"Sharecropper family near Hazlehurst, Georgia"
Ilargi: State of the Union on Wednesday. Bernanke re-confirmation decision sometime this week (his term ends January 31). Paul Volcker in a new and prominent role. The stock markets showing substantial losses in the past week. Looks like these might be make or break days for the administration.
It may be too late to get rid of Bernanke, but there's no guarantee that he can see eye to eye with Volcker. The main problem may be to find replacements for both Bernanke and Geithner. Politically these would seem positive moves, if they are executed well, but then again Obama doesn't need the blame if their firings lead to plummeting markets. And who could possibly fill any of the two spots? Everyone Wall Street is tainted, certainly with "populism" the new US buzz word. Sleepless nights all around.
And besides, nobody should be fooled into thinking that the "Volcker Rule" brings any relief from the mess we're in. It's nice to theorize about how banks should function in the future, and it may make for a few good headlines, but the problems that count are here today, not tomorrow. Nothing has been done to tackle those problems, and very little has been proposed to do so.
Unemployment is still rising. Initial jobless claims were up last week. Continuing claims were 5.99 million, from 4.58 million last year. 5.65 million persons claiming Emergency Unemployment Compensation benefits for the week ending January 2, from 2.09 million a year ago. But the White House still engages in creative accounting. White House Press Secretary Robert Gibbs said on "Fox News Sunday:
"Just last quarter, we finally saw the first positive economic job growth in more than a year, largely as a result of the recovery plan that's put money back into our economy, that saved or created 1.5 million jobs," Gibbs said.
Late last year they claimed some 650,000 created or saved jobs, and we don’t need to repeat how they got to that total. Now it’s a lot more all of a sudden. Creative counting.
Undoubtedly, Obama will spend a lot of time talking about jobs on Wednesday. And it’ll all sound great. But one week after that speech, the BLS is set to add 824,000 lost jobs to the total tally, which will lift the U3 number eerily close to 11%. So what can Washington do? The only thing in sight seems to be a flood of additional spending, and the new populist climate may not like that very much. Also, the US is already on course to hugely increase its debt, so much so that it's not clear that -or how- it will actually manage to sell it. The New York Times' Floyd Norris reminds us once more that China is not likely to buy much of it.:
Debt Burden Now Rests More on U.S. Shoulders
The United States Treasury estimated this week that during the first 11 months of last year China raised its holdings of Treasury securities by just $62 billion. That was less than 5 percent of the money the Treasury had to raise. That raised its holdings to $790 billion, leaving it the largest foreign holder of Treasury securities — Japan is second at $757 billion and Britain a distant third at $278 billion. But China’s holdings at the end of November were lower than they were at the end of July.
Not since 2001, when China was still a relatively minor investor in Treasury securities, had the country shown a decline in holdings over a six-month period. During the full year of 2009, the volume of outstanding Treasury securities owned by the public — as opposed to United States government agencies like the Federal Reserve or the Social Security Administration — rose by $1.4 trillion, a 23 percent gain, to $7.8 trillion. In dollar terms, that was the largest annual increase ever, but as a percentage increase it slightly trailed 2008. With this week’s release of the November estimate of foreign holdings, China is on course to lend just 4.6 percent of the money the government raised during the year. That compared with 20.2 percent in 2008 and a peak of 47.4 percent in 2006.
While Forbes Magazine has the following perspective:
The Global Debt Bomb
National governments will issue an estimated $4.5 trillion in debt this year, almost triple the average for mature economies over the preceding five years. The U.S. has allowed the total federal debt (including debt held by government agencies, like the Social Security fund) to balloon by 50% since 2006 to $12.3 trillion. The pain of repayment is not yet being felt, because interest rates are so low--close to 0% on short-term Treasury bills. Someday those rates are going to rise. Then the taxpayer will have the devil to pay.
Kyle Bass’ Hayman Advisors estimate that 45% of the $4.5 trillion in sovereign debt to be issued in 2010, or $2.025 trillion, will be American. Multiple voices have expressed grave doubts about the true identity of the buyers of US debt. There are serious suspicions that most of it has anonymously been bought by the Federal Reserve, simply for lack of other buyers. And that would mean the country buys its own debt, presumably in an effort to keep Treasuries attractive internationally.
In 2010, sovereign debt issued globally by mature economies will be three times what it on average was over the past 5 years. And the Federal Reserve has pledged to stop buying in a few months. It may skirt on that one a bit, but it can’t’ buy forever. Someone's going to find out.
Add to that that about half of all US states have unemployment funds that are broke, and need to borrow from the federal government to pay out benefits. Half of all states are functionally broke overall, I'd venture, but that's my guess. Los Angeles is the first major city -in this round- that talks about bankruptcy, which means many more are in similar straits. Their only recourse? Sell debt, sell bonds, or sell their possessions.
And still, the biggest political gains are seen in plans to make banks change the way they operate. That's the horse and the barn door in all their classic glory. Looking at all those trillions in debt, and all those millions without jobs, wouldn't it be time to dig in and handle the present problems first? If you don't, you run a bigger than life size risk that a few years from now, nobody could care less how a bank operates, either because they have no money to speak of (the vast majority), or because a bank would be the last place they'd put their money in.
Bailing out banks so the economy won't crash may seem to make sense at first sight, but if the economy crashes regardless, weren't those bail-outs futile? Or could you maybe even have saved the economy with the money spent on bank bail-outs? The losses that led to all this are still there, and it’s high time, or way past it, really, to see what they add up to.
And while you're at it, let's bring down the prices of those ridiculously overvalued American homes. All you need to do is take off your hands, and it'll happen like magic. Just see who offers what in a free market. But I wouldn’t want to make that choice either, because we all know who would offer what. By now it's heads you lose, tails you die, all over again. A whole year wasted with spending other people's money. Wait till they figure that one out.
The president's song won't change, though. On Wednesday, it’ll be "accentuate the positive, eliminate the negative, and don't mess with mister in-between". Or, in the words of Robert Gibbs again:
If you look at where we have gone, from losing 741,000 jobs to on the verge of creating more jobs, we've made a tremendous amount of progress.
That's the spirit! And it only cost $1 trillion per month, give or take a bonus round or two. Now if we only keep doing that for the foreseeable future, we should be just fine.
The State of the Union? Honestly?
- Some 5 million more people claim unemployment benefits than a year ago. How many more have fallen off the steep end, we simply don’t know. Job creation programs so far have been utter failures, no matter what Gibbs says. Or Obama. It's just never been a priority. The banking system has.
- 3 million homeowners lost their houses (and then there's their families). And millions more are sure to follow.
- Bankers will receive record bonuses. And the government does nothing to stop that, even though it owns large portions of the banks.
- The federal debt has increased by trillions of dollars, which we unfortunately can’t count because the government conspires to keep the data secret. Is it $12 trillion, or $23.7 trillion?
The State of the Union? Let’s say, hypothetically, that the stock markets give back the gains they've made since March 2009 over the next few months. About $6 trillion dollars worth of them, I’m told, in the US alone. What effect do you think that would have? What if the losses kept growing after that? How many companies would that bankrupt? How many investors? What state would that leave the union in?
And yes, you do have to budget for that possibility, it really is that simple. A union that has no plan B will always be driven to lie about its true state, no matter what state it's in.
Show Geithner And Bernanke The Door
by Janet Tavakoli
Both the United States and the United Kingdom have had a coordinated non-response to financial reform. If a drunk driver killed your neighbors and crashed the car into your house, you wouldn't expect a police officer to hand the offender a bottle of whiskey and the keys to a bigger, faster, and more powerful car. You would be outraged if the officer said he would only impose a fine, and then made you lend the drunk the money to pay the fine. Yet this is the modus operandi of our financial system, and now financial drunk drivers refuse blood tests and huff that their seat belts were fastened.
Both Federal Reserve Chairman Ben Bernanke and Treasury Secretary Timothy Geithner missed the critical warning signs of our recent financial crisis. In April of 2009, Steve Forbes called Geithner "the most formidable impediment to an economic recovery." Ben Bernanke repeats past mistakes and hands out cheap money with insufficient conditions or regulation. Both economists have been economical with the truth. There were alternatives to their actions during the crisis that are based on sound financial principles and do not violate the spirit of democracy.
President Obama has proposed a baby step towards financial reform. He proposes to limit ill-defined proprietary trading, limit banks' borrowings, and prevent banks from investing in hedge funds and private equity funds. Banks' lobbyists and PR spin-doctors are already working overtime to thwart him. Mainstream financial media got it badly wrong when it said that the proposal was based on populist anger. It may have motivated President Obama to (only partly take) Paul Volcker's advice, but sound financial principles back that advice.
Some bank stocks fell in price after the President's remarks yesterday. That was because savvy investors knew that speculators might no longer be able to report high risk-based earnings subsidized with taxpayer dollars. In this case, a fall in stock prices for banks driving down Wall Street should be viewed as a healthy sign. A few bank stocks rose, because they rely on traditional banking backed by sound financial principles.
Goldman Sachs's stock went down a few percentage points. It became a newly created "bank," to get on the taxpayer give-away gravy train. JPMorgan Chase claims only 1% of its revenue comes from proprietary trading, yet even before its merger with Bear Stearns, JPMorgan's market share of credit derivatives was greater than 50% for U.S. banks. That meant you could combine the credit derivatives of all other domestic banks, and JPMorgan's positions were greater. Those are just two examples. Banks' "non-proprietary" trading desks are often invisible hedge funds.
Taxpayers currently subsidize banks with cheap money supplied by the Federal Reserve. Even banks that nearly crashed our economy borrow at nearly zero interest rates, while some consumers pay nearly 30% on credit card debt. Banks enjoy a Term Asset-Backed Securities Loan Facility (TASLF) that allows them to borrow against problem assets. New banks have each issued tens of billions in FDIC guaranteed debt through the Temporary Liquidity Guarantee Program (TLGP). Banks get interest payments on the excess reserves they keep with the Fed. Accounting rules were changed in March 2009, so banks make up their own prices for assets and more easily hide losses. These are only a few of many newly-created hidden subsidies.
Taxpayers are paid only peanuts in fees for these massive subsidies while being squeezed with high interest rates and mortgage foreclosures--after our economy was devastated chiefly by several banks' malicious mischief. What has the financial crisis taught us? Among other things, we should show Bernanke and Geithner, enablers from the previous administration, the door. Paul Volcker is right to ask for a return to Glass-Steagall. It worked until it was eroded over several decades by bank lobbying. Banking and speculative trading activities--even when done for "customers"--don't mix.
"Financial innovation" must be limited, since much of it in recent years was the financial equivalent of card cheating. Banks should not be allowed to sponsor hedge funds and private equity funds, and furthermore, they should not be allowed to lend to them through prime brokerage units or other means. Financial institutions must be allowed to fail. Hedge funds require regulation. Malfeasance should be investigated and prosecuted. Credit derivatives should be traded and cleared through exchanges and made transparent. Compensation and financial incentives at banks must change. Bank employees cannot continue to reap huge rewards at no personal risk while shoving risk into the global financial system. President Obama promised us change, and he should seize this opportunity to demand sweeping financial reform.
Bernanke second term in doubt
Ben Bernanke's confirmation to a second term as Federal Reserve chairman suddenly appeared in jeopardy on Friday even after U.S. Senate Majority Leader Harry Reid said he would back him. Two Senate Democrats on Friday announced they would oppose Bernanke, citing concerns about the economy that promise to be a key campaign issue and joining the growing number of senators who have vowed to vote against his appointment.
With the U.S. job market in disarray and voters angry at Wall Street, members of Congress facing mid-term elections in November have come down hard on the central bank. Reid, late in the day, issued a qualified statement of support for Bernanke, whose current term expires on January 31. "While I will vote for his confirmation, my support is not unconditional," Reid said. "The Senate will continue to demand visible and responsible results for the people we represent."
Democratic aides said a vote is expected on Bernanke sometime next week, though one has not yet been scheduled and it was unclear when, or if, it would be. Noting the uncertainty of Bernanke's fate, one senior aide said: "I believe there will be the votes to confirm him. But it's going to be very close." Critics say the Fed failed to prevent the worst financial crisis since the Great Depression, and combated the meltdown in a way that favored the financial sector at the expense of ordinary citizens.
Senators Barbara Boxer and Russ Feingold brought the total of known "no" votes among the Democratic majority to four, while many others have said they were still on the fence. "Our next Federal Reserve chairman must represent a clean break from the failed policies of the past," Boxer said. "It is time for Main Street to have a champion at the Fed." The shift came rather abruptly and has added a new element of uncertainty to a stock market that had already been reeling in recent days. The Standard & Poor's 500 fell into the red for the year-to-date on Friday, joining the Dow and Nasdaq indexes.
"The unthinkable has become a very real possibility -- risks are rising that the Senate will unseat" Bernanke, said Michael Feroli, economist at JP Morgan. In-trade, an online betting platform, on Friday showed only a 68 percent chance that Bernanke will be confirmed, down from 95 percent just a few days back. Several Republicans have already come out against Bernanke and some have moved to block his confirmation, forcing Senate leaders to secure a super-majority of 60 votes in the 100-member chamber to move the nomination.
While Reid backed Bernanke, his deputy, Assistant Senate Democratic leader Richard Durbin was still undecided, a senior party aide said. Another member of the Senate Democratic leadership, Charles Schumer, will vote for Bernanke, an aide said. Large U.S. banks, seen as the source of the financial crisis that punished the economy with the deepest recession since the 1930s, have come under pressure from Washington for their quick return to big profits and paying outsized bonuses after receiving billions of dollars in taxpayer aid. The unemployment rate currently stands at 10 percent, with more than 15 million Americans out of work.
With mid-term elections in November, many lawmakers are loath to take any stand that appears to benefit Wall Street. That tendency has only been sharpened since this week's Republican upset for the Massachusetts Senate seat that had been a Democratic stronghold for decades. Bernanke, who was first named as chairman by former President George W. Bush, was nominated to a second term by President Barack Obama in August. "Democrats are nervous," said a senior Republican aide. "But I don't think Democrats are going to kill the president's nominee. I think he will be confirmed."
He said if Democrats are unable to secure the 60 votes needed to clear procedural hurdles they will probably not even bring the nomination up for a vote. A Democratic aide declined to speculate if that would be the case. The White House said Obama remained confident the Democratic-controlled Senate would muster the votes needed to clear procedural hurdles and confirm Bernanke's nomination. "We're going to work our side pretty hard, and we are working with people in the business community who are going to push pretty hard," an Obama administration official said.
Wall Street bankers generally have a very favorable view of Bernanke, crediting him with stabilizing the financial system with creative policies like special lending facilities for disrupted credit markets and direct purchases of mortgage and Treasury bonds. It is unclear what would happen if Bernanke, who is also serving a separate, 14-year term on the Fed's board, is not confirmed by that deadline. The law specifies that the vice chairman of the board, currently Donald Kohn, would serve in the "absence" of the chairman, but absence is not defined.
Some experts say it is possible the board could name Bernanke to serve as chairman on an acting basis. Senator Christopher Dodd has said Kohn would temporarily take over chairmanship of the board if Bernanke were not confirmed in time. "Monetary policy in its current construct would be unaffected by a delay in Bernanke's confirmation unless the delay is seen as either presaging his rejection, or indicating a politicization of the Fed and excessive government involvement," said Tony Crescenzi, market strategist and portfolio manager at bond fund Pimco.
Is It Just Us, Or Did Tim Geithner Get Fired Yesterday?
by Henry Blodget
Earlier this month, we argued that it was time for Treasury Secretary Tim Geithner to go. Our logic was simple:
- Geithner's save-Wall Street-at-any-cost policy has failed (the banks aren't lending), and it is distorting fairness and competition throughout the economy
- Geithner's role in the AIG bailout and cover-up continues to undermine confidence in the current administration (and makes it impossible for the current administration to blame AIG on the last administration)
- Geithner's "too big to fail" bailout policy has led directly to today's Wall Street bonus fiasco: There's no "bonus problem" at Lehman or Wamu.
- Geithner's insistence on always putting Wall Street first has contributed to the populist rage that is now sweeping the nation and bludgeoning Obama in the polls.
