Ilargi: As the Obama team bungles its way from mishap to mishap to yet another poorly planned multi-hundred billion initiative, their PR people take on an ever bigger role/ Both Larry Summers and White House chief economist Christina Romer do the talk-show circuit praising the plans in spite of (or because of?!) the accumulating evidence that things are not exactly going smoothly. Romer managed to push this gem past her larynx on Meet the Press: "It is an economic war. We haven’t won yet. We have staged a wonderful battle."
Meanwhile, the $1 trillion Term Asset-Backed Loan Facility (TALF), even before it starting date, needs to be hastily reworked because ... well, because it's so far been a complete failure. The administration has written restrictions and regulations into the bill, presumably for good reasons, but large banks such as JPMorgan Chase have already created special vehicles that circumvent the regulations. And what do you know, the Treasury actually likes the vehicles set up especially to nix its own rules. This is so ridiculous I wouldn't even be surprised anymore if Geithner and Summers set up the original TALF to fail, just so their buddies could show good reason to refuse having their books examined. So what you will, but the way this is going, there’s not one inch of the whole thing that will inspire one single iota of confidence.
On the contrary. TALF seeks to have private money purchase toxic derivatives with on average some 10% down, with the other 90% to be borrowed from the Fed. The newly created vehicles are intended to let investors basically buy securities on securities, with 90% or more of the risk that the securities slash derivatives are in reality worth far less than their face value transferred to guess who. Yes, good old Joe and Josey taxpayer. As long as the investors can get 10 cents on the dollar for the paper, they have no actual risk, and what risk might remain will surely be "creatively accounted" away as well. But rest assured, the economic team that has gotten everything so far will this time come up with the magical solution, even if t it takes five attempts. Or ten, or twenty-five. After all, they said so on TV. No better way than to solve a multi-trillion dollar derivatives and securities mess than to issue a whole new layer of derivatives securities smack on top of them.
The Wall Street Journal: ”Some investors [..] say the derivative securities present old and familiar problems, such as keeping the end holder of the risk of the TALF securities several steps away from the pricing of that risk.” Well, the ultimate end holder of the risk is the taxpayer, who is not just several steps, but lightyears away from the pricing of the risk, and who at the end of the day and the road stands to foot the entire bill without having any voice whatsoever in the whole smelly affair.
Now that we're on the subject of derivatives: Tiny Tim Geithner can't even tiptoe through the tulips with a convincing enough swagger to prevent AIG from paying an estimated $1 billion in bonuses to the very same geniuses who have caused $180 billion of your money to be thrown into the black hole they themselves created. Tim, and Mr President, you are the government. If you claim can't stop this sort of utterly wrong charade, hoe do you expect people to believe in your change? If the White House keeps up this level and pace of stumbling into the worst possible policy decisions, your voters might want to consider investing in a pitchfork manufacturer, or opening up a specialty store along the lines of Torches 'R' Us.
Meanwhile, the task of boosting confidence has now been delegated to the PR machine, since the policies obviously fail to accomplish it. The idea seems to be that if the "wonderful battle" mantra is repeated often enough, people will end up believing it. It's the same way that laundry detergent and cars are sold: repetition aimed at product recognition, a well-researched tactic that makes the quality of the product sold to a large extent irrelevant. Less than two months into the new presidency, it looks like we're entering the realm of Sigmund Freud, Edmund Bernays and Dick Morris, where controlling people's perception greatly trumps delivering substance. I don't know about you, but this whole spiel certainly doesn't boost my confidence.
Key House Democrat: AIG "Trying to Play the American People for Fools"
>Rep. Elijah Cummings, D-Maryland, a member of the Joint Economic Committee, today renewed his calls for AIG CEO Edward Liddy to resign after the company said it will move forward with paying out $121 million in bonuses for senior executives. "For months, I have been calling on Edward Liddy to step down from his position leading AIG, and I loudly and clearly renew that call today," Cummings said Sunday in a paper statement.
"Mr. Liddy has repeatedly taken billions of hard-earned tax dollars from the American people—many of whom have lost their homes, their savings, and their jobs—and then slapped those people in the face with that very money. Mr. Liddy continues to display reckless and irresponsible behavior at the helm of this company, and we simply cannot afford to accept it any longer." Cummings first called for Liddy to resign in November. Today the Maryland Democrat accused AIG of "trying to play the American people for fools."
"AIG has been trying to play the American people for fools by giving nearly $1 billion in bonuses by the name of ‘retention payments,’—including to employees at the FP unit whose reckless behavior drove the company into the ground," Cummings stated. "Any credibility that could have been given to Mr. Liddy’s argument that these payments are necessary to retain top talent was completely destroyed in last month’s 10-K filing when AIG itself disclosed that nearly $60 million of those retention payments are going to employees who will be terminated."
Cummings, who also sits on the House Oversight and Government Reform Committee, emphasized that "something is terribly wrong with this picture.""These payments are nothing but a reward for obvious failure, and it is an egregious offense to have the American taxpayers foot the bill," he said. "Something is terribly wrong with this picture, and the reckless behavior at AIG must stop immediately."
At A.I.G., Good Luck Following the Money
We return this week to the subject of the American International Group, the giant insurer that has received $170 billion in taxpayer guarantees, because the clamor over its rescue continues to grow. Of concern to those on both Capitol Hill and Main Street is the secrecy surrounding the $50 billion funneled to A.I.G.’s counterparties since it nearly collapsed last fall. Now that we live in bailout nation, why does the A.I.G. rescue rub so many the wrong way? Here is a hypothesis: Even as investors, employees, communities and taxpayers have been battered by the crippled financial system, A.I.G.’s counterparties were saved from losses on deals they struck with the insurer.
Add the fact that the government has resisted revealing these companies’ identities or how much federal money they received, and it’s easy to see why resentment boils. As a result of the A.I.G. rescue, taxpayers own almost 80 percent of the company. (Friday evening, as this column was going to press, rumors were swirling that A.I.G. might be releasing a list of all of its counterparties.) Representative Carolyn B. Maloney, Democrat of New York, said she had twice asked for a full accounting from Ben S. Bernanke, the chairman of the Federal Reserve, which arranged the A.I.G. rescue. She has not received it. “They have told others it is proprietary information,” Ms. Maloney said in an interview. “But we are the proprietors now. Taxpayers own the store, and we should be able to see the books.”
A.I.G., at one time the world’s largest insurer, sold contracts to these sophisticated counterparties that theoretically protected them from losing money if the debt they had purchased defaulted. Known as credit default swaps, the contracts offer the same kind of protection a homeowner receives from an insurance policy against fires and other unforeseen calamities. The arrangements behind the deals produced fees for A.I.G. while the firms buying the contracts got peace of mind. No one thought A.I.G. might have to pay hundreds of billions of dollars in claims. Until, that is, A.I.G. came under financial pressure last year. When the government stepped in to rescue A.I.G., its main and very reasonable concern was that a collapse of the insurer would drag down with it other big financial companies that were its customers. So the government shoveled taxpayers’ money into A.I.G., beginning with an $85 billion loan last September. Then the rescuer went mum.
Officials at the Fed, who continue to oversee the A.I.G. rescue, have taken the position that the terms of the insurers’ contracts are confidential and that it would be wrong for the government to break those promises by naming recipients of taxpayer money. Another concern may have been that disclosures of A.I.G.’s counterparties might make investors and depositors uneasy about the well-being of the firms getting the money. According to people briefed on the situation who were granted anonymity because they were not authorized to talk about it, the counterparties that taxpayers have bailed out include Goldman Sachs, Merrill Lynch and two French banks, Calyon and Société Générale. Along with other unidentified entities, the counterparties have received 30 percent of the $170 billion allocated to A.I.G. (Goldman has said that it had insulated itself from any financial damage that might have resulted from an A.I.G. collapse.)
Even A.I.G.’s own independent directors haven’t been told which of the counterparties were paid, according to a person with direct knowledge of the matter who requested anonymity because of confidentiality agreements. Such secrecy raised hackles because the insurance claims were paid off in full, even though widespread defaults on the underlying debt have not occurred. Why, many people wonder, did the Fed make A.I.G.’s counterparties whole on losses that have not happened yet? Why didn’t it force these financial companies to close out the contracts at a discount, making them take what is known on Wall Street as a “haircut”? Robert Arvanitis, chief executive of Risk Finance Advisors in Westport, Conn., and an expert in insurance, speculated that the United States was afraid that A.I.G.’s foreign bank counterparties would suffer large hits to their capital cushions, the amount they must set aside in case of losses.
“If somebody takes away the A.I.G. guarantee, all of a sudden the banks’ capital ratios look bad,” he said. “It might have stretched some of these banks.” Still, Mr. Arvanitis said, it is not clear that the government had to pay out 100 percent of the contracts’ value to all the counterparties. Healthier institutions could have been persuaded to take a haircut, he said. “That is what tough negotiators do,” he added. The government installed Edward M. Liddy as chief executive of A.I.G. when the company was bailed out. A former chief executive of Allstate, Mr. Liddy was also a director at Goldman Sachs before he joined A.I.G. And in January, the Fed appointed three trustees to oversee the insurer. Their job is to maximize the company’s ability to repay amounts owed to the government and to ensure that A.I.G. is managed “in a manner that will not disrupt financial market conditions,” according to the Fed.
The trustees are Jill M. Considine, former chairman of the Depository Trust Company and a former director of the Federal Reserve Bank of New York; Chester B. Feldberg, a former New York Fed official who was chairman of Barclays Americas from 2000 to 2008; and Douglas L. Foshee, chief executive of the El Paso Corporation and chairman of the Houston branch of the Federal Reserve Bank of Dallas. The trustees have already rankled a big A.I.G. shareholder. The American Federation of State, County and Municipal Employees pension plan, which owns 18,000 shares of A.I.G. common stock, had put forward a shareholder proposal on executive pay that it hoped would be put to a vote at the company’s annual meeting in May. The proposal asked the company to adopt a policy requiring senior executives at A.I.G. to retain a significant percentage of the shares they received as compensation until two years after they left the company.
Such a policy would help reward performance based on long-term value creation for shareholders, the pension plan said. But Richard Ferlauto, the director of corporate governance and pension investment at Afscme, said A.I.G. trustees have indicated they oppose the proposal. But Kevin F. Barnard, a lawyer at Arnold & Porter who represents the trustees, said they were still considering the proposal. “To my knowledge, they are batting ideas back and forth but have not made fixed decisions,” he said. Mr. Ferlauto said the compensation debate at A.I.G. would be yet another indication of how A.I.G. sees its relationship with those who continue to bail it out of trouble: taxpayers. “If they do vote against a reasonable compensation reform,” he said, “then it would be an appalling breach of faith with the American taxpayer.”
Bailout King AIG Still to Pay Millions In Bonuses
Insurance giant American International Group will award hundreds of millions of dollars in employee bonuses and retention pay despite a confrontation Wednesday between the chief executive and Treasury Secretary Timothy F. Geithner. But the company agreed to revise some executive payments after what AIG's leader, Edward M. Liddy, called a "difficult" conversation. The bonuses and other payments have been exasperating government officials, who have committed $170 billion to keep the company afloat -- far more than has been offered to any other financial firm. The issue came to a head when Geithner called Liddy and told him the payments were unacceptable and had to be renegotiated, said an administration official who was not authorized to comment on the Geithner conversation.
In a letter to Geithner yesterday, Liddy agreed to restructure some of the payments. But Liddy said he had "grave concerns" about the impact on the firm's ability to retain talented staff "if employees believe that their compensation is subject to continued and arbitrary adjustment by the U.S. Treasury." Lawyers at both the Treasury Department and AIG have concluded that the firm would risk a lawsuit if it scrapped the retention payments at the AIG Financial Products subsidiary, whose troublesome derivative trading nearly sank AIG. The company promised before the government started bailing out the firm in September that employees would be awarded more than $400 million in retention pay this year and next. "I do not like these arrangements and find it distasteful and difficult to recommend to you that we must proceed with them," Liddy wrote.
At the same time, the company said in documents provided to the Treasury, any steps that encourage specialists at AIG Financial Products to leave could open the U.S. government to further risk because of the hazards still posed by the $1.6 trillion portfolio of complex derivatives those employees are working to dispose. AIG's top seven executives, including Liddy, already agreed in November to forgo their bonuses through this year. Last week, AIG agreed to restructure bonuses for the next 43 highest ranking officers at the company, who are to receive half of their bonuses -- which total $9.6 million -- immediately, the administration official said. Another quarter of that would be disbursed on July 15 and the rest on Sept. 15. But these last two payments would depend on whether the company makes progress in restructuring its business and paying back taxpayers.
In addition, federal officials plan to recoup some of this bonus and retention pay in restructuring the company, an administration official said. Officials at the Treasury Department and the Federal Reserve took over AIG in the fall, fearing one of the world's most successful conglomerates had grown so intertwined with the global economy that the firm's impending failure could have disastrous consequences. In return for the bailout, the government took an 80 percent ownership stake in the company. Liddy was recruited by former Treasury secretary Henry M. Paulson Jr. to run the company. Since then, the rescue package has ballooned. But both the Bush and Obama administrations have been reluctant to completely and explicitly nationalize the company, though this could have avoided the current flap over bonus payments, first reported by The Washington Post.
AIG officials said debate over the bonuses and retention pay has been simmering for months. During the past year, the company has repeatedly disclosed these payments in public financial filings. But as lawmakers increasingly clamored for details of their size, outrage grew in Congress and beyond. Although the AIG Financial Products unit is proceeding with the payments, Liddy said the company would try to reduce future retention pay by at least 30 percent. In addition, the 25 highest-paid employees at Financial Products have agreed to reduce their salary to $1 for the remainder of 2009, Liddy wrote. Salaries for the rest of the firm's employees will be cut by 10 percent.
The Obama administration has been sensitive to how companies receiving government bailout money indulge their employees. Spending on jets, extravagant office furniture and bonus checks -- while not always a significant portion of corporate spending -- sours the public's view of the financial rescue effort at a time when the administration is considering asking Congress for billions of dollars more to help banks. AIG officials say that some of the upcoming bonuses are relatively modest once they are divided among employees. About 4,700 people in the company's global insurance units are receiving $600 million in retention pay. In addition, about $121 million in corporate bonuses will go to more than 6,400 people, for an average payout of about $19,000, according to AIG.
"These are not Wall Street bonuses," said one AIG executive, who was not authorized to speak on the record. "This is an insurance company." That executive also noted that the retention bonuses at AIG Financial Products were put in place in early 2008 at a time when it hadn't yet melted down. "They knew that the book was running into trouble," the executive said. "They thought they could weather the storm. But they thought they needed to keep people in their seats. They were worried." Then, of course, everything changed. Financial Products kept posting bigger and bigger losses, burying AIG under a cash crunch from which it has not recovered.
Since that collapse, company officials say, many Financial Products employees have lost nearly two-thirds of their compensation under the firm's deferred payment plan, in which bonuses are doled out over several years based on the firm's profitability. The new cutbacks raise the risk that more employees will depart before the firm can be wound down and closed. "These employees are highly specialized and/or are part of businesses that control billions of dollars of revenue and value that will be needed to repay the U.S. taxpayer," Liddy wrote in a letter last month. "Our competitors understand how valuable our top executives are, and we are acutely aware that they would like to siphon off our most talented leaders."
Over time, both the amount of retention pay and the number of recipients throughout AIG have grown. Since taking over the rescue effort of AIG, the Obama administration has imposed stricter compensation rules, banning golden parachute payments for executives leaving firms and barring executive compensation above $500,000, except in the form of stock that cannot be cashed in until the government's loans are paid back. But the government could not revoke bonuses promised before the government's rescue efforts began, officials said. Sen. Christopher J. Dodd (D-Conn.), a leading critic of excessive executive compensation, backed a measure earlier this year to curb the practices but it included an exception for bonuses agreed to before Feb. 11, 2009.
AIG Discloses Some Credit-Default Swap Counterparties After Consulting Fed
American International Group Inc., the insurer that was bailed out by the U.S. government, said counterparties including Societe Generale and Deutsche Bank AG received $22.4 billion from Sept. 16 to Dec. 31 of last year. The funds were paid out of the U.S. government’s initial $85 billion emergency loan to AIG, the New York-based insurer said in a statement today. As the value of the credit default swap portfolio fell, it triggered collateral provisions creating a “liquidity crisis” for AIG. The counterparties received additional money prior to Sept. 16, the statement said. AIG’s disclosure comes after consultation with the Federal Reserve and is intended to provide transparency around the use of government funds, the statement said. Municipalities in states including California, Virginia and Hawaii received $12.1 billion during the same period.
Romer Says Obama Staging “Wonderful Battle” Against US Recession
White House chief economist Christina Romer said the Obama administration is staging a “wonderful battle” against the U.S. recession and predicted the stimulus plan will help revive growth. “It is an economic war,” Romer, chairwoman of the White House’s Council of Economic Advisers, said today on NBC’s “Meet the Press” program. “We haven’t won yet. We have staged a wonderful battle.” U.S. gross domestic product is forecast to contract this quarter after shrinking at a 6.2 percent annual pace from October to December, the most since 1982. The jobless rate climbed to 8.1 percent last month as U.S. employers cut 651,000 workers from payrolls.
The economy’s “fundamentals are sound,” though ‘we know that temporarily we’re in a bad situation,” Romer said. She said she stands by an administration forecast that the $787 billion spending and tax cut plan will save or create 3.5 million to 4 million jobs. Romer said the administration tomorrow will announce plans to help small businesses get access to credit. “We know we’re doing a lot of help for banks, we’re doing a lot of help for homeowners. Small business people need it, too,” she said. “That’s all going to be announced tomorrow,” Romer said, adding that the money allocated will be “a significant amount.” Romer also discussed the need to jumpstart consumer spending, which comprises about 70 percent of the U.S. economy, saying Americans “have not done a lot of spending” in the last 14 months.
Purchases contracted at a 4.3 percent annual pace in the fourth quarter, the most since 1980, after shrinking at a 3.8 percent pace in the previous three months, according to figures from the Commerce Department. “We know consumers have lost a lot of wealth,” Romer said. U.S. household wealth fell by a record $5.1 trillion from October to December, almost twice the decrease in the previous quarter, as home values and stock prices plunged, Federal Reserve figures showed last week.
