Obama's green shoots all too frail


By Hossein Askari and Noureddine Krichene
Asia Times
Dec 24, 2009


United States President Barack Obama's administration has publicized and recycled every shred of good news, otherwise known as green shoots, about the US economy that it can muster. It claims credit for avoiding a depression, ending the recession, stabilizing financial markets and achieving a decline in the number of job losses. It points to a low inflationary environment, it has received repayment of some bank bailouts, and is cautiously optimistic about the future of the economy.

Yet all of this, even if multiplied by a factor of two, affords little comfort to realists looking through a crystal ball.

The story of how we got here has become a standard one and pretty much universally accepted, with differences only of emphasis. Wholesale deregulation and blind faith in financial markets under the Bill Clinton administration was followed by the US Federal Reserve's loose monetary policy from 2001.

The low interest-rate environment and cheap credit fueled speculation (more profitable), including propriety trading (on their own account) by large banks, pushing loans to subprime markets, leveraging, and Ponzi finance. This was accompanied, in a deregulated environment with blind faith in the market, by a massive expansion in derivative trading, especially in the expansion of (underpriced) credit default swaps (CDS) - giving banks (speculators) comfort against default and further fueling speculation.

Large banks and investment banks were further emboldened by their belief in the federal guarantee, although unspoken, of "too big to fail". Speculation, in turn, led to a rapid run-up in asset prices, including commodity prices, such as oil, gold, metals, food, and to volatility in exchange rates. All the while, it seemed that regulators and supervisors were asleep to the signs of asset bubbles, erosion of bank capital, and the developing risk of a pending financial collapse that were developing around them.

The US-manufactured crisis was spread to the rest of the world through a number of channels. The US economic expansion was accompanied by large and growing current account deficits; that is, the high level of private sector consumption (or low level of private sector savings) and large government fiscal deficits had their counterpart in current account deficits, matched by heavy external financing (especially from China, Europe and surplus-strong and oil-rich members of the Organization of Petroleum Exporting Countries).

The financing of the US current-account deficit led to foreigners acquiring a growing position in US equity and, especially, in debt-market instruments. Given low US interest rates and returns, foreigners turned to higher-yielding mortgage-backed securities and other toxic debt-based instruments packaged in the US.

Like their American counterparts, foreigners (especially foreign banks) in many instances simultaneously bought credit-default swaps from US institutions, such as the American Insurance Group (AIG), that were, in retrospect, grossly under-priced to cover the risk of acquiring high-yielding assets (the return on these assets minus the cost of the CDSs was still higher than comparable "less risky" assets, a clear indication that CDSs were under-priced).

At the same time, hedging and speculation in interest-rate exposure resulted in the same underlying assets being swapped as interest rate and currency swaps numerous times around the world, with the gross value of the swaps being many times their net value, and making default in one market infectious to markets around the world.

What started as an American crisis became global through the cross-border transmission of interest rates, hedging and speculating through interest-rate swaps, capital flows, and acquisition of toxic assets and credit-default swaps. Specifically, the expansionary policies in the reserve-currency country, the US, had led to lower interest rates and foreigners financing the US current-account deficit turned to toxic-debt instruments which gave a higher yield. At the same time, as mentioned earlier, in the footsteps of US expansion and rising prices, arbitrage affected commodity prices everywhere, resulting in a global boom in commodities, most noticeably in oil and food.

The US policy response
In the wake of the financial collapse, highlighted by the demise of Lehman Brothers, the US adopted policies to stabilize financial markets and to revive the economy - specifically emergency bailouts of large financial institutions, commercial banks, investment banks and insurance companies, and a massive stimulus plan to increase economic activity. At the same time, the White House and Congress agreed to look into reforms that would prevent a similar financial catastrophe in the future.

The bailout of financial institutions was implemented on a case-by-case basis, a method that is slow, unfair to the public and does not address the issue of too big to fail. How do we ensure a good deal for the public in negotiated bailouts, especially given the revolving-door culture of Wall Street? Bailouts lead to more bailouts because they give an incentive to bankers to take excessive risks in pursuit of extraordinary rewards in the future. Most importantly, after bailing out the big financial firms, we find ourselves saddled with firms that are still too big to fail and with no easy solution.

In fact, because of the mergers and takeovers that the government supported, our financial institutions are now even bigger than before and with more influence on politicians. We have done very little to avoid a worse catastrophe in the future.