We still think Geithner should go. And judging by yesterday's startling Get-Tough-On-Banks press conference, it seems Obama is coming to the same conclusion. Recall the opening words of Obama's short speech:Good morning, everybody. I just had a very productive meeting with two members of my Economic Recovery Advisory Board: Paul Volcker, who is the former chair of the Federal Reserve Board, and Bill Donaldson, previously the head of the SEC. And I deeply appreciate the counsel of these two leaders and the board, that they’ve offered as we have dealt with a broad array of very difficult economic challenges.
Note the immediate shout-out to Paul Volcker and Bill Donaldson. Note the glaring omission of Tim Geithner and Larry Summers. Note that he didn't say "meetings with my economic team" (because surely this new policy wasn't hatched in one meeting with Volcker and Donaldson. What Obama was telling America was "I just had a meeting with two new advisors, and, based on what they said, I'm launching a new policy." Note, too, that the new get-tough-on-Wall Street policy is explicitly called, "The Volcker Rule." (That in itself is shocking. Volcker is just an advisor. Tim Geithner is Obama's Treasury Secretary.)
Tim Geithner was at the press conference, way down the line -- but, by some accounts, he spent most of it staring at his shoes. He is also said to disagree with the new policy (we have problems with it, too). At the very least, yesterday's press conference seemed designed to tell America that Tim Geithner has been marginalized, that Obama is now (finally) committed to change. More likely, it was a prelude to Geithner formally being shown the door.
Obama's 'Volcker Rule' shifts power away from Geithner
For much of last year, Paul Volcker wandered the country arguing for tougher restraints on big banks while the Obama administration pursued a more moderate regulatory agenda driven by Treasury Secretary Timothy F. Geithner. Thursday morning at the White House, it seemed as if the two men had swapped places. A beaming Volcker stood at Obama's right as the president endorsed his proposal and branded it the "Volcker Rule." Geithner stood farther away, compelled to accommodate a stance he once considered less effective than his own. The moment was the product of Volcker's persistence and a desire by the White House to impose sharper checks on the financial industry than Geithner had been advocating, according to some government sources and political analysts.
It was Obama's most visible break yet from the reform philosophy that Geithner and his allies had been promoting earlier. Senior administration officials say there is now broad consensus within the White House and the Treasury for the plan advanced by Volcker, who leads an outside economic advisory group for the president. At its heart, Volcker's plan restricts banks from making speculative investments that do not benefit their customers. He has argued that such speculative activity played a key role in the financial crisis. The administration also wants to limit the ability of the largest banks to use borrowed money to fund expansion plans.
The proposals, which require congressional approval, are the most explicit restrictions the administration has tried to impose on the banking industry. It will help to have Volcker, a legendary former Federal Reserve chairman who garners respect on both sides of the aisle, on Obama's side as the White House makes a final push for a financial reform bill on Capitol Hill, a senior official noted. Advocates of Volcker's ideas were delighted. "This is a complete change of policy that was announced today. It's a fundamental shift," said Simon Johnson, a professor at MIT's Sloan School of Management. "This is coming from the political side. There are classic signs of major policy changes under pressure . . . but in a new and much more sensible direction."
Industry officials, however, said they were startled and disheartened that Geithner was overruled, in part because they supported the more moderate approach Geithner proposed last year. "His influence may have slipped," said a senior industry official who spoke on the condition of anonymity to preserve his relationship with the administration. "But you could also argue that it wasn't Geithner who lost power. It's just that the president needed Volcker politically" to look tough on big banks.
Geithner agreed with Volcker that banks' risk-taking needed to be constrained. But through much of the past year, Geithner said the best approach to limiting it is to require banks to hold more capital in reserve to cover losses, reducing their potential profits. Geithner said blanket prohibitions on specific activities would be less effective, in part because such bans would eliminate some legitimate activity unnecessarily. The shift toward Volcker's thinking began last fall, according to government officials who spoke on the condition of anonymity because the deliberations were private.
Volcker had been arguing that banks, which are sheltered by the government because lending is important to the economy, should be prevented from taking advantage of that safety net to make speculative investments. To make his case, he met with lawmakers on Capitol Hill and gave numerous speeches on the subject, traveling to at least nine cities on several continents to warn that banks had developed "unmanageable conflicts of interest" as they made investments for clients and themselves simultaneously.
"We ought to have some very large institutions whose primary purpose is a kind of fiduciary responsibility to service consumers, individuals, businesses and governments by providing outlets for their money and by providing credit," he said during one speech in Toronto. "They ought to be the core of the credit and financial system. Those institutions should not engage in highly risky entrepreneurial activity." Gradually, Volcker picked up allies. John Reed, the former chairman of Citigroup, expressed his public support. So did Mervyn King, governor of the Bank of England. His ideas began gaining traction within the administration in late October, when the president convened a meeting of his senior economic advisers in the Oval Office to hear a detailed presentation by the former Fed chairman.
There was no immediate change of course. But after the House passed a regulatory reform bill on Dec. 11 that was largely based on the Geithner's vision, the administration began to warm to Volcker's ideas, which had the political value of seeming tough on Wall Street, said sources in contact with the Treasury and White House. At the time, administration officials were growing concerned that government guarantees designed to spur lending by letting banks borrow cheaply were instead funding banks' speculative investments and fueling soaring profits, said Austan Goolsbee, a member of the president's Council of Economic Advisers.
"We started coming out of the rescue and you saw some of the biggest financial institutions . . . who had access to cheap financing . . . use that money without lending or anything, just doing their own investments," he said. "That clearly started putting [the issue] on the radar screen for us." Goolsbee said that Vice President Biden became a particular advocate for Volcker's approach. In mid-December, the president formally endorsed Volcker's approach and asked Geithner and Lawrence H. Summers, the director of the National Economic Council, to work closely with the former Fed chairman to develop proposals that could be sent to Capitol Hill. The three men had long discussions about the idea, including a lengthy one-on-one lunch between Geithner and Volcker on Christmas Eve.
Summers and Geithner had been reluctant to take on battles that weren't at the heart of the problem that fueled the crisis. But ultimately, an administration official said, the two men concluded that reform needs to be about more than just fighting the last war -- it needs to address sources of future risk as well.
The 'Volcker Rule' as a modern-day Glass-Steagall
by John Authers
For Glass-Steagall in the 1930s, read the Volcker Rule for a new decade. Instead of the crude separation of commercial and investment banking, we will now see an equally crude split of the banking business from proprietary trading, hedge funds and private equity. Some salient points on Glass-Steagall are often missed. First, for decades, it worked. The US financial reforms of the 1930s helped to deliver decades of stable economic growth and reasonably stable growth in equity markets.
Second, its very crudeness may have been the key to its success. A clear-cut if arbitrary division will be obeyed. Subtle tinkering with incentives can lead to "gaming the system", as seen most blatantly in the Basel rules that inadvertently encouraged banks to charge into subprime mortgages. A crude ban on proprietary trading may well be the best modern equivalent of the Glass-Steagall division. The short-term stock market reaction was, inevitably, negative, with US stocks down about 2 per cent. But they were due for a correction after a long rally and this could have been much worse.
The most directly affected banks were down about 5 per cent, but as they have huge and profitable holdings in hedge funds, this again says little about the market’s judgment on the overall policy. Longer term, history suggests that a reform along the lines of the Volcker rule could help shake world markets from their extreme tendency for booms and busts. The danger is that a fundamentally good idea must now be filtered through a dysfunctional US Congress in an election year. This adds to a baffling array of medium-term risks. Traders are already worried about Chinese real estate and the Greek public sector. They must now keep an eye on every twist and turn this legislation takes in Congress. The exact policy that will emerge is ambiguous – and that will unambiguously stoke market volatility in the months ahead.
Policy Pivot on Banks Followed Months of Wrangling
Former Fed Chairman Volcker, With Backing From Biden and Axelrod, Helped Shape Obama's Tougher Stance on Banks
For nearly a year, President Barack Obama's economic team resisted measures to restrict the size and activities of the biggest U.S. banks. Two days after Democrats suffered a devastating election loss in Massachusetts, the White House rolled out a proposal to do just that. The policy's evolution took months, according to congressional and administration officials. Prompted by the cajoling of former Federal Reserve Chairman Paul Volcker and other respected voices, dissenters in the administration—notably Treasury Secretary Timothy Geithner and White House economics chief Lawrence Summers—gradually dropped their opposition.
On Jan. 13, Messrs. Geithner and Summers locked down the final regulatory proposals into a memo to the president that they said was unanimous. But the timing of the rollout appears to have been finalized very quickly. Last week, Mr. Volcker met with Senate Banking Committee Chairman Christopher Dodd (D., Conn.) to present his ideas. Mr. Dodd came away unsure that the president had embraced them, lawmakers and aides on Capitol Hill said. During the weekend, as Democrats had begun to conclude the Massachusetts battle was lost, the White House decided to go ahead, even though one aide acknowledged it would look too political. White House officials said Thursday that the plan would have gone forward, regardless of Massachusetts.
The White House's relationship with Wall Street is close to its breaking point. Democratic lawmakers and the administration have made banking policy a central part of their 2010 campaign playbook. Now, America's big banks are facing a double threat: an increasingly tough policy response to the financial crisis that is getting a goose from the White House's increasingly heated political rhetoric. According to Senate officials, the president had an ally beyond Mr. Volcker. One of Mr. Obama's top political advisers, David Axelrod, was also pressing to get tougher on the big banks. In addition, Vice President Joe Biden emerged as a key Volcker ally. "Biden and Volcker are old friends," said Austan Goolsbee, a member of the White House's Council of Economic Advisers. The vice president "became a leading advocate."
On Thursday, Mr. Obama proposed a plan that would prevent banks that receive a federal backstop from investing their own money in financial markets—what is known as proprietary trading. He also pushed for new limits on the size and concentration of financial institutions. Both moves echo the Glass-Steagall Act, the Depression-era banking curbs that was repealed in 1999. The proposal marked the return of Mr. Volcker to center stage in the Obama White House. The 82-year-old chairman of the president's Economic Recovery Advisory Board consulted closely with Democrats in the House and Senate as they drafted their proposals to address "too big to fail" entities, referring to financial behemoths whose collapse might bring down the economy. Mr. Volcker spoke frequently with Mr. Obama as well.
But he faced a philosophical divide with others on the economic team. Last March, at a casual dinner of the House Financial Services capital-markets subcommittee, that panel's chairman, Rep. Paul Kanjorski, recalled a discussion over drinks with Mr. Volcker about his ideas to separate commercial banks from their trading arms. "Don't put a lot of stock in my thoughts because I'm out of vogue," the Pennsylvania Democrat said Mr. Volcker told him.
Administration officials say the White House pivot came in October. Mr. Kanjorski was pushing an amendment to the House's financial-regulation bill that would clamp down on big banks. With the amendment gaining momentum, Mr. Geithner dispatched Michael Barr, an assistant secretary at the Treasury and confidant of Mr. Kanjorski, to help shape it. That month, Mr. Geithner testified before the Financial Services Committee that he backed the amendment's scope. Treasury officials feared headlines would blare that Mr. Geithner had backed breaking up the banks. But the president continued to endure criticism, in particular from his left, that he was coddling Wall Street. In talks with his financial team, Mr. Obama started letting his frustration show, asking why he was on the wrong side of the "too big to fail" debate.
White House officials said the president called a meeting of his entire economic team to press for additional proposals. But its members were at odds: Messrs. Geithner and Summers argued that proprietary trading was a problem but not a central cause of the financial crisis, according to an official familiar with the talks. Mr. Volcker saw proprietary trading as a fundamental risk. In December, Mr. Obama decided he wanted to be on what he saw as "the right side" of the debate, according to an administration official. He asked his team to bring him specific proposals to limit the size of financial institutions and halt proprietary trading. Spurring their thinking: Goldman Sachs had sought the protection of the Federal Reserve during the financial crisis, and was now making big profits from its own trading, in part because it benefited from the explicit backing of the U.S.
It was a big step for the administration. White House economists argued that transparency and disclosure alone could shape Wall Street behavior. But Mr. Obama was now on Mr. Volcker's side. His rhetoric began shifting against Wall Street in December, when he blasted "fat cat" bankers during a television interview. Last month, the president accompanied a proposed fee on big banks to recoup Wall Street bailout funds with a fresh rhetorical blast. A senior official said the president asked Mr. Geithner in mid-December to take another look at the former Fed chairman's ideas. On Christmas Eve, Messrs. Geithner and Volcker had an extended lunch, which persuaded the Treasury secretary to get behind Mr. Volcker.
Then came Massachusetts, where Republican Scott Brown was on his way to taking the late Sen. Ted Kennedy's Senate seat—and with it, the president's lock on a Senate super-majority. As the Senate campaign raged last weekend, the economic and political team at the White House held a conference call to go over the new banking proposal and the plan to roll it out. One aide questioned whether the timing was right. Win or lose in Massachusetts, unveiling tough new bank regulations would look political. Other aides brushed by that concern. In fact, they argued, whatever Mr. Obama does after Massachusetts would be seen as political. And on the "too big to fail" front, they said, the administration needs to own the issue.
But Wait, Obama's New Bank Plan Won't Fix A Thing
by Henry Blodget
We agree with President Obama that it is ludicrous that, a year after a financial crisis almost destroyed the US economy, regulators haven't changed a thing. Tim Geithner's "Too Big To Fail" policy is firmly in place, and our financial institutions can do whatever they want again. So we were relieved to hear that Obama is finally deciding to do something about this.
But here's the problem: His new proposal won't fix a thing. Under Obama's proposal, "banks" will no longer be able to trade for their own accounts or own, sponsor, or invest in hedge funds. So if you want to trade for your own account or own, sponsor, or invest in hedge funds, then... just don't be a bank! In the fall of 2008, Lehman Brothers wasn't a bank. Neither was Bear Stearns. Or Goldman, Morgan, or Merrill Lynch. Or Fannie or Freddie. Or AIG--remember AIG? None of these firms were banks.
Under Obama's new proposal, all of these firms would have been able to trade for their own accounts and own, sponsor, or invest in hedge funds. And excuse us if our memory's faulty, but weren't these non-bank firms, along with with other non-bank firms like the idiot mortgage lenders, the ones that got us into trouble in the first place? In other words, Obama's wildly popular new plan still hasn't addressed the real problem, which is not "banks." It's Tim Geithner's "Too Big To Fail." Until we address that one--preferably by making it possible for ALL firms to fail without taking the system down with them--we won't have done a thing.)
Big Banks Have Already Figured Out The Loophole In Obama’s New Rules
Big banks have already begun poking the holes in Obama’s new rules—holes they expect their banks to pass through basically unchanged. The president promised this morning to work with Congress to ensure that no bank or financial institution that contains a bank will own, invest in or sponsor a hedge fund or a private equity fund, or proprietary trading operations unrelated to serving customers for its own profit. But sources at three banks tell us that they are already finding ways to own, investment in and sponsor hedge funds and private equity funds. Even prop trading seems safe.
A person familiar with the operations of one big Wall Street bank said it expects that new regulation will affect less than 1% of its overall business. The key phrase is "operations unrelated to serving customers." The banks plan to claim that much of the business in which it engages is related in one way or another to serving customers. Even proprietary trading, for instance, can become related to customer service if it is done through internal hedge funds in which some outside clients are permitted to invest.
One insider at a bank pointed to JP Morgan Chase’s ownership of the hedge fund Highbridge Capital. It is thought that under a strict "no hedge funds" rule, Highbridge would have to be sold off. But under the rule proposed by the Obama administration, Highbridge can be retained by JP Morgan because outside clients are permitted to invest in it. A still more devious way is to have a banks own employees be the customers who are invested in the internal hedge funds. That way trading operations can remain closed to outsiders while the regulatory requirement of relating the trading to customer service is met. Goldman Sachs is rumored to be considering this approach. (Goldman isn't commenting on the regs right now.)
"This thing is about showing the public that Obama is standing up to Wall Street. So the rhetoric is heated. But the implementation will require far less change than people think right now," a person familiar with the thinking at the upper echelons of one of our largest banks said. "The market is getting this wrong by selling off the megas," a person at another bank said.
