion and in the judgment of history.
Interestingly, the day after the Paulson interview on PBS, former Enron chief executive officer Jeff Skilling filed an appeal before the Fifth Circuit Appeals Court in New Orleans more than 15 months after he was convicted and nearly nine months after he began serving a 24-year, four-month prison term in southern Minnesota.
Skilling's top-rated legal team, led by Daniel M Petrocelli, who also famously won a wrongful death civil suit against O J Simpson on behalf of Fred Goldman, surviving father of murdered victim Ron Goldman, argues that errors by prosecutors and US District Judge Sim Lake, who presided over Skilling's first trial in Houston, require the appeals court to overturn all 19 of his convictions of conspiracy, securities fraud, insider-trading and lying to auditors. "They were in search of crimes knowing this wasn't a clear-cut case, and in particular, that Jeff Skilling hadn't done anything wrong," said Petrocelli in an interview, whose firm, O'Melveny & Meyer, reportedly was owed $30 million in legal fees by Skilling from the first trial.
The appeal said the government sought to criminalize normal business activities in its zeal to ensure someone paid for Enron's failure. "That someone was Jeff Skilling - the last man standing when the court meted out its punishment," the appeal said. Former Enron chairman Ken Lay, Skilling's co-defendant in their fraud and conspiracy trial last year, died six weeks after the pair was convicted, vacating his criminal liability.
The major arguments presented by the appeal include:
1. Prosecutors used a flawed theory that Skilling robbed Enron of his "honest services" to prove the overarching count of conspiracy to commit securities and wire fraud. A Fifth Circuit panel rejected that prosecution theory in a shareholder class action suit against Enron two months after Skilling's conviction.
2. Judge Lake gave flawed jury instructions, most notably allowing jurors to find Skilling guilty of deliberately ignoring fraud when his defense was that no fraud existed. Lake refused to move the trial from Houston, where the defense contends anger about those hurt by Enron's collapse poisoned the jury pool. Skilling never asserted an "ostrich" defense, a usual prerequisite to issuing the "deliberate ignorance" instruction.
3. Skilling's prison term is excessive and unconstitutional, being four times longer than any other convicted Enron executive, two to three times longer than comparable white-collar defendants and six years longer than the average federal sentence for murder, albeit slightly less than the record-breaking 25 years in prison being served by Bernie Ebbers, the former boss of bankrupt WorldCom.
Judge Patrick Higginbotham of the Fifth Circuit signaled last December that Skilling's legal argument could be well received regarding 14 of the 19 counts. In a ruling denying Skilling's request to remain free on bond during appeal, Higginbotham pointed to "serious frailties" in those counts, noting "difficulties brought by a decision of this court handed down after the jury's verdict". Higginbotham did not sit on the panel that issued the honest services decision, but he also wrote that Skilling had not raised issues likely to lead to reversal of all his convictions.
Skilling's appeal argues, however, that the prosecution's "honest services" theory taints all the other counts and that Skilling should get a new trial. The theory took a judicial hit in August 2006 when the appeals panel threw out convictions of four former Merrill Lynch & Co executives in the Enron case. The judges said prosecutors improperly argued that the defendants robbed Enron of their "honest services" when they helped push through a loan on Nigerian barges disguised as an asset sale in late 1999 to help the energy company meet its missed earnings targets.
The appeals panel ruled that the "honest services" theory did not apply because the Merrill Lynch defendants acted in Enron's corporate interests and did not take money or property from the energy company, even though their firm profited financially from the arrangement. There was no criminality because the money came from society, an entity that apparently has no court-recognized legal rights or advocate of legal standing in the legal system of market capitalism.
Prosecutors in the Skilling case had argued that he "robbed" Enron of his "honest services" by breaching his duty to make sure financial statements correctly reflected the state of the company.
Skilling argues in his appeal that he did not steal anything. Yet he was unjustly convicted of one count of conspiracy, a dozen counts of securities fraud, one count of insider trading and five counts of making false statements to auditors, while he was acquitted of nine counts of insider trading. The "honest services" theory was presented by the prosecution only with the conspiracy count, but the appeal argues an instruction Judge Lake gave the jury links it to the other counts as well. Oral arguments in the appeals case are expected to be scheduled for 2008.
