Mina Turner and her cousin Elizabeth in Waban, Massachusetts. 1910
Ilargi: The current and future US governments have been morphed into a tag-team. The Bush cabal feeds taxpayer dollars to the banks, while Obama takes care of the carmakers and roadbuilders. In times of crisis, it’s acceptable, nay, make that ‘necessary', 'conscionable', say the economy 'experts', to run a deficit. We'll pay it all off when manna starts raining down from heaven again. It's faith based economics. Any day now, any day now, I shall be released.
Finding out that the new AIG deal is nothing but a way to use public cash to pay off the gambling debts of US, Japanese and European big financials is not even a surprise anymore, low-life criminal as it may be. But really, Washington, the time is not far off when your choices are limited to two: courts of law or crowds carrying pitchforks.
And since the US legal system is utterly silent on the subject to date, with the exception of Andrew "Impotento" Cuomo, the day is rapidly drawing closer when there'll be fighting in the streets. I have no wish for it to happen, and would never even dream of propagating it, but unless you make sure those who break the law at the cost of trillions of dollars of public funds are prosecuted according to the law, you are inviting what history tells you cannot be avoided. And where did you say Obama is today?
When OPEC decided on its latest production cuts, I said they wouldn't hold. Even in times of plenty, compliance with cuts among members was no higher than about 50%, and it will be much less now. OPEC won't survive as a serious, functioning organization for much longer. Most members are today already in dire straits: they needed high prices, real high, and badly. Prices are now set to fall off a cliff.
When China announced its $600 billion stimulus package, markets were up for 24 hours. Then reality set in, and commodities lost their one-time 24-hour gain, and then some. Why did Beijing decide to go public with the plan, why didn’t it inject the money secretly? There's one answer only: because its domestic economic problems are far worse then we've known until now. It had to take that gamble, it had to show its hand. And it lost. Fair and square.
Investors have now recognized that if China can no longer keep up its growth numbers, while demand for oil and other commodities in the West plunges, then the commodities market is a very unattractive one. Moreover, just to make up for badly, very badly, needed and now lost revenue, oil producers will put on the market whatever and as much as they can, screw OPEC. That in turn will drive prices down further, and so on.
Russia today says it expects oil prices to go to $50 a barrel next year. Moscow knows that is very optimistic, but they must be afraid to contemplate lower prices. The ruble is under steamroller pressure, and it won't hold, no matter what Putin tries. There has been far too much capital flight from the country. The ruble will be devaluated, perhaps as soon as this week, or the entire economy risks collapse. The downside is that all savings will take a terrible hit. It's 1991 all over again for the population, and this time around the reaction may not be so peaceful. If you find this sort of thing hard to fathom, either in Russia or at home, there's this from yesterday:
”Russia is battening down the hatches for a deep slump. [..] Expecting trouble, the Kremlin has mobilised the police to crush dissent. "Anti-crisis groups have been set up in the regions to intercept any early indications of destabilisation," said President Dmitry Medvedev”
The Chinese leadership will watch events in Moscow unfold with great curiosity and attention. When the full strength of your over-leveraged economy depends on demand growth patterns in foreign countries, and you see those plummet, you don't need a Chinese Wailing Wall to see the writing. Whether you sell commodities, as Russia does, or finished products in the case of China, once you've bet double or nothing big-time and there's no more buyers at the door, you're in for ugly ugliness.
Domestic demand in both countries won’t make any difference, since it can't hold without foreign capital flowing in. China will never be a country of 1.3 billion people flipping each other’s burgers. The only reason the US could use that model was that other countries, China, Japan, in particular, injected $2 billion every single day by purchasing US Treasuries.
Those days are now over, and that allows us a peek into the future not just of China and Russia, but obviously also of the US: there's no funding for any of Obama's grand plans. He can't build infrastructure on an empty wallet and an empty stomach. Yeah, blah blah New Deal: it didn’t work till 1941, so please raise your hand if you want to volunteer for that next war.
All over the world, governments concoct plans to save their industries, and never is there an adequate answer to the question of who will buy the products the industries manufacture. No, not your own population, that doesn't work: there are foreign obligations to be paid, and for that you need exports. For all money and credit issued domestically, interest payments are due to the central banks, that's how the system works. And obviously, that interest can only be paid by exporting to, or conquering of, foreign lands. There's no such thing as economic self-sufficiency in the present system.
It's all religion, all over, everything depends on the belief that things will get better soon. But there are no signs of that happening. All governments hold on to it regardless, because the alternatives are too harsh to consider; they would pose major threats to the politicians’ powers. It'll all continue until it no longer can, and then it won't. The people in charge have a huge vested interest in trying to keep things as they are, so much so that they'll do so in the face of the worst odds, and the worst losses to the people they claim to represent.
It's in the genes of the beast. And you are the beast.
Russia lifts rates to 12% to save rouble as crisis deepens
Russia's central bank has raised interest rates a full percentage point to 12pc to prevent a collapse of the rouble following a day of mayhem on the Moscow markets, prompting concerns that the financial crisis may be spiralling out of control. The surprise move last night came after the authorities had spent $7bn of foreign reserves in a matter of hours trying to defend the currency, at a lower level. The central bank has now spent $84bn of its reserves over the last month.
"The devaluation has begun," said Lars Christensen, Russia strategist at Danske Bank. "The rouble has fallen out of its basket against the euro and the dollar. Russia is facing a serious confidence crisis and this could set off a self-fulfilling panic. What is clear is that economy is slowing drastically." Chris Weafer, strategist at UralSib, said there were echoes of the 1998 crisis. "If people lose confidence, we could have a massive run on the banks as we saw twice in the nineties: then the game is up," he told Bloomberg.
Russia is battening down the hatches for a deep slump. It has downgraded is oil forecast to $50 a barrel next year, a level that will play havoc with the state finances. Expecting trouble, the Kremlin has mobilised the police to crush dissent. "Anti-crisis groups have been set up in the regions to intercept any early indications of destabilisation," said President Dmitry Medvedev. "If anyone tries to exploit the financial crisis, the authorities should bring criminal charges. We don't want a return to the 1990s when everything was seething," he said.
Donald Jensen, an adviser to the US government, told a Russia Foundation meeting yesterday that the credit crunch posed a grave threat to the Kremlin. "This is pushing the Putin regime towards a crisis. Salaries are being held back and factories are being shut down in major cities. The regime cannot address all the demands that it is faced with," he said. The Moscow bourse was closed after the RTS index plunged 10pc, down over 70pc from its peak. Credit default swaps measuring bankruptcy risk on Russian debt jumped 150 basis points to 630 as foreign investors scrambled to hedge exposure.
"There is massive deleveraging going on in Russia on all fronts," said Luis Costa, an economist at Commerzbank. Mr Costa said the oil slide had led to an abrupt change in the fortunes of Russia, which relies on commodities for 80pc of its foreign earnings. "They are not going to have a current account surplus any longer. They could swing from plus 7pc of GDP to minus 2pc to 3pc next year, which is quite a reversal," he said.
Any devaluation is a political risk given fresh memories of the 1998 crisis, when many Russians lost their savings. The state-owned giant Sberbank has lost 2.5pc of its deposits over the last month, while smaller lenders have suffered a classic bank run. Fitch Ratings downgraded twelve banks yesterday, warning of an "increased likelihood of a deterioration in the government's ability to provide support".
Russia still has the world's third biggest foreign reserves, but these have shrunk from $598bn to under $480bn due to capital flight since the Georgia war in August. Crucially, Russia's banks, oil producers, miners, and steel companies have amassed $510bn of foreign debt, mostly in short-term loans.
Kingsmill Bond, from Russia's investment bank Troika Dialog, said the Kremlin has committed $280bn to shore up these companies. While it still has some firepower left, it cannot weather a long slump in oil prices. If crude drops to around $50 a barrel, and stays there, the combined losses on Russia's current and capital accounts will reach $110bn a year. "We estimate that the rouble could drop by around 30pc", he said.
Russian Finance Minister Sees Oil Price Averaging $50 a Barrel in 2009
Russian Finance Minister Alexei Kudrin said oil prices next year will probably average $50 a barrel as the global economic decline curbs demand for the nation's biggest export product. ``This is significantly less than what is included in the budget,'' Kudrin told lawmakers in comments shown by state broadcaster Veesti-24. ``This will in no way affect the execution of the budget -- it will be implemented,''
Kudrin said that the $135 billion Reserve Fund, earmarked for protecting the budget when oil prices drop, would be tapped to cover the possible shortfall in revenue. Next year's budget is based on a forecast of $95 per barrel. The threat to revenue comes after Prime Minister Vladimir Putin's government pledged to spend more than $200 billion to stem the worst financial crisis since 1998.
The central bank sold about 20 percent of its currency reserves, the world's third largest, since the start of August to stem a 17 percent slide in the ruble as investors pulled cash from the country in a flight to safety. The budget surplus amounted to 8.1 percent of gross domestic product, or 2.53 trillion rubles ($100 billion) in the first nine months and Kudrin said the budget will stay out of deficit at $70 per barrel.
The average price for Russia's Urals blend of crude oil will probably rise to $55 a barrel in 2010 and $60 a barrel in 2011, Kudrin told lawmakers in the upper house of parliament today. For the years beyond 2011, the government is keeping its forecast of a $65-70 per barrel average through 2023.
New AIG Rescue Designed to Pay Banks’ Gambling Debts
Banks in the U.S. and abroad are among the biggest winners in the federal government's revamped $150 billion bailout of American International Group Inc. Many banks that previously bought protection from the insurer on securities backed by now-troubled mortgage assets stand to recoup the bulk of their investments under a plan by AIG and the Federal Reserve Bank of New York to buy around $70 billion of those securities via a new company. These securities are collateralized debt obligations backed by subprime-mortgage bonds, commercial-mortgage loans and other assets.
Banks in the U.S., Europe and Canada bought credit-default swaps on these securities from AIG, which in turn promised to compensate them if the securities defaulted. Defaults haven't been a major problem, but the market values of these CDOs fell sharply over the past year or so. That enabled the banks to pry roughly $35 billion in collateral from AIG as a result of those declines and downgrades in AIG's own credit ratings. The banks that have sought and received collateral from AIG include Goldman Sachs Group Inc., Merrill Lynch & Co., UBS AG, Deutsche Bank AG and others.
Throughout its AIG rescue efforts during the past two months, the government has had the banks in its sights; it made its initial bailout of AIG in part to avoid potential bank losses that might have threatened the broader financial system. Under the plan announced Monday, the banks will get to keep the collateral they received from AIG, much of which came when the government made funds available to AIG in September. The banks also will sell the CDOs to the new facility at market prices averaging 50 cents on the dollar. The banks that participate will be compensated for the securities' full, or par, value in exchange for allowing AIG to unwind the credit-default swaps it wrote.
