U.S. Treasury building, Fifteenth Street, Washington, D.C
Different angle from yesterday, with now Treasury building in the distance.
Ilargi: You know what? No. I won’t get back into the deflation vs inflation debate. The numbers start to do the talking on issues we've for a long time said would come. Nothing special about that, it's been clear for years that the overflowing debt would grind the economy to a standstill. Yes, there are increases in various levels of money, credit, whatever you please to name it, though less than often assumed. But it is not and cannot be inflationary.
The reason why is that there's another side to the financial coin. And on that side, much more is being lost and simply evaporating into razor thin air than any government could ever print. If printing money were all it takes to ward off deflation, there would never have been deflation. If that were not true, it would be possible to reinflate a Ponzi pyramid. It is easy for most to see why such a thing could never work for Bernie Madoff, but apparently not so easy that neither can it for Ben Bernanke or Barack Obama.
As long as the US is active in international bond markets, and it will be as long as anyone is willing to buy Treasuries, inflation is simply not on the agenda. An economy that is built as a Ponzi scheme will necessarily plunge headfirst into deflation. The US economy is such an economy (and it's not alone). Whether or not it will later see inflation is hardly interesting today, because the deflationary phase will mutilate it beyond recognition.
The numbers don't lie; they’re crystal clear. And they're about to get much worse.
The Retreat of the Shadow Lenders, Why Deflation and not Inflation is the Order of the Day
by Ellen Brown
While contrarians are screaming "hyperinflation!", the money supply is actually shrinking. This is because most money today comes into existence as bank loans, and lending has shrunk substantially. That means the Fed needs to "monetize" debt just to fill the breach.
On June 3, 2009, Federal Reserve Chairman Ben Bernanke assured Congress, "The Federal Reserve will not monetize the debt." Bill Bonner, writing in The Daily Reckoning, said it had a ring to it, like President Nixon’s "I am not a crook" and President Clinton’s "I did not have sex with that woman."
Monetizing the debt is precisely what the Fed will do, says Bonner, because it has no other choice. The Chinese are growing reluctant to lend, the taxpayers are tapped out, and the deficit is at unprecedented levels. "Even good people do bad things when they get in a jam. The Feds are already in pretty deep . . . and they’re going a lot deeper."
But Mr. Bernanke denied it. "Either cuts in spending or increases in taxes will be necessary to stabilize the fiscal situation," he said.
Both alternatives will be vigorously opposed, leaving Congress in the same deadlock California has been in for the last year. That makes the monetization option at least worth a look. What is wrong with it?
Bill Bonner calls it "larceny on the grandest scale. Rather than honestly repaying what it has borrowed, a government merely prints up extra currency and uses it to pay its loans. The debt is ‘monetized’ . . . transformed into an increase in the money supply, thereby lowering the purchasing power of everybody’s savings."
So say the pundits, but in the past year the Fed has "monetized" over a trillion dollars worth of debt, yet the money supply is not expanding. As investment adviser Mark Sunshine observed in a June 12 blog:"[W]hile media talking heads were ranting about how the Fed was running their printing presses overtime to push up money supply, the facts were very different. M1 has actually declined since the middle of December, 2008. During the same six month period M2 has only risen by a little less than 3%."
The Fed is no longer reporting M3, the largest measure of the money supply, but according to Sunshine:"[W]e know that broader measures of money supply, like M3, haven’t materially risen in 2009. M3 followers can get a very rough idea of what M3 would have been, if it were published, by looking at the Federal Reserve quarterly Flow of Funds Accounts of the United States which was distributed yesterday.
As it turns out, total net borrowing of the United States (private and public) dropped approximately $255 billion in the first quarter and other indicators of M3 fell or are about flat (on a net basis). . . . [T]his data supports [the] theory that the fall in private borrowing is more than offsetting the rise in government borrowing and therefore, at least for the time being, financing the deficit isn’t a problem."
All of this flap about the Fed driving the economy into hyperinflation because it is creating money on its books reflects a fundamental misconception about how our money and banking system actually works. In monetizing the government’s debt, the Fed is just doing what banks do every day. All money is created by banks on their books, as many authorities have attested. The Fed is just stepping in where the commercial banking system has failed. Except for coins, which are issued by the government and compose only about one ten-thousandth of the money supply (M3), our money today is nothing but bank credit (or debt); and we’re now laboring under a credit freeze, which means banks aren’t creating nearly as many loans as they used to.
In February, the Bank for International Settlements published research showing that European banks could not settle their debts because of a $2 trillion shortage of U.S. dollars. Proposals for alternative reserve currencies followed. And in March, Blackstone Group CEO Stephen Schwarzman reported that up to 45% of the world’s wealth has been destroyed by the credit crisis. The missing "wealth" cannot be restored without putting the missing "money" back into the system, and that means getting the credit engine going again.
Congress, the Treasury and the Federal Reserve have therefore been throwing money at the banks, trying to build up the banks’ capital so they can make enough loans to refuel the economy. At a capital requirement of 8%, $8 in capital can be leveraged into $100 in loans. But lending remains far below earlier levels, and it’s not because the banks are refusing to lend. The banks insist that they are making as many loans as they’re allowed to make with their existing deposit and capital bases. The real bottleneck is with the "shadow lenders" – those investors who, until late 2007, bought massive amounts of bank loans bundled up as "securities," taking those loans off the banks’ books, making room for yet more loans to be originated out of the banks’ capital and deposit bases.
In a Washington Times article titled "Banks Still Standing Amid Credit Rubble," Patrice Hill wrote:"Before last fall’s financial crisis, banks provided only $8 trillion of the roughly $25 trillion in loans outstanding in the United States, while traditional bond markets provided another $7 trillion, according to the Federal Reserve. The largest share of the borrowed funds - $10 trillion - came from securitized loan markets that barely existed two decades ago. . . .
"Many legislators in Congress complain that banks aren’t lending, and cite that as an excuse to vote against further bank bailout funds. . . . But Mr. Regalia [chief economist at the U.S. Chamber of Commerce] said these critics are wrong. ‘Banks are lending more, but 70 percent of the system isn’t there anymore,’ he said."
Seventy percent of the system isn’t there anymore because the traditional bond markets and securitized loan markets have dried up. Writes Hill:"Congress’ demand that banks fill in for collapsed securities markets poses a dilemma for the banks, not only because most do not have the capacity to ramp up to such large-scale lending quickly. The securitized loan markets provided an essential part of the machinery that enabled banks to lend in the first place. By selling most of their portfolios of mortgages, business and consumer loans to investors, banks in the past freed up money to make new loans. . . .
"The market for pooled subprime loans, known as collateralized debt obligations (CDOs), collapsed at the end of 2007 and, by most accounts, will never come back. Because of the surging defaults on subprime and other exotic mortgages, investors have shied away from buying the loans, forcing banks and Wall Street firms to hold them on their books and take the losses."
The retreat of the shadow lenders has created a credit freeze globally; and when credit shrinks, the money supply shrinks with it. That means there is insufficient money to buy goods, so workers get laid off and factories get shut down, perpetuating a vicious spiral of economic collapse and depression. To reverse that cycle, credit needs to be restored; and when the banks can’t do it, the Fed needs to step in and start "monetizing" debt.
So why don’t Fed officials just say that is what they are up to and put our minds at ease? Probably because they can’t without exposing the whole banking game. The curtain would be thrown back and we the people would know that our money system is sleight of hand. The banks never had all that money they supposedly lent to us. We’ve been paying interest for something they created out of thin air! Indeed, their credit money is less substantial than air, which at least has some molecules bouncing around in it. Bank credit exists only in cyberspace.
Ben Bernanke’s predecessor Alan Greenspan was sometimes compared to the Wizard of Oz, the little man who hid behind a curtain pulling levers and twisting dials, maintaining the smoke and mirrors illusion that an all-powerful force was keeping things under control. Early in his term, Chairman Bernanke was criticized for revealing too much. "If you’re going to play the Wizard," said one TV commentator, "you have to stay behind the curtain." The Chairman has evidently learned his lesson and is now playing the role, wrapping his moves in that veil of mystery expected of the man considered the world’s most powerful banker, the Wizard who moves markets with his words.
The problem with the Wizard playing his cards close to the chest is that investors don’t know how to play theirs. The Chinese have grown so concerned about the soundness of their dollar investments that the head of China’s second-largest bank recently said the U.S. government should start issuing bonds in China’s currency, the yuan. What do we want with yuan? We need dollars; and we would be better off getting them from our own central bank than borrowing them from foreign rivals. We could then spend them on projects aimed at internal domestic development – as the Chinese themselves have been doing – and get the wheels of production turning again.
If Ben Bernanke stands by his word and refuses to monetize the federal debt, Congress should consider issuing the money itself, as the U.S. Constitution provides. The "full faith and credit of the United States" is an asset of the United States, and it should properly be issued and lent by the United States rather than by unaccountable private banks and shadow lenders. The true path to economic recovery – the path from an economy strangled in debt to one blooming in prosperity – is to reclaim money and credit as public resources, transforming money from private master to public servant.
Why the Fed Isn't Igniting Inflation
Ever since the late economist Milton Friedman wrote in 1963 that "inflation is always and everywhere a monetary phenomenon," central bankers have been on notice that printing too much of the green stuff jeopardizes their legacies as guardians of sound money. Yet Federal Reserve Chairman Ben Bernanke is unleashing a tidal wave of money to fight the global recession. The nation's monetary base—consisting of bills and coins in circulation plus banks' deposits at the Fed—has climbed 114% over the past year through May. For comparison, the biggest annual increase before this crisis, going back as far as 1960, was a little under 16%. It's only natural to wonder whether the Fed is making a big policy mistake that will lead to high inflation, either soon or a couple of years from now.
Crazy as it sounds, though, the Fed is probably going in exactly the right direction. In fact, if anything, the wave of money it's generating may not be big enough. How can that be? Because the inflationary effects of the new money are being fully offset, or more than offset, by the far-reaching and long-lasting impact of household debt repayments. Whether it's voluntary frugality or under the coercion of creditors, Americans have abruptly switched from living beyond their means to saving more and working down the debts they incurred during the bubble years.