Conflict between systemic guilt and individual guilt
The issue raised by the Skilling appeal, beyond the legal technicalities, was a conflict between systemic failure and individual responsibility. The court found Skilling guilty personally to absolve the system from guilt. The Appeals Court has ruled in related cases that convicted defendants were acting within the laws and regulations then governing their behavior. The court's decision implies that criminality rests with the system, not the individuals involved. However, logic would suggest that Skilling, by participating in a guilty system, cannot escape personal criminality even though he did not violate any laws of the system. That logic has been firmly established by the historic Nuremburg trials for war criminals.
Over the years of the liquidity boom, some people have profited very handsomely securitizing and selling subprime mortgages. These people were not even required to pay their fair share of taxes. Now in the consequential liquidity bust, these same people are home free because they have passed the risk onto unsuspecting money market and pension funds that hold the savings of middle income citizens. The structured financiers are keeping their ill-earned profit while the massive loss will be borne by millions of others who innocently thought they were investing in risk-averse instruments created by the same financiers. Even the former chairman of the Federal Reserve had been on record for having said publicly that systemic risk is a good trade-off for unprecedented economic expansion. There is a high probability that individuals responsible for the credit melt-down that will hurt millions will be brought to justice before the end of the day. The uncertainty is who they will be.
Hobson's choice
By Chan Akya
The past two weeks have provided us with a tantalizing glimpse of what lies ahead for the US economy, with the blow-up in subprime mortgages helping to unravel market confidence around the world. Global equity declines have wiped out some US$2.5 trillion of wealth, the conversion of which to consumption implies a fall of between 1% and 2% of global gross domestic product.
That kind of decline cannot be made good by growth improvements in China or India; indeed, the decline hits these countries quite hard unless they can diversify their own sources of growth.
In a previous article, [1] I wrote the following:
Dependent on the munificence of strangers like no other superpower in history, a US decline is unstoppable. That said, the surge in the value of Chinese stocks underlines the desperation rather than genius of global investors ...
If the sting of a scorpion surprises a burglar, he is caught between the need to scream, risking capture, or silently bearing the pain before gingerly withdrawing into the night. Much the same logic rules the financial markets these days, where the poor returns to be had in the US markets have driven many investors to search for alternatives, even if these appear overvalued themselves. This global epidemic of pseudo-logic will end in tears for many investors, but at least the people with the real savings have the ability to recover, which the US economy appears to lack.
Both parts of this scenario have come about, namely an obvious decline in global stock markets, which was prompted both by economic concerns in the United States and maladroit financial-markets regulation by China. [2]
Borrowers and ultimate lenders
It is a good old rule of banking that when you borrow $1 million from the bank and cannot repay, you are in trouble, but if you borrow $100 million from the bank and cannot repay, the bank is in trouble. In the above scenario, linkages through the global financial system mean that Asian banks and investors were holding a substantial portion of risk linked with the poor borrowers in the US. These are the same people whose inability to repay prompted the bankruptcy of some specialist firms that lend money to poor Americans, in turn touching off the crisis described above for global equity markets.
My point in repeating the story is to highlight the fact that the other shoe has not dropped yet - ie, Asian lenders who suffered losses from buying these securities are unlikely to purchase other US obligations until a clearer picture of the economy emerges. This translates to a withdrawal of liquidity from US financial markets, adversely affecting the prospects for the rest of the year. Americans, who are used to consuming more than they produce, will have to reverse course. The result will be akin to a fat person going on a bread-and-water diet for six months: painful, but necessary.
The likely pain of the adjustment for Americans will depend much on how quickly the rest of the world goes into recession with the US. It is important to note that any "lag" will only make the US recession more painful for Americans. For example, if only the US economy goes into recession, then oil prices will likely remain near current levels, which, combined with a falling US dollar, will keep inflation too high for any interest-rate cuts. Without such cuts, which would help to reduce monthly mortgage payments for Americans, it is likely that more people will have to declare bankruptcy, which feeds the vicious cycle of falling stock markets.
In contrast, if the rest of the world catches the recession fever from the US right away, oil prices will fall and central banks around the world can cut rates. As I explain below, the second scenario is not likely, therefore the US will have to endure a painful recession all alone.