The Bush administration is not to blame for the economic decline, former Vice President Dick Cheney said in a separate interview. “I don’t think you can blame the Bush administration for the creation of the economic circumstances,” Cheney said in an interview on CNN today. “It’s a global problem.” “The notion that you can throw it off on the prior administration is interesting rhetoric but I don’t think anybody cares about that,” Cheney said. “What people care about is what is going to work.
Summers Defends Administration's Bailout Plan
On CBS' Face The Nation, White House National Economic Council Director Lawrence Summers defended the administration's plan to stabilize the financial system, particularly its efforts to steer the so-called toxic assets of the major banks into a new private-public partnership. "It may not be the last resort but it should be the port of first call," Summers said of selling toxic assets to private investors. "That's precisely what the investment facilities that [Treasury] Secretary Geithner has spoken of are directed at — creating a vehicle that will enable banks to sell these assets not to a public owner but to a private owner who may need to receive some kind of government guaranteed financing. But I think we do want to keep it in the private sector."
Summers then made a comparison between this crisis and the savings and loan crisis 20 years ago. "People often sort of make everything be the same," Summers told host Bob Schieffer. "But you really had quite a different situation in the early '90s with the [Resolution Trust Corporation]. At that point you had a large number of closed savings and loans… Here we're frankly trying to be preventive and we're trying to help address the problems with the banks before they fail and need to be completely taken over by the government. And that presents somewhat different circumstances. That's why the private sector approach that Secretary Geithner has spoken about has such power."
Summers also defended the administration from criticism that President Obama lacks a clear plan or that that the details are not well enough known yet. "There's a clear plan," he said. "The plan has a pillar of support for the capital markets that enables banks to sell their assets to the capital markets. The plan has a pillar that is infusions of capital into banks to enable them to be in a position to lend. The pillar based on what's going to happen in the banking system is based on a careful and rigorous evaluation of the situation in the banks precisely to overcome that problem of no one knows what's going on that's described. Those are the stress tests. Those stress tests are currently underway."
Schieffer also asked Summers whether the government knew where all the money poured into the banks has gone. "We certainly have a picture of what's going on in the banks... We're getting a much closer and better reading on the situation of the banks through the stress tests that are an integral part of Secretary Geithner's financial plan," Summers said. "These banks in a year take in a trillion dollars of which the government's $25 billion or $10 billion or whatever it is, is one component. Then they lend out on a very large scale. So it's not really possible to take a particular dollar that came from the government and say where that particular dollar went. "But what I can say is that it is a crucial focus of what is a very close and intense relationship now between the supervisors and the banks following these capital infusions that there be increased lending," he added.
TALF Is Reworked After Investors Balk
After failing to sign up enough investors in time to launch the Term Asset-Backed Loan Facility early this coming week, the Federal Reserve and Wall Street are reworking the TALF program at the 11th hour. The Fed delayed the program's launch by two days, until Thursday. Wall Street dealers, including J.P. Morgan Chase & Co. and Barclays PLC's Barclays Capital, have created vehicles to participate in the TALF that would allow investors in the program to circumvent many of the restrictions laid out by the Fed. The vehicles resemble collateralized debt obligations, or CDOs, and use some of the financial engineering that was partially responsible for the collapse of the credit markets.
The Fed, eager to get what it hopes will be a $1 trillion program up and running, has blessed the vehicles because they open the TALF up to a much larger group of investors, say people familiar with the matter. The vehicles emerged late in the past week, after investors cringed at signing agreements with Wall Street firms that would facilitate the Fed's loans. They objected to the level of scrutiny that dealers would have over their books, arguing that the dealers' rules attached too many strings. Dealers were saying they take plenty of risk to facilitate the program and need to be protected in situations where the collateral or the client made mistakes or wound up ineligible.
The Fed's main goal in forming the TALF is to bring to life the asset-backed securities market that effectively subsidizes loans to consumers and businesses to buy cars, pay for their educations, buy farm equipment or use credit cards. The Fed has said it could expand the TALF to include commercial and residential mortgage lending. Through the program, an investment fund can put down $5 to $14 for every $100 it plans to spend, borrowing the remaining $95 to $86 cheaply from the Fed. It agrees to buy highly rated securities issued by lenders that the Fed deems eligible collateral for the loans. Much is at stake for TALF, including more than $10 billion in expected deals for companies, including auto lender World Omni Financial Corp. and Ford Motor Co.'s Ford Motor Credit Co., say bankers. Likewise, the Fed has a lot riding on the program after it expanded its scope before the launch.
"Should the TALF not be embraced enthusiastically by the financial community, the Fed will have to turn to further alternative steps to repair the credit system," said Joseph Brusuelas, economist at Moody's Economy.com. Under the new proposal, a bank such as Barclays or J.P. Morgan would set up a trust to buy securities with money borrowed from the Fed. The trust would then sell investors securities in the trust. Those securities would give returns similar to the TALF loan, but without the strings attached. The dealers say they could create markets for these derivative securities to trade, and a presentation by Barclays says they may be rated by credit-ratings companies and listed on the Irish Stock Exchange, a home for many CDOs.
The vehicles also would make it easier for investors that aren't eligible for TALF loans to buy into the program, like investors that are restricted by their investment guidelines from using borrowed money to buy securities. Smaller hedge funds that can't vie for large allocations of deals could also buy in through these vehicles. Some investors have raised concerns, however, noting that the structure puts these dealers at an advantage in bidding and influencing the price of new offerings. They also say the derivative securities present old and familiar problems, such as keeping the end holder of the risk of the TALF securities several steps away from the pricing of that risk.
Hedge Funds' TALF Tack Is One of Interest, Caution
Hedge funds of all sizes and strategies are expressing strong interest in the government's plan to unclog consumer-lending pipelines. Now they and other investors need to decide Friday if they will participate in the first round of borrowing through the Term Asset-Backed Securities Loan Facility, or TALF. Some of the biggest hedge funds in the business have participated in calls and meetings with other hedge-fund managers, lawyers and regulators about the program. They include Harbinger Capital Management, Highbridge Capital Management, Elliott Management Corp., Paulson & Co., Perry Capital, Citadel Investment Group, Cerberus Capital Management and D.E. Shaw Group. It isn't clear how many ultimately will participate in TALF, which eventually could finance as much as $1 trillion in deals.
Some hedge funds simply have been asked to provide input for how the program should operate or are monitoring it because of its potential impact on the markets. The Federal Reserve and Treasury Department program, starting next week, will provide cheap funding aimed at kick-starting the market for highly rated securities backed by loans for automobiles, college tuition and other assets. That market has all but frozen during the prolonged credit crisis, and getting it flowing again is seen as crucial to an economic recovery. The main question many hedge funds are weighing is whether the potential upside of participating in the first round of funding outweighs some of the still-unknowns, according to fund managers, lawyers representing both funds and dealers, and others involved in the talks.
Dealers, mostly Wall Street banks, are in the program acting as the lender, using financing provided by the Federal Reserve through a master loan agreement. It is the dealers' job to select eligible investors. The dealers have set Friday as a deadline for investors to decide whether they want to apply to participate in the first round of TALF-funded deals. At issue still are terms in the agreements between dealers and funds that hedge funds say would expose them to losses greater than what they invest in the program. Dealers are saying they have to protect themselves from potential losses. Conference calls and meetings about TALF have continued almost nonstop this week in Washington and New York, people involved in discussions say.
People involved, from the regulators to Wall Street firms and hedge funds, have made concessions, and dealers and hedge funds are both sensitive to concerns that they'll be seen as holding up TALF. Executives of the Managed Funds Association, the hedge-fund industry's chief U.S. lobbying group, have told some of the group's members that hedge funds are especially vulnerable to being painted as more concerned about profits than an economic recovery. "I expect a number of big investors will wait and participate in the April funding rather than the March funding," Paul Watterson, a fund lawyer with Schulte Roth & Zabel in New York. "There's a big gap between what the primary dealers want in the customer agreement and what the big investors in this market were expecting."
Dealer-investor agreements aren't written in stone, and the agreements also could end up being customized during negotiations between banks and hedge funds, despite efforts to have a uniform agreement in place, say people familiar with the discussions. "I think this first subscription is really a learning experience for everybody," says Chris Killian, associate director of the American Securitization Forum, which represents structured-finance market participants. "Nobody knows exactly what to expect out of this, and the agreement is going to get better because of it." The American Securitization Forum and the Securities Industry and Financial Markets Association, representing the dealers participating in TALF, drew up the roughly 40-page document designed to serve as a contract between dealers and funds seeking to invest in the program.
Hedge Funds Making Way For Government Regulation
The hedge fund industry, battered and humbled by the market downturn, is no longer planning to fight against an increased role for government in regulating and inspecting the secretive investment pools. Opposition has melted away as the market decline and prominent frauds have shattered the confidence of the pension funds, university endowments, charities and wealthy individuals who invest in the exclusive investment pools. The new openness to regulation reflects the desire of investors for a government stamp of approval before they invest their money, said Barry Greenberg, a lawyer at Akin Gump who advises hedge funds.
Congress, which this week kicked off a series of hearings on new financial regulations, is contemplating a variety of rules to govern hedge funds. The industry has shown a willingness to consider a number of new initiatives, including a registration requirement, which would subject funds to periodic examination, and the creation of a regulator with the authority to ask them questions about their investments and business practices. The industry is split over how much funds should disclose to regulators about investments. And it opposes efforts to limit what they can invest in and how much they can borrow. "There is concern about the utility of providing tons and tons of detail about individual portfolio positions," said Andrew Baker, chief executive of the Alternative Investment Management Association.
The new attitude by hedge funds reflects the new reality facing the industry. As many as 2,000 of 10,000 hedge funds closed last year as clients redeemed their investments, according to various industry estimates. And the total amount of assets invested in hedge funds worldwide was cut nearly in half to $1.9 trillion. As a result, the long-established compensation structure of funds, in which they are paid 2 percent of assets and 20 percent of profits, is being reevaluated by fund managers. In some cases, funds are receiving 1 percent of assets and 15 percent of profits. Investors "are now more skeptical about what they're paying for, and that's causing them to revisit fees with the funds they're invested," said Adam Zoia of Glocap, a firm that advises on hedge fund compensation.
A series of recent frauds has also given rise to changes in the industry. Late last month, the Securities and Exchange Commission identified what appears to be the largest hedge fund fraud ever, a scheme in New York that is accused of stealing up to $563 million from investors. Using that money, the hedge fund managers bought homes, horses and even an $80,000 teddy bear, the SEC alleged. Investors included Carnegie Mellon University, the Iowa Public Employees Retirement System and others. Joel Schwab, a managing director at HedgeFund.net, a data source on the industry, said investors are pressuring funds to hire independent administrators, brokers and auditors that will ensure everything adds up. Schwab said that even though he wasn't running a hedge fund, the Bernard L. Madoff case has heightened concern among many investors.
The SEC has tried to regulate hedge funds before. In 2004 it enacted rules requiring every hedge fund to register with the SEC, but those rules were struck down in federal court. Nevertheless, about a fifth of all fund firms have since registered with the agency. Some at the SEC are pushing for new rules to bring more scrutiny to the hedge fund market. "We're totally unable to discern what's going in this particular market," SEC Commissioner Luis A. Aguilar said. "You have no idea how many dollars are involved, you have no idea what type of risk-taking is happening, you don't know if they're investing in vanilla securities or investing in the riskiest instruments."
As Congress considers regulating hedge funds, two issues are front and center. The first is that hedge funds could grow so big that they could endanger the entire financial system: so called systemic risk. A second is that hedge funds, as unregulated entities, are ripe for fraud, either ripping off investors or manipulating the market. The Federal Reserve has been discussed by lawmakers as the likely candidate to become the regulator of systemic risk. The SEC, and potentially a sister agency responsible for certain derivatives, the Commodity Futures Trading Commission, may have other responsibilities.
There's No Pill for This Kind of Depression
It is six months since Lehman fell and the crash (or the great recession, or the collapse—it's time it got its name) began. An aspect of the story given less attention than it is due, perhaps because it doesn't lend itself to statistics, is the psychic woe beneath the economic blow. There are two parts to this. One is that we have arrived at the first fatigue. The heart-pumping drama of last September is gone, replaced by the drip-drip-drip of pink slips, foreclosures and closed stores. We are tired. It doesn't feel like 1929, but 1930. People are in a kind of suspended alarm, waiting for the future to unspool and not expecting it to unspool happily. Two, the economy isn't the only reason for our unease. There's more to it.
People sense something slipping away, a world receding, not only an economic one but a world of old structures, old ways and assumptions. People don't talk about this much because it's too big, but I suspect more than a few see themselves, deep down, as "the designated mourner," from the title of the Wallace Shawn play. I asked a friend, a perceptive writer, if he is seeing what I'm seeing. Yes, he said, there is "a pervasive sense of anxiety, as though everyone feels they're on thin ice." He wonders if it's "maybe a sense that we've had it too easy in the years since 9/11 and that the bad guys are about to appear on the horizon." An attorney in a Park Avenue firm said, "Things look like they have changed and may not come back."
He contrasted the feeling now on the streets with 2001. "Things are subdued. . . . Nine-eleven was brutal and graphic. Yet because there was real death and loss of life folks could grieve and then move on." But today, "the dread is chronic. . . . Tom Wolfe's Masters of the Universe were supposed to be invincible. The pillars of media were supposed to be there forever. The lawyers were supposed to feed through thick and thin. Not anymore." He quoted Ecclesiastes: "The heart of the wise is in the house of mourning; but the heart of fools is in the house of mirth." We are worried, he said, "about a way of life, about the loss of upward trajectory."
The sale of antidepressants and antianxiety drugs is widespread. In New York their use became common after 9/11. It continued through and, I hypothesize, may have contributed to, the high-flying, wildly imprudent Wall Street of the '00s. We look for reasons for the crash and there are many, but I wonder if Xanax, Zoloft and Klonopin, when taken by investment bankers, lessened what might have been normal, prudent anxiety, or helped confuse prudent anxiety with baseless, free-floating fear. Maybe Wall Street was high as a kite and didn't notice. Maybe that would explain Bear Stearns, and Merrill, and Citi. Gun sales continue up. The FBI's criminal background check system showed a 23% increase in February over the previous year, a 29% increase in January, a 24% increase in December and a 42% increase in November, when a record 1.5 million background checks were performed.
Yes, people fear President Obama will take away the guns he thinks they cling to, but a likely equal contributor to what The Wall Street Journal's MarketWatch called a "gun-buying binge" is captured in the slogan on one firearms maker's Web site: "Smith & Wesson stands for protection." People are scared. They are taking cash out of the bank in preparation for a long-haul bad time. A friend in Florida told me the local bank was out of hundred-dollar bills on Wednesday because a man had come in the day before and withdrawn $90,000. Five weeks ago, when I asked a Wall Street titan what one should do to be safe in the future, he took me aback with the concreteness of his advice, and its bottom-line nature.
Everyone should try to own a house, he said, no matter how big or small, but it has to have some land, on which you should learn how to grow things. He also recommended gold coins, such as American Eagles. I went to the U.S. Mint Web site the next day, but there was a six-week wait due to high demand. (I just went on the Web site again: Production of gold Eagle coins "has been temporarily suspended because of unprecedented demand" for bullion.) In Manhattan, Catholic church attendance appears to be up. Everyone seems to agree that this is so, though the archdiocese says it won't have numbers until next fall. But yes, said Joseph Zwilling, the director of communications, "from what I've heard anecdotally from various priests," the pews have been fuller.
The rector at St. Patrick's told him Ash Wednesday was "the busiest yet," with 60,000 people coming for ashes. At my local church at noon mass one day this week, there were 40 people when normally there are roughly a dozen, and the communion line stretched to the back of the church. Something is happening. Yesterday a friend sent the warning of the Evangelical pastor David Wilkerson, of Times Square Church, that a new catastrophe is imminent. This is causing a small sensation in evangelical circles. To me, one of the signal signs of the times is the number of people surfing the Internet looking for . . . something. One friend looks for small farms in distressed rural areas. Another logs on late at night looking for a house to buy in a small town out West, or down South, or in the Deep South.
She is moving all around America in her imagination. I asked if she had a picture in her head of what she was looking for, and she joked that she wanted to go where Atticus Finch made his summation to the jury. I don't think it was really a joke. She's not looking for a new place, she's looking for the old days. I spoke to a Manhattan-based psychiatrist who said there is an uptick in the number of his patients reporting depression and anxiety. He believes part of the reason is that we're in a new place, that "When people move into a new home they increasingly recognize the importance of their previous environment." Our new home is postprosperity America; the old one was the abundance; we miss it. But he also detected a political dimension to his patients' anguish.
He felt that many see our leaders as "selfish and dishonest," that "our institutions have been revealed as incompetent and undependable." People feel "unled, overwhelmed," the situation "seemingly unsalvageable." The net result? He thinks what he is seeing, within and without his practice, is a "psychological pandemic of fear" as to the future of things—of our country, and even of mankind. So where does that leave us? The writer and philosopher Laurens van der Post, in his memoir of his friendship with Carl Jung, said, "We live not only our own lives but, whether we know it or not, also the life of our time." We are actors in a moment of history, taking part in it, moving it this way or that as we move forward or back. The moment we are living now is a strange one, a disquieting one, a time that seems full of endings. Too bad there's no pill for that.
Bankruptcy Lawyer Joins Obama’s Advisory Team on GM, Chrysler
Matthew Feldman, a bankruptcy lawyer, was added by President Barack Obama’s administration to the auto industry team advising the government on the restructuring of General Motors Corp. and Chrysler LLC. Feldman, a partner at New York-based Willkie Farr & Gallagher LLP, joins other experts aiding government officials as the automakers use up an initial $17.4 billion in federal assistance. The U.S. Treasury Department last month hired law firms Cadwalader, Wickersham & Taft LLP and Sonnenschein, Nath & Rosenthal, as well as Rothschild Inc., an investment bank.
Feldman will work on restructuring analysis, said an administration official who asked not to be named because task force matters are private. Feldman will leave Willkie Farr by the end of the month to move to Washington, the law firm said yesterday in a statement distributed by Business Wire. “We’re pleased that the task force is staffing up,” GM Chief Financial Officer Ray Young said in an interview. “They aren’t just looking at General Motors. They’re looking at the total industry. It shows that they’re taking this assignment very seriously.” General Motors, which has taken $13.4 billion in aid and was seeking as much as $16.6 billion more, said March 12 that it won’t need the $2 billion requested earlier to survive this month, though it has no “update” yet on its larger request for additional funds.
