Chicago & North Western viaduct over Des Moines River near Boone, Iowa
Ilargi: I was going to write more on the Three Stooges' (Bernanke, Obama, Summers) happy messages today about all the green shoots they can see at the -far- end of the tunnel, and about Goldman Sachs getting ready to conquer that part of the planet they don't yet control, and being awarded with a 11.5% drop in share value. But I decided I'll leave all that for tomorrow, which will no doubt be another day of weirdness, when I saw Dan W.' letter below, written after he met today with the Lieutenant Governor of his home state, Vermont. It's well worth a read, just like his efforts are worthy of our attention. I know, we will have to see what comes of all this..... Politics is still politics, after all, not a game in which honesty is rewarded, and therefore neither one in which honesty is particularly considered a virtue.
NOTE: Steve Keen's article all the way at the bottom is a must read.
Dan W: Great Meeting With The Lieutenant Governor of Vermont
We met for 90 minutes. He took me, and my thoughts and concerns, seriously. He invited two state Senators into the meeting with us. He gave me guidance with regard to how I should proceed viz the "10 ideas" I presented for saving lives of Vermonters. He requested some clarification with regard to my thoughts on GDP so that he could use my thoughts to "challenge" the state's team of economists and financial consultants. I will include my letter below. I am heartened. I believe that a life---at least one---will be saved.
I thoroughly enjoyed meeting you---and Jed---today.
As per your request, here is a brief summary of my reasoning as to why Vermont is about to experience an economic Depression for the first time in three quarters of a century. (By the way, instead of focusing upon the financial "esoterica" vis-a-vis our current financial crisis---Credit Default Swaps and Counter-party Risk and Derivatives-based Debt and the end of Mark-to-Market Accounting and Securitization and Collateralized Debt Obligations, etc.---I am going to focus my arguments solely upon an examination of the realities of our shrinking GDP):
The Obama team (Mr. Summers, Mr. Geithner and Mr. Bernanke) understands that we must maintain at least 2-3% GDP growth in order to stave off economic collapse. Why? Because when GDP falls, quarter-upon-quarter, year after year, unemployment increases exponentially and consumer spending all but evaporates.
With a national GDP of somewhere around $14.6 TRILLION, the country must experience GDP GROWTH of about $425 BILLION in 2009 in order to reach 3% growth. But it is critical to remember that this need for 2-3% growth exists within a regime in which consumer spending comprises over 70% of GDP, 17% of GDP is consumer debt (over $2.5 trillion), U6 unemployment stands at roughly 16% and is getting worse by the week, the "investments" portion of GDP is collapsing, and public pensions in the U.S. are currently underfunded by more than $1 trillion.
Despite claims to the contrary, all fundamental indications are that GDP will contract not for months but for YEARS. Debt service and destruction are just beginning, and during this time of massive deleveraging and retrenchment, growth as a measure of GDP will continue to contract. The government may try to find ways to artificially inflate GDP, but the only means that they have at their disposal is either (a) the creation of more debt through borrowing and spending (debt which will have to be serviced at some point), (b) massive efforts at monetizing debt through the printing of trillions of dollars (which will inevitably precipitate either a bond market dislocation or an eventual ruinous bout of hyperinflation), or (c) the creation of a war economy not entirely unlike that developed during WWII.
Our political leaders in Washington D.C. have clearly come to the conclusion that they can only keep our economy from collapsing if they increase government spending to a level that offsets all other declines in GDP, thus creating the illusion of real productive growth. And, in order to keep the lid on the deficits and in order to keep our creditors from calling in their chips, our federal and state governments are going to have to employ massive new tax revenue and collection systems. Unfortunately, tax revenues always decline during periods of significant economic retrenchment, and the same will be true this time around.
Our political leadership is clearly not willing to let the banking industry fail due to their fear of counter-party risk and possible meltdown scenarios. But they also must recognize that GDP as a measure of consumer spending and business investment is going to contract by at least 30% over the next 12-24 months. Thus the only way to artificially prop up GDP---and thence claim that all is OK because our economy is growing!!---is to increase governmental spending to levels not seen since WWII. I would not be at all surprised to see the GE portion of GDP surpass the 50% level within the next 12-24 months.
And lest we forget, over the past year or so, most retirement funds and 401k plans have lost half of their value, if not more. Millions of people who had planned well for retirement and saved to send their kids to college, etc., are now staring a moneyless retirement square in the face. And those who are relying upon future aid from Social Security may be in for the rudest awakening of all; because, as a matter of law, Congress is NOT contractually obligated to pay Social Security benefits to anyone. (And at this point Social Security obligations are in the red over $60 trillion going forward.)
And finally, at the risk of being redundant, over 10 TRILLION DOLLARS of GDP in 2008 was a measure of consumer spending. And tens of BILLIONS of dollars of profits and wealth accumulated by hundreds of thousands of bankers and hedge fund managers and traders and the like was used to purchase yachts and mansions and cars and safari trips to Africa and thousand dollar bottles of wine and HD TVs, etc. And all of those purchases were recorded as part of our GDP. And now all of that spending is gone. Add this to the fact that every sector of the economy is retrenching, and again we’re looking at year after year of negative GDP growth.
This is a Depression. The numbers are quite clear. A 30% GDP correction must occur, and such a correction will be "depressionary". We need to plan accordingly. If we do not, Vermonters may suffer unnecessarily.
Thank you for your time.
Taxing Grandma to Subsidize Goldman Sachs
Monday afternoon, Goldman Sachs reported much larger than expected first-quarter profits on the heels of the strong earnings Wells Fargo reported last week. No one should be surprised. The Federal Reserve has provided the banks with lots of cheap funds through various emergency lending facilities and quantitative easing. The Fed has permitted the banks and financial houses to park vast sums of unmarketable paper on its books—securities made nearly worthless by the misjudgment and avarice of bankers. In return, the Fed has provided these paragons of finance with fresh, cheap funds to lend at healthy rates on credit cards, auto loans, and even mortgages.
While the Fed cuts the banks slack, the bankers are busy turning the screws on their debtors by raising credit card rates and fees, and harassing distressed borrowers with all the zeal the Roman army displayed sacking Palestine. It takes good banking skills to borrow at 3%, lend at 5%, and make a profit. It takes much less business acumen to borrow at 2%, lend at 5%, and make a profit—which is exactly what has happened. The extra fees are just gravy. Increasing the spread for banks is akin to subsidizing parts purchases for car companies. The folks at GM would look like wizards if the Fed had been similarly generous to them.
This all comes at a cost to someone—America's elderly. Many retirees depend on interest from certificates of deposit. Those rates are down dramatically and as CDs expire, retirees are compelled to reinvest their savings at lower rates and live on less income. They can take comfort that their sacrifices are helping pay off Wall Street's losses from the lavish bonuses that were paid bankers—for example, the $70.3 million Goldman doled out to CEO Lloyd Blankfein in 2007.
The contrast between how the banks and car companies are treated is the product of political acumen, not financial skills, at Goldman Sachs and other banks. Having fed the campaign machines of both political parties and lavished speaking fees on future White House economic advisors, these financial wizards have managed to purchase preferred treatment in our capital. When times are good, their troops feast like a conquering Roman army. When they fail, Washington gives them welfare on the gold plates of emperors.
Now the banks, led by Goldman, want to pay back the TARP funds and free themselves of federal restrictions on compensation. After all, as private concerns, they argue that what they pay will depend on what profits they can generate. Yet the Fed's lines of credit to banks, insurance companies, and such exceed $800 billion. Its monetary policy transfers income from retirees to the likes of Blankfein. Isn't this a great country?
Did Goldman Sachs Just Call The Top Of The Market?
It might go down as one of the all time greatest trades of all time. Goldman watched its share price soar 170 percent since the lows of November, and conducted a rush sale into a bouyant market. Just minutes after the Goldman shares prices, the market got hit by bad retail numbers and the Dow sank 100 points. Now Goldman may be able to ditch the TARP and all its attendant hassles, while its rivals will find it much more expensive--if not impossible--to do the same. It brings back the old cliche: if the smart guys are selling, should you really be buying?
Others are now wondering if Goldman's stock sale signals the top of the market, at least for financials. If Goldman believed shares were headed still higher, they would have been wise to take the offering slowly. Instead, they rushed to sell in an almost unprecedented combination of early announcement of good results and overnight pricing of a $5 billion offering. Lots of market watchers, including Boom Doom & Gloomster Marc Faber, have been saying that the markets would drop in late April. Goldman looks to be adopting this view as well.
Goldman Sachs TARP repayment plan raises questions
Goldman Sachs Group Inc.'s choice to take steps to return government bailout funds is putting pressure on government officials, who may have mixed opinions about whether they want to see the mega bank return the dough. Some regulatory observers argue that Treasury may not be so enthusiastic about taking back the funds immediately because of the negative image that it might have on the bank's struggling rivals. However, others contend that bank regulators will be enthusiastic about any returns, in part, because it shows the capital markets have begun to work again. Another positive outcome: Treasury could then re-allocate the funds to other banks in need of capital injections.