The people who worry about inflation—and there are many—may not have fully grasped the multitrillion-dollar ramifications of American households' extended deleveraging. While cleaning up debt is a good thing for the long-term health of the U.S. economy, it's hell on consumer spending, which accounts for about two-thirds of gross domestic product. The dramatic pullback in consumer spending means money that otherwise would have gone into raising prices is going into propping up the faltering economy.
Banks have drastically increased their reserves at the Fed rather than making new loans. That's the biggest cause for the increase in the monetary base. "At every level of the economy and every level of society, the demand for cash is unprecedented," says David A. Rosenberg, chief economist and strategist for Gluskin Sheff & Associates, a Toronto money manager. Says Rosenberg: "If the Fed didn't meet that demand for cash, we'd have a destabilizing deflation on our hands."
As a matter of fact, the economy is teetering on the edge of deflation—a general extended decline in prices—despite the Fed's intervention. Excluding food and energy, consumer prices rose a modest 1.8% in the 12 months through May—and including food and energy, they fell 1.3%, the most since 1950. Cutbacks by consumers are bringing about deflation in business, with unemployment in May at 9.4% and manufacturers using only 65% of their capacity, the lowest since recordkeeping began in 1948. Small businesses that were aggressively raising prices a year ago are now "worried about weak demand, the fact that they don't have many customers," says William C. Dunkelberg, chief economist of the National Federation of Independent Business.
Inflation remains a distant prospect because the retrenchment of the American consumer, which is deflationary, still has a long way to run. Consider that household debt soared from two-thirds of GDP in the early 1990s to three-quarters in 2001 to an even 100% at the end of 2008. Getting back to a more sustainable debt ratio will take years of belt-tightening. Based on today's GDP, simply returning to the 2001 level would require paying off 25% of all outstanding household debt—$3.5 trillion worth.
Even among people who can afford to keep shopping, there's a new ethic of frugality. Down with bridezillas, up with home canning of garden tomatoes. "People are doing their own oil changes again. Women are coloring their own hair," says University of Tampa marketing professor Ronald J. Kuntze. Unfortunately, for the society as a whole, paying off debt is more easily said than done. When shoppers stay home, people lose their jobs. Then they have to cut back even more to make ends meet, creating a deflationary spiral.
True, plenty of legit economists don't buy this low-inflation scenario. Sooner or later, they argue, all that money is bound to show up in prices. "We will soon see a resurgence of inflation and an increase in mortgage rates," says Stanford University economist John B. Taylor, "unless the Fed presents a clear and credible exit strategy from the unprecedented explosion of its balance sheet." For starters, Taylor says the Fed should start to wind down its purchases of Treasury bonds right away. Taylor is famous among economists as the inventor of the "Taylor rule," which describes how the Fed would or should adjust interest rates based on inflation and economic growth. He argues that the negative effects of the Fed's easy money may already be apparent in "increasing oil prices and mortgage rates, which will be a drag on the recovery."
Perhaps. But it's not clear that the evidence Taylor cites—higher oil prices and rising mortgage rates—actually indicates resurgent inflation in the U.S. It's not primarily inflation fear that's pushing up interest rates, but rather massive federal deficit spending. Investors are demanding higher yields to take even more Treasury bonds. In fact, the bond market is forecasting inflation averaging only about 1.8% a year over the next decade, judging from the spread between ordinary and inflation-indexed Treasury bonds. As for high oil prices, they probably do reflect speculation about strengthening economic growth—but perhaps not growth in the U.S. Costly oil could worsen the recession in the U.S. by sucking up money that now goes for other things.
Whether inflation could become an issue in two or three years is irrelevant anyway, argues Gluskin Sheff's Rosenberg. The important thing, he says, is to stave off deflation right now: "Once you get onto the slippery slope of a deleveraging, it's extremely difficult to climb your way out." In the past, countries where consumers retrenched, such as Japan, were able to fight their way out of recession through exports. The catch this time is that lots of countries from the U.S. to Germany to China are pegging their hopes on export-led recoveries.
It's mathematically impossible for all countries to improve their trade balances at the same time—"unless we can find another planet to export to," as Princeton University economist Paul R. Krugman joked at a recent lecture at the London School of Economics. Economists get paid to worry. But a revival of inflation soon shouldn't be at the top of their worry list.
Belt-Tightening by States Squeezes Cities and Towns
Haverhill, Mass. At first glance, this old mill town near the New Hampshire border seems to be weathering the recession well. Hard hats swarm empty brick factory buildings, turning them into upscale apartment complexes. New restaurants are opening, a suit manufacturer relocated here this spring, and the city recently got its first two national chain stores. Property-tax receipts are rising. But in the former high-school building that now serves as city hall, times are tense. Eleven city workers face layoffs and five police jobs are in jeopardy.
Parents are protesting the city-run schools' plan to cut back on gym, art and music classes. Mayor James Fiorentini has been threatening to close a firehouse if he can't get concessions from the firefighters' union. The city's budget is coming up short, largely because Massachusetts's dire financial problems have prompted it to slash aid to local governments. Haverhill (pronounced HAY-vrel) expects to lose as much as $6 million in the fiscal year beginning July 1 -- out of an operating budget of $29 million.
"It's a hell of a cut," Mr. Fiorentini said. From Riverside, Calif., to Baltimore, and from Duluth, Minn., to Phoenix, cities and towns are bracing for more big reductions in local aid and revenue-sharing from their state governments. The cuts are forcing belt-tightening moves that are very visible to voters. In a recent survey, 18 states reported cutting local aid, "and we think that's going to grow," said Scott D. Pattison, executive director of the National Association of State Budget Officers.
States are running record budget gaps as their tax revenue plunges while expenses increase. Federal stimulus money is helping to plug those holes, but most states are still struggling and have few options. Taxes are hard to raise, especially in a recession; costs for things like prisons and pensions are tough to trim. For states, local aid "is one of the things they cut, because they can," said Susan K. Urahn, managing director of the Pew Center on the States, a research group in Philadelphia. How much the cuts will amount to nationally is unknown, but Donald Boyd, a senior fellow at the Rockefeller Institute of Government in Albany, N.Y., said he expects more pain for cities than in past severe recessions.
California's budget woes are so severe Republican Gov. Arnold Schwarzenegger has proposed that the state borrow from local property-tax collections. Local officials fear they won't get their share of state gasoline-tax revenue, leaving them scrambling to pay for road maintenance and traffic signals. In Massachusetts, a longtime limit on property-tax increases and state control of sales taxes have left municipalities particularly dependent on state aid, said Geoffrey C. Beckwith, executive director of the Massachusetts Municipal Association. Faced with a $1.5 billion drop in revenue since January, state lawmakers last week agreed to cut several hundred million dollars from state aid to cities and towns, which could drop by as much as 15% in some communities.
For many cities, state-aid cuts come on top of falling local revenue. Eighteen months of declining sales taxes and building-permit fees, in addition to state cuts, have forced Duluth, Minn., to lay off 23 full-time workers and transfer the zoo to a nonprofit group. In Haverhill, the local unemployment rate for its 60,000 residents jumped to 7.8% from 4.2% a year ago, and lunchtime business at the downtown deli is slow. But when it comes to the city's budget, the mayor said state cuts are the main problem.
As the state began cutting back aid last year, the city eliminated some unfilled jobs and Mayor Fiorentini ordered the thermostats lowered in city buildings. In January, he announced a freeze on most overtime; in May, he began selling used police cars over the Internet. He is now considering closing City Hall on Friday afternoons, turning off the overnight lighting in the parking garage, outsourcing custodial work and sharing dog-catching duties with neighboring towns. Such trims won't come close to making up the lost state aid, but, "Every drop helps," the mayor said. He has many expenses he can't cut, such as utilities, pensions and interest payments on bonds. Employee health-care costs are slated to rise by $1.2 million.
The budget he was negotiating last week with the city council included cuts in one of the few areas he does control: personnel. Two full-time employees and nine part-timers are losing their jobs, including several members of the city library's 33-person staff. More than 1,600 people have signed a petition asking the mayor to reverse the planned library cuts. "The library is only 1% of the city's budget, but it is being cut 17% this fiscal year," said Library Director Carol Verny, who will have to compensate by limiting the hours of the library's children's room and computer center.
John Michitson, Mr. Fiorentini's opponent in the nonpartisan November election, said he plans to make the city's budget practices a main campaign issue. Some townspeople, such as Alan J. Boisvert, who owns Keon's restaurant on Washington Street, sympathize with Mr. Fiorentini. "The mayor's got to make some cuts he doesn't want to make," he said. Although Mr. Fiorentini worries about leaving his town with no financial cushion, he is planning to spend almost all of its $3 million reserve fund to help cover the state cutbacks. "We had a rainy-day fund," he said, "and it's raining."
Moody’s Joins S.& P. in Warning on California Debt
The state of California is facing a multinotch downgrade of its debt if it fails to resolve its enormous budget woes, Moody’s Investors Service said Friday. The warning follows a similar one from Standard & Poor’s, which put the state on a negative credit watch earlier this week because of its dismal financial condition. “If the legislature does not take action quickly, the state’s cash situation will deteriorate to the point where the controller will have to delay most nonpriority payments in July,” Moody’s said in a statement.
“Lack of action could result in a multinotch downgrade.” The California Legislature is deadlocked over the state’s budget, with Republicans refusing to pass a budget that increases taxes and Democrats refusing to make huge cuts in entitlement spending. The state’s budget deficit for 2010 is expected to be a stunning 20 percent of its general fund budget, or more than $20 billion, Moody’s said.
California already has the worst credit rating of any state in the country at A2 on the Moody’s ratings scale, which is only five places above speculative-grade, or junk-bond, status. That means a multinotch downgrade threatens to push the state into or dangerously close to junk status. The further down the credit scale California goes, the higher the state’s cost for financing, which could make it prohibitively expensive to raise cash to finance public works projects.
That is a very dangerous situation for California to be in. The state government says it needs to issue up to $9 billion in new revenue anticipation notes to cover state expenses. If the state is downgraded into junk territory, it may have a hard time raising that cash, especially given that many pension funds and institutional investors are barred from buying junk debt.
