LNL's financial crisis analyst explains how the Chinese economic growth model developed under Deng Xiaoping, and the way China used its export income to invest in US dollars and US Treasury bonds. This meant that by the beginning of the 21st century China was effectively providing the funds for Americans to purchase Chinese products.
http://mpegmedia.abc.net.au/rn/podcast/2009/08/lnl_20090826_2205.mp3
Showing posts with label doomsday. Show all posts
Showing posts with label doomsday. Show all posts
27 August 2009
30 July 2009
The Plain Truth: the dollar is even looking rocky in Philly
Says the philly Church of God...who explain...
TheTrumpet.com is the official website of the Philadelphia Trumpet newsmagazine. Each weekday, theTrumpet.com features reporting and analysis of recent global geopolitical, economic, social and religious events and trends.
The Trumpet uses a single overarching criterion that sets it apart from other news sources and keeps it focused like a laser beam on what truly is important. That criterion is prophetic significance. The Trumpet seeks to show how current events are fulfilling the biblically prophesied description of the prevailing state of affairs just before the Second Coming of Jesus Christ.
End times of a sort, any way you slice it....
http://www.thetrumpet.com/index.php?q=6279.0.116.0
Amid the global economic carnage, one winner has emerged. In a perverse turn of events, the currency of the country that started it all has gone up in value. But the U.S. dollar’s day as king may be nearing an end. Nations are beginning to worry that America’s vast debts and money-creating machines are threatening the greenback.
News out of the Far East suggests that anti-dollar sentiment is flourishing among U.S. enemies and allies alike. Is a dollar revolt brewing?
Deng Xiaoping’s Dream
Mei jin used to be the Chinese term for the U.S. dollar. It means “American gold.” It came from the dollar’s reputation as a stable store of wealth. The belief in “American gold” was so strong that it even withstood the de-linking of gold and the greenback by President Nixon in 1971. The Chinese shunned local currency when owning dollars was an option.
“Comrades, just imagine!”, Deng Xiaoping, the leader of China, said to an audience of powerful policymakers in the late 1970s. “One day we may have a foreign reserve as big as $10 billion!” According to the New York Times, a hushed awe filled the room because the number was so astronomical, seemingly so impossible. “Comrades, just imagine,” Deng continued, “with 10 billion American gold, how much China can do!”
Back then, owning “American gold” was a status symbol in China, even after the dollar could no longer be officially exchanged for real gold. Chinese horded Mei jin as a hedge against inflation—willing to purchase dollars at extravagant exchange rates—if they could find anyone who would sell. Businesses eagerly sought it from tourists. The government wanted “American gold” to back the Chinese currency.
The gigantic demand for Mei jin played a huge role in supporting the value of the dollar and keeping interest rates low in America, despite the fact that the U.S. ran huge trade and budget deficits.
Forty years later, a very different story is emerging.
A New Dirty Word
China is now the world’s largest foreign holder of dollar bonds. It owns approximately $2 trillion worth. China is also America’s most important creditor.
China has all the Mei jin it could have ever hoped for—and a whole lot more. China is overflowing with Mei jin, but like anything else that becomes easily attainable—Weimar reichmarks, Argentine pesos, Turkish lira, colored paper—as scarcity dwindles, value plummets. The implications for America are ominous.
“No one knows for sure when the tide started to turn, or the exact moment when American gold started its slow but seemingly irreversible loss of luster,” Victor Zhikai Gao, a former interpreter for Deng Xiaoping, said. But now, “[m]any Chinese people increasingly fear the rapid erosion of the American dollar.”
Many shops no longer accept dollar-based credit cards, and there are quotas on how many dollars can be converted to renminbi. Those who still keep large amounts of U.S. dollars are those who need it to send their children to U.S. schools, or to travel in other countries that still use U.S. dollars.
For the most part, Chinese multinational corporations still happily accept U.S. dollars as a form of payment—but Mei jin is on its way to becoming a derisive anti-American joke, even a dirty word. China’s appetite for holding dollars is turning into revulsion.
“China’s near-$2,000 billion in reserves, the world’s largest, are often viewed outside the country as a great strength—an insurance policy against economic turbulence. But within China, they are increasingly seen by the public and even some policymakers as something of an albatross—a huge pool of resources … that will plunge in value if the U.S. dollar collapses,” reported the Financial Times (February 23, emphasis mine).
China is stuck in a dollar trap. At least, that is what U.S. policymakers are telling the gullible public. China has lent so much money to America that if it ever tried to sell its U.S. treasuries, it would cause the rest of its treasury holdings to plummet in value. Thus, China would never dare sell. We have them in a Chinese liquidity torture trap—or so the theory goes.
China plays along, allowing U.S. officials to save face. Meanwhile, the U.S. trade deficit alone continues to send tens of billions of dollars to China each month. “We hate you guys,” Luo Ping, a director general at the China Banking Regulatory Commission, complained on a visit to New York in February. “Once you start issuing $1 to $2 trillion … we know the dollar is going to depreciate, so we hate you guys, but there is nothing much we can do.”
There you have it! China has admitted that it is stuck in the dollar trap—case closed. We can all get back to fearlessly sending China more money.
But it’s not China that is caught in a dollar trap—it’s America.
Goodbye to the Dollar
China is already making moves to diversify its holdings away from the dollar. In April it was reported that China had almost doubled its actual gold reserves from 2003 levels to 1,054 tons. Although as a percent of its foreign exchange savings China’s gold stockpile is small, from a global perspective, it is huge. China is now the world’s largest producer and fifth-largest holder of refined gold, on a par with Switzerland. But that is only counting the “officially” reported numbers. True gold holdings may be much higher.
China is also “pushing hard to put the dollar out of its misery as the currency of international trade,” according to the Shanghai Daily. China has negotiated currency swap deals for bilateral trade with Argentina, Malaysia, South Korea, Belarus and Indonesia as a way for these countries to conduct trade without relying on the U.S. dollar. Similar arrangements are in the works with Brazil and Russia.
China also pushed hard (along with the European Union) at the G-20 summit earlier this year for the International Monetary Fund to issue Special Drawing Rights (sdrs), so that countries suffering from the global economic slowdown could have access to credit markets. sdrs are, in effect, a form of global currency outside the control of any single nation that acts as a supplement or alternative to the dollar for global trade.
Does this sound like a nation caught in a trap?
“The notion that the Chinese have accumulated this massive U.S. debt portfolio and are only now wondering what to do about it is so naive it doesn’t warrant consideration,” Adrian Douglas of Market Force Analysis said. Douglas suggests that China has been using its U.S. treasury portfolio as collateral for the massive resource buying binge it has embarked upon lately.
If some day China was “forced” to announce it was selling significant portions of its U.S. treasuries—what Chinese state media have referred to as Beijing’s “nuclear option”—and the U.S. bond market consequently melted down, China could simply default and hand over the worthless U.S. bonds. Meanwhile, China would still have its accumulated stockpiles of strategic resources. Douglas says China is currently importing 70 percent more copper than it consumes, and is busily creating and filling a strategic petroleum reserve.
But China isn’t the only Asian country to show public disdain for the U.S. dollar.
No Thanks
Ii eh, domo. That is essentially what the chief finance spokesman of Japan’s opposition said concerning the U.S. dollar on April 12. Ii eh, domo means “no thanks”—as in, dollar-denominated U.S. treasuries? No thanks. Masaharu Nakagawa told the bbc that he was worried about the future value of the dollar, and that if his party were elected in the upcoming national elections it would refuse to purchase any more U.S. treasuries unless they were denominated in Japanese yen.
“If it’s [in] yen, it’s going to be all right,” Mr. Nakagawa said. “We propose that we would buy [the U.S. bonds], but it’s yen, not dollar.”
Since World War ii, Japan has been a stalwart supporter of U.S. policy and the dollar. Japan is America’s second-largest creditor after China.
Because Japan is a U.S. ally, Washington officials don’t often talk about it being stuck in a dollar trap. But this recent announcement illustrates a clear weakening of U.S.-Tokyo relations.
“We have come to assume that Japan under the Liberal Democratic Party (ldp) will always cleave to America, if only to safeguard U.S. protection against Chinese naval expansion,” wrote Ambrose Evans-Pritchard in the Telegraph. “But crashes have a habit of bringing regime change” (May 17).
Brian Reading, a Japan specialist at Lombard Street Research, says Japan may experience a “seismic shock” as voters revolt. Will Japan soon have new leadership that is less accommodating to Washington? Even America’s strongest allies are questioning the wisdom of lending money to a nation that has so much debt.
According to a recent unconfirmed report, Germany is in the dollar-skeptic camp too. Economic analyst Jim Willie quoted an unnamed source saying that Germany has demanded the “return [of] all their gold bullion held in custodial accounts on U.S. soil” (Hat Trick Letter, April 16). Dubai has recently sent the same request to London (which is also facing a currency crisis). According to Willie, Germany is acting as a “hidden archenemy” toward the U.S. and UK “on all matters pertaining to gold bullion.” He says Germany is also acting as an adviser to the Chinese on currency and gold issues.
When America’s allies, let alone its enemies, publicly question the viability of the dollar, you can be sure that things behind the scenes are even worse.
“We’re going to have a currency crisis, probably this fall or the fall of 2010,” said famed commodities investor Jim Rogers on May 12. “It’s been building up for a long time. We’ve had a huge rally in the dollar, an artificial rally in the dollar, so it’s time for a currency crisis.”
The dollar is in big trouble.
If the dollar goes down, America’s standard of living—and other, far more important implications—can’t help but follow. The dangers of debt are about to be brought home to America. Skyrocketing interest rates, plummeting currency, escalating import costs and three-digit oil prices will be just a few of the consequences.
Mei jin has lost its luster. And soon, more than just the Japanese will say “no thanks” to the U.S. dollar. •
TheTrumpet.com is the official website of the Philadelphia Trumpet newsmagazine. Each weekday, theTrumpet.com features reporting and analysis of recent global geopolitical, economic, social and religious events and trends.
The Trumpet uses a single overarching criterion that sets it apart from other news sources and keeps it focused like a laser beam on what truly is important. That criterion is prophetic significance. The Trumpet seeks to show how current events are fulfilling the biblically prophesied description of the prevailing state of affairs just before the Second Coming of Jesus Christ.
End times of a sort, any way you slice it....
http://www.thetrumpet.com/index.php?q=6279.0.116.0
Amid the global economic carnage, one winner has emerged. In a perverse turn of events, the currency of the country that started it all has gone up in value. But the U.S. dollar’s day as king may be nearing an end. Nations are beginning to worry that America’s vast debts and money-creating machines are threatening the greenback.
News out of the Far East suggests that anti-dollar sentiment is flourishing among U.S. enemies and allies alike. Is a dollar revolt brewing?
Deng Xiaoping’s Dream
Mei jin used to be the Chinese term for the U.S. dollar. It means “American gold.” It came from the dollar’s reputation as a stable store of wealth. The belief in “American gold” was so strong that it even withstood the de-linking of gold and the greenback by President Nixon in 1971. The Chinese shunned local currency when owning dollars was an option.
“Comrades, just imagine!”, Deng Xiaoping, the leader of China, said to an audience of powerful policymakers in the late 1970s. “One day we may have a foreign reserve as big as $10 billion!” According to the New York Times, a hushed awe filled the room because the number was so astronomical, seemingly so impossible. “Comrades, just imagine,” Deng continued, “with 10 billion American gold, how much China can do!”
Back then, owning “American gold” was a status symbol in China, even after the dollar could no longer be officially exchanged for real gold. Chinese horded Mei jin as a hedge against inflation—willing to purchase dollars at extravagant exchange rates—if they could find anyone who would sell. Businesses eagerly sought it from tourists. The government wanted “American gold” to back the Chinese currency.
The gigantic demand for Mei jin played a huge role in supporting the value of the dollar and keeping interest rates low in America, despite the fact that the U.S. ran huge trade and budget deficits.
Forty years later, a very different story is emerging.
A New Dirty Word
China is now the world’s largest foreign holder of dollar bonds. It owns approximately $2 trillion worth. China is also America’s most important creditor.
China has all the Mei jin it could have ever hoped for—and a whole lot more. China is overflowing with Mei jin, but like anything else that becomes easily attainable—Weimar reichmarks, Argentine pesos, Turkish lira, colored paper—as scarcity dwindles, value plummets. The implications for America are ominous.
“No one knows for sure when the tide started to turn, or the exact moment when American gold started its slow but seemingly irreversible loss of luster,” Victor Zhikai Gao, a former interpreter for Deng Xiaoping, said. But now, “[m]any Chinese people increasingly fear the rapid erosion of the American dollar.”
Many shops no longer accept dollar-based credit cards, and there are quotas on how many dollars can be converted to renminbi. Those who still keep large amounts of U.S. dollars are those who need it to send their children to U.S. schools, or to travel in other countries that still use U.S. dollars.
For the most part, Chinese multinational corporations still happily accept U.S. dollars as a form of payment—but Mei jin is on its way to becoming a derisive anti-American joke, even a dirty word. China’s appetite for holding dollars is turning into revulsion.
“China’s near-$2,000 billion in reserves, the world’s largest, are often viewed outside the country as a great strength—an insurance policy against economic turbulence. But within China, they are increasingly seen by the public and even some policymakers as something of an albatross—a huge pool of resources … that will plunge in value if the U.S. dollar collapses,” reported the Financial Times (February 23, emphasis mine).
China is stuck in a dollar trap. At least, that is what U.S. policymakers are telling the gullible public. China has lent so much money to America that if it ever tried to sell its U.S. treasuries, it would cause the rest of its treasury holdings to plummet in value. Thus, China would never dare sell. We have them in a Chinese liquidity torture trap—or so the theory goes.
China plays along, allowing U.S. officials to save face. Meanwhile, the U.S. trade deficit alone continues to send tens of billions of dollars to China each month. “We hate you guys,” Luo Ping, a director general at the China Banking Regulatory Commission, complained on a visit to New York in February. “Once you start issuing $1 to $2 trillion … we know the dollar is going to depreciate, so we hate you guys, but there is nothing much we can do.”
There you have it! China has admitted that it is stuck in the dollar trap—case closed. We can all get back to fearlessly sending China more money.
But it’s not China that is caught in a dollar trap—it’s America.
Goodbye to the Dollar
China is already making moves to diversify its holdings away from the dollar. In April it was reported that China had almost doubled its actual gold reserves from 2003 levels to 1,054 tons. Although as a percent of its foreign exchange savings China’s gold stockpile is small, from a global perspective, it is huge. China is now the world’s largest producer and fifth-largest holder of refined gold, on a par with Switzerland. But that is only counting the “officially” reported numbers. True gold holdings may be much higher.
China is also “pushing hard to put the dollar out of its misery as the currency of international trade,” according to the Shanghai Daily. China has negotiated currency swap deals for bilateral trade with Argentina, Malaysia, South Korea, Belarus and Indonesia as a way for these countries to conduct trade without relying on the U.S. dollar. Similar arrangements are in the works with Brazil and Russia.
China also pushed hard (along with the European Union) at the G-20 summit earlier this year for the International Monetary Fund to issue Special Drawing Rights (sdrs), so that countries suffering from the global economic slowdown could have access to credit markets. sdrs are, in effect, a form of global currency outside the control of any single nation that acts as a supplement or alternative to the dollar for global trade.
Does this sound like a nation caught in a trap?
“The notion that the Chinese have accumulated this massive U.S. debt portfolio and are only now wondering what to do about it is so naive it doesn’t warrant consideration,” Adrian Douglas of Market Force Analysis said. Douglas suggests that China has been using its U.S. treasury portfolio as collateral for the massive resource buying binge it has embarked upon lately.
If some day China was “forced” to announce it was selling significant portions of its U.S. treasuries—what Chinese state media have referred to as Beijing’s “nuclear option”—and the U.S. bond market consequently melted down, China could simply default and hand over the worthless U.S. bonds. Meanwhile, China would still have its accumulated stockpiles of strategic resources. Douglas says China is currently importing 70 percent more copper than it consumes, and is busily creating and filling a strategic petroleum reserve.
But China isn’t the only Asian country to show public disdain for the U.S. dollar.
No Thanks
Ii eh, domo. That is essentially what the chief finance spokesman of Japan’s opposition said concerning the U.S. dollar on April 12. Ii eh, domo means “no thanks”—as in, dollar-denominated U.S. treasuries? No thanks. Masaharu Nakagawa told the bbc that he was worried about the future value of the dollar, and that if his party were elected in the upcoming national elections it would refuse to purchase any more U.S. treasuries unless they were denominated in Japanese yen.
“If it’s [in] yen, it’s going to be all right,” Mr. Nakagawa said. “We propose that we would buy [the U.S. bonds], but it’s yen, not dollar.”
Since World War ii, Japan has been a stalwart supporter of U.S. policy and the dollar. Japan is America’s second-largest creditor after China.
Because Japan is a U.S. ally, Washington officials don’t often talk about it being stuck in a dollar trap. But this recent announcement illustrates a clear weakening of U.S.-Tokyo relations.
“We have come to assume that Japan under the Liberal Democratic Party (ldp) will always cleave to America, if only to safeguard U.S. protection against Chinese naval expansion,” wrote Ambrose Evans-Pritchard in the Telegraph. “But crashes have a habit of bringing regime change” (May 17).
Brian Reading, a Japan specialist at Lombard Street Research, says Japan may experience a “seismic shock” as voters revolt. Will Japan soon have new leadership that is less accommodating to Washington? Even America’s strongest allies are questioning the wisdom of lending money to a nation that has so much debt.
According to a recent unconfirmed report, Germany is in the dollar-skeptic camp too. Economic analyst Jim Willie quoted an unnamed source saying that Germany has demanded the “return [of] all their gold bullion held in custodial accounts on U.S. soil” (Hat Trick Letter, April 16). Dubai has recently sent the same request to London (which is also facing a currency crisis). According to Willie, Germany is acting as a “hidden archenemy” toward the U.S. and UK “on all matters pertaining to gold bullion.” He says Germany is also acting as an adviser to the Chinese on currency and gold issues.
When America’s allies, let alone its enemies, publicly question the viability of the dollar, you can be sure that things behind the scenes are even worse.
“We’re going to have a currency crisis, probably this fall or the fall of 2010,” said famed commodities investor Jim Rogers on May 12. “It’s been building up for a long time. We’ve had a huge rally in the dollar, an artificial rally in the dollar, so it’s time for a currency crisis.”
The dollar is in big trouble.
If the dollar goes down, America’s standard of living—and other, far more important implications—can’t help but follow. The dangers of debt are about to be brought home to America. Skyrocketing interest rates, plummeting currency, escalating import costs and three-digit oil prices will be just a few of the consequences.
Mei jin has lost its luster. And soon, more than just the Japanese will say “no thanks” to the U.S. dollar. •
21 July 2009
Persistent ignorance
An excellent peice from "Financial Armageddon....
Persistent Ignorance
It's funny -- or sad, depending on your perspective -- how those who supposedly know best -- the highly paid "experts" on Wall Street -- keep misreading what is happening in the real economy.
For example, all signs point to the fact that what we have been going through these past few years is not just a garden-variety recession, but a full-fledged meltdown spawned by the bursting of the biggest credit/housing bubble in history.
Yet the "Wrong Way' Corrigans" who never saw the unraveling coming, who insisted that the crisis would remain "contained" or otherwise end quickly, who kept seeing rebounds and bottoms that never quite materialized, and who are now proclaiming an end to the "recession" -- their word -- persist in trying to mislead or confuse the masses with their profoundly ignorant assurances.
The latest delusion is the notion that allegedly "good" earnings from corporate America herald the beginnings of an economic recovery. In "The Thesis Continues To Validate: GE," The Market Ticker's Karl Denninger puts paid to this silly theory.
GE (NYSE: GE) was out this morning with earnings and continues to validate my central thesis: severe economic contraction.
Revenues were down 17% - another double-digit contraction, and this is particularly troublesome in what it says about the global economy, given GE's global reach.
Again, we continue to see the same sort of theme in industrial and consumer products reporting - Harley Davidson (NYSE: HOG) reported units shipped down 30% year over year yesterday, and now GE out with a 17% year over year revenue decline.
Stocks are, at their core, priced on earnings growth, with the most-common ratio used for such metrics being P/E/G, or Price-to-earnings-growth.
But earnings are not growing, they're contracting - dramatically - in percentage terms over year-ago levels. How can it be otherwise? Even with no inefficiencies due to firms having too many employees for the revenue contraction that is occurring, a 30% reduction in business done should lead to a 30% decline in profits earned. Add to that the fact that firms are nearly always behind the curve and you have profit declines that are much larger - in some cases 100% or even going from a profit to a loss.
This is not a circumstance that will reverse in the immediate future; in order for it to do so, revenue must come back up, and in order for revenue to come back to pre-bust levels, we would have to re-inflate the credit bubble - which simply cannot happen.
Multiples are going to continue to contract. Those analysts and market callers who are all over the momentum trade can in fact make a good buck trading the momentum, but that's all they're trading - they sure aren't trading earnings acceleration or even stabilization.
The move in the market off the 666 levels in March has been driven by a false premise, egged on by CNBC and the other "mainstream media" - that this is a typical recession, it is short-lived, and we will soon go back to previous spending and business patterns.
That is not going to happen, yet it is what everyone in the media and analyst community is looking for and basing their valuation and market timing calls on.
I don't know how long we have to continue to put up numbers like this before people wake up, but wake up they eventually will. When Harley Davidson ships 30% fewer motorcycles, when GE sells 17% less "stuff" (including their financial cooking) and when company after company, including Intel, IBM and others come out with revenue numbers that are down double-digit percentages on an annualized basis, there is no possible way you can justify the multiples that these firms are selling at.
When The Port of Long Beach shows container shipments down nearly 30%, when freight carloadings are down nearly 25% year over year, when sales tax receipts are down in the double digits and when income tax collections, both personal and corporate have effectively collapsed there is simply no argument that "the recession is over" or that "trend growth is around the corner."
The fact of the matter is that port, rail and tax receipts are not subject to being "gamed" by government number-crunchers, they do not play "seasonal adjustments" (since they're year-over-year numbers), they do not represent wishes, dreams, or desires.
They represent real-time, high-frequency, "right now and in your face" economic performance metrics and are impossible to argue with.
If you, as an investor, are trying to use the market as a "forward indicator" of economic conditions, you need to look at these numbers to see whether or not what the stock market is telling you can be validated with actual economic performance - not in quarterly reports to be published in a few months (the typical economic lead-time cited for the market) but in the "right here and now" reality of economic activity.
What those high-frequency data sources are telling us, here and now, today, is that we are in the middle of a 25-30% economic contraction - exactly as I predicted would occur in 2007.
The problem with this level of indicated weakness in the economy is that we have shielded firms, especially banks, from taking the losses that should have come last year and in 2007 related to their over-extension of credit. Now those institutions are going to have to live with the reality of a much smaller economy, meaning that they will be forced to turn to dramatically increasing credit costs to customers to avoid drowning (e.g. increasing credit card rates and spreads), which is exactly what they're doing. This in turn will suck even more money out of consumers pockets, dragging consumption down even further and will force even more defaults.
This is a vicious cycle that can only be broken when the defaults that are being hidden behind the curtain of our financial institutions are forced into the open and disposed of. Yes, this will likely cause those firms to go bust. But the economic penalty we are and will continue to pay for allowing The Bezzle to continue in these firms will, if not stopped, soon choke off any hope of recovery, just as it did in 1930, and lead to precisely the same sort of economic result.
Everyone seems to be hollering about the "wonderful performance" of the banks that have reported thus far, but let's be honest - if you can borrow for nothing and charge 30% interest on plastic, you make a fortune, right? Well, for a while - until the squeeze of contracting incomes and increasing interest charges force your customers to default, at which point the charge-offs and defaults this forces in the rest of your portfolio (e.g. mortgages) kill you dead.
I see exactly nothing in any of the reported numbers thus far this quarter suggesting that we've turned an economic corner or that there will be a recovery this year or even next.
We could be near or at the bottom, but we're not, and it is precisely because we have protected the financial institutions from the consequences of their own folly in preference to the borrower (to a large degree the consumer) that this has happened. I have warned repeatedly that the actions of our regulators and government, on the path they are on, will make durable economic recovery impossible.
The anvil of these bad loans, being carried far above actual fair-market value, will remain as a millstone around the neck until we either earn them out or default them.
Our government and regulators have chosen "earn them out". The problem is that this path cannot succeed because "earn them out" requires that the economy return to trend growth - that is, 3-4% GDP - before next year. That is not going to happen; the government backstop and artificial support only work so long as they continue, and we cannot continue to borrow two trillion a year for the purpose of propping up these institutions in excess of their natural earnings power in the economy.
Yet without defaulting the bad debt that's exactly what has to happen.
If Roubini's prediction of sub-1% growth (if that) for the next couple of years is correct the squeeze between available revenue and required cash-flow from operations to keep the numbers black at the bottom of the page will become python-like over the next 12-18 months, and as the grip tightens reportable earnings will continue to contract, ultimately leading to a collapse when cash flow is exceeded by expenses.
This is the dreaded "double dip", except that it won't be a "W" as Roubini has postulated - it will look like the first three legs, but the right side "/" will instead be a flat line as credit capacity on the borrowing side collapses, destroying the banks ability to profit - without borrowers there is no interest to charge and no money to make!
Bottom line: Those who bet on the market "going much higher" from here are going to find themselves once again holding a bag handed to them by the media and market callers, just like they did in 2000 when it was said "this is just a small correction in the market" as the Nasdaq came off 5,000.
http://www.financialarmageddon.com/2009/07/persistent-ignorance.html
Persistent Ignorance
It's funny -- or sad, depending on your perspective -- how those who supposedly know best -- the highly paid "experts" on Wall Street -- keep misreading what is happening in the real economy.
For example, all signs point to the fact that what we have been going through these past few years is not just a garden-variety recession, but a full-fledged meltdown spawned by the bursting of the biggest credit/housing bubble in history.
Yet the "Wrong Way' Corrigans" who never saw the unraveling coming, who insisted that the crisis would remain "contained" or otherwise end quickly, who kept seeing rebounds and bottoms that never quite materialized, and who are now proclaiming an end to the "recession" -- their word -- persist in trying to mislead or confuse the masses with their profoundly ignorant assurances.
The latest delusion is the notion that allegedly "good" earnings from corporate America herald the beginnings of an economic recovery. In "The Thesis Continues To Validate: GE," The Market Ticker's Karl Denninger puts paid to this silly theory.
GE (NYSE: GE) was out this morning with earnings and continues to validate my central thesis: severe economic contraction.
Revenues were down 17% - another double-digit contraction, and this is particularly troublesome in what it says about the global economy, given GE's global reach.
Again, we continue to see the same sort of theme in industrial and consumer products reporting - Harley Davidson (NYSE: HOG) reported units shipped down 30% year over year yesterday, and now GE out with a 17% year over year revenue decline.
Stocks are, at their core, priced on earnings growth, with the most-common ratio used for such metrics being P/E/G, or Price-to-earnings-growth.
But earnings are not growing, they're contracting - dramatically - in percentage terms over year-ago levels. How can it be otherwise? Even with no inefficiencies due to firms having too many employees for the revenue contraction that is occurring, a 30% reduction in business done should lead to a 30% decline in profits earned. Add to that the fact that firms are nearly always behind the curve and you have profit declines that are much larger - in some cases 100% or even going from a profit to a loss.
This is not a circumstance that will reverse in the immediate future; in order for it to do so, revenue must come back up, and in order for revenue to come back to pre-bust levels, we would have to re-inflate the credit bubble - which simply cannot happen.
Multiples are going to continue to contract. Those analysts and market callers who are all over the momentum trade can in fact make a good buck trading the momentum, but that's all they're trading - they sure aren't trading earnings acceleration or even stabilization.
The move in the market off the 666 levels in March has been driven by a false premise, egged on by CNBC and the other "mainstream media" - that this is a typical recession, it is short-lived, and we will soon go back to previous spending and business patterns.
That is not going to happen, yet it is what everyone in the media and analyst community is looking for and basing their valuation and market timing calls on.