Goldman announced late Monday that it will return $10 billion in bailout money by first offering $5 billion through an equity offering. The bank also announced that it made $1.81 billion in profits in the first quarter. A New York banking attorney said Treasury pressed Goldman to accept a capital injection from the government against its will, in part, to encourage other banks to participate. He added that Treasury sought Goldman's participation so that other banks would agree to accept allocations without fearing that it would portray them in a negative light. As a result, Treasury and Goldman's primary regulator, the Federal Reserve, could seek to delay its repayment for fear of how the effort might be perceived by investors of other large financial institutions, such as Bank of America Corp., which may not be in a position to pay back the funds.
The government's response will vary depending on stress tests bank regulators are performing on financial institutions expected to be completed in a couple weeks.
A provision in the American Recovery and Reinvestment Act, which was approved in February, impedes Goldman and other financial institution recipients of bank bailout funds ability to return capital. The statute requires Treasury to negotiate with each bank's primary regulator before it approves a repayment. However, some banking attorneys believe that Goldman's ability to return the bank bailout funds would be embraced enthusiastically by Treasury Secretary Timothy Geithner and other bank regulators. "I don't think the government will deny Goldman the opportunity to repay the funds if regulators come to the conclusion that the institution does not need the money," said David Brown, partner at Alston & Bird LLP in Washington.
Brown argues that one major reason why Treasury may be supportive of having Goldman return the capital is because it can then turn around and re-deploy it by making capital injections into other banks that are seeking capital injections. "Treasury could re-spend it," Brown said. Gary Roth, partner at Alston & Bird LLP in New York, said he expects Treasury and the Federal Reserve to consider Goldman's repayment effort as a positive move. "It's a success story because at the time the initial investment was made, I don't think Goldman was in a place to make this kind of rights offering," Roth said. "The whole idea here was to allow the markets to recover and Goldman's offering is a good sign of recovery."
Already, six banks including Sun Bancorp, Inc., have paid back the government's capital injections, with interest. In addition to Goldman Sachs, a small thrift, First Niagara Financial Group Inc. announced Monday that it was raising money to pay back the government bank bailout program. First Niagara is seeking to raise $300 million to "facilitate (in consultation with the Office of Thrift Supervision) the repayment of the $184 million in preferred stock issued to the U.S. Treasury Department pursuant to the Capital Purchase Program and a related warrant for common stock." However, Brown added that bankers will take other larger considerations into account when evaluating how they will seek to repay the government.
"Every bank is thinking about how they could repay the government," Brown said. "They are wondering, 'What will Congress do next?'" One major concern: Will the government convert its preferred share capital injection, as part of the Treasury's Capital Assistance Program, into common shares, a process that for many banks could, in effect, nationalize the bank. Treasury spokesman Andrew Williams said the agency views a financial institution's raising of private capital as a positive step that contributes to the financial system's ability to continue lending through the down turn. "At the same time, we are pleased with banks that continue to participate in the program because we believe it has helped and will continue to help accomplish the goal of continued lending in the face of economic headwind," Williams said.
How Goldman’s Declining Share Price Wiped Out $1 Billion In Book Value
The way Goldman Sachs accounts for stock awards to employees wiped out about a billion in book value last quarter. Ironically, this loss came because Goldman was delivering stock to employees that was substantially cheaper than when it was originally awarded. The fact that delivering less costly stock can drain book value is an example of how complicated book keeping at investment banks can be. Often what looks like a bad thing for a bank, turns out to be a boost to the books. While what looks like a good thing can sometimes be a sap book value.
One more familiar example of this is the way banks can actually reduce their liabilities when their bond investors lose confidence in the bank. The banks account for the cost of their loans based on how much they would have to spend to buy back the loans on the market, so when investors lose confidence and send bond prices lower, the banks write-down the cost of their own debt. So a loss of confidence adds to the bottom line by reducing the liabilities.
In the first quarter of this year, Goldman lost book value because of the way it accounts for the tax deduction it gets for awarding stocks to employees. It accounts for the cost of those awards and the tax write off at the time it makes the awards. When the stock price declined, those awards were less costly because they were made with cheaper stocks. This, in turn, reduces the value of the tax write-off. In the last quarter, the decline in Goldman’s share reduced the value of the tax write-off for the stock awards by about $1 billion.
Did Goldman Goose Oil?
When oil prices spiked last summer to $147 a barrel, the biggest corporate casualty was oil pipeline giant Semgroup Holdings, a $14 billion (sales) private firm in Tulsa, Okla. It had racked up $2.4 billion in trading losses betting that oil prices would go down, including $290 million in accounts personally managed by then chief executive Thomas Kivisto. Its short positions amounted to the equivalent of 20% of the nation's crude oil inventories. With the credit crunch eliminating any hope of meeting a $500 million margin call, Semgroup filed for bankruptcy on July 22.
But now some of the people involved in cleaning up the financial mess are suggesting that Semgroup's collapse was more than just bad judgment and worse timing. There is evidence of a malevolent hand at work: oil price manipulation by traders orchestrating a short squeeze to push up the price of West Texas Intermediate crude to the point that it would generate fatal losses in Semgroup's accounts. "What transpired at Semgroup was no less than a $500 billion fraud on the people of the world," says John Catsimatidis, the billionaire grocer turned oil refiner who is attempting to reorganize Semgroup in bankruptcy court. The $500 billion is how much the world would have overpaid for crude had a successful scam pushed up oil prices by $50 a barrel for 100 days.
What's the evidence of this? Much is circumstantial. Proving oil-trading manipulation is difficult. But numerous people familiar with the events insist that Citibank, Merrill Lynch and especially Goldman Sachs had knowledge about Semgroup's trading positions from their vetting of an ill-fated $1.5 billion private placement deal last spring. "Nothing's been proven, but if somebody has your book and knows every trade, it would not be difficult to bet against that book and put the company into a tremendous liquidity squeeze," says John Tucker, who is representing Kivisto. What's known for sure is that Goldman Sachs, through J. Aron & Co., its commodities trading arm, was in prime position to use such data--and profited handsomely from Semgroup's fall. J. Aron was Semgroup's biggest counterparty, trading both physical oil flowing through pipelines and paper oil, in the form of options and futures.
When crude oil peaked in July, Semgroup ran out of cash to meet margin requirements on options contracts it had with Aron, contracts on which it had paper losses of $350 million. Desperate to survive, Semgroup asked Aron to pony up $430 million it owed on physical oil. Aron said no, declared Semgroup in default on its contracts and demanded immediate payment of losses. Some answers may emerge in late March when former FBI director Louis Freeh releases a report on the trading surrounding Semgroup's demise. He was hired by Semgroup and given subpoena power by the bankruptcy court judge in Delaware.
Meanwhile the Securities & Exchange Commission is investigating, and lawyers involved in the bankruptcy say that Manhattan District Attorney Robert Morgenthau's office is looking into the actions of New York firms in the collapse. His office declines to comment. Goldman says only that any allegations of oil price manipulation are "without foundation." Merrill and Citi declined comment. Goldman and Aron (where Goldman Chief Executive Lloyd Blankfein got his start) have had a deep connection with Semgroup. In 2004 two former Goldman bankers bought a 30% stake in Semgroup for $75 million through their New York private equity firm, Riverstone. Both men, Pierre Lapeyre and David Leuschen, had helped form Goldman's commodity trading business, and Leuschen had been a director at Aron.
In late 2007 Semgroup entered into an oil-trading agreement with Aron. The companies began trading both oil futures and physical crude. Aron sent much of the oil it bought from Semgroup to a Coffeyville, Kans. refinery in which Goldman owns a 30% stake. Semgroup's troubles mounted in the first quarter of 2008, when it had to post $2 billion in margin to cover losses. Goldman offered to underwrite a $1.5 billion private placement. Kivisto's attorney Tucker and others believe that it was in the Wall Street research for this offering that Semgroup's trading bets became fatally exposed. In April the banks (Merrill Lynch and Citibank were co-underwriters) required that Semgroup submit its trading positions to a stress test, a process one source describes as a "proctology exam." Goldman ended up abandoning the placement as investors balked at braving the liquidity crunch.
Meanwhile the futures markets had gotten wacky. On June 5, with no news catalysts, oil futures spiked $5 a barrel, the biggest one-day jump since the outbreak of the first Gulf war. The next day, on no news, the price jumped another $10 to $138. Traders say that in the days leading up to the $147 peak on July 12 there was the smell of blood in the water. "We just kept bidding the market higher," one trader says. According to a trading summary submitted with court documents, Semgroup had entered into some terribly costly trades with Aron. In February 2008 Semgroup sold Aron call options on 500,000 barrels of oil for July delivery with a strike price of $96 per barrel. That meant that at the peak Semgroup's loss on each of those barrels was $51, or $25.5 million on that trade. Goldman says it "can't comment on the trading positions of counterparties."
Shortly before it filed for bankruptcy, Semgroup sold its trading book to Barclays Capital. Barclays' bold bet was that the price of crude would fall, erasing the losses. It is believed that 30 days later Barclays was sitting on a $1 billion gain as oil indeed fell, to $114 a barrel. Barclays wouldn't comment other than to confirm it still owns the book. That prices plunged after Semgroup failed is more evidence of manipulation, says Catsimatidis: "With the portfolio in Barclays' hands they could not squeeze the shorts anymore. The jig was up, and oil collapsed." Since the bankruptcy, Aron has agreed to pay Semgroup only $90 million to settle up accounts.