"It's like a home run for some of the banks," says Carlos Mendez, a senior managing director at ICP Capital, a fixed-income investment firm in New York. "They bought insurance from a company that ran into trouble and still managed to get all, or most, of their money back." The contract cancellations will free the insurer from additional collateral calls on those swaps, which also have been responsible for billions of dollars in write-downs that AIG has logged in recent quarters. The plan is analogous to an insurer buying a house it provided fire insurance on, negating the need for an insurance policy on the home.
A person familiar with the government's rescue plan says it wasn't specifically designed to benefit individual banks at the expense of U.S. taxpayers and AIG, which will end up bearing the risk of the CDOs. However, officials wanted to give banks sufficient incentives to sell the securities so that AIG could cancel the swaps. Officials also wanted to directly address the parts of AIG's business that were causing the most financial pain to the company. "The continuing deterioration in value of the CDOs ... meant that AIG had to post more and more collateral each day, which was a drain on their resources and potentially a threat to their solvency," says Leslie Rahl, president of Capital Market Risk Advisors, a risk consultancy in New York.
In an interview this week, AIG Chief Executive Edward Liddy said the revised rescue plan "ring-fenced" key problems, including the swaps. It also helps keep these problems from affecting AIG's other businesses, while giving the company more breathing room to sell assets to pay back a large loan from the Fed that is central to the bailout. The New York Fed will provide as much as $30 billion to buy the multisector CDOs, and AIG will contribute $5 billion. AIG also will bear the risk for the first $5 billion of losses among the securities purchased. If the assets increase in value or pay off over time, the Fed and AIG will share the benefits, with most of the upside going to taxpayers.
The Fed is leading the negotiations, and most of AIG's counterparties have been contacted. If some banks choose not to cancel the swap contracts, they would still bear the risk that AIG mightn't be able to meet its obligations down the road. But most of AIG's swap counterparties on the multisector CDOs are expected to sell their securities to the new facility and cancel the credit-default-swap contracts.
Even with this deal, AIG will still bear considerable risk under its CDS portfolio, because it continues to hold contracts that protect about $300 billion in securities backed by other types of assets, such as corporate loans. The swaps on the multisector CDOs, however, had been responsible for most of the $40 billion in collateral that AIG had posted on all its swaps through Nov. 5.
S&P warns of a debt financing crisis in Europe
For those of us who want to believe we nearing the bottom of this crisis, a report fromStandard & Poor's today offers a nasty reminder why there are many more violent pulses to come. Entitled "Gaping Refunding Pipeline in Europe", it warns that $2.1 trillion of debt is coming due in Western Europe and Britain over the next three years. As you can see from the chart below, a big chunk has to be repaid over the next twelve months (front-loaded as they say in City jargon).
Given that the credit markets are still dysfunctional in Europe (worse than America, where some junk bonds are at least being issued) this will be very expensive to roll over at best. The average borrowing cost has jumped 225 basis points since August 2007 - for those who can borrow at all. "Given the soaring cost of capital, the sizable pipeline of debt coming due suggests substantial refinancing risk," said the report. In Chart 2, you can see which countries are on the hook.
Germany leads the pack, with $696bn (or 40pc of the total). But Sweden and the Netherlands have an even bigger load debt, given with the size of their economies. Banks and financial institutions account for 72pc of the debt coming due. Other companies have $586bn of debts, and that is where real trouble is going to hit. They must repay 41pc ($243bn) by the end of next year.
The roll-over crunch is going test Europe's bank rescues. What one hears from hedge fund central in Mayfair is that some sovereign states will have their guarantees subjected to an ordeal by fire. Ireland, Belgium, Austria, and Greece keep cropping up at dinners, but Britain is not safe by any means. My view - as readers know - is that the European Central Bank, the Bank of England, and the Riksbank were too slow to see the danger of this crisis. Although the Bank of England is catching up fast.
These central banks latched on the 1970s inflation parallel, mistaking the oil and food spike this year for the onset of systemic inflation when the greater danger was and is debt deflation. Note that the Bank of Japan made the same error in late 1990 when it raised rates to 6pc during the mini-spike in Asian inflation. By then the Nikkei bubble had already popped - and you know the rest of the story. That belated tightening caused havoc to the Japanese system.
It is also now clear that ECB - which denied for months until Hypo Real, Fortis, Dexia, et all collapsed in September that there was any credit crunch in Europe - were not aware that their own banks were more leveraged than US banks - and far more exposed to emerging market bubbles ($3.5 trillion in total, on BIS data). Had Europe's central bankers paid more attention to the entire global system - with all its moving parts - instead of the narrow data that forms their parochial routine, they might have avoided these pitfalls.
The damage is now done. It takes eighteen months or so for the monetary policy to feed through, so the latest rate cuts will not come in time to prevent a truly dreadful recession in Britain and Europe. I have no doubt that the tsunami of bankruptcies and job losses that we are about to see could have been avoided to a great extent.
It was central banks who created the great debt bubble in the first place by setting the price of credit too low, for too long. They then swung to the other extreme in an botched attempt to undue the damage that they had themselves caused, merely making matters worse. By all means let us punish the investment bankers who pimped for the industry of structured credit, but let's never forget the role that central banks/governments have played in this
TARP's $700 Billion Not Enough to Meet 'Phenomenal' Spending
The U.S. Treasury's $700 billion Troubled Asset Relief Program will have to be increased to meet the `phenomenal' demand for government bailouts, according to Deutsche Bank AG strategist Jim Reid. The extra $150 billion pledged to support insurer American International Group Inc. this week and the prospect of a financial package to rescue General Motors Corp., the largest U.S. automaker, from bankruptcy may drain the TARP fund, Reid wrote in a note to investors today.
"It does feel that the $700 billion TARP fund is going to have to be increased at some point in the not-too-distant future," wrote Reid, head of fundamental credit strategy at Deutsche Bank in London. Either that, "or another acronym will have to be formulated to deal with the phenomenal amount of government spending that's still likely as this crisis escalates."
Treasury Secretary Henry Paulson's TARP fund was created to help shore-up banks' balance sheets by buying toxic mortgage- linked securities. Neel Kashkari, who heads the program, said last week the government is open to all options in expanding the use of the funds. Political pressure for a bailout of GM is mounting with House Speaker Nancy Pelosi throwing her support behind the premise the automaker is too big to be allowed to fail. Bankruptcy would trigger a "devastating" domino effect that would cost millions of jobs, she said.
"Basically it appears to be bailout or bankruptcy," Reid wrote in his note. "The exact outcome is near impossible to predict with any certainty as it's now highly political." U.S. sales of GM, Ford Motor Co., and Chrysler, now owned by Cerberus Capital Management, are headed toward a 17-year low, overwhelming cost-cutting efforts including elimination of 46,000 U.S. jobs at GM since 2004, when the company last posted an annual profit.
Treasury Considers Private Capital Role in TARP
The Treasury Department, signaling a new phase in its $700 billion financial-rescue plan, is considering requiring that firms seeking future government money raise private capital in order to qualify for public assistance, according to people familiar with the matter. The move is not expected to apply to the existing $250 billion capital-purchase program, which is already injecting money into banks. But Treasury is considering attaching such conditions to any of its future capital investments, these people said.
At the same time, Treasury is unlikely to conduct any auctions to purchase bad loans and other troubled assets -- the original intention of the $700 billion rescue plan. Instead, Treasury is expected to continue focusing its firepower on injecting capital directly into the financial sector, these people said. Treasury Secretary Henry Paulson may outline some of these changes Wednesday, when he provides an update on Treasury's Troubled Asset Relief Program, known as TARP. Treasury has just $60 billion left in its rescue fund, and either the current or next administration will have to turn to Congress to request the second half of the promised $700 billion.
Treasury has so far committed $250 billion to banks and is spending an additional $40 billion to buy preferred shares in American International Group Inc., the big insurer. Treasury is expected to widen its program to inject capital into smaller, closely held banks, and is considering expanding its rescue to other nonbank financial institutions, such as insurers and specialty-finance companies. It may also do another round of financing for publicly traded banks. In addition, Treasury is under increasing pressure from Democrats in Congress to open the program to the ailing auto sector.
In another step, U.S. bank regulators could announce guidelines this week designed to encourage U.S. banks to remain active lenders as financial markets are squeezed. Many U.S. companies and individuals have become dependent on bank credit lines as financial markets have tightened up. The regulatory guidelines could also address sensitive issues of bank dividend payments and executive pay.
The fact that Treasury may now require firms to raise money marks a new phase for the government, which had resisted such a move previously. Before launching its $250 billion capital-purchase program last month, Treasury toyed with requiring banks to raise matching funds alongside any government investment, but it thought that might discourage some firms from participating. It also worried that firms would not be able to raise private money in the current market environment.
Instead, Treasury structured its investment in a way that it believed would encourage firms to eventually raise private funds. But Treasury officials now think market conditions may have improved enough that companies could raise private capital. Some economists advocate requiring companies to raise matching funds, saying it lessens the government's ability to pick winners and losers. "This idea has the great virtue of incorporating private-sector judgment on the viability and management of these financial firms," said Douglas Elmendorf, a senior fellow with the Brookings Institution and a member of President-elect Barack Obama's transition team.
The World Bank unveiled such an initiative on Tuesday for developing-country banks, in which it will put in $1 for every $2 the banks raise from others. Initially, in late September, Mr. Paulson asked Congress for authority to purchase $700 billion worth of distressed assets, arguing that banks and other institutions were suffering from the rotten assets clogging their balance sheets.
Figuring out how to purchase assets has proved tricky, in large part because it's difficult to determine how to price such assets, many of which are backed by risky mortgages and carry depressed values. Buying them at market prices would further hurt banks, since the firms would have to write down the value of those assets. But paying above-market prices could potentially hurt taxpayers if the assets never recover in price. Treasury has no current plans to purchase assets, people familiar with the matter said, and is instead focused on investing directly in firms that provide financing to the broader economy.
On Monday, Treasury and Federal Reserve officials held a phone briefing with Capitol Hill staffers about the government's revised rescue of AIG. While Treasury will buy $40 billion in preferred AIG stock, the Fed will use $50 billion to purchase distressed assets from the company. On the call, Hill staffers asked why the Fed was buying the assets instead of Treasury. Fed staffers said the structure will help insulate taxpayers, according to someone familiar with the call. Still, some lawmakers are eager to see Treasury focus exclusively on capital injections, rather than asset purchases. "The more you look at auctions or asset purchases, the more you have the same problem: How do you set the price?" said Sen. Charles Schumer (D., N.Y.).