Readers looking at this week's mild recovery in asset prices should be cognizant of this risk. I expect further downturns for US equity markets in coming weeks and months; it is likely that the widely watched Dow Jones average will close this year below the level of 10,000 from about 12,200 currently as investors adjust downward their earnings expectations as well as the multiple of earnings they are willing to pay for owning shares. In turn, this would prompt declines in other stock markets around the world, particularly in South America, whose economy, if not its politicians, depends almost entirely on US economic growth.
Why the US will stand alone
In past crises, such as the 1987 stock-market crash or the recession in the early 1990s that sank the administration of president George H W Bush, the US could depend on the munificence of strangers. In particular, the world's sole superpower attracted enough money from risk-averse investors to refloat its economy. That time has, however, come and gone as developing countries no longer "need" to buy US government bonds. Indeed, as I argued in a previous article, [3] they are better served by investing in physical assets such as commodities directly rather than diverting their savings to the low-return US markets.
In addition to the economic rationale of protecting their own growth, the world's investors are also not interested in US assets for political reasons. A quick look at the world's largest repositories of savings shows the extent of the problem: Middle Eastern investors will buy anything as long as it is not American, while Asian investors are likely to be scared off by recent losses on mortgage holdings. Other countries such as oil-rich Venezuela and Russia explicitly use their reserves as diplomatic tools.
With friends like these ...
Perhaps a diversion to consider the fragile reputation of America's politics is necessary here. The lost war in Iraq has failed to make the US government honest - indeed, the opposite appears to have happened. Like an alcoholic on the run from his treatment clinic, wrecking drink cabinets, Vice President Richard Cheney stomped into the capitals of US allies as the unapologetic face of the most unpopular US administration in recent history.
In so doing, he caused more damage to America's friends than its enemies could possibly inflict in a one-week window. To name just two, Cheney's visit has virtually guaranteed Prime Minister John Howard's re-election defeat in Australia, [4] and rendered precarious the position of Pakistan's unelected President General Pervez Musharraf, who had the indignity of being admonished by the petulant "veep".
At home, the conviction of Lewis "Scooter" Libby has added another layer of concern for the besieged White House, while the poor treatment of its war veterans in hospital will likely depress even diehard Republicans. That leaves the field wide open for a Hillary assault on the presidency next year. I expect that on her way, Senator Clinton will put into play everything that the Republicans stood for, including free trade and a measured approach to China.
This is where the Asian response becomes critical. Expecting no help from the American consumer is one thing, but also to confront political assaults is an entirely different matter. The upshot is that Asian countries will be forcefully cajoled into allowing their currencies to appreciate against the US dollar in coming months, with people like US Treasury Secretary Henry Paulson urging action (as he did this week) sooner so that these countries do not have to confront something worse later on, viz a Hillary presidency.
China has the most to lose from a currency appreciation. In addition to the accounting losses on its foreign-exchange reserves, the country will also have to set aside money to rescue its banks, whose bad debts will mount precariously when the economy suddenly lurches from export orientation to domestic consumption. The only reason to rush this through now is that waiting a few more months would make the eventual impact worse for both the US and China.
The past two weeks have provided us with a tantalizing glimpse of what lies ahead for the US economy, with the blow-up in subprime mortgages helping to unravel market confidence around the world. Global equity declines have wiped out some US$2.5 trillion of wealth, the conversion of which to consumption implies a fall of between 1% and 2% of global gross domestic product.
That kind of decline cannot be made good by growth improvements in China or India; indeed, the decline hits these countries quite hard unless they can diversify their own sources of growth.
In a previous article, [1] I wrote the following:
Dependent on the munificence of strangers like no other superpower in history, a US decline is unstoppable. That said, the surge in the value of Chinese stocks underlines the desperation rather than genius of global investors ...
If the sting of a scorpion surprises a burglar, he is caught between the need to scream, risking capture, or silently bearing the pain before gingerly withdrawing into the night. Much the same logic rules the financial markets these days, where the poor returns to be had in the US markets have driven many investors to search for alternatives, even if these appear overvalued themselves. This global epidemic of pseudo-logic will end in tears for many investors, but at least the people with the real savings have the ability to recover, which the US economy appears to lack.