I don't know how long we have to continue to put up numbers like this before people wake up, but wake up they eventually will. When Harley Davidson ships 30% fewer motorcycles, when GE sells 17% less "stuff" (including their financial cooking) and when company after company, including Intel, IBM and others come out with revenue numbers that are down double-digit percentages on an annualized basis, there is no possible way you can justify the multiples that these firms are selling at.
When The Port of Long Beach shows container shipments down nearly 30%, when freight carloadings are down nearly 25% year over year, when sales tax receipts are down in the double digits and when income tax collections, both personal and corporate have effectively collapsed there is simply no argument that "the recession is over" or that "trend growth is around the corner."
The fact of the matter is that port, rail and tax receipts are not subject to being "gamed" by government number-crunchers, they do not play "seasonal adjustments" (since they're year-over-year numbers), they do not represent wishes, dreams, or desires.
They represent real-time, high-frequency, "right now and in your face" economic performance metrics and are impossible to argue with.
If you, as an investor, are trying to use the market as a "forward indicator" of economic conditions, you need to look at these numbers to see whether or not what the stock market is telling you can be validated with actual economic performance - not in quarterly reports to be published in a few months (the typical economic lead-time cited for the market) but in the "right here and now" reality of economic activity.
What those high-frequency data sources are telling us, here and now, today, is that we are in the middle of a 25-30% economic contraction - exactly as I predicted would occur in 2007.
The problem with this level of indicated weakness in the economy is that we have shielded firms, especially banks, from taking the losses that should have come last year and in 2007 related to their over-extension of credit. Now those institutions are going to have to live with the reality of a much smaller economy, meaning that they will be forced to turn to dramatically increasing credit costs to customers to avoid drowning (e.g. increasing credit card rates and spreads), which is exactly what they're doing. This in turn will suck even more money out of consumers pockets, dragging consumption down even further and will force even more defaults.
This is a vicious cycle that can only be broken when the defaults that are being hidden behind the curtain of our financial institutions are forced into the open and disposed of. Yes, this will likely cause those firms to go bust. But the economic penalty we are and will continue to pay for allowing The Bezzle to continue in these firms will, if not stopped, soon choke off any hope of recovery, just as it did in 1930, and lead to precisely the same sort of economic result.
Everyone seems to be hollering about the "wonderful performance" of the banks that have reported thus far, but let's be honest - if you can borrow for nothing and charge 30% interest on plastic, you make a fortune, right? Well, for a while - until the squeeze of contracting incomes and increasing interest charges force your customers to default, at which point the charge-offs and defaults this forces in the rest of your portfolio (e.g. mortgages) kill you dead.
I see exactly nothing in any of the reported numbers thus far this quarter suggesting that we've turned an economic corner or that there will be a recovery this year or even next.
We could be near or at the bottom, but we're not, and it is precisely because we have protected the financial institutions from the consequences of their own folly in preference to the borrower (to a large degree the consumer) that this has happened. I have warned repeatedly that the actions of our regulators and government, on the path they are on, will make durable economic recovery impossible.
The anvil of these bad loans, being carried far above actual fair-market value, will remain as a millstone around the neck until we either earn them out or default them.
Our government and regulators have chosen "earn them out". The problem is that this path cannot succeed because "earn them out" requires that the economy return to trend growth - that is, 3-4% GDP - before next year. That is not going to happen; the government backstop and artificial support only work so long as they continue, and we cannot continue to borrow two trillion a year for the purpose of propping up these institutions in excess of their natural earnings power in the economy.
Yet without defaulting the bad debt that's exactly what has to happen.
If Roubini's prediction of sub-1% growth (if that) for the next couple of years is correct the squeeze between available revenue and required cash-flow from operations to keep the numbers black at the bottom of the page will become python-like over the next 12-18 months, and as the grip tightens reportable earnings will continue to contract, ultimately leading to a collapse when cash flow is exceeded by expenses.
This is the dreaded "double dip", except that it won't be a "W" as Roubini has postulated - it will look like the first three legs, but the right side "/" will instead be a flat line as credit capacity on the borrowing side collapses, destroying the banks ability to profit - without borrowers there is no interest to charge and no money to make!
Bottom line: Those who bet on the market "going much higher" from here are going to find themselves once again holding a bag handed to them by the media and market callers, just like they did in 2000 when it was said "this is just a small correction in the market" as the Nasdaq came off 5,000.
http://www.financialarmageddon.com/2009/07/persistent-ignorance.html
2 July 2009
3 June 2009
Endless monetisation of US debt ahead ~ Jim Willie
Behind the bushes, a powerful billboard message can be seen by the trained eye, accompanied by loud signals audible to the trained ear. The US Federal Reserve will be forced to continue the gargantuan monetization scheme. The first round was announced in mid-March, for $300 billion in USTreasurys and $750 billion in USAgency Mortgage Bonds. Most did not give a second thought, that it was a one-time event. WRONG! The monetization news dealt a powerful blow to global confidence in the US financial system generally and the USDollar specifically. The $1 trillion monetization will be repeated, and even become a quarterly event, much like a constant sub-surface flow of water to remove a foundation built upon sand.
The trip to China by USDept Treasury Secy Geithner should be viewed as a key reassurance to these important creditors, later to be viewed as a betrayal. The Chinese audience responded with loud laughter when Geithner assured them that their $2 trillion in savings was safe and secure. This was a national humiliation event, as Geithner has been muzzled. If only the USCongress had such broad wisdom and deep courage to laugh when Goldman Sachs henchmen ‘(Made Men’) from the syndicate gave regular speeches laden with deception and rationalizations for their continued fraud. Then again, the Chinese audience is not on the receiving end of graft and bribery, nor the object of revolving doors.
PLIGHT OF PRIMARY DEALER PARTNERS
The group of 20 to 22 bond dealers with contracts to sell USGovt debt securities are under siege, suffering a grand new plight. This is perhaps the best kept secret in the entire credit market right now. The USFed primary bond dealers are being squeezed. They actually have some power to respond. They are at risk, and face a possible rapid extinction. Despite the rising long-term USTBond yield, money going into USTBond purchases in general is growing like a powerful torrent. Demand for USTBonds is growing fast, very fast. Bond supply is rising faster than demand though!! The role of primary bond dealers is to hold inventory as intermediaries, a prospect that makes those dealers LOSERS right away. Auction sizes one or two years ago used to be $5 billion, $10 billion, even $15 billion on a given month. Just last week the official auction was for $110 billion, a 10-fold increase. The pushback comes from these primary bond dealers, who collectively possess the power to tell the issuer (USDept Treasury) and the agent (USFed) that buyers just do not exist in sufficient volume to absorb such huge regular supply. Fear has entered the hearts and minds of the dealers. They will soon tell their bosses at Treasury and the USFed that more monetization must come in order to lighten the supply load, or else face a renewed crisis, at least horrendous negative publicity. The credit market trucks are breaking down from the weight. The $300 billion monetization sounded like a big amount, but it is not. That amounts to two or three months in supply, if the $1800 billion in USGovt deficits is to be financed. The $1 trillion monetization MUST BE REPEATED, and even become a quarterly event. Refusal by the Treasury and USFed to monetize could result in failed auctions, crushing losses by the primary dealers, and their possible disappearance. Remember what happened to private equity firms stuck with their own stock and bond inventory? They went bust. That is precisely the risk to these bond dealers.
FORCED MONETIZATION COMMITMENT
The trend is clear for those with open eyes. The official bond auctions will continue relentlessly, probably well over $100 billion per month, for perhaps twenty months at least. Worse, the USGovt federal deficits will be much bigger than estimated. Here is a sobering fact. The USGovt tax revenues are down 35% year over year. For the first time in US history, the tax collection month of April 2009 was a net negative month. Expect the USTBond supply pressures to build, not reduce. My conclusion is clear. PURE MONETIZATION WILL SOON BE A REGULAR QUARTERLY PROMISE. IF NOT, THEN A USTBOND DEFAULT THREAT LOOMS NEAR ON THE HORIZON, OR A POWERFUL SUDDEN STOCK MARKET COLLAPSE WILL ENSUE. A monetization commitment forestalls a USTBond default at a later date.
Meanwhile, the economic impact of this unremedied crisis will slowly be recognized. Watch the job losses, which continue in huge numbers. Watch the home foreclosures, which continue in accelerating numbers. Watch the national home prices, which continue in steady declines. Recall that the USEconomic recovery that began in 2001-2002 was built upon a housing bubble as a foundation. The burst of that bubble is absolutely not a completed process. The national insolvency will take its toll on USTreasurys as a certain reflection. The debt downgrade (imminent, scheduled, expected, who cares its label?) of the UKGilts two weeks ago should have awakened the world to the perception of the USGovt debt as Third World debt paper. The government finances of the United Kingdom are no better and no worse than those of the United States. The global reserve status of the USDollar and USTreasury, the greater size of the USEconomy, these only guarantee that the impact of the US fiasco have broader shock waves. The fiasco is tied to the USGovt committed debt being transformed into debt securities, the USTreasury Bonds. It is a gigantic hairball. It is like a rattle snake swallowing a goat.
SPOTTING THE USTREASURY BLACK HOLE
The USTreasury Bond supply (skyrocketing) is growing much faster than the rising demand. The untold story is that demand is rising in stride to take the rising bond supply, FOR NOW. A rising USTBond long bond yield does not mean necessarily that money exits. Price is determined as demand meeting supply. The rising bond supply will be continuing, not just for a month or two, but for a year or two or three, maybe four. Projected USGovt federal deficits are due to occur for as far as the eye can see. Bond analysts knew that big problems would result. They have begun. Huge USGovt debt commitments ensure a skyrocket of continued USTBond supply. It is sucking in funds all over the financial markets, like a Black Hole. The stock market is at growing risk for its available funds. The primary dealers have the ability to put pressure on fund managers of a wide variety. Those managers will be urged to purchase more bonds, to alter their allocation ratios, and to respond to government pressures. Some will be lured to earn future favors. The Dow Jones Industrial stock index and the S&P500 stock index have begun to stall, after quite a run powered by short covering, relaxation of accounting rules, and widespread talk of early sightings of recovery evidence. The gargantuan outsized USTreasury Bond auctions must find funds to feed the beast, and the stock market is a nearby target. The great Black Hole of USTBond issuance and sale has the potential to draw the entire stock market into its vortex. The conclusion is simple, and the USFed must respond. The $1 trillion monetization MUST BE REPEATED, and even become a quarterly event. Refusal by the Treasury and USFed to monetize could result in painful stock market declines, the effects from which the public observes and understands well. Their pain usually results in hue & cry, and if not addressed, panic.
http://www.financialsense.com/fsu/editorials/willie/2009/0602.html
The trip to China by USDept Treasury Secy Geithner should be viewed as a key reassurance to these important creditors, later to be viewed as a betrayal. The Chinese audience responded with loud laughter when Geithner assured them that their $2 trillion in savings was safe and secure. This was a national humiliation event, as Geithner has been muzzled. If only the USCongress had such broad wisdom and deep courage to laugh when Goldman Sachs henchmen ‘(Made Men’) from the syndicate gave regular speeches laden with deception and rationalizations for their continued fraud. Then again, the Chinese audience is not on the receiving end of graft and bribery, nor the object of revolving doors.
PLIGHT OF PRIMARY DEALER PARTNERS
The group of 20 to 22 bond dealers with contracts to sell USGovt debt securities are under siege, suffering a grand new plight. This is perhaps the best kept secret in the entire credit market right now. The USFed primary bond dealers are being squeezed. They actually have some power to respond. They are at risk, and face a possible rapid extinction. Despite the rising long-term USTBond yield, money going into USTBond purchases in general is growing like a powerful torrent. Demand for USTBonds is growing fast, very fast. Bond supply is rising faster than demand though!! The role of primary bond dealers is to hold inventory as intermediaries, a prospect that makes those dealers LOSERS right away. Auction sizes one or two years ago used to be $5 billion, $10 billion, even $15 billion on a given month. Just last week the official auction was for $110 billion, a 10-fold increase. The pushback comes from these primary bond dealers, who collectively possess the power to tell the issuer (USDept Treasury) and the agent (USFed) that buyers just do not exist in sufficient volume to absorb such huge regular supply. Fear has entered the hearts and minds of the dealers. They will soon tell their bosses at Treasury and the USFed that more monetization must come in order to lighten the supply load, or else face a renewed crisis, at least horrendous negative publicity. The credit market trucks are breaking down from the weight. The $300 billion monetization sounded like a big amount, but it is not. That amounts to two or three months in supply, if the $1800 billion in USGovt deficits is to be financed. The $1 trillion monetization MUST BE REPEATED, and even become a quarterly event. Refusal by the Treasury and USFed to monetize could result in failed auctions, crushing losses by the primary dealers, and their possible disappearance. Remember what happened to private equity firms stuck with their own stock and bond inventory? They went bust. That is precisely the risk to these bond dealers.
FORCED MONETIZATION COMMITMENT
The trend is clear for those with open eyes. The official bond auctions will continue relentlessly, probably well over $100 billion per month, for perhaps twenty months at least. Worse, the USGovt federal deficits will be much bigger than estimated. Here is a sobering fact. The USGovt tax revenues are down 35% year over year. For the first time in US history, the tax collection month of April 2009 was a net negative month. Expect the USTBond supply pressures to build, not reduce. My conclusion is clear. PURE MONETIZATION WILL SOON BE A REGULAR QUARTERLY PROMISE. IF NOT, THEN A USTBOND DEFAULT THREAT LOOMS NEAR ON THE HORIZON, OR A POWERFUL SUDDEN STOCK MARKET COLLAPSE WILL ENSUE. A monetization commitment forestalls a USTBond default at a later date.
Meanwhile, the economic impact of this unremedied crisis will slowly be recognized. Watch the job losses, which continue in huge numbers. Watch the home foreclosures, which continue in accelerating numbers. Watch the national home prices, which continue in steady declines. Recall that the USEconomic recovery that began in 2001-2002 was built upon a housing bubble as a foundation. The burst of that bubble is absolutely not a completed process. The national insolvency will take its toll on USTreasurys as a certain reflection. The debt downgrade (imminent, scheduled, expected, who cares its label?) of the UKGilts two weeks ago should have awakened the world to the perception of the USGovt debt as Third World debt paper. The government finances of the United Kingdom are no better and no worse than those of the United States. The global reserve status of the USDollar and USTreasury, the greater size of the USEconomy, these only guarantee that the impact of the US fiasco have broader shock waves. The fiasco is tied to the USGovt committed debt being transformed into debt securities, the USTreasury Bonds. It is a gigantic hairball. It is like a rattle snake swallowing a goat.
SPOTTING THE USTREASURY BLACK HOLE
The USTreasury Bond supply (skyrocketing) is growing much faster than the rising demand. The untold story is that demand is rising in stride to take the rising bond supply, FOR NOW. A rising USTBond long bond yield does not mean necessarily that money exits. Price is determined as demand meeting supply. The rising bond supply will be continuing, not just for a month or two, but for a year or two or three, maybe four. Projected USGovt federal deficits are due to occur for as far as the eye can see. Bond analysts knew that big problems would result. They have begun. Huge USGovt debt commitments ensure a skyrocket of continued USTBond supply. It is sucking in funds all over the financial markets, like a Black Hole. The stock market is at growing risk for its available funds. The primary dealers have the ability to put pressure on fund managers of a wide variety. Those managers will be urged to purchase more bonds, to alter their allocation ratios, and to respond to government pressures. Some will be lured to earn future favors. The Dow Jones Industrial stock index and the S&P500 stock index have begun to stall, after quite a run powered by short covering, relaxation of accounting rules, and widespread talk of early sightings of recovery evidence. The gargantuan outsized USTreasury Bond auctions must find funds to feed the beast, and the stock market is a nearby target. The great Black Hole of USTBond issuance and sale has the potential to draw the entire stock market into its vortex. The conclusion is simple, and the USFed must respond. The $1 trillion monetization MUST BE REPEATED, and even become a quarterly event. Refusal by the Treasury and USFed to monetize could result in painful stock market declines, the effects from which the public observes and understands well. Their pain usually results in hue & cry, and if not addressed, panic.
http://www.financialsense.com/fsu/editorials/willie/2009/0602.html
28 May 2009
"Gold's in a major 3" say the Gold Guru, the jailed long waver and the technician
They said that housing was a bubble and that the stock market was doomed so they might be right, but like then, early. But they likely have the big picture plain. Peter over at arabian money sumarises the last few penny drops as follows...
1. Gold reacts as currency support for the dollar enters mid June to a slow decline (that is the official definition of a strong dollar policy, really).
2. End of 2nd week going into the beginning of the 3rd week of June Gold launches towards and this time through the neckline of the reverse head and shoulders formation.
3. Gold rises to $1224 where it hesitates.
4. The OTC derivative market takes on the dollar as short sellers into dollar support.
5. This OTC derivative currency short position builds.
6. It is the US dollar where Armstrong will get his WATERFALL.
7. The main selling takes place when Israel makes a major miscalculation.
8. Hyperinflation is always and will continue to be a currency event.
9. Hyperinflation will be a product of the upcoming massive OTC derivative short dollar raid.
‘Should I be correct in the gold price action going into late June, it will fit Armstrong’s criterion for a move to $5,000′, adds Mr. Sinclair whose predictions are not always right, and who got similarly carried away last summer.
But there is the old mantra in forecasting that if you repeat something often enough then it will be bound to happen in the end. And to be fair to Mr. Sinclair the gold positive scenario stacking up right now does look unstoppable.
http://arabianmoney.net/2009/05/27/jim-sinclairs-immediate-predictions-on-the-gold-price/
1. Gold reacts as currency support for the dollar enters mid June to a slow decline (that is the official definition of a strong dollar policy, really).
2. End of 2nd week going into the beginning of the 3rd week of June Gold launches towards and this time through the neckline of the reverse head and shoulders formation.
3. Gold rises to $1224 where it hesitates.
4. The OTC derivative market takes on the dollar as short sellers into dollar support.
5. This OTC derivative currency short position builds.
6. It is the US dollar where Armstrong will get his WATERFALL.
7. The main selling takes place when Israel makes a major miscalculation.
8. Hyperinflation is always and will continue to be a currency event.
9. Hyperinflation will be a product of the upcoming massive OTC derivative short dollar raid.
‘Should I be correct in the gold price action going into late June, it will fit Armstrong’s criterion for a move to $5,000′, adds Mr. Sinclair whose predictions are not always right, and who got similarly carried away last summer.
But there is the old mantra in forecasting that if you repeat something often enough then it will be bound to happen in the end. And to be fair to Mr. Sinclair the gold positive scenario stacking up right now does look unstoppable.
http://arabianmoney.net/2009/05/27/jim-sinclairs-immediate-predictions-on-the-gold-price/
2 May 2009
An Even Greater Depression
by Bill Bonner
London, England
Not infrequently, governments 'shoot themselves in the foot.' But in the current event, they have brought out the biggest cannon in history. We look on with amusement as they blow their fool heads off.
Readers are reminded of our Daily Reckoning Law: 'The force of a correction is equal and opposite to the deception that preceded it.' Today, we offer a corollary: 'The greatness of a depression is commensurate to the government's efforts to prevent it.'
Since these iron laws seem to contradict almost everything one hears on the subject, the burden of proof is on us. So, to the witness stand, we call our first expert, Angela Merkel. Alone among the world leaders, she seems to have kept her head:
"The crisis did not come about because we issued too little money but because we created economic growth with too much money, and it was not sustainable," explains Germany's chancellor. She went on to suggest that maybe we shouldn't repeat the errors of the past.
As a proxy for 'deception' in our handy dictum, substitute 'money.' And now consider it in its two misleading forms - credit and deficit spending. "Credit not backed by real savings is a fraud," the great economist, Kurt Richebächer, used to say. It is a fraud when it comes not from willing lenders, but from central banks, artificially reducing lending rates in order to spur the economy. Deficit spending by government is a flimflam too. Governments rarely have extra funds to spare; they have to borrow the money. Eventually, that debt will have to be paid.
During the entire last half a century leading Western economists imagined a world that couldn't exist for one minute - where consuming wealth makes people wealthier...and where simply making more credit available can stimulate consumption. Each time the economy slowed down, the authorities induced people to buy more of what they didn't need with more money they didn't have. This produced 'growth.' But it was an ersatz growth. Every dollar of borrowed money would one day have to be paid back. Every step forward would have to be followed, eventually, by another one to the rear. "Deficit spending by government is a flimflam too. Governments rarely have extra funds to spare; they have to borrow the money. Eventually, that debt will have to be paid."
In the first four U.S. recessions after the Great Depression, from the mid-'30s through the mid-'50s, the total amount of monetary stimulus was actually negative. Instead of lowering rates, the feds - witless, as usual - often increased them or left them alone. But deficit spending went up an average of 2.2% of GDP each time. Later, the feds began to get the hang of it; every recession after 1958 was met with both more credit and more spending.
As the feds put in more money and credit, they found that more money and credit was needed. At the beginning of the period an extra $2 of credit would result in $1 of extra GDP. By the time the lights went out in 2007, it took about $6 of additional credit to produce a single extra dollar of output. Each new dollar of credit had to support not only the new 'growth' the feds were after, but all the accumulated debt and mistakes from previous stimulus programs.
In the recession of 1973, Brookings Institution economist George Perry told Congress that "we should be pulling out all the stops" to fix it. The resulting fiscal and monetary stimulus program cost the U.S. 4% of GDP, according to an estimate by Jim Grant. Future generations of Fed governors and Treasury secretaries found more stops...and of course, pulled them out too. In the micro recession of 2001, for example, the combined fiscal and monetary boost amounted to 7.2% of GDP, according to Grant.
The deceptions of the Bubble Epoque, 2001-2007, were enormous. The correction has been enormous too. And here are the same economists who mismanaged the economy, offering advice to governments who mismanaged their regulatory roles, about how to keep mismanaged companies alive, so that bondholders who mismanaged their investments might not go broke. That this will result in more misery is a foregone conclusion - at least, here at The Daily Reckoning. The measure of that misery, if our iron law holds, is how adamantly governments fight to keep their mismanagement going. Just looking at the numbers, the toll will be monstrous. All over the world, interest rates have been cut and budgets padded. France's deficit is running at 8% of GDP. England is running a deficit of more than 12% of GDP. And the U.S. is mobilizing as if it had been attacked by Martians. On the credit side, the feds have cut rates more than ever before, for a monetary boost equivalent to 18% of GDP, according to Grant. As to spending, $13 trillion has been pledged...an amount equivalent to a full year's annual output of the United States of America. This response is 3 times more (adjusted to today's dollars) than the U.S. spent to fight WWII. It is 12 times more (relative to GDP) than the total committed to fight the Great Depression.
It is, we will guess, what makes a great depression even greater.
Enjoy your weekend,
Bill Bonner
The Daily Reckoning
London, England
Not infrequently, governments 'shoot themselves in the foot.' But in the current event, they have brought out the biggest cannon in history. We look on with amusement as they blow their fool heads off.
Readers are reminded of our Daily Reckoning Law: 'The force of a correction is equal and opposite to the deception that preceded it.' Today, we offer a corollary: 'The greatness of a depression is commensurate to the government's efforts to prevent it.'
Since these iron laws seem to contradict almost everything one hears on the subject, the burden of proof is on us. So, to the witness stand, we call our first expert, Angela Merkel. Alone among the world leaders, she seems to have kept her head:
"The crisis did not come about because we issued too little money but because we created economic growth with too much money, and it was not sustainable," explains Germany's chancellor. She went on to suggest that maybe we shouldn't repeat the errors of the past.
As a proxy for 'deception' in our handy dictum, substitute 'money.' And now consider it in its two misleading forms - credit and deficit spending. "Credit not backed by real savings is a fraud," the great economist, Kurt Richebächer, used to say. It is a fraud when it comes not from willing lenders, but from central banks, artificially reducing lending rates in order to spur the economy. Deficit spending by government is a flimflam too. Governments rarely have extra funds to spare; they have to borrow the money. Eventually, that debt will have to be paid.
During the entire last half a century leading Western economists imagined a world that couldn't exist for one minute - where consuming wealth makes people wealthier...and where simply making more credit available can stimulate consumption. Each time the economy slowed down, the authorities induced people to buy more of what they didn't need with more money they didn't have. This produced 'growth.' But it was an ersatz growth. Every dollar of borrowed money would one day have to be paid back. Every step forward would have to be followed, eventually, by another one to the rear. "Deficit spending by government is a flimflam too. Governments rarely have extra funds to spare; they have to borrow the money. Eventually, that debt will have to be paid."
In the first four U.S. recessions after the Great Depression, from the mid-'30s through the mid-'50s, the total amount of monetary stimulus was actually negative. Instead of lowering rates, the feds - witless, as usual - often increased them or left them alone. But deficit spending went up an average of 2.2% of GDP each time. Later, the feds began to get the hang of it; every recession after 1958 was met with both more credit and more spending.
As the feds put in more money and credit, they found that more money and credit was needed. At the beginning of the period an extra $2 of credit would result in $1 of extra GDP. By the time the lights went out in 2007, it took about $6 of additional credit to produce a single extra dollar of output. Each new dollar of credit had to support not only the new 'growth' the feds were after, but all the accumulated debt and mistakes from previous stimulus programs.
In the recession of 1973, Brookings Institution economist George Perry told Congress that "we should be pulling out all the stops" to fix it. The resulting fiscal and monetary stimulus program cost the U.S. 4% of GDP, according to an estimate by Jim Grant. Future generations of Fed governors and Treasury secretaries found more stops...and of course, pulled them out too. In the micro recession of 2001, for example, the combined fiscal and monetary boost amounted to 7.2% of GDP, according to Grant.
The deceptions of the Bubble Epoque, 2001-2007, were enormous. The correction has been enormous too. And here are the same economists who mismanaged the economy, offering advice to governments who mismanaged their regulatory roles, about how to keep mismanaged companies alive, so that bondholders who mismanaged their investments might not go broke. That this will result in more misery is a foregone conclusion - at least, here at The Daily Reckoning. The measure of that misery, if our iron law holds, is how adamantly governments fight to keep their mismanagement going. Just looking at the numbers, the toll will be monstrous. All over the world, interest rates have been cut and budgets padded. France's deficit is running at 8% of GDP. England is running a deficit of more than 12% of GDP. And the U.S. is mobilizing as if it had been attacked by Martians. On the credit side, the feds have cut rates more than ever before, for a monetary boost equivalent to 18% of GDP, according to Grant. As to spending, $13 trillion has been pledged...an amount equivalent to a full year's annual output of the United States of America. This response is 3 times more (adjusted to today's dollars) than the U.S. spent to fight WWII. It is 12 times more (relative to GDP) than the total committed to fight the Great Depression.
It is, we will guess, what makes a great depression even greater.
Enjoy your weekend,
Bill Bonner
The Daily Reckoning
25 March 2009
Rudd spruikes US dollar
don't beleive anything until its been officially denied a few times......
Rousing endorsement . . . Kevin Rudd leaves the Australian ambassador's residence in Washington, before his meeting with Barack Obama, inset. Photo: Andrew Meares
Phillip Coorey in Washington and Jacob Saulwick
March 25, 2009
KEVIN RUDD has scotched suggestions by the governor of the People's Bank of China that the US dollar should lose its status as the world's key reserve currency.
The call by the governor of the central bank, Zhou Xiaochuan, for the creation of a new world currency has added spice to the lead-up to next week's G20 meeting called to find co-ordinated solutions to the global financial crisis.
The Prime Minister, whose approach to the crisis was branded "A-plus" yesterday by the Obama Administration, said the currency issue was not on the agenda of the G20 meeting in London.
"The dollar's position on that score remains unchallenged," he told a Wall Street Journal seminar in Washington. "It's not on my agenda papers and if there's a late Chinese edition I'll review it with respectful interest."
Russia already has proposed the G20 examine the creation of a new reserve currency and reportedly has the backing of a growing number of nations.
Mr Rudd, who held talks with the US President, Barack Obama, overnight Sydney time, is conscious of China's growing importance and backs its push at the G20 to increase its stake in the International Monetary Fund.
Mr Rudd said there was a chance the Chinese economy, on which so much of the world depends, could start recovering by the second half of this year.
He told the seminar public stimulus measures and private administrative changes under way in China might "give the rest of the world a bit of a surprise on the upside in the second half of the year. Everyone around the world is waiting for China to come alive … It's too early to tell but there's a few green shoots out there."