"Our wallet is empty, our bank is closed, and our credit is dried up," Governor Arnold Schwarzenegger told a rare joint session of the California legislature early this month. "People are writing California off. They are talking about the end of the California dream." If only that was hyperbole. California, home to 38 million people, or 13 per cent of Americans, faces a stunning $24.3 billion (U.S.) budget shortfall. The state controller, John Chiang, warned last week that California is "less than 50 days away from a meltdown in the state government." The Golden State will run out of cash to pay its bills by the end of July.
Yes, this is California, which by some accounts derives its name from the tale of a fictional paradise conceived by the Spanish adventure writer Garci Rodriguez de Montalvo in the 16th century. With a GDP of $1.8 trillion, California's economy is the size of Brazil's. California is still home to Silicon Valley and Hollywood, still boasts the second-largest U.S. defence industry and third-largest oil business, still ranks first among farm states. But for such a blessed piece of real estate, California cannot seem to handle money. It has missed its constitutional budget deadline for more than 20 years running and often begins its fiscal year without a budget.
If only Schwarzenegger and the state legislature had spent at the combined rate of inflation and population growth, California would be coping with a $5.2 billion deficit. But California has been spending beyond its means for more than a decade. It has one of the largest poor populations in the United States and among the highest budgets for social services. It pays its more than 400,000 state employees above-average wages and salaries. In vain, California treasurer Bill Lockyer has made the argument to Washington that California is no less "too big to fail" than the recipients of Wall Street bank bailouts. Indeed, the impact of sharply reduced state spending and the prospect of 60,000 state-employee layoffs at a time of near-record 11 per cent unemployment in California will be considerable.
But the White House repeated this week that the Golden State is on its own, apart from California's prodigious share of U.S. President Barack Obama's $787 billion stimulus package passed in February. If only California was an isolated case. But 47 U.S. states are struggling with budget gaps, totalling an estimated $350 billion. "California's state government, saddled with anachronistic revenue and spending processes, has no choice but to contract at the worst time," said a UCLA Anderson Forecast released this week. The plain fact is that the day of reckoning has arrived for Californians over state services they have demanded yet refused to pay for in this polarized state of spendthrift liberals and ideological tax-haters.
Since a successful 1994 ballot measure calling for a "three-strikes" sentencing policy, California's $13 billion tab for prisons has come to exceed what the state spends on higher education. A voter-approved ballot initiative expanded state health-care eligibility to children and low-income women, accounting for $2.9 billion of the current shortfall. Voters have secured limits on university tuition hikes; approved bond issues for scores of new highways, parks, zoos, beaches and community swimming pools; and insisted on high minimum spending on everything from roads to environmental protection.
But Californians have also resisted funding these expenditures except through mounting debt. A fierce anti-tax tradition dates back to the infamous Proposition 13 of 1978, which not only capped property taxes, but imposed a permanent requirement of a two-thirds supermajority of legislative votes to approve any tax increase. California is the only state with such a gridlock-inducing measure. It currently holds a heavily Democratic-controlled legislature hostage to a small but determined anti-tax GOP minority. Last month, California voters overwhelmingly rejected a Schwarzenegger package of spending cuts and modest tax hikes far milder than the governor's current Draconian proposal – an expression of a populist anti-tax mood that even Dems have taken to heart.
"We got what we wanted, but we've never figured out how to pay for it," Stephen Levy, director of the Palo Alto-based Center for the Continuing Study of the California Economy told the San Jose Mercury News earlier this year. "Everybody's got somebody to blame, but in the end these are services people wanted. Look at the screaming when you close a swimming pool, let alone try to cut education." That was in February. Sure enough, since then, some teachers and students have threatened to go on hunger strikes over a proposed budget that would reduce teacher pay that has already been cut, lay off many instructors and increase class sizes.
No one is certain of the endgame for a budget that might not be hammered out on schedule, but remain unresolved through the summer, well past the start of California's next fiscal year July 1. High-stakes games of chicken are de rigueur for California lawmakers at budget time. Democratic legislative leaders have recently given in to voter sentiment with a proposed budget that cuts spending by more than $11.4 billion, not too far short of Schwarzenegger's demand for $15 billion in spending reductions.
But the Democrats are holding out for at least some tax increases. And the governor vowed again this week he will shut down the state government rather than sign a budget bill that includes a dime of tax hikes or new user fees beyond those included in his own budget proposal. A stalemate would almost certainly result in California losing its single-A Standard & Poor's credit rating, already the lowest in the U.S., in turn raising the state's debt-service costs.
Optimists are inclined to think the unprecedented severity of this budget crisis will prompt the kind of climbdown on both sides that the Democrats already have demonstrated by accepting deep cuts in programs such as AIDS/HIV treatment and health care for one million children of low income families. The Democratic legislators have held out only against Schwarzenegger's call for the outright elimination of many social-service programs. However this drama plays out, serious thought finally will have to be given to fixing an unworkable system in which pet initiatives are too easy to get onto the ballot, and a legislative supermajority on tax hikes that makes those ballot measures impossible to finance.
Of course, California has a deserved reputation as a trendsetter. Schwarzenegger, a moderate Republican, took the lead on stem-cell research immediately after then-president George W. Bush vetoed it earlier this decade. And recently Schwarzenegger has pushed for the highest automobile fuel-economy standards in the country. With its above-average birth rate, and as a magnet for immigrants from abroad and elsewhere in the U.S., California is forecast to reach 46 million residents by 2030. A pacesetter in so many other ways, California will have to become a leader rather than laggard in fiscal responsibility if its long-term prosperity is to be assured.
Got your iPhone? Try these other recession must-haves.
Every economic slump has its must-have product. In the Depression, people snapped up cars (after 1932, anyway ). In the early 1980s, they grabbed personal computers. Today, it’s smartphones.
There are good reasons for this. Smartphones make you feel brainy, organized, empowered. The perfect tool for reasoning with that angry collection agent or redirecting your friends’ negative tweets with a cool onscreen compass.
Of course, this is no ordinary slump. The Worst Financial Crisis since the Great Depression has spawned the Longest Postwar Recession and a Really, Really Bad Job Market. Even ’80s-tested boomers look a little green above the collar. So you might need more than a BlackBerry or iPhone to ward off the shadows of personal bankruptcy. Here are my picks for the four other must-haves of this Great Recession.
Readers may quibble about what I’ve left out, but no reasonable person believes you should be without:
- A personal bank regulator. I know, the FDIC was supposed to keep an eye on the banks. And the Obama administration will greatly simplify the oversight so we’ll all be able to tell whether our bank is teetering on the brink or safely dipping into the TARP, the TAF, the TALF, and the TSLF. It’s just that I’d like a second opinion.
Finding a good regulator is quite hard these days because federal agencies are expanding, what with the SEC, CFTC, FHFA, FOMC, and proposed entities like the CFPA (Consumer Financial Protection Agency) looking to protect their turf. Personally, I’m looking to pick up someone cheap at the OTS (Office of Thrift Supervision) because under the new plan it’s LTBT (Likely To Be Toast).
- A Chrysler. Everybody’s checking them out. With zero-percent financing and many dealerships set to close and anxious to sell , the deals are too good to be true. Chryslers are the credit cards of the post-crash era. No telling, though, if this bubble will end any better than the last one. (See Fiat - Corporate history.)
- A newspaper. OK, this is counterintuitive. No one subscribes to dailies anymore and fewer companies are printing them (see The Christian Science Monitor - Weekly). This makes it the perfect time to scoop up timeless antiques at rock-bottom prices.
- A job. Yes, companies used to pay you to work. That’s so 20th century. Now, cutting-edge management chic is that you work for free. It’s happening in software and airlines. Don’t balk. It’s this kind of out-of-the-box thinking that will pull us out of the current financial mess and into the promised land, a place where we shoot iPhone video of each other hard at work and free, at last, from pay.
Wall Street Critic Inspired New Consumer-Protection Agency
Harvard University law professor Elizabeth Warren dined for three hours with White House economic adviser Lawrence Summers two months ago, and discussed over curry her idea for an agency to protect consumers from bad financial products. This past week, President Barack Obama announced his plan to create a Consumer Financial Protection Agency, endorsing Ms. Warren's idea and causing an uproar in the financial-services industry.
Ms. Warren, for years a scourge of Wall Street, has emerged as an influential force in the administration's overhaul of financial regulations. The White House said the agency she helped inspire would strengthen consumer protection in areas including credit cards, mortgages and other financial products. If approved by Congress, it would be able to write new rules governing how products can be sold. In addition to Ms. Warren's dinner with Mr. Summers at Washington's Bombay Club, she met with Michael Barr, the Treasury Department's assistant secretary for financial institutions, on several occasions. The two have known each other for nearly a decade. Ms. Warren has likewise known Mr. Summers for years through their Harvard connection; he was president of the university from 2001 to 2006.
"I don't think there's any question that Elizabeth Warren's writing and advocacy on consumer protection was very influential in all of our thinking," said Mr. Summers. Mr. Summers wouldn't comment on whether Ms. Warren would be a candidate to head the agency, saying it would be "months" until it is created. Still, it is clear her input will continue. The two reconnected Wednesday at the event where Mr. Obama announced his plans and are scheduled to meet next week.
A longtime consumer advocate, Ms. Warren, who will be 60 years old on Monday, has written nine books and more than 100 scholarly articles about credit and economic stress. She worked as the chief adviser to the National Bankruptcy Review Commission, where she upset banks that accused the majority of the commission of favoring debtors. She has also been an outspoken chairwoman of the Congressional Oversight Panel, a watchdog designed to oversee the Troubled Asset Relief Program.
Ms. Warren said she started to develop the idea to form a financial-products agency while researching a 2003 book about middle-class families who used to flourish on one income but now struggle on two. She argued that the poor design of financial products was often to blame instead of overspending. She first wrote about her idea in a 2007 article in the journal Democracy. "They shouldn't be in debt because hidden tricks in their credit-card agreements increased their balances or bounced up their interest rates," she said of these families.