That's not enough for the dozens of oil producers who still haven't been paid for $430 million in oil that Semgroup delivered to Aron. "We sued J. Aron because Semgroup didn't do it," says Phillip Tholen, chief financial officer of oil company Samson Resources. "I can't fathom why they wouldn't file against J. Aron for those monies." One possible answer: the Goldman connection. Going after Aron's cash would complicate matters with Riverstone, which still wields sway over the board. The creditors have reason to keep Riverstone and Goldman happy; the duo has teamed up to buy myriad energy assets in recent years, most notably a $22 billion leveraged buyout of pipeline king Kinder Morgan. They are likely to team up again to buy choice Semgroup assets out of bankruptcy.
US dollar is a virtual currency
by Max Keiser
A Cory Doctorow column in the Guardian about gaming and currencies is a nice update to a trend I’ve been tracking since 1996 and the launch of Hollywood Stock Exchange. At the time, when I was running HSX I insisted on allowing users to convert Hollywood Dollars into U.S. dollars at a fixed exchange rate of 1 million to 1. The profit to us was pretty good because by the time a user on HSX made 1 million Hollywood dollars clicking around our site, we had served more than 1 dollar in ads. The NYT called the Hollywood Dollar the first virtual currency in existence in a story from around that time.
What’s interesting to me today, is not that virtual currencies are just now being understood as a viable piece of the overall economy but how supposedly smart people, like America’s favorite economist Paul Krugman, fail to understand, or have decided not to inform Americans that the Federal Reserve Bank and U.S. Treasury issuing U.S. dollars is no different than online game currencies. Both are fiat currencies whose value is tied to over consumption. Online virtual currencies derive value from users spending more time than they should playing games, living above their time means. And the U.S. dollar derives value from U.S. consumers over consuming ’stuff,’ living beyond their budgetary means.
Another piece of the current economics debate that I don’t get is why people warning against economic Apocalypse expect that those most effected by the downturn are going to do something to get out of the way. This goes against everything we know about why this crisis got to the levels we’re in now. Bankers, acting as croupiers of virtual currencies like the U.S. dollar, have been pumping fiat dollars into our economy like casinos in Vegas pumping in oxygen. The casino model is really all you need to know to understand the crisis and why nothing will stop it until it burns itself out. People are being told by CNBC, Larry Kudlow, Jim Cramer, NBC, CBS, ABC and the rest to ‘double down’ because their luck has got to change! HAHAHAHAHA! If you believe this, I’ve got about 100 billion Hollywood Dollars I’d like to sell you.
Cutting back financial capitalism is America’s big test
by Martin Wolf
Is the US Russia? The question seems provocative, if not outrageous. Yet the person asking it is Simon Johnson, former chief economist at the International Monetary Fund and a professor at the Sloan School of Management at the Massachusetts Institute of Technology. In an article in the May issue of the Atlantic Monthly, Prof Johnson compares the hold of the "financial oligarchy" over US policy with that of business elites in emerging countries. Do such comparisons make sense? The answer is Yes, but only up to a point. "In its depth and suddenness," argues Prof Johnson, "the US economic and financial crisis is shockingly reminiscent of moments we have recently seen in emerging markets." The similarity is evident: large inflows of foreign capital; torrid credit growth; excessive leverage; bubbles in asset prices, particularly property; and, finally, asset-price collapses and financial catastrophe.
"But," adds Prof Johnson, "there’s a deeper and more disturbing similarity: elite business interests – financiers, in the case of the US – played a central role in creating the crisis, making ever-larger gambles, with the implicit backing of the government, until the inevitable collapse." Moreover, "the great wealth that the financial sector created and concentrated gave bankers enormous political weight." Now, argues Prof Johnson, the weight of the financial sector is preventing resolution of the crisis. Banks "do not want to recognise the full extent of their losses, because that would likely expose them as insolvent ... This behaviour is corrosive: unhealthy banks either do not lend (hoarding money to shore up reserves) or they make desperate gambles on high-risk loans and investments that could pay off big, but probably won’t pay off at all. In either case, the economy suffers further, and, as it does, bank assets themselves continue to deteriorate – creating a highly destructive cycle."
Does such an analysis make sense? This is a question I thought about during my recent three-month stay in New York and visits to Washington, DC, now capital of global finance. They are why Prof Johnson’s analysis is so important. Unquestionably, we have witnessed a massive rise in the significance of the financial sector. In 2002, the sector generated an astonishing 41 per cent of US domestic corporate profits (see chart). In 2008, US private indebtedness reached 295 per cent of gross domestic product, a record, up from 112 per cent in 1976, while financial sector debt reached 121 per cent of GDP in 2008. Average pay in the sector rose from close to the average for all industries between 1948 and 1982 to 181 per cent of it in 2007.
In recent research, Thomas Philippon of New York University’s Stern School of Business and Ariell Reshef of the University of Virginia conclude that the financial sector was a high-skill, high-wage industry between 1909 and 1933. It then went into relative decline until 1980, whereupon it again started to be a high-skill, high-wage sector.* They conclude that the prime cause was deregulation, which "unleashes creativity and innovation and increases demand for skilled workers". Deregulation also generates growth of credit, the raw stuff the financial sector creates and on which it feeds. Transmutation of credit into income is why the profitability of the financial system can be illusory. Equally, the expansion of the financial sector will reverse, at least within the US: credit growth and leverage masked low or even non-existent profitability of much activity, which will disappear, and part of the debt must also be liquidated. The golden age of Wall Street is over: the return of regulation is cause and consequence of this shift.
Yet Prof Johnson makes a stronger point than this. He argues that the refusal of powerful institutions to admit losses – aided and abetted by a government in thrall to the "money-changers" – may make it impossible to escape from the crisis. Moreover, since the US enjoys the privilege of being able to borrow in its own currency it is far easier for it than for mere emerging economies to paper over cracks, turning crisis into long-term economic malaise. So we have witnessed a series of improvisations or "deals" whose underlying aim is to rescue as much of the financial system as possible in as generous a way as policymakers think they can get away with. I agree with the critique of the policies adopted so far. In the debate on the Financial Times’s economists’ forum on Treasury secretary Tim Geithner’s "public/private investment partnership", the critics are right: if it works, it is because it is a non-transparent way of transferring taxpayer wealth to banks.
But it is unlikely to fill the capital hole that the markets are, at present, ignoring, as Michael Pomerleano argues. Nor am I persuaded that the "stress tests" of bank capital under way will lead to action that fills the capital hole. Yet do these weaknesses make the US into Russia? No. In many emerging economies corruption is egregious and overt. In the US, influence comes as much from a system of beliefs as from lobbying (although the latter was not absent). What was good for Wall Street was deemed good for the world. The result was a bipartisan programme of ill-designed deregulation for the US and, given its influence, the world. Moreover, the belief that Wall Street needs to be preserved largely as it is now is mainly a consequence of fear. The view that large and complex financial institutions are too big to fail may be wrong. But it is easy to understand why intelligent policymakers shrink from testing it.
At the same time, politicians fear a public backlash against large infusions of public capital. So, like Japan, the US is caught between the elite’s fear of bankruptcy and the public’s loathing of bail-outs. This is a more complex phenomenon than the "quiet coup" Prof Johnson describes. Yet decisive restructuring is indeed necessary. This is not because returning the economy to the debt-fuelled growth of recent years is either feasible or desirable. But two things must be achieved: first, the core financial institutions must become credibly solvent; and, second, no profit-seeking private institution can remain too big to fail. That is not capitalism, but socialism. That is one of the points on which the right and the left agree. They are right. Bankruptcy – and so losses for unsecured creditors – must be a part of any durable solution. Without that change, the resolution of this crisis can only be the harbinger of the next.
*Wages and Human Capital in the US Financial Industry 1909-2006, January 2009, www.nber.org
Summers Says U.S. Economy Shows 'More Balanced' Signs Recently
The U.S. economy has presented "a more balanced picture" in recent weeks, signaling the severity of the recession may be easing, said Lawrence Summers, director of the White House National Economic Council. Both statistical and anecdotal evidence is now "more encouraging than it was" in the beginning of the year, when the economy was contracting sharply, Summers said in an interview today on Bloomberg Television. "The freefall we’ve been seeing is not going to be something we’re going to be living with indefinitely," he said.
Summers said that while the White House has been tackling the recession and financial crisis with an "unprecedented response," the problems it inherited are "very serious" and "are not going to be solved overnight." Summers cited the Obama administration’s stimulus package and its plan to relieve banks of illiquid assets clogging their balance sheets. "Even with all of that we have to recognize that this is going to take time," he said. In an earlier interview on CNBC, Summers mentioned lower inventories, improved consumer spending and stimulus tax cuts that will begin showing up in many Americans’ paychecks this month as factors that paint a brighter picture of the economy. "Many forecasters are looking for growth in the latter part of this year, and the inventory cycle points in that direction," Summers said.
Towns in Germany and Transit in Washington Feel AIG Pinch
The ripple effects of American International Group Inc.'s woes have spread from the bastions of global finance to U.S. transit authorities to little towns throughout Germany. The reach can be chalked up in part to a kind of infrastructure tax deal that gained popularity in the 1990s and spread among hundreds of municipal and state governments around the world. Now, the deals in many cases have backfired because of the giant insurer's problems. The notion was this: Localities could earn millions of dollars selling their infrastructure to U.S. banks and other investors in deals guaranteed by U.S. banks and insurance companies. The investors would get a tax break (a break that isn't allowed any longer), the benefits of which they would share with the municipalities.