Mr Zhou's proposal, which economists consider unlikely to succeed, points to nervousness in China about $US2000 billion ($2840 billion) invested in the US, and a growing willingness to throw its weight around in international affairs.
"To me it is a case of dream on - it isn't going to happen," said Mervyn Lewis, a professor of finance at the University of South Australia.
Professor Lewis said the comments reflected China's frustration that by buying US government bonds, it was having to pay for the US attempt to spend its way out of the financial crisis.
The comments follow remarks by the Premier, Wen Jiabao, this month that he was worried about China's investments in the US, and his call for prudence on the part of the US Government. If the US dollar falls, it will dramatically reduce the worth of China's national savings.
Mr Rudd's approach to the financial crisis received a rousing endorsement from the US Treasury Secretary, Timothy Geithner. He told the Journal seminar that Mr Rudd was "incredibly A-plus" on responses to the global crisis. "If we did what he advised, we'd all be in a better place," Mr Geithner said.
Today Mr Obama will unveil proposals to tighten financial regulations.
Rousing endorsement . . . Kevin Rudd leaves the Australian ambassador's residence in Washington, before his meeting with Barack Obama, inset. Photo: Andrew Meares
Phillip Coorey in Washington and Jacob Saulwick
March 25, 2009
KEVIN RUDD has scotched suggestions by the governor of the People's Bank of China that the US dollar should lose its status as the world's key reserve currency.
The call by the governor of the central bank, Zhou Xiaochuan, for the creation of a new world currency has added spice to the lead-up to next week's G20 meeting called to find co-ordinated solutions to the global financial crisis.
The Prime Minister, whose approach to the crisis was branded "A-plus" yesterday by the Obama Administration, said the currency issue was not on the agenda of the G20 meeting in London.
"The dollar's position on that score remains unchallenged," he told a Wall Street Journal seminar in Washington. "It's not on my agenda papers and if there's a late Chinese edition I'll review it with respectful interest."
Russia already has proposed the G20 examine the creation of a new reserve currency and reportedly has the backing of a growing number of nations.
Mr Rudd, who held talks with the US President, Barack Obama, overnight Sydney time, is conscious of China's growing importance and backs its push at the G20 to increase its stake in the International Monetary Fund.
Mr Rudd said there was a chance the Chinese economy, on which so much of the world depends, could start recovering by the second half of this year.
He told the seminar public stimulus measures and private administrative changes under way in China might "give the rest of the world a bit of a surprise on the upside in the second half of the year. Everyone around the world is waiting for China to come alive … It's too early to tell but there's a few green shoots out there."
Mr Zhou's proposal, which economists consider unlikely to succeed, points to nervousness in China about $US2000 billion ($2840 billion) invested in the US, and a growing willingness to throw its weight around in international affairs.
"To me it is a case of dream on - it isn't going to happen," said Mervyn Lewis, a professor of finance at the University of South Australia.
Professor Lewis said the comments reflected China's frustration that by buying US government bonds, it was having to pay for the US attempt to spend its way out of the financial crisis.
The comments follow remarks by the Premier, Wen Jiabao, this month that he was worried about China's investments in the US, and his call for prudence on the part of the US Government. If the US dollar falls, it will dramatically reduce the worth of China's national savings.
Mr Rudd's approach to the financial crisis received a rousing endorsement from the US Treasury Secretary, Timothy Geithner. He told the Journal seminar that Mr Rudd was "incredibly A-plus" on responses to the global crisis. "If we did what he advised, we'd all be in a better place," Mr Geithner said.
Today Mr Obama will unveil proposals to tighten financial regulations.
24 February 2009
A bull market in chaos ~ Final stretch in the road to ruin
Road to Ruin: Final stretch
http://itulip.com/forums/showthread.php?p=78579#post78579
by Eric Janszen (February 23, 2009)
The credit crunch may only be in its early stages and a bigger contraction in lending in coming months could have "serious implications" for the U.S. economy, Standard & Poor's Rating Services said Friday.
While politicians and others have complained that banks aren't lending, the data on credit outstanding credit in the U.S. only tenuously supports this idea, the rating agency said.
"What's behind the apparent difference between perception and reality?" Standard & Poor's credit analyst Tanya Azarchs said. "It may be that, while growth in overall credit was positive through at least third-quarter 2008, it has risen at a slower pace than at any time since 1945 -- far below the 8%-10% rate in most years."
Banks are replacing loans as they mature, but there's little net new loan growth, she noted. "That could mean that the slowdown in lending is just an opening act, and a true credit crunch may yet take the stage," Azarchs warned. - Credit crunch may only have just begun, S&P warns, MarketWatch, February 21, 2009
Renowned investor George Soros said on Friday the world financial system has effectively disintegrated, adding that there is yet no prospect of a near-term resolution to the crisis.
Soros said the turbulence is actually more severe than during the Great Depression, comparing the current situation to the demise of the Soviet Union. - Soros sees no bottom for world financial collapse, Reuters, February 21, 2009
"One year ago, we would have said things were tough in the United States, but the rest of the world was holding up," Volcker told a conference featuring Nobel laureates, economists and investors at Columbia University in New York. "The rest of the world has not held up."
In fact, the 81-year-old former chairman of the Federal Reserve said, "I don't remember any time, maybe even the Great Depression, when things went down quite so fast."
"It's broken down in the face of almost all expectation and prediction," he noted. - Volcker sees crisis leading to global regulation, AP, February 20, 2009
The method to our madness -- negative on stocks since we opened in 1998 and positive on gold since 2001 -- becomes painfully apparent.
The DJIA closed Friday at 7,367, a level first seen in May 1997 in nominal terms. Adjusted for inflation, 7,367 shares of the DOW today buys only that which 5,600 shares bought in 1997; in real terms, the stock market got kicked back to1996. As dreadful as those facts are, they could be worse - and current course and speed maintained -- will.
The Nikkei closed Friday at 7,416, off 81% from Japan's stock market bubble peak of 38,916 on December 29, 1989 -- nineteen years ago -- as Japan's credit, stock, and real estate bubbles ended and an era of debt deflation set in. Collapsing US credit, stock, and real estate bubbles confronted the US with a similar fate starting in 2007. Marking the top of the US stock market bubble at 14,165 on October 9, 2007, if the US debt deflation era goes as badly as Japan's -- is as badly managed -- we can look forward to the DOW closing at 2,700... in the year 2026.
Imagine that.
As iTulip readers who have been us from the start know, we do not believe that will happen. Instead, as we have said for ten years, the US will never pay down all the foreign debt taken on during the FIRE Economy era, from 1980 to 2006, at least not on full-value dollars. America 2008 is not Japan 1990.
Japanese policy makers transferred debt from private to public account via bailouts and fiscal stimulus, siphoning off cash flow from households and businesses to repay the loans carried on the books of banks as assets on the side of the creditor-debtor balance sheet where the political power lives, collateralized by buildings, houses, and land, which prices were inflated by the very credit that created in the onerous debts that became ever more so as the Japanese economy shrank.
Banks and other creditors convince government to pursue policies to deflate the debt against the incomes of households and productive businesses, reducing the debt the slow painful way, dragging the country deeper and deeper into a hole. The Obama administration's stimulus plan does not target spending on infrastructure projects that boost long term US economic growth and competitiveness as much as we had hoped, and it fails to confront the core problem, the need to restructure both private sector and public debt left over by the FIRE Economy.
Debt Deflation Continuation Plan
So far, one year into debt deflation, the US is executing a Japanese style Debt Deflation Continuation Plan, as if the US, with its gross external debt of 95% of GDP, and current account deficit that grew from 5% to 7% of GDP in recent years, financed by nearly $4 billion dollars per day in capital imports, is in the same position as Japan in 1991, without external debt and running a large current account surplus as the world's largest exporter of capital. The magical thinking that underpins US policies extends the core fantasy that formed the foundation of the FIRE Economy itself: an economy can grow continuously by taking on ever more debt.
The US may be starting down the path of deflating debt against the incomes of its hard working citizens and non-financial business sectors, but the situation is temporary. After more than 30 years the US is in the final stretch on the road to ruin that stated in 1971 when the US left the international gold standard and developed into the FIRE Economy starting in the early 1980s. Long before 19 years pass, US creditors will address the heart of the matter, that as markets deflate asset prices in the US - housing prices have only only lost half their bubble era gains -- the debts against them must deflate as much as well. So far, mortgage relief programs are not aimed at reduction of principle but only the size of interest payments on excessive debt. If principle on debts is not reduced by negotiated debt restructuring, the markets will eventually deflate the debt against the monetary unit of the debt, the US dollar.
False Dawn
But wait, you say, back up. Is there not a silver lining in the US economic contraction? Isn't the personal savings rate is finally rising, laying the foundation for the next economic expansion?
Sadly, no. Incomes fall during economic contractions generally as debt repayment rises, creating a statistical increase in saving because debt repayment is reported as saving. But in a post-bubble world it is not the kind of saving that winds up in bank accounts to be spent later in consumption. What we are seeing today that looks like saving for future consumption is in fact the debt left over from the FIRE Economy sucking the life out of the US economy.
Similar policies, combined with the demographics of an aging population, led to a continuous decline in personal savings in Japan since 1992, two years after the end of the assets bubbles ended that started in 1985. Not coincidentally, the savings rate in Japan peaked at the same time. Why? During a period of asset price inflation, households stop saving and take on debt. After the asset price inflation ends the savings rate then increases for a year or so as debt is repaid.
Asset price inflations and deflations exert a perverse effect and saving. First the pool of savings to be spent on future consumption shrinks during the period of asset inflation because households are fooled into believing that asset price inflation is wealth creation, that inflating stock and home prices are doing the saving for them. Income is spent on current consumption. After the bubble pops and the fake wealth is wiped out, briefly the savings rate rises as post bubble recession has not yet expressed itself as rising unemployment and incomes have not yet begun to decline. About a year later then the pool of savings starts to shrink again as unemployment rises, incomes decline, and a greater proportion of income is goes to paying off debts taken on during the boom.
Collision Course
The duplication by the current administration of Japan's misguided policy to use public and private funds to pay down debt taken on during a credit bubble era is self limiting in the US case in a way it was not for Japan; as long as the debt repayment versus restructuring is pursed, and the banking system is left in its current state of disrepair, the US economy will continue to rapidly decline. (See: How a government that is politically independent from its financial sector swiftly ends a banking crisis.)
By our estimates, due to the combined impact of the crushing weight of debt burdens created by the FIRE Economy and maintained by the current Debt Deflation Continuation Plan and absent an immediate and effective, politically independent response to the banking crisis, leading to an intensification of the credit crisis as S&P predicts, real GDP will fall 4% in 2009 and 4% again in 2010. This despite the fiscal stimulus, estimated by Adam Posen of the Peterson Institute for International Economics at $1.5 trillion when TARP and other programs are taken into account. If federal government spending continues to increase outlays at the current rate of more than 10% of 2007 GDP per year, and federal government receipts continue decline at a 7.5% annual rate in 2009 and 2010 as in 2008, the fiscal deficit as a percent of real GDP will certainly exceed 10% in 2010, and the current account deficit on a balance of payments basis rise above 10% percent, even as imports fall as previously prodigious capital exporters in the Middle East and Asia suffer current account deficits of their own.
If and when its fiscal deficit reaches third world levels, will the US -- with its massive current account deficit financed by the public sector and daily dependence on capital inflows to maintain a balance of payments - finally suffer a balance of payments crisis, rapid currency depreciation, rapidly rising cost-push inflation, and rising interest rates? What we at iTulip.com refer to as a "Poom" portion of a Ka-Poom Theory?
It could happen this year. In fact, it may be happening now.
When the Russian government found itself unable to pay the interest on its foreign debt in August 1998, nor able to borrow more money in the international financial markets, nor increase taxes on its imploding economy, nor locate private capital inside Russia willing to lend it money, it suffered a balance of payments crisis. The result was capital flight, a ruble crash, and a spike of cost-push inflation.
In theory, this can't happen to the US, or so we are told. If the US experiences a balance of payments crisis the capital has no place to flee to from the US. The US is world's least bad place to hide. The US issues the world's reserve currency. The US is the world's most politically stable major nation. The dollar has a long history of stability, having persisted for over a century without having ever been recalled, unlike any other currency in existence today. But these arguments ignore two facts.
First, historically it is the very absence of previous experience with either a severe inflation or deflation that lulls policy makers into over-stepping the bounds of market tolerances. Japan, its currency and its people's savings once wiped out by hyperinflation pursues inflation phobic policies that leave the nation vulnerable to deflation while the US, once gripped by a deflation spiral in the 1930s, pursues reckless anti-deflation policies that expose the country to a horrific hyperinflationary outcome (See Hyperinflation case revisited - Part One: On the road to hyperinflation. Will we complete the trip?).
Second, the dollar is not the only option for capital flight from economies doing even more poorly than the US as the collapsing FIRE Economy spreads economic hardship around the world. Money is has been fleeing into hard assets the in the manner of capital flight by insiders from a third world country before a balance of payments induced currency crash (See US exchange rate and capital controls or bust?).
Most observers do not see the recent rise in the price of gold (and silver as well) in this context because gold as been a cult for so long that even the gold cultists don't understand what has changed. They see the current price rise as a part of a bull market that started in 2001, but we side with Soros on this, and Volcker: we are witnessing a global systemic breakup, the end of the road we got onto in 1971. We passed the last exit in 2001, the last chance to adopt a strategy to shift to a production and savings based economy through a series of steps negotiated with trade partners. Instead we increased the debt further through a property bubble financed with fraudulent structure credit products. The road ends when the US cannot finance its debts. The end of the road is near.
Bull market in chaos: Is a US balance of payments crisis imminent?
Your sensible source for apocalyptic predictions
March 15, 2006 (Metafilter)
iTulip.com has returned. Back in the go-go days when Internet stocks ruled the world, iTulip was one of a very few voices warning about the NASDAQ bubble and the likely fallout. As bad as things got, the overall financial bubble never really popped, it just shifted into debt and real estate after furious slashing of interest rates and money-printing by the Fed. Financial manias are terrible; their unraveling has been compared with economic nuclear weapons. The only good solution to a bubble is not to have one in the first place.
When we re-opened in March 2006, we observed in an article on Credit Risk Pollution in 2006 that structured credit was an accident waiting to happen to the global financial system, and the Frankenstein Economy - the result of a breakdown in accountability between borrower and creditor -- was an accident waiting to happen to the US banking industry. Now the greatest accident of all that has been waiting to happen, and is coming upon us with the same grim predictability as the other crises forecast here over the years but astonishing speed: US dependence on capital inflows to maintain its balance of payments, which inflows depend outflows by US creditors, which outflows depend on now rapidly shrinking output.
Japan, for example, experienced its first ever trade deficits over the past five months as the yen-carry trade reversed, spiking the yen, and exports declined due to a collapse in US demand and a strengthening currency. China has been taking up the slack. When China can no longer cover US capital import needs, it's all over but the crying.
The mother of all accidents waiting to happen
Source: IMF
The nearing of a US balance of payments crisis point is, in our view, why gold crossed the $1,000 mark again Friday to close at $994 while stocks closed at 12 year real lows.
We edge ever closer to our 2:1 DOW/Gold ratio target of 5,000 for the DOW and $2,500 for gold. The DOW/Gold ratio declined from 15.34 in September 2008 to 7.65 on Friday, 50% in five months. The previous 50% drop took five years.
Our positions in Treasury bonds and gold have served us well for over a decade. A buy-and-hold 85% position in 10 year Treasuries since 1998 combined with a15% gold position since 2001 has returned north of 7% a year. However, after ten years we are growing increasingly uneasy with our Treasury bond position.
Our concern about Treasury bonds is not technical. Our long-term targets remain at $2,500 for gold and 5,000 for the DOW as they have for years. Our new concern is that we are not be taking the forecast far enough, fast enough.
Think back three years to the time iTulip re-opened. We made correct calls on gold, stocks, and Treasury bonds, the collapse of structured credit and the credit-dependent financed-based economy, the decline in the Fed Funds rate to zero, the bailout Superfund (aka TARP), unemployment exceeding 10% in 2009, and later forecast infrastructure and energy related fiscal stimulus spending. But consider how much else has happened, and how much more quickly, than even our dire forecasts predicted?
Think back to March 2006 and imagine we had also forecast the following:
Fannie Mae and Freddie Mac nationalized
Lehman Brothers and other major Wall Street investment banks bankrupt
US automakers facing bankruptcy
Major US banks facing nationalization
Collapse of Iceland's and Latvia's economies and governments
Japanese output declines more than 25% in five months
If you look back over the dozens of articles and newsletters published by us years before this crisis, warning you about it, you will find that they describe events developing more slowly and less dire than the actual events that transpired with astonishing speed. In short, while we have been accused of making overly apocalyptic forecasts we were, in the event, overly optimistic. What if we still are?
Extrapolate and recalibrate: Accelerating to the end of the road
We are getting a 1930 to 1933 financial system and debt deflation collapse but in Internet time. The Internet that operated so efficiently for ultra efficient transmission of pricing information and execution of transactions is accelerating the financial and economic crisis process far more quickly than governments can respond to it. A 20th century international regulatory and trade institutional framework is no match for 21st century computer networked financial markets. No administration can correct 30 years of errors in a few months. Unfortunately, a few months is all we have because of the accelerated rate of change we are experiencing.
History teaches us that adjustments to imbalances can be sudden and brutal, and we think it imprudent to bet that the mother of all international payments imbalances -- between the US and the rest of the world -- will be the exception.
The rise of gold from $260 to $700 in six years followed by an increase from $700 to $1000 in two years may be quickly followed by a rise from $1,000 to $5,000 in just a few months.
In other words, our forecast of gold at $2,500 and the DOW at 5,000 may be as prosaic as our other seemingly dire forecasts because our perception of the rate of change and extent of the financial system, economic, and political crisis has been too optimistic.
Our primary concern at this stage is no longer our readers' portfolios but their ability to weather a US dollar crisis if one erupts. In response, we are increasing our gold allocation to 30% and moving all Treasury holdings to the very shortest maturities, to three month Treasury bills, until we see indications that conditions are stabilizing. We encourage you to engage with the community to actively discuss strategies that are appropriate for you.
http://itulip.com/forums/showthread.php?p=78579#post78579
by Eric Janszen (February 23, 2009)
The credit crunch may only be in its early stages and a bigger contraction in lending in coming months could have "serious implications" for the U.S. economy, Standard & Poor's Rating Services said Friday.
While politicians and others have complained that banks aren't lending, the data on credit outstanding credit in the U.S. only tenuously supports this idea, the rating agency said.
"What's behind the apparent difference between perception and reality?" Standard & Poor's credit analyst Tanya Azarchs said. "It may be that, while growth in overall credit was positive through at least third-quarter 2008, it has risen at a slower pace than at any time since 1945 -- far below the 8%-10% rate in most years."
Banks are replacing loans as they mature, but there's little net new loan growth, she noted. "That could mean that the slowdown in lending is just an opening act, and a true credit crunch may yet take the stage," Azarchs warned. - Credit crunch may only have just begun, S&P warns, MarketWatch, February 21, 2009
Renowned investor George Soros said on Friday the world financial system has effectively disintegrated, adding that there is yet no prospect of a near-term resolution to the crisis.
Soros said the turbulence is actually more severe than during the Great Depression, comparing the current situation to the demise of the Soviet Union. - Soros sees no bottom for world financial collapse, Reuters, February 21, 2009
"One year ago, we would have said things were tough in the United States, but the rest of the world was holding up," Volcker told a conference featuring Nobel laureates, economists and investors at Columbia University in New York. "The rest of the world has not held up."
In fact, the 81-year-old former chairman of the Federal Reserve said, "I don't remember any time, maybe even the Great Depression, when things went down quite so fast."
"It's broken down in the face of almost all expectation and prediction," he noted. - Volcker sees crisis leading to global regulation, AP, February 20, 2009
The method to our madness -- negative on stocks since we opened in 1998 and positive on gold since 2001 -- becomes painfully apparent.
The DJIA closed Friday at 7,367, a level first seen in May 1997 in nominal terms. Adjusted for inflation, 7,367 shares of the DOW today buys only that which 5,600 shares bought in 1997; in real terms, the stock market got kicked back to1996. As dreadful as those facts are, they could be worse - and current course and speed maintained -- will.
The Nikkei closed Friday at 7,416, off 81% from Japan's stock market bubble peak of 38,916 on December 29, 1989 -- nineteen years ago -- as Japan's credit, stock, and real estate bubbles ended and an era of debt deflation set in. Collapsing US credit, stock, and real estate bubbles confronted the US with a similar fate starting in 2007. Marking the top of the US stock market bubble at 14,165 on October 9, 2007, if the US debt deflation era goes as badly as Japan's -- is as badly managed -- we can look forward to the DOW closing at 2,700... in the year 2026.
Imagine that.
As iTulip readers who have been us from the start know, we do not believe that will happen. Instead, as we have said for ten years, the US will never pay down all the foreign debt taken on during the FIRE Economy era, from 1980 to 2006, at least not on full-value dollars. America 2008 is not Japan 1990.
Japanese policy makers transferred debt from private to public account via bailouts and fiscal stimulus, siphoning off cash flow from households and businesses to repay the loans carried on the books of banks as assets on the side of the creditor-debtor balance sheet where the political power lives, collateralized by buildings, houses, and land, which prices were inflated by the very credit that created in the onerous debts that became ever more so as the Japanese economy shrank.
Banks and other creditors convince government to pursue policies to deflate the debt against the incomes of households and productive businesses, reducing the debt the slow painful way, dragging the country deeper and deeper into a hole. The Obama administration's stimulus plan does not target spending on infrastructure projects that boost long term US economic growth and competitiveness as much as we had hoped, and it fails to confront the core problem, the need to restructure both private sector and public debt left over by the FIRE Economy.
Debt Deflation Continuation Plan
So far, one year into debt deflation, the US is executing a Japanese style Debt Deflation Continuation Plan, as if the US, with its gross external debt of 95% of GDP, and current account deficit that grew from 5% to 7% of GDP in recent years, financed by nearly $4 billion dollars per day in capital imports, is in the same position as Japan in 1991, without external debt and running a large current account surplus as the world's largest exporter of capital. The magical thinking that underpins US policies extends the core fantasy that formed the foundation of the FIRE Economy itself: an economy can grow continuously by taking on ever more debt.
The US may be starting down the path of deflating debt against the incomes of its hard working citizens and non-financial business sectors, but the situation is temporary. After more than 30 years the US is in the final stretch on the road to ruin that stated in 1971 when the US left the international gold standard and developed into the FIRE Economy starting in the early 1980s. Long before 19 years pass, US creditors will address the heart of the matter, that as markets deflate asset prices in the US - housing prices have only only lost half their bubble era gains -- the debts against them must deflate as much as well. So far, mortgage relief programs are not aimed at reduction of principle but only the size of interest payments on excessive debt. If principle on debts is not reduced by negotiated debt restructuring, the markets will eventually deflate the debt against the monetary unit of the debt, the US dollar.
False Dawn
But wait, you say, back up. Is there not a silver lining in the US economic contraction? Isn't the personal savings rate is finally rising, laying the foundation for the next economic expansion?
Sadly, no. Incomes fall during economic contractions generally as debt repayment rises, creating a statistical increase in saving because debt repayment is reported as saving. But in a post-bubble world it is not the kind of saving that winds up in bank accounts to be spent later in consumption. What we are seeing today that looks like saving for future consumption is in fact the debt left over from the FIRE Economy sucking the life out of the US economy.
Similar policies, combined with the demographics of an aging population, led to a continuous decline in personal savings in Japan since 1992, two years after the end of the assets bubbles ended that started in 1985. Not coincidentally, the savings rate in Japan peaked at the same time. Why? During a period of asset price inflation, households stop saving and take on debt. After the asset price inflation ends the savings rate then increases for a year or so as debt is repaid.
Asset price inflations and deflations exert a perverse effect and saving. First the pool of savings to be spent on future consumption shrinks during the period of asset inflation because households are fooled into believing that asset price inflation is wealth creation, that inflating stock and home prices are doing the saving for them. Income is spent on current consumption. After the bubble pops and the fake wealth is wiped out, briefly the savings rate rises as post bubble recession has not yet expressed itself as rising unemployment and incomes have not yet begun to decline. About a year later then the pool of savings starts to shrink again as unemployment rises, incomes decline, and a greater proportion of income is goes to paying off debts taken on during the boom.
Collision Course
The duplication by the current administration of Japan's misguided policy to use public and private funds to pay down debt taken on during a credit bubble era is self limiting in the US case in a way it was not for Japan; as long as the debt repayment versus restructuring is pursed, and the banking system is left in its current state of disrepair, the US economy will continue to rapidly decline. (See: How a government that is politically independent from its financial sector swiftly ends a banking crisis.)
By our estimates, due to the combined impact of the crushing weight of debt burdens created by the FIRE Economy and maintained by the current Debt Deflation Continuation Plan and absent an immediate and effective, politically independent response to the banking crisis, leading to an intensification of the credit crisis as S&P predicts, real GDP will fall 4% in 2009 and 4% again in 2010. This despite the fiscal stimulus, estimated by Adam Posen of the Peterson Institute for International Economics at $1.5 trillion when TARP and other programs are taken into account. If federal government spending continues to increase outlays at the current rate of more than 10% of 2007 GDP per year, and federal government receipts continue decline at a 7.5% annual rate in 2009 and 2010 as in 2008, the fiscal deficit as a percent of real GDP will certainly exceed 10% in 2010, and the current account deficit on a balance of payments basis rise above 10% percent, even as imports fall as previously prodigious capital exporters in the Middle East and Asia suffer current account deficits of their own.
If and when its fiscal deficit reaches third world levels, will the US -- with its massive current account deficit financed by the public sector and daily dependence on capital inflows to maintain a balance of payments - finally suffer a balance of payments crisis, rapid currency depreciation, rapidly rising cost-push inflation, and rising interest rates? What we at iTulip.com refer to as a "Poom" portion of a Ka-Poom Theory?
It could happen this year. In fact, it may be happening now.
When the Russian government found itself unable to pay the interest on its foreign debt in August 1998, nor able to borrow more money in the international financial markets, nor increase taxes on its imploding economy, nor locate private capital inside Russia willing to lend it money, it suffered a balance of payments crisis. The result was capital flight, a ruble crash, and a spike of cost-push inflation.
In theory, this can't happen to the US, or so we are told. If the US experiences a balance of payments crisis the capital has no place to flee to from the US. The US is world's least bad place to hide. The US issues the world's reserve currency. The US is the world's most politically stable major nation. The dollar has a long history of stability, having persisted for over a century without having ever been recalled, unlike any other currency in existence today. But these arguments ignore two facts.
First, historically it is the very absence of previous experience with either a severe inflation or deflation that lulls policy makers into over-stepping the bounds of market tolerances. Japan, its currency and its people's savings once wiped out by hyperinflation pursues inflation phobic policies that leave the nation vulnerable to deflation while the US, once gripped by a deflation spiral in the 1930s, pursues reckless anti-deflation policies that expose the country to a horrific hyperinflationary outcome (See Hyperinflation case revisited - Part One: On the road to hyperinflation. Will we complete the trip?).
Second, the dollar is not the only option for capital flight from economies doing even more poorly than the US as the collapsing FIRE Economy spreads economic hardship around the world. Money is has been fleeing into hard assets the in the manner of capital flight by insiders from a third world country before a balance of payments induced currency crash (See US exchange rate and capital controls or bust?).
Most observers do not see the recent rise in the price of gold (and silver as well) in this context because gold as been a cult for so long that even the gold cultists don't understand what has changed. They see the current price rise as a part of a bull market that started in 2001, but we side with Soros on this, and Volcker: we are witnessing a global systemic breakup, the end of the road we got onto in 1971. We passed the last exit in 2001, the last chance to adopt a strategy to shift to a production and savings based economy through a series of steps negotiated with trade partners. Instead we increased the debt further through a property bubble financed with fraudulent structure credit products. The road ends when the US cannot finance its debts. The end of the road is near.
Bull market in chaos: Is a US balance of payments crisis imminent?