Revamping the regulation of financial products will not only help consumers make good decisions, it will also "make the market work," said Ms. Warren. She added that the market "has been badly regulated" through a system of seven federal agencies, each of which has jurisdiction over some aspect of consumer financial products. American Bankers Association Chief Executive Edward Yingling said a regulatory overhaul is "badly needed," but Mr. Obama's plan "creates a new agency with powers to mandate loans and services that go well beyond consumer protection."
Scott Talbott, senior vice president of government affairs for the Financial Services Roundtable, a Washington trade group, acknowledges the strong political headwinds behind the proposed new agency and says blocking it would be an uphill battle. Instead "it's about trying to figure out the least worst way to do the wrong thing," he said. On the possibility of Ms. Warren taking charge, Mr. Talbott said experience in the financial-services industry "should be a prerequisite." Ms. Warren doesn't have any. Ms. Warren declined to comment on whether she would be interested in the job, but added: "I think a lot of people understand the system, but they're not all bankers."
Mission Shrink: We've Gone From Saving Wall Street in Order to Save Main Street to Just Saving Wall Street
Remember how, back when taxpayers were being asked to fork over hundreds of billions of dollars to bail out Wall Street, we were told it was essential to saving Main Street? Well, in just a few months, we've gone from saving the banks in order to save the economy to just saving the banks. It's the opposite of mission creep. In announcing his proposed "overhaul of the financial regulatory system," President Obama said, "Financial institutions have an obligation to themselves and to the public to manage risks carefully. And as president, I have a responsibility to ensure that our financial system works for the economy as a whole."
But parsing through his 85-page plan, it's not clear how these reforms will ensure that our financial system works for the economy as a whole. "The Obama plan," writes Joe Nocera in the New York Times, "is little more than an attempt to stick some new regulatory fingers into a very leaky financial dam rather than rebuild the dam itself." For Obama's plan to have any lasting value, says Nocera, "he is going to have to make some bankers mad." We are already hearing the usual whining from the financial industry about too much regulation and the dampening of incentives. And we are already seeing a concerted push from the banking lobby to kneecap the newly proposed Consumer Financial Protection Agency. But, all in all, there is little there to make bankers mad.
I don't expect there will be too many on Wall Street unhappy with the massive loophole the new plan leaves by calling for so-called plain vanilla derivatives to be traded on an exchange but allowing customized derivatives -- which were at the heart of the financial meltdown -- to remain largely unregulated. This is very good news for the wheelers and dealers who helped turn Wall Street into a casino. The larger problem continues to be the administration's habit of conflating the health of the Wall Street economy with the health of the real economy -- when, in fact, the two economies have become decoupled. The Dow may be up 30 percent since March, but the numbers that matter most to everyday Americans continue to tell a very different tale.
Unemployment, the single most important statistic when it comes to taking the temperature of the real economy, is at a 26-year high. Yes, the number of people filing continuing claims last week dropped for the first time since January, but the number of new people seeking unemployment benefits rose -- as did the number of people receiving benefits under the emergency federal program that extended benefits beyond the 26-week program offered by most states. All told, over 9 million people are getting some form of unemployment compensation. And most economists are expecting unemployment to continue to rise, hitting 10 percent -- some even say 11 percent -- by 2010.
Another indication of the troubled state of the real economy is the record high credit card default rates reported in May. The numbers are staggering. Bank of America's default rate hit 12.5 percent -- up from 10.4 percent in April. Citigroup wrote off over 1-out-of-10 of its credit card loans last month. American Express did the same. If the numbers stay around these levels, credit card issuers stand to lose over $70 billion this year. And it's worth noting that a number of the biggest banks are reporting default rates higher than the "worst-case scenario" numbers from the Treasury's recent stress tests. Tim Geithner's team might need to come up with some new terms: "worst-case -- and this time we really mean it -- scenario"; "even worse than worst-case scenario"; "can't imagine a worse case -- and believe us we tried -- scenario".
On the housing front, in May foreclosures dipped 6 percent from April -- but the 321,480 homes lost was still the third-highest total on record. May was the third consecutive month with over 300,000 foreclosed properties -- the first time that's happened since RealtyTrac began tracking foreclosure numbers. Nevada, California, and Florida were the hardest hit states. In Nevada, one out of every 64 homes received a foreclosure filing last month. Nationwide, one out of every 398 homes received a foreclosure note. That's a whole lot of people looking for some place to live.
And lending -- the increase of which was supposedly the primary reason for the bank bailout -- is also down. "If the banks aren't lending money," Jeffrey Rosen, deputy chairman of Lazard told me, "the economy can't get going." But, according to the Treasury's latest report on lending by the top 21 recipients of government money, consumer and commercial lending fell 7 percent in April -- with nearly 75 percent of the banks reporting a decline in loan originations.
Despite this gloomy picture of the real economy, the administration prefers to focus on the rising sense of consumer confidence -- even though this confidence hasn't translated to greater consumer spending. "Everyone feels mildly better about where the economy is going," is how Joe Biden put it earlier this week. Perhaps the vice president needs to get out more. There are 9 million out-of-work workers, thousands of former credit card holders, and 321,480 newly homeless homeowners (and their families) who might say otherwise.
So the economic bubble continues to be deflated, but the rhetorical bubble is being pumped with plenty of hot air. Maybe we could use one of the many green shoots the administration is marveling at to pop it. If the Wall Street economy is ever going to be recoupled with the real economy, we'll have to start by recoupling rhetoric with reality
Dodd's Irish Luck
The Senator Sure Knows How to Pick an Investment.
Irish property prices have plummeted since 2002. But a "cottage" in County Galway owned by Connecticut Senator Chris Dodd has tripled in value during the same period, according to a financial disclosure form filed by the Senator this month. There are two possible explanations for this remarkable turn of fortune. Maybe Mr. Dodd is luckier than a leprechaun. Or could it be that he paid well below the market price when he bought out a co-owner in 2002 and had undervalued the property accordingly? If it's the latter, then Mr. Dodd received a "gift," in IRS parlance, and should have declared it on his financial disclosure form that year. He did not. Oh, and by the way, the seller at that low, low price has been the business partner of a man for whom Mr. Dodd lobbied to receive a Presidential pardon.
It's also been nearly a year since a former loan officer at Countrywide Financial charged that the mortgage lender had classified Mr. Dodd as a "very important person" (a.k.a., a "friend of Angelo" Mozilo, Countrywide's then-CEO). As such, Robert Feinberg said, Mr. Dodd received -- and knew he'd received -- preferential rates and fees on two mortgages he and his wife refinanced in 2003. As a power on the Senate Banking Committee, he also knew this was a conflict of interest. This was the era when Countrywide originated and then sold to Fannie Mae high volumes of subprime loans.
The SEC charged Mr. Mozilo with fraud and insider trading earlier this month, and the Los Angeles Times reported in May that there is an FBI investigation which "includes a probe of [Countrywide's] role in an influence-peddling scandal involving" Mr. Dodd. The Senate Ethics Committee won't comment on its own investigation of almost a year. Mr. Dodd denies receiving any special treatment, and nearly a year ago he promised to release the Countrywide mortgage documents and clear up the matter. We are still waiting, though he did attempt to placate the Connecticut press with a peek-a-boo release of a few select documents and a review by his own lawyers in February.
Now the Irish cottage on 10 scenic acres is bringing more trouble. At the start of the Irish real estate boom in 1994, Mr. Dodd bought the property with William Kessinger for $160,000. Mr. Kessinger has been a business partner of Edward Downe, who is a longtime friend of Mr. Dodd's. In 1986 Messrs. Dodd and Downe owned a condominium together in Washington. In 1993 Mr. Downe pleaded guilty to insider trading and securities fraud and in 2001, as Bill Clinton was preparing to leave the White House, Mr. Dodd successfully lobbied to get his friend a pardon.
The following year, 2002, Mr. Dodd bought out Mr. Kessinger's two-thirds share in the house and became the full owner. Mr. Dodd reported to the Irish government that he paid Mr. Kessinger $122,351, and Mr. Dodd says that a bank appraisal that same year valued the property at $190,000. From 2002 to 2007 Mr. Dodd reported its worth at between $100,001 and $250,000 on his annual Senate financial disclosure form. But Hartford Courant columnist Kevin Rennie began digging this year into the mismatch between what Mr. Dodd paid to Mr. Downe's business partner to become a full owner and what the property in Ireland was likely worth in 2002 amid the Irish land boom.
Last week, when Mr. Dodd filed his annual financial disclosure form, it included a new appraisal from the same appraiser putting the current value of the house at $658,000. In an effort to explain the gain despite the fact that the Irish housing market has since gone south, a spokesman for the Senator said that "The value of the cottage, or of Irish real estate generally, isn't something that the Dodds have thought much about."
However, according to Galway County records, Mr. Dodd was so uninterested in the value of those 10 acres that he tried to subdivide the property in 1998 and put up another house. No doubt because he had no idea what it was, or would be, worth. The Senate's financial disclosure forms are supposed to be a tool of honest government, and former Senator Ted Stevens was indicted for allegedly false disclosures. Mr. Dodd's miraculous property reappraisal is further grist for Senate and Justice investigators -- and especially for voters in 2010.
A Credit Squeeze for Small Business Owners
Louis Licata has shelved plans to hire three more employees for his Cleveland law firm. Jeannie Macone, of Florida, is cutting back on inventory for her trinket and home décor business. In Ohio, Patrick Allen has slashed employee travel and begun paying cash for work dinners with clients of the marketing firm that he started from scratch. A crackdown on credit limits by card companies is squeezing the nation’s 27 million small businesses, exacerbating the problems brought on by a stagnant economy.
Owning a small business has always been a challenge — half wind up failing within the first few years. But the financial crisis has dealt them a one-two punch, as big banks cut the credit card lines that many entrepreneurs were forced to lean on when a once-abundant supply of loans dried up. As of April, 59 percent of America’s small firms relied on credit cards to help finance their day-to-day operations, up from 44 percent at the end of last year, according to the National Small Business Association.
The number of small-business owners who depend on a credit card to buy items as varied as paper clips and heavy equipment has climbed steadily over the years, from just 16 percent in 1993. Today, that group makes up 11 percent of the revenue for Visa and MasterCard, from 3 percent in 1998, according to David Robertson, who publishes The Nilson Report on the credit card industry.
