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Civilization And Investment Move Eastward

By Craig Stephen

Last month’s decision by HSBC Holdings to relocate its group chief executive officer from London to Hong Kong sent a strong signal about where the bank sees its future.

Now it looks as if new research from its economics team explains this move in report titled, “The Tipping Point — The rise of the East and Demise of the West.”

Have events reached the point where the threshold has been passed and everyone just “gets it,” or is this a case of just following the new bubbles in the East?

The International Monetary Fund seems to “get it.” Last week, it released forecasts saying the world economy will recover next year, but it will clearly be led by emerging economies, namely China with 9% growth in 2010 and India with 6.4%. That compares with U.S. growth at 1.5% and a mere 0.3% for the euro region. See full story on IMF World Economic Outlook.

And this two-speed growth is certainly reflected in the economic headlines of the day. Last week, U.S. unemployment reached a 26 year-high of 9.8%. For the U.K., the IMF warned of a structurally unsustainable debt mountain approaching a massive 13% of gross domestic product.

It’s a different story in Hong Kong where attention is focused on an influx of free- spending Chinese tourists for the eight day mainland holiday centered on National Day and the Mid Autumn festival. More than half a million tourists are forecast to visit, and property developers, retailers and hotels are all expecting a brisk trade.

At the same time, for those worried about a changing of the balance of power on the world stage, it seems evidence is everywhere. Last week we watched China’s bold 60th anniversary National Day Celebration parade in Beijing, including reportedly 50 new weapons systems. Meanwhile, it was Rio de Janeiro that got the vote to host the 2016 Olympics, and not Chicago, despite a personal plea by President Obama. And how many more times will we see Group of Seven meetings in the future, rather than G20, to reflect the new profile of world growth?

HSBC forecast emerging nations will dominate world economic activity in the years ahead.

A key reason is the debt burden of the developed world. Recent policy may have stabilized financial markets in the West, says HSBC, but individuals and governments remain awash in debt. Banks no longer enjoy the funding conditions of old, and this will combine to be a drag on growth.

Looking ahead, difficult choices will need to be made on “exit strategies” from stimulus programs. The IMF says the British will have to get used to working longer before retirement and paying for health care. Alan Greenspan now says the U.S. should consider tax increases to bring down debt.

The other trend HSBC economists highlight in their “tipping point” theory is that continued low interest rates will lead to global excess liquidity flowing into developing markets. That’s where the growth is, and where banking systems are robust. We have certainly seen this in Hong Kong.

In his new residence, HSBC’s CEO Michael Geoghegan will likely spend more time with the new Hong Kong Monetary Authority Chief, Norman Chan, than with embattled British finance ministers. See full story on HSBC CEO move.

Here, Geoghegan will have a ringside seat for the action as China moves to develop yuan trading in Hong Kong and internationalize its banking system. No doubt he will also want to be close at hand if the changing dynamics of the world economy mean Hong Kong eventually pegs its currency to the yuan and not the greenback. This is a policy to which there will be no change, Chan said during his first day in the job, as might be expected.

Playing ‘tipping point’ theory

For investors, even if you agree with this tipping point theory, playing this transition is not straightforward.

Slow growth and debt is usually bad new for respective currencies and HSBC says developing country currencies should strengthen against debt-burdened currencies like sterling and the dollar.

But for corporates, it’s a more complicated story. For China with its mercantile-style economy with a large degree of state-owned enterprises, company and corporate interests are often aligned, but shareholder interests less so.

In the West, international corporates are adept at minimizing the debt burdens of their home nations with careful tax planning.

HSBC’s CEO can cut his tax bill from 50% to 17% by relocating to Hong Kong. So far the group has not changed its tax domicile.

For investors, however, playing this new growth dynamic does not necessarily mean having to buy Chinese or Indian companies. The other option is global companies positioned for this growth.

One potential scenario to which this HSBC analysis leads is the excess global capital being channeled into developing markets, not just driving growth but a new propensity for bubbles.

We may be witnessing one in the initial public offering market in Hong Kong. After a recent massive over-subscription of new IPOs ( See Sep. 20 column.), subsequently five IPOs in Hong Kong closed below subscription price. Only time will tell — how much of the rise of the East is just the rise of a bubble?

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A History Of Funny Money

by Robert Kiyosaki

How did we get into the current financial mess? Great question.

Turmoil in the Making

In 1910, seven men held a secret meeting on Jekyll Island off the coast of Georgia. It’s estimated that those seven men represented one-sixth of the world’s wealth. Six were Americans representing J.P. Morgan, John D. Rockefeller, and the U.S. government. One was a European representing the Rothschilds and Warburgs.

In 1913, the U.S. Federal Reserve Bank was created as a direct result of that secret meeting. Interestingly, the U.S. Federal Reserve Bank isn’t federal, there are no reserves, and it’s not a bank. Those seven men, some American and some European, created this new entity, commonly referred to as the Fed, to take control of the banking system and the money supply of the United States.

In 1944, a meeting in Bretton Woods, N.H., led to the creation of the International Monetary Fund and the World Bank. While the stated purposes for the two new organizations initially sounded admirable, the IMF and the World Bank were created to do to the world what the Federal Reserve Bank does to the United States.

In 1971, President Richard Nixon signed an executive order declaring that the United States no longer had to redeem its paper dollars for gold. With that, the first phase of the takeover of the world banking system and money supply was complete.

In 2008, the world is in economic turmoil. The rich are getting richer, but most people are becoming poorer. Much of this turmoil is directly related to those meetings that took place decades ago. In other words, much of this turmoil is by design.

Power and Domination

Some people say these events are part of a grand conspiracy, and that might well be. Some people say they represent the struggle between capitalists, communists and socialists, and that might be, too.

I personally don’t participate in the debate over a possible global conspiracy; it’s a waste of time. To me, the wider struggle is for power and domination. And while this struggle has done a lot of good — and a lot of bad — I just want to know how to avoid becoming its victim. I see no reason to be a mouse trying to stop a herd of elephants from fighting.

Currently, many people are suffering due to high oil price, the slowdown in the economy, loss of jobs, declines in home values, increased bankruptcies and businesses closings, savings being wiped out, the plummeting stock market, and rising inflation. These realities are all direct results of this financial power struggle, and millions of people are its victims today.

An Extreme Example

I was in South Africa in July of this year. During my television and radio interviews there, I was often asked my opinion on the world economy. Speaking bluntly, I said that South Africans had a better opportunity of comprehending the global turmoil because they’re neighbors to Zimbabwe, a country run by Robert Mugabe.

In my interviews, I said, “What Mugabe has done to Zimbabwe, the Federal Reserve Bank and the IMF are doing to the world.” Obviously, my statements disturbed many of the journalists. I did my best to comfort them and assure them I was not an anarchist. I explained, as best I could, that Zimbabwe was an extreme example of an out of control power struggle.

After they were assured I was only using Zimbabwe to illustrate my point, I said, “If you want to understand the world economy, take a refugee from Zimbabwe to lunch.” I advised them to ask the refugee these questions:

1. How fast did the economy turn?

2. When did you know that you were in financial trouble?

3. When did you finally decide to leave Zimbabwe?

4. If you could do things differently, what would you have done?

Three Approaches to a Crumbling Economy

I spoke to three young couples from Zimbabwe while I was in South Africa. Two couples were recent refugees now living in South Africa, and one couple still lives in Zimbabwe. All three couples had interesting stories to tell.

One couple said that they would have quit their jobs earlier. Instead, they hung on, hoping the economy would change. Then, virtually overnight, the value of the Zimbabwean dollar dropped and inflation went through the roof. Even though they received pay raises, the couple couldn’t survive and soon depleted their savings. They left Zimbabwe by car with almost nothing. If they could’ve done something differently, they told me, they would have started a business in Zimbabwe and began exporting products to South Africa, so that they would have had South African currency and a bank account there before they fled.

The second couple that fled the country said they saved money and paid off their house and other debts even as the Zimbabwean dollar fell in value. Looking back, they say they would’ve saved nothing and gotten deeply in debt in Zimbabwe, allowing them to pay off their debt with the cheaper dollars. Instead, they fled after they lost their jobs, leaving behind their house and owning $200,000 in nearly worthless Zimbabwean dollars.

The third couple still lives in Zimbabwe. When they saw the writing on the wall, they set up a business in South Africa and, with the profits, began acquiring tangible assets in Zimbabwe. Often, they’ll buy an asset in Zimbabwe and pay the seller in South African currency. They believe that once Mugabe is gone and order is restored, they’ll be in a strong financial position.

Many Problems, Few Solutions

There are three major problems with the events of 1913, 1944, and 1971. The first is that the Fed, the World Bank, and the IMF are allowed to create money out of nothing. This is the primary cause of global inflation. Global inflation devalues our work and our savings by raising the prices of necessities.

For example, when gas prices soared, many people said that the price of oil was going up. In reality, the main cause of the high price of oil is the decreasing value of the dollar. The Fed, the World Bank, and the IMF, like Zimbabwe, are mass-producing funny money, thereby increasing prices and devaluing our quality of life.

The second problem is that our economic crises are getting bigger. In the 1970s, the Fed faced and solved million-dollar crises. In the 1980s, it was billion-dollar crises. Today, we have trillion-dollar crises. Unfortunately, these bigger crises mean more funny money entering the system.

Apocalypse Soon

The third problem is that in 1913, the Fed only protected the large commercial banks such as Bank of America. After 1944, the Fed, the World Bank, and the IMF began bailing out Third World nations such as Tanzania and Mexico. Then, in 2008, the Fed began bailing out investment banks such as Bear Sterns, and its role in the Fannie Mae and Freddie Mac debacle is well known. By 2020, the biggest of bailout of all will probably occur: Social Security and Medicare, which will cost at least a $100 trillion.

Even if we find more oil and produce more food, prices will continue to rise because the value of the dollar will continue to decline. The dollar has lost over 90 percent of its value since the Fed was created. The U.S. dollar will continue to decline because of those seven men on Jekyll Island in 1910.

Granted, the funny-money system has done a lot of good — it has improved the world and made a lot of people rich. But it’s also done a lot of bad. I believe somewhere between today and 2020, the system will break. We’re on the eve of financial destruction, and that’s why it’s in gold I trust. I’d rather be a victor than a victim.

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The China Bubble

By James Saft

If and when China makes its currency convertible and opens its financial system the stage will be set for a bubble that should make the dotcom and housing booms look tame.

China has recently signaled its key aspirations: for a greater international role for the renminbi and for Shanghai to become a great financial capital. Neither is imminent, but both imply, if not require, a series of steps that, taken in combination with China’s legitimately great potential for growth, could lead to a bubble of magnificent and dangerous proportions.

Magnificent in that, like the dotcom bubble or the railroad boom in the U.S. in the 19th century, a bubble in domestic China is directionally right and will build useful things which will change the world. A bubble, after all, needs a good story and China has one of the best ever.

Dangerous because, like the housing bubble, it will inevitably go too far and could take down banks and banking systems globally.

Perhaps rather than dotcom or housing, the most useful template for China is closer to home; namely the Japanese bubble which preceded its ongoing malaise, according to Dylan Grice, a strategist at Societe Generale in London.

“In the medium term we face the mother of all asset bubbles in China. The fundamental story is a good one; there are just lots and lots of people to sell to,” Grice said.

“If you drop a ton of liquidity on people it is possible that they will do rational things with it, but more likely they will do something pretty stupid.”

The parallels are strong. Both China and Japan successfully industrialized and opted for high-savings, low-consumption economies which concentrated on exports, exporting capital and keeping their currencies artificially weak. The result in both cases was a huge stockpile of U.S. Treasuries.

Both, too, scared their western clients and competitors witless. Remember U.S. autoworkers ritually burning Japanese cars? This of course was mingled with admiration and a sense that the global balance of power was changing, giving bubble thinking a strong push.

Japan slowly and over a long period liberalized its capital account; allowing the yen to float freely and deregulating financial markets.

Grice points out that during some of the 1980s the world fell in love with the yen, figuring that Japan’s new ascendancy meant that it would rise and rise. As a result Japan Inc. could in effect borrow in dollars, swap it into yen and get paid for the privilege. Much of the money found its way into the stock market, sending stocks to stratospheric levels and reinforcing the bubble illusion.

The Nikkei index of stocks went to the moon and Tokyo residents ended up needing 100-year mortgages to afford tiny apartments.

GOOD AND BAD BUBBLES

Of course, that is not where it ended with Japan, which had its bust and which is still struggling with deflation, though that is in part a function of a shrinking workforce.

Japan liberalized its financial system and currency arrangements under strong pressure from the United States.

China almost certainly has more relative real power today and there is every sign that it will open up on its own terms and to its own schedule.

But open it probably will.

Chinese officials have expressed a desire for the renminbi to play a great role in world trade, naming 2020 as a date by which it can play the role of a reserve currency.

That is almost certainly going to require deregulation of financial markets, something also needed if Shanghai is to become a global financial capital.

China now buys Treasuries not because it thinks they are good value, but because those purchases maintain a competitive currency, not to mention protecting existing holdings. As that ends, much of the money will seek out high returns, and as the renminbi strengthens international capital will doubtless pile on and pile in.

That kind of liquidity and deregulation, in combination with strong national pride and a legitimately fantastic story, is a step-by-step recipe for a bubble. So it proved in Japan, so it likely will be in China.

A look at recent experience in China only underlines this. Speculation is rife and billions in government mandated loans have leaked into stock market bets.

China’s government undoubtedly understands all of this and is surely determined to maintain control. They may not find it that easy. Getting rich, as we’ve seen in the United States, is a heady business and it is easy to start to believe your own press.

As the momentum builds and the money rolls in it will be easy to see it as a great country meeting its prosperous destiny.

Given the size of the opportunity and the strength of the story, China’s bubble will be huge. Investors would do well to avoid being in the immediate vicinity when it bursts.

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Letting The Banking Rats Out Of The Bag

By Robert Scheer

The good judge smelled a rat.

“Was there some sort of ghost that performed these actions?” New York federal Judge Jed S. Rakoff demanded to know Monday in rejecting a deal that would let Bank of America off the hook in yet another banker bonus scandal. The Securities and Exchange Commission had charged the bank with covering up for outrageous bonuses given out at Merrill Lynch as the bank acquired the failed stockbrokerage, and now it was letting the bank off the hook with a chicken-feed fine.

“Do Wall Street people expect to be paid large bonuses in years when their company lost $27 billion?” the judge asked, and Lewis J. Liman, the lawyer for Bank of America, assured him they do: “My God! Bonuses on Wall Street? It is not a matter of surprise.”

But for those of us less sophisticated in the ways of Wall Street, it is a surprise that Merrill Lynch executives were rewarded for failure at the same time Bank of America was using $45 billion in taxpayer funds to take over the brokerage house. Six hundred ninety-six executives who helped run Merrill into the ground were granted more than a million bucks each.

BofA lawyer Liman attempted to put an egalitarian spin on this government-sponsored welfare for the superrich by pointing out that all told, another 39,000 Merrill employees averaged only $91,000 in bonuses, but the judge wasn’t having it: “I’m glad you think that $91,000 is not a lot of money; I wish the average American was making $91,000.”

That’s the point; the average American is paying for the banking debacle not only in taxes for the bailout but with lost jobs and homes. Yet the SEC, which is supposed to be protecting the ordinary citizen’s interests, decided to give BofA execs a bye. The question is why Bank of America and Merrill failed to inform their shareholders that such payoffs were part of the deal. The details of the bonuses were known to BofA CEO Kenneth Lewis and other top bank executives but not mentioned in the merger agreement or proxy statements sent to the company’s shareholders for approval.

The SEC complaint did accuse BofA of misleading its shareholders, but instead of digging deeply into how such decisions had been made and by whom, a deal was concocted in which BofA got off with a paltry $33 million fine. That is less than the bonus received by one of the Merrill execs. Yet the SEC deal would have closed the case on how that decision was made.

“You filed a rather uninformative, bare-bones complaint,” Judge Rakoff told SEC lawyer David Rosenfeld, who lamely defended the decision to avoid going after the bankers involved, and it is instructive of whose interest he was serving that “[t]he lawyer for Bank of America periodically whispered what appeared to be suggestions to Mr. Rosenfeld,” as a New York Times article put it.

Whispering between government regulators and the Wall Street honchos ostensibly being regulated is what got us into this mess in the first place. The SEC looked the other way as the banking bandits piled on hundreds of billions in toxic holdings, and its lawyers evidently still do not get the message that they are not supposed to be facilitators of financial rip-offs.

Thankfully, at least one judge had the courage to challenge the rules of the game and at least delay its predictable outcome. “I would be less than candid if I didn’t express my continued misgivings about this settlement at this stage,” Rakoff said. “When this settlement first came to me, it seemed to be lacking, for lack of a better word, transparency. I did not know much about the facts from the complaint, I did not know much, or really anything, about the basis of the settlement.” He said that accepting the settlement “would leave uncertain the truth of the very serious allegations made” by the SEC and whether any of the bonus money was “derived directly or indirectly from the $20 billion” that BofA received from the government.

That is the only error the judge made; the figure is actually $45 billion in government bailout funds for BofA and $118 billion more in public money to guarantee its toxic assets. Given that enormous investment of taxpayer funds, and the trillions more put at risk because of the folly of those richly rewarded banking bonus babies, transparency would indeed seem to be required as the order of the day. As Judge Rakoff concluded, Bank of America and Merrill Lynch had not only “effectively lied to their shareholders” but the money to finance their bonus scam had come “from Uncle Sam.”

Why has it been left to one stellar judge to sound the alarm, and why is Congress and the Obama administration looking the other way?

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The Me-First, Screw-Everyone-Else Crowd

By David Sirota

I know I should be mortified by the lobbyist-organized mobs of angry Brooks Brothers mannequins who are now making headlines by shutting down congressional town hall meetings. I know I should be despondent during this, the Khaki Pants Offensive in the Great American Health Care and Tax War. And yet, I’m euphorically repeating one word over and over again with a big grin on my face.

Finally.

Finally, there’s no pretense. Finally, the Me-First, Screw-Everyone-Else Crowd’s ugliest traits are there for all to behold.

The group’s core gripe is summarized in a letter I received that denounces a proposed surtax on the wealthy and corporations to pay for universal health care:

“Until recently, my family was in the top 3 percent of wage earners,” the affluent businessperson fumed in response to my July column on taxes. “We are in the group that pays close to 60 percent of this nation’s taxes … Think for a second how you would feel if you built a business and contributed more than your share to this country only to be treated like a pariah.”

This sob story about the persecuted rich fuels today’s “Tea Parties”—and I’m sure you’ve heard some version of it in your community.

I’m also fairly certain that when many of you run into the Me-First, Screw-Everyone-Else Crowd, you don’t feel like confronting the faux outrage. But on the off chance you do muster the masochistic impulse to engage, here’s a guide to navigating the conversation:

What They Will Scream: We can’t raise business taxes, because American businesses already pay excessively high taxes!

What You Should Say: Here’s the smallest violin in the world playing for the businesses. The Government Accountability Office reports that most U.S. corporations pay zero federal income tax. Additionally, as even the Bush Treasury Department admitted, America’s effective corporate tax rate is the third lowest in the industrialized world.

What They Will Scream: But the rich still “pay close to 60 percent of this nation’s taxes!”

What You Should Say: Such statistics refer only to the federal income tax. When considering all of “this nation’s taxes” including payroll, state and local levies, the top 5 percent pay just 38.5 percent of the taxes.

What They Will Scream: But 38.5 percent is disproportionately high! See? You’ve proved that the rich “contribute more than their share” of taxes!

What You Should Say: Actually, they are paying almost exactly “their share.” According to the data, the wealthiest 5 percent of America pays 38.5 percent of the total taxes precisely because they make just about that share—a whopping 36.5 percent!—of total national income. Asking these folks to pay slightly more in taxes—and still less than they did during the go-go 1990s—is hardly extreme.

Stripped of facts, your conversation partner will soon turn to unscientific terrain, claiming it is immoral to “steal” and “redistribute” income via taxes. Of course, he will be specifically railing on “stealing” for stuff like health care, which he insists gets “redistributed” only to the undeserving and the “lazy” (a classic codeword for “minorities”). But he will also say it’s OK that government sent trillions of dollars to Wall Streeters.

And that’s when you should stop wasting your breath.

What you’ve discovered is that the Me-First, Screw-Everyone-Else Crowd isn’t interested in fairness, empiricism or morality.

With 22,000 of their fellow countrymen dying annually for lack of health insurance and with Warren Buffett paying a lower effective tax rate than his secretary, the Me-First, Screw-Everyone-Else Crowd is merely using the argot of fairness, empiricism and morality to hide its real motive: selfish greed.

No argument, however rational, is going to cure these narcissists of that grotesque disease.

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By 2011 Nearly Half US Homeowners Will Owe More Than Home Worth

If you’re not already underwater on your mortgage, there’s a decent chance you will be. According to a new report from Deutsche Bank, up to 25 million American homeowners could eventually owe more than their house is worth. That would account for 48% of all mortgage holders.

This isn’t the first time we’ve heard exceptional numbers on upside-down borrowers. First American CoreLogic figures there were already 11 million homeowners in that position at the end of last year, and Moody’s Economy.com estimates we had reached 15 million by the end of March. The Deutsche Bank projection assumes house prices nationwide will drop another 14%. That forecast is starker than most and if it doesn’t come to pass, the problem of underwater borrowers won’t be nearly as severe.

The problem is already a massive one. When the value of a house is less than its mortgage, a homeowner can’t sell and pay off his debt. If a house becomes unaffordable—because of job loss, say, or an adjusting mortgage interest rate—a homeowner is trapped. Underwater borrowers are more likely to default on their mortgage than those with positive equity.

The Deustche Bank report adds another wrinkle. So far, the highest rates of underwater borrowers have been found among those people with subprime, Alt-A and Option-ARM loans. These loans, often sold to people with low credit scores or those stretching to be able to afford a house, were largely peddled at the height of the boom, and therefore often correspond to home prices that had nowhere to go but down. However, according to Deutsche Bank’s projections, a second-wave of upside borrowers is about to hit, and this time prime borrowers will account for the bulk. As of the end of March, the bank estimated that 16% of prime borrowers with conforming loans were underwater. By the end of March 2011, some 41% are projected to be. And about half of those are expected to owe at least 25% more than their house’s value.

The “good” news is that the worst of the problem is fairly concentrated geographically. Places where house prices have fallen the most have been hit the worst. That includes states that saw the wildest speculation and overbuilding—like California, Florida, Arizona and Nevada—and those that have been gutted the worst economically—like Ohio and Michigan.

But that doesn’t mean there aren’t grim pockets elsewhere. By the end of March 2011, Deutsche Bank projects 65% of borrowers in the Chicago metro area will be underwater, 71% of those in the Baltimore and Portland, Ore. areas, and 77% in greater New York City. On paper, that might look a lot better than the 93% Deutsche Bank is expecting for Fort Lauderdale, Fla. and 92% for El Centro, Calif. But to the people living in those houses, unable to move, the relative good fortune will likely be little consolation.

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The long recession: 15 reasons why the U.S. economy faces a weak recovery

by James Pethokoukis

What sort of recovery will the American economy have? With estimates of 3Q growth rising on Wall Street — along with the Dow — here is why the optimism may be overstated. First up is David Rosenberg of Gluskin Sheff (outline by me):

1. The foundation for any durable recovery in a modern industrial economy rests with the organic dynamism of the private sector. Ask anyone in Japan as to how repeated rounds of fiscal stimulus played out over the past two decades.

2. We are still in a post-bubble credit collapse world and there are still too many uncertainties associated with the outlook for the economy, corporate earnings, financial stability and fiscal rectitude (or recklessness is more like it).

3. Wages are deflating at a record rate and credit in the banking system is still contracting as banks continue to shrink their balance sheets.

4. Three-quarters of the corporate universe have no revenue growth to speak of.

5. Only one-third of the ISM industries posted growth in July and barely more than one in ten were adding to payrolls.

Now here is former bond guru David Goldman on why the recession “will last forever” (a bit tongue in cheek and in reverse order of importance):

10. No innovation. As Nobel Prize Laureate Edmund Phelps [put it recently]: “I’m not convinced that there’s going to be another wave of innovation in the offing.”

9. Speaking of innovation, the US isn’t getting the clever immigrants it used to.

8. China will hold its own but its economy is too small to act as a locomotive for the rest of the world (maybe for Korea).

7. If the rest of the economy starts competing with the Treasury for capital, interest rates rates will rise immediately and suppress economic activity.

6. The rest of the world is full up on US Treasury securities … the US is on its own financing the deficit.

5. The US consumer can’t get out of a hole.

4. American demographics look suspiciously like Japan’s in 1990, at the beginning of the “Lost Decade.” Japan’s elderly dependent ratio jumped from 18% to 26% over the 10 years; between 2010 and 2020, America’s will rise from 19% to 25%. … They have no savings to speak of and what they thought was their nest egg (home equity) just vaporized. … . The combination of demographic and wealth shocks should produce a loop-de-loop in the “marginal propensity to save” such as we have never seen before, except, of course, in Japan.

3. More taxes are en route, to pay for health care, the interest on the federal debt, or whatever. No country ever taxed its way out of a rececession.

2. The rule of law has been severely weakened in financial transactions, through heavy-handed White House intervention into the bankruptcies of the auto sector, through mortgage renegotiation, and so forth.

1. Barack Obama! … . Obama knows that if the economy crumbles and he’s the only one left with a checkbook, then everyone has to come to him. … The banks, the hedge funds, the manufacturers, the municipalities … Obama is the first American president (with the possible exception of FDR) to actually benefit from economic weakness.

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Big Banking Rolls On

by David Segal

Goldman Sachs’ surprisingly high quarterly earnings were not an isolated case in the banking world this past week—JPMorgan Chase, Bank of America and Citigroup also raked it in during the second quarter, mere months after American taxpayers bailed them out. Not surprisingly, this latest development in the banking world is ticking off a lot of said taxpaying types.

The New York Times:

Class resentment has waxed and waned in this country, but it is not typically a widespread, default emotion of the American middle class. This is at least in part because it’s an article of faith here that through some combination of hard work and luck, you might get rich, too. And why abuse, soak or heap scorn upon a group you at least have a theoretical chance of joining?

The recession — with its yawning gap between the bonus class on the one hand and the foreclosed upon and newly jobless on the other — is changing that. It’s not merely that Americans have, at least temporarily, abandoned the hope that they’ll earn scads of money. It’s the widespread sense that winners in this economy are produced by a game that’s rigged.

There was a time in this country when a company reporting a few billion in earnings could count its money while basking in polite, reverent applause.

That time ended Tuesday.

It was the morning that Goldman Sachs reported net income of $3.44 billion, a number that surprised even analysts who follow investment banking. JPMorgan Chase came two days later with news that it had earned $2.7 billion in the second quarter, even more than it earned in the same period last year, before the economy had a cardiac infarction.

Then on Friday, Citigroup and Bank of America — two of the great basket cases of the meltdown — reported outstanding numbers, too.

All of these companies were beneficiaries of gargantuan government bailouts, in assorted forms and varied sums, but if they assumed they’d hear bravos for prompt paybacks and quick turnarounds, they were in for a shock. At a time when so many people are struggling with foreclosures and are either unemployed or worried about losing a job, these earnings were bound to stir up some basic questions of fairness.

And along with those questions, a rebirth, perhaps, of a type of anger that hasn’t been widespread for a while: good old class resentment.

It’s making a comeback. As recently as April, President Obama could say at a news conference at a Group of 20 summit meeting, that Americans “don’t resent the rich; they want to be rich,” without raising eyebrows. Today, the first half of that comment is starting to sound like a stretch. And when it comes to people who earned their fortunes through the financial industry, it seems wrong.

Something closer to the current zeitgeist was captured last week by Bill O’Reilly, the Fox News commentator, who likened Goldman Sachs bankers to pigs during a scathing segment on his TV show. “You’ve got to make an example of the big boy,” he fumed in a rant about the company’s tax-avoidance methods, suggesting Goldman ought to be punished for failing to cough up its fair share of taxes. “And this is the big boy.”

Jon Stewart went the deadpan comedy route on his show this week: “Goldman Sachs makes $3.4 billion in profit from April to June. I guess the bailouts are working. For Goldman Sachs.”