The largest U.S. automaker has lost $82 billion since its last annual profit in 2004 and has been fending off speculation about bankruptcy for more than two years.
Chrysler has said it won’t have enough liquidity if it doesn’t receive additional funds and restructure liabilities by March 31. “Chrysler LLC is fully engaged with the Presidential Task Force on the Auto Industry, the U.S. Treasury and the White House during this process of ensuring the industry’s viability going forward,” Lori McTavish, a company spokeswoman, said. “We look forward to continuing our dialogue with them as the process continues to evolve.”
The government has set a March 31 deadline for GM and Chrysler to submit final plans that show they can return to profitability and repay their loans. The co-chairmen of Obama’s auto task force are Treasury Secretary Timothy Geithner and National Economic Council Director Lawrence Summers. The administration is sticking with its time line for the plans, said an official, who asked to not be named. GM, the largest U.S. automaker, is reducing executive pay and will eliminate 47,000 jobs this year as part of a restructuring required to keep the $13.4 billion in U.S. loans it has taken. Chrysler, which lost $8 billion last year, is trying to keep $4 billion it has received with its own plan to cut labor and debt costs.
With Deflation Possibly Near, This Economist Is All Abuzz
While most investors fear deflation, Gary Shilling is looking forward to it. The idiosyncratic economist manages about $100 million for clients from a small office here. For many, many years, he has predicted an era of falling prices that never arrived. Now, finally, it just might. He has a batch of advice for investors on how to weather deflation: Don't expect your house's worth to rebound. Stash your money in apartment real-estate trusts and conventional Treasurys. Don't invest in companies that carry a lot of debt or in inflation-protected Treasurys. The last time deflation appeared was in the Depression. U.S. prices slid 32% from 1929 to 1933. Suddenly, many observers these days fear that the popping of the housing bubble, along with the financial crisis, could be pushing the U.S. toward a new deflationary era.
The consumer-price index including food and energy dropped 0.8% for December, year over year, and was flat for January. When the February CPI is reported on Wednesday, many expect it to be flat or negative again. Mr. Shilling believes price drops of 2% to 3% yearly will persist long after this recession because of huge efficiencies driven by globalization and technology, plus retirement-panicked baby boomers curbing their spendthrift ways and pumping up their puny savings. That would echo similar deflationary spells during prosperous, high-growth times like the late 1800s and the 1920s. Increasingly, Mr. Shilling is getting company from economists who think deflation may be on the way, notably New York University's Nouriel Roubini and Merrill Lynch's David Rosenberg. Of course, others such as Northern Trust's Paul Kasriel, argue that heavy federal spending by the Obama administration to jump-start the economy risks just the opposite, a vexing inflation.
Yet few go as far in seeing persisting deflation as Mr. Shilling, 71 years old, a Stanford Ph.D. in economics who once was Merrill's chief economist. Deflation in the Depression was truly baleful because it fostered a falloff in demand, since consumers were leery to buy what would be cheaper in the future. And it punished debt holders, who had to pay fixed amounts even as the value of the underlying asset sunk. The same condition bedeviled Japan in the 1990s. A frequent talking head on CNBC, Mr. Shilling sometimes comes across as an oddball with his chronic bearishness. "People say I'm always negative, and when I'm right, it's like the stopped clock being right twice a day," Mr. Shilling says. Indeed, in January 2004, he predicted a housing crash within the year. "I was early," he says. Even Mr. Shilling's hobby is on the eccentric side: He keeps bees. At his Short Hills, N.J., home and a nearby property, he tends 80 hives. Mr. Shilling gives the honey away to friends in plastic bear containers with labels saying things like: "Our bountiful bees need no bailout." Over the years, Mr. Shilling has devised a virtual deflationary handbook for investors.
Good ideas: Longer-term Treasurys and certificates of deposit, which will continue to pay interest in the low single-digits. If the CPI is down 2% and 30-year Treasurys yield 3.6%, as they do now, then you get an effective 5.6%. The housing bust is showing Americans that a place to live is no longer a can't-lose investment, Mr. Shilling says. Hence, he forecasts a surge into rental apartments, which should boost now-flagging apartment REITs. In health care, Mr. Shilling thinks winners will be companies dedicated to cost containment, like pharmacy-benefit managers. His expected victims of deflation? Auto makers (savings-minded consumers will hold onto their old cars longer) and sellers of other big-ticket goods like refrigerators. He also is down on mortgage-backed securities, linked to the plummeting housing sector.
Recession forcing many to forgo medical care
The nation’s ailing economy is plunging the health care of millions of Americans into critical condition. More than half of American households have cut back on health care in the past year because of concerns about the costs, according to a new Kaiser Family Foundation survey. We’re putting off visits to the doctor and dentist. We’re postponing needed tests. We’re not filling prescriptions. We’re relying more on home remedies and over-the-counter drugs. For the persistent and resourceful, affordable medical care is available. Free clinics are packed, and hospitals are seeing more patients seeking help with their medical bills. “We’re filling more appointments than we ever had in the past,” said Sheri Wood, executive director of the Kansas City Free Health Clinic.
In Washington, President Barack Obama and Democrats in Congress have fast-tracked health care reform, working to have a plan in place this year to make coverage available to the nation’s 48 million uninsured. At a summit with health care interest groups earlier this month in Washington, Obama said there was “a clear consensus that the need for health care reform is here and now.” The recession is giving health care reform new urgency. As incomes shrink and layoffs mount, more people are losing their health insurance, putting critically needed care out of reach. For each 1 percentage point increase in the unemployment rate, about 1.1 million are added to the rolls of the uninsured, according to one estimate.
Signs are mounting that people are cutting back on health care. Nationwide, more than a million cancer survivors are foregoing what they think is necessary care because of the cost, according to new data from a National Cancer Institute researcher. Even those with discretionary income are trimming back. A survey of plastic surgeons shows big decreases in demand for high-ticket procedures such as breast augmentations and liposuction. Demand for lower-priced enhancements such as Botox has held steady or even increased. A general decline in elective procedures is one of the reasons cited by the Federal Reserve for the falling patient volumes reported by health care providers in the Fed’s San Francisco, Minneapolis and Richmond, Va., regions.
Laid-off workers who had health insurance through their employers can maintain coverage through COBRA, the federal Consolidated Omnibus Budget Reconciliation Act of 1985. But workers have had to pay 102% of the full cost of the insurance for COBRA coverage — well over $12,000 for a typical family policy. Some relief is coming from the new federal economic stimulus package. It provides a temporary 65% COBRA premium subsidy to many workers laid off from Sept. 1 of last year through the end of this year. Doctors hope the poor economy doesn’t force patients to sacrifice their health. If nothing else, people should adopt more healthful lifestyles to avoid running up medical bills, said Rex Archer, director of the Kansas City Health Department. “This is really an opportunity to rethink how you’re living,” he said.
G-20 Commits to Recovery Measures, Not Stimulus Spending
Top government officials from around the world committed to take steps to revive the ailing global economy and financial markets, but stopped short of making specific commitments to stimulus spending—a U.S. priority—and also pressured the Obama administration to fix its banking system. U.K. Chancellor of the Exchequer Alistair Darling speaks to U.S. Treasury Secretary Timothy Geithner on the sidelines of the G-20 meeting. Finance ministers and central bank governors from the Group of 20 leading nations broadly agreed to a number of measures, including implementing expansionary fiscal and monetary policies "until growth is restored." But they stopped short of agreeing on a specific 2% stimulus target U.S. officials had suggested and made only generalized commitments to new measures.
The U.S. and leading European nations have been split on whether more stimulus spending is necessary—the Germans and French are opposed—and the weekend's meeting of finance ministers didn't appear to resolve the tension. The G-20 session was held in a countryside hotel south of London in preparation for a summit meeting of G-20 heads of state and government April 2 in the British capital. Failure to reach a firmer agreement then could further unsettle global financial markets. The deteriorating health of some big banks was a dominant theme of the meeting, and officials agreed that more needed to be done to address the toxic assets eating away bank reserves and curbing bank lending. Some foreign leaders expressed surprise that U.S. efforts to contain the banking crisis hadn't been more effective or more rapidly implemented.
During the discussions, Treasury Secretary Timothy Geithner told his peers that U.S. officials acknowledged the country's role in creating the crisis and recognized a greater responsibility to lead the world out of it, one person attending the meeting said. "Damage inflicted by financial crises is brutal and indiscriminate," Mr. Geithner said in an interview after the meeting. "We all have a shared interest in a stronger recovery globally." U.K. Chancellor of the Exchequer Alistair Darling, who hosted the summit, said policy makers agreed to "to do whatever was necessary and continue to do it for as long as is necessary" to combat the financial crisis. The discussions also focused on other ways to address the financial crisis, and to ensure any new measures didn't hamper any recovery, from increasing financial-market oversight and bank-capital requirements to boosting the finances of the International Monetary Fund so it can better help emerging economies.
"You are seeing the world move together at a speed and on a scale without precedent in modern times," Mr. Geithner told reporters after the meeting. In an unusual move, the officials released a three-page "framework for financial repair and recovery" aimed at restoring bank lending. The framework was meant to address the concern of some governments that efforts to address the troubled assets at the heart of the crisis haven't been aggressive enough. Possible actions it listed included providing liquidity through government guarantees, injecting capital into banks, safeguarding deposits, and addressing impaired assets. "Some countries have not fixed their banks, so I want them to fix their banks," Canada's Finance Minister Jim Flaherty said after the meeting.
The point was also emphasized by Germany's finance minister Peer Steinbrueck. Germany, like other European nations, has been under U.S. pressure to boost its fiscal stimulus. "We are convinced it makes no sense to pump more and more money in our economy when we haven't restored the confidence on the financial markets," he told reporters during a joint press conference with his French colleague Christine Lagarde—an indication of the two countries' similar position on the matter. The original $700 billion Troubled Asset Relief Program devised by former Treasury Secretary Henry Paulson was initially designed to allow banks to rid themselves of assets that were causing spiraling losses and had destroyed confidence in the banking system. Mr. Paulson switched gears after a few weeks to focus on capital injections.
Mr. Geithner, as part of his bailout revamp, has refocused attention on the asset problem. In addition to a program already initiated with the Federal Reserve, he's expected to unveil shortly details of a public-private partnership designed to buy soured mortgages and other loans. Despite these tensions, ministers said the meeting had been marked mostly by strong agreement over the urgency for united action. Guillermo Ortiz, Mexico's central bank governor, said in an interview: "The gravity of the crisis was recognized… I've rarely seen however such a unity of views in terms of diagnosis, in terms of what needs to be done and the necessity of showing common ground." They also said further discussion was necessary. Christian Noyer, France's central bank president, said: "It's a stage, but an important stage." Policy makers also agreed to expand the resources and the clout of the IMF, which they called on to play a role monitoring the efforts of each G-20 nation.
They agreed to expand the purview and membership of the Financial Stability Forum, a global group of bank regulators, so it could better coordinate policy responses to the banking sector. Several officials mentioned the need to take aggressive steps to coordinate oversight of financial markets, including creating stronger capital requirements. The G-20 communiqué did not stress an immediate need to make changes to financial regulation. Some had expected a stronger commitment leading up to the meeting. The Obama administration is working to finish a "White Paper" that will lay out in detail the types of regulatory changes it believes are needed to oversee U.S. financial markets in the future. These ideas could be released in two weeks when Mr. Geithner testifies before the House Financial Services Committee. "We are going to be ambitious, but we are going to work with" other countries, Mr. Geithner said in the interview.
International deals on sharing tax data could take years to complete
Monaco succumbed to international pressure during the weekend, becoming the latest country to adopt O.E.C.D. standards for banking openness and information-sharing, but the United States and its main European allies in battling tax evaders faced what could be years of negotiation before they are able to proclaim victory. "There’s been dramatic progress," Angel Gurría, the secretary general of the Organization for Economic Cooperation and Development, said by telephone Sunday.
While the organization has been working since 1996 to encourage greater banking sector openness, he said, "there is a new atmosphere," partly because the financial crisis has helped to focus the attention of finance officials in the United States, Germany, Britain and France, who were eager to crack down on tax cheats to replenish their coffers. But he cautioned that thousands of double-taxation laws would have to be amended and in some cases referendums would have to be held before. "This will require changing not just culture and habits, but also laws," Mr. Gurría said. A spokesman for the Monaco government, who could not be identified because of official rules, said he expected an official announcement this week that the country would adopt the rules.
Monaco is joining Switzerland, which — along with Austria, Belgium, Luxembourg, Andorra, Liechtenstein, Singapore and Hong Kong — told the OECD in the past few weeks that it would abide by the standards outlined under Article 26 of the OECD’s Model Tax Convention that requires the tax authorities to exchange information on request if there is probable cause to suspect tax evasion. The rush of compliance comes as leaders of the Group of 20 are expected to highlight the issue — and greatly expand the list of "uncooperative tax havens" — at their meeting on April 2 in London, subjecting the holdouts to intense international scrutiny. Mr. Gurría said that there had been no effort to "blacklist" individual countries, and he noted that Hong Kong, Singapore and Macao were technically not even "tax havens" at all but merely needed to make some changes to bring their regulations in line with OECD standards.
There is some doubt about how long the enthusiasm of the newfound converts will last. After an outcry in the Swiss media following the announcement that the country would comply with the OECD standards, the Swiss government issued a statement Saturday saying the decision "does not constitute ‘the end of bank secrecy,"’ and said the government "has stated on several occasions that Switzerland has no intention of relinquishing bank secrecy." "The Swiss are trying to gain time," Nicolas Michellod, an analyst with the Zurich office of with Celent, a international financial research firm. "Negotiating new tax treaties with each country will take years." He said that could give opponents of the measure on the Swiss right, whom he described as feeling aggrieved by the international criticism, a chance to drag out any changes to the banking laws until the issue moved out of the headlines.
Still, the United States and Germany, in particular, are unlikely to be satisfied even with the latest steps, he predicted, and will keep the pressure on. Switzerland distinguishes between tax fraud and tax evasion and does not consider tax evasion to be a crime. By adopting the OECD definition, it has agreed to exchange information when provided with specific information in a specific request. The Swiss authorities said they would still not allow so-called "fishing expeditions." In one such case, UBS, the big Swiss bank, is fighting a civil case in the United States by the U.S. Internal Revenue Service that it turn over account data on 52,000 Americans.
Mr. Gurría argued that the momentum for compliance was strong. "I have read the expressions of skepticism and I find them understandable in the light of history, but I think there’s been a very important change," he said. Having accepted their obligation to comply with the standards, countries that balk when it comes time to implement them will find themselves under pressure from their trading partners and investors, he added.
Baby Boomers ‘Under Water’
A recent report suggests that the housing-market slump is hitting baby boomers particularly hard: many middle-aged homeowners had been so seduced by the rising prices of years past that they failed to save for retirement and may now owe more than their homes are worth. The Center for Economic and Policy Research in Washington, which released the report last month, estimated that 30 percent of homeowners aged 45 to 54 were in this predicament, known as being “under water.” (About 15 percent of older baby boomers, 55 to 64, fell into that category as well.) So, if these people were forced to sell their homes now, they would have to bring cash to the closing.
The center’s report also found that baby boomers in the 45-to-54 group saw their overall net worth plummet by about 45 percent over the last five years, to a median level of $94,200 from $172,400. While the drop partly reflected the meltdown of Wall Street, Dean Baker, the co-director of the Center for Economic and Policy Research, said that conservative estimates showed that home equity accounted for about $20,000 of the net income figure. Another factor that has led to a decline in personal wealth is what the report calls “the near zero level of savings nationally” from 2004 to 2009. “As a result of the bubble-inflated values of their homes, tens of millions of families opted not to save during what would typically be their peak saving years,” the report said.
The center used 2004 consumer finance data from the Federal Reserve Board that measured a typical consumer’s wealth in several categories, including stocks and home equity. Researchers then reduced those values in accordance with the drop in the Standard & Poor’s 500-stock index and the median sale price of a house as tracked by the National Association of Realtors. The November S.&P./Case-Shiller 20-city price index was also factored into the projections. Mr. Baker said he suspected that fewer baby boomer homeowners were under water in the New York metropolitan region than in other parts of the country, particularly areas where prices have fallen sharply, like Florida, Arizona and Rust Belt states like Michigan and Ohio. But he said that because of the financial industry’s persistent woes, owners in the New York area could see more significant declines in home prices this year.
Indeed, many areas in the region are already suffering. According to a report this month by Integrated Asset Services, a Denver-based real estate consulting firm, prices in Fairfield County, Conn., have dropped 42 percent since their peak in 2006, while prices in Passaic County, N.J., have dropped 26 percent. Those homeowners around age 60 whose mortgages are under water, and who might now be considering selling, should carefully weigh their options, said Richard E. Austin, a financial adviser with Lincoln Financial Advisors in Rye Brook, N.Y. Selling the house would cost them money, he noted, which could mean that they might need to liquidate other assets — even retirement savings plans like 401(k)’s.
But Mr. Austin said that if these homeowners expected real estate prices to decline for years, and if they wanted to retire someplace other than their current home, selling now could shield them from deeper losses in the future. “I wouldn’t recommend that as the first option, because I’m more of an optimist,” Mr. Austin said, adding that a better option might be to rent out the house while waiting for home prices to rebound. Even baby boomers who aren’t under water could have a more difficult time affording retirement. According to the center’s report, five years ago, the median baby boomer household, with people aged 45 to 54, had enough net assets to generate about $14,000 in annual interest once the homeowners reached age 65. Now, that figure is just under $8,000.
California Faces -New- $8 Billion Budget Shortfall
Despite closing a $42 billion budget deficit through steep cuts and new taxes last month, California now faces a $8 billion budget shortfall by July 2010 because of declining tax revenue, according to a report released Friday. About $2 billion of the deficit can be wiped immediately with money from the state's planned reserves. The study by the nonpartisan Legislative Analyst's Office said California can eliminate an additional $3 billion with funds from the federal stimulus package. The legislature plans to address the remaining $3 billion gap -- which could rise if revenue drops further -- in a spring session. The report comes as no surprise to Sacramento officials, who expected revenue to plummet as the nationwide recession worsened.
The state could also be an additional $6 billion in the red if voters don't approve a series of propositions in May that would allow the state to borrow money and redirect some spending. A Field Poll released last week showed voters supporting all the initiatives by comfortable margins. Gov. Arnold Schwarzenegger on Feb. 20 signed a $131 billion budget that closed the then $42 billion gap through July 2010. The plan raises $13 billion in revenue by raising sales taxes, income taxes and vehicle-license fees, and slashes $16 billion in spending, including $8.4 billion in education. The rest of the gap will be closed by borrowing or with federal-stimulus money.
