Thread: The crisis of wealth destruction

GLOBAL POST-CRISIS ECONOMIC OUTLOOK - Part 1
The crisis of wealth destruction


By Henry CK Liu
Asia Times
May 13, 2010


This is the first article in a series.

Part 1: The crisis of wealth destruction
Part 2: Banks in crisis: 1929 and 2007
Part 3: The Fed's no-exit strategy
Part 4: Fed's double-edged rescue
Part 5: Too big to save
Part 6: Public debt - prudence and folly
Part 7: Global sovereign debt crisis


The financial crisis that broke out in the United States around the summer of 2007 and crested around the autumn of 2008 had destroyed US$34.4 trillion of wealth globally by March 2009, when the equity markets hit their lowest points.

On October 31, 2007, the total market value of publicly traded companies around the world reached a high of $63 trillion. A year and four months later, by early March 2009, the value had dropped more than half to $28.6 trillion. The lost $34.4 trillion in wealth is more than the 2008 annual gross domestic product (GDP) of the US, the European Union and Japan combined. This
wealth deficit effect would take at least a decade to replenish even if these advanced economies were to grow at mid-single digit rate after inflation and only if no double-dip materialized in the markets. At an optimistic compounded annual growth rate of 5%, it would take more than 10 years to replenish the lost wealth in the US economy.

In the US, where the crisis originated after two decades of monetary excess that encouraged serial debt bubbles, the NYSE Euronext (US) market capitalization was $16.6 trillion in June 2007, more than concurrent US GDP of $13.8 trillion. The market capitalization fell by almost half to $7.9 trillion by March 2009. US households lost almost $8 trillion of wealth in the stock market on top of the $6 trillion loss in the market value of their homes. The total wealth loss of $14 trillion by US households in 2009 was equal to the entire 2008 US GDP.

As the financial crisis broke out first in the US in July 2007, world market capitalization took some time to feel the full impact of contagion radiating from New York, which did not register fully globally until after October 2007. In 2008 alone, market capitalization in EAME (Europe, Africa, Middle East) economies lost $10 trillion and Asian shares lost around $9.6 trillion.

Bailouts, stimulus packages and jobless recovery

As a result of over $20 trillion of government bailout/stimulus commitments/spending worldwide that began in 2008, the critically impaired global equity markets began to show tenuous signs of stabilization only two years later, by the end of 2009. Yet total world market capitalization was still only $46.6 trillion by the end of January 2010, $16.4 trillion below its peak in October 2007.

The amount of wealth lost worldwide in 2009 still exceeded 2009 US GDP of $14.2 trillion by $2.2 trillion. The NYSE Euronext (US) market capitalization was $12.2 trillion in January 2010, recovering from its low at $7.9 trillion in March 2009, but still $4.4 trillion below its peak at $16.6 trillion in June 2007.

US GDP in first quarter 2009 fell 6.3% annualized rate while surging 5.7% in the fourth quarter, mostly as a result of public sector spending equaling over 60% of annual GDP. The US government bailout and stimulus package to respond to the financial crisis added up to $9.7 trillion, enough to pay off more than 90% of the nation’s home mortgages, calculated at $10.5 trillion by the Federal Reserve. Yet home foreclosure rate continued to climb because only distressed financial institutions were bailed out, not distressed homeowners. Take away public sector spending, US GDP would fall by over 50%. This is the reason why no exit strategy can be expected to be implemented soon.

It took $20 trillion of public funds over a period of two-and-a-half years to lift the total world market capitalization of listed companies by $16.4 trillion. This means some $3.6 trillion, or 17.5%, had been burned up by transmission friction. Government intervention failed to produce a dollar-for-dollar break-even impact on battered markets, let alone generate any multiplier effect, which in normal times could be expected to be between nine and 11 times. In the meantime, with the exception of China’s, the real global economy continues to slide downward, with rising unemployment and underemployment.

The massive government injection of new money managed to stabilize world equity markets by January 2010, but only at 73.5% of its peak value in October 2007. It still left the credit markets around the world dangerously anemic and the real economy operating on intensive care and life support measures from government. This is because the bailout and stimulus money failed to land on the demand side of the economy, which has been plagued by overcapacity fueled by inadequate workers' income, masked by excessive debt, and by a drastic reversal of the wealth effect on consumer demand from the bursting of the debt bubble. The bursting of the debt bubble destroyed the wealth it buoyed, but it left the debt that fueled the bubble standing as liability in the economy.

Much of the new government money came from adding to the national debt, which taxpayers will have to pay back in future years. This money went to bail out distressed banks and financial institutions, which used it to profit from global "carry trade" speculation, as hot money that exploited interest rate arbitrage trades between economies. The toxic debts have remained in the global economy at face value, having only been transformed from private debts to public debts to prevent total collapse of the private sector. The debt bubble has been turned into a dense debt black hole of intense financial gravity the traps all light from appearing at the end of the recovery tunnel.

Much criticism by mainstream economists in the US has been focused on the controversial bailout of "too-big-to-fail" financial institutions that have continued to effectively resist critically needed regulatory reform by holding the seriously impaired economy hostage. Some critics have complained that government stimulus packages are too small for the task at hand. Only a few lonely voices have focused on public spending being directed at wrong targets. Yet such massive public spending has left many economies around the world with looming sovereign debt crises.

The critical issue of jobs

The US Labor Department reported that the economy gained 162,000 jobs in March 2010, compared with a revised reading of a 14,000 job loss in February. That makes March only the third month of gains since the recession began. A gain of 184,000 jobs had been forecast for March. But despite missing forecasts, the March numbers were generally not viewed as disappointing by economists, because revisions in January and February readings added a combined 62,000 additional jobs. This is viewed as good news overall for an economy that has suffered a net loss of 8.2 million jobs since the start of 2008, a month after the official start of the "Great Recession". This sentiment shows how weak expectation is among most forecasters. The unemployment rate remains stubbornly high, holding steady at 9.7%, matching mainstream economist expectations.

President Barack Obama immediately trumpeted the jobs report on April 2, asserting that the employment figures are signs that the government stimulus package implemented a year ago has reversed the loss of about 700,000 jobs a month that was taking place at that time. Ironically, this political spin underscores that even the mild improvement in jobs creation may be reversed as soon as the government's stimulus program runs out, or when the central bank exits from its massive intervention in the market.

The president made his claim at a specially selected company in Charlotte, North Carolina, that makes membranes for lithium batteries, symbolizing the dependence on new green technology for economic recovery. The company received a $50 million matching grant from the $787 billion stimulus program in 2009 to expand one facility and to open another elsewhere in the state.

Still, the president had to admit that "government can't reverse the toll of this recession overnight, and government on its own can't replace the 8 million jobs that have been lost. The true engine of job growth in this country has always been the private sector. What government can do is create the conditions ... for companies to hire again."

Obama said many Americans are still suffering from the job losses of the last two years. But he said despite the damage done to the labor market during the recession, the economy is poised to start adding the jobs people need. "What we can see here, at this plant, is that the worst of the storm is over; that brighter days are still ahead," the president said.

In response, Republican National Committee chairman Michael Steele issued a statement saying the jobs gain in March reported by the Labor Department is not a sign of economic health. "No matter what spin the White House puts on these job numbers, it is unacceptable for President Obama to declare economic success when unemployment remains at 9.7% and a large portion of the job growth came from temporary boost in government employment," he said.

The president appeared to be putting the cart before the horse on the issue of environmentalism and economic growth. In reality, the full implantation of a green economy will likely increase unemployment from job losses in the old energy-intensive economy. Environmentalism, like universal healthcare, is an expensive movement, and can be introduced economically only with a strong economy. It is foolhardy to expect environmentalism to revive a seriously impaired economy.

The jobs report contained sobering readings for the depth of labor market distress that has built up over the last two years. There are 15 million workers counted as unemployed in March 2010, down 607,000 since the record high of October 2009, but still the fifth-highest total on record. The average period of unemployment now stands at eight months, a record duration that has put many working families under severe hardship.

Almost one million more workers have become too discouraged to continue looking for work and are no longer counted in the unemployment rate, even as the number of discouraged job seekers fell by 200,000 since February 2010.

The discouraging news is job contractions, which have largely been confined to the private sector, despite strained and shrinking government budgets. Many local governments are beginning to be forced to face employment cuts to deal with developing budget shortfalls.