The deals generally called for top-rated guarantors to insure the municipalities' invested funds. Amid the financial crisis, downgrades of those guarantors have forced the governments to pump in more cash or other collateral, in some cases to the banks that bought the infrastructure, to compensate for the guarantor's lower credit standing with the investors. If they can't, they must cancel the deals at a loss. The deals have caused headaches among some transit agencies in the U.S. that used AIG as the insurer, including the Washington Metropolitan Area Transit Authority in the Washington, D.C., area. A spokeswoman said Friday that the Transit Authority was still dealing with the issue. "AIG's credit rating was downgraded, which put us in a technical default. But we have been making our regular payments as usual as we continue to work to try to unwind the agreements," said the spokeswoman.
AIG maintains that it is meeting its obligations to governments involved in the deals and that it still guarantees trusts where deals remain. "AIG continues to fulfill all of its payment and other obligations related to these transactions," a spokesman said. The downgrades also are proving problematic in Germany. About 160 German municipalities signed such leasing deals with a total transaction value of about €80 billion ($105 billion), said Julian Roberts, a Munich-based lawyer with law firm Roessner who works with municipalities trying to get out of deals that have soured. Similar agreements were struck around the world, but lawyers said some German municipalities embraced the unusually structured transactions more readily -- partly because Germany allows its towns and cities to engage in complex financial deals without the permission of state or federal authorities.
AIG, through its Financial Products unit, played a significant role in the business in Germany, according to cities and lawyers familiar with the deals. One deal was structured around the Bodensee water utility in southern Germany, which is owned by the city of Stuttgart and its surrounding towns and manages the water facilities and plant providing water for about four million people in the region. In 2002, it sold most of its plant and other infrastructure to Wachovia Corp., now owned by Wells Fargo & Co., for €840 million for 30 to 99 years. The utility placed the money in a trust, which invested the funds in the capital markets until the local communities would repurchase the infrastructure. AIG promised to guarantee the value of the trust, so the U.S. investors could eventually get their money back.
All went according to plan until late September, when, with AIG's downgrade, the clause in the utility's contract with Wachovia requiring that the repurchase trust be backed by a top-rated insurer forced the utility to act. Unlike some other deals, in which municipalities could offer more cash or U.S. Treasury notes as collateral to compensate for AIG's downgrade, the Bodensee utility's contract stipulated it either find a new insurer or end the contract -- and pay an estimated €57 million in fees. The utility ended the deal March 26, and after paying out of its €45 million in earnings from the contract, is still roughly €12 million in the hole. It plans to borrow and raise water rates to consumers to offset its new debts, it said. Wachovia and AIG declined to comment.
Oregon Sues Over Risks Taken in Its '529' Fund
Oregon sued OppenheimerFunds Inc., charging the New York money manager with understating the risk it took with a bond fund in Oregon's state college-savings plan. On Monday, Oregon sued the firm for losses of $36 million incurred by participants in the Oregon College Savings Plan, which Oppenheimer manages. The accounts, known as "529" plans, are a way for individuals to save tax-free for college expenses. At least four other states had hired Oppenheimer to manage parts of their college-savings plans, including Texas, New Mexico, Illinois and Maine. A spokeswoman for Illinois's state treasurer said the state is working with the other states, "to try to negotiate a settlement."
The Oregon lawsuit, filed by its attorney general on behalf of the state treasurer in a county court, says that its 529 plan lost money due to risky investments made by Oppenheimer, which weren't disclosed to the state. Oregon charges that Oppenheimer Core Bond fund, which was one of the state's 529-plan options billed as "conservative," became significantly more risky starting in late 2007 or early 2008. The fund lost 36% of its value in 2008, but its benchmark index, the Barclays Capital Aggregate Bond Index, rose 5.2%. "The Core Bond Fund was no longer a plain bond fund," the complaint says. "It had become a hedge-fund like investment fund that took extreme risks."
The complaint says the fund veered into credit-default swaps and other derivatives, which the state called "high-risk bets that were plainly inappropriate for those saving for college." "OppenheimerFunds is very disappointed by the actions of the Oregon Attorney General's Office," said Oppenheimer spokeswoman Jeaneen Pissara, adding that the firm has been cooperating with Oregon and other states in trying to resolve the matter. The firm is one of the larger managers of 529 plans, with about $4 billion under management.
Oppenheimer Core Bond fund's sharp losses in 2008 stem partly from bets on high-quality commercial mortgage-backed securities, which its manager believed would rise in value. To make these investments, the fund used a type of derivative called total-return swaps, which are agreements between parties to exchange cash flows in the future based on how a set of securities performs. But commercial mortgage securities have deteriorated since last year, thanks to the worsening economy.
More Americans wary of U.S. tax man this year
As a deep recession strips Americans of their jobs, homes and investments, the 2009 U.S. tax season promises to see a large uptick in first-time delinquent income taxpayers. "Our calls are up 280 percent," said Richard Boggs, founder and chief executive of Los Angeles-based Nationwide Tax Relief, a firm that helps delinquent taxpayers resolve tax issues. "We've seen a huge rise in what we call the rookie delinquent taxpayer," he said. "They are incredibly scared, and they have no idea what's going to happen to them because, God bless them, they've never owed before." As the weak economy puts job security and a steady flow of income on a slippery slope, many are wary of the U.S. tax man, tax consultants say.
With household balance sheets under pressure, more U.S. households are having trouble keeping up with their day-to-day bills and struggling to pay their taxes. "Folks are not paying their taxes because they are spending it on necessary living expenses," said Kristin Lavieri, an accountant with Weinstein & Anastasio, PC in Hamden, Connecticut. She added that more of the self-employed, who are required to pay taxes each quarter, are likely to end up with back taxes. "When there is not enough money for general operating expenses, there most definitely isn't going to be enough for quarterly estimates," Lavieri said. Among those not self-employed, many also have to make tough decisions that could carry long-term financial consequences.
Many withdrew funds from 401k and IRA retirement savings accounts before the permitted time, unaware of the punitive taxes and penalties this would generate, said Larry Walker Jr, president of the financial and tax services firm 4-Serenity Inc in Snellville, Georgia. Withdrawals from a retirement account before reaching the age of 59.5 are considered taxable income and generally incur an additional tax of 10 percent of the amount. Other taxpayers did not have enough tax withheld from paychecks. As a result, they now owe taxes or will not receive the amount of refund they usually do, Walker said.
"If we are seeing a nearly threefold increase in people who have tax problems who have never had tax issues, it shows that things are worse than people think right now," Boggs said. But tax woes are such a taboo issue that over 40 percent of Boggs' clients have told him nobody knows about their problems, and that often includes their spouses. "When they see a tax bill that they know they can't pay, they freeze up," Boggs said. "A very innocent procrastination can get you into a lot of hot water with the IRS." The Internal Revenue Service, which collects taxes in the United States, vowed to show its gentler side this year.
"We recognize the economic realities that are out there," IRS Commissioner Doug Shulman told reporters. "We're available to work with people." Critics are skeptical this will happen. The agency collects much of the $3 trillion that funds the government. IRS agents were given more flexibility in their collection actions, including the ability to reduce or suspend monthly payments on back taxes so those hit hard by the financial downturn are not forced to default on their tax payments. But Boggs said IRS policies are adding to the fear Americans feel for the traditionally secretive agency while outdated guidelines make the prospect of collection action scary.
National Taxpayer Advocate Nina Olson, head of an independent organization within the IRS that helps taxpayers, seemed to echo this sentiment in an annual report to Congress. The report revealed that penalty provisions in the tax code have not been comprehensively reformed since 1989, and the complexity of the tax code is a serious problem. An elderly woman in Austin, Texas, who asked not to be named, said her $3,000 debt to the IRS grew to around $60,000 in taxes and penalties over 16 years despite the fact that she paid off the initial debt within six months. The 61-year-old is disabled and suffers from multiple health problems. The IRS now takes $133 each month from her Social Security disability check.
The practice is part of the agency's Federal Payment Levy Program, which allows up to 15 percent of any federal payments a delinquent taxpayer receives to go directly to the IRS until their overdue taxes are paid in full. Olson noted that too often this automated levy system withholds Social Security payments to taxpayers with incomes below the poverty line. If these cases had been subject to human review, the report says, many would have been classified by the agency as unable to pay. Some wealthier people are also finding themselves overwhelmed by tax burdens.
"America's top earners are suffering a new one-two punch," Boggs said. "Not only are America's wealthiest suffering the largest losses in nearly a century, but the IRS will be seizing what little resources they do have left in record time," he said. "Some of my rich clients are having big problems," said Lance Wallach, CEO and president of Veba Plan LLC, a financial consultancy firm. "Hundreds of them do not have liquid cash to pay bills."
Global ad spending to fall 7%
Declines in global advertising will be much worse than expected, says a leading media buyer , which will on Tuesday unveil the grimmest forecasts yet seen for the advertising market and traditional media companies. Worldwide advertising spending, a barometer for economic confidence, will fall 6.9 per cent in 2009 to $453bn, compared with 1 per cent growth last year, predicts ZenithOptimedia, the media buying unit of Publicis, the world’s fourth-largest advertising group. The forecasts outstrip rivals’ figures released last month. Group M, owned by WPP, expects a 4.4 per cent decline this year and Carat, owned by Aegis, expects a 5.8 per cent drop.