Your sensible source for apocalyptic predictions
March 15, 2006 (Metafilter)
iTulip.com has returned. Back in the go-go days when Internet stocks ruled the world, iTulip was one of a very few voices warning about the NASDAQ bubble and the likely fallout. As bad as things got, the overall financial bubble never really popped, it just shifted into debt and real estate after furious slashing of interest rates and money-printing by the Fed. Financial manias are terrible; their unraveling has been compared with economic nuclear weapons. The only good solution to a bubble is not to have one in the first place.
When we re-opened in March 2006, we observed in an article on Credit Risk Pollution in 2006 that structured credit was an accident waiting to happen to the global financial system, and the Frankenstein Economy - the result of a breakdown in accountability between borrower and creditor -- was an accident waiting to happen to the US banking industry. Now the greatest accident of all that has been waiting to happen, and is coming upon us with the same grim predictability as the other crises forecast here over the years but astonishing speed: US dependence on capital inflows to maintain its balance of payments, which inflows depend outflows by US creditors, which outflows depend on now rapidly shrinking output.
Japan, for example, experienced its first ever trade deficits over the past five months as the yen-carry trade reversed, spiking the yen, and exports declined due to a collapse in US demand and a strengthening currency. China has been taking up the slack. When China can no longer cover US capital import needs, it's all over but the crying.
The mother of all accidents waiting to happen
Source: IMF
The nearing of a US balance of payments crisis point is, in our view, why gold crossed the $1,000 mark again Friday to close at $994 while stocks closed at 12 year real lows.
We edge ever closer to our 2:1 DOW/Gold ratio target of 5,000 for the DOW and $2,500 for gold. The DOW/Gold ratio declined from 15.34 in September 2008 to 7.65 on Friday, 50% in five months. The previous 50% drop took five years.
Our positions in Treasury bonds and gold have served us well for over a decade. A buy-and-hold 85% position in 10 year Treasuries since 1998 combined with a15% gold position since 2001 has returned north of 7% a year. However, after ten years we are growing increasingly uneasy with our Treasury bond position.
Our concern about Treasury bonds is not technical. Our long-term targets remain at $2,500 for gold and 5,000 for the DOW as they have for years. Our new concern is that we are not be taking the forecast far enough, fast enough.
Think back three years to the time iTulip re-opened. We made correct calls on gold, stocks, and Treasury bonds, the collapse of structured credit and the credit-dependent financed-based economy, the decline in the Fed Funds rate to zero, the bailout Superfund (aka TARP), unemployment exceeding 10% in 2009, and later forecast infrastructure and energy related fiscal stimulus spending. But consider how much else has happened, and how much more quickly, than even our dire forecasts predicted?
Think back to March 2006 and imagine we had also forecast the following:
Fannie Mae and Freddie Mac nationalized
Lehman Brothers and other major Wall Street investment banks bankrupt
US automakers facing bankruptcy
Major US banks facing nationalization
Collapse of Iceland's and Latvia's economies and governments
Japanese output declines more than 25% in five months
If you look back over the dozens of articles and newsletters published by us years before this crisis, warning you about it, you will find that they describe events developing more slowly and less dire than the actual events that transpired with astonishing speed. In short, while we have been accused of making overly apocalyptic forecasts we were, in the event, overly optimistic. What if we still are?
Extrapolate and recalibrate: Accelerating to the end of the road
We are getting a 1930 to 1933 financial system and debt deflation collapse but in Internet time. The Internet that operated so efficiently for ultra efficient transmission of pricing information and execution of transactions is accelerating the financial and economic crisis process far more quickly than governments can respond to it. A 20th century international regulatory and trade institutional framework is no match for 21st century computer networked financial markets. No administration can correct 30 years of errors in a few months. Unfortunately, a few months is all we have because of the accelerated rate of change we are experiencing.
History teaches us that adjustments to imbalances can be sudden and brutal, and we think it imprudent to bet that the mother of all international payments imbalances -- between the US and the rest of the world -- will be the exception.
The rise of gold from $260 to $700 in six years followed by an increase from $700 to $1000 in two years may be quickly followed by a rise from $1,000 to $5,000 in just a few months.
In other words, our forecast of gold at $2,500 and the DOW at 5,000 may be as prosaic as our other seemingly dire forecasts because our perception of the rate of change and extent of the financial system, economic, and political crisis has been too optimistic.
Our primary concern at this stage is no longer our readers' portfolios but their ability to weather a US dollar crisis if one erupts. In response, we are increasing our gold allocation to 30% and moving all Treasury holdings to the very shortest maturities, to three month Treasury bills, until we see indications that conditions are stabilizing. We encourage you to engage with the community to actively discuss strategies that are appropriate for you.
23 January 2009
The temptation of dollar seigniorage By Kosuke Takahashi ~ Asia Times
TOKYO - As the United States seeks to finance its ballooning budget deficits by printing more US dollar bills, Japanese economists are increasingly concerned that the excessive use of dollar seigniorage by US financial authorities will further shake confidence in the US currency at a time when the world lacks an alternative globally accepted currency.
The US government projects that even without the forthcoming US$825 billion fiscal stimulus package, the national budget deficit to September 2009 will be $1.19 trillion, the biggest since World War II, or 8.3% of gross domestic product (GDP). This amount is likely to grow as the US government continues to rescue failed parts of the economy. How will the US cope with its enormous and growing debt obligations?
Therein lies the issue of the dollar's international seigniorage as a savior for the US national interest.
Seigniorage is the revenue that a government raises by printing money. Suppose it costs one dollar to print a US$100 bill. As long as the world deems this bill worth $100, the US government receives the revenue of $99 every time it prints out a $100 bill (the difference being an approximation of the costs related to producing the bills) and circulates it to the markets at home and overseas. This is a perquisite of the US under the present world currency system. Neither Europe nor Japan, among other major economies, can enjoy the benefits of seigniorage globally because the euro and the yen have not become international settlement currencies.
"The US is the only nation in the world, as the key currency nation, to have privileges to earn huge seigniorage," Iwao Nakatani, a renowned economist in Tokyo, wrote in his recent best-selling book Why did capitalism self-destruct?, which is sparking a debate in Tokyo, the financial center of the world's second-biggest economy, over United States-led global capitalism.
"If the FRB [Federal Reserve Board] or the US government issues dollar bills and spreads them abroad, that's sufficient to earn enormous seigniorage - as long as people around the world see the dollar's value as stable," he wrote.
In the book, Harvard-educated Nakatani made a "confession" by saying he had been doing the wrong thing, surprising many Japanese by indicating that what he had learned in the US had proved harmful to Japanese society. The easing of regulations and the liberalization of markets in Japan had brought about an American-style widening disparity between Japan's haves and have-nots and an accumulated discrepancy between society's winners and losers, he pointed out.
Nakatani had been an ardent advocate of globalization and national structural reforms since the early 1990s under the Morihiro Hosokawa and Keizo Obuchi administrations. Nakatani's strong support of global capitalism later influenced reform policies conducted by popular former prime minister Junichiro Koizumi, a symbol of Japan's reformist policy, from 2001 to 2006.
Bernanke's views on seigniorage
It's intriguing to note what Federal Reserve chairman Ben Bernanke, then Princeton University economics professor, said about seigniorage. He wrote in his Macroeconomics textbook, co-authored with Andrew Abel, that the government can print money when it cannot (or does not want to) finance all of its spending by taxes or borrowing from the public. In the extreme case, imagine a government wants to spend $10 billion (say, on submarines) but has no ability to tax or borrow from the public. One option is for the government to print $10 billion worth of currency and use this currency to pay for the submarines.
If you replace the word "submarines" with "bailout funds", that will mirror the present US situation.
Bernanke and Abel continue: "Governments that want to finance their deficits through seigniorage do not simply print money but use an indirect procedure. First, the Treasury authorizes government borrowing equal to the amount of the budget deficit, and a correspondent quantity of new government bonds are printed and sold. However, the new government bonds are not sold to the public. Instead, the Treasury asks (or requires) the central bank to purchase the $10 billion in new bonds. The central bank pays for its purchase of new bonds by printing $10 billion in new currency, which it gives to the Treasury in exchange for the bonds."
This is what the Bernanke Fed is thinking of doing in the coming months and years. It has already snatched up a big chunk of soured mortgage-backed securities guaranteed by beleaguered mortgage-guarantors Fannie Mae and Freddie Mac. Bernanke has also said the Fed may buy "longer-term Treasury or agency securities on the open market in substantial quantities", using the Fed's balance sheet and money-creation authority to aid the ailing US economy.
The latest Fed data showed the monetary base jumped to more than $1.7 trillion this month, more than double from around $840 billion in August - a vertical takeoff in the supply of dollars.
Temptation of seigniorage
The US economy has benefited from seigniorage by printing dollar bills to finance a huge current-account deficit, for which the trade imbalance is by far the greatest reason. This enabled Washington to take its expansionary monetary and fiscal policy amid ballooning debts.
Unlike Japan, China and Europe, among other nations, the US did not have to tap the market of its own goods and services desperately. Simply put, by just printing money, it could get whatever it wanted from abroad, even without any cash on hand. Instead, the spread of the US debt bubble overseas enhanced the networking power of dollar hegemony, which in return boosted the power of dollar seigniorage. This is all debt-forgiveness resulting from the dollar key-currency system.
"Should the US Federal Reserve have properly managed money supply, being conscious of the role of the world's central bank, today's financial crash should have avoided," Nakatani wrote. "But in reality, Alan Greenspan, who had served as Fed chairman for a long time, gave top priority to economic upturn and accommodated the housing bubble. The dollar's oversupply continued. This is the root cause of today's financial crisis."
The US dollar has strengthened against other major currencies, with the notable exception of the yen, in the past months, even as the country has been at the epicenter of the deepening financial crisis. Many currency analysts see risk reduction among investors causing the money that US financial firms had invested in the world to be repatriated to the homeland, triggering dollar-buying.
But that dollar strength may not last. Once people around the world start to think an excessive dollar supply will diminish the value of the currency, they may start selling dollar-denominated assets all at once, causing devastating damage to the world economy. This is why world leaders such as Japan's Prime Minister Taro Aso have repeatedly expressed support of the dollar in the international financial system, easing people's lingering concern over the greenback.
Early signs of the worst scenario for the US are already beginning to show. International demand for long-term US financial assets fell in November as foreign investors sold Treasury, agency and corporate debt, a government report showed on January 16. Net selling of all long-term assets in November was the most since August 2007, as investors sold bonds issued by Fannie Mae, Freddie Mac and other government-sponsored enterprises for a fourth month in the past five.
"For the moment, governments around the world are supporting the dollar key-currency system," said Masaki Fukui, senior market economist in Tokyo at Mizuho Corporate Bank Ltd, a unit of Japan's second-largest financial group by market value. "But there is still a deep-seated structural problem, causing some concern. We can never say a dollar crisis won't come."
When risk aversion begins to abate, as will happen at some point, the Fed needs to act quickly to drain excessive dollar supply, or money supply. Otherwise, the dollar will be doomed and hyperinflation and economic bubbles will occur once again, which could lead to a recurrence of the global financial crisis.
Should the US give in to the temptation of dollar seigniorage, as it has done in the past, loosening money to feed debt bubbles, investors are well advised to diversify their currency positions to hedge against dollar risk. This could be yet another catalyst for undermining dollar hegemony, which the US for sure does not want to see happen.
Kosuke Takahashi is a Tokyo-based journalist.
(Copyright 2009 Asia Times Online (Holdings) Ltd. All rights reserved. Please contact us about sales, syndication and republishing.)
The US government projects that even without the forthcoming US$825 billion fiscal stimulus package, the national budget deficit to September 2009 will be $1.19 trillion, the biggest since World War II, or 8.3% of gross domestic product (GDP). This amount is likely to grow as the US government continues to rescue failed parts of the economy. How will the US cope with its enormous and growing debt obligations?
Therein lies the issue of the dollar's international seigniorage as a savior for the US national interest.
Seigniorage is the revenue that a government raises by printing money. Suppose it costs one dollar to print a US$100 bill. As long as the world deems this bill worth $100, the US government receives the revenue of $99 every time it prints out a $100 bill (the difference being an approximation of the costs related to producing the bills) and circulates it to the markets at home and overseas. This is a perquisite of the US under the present world currency system. Neither Europe nor Japan, among other major economies, can enjoy the benefits of seigniorage globally because the euro and the yen have not become international settlement currencies.
"The US is the only nation in the world, as the key currency nation, to have privileges to earn huge seigniorage," Iwao Nakatani, a renowned economist in Tokyo, wrote in his recent best-selling book Why did capitalism self-destruct?, which is sparking a debate in Tokyo, the financial center of the world's second-biggest economy, over United States-led global capitalism.
"If the FRB [Federal Reserve Board] or the US government issues dollar bills and spreads them abroad, that's sufficient to earn enormous seigniorage - as long as people around the world see the dollar's value as stable," he wrote.
In the book, Harvard-educated Nakatani made a "confession" by saying he had been doing the wrong thing, surprising many Japanese by indicating that what he had learned in the US had proved harmful to Japanese society. The easing of regulations and the liberalization of markets in Japan had brought about an American-style widening disparity between Japan's haves and have-nots and an accumulated discrepancy between society's winners and losers, he pointed out.
Nakatani had been an ardent advocate of globalization and national structural reforms since the early 1990s under the Morihiro Hosokawa and Keizo Obuchi administrations. Nakatani's strong support of global capitalism later influenced reform policies conducted by popular former prime minister Junichiro Koizumi, a symbol of Japan's reformist policy, from 2001 to 2006.
Bernanke's views on seigniorage
It's intriguing to note what Federal Reserve chairman Ben Bernanke, then Princeton University economics professor, said about seigniorage. He wrote in his Macroeconomics textbook, co-authored with Andrew Abel, that the government can print money when it cannot (or does not want to) finance all of its spending by taxes or borrowing from the public. In the extreme case, imagine a government wants to spend $10 billion (say, on submarines) but has no ability to tax or borrow from the public. One option is for the government to print $10 billion worth of currency and use this currency to pay for the submarines.
If you replace the word "submarines" with "bailout funds", that will mirror the present US situation.
Bernanke and Abel continue: "Governments that want to finance their deficits through seigniorage do not simply print money but use an indirect procedure. First, the Treasury authorizes government borrowing equal to the amount of the budget deficit, and a correspondent quantity of new government bonds are printed and sold. However, the new government bonds are not sold to the public. Instead, the Treasury asks (or requires) the central bank to purchase the $10 billion in new bonds. The central bank pays for its purchase of new bonds by printing $10 billion in new currency, which it gives to the Treasury in exchange for the bonds."
This is what the Bernanke Fed is thinking of doing in the coming months and years. It has already snatched up a big chunk of soured mortgage-backed securities guaranteed by beleaguered mortgage-guarantors Fannie Mae and Freddie Mac. Bernanke has also said the Fed may buy "longer-term Treasury or agency securities on the open market in substantial quantities", using the Fed's balance sheet and money-creation authority to aid the ailing US economy.
The latest Fed data showed the monetary base jumped to more than $1.7 trillion this month, more than double from around $840 billion in August - a vertical takeoff in the supply of dollars.
Temptation of seigniorage
The US economy has benefited from seigniorage by printing dollar bills to finance a huge current-account deficit, for which the trade imbalance is by far the greatest reason. This enabled Washington to take its expansionary monetary and fiscal policy amid ballooning debts.
Unlike Japan, China and Europe, among other nations, the US did not have to tap the market of its own goods and services desperately. Simply put, by just printing money, it could get whatever it wanted from abroad, even without any cash on hand. Instead, the spread of the US debt bubble overseas enhanced the networking power of dollar hegemony, which in return boosted the power of dollar seigniorage. This is all debt-forgiveness resulting from the dollar key-currency system.
"Should the US Federal Reserve have properly managed money supply, being conscious of the role of the world's central bank, today's financial crash should have avoided," Nakatani wrote. "But in reality, Alan Greenspan, who had served as Fed chairman for a long time, gave top priority to economic upturn and accommodated the housing bubble. The dollar's oversupply continued. This is the root cause of today's financial crisis."
The US dollar has strengthened against other major currencies, with the notable exception of the yen, in the past months, even as the country has been at the epicenter of the deepening financial crisis. Many currency analysts see risk reduction among investors causing the money that US financial firms had invested in the world to be repatriated to the homeland, triggering dollar-buying.
But that dollar strength may not last. Once people around the world start to think an excessive dollar supply will diminish the value of the currency, they may start selling dollar-denominated assets all at once, causing devastating damage to the world economy. This is why world leaders such as Japan's Prime Minister Taro Aso have repeatedly expressed support of the dollar in the international financial system, easing people's lingering concern over the greenback.
Early signs of the worst scenario for the US are already beginning to show. International demand for long-term US financial assets fell in November as foreign investors sold Treasury, agency and corporate debt, a government report showed on January 16. Net selling of all long-term assets in November was the most since August 2007, as investors sold bonds issued by Fannie Mae, Freddie Mac and other government-sponsored enterprises for a fourth month in the past five.
"For the moment, governments around the world are supporting the dollar key-currency system," said Masaki Fukui, senior market economist in Tokyo at Mizuho Corporate Bank Ltd, a unit of Japan's second-largest financial group by market value. "But there is still a deep-seated structural problem, causing some concern. We can never say a dollar crisis won't come."
When risk aversion begins to abate, as will happen at some point, the Fed needs to act quickly to drain excessive dollar supply, or money supply. Otherwise, the dollar will be doomed and hyperinflation and economic bubbles will occur once again, which could lead to a recurrence of the global financial crisis.
Should the US give in to the temptation of dollar seigniorage, as it has done in the past, loosening money to feed debt bubbles, investors are well advised to diversify their currency positions to hedge against dollar risk. This could be yet another catalyst for undermining dollar hegemony, which the US for sure does not want to see happen.
Kosuke Takahashi is a Tokyo-based journalist.
(Copyright 2009 Asia Times Online (Holdings) Ltd. All rights reserved. Please contact us about sales, syndication and republishing.)
21 January 2009
Last chance to get out of US dollar ~ Jim Willie
The quintessential event is a high probable 20% to 30% overnight USDollar devaluation, enough to cause massive financial shockwaves, like broken financial firms, bankrupted banks, badly disrupted commodity exchanges, badly disrupted stock exchanges, and much more. This might be a planned event. The global power centers might have worked a compromise to attempt to produce some instant stability. They will not achieve any stability at all, but rather a chain reaction of dislocations. My guess is that it has been forced down the USGovt’s throat, in the aftermath of the largest fraud episode in human history, against a backdrop of the largest rescue bailout nationalization stimulus stream in history. To date, it totals over $9 trillion.
USDOLLAR VULNERABILITY – SEVERE OVERNIGHT CORRECTION
The USDollar has been lifted by queer forces in the last few months. Redemptions of Credit Default Swaps are paid out in US$ terms, as large corporations fail and their asset backed bonds default. CDSwaps are insurance policy contracts. Also, the sale of speculative fund positions often results in debt liquidation, and repayment of heavy credit extended in US$ terms. Another force has been revealed. In the 4Q2008, fully $150 billion in foreign subsidiary assets, funds, and profits were brought home by US corporations, in order to repair the balance sheets and stem disaster. This has garnered little or no publicity. The repatriation flow is not to be expected to repeat each quarter, and is largely completed. The Powerz prefer to formulate false stories about Flight to Dollar Quality, or the US financial sector being the first to emerge from the credit crisis, or foreign financial structures being worse off than the US, or some total nonsense.
The USDollar DX index has more thoroughly filled the gap from 82.5 to 83.5 described in the last article. Watch the stochastix crossover signal, which might be a thinly disguised rebound near its end. The USDollar is a tired soldier here. Almost always a retest of the previous established high occurs, like the 88 registered in November. That is in progress, and probably has run its course. Little talk has come to how US firms have been harmed by rising export prices charged to foreign customers. That is a US$ negative factor. The fast deterioration of the USEconomy is an extremely negative US$ factor. Lastly, as cited over two years ago, the USEconomic trade deficit finally has come down, but mainly due to economic slowdown called recession, finally recognized. My description is of disintegration, since credit devices have been destroyed, borrowers have been rendered insolvent, banks are mostly insolvent, supply chains are locked down, and transportation systems are left idle. Most claims of imminent revival are utterly laughable.
The USTreasury Bond is offering extremely low yields to investors. The short-term Bills are offering near 0% yields in a travesty on wheels. With the US$ elevated from its Death Dance, lifted by powerful prevalent destruction, and the USTBond principal elevated from risk aversion and central bank consolidation into the valueless monolith of worthless debt eventually to suffer default, SOMETHING MUST GIVE FROM POWERFUL FORCES.
ZOMBIES IN BANK SYSTEM – ATTRACTING LAST PUBLIC FUNDS
Most US-based banks are insolvent. The largest banks have been kept afloat in the last decade by the perverse trade in credit derivatives. Rather than melt down the garbage silos called banks, and liquidating their assets, they are kept in a state of moribund animation in order to attract public funds. Such easy pickings from the USCongress, who have no idea what is going on, or else receive bribes. See the vast contributions from Fannie Mae over the years to key players today. The corruption and fraud has never in the history of the nation been easier, largely due to protection and collusion by the regulators themselves, but more importantly, due to the JPMorgan & Goldman Sachs key henchmen operating the Dept of Treasury & USFed. These are the Inside Guys. This is Counterfeit Capitalism, enough to make Jefferson or Keynes shudder. The TARP funds are a great example, gigantic intravenous injections to cadavers. They were not administered by the Paulson syndicate bosses because they knew full well that the banks were dead. So they stole the funds, a practice they have ample experience with from their mortgage fraud enterprise. The TARP is but a climax. Declaration of death would eliminate the opportunity for more rescue funds, relief efforts, and confiscation. With the insolvency, lack of adequate liquidity, the general decrepit state has led to an unsustainable situation. SOMETHING MUST GIVE FROM POWERFUL FORCES.
USDOLLAR VULNERABILITY – SEVERE OVERNIGHT CORRECTION
The USDollar has been lifted by queer forces in the last few months. Redemptions of Credit Default Swaps are paid out in US$ terms, as large corporations fail and their asset backed bonds default. CDSwaps are insurance policy contracts. Also, the sale of speculative fund positions often results in debt liquidation, and repayment of heavy credit extended in US$ terms. Another force has been revealed. In the 4Q2008, fully $150 billion in foreign subsidiary assets, funds, and profits were brought home by US corporations, in order to repair the balance sheets and stem disaster. This has garnered little or no publicity. The repatriation flow is not to be expected to repeat each quarter, and is largely completed. The Powerz prefer to formulate false stories about Flight to Dollar Quality, or the US financial sector being the first to emerge from the credit crisis, or foreign financial structures being worse off than the US, or some total nonsense.
The USDollar DX index has more thoroughly filled the gap from 82.5 to 83.5 described in the last article. Watch the stochastix crossover signal, which might be a thinly disguised rebound near its end. The USDollar is a tired soldier here. Almost always a retest of the previous established high occurs, like the 88 registered in November. That is in progress, and probably has run its course. Little talk has come to how US firms have been harmed by rising export prices charged to foreign customers. That is a US$ negative factor. The fast deterioration of the USEconomy is an extremely negative US$ factor. Lastly, as cited over two years ago, the USEconomic trade deficit finally has come down, but mainly due to economic slowdown called recession, finally recognized. My description is of disintegration, since credit devices have been destroyed, borrowers have been rendered insolvent, banks are mostly insolvent, supply chains are locked down, and transportation systems are left idle. Most claims of imminent revival are utterly laughable.
The USTreasury Bond is offering extremely low yields to investors. The short-term Bills are offering near 0% yields in a travesty on wheels. With the US$ elevated from its Death Dance, lifted by powerful prevalent destruction, and the USTBond principal elevated from risk aversion and central bank consolidation into the valueless monolith of worthless debt eventually to suffer default, SOMETHING MUST GIVE FROM POWERFUL FORCES.
ZOMBIES IN BANK SYSTEM – ATTRACTING LAST PUBLIC FUNDS
Most US-based banks are insolvent. The largest banks have been kept afloat in the last decade by the perverse trade in credit derivatives. Rather than melt down the garbage silos called banks, and liquidating their assets, they are kept in a state of moribund animation in order to attract public funds. Such easy pickings from the USCongress, who have no idea what is going on, or else receive bribes. See the vast contributions from Fannie Mae over the years to key players today. The corruption and fraud has never in the history of the nation been easier, largely due to protection and collusion by the regulators themselves, but more importantly, due to the JPMorgan & Goldman Sachs key henchmen operating the Dept of Treasury & USFed. These are the Inside Guys. This is Counterfeit Capitalism, enough to make Jefferson or Keynes shudder. The TARP funds are a great example, gigantic intravenous injections to cadavers. They were not administered by the Paulson syndicate bosses because they knew full well that the banks were dead. So they stole the funds, a practice they have ample experience with from their mortgage fraud enterprise. The TARP is but a climax. Declaration of death would eliminate the opportunity for more rescue funds, relief efforts, and confiscation. With the insolvency, lack of adequate liquidity, the general decrepit state has led to an unsustainable situation. SOMETHING MUST GIVE FROM POWERFUL FORCES.
18 December 2008
Economy "f****d" ~ Sir Richard Branson
Sir Richard Branson has delivered a characteristically blunt verdict on the state of the economy, describing it as "f****d".
But Britain's cheeriest billionaire said that he hoped that the downturn might only last a couple of years instead of becoming a repeat of the Great Depression of the 1930s as so many economists now fear.
The Virgin boss was asked his views on the economy by Five News. “I was going to say, it’s f*****, but I think I had better not have said that,” he replied.
He added: “I think it is a terrible, terrible mess, which has been brought upon us by some very irresponsible people in the banking community, some very lax regulation and we are going to have to work hard to dig ourselves out of it.
link
But Britain's cheeriest billionaire said that he hoped that the downturn might only last a couple of years instead of becoming a repeat of the Great Depression of the 1930s as so many economists now fear.
The Virgin boss was asked his views on the economy by Five News. “I was going to say, it’s f*****, but I think I had better not have said that,” he replied.
He added: “I think it is a terrible, terrible mess, which has been brought upon us by some very irresponsible people in the banking community, some very lax regulation and we are going to have to work hard to dig ourselves out of it.
link
Dollar No Longer Haven After Fed Moves Rate Near Zero
Dec. 17 (Bloomberg) -- The world’s biggest currency-trading firms say the dollar’s appeal as a haven amid the financial crisis all but evaporated.
The U.S. currency slid to a 13-year low against the yen today and had its biggest one-day decline versus the euro after the Federal Reserve reduced its target interest rate yesterday to a range of zero to 0.25 percent, the lowest among the world’s biggest economies. CMC Markets said today the currency’s prospects appear “ominous.” State Street Global markets said the dollar’s outlook has been “undermined.”
“The dollar has been under heavy downward pressure,” said Robert Minikin, a senior currency strategist in London at Standard Chartered Bank Plc. “This move is very well-justified and has a long way to run.” Standard Chartered is preparing to cut its dollar forecasts, Minikin said.
Yesterday’s rate cut brings the Fed’s target to below the Bank of Japan’s for the first time since January 1993. U.S. policy makers repeated plans to buy agency debt and mortgage- backed securities and said they will study buying Treasuries, a policy known as quantitative easing.
The dollar fell to 87.14 yen, the lowest since July 1995, before trading at 87.84 yen as of 11:46 a.m. in New York, from 89.05 yesterday. It depreciated to $1.4331 from $1.4002 and traded at $1.4437, the weakest since Sept. 30.
‘Ominous’ Outlook
The dollar is likely to decline “longer term,” analysts including New York-based Ashraf Laidi at CMC Markets wrote in a report. “Prospects ahead appear particularly ominous for the world’s reserve currency once global economic stability starts to build up.”
The Fed’s debt purchases will cause the dollar to weaken to $1.4860 per euro, analysts led by Robert Sinche, New York-based head of global currency strategy at Bank of America Corp., wrote in a report yesterday. The Fed reduced the scarcity of dollars and investors slowed the deleveraging process, which drove the currency to a 2 1/2-year high against the euro in October, Sinche said.
“Those temporary supports for the dollar appear to have eroded,” Sinche wrote. “Aggressive quantitative easing by the Fed should add to U.S. dollar supply globally and undermine the value of the dollar.”