While private-sector employment fell sharply in the past two years, the public-sector, civilian workforce continued growing until mid-2008, after which it remained essentially flat. As a result, while private-employment rolls are nearly 7% smaller than they were three years ago, public employment has grown by nearly 2%.

The boost in public-sector employment helped cushion the shock of recession. Average wages of public employees are relatively unaffected by economic conditions compared with more-elastic wages in the depressed private sector. Federal workers earned an average salary of $67,691 in 2008 for comparable occupations in both local governments and the private sector, according to Bureau of Labor Statistics data. The average pay for the same mix of jobs in the private sector was $60,046 in 2008, the most recent data available. For private-sector workers above the average range but making below $200,000, the decline in wages is much greater and unemployment rates much higher.

Federal health, pension and other benefits are worth four times what private workers on average enjoy. Even relatively lower-paid state and local government workers have higher total compensation than private workers in comparable jobs when the value of benefits is included.

In hailing the latest jobs news, President Obama warned that "it will take time to achieve the strong and sustained growth that we need."

Larry Summers, director of the Obama White House's National Economic Council, told the Financial Times in a April 2 interview that "post-bubble de-leveraging crises of the kind that the president inherited are a serious economic affliction that doesn't get cured overnight ... and there is still an enormous challenge around job creation."

Market and democratic fundamentalism

Market fundamentalism places unwarranted faith in the mythical self-correcting power of unregulated markets driven solely by the no-holds-barred, winner-takes-all self-interest of unruly market participants risking other people's money for private profit. It has also given birth to democratic fundamentalism, its political twin in capitalistic democracies.

This democratic fundamentalism, which places unwarranted faith in the wisdom of the majority popular vote on complex technical problems that most voters do not fully understand, has put an impossible demand on government to reduce the fiscal deficit while at the same time reducing taxes and increasing popular entitlement and defense expenditures. Democratic fundamentalism has rendered government in capitalistic democracies impotent in solving the fiscal crisis created by market fundamentalism.

Political campaigns in capitalistic democracies has mutated into a tactical propaganda war in which special interest groups with the most money to finance the manipulation of public opinion can exert the strongest influence on policy formulation, often at the expense of the common good and the national interest. The financial sector's effective resistance to critically needed regulatory reform by the US Congress is the latest example. The recent decision by the US Supreme Court on constitutional protection for corporations to freely spend on political campaigns is another example of democratic fundamentalism.

Supreme Court confuses money with speech

Overruling two important precedents about the First Amendment free-speech rights of corporations, a bitterly divided court in a recent five-to-four decision validated the First Amendment's most basic free speech principle - that the government has no business regulating political speech. The dissenters said that allowing corporate money to flood the political marketplace would corrupt democracy.

The ruling, Citizens United v Federal Election Commission, No 08-205, overruled two precedents: Austin v Michigan Chamber of Commerce, a 1990 decision that upheld restrictions on corporate spending to support or oppose political candidates, and McConnell v Federal Election Commission, a 2003 decision that upheld the part of the Bipartisan Campaign Reform Act of 2002 that restricted campaign spending by corporations and unions.

The 2002 law, usually called McCain-Feingold, banned the broadcast, cable or satellite transmission of "electioneering communications" paid for by corporations or labor unions from their general funds in the 30 days before a presidential primary and in the 60 days before the general elections.

McCain-Feingold, as narrowed by a 2007 Supreme Court decision, applied to communications "susceptible to no reasonable interpretation other than as an appeal to vote for or against a specific candidate".

The ruling represented a sharp doctrinal shift, and it will have major political and practical consequences. Specialists in campaign finance law said they expected the decision to reshape the way elections were conducted. The decision will be felt most immediately in the coming midterm elections, given that it comes just two days after Democrats lost a filibuster-proof majority in the senate and as popular discontent over government bailouts and corporate bonuses continues unabated.

President Obama called the decision "a major victory for big oil, Wall Street banks, health insurance companies and the other powerful interests that marshal their power every day in Washington to drown out the voices of everyday Americans."

Freedom in society has a social dimension. A person's freedom cannot be practiced by limiting the freedom of others. The concept of freedom of political speech has long incorporated the concept of equal time. One person's right to verbally attack another person exists only if the right of the attacked person to response is guaranteed. The concept of equal time is well established in the media during political campaigns. In that sense, the Supreme Court decision appeared to be as logical as the sound of one hand clapping. Corporations have every right to spend their money to promote their special political views, but it should be required also to pay for the equal time of the opposition's right of free speech so that the lack of money will not be the cause of lost of freedom of speech.

A technical rally is not a sign of recovery

In the US, a technical trading rally in the equity markets in spring 2010, rising some 60% from their lows in February of 2009, is interpreted by wishful bulls as a promising sign of a recovery of the financial markets. The bulls ignore the obvious fact that the rally has been brought on by massive government bailouts and stimulus packages. The technical rally still leaves asset prices at some 25% below their pre-crisis peak in June, 2007. While bull-market cheerleaders tout this fact as a continuing buying opportunity, objectively it is still difficult to spot any credible signs of fundamental recovery.

Yet there is a price to be paid for the technical rally. Government balance sheets worldwide are now burdened with huge amounts of toxic debt, many in amounts larger than their annual GDP figures. This toxic debt, now shifted from the private sector to the public sector, cannot be made good without new serial bubbles. This technical trading rally in the US equity markets is clearly and fundamentally unsustainable and will peter out as soon as a promised exit strategy from government intervention is implemented by the Treasury to preserve and restore the private sector.

Since most corporate profits in recent years have come from operational cost savings in the form of stagnant wages, layoffs and artificially low interest rates, a new massive wave of corporate failure will hit the anemic economy when government stimulus spending slows or when interest rates are raised by the Fed to deal with pending inflation of its own making. The resultant tidal wave of corporate bankruptcies can only be avoided with more government bailouts to restructure dysfunctional business models.

Fiscal deficits, tax cuts, National Debt, and interest rates Calls for raising interest rates to dampen debt-pushed inflation are heard from nonpartisan sources. The Congressional Budget Office (CBO) estimated that President Obama's proposed budget would add more than $9.7 trillion to the national debt over the next decade, with proposed tax cut accounting for nearly a third of that shortfall.

The Obama fiscal deficit is expected to be $1.5 trillion in 2010, at 10.3% of GDP and a post-World War II record. It is expected to be $1.3 trillion in 2011. But the CBO is considerably less sanguine about future years, predicting that deficits would never fall below 4% of GDP under Obama's current and expected fiscal policies and would begin to grow rapidly after 2015. Deficits of that magnitude would force the Treasury to continue borrowing at prodigious rates, sending the national debt soaring to 90% of GDP by 2020. Interest payments on the debt would also skyrocket by $800 billion annually over the same period.

The CBO report identifies Obama's tax-cut agenda as by far the biggest contributor to the projected budget gaps. As part of his campaign pledge to protect families making less than $250,000 a year from new taxes, the president is proposing to prevent the alternative minimum tax from expanding to ensnare millions of additional taxpayers through inflation induced bracket creep. Obama also wants to make permanent a series of temporary tax cuts enacted during the Bush presidency, which are scheduled to expire at the end of 2010. Over the next 10 years, Obama tax policies are projected to reduce revenues and increase outlays for refundable tax credits by a total gap of $3 trillion. Combined with escalating interest payments on large cumulative fiscal deficit, the tax cuts account for the entire increase in deficits that would result from Obama's tax proposals.

Other policy expenditures, such as Obama's health-care reform program and a plan to dramatically expand the federal student loan program, would have significant effects on the budget, but these programs generally would be self-financed and therefore are not expected to drive deficits higher. They would only expand the public sector in the economy, a trend that liberals and progressives think is positive and neo-liberals and conservatives think is negative.

Obama tried to convene a special bipartisan commission to develop measures to bring deficits down to 3% of GDP. The response from Republicans has not been overwhelming as they do not want to share responsibility for Obama's deficit. However, the CBO report shows that Obama could accomplish that goal simply by letting the Bush tax cuts expire at the end of 2010 to pay for revenue losses expected from proposed changes to the alternative minimum tax.