The outlook is gloomiest for newspapers. Spending is projected to fall 12 per cent. Radio and magazines are also grappling with double-digit declines. Television is expected to perform relatively well, with ad spending down 5.5 per cent, due to its vastly reduced prices, marketers’ familiarity with the medium and evidence that consumers are also watching more television, rather than going out. In contrast, the internet’s share of advertising continues to grow, reaching a projected 12.1 per cent of overall spending. In December, Zenith had expected advertising spending to decline 0.2 per cent. Since then the economic crisis has spread to emerging markets, said Jonathan Barnard, head of publications at the agency.
"A lot of markets we were expecting to show at least modest growth this year are clearly going to be down substantially," he told the Financial Times. Mr Barnard said the latest revisions reflected "reality crashing in" on advertisers. China and India continue to show "substantial promise", he added. But central and eastern Europe, where ad spending had previously been expected to grow 1.5 per cent this year, is now forecast to fall 13.9 per cent. Hungary, Turkey, Ukraine and Russia will all see "substantial declines", Mr Barnard said. Latin America, while forecast to fall 2 per cent, is the most resilient area of the world, with the Brazilian market up 7 per cent excluding currency effects. Among the more developed markets, North America will suffer the most, losing 8.3 per cent of its value this year. Western Europe, down 6.7 per cent as a whole, will see the UK and Spain suffer the greatest falls, Zenith said. Mr Barnard expects the global advertising market to resume modest growth in 2010 in most markets except North America.
GM Chairman Says Bankruptcy Looms
The interim chairman of General Motors Corp. acknowledged Tuesday that the auto maker is running out of time to reach a deal with stakeholders and the federal government to restructure outside of bankruptcy. Kent Kresa said the GM board remains convinced that an out-of-court restructuring is the preferred option, but several looming deadlines could impinge on that goal. "The times are very, very short," Mr. Kresa said in an interview. Mr. Kresa was installed at the end of March after Chairman and Chief Executive Rick Wagoner was ousted by the White House, which also handed GM a June 1 deadline to revise its restructuring plan or face bankruptcy.
"This is a very difficult thing to do," added Mr. Kresa. "We have some deadlines rapidly approaching and the probabilities are decreasing we can do outside of bankruptcy." GM faces a Friday deadline to launch a debt-for-equity swap with bondholders that would eliminate much of the company's debt. A deal with bondholders would be needed by then to have the swap under way in time for an impending bond payment. The government also is pressing for a resolution to talks involving bankrupt car-parts maker Delphi Corp., a former unit of GM that may be forced to liquidate if it can't secure more funding to continue functioning in Chapter 11 bankruptcy, Mr. Kresa said. GM is surviving on $13.4 billion in U.S. government loans, and Mr. Kresa said GM will need another infusion "very shortly."
The chairman said GM would welcome the government's willingness to let the car maker pay off some of the loans with GM stock. "Certainly, that would be helpful," he said. But any plan that would leave the U.S. government with an ownership stake in GM could be controversial. The company was able to delay a request for more U.S. funding in March, but continues to burn cash as car sales globally remain weak. Mr. Kresa said talks this week in Detroit with the White House auto task force have focused on seeking an agreement on what market assumptions GM should use in its revitalization plan. GM believes the assumptions it laid out Feb. 17 will hold up, but is still working to make that case to the task force, Mr. Kresa said.
President Barack Obama on March 30 shot down GM's restructuring plan as too slow and small in scope. The auto maker is working on a new plan but also is crafting a bankruptcy option should its revamping efforts fail. The White House said it would provide GM with enough funding to continue operating until June 1. Along with cutting a deal with bondholders to swap billions in debt for shares, GM is required by the Obama auto team to reach deep concessions from the United Auto Workers. Talks with the bondholders and union have stalled as each side demands more sacrifice from the other.
GM's preferred bankruptcy plan would break the company into two parts. One would include the company's stronger assets, such as its Chevrolet brand, that would be quickly restructured. The other would be a grouping of GM's failing assets and obligations that could be liquidated over several years in bankruptcy court. Mr. Kresa said a large team of lawyers and bankruptcy experts is working to develop GM's bankruptcy plan as the company simultaneously works on a new out-of-court scenario. "Time is not on our side on trying to get things done out of bankruptcy," Mr. Kresa said.
Chrysler Talks Bogged Down On Issues of Equity for Banks
The White House auto industry task force and negotiators for Chrysler are asking banks holding some $6.9 billion in secured debt to take just $1 billion as the automaker tries to avert bankruptcy by the end of this month. But the banks—JP Morgan Chase, Citibanak, Goldman Sachs and Morgan Stanley, which hold 75% of the debt—are remaining steadfast in refusing the deal. Their recourse, since their debt is secured by Chrysler assets such as the Jeep brand and factories, is to take their chances in a bankruptcy filing and hope they get a better deal when the assets are sold. Other lien holders include hedge funds—Elliott Management, Stairway Capital Management and Perella Weinberg Partners. There is risk in that strategy, considering the dire straits of the credit markets and shortage of buyers. Ford has been shopping its Volvo unit for two years without a deal in place yet. GM has been shopping Hummer for more than a year. Thomas Stallkamp, partner in private equity firm Ripplewood Holdings, says it is very difficult to assess real market value for assets like Jeep and Chrysler’s factories. "There is so much over capacity and still a shortage of credit…I don’t think anyone knows how much they would bring in liquidation," says Stallkamp, who was formerly President of Chrysler before Daimler-Benz bought the automaker in 1998.
That uncertainty and risk is what is driving Cerberus to play hardball with the banks, say analysts watching the deal. Banks and hedge funds holding the secured debt are looking for some equity in Chrysler for accepting such a haircut on the debt, assuming the automaker forges an alliance with Italian automaker Fiat. That deal is contingent on Chrysler getting a $6 billion government loan, which in turn depends on Chrysler getting a huge concession from its debt holders and the United Auto Workers union by April 30. If the Chrysler-Fiat alliance is successful, the banks argue, they should be able to share in the success in exchange for taking the sacrifice now. The UAW is being offered equity in exchange for giving up half the $9 billion Chrysler owes the union’s Voluntary Employee Benefit Association, which administers healthcare coverage to Chrysler’s workers and retirees. The union and bond holders at both Chrysler and GM have been in a poker game of sorts, trying to make sure one doesn’t get a better deal than the other. The proposed deal to save Chrysler now calls for Fiat to get 20% of Chrysler in exchange for the Italian automaker sharing vehicle and engine technology with Chrysler. The barter arrangement has been estimated to be worth $10 billion to $12 billion. After the company repays the federal government $10 billion in loans, the proposed deal says, according to sources familiar with the negotiations, Fiat would be allowed to buy more than an additional 30% of Chrysler—a majority ownership—for around $50 million. "The deal presented to the lenders right now is completely inequitable," says one representative of a bank on the debt holders committee not authorized to speak on the negotiations.
Based on the terms Fiat is being offered by Chrysler owner Cerberus Capital Management LLC, senior debt holders should be offered at least 25% equity in the company going forward, said the bank official. The White House has already told Cerberus that it should consider its equity in the automaker gone. "There is only so much equity…just so many slices in the pie and that is what is being fought over," said the same bank representative. If the Fiat deal goes through, there will likely be substantial management changes at Chrysler, says an executive briefed on the talks. Fiat CEO Sergio Marchionne will likely hold the title of either chairman or CEO of Chrysler. Current chairman and CEO Robert Nardelli, installed by Cerberus in 2007, will likely retire from the position since Cerberus will likely have no equity left in the automaker. Possible roles for vice chairman James Press and vice chairman Tom Lasorda have not been ironed out yet, the same executive said. If a deal satisfying the White House auto industry task force is not reached by April 30, Chrysler will be forced into bankruptcy without the White House and U.S. Treasury taking an active role by providing Debtor-In-Posession (DIP) financing. Without another source of DIP financing, Chapter 11 bankruptcy would transition to Chapter 7 liquidation, with Jeep and Chrysler’s other assets auctioned off.
Crisis costs Netherlands 26,000 euros per adult
The Dutch have lost on average 26,000 euros per adult since the beginning of the economic crisis, research shows. It is the elderly who are hurt the most. The loss of capital per capita in the Netherlands due to the crisis comes down to simple arithmetic. Take the total capital in the Netherlands on January 1, 2008 from real estate property (1.2 trillion euros), pensions (950 billion) and shares (250 billion) and then do the same on March 1, 2009. The difference is 325 billion euros. That makes an average loss of 26.000 per person over 20-years old since the beginning of the economic crisis, according to Jan Willem Velthuijsen, a professor of economics of the university in Groningen. Results of the calculations, commissioned by accounting firm PriceWaterhouseCoopers where Velthuijsen is also a partner, were published on Monday.
Velthuijsen says people who just retired or are about to retire - 15 to 20 percent of the Dutch population - are affected the most by the crisis. "This group has a lot of shares and has also built up a considerable pension. Their shares have dropped by almost 50 percent, and their pension by 20 percent. What's more: they no longer have the time to make up the difference by working," he says. The Dutch are not suffering the consequences as much as some in other countries hit by the economic crisis are, according to Velthuijsen. "The average Brit has lost almost 50.000 euros since the beginning of the crisis. This is because house prices have dropped by 20 percent in Britain. A crisis always hits the UK harder because it has more home-owners than most countries. On the upside, Britain tends to recover from a crisis sooner than other countries," he says.