Both parts of this scenario have come about, namely an obvious decline in global stock markets, which was prompted both by economic concerns in the United States and maladroit financial-markets regulation by China. [2]
Borrowers and ultimate lenders
It is a good old rule of banking that when you borrow $1 million from the bank and cannot repay, you are in trouble, but if you borrow $100 million from the bank and cannot repay, the bank is in trouble. In the above scenario, linkages through the global financial system mean that Asian banks and investors were holding a substantial portion of risk linked with the poor borrowers in the US. These are the same people whose inability to repay prompted the bankruptcy of some specialist firms that lend money to poor Americans, in turn touching off the crisis described above for global equity markets.
My point in repeating the story is to highlight the fact that the other shoe has not dropped yet - ie, Asian lenders who suffered losses from buying these securities are unlikely to purchase other US obligations until a clearer picture of the economy emerges. This translates to a withdrawal of liquidity from US financial markets, adversely affecting the prospects for the rest of the year. Americans, who are used to consuming more than they produce, will have to reverse course. The result will be akin to a fat person going on a bread-and-water diet for six months: painful, but necessary.
The likely pain of the adjustment for Americans will depend much on how quickly the rest of the world goes into recession with the US. It is important to note that any "lag" will only make the US recession more painful for Americans. For example, if only the US economy goes into recession, then oil prices will likely remain near current levels, which, combined with a falling US dollar, will keep inflation too high for any interest-rate cuts. Without such cuts, which would help to reduce monthly mortgage payments for Americans, it is likely that more people will have to declare bankruptcy, which feeds the vicious cycle of falling stock markets.
In contrast, if the rest of the world catches the recession fever from the US right away, oil prices will fall and central banks around the world can cut rates. As I explain below, the second scenario is not likely, therefore the US will have to endure a painful recession all alone.
Readers looking at this week's mild recovery in asset prices should be cognizant of this risk. I expect further downturns for US equity markets in coming weeks and months; it is likely that the widely watched Dow Jones average will close this year below the level of 10,000 from about 12,200 currently as investors adjust downward their earnings expectations as well as the multiple of earnings they are willing to pay for owning shares. In turn, this would prompt declines in other stock markets around the world, particularly in South America, whose economy, if not its politicians, depends almost entirely on US economic growth.
Why the US will stand alone
In past crises, such as the 1987 stock-market crash or the recession in the early 1990s that sank the administration of president George H W Bush, the US could depend on the munificence of strangers. In particular, the world's sole superpower attracted enough money from risk-averse investors to refloat its economy. That time has, however, come and gone as developing countries no longer "need" to buy US government bonds. Indeed, as I argued in a previous article, [3] they are better served by investing in physical assets such as commodities directly rather than diverting their savings to the low-return US markets.
In addition to the economic rationale of protecting their own growth, the world's investors are also not interested in US assets for political reasons. A quick look at the world's largest repositories of savings shows the extent of the problem: Middle Eastern investors will buy anything as long as it is not American, while Asian investors are likely to be scared off by recent losses on mortgage holdings. Other countries such as oil-rich Venezuela and Russia explicitly use their reserves as diplomatic tools.
With friends like these ...
Perhaps a diversion to consider the fragile reputation of America's politics is necessary here. The lost war in Iraq has failed to make the US government honest - indeed, the opposite appears to have happened. Like an alcoholic on the run from his treatment clinic, wrecking drink cabinets, Vice President Richard Cheney stomped into the capitals of US allies as the unapologetic face of the most unpopular US administration in recent history.
In so doing, he caused more damage to America's friends than its enemies could possibly inflict in a one-week window. To name just two, Cheney's visit has virtually guaranteed Prime Minister John Howard's re-election defeat in Australia, [4] and rendered precarious the position of Pakistan's unelected President General Pervez Musharraf, who had the indignity of being admonished by the petulant "veep".
At home, the conviction of Lewis "Scooter" Libby has added another layer of concern for the besieged White House, while the poor treatment of its war veterans in hospital will likely depress even diehard Republicans. That leaves the field wide open for a Hillary assault on the presidency next year. I expect that on her way, Senator Clinton will put into play everything that the Republicans stood for, including free trade and a measured approach to China.