Vindication: Treasury Admits TARP Critics Were Right!
When the Treasury Department first unveiled its plan to buy troubled assets from banks in September, the move was heralded by self-styled experts as a potential savior for fast-sinking banks and financial firms. Critics were characterized as ideological indignants who didn't understand the urgency of ridding bank balance sheets of toxic assets. Now the Treasury has admitted the critics were right all along.
Congressional oppoenents of the the bailout were more or less mocked for proposing alternate plans. More than once supporters of the Troubled Assets Relief Program emphasized that banks weren’t lending to each other because of the toxic assets on their balance sheet. Critics argued that there was no good way to price the assets, that the Treasury would probably overpay in an effort to secretly recapitalize banks and that it would be better to openly recapitalize them if that's what was necessary. And now the Treasury is admitting it was wrong, the critics were right and the TARP won't be used.
"Treasury has no current plans to purchase assets, people familiar with the matter said, and is instead focused on investing directly in firms that provide financing to the broader economy," the Wall Street Journal reports this morning. That news will come as a relief to critics, including Clusterstock, who argued all along that the plan to buy troubled assets was badly flawed.
But it also comes as a warning about trusting the so-called experts and the dangers of the fear and loathing tactics they employed. Critics were lambasted as irresponsible, and the experts in the government and media warned that a depression was on the way unless they the goverment bought toxic assets. But that doctrinaire approach was dead wrong, and had no basis either in economic theory or history.
The criticism of the TARP, far from being irresponsible, was exactly right and may have even convinced the government to abandon it. That's a market for ideas in action. Don't waste too much time waiting for an apology to the dissenters. The TARP supporters have already forgotten how wrong they were. The critics will just have to be satisified with the knowledge that they were right.
Democrats Plot Detroit Rescue
Democratic leaders in Congress said Tuesday they will push legislation next week to use the $700 billion Wall Street rescue fund to bail out Detroit auto makers, and President-elect Barack Obama ordered his transition team to look at ways to aid the car industry even before his inauguration. The moves come as General Motors Corp. has warned that it could face a debilitating cash shortage by year's end. On Tuesday, GM stock fell an additional 13%. The Bush administration has balked at expanding the bailout to the stricken auto makers, saying it doesn't have specific authority from Congress to do that.
In response, House Speaker Nancy Pelosi on Tuesday called for a bill giving auto makers limited access to funds from the Troubled Asset Relief Program, or TARP, which was initially set up to rescue foundering banks and Wall Street brokerages. Mr. Obama, after some initial hesitation to become publicly involved, is pressing the Bush administration to immediately free up funding through the Treasury, the Energy Department and the Federal Reserve. It is also studying other options, including installing new board members at car companies that receive assistance to ensure compliance with the strings attached to a bailout, including the adoption of a more advanced, fuel-efficient product line.
For Mr. Obama, the crisis in Detroit is turning into an early test of his leadership. Organized labor, including the United Auto Workers, invested heavily in Mr. Obama's campaign. It's a situation Mr. Obama's team had hoped to avoid, potentially giving the president-elect responsibility for an emergency before he has any real authority to deal with it. But with President Bush's clout waning, many parties are now looking to Sen. Obama -- a circumstance not seen since the interregnum between Herbert Hoover's presidency and Franklin Delano Roosevelt's in the early 1930s.
The White House didn't close the door entirely to using the TARP funds this way -- suggesting it could eventually happen. "It's hard to see how TARP funds could be made available" under the current structure of the bailout fund, said White House spokesman Tony Fratto. But "if Congress wants to change the law, we'll see how they intend to do it." To forestall a voter backlash, Obama aides and Ms. Pelosi separately made clear they intend to impose significant conditions on federal aid. Auto makers would have to offer the government equity stakes or warrants, one Obama adviser said, and would have to accept the same rules on executive compensation that financial-service companies have swallowed with the Wall Street rescue.
Auto makers receiving aid would also have to agree to strict rules aimed at building "green and clean" automobiles, one Obama adviser said. Obama advisers are also examining union work rules that could be put on the bargaining table, although Obama advisers were reluctant to insist the UAW make any more concessions on health care or retiree benefits.
All three Detroit auto makers have lobbied for government loans, saying the turmoil in the financial markets has choked off their access to capital to finance new models, consumer loans and other needs. GM faces the most acute money crunch. Obama aides say they are pressing on three issues: accelerating access to $25 billion in Energy Department loans meant to help Detroit develop more fuel-efficient cars; access to the $700 billion Wall Street bailout fund; and emergency loans from the Federal Reserve.
The president-elect doesn't want to take office Jan. 20 with the auto industry -- long the backbone of the nation's industry -- in a shambles, according to aides. "He wants to prevent a situation like Lehman, where you flail yourself into an uncontrolled bankruptcy," a senior Obama aide said Tuesday, referring to the sudden and damaging collapse of Lehman Brothers Holdings Inc. "This can't wait until Jan. 20." Dan Tarullo, a Georgetown University law professor and a top Obama adviser on trade, has been appointed to lead the auto-company transition efforts, according to Rep. Sander Levin (D., Mich.), a key lawmaker involved. Obama aides said Mr. Tarullo is one of a number of advisers assigned to the issue. Michigan Gov. Jennifer Granholm and former Michigan Rep. David Bonior have been given prominent seats at the table.
Mrs. Pelosi said House Financial Services Chairman Barney Frank (D., Mass.) will lead efforts to craft a bill to help the auto makers, working with House and Senate leaders and the administration. A Frank spokesman, Steve Adamske, said a tentative proposal could be ready by week's end. In the Senate, Maryland Democrat Barbara Mikulski is already pushing a proposal not only to help the auto makers directly but also to boost consumer demand for new autos, by making interest on car loans tax deductible. In an interview, the senator said the proposal, which will be unveiled Wednesday, would help manufacturers as well as dealers, and would be temporary. "I have a real sense of urgency for this," Sen. Mikulski said. "The cost of doing nothing would be horrendous."
Senate Republicans -- who have the votes to block any action -- have had big concerns with the spending-focused stimulus plans pushed by Democrats. But the auto issue cuts differently across the chamber, and could attract some Republican support if Democrats show restraint on the stimulus. Republican Sen. Mitch McConnell, the minority leader, has been generally supportive of the industry. His state of Kentucky is home to large auto factories run by Ford Motor Co., GM and Toyota Motor Corp. Ahead of the election, the senator sent a letter to the administration urging more rapid action on $25 billion in loans previously approved by Congress to help the industry retool.
A Republican leadership aide said Tuesday "it's hard to say" what will happen in the Senate next week on autos and the broader economic issues before Congress. The Treasury has already committed all but $60 billion of the first $350 billion installment of the Wall Street bailout funds. A Treasury push for the next tranche of funding should empower Democrats in Congress to demand its extension to the auto industry.
The legislative fate of a Detroit rescue could hinge on whether Democrats are willing to divorce it from their push for a big economic stimulus package. Democratic congressional leaders and the White House have been at an impasse for weeks on economic stimulus. Democrats want new spending on things like roads and bridges, which they contend will create jobs. Mr. Bush and congressional Republicans have strongly opposed those plans, which they contend won't help the economy. Instead, Mr. Bush is pushing for passage of the free-trade agreement with Colombia. He raised the idea Monday with Mr. Obama, although White House officials and Obama aides said Tuesday the suggestion wasn't put forward as part of a possible legislative compromise on economic issues.
"In no way did President Bush suggest that there was a quid pro quo," said Bush spokeswoman Dana Perino, noting the president's long support for Colombia and other trade deals. "He believes that they can and should pass on their own merits."
For Mr. Obama, a public intervention on behalf of Detroit puts his political capital at stake on behalf of companies that have lost the confidence of investors and many consumers -- reflected in the reluctance of banks to lend to the companies and their continuing loss of market share.
General Motors is hemorrhaging money so rapidly that its Chief Executive Officer Rick Wagoner warned this week that a rescue couldn't wait for Mr. Obama's swearing-in. Ford is also in a dire position, although that company's management said last week that they didn't face a near term crisis. The Detroit auto makers have been slammed by the recent credit-market crisis. But they went into that crisis weakened by mistakes of their own doing. The Detroit Three depended for more than a decade on profits from gas-guzzling sport-utility vehicles and pumped up sales with cheap credit, while rivals Toyota and Honda Motor Co. more aggressively pursued advanced technology vehicles and business strategies that allowed them to make money on a broader range of models.
Detroit's auto makers and the United Auto Workers have stuck by work rules that have hamstrung the companies, such as job banks that continue to pay workers who lost jobs due to automation or plant restructurings. But Democrats now face a worst-case scenario in which as many as three million jobs in and connected to the auto industry -- most of them unionized and concentrated in the politically pivotal Upper Midwest -- could be in jeopardy if the Detroit Three collapse.
UAW officials so far have told the Obama team that they don't believe they have to make concessions when it was management that got the companies into this situation. UAW chief lobbyist Alan Reuther said the latest UAW contract shifted health care and retirement burdens from the companies to the unions and created a two-tier wage structure. But the UAW ultimately may have to agree to further concessions to avoid deeper losses should one of the companies opt to restructure unmanageable debts in bankruptcy court.
No. 2 US mall operator warns of bankruptcy, shares plunge 66%
General Growth Properties Inc., the No. 2 mall operator in the United States, has warned that an ongoing slump in retail sales, combined with the credit market lockdown, has pushed the company to the brink of bankruptcy. Chicago-based General Growth Properties said in an SEC filing late Monday that it has $900 million of property secured debt and $58 million of corporate debt coming up for renewal by Dec. 1. It also faces another $3.07 billion in debt that matures in 2009.
But "given the continued weakness of the retail and credit markets," the mall operator fears it may not be able to refinance its loans at lower rates to meet its short-term cash needs. Shares of General Growth Properties (GGP) tumbled 66% to 46 cents on Tuesday. General Growth announced in August that it might sell some assets to raise capital for servicing its debt. The company operates more than 200 malls -- including the Paramus Park Mall in New Jersey, Cumberland Mall in Atlanta, Water Tower Place in Chicago and the Glendale Galleria in California -- in 44 states.
"Our potential inability to address our 2008 or 2009 debt maturities in a satisfactory fashion raises substantial doubts as to our ability to continue as a going concern," the company said in the filing. Retail real estate experts say other large mall operators could find themselves in the same situation as General Growth. Several of them have significant debt coming up for renewal at the end of 2008 and early 2009. Given the tight credit environment and dismal forecasts for retail sales in the fourth quarter, analysts said lenders probably won't refinance those loans at lower rates.