As Economy Plummets, Cashless Bartering Soars on the Internet
The next time Kevan Quinn needs his sink unclogged, he won't pay cash. Instead, Quinn will take the plumber and his family out sailing on his boat. "In this climate, when everyone's concerned about their money, this is a cracking idea," said Quinn, 49, a father of three who found his plumber on http://swapaskill.com, a bartering Web site based in Britain. "It's a great way to get things done without using cash." Bartering and swapping are booming as the global financial crisis squeezes cash out of the world's wallet. Web sites and business organizations promoting cash-free transactions are growing, from New Hampshire to New Zealand to Sri Lanka, as unemployment soars and millions are struggling to pay their bills.
"It's hot right now," said Ron Whitney of the International Reciprocal Trade Association, based in Portsmouth, Va. Whitney said that about $12 billion worth of business-to-business bartering happens each year around the world and that more than 250,000 U.S. businesses bartered goods and services last year. Now, he said, the growing recession has created new interest in that long-established business trade, as well as boosting the person-to-person swaps taking place on Web sites and in community networks worldwide. A spokesman for Craigslist, the online classified advertising service, said bartering has doubled on the site in the past year. Proposed swaps listed on the Washington area Craigslist site this week included accounting services in return for food, and a woman offering a week in her Hilton Head, S.C., vacation home for dental work for her husband.
"Obviously people are looking for other ways of getting what they need without paying for it," said Nicole Wehden, founder of Swapaskill, which will soon launch in Washington and other cities across the United States. "The general mood is gradually coming away from the spend-spend-spend culture," Wehden said. "People are taking stock and seeing if there is another way of doing things." http://U-exchange.com lists people looking for barters and swaps in more than 80 countries. California-based http://swapthing.com lists more than 3.4 million items for barter or swap, from Chevies to Frisbees to gymnastics coaching. Sites such as http://homeexchange.com are becoming increasingly popular with those who don't want to pay for a vacation home. But others cater to people who want to meet the mundane needs of everyday life without using cash or credit cards.
One person in England recently traded several old cellphones for a secondhand motorcycle, while others have traded gardening for babysitting. They are swapping skills from physical therapy to French lessons, to a woman offering services as a "secretary/stripper." It is up to the swappers to determine what is a fair trade and how to mail or exchange the goods and services. Paul Kay, co-founder of http://swapz.co.uk, said the "absolutely enormous" increase in his business also reflects a desire for transactions that are less about commerce and more about connections between people. "This is a new community spirit I've seen within the last three months as things get tighter economically," Kay said. With unemployment in the United States and Britain climbing, some people said bartering is the only way to make ends meet.
"I'm using barter Web sites just to see what we can do to survive," said Zedd Epstein, 25, who owned a business restoring historic houses in Iowa until May, when he was forced to close it as the economy soured. Epstein, in a telephone interview, said he has not been able to find work since, and he and his wife moved to California in search of jobs. Epstein said he has had several bartering jobs he found on Craigslist. He drywalled a room in exchange for some tools, he poured a concrete shed floor in return for having a new starter motor installed in his car, and he helped someone set up their TV and stereo system in return for a hot meal. "Right now, this is what people are doing to get along," said Epstein, who is studying for an electrical engineering degree.
"If you need your faucet fixed and you know auto mechanics, there's definitely a plumber out there who's out of work and has something on his car that needs to be fixed," he said. Quinn, the boat owner, said he earns a good salary as a project manager for an aviation company and two years ago decided to treat himself to a sailboat. "People assume that because you have a boat you have lots of money," said Quinn, who said buying the 36-foot craft drained a lot of his cash, which is now much more scarce. "You don't have to be on the verge of bankruptcy to swap skills," he said. Judy Berger, founder of http://whatsmineisyours.com, a swapping Web site based in Britain that focuses on fashion, said her site has 22,000 users around the world. She said that her users are swapping about 1,000 items a week and that her site is becoming "less eBay, more Facebook" as swappers create relationships with groups of swappers with similar tastes.
She said more users, mainly women, are pairing off with someone of similar size and fashion sense and constantly refreshing their wardrobe with each other's clothes. In the current economic climate, Berger said, cashless bartering allows shopaholics to find a less expensive outlet for their habit. "They are saying, 'I've saved this amount of money this year that I didn't spend on clothes,' " Berger said. "It's a new way of looking at shopping." Simon Roberts, 42, from Nottingham, England, has turned swapping into a business. In February 2008, Roberts had an old Ford van worth about $400. He was out of work and needed money, so on a whim he looked on the Internet and came across Swapz. He traded his van for an SUV worth about $3,000, he said. The SUV owner needed a van, so he was willing to make the uneven trade.
"It doesn't matter what you got, or what it costs; it's what the other person wants to pay," Roberts said. In the year since then, Roberts said he has made 39 swaps, and he estimates he is more than $30,000 ahead of where he started. He now owns a bouncy castle company, which he got in a swap for a fancy four-wheel-drive truck. He also owns a Mercedes-Benz and has about $12,000. He said he got the cash from selling one car, pocketing most of the money but using a bit to buy a cheap car and start swapping all over again. "Sell your house and get into it," Roberts said. "Honestly, I really would."
Obama's Poll Numbers Are Falling to Earth
It is simply wrong for commentators to continue to focus on President Barack Obama's high levels of popularity, and to conclude that these are indicative of high levels of public confidence in the work of his administration. Indeed, a detailed look at recent survey data shows that the opposite is most likely true. The American people are coming to express increasingly significant doubts about his initiatives, and most likely support a different agenda and different policies from those that the Obama administration has advanced.
Polling data show that Mr. Obama's approval rating is dropping and is below where George W. Bush was in an analogous period in 2001. Rasmussen Reports data shows that Mr. Obama's net presidential approval rating -- which is calculated by subtracting the number who strongly disapprove from the number who strongly approve -- is just six, his lowest rating to date. Overall, Rasmussen Reports shows a 56%-43% approval, with a third strongly disapproving of the president's performance. This is a substantial degree of polarization so early in the administration. Mr. Obama has lost virtually all of his Republican support and a good part of his Independent support, and the trend is decidedly negative.
A detailed examination of presidential popularity after 50 days on the job similarly demonstrates a substantial drop in presidential approval relative to other elected presidents in the 20th and 21st centuries. The reason for this decline most likely has to do with doubts about the administration's policies and their impact on peoples' lives. There is also a clear sense in the polling that taxes will increase for all Americans because of the stimulus, notwithstanding what the president has said about taxes going down for 95% of Americans. Close to three-quarters expect that government spending will grow under this administration.
Recent Gallup data echo these concerns. That polling shows that there are deep-seated, underlying economic concerns. Eighty-three percent say they are worried that the steps Mr. Obama is taking to fix the economy may not work and the economy will get worse. Eighty-two percent say they are worried about the amount of money being added to the deficit. Seventy-eight percent are worried about inflation growing, and 69% say they are worried about the increasing role of the government in the U.S. economy. When Gallup asked whether we should be spending more or less in the economic stimulus, by close to 3-to-1 margin voters said it is better to have spent less than to have spent more. When asked whether we are adding too much to the deficit or spending too little to improve the economy, by close to a 3-to-2 margin voters said that we are adding too much to the deficit.
Support for the stimulus package is dropping from narrow majority support to below that. There is no sense that the stimulus package itself will work quickly, and according to a recent Wall Street Journal/NBC poll, close to 60% said it would make only a marginal difference in the next two to four years. Rasmussen data shows that people now actually oppose Mr. Obama's budget, 46% to 41%. Three-quarters take this position because it will lead to too much spending. And by 2-to-1, voters reject House Speaker Nancy Pelosi's call for a second stimulus package. While over two-thirds support the plan to help homeowners refinance their mortgage, a 48%-36% plurality said that it will unfairly benefit those who have been irresponsible, echoing Rick Santelli's call to arms on CNBC.
And although a narrow majority remains confident in Mr. Obama's goals and overall direction, 45% say they do not have confidence, a number that has been growing since the inauguration less than two months ago. With three-quarters saying that they expect the economy to get worse, it is hard to see these numbers improving substantially. There is no real appetite for increasing taxes to pay for an expanded health-insurance program. Less than half would support such an idea, which is 17% less than the percentage that supported government health insurance when Bill Clinton first considered it in March of 1993. While voters blame Republicans for the lack of bipartisanship in Washington, the fact is that they do not believe Mr. Obama has made any progress in improving the impulse towards cooperation between the two parties. Further, nearly half of voters say that politics in Washington will be more partisan over the next year.
Fifty-six percent of Americans oppose giving bankers any additional government money or any guarantees backed by the government. Two-thirds say Wall Street will benefit more than the average taxpayer from the new bank bailout plan. This represents a jump in opposition to the first plan passed last October. At that time, 45% opposed the bailout and 30% supported it. Now a solid majority opposes the bank bailout, and 20% think it was a good idea. A majority believes that Mr. Obama will not be able to cut the deficit in half by the end of his term. Only less than a quarter of Americans believe that the federal government truly reflects the will of the people. Almost half disagree with the idea that no one can earn a living or live "an American life" without protection and empowerment by the government, while only one-third agree.
Despite the economic stimulus that Congress just passed and the budget and financial and mortgage bailouts that Congress is now debating, just 19% of voters believe that Congress has passed any significant legislation to improve their lives. While Congress's approval has increased, it still stands at only 18%. Over two-thirds of voters believe members of Congress are more interested in helping their own careers than in helping the American people. When it comes to the nation's economic issues, two-thirds of voters have more confidence in their own judgment than they do in the average member of Congress.
Finally, what probably accounts for a good measure of the confidence and support the Obama administration has enjoyed is the fact that they are not Republicans. Virtually all Americans, more than eight in 10, blame Republicans for the current economic woes, and the only two leaders with lower approval ratings than Harry Reid and Nancy Pelosi are Republican leaders Mitch McConnell and John Boehner. All of this is not just a subject for pollsters and analysts to debate. It shows fundamentally that public confidence in government remains low and is slipping. We face the possibility of substantial gridlock along with an absolute absence of public confidence that could come to mirror the lack of confidence in the American economy that the Dow and the S&P are currently showing.
Jon Stewart Wrecked Cramer -- Did He Elect Obama?
Before he left CNBC's Jim Cramer in the dirt, Jon Stewart had pretty much knocked CNN's "Crossfire" off the air and drawn blood from Chris Matthews and Bill Kristol, among others. But he also played a role in helping to elect Barack Obama. Mainly it was through his show's withering and wicked mockery of President Bush and Vice President Cheney for several years, and much of the same directed at John McCain and Sarah Palin (Stewart suggested that she might be "tagged and released into the wilderness"). Here are just a few of Stewart's highlights for the final year of the election campaign, excerpted from my new book, "Why Obama Won" (Sinclair Books).
January 2008: Jon Stewart played clips of various "experts" on Fox declaring that the main culprit behind our sinking financial picture and the sell-offs on Wall Street was fear of a Democratic victory in November. Stewart's comment: "How bad do the Democrats have to be to pre-f**k the economy?" He also played statements by numerous pundits hailing Fred Thompson's chances, before he ran, closing with Bill Kristol calling him truly "formidable." Stewart: "Oh, Bill Kristol, aren't you ever right?"
Joe Biden, by serendipity, was booked on The Daily Show just as everyone was mocking his quip about Obama being "the first mainstream African-American who is articulate and bright and clean and a nice-looking guy." Biden told Jon he was simply trying to be "complimentary" toward Obama, but wasn't "artful" in doing so. He said he had already called Obama, to which Stewart quipped, "I bet you did." Biden then said he also called former candidates Jesse Jackson and Al Sharpton, to which Stewart added: "And Michael Jordan?"
March 2008: Appearing on The Daily Show on the eve of the Pennsylvania primary, Barack Obama denied a hot rumor -- just started by Jon Stewart -- that he planned, if elected to the White House, to "enslave the white race." Obama quipped, "That is not our plan, Jon, but I think your paranoia might make you suitable as a debate moderator."
October 2008: Michelle Obama, the possible future First Lady, made her first appearance on The Daily Show. Jon introduced her, in scary tones, as a longtime "associate" of Barack Obama, but somehow refrained from accusing her husband of fathering two black babies. Later in the month, the candidate himself appeared. Obama cracked that no matter what he does, yes, there will be some Sean Hannity fans who won't want to go out for a beer with him. One funny bit: After Obama questioned the "Bradley Effect" -- that a lot of white supporters won't be able to pull the lever for him -- Stewart speculated that, on Election Day, Obama's own white half might suddenly decide in the voting booth: "I can't do this." "It's a problem," Obama quipped. "I've been going through therapy to make sure I vote properly on the 4th."
Then there was Bill Kristol appearing on the show to defend the McCain ticket and claim he would pull it out on election day. The New York Times columnist also predicted that Obama would disappoint his lefty supporters in office, prompting Stewart to ask, Why then are you and McCain calling him a radical leftist? But the high point was Kristol asserting that Stewart was wrong about McCain because he was "reading The New York Times too much." "But Bill," Stewart, replied, "you WORK for The New York Times." Not for much longer.
Don't touch the unsecured creditors! Clobber the tax payer instead
by Willem Buiter
Good Bank vs Bad Bank
The Good Bank solution differs significantly from the Bad Bank solution as regards its distributional implications, its medium-term and long-term incentive effects and its immediate financial stability impact.
Under the Bad Bank approach, the authorities either purchase toxic assets from the banks that made the toxic investments/loans, or they guarantee (insure) these toxic assets. Toxic assets are assets whose fair value cannot be determined with any degree of accuracy. Clean assets are assets whose fair value can easily be determined. Clean assets can be good assets (assets whose fair value equals their notional or face value) or bad assets (assets whose fair value is below their notional or face value). When the authorities acquire the toxic assets outright, they establish a legal entity to manage these assets - the Bad Bank. The publicly-owned Bad Bank either sells these toxic assets as and when they cease to be toxic and a liquid market for them re-emerges, or holds them to maturity.
Under the Bad Bank approach, the legacy banks, either sans the toxic assets or with the toxic assets guaranteed by the state, live to fight another day. The presumption is that the state overpays for the toxic assets. The price it pays is certainly greater than the immediate liquidation value of the assets by their owners. It is also likely to exceed the present discounted value of the future cash flows of the assets, or their hold-to-maturity value. Similarly, the cost of any guarantees provided by the state in the case where the toxic assets continue to be held by the banks, is likely to be less than the fair value of these guarantees.
The rationalisation for the creation of Bad Banks and for toxic asset purchases by the state that was part of the original TARP proposal - it would serve as a price discovery mechanism for potentially socially useful financial instruments that had temporarily become illiquid - is no longer credible. Most of the toxic assets ought never to have been created and, with a bit of luck, will never be seen again. So the fundamental rationale for the creation of Bad Banks and for toxic asset purchases by the state is the provision of a subsidy to the banks that made the toxic loans and investments. These beneficiaries include the top management and board of these banks, the shareholders and the unsecured and non-guaranteed creditors.
The subsidies for the legacy banks inherent in the purchase by the state of the toxic assets and/or in the guarantees provided by the state for these toxic assets are further boosted by the myriad modalities of further official financial support for these banks. These can be additional capital injections, guarantees for new borrowing or guarantees for new loans and investments by the banks.
Under the Good Bank approach, the state creates a new bank, the Good Bank, which gets the deposits and the clean assets of the old banks. The old bank gets compensation equal to the difference between the (known) value of the clean assets it loses and the value of the deposits it gives up. The state may also inject additional public capital into the Good Bank, or it may invite in additional private capital. Government financial support is given only to new lending, new investment and new funding by the Good Bank. The legacy (ex-)bank has its banking license taken away and simply manages the existing stock of toxic assets. The legacy (ex-)bank does not get any further government support.
The Hall-Woodward-Bulow good bank solution
A particularly neat example of the Good Bank solution has been proposed by Robert E. Hall of Standford University and Susan Woodward of Sand Hill Econometrics. It can be found on the Vox website. They attribute the key idea to Jeremy Bulow. In what follows I merely adapt their numerical Citicorp example to the RBS Group.
The data for the Table below come from the Annual Report & Accounts 2008 of RBS. I am doing the exercise for the whole RBS Group. As it is unlikely that home country governments would be willing (or even able) to support the foreign subsidiaries of their banks, it might have been more appropriate just to consider the UK high-street banking units of the RBS Group. I leave that as an exercise for the reader.
Total equity of the RBS Group at the end of 2008 is reported on the balance sheet as just over £80bn. Market capitalisation is around £ 8bn. I therefore subtract £72 bn from the £2,402 total assets reported for the end of 2008, which leaves adjusted total assets at £2,330 bn. The tax payer has already put £45 bn into RBS. In addition, RBS has placed £325 bn of toxic assets in the government’s Asset Protection Scheme.
This means that RBS is a dead bank walking, a zombie bank, with its market capitalisation much less than past and present government financial support, let alone past present and anticipated future government financial support, which would also be reflected in today’s market capitalisation. I could have done the same type of exercise for Lloyds Banking Group, for Citicorp, for Bank of America or for UBS and many other zombie border-crossing banks.
On the asset side of RBS group are clean assets (good and bad, but with known fair values) and toxic assets (assets with unknown fair values and derivatives. On the liability side, I distinguish deposits, debt securities and other non-deposit liabilities, and derivatives. In the US, the derivatives on both the asset and liability sides of the balance sheet would have been netted, which would have reduced the size of the balance sheet by almost one trillion pounds.
I assume that the £325 bn worth of toxic asset insurance offered by the authorities to RBS equals the stock of toxic assets on its balance sheet. This leaves RBS with just over £ 1 trillion worth of clean assets (and the derivatives, just under £1 trillion). ‘Deposits’ is shorthand for guaranteed or secured creditors. The £899 bn worth of deposits on the RBS balance sheet is, however, larger than what is formally covered by UK deposit insurance (or by the applicable deposit insurance schemes of the foreign subsidiaries). Debt securities and other non-deposit liabilities are claims on RBS by unsecured and non-guaranteed creditors. They include all unsecured debt, including subordinated debt, other junior debt and senior debt. RBS had £452 bn of this unsecured and non-guaranteed debt (plus of course some non-guaranteed and unsecured liabilities included in ‘deposits’). Then there is just under £1 trillion worth of derivatives on the liability side of the balance sheet.