Class resentment has waxed and waned in this country, but it is not typically a widespread, default emotion of the American middle class. This is at least in part because it’s an article of faith here that through some combination of hard work and luck, you might get rich, too. And why abuse, soak or heap scorn upon a group you at least have a theoretical chance of joining?

The recession — with its yawning gap between the bonus class on the one hand and the foreclosed upon and newly jobless on the other — is changing that. It’s not merely that Americans have, at least temporarily, abandoned the hope that they’ll earn scads of money. It’s the widespread sense that winners in this economy are produced by a game that’s rigged.

Which is why the response to last week’s earnings bonanza has been a mix of, among other things, bafflement and anger. If these companies can return to the festivities so quickly, were they really having the near-death experience they and the government claimed? And if taxpayers risked their money when they backstopped Wall Street’s misadventures, why aren’t they sharing in the upside now that the party has started again? And did these companies have the time to rethink the risk culture that landed us in this jam in the first place?

In private, Wall Street executives have questions of their own.

Like, wait a sec — isn’t returning to profitability exactly what you wanted us to do? And if the nation’s circulatory system of money is beginning to flow again, isn’t that good news? Oh and by the way, we are paying you back.

It’s telling that from politicians, there’s been mostly silence.

Neither Representative Barney Frank nor Senator Chris Dodd — respectively, the Democrats who lead the House and Senate committees that handle banks — issued press releases about those earnings last week, according members of their staffs. Neither returned a call for this article.

The Obama administration, meanwhile, sounded like it was searching for the seam between cautious optimism and cautious skepticism. Mr. Obama’s press secretary, Robert Gibbs, was quoted in Time magazine saying that “the president continues to have concerns that compensation will be based on risky behavior instead of performance.”

But class resentment can be a powerful tool in politics, and you don’t need to stoke it explicitly to enjoy its upsides. House Democrats have proposed a 5.4 percent surtax on those earning more than $1 million as a means of underwriting health care reform.

Whatever the wisdom of this idea, it is easier to imagine it catching on now that Goldman has posted its largest quarterly profit in 140 years — enough to set aside more than $11 billion for bonuses, with the year only half over.

Of course, taxing and tsk-tsking the rich might be gratifying, but like everything else in economics it is sure to have some unintended consequences. Already, conservative and libertarian scholars warn that if there’s enough blowback against bonuses, Wall Street will simply distribute windfalls in the form of salary — which might actually reduce incentives. Alternatively, the rich might just get better at shielding their wealth from the public.

And don’t expect the new class resentment to remain a Wall Street-only phenomenon for long. Last Monday, news broke that the “American Idol” host Ryan Seacrest would be paid $45 million to remain with the show for the next three years.

With other TV and radio gigs, as well as investments in restaurants and media companies, the guy is walking the one-man-conglomerate trail blazed by Dick Clark. While Mr. Clark never inspired much hostility, a palpable irritation greeted the “American Idol” announcement. (Mr. Seacrest was called the “Viscount of Vapidity” in the widely read Deadline Hollywood Daily blog.)

It’s true, Mr. Seacrest has never seemed as benign and lovable as Dick Clark. But there is also the question of timing. If you had to announce a multimillion-dollar raise, last week was the worst week ever.

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Chained Together – Like Those Movies With Two Prison Escapees On The Run

By Jon Markman

Imagine becoming so successful at your job that you stack up $2 trillion in income, which you conservatively place in short-term U.S. Treasury bonds for safekeeping.

Now imagine that when you try to cash in those bonds to buy a few things for your kids, the clerk at the bank abruptly shuts her window and tells you to go away.

That is essentially the situation faced by China these days as it wonders whether its plan to manufacture goods for U.S. consumers over the past two decades in exchange for a pile of credit slips was really such a hot idea.

The answer is coming up as a big, fat “uh-oh” as the U.S. deficit and debt obligations balloon to levels never before contemplated, and Beijing is denied requests to buy U.S. and Australian mines and oil properties. And as Beijing leaders talk openly, if obliquely, about their angst, they are unsettling world credit, currency and stock markets, which don’t know what to make of the idea that the world’s largest Ponzi scheme might be coming to an abrupt end.

This is a good time to assess the chilling possibilities, as the resolution of this pending crisis will afflict investors, workers and business owners alike.

What’s so Ponzi about the Chinese-U.S. relationship? Basically everything. Look at it this way:
After a currency debacle in 1998 left its economy in tatters, Beijing decided to radically restructure its financial relationship with the West. Policymakers pegged the value of China’s currency to the dollar, which had the effect of keeping it artificially low.

The cheap renminbi made it irresistibly inexpensive for U.S. companies to manufacture goods in China, even after shipping costs. As more companies shifted their operations to China, the U.S. manufacturing base was hollowed out in the name of globalization and profitability. Americans who once enjoyed high-paying factory jobs moved on to lower-paying service jobs.

China didn’t need much of anything made in America, so instead of buying cars from Detroit and furniture from North Carolina with its factory profits, it bought Treasury bills. The purchase of all those bills drove down U.S. interest rates. So as middle-class and blue-collar Americans saw their wages stagnate or decline, they discovered they could still keep their old lifestyles by borrowing.

Over the past decade, Americans were able to outspend their incomes by easily rolling their debts forward through serial home refinancing. The situation was never ideal, but it worked as long as the value of their collateral — their homes — kept rising.

As long as China kept buying Fannie Mae, Freddie Mac, and Treasury credits, the scheme worked in a strange and beautiful way: Our driveways filled up with cars and boats, shopping malls spread out across the suburban landscape, and the retailer with the closest ties to China, Wal-Mart, became the United States’ largest company.

Was that so bad? Well, now think about this in the context of a Ponzi scheme such as the one perpetrated by disgraced financier Bernie Madoff.

Madoff’s clients for years thought they were rich because he sent them brokerage statements that said so. But that scheme worked only as long as new money kept coming in. When international money flows seized up last year and too many people wanted to redeem their accounts at once, Madoff’s $50 billion game fell apart. Then his victims suddenly discovered that their brokerage statements were worthless pieces of paper. Madoff clients’ households crashed, and now one-time millionaires are broke. The reality is that they were always broke; they just didn’t know it yet.

The credit that has kept American families afloat for the past 10 years is similar to those Madoff-produced brokerage statements. The credit is good only so long as China keeps recycling funds through the Ponzi scheme. But if Beijing leaders ever decide that it’s just too risky to own U.S. dollars and debt, then the system is going to come crashing down.

Of course, it is not really in China’s interest to stop the scheme, even if it wanted to, because its own economy would likewise blow up. Satyajit Das, a credit derivatives expert in Australia, likens this to stepping on one of those land mines that are activated by the weight of a victim’s body. As soon as the weight is lifted, the mine explodes, and the person’s leg is blown off.

China is thus frozen in place, damned if it does and damned if it doesn’t. It’s a classic Catch-22. China’s cache of U.S. bonds isn’t worth anything unless the bonds are sold. But selling them on any kind of scale will gut their value.

“People need to realize that China doesn’t actually have any real U.S. money,” Das says. “Unless they can turn in their bonds and exchange them for something else, they’re only paper assets. Yet if they try to exit the position, they’ll destabilize the dollar, and the value of the rest of their assets will plunge. And that’s not even their biggest problem. It’s that they also need to keep buying Treasurys, or interest rates will go up and their capital losses will be terrible.”

In short, Das says, Beijing thought it had discovered the perfect scheme for establishing independence from the West, yet it has instead made its dependence worse than ever. And he observes that one unspoken reason that China has gone whole-hog on its massive, $650 billion fiscal stimulus program — creating more factory capacity in a country that is already reeling from overcapacity — is that the effort gives it cover to stockpile copper, oil, iron ore and other hard assets that it considers to be better stores of value than dollars.

Now here’s why this affects all of us: China and the U.S. together built the most monstrous liquidity bubble in world history as each pursued what it believed to be logical self-interest without any regulator, such as a stern global central banker, telling them that they were on a path of mutually assured destruction.

Now it’s reached the point where global capital markets will impose their own discipline. Because most money generated over the past decade was spent on consumption rather than investment — it’s as if Madoff’s clients blew their fake money on chartering jets rather than buying real property as a store of wealth — there are few new buyers of goods. This has killed U.S. retail sales, crushed employment, lifted the foreclosure rate, stymied homebuilders and undercut loan demand.

There are no good solutions. The Chinese need to open their markets and let their currency float on the open market, but they won’t for political reasons. And the U.S. needs to either halt its runaway deficit spending so that the world is not even more flooded with our debt, or swallow its pride and issue Treasurys denominated in Chinese currency. That probably won’t happen either. Which means there is only one solution left: a long, slow, boring, lonely, soul-crushing process of digging out from under the piles of debt that got us into this mess.

You might even say that the bursting of the credit Ponzi scheme has left us all in jail now with Madoff. Let’s hope that our sentence is shorter than his.

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You Can Never Have Too Much

By William Pfaff

The peculiar charm of the anthropomorphic gods of classical Greece is that they were so like us, exemplifying our weaknesses and follies, inspiring the mortal occupants of Attic Greece to the invention of philosophy—the application of natural reason to the causes and meaning of existence—and to tragedy, which deals with the irony and confrontation with justice that destroys a human of noble but flawed intentions.

If one tries to draw an urgently contemporary lesson from Greek myth, the story of Midas is irresistible. It provides a commentary on our global economic and financial crisis, in which the pursuit of wealth has ruined us.

Seventy years ago, capitalism was widely thought to have failed because of the Crash and Great Depression. Following the Second World War, however, the United States was reassured by the wartime accomplishment of American industry, while in Western Europe there was less confidence. The magical promises of revolutionary change offered by fascism and communism between the wars were discredited.

Fascism in Italy famously made the trains run on time, drained the Pontine Marshes and launched an improbable new Roman imperialism.

Nazi Germany’s people were put to work by public investment, building the first limited-access national public highway system, and by rearmament. The raison d’etre of both fascism and Nazism proved ultimately to be war.

The Soviet system attracted parts of the Western working class and intelligentsia because of its romantic millenarianism, promising to make everyone happy in a new and better world, while crushing those who stood in the way.

The Cold War effectively stranded those in Western Europe and the U.S. who had been part of the pro-communist left before the war, leaving Western governments with their prewar capitalist and social democratic economic systems to rebuild.

This proved a great success; the industrial and social systems were rebuilt in Europe, with Marshall aid, and the American economy soared to meet postwar consumer demand and to create the military-industrial system Dwight Eisenhower warned against but which the Cold War seemed to demand. Whatever the fantasy that went into the latter—and there was much—all this Western economic activity was connected to utility. In all of the democracies there was an acknowledged obligation to share the wealth.

The social transformation of the United States during the 1950s and 1960s was phenomenal, due to the education of the population, thanks to the GI Bill of Rights, and to new popular housing and innovative enterprise. In continental Europe, the early postwar decades are still commonly referred to as the “glorious years.”

What brought the Western economies from that to the present world crisis was, in my view, a revolutionary theory. The American business model was changed. At some point a consensus emerged in the academic community on a new business model. This demanded abandonment of the social concerns previously expected from business, and demanded from corporations the highest possible profits.

It advocated minimal taxation and political regulation, so as to produce the highest stockholder earnings possible. It said that a rationally perfected industrial economy must be based on maximized pursuit of self-interest, and would then automatically bring the greatest possible efficiency and return.

Maximum self-interest by management would impose maximum productivity at lowest possible wage cost from labor. Free trade and globalization would produce raw materials at lowest possible cost, and maximum sales income.

Ethical responsibility (beyond minimal legality) and civic obligation would be stripped from business as obstacles to maximized profit, which the theory claimed would in the long run automatically produce the best possible outcome for society as a whole. That is the world in which we have been living.

Now, to Midas.

In the June 19 issue of the (London) Times Literary Supplement, the Exeter University classicist Richard Seaford elaborates on an argument he first made in 2004 in a book called “Money and the Early Greek Mind.” This proposed that “the pivotal position of the Greeks” in the world culture of the period they dominated came largely from their invention of money.

Until money, an individual’s possible possessions had to be tangible, useful and necessarily limited enough to enjoy and control. One can directly possess only so much property, herds and ships, or enjoy only so much food, sex, honors, reputation and so on, before being satisfied (or sated). But you cannot possess too much money, because money is fungible, transferable, portable and theoretically unlimited in quantity.

Money thus isolates the individual because it removes him from the real world of relationships, property and useful things, to the world of potentially unlimited possession of something whose essential characteristic is that in itself it is useless. It destroys limits in society and in human relations because it places the individual, or a society, in a position, as Seaford says, of “predatory isolation.”

This was the plight of Midas. He could not drink, eat, touch or love, because anything and everything he touched turned to gold. He bore the worst of curses—which he had himself invited. He begged for mercy from the god Dionysus, who lifted the curse. Who will lift the curse from us?

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Growth Economics On A Finite Planet

by Andrew C. Revkin

Over the weekend, I asked Herman Daly, the specialist in “ecological economics” at the University of Maryland, about the recent financial turmoil. He pointed me to a short piece he wrote that was posted on the Oil Drum blog a few days ago and that he gave me permission to post below. It’s mostly about economic theory, but does get at one of the keystone concepts explored here — which is how many people, consuming how much stuff, can one livable planet support? [UPDATE 10/14: George Soros weighs in, too.]

To Dr. Daly, the implosion after the burst of trading and investment in high-concept paper offerings was inevitable, and simply a reorientation of the market toward the only real economy — the one grounded in actual assets. In the end, the only economy that can’t be gamed is one that is grounded in the way the Earth works. That is where “real wealth,” and real limits, lie, he says.

This relates to the climate challenge. The atmosphere is not an infinite dump, so if a trading system for carbon dioxide credits — like the recent financial bubble — doesn’t actually lead to progress, we’ll know it. But the consequences are likely to be less reversible than those from a credit crunch. Carbon dioxide, unlike the kinds of pollution wealthy countries dealt with in previous decades, is a persistent gas. It builds like unpaid credit card debt. The longer societies delay action, the bigger the climatic debt. Maybe it’ll all work out and the greenhouse warming from the buildup will be on the low end. But maybe not. The world tried a big financial gamble in recent years and the consequences are clear now. How will the current climate bet play out?

Another piece on the financial breakdown that is relevant to Dot Earth is Joe Nocera’s sobering “Talking Business” column on human nature and speculative bubbles. Are we doomed to irrationality in weighing risks and payoffs, whether financial or climatological? Isaac Newton got taken in by a bubble.

Below you’ll find Professor Daly’s short piece, The Crisis: Debt and Real Wealth:

The current financial debacle is really not a “liquidity” crisis as it is often euphemistically called. It is a crisis of overgrowth of financial assets relative to growth of real wealth – pretty much the opposite of too little liquidity. Financial assets have grown by a large multiple of the real economy – paper exchanging for paper is now 20 times greater than exchanges of paper for real commodities. It should be no surprise that the relative value of the vastly more abundant financial assets has fallen in terms of real assets. Real wealth is concrete; financial assets are abstractions – existing real wealth carries a lien on it in the amount of future debt.

The value of present real wealth is no longer sufficient to serve as a lien to guarantee the exploding debt. Consequently the debt is being devalued in terms of existing wealth. No one any longer is eager to trade real present wealth for debt even at high interest rates. This is because the debt is worth much less, not because there is not enough money or credit, or because “banks are not lending to each other” as commentators often say.

Can the economy grow fast enough in real terms to redeem the massive increase in debt? In a word, no. As Frederick Soddy (1926 Nobel Laureate chemist and underground economist) pointed out long ago, “you cannot permanently pit an absurd human convention, such as the spontaneous increment of debt [compound interest] against the natural law of the spontaneous decrement of wealth [entropy].”

The population of “negative pigs” (debt) can grow without limit since it is merely a number; the population of “positive pigs” (real wealth) faces severe physical constraints. The dawning realization that Soddy’s common sense was right, even though no one publicly admits it, is what underlies the crisis. The problem is not too little liquidity, but too many negative pigs growing too fast relative to the limited number of positive pigs whose growth is constrained by their digestive tracts, their gestation period, and places to put pigpens. Also there are too many two‐legged Wall Street pigs, but that is another matter.

Growth in U.S. real wealth is restrained by increasing scarcity of natural resources, both at the source end (oil depletion), and the sink end (absorptive capacity of the atmosphere for CO2). Further, spatial displacement of old stuff to make room for new stuff is increasingly costly as the world becomes more full, and increasing inequality of distribution of income prevents most people from buying much of the new stuff—except on credit (more debt). Marginal costs of growth now likely exceed marginal benefits, so that real physical growth makes us poorer, not richer (the cost of feeding and caring for the extra pigs is greater than the extra benefit). To keep up the illusion that growth is making us richer we deferred costs by issuing financial assets almost without limit, conveniently forgetting that these so‐called assets are, for society as a whole, debts to be paid back out of future real growth. That future real growth is very doubtful and consequently claims on it are devalued, regardless of liquidity.

What allowed symbolic financial assets to become so disconnected from underlying real assets? First, there is the fact that we have fiat money, not commodity money. For all its disadvantages, commodity money (gold) was at least tethered to reality by a real cost of production. Second, our fractional reserve banking system allows pyramiding of bank money (demand deposits) on top of the fiat government‐issued currency. Third, buying stocks and “derivatives” on margin allows a further pyramiding of financial assets on top the already multiplied money supply. In addition, credit card debt expands the supply of quasi‐money as do other financial “innovations” that were designed to circumvent the public‐interest regulation of commercial banks and the money supply. I would not advocate a return to commodity money, but would certainly advocate 100 percent reserve requirements for banks (approached gradually), as well as an end to the practice of buying stocks on the margin. All banks should be financial intermediaries that lend depositors’ money, not engines for creating money out of nothing and lending it at interest. If every dollar invested represented a dollar previously saved we would restore the classical economists’ balance between investment and abstinence. Fewer stupid or crooked investments would be tolerated if abstinence had to precede investment. Of course the growth economists will howl that this would slow the growth of GDP. So be it – growth has become uneconomic at the present margin as we currently measure it.

The agglomerating of mortgages of differing quality into opaque and shuffled bundles should be outlawed. One of the basic assumptions of an efficient market with a meaningful price is a homogeneous product. For example, we have the market and corresponding price for No. 2 corn – not a market and price for miscellaneous randomly aggregated grains. Only people who have no understanding of markets, or who are consciously perpetrating fraud, could have either sold or bought these negative pigs‐in‐a‐poke. Yet the aggregating mathematical wizards of Wall Street did it, and now seem surprised at their inability to correctly price these idiotic “assets.”

And very important in all this is our balance of trade deficit that has allowed us to consume as if we were really growing instead of accumulating debt. So far our surplus trading partners have been willing to lend the dollars they earned back to us by buying treasury bills – more debt “guaranteed” by liens on yet‐to‐exist wealth. Of course they also buy real assets and their future earning capacity. Our brilliant economic gurus meanwhile continue to preach deregulation of both the financial sector and of international commerce (i.e. “free” trade). Some of us have for a long time been saying that this behavior was unwise, unsustainable, unpatriotic, and probably criminal. Maybe we were right. The next shoe to drop will be repudiation of unredeemable debt either directly by bankruptcy and confiscation, or indirectly by inflation.

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Goldman Sachs

by Stephen Gandel

Goldman Sachs is a giant pig. A giant pig that blows bubbles through a wand shaped like a dollar sign. A giant pig that laughs at us when we invest in worthless dotcom stocks. A giant pig that happily watches us get carried away and burned by rising home prices. A giant pig that smiles widely when we have to fill our tanks with $4-a-gallon gas. Quite simply, the investment bank that is revered on Wall Street could just be a bunch of crooks, and greedy ones at that.

That’s the view of Goldman Sachs delivered by an article in the current issue of Rolling Stone. The rock mag’s The Great American Bubble Machine by Matt Taibbi says that the investment bank is responsible for creating, and in many cases popping, every great bubble of nearly the past 100 years in order to profit from them at our expense — and the article uses plenty of illustrations of pigs to drive home what it thinks of Goldman. Taibbi calls the U.S. a “gangster state, running on gangster economics.” He says we have an economy where “some of us have to play by the rules, while others get a note from the principal excusing them from homework ’til the end of time.” And by “others” and “gangsters,” Taibbi means the bankers of Goldman Sachs.

It’s great stuff. And it’s the kind of stuff you want to read at a time when we are still smarting from the one-two combo of the housing bubble and the credit crunch. Unless, of course, you are Goldman Sachs (or one of its hopeful shareholders).

The firm is notoriously press-shy, and doesn’t usually respond to articles. But it is firing back at Taibbi, the son of veteran NBC television reporter Mike Taibbi. A Goldman spokesperson told one reporter, “Taibbi’s article is a compilation of just about every conspiracy theory ever dreamed up about Goldman Sachs, but what real substance is there to support the theories?”

And Goldman is not alone in criticizing the article. Heidi Moore, a former reporter at the Wall Street Journal who used to cover Goldman and other investment banks for the paper, wrote in response to another journalist’s question about the piece, “For the record, I don’t think any article that contains the line ‘vampire squid sucking the face of humanity’ [Taibbi's opening description of Goldman] is real journalism.”

Moore is right that the rock mag’s piece contains a bit of exaggerating and a whole lot of hyperbole. But to call it not real journalism or lacking substance is wrong. There are plenty of facts to back up the case that Goldman generates large profits by taking advantage of others. Goldman is the only Wall Street firm so far to have paid to settle charges — $60 million to the state of Massachusetts — for creating the rotten mortgage bonds that were at the heart of the recent financial crisis. And get this: contained in Goldman’s client form is this disclaimer, “You acknowledge that we may monitor your use of the Services for our own purposes (and not for your benefit).” The firm seems to be announcing out loud that it plans to trade against its clients.

Goldman responds that this type of language is common on Wall Street. And that is the problem, and the problem with Rolling Stone’s article as well. Goldman has done plenty wrong, but not much alone. Goldman may have assisted in the dotcom and housing bubbles, but it is wrong to say that it was the single blower. The only thing Goldman is solely at fault for is being a bit better at playing the game than its peers.

Also, while many of the advantages Goldman gets are unfair, is it really Goldman’s fault? Is it Goldman’s fault that it was able to make billions of dollars with the taxpayers’ dollars it was forced to take as part of the Treasury’s Troubled Asset Relief Program? Is it Goldman’s fault that government officials from both parties regularly pick its employees or former employees to fill key regulatory positions? Goldman may benefit, but is the firm really to blame?

“The [Rolling Stone] article makes a very compelling case against Goldman Sachs, but I think the problems it identifies are pervasive in financial firms and corporate America in general,” says Nell Minow, who is the co-founder of the Corporate Library, a research firm that tracks corporate-governance issues. “We need to launch substantive financial reform rather than weighing the faults of one firm versus another.” Minow’s point is this: spend too much time on Goldman and you miss the fact of how broadly the financial system and the regulations that are supposed to keep profiteers in check failed us. And she’s right.

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Mountains of Debt: America’s Economic Realities

by Charles Wheelan, Ph.D.

Ben Franklin supposedly said that it’s better to skip supper and go to bed hungry than it is to wake up in debt. Ben would be quite disappointed in us. We Americans didn’t skip dinner; instead, we opted over the past decade to gorge at the buffet and then charge it.

We woke up as the world’s largest debtor — so deeply in debt that our global creditors are getting nervous, and rightfully so.

Here are some economic realities associated with our deepening fiscal hole.

It’s bad. As in, $11 trillion bad. That number alone doesn’t mean much, at least without context. So here is some context. First, that’s roughly $40,000 for every man, woman, and child in the country. Second, our debt is projected to grow to roughly 100 percent of GDP by 2010, meaning that, if we were to devote everything we produce as a nation to paying down debt, it would take us an entire year to pay off what we owe.

Eating Up the Global Capital Pool

Other countries have become more indebted as a percentage of GDP, but they were small countries, so they sucked up less of the global capital pool. There is only so much money in the world, and we have borrowed a shocking proportion of it. The only other time the U.S. has been so indebted was at the end of World War II.

Big debt means big interest payments. The Chinese haven’t loaned us a trillion dollars because we’re good-looking; they’ve loaned us a trillion dollars because we pay for the privilege of using that capital. Interest payments now make up more than 8 percent of the federal budget — meaning that nearly one of every 10 of your tax dollars gets you absolutely nothing in return. No schools, no bridges, no domestic wiretaps. That’s just the cost of servicing the debt we’ve run up.

And we’ve done nothing terribly productive with all that borrowed money. Debt, after all, is not inherently bad. If you borrow $100,000 to go to medical school, then you’ve probably done a very smart thing. When you graduate, your earning potential will be higher, enabling you to live better even after you pay off the loans (with interest). In this case, you used borrowed money to invest in something that made you more productive.

Now suppose that you borrowed $100,000 to sustain a lifestyle that you could not otherwise afford: to pay the rent, to buy nice clothes, and to make the payments on your luxury car. When that bill comes due (with interest), you’re no more productive than you were when you started borrowing. You borrowed used money for consumption, not investment.

Unfortunately, America’s borrowing resembles the latter more than the former. We haven’t upgraded our transportation infrastructure or made major investments in alternative energy or financed education for those who could not otherwise afford it.

Stop the Bickering

We need to stop bickering about who got us here. Was it the Bush tax cuts (yes) or the Obama stimulus (yes) or profligate Congressional spending (yes) or voters who continually reward pork more than parsimony (yes)? But analyzing just overcomplicates things. We are deeply in debt because we have routinely spent more than we collect in taxes. That’s just a mathematical reality that has become needlessly confounded with politics.

If you’re a small government conservative, that’s great. But let’s say enough of the tax cuts without corresponding spending cuts. Those aren’t tax cuts; they are tax postponements. You’ve just left the bill for future taxpayers, with interest.

And if you believe that government can and should build a stronger America, terrific. I’m sympathetic: I like early childhood education and the high-speed rail and Army sharpshooters who kill pirates. If you want those things, then pay for them.

Big government or small government, the revenues need to equal the expenditures. It really is that simple.

When the Big Bills Come Due

The big bills haven’t even come due yet. If the U.S. were a family, we’d be crouched over the kitchen table trying to figure out how to pay the Amex and Visa bills — and the gigantic Mastercard bill would still be in the mail.

The big bill still in the mail for the United States is for our entitlement programs — primarily Social Security and Medicare. We’ve made huge commitments to these programs that are not adequately funded. That Social Security check you’re counting on when you turn 65 doesn’t show up in the debt figures, but it’s still money that we will owe. Lots and lots of money.

And the Chinese are worried U.S. debt, as they should be. All debtors have creditors; ours are all over the world. The biggest one is the Chinese government, which has been buying up U.S. Treasury bonds with all the vigor and foresight of a 1990s Las Vegas real estate developer.

If we don’t honor our bonds, China doesn’t get to repossess the White House or the national parks; they don’t get to carve their own leaders on Mt. Rushmore. Treasury debt is secured by the “full faith and credit of the U.S. government” — which won’t command much at auction, if it comes to a foreclosure type situation.

Chinese officials aren’t worried about bankruptcy because the U.S. has an easier and more insidious option — we can print our way out of the problem. Our debt is denominated in dollars, and the U.S. government has the authority to print those dollars. We could take a page from the Zimbabwe policy manual and just print money to pay our bills — thereby debasing the currency, creating inflation, and devaluing the real value of what we owe.

Is that a sensible solution? No, as it imposes the costs of inflation on all of us. I don’t know anyone eager to revisit the 1970s (in terms of economic performance or fashion).

Is it a possibility? You bet. In fact, I’m surprised that long-term interest rates haven’t climbed more than they have. (When long-term lenders fear inflation, they demand higher interest rates to protect against that contingency.)

The solution to all this is straightforward: Spend less than we take in, and use the surplus to pay down debt. At the risk of lapsing into economics jargon, yes, this is going to suck. Think about it: Americans don’t like their current tax bills — which aren’t even high enough to pay for our current spending, let alone the bills we’ve run up from the past. In the future, we will have to pay more and get less.

But we’ve done it before. We paid off the debt accumulated during World War II. In fact, the ensuing decades saw some of the most impressive gains in wealth and productivity in American history. But it will require a radical change from what we’re doing now.

An economic recovery will help. But we can’t pretend that will be enough. We need to raise taxes, cut spending, and/or reform our entitlement programs. Probably all three, and in a serious way.

Will that dampen economic growth in the short run? Yes. Will it jeopardize important social programs? Yes. Will it compromise our ability to make important public investments? Yes. Does it limit what we can spend on healthcare reform? Yes.