Banks May Get Help to Escape Risk Limits
Only a year after the government stepped in to aid Goldman Sachs and Morgan Stanley by granting them access to the federal safety net, policy makers are developing an exit path that would allow them and others to escape limits on banks being proposed by the Obama administration. President Obama wants to limit the scope of risk-taking by barring banks with federally insured deposits from trading securities for their own accounts and from owning hedge funds and private equity funds. The plan, policy makers said on Friday, would effectively require bank holding companies — which Goldman and Morgan became at the height of the financial crisis — to divest themselves of these lucrative operations.
But Treasury Department officials are also seeking to give banks that do not like the proposed rules the option of dropping their status as holding companies to keep their trading and other investment businesses. The move is likely to turn the spotlight on Goldman, which could be one of the biggest potential beneficiaries because it makes sizable profits from proprietary trading and runs many private equity and hedge funds. Goldman traders are known for taking large trading positions, even as they manage trades for clients. It is less clear that Morgan Stanley would consider such a step, because it has aggressively raised deposits and reduced trading operations since its big losses during the crisis.
Allowing Goldman, or other institutions, to abandon their bank charters carries risks. Such a plan could create a two-tier system, where Goldman could pursue business activities different from its bailed-out peers like JPMorgan Chase. Goldman would lose access to the Federal Reserve’s overnight lending program, which provides emergency financing. But investors may still assume that the government would bail out Goldman if it had trouble, elevating the risk of moral hazard.
Simon Johnson, a former chief economist at the International Monetary Fund, said allowing either bank to revert to a securities firm would do little to address the underlying problem. They are so large and interconnected that a collapse would imperil the global financial system, he said. "You can call them an investment bank, a hedge fund, or a banana, but they are still too big to fail," Mr. Johnson said.
Andrew Williams, a Treasury spokesman, confirmed that the proposal would allow the banks to reverse their decision to become bank holding companies. But he said the Fed would still closely regulate companies like Goldman because they would still be systemically important. "There is no escape hatch," he said. "There is nowhere to hide. Large, interconnected, highly leveraged financial firms must be regulated on a comprehensive, consolidated basis, the same as those for big firms who run banks."
While bank holding company status is generally permanent, investors have speculated for months that Goldman might seek a way to unshackle itself from some of the additional government regulation that goes with it. Goldman officials have said privately it would like to shed its holding company status, although they have stated publicly that they do not plan to change the company’s charter. On Thursday, David A. Viniar, the bank’s chief financial officer, said the topic was not under discussion. "I just think it’s unrealistic," Mr. Viniar said in a call with reporters. "I think we’re living in a world where basically every major financial institution is going to be regulated by the Fed."
But Goldman could change its tune if the Treasury created guidelines for banks to shed their holding company status. The first step for Goldman would be to dispose of its debt, which is backed by the government, or wait until it expires in about two years, the person with knowledge of the plan said. In addition to the federal bailout, the government agreed that the Federal Deposit Insurance Corporation would back some bank debt issued when the markets were frozen and banks could not otherwise raise money. Goldman has issued $21 billion of the debt. The Treasury will include the exit strategy in the legislative proposal it is preparing to send to Congress, Mr. Williams said. Lawmakers could make significant changes to the proposal.
The plan does not now clarify what proprietary trading activities would be limited. Officials said banks would not be permitted to use their own capital for "trading unrelated to serving customers." They also said that the rules would require banks that own hedge funds and private equity funds to dispose of them over several years. Mr. Obama called the ban on trading "the Volcker Rule," in recognition of the former Fed chairman, Paul A. Volcker, who has championed the proposal to prohibit bank holding companies from owning, investing in or sponsoring hedge funds or private equity funds and from engaging in proprietary trading. Big losses by banks in the trading of financial securities helped fuel the credit crisis in 2008.
Initial Jobless Claims Surge on Year-End Filings
Jobless claims unexpectedly jumped 36,000 to 482,000 for the week ending January 16. The U.S. Labor Department qualified the report, saying the data was skewed higher by a backlog of claims stemming from the year-end holiday period. Economists surveyed by Bloomberg News had expected jobless claims to total 440,000. The four-week moving average for initial jobless rose 7,000 to 448,250.
Meanwhile, continuing claims declined 18,000 to 5.99 million -- their lowest level in a year. A year ago, initial jobless claims totaled 575,000, continuing claims totaled 4.58 million, and the four-week moving average was at 526,500. Also, states reported 5.65 million persons claiming Emergency Unemployment Compensation benefits for the week ending January 2, the latest week for which data is available, an increase of 652,364 from the prior week. A year ago, there were 2.09 million EUC claimants.
Economists view the four-week average as a better indicator of unemployment conditions, as it smooths-out anomalies for strikes, holidays, or other idiosyncratic events. Economists also monitor the continuing claims stat because it provides a snapshot of how long it's going to take the typical person to find comparable employment once he/she has sustained a job loss. In general, continuing claims above 3 million reflect a slack labor market, and point to extended 6-9 month (or longer) job searches.
Five Banks Fail; Year's Total at 9
Regulators seized five banks in Florida, Missouri, New Mexico, Oregon and Washington, lifting the total number of failures this year to nine as financial institutions struggle with loan defaults and a weak economy. Two of the five institutions had assets of more than $1 billion. The Florida bank, in Miami, was sold to an investment group that includes former North Fork Bancorp Chief Financial Officer Dan Healy. The deposits and assets of the New Mexico bank went to Texas billionaire Andrew Beal. The Federal Deposit Insurance Corp. estimated the Friday closings will cost the agency's cash-strapped deposit-insurance fund a total of $531.7 million.
Since 2008, regulators have shut down 174 banks, and the expectation is that failures will continue to accelerate in 2010 amid heightened regulatory scrutiny. FDIC Chair Sheila Bair has predicted that failures will "peak" this year and then "subside." In the first seizure Friday, the FDIC sold Miami-based Premier American Bank's four branches, $326 million in deposits and some of its assets to a subsidiary of Naples, Fla.-based Bond Street Holdings LLC, a group granted a preliminary "shelf charter" in October 2009 to establish a new national bank. Regulators have been encouraging investors to apply for such charters as a way of expanding the pool of potential buyers, and this is the first time a group was successful in using the tool to pick up a failed institution, according to the Office of the Comptroller of the Currency.
Bond Street Holdings was allowed to keep Premier American's name, and it will reopen on Monday as Premier American Bank N.A. Bond Street Holdings has raised $440 million from about 65 mutual funds, hedge funds, private equity firms and individuals, according to Mr. Healy, an investor who now is CEO and chairman of the new Premier American. Another investor is Stuart Oran, a senior managing director of advisory firm FTI Consulting and former executive with United Airlines. Mr. Healy, returning to the banking business more than three years after Melville, N.Y.-based North Fork sold to Capital One Financial Corp., said his group targeted the Southeast, particularly Florida, while looking for its first acquisition. "I anticipate there could be others," Mr. Healy said. The FDIC and Bond Street also agreed to share losses on $300 million of the failed bank's assets.
In the second failure Friday, state regulators closed Leeton, Mo.-based Bank of Leeton and the FDIC sold the sole branch and all $20.4 million in deposits to Salina, Kan.-based Sunflower Bank. The FDIC will retain most of the assets. The third failure was Charter Bank in Santa Fe, N.M. The eight branches, $851.5 million in deposits and almost all of the $1.2 billion in assets went to a subsidiary of Plano, Texas-based Beal Financial Corp. Mr. Beal is a race-car-driving, poker-playing banker who has been purchasing troubled assets throughout the financial crisis and once sued the FDIC over loans he bought following another bank seizure.
Charter Bank will reopen on Monday with the same name. Beal and FDIC agreed to share losses on $805.5 million in assets.
The fourth failure Friday was Evergreen Bank in Seattle. The FDIC transferred seven branches, all $439.4 million in deposits and almost all the $488.5 million in assets to Umpqua Bank of Roseburg, Ore. The FDIC and Umpqua will share losses on $379.5 million in assets. As part of this transaction the FDIC will acquire a "cash participant instrument," which means the agency gets some upside benefit if the acquiring bank's stock price goes up in the short term. The fifth failure Friday was Columbia River Bank of The Dalles, Ore. The 21 branches, all $1 billion in deposits and almost all $1.1 billion in assets went to Columbia State Bank of Tacoma, Wash. The FDIC and Columbia State Bank agreed to share losses on $697.4 million in assets.
Supreme Court Says Limitless, Independent Corporate Campaign Spending Is OK
The Supreme Court reversed a century of campaign-finance law Thursday morning when it ruled that corporations, unions, and nonprofits should be allowed to pour their financial resources into presidential and congressional campaigns. The majority decision by Justice Anthony Kennedy and the rest of the Court’s conservative wing, said that corporations have First Amendment rights and should be able to engage in political speech. In the 5–4 ruling, the majority said that "political speech is so ingrained in this county’s culture that speakers find ways around campaign-finance laws. Rapid changes in technology—and the creative dynamic inherent in the concept of free expression—counsel against upholding a law that restricts political speech in certain media or by certain speakers."
Today’s decision opens the door to limitless independent corporate spending. Corporations can pull together their financial resources to create television or radio commercials to support a political candidate. The ruling does not allow corporations to spend endless amounts of money on direct campaign contributions; money that would go specifically into the candidate's bank account to travel or produce campaign materials. As long as corporations don’t interact with a specific political campaign, they can directly buy ad time to support a candidate.
For example, a wealthy corporation can’t approach a candidate and ask a candidate, "would you like a check, or would you like the corporation to purchase a television commercial supporting your position on foreign policy?" says Edward Foley, law professor at Ohio State University College of Law and director of the election law program. Under campaign-finance law, this situation would not be considered an independent expenditure because it is made in consultation with the campaign and is functionally the equivalent of a campaign contribution. This ruling has the ability to affect both state and federal election laws. The Court specifically wrote that corporations should have greater First Amendment freedoms, so even if a state law says that it doesn’t want corporations spending money on the governor’s election, today’s decision would invalidate that ban.
Justices Stevens, Ginsburg, Breyer, and Sotomayor dissented. In their dissent, written by Stevens, the minority expressed its concern with increased corruption in politics. Stevens implied that big money can breed corruption, and the fact that the majority never addressed corporate corruption in its opinion makes him concerned. In a hearing today, Stevens said that corporations should not be given the same level of First Amendment protection for one simple reason—they aren’t human. Corporations don’t vote or run for political office, so they shouldn’t be placed on the same level as a U.S. citizen.
Last week, the Gaggle playfully mused that the outcome of this case could affect large-scale events, like the Super Bowl. Corporations have deep pockets to purchase expensive advertising spots like the coveted Super Bowl commercials. Now that the floodgates have opened for businesses to spend money on federal and presidential campaigns, our prediction might soon be reality.
Foreign Money in American Politics?
Some election lawyers believe that last week's landmark U.S. Supreme Court opinion may have opened a new avenue for foreign money to enter the American political system, and that the justices are inviting a repeat of the 1996 Chinese money scandal that bloodied the Clinton administration. Thursday's opinion in Citizens United v. Federal Election Commission allows corporations to spend unlimited amounts on political commercialson the grounds that corporations should be treated just like individuals when it comes to First Amendment rights.
The problem, former Federal Election Commission Chairman Scott Thomas told ABC News, is that it's much tougher to determine whether foreign money is behind a political ad when the check is cut by a multi-national corporation. "There are unfortunately lots of examples where foreign businesses or governments have tried to route money through U.S. subsidiaries and into party coffers," Thomas said. "Now we're permitting businesses to get involved directly in advocacy messaging. There will have to be a lot more scrutiny on the question of whether the money is coming from a foreign source, and whether it can be constrained."
Under current law, foreign nationals cannot donate to political candidates or pay for campaign ads. Concerns that other countries might try to influence American elections are not merely academic. In the late 1990s the Justice Department and congressional investigators uncovered efforts by foreign donors to infiltrate the American political system through donations to the Democratic Party under Bill Clinton. Among those implicated was Johnny Chung, a Clinton fund-raiser who told Federal investigators that a large part of the nearly $100,000 he gave the Democrats in the 1996 campaign came from China.
According to published reports, Democrats had to return another $1.6 million brought in by another prominent Clinton money man, John Huang, after questions were raised about the source of the funds. "It would be a very serious matter for the United States if any country were to attempt to funnel funds to one of our political parties for any reason whatsoever,'' President Clinton said at the time. The FEC tightened its restrictions to make sure foreign individuals could not make contributions. But what's to stop a foreign government from funneling money through an overseas company that has a U.S. subsidiary?
24 States’ Laws Open to Attack After Campaign Finance Ruling
In Wisconsin, conservative and pro-business groups said Friday that they were considering a lawsuit to block a proposed law that would ban corporate spending during political campaigns. In Kentucky and Colorado, lawmakers looked for provisions in their state constitutions that may need to be rewritten. And in Texas, lawyers for Tom DeLay, the former House majority leader, said the pending state campaign finance case against him should be thrown out.
A day after the United States Supreme Court ruled that the federal government may not ban political spending by corporations or unions in candidate elections, officials across the country were rushing to cope with the fallout, as laws in 24 states were directly or indirectly called into question by the ruling. "One day the Constitution of Colorado is the highest law of the state," said Robert F. Williams, a law professor at Rutgers University. "The next day it’s wastepaper."
The states that explicitly prohibit independent expenditures by unions and corporations will be most affected by the ruling. The decision, however, has consequences for all states, since they are now effectively prohibited from adopting restrictions on corporate and union spending on political campaigns. In his dissent to the 5-to-4 ruling, Justice John Paul Stevens highlighted the burden placed on states. "The court operates with a sledgehammer rather than a scalpel when it strikes down one of Congress’s most significant efforts to regulate the role that corporations and unions play in electoral politics," he wrote. "It compounds the offense by implicitly striking down a great many state laws as well."
For now, the decision does not overturn all the state laws in question, but it is only a matter of time, experts said, before the laws will be challenged in the courts or repealed by state legislatures. Since the state laws are vulnerable, it is unlikely that officials will continue enforcing them, experts said. Montana is one of the states that will probably be affected. It has one of the nation’s oldest campaign finance laws, approved by voters in 1912 after a copper baron, William A. Clark of Butte, bribed members of the State Legislature to get a United States Senate seat.
Chris Gallus, a former lobbyist and a lawyer who represents business interests in Montana, said his clients would most likely challenge the statute if it were not stricken. States that can expect to see the biggest and most sudden influx of money are those — like Ohio and Florida — where it is relatively expensive to run campaigns and where races are competitive, said Ray La Raja, a political science professor at the University of Massachusetts, Amherst. He predicted corporate spending would increase in states where control of state governments hangs in the balance. The ruling left many state lawmakers frustrated and uncertain how to proceed.
"It’s absolutely outrageous and we’ve got to find a way to deal with it," said Michael E. Gronstal, the Senate majority leader in Iowa, where lawmakers were exploring how they might keep at least some of the restrictions on political expenditures in the current state law. The decision could also affect pending trials, like that of Mr. DeLay, who was charged in 2005 with criminal violations of state campaign finance laws and money laundering. "The money laundering and conspiracy to commit money laundering charges will definitely be undermined," said Dick DeGuerin, Mr. DeLay’s lawyer. "The reason is that the foundation of the prosecution’s argument is that corporate donations are illegal in any part of the political process, but the Supreme Court just struck that idea down."
But Carl Bryan Case, the director of the Appellate Division at the Travis County District Attorney’s Office, which is handling Mr. DeLay’s case, disagreed. "The indictments against Mr. DeLay describe corporate contributions to a political campaign," he said. "What the Supreme Court addressed was independent expenditures made by third parties on their own and without having to do with campaigns." Alan Schneider, the state prosecutor in Grand Traverse County, Mich., said he was concerned about his continuing criminal investigation of Meijer Inc.’s actions in a 2007 recall election. "We’re going to have to shift our focus entirely," he said.
The court’s decision effectively overturns the section of the Michigan Campaign Finance Act that prohibits corporate financing of candidate campaigns, Mr. Schneider said. Meijer is accused of illegally funneling tens of thousands of dollars to groups to try to depose the township board in Acme Township in a 2007 recall election. "Unfortunately, we now have to drop the felony charges we were pursuing and only go after the misdemeanors," he said. "It’s frustrating."