In March 2009, the CBO estimated that US gross debt will rise from 70.2% of GDP in 2008 to 101% in 2012, while the economy is expected to stay in open-ended recession with unacceptably high unemployment at over 10%. The US is now one of the highest debtor nations in the world. The reason the US, unlike other countries, does not face the prospect of default is because of dollar hegemony under which US debts are all denominated in dollars that the US Treasury can print at will. Yet such levels of public debt, if wasted on the supply side to exacerbate supply/demand imbalance, cannot be sustained without economic penalties.

Interest payments on the skyrocketing national debt will be a serious obstacle to reducing the fiscal deficit even if interest rates stay low - an impossible prospect because of the endogenous monetary rule of the effect of rising public debt on inflation, which Milton Friedman define as always and everywhere a monetary phenomenon - i.e. excess supply of money.

The lesson from the Great Depression

The Fed's institutional perspective since the Great Depression have been largely formed by Milton Friedman's counterfactual conclusion that aggressive monetary easing after the 1929 crash could have prevented the Great Depression, though the validity of this conclusion has never been verified by events, nor has its unintended consequences been adequately analyzed.

The caveat in Friedman's monetary cure is that it requires a fiscal surplus, which would be difficult if not impossible to achieve in a depression. Events have shown that the Great Depression was finally ended by war production, not by Fed monetary or fiscal measures during the New Deal era.

Yet while the laws of finance can sometimes be violated with delayed penalty, they cannot be permanently overturned. The fact remains that central banks cannot repeatedly use easy money to fund serial debt bubbles without accumulating fatal consequences.

While undetected debt can be disguised as phantom equity through creative accounting in structured finance, it remains as liabilities in the real world that need to be reckoned with at the end of the day. Risk can be transferred globally system-wide to become less visible, but it cannot be eliminated by simply hiding it. Widely dispersed risk throughout the financial system will lead to an under-pricing of risk to give unsuspecting investors a false sense of security. In fact, thousands of small holes all over the hull will sink a ship faster than one big hole in one compartment that can be effectively sealed off. The result will be a sudden global financial meltdown when the massive Ponzi scheme of magical liquidity released by central banks is finally exposed.

Two phases of the Great Depression

It is useful to remember that there were two phases of the Great Depression. The first phase started with the stock market crash in October 1929 during Hoover's one-term presidency (1929-1933). It lasted 43 months, until five months after Franklin D Roosevelt became president in 1933, with a GDP decline from peak to trough of 36.21%, unemployment reaching an all-time high 25.36% and severe deflation as measured by the Consumer Price Index falling 27.17%.

In this phase of the Great Depression, central bankers learned that deflation was more deadly to the economy than inflation was to the government, a fact incontrovertibly demonstrated by the rise of Fascism in a Germany caught in the quick sand of hyperinflation, and the subsequent recovery of the German economy under the National Socialist full-employment strategy supported by sovereign credit. While the economic decline of first phase of the Great Depression was arrested by New Deal programs, the US economy was far from being on any recovery track by 1937, four years of Roosevelt came into office.

The second phase of the Great Depression began in 1937 during the New Deal era after the Fed doubled bank reserve requirements in 1936 to ward off anticipated inflation. The economic contraction of this phase lasted 13 months, until 1938, with a decline in GDP of 10.04%, unemployment reaching 20% and deflation moderating as measured by the CPI, falling only 2.8%.

Still, price deflation caused by tight monetary policy by Treasury secretary Henry Morgenthau (in office from 1933 to 1945) aborted the New Deal recovery, even under a Keynesian fiscal policy tilt towards deficit financing of demand management. As Roosevelt's Treasury secretary, Morgenthau was instrumental in setting up the Works Progress Administration and the Public Works of Art Project in the 1930s to moderate unemployment. But the economy did not recover until the start of World War II.

Eccles - Keynesian evangelist before Keynes

This second phase of the Great Depression can be blamed on the early policies of the Federal Reserve under Marriner S Eccles ( in office from November 15, 1934 to January 31, 194. Eccles, the president of tiny First National Bank of Ogden, Utah, became nationally famous through his successful effort to save his bank from collapse in the late summer of 1931.

Eccles defused the panic of depositors outside of his bank by announcing that his bank would stay open until all depositors were paid. He also instructed his tellers to count every small bill and check every signature to slow the prospect of his bank running out of cash. A mostly empty armored car carrying all First National's puny reserves from the Federal Reserve Bank in Salt Lake City arrived conspicuously while Eccles announced that there was plenty of money left where it came from, which was true except for the fact that none of it belonged to First National. The crowd's confidence in First National was re-established and Eccles' bank survived on a misleading statement that in a vigorous investigation would have been considered criminally fraudulent.

Eccles was a quintessential frontier entrepreneur of the US West and politically a Western Republican. Beginning with timber and sawmill operations, his family's initial capital came in the form of labor and raw material. He learned from his father, an illiterate who immigrated from Scotland in 1860, that the way to remain free was to avoid becoming indebted to the northeastern banks, which were in turn much indebted to British capital. Among Eccles' assets of railroads, mines, construction companies and farm businesses was a chain of local banks in the West.

Immersed in an atmosphere of US populism that was critical of unregulated capitalism and Northeastern "money trusts", Eccles viewed himself as an ethical capitalist who succeeded through his hard works and wits, free of oppression from big business trusts and government interference.

A Mormon polygamist, the elder Eccles had two wives and 21 children, which provided him with considerable human capital in the labor-short West. The young Eccles, at age 22 and with only a high-school education, had to assume the responsibilities of his father when he died suddenly. The Eccles construction company built the gigantic Boulder Dam, begun in 1931 and completed in 1936, renamed from Hoover Dam in the midst of the Depression and re-renamed Hoover Dam in 1941.

The market collapse of 1929 caught the inner-directed Eccles in a state of bewilderment and despair. Through eclectic reading based on common sense, he came to a startling awareness: that despite his father's conservative Scottish teachings on the importance of saving, individuals and companies and even banks, ever optimistic in their own future, tended to contribute to aggregate supply expansion to end up with overcapacity through excessive savings for investment.

It was obvious to Eccles that the problem of the 1930s was that too much money had been channeled into savings and too little into spending. This new awareness, albeit not early enough to save him from early policy error in the first two years as Fed chairman, like Saint Paul's vision on the way to Damascus, led Eccles to a radical conclusion that contradicted all that his conservative father had taught him.

From direct experience, Eccles realized that bankers like himself, by doing what seemed sound on an individual basis, by calling in loans and refusing new lending in hard times, only contributed to the financial crisis. He saw from direct experience the evidence of market failure. He concluded that to get out of the depression, government intervention - something he had been taught was evil - was necessary to place purchasing power in the hands of the public which, together with the economy and the financial system, was in dire need. In the industrial age, excessively unequal distribution of income and excessive savings for capital investment always leads to the masses exhausting their purchasing power, unable to sustain the benefits of mass production that such savings brought.

Mass consumption is required by mass production. But mass consumption requires a fair distribution of new wealth as it is currently produced (not accumulated wealth) to provide mass purchasing power. By denying the masses necessary purchasing power, capital denies itself the very demand that would justify its investment in new production. Credit can extend purchasing power but only until the credit runs out, which would soon occur without the support of adequate income.

Eccles' epiphany was his realization that Calvinist thrifty individualism does not work in a modern industrial economy. Eccles rejected the view of his fellow bankers that depressions are natural phenomena and that in the long run the destruction they wreak is healthy and government intervention only postpones the needed elimination of the unfit, thereby in the long run weakening the whole system through support for their survival.

Eccles pragmatically saw that money is not neutral, and it has an economic function independent of ownership. Money serves a social purpose if it circulates widely through transactions and investments, and is socially harmful if it is hoarded in idle savings, no matter who owns it. Liquidity is the only measure of the usefulness of money. The penchant for capital preservation on the part of those who have surplus money has a natural tendency to reduce liquidity in times of deflation and economic slowdown.

The solution is to start the money flowing again by directing it not toward those who already have a surplus of it in relation to their consumptive needs, but to those who have not enough. Giving more money to those who already have too much would take more money out of circulation into idle savings and prolong the depression.