But as Ben Franklin would have pointed out, we should have thought about that before ordering room service and then charging it to a credit card.

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The American Empire Is Bankrupt

By Chris Hedges

This week marks the end of the dollar’s reign as the world’s reserve currency. It marks the start of a terrible period of economic and political decline in the United States. And it signals the last gasp of the American imperium. That’s over. It is not coming back. And what is to come will be very, very painful.

Barack Obama, and the criminal class on Wall Street, aided by a corporate media that continues to peddle fatuous gossip and trash talk as news while we endure the greatest economic crisis in our history, may have fooled us, but the rest of the world knows we are bankrupt. And these nations are damned if they are going to continue to prop up an inflated dollar and sustain the massive federal budget deficits, swollen to over $2 trillion, which fund America’s imperial expansion in Eurasia and our system of casino capitalism. They have us by the throat. They are about to squeeze.

There are meetings being held Monday and Tuesday in Yekaterinburg, Russia, (formerly Sverdlovsk) among Chinese President Hu Jintao, Russian President Dmitry Medvedev and other top officials of the six-nation Shanghai Cooperation Organization. The United States, which asked to attend, was denied admittance. Watch what happens there carefully. The gathering is, in the words of economist Michael Hudson, “the most important meeting of the 21st century so far.”

It is the first formal step by our major trading partners to replace the dollar as the world’s reserve currency. If they succeed, the dollar will dramatically plummet in value, the cost of imports, including oil, will skyrocket, interest rates will climb and jobs will hemorrhage at a rate that will make the last few months look like boom times. State and federal services will be reduced or shut down for lack of funds. The United States will begin to resemble the Weimar Republic or Zimbabwe. Obama, endowed by many with the qualities of a savior, will suddenly look pitiful, inept and weak. And the rage that has kindled a handful of shootings and hate crimes in the past few weeks will engulf vast segments of a disenfranchised and bewildered working and middle class. The people of this class will demand vengeance, radical change, order and moral renewal, which an array of proto-fascists, from the Christian right to the goons who disseminate hate talk on Fox News, will assure the country they will impose.

I called Hudson, who has an article in Monday’s Financial Times called “The Yekaterinburg Turning Point: De-Dollarization and the Ending of America’s Financial-Military Hegemony.” “Yekaterinburg,” Hudson writes, “may become known not only as the death place of the czars but of the American empire as well.” His article is worth reading, along with John Lanchester’s disturbing exposé of the world’s banking system, titled “It’s Finished,” which appeared in the May 28 issue of the London Review of Books.

“This means the end of the dollar,” Hudson told me. “It means China, Russia, India, Pakistan, Iran are forming an official financial and military area to get America out of Eurasia. The balance-of-payments deficit is mainly military in nature. Half of America’s discretionary spending is military. The deficit ends up in the hands of foreign banks, central banks. They don’t have any choice but to recycle the money to buy U.S. government debt. The Asian countries have been financing their own military encirclement. They have been forced to accept dollars that have no chance of being repaid. They are paying for America’s military aggression against them. They want to get rid of this.”

China, as Hudson points out, has already struck bilateral trade deals with Brazil and Malaysia to denominate their trade in China’s yuan rather than the dollar, pound or euro. Russia promises to begin trading in the ruble and local currencies. The governor of China’s central bank has openly called for the abandonment of the dollar as reserve currency, suggesting in its place the use of the International Monetary Fund’s Special Drawing Rights. What the new system will be remains unclear, but the flight from the dollar has clearly begun. The goal, in the words of the Russian president, is to build a “multipolar world order” which will break the economic and, by extension, military domination by the United States. China is frantically spending its dollar reserves to buy factories and property around the globe so it can unload its U.S. currency. This is why Aluminum Corp. of China made so many major concessions in the failed attempt to salvage its $19.5 billion alliance with the Rio Tinto mining concern in Australia. It desperately needs to shed its dollars.

“China is trying to get rid of all the dollars they can in a trash-for-resource deal,” Hudson said. “They will give the dollars to countries willing to sell off their resources since America refuses to sell any of its high-tech industries, even Unocal, to the yellow peril. It realizes these dollars are going to be worthless pretty quickly.”

The architects of this new global exchange realize that if they break the dollar they also break America’s military domination. Our military spending cannot be sustained without this cycle of heavy borrowing. The official U.S. defense budget for fiscal year 2008 is $623 billion, before we add on things like nuclear research. The next closest national military budget is China’s, at $65 billion, according to the Central Intelligence Agency.

There are three categories of the balance-of-payment deficits. America imports more than it exports. This is trade. Wall Street and American corporations buy up foreign companies. This is capital movement. The third and most important balance-of-payment deficit for the past 50 years has been Pentagon spending abroad. It is primarily military spending that has been responsible for the balance-of-payments deficit for the last five decades. Look at table five in the Balance of Payments Report, published in the Survey of Current Business quarterly, and check under military spending. There you can see the deficit.

To fund our permanent war economy, we have been flooding the world with dollars. The foreign recipients turn the dollars over to their central banks for local currency. The central banks then have a problem. If a central bank does not spend the money in the United States then the exchange rate against the dollar will go up. This will penalize exporters. This has allowed America to print money without restraint to buy imports and foreign companies, fund our military expansion and ensure that foreign nations like China continue to buy our treasury bonds. This cycle appears now to be over. Once the dollar cannot flood central banks and no one buys our treasury bonds, our empire collapses. The profligate spending on the military, some $1 trillion when everything is counted, will be unsustainable.

“We will have to finance our own military spending,” Hudson warned, “and the only way to do this will be to sharply cut back wage rates. The class war is back in business. Wall Street understands that. This is why it had Bush and Obama give it $10 trillion in a huge rip-off so it can have enough money to survive.”

The desperate effort to borrow our way out of financial collapse has promoted a level of state intervention unseen since World War II. It has also led us into uncharted territory.

“We have in effect had to declare war to get us out of the hole created by our economic system,” Lanchester wrote in the London Review of Books. “There is no model or precedent for this, and no way to argue that it’s all right really, because under such-and-such a model of capitalism … there is no such model. It isn’t supposed to work like this, and there is no road-map for what’s happened.”

The cost of daily living, from buying food to getting medical care, will become difficult for all but a few as the dollar plunges. States and cities will see their pension funds drained and finally shut down. The government will be forced to sell off infrastructure, including roads and transport, to private corporations. We will be increasingly charged by privatized utilities—think Enron—for what was once regulated and subsidized. Commercial and private real estate will be worth less than half its current value. The negative equity that already plagues 25 percent of American homes will expand to include nearly all property owners. It will be difficult to borrow and impossible to sell real estate unless we accept massive losses. There will be block after block of empty stores and boarded-up houses. Foreclosures will be epidemic. There will be long lines at soup kitchens and many, many homeless. Our corporate-controlled media, already banal and trivial, will work overtime to anesthetize us with useless gossip, spectacles, sex, gratuitous violence, fear and tawdry junk politics. America will be composed of a large dispossessed underclass and a tiny empowered oligarchy that will run a ruthless and brutal system of neo-feudalism from secure compounds. Those who resist will be silenced, many by force. We will pay a terrible price, and we will pay this price soon, for the gross malfeasance of our power elite.

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Key Economic Indicator Is Ambiguous

Those bullish on global economic recovery have their data points: the steady upward climb of world stock markets, three straight months of Chinese manufacturing expansion, the weak dollar. But there are still plenty of skeptics of a rapid and robust turnaround, with their own set of numbers to cite: continued bleeding of private-sector jobs in the U.S. and Europe, more record lows in new home construction, and, er, the weak dollar.

Never before have so many experts and ordinary folk been so busy trying to gauge the timing and strength of the eventual worldwide economic rebound. One of the best indicators is found in the shipping industry. It’s global in scope and ever more indispensable in an economy so reliant on international commerce. Not surprisingly, perhaps, there is new evidence out on the open seas that both the bears and bulls can flag to help make their respective cases. (See TIME 100 panelists discuss what’s next for capitalism.)

The Baltic Dry Index is the worldwide benchmark for shipping rates of raw materials, and it has registered some eye-popping gains over the past month. The London-based index registered its 23rd straight daily gain on Wednesday, closing at 4,291, its highest mark since September and the longest streak of gains since July 2006. Daily rates for the largest Capesize ships, which typically carry iron ore, rose 6.8% on Wednesday to $93,197. Just five months ago, daily ship-rental rates were hovering just above $2,000, about the price of a great seat on opening day at the new Yankee Stadium.

Baltic Index president Jeremy Penn cautions that shipping rates can sometimes fluctuate dramatically, and are often driven by specific factors such as carrier availability in key locations. Indeed the current boost is best explained by Chinese steel production demand and a shortage of the Capesize vessels to haul the iron ore. Penn notes that it is not yet clear whether the core manufacturing that is turning again in China is linked to coming export demand or domestic infrastructure investment. “There are always quirks in the pricing,” he notes. “And at the moment it seems a very China-centric market.” (Read “Plunge in Trade Is a Boon for Singapore Ship Suppliers.”)

Still, there is inevitably a global dimension to tracking bulk rates. “It’s the price for moving raw materials, which sit at the beginning of the production chain,” Penn explains. “We can say that the complete lockup of world trade we saw at the end of last year has eased considerably.” Penn concludes that his index “is useful to look at, but it’s not the holy grail.”

That’s to say, before you run out to start an import-export business, take a look at some other numbers in the shipping world that are far less robust. Shipping by container, typically finished goods, remains troublingly cheap, a sign that consumer products are still not flowing between continents. The price for a 20-foot equivalent unit (TEU) container on an East Asia–to-Europe voyage is reportedly currently maxing out at a paltry $500. Though the pace of the drop in rates has slowed, there are signs that charter prices have still not bottomed out, having dipped below the record lows of the 2002 stock-market crunch. According to London ship broker Clarkson, a 3,500-TEU gearless Panamax vessel — the largest vessel that can go through the Panama Canal — pulls in $6,500 a day, down 34% on the $9,500 it was charging in February.

One shipping-industry insider notes that any evaluation of transport prices must include not only demand (how much cargo there is to be hauled), but also supply (the quantity of carrier capacity). The steady boom of world trade over the past decade prompted a major shipbuilding spree, with many vessels slated for completion in the coming months and years. “There are new and larger ships on order,” notes the source. “I fear that overall rates will not be as responsive to the recovery as a whole.” In other words, just as skyrocketing prices in raw-material transport don’t guarantee a robust global recovery, nor would a sluggish rebound in shipping profits preclude a bullish outlook for the overall economy.

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Appoint The Foxes To Guard The Henhouse

By Robert Scheer

Editor’s note: Minor changes were made in the description of BlackRock in the first sentence and in the timing of the Treasury Department’s decision in the second paragraph.

How much do you know about BlackRock and the hedge funds they manage? Better bone up fast, now that the folks at BlackRock are calling the shots in the government’s trillion-dollar bailout program. As both The New York Times and The Wall Street journal reported on Tuesday, BlackRock execs are now directing key elements of the government program at a time when they stand to reap great profits from the fallout of a problem they helped create.

The U.S. picked BlackRock to manage the assets once controlled by AIG and Bear Stearns and to analyze the assets of Freddie Mac and Morgan Stanley. And as if that were not enough on its plate, the Treasury Department is widely expected to select BlackRock to be one of the few firms trusted with using U.S. taxpayer dollars to buy toxic assets from the banks and then resell them in a process that presents enormous conflicts of interest with other BlackRock operations.

Bank of America, with a 47% ownership position in BlackRock, is also the owner of what was once Countrywide Financial, which led the pack in selling bad mortgages. The disposition of those failed properties under BlackRock’s tutelage will have much to do with BofA’s future profitability. As if that were not enough financial incest, the former president and other top executives of Countrywide now run a company created by BlackRock, which is profiting mightily by snapping up the sort of distressed loans that they originally had marketed.

Confused? You’re supposed to be. That’s the point of a successful hedge fund, a totally unregulated activity in which very rich people pool their money in order to more effectively rip off the rest of us. And BlackRock is at the top of that game, managing $1.3 trillion in assets. But in this round the stakes are far higher because BlackRock, which did a great deal to cause the economic meltdown, has now been put in charge of the government recovery effort.

But don’t take my word for it; check out the accounts of BlackRock’s leading role in managing the bailout in The New York Times and Wall Street Journal on Tuesday.

The New York Times: “Can a company that is being paid to price and sell troubled assets for the government buy the same kinds of assets for private clients without showing preference? And should the government seek counsel from a company whose clients stand to make or lose billions if those policies are enacted?”

The Wall Street Journal: “BlackRock helped shape the government’s toxic-asset plan, which critics have said helps vulture investors buy assets on the cheap while exposing taxpayers to the bulk of losses if the investments sour.”

Leading the pack of vulture capitalists profiting from the misery they inspired is the Private National Acceptance Co. (PennyMac), which BlackRock bankrolled. Stanford L. Kurland, chairman and CEO of PennyMac, is the former president of Countrywide Financial. A New York Times story in March headlined “Ex-Leaders of Countrywide Profit From Bad Loans” noted that Kurland’s new outfit was profiting from the misery it had helped cause: “After all, the banking behemoth (Countrywide) made risky loans to tens of thousands of Americans, helping set off a chain of events that has the economy staggering.”

Countrywide, under Kurland’s leadership, specialized in those low “teaser” interest rates that caused people to lose their homes when rates suddenly ballooned. As the Times observed, “Countrywide has become synonymous with the excesses that led to the housing bubble.” Now Kurland’s new company specializes in buying back those forfeited and at-risk properties for pennies on the dollar and making money off new loans and sales.

“It is sort of like the arsonist who sets fire to the house and then buys up the charred remains and sells it,” Margot Saunders, a lawyer with the National Consumer Law Center, told the Times.

“Kurland is seeking to capitalize on a situation that was a product of his own creation,” noted Blair A. Nicholas, a lawyer representing Arkansas teachers suing Kurland and his fellow Countrywide executives. “It is tragic and ironic. … But then again, greed is a growth industry.”

And once again the greediest will make out like bandits, with only a few of them ever being held accountable. Kurland sold $200 million in Countrywide stock shortly before the meltdown and, in any case, the spectacular failure of his banking experience only made him all that more employable.

Quoting federal banking officials, the Times reported, “They said it was important to do business with experienced mortgage operators like Mr. Kurland, who know how to creatively renegotiate delinquent loans.” Has our president never heard of recidivism?

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Roubini Now The Optimist

by Economist

IT HAS been a cheerful couple of days for those starved of bright economic news. Hopeful statistics have been trickling in from many parts of the world. On Friday May 29th revised first quarter GDP figures for America showed that the economy there had contracted slightly less than had earlier been reported. In addition durable-goods orders in the country rose by the most in 16 months. In Japan, factory output rose by 5.2% in April, the biggest monthly increase, in percentage terms, in over half a century. And in the first quarter India’s economy grew by a bullish 5.8%, compared with a year before, while South Korea’s industrial production continued to rise in April.

Even in gloomy Europe there are encouraging signs. Poland’s GDP ticked up by 0.8% in the first quarter, as did German private consumption (in the same period) and retail sales also grew, by 0.5%, in April. British consumer confidence remained steady in April, and house prices there rose both in March and May, according to one index.

For optimists, these are all signs that might point towards the beginning of the end of the “Great Recession”. Headline writers, and those who are urging stockmarkets to continue rising, will continue to talk of hopes of recovery. Yet a closer look at the detail of the latest figures suggests that hope springs eternal and will latch on to what it can—even when a more sober analysis would suggest there is a long way to go before recovery sets in.

Optimists make much of statistics that beat analysts’ expectations. But when a particular figure outdoes predictions it may be because those expectations were overly pessimistic, rather than a sign that something fundamental has changed for the better.

What, for instance, is the right reference point on the latest news on India’s economy? Doomsters might fret that it has grown at the slowest quarterly pace in several years. Cheerleaders could rejoice that it has expanded slightly faster than most people had expected. Weary of negative news, the latter explanation is a tempting way to make sense of the numbers, but the gloomy view is equally valid.

Consider, too, the figures for consumer confidence in Britain. Although consumer gloom seems to have abated, the reported level of –27 is remarkably low by historical standards. If one takes into account reports that British consumers had been growing a bit more confident in recent months, the latest statistic could suggest a halt to a small rally, which is hardly something to cheer. This example highlights the difficulty of extrapolating from a single month or quarter of data, which can easily be skewed by one-off events such as a national holiday or sudden desperate measures by retailers to offload stock. Discerning whether a more sustained recovery might be under way takes, unsurprisingly, more data.

Thus pessimists, who are unconvinced that the worst is over for the world economy, have much to reinforce their dark mood. One particular concern is that the financial and credit problems at the root of the global recession have not been dealt with satisfactorily. Keiichiro Kobayashi, a Japanese economist, has looked back to Japan’s experience in the late 1990s and argues that unless the banks are fixed, a strong recovery for the world economy is impossible. Some disagree, suggesting that economic output can bounce back even before credit and financial markets are again healthy, if consumers get their wallets open. But even if this argument is compelling in some historical cases, this time it seems that household spending in many economies will remain weak because of high levels of debt.

One man who has made his name in recent years as a doom-monger, Nouriel Roubini, an economist at New York University, recently suggested that recovery from recession was far from imminent, arguing that “it’s going to last another six to nine months”. It might not be surprising that he avoids a bullish prediction, but Mr Roubini goes one step further, noting that other economists are still suggesting a “doomsday” scenario, with continuing contraction for a long time to come, and thus even he could be considered as an optimist.

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Gillie!!!! Did You Do That?????

by Mark Ames

Is Larry Summers taking kickbacks from the banks he’s bailing out?

Last month, a little-known company where Summers served on the board of directors received a $42 million investment from a group of investors, including three banks that Summers, Obama’s effective “economy czar,” has been doling out billions in bailout money to: Goldman Sachs, Citigroup, and Morgan Stanley. The banks invested into the small startup company, Revolution Money, right at the time when Summers was administering the “stress test” to these same banks.

A month after they invested in Summers’ former company, all three banks came out of the stress test much better than anyone expected—thanks to the fact that the banks themselves were allowed to help decide how bad their problems were (Citigroup “negotiated” down its financial hole from $35 billion to $5.5 billion.)

The fact that the banks invested in the company just a few months after Summers resigned suggests the appearance of corruption, because it suggests to other firms that if you hire Larry Summers onto your board, large banks will want to invest as a favor to a politically-connected director.

Last month, it was revealed that Summers, whom President Obama appointed to essentially run the economy from his perch in the National Economic Council, earned nearly $8 million in 2008 from Wall Street banks, some of which, like Goldman Sachs and Citigroup, were now receiving tens of billions of taxpayer funds from the same Larry Summers. It turns out now that those two banks have continued paying into Summers-related businesses.

According to filings obtained for this story, Summers first joined the board of directors of Revolution Money back in 2006 (when it was called “GratisCard”), the same year that Summers was forced to resign as president of Harvard after his disastrous tenure. Revolution Money/GratisCard was a startup headed by former AOL chief Steve Case. Revolution Money billed itself as the Next Big Thing in online payment, “PayPal meets Mastercard,” according to their own pitch.

In September 2007, Revolution Money announced that it had raised $50 million from a group of investors including Citigroup, Morgan Stanley and Deutsche Bank. Some found the investment strange even then, because normally big banks don’t get involved in seeding small startups—that’s the domain of venture capitalists, not mega-banks. Especially not in September, 2007, when these same megabanks were Chernobyling their way into full-fledged balance-sheet meltdown.

What seems clear is that at least part of Revolution Money’s success in raising funds is due to their star-studded board of directors—which included not only Larry Summers, but also the notorious Frank Raines, the former Fannie Mae chief whom Time Magazine named to its “25 People To Blame For The Financial Crisis” list. Raines is still a board member.

Over the next year and a half, Revolution Money didn’t quite live up to its promise of competing with PayPal or Visa/Mastercard. At least some of this could be attributed to the difficulty of starting up an online credit card company in the middle of a triple-cluster credit crunch, banking crisis and recession. But there is also evidence that the company wasn’t run well. Another one of Steve Case’s “Revolution” brand startups, “Revolution Health,” (which also features a star-studded board of directors including Carly Fiorina, Colin Powell, and several future-Obama Administration officials) essentially folded last autumn when it was sold to Everyday Health last September and merged into that company’s operations.

In spite of all of this, on April 6, 2009, Revolution Money announced the happy news: it had just successfully raised $42 million dollars in the most difficult market since the 1930s. The investors? Goldman Sachs, Citigroup and Morgan Stanley—bankrupt institutions that Larry Summers was transferring billions in bailout funds to.

At the very same time that these three megabanks were pouring millions into Summers’ former company, Obama’s economic team, starring Larry Summers, was subjecting these same banks to a “stress test” to decide how deep in shit these same banks really were. The banks wanted the government to fudge the results for obvious reasons—who wants the world to know how deep of a hole you’ve dug for yourself?

When the stress test results were finally released, the banks all came out with glowing reports that beat expectations and caused plenty of skepticism.

In an interview for this article, William Black, a former bank regulator who exposed the $160 billion Savings & Loan scandal and its ties to powerful U.S. Senators, remarked,“Summers wasn’t hired [by Revolution Money] for his expertise because he doesn’t have relevant expertise in this kind of credit card operation.”

“He’s not a techie. He doesn’t have business expertise,” Black said. “So this is solely someone hired for the name and contacts because he’s politically active and politically connected. And that’s made all the more clear by the fact that Frank Raines was put on the board at a time when he was pushed out in disgrace from Fannie Mae. Why? Because of his political connections.”

And it worked, as the recent investment shows.

“That’s the pattern of this entity,” said Black, “Which hasn’t been doing well financially and desperately needs to get money from others, and has been able to get money from banks at a time when [these same banks] largely stopped lending to productive enterprises. But with this politically-connected entity [Revolution Money], they’re happy to dump money.”

According to a company spokesperson, Summers resigned from the board of directors at Revolution Money this January, just three months before the banks invested. On one of Revolution Money’s main websites, Revolution Money Exchange, you could still see Summers’ name still listed as a director when this story was filed

(Oddly, company filings obtained for this article show that Summers wasn’t even on Revolution Money’s board of directors in 2007-8, even though both he and Revolution Money repeatedly stated that he was on the board, and only served on GratisCard’s board in 2006, “c/o Revolution GC Holdings LLC.”)

Whatever the case, Summers was pushing Revolution Money as recently as last September, in an interview with Portfolio magazine:

“I’ve enjoyed being involved with a number of smaller companies such as the Revolution Money venture, which has a potentially very exciting credit-card technology, using credit and debit technology, using the internet that, in a sense, brings together bricks and clicks by providing both a capacity for regular retail transactions and also for online.”

Whether or not Summers has a personal interest in the company, it still stinks that a company where the head of the National Economic Council served on the board of until just a few months ago subsequently received millions in investment funds from banks Summers bailed out. Taxpayer dollars went into these banks, and from the banks into the Summers-connected firm, a firm he was hired onto precisely because his connections could bring in this kind of money.

His involvement wasn’t just incidental—if you look at the press releases, Larry Summers’ name is always touted as part of its selling point—one press release in 2007 refers to Summers as “Legendary.”

Moreover, Summers’ longtime chief of staff, Marne Levine, who also served as Summers’ chief of staff when he was in Treasury under Clinton and again at Harvard, joined Summers at Revolution Money, serving as “Director of Product Management.”

Black pointed out another sleazy aspect of Revolution Money’s pitch: it proudly boasted in late 2007 that it would make it easier than ever for people with low credit ratings to find access to lines of credit. In other words, Revolution Money billed itself as the ultimate ghetto loan shark.

According to a 2007 press release, the same one boasting of “Legendary” Larry Summers, “Unlike most bank credit card issuers who are limited to a narrow scope of credit approval guidelines specific to their bank, RevolutionCard seamlessly utilizes multiple partners to achieve unparalleled consumer approval rates.”

Nineteen months later, Larry Summers, now in control of the economy, told Meet The Press, “We need to do things to stop the marketing of credit in ways that addicts people to it and so that our households are again savings, and families are again preparing to send their kids to college, for their retirement and so forth.”

So once again, Larry Summers creates a problem that the rich profit from, then is put in charge of “fixing” it after vulnerable Americans have been picked clean.

Whether or not the three bailed-out banks’ investment in Revolution Money last month represents some kind of bribe or kickback or even the appearance of corruption is almost secondary, because the shameless cronyism is the problem, and this is the reason why America is in the horrible mess today.

“Polite society was supposed to impose social pressures to make sure this wasn’t tolerated,” Black said. “Like the old phrase about hogs being slaughtered. But now the hogs get even wealthier, even fatter.”

Everything about Summers, from his horrible track record in the developing world in the 1990s to the sleaze and plunder he’s overseeing in the White House should make us terrified. Hell, he even looks like some old Batman villain: Summers, whose trademark bullfrog neck was enough of a distraction before Obama brought him into the White House, has seen his gelatinous layers of neck-fat swell up like an amphibian guarding its eggs ever since he took control of the economy.

Get this monster out of the White House now, before he devours us all.

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Oil And Coal Going Up

By Daniel Whitten

Oil prices will return to $110 a barrel by 2015 as a rebound in economic growth worldwide boosts consumption, a U.S. Energy Department bureau said.

Prices, which rose to a six-month high of $62.45 yesterday in New York Mercantile Exchange trading, will continue climbing past 2015 to $130 by 2030, as India, China and other developing nations use more oil, the Energy Information Administration said today in its annual International Energy Outlook report.

Oil prices have tumbled from an all-time record $147.27 a barrel in July as industries and consumers pulled back after credit markets froze and the global economy fell into its first recession since World War II. Energy demand will remain weak “in the near term” until the global economy begins to rebound, which may happen as early as next year, the agency said.

“With economic recovery anticipated to begin within the next 12 to 24 months, most nations are expected to see energy consumption growth at rates anticipated prior to the recession,” the agency said in a statement.

Developing economies will have “very large impacts on international energy markets in the next several decades,” Howard Gruenspecht, the acting administrator of the Energy Information Administration, told reporters in Washington today. “Energy demand growth outside the mature economies far outstrips demand growth in the mature economies.”

$70 a Barrel

In last year’s International Energy Outlook, the agency projected oil would fall to $70 a barrel by 2015, partly because record prices would drive investment in new production.

World energy consumption is now likely to rise 44 percent by 2030 from 2006, the agency said. Demand in developing countries will increase 73 percent. Growth in Organization for Economic Cooperation and Development nations will be 15 percent.

Taking into account oil market volatility, the report includes a “high price” projection of $200 a barrel by 2030 and a low price projection of $50 per barrel.

Global natural gas consumption will rise 47 percent to 153 trillion cubic feet in 2030, from 104 trillion cubic feet in 2006, the department said.

Coal demand will rise 50 percent to 190 quadrillion British thermal units in 2030, from 127 quadrillion in 2006, if policies are not in place to limit greenhouse gas emissions, a summary of the report said.

World carbon dioxide emissions will rise to 33.1 billion metric tons in 2015 from 29 billion in 2006, and will reach 40.4 billion in 2030, a 39 percent increase, the agency said.

The House Energy and Commerce Committee approved legislation May 21 that would aim to cut U.S. emissions 17 percent by 2020. The bill must still be voted on by both full chambers of Congress.

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Roubini On Future Ecomomy

Economist Nouriel Roubini on Wednesday said the end of the global recession is likely to occur at the end of the year rather than the middle, and that U.S. growth will remain below potential afterwards.

“We are not yet at the bottom of the U.S. and the global recession,” said Roubini. “The contraction is still occurring and the recession is going to be over more toward the end of the year rather than in the middle of the year.”

“There is still too much optimism that a recovery is just around the corner,” said Roubini, a professor at New York University’s Stern School of Business and chairman of RGE Monitor, an independent economic research firm.

Roubini, who is widely credited for predicting the current economic turmoil, was speaking at the Seoul Digital Forum.

“A more sober analysis suggests we’re closer to the bottom; there is light at the end of the tunnel, but it’s going to take a while longer, and the recovery is going to be weaker than otherwise expected.”

Once the recession ends, “U.S. economic growth is going to be below potential for at least two years,” he said, amid multiple imbalances in the housing sector and the financial system, and the rise of public debt.

Roubini said the outlook for Asia was more positive than for Europe, Japan and the United States, thanks to stronger fundamentals.