David Primo, a political science professor at the University of Rochester, counseled caution about predicting the impact of the Supreme Court decision. While it grants corporations and unions new access, it is also likely to spur state officials and campaign reform groups to push for new types of restrictions. "This tug of war will continue as long as we have fundamental disagreements in the country over the role of money in politics," he said. The decision may galvanize reformers to push harder for public financing of elections.
It will also bring new pressure on states to improve their disclosure rules, experts said, since those rules will be one of the only ways left to regulate how corporations and other groups make expenditures in local races. Joseph Birkenstock, the former chief counsel for the Democratic National Committee now with the law firm Caplin & Drysdale in Washington, said states that previously banned corporate expenditures would begin adapting disclosure rules so that the public can get the same information about corporate political advertisements that is currently available for advertisements paid for by individuals or political action committees.
Richard Hasen, an election law specialist at Loyola Law School in Los Angeles, said he expected state judicial races to be especially affected by the Supreme Court decision. In recent years, he said, the states where corporate contributions were permitted saw an explosion in spending in judicial races. With the new ruling, those states and others where such donations were limited or banned are likely to see more money spent on these races. Between 2000 and 2009, spending on state supreme court races across 22 states that had competitive elections was about $207 million, up from $86 million between 1990 and 2000, according Justice at Stake, at watchdog group that monitors money in court races.
Debt Burden Now Rests More on U.S. Shoulders
by Floyd Norris
The United States government borrowed more money than ever before in 2009, but its largest lender — China — sharply reduced the amount it was willing to lend. The United States Treasury estimated this week that during the first 11 months of last year China raised its holdings of Treasury securities by just $62 billion. That was less than 5 percent of the money the Treasury had to raise. That raised its holdings to $790 billion, leaving it the largest foreign holder of Treasury securities — Japan is second at $757 billion and Britain a distant third at $278 billion. But China’s holdings at the end of November were lower than they were at the end of July.
Not since 2001, when China was still a relatively minor investor in Treasury securities, had the country shown a decline in holdings over a six-month period. During the full year of 2009, the volume of outstanding Treasury securities owned by the public — as opposed to United States government agencies like the Federal Reserve or the Social Security Administration — rose by $1.4 trillion, a 23 percent gain, to $7.8 trillion. In dollar terms, that was the largest annual increase ever, but as a percentage increase it slightly trailed 2008. With this week’s release of the November estimate of foreign holdings, China is on course to lend just 4.6 percent of the money the government raised during the year. That compared with 20.2 percent in 2008 and a peak of 47.4 percent in 2006.
The falloff in Chinese purchases did not necessarily cost the American government a lot of money, as interest rates did not soar during the year. Short-term rates actually fell. The yield on 10-year Treasuries rose to 3.6 percent, from 2.2 percent, a substantial increase but still a low rate by historical standards. Some economists have feared what could happen if China ever decided to unload the Treasury securities it owns, but the reduction of Chinese purchases probably did not result from any decision to do that, said Robert Barbera, the chief economist of ITG, an investment advisory firm.
Instead, he said, China’s main determination now was to prevent the rise of its currency against the dollar, and the country needed to buy fewer dollar-denominated securities to accomplish that goal, as the Chinese trade surplus with the United States declined. The figures on foreign holdings estimated by the Treasury Department include both official and private holdings. In China, that is mostly official, but in some other countries many of the holdings are owned by investors or money managers who could be managing portfolios on behalf of people from yet another country. It is possible that some Chinese purchases appear to be from other countries.
Other countries took up part of the slack left by the reduction in China’s purchases. Hong Kong, which is counted separately, took up more than 5 percent of the increased borrowing by the American government, and Japan provided nearly 10 percent. But total foreign purchases in the 11 months financed only 39 percent of the borrowing, leaving American investors to purchase the remainder. As recently as 2007, foreigners were buying more Treasuries than the government was issuing, enabling Americans to reduce their Treasury holdings even as the government borrowed hundreds of billions of dollars.
Fannie, Freddie Losses May Hit U.S.
The U.S. government's move to deepen its ties to mortgage-finance giants Fannie Mae and Freddie Mac by agreeing to absorb unlimited losses for the next three years is igniting a debate over whether it should bring the business operations of the companies onto its books. A decision on how the government treats Fannie and Freddie could have broader political implications. So far, the White House has resisted calls by Republicans to bring Fannie's and Freddie's obligations onto the government's books, a move that could boost the federal deficit by tens of billions of dollars. At a time when the deficit is already at a postwar high, that could create added urgency for Congress and the administration to address the companies' future.
The Congressional Budget Office has reiterated its support for bringing the companies onto the federal budget—and onto the government books—which would effectively mean accounting for their operations in the federal budget as if they were federal agencies. "Recent events clearly indicate a strengthening of the federal government's commitment to the obligations of Fannie Mae and Freddie Mac," the CBO said in a report. The CBO pegged the government's total costs of bailing out the two companies at $291 billion and said the government's takeover could cost an additional $99 billion in the coming decade.
So far, the White House has taken a different tack. It only projects costs equal to the actual cash infusions that the Treasury injects into the companies each quarter to keep them afloat. That tab is currently at $112 billion. The CBO's estimate, as opposed to the White House's, reflects the amount of taxpayer subsidy used by Fannie and Freddie as a result of lower borrowing costs enabled by their federal backing. A Treasury official said the administration had no plans to alter how it accounts for Fannie and Freddie in the federal budget. "I don't anticipate any change," said Assistant Treasury Secretary Michael Barr. "They'll have the same appearance that they've had before in the budget books." A spokesman for the White House Office of Management and Budget declined to comment.
Officials have said it wasn't necessary to bring Fannie and Freddie onto the government books until the administration decided what to do in the long term with them. In September 2008, when the government took over Fannie and Freddie through a legal process known as conservatorship, the Bush administration cited the "temporary nature of the arrangement" in opting against incorporating the obligations of the companies into the federal budget.
But some Republicans say the arrangement has become more than temporary. "These are organisms that have now become a direct arm of the U.S. government and I assume that people who are now buying these securities are looking at them that way," said Sen. Bob Corker (R., Tenn.), in an interview. He asked Treasury Secretary Tim Geithner in a letter earlier this month to explain the rationale behind the "effective nationalization" of the companies, a move that he said "should absolutely be reflected on the balance sheet of the U.S. Treasury."
While such a move would raise the federal deficit sharply, critics of the companies argue it would reflect Fannie's and Freddie's actual risks to taxpayers. "It should have been done years ago," says David Kotok, chairman of Cumberland Advisors, a Vineland, N.J., money-management firm. The debate comes amid growing concerns in Washington over how to limit government spending. The U.S. budget deficit reached a postwar record of $1.4 trillion in fiscal 2009. Republicans also see the budget issue as an opportunity to jump-start a bigger discussion about how to overhaul Fannie and Freddie. "One of the ways you cause there to be a debate about the future is to debate whether they are or are not part of our country's obligations," said Mr. Corker.
The White House said it would weigh in with its proposals on how to reshape Fannie, Freddie and the broader mortgage market when it releases its budget next month. "There's no question that the future structure of the housing market is going to have to be very different from the structure that led Fannie and Freddie to the point of conservatorship," said Lawrence Summers, Mr. Obama's chief economic adviser. "But this is an issue that's going to play out over time."
Most investors already see the companies as effectively guaranteed by the government. Changing the budgeting of the companies "would be an accounting change rather than any fundamental change" that would affect the U.S. government's triple-A credit rating, said Steven Hess, lead U.S. debt analyst for Moody's Investors Service. Moving the companies' assets and liabilities onto the government's balance sheet would bring the companies full circle. Fannie Mae, founded as a government corporation in 1938, was privatized by President Lyndon B. Johnson in 1968 to slash the government's debt obligations in the face of rising costs from the Vietnam War.
Fannie Mae, Freddie Mac Should Be Eliminated, Frank Says
A top House Democrat on Friday said his committee was preparing to recommend "abolishing" mortgage-finance giants Fannie Mae and Freddie Mac and rebuilding the U.S. housing-finance system from scratch. "The remedy here is...as I believe this committee will be recommending, abolishing Fannie Mae and Freddie Mac in their current form and coming up with a whole new system of housing finance," said Rep. Barney Frank (D., Mass.), the chairman of the House Financial Services Committee.
His comments initially rippled through bond markets on concerns that the government might pull away from the mortgage market. Many believe that's unlikely and that any revamp would include continued government involvement. The government took over the companies in September 2008 as loan losses mounted. Some Republicans have argued that the companies should ultimately be reduced in size and privatized, while at other end of the spectrum, some analysts have recommended turning the companies into government agencies. But several industry groups and academics have suggested that the government is likely to continue playing at least some role in the future of the companies.
One such report came from analysts at Standard & Poor's this past week. "It's hard for us to imagine" how enough capital could be attracted to replace Fannie and Freddie with stand-alone private companies that would be able to offer low-cost funding for 30-year fixed-rate mortgages, the analysts wrote. Some analysts have argued that starting from scratch could create more problems than they would solve, in part because Fannie and Freddie own or guarantee around half of the nation's $11 trillion in home mortgages. "Blue sky ideas are great, but they take a long time to happen," said Mahesh Swaminathan, senior mortgage strategist at Credit Suisse, at a conference last month. "When you have $5 trillion of agency mortgages, you can't really orphan them."
Mr. Frank, who didn't elaborate on forthcoming recommendations, said last month that one possible revamp could merge some functions of Fannie and Freddie that overlap with the Federal Housing Administration into the government mortgage-insurance agency. The Obama administration said it will weigh in on how to revamp the companies—and the entire housing-finance system—when it releases its budget next month. Republicans have increasingly criticized the administration for moving to overhaul the financial sector without spelling out plans for Fannie and Freddie.
In a PBS interview on Thursday, Treasury Secretary Timothy Geithner said the legislative process to overhaul Fannie, Freddie and the housing-finance system was unlikely to begin this year. "It's just a complicated thing to get right," he said. "But we are completely supportive and agree completely with the need to make sure that we take a cold, hard look at what the future of those institutions should be in our country."
Fed Officials Rebut Lawmakers' Criticism
The Federal Reserve is ratcheting up its response to congressional criticism in an effort to protect its regulatory authority and autonomy—a move that is softening some attacks but doesn't appear to be enough to win over hostile lawmakers. Fed Chairman Ben Bernanke earlier this week publicly invited congressional auditors to review the Fed's role in the rescue of American International Group Inc. 16 months ago. And the Federal Reserve Bank of New York issued a point-by-point defense of the Fed's decision to pay off AIG's trading partners 100 cents on the dollar.
Trying to blunt charges that the Fed is unnecessarily secretive, Mr. Bernanke and other officials are proclaiming their commitment to transparency. "The notion that the Federal Reserve's financial dealings are somehow kept hidden from the public is a surprisingly widely held view—and it is simply incorrect," New York Fed President William Dudley said in a speech Wednesday. The moves come as some lawmakers push for Congress to audit the Fed's monetary policy decisions and strip the central bank of its role as a major bank regulator.
After the House Oversight and Government Reform Committee subpoenaed the New York Fed for all documents related to AIG's payments to counterparties in advance of a hearing next Wednesday, the bank turned over 250,000 pages of documents and a more detailed rebuttal of criticism of its actions than it had offered previously. The statement, for instance, outlined securities laws, listed the sequence of events and cited relevant e-mails to explain why the Fed initially supported AIG in its decision not to release the identities of its trading partners. The documents didn't satisfy some House lawmakers. The committee's top Republican, Rep. Darrell Issa of California, asked the panel's chairman to require the Fed to produce more documents.
Mr. Bernanke's letter to the Government Accountability Office that the Fed "would welcome a full review by GAO of all aspects of our involvement in the extension of credit to AIG," though not a change in the Fed's position, was welcomed but deemed insufficient by congressional critics. "It's not enough," said Sen. Bernie Sanders (I., Vt.), who is leading the effort in the Senate to expand GAO audits of the Fed to include monetary policy. "They are beginning to catch on that the American people demand transparency. It's clear to me that we've got a lot further to go."
Sen. Jim DeMint (R., S.C.), who also is pushing the GAO measure, said: "It's a positive step but it doesn't relieve the need for a full audit. There are too many things going on for us not to insist on full disclosure." Some Fed critics have seized on the AIG fracas in the debate about confirming Mr. Bernanke for a second four-year term; his current term expires Jan. 31. Sen. David Vitter (R., La.), who also opposes a second term for Mr. Bernanke, called the Fed's latest moves toward transparency "very modest" and said he would "continue to focus on the need for much greater transparency" during the Senate floor proceedings.
Speaking in New York Wednesday, the chairman of the New York Fed's board, Denis Hughes, president of the New York AFL-CIO, acknowledged that many in the public believe the Fed "does not work for them" and is a stooge for the financial sector. But Mr. Hughes said that by helping create stability on Wall Street, the Fed has been "a system that's worked very well" for the nation as a whole. There is, he added, "a real danger" that a misguided Congress, supported by an angry public and uninformed news media, will do something that "will change the Federal Reserve system in a way that will make it inefficient" in its role of creating stability. It's possible that by the time Congress is done, the Fed could even be "irrelevant," he warned.
Mr. Bernanke in recent weeks has been meeting with senators to bolster the Fed's arguments for why it should maintain and expand its role in bank supervision. Some Fed officials, like some Wall Street executives, are voicing contrition to assuage a critical public. In his speech, Mr. Dudley took some blame for missing the crisis. "The Fed and other regulators, here and abroad, did not sufficiently understand the importance of some of the changes in our financial system....With hindsight, the regulatory community undoubtedly should have raised the alarm sooner," he said.
The End Game: This Time Isn't Different
by Van R. Hoisington and Lacy H. Hunt, Ph.D.
Hard Road Ahead
The U.S. is facing a long and difficult road as it attempts to correct the over-indebtedness and wasteful expenditures of the past two decades. Both current and historical research help us to understand where we are in the continuing economic crisis, and to put it in perspective.
The brilliant U.S. economist Irving Fisher first highlighted the fact that an economy's debt level could have a deleterious impact on economic growth if it is, in fact, excessive. At $3.70 of debt for every dollar of GDP, U.S. debt is excessive (Chart 1). Fisher pointed out that the unwinding of debt levels results in prolonged economic distress, and we certainly agree. In 2009, the book This Time is Different - Eight Centuries of Financial Folly, by Reinhart and Rogoff, shed new light on the role of debt by compiling a database that looked at financial crises in 66 countries over a period of 800 years. The main standard in explaining more than 250 crises studied is whether debt is excessive relative to national income, even though idiosyncrasies apply in each case. They reiterate that this old rule (excessive debt) continues to apply, and this time is not different.
Research and the Deflation Risk
We glean five important factors from this work that pertain to our present situation. First, financial imbalances occur when aggregate domestic debt is excessive relative to income, regardless of whether the government or private sector is accumulating the debt. Once debt becomes excessive, countries do not grow their way out of the problem; they must go through the time consuming and often painful processes of debt repayment and increased saving.
Second, whether the domestic debt is externally or internally owed is not as critical as the excessiveness of the debt.
Third, government actions, even involving sizeable sums of money, are far less helpful than they appear. As the book states, "Infusions of cash can make a government look like it is providing greater growth to its economy than it really is."
Fourth, Reinhart and Rogoff cover countries in debt crisis with a host of different conditions, such as growth and age of population, political regimes, technology status, education, and other idiosyncratic features. Nevertheless, economic damage as a result of extreme over-leverage has remarkably similar results, whether the barometer of performance is economic output, the labor markets, or asset prices.
Fifth, further increasing leverage to solve the problem only leads to greater systemic risk and general economic underperformance.
The real question for financial participants is whether all these influences result in inflation or deflation, and the authors' research details both outcomes. As is widely feared here in the U.S., they outline that many countries have had the right circumstances and mechanisms to inflate away their debt overhang, and, in fact, have done so by debasing their currency. Those particular circumstances are not currently present in the United States.
According to Reinhart and Rogoff the norm is that major economic contractions lead to deflation. Importantly, they call our present economic circumstances the "second great contraction."
Thus, not only has the historical "qualitative" research on the subject of deflation chronicled the deflationary impulses emanating from overindebtedness (Fisher's 1933 "Debt-Deflation Theory of Great Depressions"), but also modern "quantitative" methods have now essentially confirmed this conclusion. Over-indebtedness and major contractions lead to deflation.