Equity - market capitalisation - is a mere £ 8 billion, giving a capital ratio (equity as a percentage of assets) of 0.34%. Even with all the government support it has received, RBS group is effectively worth nothing.
The Hall-Woodward-Bulow Good Bank - Bad Bank deconstruction of the RBS balance sheet requires one key condition to hold: the value of the clean assets of RBS has to exceed that of its deposit liabilities. This will be more likely the larger the amount of non-deposit funding RBS engages in.
We split RBS into a Good Bank and a Bad Bank by giving the deposits and the clean assets of RBS to the Good Bank, leaving everything else with the Bad Bank, and giving the Bad Bank all the equity in the Good Bank. (The derivatives on both sides of the balance sheet could be given to the Good Bank instead of to the Bad Bank, assuming they are clean). Since the value of the clean assets (£1,012 bn) exceeds that of the deposits (£ 899 bn), the good bank has equity of £114 bn (mind the rounding errors!). Its capital ratio is a healthy 11.25%. If I had used a more restrictive definition of ‘deposits’, the capital ratio could easily have been over 20% or even 30%.
The Bad Bank keeps the toxic assets and derivatives of RBS. It also has the equity in the Good Bank as an asset on its balance sheet. On the liability side it has just the unsecured and non-guaranteed debt securities and other non-deposit liabilities. Its equity is, of course, the same as that of RBS: £8 bn. Its capital ratio will therefore be higher than that of RBS, because the balance sheet of the Bad Bank is smaller. Neither the equity owners of the Bad Bank nor the unsecured and non-guaranteed creditors of the Bad Bank are worse off than, respectively, the equity owners of RBS and the unsecured and non-guaranteed creditors of RBS.
To achieve the deconstruction/decomposition of RBS into a Good Bank and a Bad Bank according to the Hall-Woodward-Bulow principles would require that RBS be put into temporary administration. The new Special Resolution Regime (SRR) introduced for the UK in February 2009 provides the ideal legal setting for this. It should not take long, a weekend at most. Basically, the Bad Bank just becomes a financial portfolio of toxic assets and derivatives, plus its stake in the Good Bank. It would not be allowed to invest in any new assets or to engage in any banking activities. It would manage the existing asset portfolio down and would cease to exist once the last asset has been sold or has matured. Among the clean assets the Good Bank buys would be the buildings, equipment etc. necessary for conducting the banking operations of the Good Bank.
If the UK government had not been daft enough to guarantee the £325bn worth of toxic assets on the balance sheet of the Bad Bank, there can be little doubt that the Bad Bank I have just constructed would have failed soon after coming out of the SRR. The Bad Bank, which is just a fund restricted not to invest in new assets, would be put into administration. The shareholders would be wiped out (more than 70 percent of RBS is now government-owned), and the unsecured and non-guaranteed creditors would determine what to do with the Bad Bank and its assets. Most likely there would be a significant debt-to-equity conversion and/or a large write-down of the debt.
The government would focus its financial support on the Good Bank, either by providing it with additional capital or by guaranteeing new lending and/or new borrowing by the Good Bank. Private capital could be attracted into the Good Bank too.
Distributional differences between the Good Bank and the Bad Bank solution
The Good Bank solution favours the tax payer. The Bad Bank solution favours the unsecured and non-guaranteed creditors of the zombie banks. ‘Tax payer’ includes those beneficiaries of public spending programmes that may have to be cut to meet the fiscal cost of purchasing or guaranteeing the toxic assets under the Bad Bank solution. It also includes those who lose as a result of future inflation or sovereign default, should either of these two solutions to dealing with the public debt created as a result of the Bad Bank solution eventually be adopted.
The Bad Bank solution also favours the shareholders of the zombie banks, but in the case of RBS, this is mainly the government and therefore the taxpayers. The amount of shareholder equity involved in the zombie banks is, in any case, negligible compared to the exposure of the unsecured and non-guaranteed creditors. The Bad Bank solution also saves the jobs and perks of the top management and the boards of the zombie banks - often the very people responsible for turning a once-healthy bank into a zombie bank.
There can be no doubt that, from a distributional fairness perspective, the Good Bank solution beats the Bad Bank solution hands down.
Incentive effects of the Good Bank and the Bad Bank Solution.
The Bad Bank solution creates moral hazard, because it rewards past reckless investment and lending. It also represents an inefficient use of public funds in stimulating new lending by the banks. To stimulate new lending, a subsidy to or guarantee of new lending is more cost efficient than the ex-post insurance of losses that have already been made on old lending, even though their true magnitude is not yet known. The Good Bank solution leaves the toxic waste with those who invested in it and with those who funded these activities, freeing government funds for reducing the marginal cost of new lending or increasing the expected return to new lending.
Both as regards moral hazard (incentives for excessive future risk taking) and as regards the efficient use of government funds (’new lending bang per buck’), the Good Bank solution beats the Bad Bank solution hands down.
Financial stability implications of the Good Bank and Bad Bank solutions: saving banking, without saving bankers or the existing banks
The holders of bank debt, with the possible exception of perpetual subordinated debt (which counts as tier one capital in some countries), have become the sacred cows of this financial crisis. Regulators, central bankers and Treasury ministers are quite willing to see shareholders wiped out. After the demise of WAMU and Lehman Brothers, however, the unsecured creditors have become inviolable. Somehow, those in charge of macro-prudential stability, notably the Fed, have bought into the notion that if there is either a further default on bank debt, or a restructuring involving a significant debt-to-equity conversion, or a signficant write-down of the claims of bank bond holders, this will be the end of the world.
I just don’t buy it. Fortunately, I am not the only one. Luigi Zingales, the Robert C. McCormack Professor of Entrepreneurship and Finance at the Chicago Business School, has been advocating the case for mandatory debt-into-equity conversions, debt forgiveness and other up-tempo Chapter 11- style financialestructuring of banks and other defunct behemoths like GM, since the first days of the crisis (see e.g. (1) and his book Saving Capitalism from the Capitalists, co-authored with Raghuram Rajan). Robert Hall and Susan Woodward also feel no need to pay any special attention to or lavish any public funds on the toxic assets, their owners and those who funded them (the unsecured and non-guaranteed creditors) once the Good Bank has been established and sent on its way.
Part of the reason there appears to be this widespread belief that you have to guarantee all bank liabilities is that this is what the Swedish authorities did during their 1991-1993 banking crisis (see e.g. Lans Jonung’s paper “The Swedish model for resolving the banking crisis of 1991-93. Seven reasons why it was successful” . First, Jonung lists seven criteria for ’successful’ resolution of a banking crisis. The paper does not demonstrate that this septet constitutes a set of necessary and sufficient conditions for success - if indeed the Swedish approach is deemed to have been a success. Second, success is in the eyes of the beholder. The Swedish banking system has been hard hit again in the current crisis by its overexposure (30 percent of annual GDP) to risky investments in Central and Eastern Europe, including the Baltics and Ukraine.
Every financial boom/bubble has been characterised by rising and ultimately excessive banking sector leverage, that is, by excessive lending to banks. If all the unsecured creditors of the banking system were made whole in the previous systemic crisis, it is not really surprising that the banks, and their creditors, are back for more.
In a more systematic study of the use of blanket guarantees of bank liabilitiesLuc Laeven and Fabian Valencia find the following:“Using a sample of 42 episodes of banking crises, this paper finds that blanket guarantees are successful in reducing liquidity pressures on banks arising from deposit withdrawals. However, banks’ foreign liabilities appear virtually irresponsive to blanket guarantees. Furthermore, guarantees tend to be fiscally costly, though this positive association arises in large part because guarantees tend to be employed in conjunction with extensive liquidity support and when crises are severe.”
The proposition that the consequences of inflicting losses on holders of bank debt are awful beyond our wildest imagining is voiced incessantly and loudly by bankers and by those long bank debt, especially insurance companies and pension funds. And a vigorous campaign is underway to extend the no-default presumption to the debt of pseudo-banks like AIG.
The most over-the-top, ludicrous piece of attempted scare mongering about the systemic risk implications of default by any institution I have ever read is the internal memorandum “AIG: Is the Risk Systemic”, of 26 February 2009, which is now all over the internet. Just one small sample: “The failure of AIG would cause turmoil in the U.S. economy and global markets , and have multiple and potentially catastrophic unforeseen consequences”.
I would have thought that, on the contrary, markets have discounted the likelihood of default by many of the major border-crossing banks, and by AIG, pretty comprehensively by now. After the US authorities bailed out Bear Stearns in March 2008, letting Lehman go belly-up in September 2008 was a bad surprise. Even then, I don’t accept the interpretation that it was Lehman’s filing for bankruptcy protection that triggered the cardiac arrest in global financial markets in the second half of September 2008. Instead the financial sector convulsions of the last quarter of 2008 were caused by the realisation that (1) most of the US and European border-crossing banks were insolvent without government financial support, that (2) the rot extended to the shadow banking sector (AIG), and that (3) the US authorities (Treasury, Fed, SEC) were not on top of the issue and that Congress was bound to act irresponsibly.
But even if it had been Lehman that triggered the financial upheaval, that was then. This is now. Banks, counterparties, investors and policy makers have had 6 months to adjust to the new reality and prepare for the eventuality of default on zombie bank debt and even on AIG debt. The bonds of large zombie banks trade at spreads over government yields comparable to those of automobile manufacturers (600 - 650 basis points). Their CDS spreads put many of these banks well into the default danger zone. Their stock market valuations are consistent with those of institutions not a mile away from insolvency and default.
The fact that zombie banks or AIG are self-serving when they plead systemic risk as an argument for further government hand-outs does not mean that they are wrong. It does lead one to verify more carefully the logic of their arguments and the quality of the empirical evidence offered in support. Let me just consider the argument that the main investors in bank debt (and AIG debt) - pension funds and insurance companies - are too vulnerable and too systemically important to permit the banks (or AIG) to fail.
Pension funds don’t go broke with adverse effects on systemic stability. If they are funded, defined-contribution funds, a reduction in their asset value means that pensioners will get lower pensions. If they are defined-benefit schemes (including ‘final salary schemes’), the risk of investment surprises is shared by the sponsors and the beneficiaries. When the Dutch pension fund ABP took a big hit last year, my parents did not get any indexation of their pension benefit. In past years, pension benefits had tracked earnings inflation, and occasionally price inflation. Should coverage ratios decline enough, even nominal cuts in pension benefits can be implemented. This may cause hardship, but not financial instability. No reason to favour the pensioners over the tax payers.
As regards insurance companies, I doubt whether “Insurance is the oxygen of the free enteprise system”, as AIG would like us to believe. Certainly insurance companies like AIG are not the only suppliers of oxygen. Insurance is a regulated industry. Orderly restructuring following administration and insolvency need not interfere with the provision of any of the essential infrastructure services required for the proper functioning of a market economy.
Regulators, especially but not just in the US, have bought the ‘don’t touch the unsecured creditors’ argument. The Fed especially appears to have swallowed it hook, line and sinker. This cognitive regulatory capture has turned the Fed, with the enthusiastic support of the FDIC and the US Treasury, into the most powerful moral hazard propagation machine ever.
If a bank or an insurance company like AIG is at risk of failing but is truly too big or too interconnected to fail (rather than merely too politically connected to fail), and if a Good Bank solution is not feasible, then the institution in question should immediately be taken into public ownership or put into a special resolution regime, if one is available. From public ownership it can be put into administration. Once in administration or under a Special Resolution Regime, it can be restructured decisively through a mandatory debt-to-equity conversion or debt write-down. There is no case for sparing the unsecured creditors.
China's Way Forward
Our apartment in Beijing overlooks one of the city’s long-distance bus terminals, where people arrive from the countryside to find work or sell wares, and depart for visits or permanent returns to their home villages. Early last summer, the terminal was jammed, and most of the passengers were leaving town. At the time, the outbound flow was taken as one more last-minute sign of China’s optimistic, all-fronts effort to spiff up Beijing for its role as Olympic host. Through the spring, construction workers had toiled round the clock on any building or public-works project (notably, new subway stations) that had a chance of being completed by the time of the Games. For projects with no hope of making the deadline, workers toiled instead to put up screening walls, or to neaten the piles of I-beams and rebar that normally littered the sites.
In July the government ordered a halt to all building or demolition work anywhere near Beijing, as part of a security lockdown and in hopes that construction dust would settle out of the air. The workers, mostly migrants from poorer neighboring provinces, went home on (mostly unpaid) leave to see their families and watch the Games on village TVs. In September, as Olympic spectators were leaving Beijing, migrant workers returned, via packed buses and trains. In the capital as in fast-growing cities all across China, country people stand out in the urban crowd. Their hands and faces are more weathered, their clothes simpler and more ragged. Often they move about town lugging unwieldy bundles of bedding and belongings wrapped in the plaid-patterned, woven-plastic fabric that somehow has become standard for such purposes in poor countries around the world.
This post-Olympic flow back into the city was expected—but what happened next was not. In mid-October, at about the time retail sales were collapsing in the United States, we started seeing extra buses muster each morning with full loads of migrants headed out of town again. On an icy afternoon in November, I passed a site where a huge new office complex was being built. Its towering construction cranes, which just a week earlier had been swinging loads of cement and steel so close to the sidewalk that passersby ducked, were motionless. The frontage road was lined with buses whose license plates were from Hebei province—the sticks. A driver told me that the convoy would take workers back to their home village—“For now, no work”—and then come back for another load as soon as it dropped this batch off. Through the rest of the winter and early this spring, Beijing’s air stayed notably clearer than it had been at the same time a year ago. Part of that was because of unusually windy weather, and part may have been a residual benefit of Olympic cleanup measures. But it was also a sign that fewer factories were running in the heavy-industrial districts upwind of Beijing.
The outbound buses and the better air were our local indicators of the economic contraction being felt in practically every corner of the world. And there were signs of it everywhere in China. Container ships sitting, moored and idle, in the harbor of Hong Kong. Revenues down in Macau’s casinos. Seas of empty seats aboard a small Airbus on the Shanghai-Beijing shuttle flight. (The first time I took that trip, in 2006, it was aboard a 747 with every seat full.) A report that a million or more of this year’s university graduates were still looking for jobs. Protests across the country, as real-estate developers and small-factory owners went bankrupt—and disappeared without paying employees months of back wages. Thousands of factories in Dongguan, in Guangdong province just north of Hong Kong, had been the real-life incarnation of the world’s stereotype of low-wage Chinese workers turning out low-value goods—cheap dolls and toys, Halloween masks, the bulk of the world’s Christmas presents and decorations. Within months the area was transformed into China’s rust belt.
You never know which statistics to believe in China, but in January a local official in Dongguan told me that at least 1 million factory workers had recently lost their jobs within five miles of where I was, and probably another million in nearby manufacturing areas of Guangdong province. The electronics supplier Foxconn, whose gigantic compound in Shenzhen turns out components for Apple, Dell, HP, and countless other companies and which had recently employed more than 250,000 workers, sent all its employees on a one-month unpaid furlough late last year. Reports in the Chinese press said Foxconn might lay off 100,000 worldwide.
Is the “China Story” as we’ve known it—the three-decade-long story of modernization and prosperity supervised by an authoritarian regime whose economic success excuses most complaints and failings—over? Has it reached its limits and exposed its contradictions? If China does not keep moving forward and growing, will it tear itself apart? Observers outside China often compare its difficulties to Japan’s a generation earlier. Few people inside China think the two economies have much in common—one is full of impoverished peasants, while the other has practically eliminated poverty; one is rushing toward industrialization while the other has been an industrial power for more than a century. But in recent months, I’ve heard countless Americans and a few Europeans ask, “Isn’t this just like the ‘Japan scare’ of the 1980s?” The question is shorthand for saying: “Japan seemed unstoppable 20 years ago and has been a sick man ever since. Is ‘rising’ China perhaps due for a similar reassessment?”
From Chinese intellectuals and officials I’ve more often heard a cautionary comparison to the old Soviet Union, implying that political control and territorial dominion could be undone by economic failure. By this logic, the Chinese Communist Party has no choice but to keep the country’s business growing as fast as possible, since a steady increase in material welfare is the real basis of the party’s legitimacy. If the economy were ever to stagnate—which is generally understood to mean a growth rate that falls below about 8 percent per year—then a larger share of the Chinese public might register dis content with Communist rule. And then anything could happen. The territorial contrast between the vast old Soviet empire and today’s shrunken Russian state may help explain the Chinese government’s intransigence about any threat of what it dismisses as “splittism” concerning Tibet, the Muslim region of Xinjiang, or Taiwan.
The Japanese and Soviet comparisons are awkward because of obvious differences from China. At no point in its history did the Soviet Union achieve anything like China’s sustained record of high-speed growth. So the “stagnation” that helped bring the Soviet regime down was in fact real, decades-long economic decline. Japan’s prolonged “sickness” is one most countries would envy: with half as many people as America and one-tenth as many as China, Japan still has the world’s second-largest economy and many of its strongest industrial brands, including the world’s largest carmaker, Toyota. Moreover, both Japan and the Soviet Union at times presented themselves as models of different paths toward modernity. Modern China is a force and a reality, but not a model or an idea that others might replicate. The Chinese system will remain unique. (The one nation that shares its scale, India, does not share its political precepts. No other nation that could build roads, airports, and industrial parks as modern as China’s could impose so repressive a political regime.)
Still, thinking of how previous models might apply to China raises a valid point. The Soviet Union’s political control was finally undone by its economic failures. And the parts of Japan’s system that truly don’t work—mainly the financial markets, which have yet to emerge from a 20-year slump—reflect its difficulty in adjusting to changes in the world economy. So if China’s rise is not undone by the risks that have been evident for years—pollution, water shortage, corruption, the widening rich-poor social gap, safety standards so primitive that on average more than 250 people die each day in coal-mine accidents—might China prove vulnerable to Soviet-style discontent born of a slowing economy? Or to Japanese-style inability to understand how the world is changing all around it? My guess is No. China faces big problems, and its modern history has been marked by the unforeseen. Perhaps we will look back at the spectacle and choreography of the Beijing Olympics opening ceremonies as the last time the world thought there was no limit to what China could achieve. But I am betting the other way.