But credit card terms have worsened sharply with the recession: three-quarters of small business said they have seen a large cut in limits over the last six months. That would not be so bad if other forms of credit were easily accessible. But banks and credit card companies, which opened their coffers when the economy was flourishing, are now pulling back from nearly everything that hints of risk.
"I’m a business in a bad time that wants to expand," said Mr. Licata, who added that he had been unable to get loans at Cleveland’s banks since the recession set in. Recently, the limit on three of the credit cards he uses for his law firm was slashed by a total of $60,000, he said, dousing plans to enlarge his business. Of course, consumers have been squeezed by higher interest rates and reduced credit lines by credit card companies, too.
But small businesses were not included in the credit card reform legislation signed into law last month by President Obama, which limits excessive fees and interest rate increases on existing balances starting next year. A bipartisan coalition of senators is seeking to extend the legislation to small business. "The way that the economy is going to come out of a recession is not by big business hiring but by small business hiring," said Senator Mary L. Landrieu, Democrat of Louisiana, who is championing the measure. Denying small businesses access to credit is having "spiraling" effect on the economy, she added.
Bankers say that credit card companies have no choice but to reduce credit to small businesses. Credit card delinquency among small-business owners is more than 12 percent, roughly two percentage points higher than credit card charge-offs among consumers, according to Mr. Robertson of The Nilson Report. Kenneth J. Clayton, senior vice president of card policy for the American Bankers Association, said applying the credit card reform law to small businesses would further crimp credit, since it would limit credit card companies’ ability to manage risk. Already, he said, the companies have had to restrict credit to small businesses because of rising defaults and uncertainty.
"They are looking very closely at the ability of small business to pay them back," he said. "They have to. They have no choice." Tom Sclafani, a spokesman for American Express, said credit lines offered when the economy was booming might not be appropriate when growth contracts. The company has been cutting credit lines based in part on the overall debt level of the business. "What we are trying to do is strike a balance between a customer’s spending needs and managing credit risk," he said.
American Express offered the first credit card tailored to small business 20 years ago. Other companies came onto the playing field over the last decade, when a healthy economy turned small businesses into a lucrative source of new accounts as the consumer market became saturated. Credit card companies became increasingly aggressive in soliciting new business. Many banks began offering their own credit cards to small businesses, in lieu of loans. And many small vendors began preferring, or even requiring, payments with credit cards.
Where small businesses had traditionally relied on bank loans, personal savings or relatives to help pay for their operations, credit cards provided additional flexibility and ease. Low introductory offers and rewards programs were icing on the cake. The market grew so rapidly that at least one company, Pennsylvania-based Advanta, decided to focus exclusively on credit cards for small-business customers. By 2006, just five years after it was founded, its profit from business credit cards surged 54 percent over the previous year. Eventually, more than one million small businesses took an Advanta card.
Then the economy went into a tailspin, and took Advanta’s fortunes with it. The company last month announced that it would no longer pay for additional purchases, leaving many customers in a bind. Now, small businesses "are really having to scramble because often they don’t have the kind of flexibility they had before," said Todd McCracken, president of the National Small Business Association. Further, credit scores of small businesses have been hurt as banks cut credit limits, making it even harder to get other types of credit. "It feeds on itself," he said.
Mr. Allen, the owner of the financial and insurance marketing firm in Ohio, said he recently took some insurance agents on an Alaska cruise where he tried to charge drinks and several side trips on his credit card, only to be denied. To his astonishment, his limit had been cut with no notice. After he returned to Ohio, Mr. Allen said he met some clients for dinner. Normally, he said he would have whipped out a credit card to pay the bill. Instead, he paid in cash. Mr. Allen said he has also scaled back travel because credit was tight and business was slower than normal.
"You’ve got to play a balancing act," Mr. Allen said. "This is going to be a moving target." Mrs. Macone, the owner of the business in Florida selling equestrian-themed trinkets and home décor to retail outlets, said she had to retool her business in part because the credit lines on her cards were suddenly slashed, even though she maintained she paid her bills on time. Traditionally, she has relied on her credit cards to purchase inventory, which she then paid off as her customers settled their accounts.
But last fall, Ms. Macone, who took out a credit card with Advanta, opened her bill to find the company had raised her interest rate above 30 percent. A short time later, Advanta reduced her spending limit from $30,000 to $5,000. "When you have a business, it’s like, ‘$5,000? Please, what good is that?’ "
Advanta said it was responding to worsening conditions. "Across the card industry, card issuers have been increasing interest rates and reducing credit lines to protect themselves against a riskier economic environment," said Amy Holderer, a spokeswoman. "We are no different." Ms. Macone said she has had to lay off three part-time workers who used to assemble orders for shipment in her warehouse, and cut the hours of two other employees. "I’m the warehouse help now — my husband and I," she said. "I’m back out there picking orders. I haven’t picked orders in 10 years."
Corporate Lenders' Cry: Let Us Be
Some industrial-loan company executives said Friday that they are lobbying Congress to defeat a proposal by the Obama administration that would force them to convert to bank-holding companies. "At all costs, we have to fight any kind of legislation that would cause us not to be able to own this bank," said Michael Lizárraga, who runs Telacu, a Los Angeles nonprofit agency that owns a so-called ILC called Community Commerce Bank.
The ILC offers federally insured savings accounts and funnels the deposits into loans to Hispanic and African-American customers. Community Commerce Bank has grown to $400 million in assets, but might be forced to close if the White House plan clears Congress. The measure would eliminate ILCs that provide a wide range of financial services but aren't technically structured as banks. Converting to a bank-holding company would subject ILCs to more-stringent regulatory oversight and capital requirements.
The White House proposal to clamp down on ILCs is part of a broader effort to bring all areas of the financial system under a single, powerful regulator. The goal is to avoid new risks bubbling up in areas that historically haven't been closely scrutinized by regulators. "If this crisis has told us anything, it's that risk to our system can come from almost any quarter," Treasury Secretary Timothy Geithner said Thursday in testimony on Capitol Hill. The measure would affect companies from retailer Target Corp., which uses its ILC to issue some of its credit cards, to a vehicle-financing unit of BMW AG.
"We are clearly not in favor of the provision and we will be involved in making sure our voice is heard," said Michael Dubyak, chairman and chief executive of Wright Express Corp., of South Portland, Maine. Wright Express uses its ILC to issue a MasterCard-branded credit card to customers. Bill Himpler, executive vice president at the American Financial Services Association, said the trade group of ILCs has begun lobbying lawmakers to kill the proposal on the grounds it would restrict availability of credit in the midst of a recession.
Bankers and lawmakers in Utah, home to most of the ILCs, also have expressed opposition to the proposal. They are being joined by officials in Nevada, the home state of Senate Majority Leader Harry Reid and ILCs run by Toyota Motor Corp. and Harley-Davidson Inc., which also hope to derail the measure. "I don't like the notion that we could do harm to a couple of businesses that are a part of the Nevada economy," said Bill Uffelman, president of the Nevada Bankers Association. Mr. Uffelman plans to discuss his concerns with members of Nevada's congressional delegation, including Sen. Reid, whom he described as a longtime ILC supporter.
The provision may have less impact on ILC owners like Target that provide financial services in multiple ways. A spokesman for the Minneapolis retailer said its Utah-based ILC is "not of consequence to our business," noting that Target issues most store-branded credit cards through a South Dakota bank charter and processes transactions through a third party. Target said it is studying the provision to determine what would happen to those accounts if the provision passes.
Medallion Financial Corp., which uses its Utah ILC charter to provide loans for taxi permits in New York, Chicago and other cities, has been planning to convert to a bank-holding company. President Andrew Murstein said the company wants to become a banking company so it can access the Federal Reserve's discount window and take on more debt.
Back in the U.S.S.A.
by Peter Schiff
Harry Browne, the former Libertarian Party candidate for president, used to say: "the government is great at breaking your leg, handing you a crutch, and saying ‘You see, without me you couldn’t walk.’" That maxim is clearly illustrated by the financial industry regulatory reforms proposed this week by the Obama Administration.
In seeking to undo the damage inflicted over the past decade by misguided government policies, the new regulatory regime would ensure that the problems underlying our financial system will only get worse. As was the case with the deeply flawed Sarbanes-Oxley legislation of 2002, or the misguided provisions of the Patriot Act of 2001, such as the torturous anti-money laundering requirements, the move will further burden the financial services industry with unnecessary regulation that will drive up costs, lower quality, and shelter the biggest and least innovative companies. Ultimately, the structure will put the entire U.S. financial industry at a global competitive disadvantage.
The underlying problem is that the excessive risk taking which brought about the crisis was not market-driven, but a direct consequence of government interference with risk-inhibiting market forces. Rather than learning from its mistakes and allowing market forces to once again control risks and efficiently allocate resources, the government is merely repeating its mistakes on a grander scale – thereby sowing the seeds for an even greater crisis in the future.
As is typical of government attempts to control economic outcomes, Obama’s plans focuses on the symptoms of the disease and not the cause. The American financial system imploded for two reasons: cheap money and moral hazard – both of which were supplied by the government. Under the proposed new regulatory structures, these toxic ingredients will be combined in ever-increasing quantities.
The proposals most notably involve extra regulatory oversight of financial entities that the government deems "too big to fail." This implies that it is desirable to have such entities in the first place, and that the government will continue to back those large organizations that fall under its protection. These "too big to fail" firms will enjoy a competitive advantage over smaller firms in attracting capital, as lenders will perceive zero risk in extending them credit. This will cause these firms to grow even larger, producing even greater systemic risks and larger losses when the next round of bailouts arrives. Meanwhile, smaller firms which seek to expand, and which propose no systemic risks, will face greater challenges as higher capital costs render them less competitive.
If the government did not provide these bailouts or guarantees, then the market itself would ensure organizations did not grow beyond their ability to attract capital. It is only when market discipline is overcome by government guarantees that systemic risks arise. Obama proposes to entrust the critical job of "systemic risk regulator" to the Federal Reserve, the very organization that has proven most adept at creating systemic risk. This is like making Keith Richards the head of the DEA.