If General Growth does file for bankruptcy, the company's real estate portfolio could be broken up and its malls acquired by other mall operators, said Ivan Friedman, president & CEO of RCS Retail Real Estate Advisors. "General Growth has some very valuable properties," he said. Although Friedman said it's extremely rare for a mall to be shut down, Friedman did warn that falling store occupancies pose a real challenge to mall operators. A worsening economy has forced more Americans to clamp down on their shopping habits. Subsequently, a pronounced slump in retail sales has forced many chain stores to exit malls.
Store vacancies at regional malls are up 6.6%, the largest increase since early 2002, according to real estate research firm Reis. In some malls, store occupancy rates are falling below 75%. "You can keep a mall open with 60-70% [store] occupancy," Friedman said. "But if it falls to below 40%, then the weakest malls could be forced to close." "We are in a real retail tsunami right now," Friedman said.
Ilargi: I don’t always agree with what Willem Buiter writes. And I don't need vindication either for what I have already said about Obama's defunct-from-the-get-go economic team. Still, It's good to see that I'm not alone in saying it. Besides me, Buiter is the first writer I’ve seen making these points.
No change, no hope: Obama’s Transition Economic Advisory Board
I’m afraid this post is going to be rather boring (the comment “What’s new?” is taken as made). I intend to take you on a trip through Barack Obama’s Transition Economic Advisory Board.
It members are:
- DAVID E. BONIOR, a former Democratic Congressman from Michigan and John Edwards’s campaign manager. Has been active in union advocacy. He is now a professor of labour studies at Wayne State University. He opposes NAFTA and abortion. He has a BA and MA, but I cannot find out in what subject(s). He is 63 years old.
- WARREN E. BUFFETT, the billionaire investor and chairman of Berkshire Hathaway; he has a BS and MS in Economics. He is 78 years old.
- ROEL C. CAMPOS, a lawyer and former member of the Securities and Exchange Commission under appointed by Bush Jr. He is 58 or 59 years old.
- WILLIAM H. DALEY, a senior executive at JP Morgan Chase, former Commerce Secretary under Clinton and chairman of Al Gore’s presidential campaign. He is a lawyer. He is 60 years old.
- WILLIAM H. DONALDSON, a former Chairman of the S.E.C. As Chairman, Mr. Donaldson presided over the meeting at the SEC on April 28, 2004, held at the request of the major Wall Street investment banks. These requested that the SEC release them from the so-called “net capital rule” - the requirement that they hold capital reserves in their brokerage units. The request was granted, and leverage in the investment banks exploded. He is a CFA. He is 77 years old.
- ROGER W. FERGUSON Jr., Chief Executive of TIAA-CREF, former vice chairman of the Federal Reserve, with special responsibility for regulatory issues. He is an economist. He is 57 years old.
- JENNIFER M. GRANHOLM, Governor of Michigan. She is a protectionist (’Fair Trade’ fan) and a lawyer. She is 49 years old.
- ANNE M. MULCAHY, Chairwoman and Chief Executive of Xerox. She has a degree in English and journalism. She is 56 years old.
- RICHARD D. PARSONS, Chairman of Time Warner; he is a former banker and a lawyer. He is 60 years old.
- PENNY S. PRITZKER, Senior executive, Hyatt; she was national finance chairwoman for the Obama campaign. She has a BA in Economics and a JD/MBA. She is 59 years old.
- ROBERT B. REICH, Author, academic and former Labor Secretary under Clinton. He is a lawyer. He is 62 years old.
- ROBERT E. RUBIN, Chairman of Citigroup and former Treasury Secretary under Clinton. He is a lawyer. He is 70 years old.
- ERIC E. SCHMIDT, Chairman and chief executive, Google. He has a degree in Electrical Engineering and Computer Sciences. He is 53 years old.
- LAWRENCE H. SUMMERS, Academic and former Treasury Secretary under Clinton. He is an economist. He is 53 years old.
- LAURA D’ANDREA TYSON, Academic and former chairwoman of the President’s Council of Economic Advisors and of the National Economic Council under Clinton. She is an economist. She is 61 years old.
- ANTONIO R. VILLARAIGOSA, Mayor of Los Angeles and former union organiser. He failed the California Bar exam four times. He is 55 years old.
- PAUL A. VOLCKER, former chairman of the Federal Reserve under Carter and Reagan. He is an economist. He is 81 years old.
A few features of this list jump out at the reader:
They’re old! The mean age is 61.9 years and the median is 60. Old age is good. I plan to enjoy it extensively and expect to be listened to respectfully by young whippersnappers. But even so… The youngest member is 49 years old. Were there no persons in their early 40s, their 30s or their late 20s who could brighten up this sexagenarian coterie?
Too few serious economists! There are far too few members with an serious background in economics, capable of grasping the complexities of the financial crisis, budgetary policy, monetary policy, international trade and global financial issues, tax reform, prioritising infrastructure spending, the economics of education, health insurance, health care, education and the environment. Experience running a business is of no help when it comes to preparing for and planning broad structural economic reforms.
Most of this Transition Economic Advisory Board appears completely out of its depth - dead wood at best - a ball and chain at worst. I count only four of the 17 members as card-carrying, qualified economists – Roger Ferguson, Larry Summers, Laura Tyson and Paul Volcker. Where are Austan Goolsbee, Jason Furman and Peter Orszag? Where are Jo Stiglitz and Paul Krugman? If they are otherwise engaged, there are dozens of intelligent, wise and politically savvy younger economists who could play a useful role in the presidential transition process.
Far too many lawyers! I count eight of them. America is held back and at times almost suffocated by an overgrown legal infrastructure and an overweening legal profession, much in the same way that the UK was held back and almost suffocated by organised labour during the last years before Margaret Thatcher came to power. Lest I be the target of a class action suit by the US legal profession, let me state here that (a) some of my best friends are (or were) lawyers and that (b) a limited quantum of lawyers is necessary to support the essential infrastructure of the rule of law.
Unfortunately, in the US, the legal profession has grown to an astonishing size and has become a veritable succubus preying on the body politic and on the economic resource base of the country - the ultimate rent-seeking, wealth destroying profession. According to Legal Reform Now! there are 1,143,358 lawyers in the US, one for every 200 adults. The main problem is not that there are over a million socially unproductive lawyers in the US. The problem is that these lawyers are an essential component of a dysfunctional legal framework that has created the most litigious society in the world.
The damage this dysfunctional legal framework causes must be measured not primarily by the direct cost of litigation, astounding though it is, but through the actions not undertaken and the creative and productive deeds not done because of fear of litigation. The first thing we do… Except for a depressingly small minority among them, lawyers know nothing. They are incapable of logic. They don’t know the difference between necessary and sufficient conditions or between type I and type II errors. Indeed, any concept of probability is alien to them.
They don’t understand the concepts of opportunity cost and trade off. They cannot distinguish between normative and positive statements. They are so focused on winning an argument through technicalities, that they no longer would recognise the truth if it bit them in the butt. If you are very lucky, a lawyer will give you nothing but the truth. You will never get the truth, let alone the whole truth. Things have degenerated to the point that lawyers and the legal profession not only routinely undermine justice, but even the law.
But the American political system is completely dominated by this largely socially unproductive and parasitic profession. Consider the membership of the House and the Senate (according to the Congressional Research Service 170 members of the House (out of 435) and 60 Senators (out of 100) are lawyers). Consider the professional training and background of past and future presidents (including Obama, 26 out of 44 presidents were lawyers) - and weep.
They are protectionist! David Bonior, Jennifer M. Granholm (both Michigan politicians), Antonio Villaraigosa and Robert Reich are all ‘fair traders’, that is, rabid protectionists. Laura Tyson has long been a crypto-protectionist and Larry Summers has stepped repeatedly over the boundary between legitimate critiques of certain extravagant claims concerning the joys of globalisation and simple trade protectionism.
They are the unalluring faces of past failures! Roel Campos and William Donaldson served on the SEC when this organisation aided and abetted the excesses of the investment banks that contributed so much to the financial and economic crisis now facing us. Robert Rubin has been a life-long leading light in the banking system that has just imploded and is dragging the real economy with it. William Daley is Robert Rubin lite. Both Rubin and Summers were deeply involved in the Clinton era bail-outs in emerging markets. Both exhibited the characteristic myopia and inability to make credible commitments that turned many of these bail-outs into moral hazard incubators.
Larry Summers in particular has never seen a bail-out he did not like and never one so large that he did not want to boost its size further. He will have a field day in the current crisis. The one beacon of hope in this fog of mediocrity is Paul Volcker, a truly great man with more character, intelligence and vision than the rest of the Board put together. But can he, on his own, salvage this wreck in the making? I hope so, but I doubt it.
To summarize: the members of Obama’s Transition Economic Advisory Board are too old, too uninspiring and too much part of the problem to deliver the change America needs and to keep alive the hope that Obama may have inspired through his election. A wasted opportunity.
Bank holding company status: Don't leave home without it
American Express said it won approval to become a bank holding company, in a step that could cut its borrowing costs and give it more access to government money. American Express, the fourth-largest U.S. credit card issuer, offered more credit to more customers even as the housing crisis began last year, and is paying the price as delinquencies rise. Adding to its difficulties, its main sources of funding have grown more expensive as secured and unsecured bond markets have shut down.
Investors are wondering whether financial companies that loan money but fund themselves mainly in the bond markets are a thing of the past. Goldman Sachs and Morgan Stanley both became banks in September. With American Express winning U.S. Federal Reserve approval to convert to a bank holding company, it can issue bonds that are government guaranteed through the end of June 2012.
The company can also apply to receive money under the U.S. Treasury’s $700 billion Troubled Assets Relief Program, which is making direct investments in banks, insurers and possibly other financial companies. Analyst Moshe Orenbuch at Credit Suisse estimates that American Express would be eligible for several billion dollars of capital under the program. The company will also find it easier to buy banks now, and take deposits from consumers and companies, which can be a cheap source of funding.
“Given the continued volatility in the financial markets, we want to be best positioned to take advantage of the various programs the federal government has introduced ... to support U.S. financial institutions,” Kenneth Chenault, chairman and chief executive officer of American Express, said in a statement. “With Federal Reserve oversight we should gain greater access to the capital on offer,” he added. But investors cautioned that being a bank does not solve all of American Express’ difficulties.
A growing number of financial institutions are looking to buy banks and gather deposits. “There’s a lot of competition for deposits now, and pricing for deposits is still high,” said Blake Howells, director of equity research at Becker Capital Management in Portland, Oregon.
American Express’ borrowing costs relative to a benchmark rate have risen dramatically this year. The company is paying about 1.65 percentage points more than one-month Libor to fund itself, compared with its average in recent years of 0.20 to 0.40 percentage point. The funding pressure is combining with credit pressure. The default rate among its credit card clients in the United States almost doubled in the third quarter of 2008 from a year earlier.