This is where the Asian response becomes critical. Expecting no help from the American consumer is one thing, but also to confront political assaults is an entirely different matter. The upshot is that Asian countries will be forcefully cajoled into allowing their currencies to appreciate against the US dollar in coming months, with people like US Treasury Secretary Henry Paulson urging action (as he did this week) sooner so that these countries do not have to confront something worse later on, viz a Hillary presidency.
China has the most to lose from a currency appreciation. In addition to the accounting losses on its foreign-exchange reserves, the country will also have to set aside money to rescue its banks, whose bad debts will mount precariously when the economy suddenly lurches from export orientation to domestic consumption. The only reason to rush this through now is that waiting a few more months would make the eventual impact worse for both the US and China.
'Cracks' in credit
By Chan Akya
Not a day goes by without a major European or US bank announcing some kind of financial complication or the other. While much of the problem lies with exposures to the US subprime market, it is perhaps no exaggeration to point out that when banks cannot or will not lend to one another, the global financial system is for all intent and purposes broken.
There are multiple facets of this problem, as I described in recent articles: first, the penchant of Asian countries to preserve fixed currency values against the US dollar, which has caused the massive and unnecessary reserves buildup that underpins the whole deck of cards that the financial system is today. The second issue is the repackaging of billions of dollars of US housing (mortgage) debt, the defaults on which threaten to wipe out many years of already meager investment returns for Asian central and commercial banks. Third, we have the reactions from the Western central banks such as the US Federal Reserve and the European Central Bank that are aimed at stabilizing the financial system but draw much on the implicit support of Asian savers.
Caveat venditor
Since the mid-1980s, the United States has waged an undeclared war against Colombian drug suppliers. Reeling from a mounting problem of substance abuse in urban America and the inevitable decay this caused across the productive landscape, US lawmakers in essence took international law into their own hands and authorized their military and Central Intelligence Agency to attack the various Colombian drug cartels (such as those based in Medellin, Cali et al).
I have no sympathy with drug pushers, but the attacks on Colombia, which included precision air strikes deep within sovereign territory, did raise two important questions: first on the right international protocols that must be observed and, perhaps more important, the second consideration of why the United States wasn't tackling its end of the problem with equal fervor or aggression.
I will leave the first issue for diplomats to consider and address, especially as the pattern has repeated since then, with the most recent examples being the invasion of Afghanistan and Iraq, ostensibly under the guise of killing terrorists based there.
The second issue raised above, though, goes much deeper, into the moral values that the United States upholds. The principle of caveat emptor or "buyer beware" has held for centuries. It in essence implies that anyone purchasing a product must bear the consequences of subsequent performance. In the case of illegal drugs, though, the US government changed this core principle to caveat venditor or "seller beware", in other words transferring the onus of the problem to the sellers and indeed their countries.
Attempts at destroying supply lines without changing the demand situation, as more and more American youngsters and their parents get stoned, obviously runs counter to good economic principles. Prices simply go up and, when they do, suppliers become increasingly desperate and therefore ruthless. Within the "community" of US drug pushers, the "war on drugs" thus caused the gentlemanly Italian mobsters rapidly to give way to the ruthless Latin American gangs who left a much greater trail of carnage behind.
The lack of a comprehensive program to reduce drug usage by youngsters and nip the demand problem in the bud remains an extremely relevant one even today, well after the "war on drugs" started some 30 years ago. The biggest weakness in the US armory is thus its own inability to cut demand. Without such ability the country can pursue drug pushers to the moon (which is not a function of how "high" they can get) and still fail to curb the problem.
Credit is addictive too
Much like the supposed highs from using illegal drugs, borrowing outside of one's means provides the opportunity for people to make more than their fair share of income. This leveraging effect has been at the heart of much of the value that the United States supposedly created for itself in the past 20 years. Take it away and suddenly the famed finance-based economy simply falls apart like a house of cards.