Debt Overwhelms Monetary Policy
It has been more than a year since the Federal Reserve began a massive expansion of Federal Reserve Bank credit, from $1 trillion to $2.2 trillion, flooding the banking system with reserves. This unprecedented action naturally raised inflationary fears since it was assumed that this was the beginning of a monetary creation process which would eventually lead to job and income growth, excessive expenditures, and finally massive price increases.
If the economy were not in the throes of writing down bad debts that were caused by a massive decline in asset prices, it is possible that the money supply (M2) in response to this increase in reserves could have expanded by $4 trillion, or 96%. According to the late Nobel prize winning economist Milton Friedman, an increase in M2 of that magnitude would have been highly inflationary. However, M2 did not explode. Instead, in the past twelve months this aggregate has risen only 3%. This is less than 1/2 of the average growth rate over the past fifty years (Chart 2).
If, as Friedman assumed, the velocity of money is stable (MV=GDP) then nominal GDP expansion in the ensuing quarters can be expected to grow about 3%. If prices rise about 1.5%, then real GDP growth would also rise about 1.5%, which is far below the level of growth needed to employ new labor force entrants and existing unemployed or to more fully utilize our present unused capacity in our factories. In the last six months the growth rate of M2 has slowed to near zero. If this pattern continues, it would be rational to expect GDP to grind to zero with no change in the price level.
The very first step toward an inflationary cycle has to be to get the monetary aggregates expanding vigorously. That cannot be accomplished with the Fed "printing money", i.e., adding more reserves into banks that cannot or will not make loans. The reason this process has not begun (and will not for a time) is the overhang of excessive indebtedness and asset price depreciations. No one needs to borrow, or has the resources or balance sheet to borrow, and banks are busily writing off bad debt. Irving Fisher warned of that process (note our Third Quarter 2009 quarterly letter).
Over-indebtedness Creates Excess Supply
Despite the concurrent developments of little money growth and declining loan growth (Chart 3), the fear nevertheless remains that an inflation surprise might be just around the corner. The reason to discount this notion is that excessive debt has contributed greatly to a flat, or perfectly elastic aggregate supply curve. A country's inflation is determined by the interaction of aggregate supply and demand. Friedman wrote that a large increase in money in the hands of the non-bank public would be inflationary because he assumed a normal upward sloping aggregate supply curve (Chart 4). In this case the aggregate demand for goods (depicted as the demand curve Line A) would shift outward to Line A1, and thus prices would naturally rise. You will note what happens to prices if a demand curve B is intersecting the supply curve in the so-called Keynesian range where it is flat. If aggregate demand increases to B1, prices do not change.
Whether the supply curve is in a flat, normal, or upward sloping position depends on the extent of excess resources in the economy. Today it is obvious that the U.S. economy has plentiful excess resources, so any increase in demand will result in little price change. This will be the case until our unemployment rate of over 17% (the U6 measure) drops by a considerable amount and we begin to use our factories well above our current 68% utilization rate.
Thus, our current economic circumstances guarantee there will be no surprise inflation. Employing those who are out of work and fully utilizing our resources will be a slow process. More importantly, it will take time to get the monetary engine reignited. Banks will have to begin lending and people and companies will have to determine that prospects are good enough to take the risk for expansion and investment. It will take years for these processes to get started because of our over-indebtedness and falling asset prices.
The consequences of excessive debt are already painful at the household level. The civilian employment to population ratio, a highly important barometer of the average household's standard of living, fell to 58.2% in December, the lowest reading in 26 years and down from a peak of 64.7% in April of 2000 (Chart 5). Thus, the standard of living has worsened as the debt to GDP ratio has marched steadily higher. With debt to GDP still rising, a further deterioration of the standard of living is inescapable.
Debt and Fiscal Policy
Deficit spending only provides a transitory boost to the economy. It initially raises GDP, as it did in the second half of 2009, but then the effect dissipates and later is reversed, as financial resources available to the private sector are reduced. In a separate research study Rogoff and Reinhart write, "At the height of Japan's banking crisis in the 1990s, repaving the streets in Tokyo became a routine exercise. As a result, Japan's gross (government) debt-to-GDP ratio is now nearly 200% and a drag on what once was a vibrant economy." Our present high deficit situation suggests that taxes will rise (including those of state and local governments), depressing economic activity further. In addition to the expiration of the 2001 and 2003 tax cuts, the Obama administration is proposing substantial taxes on financial institutions to pay for the cost of the financial bailout. Since the tax multiplier is high, this will reinforce the drag on economic activity from the lagged effects of deficit spending.
Since 1990 Treasury bond yields have steadily moved downward in line with a more benign inflationary environment (Chart 6). Those yearly declines in yields continued last year with an average interest rate of 4.07% versus 4.28% in 2008. Obvious sharp reversals have occurred in their downward trend due to shifts in psychology reacting to generally transitory factors, as we saw in 2009. To remain fully invested in long Treasuries in this high volatility environment requires a simple discipline based on the academic literature which demonstrates that over time bond yields move in the same direction as inflation (Fisher equation).
Presently, we view the inflationary environment as benign because: 1) the U.S. economic system is overleveraged and academic research confirms that this circumstance leads to deflation; 2) monetary policy is, and will continue to be, ineffectual as efforts to spur growth are thwarted by declining asset prices, loan destruction, and adverse regulatory influences; 3) the federal government's spending spree will necessarily cause taxes and borrowings to rise, further stunting any economic growth. These factors ensure that inflation will be quiescent. Interest rates easily can and do rise for short periods, but remaining elevated in a disinflationary environment is contrary to the historical experience. We are owners and buyers of long U.S. Treasury debt.
Ilargi: Please note that AIG counterparties were paid off in full on Novermber 25 2008, one whole day after Geithner was named Treasury Secretary by Obama, and was ostensibly recused from direct involvement with the procedures ("working on issues involving specific companies, including AIG"), even though he was still boss of the New York Fed, which had never done anything involvng this kind of money, ever. As to how credible that is, you do the math.
AIG, New York Fed Pay Banks in Full, Limit Disclosure: Timeline
American International Group Inc., the bailed-out insurer, included the word "redacted" more than 1,000 times in regulatory filings tied to agreements for paying banks that bought credit-default swaps from the company. The insurer, asked by the Federal Reserve Bank of New York to limit disclosure, excluded a list of banks and collateral postings from a pair of 2008 filings, and then sought confidential treatment for the document in 2009 before making redacted versions available to the public.
The House Oversight and Government Reform Committee has ordered the New York Fed to turn over e-mails and phone logs from Timothy F. Geithner tied to AIG’s rescue in 2008, when he led the regulator. Lawmakers have criticized AIG’s rescue, which swelled to $182.3 billion, as a "backdoor bailout" of banks including Goldman Sachs Group Inc., and Geithner, now Treasury secretary, agreed to testify before the panel. Below is a timeline outlining New York-based AIG’s disclosures along with comments from the New York Fed and the Securities and Exchange Commission to the insurer.
Nov. 10, 2008: AIG says the New York Fed will contribute as much as $30 billion to a facility to retire credit-default swaps sold by the insurer to protect banks from losses on securities tied to subprime mortgages. The insurer will contribute as much as $5 billion, and the facility, named Maiden Lane III, will buy about $70 billion in collateralized debt obligations from the banks that bought protection, AIG says.
Nov. 11, 2008: Elias Habayeb, then-Chief Financial Officer of AIG’s Financial Services division, e-mails executives that he wants to clear up "confusion" about the price the company will pay to retire derivatives. "The Fed offered all counterparties par," Habayeb says. "I think we should be clear on that point." Nicholas Ashooh, then-senior vice president in charge of AIG’s communications, replies to Habayeb that his proposed explanation "would be very helpful, but I understand that the Fed is very sensitive and we have to clear it with them."
Nov. 24, 2008: Geithner is nominated for Treasury secretary by President-elect Barack Obama. Geithner is recused from "working on issues involving specific companies, including AIG," a Treasury spokeswoman later says.
Nov. 25, 2008: Maiden Lane III begins buying CDOs from AIG’s counterparties.
Dec. 2, 2008: AIG submits a regulatory filing detailing the terms of the Maiden Lane III agreement. The filing contains a so-called shortfall agreement between Maiden Lane III and AIG listing terms of payments should the vehicle need more funds. The accord refers to Schedule A, the document listing counterparties, collateral postings and market declines on the derivative contracts. The Schedule A isn’t included.
The filing states that on Nov. 25, "ML III bought approximately $46.1 billion in par amount of Multi-Sector CDOs through a net payment to CDS counterparties of approximately $20.1 billion, and AIGFP terminated the related CDS with the same notional amount. The aggregate cost of the purchases and terminations was funded through approximately $15.1 billion of borrowings under the Senior Loan, the surrender by AIGFP of approximately $25.9 billion of collateral previously posted by AIGFP to CDS counterparties in respect of the terminated CDS and AIG’s equity investment in ML III of $5 billion."
Dec. 21, 2008: AIG sends a draft of its regulatory filing detailing the purchase of additional CDOs to New York Fed lawyers. "Counterparties received 100 percent of the par value of the Multi-Sector CDOs sold and the related CDS have been terminated," the draft says.
Dec. 23, 2008: The New York Fed sends AIG a marked-up version of the filing draft, crossing out the explanation of AIG paying 100 percent. The New York Fed also crosses out a reference to an amendment of the company’s shortfall agreement and asks if including the amendment is "necessary or helpful?"
Dec. 24, 2008: AIG submits filing saying it retired another $16 billion in credit-default swaps after buying the underlying securities through Maiden Lane III, bringing the total collateralized debt obligations purchased to about $62 billion. The filing omits the sentence that said "counterparties received 100 percent." The filing has the amendment to the shortfall agreement, which mentions Schedule A without including it.
Dec. 30, 2008: The SEC writes a letter to then-Chief Executive officer Edward Liddy telling AIG to provide a Schedule A for the shortfall agreement in its Dec. 24 and Dec. 2 filings. "You are required to file the entire agreement, including all exhibits, schedules, appendices and any document which is incorporated in the agreement," the SEC’s letter says.
Jan. 13, 2009: Peter Bazos, an outside lawyer for the New York Fed, writes to AIG in an e-mail, asking the company to "Please omit/redact the column headings included in the Schedule" in an amendment of the Dec. 24, 2008, filing. Diego Rotsztain, then an outside lawyer for the New York Fed, writes the company an e-mail saying "AIG should be getting a call from the SEC to discuss the special procedures to be followed in connection with the submission of the confidential- treatment request."
Jan. 14, 2009: Anthony Greco, an outside lawyer representing AIG, writes to Bazos and asks, "We will defer to you on this, but could you please provide us the basis for the headings being confidential? The letter appears to be directed towards the information contained in the columns as opposed to the headings themselves." AIG files an amendment to the accord. In the page available to the public with the headline "Schedule A to Shortfall Agreement," the insurer excludes the table listing banks, writedowns and collateral postings. "The confidential portion of this Schedule A has been omitted and filed separately with the Securities and Exchange Commission," AIG says in the filing. "Confidential Treatment has been requested for the omitted portions."
Jan. 27, 2009: Geithner is sworn in as Treasury secretary and will be replaced at the New York Fed by William Dudley.
March 5, 2009: Senators including Christopher Dodd, a Connecticut Democrat, tell Federal Reserve Vice Chairman Donald Kohn that the regulator should reveal the banks that bought credit-default swaps from AIG. "We need AIG to be stable and to continue in a stable condition," Kohn tells a Senate panel. "And I would be very concerned that if we gave out the names of counterparties here, people wouldn’t want to be doing business with AIG."
March 12, 2009: Kathleen Shannon, an AIG deputy general counsel, writes to the insurer’s executives in an e-mail about the conflicting pressures from the New York Fed and SEC regarding amendments to the filings. She says she believes the New York Fed doesn’t want the insurer to include names of the tranches of the securities tied to the swaps or their Committee on Uniform Securities Identification Procedures numbers, or CUSIPs.
"In order to make only the disclosure that the Fed wants us to make," Shannon writes, "we need to have a reasonable basis for believing and arguing to the SEC that the information we are seeking to protect is not already publicly available." AIG’s then-General Counsel Anastasia Kelly e-mails the New York Fed a draft of a letter to the SEC saying that the insurer intends to withdraw its request for confidential treatment because some of the information had been reported by the media.
March 13, 2009: New York Fed lawyer James Bergin writes an e- mail to the New York Fed and AIG executives that he wants to set up a 2 p.m. conference call with the insurer and the SEC. "AIG is still confirming their comfort with certain of the redactions we’d like made on the 8-K schedule," Bergin writes. Bergin writes in a separate e-mail that "I’d suggest also we have a call among AIG and FRBNY prior to the 2 p.m. so that we have our ducks in a row."
March 15, 2009: AIG, under pressure from regulators, releases a statement that discloses the names of its counterparties, which includes banks such as Goldman Sachs and Deutsche Bank AG. The counterparties received about $50 billion in forfeited collateral postings and Maiden Lane III payments since the Sept. 16, 2008, rescue, the statement says. The statement lists a sum of payments to each bank. It doesn’t identify the securities tied to the swaps or list the value of individual purchases by the banks.
March 16, 2009: AIG amends its Dec. 2 and Dec. 24 filings to include a list of derivative transactions and the insurer’s counterparties. The updated Dec. 2 filing includes a Schedule A that lists the names of counterparties on about 165 contracts, while the amended Dec. 24 filing includes about 180 contracts. AIG redacts the notional value of the trades, market declines, collateral posted, tranche names and CUSIPs. Each of the Schedule A documents includes the word "redacted" more than 800 times.
April 28, 2009: New York Fed posts a portfolio breakdown for Maiden Lane III on its Web site. The summary includes the value of assets that are tied to residential- and commercial-mortgage- backed securities and credit ratings for the holdings.
May 15, 2009: AIG amends its Dec. 2 and Dec. 24 filings to include the lists of collateral postings and mark-to-market losses on derivatives contracts. The amended Dec. 24 filing also includes the CUSIPs, tranche names and notional amounts for 10 contracts. The word "redacted" appears more than 400 times in each filing.
May 22, 2009: AIG may withhold the redacted information from Schedule A until Nov. 25, 2018, a decade after the date when Maiden Lane began purchasing assets, the SEC says. The information "qualifies as confidential commercial or financial information under the Freedom of Information Act," based on statements from AIG, the SEC says in a letter.
Nov. 17, 2009: Neil Barofsky, the special inspector general charged with policing the Troubled Asset Relief Program, says disclosure of swaps details didn’t bring on the "dire consequences" that Kohn said could accompany its release. "Notwithstanding the Federal Reserve’s warnings, the sky did not fall; there is no indication that AIG’s disclosure undermined the stability of AIG or the market," Barofsky wrote in a report. "The default position, whenever government funds are deployed in a crisis to support markets or institutions, should be that the public is entitled to know what is being done with government funds."
Jan. 7, 2010: Bloomberg reports that e-mails obtained by Representative Darrell Issa show the New York Fed pressed AIG to withhold details from the public about the insurer’s payments to banks.
Jan. 8, 2010: Thomas Baxter, general counsel of the New York Fed, writes to lawmakers saying efforts to limit AIG’s disclosure "did not warrant" Geithner’s attention.
Jan. 13, 2010: Edolphus Towns, the New York Democrat who is chairman of the oversight committee, subpoenas Geithner’s e- mails, phone logs and meeting notes tied to the bailout of AIG.
Jan. 19, 2010: The New York Fed produces more than 250,000 pages of documents in response to the House subpoena. The regulator says that it "assisted AIG in ensuring the accuracy of its disclosures and protected important U.S. taxpayer interests." AIG was responsible for its disclosures, and the New York Fed asked AIG to remove a reference to the bank payments because it wasn’t "precisely accurate," the regulator says in a statement.
Exiting New Jersey's Fiscal Nightmare
"I'm gonna govern like a one-termer." That’s the promise of New Jersey’s Chris Christie, who became New Jersey’s 55th governor this week. If true, it’s a welcome development, because fixing New Jersey’s fiscal mess isn’t a matter of mere accounting. It will require tackling institutionalized corruption head on. The Garden State’s budget has been crippled by spending schemes that largely benefit a well-paid and unionized public sector, itself a creation of New Jersey’s entrenched political class.