Given the Federal Reserve’s disastrous monetary policy over the past decade, any attempt to expand the Fed’s role should be vigorously opposed. Through decades of short-sighted interest rate decisions, the Fed has proven time and again that it is only able to close the barn door after the entire herd has escaped. If setting interest rates had been left to the free market, none of the excesses we have seen in the credit market would have been remotely possible.
The perverse result will be that our government and the Fed gain more power as a direct result of their own incompetence. Such was also the case with Freddie and Fannie, which should have been allowed to fail, but were nationalized instead, leaving them in a position to do even more damage. The new round of regulations ignores them completely. Along those lines, ratings agencies such as Standard and Poor’s and Moody’s that completely missed the mark were also spared. Perhaps this special treatment is a way of ensuring that Treasury debt maintains its bogus AAA rating.
Unfortunately, despite their intent, my guess is that the new regulations will most severely impact smaller firms, like my own, that never engaged in reckless behavior. This will further reward those "too big to fail" firms, whose economies of scale and cozy relationships with regulators leave them better positioned than their smaller rivals to absorb the costs of the added red tape.
With the transition now fully under way, I propose we end the pretense and rename our country: "The United Socialist States of America." In fact, given all the czars already in Washington, we might as well go with the Russian theme completely: appoint a Politburo, move into dilapidated housing blocks, and parade our missiles in the streets. On the bright side, there’s always the borscht.
China ministry "regrets" U.S. tire trade finding
China's Ministry of Commerce expressed "deep regret" at a U.S. trade panel ruling that Chinese tires had flooded the U.S. market, the first step in what could be the Obama administration's first trade dispute with Beijing. The International Trade Commission found that a surge of low-cost tires from China had disrupted U.S. markets, following a complaint by the United Steelworkers union which hopes to cap Chinese tire imports at their 2005 level.
"China has repeatedly expressed its opposition to foreign governments' using safeguard clauses to launch investigations of Chinese products," Commerce Ministry spokesman Yao Jian said in a statement posted on the ministry's website on Friday. "The decision does not conform to objective facts, and also violates relevant World Trade Organization rules in addition to U.S. law."
Lawyers representing Chinese tire producers argue that U.S. companies largely abandoned the low-range tire market before Chinese manufacturers moved in. They also noted that no U.S. tire producers had joined the steelworkers' complaint. "We hope the U.S. will fully consider the actual situation of this case and proceed from the overall interests of the two countries' industries," Yao said. U.S.-based steel makers have long complained that Chinese incentives to its steel industry have resulted in a flood of steel exports to countries like the United States. Tires are often reinforced with steel wire.
The union's complaint says that closings of U.S. plants by Goodyear, Continental Tire, and Bridgestone/Firestone have cost thousands of jobs. This is not the first time that imported Chinese tires have ruffled relations between the two countries. Two years ago, Chinese-made radial tires imported by an American dealer were recalled after the manufacturer stopped including a safety feature that prevented the tires from separating.
The Peak Oil Crisis: The Year of the Dollar
Our peak oil crisis is morphing into a dollar crisis. Despite record inventories, and millions of barrels sitting in anchored tankers, oil prices continue to rise. Earlier this week the average price of gasoline rose to $3 in California and many are predicting that the rest of us will be seeing $3 gasoline later this year. While analysts are moaning that $70 oil is not justified by supply and demand, it seems that oil has become a favored store of value as massive US deficits eat away at the value of the dollar. The dollar goes down; oil goes up. For now there is so much excess capacity that geopolitical developments, stockpile reports and run-of-the-mill oil news has only a minor effect on oil prices.
Much of the recent run up in prices was based on this spring’s “green shoots rally,” in which many professed to see signs that the recession would soon be over, and that increased demand would send oil prices ever higher. The rally, which had its origins in a change in accounting standards allowing insolvent banks to pretend they were doing well for a while longer, seems to be slowing and may be coming to a close. While the psychology of the equity markets is in a world of its own, most analysts, who don’t draw a paycheck from the financial services industry, are saying that the tough times are only beginning.
Some who have studied the Great Depression are talking of a downturn lasting a decade or more. Should this sentiment become widespread and the equity markets start to move down again, it is an open question as to what happens to oil prices. Can a falling dollar offset reduced prospects for oil consumption from faltering economies? The underlying cause for the dollar’s weakness is the massive deficit the U.S. government is running, and the continuing sale of billions of dollars worth of treasury securities. This in turn has left foreign investors worried that the value of their U.S. treasury holdings will one day be worth much less than they invested.
For the foreseeable future, these investors have nowhere else to turn, for the minute they stop buying or try to sell significant quantities of U.S. obligations, they would immediately crash the dollar and their worst fears would be realized. For now, China, Russia and other large holders of U.S. treasury securities are trying to make the best of a bad situation. They are talking among themselves about how they might transition to a new world reserve currency and are slowly reducing purchases of additional U.S. treasury securities.
For the immediate future, Washington has little choice other than to issue unprecedented amounts of debt. Although the administration assures us it will start cutting the deficit someday, this is tied to an improved economic situation that seems problematic. Despite massive intervention and purchase of treasury securities by the Federal Reserve, U.S. interest rates are already moving up, with the rate on the average 30-year mortgage loan increasing from 4.86 to 5.59 percent in the last few weeks, thereby choking off much refinancing and some new loans. Another couple of jumps like this, and the U.S. real estate industry will be having a lot more trouble.
If the U.S. dollar continues to fall, there is reason to believe that increasing amounts of oil will be purchased as a hedge and that the price of oil will continue to rise. The increase in oil prices does not have to be as fast, nor go as high as it did last year to create serious economic problems. The U.S. economy is in worse shape than it was 18 months ago, and is far more susceptible to the damage that would be wrought by sustained exposure to $3 or $4 gasoline. Every 10-cent increase in the price of gasoline takes $40 million dollars a day away from other consumer purchases. The increase in gasoline prices over the last six months is now draining an additional $400 million a day from consumers’ pockets. For every cent gasoline prices increase, sales of something else go down by $4 million dollars each day.
As strange as it may seem, the peak oil crisis, which has been focused on geologic constraints to oil production, supply and demand, geopolitical threats and inadequate investment, seems to be morphing into an issue of how much debt the U.S. Treasury can sell and still keep interest rates under control. We can be certain that the U.S. Congress and government will not stand by and watch oil price increases driven by a falling dollar wreck the economy. As we saw last summer, there will be calls to break the dollar’s link to oil by restricting or even banning speculation. How well this will work in a globalized world is anybody’s guess. Unless there is worldwide agreement, activities banned in the U.S. could continue in Europe, the Middle East or Asia.
The more traditional constraints on world oil production – geologic, geopolitical and inadequate investment – are likely to come into play within the next three or four years, no matter the course of the current recession. Right now there is a surplus of production capacity, and indeed, already produced oil which is sitting around looking for consumers. If for one reason or another the recession deepens over the next year or so, then these surpluses are likely to grow. It would be a great irony if oil prices were to continue increasing in the midst of substantial surpluses and falling demand.
Canada's MPs and their spending secrets
Canada's 308 members of Parliament claim almost $128 million a year in personal and office expenses – spending that's risen 42% since 2000. But when the Star asked where the money was going, almost everyone refused to talk
Eleven dollars and 45 cents for computer mouse pads, telephone equipment worth $13, a $15 rug and a $10,203 bill to move an MP's Parliament Hill office 37 steps, from one side of a stairwell to the other. That is about all that's known of the almost $128 million in expenses claimed by federal politicians in the last fiscal year. The rest of it – the mundane, the understandable and the exorbitant – may never be revealed thanks to a culture of secrecy on Parliament Hill that appears to have bled across partisan lines.
Twenty cabinet ministers and backbenchers resigned or will retire in Britain after a newspaper was handed a computer disc containing expense claims on everything from a moat-cleaning service to the rental of a dirty movie. A heavily censored version of all British MPs' expenses for the past three years was released on a parliamentary website this week and Scotland Yard launched a criminal investigation into some claims yesterday. The House of Representatives in Washington now plans to post members' expenses online each quarter, and similar pre-emptive plans are developing in New Zealand.
But nothing of that sort is likely to bring more transparency to Ottawa. In Canada, you can see how much of your money your MP has spent – an annual tally comes out each fall – but you have no right to learn how they spent it. Of the 37 MPs contacted in the past several weeks, just four agreed to disclose the detailed information on specific expenses requested by the Toronto Star. A vast number simply ignored the appeal. Then scripted responses began streaming in from politicians of all parties in the House of Commons.
"I would remind you that for expenses to be approved, receipts need to be submitted to the House of Commons," said Zachary Healy, a Conservative party spokesman. "Receipts have been provided for all expenses, and they have been disclosed according to the rules currently in place," said Karl Bélanger, the senior press secretary to NDP Leader Jack Layton. "If an expense does not meet the guidelines ... it is refused," said an aide to Liberal MP Glen Pearson. Even the Bloc Québécois, which said weeks ago that it had no fear of opening its expense claims for a look-see by the auditor general, dismissed requests for assistance and transparency. "Alors bonne chance," said Karyne Duplessis Piché, media relations officer for the Bloc caucus.
A secretive and powerful committee of eight MPs – four each from the government and the opposition – keeps watch over their colleagues' bills. The Board of Internal Economy meets every few weeks behind closed doors to decide how a portion of taxpayers' money is spent running the House of Commons and compensating elected officials. On March 9, they agreed to cover the legal expenses for six lawsuits brought against MPs for defamation, libel and employment disputes. They approved an out-of-court settlement to clear up another case involving an unnamed politician. The only public record of the payout is two lines in an obscure summary of the meeting.
The board won't say who's being sued, what prompted the lawsuit or how much the legal defences are costing taxpayers. "At some point here there has to be some capacity to treat members in some confidence," said board spokesman Mauril Bélanger, the Liberal MP for Ottawa-Vanier. "These are such matters." It's much the same for expenses, though there is a list of rules to separate the legitimate claims from the frivolous. There are also audits and all-party oversight of the money. Bélanger even appeared to take offence at suggestions the expense system was something less than fully transparent.