A typical person would carefully examine what he can afford before taking out a loan, especially on an asset as important as a house. He would then find something that fits his budget, move in and hope for the best. This is not without risk, but at least the basic process of taking only risks acceptable to everyone is indeed followed. The process also has an advantage in that when someone makes a choice of, say, a mortgage that cannot be afforded, the banking counter-party typically turns him down, forcing him to reduce his expectations.
During the 1990s, though, the US basically discarded every basic principle of banking. First, a central banker intent on protecting Wall Street bonuses jumped the gun on cutting interest rates sharply, in essence creating negative interest rates that presaged rampant asset inflation. The moves were already quite controversial because of what had happened in Hong Kong during the early 1990s, when the currency peg to the US dollar kept interest rates below the local inflation rate, in essence fueling a massive asset bubble that popped painfully in the late '90s and caused house prices to fall some 50%. Despite the wealth of historical and recent examples, then-Federal Reserve chairman Alan Greenspan and his cohorts chose to keep interest rates too low.
Of course, one shouldn't judge Greenspan too harshly either. He found himself presiding over an economy that had lost all of its productive capabilities (this was partly to blame for the drug problem cited above). The US could no longer make stuff, ranging from refrigerators to cars, that could compete with the offerings from Japan and Europe on either price or quality. In that context, creating a nation of software developers (the Internet boom and bust) and then property developers (real-estate boom and bust) seems a logical choice.
As borrowers expanded their appetite for loans and depended increasingly on house-price appreciation to repay mortgage debt, US banks of course felt the need to sell down their risks increasingly, in turn spawning the financial innovations that I wrote about in previous articles. Selling down the risk to hapless Asian savers seeking higher returns than Treasury bonds also freed up the banks to make more loans.
Therein lay the crux of the current crisis - as banks originated ways to distribute risk, they did not care about underlying credit quality to the same extent that they would have if the loans had sat in their own books. Investors buying into securitized transactions relied on data that had been gathered during periods when the banks did care about underlying credit quality. Removal of this crucial factor was to cause a massive increase in underlying problems soon enough.
Implications
Dealing with all these issues holistically requires us to examine the primary causal factor, which inevitably is the excessive consumption of the US consumer. In another article, I described the United States as a corpulent feline that threatens the world with its firepower even as its own economy dies from within. This will come back to haunt both East Asia and the Middle East in coming weeks and months.
The collapse of market confidence has hit the North American and European financial systems hard. Banks fear the simple activity of lending to one another in the overnight market, necessitating that central banks cut rates for emergency funding (known as the discount window) and the Fed being pushed to cut rates next month, which now appears a dead certainty. However, neither rate cuts nor central-bank intervention will work without the crucial ingredient of the US getting more support from the rest of the world.
This is where the principle of caveat venditor that I described above will come into operation. In essence, US legislators have already started blaming lenders for the problems being faced by borrowers. The country's most famous bond manager, Bill Gross at PIMCO, has gone to the extraordinary length of suggesting direct government assistance for affected mortgage borrowers. I don't know if he plans to run for election as the next governor of California, but this is among the silliest things said by pretty much anyone in the markets recently.
Thus lenders will be asked to pony up for further restructuring payments in one way or the other - either by accepting lower interest rates or by facing the dreaded haircuts that I wrote about previously. They wouldn't be given the option to sell down risk, though, as the financial system has frozen up. Government officials including US Treasury Secretary Hank Paulson have reportedly made dozens of calls to Asian central banks this week demanding support for their markets, to be provided through emergency issues of loans for banks in Europe and North America.
A lack of cooperation would inevitably increase the chances for more nasty outcomes - including trade sanctions of the sort that the US is now mulling on China ostensibly for quality-control reasons but more likely for the ones stated above. This is eerily similar to the treatment meted out to Colombia in the 1990s, albeit for entirely different matters. Once again, the United States rides to the rescue of its citizens at the expense of all else.
It remains an unmitigated principle of banking that if one owes a million dollars to a bank and cannot pay, one is in trouble, but if one owes a billion dollars to a bank and cannot pay, the bank is in trouble. By lending to inept bankers in North America and Europe, Asian savers will now realize how true that principle is.