The solution is to give money to the most needy, since they will spend it immediately. The only institution that can do this transfer of money for the good of the system is the federal government, which can issue or borrow money backed by the full faith and credit of the nation, and put it in the hands of the masses, who would spend it immediately, thus creating needed demand. Transfer of money through employment is not the same of transfer of wealth. Deficit financing of fiscal expenditure is the only way to inject money and improve liquidity in a stalled economy. Thus Eccles promoted a limited war on poverty and unemployment, not on moral but on utilitarian grounds.

Now, the interesting thing is, Eccles, who never attended university or studied economics formally, articulated his pragmatic conclusions in speeches a good three years before Keynes wrote his epoch-making The General Theory of Employment, Interest, and Money (1936). John Galbraith in his Money: Whence It Came, Where It Went (1975) explained: "The effect of The General Theory was to legitimize ideas that were in circulation." With scientific logic and mathematical precision, Keynes made crackpot ideas like those promoted by Eccles respectable in learned circles, even though Keynes himself was considered a crackpot by New York Fed president Benjamin Strong as late as 1927.

In a single testimony in 1933, Eccles in his salt-of-the-earth manner convinced an eager US Congress of his new economic principle. He outlined a specific agenda for how the federal government could save the economy by spending more money on unemployment relief, public works, agricultural allotment, farm-mortgage refinancing, settlement of foreign war debts, and so forth.

Eccles also proposed structural systemic reform for achieving long-term stability: federal insurance for bank deposits, minimum wage standards, compulsory retirement pension schemes - in fact, the core program that came to be known as the New Deal.

Eccles also helped launched the era of liberal credits, through government guarantee mortgages and interest subsidies, making middle-class and low-income home ownership a reality. It was not a plan to do away with capitalism as much as it was to save capitalism from itself. Eccles' plan was to give the masses high income on which liberal credits could finance a nation of homeowners. It was fundamentally different from the neo-liberal program of depressing worker income through cross-border wage arbitrage while financing home ownership with subprime mortgages.

Eccles also rescued the Federal Reserve System from institutional disgrace. For this, the Fed building in Washington has since been named after him. The evolution of political economy models in the early 1930s, a crucial period of change in the supervision and regulation of the financial sector, can be clearly seen in the opposing policies of the Hoover and Roosevelt administrations. It resulted in a change of focus in the Federal Reserve Board from orthodox sound money initiatives to a heterodox Keynesian outlook, which was reversed by the monetarism of Milton Friedman. Under Eccles, the push toward centralizing the monetary powers of the Federal Reserve System at the Board, away from the regional Federal Reserve Banks, was implemented.

With support from Roosevelt, despite bitter opposition from big money center banks, Eccles personally designed the legislation that reformed the Federal Reserve System, the central bank of the United States founded by Congress in 1913 (by the Glass-Owen Federal Reserve Act), to provide the nation with a safer, more flexible, and more stable monetary and financial/banking system. An important founding objective of the original Federal Reserve System had been to fight inflation by controlling the money supply through setting the short-term interest rate, known as the Fed Funds Rate (FFR), and bank reserve ratios. By 1915, the Fed had regulatory control over half of the nation's banking capital and by 1928 about 80%.

The Banking Act of 1935, designed by Eccles, modified the Federal Reserve Act by stripping the 12 district Federal Reserve Banks of their autonomous privileges and veto powers and concentrated monetary policy power in the seven-member board of governors in Washington. Eccles served as chairman for 14 years while he continued to function as an inner-circle policymaker in the White House. The Fed under Eccles had no pretension of political independence. Galbraith described the Fed under Eccles as "the center of Keynesian evangelism in Washington".

Morgenthau and the Bretton Woods Conference

To finance World War II, Morgenthau initiated an elaborate marketing system for war bonds. He arranged unlimited Federal Reserve support for Treasury borrowing to allow it to stand ready to buy all war bonds not bought by the public at a pre-agreed yield to keep interest rates low. The War Bond program raised $185 billion at below market interest rates to finance the war.

Morgenthau made his most significant contribution as chairman of the Bretton Woods Conference in New Hampshire, in 1944. This conference, the keystone of postwar international finance architecture, established the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (World Bank) and pegged all international currencies to the US dollar at a fixed rate worked out between central banks. The dollar was in turn pegged to gold at $35 per ounce. US citizens were forbidden by law to own gold or to speculate on its monetary value. Morgenthau resigned shortly after the accession of Harry S Truman to the presidency. The Bretton Woods monetary regime collapsed in 1971 when president Richard Nixon suspended the dollar from gold.

The economy finally recovered on heavy war spending in 1941. Yet a short recession took place in 1945 as war production began to wind down for the European theater. It lasted eight months, with GDP declining 14.48%, unemployment reaching 3.4% even before troops were fully discharged, and inflation of 1.69% as war-time wage-price control began to be phased out.

Next: Two different bank crises - 1929 and 2007

Henry C K Liu is chairman of a New York-based private investment group. His website is at http://www.henryckliu.com.

Copyright 2010 Asia Times Online (Holdings) Ltd.

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THE POST-CRISIS OUTLOOK - Part 2
Banks in crisis: 1929 and 2007


By Henry C K Liu
Asia Times
May 14, 2010


This is the second article in a series.

Part 1: The crisis of wealth destruction


The 1929 banking crisis that launched the Great Depression was caused by stressed banks whose highly leveraged retail borrowers were unable to meet margin calls on their stock market losses, resulting in bank runs from panicky depositors unprotected by government insurance.

In the 1920s, there were very few traders other than professional technical types. The average retail investors were in for the long-term, trading infrequently, albeit buying on high margin. They bought mostly to hold, based on expectations that prices would rise endlessly.

By contrast, the 1990s and 2000s were the decades of the day trader and big-time institutions. Powerful traders in major investment banking houses overwhelmed old-fashion investment bankers and gained control with their high profit performance. They turned the financial industry from a funding service to the economy into a frenzied independent trading machine. Many of the investing public aspired to be a Master of the Universe, as caricatured in Tom Wolf’s Bonfire of the Vanities, which was turned into a movie starring Tom Hanks. Derivative trading by hedge funds was routinely financed through broker dealers funded by banks at astronomically high leverage.

Greenspan - the Wizard of Bubble Land

The debt joyride was by no means all smooth sailing in a calm sea. Repeated mini-crises were purposely ignored by regulators who should have known better. Federal Reserve chairman Alan Greenspan, notwithstanding his denial of responsibility in helping throughout the 1990s to unleash serial equity bubbles, had this to say in 2004, three years before the 2007 tsunami of a century, in hindsight after the bubble burst in 2000: "Instead of trying to contain a putative bubble by drastic actions with largely unpredictable consequences, we chose, as we noted in our mid-1999 congressional testimony, to focus on policies to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion." The Greenspan Fed adopted the role of a clean-up crew of otherwise avoidable financial debris rather than that of a preventive guardian of public financial health. Greenspan's one-note monetary melody throughout his 18-year-long tenure as the nation's central banker had been when in doubt, ease.

LTCM - the crisis the Fed papered over

In the 1920s, there were no derivative markets. In the case of Long-Term Capital Management (LTCM), the hedge fund that failed in 1998, the firm had equity of US$4.72 billion and had borrowed more than $124.5 billion to acquire assets of about $129 billion, for a debt-equity ratio of about 25 to 1. Even that was conservative when compared with the 40 to 1 ratio used by investment banks in the decade that followed.

LTCM had off-balance-sheet derivative positions with a notional value of about $1.25 trillion, most of which were in interest rate derivatives such as interest rate swaps, equaling 5% of the entire global market. LTCM also invested in other derivatives such as equity options. LTCM eventually bailed out by its counterparty creditors under the guidance of the New York Fed (see The Folly of Deregulation, Asia Times Online, December 3, 2009.)

The Enron fraud

In the 1920s, there was no structured finance or securitization of debt. The case some 80 years later of Enron, a large brave new energy trader, and its spectacular bankruptcy marked the high watermark of legalized financial fraud. The evidence is undeniable that the Enron scandal exposed critical flaws in the entire financial system and the ineffective policing of US capital markets and corporate governance. In a December 18, 2001, senate commerce Committee hearing on the Enron collapse, Arthur Levitt, former Democratic head of the Securities and Exchange Commission (SEC), characterized corporate financial statements as "a Potemkin village of deceit". Senator Ernest Hollings, a Democrat from South Carolina, characterized Enron chairman Kenneth Lay's political prowess as "cash and carry government". Embarrassingly, the New York Times reported the following day that Hollings had received campaign contributions from Enron and its auditor Arthur Andersen dating from 1989.