“The latest economic indicators from Korea … suggest there is the beginning of an economic recovery, and growth might be already positive in the second quarter.”

The downside risk, Roubini said, was if advanced countries did not recover fast enough and if China’s rate of growth started to slow again.

Roubini predicted China would post a 6% growth rate this year, a “hard landing” considering it grew by 10% for a decade.

A robust recovery in Korean, China and other countries in the region would depend upon relying less on external demand and export-led growth and relying more on domestic growth, he said.

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Deflation Followed By Hyperinflation in the US

The U.S. economy will enter “hyperinflation” approaching the levels in Zimbabwe because the Federal Reserve will be reluctant to raise interest rates, investor Marc Faber said.

Prices may increase at rates “close to” Zimbabwe’s gains, Faber said in an interview with Bloomberg Television in Hong Kong. Zimbabwe’s inflation rate reached 231,000,000% in July, the last annual rate published by the statistics office.

“I am 100% sure that the U.S. will go into hyperinflation,” Faber said. “The problem with government debt growing so much is that when the time will come and the Fed should increase interest rates, they will be very reluctant to do so and so inflation will start to accelerate.”

Federal Reserve Bank of Philadelphia President Charles Plosser said on May 21 inflation may rise to 2.5% in 2011. That exceeds the central bank officials’ long-run preferred range of 1.7% to 2% and contrasts with the concerns of some officials and economists that the economic slump may provoke a broad decline in prices.

“There are some concerns of a risk from inflation from all the liquidity injected into the banking system but it’s not an immediate threat right now given all the excess capacity in the U.S. economy,” said David Cohen, head of Asian economic forecasting at Action Economics in Singapore. “I have a little more confidence that the Fed has an exit strategy for draining all the liquidity at the appropriate time.”

Action Economics is predicting inflation of minus 0.4% in the U.S. this year, with prices increasing by 1.8% and 2% in 2010 and 2011, respectively, Cohen said.

Near Zero

The U.S.’s main interest rate may need to stay near 0% for several years given the recession’s depth and forecasts that unemployment will reach 9% or higher, Glenn Rudebusch, associate director of research at the Federal Reserve Bank of San Francisco, said yesterday.

Members of the rate-setting Federal Open Market Committee have held the federal funds rate, the overnight lending rate between banks, in a range of 0% to 0.25% since December to revive lending and end the worst recession in 50 years.

The global economy won’t return to the “prosperity” of 2006 and 2007 even as it rebounds from a recession, Faber said.

Equities in the U.S. won’t fall to new lows, helped by increased money supply, he said. Still, global stocks are “rather overbought” and are “not cheap,” Faber added.

Faber still favors Asian stocks relative to U.S. government bonds and said Japanese equities may outperform many other markets over a five-year period. “Of all the regions in the world, Asia is still the most attractive by far,” he said.

Gloom, Doom

Faber, the publisher of the Gloom, Boom & Doom report, said on April 7 stocks could fall as much as 10% before resuming gains. The Standard & Poor’s 500 Index has since climbed 9%.

Faber, who said he’s adding to his gold investments, advised buying the precious metal at the start of its eight-year rally, when it traded for less than US$300 an ounce. The metal topped US$1,000 last year and traded at US$949.85 an ounce at 12:50 p.m. Hong Kong time. He also told investors to bail out of U.S. stocks a week before the so-called Black Monday crash in 1987, according to his Web site.

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Our Lost Decade?

by Douglas A. McIntyre

Depending on the source, Japan’s mythic “Lost Decade” lasted from 1989 to 2003, or sometime later if the exact bottom of the real estate market in the Asian nation is taken into account. Because the period began with easy access to capital followed by a sharp drop in the stock market and property values, it is now being compared to what many economists believe began in the US two years ago. They fear, probably with good reason, that GDP growth will simply stay in a narrow band of extremely modest growth or no growth at all and the lack of consumer and business spending and demand for exports will cause deflation.

The American economy should be so lucky. Buried among the Fed’s most recent comments on the economy were concerns about the financial and credit markets as well as employment and spending. Since the minutes are distilled before being sent out to be reviewed by an anxious public, the actual concerns among the Fed governors has probably been significantly understated. (See pictures of the Top 10 scared traders.)

After a period of a few weeks in which investors and analysts felt a little better about the prospects of the economy at the end of the year, the pallbearers have returned. The enthusiasm about a recovery in the banking system was sandwiched by bad news from bank analysts who think the largest financial firms will have to raise tens of billions of extra dollars on the one side and Congressmen who say that they will not provide more TARP money on the other. With insurance companies now begging for dollars as well, there is not going to be enough bailout money to go around. Bank of America (BAC), which one analyst said would have to raise $36.6 billion, has dropped from $7.77 to $6.91 in five trading days. No one could figure out where that money would come from.

Banking problems were at the front of the gauntlet of bad news. The rise in prime mortgage defaults dampened the hopes that the housing market was in the midst of a comeback and the first few companies that have announced earnings have done no better than their gloomy forecasts said that they would. Berkshire Hathaway (BRK) lost its Triple-A rating as GE (GE) did just a few weeks ago. The period of the Fort Knox balance sheet is over in America. As of the Berkshire news, all corporate debt officially carries risk.

The concern about the American economy which is re-emerging is not whether it will run sideways for years the way that the Japanese economy did; it is whether the US GDP and employment will continue to tumble and go on looking for a bottom for several months.

The most important warning sign that the economy is sliding again is when the media seeks out the pessimists among the bureau for famous analysts and financiers. Wilbur Ross and George Soros are getting too much air time. They rarely have good things to say about the future. They may be making bets in the market that key economic measurements will deteriorate so their motives are suspect. But, they are probably right anyway. Billionaires have proven track records for prescience. Once they begin to circle, it is almost certain that something is about to die.

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Is It Over?

Mike Larson writes: It’s hard to find anyone who’s still bearish on the economy or the market these days. Listen to the average pundit on CNBC and this is what you’ll hear:

The credit crisis? It’s over! Quit worrying.

The real estate mess? Fixed! No problem.

The economy? Rebounding. The worst is behind us.

The markets? They’re headed to infinity and beyond! Better get on board.

I’ve talked about the credit crisis a few times in previous Money and Markets columns. And no less an authority than the International Monetary Fund (IMF) believes we’ve only acknowledged $1.29 trillion of the $4 trillion in total global credit losses to date. That means we’re not even a THIRD of the way through the process.

In the real estate arena, we’re seeing tentative signs of life in some hard-hit markets. But it’s the distressed, “fire sale” stuff that’s moving. Inventory levels remain high, and foreclosures show no sign of abating. In fact, foreclosure filings hit a new record high of 341,000 in March — a gain driven by rising unemployment, falling home prices, and the expiration of several, temporary state and industry moratoriums.

And that’s just on the RESIDENTIAL front!

Commercial real estate is suffering, too. In fact, General Growth Properties, the second-largest mall operator in the U.S., just filed the biggest real estate bankruptcy in U.S. history.

The COMMERCIAL real estate business is in full-scale meltdown mode. Prices are plunging, vacancies are soaring, and rents are dropping. Office tenants recently vacated a whopping 24.9 million square feet of space, the most since the 9/11 attacks. And General Growth Properties, the second-biggest mall operator in the U.S., just filed for Chapter 11 bankruptcy protection. The company is buried under $27 billion in debt, and its bankruptcy is the largest EVER seen in the commercial real estate industry.

It’s (still) the Economy, Stupid!

But it’s the economy that could be the weakest link here. Several companies have come out and said that business isn’t getting any worse. Some of the earnings reports I’ve read talk about how conditions are now simply horrendous, rather than Armageddon-like.

But does that mean things are getting better? Is the economy really ramping up? Is the worst really behind us? I find that hard to believe. Just consider what we learned this week …

The consumer is still on the ropes! Retail sales plunged 1.1 percent in March. That was a huge swing from the 0.3 percent gain in February, and much worse than forecast.
No matter how you slice and dice the numbers (exclude autos, exclude gas, etc.), you still come to the same conclusion: The consumer is on the ropes and not in the mood to blow his dwindling paycheck at the mall. That’s unlikely to change anytime soon, not with the level of continuing jobless claims now running at more than 6 MILLION — the highest in U.S. history.

The amount of factory space being used fell to 69.3 percent — its lowest level … EVER!

Factories are sitting idle! Industrial production dropped 1.5 percent in March. That was far worse than the 0.9 percent dip that was expected and the 14th decline in the past 15 months. Capacity utilization — the amount of available space that’s actually being used — fell to 69.3 percent. That’s the lowest level in the 42 years the government has been keeping track!
Deflation is far from dead! The Federal Reserve has been pumping money into the economy like mad to offset deflation. But so far, it doesn’t seem to be working out that well. The Producer Price Index (PPI) dropped 1.2 percent last month, much worse than the forecast for a flat reading.
On a year-over-year basis, wholesale prices are now falling at a 3.5 percent rate. That’s the deepest rate of deflation recorded in this country since January 1950! In addition, consumer-level deflation came in at 0.4 percent, the most since 1955.

Garden Variety Recession… Or Something Else?

Many Wall Street investors are operating under the assumption that this is a garden variety recession. They’re saying that the modicum of “less worse” news we’ve seen is a harbinger of “recovery.” They expect consumer spending to resume its normal pace, factories to ramp production back up, and everything to be hunky dory by year end.

This recent rally will be very sharp, relatively short-lived, and ultimately, doomed to fail.

But if this is a much deeper economic decline … one driven by the biggest bout of debt destruction and deleveraging this country has seen since the Great Depression … that’s a different story. In that case, the Fed’s reflation efforts will fail. At best, the economy will muddle along. At worst, it will slip even further down the rabbit hole. And stocks will ultimately head lower.

I don’t have a perfect crystal ball. But I believe the risk of a Japan-style economic stagnation is much higher than the traditional Wall Street pundit thinks it is. And I believe this recent rally smells more like the bear market variety — very sharp, relatively short-lived, and ultimately, doomed to fail. So I most certainly wouldn’t be chasing it.

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Little Dorrit – Debtors Prisons In Florida

In a little-noticed trend blamed on the state’s hard economic times, several courts in Florida have resurrected the de facto debtor’s prison — having thousands of Floridians jailed for failing to pay assessed court fees and fines. The shortsighted plan threatens to run afoul of the U.S. Constitution. It appears to generate little additional revenue relative to the misery it causes, and it should be stopped.

A recent report by the nonprofit Brennan Center at New York University School of Law highlights the difficulty of trying to get what one researcher called “blood from stone.” In Leon County’s Collection Court, defendants who fail to pay their court-ordered costs and fines — often hundreds of dollars — are notified to appear at Collections Court and later arrested if they don’t show. In the 12 months studied, there were 838 arrests for not appearing in court or failing to pay what was owed. Most people spent hours in jail, but some were held for a week or more.

At $53 per day of incarceration, it is an expensive way to try to collect from people who generally are struggling to meet the expenses of daily living. The center calculated that those incarcerated cost the system $62,085 to bring in $80,450 in debts.

Jail time for being broke is no way to help people get back on their feet after a run-in with the legal system. Judges should be exercising the option in state law that allows them to convert court-ordered obligations into community service. But with the Florida Legislature looking for revenue to fund the courts and other state services, judges are under pressure to wring every available penny out of those who owe.

The nonpayment problem is only likely to worsen. In Tallahassee, lawmakers are debating raising court fees and fines even further to raise general revenue for the state. Meanwhile, the state’s rising unemployment rate will make it tougher for Floridians with a criminal record to find a decent job. Do we really want our jails filled with people whose only “crime” is that they are poor?

About a third of Florida counties use collections courts, but even those without them jail people for their debts. In Pinellas, Hillsborough and Hernando counties, collection agencies are used to extract the overdue fines and fees. But defendants who violate their probation by failing to pay can find themselves in jail if a judge believes they have not coughed up what they can.

Author Charles Dickens familiarized his readers with England’s system of squalid debtors’ prisons. Dickens’ father was imprisoned in Marshalsea for debts and Dickens set Little Dorrit there. But that country saw the light in the mid 19th century and outlawed jail for debtors.

In the United States, it is unconstitutional to incarcerate someone solely for failing to pay a debt. Florida officials get around this by claiming the defendants are going to jail not for their debts but for violating a court order. That is what you would call a self-serving technicality. The truth is that Florida has enthusiastically resurrected debtors’ prison. How Dickensian is that?

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Banks On The Mend?

by Douglas A. McIntyre

Investors find it disconcerting to see the stocks in the huge financial institutions that are at the foundation of the global capital system trading up and down 25% a day, and, in some cases trading in the pennies. Banks became the visible and ugly wound that reminded Wall St. each day what it had torn down what it spent decades building, which was a money-making machine driven by leverage and the cleverest synthetic financial instruments the world has ever seen.

But, the great banking crisis of 2008 is over. It began last September 15 when Lehman Brothers filed for bankruptcy and bottomed when Citigroup (C) traded below $1 last month. Most analysts believe that mortgage-backed securities which included packages of subprime home loans failed when mortgage default rates went up and housing prices raced down. That is only partially true. Banks made a tremendous series of ill-advised loans to private equity firms, hedge funds, commercial real estate holders, and the average man with a credit card balance which he cannot pay. (See pictures of the top 10 scared traders.)

When people look back on the near-collapse of the banking system they may say that the Congress and Henry Paulson threw enough money into the path of the oncoming failure of the credit system to slow it down so that the government could properly go through the process of guaranteeing parts of the balance sheets of firms including Citigroup (C) and Bank of America (BAC). The initial TARP may also have provided time for the new Administration to put together its widely hailed bank “stress test” program meant to determine which of the big financial institutions have dysentery and which do not. Finally, the hundreds of billions of dollars that went into the largest banks late last year allowed Secretary Geithner to produce his public/private partnership to buy toxic assets off of bank balance sheets.

All of those plans, no matter how well-intentioned they may seem, are unnecessary now. Wells Fargo (WFC) indicated that it made about $3 billion in the first quarter of the year and declared its buyout of the deeply troubled Wachovia to be a success. Wells Fargo (WFC) said that the low cost of money from the government combined with a surging demand for mortgages was all the medicine that it required.

Banks stocks reacted to the news, which took the markets completely by surprise, by driving up Wells Fargo’s stock by 32%. Bank of America (BAC) shares jumped 35%.

Oddly absent from the discussion of how well Wells Fargo did is why the government was in the midst of testing bank balance sheets at all. The experts at the Treasury had been thrown off the scent and consequently had missed the fact that there was not need to test what is already working well. The same holds true for the Geithner plan to take toxic assets off bank balance sheets. It is academic now. What banks are earning from the difference between the cost of capital and the income from lending is now great enough for the banking system to be self-sustaining again.

What will happen at this point is that bank stocks will not go up much more, but they will not dive sharply down either. There is enough evidence in comments from the CEOs of Citi and B of A and in the Wells Fargo earnings to show that the idea that banks are insolvent and probably in need of nationalization is no longer part of the consideration of how the problems with the system will be settled.

It is equally safe to say that the large American banks are works in progress which are, in most ways, still dilapidated. Treasury Department analysts may not have the IQs of the PhDs who created mortgage-backed securities, but they did not do their detective work blindly when they insisted that bank balance sheets and loan portfolios needed close examination. It is also true that the private capital firms which plan to buy toxic assets using taxpayer money were not enticed into the new program based on an illusion. The banking system is still terribly weak and there is almost no one with an in-depth knowledge of the credit market tapestry who does not believe that there are hundreds of billions of Confederate dollars being held in the vaults of the major banks. (See the 25 people to blame for the financial crisis.)

The banking crisis may be over, but what is left is a reclamation job that will probably take years to complete, will still have a taxpayer price tag of over $1 trillion, and will leave America’s largest financial firms as institutions of modest power and a regulated scope which will prevent them from looking anything like what they did two years ago.

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Stalled U.S. economy may need years to recover

By Louis Uchitelle

As the recession grinds on, more and more of America’s means of production – its workers, its factories, its retail outlets, its freight lines, its bank lending, even its new inventions – are being mothballed.

This idled capacity, like baseball players after a winter off, takes time to bring back into robust use. So even if the recession miraculously ended tomorrow, economists estimate that at least three years would pass before full employment returned and output rose enough for the economy to operate at full throttle.

While stock market investors have embraced tentative signs of improvement in the mortgage market and elsewhere, even a sharp pickup in demand for products and services will take considerable time to play out.

The mathematics are daunting. The shortfall is running at more than $1 trillion in annual sales and other transactions. Only once since the Great Depression has there been such a severe loss of output – in the 1981-82 recession – and after that downturn, it was seven years before the economy regained the lost production.

Recovery from the current recession could be similarly sluggish. New occupants must be found for empty stores. Factory owners who are hesitant to ramp up production will wait until they are sure of demand. Hiring the right people for an operation will take time. And imports, entering the country in ever greater quantities, will slow any expansion by siphoning sales from domestic producers.

Then there is the growth rate itself. In the six years of recovery from the 2001 recession to the current one, the economy grew at an average annual rate of only 2.5 percent, adjusted for inflation. If that growth rate were to resume, just $350 billion a year would be added back, requiring three years to restore the $1 trillion in lost capacity. But getting the economy to grow at all after so much output has been lost, and so many jobs, is no easy task.

“Excess capacity, once entrenched, perpetuates itself, and that is what is happening now,” said James Crotty, an economist at the University of Massachusetts, Amherst. “Companies cannot hire workers to make more goods and provide more services until their sales go up. But people can’t buy goods and services until they are hired – so the excess capacity just sits there.”

It shows up everywhere. Lawyers are booking fewer hours. Retail space goes begging. Tourism is down. So are cell phone use, airline bookings, freight traffic and household borrowing, which is less than half what it was on the eve of the recession, the Federal Reserve reports.

With orders dwindling, manufacturers are using less than 68 percent of the nation’s factory capacity, the lowest level since records were first kept in 1948. And while entrepreneurs are as inventive as ever, they may not be able to get venture capitalists to bankroll their creations.

“We and others are funding start-ups as slowly as possible, or not at all,” said Howard Anderson, a founding partner of Battery Ventures in Waltham, Mass., and a senior lecturer at the Massachusetts Institute of Technology.

He cites as an example a hand-held device, similar in shape to an iPod, that restaurant diners would use to order food and drink electronically. Waiters would bring the orders, but not take them.

“The prototype just sits there,” Anderson said, “and maybe the inventors will get funding to produce and market their device – and maybe their company never gets born.”

If there is an upside, it is the absence of inflationary pressure. With so much excess capacity rattling around, shortages do not develop that would push up prices. Indeed, interest rates are kept low to encourage more borrowing and spending. Neither is happening. Instead, demand continues to shrink and idle capacity to build up.

The Obama administration, like the Roosevelt administration 75 years ago, is trying to break this logjam through government spending, using it in effect as a substitute for consumers who are jobless or short of credit. The spending is also a substitute for companies that hesitate to extend themselves or see no profit in doing so.

But President Barack Obama’s solution, the recently enacted stimulus package, spreads $787 billion over two years. So even if every dollar of spending restored a dollar of output, Obama would be nearing the end of his first term before output approached the level achieved just before the start of the recession in December 2007.

Or so says Robert J. Gordon, an economist at Northwestern University who specializes in tracking the gap between actual output and potential output, aka full capacity. The Roosevelt economy also languished well below full capacity, Gordon said, until the summer of 1940, when France fell to Hitler’s armies.

From then until the attack on Pearl HarborZZTO, 18 months later, a galvanized administration more than doubled federal outlays – soon accounting for $1 of every $4 spent in the country – and the United States entered the war with its economy operating almost at full capacity.

(Government currently accounts for $1 of every $5 spent, barely more than in 2007, and most of that spending is at the state and local levels, the opposite of 1940-41, when federal outlays shot up.)

“What you had was a revolution in the labor force,” Gordon said. “Women poured into jobs in droves, often replacing men, and every factory went to three shifts.”

By the time Japan surrendered in 1945, the U.S. economy, propelled by war spending, was operating beyond what the experts thought of as full capacity, demonstrating the “squishiness” of the concept, as Gordon put it. Just the swing from one to three shifts alters capacity, he said, and so does the more intensive use of floor space.

Capacity stretched again in the 1950 s and ‘60 s, to feed demand created by the wars in Korea and Vietnam, and then again in the late 1990 s, propelled by the dot-com boom. And there were downdrafts as recessions sapped demand, but none as punishing as the current one.

Sixteen months into this recession, the economy is operating at 7 percent below its potential capacity, the Congressional Budget Office reported last month. If that were to continue, today’s $14 trillion economy would be a $13 trillion economy by this time next year.

Labor is contributing hugely to the shortfall. More than 24 million men and women, or 15.6 percent of the labor force, are either hunting for work or working fewer hours than they would like to work, or are too discouraged to seek work, although they would take jobs if offered them, the Bureau of Labor Statistics reports.

The ranks of this “underutilized” group – the bureau’s label – are up by 10 million since early last year. Generating work for so many people would take several years, even if the nation’s employers stopped shedding more than 600,000 jobs a month, as they have done since December, and began hiring robustly.

“We have rarely been in this deep a hole,” said Nigel Gault, chief domestic economist for IHS Global Insight.

His concern is that nearly every nation – not just the United States – is suffering from idle capacity as the recession that started in America grips Europe and Asia. Struggling for sales in a marketplace swamped with goods and services, companies are cutting prices and shutting down operations, trying to keep supply in line with dwindling demand.

The cutback is particularly severe in the auto industry, which had the capacity, going into the recession, to make nearly twice as many cars in the United States as are now being sold here. Indeed, some of the factories being closed are unlikely to ever reopen.

“Eventually, once this recession is over, we will fill up capacity,” Gault said. “Not only that, capacity itself will inevitably expand as the labor force grows and innovation kicks in. But the new capacity won’t be as great as it would have been if we had not gone through this terrible experience.”

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Economic Global Winter Ahead

By Martin Hutchinson

With increasing frequency over the past few weeks, statistics have emerged suggesting that the first shoots of economic spring are emerging and that the bottom of the US and global recession is only just round the corner. Higher vehicle sales and factory orders, the Institute of Supply Management monthly index and slightly higher personal income and retail sales figures have all burgeoned like early crocuses, suggesting that the slope into economic decline has turned shallower, so we may reach bottom about mid-year.

Had we not been afflicted with a global epidemic of panicking governments, those modest green shoots might indeed have blossomed into a genuine spring. However, governments’ misguided activities have darkened the global outlook. Far from entering spring, we are still in the opening stages of a winter that has become nuclear and will blight the world for the best part of a decade.

There is no necessity for a severe recession, such as the present one, to be excessively long; it depends on the government policies pursued. At one extreme are the Great Depression, both severe and lengthy, and the Japanese rolling recession of the 1990s, appallingly lengthy but at no time particularly severe. As is generally agreed, both these downturns were artificially prolonged by misguided government action.

At the other extreme, we can examine the British recession of 1816-17, after the end of the Napoleonic Wars. This would have been severe in any case because of the transition to peace after 20 years of war and the immense financing difficulties and investment “crowding out” effect caused by Britain’s 1815 public debt burden of over 250% of gross domestic Product (GDP), 50% larger than Japan’s today and double Italy’s.

However, the downturn was made much worse by the April 12, 1815, eruption of Indonesia’s Mount Tambora, the largest volcanic eruption in recorded history. This deposited 100 billion tonnes of volcanic ash over the world’s surface and caused in 1816 the “Year without a summer” – with fairly mild effects in southern climates and the United States, but causing the entire British harvest to rot in the fields. More serious, therefore, than a mere banking crisis.

Lord Liverpool, Britain’s prime minister, implemented only one policy to fight recession. In February 1817, with parliamentary approval, he suspended the operation of the Habeas Corpus Act, in order that any impending riots could be efficiently quelled. This well-designed “stimulus package” proved remarkably successful. Only one small disturbance occurred and by December, 1817, after a bountiful 1817 harvest, Liverpool was able to end the suspension, as the recession was over and the threat to public order gone. Total recession duration: about a year, though there was a second “dip” in 1819 because of the 20% deflation needed to put Britain back on the gold standard.

In the current global unpleasantness, there are alas no world leaders with Liverpool’s economic grasp (having David Ricardo as economic advisor doubtless helped). Even compared with other recessions within living memory, such as 1974 and 1982, the reaction from the global political class has been notably panicky and hysterical – US$5 trillion of global stimulus programs, largely consisting of public spending, are unlikely to increase the stability of the global economy, and nor are the moves by three of the world’s four most important central banks to “quantitative easing” – the monetary policy of the early Weimar Republic.

Under Weimar, the profits from “seigniorage” – the issue of new money – financed around 50% of public spending in 1919-23. Notoriously, this resulted in a trillion-fold devaluation of the mark by November 1923. In the United States today, around 15% of public spending is being financed through seigniorage – the Fed is purchasing $300 billion of Treasury bonds over six months, an annual rate of $600 billion per annum, 15% of 2009 federal spending of $4 trillion.

The US may still be the right side of the Weimar dividing line, but in Britain the figures are more alarming. The Bank of England is purchasing 75 billion pounds of gilts over three months, an annual rate of 300 billion pounds per year or more than 65% of Britain’s projected 2009 central government expenditure of 454.6 billion pounds. Of course, the Bank of England may not repeat its gilt purchases every three months, but at least in the short term it is disturbing that Britain is currently “printing money” faster than Weimar Germany.

On the fiscal side, the figures are equally exciting. The United States, Britain and Japan are all running fiscal deficits of more than 10% of GDP in 2009. Once you factor in the newly released Organization for Economic Cooperation and Development’s more pessimistic economic forecasts, they will run even larger deficits in 2010. Furthermore, if recovery is at all sluggish, the “output gaps” between those countries’ actual GDP and their increasingly theoretical “full employment” GDP are likely to produce fiscal deficits close to the same level in 2011 and possibly thereafter.

There seems to be no recognition among policymakers of how dangerous these profligate policies are. Only last week, at the Group of 20 meeting in London, the world agreed to provide yet another $1 trillion of capital to the international bureaucrats of the International Monetary Fund and the World Bank, who will on past form divert it almost entirely to governments of the countries most devoted to overspending.

Deserving countries, in Latin America and East Asia, which have managed their affairs properly without excessive balance of payments or budget deficits will see little of this money, and nor will the beleaguered emerging markets private sector. Like the world’s other fiscal deficits, the IMF and World Bank funding will have to be borrowed, and in being borrowed will create either inflation or “crowding out” of truly productive Western and emerging market corporations, whose funding needs will become more desperate as the global recession drags on.

Except in a few countries such as Germany and China, which had previously been fiscally conservative with low or negative budget deficits, the correct amount of “fiscal stimulus” in this downturn was zero or negative. Most countries were already running substantial budget deficits in the boom, and the automatic stabilizers in all big-government economies would anyway have widened budget deficits beyond all past peacetime records, even without stimulus.

Similarly, the global economy has been bedeviled for the last decade by excessive money creation. The correct policy in the downturn would have been to hold monetary policy tight, in order to fight the inflation threatened through past excesses and the budget deficits, providing only the minimum liquidity needed to ensure that the money markets continued functioning.

Given the marginal short-term benefits of current global policies and their huge long-term costs, one would imagine that the world’s politicians were all running for election this year, perhaps about August, after the bottoming out of the initial recession has become fully apparent but before the long-term disasters of inflation and sluggish recovery are fully manifest.

However this theory doesn’t quite work. Germany’s Angela Merkel is running for re-election but has been notably cautious on both fiscal and monetary policy, while France’s Nicolas Sarkozy, Russia’s Dmitry Medvedev and, in the US, President Barack Obama are with us until 2012.

Nevertheless, imminent re-election is certainly a factor with the enthusiastic expansionists Taro Aso of Japan, Manmohan Singh of India and Gordon Brown of Britain. In all three countries, near-term fiscal disaster is close enough and unpleasant enough that rational people would prefer retirement to having to face it after winning re-election – but these people are politicians!

While the current downturn may reach bottom by the summer, therefore, recovery is likely to be very slow indeed. Government borrowing will crowd out much private investment, reducing the potential of the global economy as funding is diverted from new investment into less productive courses. At the same time, inflation, caused by excessively stimulative monetary and fiscal policies, will return to plague the global economy as in the 1970s, forcing a return to restrictive monetary and fiscal policies if a global repeat of the Weimar disaster is to be avoided. (Chinese central bankers seeking to invest their reserves in something sound will find no available outlet other than gold). Political panic may have marginally reduced the depth of the recession, but it will enormously increase its duration.