“An unemployed consumer is going to be a big challenge,” for American Express, Anton Schutz, president and chief investment officer at Mendon Capital, said at the Reuters Global Finance Summit, on Monday prior to the announcement. “Their clients are hurting and, on top of that, their upper income client base isn’t spending either, which is hitting the travel side of their business.” American Express already has two U.S. bank subsidiaries: American Express Centurion Bank, an industrial loan bank chartered in Utah, and American Express Bank FSB, a federal savings bank.
Through those institutions, the company issues proprietary credit and charge cards, funds cardmember loans and offers certificates of deposit. But those banks are relatively small. Goldman Sachs and Morgan Stanley became bank holding companies in September, meaning that when Bank of America buys Merrill Lynch & Co, there will be no standalone U.S. investment banks left. Other companies that lend and fund themselves in the bond markets are looking at becoming bank holding companies, most notably CIT Group Inc.
Buffett, Ross teaming up to purchase U.S. bond insurer
The insurance businesses of billionaire investors Warren Buffett and Wilbur Ross are close to buying all or part of the U.S. bond insurance unit of Dexia, Belgian business daily De Tijd said on Tuesday. “The transaction is in the final stages, according to several sources,” the newspaper said on its website.
Belgian-French financial services group Dexia, which received a 6.4 billion euro ($8.3 billion) bailout from the French, Belgian and Luxembourg governments in September, has said it will present the results of a strategic review on Friday. This could include a decision on the fate of Financial Security Assurance (FSA), the U.S. bond insurance arm that made a first-half net loss of $752 million and whose triple A credit rating is under threat.
Dexia’s board charged new Chief Executive Pierre Mariani with exploring options to reduce the risk associated with FSA’s activities and had said he should do so by this Friday, when Dexia also presents its third-quarter results. Reacting to what it called “rumors” that it would consider selling all or part of FSA, Dexia confirmed Mr. Mariani was looking at options for the unit and that the group would communicate further in due course.
Dexia, which has provided FSA with a $5 billion unsecured standby credit line, decided in August that FSA would exit the risky asset-backed securities market and focus on guaranteeing municipal bonds, though it still has a portfolio of riskier assets. De Tijd said insurers Berkshire Hathaway Assurance and Assured Guaranty were particularly interested in the “healthy” part of FSA—guaranteeing municipal bonds—but there were also talks about its riskier activities. The latter might be placed in a separate holding, De Tijd said.
Mr. Buffett started Berkshire Hathaway Assurance at the start of this year, while Mr. Ross is a large shareholder in Assured Guaranty. WL Ross & Co holds 13.4% of Assured and agreed in September to buy up to 5 million additional shares, which would bring its holding up to 18.9%.
Best Buy Cuts Full-Year Profit Forecast on 'Seismic' Slowdown in Spending
Best Buy Co., the largest U.S. electronics retailer, said full-year profit will be lower than it expected because of the recent turmoil in the financial markets and the U.S. economic slump The shares dropped as much as 17 percent in early New York trading after the chain said profit for the year through February 2009 will be $2.30 to $2.90 a share. Revenue may range from $43.7 billion to $45.5 billion, Best Buy said today in a statement.
Sales at stores open at least 14 months may decline as much as 15 percent in the four months through February as consumers grappling with the worst financial crisis since the Great Depression cut back on spending. Circuit City Stores Inc., Best Buy’s largest electronics competitor, filed for bankruptcy protection Nov. 10 after suppliers cut off credit and demanded cash for shipments.
“In 42 years of retailing, we’ve never seen such difficult times for the consumer,” Brian Dunn, president and chief operating officer, said in the statement. “People are making dramatic changes in how much they spend, and we’re not immune from those forces.” Best Buy forecast in September adjusted full-year profit of $3.25 to $3.40 a share on revenue of $47 billion. Analysts surveyed by Bloomberg estimated profit of $3.04 a share on sales of $46.4 billion.
Bank of England Warns of Deflation, Deeper Recession, to Cut Rates to 'Whatever Level is Necessary'
Bank of England Governor Mervyn King said policy makers are prepared to reduce interest rates as low as needed to prevent a recession from fueling deflationary pressures. Asked whether he would take rates to zero, King said today policy makers "are prepared to cut bank rate to whatever level is necessary" to make sure inflation hits the central bank's target. The Bank of England's forecasts, published today, said inflation may slow "well below" their 2 percent goal in 2009.
The pound dropped to a record low against the euro after King today forecast a deepening recession. The bank has already trimmed the benchmark rate twice in the last month, reducing it by 1 1/2 percentage points last week to a five-decade low of 3 percent. The downturn has worsened in the past month, reports show. Unemployment rose at the fastest pace in 16 years in October, house prices are falling the most in a quarter century and manufacturing is in its worst recession since the early 1980s. Until last week, the central bank's benchmark was the highest among the Group of Seven nations.
"Today's inflation report is a courageous acknowledgment that they are definitely behind the curve and quick action is definitely needed," said Chiara Corsa, an economist at UniCredit MIB. "Risks of a deflation scenario loom at the horizon." The pound dropped to 82.38 pence per euro, extending its decline this year to 10 percent. Against the dollar, it dropped to the lowest since August 2002, falling to $1.5201 and has lost a quarter of its value since January.
The deterioration in the U.K. currency can be "a helpful part of the rebalancing, provided it doesn't affect our ability to meet the inflation target," King said. The bank has "no wish to see it fall very sharply." The Bank of England's key rate is now the second-highest among the Group of Seven nations. The Federal Reserve last month lowered its main rate to 1 percent, matching the lowest in a half century, and this month the European Central Bank cut its benchmark by a half point to 3.25 percent.
The Bank of England's forecasts show the U.K. economy will contract through 2009 and inflation will slow below the government's 1 percent minimum unless it cuts rates further. Slowing growth and falling commodity prices are sparking concerns that inflation could give way to deflationary pressures. U.K. manufacturers' raw material costs and output prices fell at the fastest pace in 22 years in October, the Office for National Statistics said Nov. 10. The central bank's forecasts, presented as fan charts, show deflation has slipped into the range of possible outcomes over the next three years and King conceded there's a "risk" that consumer prices will start to fall. The bank's central forecast is still for an inflation rate just over 1 percent, based on market interest rate expectations.
The Bank of England tries to hit a central inflation target of 2 percent and is obliged to keep it within a range of 1 to 3 percent. Today's report prompted some banks to lower forecasts for the benchmark U.K. interest rate. Barclays Capital and BNP Paribas forecast a 1 percentage-point reduction at the December decision, compared with an earlier prediction for a half-point cut.
King, fielding criticism that he underestimated the risks facing the economy, said "the world has changed" since the collapse of Lehman Brothers Holdings Inc. in September. "We have seen the biggest banking crisis since the outbreak of the First World War and arguably even bigger than that," he said.
The forecast revisions are the largest the Bank of England has made since gaining rate-setting authority in 1997. In a television interview pooled among broadcasters, King said that while the U.K. faces "unprecedented times," the economy may improve as soon as next year. "I think 2009 will be a difficult year but I would hope that by the end of that we would start to see clear signs of improvement," he said. "When the facts change, then we'll change bank rate," King said. "That's what we've done, and we're ready to do it again."
UK faces deflation for first time in 50 years
The Bank of England is heading into uncharted territory next year as policymakers face up to the UK's first bout of deflation in nearly 50 years. The Bank's forecasts are set to show inflation tumbling during 2009 as oil and energy costs shift lower in the latest twist of a turbulent ride for prices. The Consumer Prices Index - currently at 5.2 per cent - has been a headache for rate-setters throughout 2008 but is likely to plunge to 1 per cent or less next year.
Experts say the official measure of inflation could even turn negative for the first time since 1960 - the year John F Kennedy won the race to become US president. Shoppers coping with the rampant inflation of the past six months could be forgiven for welcoming the potential boost to the pound in their pocket. But they may not be so keen on the prospect of falling wages while saddled with the burden of debts piled up in the good times.
The one silver lining for homeowners with inflation was that the value of their big debts such as mortgages was eaten away more quickly. With deflation the opposite is the case. A prolonged bout can lead to businesses and consumers deferring spending amid expectations that prices fall further still. Benefit payments such as the state pension are also pegged to the cost of living. While this stood at 5.2 per cent in September, a period of deflation next year could herald much smaller increases for millions of people.
And the impact of a severe recession on prices could spark a prolonged period of deflation to match that seen by countries such as Japan, economists warn. The volatile path of inflation in the past 18 months - and its likely descent over the year ahead - was unprecedented during the whole of the Bank's first decade of independence. Governor Mervyn King has to write a letter of explanation to the Chancellor whenever CPI rises or falls more than 1 per cent above its 2 per cent target.
It was nearly 10 years before any Governor had to write such a letter - in March last year - after an early spike in oil and energy costs. CPI was below target within six months as lower energy bills took effect, although this was a brief respite as oil hit 147 dollars a barrel and two rounds of gas and electricity price hikes sent it spiralling higher again. The prospect of several letters on the way up - two so far and a third due next month - is now matched by the possibility of more missives on the way down late next year as energy and commodity prices slide and demand falls in a recession.
The all-time low for the CPI was 0.5 per cent in May 2000, although at the time the Bank's Monetary Policy Committee was tracking the more inclusive Retail Prices Index, then reflecting rising house prices. Capital Economics' chief European economist Jonathan Loynes, said: "The forces that have lifted UK inflation sharply higher over the last year or so are now set to work strongly in the opposite direction." There is now a "good chance" that CPI inflation turns briefly negative in around a year before the deflationary effects of falling food and energy prices start to fade, he added.
RPI - which includes items such as mortgage interest payments - could hit around -2 per cent as banks eventually pass on lower repayments, Capital Economics said. Coupled with the steadily growing chances of a deep recession, the prospects for the UK economy look bleak. "There is a clear danger that the huge amounts of spare capacity created by the recession prompt a more prolonged period of falling prices further ahead which threatens to turn into a Japanese-style deflationary spiral," Mr Loynes said.
Sterling crisis threatens England's reflationary plans
As Gordon Brown plans his reflationary strategy, an old bogey has returned to haunt the Government's ambitions – the possibility of a sterling crisis. With the pound falling to a new 12-year low against a trade-weighted basket of currencies and an all-time low against the euro, it might be argued that it has already arrived.
The pound has always been an issue for Labour governments. So terrified was the current Labour regime of having its agenda once again frustrated by the foreign exchange markets that when it came to power it ceded control of monetary policy to an independent Bank of England and put in place strict fiscal rules to govern the public finances.