The other way to rescue the financial system would have been to nationalize all threatened institutions that were too big to fail, break them up, so that they are no longer too big to fail, and auction the pieces one by one to get the best price for the public. This would have saved the financial system, restored financial stability in quick order and resolved the problem of "too big to fail" once and for all, as long as we adopt financial regulations to avoid such an eventuality in the future - regulations to keep size in check. We are still burdened with the same problem - "too big to fail" institutions - institutions that have the power, which they use freely, to block meaningful reform.

The second prong of the economic revival plan was a massive stimulus plan. Because of strongly expansionary demand policies under the George W Bush administration, US national savings became very low or even negative. Low savings invalidate a basic assumption for a Keynesian expansionary fiscal policy and make the financing of the deficit from real domestic savings unfeasible.

The only sound financing option would have been foreign financing as in previous fiscal deficits. On the one hand and under this assumption, the US fiscal deficit will have a negligible impact on US real gross domestic product (GDP); it will mainly increase domestic consumption; and as experience in the recent years has shown, it will end up stimulating, through classical multiplier effect, China, Japan, and commodity-producing countries.

In other words, Obama's plan will end up creating most of the 3.5 million jobs outside the US, and far fewer jobs domestically, something that we have witnessed with the unemployment rate rising significantly above anything that the administration had expected. The administration's senior advisors had predicted a maximum unemployment rate of about 8%, while we predicted double-digit unemployment, cresting in the 11-12% range. The unemployment rate has already hit 10.2%, falling back to 10%, and most economists predict that it will go up again.

On the other hand, if foreign financing were discouraged by ridiculously low interest rates and fears of an expected further depreciation of the US dollar, the fiscal deficit would have to be financed through monetization. This scenario is the most likely and the most detrimental. If it materializes, it will trigger inflationary dynamics that will be difficult to control, with a depreciating US dollar and a rapidly falling real economy.

The third policy to tackle the economic crisis was financial reform. The White House adopted a limited range of reforms, including a new agency to protect borrowers from abuse by lenders, granting the Fed extensive new powers to monitor the financial sector, enabling the Federal Deposit Insurance Corporation to deal with non-bank as well as bank financial failures, requiring financial brokers to act in the interest of their clients, and new reporting requirements for derivative trading.

On December 11, the US House of Representatives by a narrow margin adopted most of these proposals on a watered-down basis. It is unlikely that the Senate will go even this far. Moreover, it should be noted that little has been done to break up the firms that are too big to fail, to revamp the board of directors of financial institutions to eliminate conflicts of interest, to separate the position of chairman and CEO, to afford stockholders a vote on executive pay, and most importantly to close the revolving door between Wall Street and the government.

As long as Wall Street executives dominate the federal financial decision-making process and contribute vast sums to election campaigns, the needed reforms will not be adopted. The large firms were rescued. They were not penalized. They have amassed fortunes - just look at what has happened to the equity of the partners in Goldman Sachs since the firm went public. They will just keep repeating their risk taking activities at our expense.

G-20 and IMF policies
While the US has travelled the path outlined above, others have adopted some of the same policies as indicated by the stand of the Group of 20 (G-20) countries. Most strikingly, with a view to inflating their way out of debt and precluding price deflation, money creation has been proceeding at unprecedented rates in the major countries: 18% in the US, 14% in the euro zone, 14% in the UK, and 29% in China. Only Japan has been cautious, at less than 1%.

Between the April and September G-20 2009 summits, oil prices rose by 53%, natural gas prices by 60%, gold price crossed the US$1,000 mark, rising by 18%, and food prices rose by 23%, with sugar rising by 58%. Exchange rate instability continues at a high level. The dollar depreciated by 16% against the euro and 12% against the yen. Yet, such an environment was deemed by the G-20 leaders as an environment of price stability.

What the rise in key commodity prices and currency fluctuations will be before the next G-20 summit in Canada in June 2010 should be a matter of concern. An extrapolation of trends between April and September 2009 could only usher more disruption for economic growth and employment.

The G-20 has not put in place policies conducive to growth and stability. Instead it has put in place policies that are escalating fiscal and monetary expansion in many countries and encouraging poor countries to follow unsustainable financial policies. These policies have been tested in the past and they led to stagflation during the 1970s. Friedrich von Hayek argued that similar policies aggravated the Great Depression and prevented the price adjustments that could have corrected the over-inflated prices that emerged in the bubbles that led to the crisis. By pledging to "sustain our strong policy response until a durable recovery is secured, we will avoid any premature withdrawal of stimulus". The G-20 could push the world economy into a long period of stagflation.