It therefore follows that the sharp recoveries in global stock markets in the last few weeks are wildly premature. At current levels, US stocks are only marginally above their equilibrium value, based on US economic performance in the decades to 2007, but there is now no certainty that we are in the economy of 2007, or anything like it. With higher taxes and a large “output gap” such as is appearing between actual and potential GDP, which will remain with us for many years, the profitability and growth of US industry will be permanently damaged, so stock prices should in equilibrium be correspondingly lower.

There is thus likely to be another downward “leg” in the US stock market’s long decline from its bubble-induced euphoria of 1995-2007, taking it to around the historical low valuations of periods such as 1949 when the cult of the equity was dead and buried. Taking “normalized” post-recession earnings on the Standard & Poor’s 500 as being around $60, and applying a 1949 multiple of about seven times earnings, would give a bottom for the S&P 500 of about 420, equivalent to below 4,000 on the Dow. In other words, the likely market bottom is at about half its current level.

The global economic climate, far from bursting into bloom, is likely to endure a prolonged winter, extending over several years, as if nuclear war or a volcano larger than Tambora had struck the world in 2008. For the global economy, it will be the White Witch’s Narnia – always winter and never Christmas.

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Prolonged Downturn

Jennifer Ablan and Daniel Burns

The U.S. economy is in for a “lasting slowdown” and could face a Japanese-style period of relatively low growth with the added problem of high inflation, billionaire investor George Soros said on Monday.

Soros told Reuters Financial Television that rescuing U.S. banks could turn them into “zombies” that suck the lifeblood of the economy, prolonging the economic slowdown.

“I don’t expect the U.S. economy to recover in the third or fourth quarter so I think we are in for a pretty lasting slowdown,” Soros said, adding that in 2010 there might be “something” in terms of U.S. growth.

Most economists expect the U.S. economy to stop contracting in the third quarter and resume growing in the fourth quarter, according to a latest monthly poll of forecasts by Reuters.

The recovery will look like “an inverted square root sign,” Soros said: “You hit bottom and you automatically rebound some, but then you don’t come out of it in a V-shape recovery or anything like that. You settle down — step down.”

In the fourth quarter, the U.S. economy contracted at a 6.3 percent annualized rate, and economists think the first quarter’s slide will be at least as severe, if not worse.

Healing the banking system, which is “basically insolvent,” and housing markets is crucial to recovery, Soros said.

The public-private investment funds — unveiled by the Treasury last month to get bad debts off bank balance sheets — are going to work but won’t be enough to recapitalize the banks so they are able to or willing to provide credit, he said.

Even a steep yield curve won’t generate enough profits to keep the banks out of their vulnerable situation.

“What we have created now is a situation where the banks who will be able to earn their way out of a hole, but by doing that, they are going to weigh on the economy.

“Instead of stimulating the economy, they will draw the lifeblood, so to speak, of profits away from the real economy in order to keep themselves alive.”

Soros, whose latest book, “The Crash of 2008 and What it Means,” has made prescient calls during the credit crisis.

A year ago, he told Reuters that global losses were likely to top $1 trillion. U.S. and European banks have recorded more than $700 billion in losses and write-downs, as of February 5, 2009, according to Reuters data.

DOLLAR IS VULNERABLE

Soros said the “stress tests” of banks being conducted by Treasury, to determine their financial resilience, could be a precursor to a more successful recapitalization of the banks.

He also said the U.S. dollar is under selling pressure and one day could be replaced as a world reserve currency, possibly by the International Monetary Fund’s Special Drawing Rights, a currency basket comprising dollars, euros, yen and sterling.

“I think the dollar is now under question and I think the system will need to be reformed, so that the United States will be subject to the same discipline as is imposed on other countries,” said Soros, whose famous bet against the British pound earned his Quantum Fund $1 billion in 1992.

“Being the main issuer of international currency, we have been exempt and we have abused that because we have effectively consumed 6.5 percent more than we have produced. That is now coming to an end.”

Soros said there was a risk of a “tipping point” for the dollar which would see it slump, triggering higher interest rates and choking growth.

“This leads you to what used to be stagflation — stop, go. And I think that is what’s probably in store, rather than… hyperinflation.”

China recently proposed greater use of SDRs, possibly as an eventual global reserve currency.

“In the long run, having an international accounting unit rather than the dollar may, in fact, be to our advantage so we can’t splurge — you know, it felt very good for 25 years but now we are paying a very heavy price,” Soros said.

U.S. consumer spending has to fall to 60 percent of gross domestic product, compared two-thirds now, he continued.

China will emerge first from recession, probably this year, and will lead global growth in 2010, Soros added.

World policymakers are “actually beginning to catch up” with the crisis and efforts to fix structural problems in the financial system, he said referring to last week’s meeting of leaders of G20 countries.

Turning to Europe, the euro has been “a tremendous advantage” to countries that use it, adding there’s “no question of a weaker country dropping out,” Soros said.

More funds for the IMF will help it stabilize struggling Eastern Europe but the Baltic states still face “serious problems” and Ukraine is not far from default, he warned.

Widespread use of credit default swaps has worsened the risks for Europe, he said, though he added that Germany, the euro zone’s biggest economy, is becoming more open to offering help. “Germany, which has been the most reserved about being the deep pocket of the rest of Europe, has recognized that it too has a responsibility toward the new member states.”

Germany has been one of the most reluctant major economies to meet U.S. calls for more fiscal stimulus spending to boost the global economy and fight the financial crisis.

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This Is The Black Swan

by Paul B. Farrell

Dateline Mumbai, India. Ready for your final question on the Slumdog Game Show? Yes? Good. The prize, twenty million. The question: Will America’s recovery package of stimulus handouts, bank bailouts and home foreclosure relief plans work? You must pick one of three answers:

Yes, I know Obamanomics is putting America on the road to recovery
Definitely not, Obama’s wasting money, delaying the Great Depression 2
No one knows

The question’s on everyone’s mind: 95 million Main Street investors, yes. But especially dominating our talking heads, politicians, economists, quants and other Street geniuses. They failed you. But still they want you to believe they know “The Answer.”

So can you trust them to have a magical formula for predicting the next “tipping point,” the next “Black Swan” in our future? No. The correct answer is (c), Warren Buffett’s answer. Here’s why.

Background: First, Wall Street’s narrow equations always leave out key macroeconomic data. Always. They cannot handle “big picture” issues. Their formulas are what mathematicians call “indeterminate equations,” with an infinite set of solutions. Guesses. So Wall Street invariably ignores big-picture issues that lead to meltdowns. Meanwhile, they get rich playing with your money.

Second: The Buddha would call Wall Street’s mathematical problem, a Zen koan, an impossible question. And he’d warn you to: “Believe nothing, no matter where you read it or who has said it, not even if I have said it, unless it agrees with your own reason and your own common sense.”

We all know Wall Street focuses narrowly on the short-term, quarterly earnings. “Long-term” is their year-end bonus time. They are clueless when it comes to the broader, long-term macroeconomic information essential to solving big-picture economic equations that’ll lead to America’s long-term success. “Believe no one … but yourself.”

So as you read further, please keep in the back of your mind these 13 rare, overlapping “tipping points,” unpredictable macroeconomic events that lurk in our peripheral vision as economic time bombs with “massive consequences” according to “Black Swan” math. Always deadly, yet invariably left out, denied, ignored or worse — totally missed — by Wall Street’s geniuses in their equations:

Massive debt: government, private; Fed printing money, tax increases
Population: exploding demand, resources depleting, conflict, rebellion
Lobbyists: feeding frenzy, 40,000 run Washington, sabotaging democracy
Derivatives: $683 trillion hiding in shaky global “shadow banking system”
Petro czars: Exxon, Saudis, Chavez, Iran — all vulnerable, unstable, risky
Universal health care: 46 million uninsured; costs inflating debt
War on drugs: massive global failure: Afghan, Mexico, Latin America.
Deflation? Inflation? Stagflation? 1970’s sideways market ahead?
Entitlements: Social Security, Medicare, drug benefits may soon sink us
Politics: “Grand Obstructionist Party” Or “New Contract with America?”
Savings: sabotaging consumer spending, the engine driving the economy
Climate change: Pentagon sees increasing tension, triggering new wars
Socialism and nationalization: will free markets return, or sink us?

More significant, although invariably left out of Wall Street’s equations, true economic tipping points will grow to a “moment of critical mass, the threshold, the boiling point,” according to author Malcolm Gladwell, where “change” (whether positive or negative) is “unstoppable.” And although left out, these macroeconomic variables can account for over 90% of the risk in an economic equation or derivatives contract, as we’ve discovered so painfully this past year.

Buffett got the right answer, (c): “Nobody really knows.” Every other forecaster is a charlatan, but won’t admit they’re faking it: For example, in his latest book, “The Great Depression Ahead,” Harry Dent predicts the Dow crashing to 3,800, and a Depression lasting from 2012 to 2017. Fortunately, Forbes’ publisher Rich Karlgaard adds that Dent’s “the world’s perfect contra-indicator,” reminding us that Dent predicted Dow 35,000 in his 1998 bestseller, “The Roaring 2000s.”

Another example: If you really want to spin out, read “The Next 100 Years,” the mew bestseller by intelligence expert and perma-optimist George Friedman. He sees what Buffett can’t, sees past Dent, predicts “the North American Age has begun … dominated by the United States for the next hundred years.”

“Trust no one.” Years ago a BusinessWeek article put it this way: “What do you call an economist with a prediction? Wrong.” In late 2007 Barron’s reported that many pros “expect the Dow Jones industrials to reach 15,000″ in 2008. Fortune, on the other hand, warned that: “Wall Street prognosticators are every bit as deluded and inaccurate as they ever were.” They lost about 38% in 2008.

And now Bernanke is warning us to expect “negative growth” in 2009, a contraction of perhaps 1.3%, with an increase in unemployment to 9%. Should you believe him? He was so wrong in 2007.
Yes, something’s missing in Wall Street’s brain

Henry Kaufman, former vice chairman and chief economist at Salomon where he worked for 24 years recently analyzed the problem in a Journal op-ed piece, “The Great Interest Rate Wave,” a brilliant, succinct review of trends in the Fed rate since 1946, post-WWII.

Kaufman focuses us on the issues: “Why are we so poor at managing our key economic institutions while at the same time so accomplished in medicine, engineering and telecommunications? Why can we land men on the moon with pinpoint accuracy, yet fail to steer our economy away from the rocks? Why do our computers work so well — except when we use them to manage derivatives and hedge funds?”

“The answer,” warns Kaufman, “lies in methodology. In science and technology, we rely on the scientific method: experimental design with dependent and independent variables and with reproducible results. By the 1980s, many economists had embraced the theory of ‘rational expectations,’ which essentially held that markets were all-knowing and infallible. All of this infused the profession with an aura of authority, authenticity and accuracy.”

But unfortunately, this aura has had unintended consequences lately: “The computations were correct, but far too often the conclusions drawn from them were not. This is because the models rely on historical data but fail to take into account the profound impact of structural changes in our economy and in financial markets that have unfolded in the postwar decades.”

Worse yet, not only do Wall Street’s equations rely on historical data, they fail to account for all the “Black Swans” luring outside their periphery vision: “Structural changes, including securitization, globalization and the explosion of debt, have altered financial behavior in ways that the econometric models miss. In the decades since World War II, they have liberated financial risk-taking, as markets learned to game the system beyond the parameters of quantitative models.”

Tipping Points, Black Swans and Fuzzy Math equations

“Black Swan” author Nassim Nicholas Taleb is far more caustic in his Fortune indictment: “It is the ’science’ of risk management that effectively turned” Wall Street into clueless robots. “We replaced so much experience and common sense with ‘models’ that work worse than astrology, because they assume that the Black Swan does not exist. Trying to model something that escapes modelization is the heart of the problem.”

Taleb is brutal: “Greed pushes bankers to take the maximum amount of ‘hidden risks,’ those risks that do not show on a regular basis because the models miss it, but end up causing blowups. Banking is a very treacherous business because you don’t realize it is risky until it is too late,” till after a Black Swan surprises us, triggering an economic meltdown, like now, and we’re stuck cleaning up the mess.

“Believe no one:” But if you still believe you are certain you do know the answer to the question here — that (a) The Obamanomics “stimulus-bailout-foreclosure recovery” programs will lead to an economic recovery for America and across the world or (b) you are certain that they will simply delay the inevitable, driving us over the proverbial cliff and into “GD2,” the “Great Depression 2?” — remember, just like in the Slumdog Millionaire game-show, in the final analysis, you must pick the answer. Trust no one.

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It’s All Over And We Lost

by Martin Wolf

Has Barack Obama’s presidency already failed? In normal times, this would be a ludicrous question. But these are not normal times. They are times of great danger. Today, the new US administration can disown responsibility for its inheritance; tomorrow, it will own it. Today, it can offer solutions; tomorrow it will have become the problem. Today, it is in control of events; tomorrow, events will take control of it. Doing too little is now far riskier than doing too much. If he fails to act decisively, the president risks being overwhelmed, like his predecessor. The costs to the US and the world of another failed presidency do not bear contemplating.

What is needed? The answer is: focus and ferocity. If Mr Obama does not fix this crisis, all he hopes from his presidency will be lost. If he does, he can reshape the agenda. Hoping for the best is foolish. He should expect the worst and act accordingly.

Yet hoping for the best is what one sees in the stimulus programme and – so far as I can judge from Tuesday’s sketchy announcement by Tim Geithner, Treasury secretary – also in the new plans for fixing the banking system. I commented on the former last week. I would merely add that it is extraordinary that a popular new president, confronting a once-in-80-years’ economic crisis, has let Congress shape the outcome.

The banking programme seems to be yet another child of the failed interventions of the past one and a half years: optimistic and indecisive. If this “progeny of the troubled asset relief programme” fails, Mr Obama’s credibility will be ruined. Now is the time for action that seems close to certain to resolve the problem; this, however, does not seem to be it.

All along two contrasting views have been held on what ails the financial system. The first is that this is essentially a panic. The second is that this is a problem of insolvency.

Under the first view, the prices of a defined set of “toxic assets” have been driven below their long-run value and in some cases have become impossible to sell. The solution, many suggest, is for governments to make a market, buy assets or insure banks against losses. This was the rationale for the original Tarp and the “super-SIV (special investment vehicle)” proposed by Henry (Hank) Paulson, the previous Treasury secretary, in 2007.

Under the second view, a sizeable proportion of financial institutions are insolvent: their assets are, under plausible assumptions, worth less than their liabilities. The International Monetary Fund argues that potential losses on US-originated credit assets alone are now $2,200bn (€1,700bn, £1,500bn), up from $1,400bn just last October. This is almost identical to the latest estimates from Goldman Sachs. In recent comments to the Financial Times, Nouriel Roubini of RGE Monitor and the Stern School of New York University estimates peak losses on US-generated assets at $3,600bn. Fortunately for the US, half of these losses will fall abroad. But, the rest of the world will strike back: as the world economy implodes, huge losses abroad – on sovereign, housing and corporate debt – will surely fall on US institutions, with dire effects.

Personally, I have little doubt that the second view is correct and, as the world economy deteriorates, will become ever more so. But this is not the heart of the matter. That is whether, in the presence of such uncertainty, it can be right to base policy on hoping for the best. The answer is clear: rational policymakers must assume the worst. If this proved pessimistic, they would end up with an over-capitalised financial system. If the optimistic choice turned out to be wrong, they would have zombie banks and a discredited government. This choice is surely a “no brainer”.

The new plan seems to make sense if and only if the principal problem is illiquidity. Offering guarantees and buying some portion of the toxic assets, while limiting new capital injections to less than the $350bn left in the Tarp, cannot deal with the insolvency problem identified by informed observers. Indeed, any toxic asset purchase or guarantee programme must be an ineffective, inefficient and inequitable way to rescue inadequately capitalised financial institutions: ineffective, because the government must buy vast amounts of doubtful assets at excessive prices or provide over-generous guarantees, to render insolvent banks solvent; inefficient, because big capital injections or conversion of debt into equity are better ways to recapitalise banks; and inequitable, because big subsidies would go to failed institutions and private buyers of bad assets.

Why then is the administration making what appears to be a blunder? It may be that it is hoping for the best. But it also seems it has set itself the wrong question. It has not asked what needs to be done to be sure of a solution. It has asked itself, instead, what is the best it can do given three arbitrary, self-imposed constraints: no nationalisation; no losses for bondholders; and no more money from Congress. Yet why does a new administration, confronting a huge crisis, not try to change the terms of debate? This timidity is depressing. Trying to make up for this mistake by imposing pettifogging conditions on assisted institutions is more likely to compound the error than to reduce it.

Assume that the problem is insolvency and the modest market value of US commercial banks (about $400bn) derives from government support (see charts). Assume, too, that it is impossible to raise large amounts of private capital today. Then there has to be recapitalisation in one of the two ways indicated above. Both have disadvantages: government recapitalisation is a bail-out of creditors and involves temporary state administration; debt-for-equity swaps would damage bond markets, insurance companies and pension funds. But the choice is inescapable.

If Mr Geithner or Lawrence Summers, head of the national economic council, were advising the US as a foreign country, they would point this out, brutally. Dominique Strauss-Kahn, IMF managing director, said the same thing, very gently, in Malaysia last Saturday.

The correct advice remains the one the US gave the Japanese and others during the 1990s: admit reality, restructure banks and, above all, slay zombie institutions at once. It is an important, but secondary, question whether the right answer is to create new “good banks”, leaving old bad banks to perish, as my colleague, Willem Buiter, recommends, or new “bad banks”, leaving cleansed old banks to survive. I also am inclined to the former, because the culture of the old banks seems so toxic.

By asking the wrong question, Mr Obama is taking a huge gamble. He should have resolved to cleanse these Augean banking stables. He needs to rethink, if it is not already too late.

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Speech by Adair Turner, Chairman, FSA

It is stating the obvious to say that over the last 18 months, and even more so the last four, the world financial system – and particularly but not exclusively the world banking system – has suffered a crisis as bad as any since the stock market crashes of 1929 and the various banking crises that followed. As a result, banking systems in many countries are suffering from an impaired ability to play their vital role in credit extension to the real economy and a process of deleveraging threatens severe adverse effects on real economic prospects. The crisis therefore presents the financial authorities – central banks, regulators and finance ministries – with two challenges:
The first and most urgent is to design short-term policies so as to at least limit the adverse impact of deleveraging and deflation on the real economy. We cannot make that impact nil, but we do know how to avoid the policy mistakes which turned the initial problems of 1929-30 into the Great Depression. Fiscal and monetary policies need to be carefully designed, and – as we approach a zero interest rate and consider quantitative easing options – need to be increasingly coordinated. And there are a wide range of policies which can be taken to free up financial markets – measures which Ben Bernanke last week labeled “Credit Easing” – funding guarantees, liquidity provision, tail risk insurance, direct central bank purchases of assets, and regulatory approaches to capital regulation which avoid unnecessary pro cyclicality in capital adequacy requirements. The measures announced by the Chancellor of Exchequer on Monday were designed as an integrated package, which will have a significant impact. And if more measures are acquired they can and will be taken.
It is not, however, on this challenge of short-term economic management – where the lead must be with the fiscal and monetary authorities – that I’m going to talk tonight. But instead on the second challenge: how to design the future regulation and supervision of financial services so that we significantly reduce the probability and severity of future financial crises? Last September, when I took over as Chairman of the FSA, the Chancellor asked me to conduct a review of our regulation and supervision of the banking system, and I will deliver that Review in March, alongside the publication of a comprehensive FSA Discussion Paper. That paper will set out the changes the FSA has already made, those where we have proposals in principle but need to consult on details, and those where we have defined our objectives but now need to play our role in achieving international agreement.

Those proposals for regulatory change need to be grounded in analysis of what happened – why this crisis occurred. Tonight therefore I will concentrate on that analysis. I will then draw out some issues and possible implications relating to the future shape and size of the banking and credit mediation markets. I will finally and briefly outline three changes which we know are in principle essential.

What happened and why?

So what happened? Why did this extreme crisis occur? I think with hindsight – and it is only with hindsight – a fairly compelling and broadly agreed explanation of what has occurred can be set out. At the core of the crisis was an interplay between macroeconomic imbalances which have become particularly prevalent over the last 10-15 years, and financial market developments which have been going on for 30 years but which accelerated over the last ten under the influence of the macro imbalances.

Macro-imbalances. First, the macro side. The last decade [Exhibit 1] has seen an explosion of world macro-imbalances, with very large current account surpluses piling up in the oil exporting countries, China, Japan and some other east Asian developing nations, and large current account deficits piling up in the USA, but also in the UK, in Ireland, Spain and some other countries. A key driver of those imbalances has been very high savings rates in countries like China; since these high savings are in excess of domestic investment, China and other countries must accumulate claims on the rest of the world. But since, in addition, those countries are committed to fixed or significantly managed exchange rates, these rising claims take the form of central bank reserves, typically invested not in a wide array of equity, property or fixed income assets – but almost exclusively in apparently risk-free or close to risk-free government bonds or government guaranteed bonds.

This in turn has driven a reduction in real risk free rates of interest to historically low levels [Exhibit 2]. In 1990 you could invest in the UK or the US in risk-free index-linked government bonds at a yield to maturity of over 3% real; for the last five years the yield has been less than 2% and at times as low as 1%.

These very low medium- and long-term real interest rates have in turn driven two effects:
First, they have helped drive rapid growth of credit extension in some developed countries, particularly in the US and the UK – and particularly but not exclusively for residential mortgages [Exhibit 3] – with this growth accompanied by a degradation of credit standards, and fuelling property price booms which for a time made those lower credit standards appear costless.
And secondly, they had driven among investors a ferocious search for yield – a desire among any investor who wishes to invest in bond-like instruments to gain as much as possible spread above the risk-free rate, to offset at least partially the declining risk-free rate. Twenty years ago a pension fund or insurance company selling annuities could invest at 3.5% real yield to maturity on an entirely risk-free basis; now only 1.5%: any products which appear to add 10, 20 or 30 basis points to that yield without adding too much risk look very attractive.

Financial sector innovation. The fundamental macro economic imbalances have thus stimulated demands which have been met by a wave of financial innovation, focused on the origination, packaging, trading and distribution of securitised credit instruments. Simple forms of securitised credit – corporate bonds – have of course existed for almost as long as modern banking. In the US, securitised credit has also played a major role in mortgage lending since the creation of Fannie Mae in the 1930s; and securitisation had been playing a steadily increasing role in the global financial system and in particular in the American financial system for a decade and a half before the mid-1990s. But it was from the mid-1990s that the system entered explosive growth in both scale and complexity:
With huge growth in the value of the total stock of credit securities [Exhibit 4]
An explosion in the complexity of the securities sold, with the growth of the alphabet soup of structured credit products.
And with the related explosion of the volume of credit derivatives, enabling investors and traders to hedge underlying credit exposures, or to create synthetic credit exposures. [Exhibit 5]

All of these developments, in different ways, seeking to satisfy the demand for yield uplift, and all predicated on the belief that by slicing and dicing, structuring and hedging, using sophisticated mathematical models to understand and manage risk, we can “create value” by offering investors combinations of risk and return which are more attractive than those available from direct purchase of the underlying credit exposures.

This explosion was supported by and in itself drove big increases in the leverage of major financial institutions – in particular investment banks and the investment banking activities of some large universal banks. [Exhibit 6]

And as it developed the rapid growth began to drive and to be driven by one of those self-fulfilling cycles of falling risk aversion and rising irrational exuberance to which all liquid traded markets seem at times to be susceptible:
Credit spreads on a wide range of securities and loans falling to clearly inadequate levels. [Exhibit 7]
The price charged for the absorption of volatility risk falling because volatility seemed to have declined. [Exhibit 8]
And these falling spreads and volatility prices driving up the current value of a range of instruments, marked to market value on the books of banks, investment banks and hedge funds – fuelling in turn higher apparent profits and higher bonuses, and as a result reinforcing management and traders certainty that they must be doing the right thing.

Until we reached the point where people began to fear that the music was about to stop – but where others felt, in Chuck Prince’s words, that they had to keep dancing till the band stopped, which it did in summer and autumn 2007.

A cycle therefore of irrational boom and then bust; and therefore in some ways no different from other cycles which we have seen in markets in the past: in equities, in property, in South Sea project participations, in tulips. But what makes this one different – and potentially more economically destructive to the real economy – is that it is the first major global boom and bust of securitised credit instruments. Because at the core of this story is the development of a new model for delivering credit intermediation – the originate and distribute model of securitised credit. And one of the crucial questions we therefore have to ask is whether this originate and distribute model is inherently riskier than the one that it has partially replaced – or whether, provided we regulate it more effectively, it is capable of being a more stable system, or indeed of delivering the positive benefits of increased financial stability which its advocates originally proposed.

So before talking about the response to the crisis, I will make four observations relating to the growth and the implications of the securitised credit intermediation model:
Securitised credit: initial proposition and subsequent evolution

First, as already said, securitised credit has a history going back many decades. But it really began to take off in the 1980s, and it is interesting to revisit the arguments made in its favour at that time. One argument was greater liquidity for end investors (an issue I’ll come back to), but another crucial argument was that securitisation would reduce risks for individual banks by passing credit risk to end investors, reducing the need for unnecessary and expensive bank capital [Exhibit 9]. Rather than a regional bank in the US holding a dangerously undiversified holding of credit exposures in that particular region, which created the danger of a self-reinforcing cycle between the decline in a regional economy and the decline in the capital capacity of regional banks – much better to package up the loans and sell them through to a diversified set of end investors. And indeed it was argued that securitised credit intermediation could reduce risks for the whole banking system, since while some of the credit risk would be held by the originating bank and some by other banks acting as investors, much would be passed through to end non-bank investors. Credit losses would therefore be less likely to produce banking system failure.

But that is not what happened. Because when the music stopped – as these figures from the IMF Global Financial Stability Report of April, 2008 make clear [Exhibit 10] – the majority of the holdings of the securitised credit, and the vast majority of the losses which arose, did not lie in the books of end investors intending to hold the assets to maturity, but on the books of highly leveraged banks and bank-like institutions.

Because what increasingly happened [Exhibit 11] was that the credit securitised and taken off one bank’s balance sheet, rather than being simply sold through to an end investor, was:
bought by the propriety trading desk of another bank;
or sold by the first bank but with part of the risk retained via the use of credit derivatives; or
used as collateral to raise short-term liquidity – creating a complex chain of multiple relationships between multiple institutions, each performing a different small size of the credit intermediation and maturity transformation process, and each with a leveraged balance sheet requiring a small slice of capital to support that function.

Some banks were truly doing “originate and distribute”: but the trading operations of other banks (and sometimes of the same bank) were doing “acquire and arbitrage1. The new model left most of the risk still somewhere on the balance sheets of banks and bank-like institutions but in a much more complex and less transparent fashion.

Changing forms of maturity transformation

My second point is that in this story, what happened to maturity transformation and to assumptions about liquidity was particularly important. One of the key socially valuable functions of the banking system is to deliver maturity transformation, holding longer term assets than liabilities, and thus enabling the non-bank sector to hold shorter term assets than liabilities. This absorbs the risks arising from uncertainties in the cash flows of households and corporates, and results in a term structure of interest rates more favourable to long-term capital investment than would pertain if no such maturity transformation were being performed.

It is a very important function of undeniable social value, but also one which creates risks. If everybody wants their money back on the contractual date, no bank could repay them all. Therefore we have insurance via lines from other banks, liquidity policies to measure and limit the extent of maturity transformation, and ‘lender of last resort’ facilities provided by the central bank. A complex balancing act of individual bank practices, regulatory policies and central bank facilities and discretion, but at least one we know is of central importance.

But one of the striking developments of the last several decades has been that a growing part of this maturity transformation has been occurring not on the books of regulated banks with central bank access, but on the off-balance sheets of banks, and on the balance sheets of shadow banks or near banks. SIVs and conduits performed large-scale maturity transformation between short-term promises to noteholders and much longer term instruments held on the asset side. Investment banks funded holdings of long-term to maturity assets with much shorter term liabilities. And while mutual funds with long-term assets and immediately available redemption were not banks since their liabilities to investors did not have certain capital value, the implicit promise not to “break the buck” meant that their behaviour in a liquidity crisis – selling assets rapidly to meet redemptions – could reinforce the liquidity crisis elsewhere.