Until Enron filed for bankruptcy in 2001, the system's top law firms and accounting firms were providing professional opinion that what went on in Enron was "technically" legal. The international dealings of Enron received unfailing support from the US government. Many of the schemes undertaken by Enron and other companies were devised by investment bankers who collected fat fees advising their clients and who profited handsomely from providing financing for schemes they knew were towers of mirage. It was known in the industry as "finance engineering", and the vehicle was structured finance or derivatives (see Capitalism's bad apples: It's the barrel that's rotten, Asia Times Online, August 1, 2002).

Greenspan - Enron Prize recipient

Alan Greenspan, then chairman of the Federal Reserve since 1988, gave a lecture at Stude Concert Hall sponsored by the James A Baker III Institute for Public Policy on November 13, 2001. Following his lecture, he received the Baker Institute's Enron Prize for Distinguished Public Service. The prize, made possible through a generous and highly appreciated gift from the Enron Corporation, recognizes outstanding individuals for their contributions to public service.

Greenspan's speech to an admiring audience offered an assessment of what lay ahead for the energy industry. In the wake of the September 11 attacks that year and the then weakened state of the economy, Greenspan stressed the need for policies that ensure long-term economic growth. "One of the most important objectives of those policies should be an assured availability of energy," he said.

Greenspan said this imperative has taken on added significance in light of heightened tensions in the Middle East, where two-thirds of the world's proven oil reserves reside. He noted that the Baker Institute was conducting major research on energy supply and security issues.

Looking back at the dominant role played by the US in world oil markets for most of the industry's first century, Greenspan cited John D Rockefeller and Standard Oil as the origin of US pricing power, notwithstanding that the nation saw fit to break up the Rockefeller/Standard Oil trust in 1911. Following the breakup, Greenspan said, this power remained with American oil companies and later with the Texas Railroad Commission. This control ended in 1971 when remaining excess capacity in the US and oil pricing power shifted to the Persian Gulf. Greenspan was saying better Standard Oil than the Organization for Petroleum Exporting Countries (OPEC). He seemed oblivious to the development since the 1973 oil embargo that US oil companies had been working hand in glove with OPEC producers to keep oil prices high.

The power of markets against market power

"The story since 1973 has been more one of the power of markets than one of market power," Greenspan said. He noted that the projection that rationing would be the only solution to the gap between supply and demand in the 1970s did not happen. While government-mandated standards for fuel efficiency eased gasoline demand, he said that observers believed market forces alone would have driven increased fuel efficiency. Greenspan appeared to be the only one who sincerely believed that a free market existed or could exist for the trading of oil. All oil traders know that the price of oil is one of the most manipulated components in world trade.

"It is encouraging that, in market economies, well-publicized forecasts of crises more often than not fail to develop, or at least not with the frequency and intensity proclaimed by headline writers," Greenspan said, crediting free markets with mitigating the oil crisis.

As it turned out, the California energy crisis of rolling blackouts was not caused by Middle East geopolitics. It was the handy work of fraudulent trading strategies.

Greenspan against reform

All though the 1990s and early 2000s, there were much talk of reform that led nowhere near what was actually needed. Less than a decade later, a financial crisis that Greenspan characterized as the market failure of a century imploded with a big bang.

On Greenspan's 18-year watch at the Fed, assets of government-sponsored enterprises (GSE) ballooned 830%, from $346 billion to $2.872 trillion. GSEs, particularly Fannie Mae and Freddie Mac, are financing entities created by the US Congress to fund subsidized loans to certain groups of borrowers such as middle- and low-income homeowners, farmers and students. Agency mortgage-backed securities (MBSs) surged 670% to $3.55 trillion. Outstanding asset-backed securities (ABSs) exploded from $75 billion to more than $2.7 trillion.

Greenspan presided over the greatest expansion of speculative finance in history, including a trillion-dollar hedge-fund industry, bloated Wall Street firm balance sheets approaching $2 trillion, a $3.3 trillion daily repo (repurchase agreement) market, and a global derivatives market with notional values surpassing an unfathomable $220 trillion.

Granted, notional values are not true risk exposures. But a swing of 1% in interest rate on a notional value of $220 trillion is $2.2 trillion, approximately 20% of US gross domestic product (GDP). Much of the derivative trade were hedged, meaning the risks were mutually canceling. But the hedges only would hold without counterparty default. All that was needed to unleash a systemic failure was for the weakest link to fail. Greenspan created a situation that permitted the market to speculate on risks that it could not afford.

Having released synthetic credit of dangerously high notional value, Greenspan raised the Fed funds rate target from its lowest point of 1% set on June 23, 2003, to 4.50% on January 31, 2006, to dampen inflation expectations, before retiring as chairman. Ben Bernanke, his successor as of February 1, 2006, continued increasing the Fed funds rate target in three more steps to 5.25% on June 29, 2006, the cumulative effect adding aggregate interest payments to the financial system greater than US GDP in 2006.

That was like striking a match to light a candle in a dark kitchen filled with leaked gas. Under such fragile conditions, there was little wonder that the market collapsed a year later. (See Why the US subprime mortgage bust will spread (to the global finance system), Asia Times Online, March 16, 2007, written at a time when mainstream opinion was that the housing market crisis, being geographically disaggregated, would not spread.)

Much of the precautionary measures instituted during the New Deal to prevent a reply of the 1929 crash, such as the separation of investment banking from commercial banking, requiring banks to be neutral intermediary of capital funds rather than profit-seeking market makers, in the form of the Banking Act of 1933 (Glass-Steagall), were repealed as a result of bank lobbying. Glass-Steagall was replaced by the Financial Services Modernization Act of 1999, (Pub.L. 106-102, 113 Stat. 1338, enacted November 12, 1999), aka the Gramm, Leach-Bliley Act (GLBA).

Wholesale credit market failure

Yet with the benefit of deposit insurance instituted during the New Deal remaining operative, the financial crisis that began in mid-2007 was caused not by bank runs from depositors but by a meltdown of the wholesale credit market when risk-averse sophisticated institutional investors of short-term debt instruments shied away en mass.

The wholesale credit market failure left banks in a precarious state of being unable to roll over their short-term debt to support their long-term loans. Even though the market meltdown had a liquidity dimension, the real cause of system-wide counterparty default was imminent insolvency resulting from banks holding collateral whose values fell below liability levels in a matter of days. For many large, publicly listed banks, proprietary trading losses also reduced their capital to insolvency levels, causing sharp falls in their share prices.

Citigroup shares fell from $70.80 in July 31, 2007 to $1.02 on March 4, 2009. Citigroup market capitalization dropped to $6 billion from $300 billion two years prior.

Citi shares were trading at $4.54 on April 2010 after having received $320 billion of bailout help from the Treasury in November 2008. Citigroup and Federal regulators negotiated a plan to stabilize the bank-holding company, with the US Treasury guaranteeing about $306 billion in loans and securities and investing about $20 billion directly in the company. The assets remain on Citi's balance sheet; the technical term for this arrangement is "ring fencing" or hypothecation, the dedication of the revenue of a specific tax for a specific expenditure purpose. In a New York Times op-ed, author Michael Lewis and hedge fund manager David Einhorn described the $306 billion guarantee as "an undisguised gift" without any real crisis motivating it.

From October 2008 to January 2009, the US Treasury provided Citigroup with three rounds of financial aid worth $45 billion. The bank said in December 2009 that it would pay back the money. The firm has to pay back $20 billion of the aid as the US government acquired 34% of Citigroup's capital. The government also imposed executive pay restrictions which the bank was eager to dodge fearing the exodus of "talented" employees. Even though the bank was optimistic about the plan, offering $15 billion in common stock, there were some within the bank who questioned whether the aid should be paid back so soon. Some government officials also voiced concerns that the US economy might head back into recession causing consumer credit losses and commercial real estate losses.

"The basic objective is to make sure as we exit ... we're leaving the capital position of the institutions stronger, not weaker," said US Treasury Secretary Timothy Geithner, as if merely stating the goal is as good as achieving it.