Up until quite recently, it seemed to work. The markets learned to love New Labour and foreign capital flowed into Britain as if it were Switzerland by the sea. In the process, it helped fund an explosion of credit, and pretty soon Britons became the most indebted individuals in the world. After a few years of hair-shirted self restraint, the Government caught the habit too, and turned the public spending taps to full on.
Labour returned to its bad old free spending ways, but amazingly the markets seemed to tolerate it. This led to much delusional thinking among policy makers to the effect that they had created a new and soundly based economic renaissance that would indefinitely allow the country to live beyond its means. Mr Brown now proposes to fight the downturn by borrowing even more. According to reports, he's contemplating a £15bn reflationary package to be funded at a later stage by tax rises when the moment of greatest economic peril is past. The markets have got other ideas.
According to research by Bank of New York Mellon (BNYM), the pattern of relatively stable inflows of foreign capital into UK fixed-income instruments reversed sharply in September, helping to explain the severe weakening in the pound that began to occur at about that time. Hard though these figures are to believe, BNYM estimates that outflows from UK fixed instruments since 10 September have reversed 75 per cent of the inflows from 2004 onwards.
If that's true, it amounts to a quite astonishing turnaround in foreign perceptions of the relative attractions of the UK economy. Even if the figures have been exaggerated by some statistical quirk, as seems likely, the point is well made. An already ballooning budget deficit has been further swollen by the hundreds of billions being spent on bank bailouts. On top of that, the Government now proposes to spend even more reflating the economy. This may be the only way of avoiding a really bloody recession, but that doesn't make the markets any more inclined to fund it.
All over the world, foreigners have been repatriating money. Moving assets closer to home is part of the flight to safety which has become one of the defining features of the credit crunch. Previously available pools of foreign liquidity are drying up. For instance, the Chinese have started to spend some of their current account surplus on reflating their own domestic economy. With the declining oil price, Middle Eastern and Russian capital surpluses have also been chopped back to size.
As a consequence, the UK Government may be about to run into the same funding difficulties as have befallen the stricken banks. Like the banks, the country as a whole has become overly dependent on leverage and wholesale money markets. These sources of money are being fast withdrawn. At the very least, the Government may have to get used to paying a lot more for its money than it used to, notwithstanding the Bank of England's attempts to cut interest rates.
Currency devaluation can be a useful tool in fighting recession by making domestic goods and services more competitive. But if it turns into a rout, it has the opposite effect of being inflationary, raising interest rates and deterring foreign investment. The Prime Minister wants to be seen as bold and decisive in his response to the gathering financial and economic crisis.
The banks have become incapable of performing their usual function of borrowing to lend. Mr Brown hopes to fix the problem by having the Government do it instead. Yet it is a strange sort of solution to over-indebtedness that says we should be taking on even more of the stuff. The Government may be about to find out the hard way that it is still not possible for nations to buck the markets.
Number of first-time UK home buyers hits all-time low
The number of first-time buyers has more than halved in the past year, according to the Council of Mortgage Lenders. The latest figures from the Council of Mortgage Lenders also showed first-time buyers are now at their lowest quarterly figure since 1974. It said a mere 13,400 loans were given to first-time buyers last month, compared to 28,200 in September 2007. It brings the total number of first-time buyers for the three months to the end of September to 44,500, compared to a height of almost four times as many – 164,400 – during the same period in 2001.
The fall comes amid widespread expectations that house prices are expected to drop further due to rising unemployment and the shrinking economy. Figures from the Department of Communities and Local Government, said house prices lost 5.1 per cent of their value during the year to the end of September. But the decline, which is based on mortgage completions is not as high as that recently released by Halifax, which bases its figures on mortgage approvals.
The average home has lost more than £30,000 in value during the past year, a 15 per cent decline, according to Halifax, Britain's biggest mortgage lender. David Hollingworth, of mortgage brokers London & Country, said: "It's no surprise to see that first-time buyer transactions are less than half the level of a year ago as most stay away as prices continue to fall. The good news for first-time buyers is that purchase prices have fallen but they continue to be hit by lenders' tightening of mortgage availability and the consequent need for large deposits."
The Council of Mortgage Lenders also revealed there were 35,000 loans for house purchase worth £5 billion in September, down 15 per cent in volume and 15 per cent in value from August, and less than half September 2007 levels. And it said there were 62,000 loans for remortgage worth £8.5 billion in September, down 15 per cent in volume and 16 per cent in value from August, but still around two thirds of September 2007 levels.
Michael Coogan, director general of the CML, said house purchase activity had reached "exceptionally low levels". He added: "Banks and building societies do want to support home owners, but they have limited funds available and are, quite reasonably, taking a prudent approach to risk."
Credit card firms attacked for hiking UK rates to 17%
Credit card companies are being told to end sudden rises in charges after Gordon Brown criticised some of them over claims that they were exploiting the vulnerable during the recession. Mr Brown, who is said to be deeply concerned about the behaviour of some companies, called yesterday for a “new responsible approach” to lending as the companies were summoned to talks with the Government.
Lord Mandelson, the Business Secretary, called on companies last night to pass on rate cuts and treat their customers fairly and sympathetically. He wants the companies to work with the Business Department on how to deal with debt. A survey of more than 200 cards by Defaqto, a banking research group, found that although the Bank of England reduced its rate to 3 per cent, the cost of borrowing on cards rose to 17.6 per cent and rates on store cards rose to 25 per cent.
Mr Brown was said by his spokesman to be concerned that some companies had increased rates by as much as 10 per cent overnight. While many companies behaved responsibly, the action of others was difficult to defend, he said. Mr Brown indicated that protection for homeowners struggling financially would be tightened. He said it was not acceptable that lenders were still able, in some cases, to repossess the homes of people who defaulted on their mortgage payments without a court order.
A spokesman for RBS said: “Interest rate decisions on our credit cards are not based on Bank of England base rate moves but on a range of factors, including the Libor rate, which is how we fund our money, and this rate has remained particularly high.”
Foreign investors are deserting Britain with good reason
Gordon Brown, the UK prime minister, hoped to banish boom and bust, yet enjoyed the former and now faces the latter. As in the past the UK has a funding crisis. Investors are wary of a nation with a big trade deficit and a government with a vaulting budget one. Unlike in the past, high inflation is not part of the crisis. Instead the Bank of England now forecasts inflation of only 1pc, half its 2pc target, and sees a risk of deflation that could make the downturn all the worse.
The pain is just beginning to be felt. Unemployment rose in September to a decade high of 1.8m. Many more jobs will be lost as consumers across the country tighten their belts. Meanwhile the government is loosening its own belt. Brown is gradually making his preference clear. The shift in policy will be from “tax and spend” to “keep spending and, perhaps, cut taxes”. That risks turning a budgetary position that became dubious even when the economy was bubbling to one that is terrible now the home-made soup has gone cold.
The government’s deficit and its debt are set to soar at an astonishing rate. The Economist Intelligence Unit forecasts a deficit that is 8.4pc of GDP by 2009/10 - three times in excess of the prudent limits set by the Maastricht treaty. Annual government borrowing is set to rocket above an annual £100bn. Foreign investors are wary. A deflationary recession, in which earnings are low, would make the government’s soaring deficit and debt all the more onerous.
Foreign investors, until recently the chief buyers of UK government debt, are pulling out fast. That outflow is reflected in a precipitous drop in the pound, down on Wednesday to its lowest level since 1996 on a trade-weighted basis. The UK’s outlook is clear. The paths for growth, the Bank of England policy interest rate, jobs and the pound are all sharply down. The paths for the government deficit and its debt are sharply up. Bust is following boom. There is no easy way out.
G20 financial summit may become a fittingly inept end to Bush administration
When George W. Bush toasts his assembled dinner guests in the State Dining Room at the White House on Friday evening, the poignancy of the moment is unlikely to be lost on him. Flanked by premiers from across the developed and developing world, the outgoing US President will be only too aware that the discussions that follow, both at dinner and the next day's Summit on Financial Markets and the World Economy, will not only be his last as the leader of the free world but are equally unlikely to result in any significant changes to the existing world order.
Billed by protagonists as a chance to alter the global financial system once and for all in the wake of the continuing credit crisis, this weekend's meeting of the G20 nations – including countries as far flung as Argentina and Australia – is likely to lead to a final black mark for a presidency already shrouded in international ineptitude. The Bush administration's attitude to the gathering up to now has been telling, with France's Nicolas Sarkozy forcing the President's hand into even hosting the event in the first place.
Since then, Bush has kept largely mum on the event, allowing a vacuum to form which some commentators predict could be filled by a backlash from developing countries – such as Russia and Brazil – against the US, blaming it for triggering the financial crisis in the first place. As with any international summit, such a vacuum will be quickly filled, with the aim of each attending country to get their point across as early and as loudly as possible.
Britain's Prime Minister Gordon Brown led from the front on this, calling for the summit to be a "Bretton Woods II" – with reference to the post-War agreement, named after the New Hampshire town in which the summit took place, that created the International Monetary Fund and what would become the World Bank. On Monday night at the Lord Mayor's banquet, Mr Brown called for the forging of a new world order, to be led by the UK, Europe and the US, central to which has to be a concerted global approach to solving the economy.
His speech focused on five key ways of tackling the economy – including the recapitalisation of banks, in which the UK took a strident lead which many others, including the US, followed, and better international co-ordination of fiscal and monetary policy. "My message is that we must be internationalist not protectionist, interventionist not neutral, progressive not reactive, and forward-looking not frozen by events. We can seize the moment and in doing so build a truly global society," said the UK premier. But whether this weekend's summit is the place that all this rebuilding will actually happen remains to be seen.
For all the talk of Bretton Woods, it should be remembered that the original Bretton Woods agreement followed three weeks of negotiations, with 44 countries present. Bretton Woods changed the whole financial landscape, and was predicated on a realisation that free trade was the only way forward. This weekend's talks take place over less than 24 hours, with approximately half the number of countries present, and there appears no over-arching economic ethos to unite those attending, other than the agreement that a solution to stop such a credit crisis from happening again has to be found.
Even with the G20 finance ministers meeting that took place in Sao Paulo last weekend acting as a pre-cursor, it is difficult to see how this coming weekend's meeting can produce anything other than a statement of intent rather than an actual new financial world order. One of the real problems facing the assembled leaders this weekend will be the sheer range of topics that can and will be discussed. From breathing new life into the Doha trade rounds to looking at how best to regulate global banks, each country has its own agenda.
The UK delegation believes strongly that a new international regulator to monitor the activities of the world's 30 largest banks should be established. But the French, under Mr Sarkozy, will push for increased government control on lending practices, with a particular focus on cross-border lending, with the French premier last week saying he wants "to change the rules of the game." For her part, German Chancellor Angela Merkel is taking a more puritanical route, and wants to see hedge funds penalised and an end to big bonuses for bankers. And that's just three countries.