State Street Global Markets, a unit of the world’s largest money manager for institutions, said the Fed’s move is “perilous” for the dollar as investors accumulated an “extreme” long position on the currency, or bets it will climb.
Record Low Yields
“This implies a significant potential for a dollar unwind if the real money community attempts to chase price,” Hong Kong-based strategist Dwyfor Evans wrote today in a report. The shift toward quantitative easing “has undermined the U.S. dollar significantly over recent weeks.”
The dollar declined 11 percent against the euro and 8 percent against the yen this month as yields on two-, five-, 10- and 30-year Treasuries fell to record lows, encouraging investors to look outside the U.S. for higher returns.
“The dollar is going to struggle while it has low yields,” said Roddy MacPherson, the Edinburgh-based head of currency strategy at Scottish Widows Investment Partnership Ltd., which manages the equivalent of $152 billion. “We’re looking to add to our short dollar position if U.S. yields continue downward.”
UBS Stays Bullish
MacPherson said he moved toward a short dollar position, or a bet it will depreciate, against the euro in the past four days. The currency may end next year at $1.40 per euro, he said.
For UBS AG, the world’s second-largest foreign-exchange trader, demand for cash amid the freeze in bank lending will support the currency. The Libor-OIS spread, a gauge of cash scarcity favored by former Fed Chairman Alan Greenspan, was at 140 basis points today, or about 14 times its average in the five years before the credit crisis began.
“There is still a premium on liquidity, which will be supportive to the dollar even in the current environment,” said Geoff Kendrick, a senior strategist in London at UBS.
Goldman Sachs Group Inc. said investors can profit from the dollar’s decline by selling the currency for its Canadian counterpart.
The U.S. currency’s drop is becoming “broader-based,” Jens Nordvig, a New York-based strategist for the U.S. securities firm, wrote today. “Temporary dollar demand from deleveraging and funding flows has come to an end. The prospect of aggressive quantitative easing is starting to have a significant negative impact on the dollar.”
link
The U.S. currency slid to a 13-year low against the yen today and had its biggest one-day decline versus the euro after the Federal Reserve reduced its target interest rate yesterday to a range of zero to 0.25 percent, the lowest among the world’s biggest economies. CMC Markets said today the currency’s prospects appear “ominous.” State Street Global markets said the dollar’s outlook has been “undermined.”
“The dollar has been under heavy downward pressure,” said Robert Minikin, a senior currency strategist in London at Standard Chartered Bank Plc. “This move is very well-justified and has a long way to run.” Standard Chartered is preparing to cut its dollar forecasts, Minikin said.
Yesterday’s rate cut brings the Fed’s target to below the Bank of Japan’s for the first time since January 1993. U.S. policy makers repeated plans to buy agency debt and mortgage- backed securities and said they will study buying Treasuries, a policy known as quantitative easing.
The dollar fell to 87.14 yen, the lowest since July 1995, before trading at 87.84 yen as of 11:46 a.m. in New York, from 89.05 yesterday. It depreciated to $1.4331 from $1.4002 and traded at $1.4437, the weakest since Sept. 30.
‘Ominous’ Outlook
The dollar is likely to decline “longer term,” analysts including New York-based Ashraf Laidi at CMC Markets wrote in a report. “Prospects ahead appear particularly ominous for the world’s reserve currency once global economic stability starts to build up.”
The Fed’s debt purchases will cause the dollar to weaken to $1.4860 per euro, analysts led by Robert Sinche, New York-based head of global currency strategy at Bank of America Corp., wrote in a report yesterday. The Fed reduced the scarcity of dollars and investors slowed the deleveraging process, which drove the currency to a 2 1/2-year high against the euro in October, Sinche said.
“Those temporary supports for the dollar appear to have eroded,” Sinche wrote. “Aggressive quantitative easing by the Fed should add to U.S. dollar supply globally and undermine the value of the dollar.”
State Street Global Markets, a unit of the world’s largest money manager for institutions, said the Fed’s move is “perilous” for the dollar as investors accumulated an “extreme” long position on the currency, or bets it will climb.
Record Low Yields
“This implies a significant potential for a dollar unwind if the real money community attempts to chase price,” Hong Kong-based strategist Dwyfor Evans wrote today in a report. The shift toward quantitative easing “has undermined the U.S. dollar significantly over recent weeks.”
The dollar declined 11 percent against the euro and 8 percent against the yen this month as yields on two-, five-, 10- and 30-year Treasuries fell to record lows, encouraging investors to look outside the U.S. for higher returns.
“The dollar is going to struggle while it has low yields,” said Roddy MacPherson, the Edinburgh-based head of currency strategy at Scottish Widows Investment Partnership Ltd., which manages the equivalent of $152 billion. “We’re looking to add to our short dollar position if U.S. yields continue downward.”
UBS Stays Bullish
MacPherson said he moved toward a short dollar position, or a bet it will depreciate, against the euro in the past four days. The currency may end next year at $1.40 per euro, he said.
For UBS AG, the world’s second-largest foreign-exchange trader, demand for cash amid the freeze in bank lending will support the currency. The Libor-OIS spread, a gauge of cash scarcity favored by former Fed Chairman Alan Greenspan, was at 140 basis points today, or about 14 times its average in the five years before the credit crisis began.
“There is still a premium on liquidity, which will be supportive to the dollar even in the current environment,” said Geoff Kendrick, a senior strategist in London at UBS.
Goldman Sachs Group Inc. said investors can profit from the dollar’s decline by selling the currency for its Canadian counterpart.
The U.S. currency’s drop is becoming “broader-based,” Jens Nordvig, a New York-based strategist for the U.S. securities firm, wrote today. “Temporary dollar demand from deleveraging and funding flows has come to an end. The prospect of aggressive quantitative easing is starting to have a significant negative impact on the dollar.”
link
16 December 2008
Dinosaur killer ~ the TIC data
Treasury International Capital (TIC) Data for October
Actual: 1.5B
Forecast: 40.0B
Previous: 66.2B
Net foreign purchases of long-term securities were $1.5 billion.
* Net foreign purchases of long-term U.S. securities were negative $34.8 billion. Of this, net purchases by private foreign investors were negative $17.5 billion, and net purchases by foreign official institutions were negative $17.2 billion.
* U.S. residents sold a net $36.3 billion of long-term foreign securities.
Net foreign acquisition of long-term securities, taking into account adjustments, is estimated to have been negative $13.3 billion.
Foreign holdings of dollar-denominated short-term U.S. securities, including Treasury bills, and other custody liabilities increased $92.4 billion. Foreign holdings of Treasury bills increased $147.4 billion.
Banks' own net dollar-denominated liabilities to foreign residents increased $207.3 billion.
Monthly net TIC flows were $286.3 billion. Of this, net foreign private flows were $274.5 billion, and net foreign official flows were $11.9 billion.
http://www.treas.gov/press/releases/hp1326.htm
Actual: 1.5B
Forecast: 40.0B
Previous: 66.2B
Net foreign purchases of long-term securities were $1.5 billion.
* Net foreign purchases of long-term U.S. securities were negative $34.8 billion. Of this, net purchases by private foreign investors were negative $17.5 billion, and net purchases by foreign official institutions were negative $17.2 billion.
* U.S. residents sold a net $36.3 billion of long-term foreign securities.
Net foreign acquisition of long-term securities, taking into account adjustments, is estimated to have been negative $13.3 billion.
Foreign holdings of dollar-denominated short-term U.S. securities, including Treasury bills, and other custody liabilities increased $92.4 billion. Foreign holdings of Treasury bills increased $147.4 billion.
Banks' own net dollar-denominated liabilities to foreign residents increased $207.3 billion.
Monthly net TIC flows were $286.3 billion. Of this, net foreign private flows were $274.5 billion, and net foreign official flows were $11.9 billion.
http://www.treas.gov/press/releases/hp1326.htm
5 December 2008
Podcast: Satyajit Das on Late Night Live
A final conversation for the year with LNL's financial crisis analyst. He talks about President-elect Obama's key economic advisers, the likely future of banking, and the effects that have been felt around the world.
Satyajit Das
Satyajit Das
who is Glenn Beck, dunno but he's right here!
Now, the reason why I am so impressed and I believe that the clock is ticking and I have a renewed sense of urgency. I want you to listen to this. I want you to listen to this news story. I'm going to read it verbatim and I want to see if any of this sounds familiar. Citigroup says gold could rise over $2,000 next year as the world unravels. Again, Citigroup says gold could rise over $2,000 next year as the world unravels. Gold is poised for a dramatic surge and the blast through $2,000 an ounce by the end of next year as central banks listen carefully as central banks flood the world's monetary system with liquidity. This is according to an internal client note from U.S. bank Citigroup. The bank said that the damage caused by the financial excesses of the last 25 years was forcing the world's authorities to take steps that they had never tried before. This gamble was likely to end in one of two extreme ways, with either a resurgence of inflation and trust me, gang, trust me they're not talking about regular inflation or a downward spiral into Depression, civil disorder and possibly wars. Both outcomes will cause a rush for gold. Quote: They are throwing the kitchen sink at this, said Tom Fitzpatrick. The bank's chief technical strategist. Quote: The world is not going back to normal after the magnitude of what they have done. When the dust settles on this, the world will, it will see that it will either work and the money they have pushed into the system will feed through an inflation shock, or it will not work because too much damage has already been done and we will see continued financial deterioration causing further economic deterioration and the risk of a feedback loop. We don't think that this is the more likely outcome. I do. But each week as it passes and each month passes, there is a growing danger of a vicious circle as confidence erodes. This will lead I'm still quoting from Citigroup: This will lead to political instability. We are already seeing countries on the periphery of Europe under severe stress. Some leaders remember, Citigroup is talking about the crazy edges of Europe. But see if any of this sounds familiar. Some leaders are now at record levels of unpopularity. There is a risk of domestic unrest starting with strikes because people are feeling disenfranchised, end quote. May the heavens open up and sing praises, hallelujah, finally someone with some credibility is talking about disenfranchisement. Quote: What happens if there is a meltdown in a country like Pakistan, which is a nuclear power? People react when they have their backs against the wall. We're already seeing doubts listen to this: We are already seeing doubts emerge about the sovereign debts of developed AAA rated countries, which is not something you can ignore. So you know, developed AAA rated countries are countries like America. Gold traders are paying close attention to reports from Beijing that China is thinking of boosting its gold reserves from 600 tons to near 4,000 tons in a way to diversify away from paper currencies. What does that mean? Whose paper do they hold? Ours. They hold our currencies. If they are talking about going from 600 tons of gold to near 4,000 tons of gold, they need to sell their currencies and their treasuries. What does that do to the American dollar? "Oh, no one will ever do that because they need us." Everyone is in survival mode. Mr. Fitzpatrick said Britain had made a mistake selling off half its gold at the bottom of the market between '99 and 2000. People have started to question the value of government debt, end quote. Meanwhile, our leaders are saying pay no attention to debt. Meanwhile, the Fed which unbeknownst unfortunately to a lot of people, the ones who hold our treasury notes, the ones who it's backed by the Fed that is a treasury note, a promise the Fed will not release any information on how much gold it holds. The Fed won't allow any accounting on what they actually have. Citigroup said the blastoff was likely to occur within two years and possibly as soon as 2009. Gold was trading yesterday at $812 an ounce. It is well off the all time peak of $1,030 in February, but has held up much better than other commodities over the last few months referring to its historic role as a safe haven store of value and a de facto currency. Gold has tripled over the last three years in value, vastly outperforming Wall Street and European, it says bonuses here but it can't be bonuses, stocks.
Okay, look, here's the thing. Citi does this sound familiar? Does this, have you heard this maybe a year ago from anybody? This is a huge, huge development. This is Citigroup saying this and when somebody like Citigroup says this, it causes a shock to the system. It causes a shock to the market. So hear me clearly. They are not telling you the full truth, just like the President won't tell you the full truth because they know what it means if they panic. They know what it means if they say something that causes people to panic. This is the next level in getting people prepared for what's coming.
Let me go through this piece by piece. Gold could blast through $2,000 an ounce by the end of next year. It is going to blow through. You mark that down, Stu, if we're still on the radio in 12 months, it will go through $2,000 an ounce. The bank says it's caused by the financial excesses of the last 25 years. That is true. The gamble is going to end in one of two extreme ways: Either with a resurgence of inflation they are not talking about inflation. Study the Weimar Republic. They are talking about hyperinflation. You cannot inflate the world's money supply to the point that we have. They are lying to you. They are trying to take this down let's look at them in the best possible light. They are trying to take this system down as slowly as they can so you can prepare, but I'm telling you you are running out of time to prepare. You must prepare your household, you must prepare your children, you must do logical, well thought out things to be able to prepare your family and please do not do them in a panic fashion. I don't tell you these things to panic you. I tell you this with a sense of urgency so you may move with a sense of urgency and it is the same reason why CitiBank is telling you this today. They say it's either going to be inflation or a downward spiral into Depression, civil disorder and possible wars. They are talking about this on a global scale. They don't say that this is the United States but, gang, there's trouble coming. They are throwing the kitchen sink at this. This is what I told you a year ago. I said there's going to come a point to where they're going to open up these valves so far that nothing will react. The stock market won't react, nothing will. And they've got to turn those valves the other way because if they don't turn them the other way and shut this money supply off and do it quickly, you are going to have massive inflation. Well, not only have they not shut those valves off, they've opened them up even more. You cannot do these things. No matter what our arrogance tells us that, "oh, well, we've got it under control; oh, well, this will happen or this will happen," these people are trying to change the course of a hurricane and they're making it worse, unless you prepare. I told you a year ago, I told you when I pulled out of the market, I got a phone call, this is over a year ago and I said I pulled everything out. And I got a phone call and they said, you're telling people to pull out of the stock market, you are only making things worse. I said nobody's listening to me, nobody's listening to me at this point. I'm just telling you what I've done, you make your own decision. But you know what and I prayed about this because I felt I almost felt in a way like a betrayer of my country because I thought, how am I pulling my money out? We need to be able to have jobs, we need to be able to build. And it came to me, there must be someone with something left to be able to restart. You must protect your family. You must protect these things because you're going to need to be able to restart. There's got to be somebody left to be able to say, "Okay, let's pick ourselves back up." The world is not going back to normal. This is a quote: The world is not going back to normal after the magnitude of what they have done. That's Citigroup: The world will not go back to normal after the magnitude of what they've done. This is what I told you three weeks ago when I said the G20 were meeting. I said they're dropping framework. It's a new world order. They know. They know what's coming. They are saying, "We just need to see what we can do." No, they are not. They are dropping in the new world order. If I know it, if my sources are good enough and I'm smart enough, a guy who never took an economics course in my life, can look at all of these things and say, wait a minute, wait a minute, wait a minute, no way out, you're blocking all the exits, you know they do. They see it. This will lead to political instability, and they talk about European countries like Hungary, there is risk of domestic unrest starting with strikes.
glenn beck
Okay, look, here's the thing. Citi does this sound familiar? Does this, have you heard this maybe a year ago from anybody? This is a huge, huge development. This is Citigroup saying this and when somebody like Citigroup says this, it causes a shock to the system. It causes a shock to the market. So hear me clearly. They are not telling you the full truth, just like the President won't tell you the full truth because they know what it means if they panic. They know what it means if they say something that causes people to panic. This is the next level in getting people prepared for what's coming.
Let me go through this piece by piece. Gold could blast through $2,000 an ounce by the end of next year. It is going to blow through. You mark that down, Stu, if we're still on the radio in 12 months, it will go through $2,000 an ounce. The bank says it's caused by the financial excesses of the last 25 years. That is true. The gamble is going to end in one of two extreme ways: Either with a resurgence of inflation they are not talking about inflation. Study the Weimar Republic. They are talking about hyperinflation. You cannot inflate the world's money supply to the point that we have. They are lying to you. They are trying to take this down let's look at them in the best possible light. They are trying to take this system down as slowly as they can so you can prepare, but I'm telling you you are running out of time to prepare. You must prepare your household, you must prepare your children, you must do logical, well thought out things to be able to prepare your family and please do not do them in a panic fashion. I don't tell you these things to panic you. I tell you this with a sense of urgency so you may move with a sense of urgency and it is the same reason why CitiBank is telling you this today. They say it's either going to be inflation or a downward spiral into Depression, civil disorder and possible wars. They are talking about this on a global scale. They don't say that this is the United States but, gang, there's trouble coming. They are throwing the kitchen sink at this. This is what I told you a year ago. I said there's going to come a point to where they're going to open up these valves so far that nothing will react. The stock market won't react, nothing will. And they've got to turn those valves the other way because if they don't turn them the other way and shut this money supply off and do it quickly, you are going to have massive inflation. Well, not only have they not shut those valves off, they've opened them up even more. You cannot do these things. No matter what our arrogance tells us that, "oh, well, we've got it under control; oh, well, this will happen or this will happen," these people are trying to change the course of a hurricane and they're making it worse, unless you prepare. I told you a year ago, I told you when I pulled out of the market, I got a phone call, this is over a year ago and I said I pulled everything out. And I got a phone call and they said, you're telling people to pull out of the stock market, you are only making things worse. I said nobody's listening to me, nobody's listening to me at this point. I'm just telling you what I've done, you make your own decision. But you know what and I prayed about this because I felt I almost felt in a way like a betrayer of my country because I thought, how am I pulling my money out? We need to be able to have jobs, we need to be able to build. And it came to me, there must be someone with something left to be able to restart. You must protect your family. You must protect these things because you're going to need to be able to restart. There's got to be somebody left to be able to say, "Okay, let's pick ourselves back up." The world is not going back to normal. This is a quote: The world is not going back to normal after the magnitude of what they have done. That's Citigroup: The world will not go back to normal after the magnitude of what they've done. This is what I told you three weeks ago when I said the G20 were meeting. I said they're dropping framework. It's a new world order. They know. They know what's coming. They are saying, "We just need to see what we can do." No, they are not. They are dropping in the new world order. If I know it, if my sources are good enough and I'm smart enough, a guy who never took an economics course in my life, can look at all of these things and say, wait a minute, wait a minute, wait a minute, no way out, you're blocking all the exits, you know they do. They see it. This will lead to political instability, and they talk about European countries like Hungary, there is risk of domestic unrest starting with strikes.
glenn beck
27 November 2008
Mass extinction on Planet Finance
(After the post bubble revulsion, asset holders are awakening from the the dream that the moneyness of credit is 100%. The current turmoil is nothing less than the market in search for the security of reliable money, that search will end when savers discover the one special attribute of "real money" is precisely what distinguishes it from the dross that passes for money today and is the very thing they seek.
What the market seeks is a divisable asset with no counterparty risk that is impossible to counterfeit, by that definition, money is what it has always been: gold and silver and nothing else.
Why was I dogged with a terrible dread for the last four years and completely obsessed with the absolute certanity that the current economic order was about to collapse. My iconoclasm and alienation from the mainstream and my understanding of the history of human economic folly.
Based on the aggregates, this downturn, from a technical perspective may be a turn of supercycle degree correcting the rise of the west from 1712 and therefore a bust much more significant than the Great Depression.
We don't make social transformations from a carbon based energy addiction where social rank is defined by the nicest granite countertops to a sustainable hitech world with a completely distributed energy system, a healthy communal life and the classic human virtues seemlessly. The old must die before the new emerges.
As the article below demonstrates; if you want to know the future consult the historian and philosopher, not those most at ease in the current order.
Thats my take anyway.
Kevin McKern
Wall Street Lays Another Egg
Not so long ago, the dollar stood for a sum of gold, and bankers knew the people they lent to. The author charts the emergence of an abstract, even absurd world—call it Planet Finance—where mathematical models ignored both history and human nature, and value had no meaning.
by
Niall Ferguson
December 2008
The bigger they come: Uncle Sam and Wall Street take the hardest fall since the Depression.
This year we have lived through something more than a financial crisis. We have witnessed the death of a planet. Call it Planet Finance. Two years ago, in 2006, the measured economic output of the entire world was worth around $48.6 trillion. The total market capitalization of the world’s stock markets was $50.6 trillion, 4 percent larger. The total value of domestic and international bonds was $67.9 trillion, 40 percent larger. Planet Finance was beginning to dwarf Planet Earth.
Planet Finance seemed to spin faster, too. Every day $3.1 trillion changed hands on foreign-exchange markets. Every month $5.8 trillion changed hands on global stock markets. And all the time new financial life-forms were evolving. The total annual issuance of mortgage-backed securities, including fancy new “collateralized debt obligations” (C.D.O.’s), rose to more than $1 trillion. The volume of “derivatives”—contracts such as options and swaps—grew even faster, so that by the end of 2006 their notional value was just over $400 trillion. Before the 1980s, such things were virtually unknown. In the space of a few years their populations exploded. On Planet Finance, the securities outnumbered the people; the transactions outnumbered the relationships.
Read Niall Ferguson’s prescient article on today’s financial woes, Empire Falls (November 2006).
New institutions also proliferated. In 1990 there were just 610 hedge funds, with $38.9 billion under management. At the end of 2006 there were 9,462, with $1.5 trillion under management. Private-equity partnerships also went forth and multiplied. Banks, meanwhile, set up a host of “conduits” and “structured investment vehicles” (sivs—surely the most apt acronym in financial history) to keep potentially risky assets off their balance sheets. It was as if an entire shadow banking system had come into being.
Then, beginning in the summer of 2007, Planet Finance began to self-destruct in what the International Monetary Fund soon acknowledged to be “the largest financial shock since the Great Depression.” Did the crisis of 2007–8 happen because American companies had gotten worse at designing new products? Had the pace of technological innovation or productivity growth suddenly slackened? No. The proximate cause of the economic uncertainty of 2008 was financial: to be precise, a crunch in the credit markets triggered by mounting defaults on a hitherto obscure species of housing loan known euphemistically as “subprime mortgages.”
Central banks in the United States and Europe sought to alleviate the pressure on the banks with interest-rate cuts and offers of funds through special “term auction facilities.” Yet the market rates at which banks could borrow money, whether by issuing commercial paper, selling bonds, or borrowing from one another, failed to follow the lead of the official federal-funds rate. The banks had to turn not only to Western central banks for short-term assistance to rebuild their reserves but also to Asian and Middle Eastern sovereign-wealth funds for equity injections. When these sources proved insufficient, investors—and speculative short-sellers—began to lose faith.
B
eginning with Bear Stearns, Wall Street’s investment banks entered a death spiral that ended with their being either taken over by a commercial bank (as Bear was, followed by Merrill Lynch) or driven into bankruptcy (as Lehman Brothers was). In September the two survivors—Goldman Sachs and Morgan Stanley—formally ceased to be investment banks, signaling the death of a business model that dated back to the Depression. Other institutions deemed “too big to fail” by the U.S. Treasury were effectively taken over by the government, including the mortgage lenders and guarantors Fannie Mae and Freddie Mac and the insurance giant American International Group (A.I.G.).
By September 18 the U.S. financial system was gripped by such panic that the Treasury had to abandon this ad hoc policy. Treasury Secretary Henry Paulson hastily devised a plan whereby the government would be authorized to buy “troubled” securities with up to $700 billion of taxpayers’ money—a figure apparently plucked from the air. When a modified version of the measure was rejected by Congress 11 days later, there was panic. When it was passed four days after that, there was more panic. Now it wasn’t just bank stocks that were tanking. The entire stock market seemed to be in free fall as fears mounted that the credit crunch was going to trigger a recession. Moreover, the crisis was now clearly global in scale. European banks were in much the same trouble as their American counterparts, while emerging-market stock markets were crashing. A week of frenetic improvisation by national governments culminated on the weekend of October 11–12, when the United States reluctantly followed the British government’s lead, buying equity stakes in banks rather than just their dodgy assets and offering unprecedented guarantees of banks’ debt and deposits.
Since these events coincided with the final phase of a U.S. presidential-election campaign, it was not surprising that some rather simplistic lessons were soon being touted by candidates and commentators. The crisis, some said, was the result of excessive deregulation of financial markets. Others sought to lay the blame on unscrupulous speculators: short-sellers, who borrowed the stocks of vulnerable banks and sold them in the expectation of further price declines. Still other suspects in the frame were negligent regulators and corrupt congressmen.
This hunt for scapegoats is futile. To understand the downfall of Planet Finance, you need to take several steps back and locate this crisis in the long run of financial history. Only then will you see that we have all played a part in this latest sorry example of what the Victorian journalist Charles Mackay described in his 1841 book, Extraordinary Popular Delusions and the Madness of Crowds.
Nothing New
As long as there have been banks, bond markets, and stock markets, there have been financial crises. Banks went bust in the days of the Medici. There were bond-market panics in the Venice of Shylock’s day. And the world’s first stock-market crash happened in 1720, when the Mississippi Company—the Enron of its day—blew up. According to economists Carmen Reinhart and Kenneth Rogoff, the financial history of the past 800 years is a litany of debt defaults, banking crises, currency crises, and inflationary spikes. Moreover, financial crises seldom happen without inflicting pain on the wider economy. Another recent paper, co-authored by Rogoff’s Harvard colleague Robert Barro, has identified 148 crises since 1870 in which a country experienced a cumulative decline in gross domestic product (G.D.P.) of at least 10 percent, implying a probability of financial disaster of around 3.6 percent per year.
If stock-market movements followed the normal-distribution, or bell, curve, like human heights, an annual drop of 10 percent or more would happen only once every 500 years, whereas in the case of the Dow Jones Industrial Average it has happened in 20 of the last 100 years. And stock-market plunges of 20 percent or more would be unheard of—rather like people a foot and a half tall—whereas in fact there have been eight such crashes in the past century.
The most famous financial crisis—the Wall Street Crash—is conventionally said to have begun on “Black Thursday,” October 24, 1929, when the Dow declined by 2 percent, though in fact the market had been slipping since early September and had suffered a sharp, 6 percent drop on October 23. On “Black Monday,” October 28, it plunged by 13 percent, and the next day by a further 12 percent. In the course of the next three years the U.S. stock market declined by a staggering 89 percent, reaching its nadir in July 1932. The index did not regain its 1929 peak until November 1954.
That helps put our current troubles into perspective. From its peak of 14,164, on October 9, 2007, to a dismal level of 8,579, exactly a year later, the Dow declined by 39 percent. By contrast, on a single day just over two decades ago—October 19, 1987—the index fell by 23 percent, one of only four days in history when the index has fallen by more than 10 percent in a single trading session.
This crisis, however, is about much more than just the stock market. It needs to be understood as a fundamental breakdown of the entire financial system, extending from the monetary-and-banking system through the bond market, the stock market, the insurance market, and the real-estate market. It affects not only established financial institutions such as investment banks but also relatively novel ones such as hedge funds. It is global in scope and unfathomable in scale.
Had it not been for the frantic efforts of the Federal Reserve and the Treasury, to say nothing of their counterparts in almost equally afflicted Europe, there would by now have been a repeat of that “great contraction” of credit and economic activity that was the prime mover of the Depression. Back then, the Fed and the Treasury did next to nothing to prevent bank failures from translating into a drastic contraction of credit and hence of business activity and employment. If the more openhanded monetary and fiscal authorities of today are ultimately successful in preventing a comparable slump of output, future historians may end up calling this “the Great Repression.” This is the Depression they are hoping to bottle up—a Depression in denial.
To understand why we have come so close to a rerun of the 1930s, we need to begin at the beginning, with banks and the money they make. From the Middle Ages until the mid-20th century, most banks made their money by maximizing the difference between the costs of their liabilities (payments to depositors) and the earnings on their assets (interest and commissions on loans). Some banks also made money by financing trade, discounting the commercial bills issued by merchants. Others issued and traded bonds and stocks, or dealt in commodities (especially precious metals). But the core business of banking was simple. It consisted, as the third Lord Rothschild pithily put it, “essentially of facilitating the movement of money from Point A, where it is, to Point B, where it is needed.”
The system evolved gradually. First came the invention of cashless intra-bank and inter-bank transactions, which allowed debts to be settled between account holders without having money physically change hands. Then came the idea of fractional-reserve banking, whereby banks kept only a small proportion of their existing deposits on hand to satisfy the needs of depositors (who seldom wanted all their money simultaneously), allowing the rest to be lent out profitably. That was followed by the rise of special public banks with monopolies on the issuing of banknotes and other powers and privileges: the first central banks.