"Are you suggesting there are scandals in the House of Commons?" the veteran MP asked. "I'm suggesting there aren't any ... I would argue, sir, that the level of scrutiny that is currently applied ensures that things that may have happened elsewhere are not happening here." Don Boudria, a Liberal MP from 1984 to 2006 who also sat on the board, said federal politicians need discretion to manage staff salaries, office rentals and other purchases that make representing a constituency "like a miniature business." But the checks and balances on MPs' expenses make Canada "a model that could be emulated in other countries," he added.
For now, Canadians have to trust that this is true. If someone objected to a decision made by the board, or even the secrecy surrounding how those decisions are made, there's not much they can do about it. The board has the final say on all of these matters – the judge, jury and court of appeal. "They always say that the board meets in secret. Well, the boards of directors of most corporations meet privately also," said John Reynolds, a former Conservative MP who sat on the board for six years before he left politics ahead of the 2006 federal election. "You can't run corporations that have public board meetings and the public attending your board meeting because you're talking about staff, you're talking about people."
Here's how the MPs' spending breaks down:
All expenses for the country's 308 MPs totalled $127,850,218 for the year ended March 31, 2008. That represents a jump of almost 42 per cent since the 2000-01 fiscal year, when 301 MPs spent $90,174,779. The claims cover a politician's riding office, where there is an allotted amount that MPs can bill for expenses, staff, travel, advertising and building rental. A second grouping of expenses covers goods and services provided by the Commons for an MP's Parliament Hill office, including telephone, printing, office supplies and a $5,000 fund for furniture and equipment improvement.
The different budget allotments are strictly administered, meaning MPs cannot use money set aside for travel between Ottawa and their constituency to buy fancy suits, Boudria said. "You can't do that even if you didn't travel all year ... You'd send it in and it would be sent back." The Star sought a detailed list of the $707,135 in expenses for services provided by the House of Commons labelled in annual disclosure statements as "Other." That category provides MPs the widest latitude in spending and provides the greatest variance on spending.
In the 2007-08 fiscal year, the amounts billed ranged from $2 for Bloc Leader Gilles Duceppe, to $2,418 for Brampton Liberal MP Ruby Dhalla, to $17,910 for Helena Guergis, the Tory from Simcoe-Grey, to $314,542 for Winnipeg Conservative Steven Fletcher, who is quadriplegic. A few days after a reporter first placed telephone calls to a number of politicians, Liberal MPs alerted their whip, the person who makes sure all party members are operating in unison. The whip, Cape Breton MP Rodger Cuzner, promptly called the Star seeking more details about the request. Cuzner said the rules surrounding expenses are one of the first things newly elected members are taught upon arrival in Ottawa.
To prove there are checks in place, he admitted that several of his own past expense claims have been denied or deemed improper. Bélanger also said he had an advertising expense rejected because he had not included his constituency contact information in the publication. And as recently as March 26, the board rejected the claims of an MP who tried to expense child-care bills, according to a summary of the meeting. Cuzner insisted that Liberals have nothing to hide, but added: "My reservation would be for individual MPs making their claims public when not everyone's is public." He promised to "give it some thought" and try to find a way to help, but he never called back.
Only four MPs, all Liberals – Peter Milliken from Kingston, who is the Commons Speaker and the chair of the Board of Internal Economy, Jim Karygiannis, who represents the Toronto riding of Scarborough-Agincourt, former Liberal leader Stéphane Dion and Marlene Jennings from Montreal – agreed to release a breakdown of their expenses. Milliken claimed the mouse pads and rental of an office water cooler at a cost of $176. Karygiannis billed for a $13 telephone cord. Dion claimed a $15 carpet during his brief stint as party leader.
Jennings was billed $3,404.30 by the House of Commons to physically move her Ottawa office 37 steps down the hall into an office vacated by former Toronto Liberal MP Bill Graham in early 2008. It cost $5,662.33 to paint the office and upholster two sofas, $836.44 for office repairs and $299.99 in information technology charges. All the work was performed by government staff and the used furniture in her office was provided by the House of Commons, which automatically gives each item a monetary value, Jennings said. The possible reasons MPs weren't more forthcoming are quite simple, according to a number of current and former officials.
First, there's no rule demanding that they do so. The bylaws state that only an MP or the board can authorize such a disclosure. It's also nobody's business, said Reynolds, who retired from elected office in 2006 and now works in Vancouver as a strategic consultant with the Lang Michener law firm. Making individual expense claims public, something already required of cabinet ministers and senior bureaucrats, only feeds a scandal-obsessed media, he said. "I don't think it's important that somebody knows what somebody eats for their supper. It then becomes a story. So-and-so eats a steak and somebody else lives on a hamburger. ... There are people who like that stuff and that's why the National Enquirer sells so well."
But as with most bodies that conduct themselves far from public scrutiny, Bélanger said the board could decide at any time to shine more light on the hidden millions. Problems coming to light or scandals such as the one that continues to unfold in Britain could speed up that process. But then again, maybe not. "Things have evolved over the past. I can't see why they wouldn't necessarily evolve over the future as well," Bélanger said. "In what shape and at what rate? I can't predict that, but I can see things changing."
Fear the Dark Side of China's Lending Surge
China's credit boom has increased bank lending by more than 6 trillion yuan since December. Many analysts think an economic boom will follow in the second half 2009. They will be disappointed. Much of this lending has not been used to support tangible projects but, instead, has been channeled into asset markets. Many boom forecasters think asset market speculation will lead to spending growth through the wealth effect. But creating a bubble to support an economy brings, at best, a few short-term benefits along with a lot of long-term pain.
Moreover, some of this speculation is actually hurting China's economy by driving asset prices higher. The current surge in commodity prices, for example, is being fueled by China's demand for speculative inventory. Damage to the domestic economy is already significant. If lending doesn't cool soon, this speculative force will transfer even more Chinese cash overseas and trigger long-term stagflation.
Commodity prices have skyrocketed since March. The Reuters-Jefferies CRB Index has risen by about one-third. Several important commodities such as oil and copper have doubled in value from this year's lows. As I have argued before, demand from financial buyers is driving commodity prices. The weak global economy can't support high commodity prices. Instead, low interest rates and inflation fears are driving money into commodity buying. Exchange-traded funds (ETFs) alone account for half of the activity on the oil futures market. ETFs allow retail investors to act like hedge funds. This product has serious implications for monetary policymaking. One consequence is that inflation fears could lead to inflation through massive deployment of money into inflation-hedging assets such as commodities.
Financial demand alone can't support commodity prices. Financial investors can't take physical delivery and must sell maturing futures contracts. This force can lead to a steep price curve over time. Early this year, the six-month futures price for oil was US$ 20 higher than the spot price. Investors faced huge losses unless spot prices rose. A wide gap between spot and futures prices increased inventory demand as arbitrageurs sought to profit from the difference between warehousing costs and the gap between spot and futures prices. That demand flattened the price curve and limited losses for financial investors. Without inventory demand, financial speculation doesn't work.
For some commodities, warehousing costs are low, limiting net losses for financial buyers. Some commodities can be used just like stocks, bonds and other financial products. Precious metals, for example, are like that. Copper, although 5,000 times less valuable than gold, still has low warehousing costs relative to its value. Some commodities such as lumber and iron ore are bulky, costly to warehouse, and should be less susceptible to financial speculation. Chinese players, however, are changing that formula by leveraging China's size. They've made everything open to speculation. There's little doubt that China's bank lending since last December has driven speculative inventory demand for commodities. Chinese banks lend for commodity purchases, allowing the underlying commodities to be used as collateral. These loans are structured like mortgages.
Banks usually have to be extremely cautious about such lending, as commodity prices fluctuate far more than property prices. But Chinese banks are relatively lenient. As an industrializing economy, China's support for industrial activities such as raw material purchases for production is understandable. However, when commodities are bought on speculation, lenders face high risks without benefiting the economy. In some cases, this practice hurts banks and the economy at the same time. Speculative demand for iron ore, for example, is seriously hurting China's national interests. Rio Tinto risked bankruptcy following its overpriced, debt-financed takeover of Alcan. When iron ore prices fell by two-thirds from the peak, the market started getting worried about Rio Tinto's viability, and its share price sank.
Chinalco then negotiated a US$ 19 billion investment in Rio Tinto. After that, Rio Tinto's share price nearly tripled. Rio Tinto then decided to issue new shares and cancel the Chinalco investment. Chinalco essentially gave Rio Tinto a free call option, and was ditched when a better option became available. The issue is why its share price has done so well. The international media has been following reports of record commodity imports by China. The surge is being portrayed as reflecting China's recovering economy. Indeed, the international financial market is portraying China's perceived recovery as a harbinger for global recovery. It is a major factor pushing up stock prices around the world.
But China's imports are mostly for speculative inventories. Bank loans were so cheap and easy to get that many commodity distributors used financing for speculation. The first wave of purchases was to arbitrage the difference between spot and futures prices. That was smart. But now that price curves have flattened for most commodities, these imports are based on speculation that prices will increase. Demand from China's army of speculators is driving up prices, making their expectations self-fulfilling in the short term.
The failure of Chinalco's investment in Rio Tinto has been costly for China. After watching its share price triple, Rio Tinto saw it could raise money more cheaply by issuing new shares to pay down debt. The potential financial loss to Chinalco isn't the point. Rather, higher costs will stem from a further monopolization of the iron ore market because Rio Tinto, after scrapping the Chinalco deal, entered into an iron ore joint venture with BHP Billiton. Even though these two mining giants will keep separate marketing channels, joint production will allow them to collude on production levels, significantly impacting future ore prices.
The iron ore market has been brutal for China, partly due to China's own inefficient system. China imports more ore than Europe and Japan combined. Skyrocketing prices have cost China dearly. For four decades before 2003, fine iron ore prices fluctuated between US$ 20 and US$ 30 a ton. As ore was plentiful, prices were driven by production costs. After 2003, Chinese demand drove prices out of this range. Contract prices quadrupled to nearly US$ 100 per ton, and the spot price reached nearly US$ 200 a ton in 2008. The gradual concentration of major iron ore mines by the world's three largest suppliers was a major reason for this price increase. The nature of Chinese demand was another major reason. China's steel production capacity has skyrocketed, even though capacity is fragmented.