Let’s begin by considering how bad things could get, for China and those it influences. The clearest approach I’ve heard to this question comes from Michael Pettis, the Beijing-based finance professor whose side business as a rock-music impresario I described in the March Atlantic. To think about China’s predicament in the late 2000s, he says, you should think about America’s in the 1920s. Through the early 1900s, the United States played a role in the world economy surprisingly similar to China’s in recent years. Until the start of World War I, the United States had long been a “net debtor” country. It had relied on foreign loans and investments to build the factories and lay the railroads that ultimately made it an industrial titan. By the end of World War I, it had become a “net creditor,” as its undamaged industrial base supplied European combatants and the former customers of ruined European companies.
In the 1920s, its farms and industries made America the workshop of the world. It ran trade surpluses with most other economies, which meant that a disproportionate share of the world’s jobs were in America (it was doing work that other people consumed), and a disproportionate share of what it made went for other people’s use. Foreigners paid the difference by transferring gold reserves—John Maynard Keynes complained at the time that the United States was amassing “all the bullion in the world”—or taking on loans and investments from Americans. So far, this is like China’s story. And so far, so good. This very role as global exporter made the United States unusually vulnerable when global demand collapsed in the 1930s. Having had more than its “fair” share of the world’s jobs to begin with, America had more of them to lose. This doesn’t mean that Americans suffered more deeply than Europeans. We got Franklin Roosevelt; they got Hitler, Stalin, Franco, and Mussolini. But as a matter of plain economics, the layoffs and unemployment of the Depression years were worse in the United States.
That is the problem for China now. Many Americans would assume that China’s recent history of trade surpluses would be its bulwark during a recession. In the long run, it will be, because it has provided a $2 trillion war chest in foreign holdings. But in the short run, China’s reliance on foreign customers turns out to be a serious vulnerability. Pettis wrote recently that China’s worldwide trade surplus, “the cleanest measure of overcapacity”—factories that are running and workers who are employed only because of foreign customers—is by one measure at least as large as America’s was in 1929. China today, like America then, has a trade surplus equal to about 0.5 percent of global economic output. But as a proportion of its own economic output, China’s trade surplus is much bigger than America’s was. In proportional terms, today’s China is five times as reliant on foreign customers to create domestic jobs as America was in 1929. So unless China can find a way to keep selling when its customers have stopped buying, it will face a proportionately greater employment shock.
That China might indeed try to keep selling is the concluding part of Pettis’s cautionary analogy to the Depression era. As stock markets crashed and economies collapsed, the U.S. trade surplus nearly disappeared. American businesses, desperate to preserve markets and jobs, lobbied for passage of the infamous Smoot-Hawley Tariff, which increased duties on a list of some 20,000 imported goods. Soon afterward, other countries retaliated with similar tariffs; world trade dried up, and the Great Depression was on. When people use the words “Smoot-Hawley” today, they usually mean them as a warning that any interference with trade, especially by the United States, could again prove disastrous. Pettis’s point is different, and in a way more worrisome. The real damage of Smoot-Hawley, he says, was less economic than political. Other countries understood that the United States was trying to protect its trade surplus and therefore its workforce. They didn’t like it as a political matter, and they struck back.
If that were to happen again, would it be because of “Buy American” provisions or other forms of American “protectionism” editorial pages so often warn against? That’s the wrong thing to worry about, according to this logic. The real counterpart to Smoot-Hawley would be Chinese protectionism—or rather, any effort by China to defend its huge trade surpluses, as the U.S. once did. China’s government is unlikely to rely on outright Smoot-Hawley–style tariffs. Instead it could increase subsidies to exporters; it could try to push the RMB’s value back down, after three years of letting the currency rise; it could encourage manufacturers to restrain wages; it could impose indirect barriers to imports, as with its recent pressure on China’s airlines to cancel outstanding orders for Boeing and Airbus airplanes. By early this year, China’s government was in fact doing every one of these things. As a result its global trade surplus, instead of shrinking as expected when the world economy deteriorated, grew dramatically.
Exports fell, but imports fell much more: in January, exports declined by 17 percent and imports by more than twice as much—by 43 percent. This is an economic problem for other countries. But it could be an even more serious political provocation, if China is seen as forcing its share of unemployment problems onto everyone else. And thus, to bring this scenario to a close, the best China can expect from today’s shocks might be unemployment rates higher than America’s in the ’30s. The worst would be for China to start a trade war that makes things even harder for itself. China’s emergence as America’s financier has steadily increased its leverage over the United States. But in the short run—rather, for however long the current crisis lasts—the two countries really are codependent in a way neither fully anticipated. Early this year,
Chinese officials began saying more and more bluntly what Gao Xiqing, who manages some $200 billion of Chinese holdings in the United States, conveyed artfully in an interview in our pages in December 2008: that if America wants to keep using China’s money, it had better put its economy back on track. It should be saving and investing more, borrowing and consuming less. At the Davos conference in January, Premier Wen Jiabao made the point by outright scolding America for dragging down everyone with its excesses. Okay already! But the more Americans obey these orders, the worse things look for China in the short run, since American overconsumption is exactly what has kept those Chinese factories a-hum. Americans are in a similar bind with their complaints about China. U.S. officials want China to reduce its trade surplus—while also hoping that China’s financiers will keep buying U.S. Treasury notes and stocks in U.S. companies with the dollars they get from that very trade surplus. We can’t have it both ways. The Chinese can give us money, or they can give us back some jobs, but not both.
So America will keep looking for the bottom of its economic descent, while Chinese businesses and workers endure a severe blow—one China’s leaders can’t really change by lecturing Americans. Why do I think the Chinese have good reasons for hope? One answer lies in the realm of straight economics. Some of the lost demand is sure to be picked up within China itself, thanks to a stimulus plan that, at some 4 trillion RMB (about $600 billion), is proportionately much larger than the one proposed by the Obama administration, because the Chinese economy is so much smaller than America’s. Yes, there are grounds for skepticism about the Chinese plan. Some of the total represents a new label for projects already approved or begun. Some of the 4 trillion RMB is supposed to come not from the central government but from local and provincial authorities, who have no obvious way to raise it during a recession.
Although one important element will be basic health-care coverage for average Chinese citizens, most of the money will be spent on construction projects, especially for transportation and infrastructure: more highways, an expanded high-speed railroad system, scores of new airports all across the country. Construction is the Chinese government’s first response to most problems—if it is worried that its universities are weak by international standards, it approves a plan to build new research centers—and the construction projects are subject to insider deals and kickbacks like those in most of the world. But laying concrete and raising girders employs a lot of people, especially the way those tasks are done in China, so this will be an option for some of the migrant workers now being sent home from factories. Heaped on my desk are other sector-by-sector analyses suggesting that the rebound may come more quickly than the gross-demand figures indicate. “When can we expect to see signs of life in the mainland economy?” asked Andy Rothman, of CLSA Asia-Pacific Markets, in one such report, about the cement and steel industries. “Our answer is, March or April 2009,” when the first orders from the stimulus program will reach steel and cement companies.
As in America, real-estate values have fallen throughout China; but China’s bad-loan problem is nothing like America’s subprime-loan disaster. America’s banks have too little money. China’s have a lot, and the main reason they have not been lending is that until very recently the government was more worried about inflation than anything else. “Chinese banks are not only very liquid, they will lend when directed by the Party, which appoints all senior bankers,” Rothman wrote. They are being so directed now. I have a lot more reports from a lot more sectors, but all lead toward the same conclusion: China’s economy may suffer more than most others, but it also has more tools and resources in reserve than most others. Beyond straight economics, the “China is over” hypothesis seems to miss important cultural and political realities. Its unspoken premise is that average Chinese people just barely tolerate the social bargain the government now offers—limited freedom, potentially unlimited wealth. So if the regime ever falls short on its material promises, the deal will be off and people will rebel.
This does not square with what I have seen. I have often wondered why so many people in different roles and regions in China seem vivid. The answer has to be more than contrast with my own blandness. I think it is because being in China today is like being in Western Europe in the 1950s. No one’s family story is dull or uneventful. People doing routine jobs have been through great hardships and dramatic swings of fate. Last year I interviewed a party official in Shanxi province who was laying out his regional-development plans. Every 10 or 15 minutes, he would stop and say (through an interpreter), “Do you understand? If it had not been for Deng Xiaoping, I would be behind an ox in a field right now. I would not be sitting here wearing a necktie and talking to a foreigner.” Or, “Do you understand how different this is? My mother has bound feet!” A scholar I know in Beijing once offhandedly remarked that he had developed self-confidence when learning that he could survive for four years as a teenager on a labor gang during the Cultural Revolution. People in their teens and 20s were not on the labor gangs—kids today!—but they have heard the stories.
Layoffs and stagnant wages? People have seen worse. Last summer my wife and I went through villages in Sichuan province where refugees from earthquakes prepared for the next few years of residence in temporary shelters and tents. Laid-off migrant workers are returning to many of these same villages now. This is terribly hard, but in the same villages, grandparents remember when half the local population starved to death during the famines of Mao’s disastrous “Great Leap Forward” in the 1950s.
When my wife and I first visited China in the mid-1980s, most people with paying jobs toiled in big, primitive, inefficient factories for the so-called state-owned enterprises, or SOEs. In one unheated, acres-wide factory in Hangzhou, we saw some 5,000 women attending old-fashioned looms to make hangings and tapestries of traditional Chinese scenes, with no indication that anyone ever bought them. Some SOEs persist—most of the very biggest companies in China, from the oil and telecom firms to the major airlines, are their spin-offs or descendants.
But when Deng Xiaoping’s economic reforms began in earnest in the 1990s, the most wasteful SOEs were closed down—eliminating many tens of millions of jobs in just a few years. Chinese social-realist novels set in the 1990s are about people laid off from the SOEs. Those set in the 2000s are about migrant workers—or urban professionals. The SOE recession was a major social strain, but it did not come close to bringing the government down. The Chinese people weathered that downturn—and more significant, so did the system that rules the country. People in China are as demanding as anyone else, and expectations have risen. But it is hard to see why the hardships just ahead will be the ones the Chinese public finds intolerable or that push the system toward Soviet-style collapse.
Westerners who have not traveled in China might be surprised at how outspoken ordinary Chinese people can be. When cars or bicycles collide (often), the parties involved get out to yell at each other and at the cops, and plead their case to the gathering crowd. Workers complain about bosses who have cheated them. Residents complain about the landlord. In Western China my wife and I met families from villages that were being flooded by new dam projects. They showed us around the new quarters they’d been assigned, pointing out the cracks and defects and itemizing the ways it was worse than where they used to live. It all seems normal to an American.
But when people complain, it is usually about those crooked bosses, reporters, mayors, or bureaucrats—not about the system or its rulers. Principled protests against the system and its repression certainly do exist, as with the daring “Charter 08” petition for civil liberties signed by more than 300 intellectuals late last year. But that is not the norm. Ten years ago, when the Asian financial crisis drove China’s unemployment rate above 10 percent, demonstrations broke out across the country. “But the laid-off workers were almost always fighting for their rights—unemployment benefits that they believed were stolen by local officials—rather than fighting against the central government policies that led to the job loss,” Andy Rothman of CLSA wrote recently. Perhaps these workers are missing the big picture, but for now they generally act as if they expect the national system to protect them against lapses at the local level.
There is one more part of the big picture: the opportunities that today’s disruption may be opening for future Chinese growth. Nearly 30 years ago, during another big worldwide downturn, I went to Silicon Valley and to Detroit for this magazine, to compare the way two different industrial cultures coped with economic hardship. Many of the companies I visited in each place are still with us—GM and Ford in Detroit; Apple, Intel, and HP in Silicon Valley. But quite a few I visited in California have now vanished. (Remember Eagle Computer Company, or Osborne?) We know that the high-tech industry is a source of growth, but—unless you work in it—you can easily forget that it’s extremely volatile. Then as now, people in the high-tech business emphasized that even though no one likes being disrupted, the volatility of America’s industrial culture is a necessary part of its success. It couldn’t produce so many new companies with new technologies if it weren’t so ruthless at eliminating old ones.
Chinese industry has also been volatile, but in a way that has done less good for China’s economy as a whole. The small-business culture of China is one of the few parts of the world where Americans are considered sluggish and hyper-deliberative. As small companies scramble against each other to cut pennies from costs and minutes from schedules, they have become more nimble as subcontractors. But they still don’t keep much of the final rewards for themselves. Thus today’s shock is more than such companies can offset just by cutting costs. In Beijing, in Shanghai, in Shenzhen, and elsewhere, I’ve recently visited companies that are trying to use the disruption of this moment to enter wholly new markets and do what so few Chinese firms have yet done: make high-tech, high-value products that bring high rewards. In a country as big and chaotic as China, you can find illustrations of any “trend” you want. But in only a few weeks of asking, I found indications of companies that were growing rather than shrinking, and of corporate leaders who were pouring in money based on their belief that now, when competitors are at their weakest and talent and assets could be snapped up cheap, is the time to prepare for their next big advance.
In Shenzhen, north of Hong Kong, I went to see Liam Casey, the Irish entrepreneur I described two years ago as “Mr. China” for his success in matching big, famous foreign companies with small, obscure Chinese factories that can produce brand-name products quickly and well. Casey said that of the top 100 Chinese companies he works with regularly, not one had gone out of business. While many were struggling, some viewed the recession as a chance to move into higher-value work and introduce their own advanced products rather than serving strictly as subcontractors. (Several such items, like new tablet computers and handheld GPS devices, were displayed at the latest Consumer Electronics Show in Las Vegas.) In a far-southern suburb of Beijing, I visited a new “retail research center” being built by a very large Chinese retail company I agreed not to name. Chinese retailers have at least as many problems as their counterparts overseas. Apart from the global falloff in demand, their customers recognize the difference between modern, efficient operators like Carrefour, Wal-Mart, Best Buy, and IKEA, all well-established in China, and the local department stores that bring a Soviet-era touch to convenience and customer care. Traditional Chinese-owned grocery and department stores can be dirty and dark; at some, you need to queue in one line to choose a product, another to pay, and yet another to show the receipt and pick up your item.
The CEO of one of the antiquated operators spent a week at a major U.S. consumer-goods company and became a convert to the idea that stores should be laid out for the customer’s convenience and interest. And with the zeal of a convert, he hired an American hotshot as his adviser and is now building a research center next to the “corporate learning center” he recently completed. At the learning center, employees take classes on international standards of service, cleanliness, and convenience, and act out drills of how to handle customers. In the new research center, the company will try out different floor plans, displays, and sale offers for its stores, and then see which ones appeal to focus groups of Chinese shoppers. The whole approach could turn out to be a boondoggle. But the American adviser, who showed me around, had moved his young family to Beijing because he believed the company was sincere about learning to meet the likes of Carrefour on their own terms.
At the far-opposite end of Greater Beijing, in a special government-sponsored research park, I visited the China Research Lab of IBM. The lab’s director, Thomas Li, has a life story like those I have heard at many successful tech and manufacturing companies. He was raised in Taiwan, by parents who had grown up on the mainland. He went to America for his doctorate, had a successful career with a U.S. firm—and then decided, for reasons of opportunity and sentiment, to be part of everything going on in mainland China. In 2002 Li moved with his family to Beijing, where he directs a 200-person team of mainly Chinese-trained computer scientists. One product demo made me wish I could get out a checkbook on the spot. It addressed two of the real-world problems most difficult for computers to handle: converting spoken language to written text, and converting written text from one language to another. Computers have “done” both of these tasks for years, but they have not done them accurately enough to be worth the bother. Having watched many similar demonstrations, I was startled by this one. My wife and I were the only native speakers of English in the room. But when each of us spoke into the voice-recognition system, it produced nearly perfect real-time versions of what we said. I had been speaking with deliberate clarity, so as a test I said the following words at fast conversational speed: “I never worry that my apartment is bugged in Beijing, because I figure there aren’t that many non-native speakers who can understand high-speed slangy American speech.” Those very words, except “slangy” (which had become “slinky”), were on the screen. Hmmmm.
Although everyone in Li’s lab speaks English, differences in accent can be a barrier in discussions with native speakers. So on video conference calls with their IBM colleagues in Armonk, New York, the Chinese scientists listen to what is said in English—and see a nearly real-time English transcription running across the bottom of the screen, which greatly aids their comprehension. I am sure it is not perfect, but I have seen enough such projects through the decades to be impressed with this one. Based on another demo I saw, it is already mature enough to allow spoken words—from TV, radio, commercials, YouTube—to be indexed and therefore retrieved as accurately as ordinary text. The words could then be translated and searched, in the original language or others, so that video clips, say, would be easy to find by a phrase (“axis of evil”) someone says in them.
Two other projects directly addressed the opportunities created by hard times. One, with the internal working name Pangoo, is meant for the millions of family businesses too big to continue keeping their accounts and records by hand, and too small to afford regular business-management software. It is a suite of business applications—account management, billing, Web design—tailored by Chinese-trained computer scientists for Chinese companies that need to save money. Another allows Chinese companies to minimize power use and other sources of pollution when determining how to time their production schedules and obtain supplies. Other companies in other countries are working toward similar goals. This project impressed me because a fairly autonomous, Chinese-run and -staffed division of a major global company was acting as if today’s economic turmoil was an opportunity. The most dramatic illustration of a Chinese firm trying to capitalize on this moment occurred in the far-eastern corner of Shenzhen. There, a purely Chinese startup firm called BYD has announced plans that would seem laughable were it not for what the company has already achieved.
In 1987, Wang Chuanfu got his bachelor’s degree in metallurgy from Central South University, in Changsha. Eight years later, in his early 30s, he founded the BYD Company with a cousin and a friend, to specialize in battery development. Seven years after that, in 2002, the company went public on the Hong Kong stock exchange. By 2005, BYD was the leading small-battery company in the world. If you use a cell phone, a digital camera, an iPod, an electric toothbrush, a portable vacuum cleaner, you’re probably using one of its batteries. It employs some 130,000 people at seven main facilities in China. I spent an afternoon touring its Shenzhen works, complete with soccer stadium for employee games, extensive apartment complexes for employees’ families and schools for their children, and gardens with the palm trees that Shenzhen’s tropical climate permits.
“Dr. Wang was trained in material sciences, and our senior leaders are expert in material sciences,” Stella Li, the company’s senior vice president, told me. “We feel that if you understand materials very well, many things are possible.” In particular she meant the development that propelled BYD into international news late last year: its unveiling of the world’s first mass-produced battery-powered hybrid car that could be recharged on normal household current. The new F3DM model, which I drove around a parking lot, can run for at least 60 miles purely on battery power, after which a gasoline engine kicks in. The iron-based battery recharges fully in seven hours; it is said to be good for well over 1,000 charge/recharge cycles, an unusually high number. When I pressed the “gas”—and I was alone in the car, with no minder—I was pushed back in the seat as far as I am with my normal car. The announced retail price for the car is $22,000—expensive in China, cheap in the U.S. or European market, where no comparable plug-in cars are yet on the market.