With these innovations, money ceased to be understood as precious metal minted into coins. Now it was the sum total of specific liabilities (deposits and reserves) incurred by banks. Credit was the other side of banks’ balance sheets: the total of their assets; in other words, the loans they made. Some of this money might still consist of precious metal, though a rising proportion of that would be held in the central bank’s vault. Most would be made up of banknotes and coins recognized as “legal tender,” along with money that was visible only in current- and deposit-account statements.
Until the late 20th century, the system of bank money retained an anchor in the pre-modern conception of money in the form of the gold standard: fixed ratios between units of account and quantities of precious metal. As early as 1924, the English economist John Maynard Keynes dismissed the gold standard as a “barbarous relic,” but the last vestige of the system did not disappear until August 15, 1971—the day President Richard Nixon closed the so-called gold window, through which foreign central banks could still exchange dollars for gold. With that, the centuries-old link between money and precious metal was broken.
Though we tend to think of money today as being made of paper, in reality most of it now consists of bank deposits. If we measure the ratio of actual money to output in developed economies, it becomes clear that the trend since the 1970s has been for that ratio to rise from around 70 percent, before the closing of the gold window, to more than 100 percent by 2005. The corollary has been a parallel growth of credit on the other side of bank balance sheets. A significant component of that credit growth has been a surge of lending to consumers. Back in 1952, the ratio of household debt to disposable income was less than 40 percent in the United States. At its peak in 2007, it reached 133 percent, up from 90 percent a decade before. Today Americans carry a total of $2.56 trillion in consumer debt, up by more than a fifth since 2000.
Even more spectacular, however, has been the rising indebtedness of banks themselves. In 1980, bank indebtedness was equivalent to 21 percent of U.S. gross domestic product. In 2007 the figure was 116 percent. Another measure of this was the declining capital adequacy of banks. On the eve of “the Great Repression,” average bank capital in Europe was equivalent to less than 10 percent of assets; at the beginning of the 20th century, it was around 25 percent. It was not unusual for investment banks’ balance sheets to be as much as 20 or 30 times larger than their capital, thanks in large part to a 2004 rule change by the Securities and Exchange Commission that exempted the five largest of those banks from the regulation that had capped their debt-to-capital ratio at 12 to 1. The Age of Leverage had truly arrived for Planet Finance.
Credit and money, in other words, have for decades been growing more rapidly than underlying economic activity. Is it any wonder, then, that money has ceased to hold its value the way it did in the era of the gold standard? The motto “In God we trust” was added to the dollar bill in 1957. Since then its purchasing power, relative to the consumer price index, has declined by a staggering 87 percent. Average annual inflation during that period has been more than 4 percent. A man who decided to put his savings into gold in 1970 could have bought just over 27.8 ounces of the precious metal for $1,000. At the time of writing, with gold trading at $900 an ounce, he could have sold it for around $25,000.
Those few goldbugs who always doubted the soundness of fiat money—paper currency without a metal anchor—have in large measure been vindicated. But why were the rest of us so blinded by money illusion?
Blowing Bubbles
In the immediate aftermath of the death of gold as the anchor of the monetary system, the problem of inflation affected mainly retail prices and wages. Today, only around one out of seven countries has an inflation rate above 10 percent, and only one, Zimbabwe, is afflicted with hyperinflation. But back in 1979 at least 7 countries had an annual inflation rate above 50 percent, and more than 60 countries—including Britain and the United States—had inflation in double digits.
Inflation has come down since then, partly because many of the items we buy—from clothes to computers—have gotten cheaper as a result of technological innovation and the relocation of production to low-wage economies in Asia. It has also been reduced because of a worldwide transformation in monetary policy, which began with the monetarist-inspired increases in short-term rates implemented by the Federal Reserve in 1979. Just as important, some of the structural drivers of inflation, such as powerful trade unions, have also been weakened.
By the 1980s, in any case, more and more people had grasped how to protect their wealth from inflation: by investing it in assets they expected to appreciate in line with, or ahead of, the cost of living. These assets could take multiple forms, from modern art to vintage wine, but the most popular proved to be stocks and real estate. Once it became clear that this formula worked, the Age of Leverage could begin. For it clearly made sense to borrow to the hilt to maximize your holdings of stocks and real estate if these promised to generate higher rates of return than the interest payments on your borrowings. Between 1990 and 2004, most American households did not see an appreciable improvement in their incomes. Adjusted for inflation, the median household income rose by about 6 percent. But people could raise their living standards by borrowing and investing in stocks and housing.
Nearly all of us did it. And the bankers were there to help. Not only could they borrow more cheaply from one another than we could borrow from them; increasingly they devised all kinds of new mortgages that looked more attractive to us (and promised to be more lucrative to them) than boring old 30-year fixed-rate deals. Moreover, the banks were just as ready to play the asset markets as we were. Proprietary trading soon became the most profitable arm of investment banking: buying and selling assets on the bank’s own account.
Losing our shirt? The problem is that our banks are also losing theirs. Illustration by Barry Blitt.
There was, however, a catch. The Age of Leverage was also an age of bubbles, beginning with the dot-com bubble of the irrationally exuberant 1990s and ending with the real-estate mania of the exuberantly irrational 2000s. Why was this?
The future is in large measure uncertain, so our assessments of future asset prices are bound to vary. If we were all calculating machines, we would simultaneously process all the available information and come to the same conclusion. But we are human beings, and as such are prone to myopia and mood swings. When asset prices surge upward in sync, it is as if investors are gripped by a kind of collective euphoria. Conversely, when their “animal spirits” flip from greed to fear, the bubble that their earlier euphoria inflated can burst with amazing suddenness. Zoological imagery is an integral part of the culture of Planet Finance. Optimistic buyers are “bulls,” pessimistic sellers are “bears.” The real point, however, is that stock markets are mirrors of the human psyche. Like Homo sapiens, they can become depressed. They can even suffer complete breakdowns.
This is no new insight. In the 400 years since the first shares were bought and sold on the Amsterdam Beurs, there has been a long succession of financial bubbles. Time and again, asset prices have soared to unsustainable heights only to crash downward again. So familiar is this pattern—described by the economic historian Charles Kindleberger—that it is possible to distill it into five stages:
(1) Displacement: Some change in economic circumstances creates new and profitable opportunities. (2) Euphoria, or overtrading: A feedback process sets in whereby expectation of rising profits leads to rapid growth in asset prices. (3) Mania, or bubble: The prospect of easy capital gains attracts first-time investors and swindlers eager to mulct them of their money. (4) Distress: The insiders discern that profits cannot possibly justify the now exorbitant price of the assets and begin to take profits by selling. (5) Revulsion, or discredit: As asset prices fall, the outsiders stampede for the exits, causing the bubble to burst.
The key point is that without easy credit creation a true bubble cannot occur. That is why so many bubbles have their origins in the sins of omission and commission of central banks.
The bubbles of our time had their origins in the aftermath of the 1987 stock-market crash, when then novice Federal Reserve chairman Alan Greenspan boldly affirmed the Fed’s “readiness to serve as a source of liquidity to support the economic and financial system.” This sent a signal to the markets, particularly the New York banks: if things got really bad, he stood ready to bail them out. Thus was born the “Greenspan put”—the implicit option the Fed gave traders to be able to sell their stocks at today’s prices even in the event of a meltdown tomorrow.
Having contained a panic once, Greenspan thereafter had a dilemma lurking in the back of his mind: whether or not to act pre-emptively the next time—to prevent a panic altogether. This dilemma came to the fore as a classic stock-market bubble took shape in the mid-90s. The displacement in this case was the explosion of innovation by the technology and software industry as personal computers met the Internet. But, as in all of history’s bubbles, an accommodative monetary policy also played a role. From a peak of 6 percent in February 1995, the federal-funds target rate had been reduced to 5.25 percent by January 1996. It was then cut in steps, in the fall of 1998, down to 4.75 percent, and it remained at that level until June 1999, by which time the Dow had passed the 10,000 mark.
Why did the Fed allow euphoria to run loose in the 1990s? Partly because Greenspan and his colleagues underestimated the momentum of the technology bubble; as early as December 1995, with the Dow just past the 5,000 mark, members of the Fed’s Open Market Committee speculated that the market might be approaching its peak. Partly, also, because Greenspan came to the conclusion that it was not the Fed’s responsibility to worry about asset-price inflation, only consumer-price inflation, and this, he believed, was being reduced by a major improvement in productivity due precisely to the tech boom.
Greenspan could not postpone a stock-exchange crash indefinitely. After Silicon Valley’s dot-com bubble peaked, in March 2000, the U.S. stock market fell by almost half over the next two and a half years. It was not until May 2007 that investors in the Standard & Poor’s 500 had recouped their losses. But the Fed’s response to the sell-off—and the massive shot of liquidity it injected into the financial markets after the 9/11 terrorist attacks—prevented the “correction” from precipitating a depression. Not only were the 1930s averted; so too, it seemed, was a repeat of the Japanese experience after 1989, when a conscious effort by the central bank to prick an asset bubble had ended up triggering an 80 percent stock-market sell-off, a real-estate collapse, and a decade of economic stagnation.
What was not immediately obvious was that Greenspan’s easy-money policy was already generating another bubble—this time in the financial market that a majority of Americans have been encouraged for generations to play: the real-estate market.
The American Dream
Real estate is the English-speaking world’s favorite economic game. No other facet of financial life has such a hold on the popular imagination. The real-estate market is unique. Every adult, no matter how economically illiterate, has a view on its future prospects. Through the evergreen board game Monopoly, even children are taught how to climb the property ladder.
Once upon a time, people saved a portion of their earnings for the proverbial rainy day, stowing the cash in a mattress or a bank safe. The Age of Leverage, as we have seen, brought a growing reliance on borrowing to buy assets in the expectation of their future appreciation in value. For a majority of families, this meant a leveraged investment in a house. That strategy had one very obvious flaw. It represented a one-way, totally unhedged bet on a single asset.
To be sure, investing in housing paid off handsomely for more than half a century, up until 2006. Suppose you had put $100,000 into the U.S. property market back in the first quarter of 1987. According to the Case-Shiller national home-price index, you would have nearly tripled your money by the first quarter of 2007, to $299,000. On the other hand, if you had put the same money into the S&P 500, and had continued to re-invest the dividend income in that index, you would have ended up with $772,000 to play with—more than double what you would have made on bricks and mortar.
There is, obviously, an important difference between a house and a stock-market index. You cannot live in a stock-market index. For the sake of a fair comparison, allowance must therefore be made for the rent you save by owning your house (or the rent you can collect if you own a second property). A simple way to proceed is just to leave out both dividends and rents. In that case the difference is somewhat reduced. In the two decades after 1987, the S&P 500, excluding dividends, rose by a factor of just over six, meaning that an investment of $100,000 would be worth some $600,000. But that still comfortably beat housing.
There are three other considerations to bear in mind when trying to compare housing with other forms of assets. The first is depreciation. Stocks do not wear out and require new roofs; houses do. The second is liquidity. As assets, houses are a great deal more expensive to convert into cash than stocks. The third is volatility. Housing markets since World War II have been far less volatile than stock markets. Yet that is not to say that house prices have never deviated from a steady upward path. In Britain between 1989 and 1995, for example, the average house price fell by 18 percent, or, in inflation-adjusted terms, by more than a third—37 percent. In London, the real decline was closer to 47 percent. In Japan between 1990 and 2000, property prices fell by more than 60 percent.
The recent decline of property prices in the United States should therefore have come as less of a shock than it did. Between July 2006 and June 2008, the Case-Shiller index of home prices in 20 big American cities declined on average by 19 percent. In some of these cities—Phoenix, San Diego, Los Angeles, and Miami—the total decline was as much as a third. Seen in international perspective, those are not unprecedented figures. Seen in the context of the post-2000 bubble, prices have yet to return to their starting point. On average, house prices are still 50 percent higher than they were at the beginning of this process.
So why were we oblivious to the likely bursting of the real-estate bubble? The answer is that for generations we have been brainwashed into thinking that borrowing to buy a house is the only rational financial strategy to pursue. Think of Frank Capra’s classic 1946 movie, It’s a Wonderful Life, which tells the story of the family-owned Bailey Building & Loan, a small-town mortgage firm that George Bailey (played by James Stewart) struggles to keep afloat in the teeth of the Depression. “You know, George,” his father tells him, “I feel that in a small way we are doing something important. It’s satisfying a fundamental urge. It’s deep in the race for a man to want his own roof and walls and fireplace, and we’re helping him get those things in our shabby little office.” George gets the message, as he passionately explains to the villainous slumlord Potter after Bailey Sr.’s death: “[My father] never once thought of himself.… But he did help a few people get out of your slums, Mr. Potter. And what’s wrong with that? … Doesn’t it make them better citizens? Doesn’t it make them better customers?”
There, in a nutshell, is one of the key concepts of the 20th century: the notion that property ownership enhances citizenship, and that therefore a property-owning democracy is more socially and politically stable than a democracy divided into an elite of landlords and a majority of property-less tenants. So deeply rooted is this idea in our political culture that it comes as a surprise to learn that it was invented just 70 years ago.
Fannie, Ginnie, and Freddie
Prior to the 1930s, only a minority of Americans owned their homes. During the Depression, however, the Roosevelt administration created a whole complex of institutions to change that. A Federal Home Loan Bank Board was set up in 1932 to encourage and oversee local mortgage lenders known as savings-and-loans (S&Ls)—mutual associations that took in deposits and lent to homebuyers. Under the New Deal, the Home Owners’ Loan Corporation stepped in to refinance mortgages on longer terms, up to 15 years. To reassure depositors, who had been traumatized by the thousands of bank failures of the previous three years, Roosevelt introduced federal deposit insurance. And by providing federally backed insurance for mortgage lenders, the Federal Housing Administration (F.H.A.) sought to encourage large (up to 80 percent of the purchase price), long (20- to 25-year), fully amortized, low-interest loans.
By standardizing the long-term mortgage and creating a national system of official inspection and valuation, the F.H.A. laid the foundation for a secondary market in mortgages. This market came to life in 1938, when a new Federal National Mortgage Association—nicknamed Fannie Mae—was authorized to issue bonds and use the proceeds to buy mortgages from the local S&Ls, which were restricted by regulation both in terms of geography (they could not lend to borrowers more than 50 miles from their offices) and in terms of the rates they could offer (the so-called Regulation Q, which imposed a low ceiling on interest paid on deposits). Because these changes tended to reduce the average monthly payment on a mortgage, the F.H.A. made home ownership viable for many more Americans than ever before. Indeed, it is not too much to say that the modern United States, with its seductively samey suburbs, was born with Fannie Mae. Between 1940 and 1960, the home-ownership rate soared from 43 to 62 percent.
These were not the only ways in which the federal government sought to encourage Americans to own their own homes. Mortgage-interest payments were always tax-deductible, from the inception of the federal income tax in 1913. As Ronald Reagan said when the rationality of this tax break was challenged, mortgage-interest relief was “part of the American dream.”
In 1968, to broaden the secondary-mortgage market still further, Fannie Mae was split in two—the Government National Mortgage Association (Ginnie Mae), which was to cater to poor borrowers, and a rechartered Fannie Mae, now a privately owned government-sponsored enterprise (G.S.E.). Two years later, to provide competition for Fannie Mae, the Federal Home Loan Mortgage Corporation (Freddie Mac) was set up. In addition, Fannie Mae was permitted to buy conventional as well as government-guaranteed mortgages. Later, with the Community Reinvestment Act of 1977, American banks found themselves under pressure for the first time to lend to poor, minority communities.
These changes presaged a more radical modification to the New Deal system. In the late 1970s, the savings-and-loan industry was hit first by double-digit inflation and then by sharply rising interest rates. This double punch was potentially lethal. The S&Ls were simultaneously losing money on long-term, fixed-rate mortgages, due to inflation, and hemorrhaging deposits to higher-interest money-market funds. The response in Washington from both the Carter and Reagan administrations was to try to salvage the S&Ls with tax breaks and deregulation. When the new legislation was passed, President Reagan declared, “All in all, I think we hit the jackpot.” Some people certainly did.
On the one hand, S&Ls could now invest in whatever they liked, not just local long-term mortgages. Commercial property, stocks, junk bonds—anything was allowed. They could even issue credit cards. On the other, they could now pay whatever interest rate they liked to depositors. Yet all their deposits were still effectively insured, with the maximum covered amount raised from $40,000 to $100,000, thanks to a government regulation two years earlier. And if ordinary deposits did not suffice, the S&Ls could raise money in the form of brokered deposits from middlemen. What happened next perfectly illustrated the great financial precept first enunciated by William Crawford, the commissioner of the California Department of Savings and Loan: “The best way to rob a bank is to own one.” Some S&Ls bet their depositors’ money on highly dubious real-estate developments. Many simply stole the money, as if deregulation meant that the law no longer applied to them at all.
When the ensuing bubble burst, nearly 300 S&Ls collapsed, while another 747 were closed or reorganized under the auspices of the Resolution Trust Corporation, established by Congress in 1989 to clear up the mess. The final cost of the crisis was $153 billion (around 3 percent of the 1989 G.D.P.), of which taxpayers had to pay $124 billion.
But even as the S&Ls were going belly-up, they offered another, very different group of American financial institutions a fast track to megabucks. To the bond traders at Salomon Brothers, the New York investment bank, the breakdown of the New Deal mortgage system was not a crisis but a wonderful opportunity. As profit-hungry as their language was profane, the self-styled “Big Swinging Dicks” at Salomon saw a way of exploiting the gyrating interest rates of the early 1980s.
The idea was to re-invent mortgages by bundling thousands of them together as the backing for new and alluring securities that could be sold as alternatives to traditional government and corporate bonds—in short, to convert mortgages into bonds. Once lumped together, the interest payments due on the mortgages could be subdivided into strips with different maturities and credit risks. The first issue of this new kind of mortgage-backed security (known as a “collateralized mortgage obligation”) occurred in June 1983. The dawn of securitization was a necessary prelude to the Age of Leverage.
Once again, however, it was the federal government that stood ready to pick up the tab in a crisis. For the majority of mortgages continued to enjoy an implicit guarantee from the government-sponsored trio of Fannie, Freddie, and Ginnie, meaning that bonds which used those mortgages as collateral could be represented as virtual government bonds and considered “investment grade.” Between 1980 and 2007, the volume of such G.S.E.-backed mortgage-backed securities grew from less than $200 billion to more than $4 trillion. In 1980 only 10 percent of the home-mortgage market was securitized; by 2007, 56 percent of it was.
These changes swept away the last vestiges of the business model depicted in It’s a Wonderful Life. Once there had been meaningful social ties between mortgage lenders and borrowers. James Stewart’s character knew both the depositors and the debtors. By contrast, in a securitized market the interest you paid on your mortgage ultimately went to someone who had no idea you existed. The full implications of this transition for ordinary homeowners would become apparent only 25 years later.
The Lessons of Detroit
In July 2007, I paid a visit to Detroit, because I had the feeling that what was happening there was the shape of things to come in the United States as a whole. In the space of 10 years, house prices in Detroit, which probably possesses the worst housing stock of any American city other than New Orleans, had risen by more than a third—not much compared with the nationwide bubble, but still hard to explain, given the city’s chronically depressed economic state. As I discovered, the explanation lay in fundamental changes in the rules of the housing game.
I arrived at the end of a borrowing spree. For several years agents and brokers selling subprime mortgages had been flooding Detroit with radio, television, and direct-mail advertisements, offering what sounded like attractive deals. In 2006, for example, subprime lenders pumped more than a billion dollars into 22 Detroit Zip Codes.
These were not the old 30-year fixed-rate mortgages invented in the New Deal. On the contrary, a high proportion were adjustable-rate mortgages—in other words, the interest rate could vary according to changes in short-term lending rates. Many were also interest-only mortgages, without amortization (repayment of principal), even when the principal represented 100 percent of the assessed value of the mortgaged property. And most had introductory “teaser” periods, whereby the initial interest payments—usually for the first two years—were kept artificially low, with the cost of the loan backloaded. All of these devices were intended to allow an immediate reduction in the debt-servicing costs of the borrower.
In Detroit only a minority of these loans were going to first-time buyers. They were nearly all refinancing deals, which allowed borrowers to treat their homes as cash machines, converting their existing equity into cash and using the proceeds to pay off credit-card debts, carry out renovations, or buy new consumer durables. However, the combination of declining long-term interest rates and ever more alluring mortgage deals did attract new buyers into the housing market. By 2005, 69 percent of all U.S. householders were homeowners; 10 years earlier it had been 64 percent. About half of that increase could be attributed to the subprime-lending boom.
Significantly, a disproportionate number of subprime borrowers belonged to ethnic minorities. Indeed, I found myself wondering, as I drove around Detroit, if “subprime” was in fact a new financial euphemism for “black.” This was no idle supposition. According to a joint study by, among others, the Massachusetts Affordable Housing Alliance, 55 percent of black and Latino borrowers in Boston who had obtained loans for single-family homes in 2005 had been given subprime mortgages; the figure for white borrowers was just 13 percent. More than three-quarters of black and Latino borrowers from Washington Mutual were classed as subprime, whereas only 17 percent of white borrowers were. According to a report in The Wall Street Journal, minority ownership increased by 3.1 million between 2002 and 2007.
Here, surely, was the zenith of the property-owning democracy. It was an achievement that the Bush administration was proud of. “We want everybody in America to own their own home,” President George W. Bush had said in October 2002. Having challenged lenders to create 5.5 million new minority homeowners by the end of the decade, Bush signed the American Dream Downpayment Act in 2003, a measure designed to subsidize first-time house purchases in low-income groups. Between 2000 and 2006, the share of undocumented subprime contracts rose from 17 to 44 percent. Fannie Mae and Freddie Mac also came under pressure from the Department of Housing and Urban Development to support the subprime market. As Bush put it in December 2003, “It is in our national interest that more people own their own home.” Few people dissented.
As a business model, subprime lending worked beautifully—as long, that is, as interest rates stayed low, people kept their jobs, and real-estate prices continued to rise. Such conditions could not be relied upon to last, however, least of all in a city like Detroit. But that did not worry the subprime lenders. They simply followed the trail blazed by mainstream mortgage lenders in the 1980s. Having pocketed fat commissions on the signing of the original loan contracts, they hastily resold their loans in bulk to Wall Street banks. The banks, in turn, bundled the loans into high-yielding mortgage-backed securities and sold them to investors around the world, all eager for a few hundredths of a percentage point more of return on their capital. Repackaged as C.D.O.’s, these subprime securities could be transformed from risky loans to flaky borrowers into triple-A-rated investment-grade securities. All that was required was certification from one of the rating agencies that at least the top tier of these securities was unlikely to go into default.
The risk was spread across the globe, from American state pension funds to public-hospital networks in Australia, to town councils near the Arctic Circle. In Norway, for example, eight municipalities, including Rana and Hemnes, invested some $120 million of their taxpayers’ money in C.D.O.’s secured on American subprime mortgages.
In Detroit the rise of subprime mortgages had in fact coincided with a new slump in the inexorably declining automobile industry. That anticipated a wider American slowdown, an almost inevitable consequence of a tightening of monetary policy as the Federal Reserve belatedly raised short-term interest rates from 1 percent to 5.25 percent. As soon as the teaser rates expired and mortgages were reset at new and much higher interest rates, hundreds of Detroit households swiftly fell behind in their mortgage payments. The effect was to burst the real-estate bubble, causing house prices to start falling significantly for the first time since the early 1990s. And the further house prices fell, the more homeowners found themselves with “negative equity”—in other words, owing more money than their homes were worth.
The rest—the chain reaction as defaults in Detroit and elsewhere unleashed huge losses on C.D.O.’s in financial institutions all around the world—you know.
Drunk on Derivatives
Do you, however, know about the second-order effects of this crisis in the markets for derivatives? Do you in fact know what a derivative is? Once excoriated by Warren Buffett as “financial weapons of mass destruction,” derivatives are what make this crisis both unique and unfathomable in its ramifications. To understand what they are, you need, literally, to go back to the future.
For a farmer planting a crop, nothing is more crucial than the future price it will fetch after it has been harvested and taken to market. A futures contract allows him to protect himself by committing a merchant to buy his crop when it comes to market at a price agreed upon when the seeds are being planted. If the market price on the day of delivery is lower than expected, the farmer is protected.
The earliest forms of protection for farmers were known as forward contracts, which were simply bilateral agreements between seller and buyer. A true futures contract, however, is a standardized instrument issued by a futures exchange and hence tradable. With the development of a standard “to arrive” futures contract, along with a set of rules to enforce settlement and, finally, an effective clearinghouse, the first true futures market was born.
Because they are derived from the value of underlying assets, all futures contracts are forms of derivatives. Closely related, though distinct from futures, are the contracts known as options. In essence, the buyer of a “call” option has the right, but not the obligation, to buy an agreed-upon quantity of a particular commodity or financial asset from the seller (“writer”) of the option at a certain time (the expiration date) for a certain price (known as the “strike price”). Clearly, the buyer of a call option expects the price of the underlying instrument to rise in the future. When the price passes the agreed-upon strike price, the option is “in the money”—and so is the smart guy who bought it. A “put” option is just the opposite: the buyer has the right but not the obligation to sell an agreed-upon quantity of something to the seller of the option at an agreed-upon price.
A third kind of derivative is the interest-rate “swap,” which is effectively a bet between two parties on the future path of interest rates. A pure interest-rate swap allows two parties already receiving interest payments literally to swap them, allowing someone receiving a variable rate of interest to exchange it for a fixed rate, in case interest rates decline. A credit-default swap (C.D.S.), meanwhile, offers protection against a company’s defaulting on its bonds.
Bringing down the bull: The pain of America’s financial crisis is felt all over the world. Illustration by Brad Holland.
There was a time when derivatives were standardized instruments traded on exchanges such as the Chicago Board of Trade. Now, however, the vast proportion are custom-made and sold “over the counter” (O.T.C.), often by banks, which charge attractive commissions for their services, but also by insurance companies (notably A.I.G.). According to the Bank for International Settlements, the total notional amounts outstanding of O.T.C. derivative contracts—arranged on an ad hoc basis between two parties—reached a staggering $596 trillion in December 2007, with a gross market value of just over $14.5 trillion.
But how exactly do you price a derivative? What precisely is an option worth? The answers to those questions required a revolution in financial theory. From an academic point of view, what this revolution achieved was highly impressive. But the events of the 1990s, as the rise of quantitative finance replaced preppies with quants (quantitative analysts) all along Wall Street, revealed a new truth: those whom the gods want to destroy they first teach math.
Working closely with Fischer Black, of the consulting firm Arthur D. Little, M.I.T.’s Myron Scholes invented a groundbreaking new theory of pricing options, to which his colleague Robert Merton also contributed. (Scholes and Merton would share the 1997 Nobel Prize in economics.) They reasoned that a call option’s value depended on six variables: the current market price of the stock (S), the agreed future price at which the stock could be bought (L), the time until the expiration date of the option (t), the risk-free rate of return in the economy as a whole (r), the probability that the option will be exercised (N), and—the crucial variable—the expected volatility of the stock, i.e., the likely fluctuations of its price between the time of purchase and the expiration date (s). With wonderful mathematical wizardry, the quants reduced the price of a call option to this formula (the Black-Scholes formula):
Feeling a bit baffled? Can’t follow the algebra? That was just fine by the quants. To make money from this magic formula, they needed markets to be full of people who didn’t have a clue about how to price options but relied instead on their (seldom accurate) gut instincts. They also needed a great deal of computing power, a force which had been transforming the financial markets since the early 1980s. Their final requirement was a partner with some market savvy in order to make the leap from the faculty club to the trading floor. Black, who would soon be struck down by cancer, could not be that partner. But John Meriwether could. The former head of the bond-arbitrage group at Salomon Brothers, Meriwether had made his first fortune in the wake of the S&L meltdown of the late 1980s. The hedge fund he created with Scholes and Merton in 1994 was called Long-Term Capital Management.