The other party with a role for financial reforms and supporting economic recovery has been the International Monetary Fund (IMF). The IMF has endorsed the expansionary policies put in place by leading industrial countries in Istanbul earlier this year, as reflected in its communique of October 4, 2009: "We commit to maintaining supportive fiscal, monetary, and financial sector policies until a durable recovery is secured, and stand ready to act further as needed to revive credit, recover lost jobs, and reverse setbacks in poverty reduction. We welcome the outcomes of the G-20 Summit in Pittsburgh and support its commitment to articulating policies for strong, sustained, and balanced growth in the global economy."

The IMF endorsement of policies that have resulted in financial uncertainties and violent exchange-rate instabilities, and afforded no comprehensive approach for international monetary reform can only pave the way for another financial calamity.

The G-20 has used the IMF as a vehicle for instantaneous and unconditional loans to developing countries. Accordingly, the G-20 pushed IMF lending power to over $1 trillion. Such gigantic lending was never contemplated before. Excessive lending to developing countries would end up, as in the past, with another debt crisis similar to the generalized debt crisis of the 1980s. Many developing countries are importers of industrial products and exporters of primary products; they have limited export revenues for repaying fast-expanding debt. It would appear that the IMF has been used by the powerful in the G-20 to create markets for their exports in developing countries as they load them up with burdensome debt.

The IMF's Istanbul communique praised the G-20 for its loose fiscal and monetary policies as conducive to strong, sustained, and balanced growth in world economy. The communique acknowledged setbacks in poverty reduction. These setbacks could be further aggravated with rapidly rising unemployment in industrial countries and rapidly declining real incomes of workers. The communique ignored heightened uncertainties that were plaguing the world economy. Gold prices are setting new records above the $1,000 mark. What will be the price of gold six month from now? Although oil has climbed above $75/barrel mark, will it revisit its July 2008 highs? Or what will be the dollar-euro exchange rate? How much is the rest of the world willing to finance record US fiscal deficits at 13% of GDP while acquiring more and more depreciating dollars?

Central bankers are even under increasing pressure to hedge their foreign reserves by buying more gold. Investors could shun dollar assets. A run on the US dollar would create unimaginable exchange rate instabilities. Achieving strong and sustained economic growth with such instabilities would indeed be miraculous.

Here we are, in a place that can hardly be characterized as economic normalcy and yet the Obama administration touts that success has been achieved on all fronts except on the job front and the slow speed of the ongoing economic recovery. We are nowhere near as optimistic. We see many dark clouds. Although the world has so far avoided a global financial collapse and an economic depression, the future can be hardly coined as bright. By avoiding the abyss, governments have relaxed and are no longer addressing critical economic and financial policies and reforms that are desperately needed.

Our concerns
First, the US current account was roughly in balance in 1991. But by 2006, the deficit was about 6.5% of GDP. The American consumer and the government went on a consumption binge. They borrowed and borrowed from foreigners to finance these expenditures.

This level of deficit is unsustainable for the average country - but the United States is no ordinary country. It is different as the dollar is used as a reserve currency, so the US prints more dollars. But there is a limit to this printing of dollars, as foreigners may no longer accept dollars.

The economic downturn has reduced the US current account deficit but as soon as the US economy recovers, the US external deficit could return with a vengeance to the 4-6% range. If the US fiscal deficit explodes (see below), as some expect, the current account deficit and foreign debt could expand to levels never seen before, as the counterpart of the public deficit and private non-saving shows up in a current account deficit. The Peterson Institute states:
By 2030 the current account deficit would soar to more than $5 trillion annually, or more than 15% of US GDP, if policymakers fail to take decisive action to reduce the size of future budget deficits once the economy improves enough to do so. As a result, the net foreign debt of the United States would rise to $50 trillion, or more than 140% of GDP - far above any conceivably sustainable position.
Second, the massive federal bailouts have in our mind replaced private debt with public debt. The outlook for the government budget deficit (with implications for the current account) and national debt does not look bright. In 2008 the deficit as a percentage of GDP stood at 3.2%, in 2009 it was 11.2% and was projected at 9.0% for 2010 by the Congressional Budget Office (CBO). But the CBO goes on to add: " ... as the economy recovers, if current laws and policies remained in place, the deficit would shrink but remain above $500 billion per year, or more than 3% of GDP, throughout the 2010-2019 period. As a result, debt held by the public would continue to grow as a percentage of GDP during that time. That debt, which was as low as 33% of GDP in 2001, would reach an estimated 54% of GDP this year and grow to 68% of GDP by 2019. Those baseline projections ... reflect spending and revenue assumptions that may underestimate potential deficits.