The loss in purchasing power has had only a limited effect on consumption in the Netherlands: 300 euros per year, according to PriceWaterhouseCooper. "Other than those in emerging economies the Dutch usually have a moderate reaction to fluctuations in purchasing power. The effect would be bigger if wages went down. But for now there is only a decrease in wealth. Research shows that when people feel less rich, what they spend less corresponds to 3 percent of the actual loss of purchasing power. So we have become a bit more cautious but only 300 euros worth." And what are the Dutch saving on? Mostly on luxury products like holidays or major purchases like cars or new kitchens. It explains the big closing sale sign outside the kitchen and bathroom outlet Quattro in Rotterdam, which is reducing its shopping floor by 50 percent.
"There is a crisis in the kitchen segment," says manager Stephane Stein. "Just look how quiet it is. It is Easter weekend but there are no more people than on an average Saturday." Stein says he has sold 45 percent fewer kitchens in the past few months. "House sales are down, so the sale of kitchens and bathrooms follows. Eight new houses for which we were going to supply the kitchens have been cancelled. And the remaining customers are driving a tougher bargain than ever before." Is this just the beginning? As far as the stock-market goes, Velthuijsen thinks the worst is probably over. House prices will continue to fall although not to the extent they have in Britain. Pensions are a particular problem in the Netherlands, where 40 percent of pensions are capital-funded, compared to a European average of only 8 percent.
This means that Dutch pensions have suffered considerably more than those of other European countries. This affects people who have just retired or are about to retire the most. "Their wealth will be diminished by 20 percent for the rest of their lives," says Velthuijsen. "That's not nothing." On the other hand: "Let's not forget that we all got a lot richer in the past 15 years." But 56-year old Mr. Visser, who is enjoying an ice cream outside the Rotterdam mall, is not spending less just yet - even if he admits that his pension, his shares and his house have all lost value. "I'm an optimist: the economy always goes up and down. I hope to retire in six years time, at which point I will want to cash in my shares. Hopefully the market will have corrected by then - just like it did after the 2001 internet bubble burst."
Oil Industry Braces for Drop in U.S. Thirst for Gasoline
Since Henry Ford began mass production of the Model T nearly a century ago, car-loving Americans have gulped ever-increasing volumes of gasoline. A growing number of industry players believe that era is over. Among those who say U.S. consumption of gasoline has peaked are executives at the world's biggest publicly traded oil company, Exxon Mobil Corp., as well as many private analysts and government energy forecasters. The reasons include changes in the way Americans live and the transportation they choose, along with a growing emphasis on alternative fuels. The result could be profound transformations not only for the companies that refine gasoline from crude oil but also for state and federal budgets and for consumers. Much of contemporary America, from the design of its cities to its tax code and its foreign policy, is predicated on a growing thirst for gasoline.
As Americans commute less, use more fuel efficient cars and take more public transportation, gas stations have shut down. There are 11% fewer places to pump gas in the U.S. today than there were a little over a decade ago. In the vast market for crude oil, American gasoline consumption matters. One of every 10 barrels of crude ends up in U.S. gasoline tanks, more than is used by the entire Chinese economy. Right now, the recession is curbing U.S. gasoline consumption, as laid-off workers stop commuting and budget-conscious families forgo long road trips. Drivers filled their cars with 371.2 million gallons of petroleum-based gasoline every day in 2007, according to the U.S. Energy Information Administration. It expects that to fall 6.9% to 345.7 million gallons in 2009, as demand at the pump declines and the use of plant-based ethanol increases. Even if usage climbs after the recession ends, it won't exceed 2007 levels, according to EIA forecasts.
Demand for all petroleum-based transportation fuels -- gasoline, diesel and jet fuel -- fell 7.1% last year, according to the EIA. This is the steepest one-year decline since at least 1950, as far back as the federal government has reliable data. Many industry observers have become convinced the drop in consumption won't reverse even when economic growth resumes. In December, the EIA said gasoline consumption by U.S. drivers had peaked, in part because of growing consumer interest in fuel efficiency. Exxon believes U.S. fuel demand to keep cars, SUVs and pickups moving will shrink 22% between now and 2030. "We are probably at or very near a peak in terms of light-duty gasoline demand," says Scott Nauman, Exxon's head of energy forecasting. If Exxon is right, the full impact of falling demand for fuel would take years to be felt. But some deep changes are under way. Declining gasoline-tax revenue is forcing local and federal governments to search for new sources of funding. Oil refiners, which for decades focused on bringing U.S. drivers more gallons of gasoline, are retooling their businesses. Some have said they could shut down some of their refineries entirely, along with thousands of small gas stations. Oil companies are beginning to invest in biofuels and battery technology.
Diverse trends are adding up to a steady drain on gasoline demand. Gasoline engines are being designed to burn fuel more efficiently. Hybrid and other advanced-technology vehicles that minimize gasoline usage are joining the nation's fleet. Tanks of gasoline and diesel fuel are being leavened with increasing amounts of biofuel, now made mostly from corn but in the future also from perennial grasses and municipal waste. President Barack Obama's pledge to end the "tyranny of oil," and a push for energy efficiency and biofuels in recent legislation, could accelerate these trends. Skeptics of the notion that gasoline demand has peaked point to a population that is likely to keep growing as Americans have children at roughly the same pace and the flow of immigrants increases. "Anyone who looks at population must think there is going to be some big bird flu if they think we've peaked," says Tom Kloza, chief analyst at Oil Price Information Service, a firm in Wall, N.J., that tracks prices and consumption.
Lower gasoline prices are back after a multiyear spike in prices. That could reignite consumers' desire for big, fuel-guzzling SUVs and tolerance of long commutes, especially when the economy strengthens. After the 1979 spike in crude-oil prices, U.S. gasoline consumption dropped for four years, but then rose again when fuel prices plummeted in the mid- to late-1980s. This time, the forces suppressing gasoline usage are formidable. The 2007 Energy Independence and Security Act toughened requirements for both efficiency and biofuels use. By 2020, vehicles sold in the U.S. must average 35 miles a gallon, versus 27.5 for cars now and 23.5 for light trucks. The Obama administration is working on proposals to further increase the standard. Makers of U.S. transportation fuel must blend in 36 billion gallons of biofuels a year by 2022, compared with about 11 billion this year.
High corn prices last year, combined with low gasoline demand from consumers, decimated ethanol producers' margins, forcing several into bankruptcy. But government mandates requiring refiners to blend ethanol into gasoline aren't expected to change. The 2009 economic-stimulus law includes large new loan guarantees to help renewable-energy businesses get financing -- and provides huge incentives for oil companies to dive in, too. Most big oil companies declined to discuss their views on the direction of demand for petroleum-based gasoline for this article, but most are expanding their push into alternative fuels.
U.S. government policy is pushing gasoline consumption "down, down, down," says Ed Feo, a partner with law firm Milbank, Tweed, Hadley & McCloy LLP, who advises clients on renewable-energy policy. "There isn't a single policy I can think of that supports increasing gasoline use." Americans are changing, too. Demographic shifts that once spurred higher gasoline consumption have run their course, such as more women joining the work force and the flight to the suburbs. More people are minimizing their commutes by living closer to their jobs. Inner cities and surrounding suburbs are growing denser, shortening trips to work and to the mall. Between the early 1990s and 2007, the majority of metropolitan areas in the U.S. saw an increase in the share of residential permits granted near or in their downtown centers, according to the Environmental Protection Agency. One quarter of new homes constructed in the Denver area in 2007, for example, were in the central city, up from 5% in the early 1990s. In Chicago, that figure rose to 40% from 7% in the same period.
A growing number of Americans are commuting by bus or train or working from home. And even as the population continues to rise, the rate of gasoline consumption appears to be slowing. From 1960 to 1970, the U.S. population grew 13% while vehicle miles rose 54% and gasoline demand 45%, according to government data. Between 1990 and 2000, the population grew at the same 13% rate, but miles driven rose only 28% and gasoline demand by 17%. A very different scenario is playing out in China and other parts of the developing world. Exxon expects China's passenger-vehicle fuel demand to triple by 2030, as the number of cars per capita grows along with its economy. The company is starting up a giant refinery complex in China that will feed a network of 750 gas stations. In the U.S., Exxon is getting out of the business of gasoline retailing, where profits are shrinking, and leaving it to others to own and operate Exxon stations.
In contrast to China, the number of miles Americans drive started falling in December 2007. There have been a few other declines, but this one is longer and steeper than any other since 1971, the year that the government began tracking monthly data. These trends are reflected in Seattle resident John Scroggs's odometer. A decade ago, the information-technology specialist logged 10,000 miles a year in his Jeep Grand Cherokee. Today he drives only about 6,000 miles a year in a Toyota Prius hybrid, using only a quarter as much gasoline. Mr. Scroggs, 43 years old, works from home one day a week and commutes to his job downtown by bus to avoid traffic snarls and expensive parking.