While it is difficult to get the aggregate figures, it therefore seems highly likely that the aggregate degree of maturity transformation being performed by the financial system in total has increased substantially over the decades. And it is certainly clear that a wide range of institutions – both banks and near banks – have been relying on “liquidity through marketability” to assure themselves that their maturity transformation activity is safe. “Liquidity through marketability” – i.e. I can count this as a one-day asset because I can sell it within a day in a liquid market – has always been an important concept. Instruments which have long contractual tenor but which can be sold or discounted to generate immediately funds have been a key element in bank liquidity management since the days of Bagehot. But the extent to which the bank and near-bank system in total has relied on “liquidity through marketability” has increased dramatically over the last three decades and particularly in the years running up to the crash. The system in total has become significantly more reliant on the assumption that a very wide range of assets could be counted as liquid because they would always be sellable in liquid markets2.

And while some of these developments – in particular the growth of SIVs, and investment bank balance sheets and mutual funds – were most prevalent in the US and less important elsewhere, the impact in a global funds market was felt throughout the world. Northern Rock and Bradford & Bingley were directly or indirectly dependent on the maturity transformation function of US mutual funds and SIVs, enabling them to access the funds of short-term US investors to provide long-term UK mortgages , with the macro-imbalances I mentioned earlier, including the feature that while the US was a huge net recipient of Asian central bank investment, it was simultaneously on the private-sector side, a large net investor in, among other things, British residential mortgage backed securities [Exhibit 12]

Irrational exuberance in credit prices more harmful than in equities?

So we have had the huge growth in securitised credit intermediation and a related increasing reliance of the total system on liquidity assured by marketability. That raises the question of whether a system of securitised credit intermediation is inherently more risky, at the systemic rather than the idiosyncratic level, than a system of on-balance sheet intermediation.

In a securitised system, credits become marketable instruments, tradeable in liquid markets. And we know from history that all liquid markets – markets where you can buy something one day in the hope of selling it the next day for profit – can be susceptible to swings in sentiment which produce significant divergence from rational equilibrium prices. The historical record of such irrational swings has been extensively documented by economists such as Kindlebeger, Minsky and Shiller: and the root causes of these swings in human psychology and in the incentives facing institutions and individual traders are increasingly well understood. Internet equity prices in 2000 were driven irrationally high by irrational exuberance, and subsequently fell. Bond yields were driven irrationally low and prices irrationally high by irrational exuberance between 2002 and early 2007, and the yields subsequently soared, the prices collapsed.

But while the former boom and bust in equity prices had surprisingly small consequences for the real economy, the latter boom and bust is likely to have a much bigger one. And that contrast may be inherent. It may well be that the world economy has greater ability to absorb without dire consequences severe cases of irrational exuberance and then depression in equity prices, than in the prices of a broad range of credit instruments, held to a significant extent on the trading books of banks, shadow banks or near banks. Banks are highly leveraged: they perform maturity transformation which exposes them to liquidity risk: and they are involved in a process of continual rollover of new credit supply to the real economy without which economies will contract. Irrational swings in the prices of credit securities held by banks, and thus in their capital resources, are therefore likely to be far more economically significant than irrational swings in the prices of equity investments held by end investors.

It is therefore possible that the growth of the securitised credits intermediation model has increased some aspects of systemic risk in ways which are not just the result of poor execution – bad remuneration practices, inadequate risk management or disclosure, failures in the credit-rating process – but absolutely inherent.

But if that is true, it would be precisely the opposite of what many clever, hardworking and well-meaning people believed about the securitised credit markets only two years ago. The IMF’s Global Financial Stability Report of April 2006 stated that [Exhibit 13] ‘the dispersion of credit risk by banks to a broader and more diverse set of investors, rather than warehousing such risk on their balance sheets, has helped to make the banking and overall financial system more resilient’. It noted that this dispersion would help to “mitigate and absorb shocks to the financial system” with the result that “improved resilience may be seen in fewer bank failures and more consistent credit provision”. And many other economists argued that in addition to increasing financial stability, the development of securitised credit, structured credit, and of credit derivatives, by creating or completing markets which had not previously existed, must have increased economic allocative efficiency.

The core issue which we now need to face is whether in that analysis we significantly overstated the allocative efficiency benefits which could possibly have arisen from this completion of markets, even if they had operated rationally, and significantly underestimated the inherent dangers that any liquid-traded market will at times be susceptible to irrational exuberance followed by irrational despair.

The growth of the financial sector: fundamental benign effects, illusory profits and rent extraction.

My fourth and final observation about the growth of the securitised credit markets is that it is striking that it has been accompanied by a quite remarkable growth in the relative size of wholesale financial services within the overall economy. If, for instance, we look at debt as a percent of GDP – an income measure of leverage – [Exhibit 15] we do indeed see a growth of household debt as a percent of GDP, and to a smaller extent of corporate debt as a percent of GDP, but what is really striking is the extent to which the debt of financial companies as a percent of GDP has grown, both in the US and in the UK.

On a consolidated basis of course – i.e. stripping out claims between financial institutions – financial sector assets and liabilities can only grow pari passu with non-financial sector liabilities and assets. So what this disproportionate growth represents is an explosion of claims within the financial system, between banks and investment banks and hedge funds – that multiplication of balance sheets involved in the credit intermediation process which I suggested earlier has accompanied the increasing complexity of securitization.

This huge growth of intra-financial system leverage has a relevance to the urgent issue of short-term macro-economic management. The more that we can ensure that bank deleveraging takes the form of the stripping out of inter-trader complexity, and the less it takes the form of deleveraging vis-á-vis the non-bank real economy, the better. But for this evening my focus is on why this growth has occurred, why indeed many other measures of financial system importance – output as a percent of total GDP, profits as a percent of total corporate profits, as financial sector market cap as a percent of total equity market capitalisation [Exhibit 16], show a similar long-term trend, with a strong acceleration in the last five years up to 2007.

For this growth appears to be at variance with one of the other arguments made for securitisation, that it would be a more cost efficient system – delivering the service of credit intermediation to the real economy at a lower total cost. So why has the wholesale financial services industry instead had to grow so significantly?

Well, there are some underlying and entirely benign factors which do tend to increase the relative importance of financial services (retail and wholesale combined) as incomes grow. The wealthier people become, the more lifecycle consumption smoothing that occurs, and the more diverse they become in their preferences for consumption at different points in their life cycle; as a result there is a simultaneous increase in demand for both savings and borrowing products. And the more complex and globalised the world economy becomes, the more complex are the functions which the world’s banks have to perform in intermediating credit and other flows, and in themselves managing and helping corporates manage, the risks that arise from global operations, and fluctuating exchange rates, interest rates and commodity prices. In general, income per capita and financial sector value added as a percent of GDP are somewhat correlated, across at least a range of income per capita levels, for inherent and benign reasons.

But it is also possible that the importance of financial services as a percent of GDP has been swollen by two other factors – one of which is illusory and short term, and the other harmful and longer term.
The illusory one arises from mark to market profits in a rising market. If the bank and near-bank system in total holds a net long position in those assets which we mark to market – which it does – and if irrational exuberance can push the price of those assets to irrationally high levels (which I think it clearly did in the years running up to early 2007) then mark to market accounting will swell declared profit in an unsustainable way, but in a way which, reflected in bonuses, may reinforce management and traders’ determination to do more of the clever stuff, which is delivering those profits.
The possible long-term and harmful possibility is rent extraction. For there must be a suspicion that some and perhaps much of the structuring and trading activity involved in the complex version of securitised credit, was not required to deliver credit intermediation efficiently, but achieved an economic rent extraction made possible by the opacity of margins and the asymmetry of information and knowledge between end users of financial services and producers. Simply put, wholesale financial services, and in particular that element devoted to securitised credit intermediation and to the trading of securitised credit instruments – grew to a size unjustified by the value of its service to the real economy, and is now going through a downsizing, part of which is cyclical, but part a permanent one-off adjustment to a more economically efficient size.

Now of course, if you are an extreme Chicago school economic liberal, what I have said cannot be the case. If the industry grew dramatically in the decade to 2007 that must be because it was performing value added services: if complex product innovations were able to sustain themselves economically, they must have been socially useful innovations. But after what has happened, I think we know that that is not the case. I think we know that imperfections and irrationality in financial markets which are not fixable just by disclosure, but are inherent, mean that financial innovation which delivers no fundamental economic benefit, can for a time flourish and earn for the individuals and institutions which innovated, very large returns.

Not all innovation is equally useful. If by some terrible accident the world lost the knowledge required to manufacture one of our major drugs or vaccines, human welfare would be seriously harmed. If the instructions for creating a CDO squared have now been mislaid, we will I think get along quite well without. And in the years running up to 2007, too much of the developed world’s intellectual talent was devoted to ever more complex financial innovations, whose maximum possible benefit in terms of allocative efficiency was at best marginal, and which in their complexity and opacity created large financial stability risks.
Implications and what to do next

So if that’s what happened, and some of the reasons why it happened, what are the implications for the possible future shape of the financial system, and what are the implications for how we should manage the future financial system?

One implication is that there is a very important macro element to the required response.

Major macro-economic imbalances – large surpluses and deficits – were an important underlying driver of what occurred, and their more effective management is important not just to a more stable global system in the long term, but to the challenge of limiting the severity of the immediate economic downturn. The fundamental problem of potentially asymmetries between the policy responses of deficit countries and surplus countries, which lay at the root of the mismanagement of the gold standard in the 1920s and early 30s, and which Keynes warned of ahead of Bretton Woods, remain a crucial issue today. Without more Chinese consumption to balance more Americans saving, the deflationary impact of the crisis could be prolonged.

And looking to the long-term, as we think about what is needed to avoid future crises, it is clear that better analysis of and response to macro-prudential problems – problems which lie at the interface between macro-economic policy and financial system regulation – will be vital. The FSA has been more open than I think any institution involved in this crisis in admitting that it made mistakes in the institution specific supervision of northern rock. But I think the best judgement is that better institution specific supervision of Northern Rock would have made only a very small difference to the shape and impact of this global crisis.

The far bigger failure – shared by bankers, regulators, central banks, finance ministers and academics across the world – was the failure to identify that the whole system was fraught with market-wide, systemic risk. The key problem was not that the supervision of Northern Rock was insufficient, but that we failed to piece together the jigsaw puzzle of a large UK current account deficit, rapid credit extension and house price rises, the purchase of UK mortgage-backed securities by institutions in the US performing a new form of maturity transformation, and the potential for irrational exuberance in the market price of credit. We failed to realize that there was an increase in total system risk to which financial regulators overall – authorities, central banks and fiscal authorities – needed to respond.

Regulators were too focused on the institution-by-institution supervision of idiosyncratic risk: central banks too focused on monetary policy tightly defined, meeting inflation targets. And reports which did look at the overall picture, for instance the IMF Global Financial Stability Report which I quoted earlier, sometimes simply got it wrong, and when they did get it right, for instance in their warnings about over rapid credit growth in the UK and the US, were largely ignored.

In future, regulators need to do more sectoral analysis and be more willing to make judgements about the sustainability of whole business models, not just the quality of their execution. Central banks and regulators between them need to integrate macro-economic analysis with macro-prudential analysis, and to identify the combination of measures which can take away the punch bowl before the party gets out of hand. We also need to create deliberate mechanisms to increase the likelihood that major analytical institutions such as the IMF challenge the conventional wisdom rather than go along with it. And we need to ensure that when the IMF or other international surveillance bodies do issue warnings, that big powerful countries, and not just weaker developing countries potentially dependent on IMF support, feel that they have to respond.

Alongside that more effective macro-prudential analysis, however, we also need more effective approaches to the regulations which govern the financial system. That regulation needs to be designed in the light of how the system we are regulating is likely to evolve. Two questions can help frame our thinking about the future: what is going to happen, and what should happen, to the originate and distribute securitised credit model: and what will and should be the institutional relationship between “narrow banking” – deposit taking, extending loans, and providing payment services – and more complex treasury and trading activities?

On the originate and distribute, securitised credit model, I argued earlier that, especially if it involved a substantial holding and trading of securitised credit instruments on the balance sheets of banks involved in maturity transformation, it created significant and inherent risks. But it does not follow that the originate and distribute model will now or should now largely disappear. Some of the arguments which were advanced in favour of this model can be good ones: taking regionally or sectorally concentrated credit risk off bank balance sheets and distributing it to diversified investors, could be beneficial. Many forms of credit, for instance residential mortgages, are best credit assessed via quantitative scoring techniques, rather than by individual bank officer judgement, and can therefore be turned into securities, the risk of which can be well captured in credit ratings. And while we are now facing a crisis of the securitised credit model, we must remember that the past has had many examples of credit crises in good old fashioned on balance sheet banking – the British secondary banking crisis of 1973 to 74, the US savings and loans debacle of the 1980s, the Japanese and Swedish banking crises of the 1990s.

It is therefore, I believe, highly likely that the future system will and should involve a combination of traditional on balance sheet credit intermediation and securitised intermediation, and that a combination of better regulation and market response to the crisis, should and will produce a safer version of the originate and distribute model – less complex, more transparent to end investors, with less exclusive reliance on credit ratings and more independent judgement, and with less packaging and trading of securitised credit through multiple balance sheets. The securitised originate and distribute model will change significantly but it will still play an important role in national and global credit intermediation.

Narrow banking and investment banking. The somewhat related issue is then, should the different functions of classic on balance sheet banking – deposit taking, loan extension, and payment services provision – and more complex and risky investment banking activities be done in the same institutions or in separate firms. The actual trend of the last year has clearly been for these functions to be combined to a greater extent than before – as Bear Stearns has folded into JP Morgan, Merrill Lynch into Bank of America, and part of Lehmans into Barclays, and as Morgan Stanley and Goldman Sachs have become bank holding companies with access to the Fed discount window and covered by the implicit assumption that the US government would consider them too important to fail.

But even while this is been the de facto trend, several commentators have argued that regulation should be designed to produce the precisely opposite result – a separation of “narrow banking” from risky investment bank trading activities, a re-imposition in the US of the Glass Steagall separation of commercial and investment banking, and the introduction of that separation for the first time into European bank regulation.

At times this vision is expressed in terms close to a nostalgic elegy for a past age of innocence and stability: with Captain Mainwaring back behind the desk in the branch at Walmington-on-Sea casting a censorious eye over any householder or small-business man silly enough to want to take on too much credit, while the wide boys of the City and Wall Street are free to speculate but well away from sober middle England. But there is a very important issue here; we need to think carefully about how to insulate the vital functions of deposit taking, maturity transformation, and credit extension, from adverse impacts arising from the potential irrationality of liquid traded markets; we need to control the extent to which large universal banks can take the benefits of stable retail funding, deposit insurance and too big to fail status, and use them to fund activities of little economic value and/or of high risk, such as unnecessarily large proprietary trading.

I am not convinced, however, that this can or should take the form of any absolute separation between institutions which do to narrow banking and those which perform investment banking activities. The desire for this distinction fails, I think, to reflect the fact that the originate and distribute model can have some advantages, and the fact that in between narrow banking as performed by say a building society, and pure proprietary trading performed by say a hedge fund, there are a wide range of functions essential to the provision of finance to major corporates, to the lubrication of global capital flows, and to the management of risk naturally arising in a world of fluctuating exchange rates, interest rates and commodity prices, which mean that global banks involved in deposit taking, and credit extension are also involved in complex treasury and market making activities.

A crucial issue for regulators is therefore going to continue to be how we regulate the very large and very complex systemically important banks which are too big to fail and which are involved both in narrow banking and in complex treasury and trading activities. The Group of 30 Report Financial Reform: A Framework for financial stability, published last Thursday, suggested that “large systemically important banking institutions should be restricted in undertaking proprietary activities that present particularly high risks”. The precise ways in which we achieve this end need to be carefully considered, and the crucial change may be simply the better treatment of trading book capital, which I will come to shortly: but the issue certainly needs to be addressed.

So let me turn finally to the key elements of the regulatory response required to reduce the probability and severity of future financial crises, whether arising from classic on balance sheet banking or from the securitized model of credit intermediation. The response needs to be multifaceted, and there are many facets which I am not going to discuss tonight, but which will be covered in the Review and Discussion Paper to be published in March. These include actions relating to remuneration and incentives, to rating agencies, to counterparty risk in derivatives. They also involve consideration of the appropriate balance between mark to market and accrual accounting principles in published accounts. And, very importantly, we need to address issues relating to the regulation of large cross-border financial institutions, the realistic scope for global supervisory coordination, appropriate structures for local operations (subsidiaries or branches) and the appropriate balance of responsibility between home and host supervisors; the events of the last year – the Icelandic bank and Lehmans failures in particular – have taught us that we live in a world of global finance and global banks, but where, when disaster strikes, bankruptcy procedures and fiscal support are national, and we need to be clear about the implications of such a world.

But while all these issues are all important, there are three regulatory responses which I would like to highlight as the most fundamental and where what we need to do is in principle now clear.

New approaches to capital adequacy

The first is new approaches to the regulation of the capital adequacy of banks. These have of course been extensively revised by the introduction of Basel 2, which has aimed to achieve greater sensitivity of capital levels to the different risks which banks are running, and there are certainly benefits to the Basel 2 approach on which the future system should build. It is important to realize that the crisis developed under the Basel 1 regime not Basel 2, and that Basel 2 would have addressed some of the problems which led to it – for instance the failure to distinguish between the capital required to support mortgages of different credit quality. But it is also clear that we will need to adjust Basel 2 in a number of ways. The general direction of travel will be towards higher levels of bank capital than have been required in the past, and in particular capital which moves more appropriately with the economic cycle and more capital required against trading books and the taking of market risk.
On the economic cycle, there has been considerable commentary on the procyclical nature of Basel 2 risk-sensitive capital measures, and it is inevitable that any system which is risk sensitive, unless deliberate countervailing adjustments are made, will be to a degree procyclical i.e. capital requirements will rise as we head into a recession and credit quality declines. But it is important to note that the degree to which Basel 2 is procyclical in relation to the banking books – credit extension on balance sheet – depends crucially on how it is implemented and can be significantly reduced if banks use appropriate through-the-cycle approaches to estimation of probability of default and loss given default. It is therefore important to ensure that the detailed implementation of Basel 2 does not introduce unnecessary and unintended procyclicality, and the FSA on Monday issued a clarification of our approach designed to ensure this.

Looking forward, however, we need to go beyond the avoidance of unnecessary procyclicality and to create a system which introduces significant counter cyclicality, requiring banks to build up substantial capital buffers in good economic times – ratios well above absolute minimum levels – so that they can run them down in bad. Such an approach makes sense from a micro-prudential point of view, reducing the risk of bank failure. But it is also desirable from a macro-prudential and macro-economic perspective: it will tend to place at least some restraint on over-rapid expansion in the boom, and it will reduce the danger that impaired capital makes it more difficult for banks to lend in recessionary times, thus making the recession worse. Ideally, such a regime must be agreed at international level, and the FSA is working closely within the Basel Committee on Banking Supervision and the Financial Stability Forum to design the details. There are many of those details to be worked out; whether the buffer requirements will be defined in formulaic terms, as in the Spanish dynamic provisioning system, or by regulator discretion; and how to deal with the complexity of different economic cycles in the different countries in which a cross-border bank may operate. But the principle is clear.
And equally it is clear that in respect to the trading books of banks, we need to remove procyclicality and to increase capital requirements not just marginally but by several times. The present system of capital regulation of trading books is from a prudential point of view seriously deficient. Its reliance on value at risk (VAR) measures derived (usually) from the observation of the last year’s movements in market prices is clearly procyclical: if volatility goes down in a year, the measure tells banks that risks looking forward have reduced, and thus fails to allow for the fact that historically low volatility may actually be an indication of irrationally low risk aversion and therefore increased systemic risk. It fails to allow effectively for the low probability tail events which are crucial to extreme idiosyncratic and even more so to overall systemic risk. And, overall, the level of capital required against trading books has been simply too low relative to the risks being taken, given what we now understand about the systemic dangers of relying on liquidity through marketability, and about the susceptibility of securitised credit markets to irrational exuberance, sudden liquidity disappearance and rapid price collapse. Major banks with a large percentage of their balance sheets devoted to trading activity, have been required to hold only very thin slices of capital against it [Exhibit 16]. That will change radically given the proposals already issued by the Basel Committee, and these changes in themselves are likely to result in a significant contraction in the scale of future trading books.

And, looking forward, the FSA believes that a fundamental review is required of how trading books are defined and how risks in trading books are estimated. VAR-based approaches were originally developed to model the risks in trading in markets likely to be continually and deeply liquid (e.g. government securities, major currency FX swaps and interest rates derivatives), and were adopted by regulators in the mid-1990s when a high proportion of bank trading was concentrated in such highly liquid instruments. Over the last decade and a half, however, trading books have expanded rapidly to encompass the holding of many debt securities whose markets are imperfectly liquid even in normal times and which became suddenly illiquid when the downturn occurred; this booking of potentially illiquid assets in trading books was indeed in part driven by the lower capital charge there incurred. The FSA will be proposing to the Basel Committee that a fundamental review of the division between the trading and banking books and of the appropriate use of VAR to measure risk is now required.

New approaches to liquidity

New approaches to the management and regulation of liquidity are equally important. Indeed, we need to ensure that the regulation of liquidity is recognised as being at least as important as capital adequacy, a sense which was to a degree lost over the last several decades, with intense regulatory focus and international debates on capital adequacy, but less focus on liquidity – no Basel 1 or Basel 2 for liquidity to match the equivalents for capital.

That lack of a defined international standard has reflected the extreme complexity of the liquidity risk, which makes it difficult to achieve effective regulation through generally applicable quantitative ratios equivalent to capital adequacy ratios. Many developed economies did in the past require limits to defined ratios, such as loans to deposits; but it is less clear today that deposits are inherently more sticky than other categories of funding in a world of internet retail deposits and wholesale depositors (corporates, local authorities, charities, etc) with multiple options to redeploy spare funds.3 And the emergence of the originate and distribute securitised credit model has been accompanied by increasing options to manage liquidity through secured funding (e.g. repos), and an increased reliance on liquidity through marketability, making bank liquidity risk assessment crucially dependent on assumptions about the liquidity of specific asset and secured funding markets, which it is difficult to reduce to simple quantitative rules.

Measuring and limiting liquidity risk is, however, crucial and reforms to regulation need to include both far more effective ways for assessing and limiting the liquidity risks which individual institutions face and a better understanding of market-wide liquidity risks. The FSA’s Consultation Paper on Liquidity published in December, therefore proposes a major reform of our liquidity supervision. It will put in place:
Significantly enhanced reporting requirements focused on a detailed mismatch ladder analysis and applicable to all banks and building societies.
Regulations which will require all banks to focus on the combined liquidity effect of their holdings of liquid assets, the maturity (on both a contractual and behavioural basis) of their assets and liabilities, and the term, diversity and reliability of funding sources.

For simpler mortgage banks and building societies this will be underpinned by a quantitative “buffer ratio” rule, which will restrain reliance on wholesale funds.

And for larger banks it will be achieved by a regime which requires the development by each bank and review by supervisors of a detailed Individual Liquidity Assessment, on the basis of which we will give Individual Liquidity Guidance, including the required level of a liquid assets buffer, which will be defined on a standardised basis but whose required level will be tailored to individual circumstance.

At the core of the assessment and guidance will be stress-test scenarios, rather than models which seek to infer the probability distribution of risks from the observation of past fluctuations. This reflects the fact that liquidity risk assessment is inherently concerned with low probability but extreme events. And crucially the stress tests will need to cover potential market-wide stresses as well as idiosyncratic stresses, reflecting the lesson of the financial crisis that market-wide collapses in the liquidity of specific asset or funding markets can have huge impacts which analysis of individual specific risks will not capture.

This new regime and the related reporting requirements will greatly enhance our ability to understand emerging liquidity risks in individual institutions and across the whole economy, and to conduct sectoral analysis which can identify outlier business models and management practices. On the basis of this increased understanding, we will keep under review the appropriate balance of quantitative rules, stress test based analyses, and discretionary guidance. We anticipate that the new regime will result in major changes in the extent and nature of maturity transformation in the overall banking system, with banks holding more liquid assets and a greater proportion of those assets held in government securities, an incentive for banks to encourage more retail time deposits and less instant access, less reliance on short-term wholesale funding, and, as a result, a check on rapid and unsustainable expansion of bank lending during favourable economic times.

Regulation by economics substance: shadow banks and near banks

The third key priority is to ensure that in future financial activities are always regulated according to their economic substance not their legal form. One of the striking features of the years running up to the crisis, as I stressed earlier, was that a core banking function – maturity transformation – was increasingly being performed by institutions which were not legally banks, but the off balance sheet vehicles of banks, (SIVs and conduits), investment banks and mutual funds. To different degrees in different countries these ‘near banks’ or shadow banks escaped the capital, leverage and liquidity regulation which would apply to banks. In the case of SIVs they also escaped the degree of disclosure and accounting treatment which would have applied if the economic activities were performed on balance sheet. In future it is essential that if an economic activity is bank-like and poses a significant risk to consumer or financial stability, regulators can extend banking-style regulation. And essential that accounting treatment reflects the economic reality of risks being taken.

Applying these principles will have more implications for legal powers and regulatory structures in some other countries – and in particular in the US – than in the UK. European approaches to the bank capital adequacy have always applied to investment banks: the requirements set down for trading book capital were in retrospect inadequate, but in Europe investment banks did not lie outside a regulatory boundary. In the US, with a fragmented regulatory structure, there is a greater need to look at structures and powers. But, across the world, regulators need to continually assess how evolving industry structures and institutional roles are changing the nature of risk, both for individual institutions and for the whole system, and if necessary to adapt the coverage of prudential regulation over time.

This will at times require judgements about the appropriate treatment of institutions which have some of the risk characteristics of banks but not others. Two examples:
The first is mutual funds taking consumer investments which are liquid in nature (immediate or very short redemption) and investing in long-term securities. These are not banks, the crucial distinction being that the liquidity of the promise to savers is not matched by certainty of capital value at redemption. But if they have made assurances that they will maintain a stable net asset value, that they will not “break the buck”, they may in a liquidity crisis act in a fashion which exacerbates that crisis, selling rapidly to meet redemptions and fuelling the deflationary cycle. That is why the G30 report recommends that “money market funds which want to continue to offer bank-like services… and assurances” should be reorganised as special purpose banks and regulated as such. This is a pressing issue for the US but not the UK: for a variety of reasons mutual funds of this character have not developed here. But if they ever did develop in future, we would need to keep under review at what point bank-like characteristics justify bank like regulation.
The second is hedge funds, whose asset managers are present in the UK, and who are regulated as asset managers by the FSA, though the actual legal fund is usually registered offshore and not subject to prudential regulation. Here the issue, now being considered by fora such as the Financial Stability Forum, is whether the funds themselves should be regulated and subject to prudential limits on leverage or liquidity. The argument against is that these institutions are not banks: they do not deal directly with the general population but with professional sophisticated investors; leverage levels are in general (though with some exceptions) far lower than those of banks (typically two or three not twenty); and they do not perform contractual maturity transformation, since they have the power to limit the speed of redemptions via redemption gates. In general (again with some possible exceptions) they neither have the scale nor the characteristics which would require that individual hedge funds be treated as systemically important and thus too big to fail. But in aggregate, they may nevertheless play a role with systemic effects which regulators and central banks need to understand, but which currently we lack the data to analyse effectively. Rapid deleveraging by hedge funds has probably over the last six months played a non-trivial role in exacerbating financial instability. It is for these reasons that the G30 report suggested that regulators should have the power to gather detailed information from hedge funds, so that we and central banks are better able to judge their evolving systemic importance: and recommended that “for funds above the size judged to be potentially systemically significant, the prudential regulator should have the authority to establish appropriate standards for capital, liquidity and risk management”. That halfway house on hedge funds – information and the power to respond to future developments in size, concentration, leverage levels, and practices – would be in line with the principle of focusing on economic substance not legal form.
Conclusion

To conclude, let me return to my opening thought. We are in the middle of an economic downturn which, to a far greater extent than any since the 1930s, is the result of developments which were to a degree internal to the global financial system. Developments in the banking and the near-bank system, which had been lauded as improving allocative efficiency and financial stability, have in fact caused serious harm to the real economy. The changes which we need to make to create a sounder system for the future will be profound. Their guiding principle should be that they should create a banking system focused on the delivery of the value-added functions of banking which are so essential to a market economy.