"One clear message from our discussions here for the G20 is that governments must in no sense drop their guard at this point," said Sir Howard Davies, director of the London School of Economics and former chairman of the Financial Services Authority. "The forthcoming summit should identify the directions for change," he added at a World Economic Forum event in Dubai. Sir Howard is right – identification is likely to be the name of the game, with further talks necessary before any concrete changes to regulatory systems can be made. It is for this reason that Mr Sarkozy, showing more leadership than most, is pushing for a follow-up event to this one to be held by the end of February.
The other main hindrance from anything cataclysmic happening this weekend is that the one man most of those world leaders present would like to see is unlikely to be present. Unless he has an 11th-hour change of heart, or unless Mr Bush personally invites him to attend, President-elect Barack Obama feels that as there is only one President at a time, he must stay out of the limelight at this weekend's gathering.
Although such a stance may be in line with protocol, it will not help the outcomes of the summit, as other leaders look to the US for a lead in such matters, especially when many of the problems emanated from the American economy in the first place. With Mr Bush now a lame-duck President – with his approval ratings hitting a new low on Monday – and Mr Obama not attending, the chances of this weekend's summit being anything other than a high-profile talking shop look increasingly slim.
World Bank makes $100 billion pledge to poorest nations
The World Bank said last night it was gearing up to lend $100bn (£63bn) over the next three years to protect developing nations from the economic contagion spreading from richer western countries. Dashing hopes that the world's emerging economies might escape relatively unscathed from the downturn, the Bank said it expected almost 40 million people to fall into poverty as a result of the turmoil caused by the global credit crunch.
The bank said it expected growth in developing countries to be 4.5% next year, against the 6.4% it had previously pencilled in, adding that each percentage point off growth rates meant 20 million people slipping into poverty. This, it added, would be in addition to the 100 million pushed below the poverty line by the sharp increase in food and energy prices over the past two years.
Speaking ahead of the meeting of the G20 group of developed and developing nations in Washington this weekend, Robert Zoellick, the bank's president, said: "Leaders meeting on Saturday to discuss the global financial crisis must not lose sight of the human crisis. As always, it is the poorest and most vulnerable who are the hardest hit. "The response to this crisis must be global, coordinated, flexible and fast. While the challenges need to be addressed at the country level, it is more critical than ever that the international community acts in a coordinated and supportive way to make each country's task easier."
The bank believes next year will be one of the weakest for global activity since the second world war, with a 0.1% contraction in high-income countries leaving global growth at only 1%. Sharply tighter credit conditions and weaker growth are expected to cut into government revenue in poor countries and affect their ability to invest to meet the goals set by the United Nations for education, health and gender equality, as well as the long-term infrastructure expenditure needed to sustain growth.
As a result, the bank is planning to increase lending to developing countries from $13.5bn this year to $35bn annually in 2009, 2010 and 2011. Aside from expanded lending, the World Bank Group is also working to speed up grants and long-term, interest-free loans to the world's 78 poorest countries, 39 of which are in Africa.
Help will be targeted at countries that have had to shelve plans to enter global capital markets, and those affected by the recent plunge in commodity markets, the weakening of exports or the drying up of remittances from abroad. Zoellick said: "Working with the IMF, UN agencies, regional development banks and others, the World Bank is helping both governments and the private sector through lending, equity investments, innovative new tools and safety net programmes."
The Total Pie Shrinking: Where the 'Denominator Effect' Lurks
The "denominator effect" looms as the next force that could pressure the slumping real-estate market. Falling stock prices are leaving institutional investors overexposed to real estate, which could trigger further declines in property values as some of the market's most-active players move to the sidelines to recalibrate their portfolios.
Big pension funds, college endowments and insurance companies typically allocate most of their investment dollars to stocks and bonds and sometimes a smaller amount -- about 6% to 10% for pension funds and as much as 30% for other institutions -- to real estate. In the past decade, as real-estate values rose rapidly, many institutional investors expanded their real-estate holdings and in many cases became fully invested in the sector or close to it, bumping up against their preferred allocations. Now that stock values are beaten down, and because real estate is typically appraised only once a year and not daily like stocks, the relative size of the real-estate portfolio has grown and in many cases is now higher than the funds' guidelines. This is known as the denominator effect.
Real-estate demand "has been destroyed effectively by the unintended consequence of the total pie shrinking," said Stephen B. Hansen, a managing director at ING Clarion Partners LLC in New York. ING Clarion is an arm of ING Real Estate, which manages some $180 billion in assets for large institutions and other investors. "Certainly these institutions are less prone to making new real-estate investments today than anytime in the past seven or eight years," Mr. Hansen said. Last December, a swath of pension funds surveyed by Institutional Real Estate Inc. held a total of $331.5 billion, or 8.5% of their portfolios, in real estate. In sum, these funds were below an average target allocation of 9.6% in real estate by a total of $42.9 billion. Last month, these same funds still held about $321.6 billion in real estate.
But because of the declining stock market, they held $42.2 billion of property beyond their target, with an average of 11.1% of their portfolios in real estate. The consequences of the denominator effect will take months, if not years, to play out. Funds are loath to try to sell their privately held real-estate holdings in the current market, in which transactions have reached a virtual standstill because of the lack of debt financing. They also are wary of not meeting capital calls from investment funds to which they already are committed.
Institutional investors concerned about their real-estate allocation may respond to the denominator effect by pulling back on future investment -- setting the stage for a further decline in demand for commercial real estate next year, and adding to the downward price pressure in an already embattled market. "We'll continue to fulfill the commitments we've made as they're called," said Jeffrey W. States, chief investment officer of the Sacramento County Employees' Retirement System, with $5.7 billion in assets in June. "But I think the denominator effect does have the impact of slowing any additional activity we do until we start to see the asset values move back."
The San Francisco Employees' Retirement System, which had $18.8 billion in assets as of January 2008, is taking a similar approach. "If the denominator doesn't come back into sync, then our new investments would be curtailed," said Richard Peterson, a trustee of the pension fund. In the public market, the consequence of institutional investors seeking to reduce their real-estate exposure already may be having an impact. The shares of publicly traded equity real-estate investment trusts -- which pool money to make property investments and return most of their profits to investors -- have plunged 28% during the past month, while the broader stock market has stayed about flat.
Some industry leaders say the outsize decline in REITs stems in part from institutions trying to unload some of their real-estate holdings. REIT stocks are "easier to sell than selling an asset or selling fund positions," said Michael D. Fascitelli, president of Vornado Realty Trust Inc., a commercial-property REIT with $21 billion in assets. "That's why our stock is off a lot more." Vornado shares have lost 20% of their value during the past month. As institutions cast a wary eye to their real-estate exposure as their overall portfolio shrinks, an outflow of capital may spell more bad news for a commercial real-estate market already being hit by a frozen credit market and sagging demand for retail and office space.
Pension funds provided $157.1 billion of the $1.16 trillion of equity real-estate capital available in 2008, according to the non-profit Urban Land Institute and PricewaterhouseCoopers. "Some are redeeming, some are not putting any more money in," Charles Leitner, the global head of Deutsche Bank Group's RREEF Alternative Investments, said of institutional investors. "There's no new capital coming in."
Why Your FDIC-Backed Bank Could Fail
by Robert Prechter
This informative article has been excerpted from Bob Prechter's New York Times bestseller Conquer the Crash. Unlike recent news articles that are responding to the banking crisis, it was published in 2002 before anyone was even talking about bank safety.
Between 1929 and 1933, 9000 banks in the United States closed their doors. President Roosevelt shut down all banks for a short time after his inauguration. In December 2001, the government of Argentina froze virtually all bank deposits, barring customers from withdrawing the money they thought they had. Sometimes such restrictions happen naturally, when banks fail; sometimes they are imposed. Sometimes the restrictions are temporary; sometimes they remain for a long time.
Why do banks fail? For nearly 200 years, the courts have sanctioned an interpretation of the term "deposits" to mean not funds that you deliver for safekeeping but a loan to your bank. Your bank balance, then, is an IOU from the bank to you, even though there is no loan contract and no required interest payment. Thus, legally speaking, you have a claim on your money deposited in a bank, but practically speaking, you have a claim only on the loans that the bank makes with your money.
If a large portion of those loans is tied up or becomes worthless, your money claim is compromised. A bank failure simply means that the bank has reneged on its promise to pay you back. The bottom line is that your money is only as safe as the bank's loans. In boom times, banks become imprudent and lend to almost anyone. In busts, they can't get much of that money back due to widespread defaults. If the bank's portfolio collapses in value, say, like those of the Savings & Loan institutions in the U.S. in the late 1980s and early 1990s, the bank is broke, and its depositors' savings are gone.
Because U.S. banks are no longer required to hold any of their deposits in reserve, many banks keep on hand just the bare minimum amount of cash needed for everyday transactions. Others keep a bit more. According to the latest Fed figures, the net loan-to-deposit ratio at U.S. commercial banks is 90 percent. This figure omits loans considered "securities" such as corporate, municipal and mortgage-backed bonds, which from my point of view are just as dangerous as everyday bank loans. The true loan-to-deposit ratio, then, is 125 percent and rising. Banks are not just lent to the hilt; they're past it.
Some bank loans, at least in the current  benign environment, could be liquidated quickly, but in a fearful market, liquidity even on these so-called "securities" will dry up. If just a few more depositors than normal were to withdraw money, banks would have to sell some of these assets, depressing prices and depleting the value of the securities remaining in their portfolios. If enough depositors were to attempt simultaneous withdrawals, banks would have to refuse. Banks with the lowest liquidity ratios will be particularly susceptible to runs in a depression. They may not be technically broke, but you still couldn't get your money, at least until the banks' loans were paid off.
You would think that banks would learn to behave differently with centuries of history to guide them, but for the most part, they don't. The pressure to show good earnings to stockholders and to offer competitive interest rates to depositors induces them to make risky loans. The Federal Reserve's monopoly powers have allowed U.S. banks to lend aggressively, so far without repercussion. For bankers to educate depositors about safety would be to disturb their main source of profits.
The U.S. government's Federal Deposit Insurance Corporation guarantees to refund depositors' losses up to $100,000, which seems to make safety a moot point. Actually, this guarantee just makes things far worse, for two reasons. First, it removes a major motivation for banks to be conservative with your money. Depositors feel safe, so who cares what's going on behind closed doors? Second, did you know that most of the FDIC's money comes from other banks? This funding scheme makes prudent banks pay to save the imprudent ones, imparting weak banks' frailty to the strong ones. When the FDIC rescues weak banks by charging healthier ones higher "premiums," overall bank deposits are depleted, causing the net loan-to-deposit ratio to rise.