The magnitude of the damage is daunting. Last year’s $7 billion budgetary shortfall now stands at $8 billion and growing. The fiscal patches of 2009—stimulus money, tax hikes, and program cuts—spent their magic six months into FY 2010. With the nation’s highest property taxes (an average of $7000 per capita), an eight-bracket, progressive income tax, a $45 billion debt load, and the net loss of more than half a million residents since 2000, New Jersey is suffering the painful fallout of its long-running policy of fleecing residents to benefit politically-connected special interests.
Christie’s first challenge is to cut $8 billion. But, as many of his predecessors have discovered, fine-toothed scouring will not contain a budget that has been designed to expand. To get a sense of how intractable New Jersey’s budget has proven to previous reformers, consider the largest category of spending. Forty-one percent of New Jersey’s budget, $13 billion in FY 2009, is dedicated to the Property Tax Relief Fund (PTRF). In 1976 the state Supreme Court ruled that New Jersey’s reliance on property taxes to fund schools disadvantaged poor districts and ordered the state to find supplemental revenues. The legislature complied by creating a nearly-flat income tax and dedicating all of the revenue to providing "indirect property tax relief."
About 78 percent of the fund is spent on the state’s 605 school districts, with nearly half concentrated on 31 court-designated low-income "Abbott districts." Another 6 percent of the fund supplements revenues in New Jersey’s 566 municipal governments and 15 percent is sporadically awarded as homeowner rebates to help take the bite out of individual property tax bills. The fund has failed on all counts. Property taxes have risen every year since 1978. Homeowner rebates, averaging less than $1000 when distributed, do little to dull property tax pain. And in the meantime, the court has continued to monitor the Abbott districts, often with disastrous results. For example, a decision requiring poor school districts to spend as much per pupil as the wealthiest school district has transformed New Jersey’s income tax into an eight-bracket beast with a top rate of 10.75 percent on those earning over a million dollars a year.
In spite of this massive transfer of resources to poor districts, however, outcomes remain abysmal. Since 1998, Camden has received $2.8 billion for its schools and has spent close to $24,000 per pupil. Yet last year, just 18 percent of Camden’s 8th graders scored proficient in math. By contrast, Woodbridge Township has received $169 million in school aid over the period, spending a little more than $10,000 per pupil. Nearly 75 percent of Woodbridge’s middle school students met or exceeded proficiency in math.
The perverse outcomes of such decisions won’t be easily undone. In essence, spending that should have been determined by the legislature has been decreed by the court, which claims it is upholding New Jersey’s constitutional guarantee to provide children a "thorough and efficient" education. The biggest benefactor of Abbott’s spending largesse is the New Jersey Education Association (NJEA), which is adamantly opposed to any attempt to rein in costs.
This is just one of the decades-in-the-making disasters confronting the state. Since 1990 local governments have added 45,500 new jobs. Nearly all of them are represented by one of a dozen unions, which have helped secure some of the plushest public sector jobs in the nation. It’s easy to see how property taxes have grown at twice the rate of inflation over the past decade. A government worker in New Jersey earns an average of $58,963, a police officer averages $84,223 (the second highest in the nation), and six-figure public sector salaries are commonplace. Compare this to neighboring Philadelphia, where the average police salary is $49,000. According to one estimate, of the $23 billion New Jersey raised in property taxes in 2008, $18 billion was spent on police, municipal, and teacher salaries.
The tab for public workers doesn’t end there. Factor in the state’s pension plan, currently under-funded by $34 billion. The New Jersey Taxpayers’ Association calculates pension payouts for the average teacher range from $1.6 million to $2.5 million, per retiree. For the average police officer, that range totals between $3.2 million and $6 million, per retiree. As he takes office this week, Christie’s real challenge is to stop this exploitation of the state’s treasury by the public sector unions. Here are some easy ways to start. He can lead the charge in rooting out obvious public sector excess, such as massive cash payouts for unused leave, and paid time off for holiday shopping.
More difficult but still essential is changing the state’s budget rules. Christie must pull the plug on the Property Tax Relief Fund and reject the state Supreme Court’s Abbott funding requirements. He must return the state to a flatter income tax and put the revenues in the general fund. And finally, he must discontinue the fiction that this immense redistribution of revenues has anything to do with property tax relief. Christie seems serious about his one-term pledge. He once told the unions he may declare a "fiscal state of emergency"—a move the public sector unions call "dictatorial." That would allow him to void former Gov. Jon Corzine’s agreement to double the rate of increase in union salaries in 2011. Christie also has strong words for the NJEA: "They need to get realistic that change is coming." He supports both charter schools and vouchers, noting that competition will force failing schools to "change or perish."
He’s also proposed cutting back on two wasteful programs, the "Extraordinary Aid" and "Special Aid" to municipalities, both of which simply subsidize municipal mismanagement. Another bold policy sign is Christie’s nomination of former Jersey City mayor and outspoken school choice proponent Bret Schundler to serve as education commissioner. These are good signs, but implementation is the hard part—especially in a political climate where patronage and rent-seeking seem to be the explicit goal of most policy makers. Chris Christie has his work cut out for him.
Two Dozen States’ Unemployment Funds in the Red, Nine More Within Six Months
The record 20 million Americans who collected unemployment insurance benefits last year landed on a safety net that was already deeply frayed. A historical compromise has left responsibility for unemployment benefits largely in the hands of states, and they have fulfilled this charge with varying degrees of effectiveness. In a series last summer with public radio’s Marketplace, we reported that only a handful of states had built up reserves sufficient to weather the Great Recession – and forecast a spate of borrowing by states where reserves ran out.
Half a year later, the direst predictions seem to be coming true: So far 25 states have borrowed more than $25 billion to keep benefits flowing after their trust funds ran dry. In many other states the situation is deteriorating fast. Our new unemployment insurance tracker monitors states’ trust funds using the most up-to-date data available on the Web – and projects the health of funds six months into the future. To help readers understand the roots of each state’s fiscal fiasco or success it also pulls together other helpful information and historical data that can be downloaded. According to our projections, Arizona, Colorado, Hawaii, Kansas, Maryland, Massachussetts, New Hampshire, Tennessee and Vermont will find themselves in the red within six months.
And while states’ poor fiscal planning is a serious topic on its own, our tracker also follows the increasing human toll: so far businesses in 36 states face tax increases this year, ranging from a few dollars per worker to more than a thousand. Six states have moved to cut, freeze or otherwise restrict benefits, a number that is likely to increase. (See our breakdown of states’ projected increase in taxes—and cuts in benefits.) Some states have focused the pain, like Virginia, where unemployed seniors who also receive Social Security face steep benefit cuts. Other states, like Pennsylvania, have taken a broader approach: all unemployment beneficiaries will receive 2.4 percent smaller checks starting this month.
Los Angeles mayor Villaraigosa says no bankruptcy for the city
With city officials declaring that "bankruptcy is not an option," Mayor Antonio Villaraigosa released a long-term plan for the city's finances Thursday, including several billion dollars in potential savings and possible layoffs of 1,000 workers. In a letter to City Administrative Officer Miguel Santana, the mayor and City Council leaders called for the start of steps needed to make layoffs and perform studies on dealing with this year's continuing shortfall of $200 million and the projected $400 million deficit for next year.
"This mayor has no interest in going down the road to bankruptcy," said Deputy Mayor Matt Szabo, who has been assigned the task of developing the overall financial strategy for the city. The five-page letter from Villaraigosa, also signed by Council President Eric Garcetti and council members Bernard Parks, Jan Perry, Greig Smith and Dennis Zine, sets the stage for a series of decisions to reduce spending in the city's $7.01 billion budget. There are no plans to ask voters for a tax increase, but the mayor is looking at whether a ballot proposal will be needed to reform the city's pension system. "We are looking at a three-year series of recommendations that will try to end the structural deficit the city has had for years," said Benjamin Ceja, the mayor's budget director.
Santana's office also released a report showing the city's revenues continue to decline, particularly in consumer-sensitive areas such as hotel and sales tax. Also, holiday season sales were much less than expected. Part of the problem for the city is that although there is general consensus that the economy has begun to improve, local government is the last area to see any benefit. Szabo said the mayor was trying to change the cycle in which the budget is presented - normally on April 20 - and include the council earlier in decisions because of the city's financial problems. Parks, who chairs the Budget and Finance Committee, is planning a series of public hearings around the city, with the first scheduled for 6p.m. Monday at Van Nuys City Hall. The city also has been conducting an Internet survey on what the public would prefer to see cut.
Proposals for between now and July 1 call for layoffs and cuts in nonessential services. "We will consider the elimination, consolidation or outsourcing of city assets and services, furloughs and layoffs where permissible," the letter said. The city already has had layoffs for some workers but avoided additional layoffs this year with an Early Retirement Incentive Program made available to 2,400 workers. The letter asked that ERIP be extended to an additional 363 workers. Cuts in service and outsourcing being considered could be for services like cleaning restrooms at parks, Szabo said. "We are focusing our attention on what services must be performed by a city worker," Szabo said. "No one is going to argue that police and fire services should be contracted out. That is a core city service. Other services the public demands, we might be able to provide cheaper."
Options looked at for the long term include either the sale or private operation of assets such as parking facilities, golf courses, the Los Angeles Zoo, Animal Services and the Van Nuys and Ontario airports. The city also is looking at eliminating some departments and consolidating others. "But we are not looking to public-private partnerships to be a one-time benefit," Szabo said. "It would have to be a long-term benefit to the city. We have seen Sacramento do that and it is a downward death spiral." Some of these proposals were advanced more than a decade ago by former Mayor Richard Riordan but were blocked by opposition from the public, unions and the City Council.
This year, however, Szabo said he believes there is a different dynamic. "Gridlock and partisanship is not an issue here like it is in Sacramento," Szabo said. "This mayor and this City Council are working together to address our problems." The reduction in employees will involve either laying off workers or transferring them to a city agency that is not financed through the general fund. For example, the Bureau of Sanitation is funded through the trash fee and has a number of vacancies, Szabo said. The city will try to transfer workers from a different city agency to Sanitation to continue a basic service with no cost to the general fund, Szabo said.
Also, he said, the mayor remains committed to the growth of the Los Angeles Police Department. "The mayor's goal is to protect the gains made by the police," Szabo said." The plan also calls on city unions to reopen contract talks. The Coalition of City Unions, which agreed to the ERIP program this year and forgoing cost of living increases for two years, said it was reviewing the letters and believes the city has not done enough to implement the retirement program or other savings. "We found a way to take people off the payroll and the city has not done what it has to do," said Victor Gordo, an official with the Coalition of City Unions. "If the city had acted when we first suggested it, they wouldn't have the problems they face."
Whitney Tilson: I'm Shorting The Hell Out Of Homebuilders Because America Won't Need Any Homes For Years
Whitney Tilson makes a pretty simple, yet solid point against U.S. homebuilders. The U.S. has a massive oversupply of housing right now, as evidenced by the collapse of housing prices. Millions of additional foreclosures are on the way as well. Thus until the U.S. works off its massive oversupply of housing, it won't need any new houses for a long, long time. Thus there will be little work for homebuilders and their employees even if the economy is recovering.
Conveniently, homebuilding stocks such as KB Homes (KBH), DR Horton (DHI), and Lennar (LEN) have rallied quite a bit from their March 2009 lows, even if they've come off from their 52-week highs already. Whitney Tilson has homebuilders as a major short position; it's certainly an idea worth investigating.
Start at 3:00
- "So we think over the next couple of years, there are millions more foreclosures."
- "We're not predicting calamity, but it's going to keep the housing market under pressure."
- "Homebuilding is our single biggest category of short."
- "There's no need for new houses for at least a couple of years in this country."
The Global Debt Bomb
Kyle Bass has bet the house against Japan--his own house, that is. The Dallas hedge fund manager (no relation to the famous Bass family of Fort Worth) is so convinced the Japanese government's profligate spending will drive the nation to the brink of default that he financed his home with a five-year loan denominated in yen, which he hopes will be cheaper to pay back than dollars. Through his hedge fund, Hayman Advisors, Bass has also bought $6 million worth of securities that will jump in value if interest rates on ten-year Japanese government bonds, currently a minuscule 1.3%, rise to something more like ten-year Treasuries in the U.S. (a recent 3.4%). A former Bear Stearns trader, Bass turned $110 million into $700 million by betting against subprime debt in 2006. "Japan is the most asymmetric opportunity I have ever seen," he says, "way better than subprime."
Bass could be wrong on Japan. The island nation (and the world's second-largest economy) has defied skeptics for so long that experienced traders call betting against it "the widowmaker." But he may be right on the bigger picture. If 2008 was the year of the subprime meltdown, 2010, he thinks, will be the year entire nations start going broke.
The world has issued so much debt in the past two years fighting the Great Recession that paying it all back is going to be hell--for Americans, along with everybody else. Taxes will have to rise around the globe, hobbling job growth and economic recovery. Traders like Bass could make a lot of money betting against sovereign debt the way they shorted subprime loans at the peak of the housing bubble.
National governments will issue an estimated $4.5 trillion in debt this year, almost triple the average for mature economies over the preceding five years. The U.S. has allowed the total federal debt (including debt held by government agencies, like the Social Security fund) to balloon by 50% since 2006 to $12.3 trillion. The pain of repayment is not yet being felt, because interest rates are so low--close to 0% on short-term Treasury bills. Someday those rates are going to rise. Then the taxpayer will have the devil to pay.
Whether or not you believe the spending spree was morally justified, you have to be concerned about the prospect of a dismal, debt-burdened fiscal future. More debt weighs heavily on GDP, says Carmen Reinhart, a University of Maryland economist. The coauthor, with Harvard professor Kenneth Rogoff, of This Time It's Different: Eight Centuries of Financial Folly (Princeton, 2009), Reinhart has found that a 90% ratio of government debt to GDP is a tipping point in economic growth. Beyond that, developed economies have growth rates two percentage points lower, on average, than economies that have not yet crossed the line. (The danger point is lower in emerging markets.) "It's not a linear process," she says. "You increase it over and beyond a high threshold, and boom!" The U.S. government-debt-to-GDP ratio is 84%.
We've been through this scenario before. It's especially ugly because we get hit by inflation, too. In the years immediately after World War II inflation surged past 6%, while economic growth flagged and the government-debt-to-GDP level exceeded 90%, note Reinhart and Rogoff. The country worked that ratio down over the next half-century. Now the ratio is shooting up again.
America is a nation of spendthrifts, addicted to easy credit and dependent on the kindness of savers overseas to keep us comfortable. Our retail industry hangs on credit cards and our real estate on 95% financing and the tax rewards for mortgage interest. The personal savings rate has climbed from negative 0.4% in 2006 to a positive 4.5% rate now, but that is still a pathetic figure for a nation whose government is un-saving all that and more with its deficit budget. Politicians on this continent are good at compassion, whether trying to help people stay in their overpriced homes or offering health care to millions of those without it. They are not so adept at nurturing growth.
If the GDP doesn't expand at "normal" rates of 3% to 5% coming out of this recession, wrestling down the debt will be very tough, indeed--perhaps impossible without drastic cuts in spending and higher tax rates on many fronts. The Congressional Budget Office currently projects the fiscal deficit will decline from 10% of GDP next year to around 4.4% from 2013 to 2015. But that assumes economic expansion of at least 4%, not the 2% predicted in the study by Reinhart and Rogoff. You see the vicious cycle here: Debt depresses growth, and then low growth makes paying down the debt an impossible task.
U.S. corporate income tax receipts were down 55% in the year ended Sept. 30, 2009 to $138 billion. It may be a long while before these tax collections get back to where they were. As corporate profits recover, factory utilization will be up and inflation will be close behind. At that point the 0% yield on Treasury bills will be history. Rolling over the national debt will become a lot more expensive. Higher rates on Treasuries will work their way through the debt market, driving up the cost of money for homeowners, businesses and already struggling state and local governments.
"The economy over the last six months has been on a sugar high," says Benn Steil, senior fellow at the Council on Foreign Relations and author of Money, Markets and Sovereignty (Yale, 2009), a survey of the relationship between money and the state. If Congress and the Obama Administration don't trim deficits, he says, "we will get to the point where credit is much more expensive in the U.S. than it ever has been in the past."