In its brief, four-year life, Long-Term was the brightest star in the hedge-fund firmament, generating mind-blowing returns for its elite club of investors and even more money for its founders. Needless to say, the firm did more than just trade options, though selling puts on the stock market became such a big part of its business that it was nicknamed “the central bank of volatility” by banks buying insurance against a big stock-market sell-off. In fact, the partners were simultaneously pursuing multiple trading strategies, about 100 of them, with a total of 7,600 positions. This conformed to a second key rule of the new mathematical finance: the virtue of diversification, a principle that had been formalized by Harry M. Markowitz, of the Rand Corporation. Diversification was all about having a multitude of uncorrelated positions. One might go wrong, or even two. But thousands just could not go wrong simultaneously.
The mathematics were reassuring. According to the firm’s “Value at Risk” models, it would take a 10-s (in other words, 10-standard-deviation) event to cause the firm to lose all its capital in a single year. But the probability of such an event, according to the quants, was 1 in 10,24—or effectively zero. Indeed, the models said the most Long-Term was likely to lose in a single day was $45 million. For that reason, the partners felt no compunction about leveraging their trades. At the end of August 1997, the fund’s capital was $6.7 billion, but the debt-financed assets on its balance sheet amounted to $126 billion, a ratio of assets to capital of 19 to 1.
There is no need to rehearse here the story of Long-Term’s downfall, which was precipitated by a Russian debt default. Suffice it to say that on Friday, August 21, 1998, the firm lost $550 million—15 percent of its entire capital, and vastly more than its mathematical models had said was possible. The key point is to appreciate why the quants were so wrong.
The problem lay with the assumptions that underlie so much of mathematical finance. In order to construct their models, the quants had to postulate a planet where the inhabitants were omniscient and perfectly rational; where they instantly absorbed all new information and used it to maximize profits; where they never stopped trading; where markets were continuous, frictionless, and completely liquid. Financial markets on this planet followed a “random walk,” meaning that each day’s prices were quite unrelated to the previous day’s, but reflected no more and no less than all the relevant information currently available. The returns on this planet’s stock market were normally distributed along the bell curve, with most years clustered closely around the mean, and two-thirds of them within one standard deviation of the mean. On such a planet, a “six standard deviation” sell-off would be about as common as a person shorter than one foot in our world. It would happen only once in four million years of trading.
But Long-Term was not located on Planet Finance. It was based in Greenwich, Connecticut, on Planet Earth, a place inhabited by emotional human beings, always capable of flipping suddenly and en masse from greed to fear. In the case of Long-Term, the herding problem was acute, because many other firms had begun trying to copy Long-Term’s strategies in the hope of replicating its stellar performance. When things began to go wrong, there was a truly bovine stampede for the exits. The result was a massive, synchronized downturn in virtually all asset markets. Diversification was no defense in such a crisis. As one leading London hedge-fund manager later put it to Meriwether, “John, you were the correlation.”
There was, however, another reason why Long-Term failed. The quants’ Value at Risk models had implied that the loss the firm suffered in August 1998 was so unlikely that it ought never to have happened in the entire life of the universe. But that was because the models were working with just five years of data. If they had gone back even 11 years, they would have captured the 1987 stock-market crash. If they had gone back 80 years they would have captured the last great Russian default, after the 1917 revolution. Meriwether himself, born in 1947, ruefully observed, “If I had lived through the Depression, I would have been in a better position to understand events.” To put it bluntly, the Nobel Prize winners knew plenty of mathematics but not enough history.
One might assume that, after the catastrophic failure of L.T.C.M., quantitative hedge funds would have vanished from the financial scene, and derivatives such as options would be sold a good deal more circumspectly. Yet the very reverse happened. Far from declining, in the past 10 years hedge funds of every type have exploded in number and in the volume of assets they manage, with quantitative hedge funds such as Renaissance, Citadel, and D. E. Shaw emerging as leading players. The growth of derivatives has also been spectacular—and it has continued despite the onset of the credit crunch. Between December 2005 and December 2007, the notional amounts outstanding for all derivatives increased from $298 trillion to $596 trillion. Credit-default swaps quadrupled, from $14 trillion to $58 trillion.
An intimation of the problems likely to arise came in September, when the government takeover of Fannie and Freddie cast doubt on the status of derivative contracts protecting the holders of more than $1.4 trillion of their bonds against default. The consequences of the failure of Lehman Brothers were substantially greater, because the firm was the counter-party in so many derivative contracts.
The big question is whether those active in the market waited too long to set up some kind of clearing mechanism. If, as seems inevitable, there is an upsurge in corporate defaults as the U.S. slides into recession, the whole system could completely seize up.
Just 10 years ago, during the Asian crisis of 1997–98, it was conventional wisdom that financial crises were more likely to happen on the periphery of the world economy—in the so-called emerging markets of East Asia and Latin America. Yet the biggest threats to the global financial system in this new century have come not from the periphery but from the core. The explanation for this strange role reversal may in fact lie in the way emerging markets changed their behavior after 1998.
For many decades it was assumed that poor countries could become rich only by borrowing capital from wealthy countries. Recurrent debt crises and currency crises associated with sudden withdrawals of Western money led to a rethinking, inspired largely by the Chinese example.
When the Chinese wanted to attract foreign capital, they insisted that it take the form of direct investment. That meant that instead of borrowing from Western banks to finance its industrial development, as many emerging markets did, China got foreigners to build factories in Chinese enterprise zones—large, lumpy assets that could not easily be withdrawn in a crisis.
The crucial point, though, is that the bulk of Chinese investment has been financed from China’s own savings. Cautious after years of instability and unused to the panoply of credit facilities we have in the West, Chinese households save a high proportion of their rising incomes, in marked contrast to Americans, who in recent years have saved almost none at all. Chinese corporations save an even larger proportion of their soaring profits. The remarkable thing is that a growing share of that savings surplus has ended up being lent to the United States. In effect, the People’s Republic of China has become banker to the United States of America.
The Chinese have not been acting out of altruism. Until very recently, the best way for China to employ its vast population was by exporting manufactured goods to the spendthrift U.S. consumer. To ensure that those exports were irresistibly cheap, China had to fight the tendency for its currency to strengthen against the dollar by buying literally billions of dollars on world markets. In 2006, Chinese holdings of dollars reached 700 billion. Other Asian and Middle Eastern economies adopted much the same strategy.
The benefits for the United States were manifold. Asian imports kept down U.S. inflation. Asian labor kept down U.S. wage costs. Above all, Asian savings kept down U.S. interest rates. But there was a catch. The more Asia was willing to lend to the United States, the more Americans were willing to borrow. The Asian savings glut was thus the underlying cause of the surge in bank lending, bond issuance, and new derivative contracts that Planet Finance witnessed after 2000. It was the underlying cause of the hedge-fund population explosion. It was the underlying reason why private-equity partnerships were able to borrow money left, right, and center to finance leveraged buyouts. And it was the underlying reason why the U.S. mortgage market was so awash with cash by 2006 that you could get a 100 percent mortgage with no income, no job, and no assets.
Whether or not China is now sufficiently “decoupled” from the United States that it can insulate itself from our credit crunch remains to be seen. At the time of writing, however, it looks very doubtful.
Back to Reality
The modern financial system is the product of centuries of economic evolution. Banks transformed money from metal coins into accounts, allowing ever larger aggregations of borrowing and lending. From the Renaissance on, government bonds introduced the securitization of streams of interest payments. From the 17th century on, equity in corporations could be bought and sold in public stock markets. From the 18th century on, central banks slowly learned how to moderate or exacerbate the business cycle. From the 19th century on, insurance was supplemented by futures, the first derivatives. And from the 20th century on, households were encouraged by government to skew their portfolios in favor of real estate.
Read Niall Ferguson’s prescient article on today’s financial woes, Empire Falls (November 2006).
Economies that combined all these institutional innovations performed better over the long run than those that did not, because financial intermediation generally permits a more efficient allocation of resources than, say, feudalism or central planning. For this reason, it is not wholly surprising that the Western financial model tended to spread around the world, first in the guise of imperialism, then in the guise of globalization.
Yet money’s ascent has not been, and can never be, a smooth one. On the contrary, financial history is a roller-coaster ride of ups and downs, bubbles and busts, manias and panics, shocks and crashes. The excesses of the Age of Leverage—the deluge of paper money, the asset-price inflation, the explosion of consumer and bank debt, and the hypertrophic growth of derivatives—were bound sooner or later to produce a really big crisis.
It remains unclear whether this crisis will have economic and social effects as disastrous as those of the Great Depression, or whether the monetary and fiscal authorities will succeed in achieving a Great Repression, averting a 1930s-style “great contraction” of credit and output by transferring the as yet unquantifiable losses from banks to taxpayers.
Either way, Planet Finance has now returned to Planet Earth with a bang. The key figures of the Age of Leverage—the lax central bankers, the reckless investment bankers, the hubristic quants—are now feeling the full force of this planet’s gravity.
But what about the rest of us, the rank-and-file members of the deluded crowd? Well, we shall now have to question some of our most deeply rooted assumptions—not only about the benefits of paper money but also about the rationale of the property-owning democracy itself.
On Planet Finance it may have made sense to borrow billions of dollars to finance a massive speculation on the future prices of American houses, and then to erect on the back of this trade a vast inverted pyramid of incomprehensible securities and derivatives.
But back here on Planet Earth it suddenly seems like an extraordinary popular delusion.
Niall Ferguson is Laurence A. Tisch Professor of History at Harvard University and a Senior Fellow of the Hoover Institution at Stanford, and the author of The War of the World: Twentieth-Century Conflict and the Descent of the West.
What the market seeks is a divisable asset with no counterparty risk that is impossible to counterfeit, by that definition, money is what it has always been: gold and silver and nothing else.
Why was I dogged with a terrible dread for the last four years and completely obsessed with the absolute certanity that the current economic order was about to collapse. My iconoclasm and alienation from the mainstream and my understanding of the history of human economic folly.
Based on the aggregates, this downturn, from a technical perspective may be a turn of supercycle degree correcting the rise of the west from 1712 and therefore a bust much more significant than the Great Depression.
We don't make social transformations from a carbon based energy addiction where social rank is defined by the nicest granite countertops to a sustainable hitech world with a completely distributed energy system, a healthy communal life and the classic human virtues seemlessly. The old must die before the new emerges.
As the article below demonstrates; if you want to know the future consult the historian and philosopher, not those most at ease in the current order.
Thats my take anyway.
Kevin McKern
Wall Street Lays Another Egg
Not so long ago, the dollar stood for a sum of gold, and bankers knew the people they lent to. The author charts the emergence of an abstract, even absurd world—call it Planet Finance—where mathematical models ignored both history and human nature, and value had no meaning.
by
Niall Ferguson
December 2008
The bigger they come: Uncle Sam and Wall Street take the hardest fall since the Depression.
This year we have lived through something more than a financial crisis. We have witnessed the death of a planet. Call it Planet Finance. Two years ago, in 2006, the measured economic output of the entire world was worth around $48.6 trillion. The total market capitalization of the world’s stock markets was $50.6 trillion, 4 percent larger. The total value of domestic and international bonds was $67.9 trillion, 40 percent larger. Planet Finance was beginning to dwarf Planet Earth.
Planet Finance seemed to spin faster, too. Every day $3.1 trillion changed hands on foreign-exchange markets. Every month $5.8 trillion changed hands on global stock markets. And all the time new financial life-forms were evolving. The total annual issuance of mortgage-backed securities, including fancy new “collateralized debt obligations” (C.D.O.’s), rose to more than $1 trillion. The volume of “derivatives”—contracts such as options and swaps—grew even faster, so that by the end of 2006 their notional value was just over $400 trillion. Before the 1980s, such things were virtually unknown. In the space of a few years their populations exploded. On Planet Finance, the securities outnumbered the people; the transactions outnumbered the relationships.
Read Niall Ferguson’s prescient article on today’s financial woes, Empire Falls (November 2006).
New institutions also proliferated. In 1990 there were just 610 hedge funds, with $38.9 billion under management. At the end of 2006 there were 9,462, with $1.5 trillion under management. Private-equity partnerships also went forth and multiplied. Banks, meanwhile, set up a host of “conduits” and “structured investment vehicles” (sivs—surely the most apt acronym in financial history) to keep potentially risky assets off their balance sheets. It was as if an entire shadow banking system had come into being.
Then, beginning in the summer of 2007, Planet Finance began to self-destruct in what the International Monetary Fund soon acknowledged to be “the largest financial shock since the Great Depression.” Did the crisis of 2007–8 happen because American companies had gotten worse at designing new products? Had the pace of technological innovation or productivity growth suddenly slackened? No. The proximate cause of the economic uncertainty of 2008 was financial: to be precise, a crunch in the credit markets triggered by mounting defaults on a hitherto obscure species of housing loan known euphemistically as “subprime mortgages.”
Central banks in the United States and Europe sought to alleviate the pressure on the banks with interest-rate cuts and offers of funds through special “term auction facilities.” Yet the market rates at which banks could borrow money, whether by issuing commercial paper, selling bonds, or borrowing from one another, failed to follow the lead of the official federal-funds rate. The banks had to turn not only to Western central banks for short-term assistance to rebuild their reserves but also to Asian and Middle Eastern sovereign-wealth funds for equity injections. When these sources proved insufficient, investors—and speculative short-sellers—began to lose faith.
B
eginning with Bear Stearns, Wall Street’s investment banks entered a death spiral that ended with their being either taken over by a commercial bank (as Bear was, followed by Merrill Lynch) or driven into bankruptcy (as Lehman Brothers was). In September the two survivors—Goldman Sachs and Morgan Stanley—formally ceased to be investment banks, signaling the death of a business model that dated back to the Depression. Other institutions deemed “too big to fail” by the U.S. Treasury were effectively taken over by the government, including the mortgage lenders and guarantors Fannie Mae and Freddie Mac and the insurance giant American International Group (A.I.G.).
By September 18 the U.S. financial system was gripped by such panic that the Treasury had to abandon this ad hoc policy. Treasury Secretary Henry Paulson hastily devised a plan whereby the government would be authorized to buy “troubled” securities with up to $700 billion of taxpayers’ money—a figure apparently plucked from the air. When a modified version of the measure was rejected by Congress 11 days later, there was panic. When it was passed four days after that, there was more panic. Now it wasn’t just bank stocks that were tanking. The entire stock market seemed to be in free fall as fears mounted that the credit crunch was going to trigger a recession. Moreover, the crisis was now clearly global in scale. European banks were in much the same trouble as their American counterparts, while emerging-market stock markets were crashing. A week of frenetic improvisation by national governments culminated on the weekend of October 11–12, when the United States reluctantly followed the British government’s lead, buying equity stakes in banks rather than just their dodgy assets and offering unprecedented guarantees of banks’ debt and deposits.
Since these events coincided with the final phase of a U.S. presidential-election campaign, it was not surprising that some rather simplistic lessons were soon being touted by candidates and commentators. The crisis, some said, was the result of excessive deregulation of financial markets. Others sought to lay the blame on unscrupulous speculators: short-sellers, who borrowed the stocks of vulnerable banks and sold them in the expectation of further price declines. Still other suspects in the frame were negligent regulators and corrupt congressmen.
This hunt for scapegoats is futile. To understand the downfall of Planet Finance, you need to take several steps back and locate this crisis in the long run of financial history. Only then will you see that we have all played a part in this latest sorry example of what the Victorian journalist Charles Mackay described in his 1841 book, Extraordinary Popular Delusions and the Madness of Crowds.
Nothing New
As long as there have been banks, bond markets, and stock markets, there have been financial crises. Banks went bust in the days of the Medici. There were bond-market panics in the Venice of Shylock’s day. And the world’s first stock-market crash happened in 1720, when the Mississippi Company—the Enron of its day—blew up. According to economists Carmen Reinhart and Kenneth Rogoff, the financial history of the past 800 years is a litany of debt defaults, banking crises, currency crises, and inflationary spikes. Moreover, financial crises seldom happen without inflicting pain on the wider economy. Another recent paper, co-authored by Rogoff’s Harvard colleague Robert Barro, has identified 148 crises since 1870 in which a country experienced a cumulative decline in gross domestic product (G.D.P.) of at least 10 percent, implying a probability of financial disaster of around 3.6 percent per year.
If stock-market movements followed the normal-distribution, or bell, curve, like human heights, an annual drop of 10 percent or more would happen only once every 500 years, whereas in the case of the Dow Jones Industrial Average it has happened in 20 of the last 100 years. And stock-market plunges of 20 percent or more would be unheard of—rather like people a foot and a half tall—whereas in fact there have been eight such crashes in the past century.
The most famous financial crisis—the Wall Street Crash—is conventionally said to have begun on “Black Thursday,” October 24, 1929, when the Dow declined by 2 percent, though in fact the market had been slipping since early September and had suffered a sharp, 6 percent drop on October 23. On “Black Monday,” October 28, it plunged by 13 percent, and the next day by a further 12 percent. In the course of the next three years the U.S. stock market declined by a staggering 89 percent, reaching its nadir in July 1932. The index did not regain its 1929 peak until November 1954.
That helps put our current troubles into perspective. From its peak of 14,164, on October 9, 2007, to a dismal level of 8,579, exactly a year later, the Dow declined by 39 percent. By contrast, on a single day just over two decades ago—October 19, 1987—the index fell by 23 percent, one of only four days in history when the index has fallen by more than 10 percent in a single trading session.
This crisis, however, is about much more than just the stock market. It needs to be understood as a fundamental breakdown of the entire financial system, extending from the monetary-and-banking system through the bond market, the stock market, the insurance market, and the real-estate market. It affects not only established financial institutions such as investment banks but also relatively novel ones such as hedge funds. It is global in scope and unfathomable in scale.
Had it not been for the frantic efforts of the Federal Reserve and the Treasury, to say nothing of their counterparts in almost equally afflicted Europe, there would by now have been a repeat of that “great contraction” of credit and economic activity that was the prime mover of the Depression. Back then, the Fed and the Treasury did next to nothing to prevent bank failures from translating into a drastic contraction of credit and hence of business activity and employment. If the more openhanded monetary and fiscal authorities of today are ultimately successful in preventing a comparable slump of output, future historians may end up calling this “the Great Repression.” This is the Depression they are hoping to bottle up—a Depression in denial.
To understand why we have come so close to a rerun of the 1930s, we need to begin at the beginning, with banks and the money they make. From the Middle Ages until the mid-20th century, most banks made their money by maximizing the difference between the costs of their liabilities (payments to depositors) and the earnings on their assets (interest and commissions on loans). Some banks also made money by financing trade, discounting the commercial bills issued by merchants. Others issued and traded bonds and stocks, or dealt in commodities (especially precious metals). But the core business of banking was simple. It consisted, as the third Lord Rothschild pithily put it, “essentially of facilitating the movement of money from Point A, where it is, to Point B, where it is needed.”
The system evolved gradually. First came the invention of cashless intra-bank and inter-bank transactions, which allowed debts to be settled between account holders without having money physically change hands. Then came the idea of fractional-reserve banking, whereby banks kept only a small proportion of their existing deposits on hand to satisfy the needs of depositors (who seldom wanted all their money simultaneously), allowing the rest to be lent out profitably. That was followed by the rise of special public banks with monopolies on the issuing of banknotes and other powers and privileges: the first central banks.
With these innovations, money ceased to be understood as precious metal minted into coins. Now it was the sum total of specific liabilities (deposits and reserves) incurred by banks. Credit was the other side of banks’ balance sheets: the total of their assets; in other words, the loans they made. Some of this money might still consist of precious metal, though a rising proportion of that would be held in the central bank’s vault. Most would be made up of banknotes and coins recognized as “legal tender,” along with money that was visible only in current- and deposit-account statements.
Until the late 20th century, the system of bank money retained an anchor in the pre-modern conception of money in the form of the gold standard: fixed ratios between units of account and quantities of precious metal. As early as 1924, the English economist John Maynard Keynes dismissed the gold standard as a “barbarous relic,” but the last vestige of the system did not disappear until August 15, 1971—the day President Richard Nixon closed the so-called gold window, through which foreign central banks could still exchange dollars for gold. With that, the centuries-old link between money and precious metal was broken.
Though we tend to think of money today as being made of paper, in reality most of it now consists of bank deposits. If we measure the ratio of actual money to output in developed economies, it becomes clear that the trend since the 1970s has been for that ratio to rise from around 70 percent, before the closing of the gold window, to more than 100 percent by 2005. The corollary has been a parallel growth of credit on the other side of bank balance sheets. A significant component of that credit growth has been a surge of lending to consumers. Back in 1952, the ratio of household debt to disposable income was less than 40 percent in the United States. At its peak in 2007, it reached 133 percent, up from 90 percent a decade before. Today Americans carry a total of $2.56 trillion in consumer debt, up by more than a fifth since 2000.
Even more spectacular, however, has been the rising indebtedness of banks themselves. In 1980, bank indebtedness was equivalent to 21 percent of U.S. gross domestic product. In 2007 the figure was 116 percent. Another measure of this was the declining capital adequacy of banks. On the eve of “the Great Repression,” average bank capital in Europe was equivalent to less than 10 percent of assets; at the beginning of the 20th century, it was around 25 percent. It was not unusual for investment banks’ balance sheets to be as much as 20 or 30 times larger than their capital, thanks in large part to a 2004 rule change by the Securities and Exchange Commission that exempted the five largest of those banks from the regulation that had capped their debt-to-capital ratio at 12 to 1. The Age of Leverage had truly arrived for Planet Finance.
Credit and money, in other words, have for decades been growing more rapidly than underlying economic activity. Is it any wonder, then, that money has ceased to hold its value the way it did in the era of the gold standard? The motto “In God we trust” was added to the dollar bill in 1957. Since then its purchasing power, relative to the consumer price index, has declined by a staggering 87 percent. Average annual inflation during that period has been more than 4 percent. A man who decided to put his savings into gold in 1970 could have bought just over 27.8 ounces of the precious metal for $1,000. At the time of writing, with gold trading at $900 an ounce, he could have sold it for around $25,000.
Those few goldbugs who always doubted the soundness of fiat money—paper currency without a metal anchor—have in large measure been vindicated. But why were the rest of us so blinded by money illusion?
Blowing Bubbles
In the immediate aftermath of the death of gold as the anchor of the monetary system, the problem of inflation affected mainly retail prices and wages. Today, only around one out of seven countries has an inflation rate above 10 percent, and only one, Zimbabwe, is afflicted with hyperinflation. But back in 1979 at least 7 countries had an annual inflation rate above 50 percent, and more than 60 countries—including Britain and the United States—had inflation in double digits.
Inflation has come down since then, partly because many of the items we buy—from clothes to computers—have gotten cheaper as a result of technological innovation and the relocation of production to low-wage economies in Asia. It has also been reduced because of a worldwide transformation in monetary policy, which began with the monetarist-inspired increases in short-term rates implemented by the Federal Reserve in 1979. Just as important, some of the structural drivers of inflation, such as powerful trade unions, have also been weakened.
By the 1980s, in any case, more and more people had grasped how to protect their wealth from inflation: by investing it in assets they expected to appreciate in line with, or ahead of, the cost of living. These assets could take multiple forms, from modern art to vintage wine, but the most popular proved to be stocks and real estate. Once it became clear that this formula worked, the Age of Leverage could begin. For it clearly made sense to borrow to the hilt to maximize your holdings of stocks and real estate if these promised to generate higher rates of return than the interest payments on your borrowings. Between 1990 and 2004, most American households did not see an appreciable improvement in their incomes. Adjusted for inflation, the median household income rose by about 6 percent. But people could raise their living standards by borrowing and investing in stocks and housing.
Nearly all of us did it. And the bankers were there to help. Not only could they borrow more cheaply from one another than we could borrow from them; increasingly they devised all kinds of new mortgages that looked more attractive to us (and promised to be more lucrative to them) than boring old 30-year fixed-rate deals. Moreover, the banks were just as ready to play the asset markets as we were. Proprietary trading soon became the most profitable arm of investment banking: buying and selling assets on the bank’s own account.
Losing our shirt? The problem is that our banks are also losing theirs. Illustration by Barry Blitt.
There was, however, a catch. The Age of Leverage was also an age of bubbles, beginning with the dot-com bubble of the irrationally exuberant 1990s and ending with the real-estate mania of the exuberantly irrational 2000s. Why was this?
The future is in large measure uncertain, so our assessments of future asset prices are bound to vary. If we were all calculating machines, we would simultaneously process all the available information and come to the same conclusion. But we are human beings, and as such are prone to myopia and mood swings. When asset prices surge upward in sync, it is as if investors are gripped by a kind of collective euphoria. Conversely, when their “animal spirits” flip from greed to fear, the bubble that their earlier euphoria inflated can burst with amazing suddenness. Zoological imagery is an integral part of the culture of Planet Finance. Optimistic buyers are “bulls,” pessimistic sellers are “bears.” The real point, however, is that stock markets are mirrors of the human psyche. Like Homo sapiens, they can become depressed. They can even suffer complete breakdowns.
This is no new insight. In the 400 years since the first shares were bought and sold on the Amsterdam Beurs, there has been a long succession of financial bubbles. Time and again, asset prices have soared to unsustainable heights only to crash downward again. So familiar is this pattern—described by the economic historian Charles Kindleberger—that it is possible to distill it into five stages:
(1) Displacement: Some change in economic circumstances creates new and profitable opportunities. (2) Euphoria, or overtrading: A feedback process sets in whereby expectation of rising profits leads to rapid growth in asset prices. (3) Mania, or bubble: The prospect of easy capital gains attracts first-time investors and swindlers eager to mulct them of their money. (4) Distress: The insiders discern that profits cannot possibly justify the now exorbitant price of the assets and begin to take profits by selling. (5) Revulsion, or discredit: As asset prices fall, the outsiders stampede for the exits, causing the bubble to burst.
The key point is that without easy credit creation a true bubble cannot occur. That is why so many bubbles have their origins in the sins of omission and commission of central banks.
The bubbles of our time had their origins in the aftermath of the 1987 stock-market crash, when then novice Federal Reserve chairman Alan Greenspan boldly affirmed the Fed’s “readiness to serve as a source of liquidity to support the economic and financial system.” This sent a signal to the markets, particularly the New York banks: if things got really bad, he stood ready to bail them out. Thus was born the “Greenspan put”—the implicit option the Fed gave traders to be able to sell their stocks at today’s prices even in the event of a meltdown tomorrow.
Having contained a panic once, Greenspan thereafter had a dilemma lurking in the back of his mind: whether or not to act pre-emptively the next time—to prevent a panic altogether. This dilemma came to the fore as a classic stock-market bubble took shape in the mid-90s. The displacement in this case was the explosion of innovation by the technology and software industry as personal computers met the Internet. But, as in all of history’s bubbles, an accommodative monetary policy also played a role. From a peak of 6 percent in February 1995, the federal-funds target rate had been reduced to 5.25 percent by January 1996. It was then cut in steps, in the fall of 1998, down to 4.75 percent, and it remained at that level until June 1999, by which time the Dow had passed the 10,000 mark.
Why did the Fed allow euphoria to run loose in the 1990s? Partly because Greenspan and his colleagues underestimated the momentum of the technology bubble; as early as December 1995, with the Dow just past the 5,000 mark, members of the Fed’s Open Market Committee speculated that the market might be approaching its peak. Partly, also, because Greenspan came to the conclusion that it was not the Fed’s responsibility to worry about asset-price inflation, only consumer-price inflation, and this, he believed, was being reduced by a major improvement in productivity due precisely to the tech boom.
Greenspan could not postpone a stock-exchange crash indefinitely. After Silicon Valley’s dot-com bubble peaked, in March 2000, the U.S. stock market fell by almost half over the next two and a half years. It was not until May 2007 that investors in the Standard & Poor’s 500 had recouped their losses. But the Fed’s response to the sell-off—and the massive shot of liquidity it injected into the financial markets after the 9/11 terrorist attacks—prevented the “correction” from precipitating a depression. Not only were the 1930s averted; so too, it seemed, was a repeat of the Japanese experience after 1989, when a conscious effort by the central bank to prick an asset bubble had ended up triggering an 80 percent stock-market sell-off, a real-estate collapse, and a decade of economic stagnation.
What was not immediately obvious was that Greenspan’s easy-money policy was already generating another bubble—this time in the financial market that a majority of Americans have been encouraged for generations to play: the real-estate market.