Whether BYD will eventually be known only for producing the first such electric car (as Osborne Computer was known for producing the first, suitcase-size “portable” in the early 1980s) or instead becomes the leading producer, no one can tell. When Wang unveiled the car at the Detroit Auto Show a month after I saw it in Shenzhen, much of the U.S. press tittered about mistranslations in the BYD promotional material and the stodginess of the car’s design. “Oh, we can always make the car look better!” Stella Li told me when I asked her about that. “Designing the car, building the car, that is the easy part.” She was being deliberately breezy: she went on to explain the company’s faith that its demonstrated edge in battery technology, plus its engineering skills and “vertically integrated” manufacturing system—it builds almost all of the car’s components itself—will give it a long-term advantage. And against the snickering of the U.S. auto press was Warren Buffett’s purchase of 10 percent of the company, for $230 million, late last year. The company’s official goal is to be the biggest automaker in China by 2015, and the biggest in the world by 2025. Wang’s unveiling of the car in Shenzhen coincided with U.S. congressional debate about emergency aid to GM and Chrysler. I asked Wang if he had any tips for the U.S. companies. He is a quiet, nerdish man who seemed to blanch as he heard the question translated. “For 100 years, nothing has changed in Detroit,” he finally said (through the interpreter). “I think they need to reconsider their product lines.”
China is down. It is not out. This has important implications for America. If China were truly like the old Soviet Union, the coming mass unemployment might be the shock that finally turned the people against their rulers. If it were truly like Japan, it might spend a decade or two chugging along but not aligning its systems to new international realities. In either case, Americans might feel sorry for China’s still-impoverished masses—but less worried about its competitive challenge. I suspect that China will be like neither. Most of its people will still be very poor. Most of the jobs they hold—when they have jobs—will still be near the bottom of the global value chain. But they will not, I believe, be in fundamental revolt against the country’s governing system. And the companies they create, manage, and work for will be constantly trying to improve their position on that value chain. Two years ago, after reporting on factories in Shenzhen, I described an economic symbiosis in which Chinese workers assembled many of the world’s products—while inventors, designers, shareholders, and consumers from America or other rich countries got the lion’s share of the financial returns. It is the announced policy of the Chinese government, and of many Chinese companies, to keep more of the rewards in China.
Outsiders can rightly criticize the Chinese government if it tries to sneak in new export subsidies or push the RMB’s value back down. But no one can criticize its ambition to increase the rewards for its people’s work. Many Chinese companies will fail or make mistakes under today’s intense pressure. But many are using the moment to prepare for their next advance. The question for Americans to think about is how we are using the same moment.
Money and the Turning of the Age
As the economic meltdown proceeds to its next phase, we begin to see the unreality of much that we thought real. The verities of two generations become uncertain, and despite a lingering hope that a return to normalcy is just around the corner -- in "the third quarter of 2009" or "by the middle of 2010" -- the realization is dawning that normal isn't coming back. When faced with an abrupt shift in personal reality, whether the death of a loved one, or the Gestapo coming into town, human beings usually react first with denial. My first response when tragedy hits is usually, "I can't believe this is happening!" I was not surprised, then, that our nation's political and corporate leaders spent a long time denying that a crisis was underway. Consider some quotes from 2007: "The country's economic fundamentals are sound," said George W. Bush. "I don't see subprime mortgage market troubles imposing a serious problem. I think it's going to be largely contained," said Treasury Secretary Paulson. "A recession is unlikely." "We are experiencing a correction in the housing sector." "America is not in recession." "It is likely that housing prices won't recover until early 2009."
Of course, many of these pronouncements were insincere, efforts at perception management. The authorities hoped that by controlling the public perception of reality, they could control reality itself; that by the manipulation of symbols they could manipulate the reality they represent. This, in essence, is what anthropologists call "magico-religious thinking." It is not without reason that our financial elites have been called a priesthood. Donning ceremonial garb, speaking an arcane language, wielding mysterious inscriptions, they can with a mere word, or a mere stroke of a pen, cause fortunes and nations to rise and fall. You see, magico-religious thinking normally works. Whether it is a shamanic rite, the signing of an appropriations bill, or the posting of an account balance, when a ritual is embedded in a story that people believe, they act accordingly, playing out the roles the story assigns to them, and responding to the reality the story establishes. In former times, when a shamanic rite was seen to have failed, everyone knew this was a momentous event, signaling the End of the World, a shift in what was real and what was not, the end of the old Story of the People and the beginning, perhaps, of a new one. What, from this perspective, is the significance of the accelerating failure of the rites of finance?
We like to scoff at primitive cave-dwellers who imagined that their representations of animals on cave walls could magically affect the hunt. Yet today we produce our own talismans, our own systems of magic symbology, and indeed affect physical reality through them. A few numbers change here and there, and thousands of workers erect a skyscraper. Some other numbers change, and a venerable business shuts its doors. The foreign debt of a Third-World country, again mere numbers in a computer, consigns its people to endless enslavement producing commodity goods that are shipped abroad. College students, ridden with anxiety, deny their dreams and hurry into the workforce to pay off their student loans, their very will subject to a piece of paper with magical symbols ("Account Statement") sent to them once every moon, like some magical chit in a voodoo cult. These slips of paper that we call money, these electronic blips, bear a potent magic indeed!
How does magic work? Rituals and talismans affirm and perpetuate the consensus stories we all participate in, stories which form our reality, coordinate our labor, and organize our lives. Only in exceptional times do they stop working: the times of a breakdown in the story of the people. We are entering such times today. That is why none of the economic measures enacted so far to contain the crisis have worked, and why the current stimulus package won't work either. None go deep enough. The only reform that can possibly be effective will be one that embodies, affirms, and perpetuates a new story of the people (if we can agree on one). To see what that might be, let us dig down through the layers of failing realities and their relationship to money.
When the government's first response to the crisis -- denial -- proved futile, the Federal Reserve and Treasury Department tried another sort of perception management. Deploying their arsenal of mystical incantations, they signaled that the government would not allow major financial institutions such as Fannie Mae to fail. They hoped that their assurances would be enough to maintain confidence in the assets that depended on these firms' continued solvency and prosperity. It would have worked if the story these symbolic measures invoked was not already broken. But it was. Specifically, what was broken was the story assigning value to mortgage-backed securities and other derivatives based on unrepayable loans. Unlike camels or bushels of grain, but like all modern currencies, these have value only because people believe they have value. Moreover, this is not an isolated belief, but is inextricably linked with millions of other beliefs, conventions, habits, agreements, and rituals.
The next step was to begin injecting massive amounts of cash into failing financial institutions, either in exchange for equity (effectively nationalizing them, as in the case of Fannie Mae, Freddie Mac, and AIG), or in exchange for essentially nothing whatsoever, as in the TARP program. In the latter, the Treasury Department (using your tax dollars) guaranteed or bought banks' toxic assets in hopes of improving their balance sheets so that they would start lending again, thus keeping the credit bubble expanding. It didn't work. The banks just kept the money (except what they paid to their own executives as bonuses) as a hedge against their exposure to untold quantities of additional bad assets, or they used it to acquire smaller, healthier banks. They weren't about to lend more to consumers who were already maxed out, nor to over-leveraged businesses in the teeth of a recession. Property values continued to fall, credit default rates continued to rise, and the whole edifice of derivative assets built upon them continued to crumble. Consumption and business activity plummeted, unemployment skyrocketed, and people in Europe began rioting in the streets. And why? Just because some numbers changed in some computers. It is truly amazing. It only makes sense when you see these numbers as talismans embodying agreements. A supplier digs minerals out of the ground and sends them to a factory, in exchange for what? For a few slips of paper, or more likely, in exchange for some bits moving around in a computer, which can only happen with the permission of a bank (that "provides credit").
Before we become too alarmed about the impending giveaway of $8 trillion dollars on top of the $2 trillion we have already given to the wealthy, let us touch back again upon the reality of money. What actually happens when this money is given away? Almost nothing happens. What happens is that bits change in computers, and the few people who understand the interpretations of those bits declare that money has been transferred. Those bits are the symbolic representation of an agreement about a story. This story includes who is rich and who is poor, who owns and who owes. It is said that our children and grandchildren will be paying these bailout and stimulus debts, but they could also simply be declared into non-existence. They are only as real as the story we agree on that contains them. Our grandchildren will pay them only if the story, the system of meanings, that defines those debts still exists. But I think more and more people sense that the federal debt, the U.S. foreign debt, and a lot of our private mortgage and credit card debts will never be repaid.
We think that those Wall Street tycoons absconded with billions, but what are these billions? They too are numbers in computers, and could theoretically be erased by fiat. The same with the money we owe China. It could be gone with a simple declaration. We can thus understand the massive giveaways of money in the TARP, TALF, and PPIF programs as yet another exercise in perception management, though this time it is an unconscious exercise. These giveaways are ritual acts that attempt to perpetuate a story, a matrix of agreements, and the human activities that surround it. They are an attempt to uphold the magical power of the voodoo chits that keep the college grad on a career path and the middle-aged man enslaved to his mortgage; that give the power to a few to move literal mountains, while keeping the many in chains.
Speaking of China, I find it instructive to look at the physical reality underlying the trade deficit. Basically what is happening is that China is shipping us vast quantities of stuff -- clothes, toys, electronics, nearly everything in Wal-Mart -- and in return we rearrange some bits in some computers. Meanwhile, Chinese laborers work just as hard as we do, yet their day's wages buy much less. In the old days of explicit empires, China would have been called a "vassal state" and the stuff it sends us would have been called "tribute." Yet China too will do everything it can to sustain the present Story of Money, for essentially the same reason we do: its elites benefit from it. It is just as in Ancient Rome. The elites of the imperial capital and the provinces prosper at the expense of the misery of the people, which increases over time. To keep it in check, in the capital at least, the masses are kept docile and stupid with bread and circuses: cheap food, cheap thrills, celebrity news, and the Superbowl.
Whether we declare it to end, or whether it ends of its own accord, the story of money will bring down a lot with it. That is why the United States won't simply default on its debt. If it did, then the story under which the Middle East ships us its oil, Japan its electronics, India its textiles, and China its plastic would come to an end. Unfortunately, or rather fortunately, that story cannot be saved forever. The reasons are complex, so I'll just point you in the right direction if you want to research it yourself. Essentially, at some point China (and other creditor nations) will have to appreciate its currency, replace exports with domestic demand, and raise interest rates in order to combat disastrous inflation caused by its pumping yuan into its economy in exchange for all the dollars flowing in from its exporters. The result will be a run on the dollar, a global calamity that will put an end to money as we have known it. When that happens, our government will have only two choices: extreme austerity measures such as those we have long perpetrated on other countries through the IMF, or a bout of currency-destroying hyperinflation. The latter is probably inevitable; austerity would only stave it off temporarily. That would be the end of our current story of money, for it would render all financial wealth (and debt) worthless.
When money evaporates as it is doing in the current cycle of debt deflation, little changes right away in the physical world. Stacks of currency do not go up in flames (but even if they did, that is not too momentous a physical event). Factories do not blow up, engines do not grind to a halt, oil wells do not dry up, people's economic skills do not disappear. All of the materials and skills that are exchanged in human economy, upon which we rely for food, shelter, transportation, entertainment, and so on, still exist as before. What has disappeared is our capacity to coordinate our activities and focus our common efforts. We can still envision a new airport, but we can no longer build it. The magic talisman by which the pronouncement, "An airport shall be built here" crystallizes into material reality has lost its power. Human hands, minds, and machinery retain all their capacities, yet we can no longer do what we once could do. The only thing that has changed is our perceptions.
Clearly, the TARP program and other bailouts are also an exercise in perception management, but on a deeper, less conscious level. Because what is money, anyway? Money is merely a social agreement, a story that assigns meaning and roles. The classical definition of money -- a medium of exchange, a store of value, a unit of account -- describe what money does, but not what it is. Physically, it is now next to nothing: slips of paper, bits in computers. Socially, it is next to everything: the primary agent for the coordination of human activity and the focusing of collective human intention. The government's deployment of trillions of dollars in money is thus little different from its earlier deployment of empty words. Both are nothing but the manipulation of various types of symbols, and both have failed for an identical reason as well: the story they are trying to perpetuate has run its course. The normalcy we took as normalcy was unsustainable. It is unsustainable on two levels. The first level is the debt pyramid, the exponential growth of money that inevitably outstrips the real economy.
The first level of unsustainable normalcy is based on what Michael Hudson calls "the miracle of compound interest." Interest rates always tend to exceed the rate of real economic growth, which in the absence of defaults means that money grows faster than the volume of goods and services it buys, and that debt grows faster than gross domestic product (GDP). This has indeed been the case in the last 60 years in the United States, as private debt has risen from about 50% to about 350% of GDP. This cannot go on forever: to take an extreme example, a dollar invested at only 3% interest in the year 1 A.D. would be worth about $100,000,000,000,000,000,000,000,000 today. Such sustained exponential growth is obviously impossible, so what happens? What must happen is that from time to time, some of this money must disappear through one of two ways: defaults, or inflation. Both of these results are ultimately good for debtors and bad for creditors; they transfer wealth to those who owe from those who own. Inflation means that the real value of loans shrinks over time: loans are repaid with cheaper dollars. Defaults mean that some creditors don't get paid back at all, and have to take a loss.
U.S. fiscal policy for the last two generations has attempted to prevent both, but the narrow road between them is shrinking to nothing. If income from production of goods and services is insufficient to service debt, then the creditors begin to seize assets instead. This is what has happened both in the American economy and globally. Mortgages, for example, were originally a path toward owning your own home free and clear, starting with 20% equity. Today few ever dream of actually one day repaying their mortgage, but only of endlessly refinancing it, in effect renting the house from the bank. Globally, Third World countries find themselves in a similar situation, as they are forced to sell off national assets and gut social services under IMF austerity programs. Just as you might feel your entire productive labor is in the service of debt repayment, so is their entire economy directed toward producing commodity goods to repay foreign debt.
Eventually, debtors run out of seizable assets. The crash underway today should have actually happened many years ago, except that various phony and inflated assets were created to keep it going a little longer as the financial industry cannibalized itself, covering debt with more debt. The efforts to shore up this edifice cannot work, because it must keep growing -- all those debts bear interest. Yet the authorities keep trying. When you hear the words "rescue the financial system," translate it in your mind into "keep the debts on the books." They are trying to find a way for you (and debtor nations too) to keep paying and for the debt to keep growing. A debt pyramid cannot grow forever, because eventually, after all the debtors' assets are gone, and all their disposable income has been devoted to debt payments, creditors have no choice but to lend debtors the money to make their payments. Soon the outstanding balance is so high that they have to borrow money even to pay interest, which means that money is no longer flowing, and can no longer flow, from debtor to creditor. This is the final stage, usually short, though prolonged in our day by Wall Street's financial "wizardry." The loans and any derivatives built on them begin to lose their value, and debt deflation ensues.
I have just described the leadup to a deflationary depression. As it dawns on our leaders that we are not experiencing a mere "retrenchment," "correction," or "recession," but are at the brink of a full-fledged deflationary depression, they are now beginning to act accordingly. When debts become unpayable, one can either reduce or eliminate the debt entirely, or one can try to increase the income of the debtor so that he can continue to make payments. The holders of wealth, whose interests determine government policy, would obviously prefer the latter, since a reduction in your debt is a reduction in their wealth. Consequently, the first response of the Obama administration to the deflationary crisis is economic stimulus. It will be more reluctant to adopt the second option, although we are beginning to hear calls for bank nationalizations, debt writedowns, and debt forgiveness now as well.
Both responses have as their ultimate goal the reigniting of economic growth, something nearly everyone agrees on. Here we enter into a second, deeper, story of money. I believe that even the most radical measures proposed today can have at best only a temporary effect: if they instigate economic growth it will be anemic and short-lived. That is because economic growth as we define it today, and money as we define it today, is part of a Story of the People that too is becoming obsolete. Reflecting this obsolescence, the true nature of the crisis will become apparent as each progressively more radical solution fails to restore the status quo. What we are facing today is not merely a Minskian bubble collapse, nor merely, even a deflationary unwinding of credit: it is nothing less than a Marxian "historical crisis of capital," resurging now at a time when all the measures that have kept it at bay for two centuries have finally been exhausted. The Marxian crisis is deeply related to the depletion of social, cultural, natural, and spiritual capital I describe in previous essays of this series. I will now describe this relationship, and then recast the Revolution in terms of a metamorphosis of the Story of the People.
First, a simplified description of a Marxian crisis. Consider an industry, say automobiles, comprising a number of competing firms. As competition forces profit margins lower and lower, each firm strives to cut costs and improve efficiency to avoid going out of business. They do this by reducing labor costs, adopting new technology, and increasing manufacturing capacity to take advantage of economies of scale. Several vicious circles begin. For one, increased capacity drives prices and profit margins per unit still lower, forcing each firm to expand capacity still more to compete. The policies that benefit each firm harm the industry as a whole: the response to industry-wide overcapacity is to build yet more capacity. Second, reducing labor costs through wage cuts, layoffs, and labor-saving technology reduces the purchasing power of workers, leading to weaker demand, lower profits, and the need to reduce labor costs still further. Weaker firms go out of business, capital is concentrated into fewer and fewer hands, and unemployment rises, leading to social breakdown and revolution.
More generally, once the fulfillment of essential human needs is removed from its organic matrix of nature and community and taken over by machine processes, it becomes subject to economies of scale and technological improvements in efficiency, allowing these needs to be met with decreasing human effort. Marx, believing that profit comes from the expropriation of the added value of labor, concluded that profits will inevitably fall in any mature industry. In other words, marginal return on capital falls, price competition increases, profits drop and wages drop along with them. Needs can be met with less effort than ever before, yet because of the polarization of wealth, fewer and fewer of them actually are met. A minority is awash in cheap junk it barely needs, while the majority lacks for the basic necessities it once enjoyed, without exchange of money, a generation or two before.