Most states are already having trouble paying their bills and, of course, don't have printing presses with which to finance their debts. They are turning to Washington for help and may succeed in putting some of their liabilities on the federal balance sheet. With growing off-balance-sheet obligations, notably unfunded pension liabilities (see graphic in "Debt Weight Scorecore"), the states will be competing for years with the federal government for scarce taxpayer dollars.
"U.S. states are like emerging markets," says Reinhart. "They spend a lot during the boom years and then are forced to retrench during the down years." Cutting expenses sounds good theoretically, but look at California: Students (and faculty) are up in arms over proposed tuition increases and cutbacks at the state's once prestigious university system; state employees are mounting a fierce legal battle against furloughs and other wage concessions.
Mainstream credit analysts are worried. The U.S. has been able to sell vast amounts of debt because the Treasury market, with $500 billion a day in turnover, is considered safe and dwarfs all other debt markets. But Brian Coulton, head of global economics at Fitch Ratings in London, warns that once rock-solid economies like the U.S. and the U.K. could join shakier nations like Japan and Ireland in losing their aaa ratings if they don't get their bad habits under control. "While aaas can borrow in the short term, very high and rising government debt-to-GDP ratios are ultimately not consistent with aaa status," Coulton says.
Governments around the world will issue an estimated $4.5 trillion in debt this year, triple the five-year average for industrial countries.
It's the Total Debt, Stupid
Private banking assets tend to become public problems in a crisis. By that measure European countries are far worse off than the U.S.
A FORBES survey of sovereign credit, taking into account trends in spending and revenue, economic freedom and the price of the debt insurance, a.k.a. credit default swaps, ranks the U.S. number 35 in a class of 85, below Germany, the Netherlands and China. The cds market is priced to imply a 3.1% chance of default over five years on Treasury debt. Other countries are likely to hit the debt wall sooner, and with greater impact. The U.K., for example, is 38 on the list, two notches above Slovenia. One culprit is much higher levels of private banking debt that could land on the British government balance sheet á la Fannie Mae and Freddie Mac in the U.S. The sovereign debt of the U.K., plus the assets of its five largest banks, exceeds 500% of GDP, compared with 200% in the U.S. Even closer to the edge is Ireland. Sovereign debt is at 41% of GDP. But total banking-system assets are another 800% of GDP (see graph above). If those assets sour, the government will almost certainly step in to protect the banking system, as Iceland was forced to do in 2008. Iceland's currency and stock market collapsed soon thereafter, and its president recently blocked a law to repay $5 billion-plus to British and Dutch investors. That move puts at risk a pending bailout package for Iceland from the International Monetary Fund and its application to join the European Union.
Most investors seem to believe, as the late Citibank chairman Walter Wriston put it, that "countries don't go bust." The opposite is true. "There was a massive default wave in 1980s and 1990s," says Reinhart. Investors may not have paid much attention since the defaults were mostly in emerging market countries like Guatemala and Romania. But the deadbeats included current investor favorites like Brazil, which defaulted in 1983, went through a bout of hyperinflation in 1990 and effectively defaulted again, for the same reason, in 2000. Reinhart and Rogoff show that, on average, nations add 86% to their debt loads within three years of a credit crisis. At the same time, government revenue falls an average of 2% in the second year after the onset of the troubles (see timeline, below).
The Stumble Cycle
Sovereign defaults--when a country stops paying its bills--go in waves, often following global financial crises, wars or the boom-bust cycles of commodities. Some countries, like Spain and Austria, mend their ways; others, like Argentina, are repeat offenders.
The combination can be fatal for investors holding bonds issued by financially shaky countries like Argentina or Greece, which sell a lot of their debt outside their own borders (as does the U.S.--45% of all publicly held debt). As a nation's finances deteriorate, foreign investors sell their bonds, putting upward pressure on interest rates. That usually sets off a spiral including a deteriorating currency, which, if the bonds are denominated in foreign currencies, makes it impossible for the country to pay its debt. Greece doesn't have to worry about this last syndrome, because it uses the euro. But that might make things worse since it can't print its way out of its financial difficulties. "It's like entering a prize fight with one hand tied behind your back," Bass says. Argentina takes a different tack. Still struggling in the wake of its 2002 default on foreign-held debt, its president recently tried, and failed, to seize central-bank dollar deposits (and cashier her central banker) in order to repay overseas debt.
Even if countries don't stiff creditors outright, they can sometimes accomplish the same thing through inflation. Reinhart and Rogoff found this to be the case in roughly one-third of the countries they tracked that had currency depreciation rates above 15% a year, following the 1980-81 recession. Of course, this works only for debt denominated in the home currency and only if investors are taken by surprise. If they see inflation and devaluation coming, they price it into the interest they collect.
Making money on sovereign defaults isn't as easy as picking off subprime mortgages. Credit default swaps on potential basket cases like Dubai, Greece and Ukraine have doubled and tripled in price over the past 12 months as their debt loads grew. To buy insurance against a default in Greece over the next five years costs 3.4% a year.
How about Switzerland--once considered an impregnable money center? Credit default swaps on Swiss debt cost 46 basis points (0.46% a year), compared with 33 for the U.S. The Swiss government is not itself deeply in hock, but it may have to bail out its private banks in the manner of Iceland or Uncle Sam. Swiss private-bank debt is seven times GDP. The U.S. isn't a disinterested bystander: The Swiss central bank borrowed $40 billion from the Federal Reserve under a little-known swaps program last year to remove bad assets denominated in dollars from private banks. The Fed considers the transaction low risk because the Swiss promise to repay in dollars. But it signals how losses on private loans--in this case, U.S. subprime mortgages--can cycle back into a problem for the Swiss government. As hedge fund operator Bass notes, a 10% hit on Swiss banking assets would represent 80% of its 2008 GDP of $488 billion and 400% of annual government revenue. "You can invest a very small portion of capital, so if you're wrong it costs very little," says Bass. "If you're right it can pay hundreds of percent."
Shorting countries comes naturally to Bass, 40, who has spent most of his career investigating overvalued stocks and bonds. The son of the onetime manager of the Fountainbleau Hotel in Miami, Bass grew up in Dallas and won a diving scholarship from Texas Christian University in Fort Worth, where he studied real estate and finance.
He spent most of the 1990s at Bear Stearns in Dallas, attracting a group of well-heeled clients who took his advice on shorting stocks like Delgratia Mining Corp. of Vancouver, B.C., which plunged after a highly touted gold find in Nevada turned out to be a hoax.
Around that time Bass learned the danger of betting too much on his own research. He shorted the stock of RadiSys, a telecom technology maker in Hillsboro, Ore., after he called the company's recently departed chief financial officer at home and was told of possible financial irregularities. (None was ever uncovered.) Bass was forced to take steep losses after Carlton Lutz, then an influential stock promoter, called RadiSys "the son of Intel " in his newsletter and the stock doubled. (More recently the company lost $58 million on revenue of $320 million in the 12 months ended Sept. 30.) "Even when you do great investigative work and you understand the accounting, it doesn't matter if you know everything," Bass says. "You can still lose a fortune."
Last spring Bass lost $110 million buying credit default swaps on Portugal, Ireland, Italy and Greece. He may have been right but too early. He is holding on.
His biggest potential score is in Japan. Government debt has soared to 190% of GDP from 50% in the mid-1990s, hitting an estimated $10 trillion in 2009. But because interest rates are so low, the government paid only 2.6% of GDP to service its debt in 2008, less than the U.S. at 2.9%.
Yet low rates mask a growing problem for Japan. The government took in $500 billion in taxes last year, plus another $100 billion in other revenue that included money borrowed by a government investment program. But the Tokyo feds spent $980 billion, including $100 billion-plus on interest and $190 billion or so it transferred to regional and municipal governments. That left a $360 billion hole it could plug only by writing more IOUs, on top of the debt it must roll over each year as bonds mature.
Today Japan can borrow all it wants from its own citizens. Over the decades they have dutifully (if mechanically) piled up a $7.7 trillion cache of savings they keep mostly in low-yielding bank deposits. Those savings equal two-thirds of the total household wealth of Germany, France and the U.K. combined, says John Richards, North American head of strategy at RBS, who spent the early 1990s in Japan trying to build a channel for selling Japanese government bonds overseas (the country still sells but 6% of its debt to foreigners). "You ask how would Japan turn into a sovereign debt crisis and you can't find the trigger," Richards says. "Shorting the yen because you think there's going to be a rollover crisis makes no sense at all."
The trigger could be demographics. Japan's population is aging quickly. Today 22% of Japanese are 65 or older; in 20 years it will rise to 30% or so (compared with a current 13% of Americans and 20% in 2030). At the same time Japan's total population peaked at 128 million in 2004 and has settled into long-term decline.
The Leverage Factor
Total U.S. debt, including banking liabilities, has soared relative to economic growth over the past 20 years.
The combination means Japan's government pension fund has become a net seller of government bonds, while the nation's savings rate has plunged from 18.4% in 1982 to 3.3% today. When that drops to zero, Japan will be forced to look overseas for financing--and risks exposing itself to international rates.
JPMorgan Chase analyst Masaaki Kanno in Tokyo says that Japanese bonds are in a bubble that could pop in the next three to five years, as savings rates drop. Even if the government can somehow keep borrowing at a 1.4% interest rate, he says, interest expense will rise to roughly $200 billion by 2019, or 45% of government revenue, unless it pushes through a big increase in the national value-added tax.
But those rates are unlikely to hold. For years the government has been able to replace bonds paying as much as 7% interest with steadily lower-rate debt. The favorable rollovers ended in 2007, leaving the government much more vulnerable if it has to sell debt overseas, where ten-year rates are two to three percentage points higher than Japan's. If rates rise past 3%--the scenario Bass is betting on--interest expense will exceed total government revenue by 2019.
The process will accelerate if the yen falls and interest rates rise, prompting Japanese savers to pull their money from low-yielding bank accounts, which, in turn, are invested in government bonds. "That will be the beginning of a vicious cycle," Kanno says, when "consumers will realize what is happening" and shift their money to more attractive investments overseas. Bass thinks the crisis will come sooner. For $6 million he has secured options on $12 billion in ten-year government bonds that will pay $125 million if Japanese rates rise to 4%.
"The good news is the wolf's at the door in Japan and that we in the U.S. have front row seats to see what's going to happen," he says. "I hope we learn something from it."
The U.K. Is About To Crash Along With The Sovereign-Default PIIGS
Portugal, Italy, Ireland, Greece, and Spain, are the 'PIIGS', and they're teetering on the brink of sovereign default. Yet the world needs to come up with a new acrononym fast because the U.K. is rapidly joining their ranks. Check out the chart below, taken from a Citi report. It shows each nation's credit default swap spread vs. its 'DDI', which is basically just a measure of financial condition. (Citi: 'The "DDI" averages the debt/GDP ratio and deficit/GDP ratio of each country and calculates each country as a % of the average') The U.K. looks just as bad as the most notorious sovereign debt potential disasters:
UK car production falls 31% amid scrappage scheme
The motor industry today braced itself for a tough year ahead after its trade body announced that British car production fell by 31 per cent in 2009 compared with previous year. In 2009, 999,460 cars were produced, more than three quarters of which were exported, according to The Society of Motoring Manufacturers (SMMT). This compares with 1,446, 619 the year before. The fall was despite a rise of 58.5 per cent in December, the biggest increase since 1976, as buyers rushed to beat the return of VAT to 17.5 per cent and take advantage of the remains of the scrappage scheme, which is due to end in February or when the funds run out. In December, the SMMT estimated that there was about £125 million left in the scheme. Car companies have cut back throughout the year on manufacturing as consumer demand faltered, with Honda even stopping production at its plant at Swindon, Wiltshire, for four months from February. General Motors, the US car group, has also cut 350 jobs at its Luton plant.
In the first half of the year, car production declined, but by November it had had risen, by 15.7 per cent, for the first time since September, 2008. Paul Everitt, chief executive of the SMMT, said that year ahead would be "extremely challenging." However, he added: "The significant rise in December vehicle production is welcome news and signals some greater stability across global automotive markets. "The return of economic growth and a competitive exchange rate will help UK producers. Car and commercial vehicle production remain well below pre-recession levels and it is essential that there continues to be a focus on creating more and better-priced finance for businesses and consumers." Meanwhile, commercial vehicle output rose in December for the first time in 17 months, rising 15.6 per cent to 7,271.
Greece will fix itself from inside the eurozone
by George Provopoulos
In recent months, some commentators have argued that Europe’s single currency project is destined to become unstuck. According to this line of reasoning, the fiscal crisis in Greece is unfailingly pushing that country towards an exit from its immutable fixed exchange rate arrangement within the eurozone. Greece, in other words, will suffer the same fate as all undisciplined countries that previously adopted hard pegs, such as Argentina in the early 2000s. Another Greek tragedy, so the argument goes, is waiting to be played out.
This view is based on flawed reasoning. At the heart of Greece’s recent economic problems has been a loss of competitiveness since Greece joined the euro area in 2001. This loss is due to structural weaknesses, including fiscal profligacy in a period of robust growth when fiscal adjustment was called for, and a large government sector, up by 6 percentage points of gross domestic product (to 51 per cent) since Greece joined the eurozone. Rigidities in labour and product markets have contributed to persistently higher wage and price inflation than in the rest of the euro area, undermining competitiveness. Rising fiscal deficits have pushed up borrowing costs, adding to those deficits. The expanded public sector has eroded the export base and exacerbated inefficiency. The net result has been a twin deficit problem – large and unsustainable fiscal and external imbalances.
The problems faced by the Greek economy are extremely serious. However, the key question is whether it will be easier to solve them from inside or outside the eurozone. My answer is that it will be unequivocally easier to solve these problems from within the euro area. Those who argue that Greece will wind up leaving the eurozone believe it lacks the will to slash the structural fiscal deficit and to implement the cost adjustments and structural reforms needed to restore competitiveness. They argue that a devaluation of a new national currency would be like waving a magic wand, thereby restoring competitiveness. But would it?
During the 1980s, Greece had another twin-deficit problem and its own national currency, the drachma. It waved the magic wand twice, with large devaluations of the drachma in 1983 and in 1985, but in the absence of long-lasting structural adjustment and sustained fiscal contraction. The devaluations were followed by higher wage growth and inflation, with no sustained improvement in competitiveness. Speculative attacks against the drachma were avoided only because of strict controls on capital flows, an option that is no longer feasible or desirable. The twin-deficit problem remained. So much for the magic wand of currency devaluation.
Suppose, however, that Greece were to neglect these lessons and adopt a new national currency. What would an exit from the eurozone imply? Here are some likely consequences.
- Any devaluation of the new currency would increase the cost of imports, raising inflation.
- Monetary policy would lack the credibility established by the European Central Bank. As a result, inflation expectations would rise.
- Expectations of further devaluations would arise, increasing both currency-risk?and country-risk premiums.
- The above factors would push up nominal interest rates, leading to higher costs of servicing the public debt and undermining fiscal adjustment, thereby taking resources away from other, productive areas.
- The costs of converting currencies with the remaining members of the eurozone would be re-introduced, inhibiting trade and investment.
- The exchange-rate uncertainty with the euro area would increase the costs of conducting business, further deterring trade and investment.
- Existing euro-denominated debt would become foreign-currency debt. Any devaluation of the new domestic currency against the euro would increase the debt burden.
- Greece would no longer benefit from the economies of scale, including the enlargement of the foreign exchange market, which decreases the volatility of prices in that market, derived from sharing the euro.
The Greek economy currently stands at a crossroads. The fact of the matter is that it will be immensely less costly for Greece to eradicate its problems from within the eurozone. Rather than a Greek tragedy, a more appropriate analogy for the Greek economy stems from Homer’s Odyssey. In that epic, the enchanting sounds of the sirens enticed sailors to jump to their deaths in the sea. Those who suggest Greece might leave the eurozone are like Homer’s sirens. Greece will not be tempted by these short-term options, but will undertake the necessary, bold adjustments. The future of its economy is unwaveringly tied to the mast provided by the euro.