There is always another choice open for Asian policymakers. That would be to examine the system as it stands now and decide that ultimately the United States can simply never repay its debts. This would mean calling the greatest bluff in history, that of US financial strength, and letting the system collapse under its own weight. Doing this would cause significant short-term pain to the global economy, but eventually the removal of excessive US consumption cannot but be a good thing for the rest of the world.
Pushing that process through, though, requires both vision and popular legitimacy, and Asia's tragedy is that I cannot think of a single policymaker around the region who has both. Despise it if you will, but Asian savers will remain under the thumb of their biggest borrower for a long time yet.
Not a day goes by without a major European or US bank announcing some kind of financial complication or the other. While much of the problem lies with exposures to the US subprime market, it is perhaps no exaggeration to point out that when banks cannot or will not lend to one another, the global financial system is for all intent and purposes broken.
There are multiple facets of this problem, as I described in recent articles: first, the penchant of Asian countries to preserve fixed currency values against the US dollar, which has caused the massive and unnecessary reserves buildup that underpins the whole deck of cards that the financial system is today. The second issue is the repackaging of billions of dollars of US housing (mortgage) debt, the defaults on which threaten to wipe out many years of already meager investment returns for Asian central and commercial banks. Third, we have the reactions from the Western central banks such as the US Federal Reserve and the European Central Bank that are aimed at stabilizing the financial system but draw much on the implicit support of Asian savers.
Caveat venditor
Since the mid-1980s, the United States has waged an undeclared war against Colombian drug suppliers. Reeling from a mounting problem of substance abuse in urban America and the inevitable decay this caused across the productive landscape, US lawmakers in essence took international law into their own hands and authorized their military and Central Intelligence Agency to attack the various Colombian drug cartels (such as those based in Medellin, Cali et al).
I have no sympathy with drug pushers, but the attacks on Colombia, which included precision air strikes deep within sovereign territory, did raise two important questions: first on the right international protocols that must be observed and, perhaps more important, the second consideration of why the United States wasn't tackling its end of the problem with equal fervor or aggression.
I will leave the first issue for diplomats to consider and address, especially as the pattern has repeated since then, with the most recent examples being the invasion of Afghanistan and Iraq, ostensibly under the guise of killing terrorists based there.
The second issue raised above, though, goes much deeper, into the moral values that the United States upholds. The principle of caveat emptor or "buyer beware" has held for centuries. It in essence implies that anyone purchasing a product must bear the consequences of subsequent performance. In the case of illegal drugs, though, the US government changed this core principle to caveat venditor or "seller beware", in other words transferring the onus of the problem to the sellers and indeed their countries.
Attempts at destroying supply lines without changing the demand situation, as more and more American youngsters and their parents get stoned, obviously runs counter to good economic principles. Prices simply go up and, when they do, suppliers become increasingly desperate and therefore ruthless. Within the "community" of US drug pushers, the "war on drugs" thus caused the gentlemanly Italian mobsters rapidly to give way to the ruthless Latin American gangs who left a much greater trail of carnage behind.
The lack of a comprehensive program to reduce drug usage by youngsters and nip the demand problem in the bud remains an extremely relevant one even today, well after the "war on drugs" started some 30 years ago. The biggest weakness in the US armory is thus its own inability to cut demand. Without such ability the country can pursue drug pushers to the moon (which is not a function of how "high" they can get) and still fail to curb the problem.
Credit is addictive too
Much like the supposed highs from using illegal drugs, borrowing outside of one's means provides the opportunity for people to make more than their fair share of income. This leveraging effect has been at the heart of much of the value that the United States supposedly created for itself in the past 20 years. Take it away and suddenly the famed finance-based economy simply falls apart like a house of cards.
A typical person would carefully examine what he can afford before taking out a loan, especially on an asset as important as a house. He would then find something that fits his budget, move in and hope for the best. This is not without risk, but at least the basic process of taking only risks acceptable to everyone is indeed followed. The process also has an advantage in that when someone makes a choice of, say, a mortgage that cannot be afforded, the banking counter-party typically turns him down, forcing him to reduce his expectations.