Tax deduction stealth bailout

Under the George W Bush administration, the Internal Revenue Service (IRS), an arm of the Treasury Department, changed a number of rules during the financial crisis to reduce the tax burden on financial firms and to encourage mergers, letting Wells Fargo cut billions of dollars from its tax bill by buying the ailing Wachovia. The government was consciously forfeiting future tax revenues from these companies as another form of assistance.

On December 16, 2009, the Bush government quietly agreed to forgo billions of dollars in potential tax payments from Citigroup as part of the deal to help wean the company from the massive taxpayer bailout that enabled it to survive its blunders that helped cause the financial crisis. The IRS issued an unusual exception to long-standing tax rules for the benefit of Citigroup and a few other companies that had been partially acquired by the government.

As a result of the exception, Citigroup will be allowed to retain billions of dollars worth of tax breaks that otherwise would decline in value when the government sells back its Citigroup stake to private investors. The Obama administration, in updating the exceptions, has said taxpayers are likely to profit from the sale of the Citigroup shares. Many accounting experts, however, are of the opinion that the lost tax revenue could easily outstrip those profits.

Treasury officials said the most recent change was part of a broader decision initially made to shelter companies that accepted federal aid under the Troubled Assets Relief Program from the normal consequences of such an investment. Officials also said the ruling benefited taxpayers because it made shares in Citigroup more valuable and asserted that, without the ruling, Citigroup could not have repaid the government at this time.

"This rule was designed to stop corporate raiders from using loss corporations to evade taxes, and was never intended to address the unprecedented situation where the government owned shares in banks," Treasury spokeswoman Nayyera Haq said. "And it was certainly not written to prevent the government from selling its shares for a profit."

When working as spokeswoman for Representative John Salazar, Democrat of Colorado, Nayyera Haq joined with 22 other Muslims aides on Capitol Hill to form the Congressional Muslim Staffers Association, after hearing a radio interview in which Tom Tancredo, a Colorado Republican, in response to a question on what should be done if Muslim terrorists attacked the United States, suggested bombing Islam's holy sites, including Mecca. "That's when I realized there was something really wrong," said Ms Haq. "Not just with members of congress, but as Americans and our approach to dealing with 'others'."

Byzantine partisan politics

The Democrat-controlled congress, concerned that the lame-duck Bush Treasury was bypassing congress to rewrite tax laws, passed legislation early in 2009 that reversed the ruling that benefited Wells Fargo in 2008 and restricted the ability of the IRS to make further changes. A Democratic aide to the senate finance committee, which oversees federal tax policy, said the Obama administration, just as the Bush administration did, had the legal authority to issue the new exception, but now Republican aides to the committee say they are reviewing the issue.

A senior Republican staffer now questions the Obama administrations's echo of the Bush rationale. "You're manipulating tax rules so that the market value of the stock is higher than it would be under current law," said the aide, speaking on the condition of anonymity. "It inflates the returns that they're showing from TARP and that looks good for them." Never mind that TARP had first been initiated by Republican Treasury secretary Henry Paulson.

The Obama administration and some of the nation's largest banks have hastened to file for separation in recent months. Bank of America, followed by Citigroup and Wells Fargo, agreed to repay federal aid. While the healthiest banks had already escaped earlier this year, the new round of departures involves banks still facing serious financial problems. It seems obvious that executive pay restriction has much to do with the mad rush to independence.

The banks say the strings attached to the bailout, including limits on executive compensation, have restricted their ability to compete and return to health. Executives also have chafed under the stigma of living on the federal dole. President Obama chided 11 of the nation's top bankers at the White House for not trying hard enough to make small-business loans.

The Obama administration also is eager to wind down a bailout program that has become one of its largest political liabilities in this season of populist discontent. Officials defend the program as necessary and effective under emergency conditions, but the president has acknowledged that the bailout is "wildly unpopular" and officials have been at pains to say they do not relish helping banks that seem to be milking the crisis for narrow advantage.

The root cause of excess debt for both crises

Both bank crises, though 80 years apart, have the same root cause of excess debt, but the contours of the crises are quite different.

In both crises, the function of the stock market as a venue for raising capital was distorted to one where most of the investing population expected to make unearned fortunes by speculating on stock prices. Capital formed from savings became dissatisfied with a fair return from sound, long-term investment based on economic fundamentals. Instead, highly leverage capital began to seek outsized returns from risky assets technically driven to high prices in debt-financed bubbles in hope of selling them to latecomer investors for spectacular profit before inflated prices expectedly returned to normal levels. Prices continued to rise in an expanding bubble as a result of escalating mass speculation, creating an unrealistic expectation that prices could only rise from artificially generated high demand over limited supply.

But prices could not continue to rise without fundamental growth, and fundamental growth cannot take place without sound long-term investment to increase productivity that keeps income rising. As soon as asset prices began to fall from correction on an overbought market, a large number of highly leveraged institutional speculators were forced to liquidate with high losses. Bankers and brokers continued to act as market cheerleaders, calling every decline as merely market corrections that were windows of buying opportunity, while the smart money was unloading their excess risk onto unsuspecting and less-informed speculators worldwide. Structured finance also allowed conservative institutional investors to invest in highly rated derivatives of subprime loans.

Worse still, in the 2007 crisis, much of the institutional money came from pension funds of the working population whose savings were seeking high returns from risky speculative financial derivatives of the population's own highly leveraged debts, mainly in bloated housing and consumer credit sectors that were not supported by stagnant debtor income.

Both crises, though 80 years apart, involved banking system failures brought on by an abrupt loss of confidence in a market infested with excessive leverage. The 1929 crisis manifested itself first in the retail markets, while the 2007 crisis began in the wholesale markets. Yet the leverage was much higher in 2007 and the face amount of exposure much bigger. In 1920, the average leverage was 10 times. To put it another way, the margin set at was 10%, which meant $10 of equity for every $100 of speculative trade. In 2007, the going leverage has risen to 40 times, or $10 of equity for every $400 of speculative trade.

Both crises, involved problems of sudden illiquidity, but due to finance globalization and electronic trading developed in recent decades, the 2007 banking crisis was faced with an additional problem of fast-paced global contagion triggered by insolvency in financial institutions that were "too big to fail" without triggering serious global systemic consequences. The problem remains unsolved as post-crisis regulatory reform is watered down in a US Congress highly influenced by special interests financed lobbying.

Bank capital ratio

Conspicuously missing from the House regulatory reform bill (Wall Street Reform and Consumer Protection Act of 2009 - HR 4173) is required capital ratio, the minimum level of capital that banks should be required to hold for every dollar they lend. The bill also does not define what can be counted as capital, or how much of that capital should be readily available to provide adequate liquidity. Those important questions are being left to the new regulators to sort out later, without any assurance of adequate technical capability for the challenging task.

Rating agency immunity

Rhode Island Democrat Senator Jack Reed criticized Standard & Poor's for its "cynical" attempt to resist regulatory reform by asking Republican members of Congress to oppose legislation that would make it easier for market victims to sue credit-rating firms for misleading rating. "The same companies that helped cause the financial crisis are now trying to block reform," Reed, who drafted the litigation provision, said in a statement on April 6, 2010. "This cynical attempt by Wall Street lobbyists to kill Wall Street reform before it has a chance to see the light of day must be resoundingly rejected."

The senate banking committee under Democrat chairman Christopher Dodd on March 23 approved landmark financial regulatory reform legislation, pushing the fight over the issue to the full senate in April. The Democrat-controlled committee voted 13-10 along party lines to pass a 1,336-page bill, which will need 60 votes to move for a vote on the senate floor, a calculation that was key to Republicans' acquiescence to a quick committee decision. All Republican committee members voted against the Democratic measure at a working session that lasted only 30 minutes.

In the full senate, the Democrats will need to pick up some Republican support to win passage. Democrats control only 59 votes out of 100 in the chamber since it lost the critical seat of the late senator Teddy Kennedy to Scott Brown, a Massachusetts Republican. The Democrats would need to muster 60 votes to overcome procedural roadblocks, such as a filibuster, that Republicans are likely to throw up to stall a vote.

Just hours before voting, the committee dropped plans for a week long debate of 400 amendments that were to be offered by both Republicans and Democrats to a bill unveiled in the previous week by Dodd.