The writer is governor of the Bank of Greece and a member of the ECB Governing Council
Portugal's Make-or-Break Budget
Greece's debt problems have boosted interest in Portugal's 2010 budget plan on Tuesday, which international investors will study for signs of similar fiscal frailty. Portuguese stocks and bonds have been sold off sharply recently because of Portugal's high long-term deficits and low growth prospects. The government of Socialist Prime Minister Jose Socrates faces a deficit that is estimated to have reached 8% of gross domestic product last year and the European Commission has given Portugal until 2013 to bring the deficit below the 3%-of-GDP threshold required by European Union rules.
Late last year, Greece's recognition that its budget deficit was much larger than previously thought triggered a sharp rise in financing costs for that country, as well as others with weakened public finances such as Portugal, Ireland and Spain. Portugal "has seen what happened in Greece, so that might encourage more austerity measures in the [budget] plan," said Sean Maloney, a fixed-income strategist at Nomura in London. "But any flippancy, if you like, in the policies to bring about a better number than in 2009 will be treated with a fair amount of suspicion by the markets. The market isn't just looking for promises in terms of their goals, they're also looking for some nuts and bolts."
International credit ratings companies are similarly skeptical. Last month, Moody's Investors Service and Standard & Poor's Corp. both warned of possible downgrades on Portuguese debt. Moody's then lumped Portugal in with Greece, saying both countries' economies risked a "slow death" as their debt payments rise. In October Moody's changed the outlook on Portugal's Aa2 ratings to negative from stable, citing a "trend growth rate in the [Portuguese] economy that is likely to remain relatively low, thereby limiting the government's ability to grow out of its debt problems."
Portugal has had one of the slowest-growing economies in the EU for years. Since 2001, its economy's performance has lagged behind the average growth in the 16 countries now sharing the euro in every year except for 2001 and 2009. The economy's fastest growth during that period was 2%, in 2001, and it has grown by more than 1% only four of the years in that period, while shrinking in two of them. It has lost low-wage jobs to Eastern Europe and to China in recent years and government steps to address this, including improving the education system, widening the use of the Internet and investing more in research, will take some time to work their way into the economy.
Bank of Portugal Governor Vitor Constancio pointed to the problem in an interview broadcast Friday on CNBC, when he said there's a need for a "change in the productive structure." The government said it plans to freeze public-sector workers' salaries this year. Portugal's biggest opposition party, the Social Democratic Party, has said it will cooperate to cut the deficit, offering key support to a government that lost its absolute majority in national elections in September. Those announcements "constitute clear signs of the government's intentions to start budget deficit reduction in 2010," said Alberto Soares, the head of Portugal's treasury and debt agency, the IGCP, in a statement last week. The spending plan for this year should shave one or two percentage points off the deficit, helped partly by a budding recovery of Portugal's economy and partly by measures taken a few years ago to slash an earlier outsized deficit, economists said.
When Mr. Socrates was first elected prime minister at the beginning of 2005, he inherited a budget plan that would have left the country with a deficit equal to 6.8% of GDP. His government then passed a revised budget that brought the figure in at 6.1% for the year. Tax increases, spending cuts and reforms to the social-security and health-care systems lowered the deficit further to 2.6% of GDP in 2007 and 2.7% in 2008. "They did it in the past, and given the pressure they're under, and the developments in Greece, I'm sure they'll be able to do it again," said Rui Constantino, chief economist at Santander Totta in Lisbon. "It will be difficult, and the macro outlook is uncertain, but they had a much tougher situation in 2005. They definitely need a plan to calm down the ratings agencies for the time being." Part of the expected deficit reduction should come from cyclical factors as the economy slowly starts to recover from last year's recession, slowing the growth in unemployment claims and boosting tax revenue.
Apart from freezing public-sector wages, there are other factors that would help reduce spending. Some of the stimulus spending in the 2009 budget plan is due to run out, and the spending associated with the three elections held in 2009 won't be repeated this year. Wage restraint and the earlier reforms to social security should also make it easier to cut the deficit. "There are two things that might be very helpful, not just for this year but for the long term," said Goncalo Pascoal, chief economist at Banco Comercial Portugues in Lisbon. "One is social security reform. The other is that public workers, civil servants, are much more aware that wage increases will need to be very moderate."
China gets growth and a nasty dilemma
Chinese Premier Wen Jiabao once said 2009 would be China's toughest economic period in fifty years. He wasn't thinking ahead. In 2010, policymakers face a seemingly impossible mission – continuing 2009's growth of 8.7 per cent while curbing resurgent inflation. December's figures show the government is already behind the curve. The annual inflation rate for consumer prices was a seemingly mild 1.9 per cent in December. But that number understates the threat. The consumer price index excludes the rapidly rising cost of property.
And year-on-year changes miss the most recent trend. In the most recent month, prices rose 0.8 per cent – a nerve-racking 10 per cent annualised rate. Food prices, which made up 90 per cent of December's annual CPI increase, are rising fastest. Bad weather doesn't help. But easy money is what turns shortages into much higher prices. Producer prices are now rising at an annualised 11 per cent. Those increases are being passed on to consumers – China's two leading alcohol brands have raised prices by around 10 per cent and Coca-Cola is threatening to follow suit.
Non-food prices are not exempt either. Makers of cars and home appliances face rising costs and are no longer under pressure to cut inventories through cut-price sales, not after respective 58 and 25 per cent revenue increases in December. Price rises look inevitable. Welcome growth and excessive inflation have the same monetary source – a flood of bank lending. A rate hike would now be the best medicine, but it comes with uncertain and possibly hazardous side effects.
Fragile parts of the economy, like private investment and services, could be hurt. Some debt-funded construction projects – there was a mammoth 4 trillion yuan ($586 billion) of infrastructure investment in 2009 – could be delayed. There are other buttons Beijing could push, but they are no more attractive. Revaluing the too-cheap yuan would cut producers' imported commodity bills, protect consumers from some price hikes and curb speculative liquidity from overseas, but at the cost of export jobs. Premier Wen may yet yearn for the halcyon days of "tough" 2009.
Russia diversifies into Canadian dollars
Russia’s central bank announced on Wednesday that it had started buying Canadian dollars and securities in a bid to diversify its foreign exchange reserves. Analysts said the move could be a sign of increased diversification of emerging market central bank assets away from the dollar and into investments denominated in other commodity-linked currencies, such as the Australian dollar.
Adam Cole at RBC Capital Markets said if taken in isolation, Russia’s announcement that it was buying Canadian dollars was not significant, but if it was part of a broader trend, then it was an important step. "If it is a barometer for the activity of other central banks, then its is structurally positive for the currencies of countries like Canada and Australia that have a commodity bias in their economies," he said. Although not officially confirmed, traders said that other emerging market central banks, including some in Asia which hold large foreign exchange reserves, have also been active in the foreign exchange market in recent weeks buying both Canadian dollars and Australian dollars.
Alexei Ulyukayev, first deputy chairman of Russia’s central bank, said that it would invest in Canadian dollar-denominated deposits and bonds. "The Canadian financial market is not very deep, so we can invest in deposits in significant volumes, while the bond market is limited," he said. Although the central bank did not specify how much of its reserves it was allocating to assets denominated in the Canadian dollar, analysts estimated that the central bank could put up to $9bn, or 2 per cent, of its foreign exchange reserves into the currency.
Russia’s foreign exchange reserves, the world’s third largest, stood at $439bn at the end of December. These stockpiles have grown by 14 per cent since the start of the rally on global asset markets in March as rising commodity prices have boosted mineral-rich Russia’s coffers. Ahead of Wednesday’s announcement, Russia’s foreign exchange reserves were evenly split between dollar and euros. Alarmed at the plummeting value of the dollars in its holdings, Russia has been at the vanguard of countries calling for the US authorities to stem the fall of its currency. Last year, along with China, Russia urged the creation of a new supra-national currency to replace the dollar as the world’s reserve currency.
The dollar has fallen more than 12 per cent on a trade-weighted basis since March. Commodity-linked currencies have rallied strongly, however, with the Canadian dollar up 24 per cent against the US dollar over that period and the Australian dollar 40 per cent higher. This has prompted Russia to diversify its holdings. Indeed, in addition to its plans to buy Canadian dollars, Sergei Ignatiev, chairman of the Russia’s central bank, said last month that its was "discussing the possibility" of buying Australian dollars.
But some analysts warned that emerging market central banks might be in danger of buying commodity-linked currencies at the top of the market. "In the long run it makes perfect sense for emerging market countries to diversify into commodity linked currencies," said Simon Derrick at Bank of New York Mellon. "But in the short-term, I would urge caution given that many commodity-linked currencies currently stand at extremely high levels on a historical basis."
Gold: Something’s Brewing
by Brad Zigler
Mornings around here are fragrant: We all wake up to smell the coffee brewing. There's something brewing in the gold market, though, that might not be so pleasant. Lease rates in the London bullion market have risen precipitously. Well, it's not so much that lease rates are rising - they're pretty cheap compared with their year-ago levels - it's more that forward rates are at historic lows. Forward rates determine the pricing of bullion transactions in the over-the-counter market. A decline in forward rates implies one of two things: There's either a scarcity of metal available for swap or lease transactions, or there's heavy forward selling.
So, which is it? Well, we can gather some clues from the COMEX market. The latest Commodity Futures Trading Commission data show commercial accounts engaging in heavy selling and long liquidation. To boot, money managers have built their largest short position since August 2009 (and, if you're a contrarian, small speculators have taken up their strongest long position in a year and a half). Given all that, the aroma wafting from the gold market seems to be a harbinger of a sell-off. Technically, gold's stalled now. Key support for the February COMEX contract sits at $1,120 after bulls backed off from a test of the halfway point for the contract's December swoon. A close below that level makes the sell-off case.
If February's price closes below the $1,111 level, the December low at $1,075 then becomes the bears' target. No guarantees, of course, but at that point, bulls will have to consider how much they're in love with a four-figure gold price. How's that smell?
Ominous lessons of the 1930s for Europe
by Paul De Grauwe
The Great Depression taught us several lessons. The first one is that central banks must be ready to provide ample liquidity to save the banking system. Present-day central banks did exactly that. They did not repeat the mistakes of the 1930s when their predecessors tightened money in the face of a banking crisis. The second lesson is that governments should not try to balance the budget when economic activity collapses. Governments today did not repeat the mistakes made by many governments in the 1930s that desperately tried to balance their books when the economy crashed.
There is one area of policymaking where authorities may not have learned the lessons of history and are in the process of repeating the same mistakes. During much of the 1930s a number of continental European countries, the so-called gold bloc countries (France, Italy, Belgium, the Netherlands and Switzerland) kept their currencies pegged to gold. When in the early 1930s Great Britain and the US went off gold and devalued their currencies, the gold bloc countries found their currencies to be massively overvalued. This had the effect of depressing their exports and of prolonging the economic depression in these countries.
It is remarkable to see that the same mistakes are being repeated today involving some of the same countries as during the 1930s. This time it is again the continental western European countries tied together in the eurozone that have seen their currency, the euro, become strongly overvalued. The two countries that in the 1930s responded to the crisis by devaluing their currencies, the US and the UK, today have also allowed their currencies to depreciate significantly. Since the start of the financial crisis the pound has depreciated against the euro by about 30 per cent. After having strengthened against the euro prior to the banking crisis of October 2008, the dollar has depreciated against the euro by close to 20 per cent.
Thus, as in the 1930s, the dividing line is the same. The US and the UK have allowed their currencies to depreciate; the continental European countries tied in the euro area have allowed their currency to become significantly overvalued. Even the numbers are of the same order of magnitude. During the 1930s the overvaluation of the gold-bloc currencies amounted to 20 to 30 per cent. Today, the euro is overvalued by similar percentages against the dollar and the pound. Why do the euro area countries repeat the same policies as the gold bloc countries in the 1930s?
The answer is economic orthodoxy. In the 1930s it was the orthodoxy inspired by the last vestiges of the gold standard. Today the economic orthodoxy that inspires the European Central Bank is very different, but no less constraining. It is the view that the foreign exchange market is better placed than the central bank to decide about the appropriate level of the exchange rate. A central bank should be concerned with keeping inflation low and not with meddling in the forex market. As a result, the ECB has not been willing to gear its monetary policy towards some exchange rate objective.
Just as in the 1930s, the euro area countries will pay a price for this orthodoxy. The price will be a slower and more protracted recovery from the recession. This will also make it more difficult to deal with the internal disequilibria within the eurozone between the deficit and the surplus countries that Martin Wolf described so vividly in these pages.
One could object to this analysis that the central bank is powerless to affect the exchange rate. This is a misconception. A central bank can always drive down the value of its currency by a sufficiently large increase in its supply. And that is what the US and the UK have done with their policies of quantitative easing that have gone farther in flooding the US and UK money markets with liquidity than in the euro area. True, since the start of the crisis, the ECB has injected plenty of liquidity in the euro money markets to support the banking system. Yet it has been much more timid than the US Federal Reserve and the Bank of England in creating liquidity. While the latter more than doubled the size of their balance sheets since October 2008 and thereby more than doubled the supply of central bank money, the ECB’s balance sheet increased by less than 50 per cent.
Such an imbalance in the expansion of central bank money inevitably spills over in the foreign exchange markets. The massive supply of dollars and pounds created by the US and UK monetary authorities was transmitted to other financial markets in search of higher yields and in so doing put upward pressure on the value of the euro. Thus the greater timidity of the ECB in providing liquidity is an important factor explaining why the euro has rallied since the start of the banking crisis and why it is now excessively overvalued.
Ultimately a central bank has to make choices. The Fed and the Bank of England have opted for massive programmes of liquidity creation, attaching a low weight to the possible inflationary consequences of their actions. The ECB has been more conservative in its liquidity, creating programmes attaching a low weight to the consequences for the exchange rate and to the chances of a quick recovery. The future will tell us which of these choices was right.
The writer is professor of economics at the University of Leuven
One quarter of US grain crops fed to cars - not people, new figures show
One-quarter of all the maize and other grain crops grown in the US now ends up as biofuel in cars rather than being used to feed people, according to new analysis which suggests that the biofuel revolution launched by former President George Bush in 2007 is impacting on world food supplies. The 2009 figures from the US Department of Agriculture shows ethanol production rising to record levels driven by farm subsidies and laws which require vehicles to use increasing amounts of biofuels.
"The grain grown to produce fuel in the US [in 2009] was enough to feed 330 million people for one year at average world consumption levels," said Lester Brown, the director of the Earth Policy Institute, a Washington thinktank ithat conducted the analysis. Last year 107m tonnes of grain, mostly corn, was grown by US farmers to be blended with petrol. This was nearly twice as much as in 2007, when Bush challenged farmers to increase production by 500% by 2017 to save cut oil imports and reduce carbon emissions. More than 80 new ethanol plants have been built since then, with more expected by 2015, by which time the US will need to produce a further 5bn gallons of ethanol if it is to meet its renewable fuel standard.
According to Brown, the growing demand for US ethanol derived from grains helped to push world grain prices to record highs between late 2006 and 2008. In 2008, the Guardian revealed a secret World Bank report that concluded that the drive for biofuels by American and European governments had pushed up food prices by 75%, in stark contrast to US claims that prices had risen only 2-3% as a result. Since then, the number of hungry people in the world has increased to over 1 billion people, according to the UN's World Food programme.
"Continuing to divert more food to fuel, as is now mandated by the US federal government in its renewable fuel standard, will likely only reinforce the disturbing rise in world hunger. By subsidising the production of ethanol to the tune of some $6bn each year, US taxpayers are in effect subsidising rising food bills at home and around the world," said Brown. "The worst economic crisis since the great depression has recently brought food prices down from their peak, but they still remain well above their long-term average levels."
The US is by far the world's leading grain exporter, exporting more than Argentina, Australia, Canada, and Russia combined. In 2008, the UN called for a comprehensive review of biofuel production from food crops. "There is a direct link between biofuels and food prices. The needs of the hungry must come before the needs of cars," said Meredith Alexander, biofuels campaigner at ActionAid in London. As well as the effect on food, campaigners also argue that many scientists question whether biofuels made from food crops actually save any greenhouse gas emissions.
But ethanol producers deny that their record production means less food. "Continued innovation in ethanol production and agricultural technology means that we don't have to make a false choice between food and fuel. We can more than meet the demand for food and livestock feed while reducing our dependence on foreign oil through the production of homegrown renewable ethanol," said Tom Buis, the chief executive of industry group Growth Energy.