During the 1990s, though, the US basically discarded every basic principle of banking. First, a central banker intent on protecting Wall Street bonuses jumped the gun on cutting interest rates sharply, in essence creating negative interest rates that presaged rampant asset inflation. The moves were already quite controversial because of what had happened in Hong Kong during the early 1990s, when the currency peg to the US dollar kept interest rates below the local inflation rate, in essence fueling a massive asset bubble that popped painfully in the late '90s and caused house prices to fall some 50%. Despite the wealth of historical and recent examples, then-Federal Reserve chairman Alan Greenspan and his cohorts chose to keep interest rates too low.
Of course, one shouldn't judge Greenspan too harshly either. He found himself presiding over an economy that had lost all of its productive capabilities (this was partly to blame for the drug problem cited above). The US could no longer make stuff, ranging from refrigerators to cars, that could compete with the offerings from Japan and Europe on either price or quality. In that context, creating a nation of software developers (the Internet boom and bust) and then property developers (real-estate boom and bust) seems a logical choice.
As borrowers expanded their appetite for loans and depended increasingly on house-price appreciation to repay mortgage debt, US banks of course felt the need to sell down their risks increasingly, in turn spawning the financial innovations that I wrote about in previous articles. Selling down the risk to hapless Asian savers seeking higher returns than Treasury bonds also freed up the banks to make more loans.
Therein lay the crux of the current crisis - as banks originated ways to distribute risk, they did not care about underlying credit quality to the same extent that they would have if the loans had sat in their own books. Investors buying into securitized transactions relied on data that had been gathered during periods when the banks did care about underlying credit quality. Removal of this crucial factor was to cause a massive increase in underlying problems soon enough.
Implications
Dealing with all these issues holistically requires us to examine the primary causal factor, which inevitably is the excessive consumption of the US consumer. In another article, I described the United States as a corpulent feline that threatens the world with its firepower even as its own economy dies from within. This will come back to haunt both East Asia and the Middle East in coming weeks and months.
The collapse of market confidence has hit the North American and European financial systems hard. Banks fear the simple activity of lending to one another in the overnight market, necessitating that central banks cut rates for emergency funding (known as the discount window) and the Fed being pushed to cut rates next month, which now appears a dead certainty. However, neither rate cuts nor central-bank intervention will work without the crucial ingredient of the US getting more support from the rest of the world.
This is where the principle of caveat venditor that I described above will come into operation. In essence, US legislators have already started blaming lenders for the problems being faced by borrowers. The country's most famous bond manager, Bill Gross at PIMCO, has gone to the extraordinary length of suggesting direct government assistance for affected mortgage borrowers. I don't know if he plans to run for election as the next governor of California, but this is among the silliest things said by pretty much anyone in the markets recently.
Thus lenders will be asked to pony up for further restructuring payments in one way or the other - either by accepting lower interest rates or by facing the dreaded haircuts that I wrote about previously. They wouldn't be given the option to sell down risk, though, as the financial system has frozen up. Government officials including US Treasury Secretary Hank Paulson have reportedly made dozens of calls to Asian central banks this week demanding support for their markets, to be provided through emergency issues of loans for banks in Europe and North America.
A lack of cooperation would inevitably increase the chances for more nasty outcomes - including trade sanctions of the sort that the US is now mulling on China ostensibly for quality-control reasons but more likely for the ones stated above. This is eerily similar to the treatment meted out to Colombia in the 1990s, albeit for entirely different matters. Once again, the United States rides to the rescue of its citizens at the expense of all else.
It remains an unmitigated principle of banking that if one owes a million dollars to a bank and cannot pay, one is in trouble, but if one owes a billion dollars to a bank and cannot pay, the bank is in trouble. By lending to inept bankers in North America and Europe, Asian savers will now realize how true that principle is.
There is always another choice open for Asian policymakers. That would be to examine the system as it stands now and decide that ultimately the United States can simply never repay its debts. This would mean calling the greatest bluff in history, that of US financial strength, and letting the system collapse under its own weight. Doing this would cause significant short-term pain to the global economy, but eventually the removal of excessive US consumption cannot but be a good thing for the rest of the world.
Pushing that process through, though, requires both vision and popular legitimacy, and Asia's tragedy is that I cannot think of a single policymaker around the region who has both. Despise it if you will, but Asian savers will remain under the thumb of their biggest borrower for a long time yet.
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