This result, in turn, means that in times of bank stress, it will take a progressively smaller percentage of depositors to cause unmanageable bank runs. If banks collapse in great enough quantity, the FDIC will be unable to rescue them all, and the more it charges surviving banks in "premiums," the more banks it will endanger. Thus, this form of insurance compromises the entire system. Ultimately, the federal government guarantees the FDIC's deposit insurance, which sounds like a sure thing. But if tax receipts fall, the government will be hard pressed to save a large number of banks with its own diminishing supply of capital. The FDIC calls its sticker "a symbol of confidence," and that's exactly what it is.
The first casualty of the crisis: Iceland. Government default is likely
Iceland’s banking system is ruined. GDP is down 65% in euro terms. Many companies face bankruptcy; others think of moving abroad. A third of the population is considering emigration. The British and Dutch governments demand compensation, amounting to over 100% of Icelandic GDP, for their citizens who held high-interest deposits in local branches of Icelandic banks. Europe’s leaders urgently need to take step to prevent similar things from happening to small nations with big banking sectors.
Iceland experienced the deepest and most rapid financial crisis recorded in peacetime when its three major banks all collapsed in the same week in October 2008. It is the first developed country to request assistance from the IMF in 30 years. Following the use of anti-terror laws by the UK authorities against the Icelandic bank Landsbanki and the Icelandic authorities on 7 October, the Icelandic payment system effectively came to a standstill, with extreme difficulties in transferring money between Iceland and abroad. For an economy as dependent on imports and exports as Iceland this has been catastrophic.
While it is now possible to transfer money with some difficulty, the Icelandic currency market is now operating under capital controls while the government seeks funding to re-float the Icelandic krona under the supervision of the IMF. There are still multiple simultaneous exchange rates for the krona. Negotiations with the IMF have finished, but at the time of writing the IMF has delayed a formal decision. Icelandic authorities claim this is due to pressure from the UK and Netherlands to compensate the citizens who deposited money in British and Dutch branches of the Icelandic bank Icesave. The net losses on those accounts may exceed the Icelandic GDP, and the two governments are demanding that the Icelandic government pay a substantial portion of that. The likely outcome would be sovereign default.
How did we get here? Inflation targeting gone wrong
The original reasons for Iceland’s failure are series of policy mistakes dating back to the beginning of the decade. The first main cause of the crisis was the use of inflation targeting. Throughout the period of inflation targeting, inflation was generally above its target rate. In response, the central bank keep rates high, exceeding 15% at times. In a small economy like Iceland, high interest rates encourage domestic firms and households to borrow in foreign currency; it also attracts carry traders speculating against ‘uncovered interest parity’. The result was a large foreign-currency inflow. This lead to a sharp exchange rate appreciation that gave Icelanders an illusion of wealth and doubly rewarding the carry traders.
The currency inflows also encouraged economic growth and inflation; outcomes that induced the Central Bank to raise interest rates further. The end result was a bubble caused by the interaction of high domestic interest rates, currency appreciation, and capital inflows. While the stylized facts about currency inflows suggest that they should lead to lower domestic prices, in Iceland the impact was opposite.
Why did inflation targeting fail?
The reasons for the failure of inflation targeting are not completely clear, a key reason seems to be that foreign currency effectively became a part of the local money supply and the rapidly appreciating exchange-rate lead directly to the creation of new sectors of the economy. The exchange rate became increasingly out of touch with economic fundamentals, with a rapid depreciation of the currency inevitable. This should have been clear to the Central Bank, which wasted several good opportunities to prevent exchange rate appreciations and build up reserves.
Peculiar Central Bank governance structure
Adding to this is the peculiar governance structure of the Central Bank of Iceland. Uniquely, it does not have one but three governors. One or more of those has generally been a former politician. Consequently, the governance of the Central Bank of Iceland has always been perceived to be closely tied to the central government, raising doubts about its independence. Currently, the chairman of the board of governors is a former long-standing Prime Minister.
Central bank governors should of course be absolutely impartial, and having a politician as a governor creates a perception of politicization of central bank decisions. In addition, such governance structure carries with it unfortunate consequences that become especially visible in the financial crisis. By choosing governors based on their political background rather than economic or financial expertise, the Central Bank may be perceived to be ill-equipped to deal with an economy in crisis.
Oversized banking sector
The second factor in the implosion of the Icelandic economy was the size of its banking sector. Before the crisis, the Icelandic banks had foreign assets worth around 10 times the Icelandic GDP, with debts to match. In normal economic circumstances this is not a cause for worry, so long as the banks are prudently run. Indeed, the Icelandic banks were better capitalized and with a lower exposure to high risk assets than many of their European counterparts.
If banks are too big to save, failure is a self-fulfilling prophecy
In this crisis, the strength of a bank’s balance sheet is of little consequence. What matters is the explicit or implicit guarantee provided by the state to the banks to back up their assets and provide liquidity. Therefore, the size of the state relative to the size of the banks becomes the crucial factor. If the banks become too big to save, their failure becomes a self-fulfilling prophecy. The relative size of the Icelandic banking system means that the government was in no position to guarantee the banks, unlike in other European countries. This effect was further escalated and the collapse brought forward by the failure of the Central Bank to extend its foreign currency reserves.
The final collapse was brought on by the bankruptcy of almost the entire Icelandic banking system. We may never know if the collapse of the banks was inevitable, but the manner in which they went into bankruptcy turned out to be extremely damaging to the Icelandic economy, and indeed damaging to the economy of the United Kingdom and other European countries. The final damage to both Iceland and the rest of the European economies would have been preventable if the authorities of these countries have acted more prudently.
While at the time of writing it is somewhat difficult to estimate the recovery rate from the sale of private sector assets, a common estimate for the net loss to foreign creditors because of private debt of Icelandic entities is in excess of $40 billion. The Icelandic authorities did not appreciate the seriousness of the situation in spite of being repeatedly warned, both in domestic and foreign reports. One prominent but typical example is Buiter and Sibert (2008). In addition, the Icelandic authorities communicated badly with their international counterparts, leading to an atmosphere of mistrust. The UK authorities exasperated with responses from Iceland overreacted, using antiterrorist laws to take over Icelandic assets, and causing the bankruptcy of the remaining Icelandic bank. Ultimately, this led to Iceland’s pariah status in the financial system.
British and Dutch claims on the Icelandic government
The current difficulties facing Iceland relate to its dispute with the Netherlands and the UK over high interest savings accounts, Icesave. Landsbanki set these savings accounts up as a branch of the Icelandic entity, meaning they were regulated and insured in Iceland, not in the UK or the Netherlands. Icesave offered interest rates much above those prevailing in the market at the time, often 50% more than offered by British high street banks. In turn, this attracted £4.5 billion in the UK with close to one £billion in the Netherlands. Landsbanki operated these saving accounts under local UK and Dutch branches of the Icelandic entity, meaning they were primarily regulated and insured in Iceland, although also falling under local authorities in the UK and the Netherlands. Hence the Icelandic, British and Dutch regulators approved its operations and allowed it to continue attracting substantial inflows of money.
Since the difficulties facing Landsbanki were well documented, the financial regulators of the three countries are at fault for allowing it to continue attracting funds. Landsbanki went into administration following the emergency legislation in Iceland.. The final losses related to Icesave are not available at the time of writing, but recovery rates are expected to be low, with total losses expected to be close to £5 billion. The amount in the Icelandic deposit insurance fund only covers a small fraction of these losses.
Both the Dutch and the UK governments have sought to recover the losses to their savers from the Icelandic government. Their demands are threefold. First, that it use the deposit insurance fund to compensate deposit holders in Icesave. Second, that it make good on the amounts promised by the insurance fund, around EUR 20,000. Finally, that it make good on all losses. The last claim is based on emergency legislation passed in Iceland October 6, and the fact that the government of Iceland has promised to compensate Icelandic deposit holders the full amount, and it cannot discriminate between Icelandic and European deposit holders.
Murky legal situation
The legal picture however is unclear. Under European law 1% of deposits go into a deposit insurance fund, providing savers with a protection of €20,000 in case of bank failure. Apparently, the European law did not foresee the possibility of a whole banking system collapsing nor spell out the legal obligation of governments to top up the deposit insurance fund. Furthermore, the legal impact of the Icelandic emergency law is unclear. Consequently, the Icelandic government is disputing some of the British and Dutch claims.
Blood out of a rock
Regardless of the legal issues, the ability of the Icelandic Government to meet these claims is very limited. The damage to the Icelandic economy is extensive. The economy is expected to contract by around 15% and the exchange rate has fallen sharply. By using exchange rates obtained from the ECB November 7 the Icelandic GDP is about EUR 5.5 billion, at 200 kronas per euro. In euro terms GDP has fallen by 65%. (This calculation is based on the Icelandic GDP falling from 1,300 billion Icelandic kronas to 1,105 and a Euro exchange rate of 200.
One year ago, the exchange rate was 83. In domestic currency terms the Icelandic GDP has contracted by 15% due to the crisis, in Euro terms 65%.) The total losses to Icesave may therefore exceed the Icelandic GDP. While the amount being claimed by the UK and the Netherlands governments is unclear, it may approximate 100% of the Icelandic GDP. By comparison, the total amount of reparations payments demanded of Germany following World War I was around 85% of GDP.
Resolution and the way forward
Any resolution of the immediate problems facing Iceland is dependent on the UK and the Netherlands settling with Iceland. Unfortunately, the ability of the Icelandic government to meet their current demands is very much in doubt. Opinion polls in Iceland indicate that one third of the population is considering emigration. Further economic hardship due to Icesave obligations may make that expression of opinion a reality. Meanwhile, many companies are facing bankruptcy and others are contemplating moving their headquarters and operations abroad.
With the youngest and most highly educated part of the population emigrating along with many of its successful manufacturing and export companies, it is hard to see how the Icelandic State could service the debt created by the Icesave obligations to the UK and the Netherlands, making government default likely. The economic rational for continuing to pursue the Icesave case with the current vigor is therefore very much in doubt. If a reasonable settlement cannot be reached and with the legal questions still uncertain it would be better for all three parties to have this dispute settled by the courts rather than by force as now.
Ilargi: I know this is off-topic, but hey, this is my joint, and I can do what I want. I'm neither gay nor Californian, or even American, but I still feel deeply hurt by Prop. 8. Unless and until we are all free, none of us is.
And if you want to make a distinction somewhere in there, be it on religious or other grounds, remember that you then fall into the same trap that made slavery acceptable for 500 years, led to pogroms for 1000+ years, concentration camps in the recent past and much much more. Get out of other people's lives and loves, you have no place there, other than to celebrate their beauty.
Bless you Keith.
Keith Olbermann on Proposition 8