What is this overproduction that is so central to the crisis of capital? It means production in excess of human needs. Therefore, one way to delay -- perhaps forever -- the Marxian crisis is to find new needs to meet. Technology is the agent of this process: for example, the telephone met a need for long-distance communication, opening a new industry -- telecommunications -- for rapid growth and high profits. The ideology I call the Technological Program says that there is no limit to technology's ability to discover and meet new human needs. Economists cite this as the primary flaw in Marx's reasoning: he didn't account for our technological ability to innovate, to constantly create new high-profit industries to supplant mature ones. This is an ideology of endless growth, an economy of onward and upward. It scoffs at any naysayer who would question the infinite human capacity to create and innovate. It says there are no limits to growth: certainly not energy -- we will invent new energy technologies and reduce demand through miniaturization and efficiency. Certainly not food supply -- we will increase it through biotechnology while limiting human population growth and/or colonizing new planets and eventually engineering whole new ecosystems. Marx was only right if human inventiveness is finite.
According to this understanding, the restless anxiety and competition inherent in our money system is a good thing, impelling us to fulfill our destiny as lords and masters of the universe. As I have explained in earlier essays, money as we know it today has a built-in imperative to grow endlessly. Its growth carries the underlying real economy along with it, motivating the endless creation of new goods and services, and therefore (our ideology concludes) the endless creation of new and undreamed of forms of wealth. From within that ideology, the present economic crisis is seen as merely a financial crisis, caused by the expansion of credit outstripping the expansion of the real economy. At worst, after a wave of bankruptcies and defaults, the excess money will have cleared away, and growth can begin anew. The possibility and desirability of renewed growth is seldom questioned, except by committed environmentalists.
I would like to point out a fatal flaw in this logic, one that does not deny the infinite creativity of the human spirit. I find most limits-of-growth arguments dispiriting, as they imply an arrest of our unique human gifts, culture and technology. But there is a flaw in the critique of the inevitable Marxian crisis that does not depend on denying our gifts. You see, generally speaking, technology does not actually meet new needs; it merely changes the way in which existing needs are met. Consider telecommunications. Human beings do not have an abstract need for long-distance communication. We have a need to stay in contact with people with whom we share emotional and economic ties. In past times, these people were usually close by. A hunter-gatherer or 14th century Russian peasant would have had little use for a telephone. Telephones began to meet a need only when other developments in technology and culture spread human beings farther apart, splintering extended families and local communities. So the basic need they meet is not something new under the sun.
Consider another technological offering, one to which my children, to my great consternation, seem irresistibly attracted: massively multi-player online fantasy role playing games. The need these meet is not anything new under the sun either. Pre-teens and teenagers have a strong need to go exploring, to have adventures, and to establish an identity via interactions with peers that reference this exploration and adventure. In past times, this happened in the actual outdoors. When I was a child we had nothing like the freedom of generations before us, as you might read about in Tom Sawyer, yet still my friends and I would sometimes wander for miles, to a creek or an unused quarry pit, an undeveloped hilltop, the train tracks. Today, one rarely finds groups of kids roaming around, when every bit of land is fenced and marked with No Trespassing signs, and when society is obsessed with safety, and when children are so overscheduled and driven to perform. Technology and culture have robbed children of something they deeply need, and then, in the form of video games, sold it back to them.
I remember the day I realized what was happening. I happened to watch an episode of the Pokemon television show, which is basically about three kids roaming around having magical adventures. These on-screen, fictitious, trademarked characters were having the magical adventures that real children once had, but now must pay for the privilege of watching. As a result, GDP has grown. New "goods and services" (by definition, things that are part of the money economy) have been created, replacing functions that were once fulfilled for free. A little reflection reveals that nearly every good and service available today meets needs that were once met for free. What about medical technology? Compare our own poor health with the marvelous health enjoyed by hunter-gatherers and primitive agriculturalists, and it is clear that we are purchasing, at great expense, our ability to physically function. Child care? Food processing? Transportation? The textile industry? Space does not permit me to analyze each of these for what necessities have been stolen and sold back to us. I will offer one more piece of evidence for my view: if the growth of money really were driving the technological and cultural meeting of new needs, then wouldn't we be more fulfilled than any humans before us?
As Henry Miller wrote in The World of Sex, We devise astounding means of communication, but do we communicate with one another? We move our bodies to and fro at incredible speeds, but do we really leave the spot we started from? Mentally, morally, spiritually, we are fettered. What have we achieved in mowing down mountain ranges, harnessing the energy of mighty rivers, or moving whole populations about like chess pieces, if we ourselves remain the same restless, miserable, frustrated creatures we were before? To call such activity progress is utter delusion. We may succeed in altering the face of the earth until it is unrecognizable even to the Creator, but if we are unaffected wherein lies the meaning?
Despite what the GDP statistics say, what has happened is not the creation of new wealth at all. What has happened is the conversion of existing wealth into money. We have converted nature into commodities and relationships into services. From time to time throughout modern history, our ability to do this has reached a temporary impasse. Whenever that happens, a Marxian crisis of capital looms: falling returns on capital investment (falling profit margins), falling real wages, transfer of investment into financial speculation, rising indebtedness, and so on in a self-reinforcing circle of misery that can only end in systemic collapse. So far, the powers that be have successfully postponed the crisis each time. There are several ways to do so, but each is a temporary solution unless it can escalate indefinitely. One is colonization: to find distant people who still meet their own needs without money, stripmine their natural resources and social capital from them, and sell enough back to them to keep them alive. This strategy manifests as low wages and commodity exports. Another strategy is war, which consumes vast amounts of production and destroys productive capacity and infrastructure so that it may be rebuilt again. That was how WWII ended the Great Depression, and that is why so many companies lined up hungrily behind the United States armed forces hoping to get a piece of the reconstruction contracts for Iraq. However, war too is becoming obsolete as a solution to the crisis of capital.
For one thing, productive capacity rises faster than the military industry's ability to absorb it. Secondly, with the advent of nuclear weapons, total war is no longer an option.\ To maintain the exponential growth of money, then either the volume of goods and services must be able to keep pace with it, or imperialism and war must be able to escalate indefinitely. All three have reached their limit. There is nowhere to turn. The credit bubble that is blamed as the source of our current economic woes was not a cause of them at all, but only a symptom. When returns on capital investment began falling in the early 1970s, capital began a desperate search for other ways to maintain its expansion. When each bubble popped -- commodities in the late 1970s, S&L real estate investments in the 1980s, the dotcom stocks in the 1990s, and real estate and financial derivatives in the 2000s -- capital immediately moved on to the next bubble, maintaining an illusion of economic expansion. But the real economy was stagnating. There were not enough needs to meet the overcapacity of production, not enough social and natural capital left to convert into money.
Today, the impasse in our ability to convert nature into commodities and relationships into services is not temporary. There is little more we can convert. Technological progress and refinements to industrial methods will not help us take more fish from the seas -- the fish are mostly gone. It will not help us increase the timber harvest -- the forests are already stressed to capacity. It will not allow us to pump more oil -- the reserves are drying up. We cannot expand the service sector -- there are hardly any things we do for each other that we don't pay for already. There is no more room for economic growth as we have known it; that is, no more room for the conversion of life and the world into money. Therefore, even if we follow the more radical policy prescriptions from the left, hoping by an annulment of debts and a redistribution of income to ignite renewed economic growth, we can only succeed in depleting what remains of our divine bequeathment of nature, culture, and community.
At best, Obama's policies as they stand today will allow a modest, shortlived expansion as the functions that were demonetized during the depression are remonetized. For example, because of the economic situation, some friends and I cover for each other's child care needs, whereas in prosperous times we sent our kids to preschool. Our reciprocity represents an opportunity for economic growth: what we do for each other freely can be converted into monetized services. Generalized to the whole society, this is only an opportunity to grow back to where we were before, at which point the same crisis will emerge again. "Shrink in order to grow," the essence of war and deflation, is only effective, and decreasingly so, as a holding action while new realms of unmonetized social and natural capital are accessed.
The story that is ending in our time, then, goes much deeper than the story of money. I call this story The Ascent of Humanity. It is a story of endless growth, and the money system we have today is an embodiment of that story, enabling and propelling the conversion of the natural realm into the human realm. It began millennia ago, when humans first tamed fire and made tools; it accelerated when we applied these tools to the domestication of animals and plants, and began to conquer the wild, to make the world ours. It reached its glorious zenith in the age of the Machine, when we created a wholly artificial world, harnessing all the forces of nature and imagining ourselves to be its lords and possessors. And now, that story is drawing to a close, as the inexorable realization dawns that the story is not true. Despite our pretenses, the world is not really ours; despite our illusions, we are not in control of it. As the unintended consequences of technology proliferate, as our our communities, our health, and the ecological basis of civilization deteriorate, as we explore new depths of misery, violence, and alienation, we enter the final stages of a story nearing completion: crisis, climax, and denouement. The rituals of our storytellers are to no avail. No story can persist beyond its ending.
It is time, therefore, to enter into a new story, and a new kind of money that embodies it. Just as life does not end with adolescence, neither does civilization's evolution stop with the end of growth. We are in the midst of a transition parallel to an adolescent's transition into adulthood. Physical growth ceases, and ones vital resources turn inward to foster growth in other realms. In childhood, it is right for a person to do what is necessary to grow, both physically and mentally. A good mother provides the resources for this growth, as our Mother Earth has done for us. We began in the womb of hunter-gatherer existence, in which we made no distinction between human and nature, but were enwombed within it. An infant does not have a strong self-other distinction, but takes time to form an identity and an ego, and to learn that the world is not an extension of the self. So it has been for humanity collectively. Whereas the hunter-gatherer had no concept of a separate "nature" distinct from "human", the agriculturist, whose livelihood depending on the objectification and manipulation of nature, came to think of nature as a separate category. In the childhood of agricultural civilization, humanity developed a separate identity and grew large.
We had our adolescent growth spurt with industry, and on the mental plane entered through Cartesian science the extreme of separation, the fully developed ego and hyperrationality of the teenager who, like humanity in the Age of Science, completes the stage of cognitive development known as "formal operations", consisting of the manipulation of abstractions. But as the extreme of yang contains the birth of yin, so does the extreme of separation contain the seed of what comes next: reunion. Because in adolescence, you fall in love, and your world of perfect reason and perfect selfishness falls apart as the self expands to include the beloved within its bounds. Fully individuated from the Other, you can fall in love with it, and experience a reunion greater than the original union, for it contains within it the entire journey of separation. The environmental movement and numerous spiritual movements are all evidence that we are falling in love again with planet earth.
From this perspective, it is obvious that a money system that compels continued physical growth, that compels taking more and more from the earth, is obsolete. It is incompatible with love, with reunion. That is why no financial or economic reform can possibly work that does not include a new kind of money. The new money must embody a new story, one that treats nature not as a mother but as a lover. We will still have a need for money for a long time to come, because we need magical symbols to reify our Story of the People, to apply it to the physical world as a creative template. The essential character of money will not change: it will consist of magical talismans, whether physical or electronic, through which we assign roles, focus intention, and coordinate human activity.
I have described the currency of Reunion in previous essays in this series, as well as in The Ascent of Humanity. I want to emphasize that there is a personal, some might say spiritual, dimension to the metamorphosis of stories that we are entering. Today's usury-money is part of a story of separation, in which "more for me is less for you." That is the essence of interest: I will only "share" money with you if I end up with even more of it in return. On the systemic level as well, interest on money creates competition, anxiety, and the polarization of wealth. Meanwhile, the phrase "more for me is less for you" is also the motto of the ego, and a truism given the discrete and separate self of modern economics, biology, and philosophy.
Only when our sense-of-self expands to include others, through the process called love, is that truism replaced by its opposite: "More for you is also more for me." This is the essential truth embodied in the world's authentic spiritual teachings, from Jesus's Golden Rule, which has been misconstrued and should read: "As you do unto others, so also do you to unto yourself", to the Buddhist doctrine of karma. However, to merely understand and agree with these teachings is not enough; many of us walk around with a divide between what we believe and what we live. An actual transformation in the way we experience being is necessary, and such a transformation usually comes about in much the same way as our collective transformation is happening now: through a collapse of the old story of self and world, and the birth of a new one. For the self, too, is ultimately a story, with a beginning and an end. Have you ever gone through an experience that leaves you, afterward, hardly knowing who you are?
The transition from the small, rational, ego self to a larger, more connected one normally happens in late adolescence and, according to Joseph Chilton Pearce, corresponds to developments in the mysterious "fourth brain": the prefrontal cortex, whose functions are largely unknown. Ancient tribal cultures had various coming-of-age ceremonies and ordeals that purposely shattered the smaller identity through isolation, pain, fasting, psychedelic plants, or other means, and then rebuilt and reincorporated it into a larger, transpersonal identity. Though we intuitively seek them out in the form of drinking, drugs, fraternity and military hazing, and so on, modern men and women usually have only a partial experience of this process, leaving us in a kind of perpetual adolescence. It ends only when fate intervenes to tear our world apart. Then we can enter a wider self, in which giving comes just as naturally as taking. Naturally, you give according to your abilities and, linked with others of like spirit, you receive according to your needs.
Not coincidentally, I have just paraphrased a fundamental tenet of socialism: "From each according to his abilities, to each according to his needs." This is a good description of any gift network, whether a human body, an ecosystem, or a tribal gift culture. As previous essays describe, it is also a good description of an economy based on demurrage currency -- money that, like all things of nature, decays with time. Demurrage currency contributes to a very different story of the people, of the self, and of the world than usury-money. It is cyclical rather than exponential, always returning to its source; it redefines wealth as a function of one's generosity and not one's accumulation; it is the manifestation of abundance not scarcity. It has the potential to recreate the gift dynamics of primitive societies on a global scale, bringing forth human gifts and directing them toward human needs. It nullifies the discounting of future cash flows that enables us to destroy the future for the sake of the present: under demurrage, the best business decision is the best ecological decision and the best social decision. It is thus a currency of sustainability. Because it is not compelled to grow over time, neither does it drag more and more of the world into the realm of commodities and services.
I remember as a teenager reading Ayn Rand's Atlas Shrugged, whose black-and-white characters, hyperrationality, and moral absolutism appealed strongly to my adolescent mind. The book is a manifesto of the discrete and separate self, the mercenary ego, and it appeals to adolescent minds to this day. Alan Greenspan is a great fan, though perhaps he too is going through a transformation as the world falls apart. In any event, the book devoted its most vitriolic ridicule to the phrase "From each according to his abilities, to each according to his needs," painting a picture of people outdoing each other in their self-portrayals of neediness so that they could be allotted a greater share of resources, while producers had no motivation to produce. This scenario, which was in certain respects played out in the communist block, echoes a primal fear of the scarcity-conditioned modern self -- what if I give, and receive nothing in return? This desire of an assurance of return, a compensation for the risk of generosity, is the fundamental mindset of interest and, as I have described, an adolescent mindset to be superseded by a more expansive adult self that has matured into full membership in the community of being. But don't just take my word for it. A little reflection reveals that no one can be fulfilled without the opportunity to give fully of her gifts. What makes a job unfulfilling? No matter how highly paid, if you lack the opportunity to fully apply your gifts toward a purpose that inspires you, any job eventually becomes soul-destroying. We are here to express our gifts; it is among our deepest desires and we cannot be fully alive otherwise.
The Marxian crisis of capital offers another perspective on the expression of human gifts. Most needs have been monetized, while the amount of labor needed to meet those monetized needs is falling. Therefore, in order for human gifts to receive their full expression, all this excess human creativity must therefore turn elsewhere, toward needs or purposes that are inimical to the money of Separation. For indeed, the regime of money has destroyed, and continues to destroy, much that is beautiful -- indeed, every public good that cannot be made private. Here are a few examples: a starry night sky free of light pollution; a countryside free of road noise; a vibrant multi-cultural local urban economy; unpolluted lakes, rivers, and seas; the ecological basis of human civilization. Many of us have gifts that would contribute to all of these things, yet no one will pay us to give them. That's because money as we know it ultimately rests on converting the public into the private. The new money will encourage the opposite, and the conflict between our ideals and practical financial reality will end. The era of taking will be over. The era of the Gift will begin.
Usury-money is the money of growth, and it was perfect for humanity's growth stage on earth, and for the story of ascent, of dominance and mastery. The next stage is one of cocreative partnership with earth. The Story of the People for this new stage is coming together right now. Its weavers are the visionaries of fields like permaculture, holistic medicine, renewable energy, mycoremediation, local currencies, restorative justice, attachment parenting, and a million more. To undo the damage that the Age of Usury has wrought on nature, culture, health, and spirit will require all the gifts that make us human, and indeed is so impossibly demanding that it will take those gifts to a new level of development.
Just as usury-money has mobilized humanity's gifts for the purposes of growth and domination, the new money will mobilize them for healing and beauty. Because money will not be under compulsion to grow, no longer will art be under compulsion to sell itself. Today, any endeavor that does not involve an expansion of the realm of monetized goods and services must go against the economic current. Such is the character of exponential money. But cyclical money has a different character: anything that violate's nature's law "Waste is food" will go against the economic current. The division between work and art will disappear, and it will no longer be possible to be a sellout. The conflict between our idealism and economic necessity will vanish.
This might seem hopelessly naive, vague, and idealistic. I draw out the logic in The Ascent of Humanity and the previous essays in this series. My upcoming book will flesh it out in greater detail. For now, weigh the competing voices of your idealism and your cynicism, and ask yourself, "Can you bear to settle for anything less?" Can you bear to accept a world of great and growing ugliness? Can you stand to believe that it is inevitable? You cannot. Such a belief will slowly but surely kill your soul. That is because it is not true. The mind likes cynicism, its comfort and safety, and hesitates to believe anything extraordinary, but the heart urges otherwise; it urges us to beauty, and only by heeding its call can we dare create a new Story of the People.
We are here to create something beautiful; I call it "the more beautiful world our hearts tell us is possible." As the truth of that sinks in, deeper and deeper, and as the convergence of crises pushes us out of the old world, I think that more and more people will live from that truth: the truth that more for you is not less for me; the truth that what I do unto you, so I do unto myself; the truth of living to give what you can and take what you need. We can start doing it right now. We are afraid, but when we do it for real, the world meets our needs and more. We then find that the story of Separation, embodied in the money we have known, is not true and never was. Yet, the last ten millennia were not in vain. Sometimes it is necessary to live a lie to its fullest before we are ready to take the next step into the truth. The lie of separation in the age of usury is now complete. We have explored its fullness, its furthest extremes, and seen all it has wrought, the deserts and the prisons, the concentration camps and the wars, the wastage of the good, the true, and the beautiful. Now, the capacities we have developed through this long journey of ascent will serve us well in the imminent Age of Reunion.