1 Even the banks which were largely doing “originate and distribute” would often however have to warehouse significant quantities on balance sheet before packaging and distributing, and could be left with liquidity strains and future potential losses if liquidity suddenly dried up (e.g. Northern Rock)

2This assumption seems also at time to have been based on a misunderstanding of the inference that could be drawn from a credit rating, with high ratings treated as carrying the inference of liquidity, rather than simply lower credit default.

3Loan to deposit ratios limits continue however to be used in some emerging economies. A number of emerging economies e.g. India, also continue to use reserve asset ratios as monetary policy instruments, with significantly liquid balance sheets a resulting byproduct.

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How Much Debt Is Too Much?

by Martin Wolf

How much debt is too much? Nobody knows. But the governments of highly indebted high-income economies – such as the US and UK – think they know the answer: more than today. They want even more credit to flow to their struggling private sectors. Is that an attainable ambition and, if so, how might it be achieved?

Let us start with some facts. The ratio of US public and private debt to gross domestic product reached 358 per cent in the third quarter of 2008. This was much the highest in US history (see charts). The previous peak of 300 per cent was reached in 1933, during the Great Depression.

Nearly all of this debt is private. That reached an all-time high of 294 per cent of GDP in 2007, a rise of 105 percentage points over the previous decade. The same thing happened to the UK, on a yet more impressive scale. This has been a gigantic debt and credit expansion.

Particularly remarkable is the composition of the increased debt. In the early 1930s, most US private debt was owed by non-financial companies: so balance-sheet deflation occurred in companies, as was also the case in Japan in the 1990s. This time, however, the big increase in debt was in the financial and household sectors.

Over the past three decades the debt of the US financial sector grew six times faster than nominal GDP. The consequent increases in its scale and leverage explain why, at the peak, the financial sector allegedly generated 40 per cent of US corporate profits. Something decidedly unhealthy was going on: instead of being a servant, finance had become the economy’s master. In a superb brief account of today’s calamity, Lord Turner, chairman of the UK’s Financial Services Authority, refers explicitly to “illusory profits”*.

Moreover, household debt – much of it associated with housing – also rose rapidly: from 66 per cent of US GDP in 1997 to 100 per cent in 2007. A slightly bigger jump in household indebtedness can be seen in the UK.

What do such rises in indebtedness portend? The answer might be: nothing. After all, over the world, debt nets to zero. In principle, the ability to transfer purchasing power from lenders to borrowers is highly desirable: as a British advertising campaign once claimed, credit “takes the waiting out of wanting”. Yet people can also make big mistakes, particularly if they confuse bubbles with permanently high prices. The financial sector is particularly prone to such blunders. As Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard comment: “Systemic banking crises are typically preceded by asset price bubbles, large capital inflows and credit booms, in rich and poor countries alike”**.

Once such asset bubbles burst, it becomes hard to find borrowers and lenders who are either willing or creditworthy. The over-indebted start paying down their debts, instead, as now. Desired savings also soar. Realised savings may not rise, however: incomes may collapse, instead. This is what John Maynard Keynes called “the paradox of thrift”. The result will be a slump caused by balance sheet collapse rather than attempts to control high inflation.

What then might be done?

Some recommend a “liquidation”. A chain of bankruptcy would indeed eliminate a debt overhang, as happened in the 1930s. But, with much of the economy enmeshed in bankruptcy and the financial sector imploding, a depression would result. To choose that option must be insane.

Less unappealing is organised mass bankruptcy. Proposals for an organised debt-for-equity swap in failed or enfeebled financial institutions fall into this category. So, too, does allowing courts to modify mortgage contracts. Executed efficiently and expeditiously, such ideas are attractive. Costs would fall on shareholders and creditors, not taxpayers, and so sustain the principle of private responsibility.

An opposite approach is to sustain existing levels of debt, by slashing its cost to borrowers and trying to grow out of it over many years. This is what current monetary policies seek to achieve. It is a good idea, however unpleasant to creditors. But this would not generate much additional borrowing or fresh spending; it would not stop the indebted from trying to lower their debt; and it would not restore the financial sector to health.

Yet another approach is to replace private debt with public debt. That is what recapitalisation of banks now means. Over time, private-sector debt should fall, while public-sector debt, explicit and implicit, rises. Socialising debt increases the chances of growing out of it. That has happened before, notably in the case of UK public debt over the course of the 19th century.

Finally, there is inflation. If central banks and governments are aggressive enough, they can generate inflation, which will lower the debt burden. But they will imperil – if not terminate – the experiment with unbacked fiat (or man-made) money that started in 1971.

So which is the best approach?

At the overall level, it must largely be to grow out of the debt overhang, with socialisation of a part of it an essential element. Relapse into inflation would be a huge policy failure. A plan is also needed to deal with the plight of many households and with the overextended and undercapitalised financial sector.

The financial sector, as a whole, cannot deleverage by selling assets. It would be helpful if claims of global financial institutions could be netted out, instead, though that would require international co-operation. The Obama administration must also soon launch a recapitalisation of US banking, but not by buying the “toxic assets” at above-market prices. A debt-equity swap would be preferable. If that is politically impossible or too destabilising, publicly financed recapitalisation is inevitable. Just do not dare to call it nationalisation.

Whatever is done, one compelling truth cannot be evaded. It is going to be very hard to generate substantial net borrowing by households and non-financial corporations in the high-income countries with high internal debt. It is unimaginable that they will return to levels of private-sector borrowing, spending and increases in debt that characterised these countries for so long. Countries with large current account surpluses have long demanded an end to the profligate borrowing and spending of the customers upon whom they depended. They should have been careful what they wished for: they have now got it. Enjoy!

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Big Investor Says More Financial Disintegration Ahead

Renowned investor George Soros said on Friday the world financial system has effectively disintegrated, adding that there is yet no prospect of a near-term resolution to the crisis.

Soros said the turbulence is actually more severe than during the Great Depression, comparing the current situation to the demise of the Soviet Union.

He said the bankruptcy of Lehman Brothers in September marked a turning point in the functioning of the market system.

“We witnessed the collapse of the financial system,” Soros said at a Columbia University dinner. “It was placed on life support, and it’s still on life support. There’s no sign that we are anywhere near a bottom.”

His comments echoed those made earlier at the same conference by Paul Volcker, a former Federal Reserve chairman who is now a top adviser to President Barack Obama.

Volcker said industrial production around the world was declining even more rapidly than in the United States, which is itself under severe strain.

“I don’t remember any time, maybe even in the Great Depression, when things went down quite so fast, quite so uniformly around the world,” Volcker said.

(Reporting by Pedro Nicolaci da Costa and Juan Lagorio; Editing by Gary Hill)

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More Down Days Ahead

by Chris Nicholson

Markets across Europe fell Friday on disappointing corporate news and weak economic data. The slide follows a down day in Asia and a difficult day on Wall Street, where the Dow Jones industrial average closed at its lowest in six years.

The Dow Jones Euro Stoxx 50 index, a benchmark for the euro region, was down 3.3 percent by midday, to its lowest level at least five years. The DAX in Frankfurt slid 3.5 percent as investors shed financial and industrial stocks, while the CAC 40 in France was down almost as much. The FTSE 100 in London fell 2.6 percent.

The president of the European Central Bank, Jean-Claude Trichet, said Friday that the markets were experiencing an “ongoing correction,” but would not put a timetable on when the crisis might lessen, The Associated Press reported from Paris.

Mr. Trichet said the crisis was the first major test of the globalized economy and had shown that “everything must change.”

In New York, Wall Street seemed poised to extend its losses Friday. Financial shares led the decline Thursday amid concerns about the plans by the Obama administration to help homeowners in foreclosure and shore up the struggling banking system.

Investors will also absorb a new report consumer prices, which is a key measure of inflation and should offer some insight into how the economy is performing.

“We thought the low points of last fall were behind us, but we seem to be in for more disappointments,” said Vincent Juvyns, a strategist at ING Investment in Brussels. “The markets have lost all sense of direction, which makes it hard to take a position.”

Corporate news across the region seemed to confirm fears.

Anglo American, the mining giant, was down nearly 16 percent by midday after announcing it would cut 19,000 jobs, or a tenth of its work force, and suspend dividend payments for 2008 as its business deteriorated on weak global demand.

In France, Compagnie de Saint-Gobain, which supplies construction materials, tumbled 16 percent after announcing it would seek to sell shares to raise 1.5 billion euros, or $1.9 billion, in capital, while confirming yet more job cuts.

And UBS, the Swiss bank, is facing more problems with prosecutors in Washington. A day after the bank agreed to pay $780 million to settle claims that it defrauded the Internal Revenue Service, the federal government went to court seeking the release the names of 52,000 wealthy clients. UBS shares fell more than 16 percent at midday, after rallying almost 5 percent Thursday on news of an initial settlement.

AXA, on of the largest insurers in Europe, was down nearly 14 percent in Paris after Standard & Poor’s downgraded its credit rating, citing uncertain earnings.

The Swedish automaker Saab filed for bankruptcy to seek protection from its creditors after General Motors said it would cut ties with the company after decades of losses.

“We’re at a stage in the economic cycle where we have to prepare for the worst,” Mr. Juvyns said. “Companies are firing to cut costs, since we face a contraction in G.D.P. for the first half of the year.”

Arnaud Cayla, a fund manager at Barclays Asset Management France in Paris, said that while most companies would survive the crisis, they would have to adjust to lower demand.

“We’re flirting with deflation,” Mr. Cayla said, “but it’s still too early to say.”

Discouraging economic news for the euro zone added to the slide. The purchasing managers’ index, which estimates business activity, showed the downturn accelerating in the first weeks of February in the 16 nations that share the euro. The index is based on a survey of purchasing managers by Markit Economics.

The composite index of activity in services and manufacturing slipped to 36.2 in February, from 38.3 in January, with services hit hardest. Any number below 50 indicates an economic contraction.

In Britain, the Council of Mortgage Lenders reported Friday that 40,000 people had lost their homes in 2008, an increase of 54 percent on a year earlier, and the number is expected to nearly double in 2009 to 75,000.

“The next trap for the financial markets is state debt,” Cayla said. “We’re concerned about the health of governments, and what their signatures mean.”

Asia saw a less dramatic sell-off, led by the Kospi index in South Korea, which fell 3.72 percent dragged down by financial and industrial stocks. In Japan, the Nikkei 225 slipped 1.6 percent, with equities in banks, retail and communications falling furthest. The Hang Seng in Hong Kong dropped 2.49 percent, with financials there also seeing the heaviest losses.

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Move Over Beethoven

By The Economist

THE days when subprime mortgages were what kept bankers awake at night are long gone—though thanks only to the barrage of explosions in other corners of finance. In terms of toxicity, however, subprime has had no equal. Until now, perhaps. Even as credit markets, particularly corporate-debt markets, show some signs of improvement, mortgage loans to supposedly better-heeled Americans are souring at a gut-wrenching rate.

Of particular concern are “Alt-A” mortgages, offered to borrowers sandwiched between subprime and prime. This market was trumpeted as a means of extending home ownership to those, such as the self-employed, with a reasonable credit standing but unsteady income. Its practitioners specialised in loans with scant documentation and exotica such as negative-amortisation mortgages, which allow borrowers to pay less than the accrued interest, with the difference added to the loan balance.

That Alt-A has troubles comes as no surprise. Last summer, for instance, it helped to bring down IndyMac, a Californian bank. But the speed with which loans have soured in recent months, and the reaction of rating agencies, have been startling. Delinquencies rocketed in the final months of 2008. They even rose sharply for loans made in 2005, before underwriting turned really sloppy (see chart).

The rating agencies are rushing to catch up with this grim reality. Moody’s, which last summer had issued a sanguine outlook for Alt-A, recently quadrupled its loss projections on bonds backed by such loans. A steady flow of downgrades has turned into a flood in recent weeks, with thousands of Alt-A tranches taking the plunge. The falls have been unusually steep: of the $59 billion of AAA-rated securities that Moody’s cut between January 29th and February 2nd, an astonishing 91% went straight to junk, according to Laurie Goodman of Amherst Securities. In ratings terms, Alt-A is doing worse than subprime.

Moody’s calls this “unprecedented”. That is putting it mildly. It now expects losses for 2006-07 Alt-A securitisations to top 20%, compared with an historical average of well under 1%. In an ugly echo of the fiasco over collateralised-debt obligations, holders lower down the structure can expect total write-offs, while the vast majority of senior holders will not be spared substantial losses.

The sums involved are depressingly large. In the worst case, losses on the $600 billion of securitised Alt-A debt outstanding—roughly the same as the stock of subprime securities—could reach $150 billion, reckons David Watts of CreditSights, a research firm. Analysts at Goldman Sachs put possible write-downs on the $1.3 trillion of total Alt-A debt—including both securitised and unsecuritised loans—at $600 billion, almost as much as expected subprime losses. Add in option ARMs, a particularly virulent type of adjustable-rate loan, many of which are essentially the same as Alt-A, and the potential hit climbs towards $1 trillion.

Part of the problem is that much of the Alt-A lending came at the tail-end of the credit boom in late 2006 and early 2007. By then, subprime was already getting a bad name. So Wall Street hit on a ruse: it took borrowers who in normal times would have been subprime and dressed them up as “mid-prime”. Many of these loans were doomed from the start. According to the Bank for International Settlements, a staggering 40% of American mortgages originated in the first quarter of 2007 were interest-only or negative-amortisation loans.

In theory, interest-rate declines over the past year should offset the “payment shock” felt by borrowers whose loans reset from low teaser rates to higher ones. But house prices have fallen so steeply that perhaps half of all Alt-A borrowers are in negative equity; for many, walking away may seem the best option. Moreover, option-ARM borrowers who had not expected to start repaying principal until 2015 or later may now have to do so as early as this year, because they are hitting triggers that recast the loan early. Government efforts to stem foreclosures should help these unfortunates, though they may do little for owners of mortgage-backed bonds, who could face higher losses as a result of “cramdowns”, in which bankruptcy courts order a reduction in the principal owed.

Alt-Aaaaaargh
The pain will be felt across the financial industry. Insurance firms, which gobbled up large but unknown quantities of highly rated Alt-A paper, will now be forced sellers since they are not permitted to hold securities rated below investment grade.

Banks have already sold a sizeable chunk of their Alt-A holdings to hedge funds and other asset-management firms, often at large discounts. UBS’s exposure has fallen from $26.6 billion to just $2.3 billion, for instance. But other European banks were not so zealous. ING, a Dutch bank, still has €27.7 billion ($35.1 billion) of Alt-A debt. American banks are sitting on perhaps $800 billion of the stuff.

As the market prices of mortgage securities have fallen, banks have had to mark down their holdings, taking “unrealised” losses that erode their capital position. Multi-notch downgrades could put further downward pressure on prices. They hit capital in another way, too, because junk-rated debt carries a punitive risk weighting; banks must set aside five times as much capital as they have to for top-notch securities. Rating cuts also affect income statements, by pushing banks to acknowledge that losses which they had classified as temporary are now permanent.

The weakest may now need to raise fresh equity. If they are lucky, banks will be able to palm some of the risk on to governments via asset guarantees or “bad banks” that assume their noxious assets. The Dutch government has agreed to bear the risk on much of ING’s Alt-A holdings, and Citigroup’s $11.4 billion exposure to Alt-A bonds falls under a guarantee that formed part of its November bail-out. It will receive further help from the industry-wide bank-rescue package that the Obama administration is preparing.

What the taxpayer will get in return is far from clear. Officials are still wrestling with how to value beaten-up mortgages. Assessing the worth of Alt-A loans can be especially tricky because they are maddeningly heterogeneous, thanks to a broad assortment of payment options. Less rigorous banks carry some holdings at around 60 cents on the dollar. Morgan Stanley’s are marked at half that. Its shares have rebounded recently, partly on hopes that it will be able to write up these securities once the government unveils its bail-out.

The biggest single Alt-A casualties are America’s bungling mortgage agencies, Fannie Mae and Freddie Mac. They waded into the market in 2006-07, snaffling up business in red-hot states such as California and Arizona, comforted by down-payments of 20%. When house prices there fell by more than that, they were left holding the first loss, since borrowers who put in that much equity do not have to take out mortgage insurance.

Rotten as Alt-A loans are, worse may be to come. As unemployment in America heads towards 8%, even strongly underwritten loans will go bad. Bankers are growing increasingly anxious about the $1.1 trillion of prime mortgage loans and securities, much of which they held on to themselves, assuming it to be bombproof. This sits on their books at “much more optimistic” values than lower-grade mortgages, says one. Some 70% of prime securities will eventually have their ratings cut, according to a “downgrade-o-meter” produced by JPMorgan Chase. As Guy Cecala of Inside Mortgage Finance, a newsletter, puts it: “The mortgage storm’s first wave was subprime. Now we are being buffeted by Alt-A. But a bigger wave is on the horizon, and it cuts across all loan types.”

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Roubini Thinks 1,400 US Banks Will Fail

How many banks will fail in the U.S. over the next year as the recession deepens? Answering that is like trying to guess whether a poker player will draw an ace on any given hand. Someone may have a big computer program that can find that number, but like most statistics. It is right until it is not.

According to Reuters, there are over 8,300 FDIC-insured banks in America. Last August, dour economist Nouriel Roubini told Barron’s that 1,400 banks in the U.S. would eventually fail. That was long before almost anyone had a sense of how tremendously damaging the recession would be.

Recently, research firm RBC Capital Markets revised its estimate for bank failures from 200 to 300 over the next three years to 1,000. RBC said it based its forecast on talks with industry experts and the amount of assets on which banks are not collecting interest as a percentage of tangible capital and loss reserves. (See pictures of the Top 10 scared traders.)

What is disquieting about the RBC figure is not just how large it is. More alarming is that the size of the revision is so big. How could 700 banks be added to the list so quickly? It is hard to say whether it should shake investor confidence in RBC projections or the strength of bank balance sheets.

One of the signs of a real panic is that the people in the midst of it to some extent lose their minds. They are robbed of their ability to reason and see things clearly. They lose the compass they may have had. Even the analytic ability of “experts” is compromised, so the spreads among forecasts get very broad as things get worse. It might be of some comfort that all analysts think that 555 banks will fail in the next 24 months. Instead, some put the number at 200 and others at 1,400. The facts at the center of the analytic process change so fast that even the well-trained experts cannot keep up with and integrate the constantly changing information, in order to offer consistent predictions.

A number of writers in the media have noticed that people have become numb to the negative information around them. The focus of the individual has moved inward to his own economic survival. Attaching that to some reference point in the outside world becomes too painful when all of the news is alarming.

Many people, however, are willing to look at the economy, no matter how bad it is, in the hope of taking away some clue about their own financial futures. Mostly, they are finding that they are out of luck. The analysis they would like to have is so confusing and contradictory that it is nearly useless. Bank failure rates are only one of the issues that confound people, and they do not to be confounded more than they already are.

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Big Industry is Worried

By Francesco Guerrera and Justin Baer

The US economy is suffering its steepest downturn since at least the 1970s and could descend into a depression, Jeff Immelt, General Electric’s chief executive, warned on Thursday.

He said businesses and consumers alike were struggling to contend with tumultuous markets and a financial-services industry under siege.

“Unlike the other downturns that I’ve been a part of, this one is faced with limited liquidity,” Mr Immelt, GE’s chief since 2001 told a conference. “Once you break through ’74-’75, you don’t stop ’til you get to 1929.”

When asked whether he would call the current slowdown a recession or a depression, Mr Immelt joked that he would need to refer to his college economics text book for a precise answer but said “it is one of those”.

He contended that governments were “firing as many bullets” as they could to stimulate economic growth and stabilise the credit markets. Those measures, he said, should begin to take hold by early next year.

“Governments are all in,” he said. “And in my view, government always wins.”

GE remains one of the world’s largest and most-profitable companies, with operations in dozens of countries and an array of businesses that range from aircraft engines and medical-imaging equipment to cable television and lightbulbs. Yet the unfolding credit crisis has crimped profit at GE’s own financial services business, raising concerns for the company’s strategy and once-unquestioned financial strength.

GE has responded to the crisis with steps to shrink the finance arm, GE Capital, and its funding needs. But unlike GE’s response to the early 1990s downturn, Mr Immelt said the company would not rebuild GE Capital through a spate of acquisitions of distressed assets. Any likely acquisition targets would instead augment GE’s industrial businesses.

At the discussion, which was hosted by the Wall Street Journal, Boston Consulting Group and IESE Business School, Mr Immelt reiterated that he would not cut GE’s stock dividend or veer away from a plan to run GE as a company with a triple A credit grade, even if ratings firms eventually opt to lower its debt.

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On The Cusp Of Economic History

By Martin Wolf

A hyperpower’s place is in the wrong. This is particularly true when, as last week at the annual meeting of the World Economic Forum in Davos, the hyperpower in question is barely represented, at least at the official level. But, truth to tell, the critics of the US – led by prime ministers Wen Jiabao of China and Vladimir Putin of Russia – had an easy story of incompetence and malfeasance to tell.

Yet, however easy it may be to blame the US for the current global economic woes, it is also to the US that the world looks for a solution.

The general mood in Davos was one of gloom verging on despair. The gloom is justified, as the update of the World Economic Outlook from the International Monetary Fund makes plain. Global economic growth is now projected to fall to a mere ½ per cent this year, its lowest rate since the second world war. Output in high-income countries is expected to fall by 2 per cent, the first annual contraction since 1945. Industrial production and merchandise exports are in free fall, as consumers decide they do not need that new car or other goody right now (see charts).

Given the rate at which they have been downgraded, reality could be far worse even than these forecasts. The global downward spiral of uncertainty, caution and cutbacks in lending and spending may continue. Alternatively, policy action may turn the ship around. But that action must be decisive. This is particularly true for the Obama administration, on which so much depends. It has a golden opportunity to reverse the spiral now. After that it becomes part of the problem. So far the evidence is discouraging. It should be far bolder.

Not all news is dreadful. Spreads between expected official interest rates and those on inter-bank lending have fallen sharply; those between US Treasury bonds and risky assets are also easing, though they remain at very high levels. The decline in oil prices represents a huge shift in income from savers to spenders. Since today’s collapse in demand and output is the lagged result of past disruption, better news may lie ahead.

Alas, such optimism must be kept in check. As the update of the IMF’s Global Financial Stability Report notes: “Worsening credit conditions … have raised our estimate of the potential deterioration in US-originated credit assets … from $1.4 trillion in the October 2008 GFSR to $2.2 trillion.” Losses are also spreading to many other asset classes and economies as the slump worsens.

Private credit growth is falling across most economies. Trade finance has been particularly affected, with dire results. The flow of private funds to emerging economies is collapsing: according to the Washington-based Institute for International Finance, net private flows are projected to be just $165bn in 2009, down from $466bn in 2008. Central and eastern Europe is particularly vulnerable.

Protectionist pressures are rising rapidly, not only in finance, but in trade. On the former, Gordon Brown, UK prime minister, turned up in Davos as hypocrite-in-chief, bemoaning the rise of the financial protectionism his own government has been practising. On the latter, nothing can surpass the folly of the Buy America provision in the draft US stimulus package. This is an invitation to retaliation. For a country that must export its way out of its slump, this is mad. For one that made an open global economy the keystone of its foreign policy for two generations, it is vandalism. Is this the change we must believe in?

Contrary to views expressed in some circles, notably in the US, depressions are neither good for us, nor unavoidable. What is needed is determined and globally co-ordinated action. The lead must come from the US: it remains the hyperpower; the economic system is one it promoted; and the crisis had much to do with mistakes its policymakers and private institutions made, even if aided and abetted by mistakes elsewhere.

So what are the principles to be followed? I suggest the following:

First, focus all attention on reversing the collapse in demand now, rather than on the global architecture.

Second, employ overwhelming force. The time for “shock and awe” in economic policymaking is now.

Third, make future normalisation of fiscal and monetary policies credible.

Fourth, act in concert. Even the US cannot solve its problems alone.

Fifth, avoid protectionism.

Sixth, strengthen the ability of global institutions to help the weaker.

So how are we doing against these standards? “Better than in the 1930s” is the best one can say. The world desperately needs Mr Obama to take a firmer grip at home and lead abroad. The plans he is now announcing give him a chance of doing the former. The April summit of the Group of 20 countries, in London, is his chance for achieving the latter.

Unfortunately, what is coming out of the US is desperately discouraging. Instead of an overwhelming fiscal stimulus, what is emerging is too small, too wasteful and too ill-focused. Instead of decisive action to recapitalise banks, which must mean temporary public control of insolvent banks, the US may be returning to the immoral and ineffective policy of bailing out those who now hold the “toxic assets”. Instead of acting as a global leader, there is resort to protectionism and a “blame game”.

This way lies a catastrophe. I expect little enlightenment from the rest of the globe: the European Central Bank is allowing the eurozone to collapse into deep recession; Japan is in meltdown; China has at least announced a big stimulus package, but it lacks a credible plan for needed structural reforms; and most other emerging countries can only try to stay afloat in these storm-tossed seas. Their accumulated foreign currency reserves of the 2000s will help. But the resources available to the IMF, even with their hoped-for doubling, are too small to give most emerging economies the confidence they need to risk keeping their spending up.

Decisions taken in the next few months will shape the world for a generation. If we get through this crisis without collapse, we will have the time and the chance to construct a better and more stable global order. If we do not, that opportunity may not recur for decades.

We are living on the cusp of history. The priority is to reverse the downward spiral of despair through overwhelming and concerted action. That will only occur if the US now gives the leadership we need. Mr Obama may even find, as many presidents have found before him, that leading the world is easier and more rewarding than cajoling a recalcitrant Congress. This may not be the challenge he expected. But it is the challenge he confronts. History will judge his presidency on whether he dares to succeed.

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Economy Still Sliding

By Timothy R. Homan

The U.S. economy is likely to keep deteriorating in early 2009 after shrinking last quarter by the most since 1982, as consumers and businesses retrench.

The 3.8 percent annual pace of contraction in the fourth quarter was less than forecast, with a buildup of unsold goods cushioning the blow. Excluding inventories, the decline was 5.1 percent, the Commerce Department said yesterday in Washington.

Job cuts announced this month by companies from Starbucks Corp. and Pep Boys – Manny, Moe & Jack to Eastman Kodak Co. mean there’ll be little respite in the first half of this year, economists said. The Obama administration used the figures to reinforce its call for Congress to pass a stimulus package in excess of $800 billion to arrest the economy’s decline.

“The recession is going to last through most of 2009, and we’ll be lucky to have growth back at zero by the end of the year,” Kenneth Rogoff, a Harvard University economics professor, said in a Bloomberg Television interview from Davos, Switzerland, yesterday. Economic growth “will be pretty tepid for a long time.”

U.S. stocks fell yesterday, capping the market’s worst January, as more companies reported disappointing earnings. The Standard & Poor’s 500 Stock Index decreased 2.3 percent to close at 825.88. Treasuries advanced, sending benchmark 10-year note yields to 2.84 percent from 2.86 percent late on Jan. 29.

“This is a continuing disaster for America’s working families,” Obama said at the White House yesterday. “They need us to pass the American Recovery and Investment Plan,” designed to save more than 3 million jobs, he said. House lawmakers passed the stimulus Jan. 28, moving action to the Senate next week.

Spending Slump

Yesterday’s report underscored the hit to households from the biggest wealth destruction on record. Consumer spending, which accounts for about 70 percent of the economy, dropped 3.5 percent following a 3.8 percent fall the previous three months. It’s the first time decreases exceeded 3 percent back-to-back since records began in 1947.

The Institute for Supply Management-Chicago said yesterday its business barometer decreased to 33.3 from 35.1 the prior month. The index has remained below 50, the dividing line for contraction, for four months. Meanwhile, consumer confidence rose less than forecast this month, a Reuters/University of Michigan index showed. The gauge climbed to 61.2 from 60.1 in December.

A separate report showed that employment costs in the U.S. rose at the slowest pace in almost a decade in the fourth quarter as companies limited wage gains and benefits. The Labor Department’s employment-cost index rose 0.5 percent.

GDP was forecast to contract at a 5.5 percent annual pace last quarter, according to the median estimate of 79 economists surveyed by Bloomberg News.