"We go for relatively long stretches not going anywhere beyond five miles away," he says. As people like Mr. Scroggs pump fewer gallons, government has less money available for one of its most basic functions: keeping roads in working order. Federal gasoline-tax revenue fell 3% last year, according to the Department of Transportation. That plus other tax shortfalls left Congress having to plug an $8 billion hole last year in the Highway Trust Fund, previously kept flush by growing gasoline use. Localities have begun facing their own gas-tax gaps. Neon-lit Las Vegas offers a glimpse of a possible future of transportation-budget squeezes. To save money, local officials are building some new roads without street lights, curbs or traffic lights. They've cut two bus routes in the suburbs.
One remedy proposed by a commission Congress formed to study the problem: Base taxes on the number of miles people drive, rather than on how many gallons they pump. The aim is to continue raising money as biofuels and other fuels displace oil-based gasoline. Oregon is considering the idea. More than a dozen states are considering an increase in their own gasoline taxes. Refiners must adjust not only for less driving but for a higher biofuels component in what they sell. Last year, plant-based fuel made up about 7% of the gasoline Americans pumped into their tanks, according to an analysis of government data by researchers at the University of Texas's Center for International Energy and Environmental Policy. The federal EIA forecasts a doubling of that percentage over the next decade as mandates to use more biofuels kick in.
The lost business from falling gasoline demand has contributed to the demise of at least one oil refiner. Flying J Inc. filed for bankruptcy reorganization in December. It closed its refinery in Bakersfield, Calif., and hasn't said when or if it will restart production. Larger Sunoco Inc. says if it can't sell a refinery in Tulsa, Okla., by the end of the year, it will shut it down entirely. Other crude-oil refiners are moving in to the biofuel business as new fuels grab market share. Big refiner Valero Energy Corp. started a renewable-fuels division last year. In March, Valero won a bid to buy a group of ethanol plants for $477 million out of the Chapter 11 bankruptcy of VeraSun Energy Corp. Numerous start-up companies are building "biorefineries" to turn plants into ethanol or diesel, a response to mandates that say these fuels can't all be made from corn. One concern is that if too much corn is grown for fuel it could result in higher prices for corn-based food products. A Colorado company called Range Fuels Inc. is building a facility in Georgia to turn lumber-industry waste into ethanol, initially at 10 million gallons a year.
Gas stations are also feeling squeezed. There are 11% fewer in the U.S. than a decade ago, according to trade publication NPN Magazine. The trend, partly a result of retail consolidation, accelerated last year due to weak gasoline demand. In Springfield, N.J., a 99-year-old Exxon station attached to a small auto-repair shop may not make it to 100. Exxon told the owner last year that it was "uneconomical" to keep supplying the station with gasoline and the oil giant wanted to remove its tanks, says Jeff Pinkava, the owner and a great-grandson of the station's founder. He filed a suit in an effort to keep the tanks, because the pumps attract customers for oil changes and other garage work. The case is pending. Exxon declined to comment. The station has provided for the family for four generations, said Mr. Pinkava. Now, he says, Exxon is "kicking us to the curb."
The Global Financial Crisis: How bad will it get?
by Steve Keen
I might start with when I started issuing the warnings. That was in December of 2005. I’d started researching what I’d call the debt deflation theory of great depressions in my PhD, working on the advances done by a guy called Hyman Minsky, who’s somebody who the economic students in the back row should definitely start looking up as soon as they get back to the library. Because answering one of the questions Bernie posed, "Who saw this coming?", the only answer is Hyman Minsky in the most recent history, and before him, Irving Fischer during the Great Depression.
Those two men, and the theoretical history they are part of, really gives us a far better explanation of what we’ve got ourselves into. Indeed if they’d been heeded, we wouldn’t be having this meeting. So, I think one of the reasons we’re having the crisis now is not entirely caused by the economics profession; but I believe by the direction economics took after the second world war and was amplified after the period of stagflation in the 1970’s is a major contributor to the scale of the crisis we’re in and why I don’t believe policy makers have any idea of how to get us out of it. In fact what I think we’re going to have to wait on is basically the current set of policy makers abandoning all hope and certainly the political leaders abandoning hope in them before we’re going to see any sort of change around out of this crisis.
Now as to how bad it’s going to get - you have to know what caused it in the first place to have any idea there. And this is again why you tend to get, "I don’t know" type answers from most economists—and that goes right up to and including people like Joseph Stiglitz and Paul Krugman. The reason they don’t know is that their economic theory is the wrong one. They’ve got a model of how the economy operates and it’s got no relevance to the real world, you’re not going to understand what’s happening in the real world when somebody asks you a question about it. So I, for some years, have been arguing that economic theory as it’s being taught in universities and as is commonly believed, is an utterly fallacious view of how the world operates.
I published a book called Debunking Economics to make that case back in 2001. And the reason that economists can’t understand what’s happening in the economy is, and I know this is going to sound ludicrous to anybody who hasn’t actually studied economics, is that economists convinced themselves when they were about 18 years old that neither money nor debt matter. Now, if you start from that mental position, how are you going to understand the real world in which we have manifestly clear now money and debt are crucial. Now the reason they have their particular mythology inculcated into them is that early in their first year courses, back when I did economics, and now in second year because the courses have been dumbed down so much in the last 30 years, they learned what’s called the money illusion. And they get shown a model which has a proposition made that you can separate a consumer’s taste from their income.
And then consumers are all supposed to know exactly what they desire in any particular combination of relative prices. And if you say, well let’s say we double all relative prices and double your income what combination are you going to choose? And the student does the mental exercise or the mathematical or graphical one and says, "Well, duh, the same combination." Being naive enough not to have credit cards at that stage, certainly when I was going through University, most of the students accept this and go on to believe that it isn’t absolute prices and money that matter but it’s relative prices. And they end up building mathematical models of how the economy operates that leave out of the equations, out of their variables, both debt and money. Then along comes the real world, after 40 years of that and I’m sorry suddenly you realize your models don’t make any sense whatsoever. So a model that does make sense is Minsky’s. And it comes out of the work of Irving Fischer originally.
And the argument that Minsky made was that we live in an uncertain world and the mathematical world that economists swallow when they are at University—which is largely known as neoclassical economics—teaches them that you don’t need to know absolute prices, you only need to know relative ones. That all transactions are relative, that absolute magnitudes don’t matter and that credit can be forgotten about. Well, it can’t in the real world. And that’s the lesson Irving Fisher learned the very hard way in the 1920’s and early 1930’s. Minsky put it together quite effectively to say, "In the uncertain world with financial obligations, absolute prices are the links between the debts you accumulated in the past and your capacity to service them now." And if you have a world where you borrow money to finance activity, and that’s the world we live in, then those absolute prices are crucial and so to is the level of debt.
As the level of debt rises, you have an increasing need to devote part of your current monetary income to servicing those monetary charges. And if you have debt and you’re trying to repay it, then the little mathematical models the students use that got shoved down their throats in first year before they are mature enough to bite the hand of the lecturer that’s feeding it to them, don’t work. Because if you do double all prices and double incomes you do not get back to the same situation because it’s a non-linear process of repaying your debt. You might get 1.73 times as much consumption. You might get 2.03, 2.07. You can’t say. So the argument that says you don’t need to worry about absolute prices is false as soon as you allow the existence of a world in which debt exists and in which people have some need to pay their debt off over time. So that mental construct that academic and then ultimately reserve bank economists use is on entirely the wrong track and it’s why they missed this whole process happening.
Now Minsky argues that the world you’ve got to look at is the one which is modeled from the point of view, not of the barter economy, which is the mental model that economists adopt in first year and don’t realize they’ve done it, but a Wall Street model. He said that in the Wall Street world it’s a world of credit driven systems with financial obligations being absolutely paramount, an uncertain future and people trying to speculate and invest to make money. In that world they will borrow money, in a particular stage of the trade cycle. And here come two more terms that don’t turn up in conventional economic thinking: history and time. Now I don’t need to ask the economics students here, "Have you studied economic history?" because I know the answer to the question—they haven’t. Economic history is abolished from most university courses around the world. So students don’t actually learn history when they are doing economics.
And I have often see people who haven’t had the misfortune of having an education in economics, saying, "Haven’t central bankers learned about this stuff? Don’t they apply the lessons of history of the 1930s and the 1890s? The 1870s?" For those who actually know their history, the answer is no they don’t. They don’t study economic history. Well, that’s one thing they’d better change. They also don’t study the history of their own discipline. So they have no idea where the ideas come from. I’m proud to say that the University of Western Sydney, where I teach, is the only university in the country with a compulsory course in the history of economic thought. And history itself is not part of economic theory, nor is time. Again, most economic models work on what’s called comparative statics. Or what they laughingly call general equilibrium. And all these ideas leave out of existence the very function of time.
So, Minsky starts from history and time. And he says, let’s imagine a time in history where there was a previous financial crisis. And you’re all thinking that must be 1990, maybe the younger ones are thinking 2000. So, 1990-1991 we had a financial crisis in the past. Bernie was part of that experience and remembers it well. And as a result of that crisis, everybody is conservative about the amount of debt they are going to consider taking on. That applies both to lenders and borrowers. Because everybody is conservative, the only projects that are put forward for funding are projects that actually are likely to have a cash flow that’s going to exceed their financial commitments. And because the economy has recovered from that crisis, however that might have happened, most of those projects succeed. Because they succeed, everybody thinks, "Ah, we were too conservative last time around. If we’d actually borrowed more money, been more leveraged, we would have made a larger profit." So, as a result of that, people start to relax their risk premiums so they become more adventurous.