"Because they presume no changes in current tax laws, the projections assume the expiration of tax reductions enacted earlier in this decade and provisions that have kept the alternative minimum tax (AMT) from affecting many more taxpayers. Consequently, those assumptions result in projected revenues that, as a percentage of GDP, would be high by historical standards. They also assume that future annual appropriations are held constant in real (inflation-adjusted) terms, resulting in projections of discretionary spending that would be low, relative to GDP, by historical standards.

"Many other policy outcomes are possible, however. If, for example, those tax reductions were assumed to continue (along with the indexing of the AMT for inflation) and future annual appropriations were assumed to remain at their 2009 share of GDP, the deficit in 2019 would equal 8.5% of GDP.

"Beyond the 10-year budget window, the nation will face further significant fiscal challenges posed by rising health care costs and the aging of the population. Continued large deficits and the resulting increases in federal debt would, over time, reduce economic growth. Putting the nation on a sustainable fiscal course will require some combination of lower spending and higher revenues than the amounts now projected."

It is difficult to see how the US can reduce its budget deficit from the above projections, which though dismal are in our view still based on optimistic assumptions. The only way to turn things around is to achieve higher growth (requiring higher productivity and investment), cut expenditures (while fighting two wars and with massive social pressures including the provision of healthcare), and/or increase taxes significantly (reducing private consumption). While all of these would be possible in theory, they are almost impossible in Washington, a town paralyzed by partisan politics and susceptible to pressure from lobbyists. If the deficit cannot be reduced, then the current account is likely to remain at a significant level, requiring foreign borrowing.

Significant US foreign borrowing into the future raises questions of its own. Will the Chinese, other surplus Asian countries, and OPEC countries continue to acquire dollars? Will exchange rates stay volatile? Could there be a collapse of the dollar? Isn't it time to embrace international monetary reform while we have room for maneuver? See point five below.

Third, the United States is not the only industrialized country with large budget deficits and massive government debt. Greece, Spain and Ireland, in the European Union, and others outside Europe, are arguably in weaker fiscal position than the United States. Reduced tax collection and massive bailouts have taken a heavy toll. Can these countries borrow or will they have to retrench significantly and negatively impacting the global economic recovery? We worry that the EU may not be in a position to support these countries as they struggle to re-establish fiscal credibility.

Fourth, US banks are flush with cash. In August 2008, they held less than $10 billion in excess reserves. By November 2009, they held about $1.6 trillion. The Fed has pushed this cash out to keep interest rates low and to encourage banks to lend to business to revive the economy and increase employment. Yet the banks are not lending. Moreover, the Fed's deliberate policy to re-inflate housing prices and the price level would be conflicting with growth and employment.

The massive reserve holding of US banks is a clear indication that the prime market has little room to absorb unlimited credit and the only outlet is the sub-prime market. Banks have learned the hard lesson and can no longer extend subprime loans that would lead to losses. The Fed has decided to circumvent banks (who won't extend credit as before to the subprime market), inject $1 trillion in consumer loans in the subprime market, and bears potential losses from these loans. The deterioration in the Fed's balance sheet is worrisome.

What would happen to inflation if banks decided all of a sudden to lend this money out? The Fed's response has been that it will persuade banks by offering them a higher interest rate to keep their excess reserves with the Fed (yet again rewarding bankers). This is hardly comforting for holders of US debt. In particular, foreign holders of US debt have become increasingly concerned with the potential of a collapse in the dollar as a result of the Fed's inflation-debt trap.

Fifth, in part because of what we have said above, a reform of the international payments system is becoming increasingly more urgent. The gold standard worked smoothly until about 1908 or so. The Bretton Woods gold exchange standard had at least worked well during 1945-1965. These systems were fixed exchange-rate systems. The main requirement for stability under a fixed exchange rate system is the need to coordinate policies. Namely if macroeconomic policies diverge, then there is a need to adjust exchange rates.

The two main causes of divergence have been: excessive fiscal deficits financed with printing money and unchecked credit expansion in reserve currency centers (in the earlier period Britain and in the latter period the United States). These two causes have faulted previous payments systems. Any reform of the international reserve system should aim therefore at eliminating these two causes of instability.