Without Stimulus

“Without the stimulus plan, the economy would be flat to declining in the second half of the year,” said Laurence Meyer, vice chairman of Macroeconomic Advisers LLC in Washington and a former Federal Reserve Governor. With the recovery package, the unemployment rate may peak at 8 percent instead of 9.5 percent or higher, he added.

The world’s largest economy shrank at a 0.5 percent annual rate from July through September. The back-to-back contraction is the first since 1991.

Economists at Morgan Stanley and Deutsche Bank Securities Inc. in New York lowered their forecasts for growth in the first three months of 2009 following the report. They both now estimate the economy’s worst drop will occur this quarter.

For all of 2008, the economy expanded 1.3 percent as a boost from exports and government tax rebates in the first half of the year helped offset the deepening spending slump.

Prices Cool

The GDP price gauge dropped at a 0.1 percent annual pace in the fourth quarter, the most since 1954, reflecting the slump in commodity prices. The Fed’s preferred measure, linked to consumer spending and excluding food and fuel, rose at a 0.6 percent pace, the least since 1962.

Unadjusted for inflation, GDP shrank at a 4.1 percent pace, the most since the first three months of 1958. The drop in so- called nominal growth explains why corporate profits slumped as the year ended.

“This is a severe, steep, broadly based recession” with “no quick fix,” Stephen Roach, chairman of Morgan Stanley Asia Ltd., said in a Bloomberg Television interview from Davos, Switzerland yesterday.

Americans may pull back further as employers slash payrolls. Companies cut 524,000 workers in December, bringing total job cuts for last year to almost 2.6 million. The unemployment rate last month was 7.2 percent, up from 4.9 percent a year before.

Job Cuts

More cutbacks are on the way. Kodak, Target Corp. and Texas Instruments Inc. are among U.S. companies that announced thousands of layoffs this week.

Target, the second-biggest U.S. discount retailer, said this week it will slash 600 existing jobs and 400 open positions, mainly in its hometown of Minneapolis. It also said it will close a distribution center in Little Rock, Arkansas, later this year that employs 500 workers.

“We are clearly operating in an unprecedented economic environment that requires us to make some extremely difficult decisions,” Chief Executive Officer Gregg Steinhafel said in a Jan. 27 statement.

The economic slump intensified last quarter as companies also retrenched. Business investment dropped at a 19 percent pace, the most since 1975. Purchases of equipment and software dropped at a 28 percent pace, the most in a half century.

Housing Slump

The slump in home construction also accelerated, contracting at a 24 percent pace last quarter after a 16 percent drop in the previous three months.

PPG Industries Inc., the world’s second-biggest paint maker, said this week that it may cut as many as 4,500 employees, or 10 percent of its workforce, because of weak global demand from automakers and homebuilders.

“We are probably looking at the sharpest downturn that anyone working at our company has seen,” Chief Executive Officer Charles E. Bunch said in an interview Jan. 27. “The regions outside of North America, which had been really helping PPG in the first three quarters of last year, have sort of caught the disease that started here in the U.S. with the credit crisis.”

The slowdown in global demand indicates American exports are unlikely to contribute to growth in early 2009. World growth will be 0.5 percent this year, the weakest postwar pace, the International Monetary Fund said Jan. 28.

Inventories grew at a $6.2 billion pace in the fourth quarter, the first gain in more than a year. Its contribution to growth was the biggest since the fourth quarter of 2005.

The Fed this week said it’s prepared to purchase Treasury securities to shore up lending and warned inflation may recede too rapidly. Fed policy makers voted to leave the benchmark interest rate as low as zero.

The GDP report is the first for the quarter and will be revised in February and March as more information becomes available.

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Piggybacking on Capitalism, China and Russia Blame It for Crisis

By CARTER DOUGHERTY and KATRIN BENNHOLD

DAVOS, Switzerland — The leaders of the former bastions of the Communist bloc took the stage here on Wednesday to rebuke their capitalist brothers for dragging the world into crisis but also to assure them that, working together, they can rapidly restore the global economy to health.

“A year ago, American delegates speaking from this rostrum emphasized the U.S. economy’s fundamental stability and its cloudless prospects,” he said, speaking through a translator. “Today, investment banks, the pride of Wall Street, have virtually ceased to exist.”

But the damage goes beyond Wall Street, he said. “The entire economic growth system, where one regional center prints money without respite and consumes material wealth, while another regional center manufactures inexpensive goods and saves money printed by other governments, has suffered a major setback.”

The Chinese premier, Wen Jiabao, left little doubt that Beijing blamed the United States for the economic breakdown. “Inappropriate macroeconomic policies,” an “unsustainable model of development characterized by prolonged low savings and high consumption,” the “blind pursuit of profit” and “the failure of financial supervision” all contributed, he said.

Like Mr. Putin, he was upbeat about prospects for the future and expressed an eagerness to work with the West on solving common economic problems.

Mr. Wen was eager to assure investors that China was poised to rebound. “I can give you a definitive answer,” he said of the prospect that his economy would recover strongly. “Yes, it will; we are full of confidence.”

He said that the Chinese government had set a goal of 8 percent growth this year, which he called “an attainable target through hard work.” He reeled off statistics showing that bank lending and investment, after slowing sharply in the fall, picked up in December and January.

“The harsh winter will be gone and spring is around the corner,” Mr. Wen said.

In his 30-minute speech, Mr. Putin portrayed Russia as a reliable partner in energy, trade and politics despite the economic crisis, which has dragged down Russia’s growth rates and drastically reduced its revenue from oil, a major export. “We can’t afford being isolationist or economically selfish,” he said, adding, “We are all in the same boat.”

As recently as December, Mr. Putin had harsh words for the United States. On Wednesday, he struck a more conciliatory note, saying he would not dwell on who was responsible and talking instead about “mutual interests” and “mutual dependencies.”

“We hope that our partners in Europe, Asia and America — and I’m also addressing the new administration, we wish them well — I hope they will be willing to cooperate constructively,” he said.

Some Russians in attendance here said Moscow’s dependence on Western investors — Russia’s stock market is down more than 70 percent from its peak, for example — might have played a role in Mr. Putin’s adopting a less combative stance.

Mr. Wen admitted that the Chinese were feeling the ill effects of the economic downturn. “We are facing severe challenges, including notably shrinking external demand, overcapacity in some sectors, difficult business conditions for enterprises, rising unemployment in urban areas and greater downward pressure on economic growth,” he said.

Given the outlook for the year, financial experts said, the leaders’ choice of accommodation over recrimination was probably a wise course.

“We cannot underestimate the challenges and dangers that the world economy faces in 2009,” Stephen S. Roach, chairman of Morgan Stanley Asia, said at the forum’s traditional opening debate on the macroeconomic outlook. “It will most likely be the first year since World War II when G.D.P. actually contracts.”

Mr. Roach cast doubt on some of Mr. Wen’s sunny pronouncements about China’s economy and noted that shipments from Taiwan and Japan were also down. “As the Chinese economy has hit a wall, the rest of Asia has followed suit,” he added.

Echoing a widely held view in the global business community, Heizo Takenaka, director of the Global Security Research Institute at Keio University in Japan, said fear had taken over as the main driver of the crisis.

“The current situation is something more than a financial and economic crisis,” Mr. Takenaka said. “We face a confidence crisis” requiring a strong government and central banks.

The most panicky of all, Mr. Roach said, are American consumers, who are retrenching after a decade-long binge fed by inflated housing prices. He predicted that they were only “20 percent into a multiyear” adjustment that would leave them much more frugal.

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Gloom in Davos

By Matthew Benjamin and Simon Kennedy

Gloom is deepening among business leaders and economists, casting a pall over this year’s World Economic Forum in Davos, Switzerland.

“The crisis is getting worse,” Rupert Murdoch, chief executive officer of News Corp., said at a press conference to kick off the five-day event today. “It’s going to take very drastic action to turn that around, if it can be turned around, quickly. I believe it will take quite a long time.”

Concerns over the economic outlook are virulent as executives from JPMorgan Chase & Co.’s Jamie Dimon to Stephen Green of HSBC Holdings Plc join more than 2,500 counterparts, academics and policy makers in the ski resort for five days of soul-searching and deal-making.

“You have to realize the size of the problem confronting us today is significantly larger than in the ‘30s,” George Soros, the billionaire hedge-fund owner and philanthropist, said today. “The situation will continue to deteriorate.”

Just one in five of 1,124 chief executives in 50 nations said they were very confident about prospects for revenue growth in 2009, down from half last year, and more than a quarter said they were pessimistic, a survey by PricewaterhouseCoopers LLP showed. The sentiment was the worst since the accounting and consulting firm began tracking the CEO outlook in 2003.

The global economy will slow close to a halt this year as more than $2 trillion of bad assets in the U.S. help sink economies from Russia to the U.K., the International Monetary Fund said today.

‘Pretty Grim’

“The outlook is pretty grim,” said Howard Davies, director of the London School of Economics and a former Bank of England policy maker who is in Davos. “Things are not good and business surveys are coming out showing they’re getting even worse.”

What began as a financial meltdown 17 months ago has morphed into an economic calamity unseen since the Great Depression.

In the past year, Lehman Brothers Holdings Inc. and Bear Stearns Cos. have collapsed and officials around the world have committed trillions to prevent more from toppling. The Standard & Poor’s 500 Index is still falling after its worst year since 1937 as the U.S., Japan and Europe sink into their first simultaneous recession since World War II.

World Bank Chief Economist Justin Lin said today the world was in a “protracted recession” and that injecting capital into banks won’t revive it. “We need to have coordinated fiscal stimulus that’s large enough,” he said.

‘Delusional’

It’s “delusional” to expect the U.S. fiscal stimulus plan crafted by President Barack Obama to “jump start” the economy, Stephen Roach, Morgan Stanley Asia’s chairman, told a panel in Davos today.

The executives polled by PricewaterhouseCoopers survey don’t see a turnaround soon.

Only about a third were very confident about growth in the next three years, down from 42 percent last year. Almost seven in 10 said their companies will be affected by the credit crisis, and 70 percent of those said they will delay planned investments as a result.

Just 13 percent of U.S. executives said they were “very confident” about revenue growth in the next 12 months, compared with 36 percent last year, while 15 percent in Western Europe expressed the same sentiment, down from 44 percent. Among developed economies, French executives were the most skittish, with just 5 percent calling themselves very optimistic.

Emerging Markets

Business leaders in emerging markets were more confident. Seven in 10 Indian executives expressed optimism about their company’s growth, as did about three in 10 of those in Brazil, Russia and China.

One further bright spot: Only about a quarter of the business chiefs said they plan to cut payrolls in the coming year, while 35 percent said they intended to maintain staffing levels. That would be welcome news to workers as unemployment accelerates around the world with Home Depot Inc., Caterpillar Inc. and ING Groep NV among those axing positions this week.

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Bank Failures Continue

by Andy Serwer

How many banks will fail this year? No one knows of course, but the answer is many. So far in 2009, we’ve already had three, putting us on a one-per-week pace. That could mean a doubling of last year’s tally of 25, and only slightly less than the total number of failures heretofore over the entire decade (57).

On Friday, regulators shut down First Centennial Bank in California of Redlands. (Redlands, the “Jewel of the Inland Empire” is located in San Bernardino County off I-10 on the way to Joshua Tree and Palm Springs.) On January 16, Bank of Clark County, Vancouver, Washington (love the Vancouver Sausage Fest each September) and National Bank of Commerce, Berkeley, Illinois (home to World Dryer Corp) both went splat.

It’s dire and scary stuff, but sadly we have seen much worse in this country and you don’t have to go back to the 1930s to find it. True, the 1930s were a disaster for banks. In the panic of 1933, more than 4,000 failed which led to the creation of the Federal Deposit Insurance Corporation. But the FDIC hardly made bank failures obsolete. Since 1934 some 3,565 banks have flamed out in this country. A great majority of them hit the wall in the 15-year period between 1979 and 1994. The peak year was 1989, when 534 banks either failed or required “assistance transactions” from the FDIC. This massive failing was of course brought on by the savings and loan crisis that devastated thousands of banks. (To be clear not all these banks technically failed. The FDIC website indicates there are nine possible interventions, including some where the institution’s charter survives, such as “reprivatizations,” and others where the charter is terminated, such as a purchase and assumption where the institution is sold. No question though that every bank on this list at the FDIC website had basically failed.)

So 25 or 50 bank failures, or even a few dozen more, pales in comparison to the number of failures 20 years ago. But that’s cold comfort for a number of reasons.

First, remember that big banks were in lousy shape back then too. In May 1984, Continental Illinois, the nation’s seventh-largest bank became insolvent. Interestingly the bank, which became 80% owned by the U.S. government, was bought by Bank of America in 1994, which of course has its own problems right now.

Other big bank failures back then include First Republic of Dallas (1988) and Bank of New England (1991). You may also remember that in 1990, Saudi investor Prince Alwaleed pumped hundreds of millions of dollars into Citibank (C, Fortune 500), (as he did again recently), to shore up that battered bank’s balance sheets. Alwaleed’s Wiki page notes, “his investments in Citibank earned him the title of “Saudi Warren Buffett,” though the past tense here seems most appropriate.

Even with all that historical pain. though, I would argue the situation is worse today. True we don’t have the plethora of failures as we did back in the day–though we still might. But last year’s Washington Mutual’s failure far and away topped Continental Illinois’s demise as the biggest in U.S. history and IndyMac now checks in as #3. And, of course, I think it is unassailable that Citi is in worse shape today with tens of billions of dollars of losses and tens of billions of dollars of government guarantees. Bank of America (BAC, Fortune 500) is in the deep soup too. Not a surprise then that the Keefe Bruyette Woods Bank Index (KBW) (which has 24 bank stocks) has fallen some 80% from its peak in February 2007. That’s huge! But it is also almost exactly the same decline financial stocks experienced in 1929 to 1933.

Bottom line is this: When the only benchmarks we have to compare the current situation with the banks are the 1930s and the savings and loan crisis, you know you are a really bad place.

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It Gets Worse

by Rex Nutting

The U.S. economy contracted violently in the fourth quarter, with gross domestic product falling at its fastest pace in more than 25 years, economists said ahead of what promises to be a grim week of economic news.
“Real economic activity fell off a cliff during the fourth quarter, producing a sharp drop in employment, output and spending,” wrote economists at Wachovia.
And the worst part is that it’s not over. Economists expect another huge decline in the first quarter, with a smaller contraction in the second quarter.
GDP is expected to have fallen at a 5.5% annualized rate in the final three months of last year, according to the median forecast of economists surveyed by MarketWatch. That would be the biggest decline since the 6.4% drop in early 1982 and one of the worst quarters in the post-World War II era.
The government will release its first estimate of fourth-quarter GDP on Friday, the culmination of a very busy week on the economic calendar. See Economic Calendar.
Other major releases will include durable-goods orders for December, home sales for December, and consumer confidence surveys for January.
In addition, economists will be watching the weekly jobless claims data for more clues about the health of the labor market. We could see first-time claims breach the 600,000 mark for the first time since the early 1980s.
None of the news in the coming week is expected to be positive.
The bad GDP story
Almost everything that could have gone wrong did after the credit crisis worsened in September.
More than 1.5 million jobs were destroyed in the quarter. Consumer spending fell again. Businesses put investment plans on hold. Home builders threw in the towel. Export markets dried up.
The only bright spot was the collapse in prices for oil and other commodities, a sudden reversal caused directly by the global slump. This has boosted consumers’ spending power, but has also slammed corporate profits.
“The weakness was very widespread, with every type of final expenditure falling,” wrote economist Michael Feroli of J.P. Morgan, who expects final sales to fall 5.9% annualized, which would be the third worst quarter since 1949.
According to Feroli’s estimates, consumer spending likely declined at a 3.6% annual pace, about the same as the 3.8% drop in the third quarter. Business investment probably declined at a 20% pace, while residential investment plunged at a 30% pace, the worst yet in this episode. He expects nonresidential construction to fall 2%, the first decline in about three years, with bigger drops to come. And net exports are expected to fall, a big turnaround from earlier in the year when exports kept the economy above water.
The only positive contributors to GDP are expected to be government spending and inventories.
Government spending is expected to surge in the coming quarters given the huge fiscal stimulus being promised by the Obama administration and Congress.
On the other hand, inventories are expected to be a drag on growth going forward. Companies have kept their inventories lean, but not lean enough.
“Given the rate at which sales are falling, that means that the inventory-to-sales ratio is rising sharply, and production will have to fall further in the first quarter to work off the excess supplies,” wrote Brian Bethune and Nigel Gault, economists for IHS Global Insight.
Every other time in the modern era that the U.S. economy has contracted more than 5% in a quarter, falling inventories have been a major reason, if not the single biggest factor. Usually, really bad recessions are worsened by the need for companies to get rid of all the stuff they made but nobody bought. Once the inventories are sold off, the economy can grow quickly again because idled workers are called back.
But so far in this recession, the inventory cycle hasn’t been a major factor, outside of the housing and auto sectors. That means that we can’t look forward to a quick reacceleration as the inventory cycle turns. This recession is rooted in a severe credit squeeze and a fundamental readjustment in consumer demand, not in the typical inventory cycle.
Policy to the rescue?
Most economists are cautiously optimistic about a modest recovery later this year. The turn in the inventory cycle is one reason, but a bigger cause for hope is the massive amount of work by the Federal Reserve and the government.
“Despite the current and expected near-term weakness, we caution against simply extrapolating. While momentum is currently downward, policy action has been stepped up dramatically, with more measures likely,” wrote Maury Harris and Jim O’Sullivan, economists for UBS, who were among the few economists who saw this coming.
The Federal Open Market Committee meets Tuesday and Wednesday to consider the impact of what they’ve done and what they’ll try next. Interest-rates are as low as they can go, so the FOMC will put its full attention on the nontraditional measures it’s employed to thaw out the credit markets.
The conventional wisdom is that nothing has worked, but that’s not really accurate. First off, governments in the developed world have made it clear that they won’t allow the financial system to fail, which has lessened the fear of a systemic collapse. If what they’ve tried so far doesn’t work, there are other things that can be done, including nationalization of the banks as a last resort.
There are signs of improvement already, especially in the short-term funding markets, where the Fed has concentrated its efforts lately. Credit spreads between government debt and the London interbank offered rate, commercial paper and mortgages are falling, although they certainly aren’t back to normal levels.
Yes, the days are cold and dark, but spring will come. It always does

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Roubini forecasts recession will last 2 years

By Rex Nutting

The U.S. recession will last two full years, with gross domestic product falling a cumulative 5%, said Nouriel Roubini, chairman of RGE Monitor. Roubini was one of the first economists to predict the recession and the credit crunch stemming from the housing bubble. For 2009, Roubini predicts GDP will fall 3.4%, with declines in every quarter of the year. The unemployment rate should peak at about 9% in early 2010, he said. Consumer prices will fall about 2% in 2009. Housing prices will probably overshoot, dropping 44% from the peak through mid-2010. “The U.S. economy cannot avoid a severe contraction that has already started and the policy response will have only a limited and delayed effect that will be felt more in 2010 than 2009,” he said.

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A Turning Point

by Henry Kissinger

As the new U.S. administration prepares to take office amid grave financial and international crises, it may seem counterintuitive to argue that the very unsettled nature of the international system generates a unique opportunity for creative diplomacy.

That opportunity involves a seeming contradiction. On one level, the financial collapse represents a major blow to the standing of the United States. While American political judgments have often proved controversial, the American prescription for a world financial order has generally been unchallenged. Now disillusionment with the United States’ management of it is widespread.

At the same time, the magnitude of the debacle makes it impossible for the rest of the world to shelter any longer behind American predominance or American failings.

Every country will have to reassess its own contribution to the prevailing crisis. Each will seek to make itself independent, to the greatest possible degree, of the conditions that produced the collapse; at the same time, each will be obliged to face the reality that its dilemmas can be mastered only by common action.

Even the most affluent countries will confront shrinking resources. Each will have to redefine its national priorities. An international order will emerge if a system of compatible priorities comes into being. It will fragment disastrously if the various priorities cannot be reconciled.

The nadir of the existing international financial system coincides with simultaneous political crises around the globe. Never have so many transformations occurred at the same time in so many different parts of the world and been made globally accessible via instantaneous communication. The alternative to a new international order is chaos.

The financial and political crises are, in fact, closely related partly because, during the period of economic exuberance, a gap had opened up between the economic and the political organization of the world.

The economic world has been globalized. Its institutions have a global reach and have operated by maxims that assumed a self-regulating global market.

The financial collapse exposed the mirage. It made evident the absence of global institutions to cushion the shock and to reverse the trend. Inevitably, when the affected publics turned to their national political institutions, these were driven principally by domestic politics, not considerations of world order.

Every major country has attempted to solve its immediate problems essentially on its own and to defer common action to a later, less crisis-driven point. So-called rescue packages have emerged on a piecemeal national basis, generally by substituting seemingly unlimited governmental credit for the domestic credit that produced the debacle in the first place – so far without more than stemming incipient panic.

International order will not come about either in the political or economic field until there emerge general rules toward which countries can orient themselves.

In the end, the political and economic systems can be harmonized in only one of two ways: by creating an international political regulatory system with the same reach as that of the economic world; or by shrinking the economic units to a size manageable by existing political structures, which is likely to lead to a new mercantilism, perhaps of regional units.

A new Bretton Woods-kind of global agreement is by far the preferable outcome. America’s role in this enterprise will be decisive. Paradoxically, American influence will be great in proportion to the modesty in our conduct; we need to modify the righteousness that has characterized too many American attitudes, especially since the collapse of the Soviet Union.

That seminal event and the subsequent period of nearly uninterrupted global growth induced too many to equate world order with the acceptance of American designs, including our domestic preferences.

The result was a certain inherent unilateralism – the standard complaint of European critics – or else an insistent kind of consultation by which nations were invited to prove their fitness to enter the international system by conforming to American prescriptions.

Not since the inauguration of President John F. Kennedy half a century ago has a new administration come into office with such a reservoir of expectations. It is unprecedented that all the principal actors on the world stage are avowing their desire to undertake the transformations imposed on them by the world crisis in collaboration with the United States.

The extraordinary impact of the president-elect on the imagination of humanity is an important element in shaping a new world order. But it defines an opportunity, not a policy.

The ultimate challenge is to shape the common concern of most countries and all major ones regarding the economic crisis, together with a common fear of jihadist terrorism, into a common strategy reinforced by the realization that the new issues like proliferation, energy and climate change permit no national or regional solution.

The new administration could make no worse mistake than to rest on its initial popularity. The cooperative mood of the moment needs to be channeled into a grand strategy going beyond the controversies of the recent past.

The charge of American unilateralism has some basis in fact; it also has become an alibi for a key European difference with America: that the United States still conducts itself as a national state capable of asking its people for sacrifices for the sake of the future, while Europe, suspended between abandoning its national framework and a yet-to-be-reached political substitute, finds it much harder to defer present benefits.

Hence its concentration on soft power. Most Atlantic controversies have been substantive and only marginally procedural; there would have been conflict no matter how intense the consultation. The Atlantic partnership will depend much more on common policies than agreed procedures.

The role of China in a new world order is equally crucial. A relationship that started on both sides as essentially a strategic design to constrain a common adversary has evolved over the decades into a pillar of the international system.

China made possible the American consumption splurge by buying American debt; America helped the modernization and reform of the Chinese economy by opening its markets to Chinese goods.

Both sides overestimated the durability of this arrangement. But while it lasted, it sustained unprecedented global growth. It mitigated as well the concerns over China’s role once China emerged in full force as a fellow superpower. A consensus had developed according to which adversarial relations between these pillars of the international system would destroy much that had been achieved and benefit no one. That conviction needs to be preserved and reinforced.

Each side of the Pacific needs the cooperation of the other in addressing the consequences of the financial crisis. Now that the global financial collapse has devastated Chinese export markets, China is emphasizing infrastructure development and domestic consumption.

It will not be easy to shift gears rapidly, and the Chinese growth rate may fall temporarily below the 7.5 percent that Chinese experts have always defined as the line that challenges political stability. America needs Chinese cooperation to address its current account imbalance and to prevent its exploding deficits from sparking a devastating inflation.

What kind of global economic order arises will depend importantly on how China and America deal with each other over the next few years. A frustrated China may take another look at an exclusive regional Asian structure, for which the nucleus already exists in the Asean-plus-three concept.

At the same time, if protectionism grows in America or if China comes to be seen as a long-term adversary, a self-fulfilling prophecy may blight the prospects of global order.

Such a return to mercantilism and 19th-century diplomacy would divide the world into competing regional units with dangerous long-term consequences.

The Sino-American relationship needs to be taken to a new level. The current crisis can be overcome only by developing a sense of common purpose. Such issues as proliferation of weapons of mass destruction, energy and the environment demand strengthened political ties between China and the United States.

This generation of leaders has the opportunity to shape trans-Pacific relations into a design for a common destiny, much as was done with trans-Atlantic relations in the immediate postwar period – except that the challenges now are more political and economic than military.

Such a vision must embrace as well such countries as Japan, Korea, India, Indonesia, Australia and New Zealand, whether as part of trans-Pacific structures or, in regional arrangements, dealing with special subjects as energy, proliferation and the environment.

The complexity of the emerging world requires from America a more historical approach than the insistence that every problem has a final solution expressible in programs with specific time limits not infrequently geared to our political process.

We must learn to operate within the attainable and be prepared to pursue ultimate ends by the accumulation of nuance.

An international order can be permanent only if its participants have a share not only in building but also in securing it. In this manner, America and its potential partners have a unique opportunity to transform a moment of crisis into a vision of hope.

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Another Bear Rally Down

by David Calloway

Everybody should have known the holidays would only delay it. The freight train of job cuts, plunging earnings and massive spending cutbacks set to hit the economy was, thankfully, pushed back a few weeks while stunned investors and workers across the globe caught their breath after the worst fourth quarter in decades.
But now the great dying has begun, and I’m not talking about German billionaires throwing themselves in front of trains or French aristocrats slitting their wrists, as alarming as these incidents have been. No, earnings season, the time for companies to ‘fess up just how bad it’s been for them in the last three months, is here.
The decline of 245 points, or almost 3%, was the first evidence of 2009 that we are about to finally arrive at that time when “the worst is yet to come.” A rally since late November in the markets gave hope that equity investors, a forward-looking indicator, may see the bottom for the economy in the first half of this year.
That may still be true, but we still have to get there. And the next few weeks of earnings warnings and then actual earnings, along with outlooks for the next three months, are expected to be littered with bad news. It’s not just layoffs and plant closings, which are bad enough on hard-working folks and the surrounding economy. And it’s not just bank failures, or collapsing investment banks and hedge funds.
Companies will start going completely out of business, including retail firms, biotech companies, and many, many mom-and-pops out there in everything from auto parts to bars and restaurants. Much of it will be tied to consumers pulling in their horns. They were willing to buy the Christmas tree or the holiday trip to grandma’s house. But now that we’re in January, getting more exercise is no longer on the top of the annual resolutions list.
Investors won’t be safe either, especially with time bombs like Wednesday’s fraud at India’s Satyam Computer Services
going off with alarming frequency, causing its shares to fall almost 80%. This is the time in the cycle where all the frauds come out — Enron, Worldcom, Madoff. They’re all exposed when the tide goes out.
You think Ken Lay isn’t chuckling on some cloud somewhere about all this? Is it a coincidence that Jeff Skilling was back in the news this week? Already somebody is calling Satyam India’s Enron. There will be more to come.
So what will signal the turning point? Could it come during the worst of earnings season? Perhaps. But I expect it will come afterward, and that it will be tied to oil prices.
The collapse of the oil bubble was stunning in its ferocity, equally if not more stunning than the rapid inflation of the bubble itself. Likewise, crude is now oversold and while it looks set to fall below $40 a barrel and maybe well into the 30s, investors will flock back to it at the first sign of an economic rebound. That will in turn spark energy stocks, and probably financial stocks, and we’ll be off to the races again.
Obama’s inauguration and the swift passage of his economic stimulus package will provide some gauze for the wounded markets, but there is still too much to work through to think the passing of the torch will be the catalyst.
In the meantime, financial advisers will continue to recommend the old saw that the best position for investors is indeed the fetal position, and asset managers sitting on cash and low-yielding bonds will be awaiting any sort of signal that the worst of the actual economic pain is over. When the economy does get ready to turn, the markets will react quickly.
But it isn’t there yet.

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