China's local governments have been obsessed with promoting steel industry growth, which is the reason for fragmentation. Huge demand and numerous small players are a perfect setup for price increases by the Big Three miners, which often cite high spot prices as the reason for jagging up contract prices. But the spot market is relatively small, and mines can easily manipulate spot prices by reducing supply. On the other hand, numerous Chinese steel mills simultaneously want to buy ore to sustain production so their governments can report higher GDP rates, even if higher GDP is money-losing. China's steel industry is structured to hurt China's best interests.
As steel demand collapsed in the fourth quarter 2008 and first quarter 2009, steel prices fell sharply. That should have led to a collapse in ore demand. But the bank lending surge armed Chinese ore distributors, giving them money for speculating and stocking up. That significantly strengthened the hand of the Big Three. The tie-up of BHP and Rio Tinto further increased their monopoly power. Even though China is the biggest buyer of ore by far, it has had no power in price setting. The global recession should have benefited China. Instead, the lending surge worsened China's position by financing Chinese speculative demand.
China is a resource scarce economy. Its import needs will only increase. International suppliers are trying to take advantage of the situation by consolidating. But Chinese buyers are fragmented due to local government protection. China's lending surge made matters worse by creating excessive speculative demand. What is happening in the commodity market is glaring proof that China's lending surge is hurting the country. Even more serious is that it is leading Chinese companies away from real business and further toward asset speculation – virtual business.
The tough economy and easy credit conditions encouraged many companies to try profiting from asset appreciation. They borrowed money and put it into the stock market. And since China's stock market has risen 70 percent since last November, many businesses feel vindicated for focusing on the asset market. This speculation spread to Hong Kong. Mainland money may have been behind a recent rise in the Hang Seng Index to 19,000 from 15,000, as well as Hong Kong luxury property sales. One way or another, it seems the money source was China's lending binge.
Borrowing money for asset market speculation is not restricted to private companies. State-owned enterprises (SOEs) appear to be lending money to private companies at high interest rates, i.e. loan sharking, using money borrowed at low rates from state-owned banks. Of course, we can't estimate the magnitude of such SOE lending. But it has replaced high interest rate financing in the gray economy.
As the economy weakened in late 2008, private lenders began demanding money back from distressed private companies. Loans from state-owned enterprises may have kept many private companies from going bankrupt. It has served to re-channel bank lending into cash for individuals and businesses that were in the lending business. This money may have flowed into asset markets. It is part of the phenomenon of the private sector withdrawing from the real economy into the virtual one.
It's worrisome that businessmen have become de facto fund managers and speculators. This happened 10 years ago in Hong Kong, and since then the city's economy has stagnated. Some may argue that China has SOEs to lead the economy. However, private companies account for most employment in China, even though SOEs account for a larger portion of GDP. Now, the government is spending huge amounts of money to provide temporary employment for 2009 college graduates.
If private sector employment doesn't grow, the government may have to spend even more next year. The government is using fiscal stimulus and bank lending to support economic recovery. But the recovery may be a jobless one. China needs a dynamic private sector to resolve the employment problem. We are seeing a dark side to the lending surge as commodity speculation hurts the economy. More lending may lead to higher commodity prices, threatening stagflation. Cheap loans benefit overseas commodity suppliers, not necessarily the Chinese economy. Lending policy should consider this self-inflicted damage.
Many analysts argue GDP growth follows loan growth, and inflation is a problem only when the economy overheats. This is naive. Borrowed money channeled into speculation leads to inflation. And China may face a lasting employment crisis if private companies don't expand. This lending surge proves China's economic problems can't be resolved with liquidity. China's growth model is based on government-led investment and foreign enterprise-led export. As exports grew in the past, the government channeled income into investment to support more export growth. Now that the global economy and China's exports have collapsed, there will be no income growth to support investment growth. The government's current investment stimulus is tapping a money pool accumulated from past exports. Eventually, the pool will dry up.
If exports remain weak for several years, China's only chance for returning to high growth will be to shift demand to the domestic household sector. This would require significant rebalancing of wealth and income. A new growth cycle could start by distributing shares of listed SOEs to Chinese households, creating a virtuous cycle that lasts a decade. Putting money into speculative investments isn't totally irrational. It's better than expanding capacity which, without export customers, would surely lead to losses. Businesses currently lack incentive to invest. But many boom forecasters wrongly assume that recent asset appreciation, fueled by speculation, signaled an end to economic problems. That's an illusion. The lending surge may have created more problems than it resolved.
How Porsche’s VW Dream Became a Nightmare
When Wolfgang Porsche learned that his family’s sports-car maker, once bent on taking over Volkswagen, now had to beg its giant rival for money, he looked as if he were going to faint. “He went absolutely white,” said one person briefed on that secret meeting, which involved executives from both companies. “It was as though he’d heard someone died.” A day later, on March 23, fax machines around Germany spit out a piece of paper for Volkswagen’s board members to sign: an emergency loan of €700 million, or $977 million, for Porsche from its former prey — Volkswagen.
The meeting at the office of the governor of Lower Saxony state, where Volkswagen is based, effectively ended Porsche’s audacious bid to become the largest automaker in Europe. And the consequences of the Porsche family’s overreaching go further as its car making business, while still profitable, faces the end of its cherished independence. Mr. Porsche is now on the verge of accepting Porsche’s integration into Volkswagen, rather than the hoped-for David-versus-Goliath takeover. On top of that embarrassment, Porsche also is seeking outside investors and a government bailout.
“This is becoming a reverse takeover on a financial level,” said Arndt Ellinghorst, head of automotive research at Credit Suisse in London. “Porsche has debt and VW has the luxury of cash.” Porsche said Friday that its nine-month sales dropped 15 percent, to €4.6 billion. The company reiterated that revenue and earnings would fall this year, based on “extremely poor business” in the first three months of 2009.
The sports car maker has entered exclusive talks with the Qatar Investment Authority, the sovereign wealth fund of the energy-rich Persian Gulf emirate. It could acquire as much as 25 percent of Porsche’s voting shares, which have long kept the Porsche family firmly in charge. The Qataris, who would get a seat on Porsche’s supervisory board, may also purchase the options Porsche has on VW shares.
Qatar could bring as much as €5 billion into the company, analysts estimate, helping to relieve the €9 billion debt load that Porsche incurred to acquire 50.76 percent of Volkswagen. To tide it over, Porsche has applied for a loan of €1.75 billion from a fund the German government set up in March to help companies through the financial crisis. The request is being reviewed in Berlin, with a response expected in the coming days or weeks.
The surprising turnabout is the latest in a history of squabbles between the Porsche and Piëch clans — both descended from Ferdinand Porsche, who created the Volkswagen Beetle in the 1930s. After World War II, Ferdinand Porsche’s son, Ferry, set up his own company, which became Porsche. Mr. Porsche’s daughter Louise married Anton Piëch, a Viennese lawyer; their son, Ferdinand, is now chairman of Volkswagen and sits on Porsche’s board.
“In the end, this is about clans,” said Stefan Bratzel, head of the automotive research center at the University of Applied Sciences and Economics in Bergisch-Gladbach, near Cologne. “It is the Porsche clan versus the Piëch clan, who belong to a single familial line, but maybe that makes the conflict that much harder.” In the early 1980s, the Porsche and Piëch clans beat back an attempt by an errant cousin, Ernst Piëch, to sell his shares to a Kuwaiti investor. Instead, the Porsches bought him out, ensuring Wolfgang Porsche’s appointment as chairman years later.
Four years ago, Porsche acquired a 20 percent stake in Volkswagen. Porsche’s chief executive, Wendelin Wiedeking, called the move defensive, aimed at protecting one of his company’s most important partners from a hostile takeover. But as time passed, it became clear that Porsche wanted full control so the tiny car maker could share the costs of developing new technologies with much-larger Volkswagen. That reflected a conviction, recently articulated by Sergio Marchionne, the chief executive of Fiat, that only automakers that command major economies of scale would survive in the global economy.
In October, Porsche set off an epic “short-squeeze” by announcing that it had shares and options equal to nearly 75 percent of Volkswagen’s stock. That forced hedge funds and traders who had sold the shares short — a process that involves lending them out — to buy them back at astronomical prices. For a brief period, VW was the world’s most valuable company. The Porsche finance chief, Holger Härter, was a minor legend, the German who had beaten London and New York traders at their own game. But, in retrospect, Porsche appears to have scored a Pyrrhic victory.
Getting the last 8 percent to 10 percent of Volkswagen it bought may have been what broke Porsche, according to a person familiar with its finances, who requested anonymity because the subject involved confidential data. Porsche appears to have paid about €6 billion for that segment of stock, enlarging its debt just when capital markets turned reluctant to lend money anew. The result is that even a Qatari investment, or a loan from the government, cannot revitalize the project for taking full control of VW, analysts said. “This does not create a chance for Porsche to resume the takeover of VW,” said Daniel Schwarz, an automotive analyst at Commerzbank in Frankfurt. “That scenario does not exist anymore.”
On May 6, Porsche and Volkswagen set a four-week deadline for creating an “integrated” auto concern, but the deadline came and went amid some very public sniping from Ferdinand Piëch. The conflict centers on whether a fusion would simply make Porsche the 10th brand within the sprawling VW empire, or whether it would have a merger-of-equals quality. Mr. Piëch has long been something of a black sheep in the family as well. He left an engineering job at Porsche to pursue a career at Volkswagen. A legendary alpha male who is known to arouse fear among his underlings, Mr. Piëch has made it clear that the goal is to reel Porsche in on VW’s terms.
In mid-May at the unveiling of a new version of the VW Polo, a small hatchback, Mr. Piëch publicly badmouthed both Mr. Wiedeking and Mr. Härter. They were partly responsible for the sports-car maker’s precarious financial position, he said, and cash-rich VW would not bail them out with no strings attached. The statement stunned Porsche shareholders, but Mr. Piëch has made it clear that his interests lie primarily with Volkswagen, which analysts say is likely to push harder now to seize control of Porsche. “German law clearly says you cannot say things publicly that violate the overriding general interest of the company,” said Christian Strenger, a board member of DWS Investments, one of Germany’s largest fund managers. “But Mr. Piëch apparently wishes to put Porsche on the ropes.”