The shift came after Republicans decided not to offer their 300 amendments, opting instead to take their fight to the senate floor, where they have a better chance at blocking reforms that are opposed by their party, the banks they represent and Wall Street interests that fund their campaign costs.

"Republicans will not offer hundreds of amendments that would only be defeated at the committee level," said Richard Shelby, the top Republican on the committee. The tactical adjustment followed a narrow win on Sunday, March 21, in the House of Representatives for the Democrats and the White House on healthcare reform - another top priority on the Obama agenda.

The Dodd bill would set up a council of regulators to oversee financial risk, create an orderly process for liquidating distressed financial firms, regulate derivatives markets, and take other steps meant to avert another financial crisis caused by the too-big-to-failed syndrome.

President Barack Obama welcomed the Dodd committee vote. "We are now one step closer to passing real financial reform that will bring oversight and accountability to our financial system and help ensure that the American taxpayer never again pays the price for the irresponsibility of our largest banks and financial institutions," the president said. Obama vowed in a statement to fight to strengthen the measure and urged senators on the floor to resist efforts to water it down. The bipartisan appeal fell on deaf ears.

The committee's approval of the Dodd bill, which critics complained was a watered-downed compromise, marks the biggest concrete step yet taken by the senate toward putting in place new rules for banks and capital markets, two years after the collapse of Bear Stearns ushered in the worst financial crisis since World War II.

While Republicans have worked closely with bank lobbyists to block reforms that they think will threaten financial industry profits, some liberal Republicans concur that regulatory reform is needed up to a point. They disagree with Democrats on how fundamental reform should reach.

Shelby said he remains hopeful that "broad consensus" can be reached on reform as the Dodd bill moves toward the floor. The senate began a two-week recess on Friday, March 26. With its return on April 12, Democratic leaders started to decide how and when to bring financial reform to the floor.

Republican Senator Judd Gregg said in a statement that he wants to continue working with Democrats, but he criticized the Dodd bill on several fronts. Senator Bob Corker, a Republican who tried but failed to broker a bipartisan deal with Dodd, called the committee's unexpectedly quick vote "dysfunctional". But he added that "there is still an opportunity to produce a sound piece of legislation that will merit broad bipartisan support from the full Senate and stand the test of time." In other words, the Republicans hope to water down fundamental reform further.

Failure by the senate to produce a bill by July would hand Obama and the Democrats a defeat heading into the November mid-term congressional elections, and leave a cloud of political uncertainty hanging over the financial services industry.

Consumer protection

The Consumer Financial Protection Agency (CFPA), much fought for by reformers, has been put under the Federal Reserve by the senate bill. Advocates for an independent agency argue that the Federal Reserve has always had consumer protection power that it repeatedly failed to use to prevent the crisis from hurting consumers.

Under the senate bill, the Federal Reserve will oversee banks with assets of $50 billion or more, together with a vaguely defined "systemically risky [non-bank] institutions". In other words, the same players who brought on the crisis and the bailout with tax payer money are still running the show, albeit with a new, improved script.

The senate bill is criticized by reformers in the following areas:

A new systemic risk council stuffed with the same players: the Federal Reserve, the Treasury, the Federal Deposit Insurance Corporation (FDIC) and the Securities and Exchange Commission would be a sham, as a 75% majority vote on the council can overturn any rulings of the CFPA.

Over the counter (OTC) derivatives are to be regulated but as in the House bill. But there are enough loopholes and exemptions to render regulation meaningless.

Shareholder votes on executive compensation will be non-binding only.

The Volcker rule to limit bank proprietary trading appears to be dead on arrival.

The proposal to audit the Fed is not even mentioned - so much for oversight discovery on $2 trillion dollars in loans the Fed has given Wall Street.

Smaller bank holding companies, if they hold a federal charter, would be overseen by a new regulator formed out of the Office of the Comptroller of the Currency, which already oversees national banks.

The FDIC, which already oversees state-chartered banks that are not members of the Fed system, would gain oversight over those that are.

No-holds-barred bank lobbying

JPMorgan Chase and Co reportedly spent $6.2 million in 2009, up from its pre-crisis annual spending of around $4 million, on lobbying lawmakers against regulatory reform proposals that would further restrict credit-card lending and increase fees on federal depositor insurance. Citibank spent over $7 million in 2007, $6.5 million in 2008 and $4.8 million in 2009 on lobbying.

JPMorgan chairman James Dimon called proposed consumer protection measures "Un-American". Having earlier embraced the Trouble Asset Relief Program (TARP) by receiving $25 billion in government bailout money as a "patriotic duty" even though his bank allegedly did not need the money, Dimon protested publicly against the Treasury's requirement of banks that had received TARP money to raise fresh capital from the market before they exit from TARP, as it would force banks to pay a high cost for the funds. The bank repaid the $25 billion of Tarp fund in June 2009, but continued to fight with the government on the value of warrants it needed to buy back from the Treasury Department to officially conclude the transaction. JPMorgan ultimately waived its right to buy the warrants as part of the initial TARP terms so that Treasury could hold an auction to get a higher price, which netted the Treasury a $936 million gain in December 2009.

A request from White House Chief of Staff Rahm Emanuel to a high Morgan executive, former commerce secretary William Daley, a scion of a prominent Chicago Democratic political dynasty, asking for the bank's support for the proposed creation of a new consumer protection agency, was vetoed by Dimon on grounds that sufficient consumer safeguards are already in place.

In a recent 36-page annual letter to shareholders, Dimon wrote: "It is critical that the reforms actually provide the important safeguard without unnecessary disrupting the health of the overall financial system." In other words, no fundamental reform will be accepted.

Post-war recessions and the Marshal Plan

While World War II ended the Great Depression, the first post-war recession occurred between 1948 and 1949, lasting 10 months, with a GDP decline of 1.58%, unemployment reaching 7.9% and deflation as measured by the Consumer Price Index falling 2.07%. The recession ended with military spending in arming North Atlantic Treaty Organization (NATO) members as president Harry Truman launched the Cold War and military spending in the Korean War, which also jumped started the Asian Tiger economies with massive US procurement in Asia. The revival of the war-torn Japanese economy began with US military spending in the Cold War in Asia, half a decade after the Marshall Plan and NATO spending jump-started the revival of war-torn Europe. Soviet rejection of the Marshall Plan marked the beginning of the Cold War.

The Marshall Plan was created as part of the Truman Doctrine of containment of Soviet communism. It was more than an altruistic aid program to help Europe recover from war damage. It sought to restructure Western European economies away from their prewar socialist direction and onto a new path towards US-style market capitalism under a new monetary regime based on a gold-backed dollar worked out at Bretton Woods, and to keep budding European social democracy from mutating into populist communism through electoral politics.

The strategic geopolitical purpose was to integrate Western Europe firmly into the postwar Pax Americana of free-market fundamentalism and a regional anti-Soviet military alliance in the form of NATO based on collective security, having rejected the lesson of the role of interlinked alliances in igniting World War I. For the first two decades of NATO's existence, the US supplied most of the organization's military materiel. The Marshall Plan was the linchpin of US strategy to neutralize a perceived rising Soviet threat. It helped to trigger the Cold War, which undeniably had its economic benefits for the capitalist system at the expense of the socialist system. Truman left the national debt at 74.3% of GDP by the end of his presidency.

The Eisenhower recessions

There were three short, mild recessions during the Eisenhower presidency (1953-61). The first occurred between 1953 and 1954, lasting 10 months, with GDP declining 2.53%, unemployment reaching 5.9% and inflation at 0.37%. The second recession under Eisenhower occurred between 1957 and 1958, lasting 8 months, with GDP declining 3.14%, unemployment reaching 7.4% and inflation of 2.12%. The third Eisenhower recession occurred between 1960 and 1961, lasting 10 months, with a slight decline of GDP of 0.53%, but unemployment reaching 6.9% and inflation of 1.02%. The standard Eisenhower cure for recessions was new military contracts to the industrial sector. Eisenhower left the national debt at 56% of GDP. Eisenhower left office with a warning to the nation of the danger of a military-industrial complex.