As Minsky put it, quite classically, "Stability, in a world with an uncertain future, and complex financial instruments, is destabilizing." So the experience of a period of stable growth, leads to rising expectations, and sets off the next bubble. When the next bubble begins, you suddenly have a period of self-fufilling expectations for awhile –where that high level of investment and a larger growth in the money supply, which is not under the control of the reserve bank, but caused by the willingness of borrowers to take on debt. That expansion of the money supply drives the big economic activity and makes it profitable once more to speculate on asset prices. You then get caught in another bubble for awhile where partly positive feed back systems are good which boosts investment and spending and improve confidence, that illusive word, rise and cause a boom in the real economy to take place. But you also have a boom in the artificial economy –the speculative world.
And that often comes to dominate the real world. I remember one, Robert Holmes a Court I think, one of the classic speculators from the end of the last bubble, saying he didn’t like to invest in real projects because he could only expect a rate of return of only 5 or 10 percent and he was much happier with 20. A twenty percent rate of return is a recipe for catastrophe in the future. It can’t be sustained. So, you get this bubble going on and then out of that bubble come people like those speculators: the Bonds, the Skases and so on of the 1990s, the "Fast Eddies" of the most recent period, who only make money because asset prices are rising. They buy assets on a rising market, they pay amounts of money for those assets which are beyond debt servicing of the debt exceeds cash flow from the businesses.
The only way they can get out of trouble is by re-leveraging later for a larger level of debt or selling the asset on a rising market which is what they do. Now, of course, ultimately that momentum has to break down because even though asset prices are rising, debt is rising faster. And that is the thing which as been left out of reserve bank visions around the world, including Australia. Debt rises faster than the asset prices rise, the servicing costs rise faster. Ultimately, you may have a boom coming out of that as we did back in the 1970s and the 1990s, that changes income relativities as well, and that can shock the system internally and turn it around. So that wage demands get to be higher than people anticipated, raw material prices go through the roof and undercut profitability, and so on. You then reach a crisis. The asset bubble bursts, and you are back where you started again in a debt induced recession.
Now that’s the process we’ve been going through in the Western economies since the mid ’60s. The first major financial was 1966. If you go back and take a look at the Dow Jones then and see the collapse that happened then, it was at that stage that the biggest stock market crash since 1929. I recommend going and look at Robert Schiller’s home page where Robert has done an excellent job of assembling long term data series on asset prices, particularly share markets and houses in America. And you will see that bubble in price to earnings ratio where the earnings are over a ten year period. And that price to earnings ration points out two major bubbles in the past, the 1929 bubble and the 1966. We are now well above that level and so is the driving factor which is the level of debt.
Now to give you an idea of how much debt has grown during this whole process, again what Minsky talked about was the tendency for the ratio of debt to income ratio to ratchet up over time. The reason for that is that you borrow money during a boom and you have to repay it during a slump. You don’t quite have the cash flows you thought you would to service the debt, so when you’ve got it down to a reasonable level, it’s not quite back to as low a level as before the last bubble began. So, you get a series of ratcheting up of the level of debt. And the more you overlay speculative lending, where you borrow money not to invest in real projects, but to gamble on asset prices, the more you drive that level up. That’s certainly been the case in the Australian situation, and the American. If we go back to 1945, the ratio of debt to GDP was roughly 45%. So, it owed less than half a year’s income to pay all it’s debts off if it ever wanted to do that. It now owes 290% of it’s GDP. That’s not factoring in the obvious nettable outcome of all the monstrous derivatives that have been pumped around the system.
The most irresponsible of them in this most recent crisis is something we’ve never seen in history before. For those who want to see how bad that is and go to the Bank of International Settlements page and look for the data there on over-the-counter transactions derivatives. You’ll see that as of July 2008, there was $683 trillion worth of outstanding derivative contracts out there. Now, when that gets netted out we’re going to see a fairly substantial increase in even that astronomical level of debt. Putting 290% of GDP in context, in terms of debt levels, that is 60% higher than the peak debt reached during the Great Depression in America and about 120% higher than it reached when the Depression began. The reason the ratio was that high during the Great Depression was because the level of debt caused a period of deflation. And that deflation and collapsing output meant that even though Americans reduced their nominal debt levels from 1929 to 1932, their indebtedness relative to their income rose from about 175% of GDP to 235% of GDP. Now, we’re starting this crisis at 290% of GDP.
In that sense I’m saying that debt is the actual cause of the disease and and the cause in the American case is pretty close to 1.5 to 2 times as bad as the Great Depression. So, I think it’s going to be… we’ll be lucky to come out of things as well as the Great Depression. We’ll certainly come out worse than 1990. People who believe we’re going to stop at less than double digit rates of unemployment are, I think, deluding themselves. And that’s unfortunately what economists normally do. We also have deflation hitting us. In 1930-1931 the rate of falling prices in American was roughly 10% per annum. The maximum rate of fall of prices in any particular month occurred in 1932 or 1933 and it was about 2%. The second largest rate of fall in consumer prices in recorded history was in November of last year. Already. So there’s all sorts of signals that this could be a worse crisis than the Great Depression.
Now, how much confidence do I have in policy makers today to get us out of it? None. There are several reasons for that. First of all, the people in charge at the moment did not see this coming. Again, Bernie was talking about how economists were thinking about how they’d abolished the trade cycle. They actually had a whole debate going in American, particularly American journals, but also English ones, called the Great Moderation. And their description, up to and including the beginning of 2007 of what was happening in the macro economy was a reduction in the volatility in the trade cycle: more consistent growth, less bouts of inflation, more stability. And one of those many foolish economic commentators in the newspapers, for the London Times, had a piece published in the beginning of 2007 called the "Great Moderation" which began with the line, "History will marvel at the stability of our era." I don’t think he was being ironic. He actually believed it.
Even though I support the stimulus the Rudd government has given, why I don’t think it’s going to work is because of the nature of this particular turn around. We had a cycle in ‘73, we had a cycle in ‘89, each time the recovery from that cycle involved, not restoration of true stability, but a restarting of the engine of private borrowing. If you go back to 1973 in Australia, I think the debt to GDP ratio then was about 45%. It slumped slightly, and then it took off again. We got to 1983 or ‘84, another bubble, a super bubble in debt occurred at that stage, took out debt ratio to about 90%. It slumped to about 85% by ‘92-’93, then took off again. It’s now, in Australia’s case, peaked at about 165% of GDP. If you factor in corporate bond issues, it’s about 177% of GDP. That is 7 times the ratio of debt to GDP we had back in the 1960s.
Now, we don’t have to have a period of ever accelerating debt. A lot of fringe thinkers in economics believe that’s the case. Probably the best period of economic performance in Australia’s history was the post war period from 1945 to 1965 even though it includes the credit crunch Bernie talked about a moment ago. Across that whole period, that 20 to 25 year period, the ratio of debt to GDP was stable at about 25% of GDP. Now, at that stage, debt was doing what debt should, and that’s providing working capital to corporations, investment funds for those who don’t have enough retained earnings to do it and a small amount of money for people to buy houses who wanted to own their own houses rather than renting. That’s the legitimate function of the financial system.
In Australia’s case, in mid-1964, the ratio of debt to GDP started to accelerate, and from that stage on, debt was grown 4.2% faster than GDP on average for the next 45 years. Now, that’s unsustainable. I know that, again having some conversations with Reserve Bank staff, their attitude was, and this in print from the current Governor in a hearing before the House of Representatives committee about 3 or 4 years ago, that there’s an inverse relationship between debt servicing and interest rates. So, when interest rates fall, debt will rise. And when interest rate rise, debt will fall. That’s not at all what happened, unfortunately. A good look at the data shows simply an exponential take off of debt to GDP, independent of what interest rates were doing. If you simply look at the ratio of debt to GDP, and do a regression on that, using an exponential function, you’ll find a correlation between a simple exponential growth of that ratio and the actual data of .9912.
Now, I know most people don’t know what I’m talking about, but I’m saying 99% of the increase in the debt ratio can be explained by simply saying debt grows 4.2% faster than GDP. Now, that is an impossible situation to maintain indefinitely because ultimately your debt is going to be a hundred times your GDP and of course you can’t service that amount no matter what interest rates are. It’s going to have to change direction. It’s changing direction now. In Australia’s case the level of debt to GDP, is almost 3 times what we had prior to the Great Depression. And there I come to a strong criticism of how our Reserve Banks have behaved. Because they have ignored the actual dynamics of the capitalist economy, because they haven’t understood them, they followed the wrong theories. I might actually add, without knowing that there are alternative theories. Because they’ve done that, they’ve ignored the actual problem as it’s run away from us.
And therefore their decisions have actually encouraged the financial system to get back on the speculative band wagon when they should have been kicking them off it in the first place. If you look at the data, I think it’s fairly convincing if we hadn’t had central banks then in 1987 we would have had a crisis about the same size or smaller than the Great Depression. It would have been attenuated by the scale of government. That would have turned us around. We’ve gone another 20 years and we therefore, I think, face a crisis which is bigger than the Great Depression and of which our managers of the economy have less of an idea of how the economy functions, than we had back in 1929.
It’s going to be a long one. Thank you.