Here is where a new reserve currency comes in. More specifically, a world currency would neither finance fiscal deficits nor become a countercyclical source of money for inducing economic booms and preventing the working of price mechanisms. While under a floating system, the need for policy coordination is theoretically not needed; in practice, reserve currency centers have neglected the international role of their currencies and have caused disruptive expansionary and contractionary cycles, affecting exchange rates, trade and external balances.

A reform of the world currency reserve system does not aim at diminishing the role of other currencies such the US dollar, the Japanese yen, the euro, the British pound, or the Swiss franc as reserve currencies and medium of international payments. It aims mainly at establishing a world central bank and a reserve currency that belong to no government and would never be called to finance fiscal deficits or engage into countercyclical policies.

Such a proposal would be closely in line with John Maynard Keynes' 1943 plan that called for a world emitting entity and a reserve currency, which he named "bancor". A new world currency would operate alongside all other currencies; however, it would obey strictly different rules and would enjoy considerable stability in terms of its purchasing power value.

The proposed world central bank would not engage in lending operations or in setting interest rates. It would operate as a 100% reserve bank, providing a reserve asset and settling payment operations. Its initial capital could be subscribed in gold. Countries could acquire the reserve currency through export and other credit operations and use it for imports and debit operations.
The value of a world currency would be defined in relation to a standard, such as a commodity basket as in Keynes' original plan or as suggested by others; thus the reserve currency would have constant purchasing power in terms of internationally trade commodities. Unlike the IMF's Special Drawing Rights (SDR), which is a purely credit money with limited usage among designated users (member countries) and necessitating interest payments by users, a world currency would be a full-fledged currency, materialized by a bank note, and could be used unrestrictedly as any medium of exchange.

The world is yearning for financial stability. A world reserve currency may even turn out to be more beneficial for countries that today jealously guard their reserve currency status. The presence of a world currency would enable reserve centers to tackle their domestic priorities without necessarily causing instability in the rest of the world. Speculation would be reduced, commodity prices would be stabilized, and trade could grow without going through major cycles. Sadly, policymaking is always reactionary - the global financial system must be at the abyss before obvious reforms are adopted.

Sixth, the task of US policymakers to reduce expenditures and increase taxes is made all the more difficult because of stagnant or declining real incomes for the majority of Americans over the last 30 years. The income and wealth distribution in the US is today the most uneven it has been since data have been complied.

In 2007, the top 3.6%, with incomes over $200,000, earned 17.5% of the national income; the real incomes of the bottom 80% of Americans has either declined or stayed constant in comparison to 1977; only the real incomes of the top 20% have increased over the last 30 or so years, with the share of income going to the top 1% of families doubling from 8% in 1980 to 16% in 2004. These gains are particularly noticeable for the top 0.1%.

With such a disparity, the picture is even more disturbing when we look at wealth distribution in the United States; the richest 1% of families own about 40% of the nation's net worth, the top 10% of families own over 70%, and the bottom 40% of the population own less than 1%, according to the Survey of Consumer Finances, the Federal Reserve. The rich resist a significant shift in the tax burden and the less fortunate cannot tolerate a significant tax increase. The government has little room for maneuver. It's time for the rich to be more patriotic and show solidarity with the their fellow Americans.

Seventh, as nations continue to face high levels of unemployment and stagnant incomes, there is a temptation to resort to protectionism, something that would only exacerbate the global economic recovery and economic stagnation.

Eighth, the financial crisis was in large part a result of excessive debt and leveraging. Is this not something that will keep repeating itself? Do we need a basic overhaul of the financial system to rely more on equity-based financing and risk sharing?

Ninth, the United States, and indeed other countries, have not adopted the needed financial reforms to address the problems of too-big-to-fail, re-regulation to eliminate excessive risk-taking, and ultimately the role of the financial sector in the economy. Should the role of the financial sector be limited as an intermediary between savers and investors as it does little else that is productive? Is there not a need to look into why the financial sector's share of profits in the US economy has increased so dramatically from 17% in the 1970s to 41% in this decade?

Tenth, given this global picture, can we expect business executives to be sufficiently optimistic to increase investment and employment? The private sector will expand cautiously at best, keeping excess cash handy just in case. At best, global economic recovery will be slow and painful, with the poorest nations, as usual, suffering the most.

In conclusion, while we can agree with President Obama's economic advisors that the world has avoided a total financial meltdown, in our view it has not addressed the looming economic, financial and social problems that we see as fixtures on the horizon.

Hossein Askari is professor of international business and international affairs at George Washington University. Noureddine Krichene is an economist with a PhD from UCLA.

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