The American Dream
Real estate is the English-speaking world’s favorite economic game. No other facet of financial life has such a hold on the popular imagination. The real-estate market is unique. Every adult, no matter how economically illiterate, has a view on its future prospects. Through the evergreen board game Monopoly, even children are taught how to climb the property ladder.
Once upon a time, people saved a portion of their earnings for the proverbial rainy day, stowing the cash in a mattress or a bank safe. The Age of Leverage, as we have seen, brought a growing reliance on borrowing to buy assets in the expectation of their future appreciation in value. For a majority of families, this meant a leveraged investment in a house. That strategy had one very obvious flaw. It represented a one-way, totally unhedged bet on a single asset.
To be sure, investing in housing paid off handsomely for more than half a century, up until 2006. Suppose you had put $100,000 into the U.S. property market back in the first quarter of 1987. According to the Case-Shiller national home-price index, you would have nearly tripled your money by the first quarter of 2007, to $299,000. On the other hand, if you had put the same money into the S&P 500, and had continued to re-invest the dividend income in that index, you would have ended up with $772,000 to play with—more than double what you would have made on bricks and mortar.
There is, obviously, an important difference between a house and a stock-market index. You cannot live in a stock-market index. For the sake of a fair comparison, allowance must therefore be made for the rent you save by owning your house (or the rent you can collect if you own a second property). A simple way to proceed is just to leave out both dividends and rents. In that case the difference is somewhat reduced. In the two decades after 1987, the S&P 500, excluding dividends, rose by a factor of just over six, meaning that an investment of $100,000 would be worth some $600,000. But that still comfortably beat housing.
There are three other considerations to bear in mind when trying to compare housing with other forms of assets. The first is depreciation. Stocks do not wear out and require new roofs; houses do. The second is liquidity. As assets, houses are a great deal more expensive to convert into cash than stocks. The third is volatility. Housing markets since World War II have been far less volatile than stock markets. Yet that is not to say that house prices have never deviated from a steady upward path. In Britain between 1989 and 1995, for example, the average house price fell by 18 percent, or, in inflation-adjusted terms, by more than a third—37 percent. In London, the real decline was closer to 47 percent. In Japan between 1990 and 2000, property prices fell by more than 60 percent.
The recent decline of property prices in the United States should therefore have come as less of a shock than it did. Between July 2006 and June 2008, the Case-Shiller index of home prices in 20 big American cities declined on average by 19 percent. In some of these cities—Phoenix, San Diego, Los Angeles, and Miami—the total decline was as much as a third. Seen in international perspective, those are not unprecedented figures. Seen in the context of the post-2000 bubble, prices have yet to return to their starting point. On average, house prices are still 50 percent higher than they were at the beginning of this process.
So why were we oblivious to the likely bursting of the real-estate bubble? The answer is that for generations we have been brainwashed into thinking that borrowing to buy a house is the only rational financial strategy to pursue. Think of Frank Capra’s classic 1946 movie, It’s a Wonderful Life, which tells the story of the family-owned Bailey Building & Loan, a small-town mortgage firm that George Bailey (played by James Stewart) struggles to keep afloat in the teeth of the Depression. “You know, George,” his father tells him, “I feel that in a small way we are doing something important. It’s satisfying a fundamental urge. It’s deep in the race for a man to want his own roof and walls and fireplace, and we’re helping him get those things in our shabby little office.” George gets the message, as he passionately explains to the villainous slumlord Potter after Bailey Sr.’s death: “[My father] never once thought of himself.… But he did help a few people get out of your slums, Mr. Potter. And what’s wrong with that? … Doesn’t it make them better citizens? Doesn’t it make them better customers?”
There, in a nutshell, is one of the key concepts of the 20th century: the notion that property ownership enhances citizenship, and that therefore a property-owning democracy is more socially and politically stable than a democracy divided into an elite of landlords and a majority of property-less tenants. So deeply rooted is this idea in our political culture that it comes as a surprise to learn that it was invented just 70 years ago.
Fannie, Ginnie, and Freddie
Prior to the 1930s, only a minority of Americans owned their homes. During the Depression, however, the Roosevelt administration created a whole complex of institutions to change that. A Federal Home Loan Bank Board was set up in 1932 to encourage and oversee local mortgage lenders known as savings-and-loans (S&Ls)—mutual associations that took in deposits and lent to homebuyers. Under the New Deal, the Home Owners’ Loan Corporation stepped in to refinance mortgages on longer terms, up to 15 years. To reassure depositors, who had been traumatized by the thousands of bank failures of the previous three years, Roosevelt introduced federal deposit insurance. And by providing federally backed insurance for mortgage lenders, the Federal Housing Administration (F.H.A.) sought to encourage large (up to 80 percent of the purchase price), long (20- to 25-year), fully amortized, low-interest loans.
By standardizing the long-term mortgage and creating a national system of official inspection and valuation, the F.H.A. laid the foundation for a secondary market in mortgages. This market came to life in 1938, when a new Federal National Mortgage Association—nicknamed Fannie Mae—was authorized to issue bonds and use the proceeds to buy mortgages from the local S&Ls, which were restricted by regulation both in terms of geography (they could not lend to borrowers more than 50 miles from their offices) and in terms of the rates they could offer (the so-called Regulation Q, which imposed a low ceiling on interest paid on deposits). Because these changes tended to reduce the average monthly payment on a mortgage, the F.H.A. made home ownership viable for many more Americans than ever before. Indeed, it is not too much to say that the modern United States, with its seductively samey suburbs, was born with Fannie Mae. Between 1940 and 1960, the home-ownership rate soared from 43 to 62 percent.
These were not the only ways in which the federal government sought to encourage Americans to own their own homes. Mortgage-interest payments were always tax-deductible, from the inception of the federal income tax in 1913. As Ronald Reagan said when the rationality of this tax break was challenged, mortgage-interest relief was “part of the American dream.”
In 1968, to broaden the secondary-mortgage market still further, Fannie Mae was split in two—the Government National Mortgage Association (Ginnie Mae), which was to cater to poor borrowers, and a rechartered Fannie Mae, now a privately owned government-sponsored enterprise (G.S.E.). Two years later, to provide competition for Fannie Mae, the Federal Home Loan Mortgage Corporation (Freddie Mac) was set up. In addition, Fannie Mae was permitted to buy conventional as well as government-guaranteed mortgages. Later, with the Community Reinvestment Act of 1977, American banks found themselves under pressure for the first time to lend to poor, minority communities.
These changes presaged a more radical modification to the New Deal system. In the late 1970s, the savings-and-loan industry was hit first by double-digit inflation and then by sharply rising interest rates. This double punch was potentially lethal. The S&Ls were simultaneously losing money on long-term, fixed-rate mortgages, due to inflation, and hemorrhaging deposits to higher-interest money-market funds. The response in Washington from both the Carter and Reagan administrations was to try to salvage the S&Ls with tax breaks and deregulation. When the new legislation was passed, President Reagan declared, “All in all, I think we hit the jackpot.” Some people certainly did.
On the one hand, S&Ls could now invest in whatever they liked, not just local long-term mortgages. Commercial property, stocks, junk bonds—anything was allowed. They could even issue credit cards. On the other, they could now pay whatever interest rate they liked to depositors. Yet all their deposits were still effectively insured, with the maximum covered amount raised from $40,000 to $100,000, thanks to a government regulation two years earlier. And if ordinary deposits did not suffice, the S&Ls could raise money in the form of brokered deposits from middlemen. What happened next perfectly illustrated the great financial precept first enunciated by William Crawford, the commissioner of the California Department of Savings and Loan: “The best way to rob a bank is to own one.” Some S&Ls bet their depositors’ money on highly dubious real-estate developments. Many simply stole the money, as if deregulation meant that the law no longer applied to them at all.
When the ensuing bubble burst, nearly 300 S&Ls collapsed, while another 747 were closed or reorganized under the auspices of the Resolution Trust Corporation, established by Congress in 1989 to clear up the mess. The final cost of the crisis was $153 billion (around 3 percent of the 1989 G.D.P.), of which taxpayers had to pay $124 billion.
But even as the S&Ls were going belly-up, they offered another, very different group of American financial institutions a fast track to megabucks. To the bond traders at Salomon Brothers, the New York investment bank, the breakdown of the New Deal mortgage system was not a crisis but a wonderful opportunity. As profit-hungry as their language was profane, the self-styled “Big Swinging Dicks” at Salomon saw a way of exploiting the gyrating interest rates of the early 1980s.
The idea was to re-invent mortgages by bundling thousands of them together as the backing for new and alluring securities that could be sold as alternatives to traditional government and corporate bonds—in short, to convert mortgages into bonds. Once lumped together, the interest payments due on the mortgages could be subdivided into strips with different maturities and credit risks. The first issue of this new kind of mortgage-backed security (known as a “collateralized mortgage obligation”) occurred in June 1983. The dawn of securitization was a necessary prelude to the Age of Leverage.
Once again, however, it was the federal government that stood ready to pick up the tab in a crisis. For the majority of mortgages continued to enjoy an implicit guarantee from the government-sponsored trio of Fannie, Freddie, and Ginnie, meaning that bonds which used those mortgages as collateral could be represented as virtual government bonds and considered “investment grade.” Between 1980 and 2007, the volume of such G.S.E.-backed mortgage-backed securities grew from less than $200 billion to more than $4 trillion. In 1980 only 10 percent of the home-mortgage market was securitized; by 2007, 56 percent of it was.
These changes swept away the last vestiges of the business model depicted in It’s a Wonderful Life. Once there had been meaningful social ties between mortgage lenders and borrowers. James Stewart’s character knew both the depositors and the debtors. By contrast, in a securitized market the interest you paid on your mortgage ultimately went to someone who had no idea you existed. The full implications of this transition for ordinary homeowners would become apparent only 25 years later.
The Lessons of Detroit
In July 2007, I paid a visit to Detroit, because I had the feeling that what was happening there was the shape of things to come in the United States as a whole. In the space of 10 years, house prices in Detroit, which probably possesses the worst housing stock of any American city other than New Orleans, had risen by more than a third—not much compared with the nationwide bubble, but still hard to explain, given the city’s chronically depressed economic state. As I discovered, the explanation lay in fundamental changes in the rules of the housing game.
I arrived at the end of a borrowing spree. For several years agents and brokers selling subprime mortgages had been flooding Detroit with radio, television, and direct-mail advertisements, offering what sounded like attractive deals. In 2006, for example, subprime lenders pumped more than a billion dollars into 22 Detroit Zip Codes.
These were not the old 30-year fixed-rate mortgages invented in the New Deal. On the contrary, a high proportion were adjustable-rate mortgages—in other words, the interest rate could vary according to changes in short-term lending rates. Many were also interest-only mortgages, without amortization (repayment of principal), even when the principal represented 100 percent of the assessed value of the mortgaged property. And most had introductory “teaser” periods, whereby the initial interest payments—usually for the first two years—were kept artificially low, with the cost of the loan backloaded. All of these devices were intended to allow an immediate reduction in the debt-servicing costs of the borrower.
In Detroit only a minority of these loans were going to first-time buyers. They were nearly all refinancing deals, which allowed borrowers to treat their homes as cash machines, converting their existing equity into cash and using the proceeds to pay off credit-card debts, carry out renovations, or buy new consumer durables. However, the combination of declining long-term interest rates and ever more alluring mortgage deals did attract new buyers into the housing market. By 2005, 69 percent of all U.S. householders were homeowners; 10 years earlier it had been 64 percent. About half of that increase could be attributed to the subprime-lending boom.
Significantly, a disproportionate number of subprime borrowers belonged to ethnic minorities. Indeed, I found myself wondering, as I drove around Detroit, if “subprime” was in fact a new financial euphemism for “black.” This was no idle supposition. According to a joint study by, among others, the Massachusetts Affordable Housing Alliance, 55 percent of black and Latino borrowers in Boston who had obtained loans for single-family homes in 2005 had been given subprime mortgages; the figure for white borrowers was just 13 percent. More than three-quarters of black and Latino borrowers from Washington Mutual were classed as subprime, whereas only 17 percent of white borrowers were. According to a report in The Wall Street Journal, minority ownership increased by 3.1 million between 2002 and 2007.
Here, surely, was the zenith of the property-owning democracy. It was an achievement that the Bush administration was proud of. “We want everybody in America to own their own home,” President George W. Bush had said in October 2002. Having challenged lenders to create 5.5 million new minority homeowners by the end of the decade, Bush signed the American Dream Downpayment Act in 2003, a measure designed to subsidize first-time house purchases in low-income groups. Between 2000 and 2006, the share of undocumented subprime contracts rose from 17 to 44 percent. Fannie Mae and Freddie Mac also came under pressure from the Department of Housing and Urban Development to support the subprime market. As Bush put it in December 2003, “It is in our national interest that more people own their own home.” Few people dissented.
As a business model, subprime lending worked beautifully—as long, that is, as interest rates stayed low, people kept their jobs, and real-estate prices continued to rise. Such conditions could not be relied upon to last, however, least of all in a city like Detroit. But that did not worry the subprime lenders. They simply followed the trail blazed by mainstream mortgage lenders in the 1980s. Having pocketed fat commissions on the signing of the original loan contracts, they hastily resold their loans in bulk to Wall Street banks. The banks, in turn, bundled the loans into high-yielding mortgage-backed securities and sold them to investors around the world, all eager for a few hundredths of a percentage point more of return on their capital. Repackaged as C.D.O.’s, these subprime securities could be transformed from risky loans to flaky borrowers into triple-A-rated investment-grade securities. All that was required was certification from one of the rating agencies that at least the top tier of these securities was unlikely to go into default.
The risk was spread across the globe, from American state pension funds to public-hospital networks in Australia, to town councils near the Arctic Circle. In Norway, for example, eight municipalities, including Rana and Hemnes, invested some $120 million of their taxpayers’ money in C.D.O.’s secured on American subprime mortgages.
In Detroit the rise of subprime mortgages had in fact coincided with a new slump in the inexorably declining automobile industry. That anticipated a wider American slowdown, an almost inevitable consequence of a tightening of monetary policy as the Federal Reserve belatedly raised short-term interest rates from 1 percent to 5.25 percent. As soon as the teaser rates expired and mortgages were reset at new and much higher interest rates, hundreds of Detroit households swiftly fell behind in their mortgage payments. The effect was to burst the real-estate bubble, causing house prices to start falling significantly for the first time since the early 1990s. And the further house prices fell, the more homeowners found themselves with “negative equity”—in other words, owing more money than their homes were worth.
The rest—the chain reaction as defaults in Detroit and elsewhere unleashed huge losses on C.D.O.’s in financial institutions all around the world—you know.
Drunk on Derivatives
Do you, however, know about the second-order effects of this crisis in the markets for derivatives? Do you in fact know what a derivative is? Once excoriated by Warren Buffett as “financial weapons of mass destruction,” derivatives are what make this crisis both unique and unfathomable in its ramifications. To understand what they are, you need, literally, to go back to the future.
For a farmer planting a crop, nothing is more crucial than the future price it will fetch after it has been harvested and taken to market. A futures contract allows him to protect himself by committing a merchant to buy his crop when it comes to market at a price agreed upon when the seeds are being planted. If the market price on the day of delivery is lower than expected, the farmer is protected.
The earliest forms of protection for farmers were known as forward contracts, which were simply bilateral agreements between seller and buyer. A true futures contract, however, is a standardized instrument issued by a futures exchange and hence tradable. With the development of a standard “to arrive” futures contract, along with a set of rules to enforce settlement and, finally, an effective clearinghouse, the first true futures market was born.
Because they are derived from the value of underlying assets, all futures contracts are forms of derivatives. Closely related, though distinct from futures, are the contracts known as options. In essence, the buyer of a “call” option has the right, but not the obligation, to buy an agreed-upon quantity of a particular commodity or financial asset from the seller (“writer”) of the option at a certain time (the expiration date) for a certain price (known as the “strike price”). Clearly, the buyer of a call option expects the price of the underlying instrument to rise in the future. When the price passes the agreed-upon strike price, the option is “in the money”—and so is the smart guy who bought it. A “put” option is just the opposite: the buyer has the right but not the obligation to sell an agreed-upon quantity of something to the seller of the option at an agreed-upon price.
A third kind of derivative is the interest-rate “swap,” which is effectively a bet between two parties on the future path of interest rates. A pure interest-rate swap allows two parties already receiving interest payments literally to swap them, allowing someone receiving a variable rate of interest to exchange it for a fixed rate, in case interest rates decline. A credit-default swap (C.D.S.), meanwhile, offers protection against a company’s defaulting on its bonds.
Bringing down the bull: The pain of America’s financial crisis is felt all over the world. Illustration by Brad Holland.
There was a time when derivatives were standardized instruments traded on exchanges such as the Chicago Board of Trade. Now, however, the vast proportion are custom-made and sold “over the counter” (O.T.C.), often by banks, which charge attractive commissions for their services, but also by insurance companies (notably A.I.G.). According to the Bank for International Settlements, the total notional amounts outstanding of O.T.C. derivative contracts—arranged on an ad hoc basis between two parties—reached a staggering $596 trillion in December 2007, with a gross market value of just over $14.5 trillion.
But how exactly do you price a derivative? What precisely is an option worth? The answers to those questions required a revolution in financial theory. From an academic point of view, what this revolution achieved was highly impressive. But the events of the 1990s, as the rise of quantitative finance replaced preppies with quants (quantitative analysts) all along Wall Street, revealed a new truth: those whom the gods want to destroy they first teach math.
Working closely with Fischer Black, of the consulting firm Arthur D. Little, M.I.T.’s Myron Scholes invented a groundbreaking new theory of pricing options, to which his colleague Robert Merton also contributed. (Scholes and Merton would share the 1997 Nobel Prize in economics.) They reasoned that a call option’s value depended on six variables: the current market price of the stock (S), the agreed future price at which the stock could be bought (L), the time until the expiration date of the option (t), the risk-free rate of return in the economy as a whole (r), the probability that the option will be exercised (N), and—the crucial variable—the expected volatility of the stock, i.e., the likely fluctuations of its price between the time of purchase and the expiration date (s). With wonderful mathematical wizardry, the quants reduced the price of a call option to this formula (the Black-Scholes formula):
Feeling a bit baffled? Can’t follow the algebra? That was just fine by the quants. To make money from this magic formula, they needed markets to be full of people who didn’t have a clue about how to price options but relied instead on their (seldom accurate) gut instincts. They also needed a great deal of computing power, a force which had been transforming the financial markets since the early 1980s. Their final requirement was a partner with some market savvy in order to make the leap from the faculty club to the trading floor. Black, who would soon be struck down by cancer, could not be that partner. But John Meriwether could. The former head of the bond-arbitrage group at Salomon Brothers, Meriwether had made his first fortune in the wake of the S&L meltdown of the late 1980s. The hedge fund he created with Scholes and Merton in 1994 was called Long-Term Capital Management.
In its brief, four-year life, Long-Term was the brightest star in the hedge-fund firmament, generating mind-blowing returns for its elite club of investors and even more money for its founders. Needless to say, the firm did more than just trade options, though selling puts on the stock market became such a big part of its business that it was nicknamed “the central bank of volatility” by banks buying insurance against a big stock-market sell-off. In fact, the partners were simultaneously pursuing multiple trading strategies, about 100 of them, with a total of 7,600 positions. This conformed to a second key rule of the new mathematical finance: the virtue of diversification, a principle that had been formalized by Harry M. Markowitz, of the Rand Corporation. Diversification was all about having a multitude of uncorrelated positions. One might go wrong, or even two. But thousands just could not go wrong simultaneously.
The mathematics were reassuring. According to the firm’s “Value at Risk” models, it would take a 10-s (in other words, 10-standard-deviation) event to cause the firm to lose all its capital in a single year. But the probability of such an event, according to the quants, was 1 in 10,24—or effectively zero. Indeed, the models said the most Long-Term was likely to lose in a single day was $45 million. For that reason, the partners felt no compunction about leveraging their trades. At the end of August 1997, the fund’s capital was $6.7 billion, but the debt-financed assets on its balance sheet amounted to $126 billion, a ratio of assets to capital of 19 to 1.
There is no need to rehearse here the story of Long-Term’s downfall, which was precipitated by a Russian debt default. Suffice it to say that on Friday, August 21, 1998, the firm lost $550 million—15 percent of its entire capital, and vastly more than its mathematical models had said was possible. The key point is to appreciate why the quants were so wrong.
The problem lay with the assumptions that underlie so much of mathematical finance. In order to construct their models, the quants had to postulate a planet where the inhabitants were omniscient and perfectly rational; where they instantly absorbed all new information and used it to maximize profits; where they never stopped trading; where markets were continuous, frictionless, and completely liquid. Financial markets on this planet followed a “random walk,” meaning that each day’s prices were quite unrelated to the previous day’s, but reflected no more and no less than all the relevant information currently available. The returns on this planet’s stock market were normally distributed along the bell curve, with most years clustered closely around the mean, and two-thirds of them within one standard deviation of the mean. On such a planet, a “six standard deviation” sell-off would be about as common as a person shorter than one foot in our world. It would happen only once in four million years of trading.
But Long-Term was not located on Planet Finance. It was based in Greenwich, Connecticut, on Planet Earth, a place inhabited by emotional human beings, always capable of flipping suddenly and en masse from greed to fear. In the case of Long-Term, the herding problem was acute, because many other firms had begun trying to copy Long-Term’s strategies in the hope of replicating its stellar performance. When things began to go wrong, there was a truly bovine stampede for the exits. The result was a massive, synchronized downturn in virtually all asset markets. Diversification was no defense in such a crisis. As one leading London hedge-fund manager later put it to Meriwether, “John, you were the correlation.”
There was, however, another reason why Long-Term failed. The quants’ Value at Risk models had implied that the loss the firm suffered in August 1998 was so unlikely that it ought never to have happened in the entire life of the universe. But that was because the models were working with just five years of data. If they had gone back even 11 years, they would have captured the 1987 stock-market crash. If they had gone back 80 years they would have captured the last great Russian default, after the 1917 revolution. Meriwether himself, born in 1947, ruefully observed, “If I had lived through the Depression, I would have been in a better position to understand events.” To put it bluntly, the Nobel Prize winners knew plenty of mathematics but not enough history.
One might assume that, after the catastrophic failure of L.T.C.M., quantitative hedge funds would have vanished from the financial scene, and derivatives such as options would be sold a good deal more circumspectly. Yet the very reverse happened. Far from declining, in the past 10 years hedge funds of every type have exploded in number and in the volume of assets they manage, with quantitative hedge funds such as Renaissance, Citadel, and D. E. Shaw emerging as leading players. The growth of derivatives has also been spectacular—and it has continued despite the onset of the credit crunch. Between December 2005 and December 2007, the notional amounts outstanding for all derivatives increased from $298 trillion to $596 trillion. Credit-default swaps quadrupled, from $14 trillion to $58 trillion.
An intimation of the problems likely to arise came in September, when the government takeover of Fannie and Freddie cast doubt on the status of derivative contracts protecting the holders of more than $1.4 trillion of their bonds against default. The consequences of the failure of Lehman Brothers were substantially greater, because the firm was the counter-party in so many derivative contracts.
The big question is whether those active in the market waited too long to set up some kind of clearing mechanism. If, as seems inevitable, there is an upsurge in corporate defaults as the U.S. slides into recession, the whole system could completely seize up.
Just 10 years ago, during the Asian crisis of 1997–98, it was conventional wisdom that financial crises were more likely to happen on the periphery of the world economy—in the so-called emerging markets of East Asia and Latin America. Yet the biggest threats to the global financial system in this new century have come not from the periphery but from the core. The explanation for this strange role reversal may in fact lie in the way emerging markets changed their behavior after 1998.
For many decades it was assumed that poor countries could become rich only by borrowing capital from wealthy countries. Recurrent debt crises and currency crises associated with sudden withdrawals of Western money led to a rethinking, inspired largely by the Chinese example.
When the Chinese wanted to attract foreign capital, they insisted that it take the form of direct investment. That meant that instead of borrowing from Western banks to finance its industrial development, as many emerging markets did, China got foreigners to build factories in Chinese enterprise zones—large, lumpy assets that could not easily be withdrawn in a crisis.
The crucial point, though, is that the bulk of Chinese investment has been financed from China’s own savings. Cautious after years of instability and unused to the panoply of credit facilities we have in the West, Chinese households save a high proportion of their rising incomes, in marked contrast to Americans, who in recent years have saved almost none at all. Chinese corporations save an even larger proportion of their soaring profits. The remarkable thing is that a growing share of that savings surplus has ended up being lent to the United States. In effect, the People’s Republic of China has become banker to the United States of America.
The Chinese have not been acting out of altruism. Until very recently, the best way for China to employ its vast population was by exporting manufactured goods to the spendthrift U.S. consumer. To ensure that those exports were irresistibly cheap, China had to fight the tendency for its currency to strengthen against the dollar by buying literally billions of dollars on world markets. In 2006, Chinese holdings of dollars reached 700 billion. Other Asian and Middle Eastern economies adopted much the same strategy.
The benefits for the United States were manifold. Asian imports kept down U.S. inflation. Asian labor kept down U.S. wage costs. Above all, Asian savings kept down U.S. interest rates. But there was a catch. The more Asia was willing to lend to the United States, the more Americans were willing to borrow. The Asian savings glut was thus the underlying cause of the surge in bank lending, bond issuance, and new derivative contracts that Planet Finance witnessed after 2000. It was the underlying cause of the hedge-fund population explosion. It was the underlying reason why private-equity partnerships were able to borrow money left, right, and center to finance leveraged buyouts. And it was the underlying reason why the U.S. mortgage market was so awash with cash by 2006 that you could get a 100 percent mortgage with no income, no job, and no assets.
Whether or not China is now sufficiently “decoupled” from the United States that it can insulate itself from our credit crunch remains to be seen. At the time of writing, however, it looks very doubtful.
Back to Reality
The modern financial system is the product of centuries of economic evolution. Banks transformed money from metal coins into accounts, allowing ever larger aggregations of borrowing and lending. From the Renaissance on, government bonds introduced the securitization of streams of interest payments. From the 17th century on, equity in corporations could be bought and sold in public stock markets. From the 18th century on, central banks slowly learned how to moderate or exacerbate the business cycle. From the 19th century on, insurance was supplemented by futures, the first derivatives. And from the 20th century on, households were encouraged by government to skew their portfolios in favor of real estate.
Read Niall Ferguson’s prescient article on today’s financial woes, Empire Falls (November 2006).
Economies that combined all these institutional innovations performed better over the long run than those that did not, because financial intermediation generally permits a more efficient allocation of resources than, say, feudalism or central planning. For this reason, it is not wholly surprising that the Western financial model tended to spread around the world, first in the guise of imperialism, then in the guise of globalization.
Yet money’s ascent has not been, and can never be, a smooth one. On the contrary, financial history is a roller-coaster ride of ups and downs, bubbles and busts, manias and panics, shocks and crashes. The excesses of the Age of Leverage—the deluge of paper money, the asset-price inflation, the explosion of consumer and bank debt, and the hypertrophic growth of derivatives—were bound sooner or later to produce a really big crisis.
It remains unclear whether this crisis will have economic and social effects as disastrous as those of the Great Depression, or whether the monetary and fiscal authorities will succeed in achieving a Great Repression, averting a 1930s-style “great contraction” of credit and output by transferring the as yet unquantifiable losses from banks to taxpayers.
Either way, Planet Finance has now returned to Planet Earth with a bang. The key figures of the Age of Leverage—the lax central bankers, the reckless investment bankers, the hubristic quants—are now feeling the full force of this planet’s gravity.
But what about the rest of us, the rank-and-file members of the deluded crowd? Well, we shall now have to question some of our most deeply rooted assumptions—not only about the benefits of paper money but also about the rationale of the property-owning democracy itself.
On Planet Finance it may have made sense to borrow billions of dollars to finance a massive speculation on the future prices of American houses, and then to erect on the back of this trade a vast inverted pyramid of incomprehensible securities and derivatives.
But back here on Planet Earth it suddenly seems like an extraordinary popular delusion.
Niall Ferguson is Laurence A. Tisch Professor of History at Harvard University and a Senior Fellow of the Hoover Institution at Stanford, and the author of The War of the World: Twentieth-Century Conflict and the Descent of the West.
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