The Kennedy/Johnson recessions

The Kennedy presidency, cut short by assassination on November 22, 1963, was spared recessions as Kennedy maintained high government spending by continuing the Cold War and the arms race with the Soviet Union, topped with the Apollo program to land a man on the moon. The Kennedy tax cut in the Revenue Act of 1964, pushed through in 1964 by Johnson, was 1.9% of the net national Income as measured by the net national product, more than the Reagan tax cut of 1.4% in the Economic Recovery Act of 1981. Popular image and political rhetoric notwithstanding, Reagan was not the most aggressive tax cutter in US history, not was he the most conservative in fiscal affairs.

Despite heavy spending on the Vietnam War, a short recession occurred between 1969 and 1970 during the last year of the Lyndon B Johnson presidency, lasting 11 months, with GDP declining 0.16%, unemployment reaching 5.9%, but inflation climbed to 5.04%. The economy managed to produce simultaneously for both guns and butter, but war expenditure robbed LBJ of the funds needed to finance his Great Society dream. LBJ left the national debt at 42.5% of GDP, substantially lower than Ronald Reagan did.

Recessions from Nixon to George H W Bush

The presidency of Richard Nixon saw one recession, between 1973 and 1975, as Nixon wound down the Vietnam War. The recession was the longest since the Great Depression, lasting 16 months, with a GDP decline of 3.19%, unemployment reaching 8.6% and inflation rising to an unprecedented 14.81%. It was the first stagflation recession rather than a deflationary recession. Nixon left the national debt at 37.1% of GDP at the end of his first term and Ford left the national debt at 36.3% of GDP.

Jimmy Carter had one short recession in 1980 during his presidency (1977 to 1981), lasting six months, with a GDP decline of 2.23%, unemployment reaching 7.8% - unacceptably high for a self-proclaimed populist president - with inflation still at 6.3% despite the Volcker Fed's bloodletting monetarist measures to fight run-away inflation. Nevertheless, Carter left the national debt at 33.4% of GDP, the lowest since World War II.

Under Ronald Reagan, the country had two recessions, the first between 1981 and 1982 - matching the Nixon recession record at 16 months long - with GDP declining 2.64%. But unemployment reached double digit for the first time since the Great Depression, to 10.8%, with inflation hitting 6.99%. The Reagan tax cut of 1981, coupled with Reagan military budget, left the US with a national debt of 51.9% of GDP, compared to Jimmy Carter's 33.4%.

In the 1988 presidential election, George H W Bush defeated Democratic challenger Michael Dukakis because the Greenspan Fed's aggressive intervention had prevented the 1987 stock market crash from developing into a recession. But a recession occurred between 1990 and 1991 in the aftermath of the savings & loan crisis, lasting eight months, with a GDP decline of 1.36%, unemployment reaching 6.8% and inflation of 3.53%.

In the 1992 presidential election, Bush, appearing oblivious to the effect of the ailing economy on the voting public, lost to Bill Clinton (43% of the vote against Bush's 37.4%), with billionaire populist Ross Perot as an independent candidate spoiler (18.9% of the vote). Clinton's campaign slogan of "it's the economy, stupid!" took advantage of Bush's decline in the polls, in which his standing had reached as high as 89% immediately following the Gulf War (Aug 2, 1990 - Feb 28, 1991). Bush left the national debt at 64.1% of GDP.

The Clinton prosperity and its costs

Clinton presided over the longest period of peace-time economic expansion in American history, which included balanced budgets and fiscal surpluses. But there was a price to pay. His Third Way economic approach, a centrist program of privatization, deregulation and globalization as espoused by Antony Giddens, paved the way for the crisis of the financial sector in 2007 with endless easy money provided by the Greenspan Fed. The Clinton prosperity, fueled by neo-liberal market fundamentalist ideology, became the root cause of the financial crisis two decades later, even though Clinton left the national debt at 57.3% of GDP, 6.8 percentage points lower than when Bush left it, but 23.9 percentage points higher than when Carter left it.

The second Bush recession and the 2007 market failure

The dot com bust led to the recession of 2001 as George W Bush entered the White House. The recession, a parting gift from Clinton policies, was shortened by Greenspan's monetary response to the September 11, 2001, terrorists attacks on the United States. As a result, the recession lasted only eight months, with a real GDP decline of 0.73%, unemployment falling to 5.5%, below the 6% structural unemployment line, lowest since World War II and with inflation at 0.68%. But a financial tsunami building in deregulated financial markets fueled by brave new financial innovation of derivatives finally exploded in mid-2007 to launch a market meltdown that earned it the label of the Great Recession. George W Bush left the national debt at 69.2% of GDP at the end of his two terms.

Ronald Reagan, George H W Bush and George W Bush were the only presidents who left the national debt higher than it was when they entered the White House. So much for the Republican claim of being the party of fiscal conservatism.

The entire Obama presidency to date has been mired in the recession that started in George W Bush's presidency. Obama's approval rating was 50% when he took office in January 2009 and rose to 68% by April. It fell to 44% in the latest CBS News Poll in April 2010, the lowest level of his tenure in office so far. That compares with 49% in late March, just before he signed the healthcare reform bill into law.

Learning the wrong lessons

Despite claims of having learned from the errors of passivity allegedly made by the Fed in the 1930s, and that the resultant, supposedly wiser measures taken by the Ben Bernanke Fed having prevented a market freefall, the jury is still out on whether this new massive interventionist approach will save the world from another Great Depression and at what cost. As students in Econ 101 learn, there is no free lunch in economics. Free lunches are found mostly in Ponzi and pyramid schemes, even if they are concocted by governments.

To date, the Great Recession that began in 2007 has lasted 30 months. There is no end yet in sight. Impaired markets remain anemic, still facing a possible double dip, with unemployment reaching 9.7% and expecting to stay high for a long time, the consumer price index (CPI) rising 2.76%, and asset price deflation reversing wealth effects on households. On the domestic horizon are a massive pension fund crisis, a commercial real estate loan default crisis and a crisis of state and local government fiscal insolvency. On the global horizon are a sovereign debt crisis, a foreign exchange crisis and a pending global trade war.

Applying the counterfactual conclusion of Milton Friedman on the errors the Fed that led to the Great Depression, the Fed under Greenspan and Bernanke signed on to Friedmanesque monetarism to make extended use of the Fed's nearly unlimited power to provide liquidity to override business cycles in free markets. This approach robbed the free-market economy of its self-correction adjustment to produce serial bubbles in a managed market on the supply side, in opposition to the Keynesian approach of demand management.

In contrast to Fed passivity after the 1929 crash, the Bernanke Fed in 2007 at first made massive funds available to distressed banks and other financial institutions. But it simultaneously used open market operations to sterilize any enlargement of the monetary base and to prevent any increase in total bank reserves in the system. While the Fed in 1929 failed to inject liquidity into the banking system, the Fed in 2007 failed to cause the massive liquidity it injected into the banking system to flow into the broader economy to increase demand. An imbalance of excess supply and inadequate demand reduced the Fed to the equivalent of pushing on the credit string.

As the crisis intensified in the second half of 2007, the Fed used Section 13 (3), a seldom used authority granted by congress during the Great Depression, to provide emergency loans to distressed non-bank firms. The Fed also lowered the Fed funds rate target in quick succession, effectively to near zero, below which the Fed cannot go. Thus the Fed essentially used up its only bullet.

In addition, the Fed purchased large amounts of US Treasuries to inject liquidity into the credit markets, particularly in the repo and commercial paper markets. The Fed also bought distressed agency debt and toxic mortgage-backed securities at face value to provide liquidity to large financial institutions holding the most senior debts, in effect expanding to unprecedented levels the Fed's balance sheet, the monetary base and broader monetary aggregates.

The 2007 financial crisis began with the collapse of the residential real estate debt bubble in the US, which had been financed by highly leveraged sub-prime mortgages that were securitized in structured finance instruments of hierarchical levels of risk and compensatory returns. These securitized instruments were sold to both institutional and retail investors worldwide who mostly bought them with highly leveraged debt. When prices of these instruments collapse from foreclosed mortgages, investors were unable to meet margin calls and defaulted en mass, causing a global chain of counterparty defaults. As the market for these securities and derivative contracts failed, the Fed acted as a market maker of last resort for these toxic instruments and contracts. The result was that most of the toxic securities and liabilities ended up on the Fed's balance sheet.

Structured finance, the fatal virus

Structured finance allows general risk normally embedded in all debts to be unbundled into structured instruments that allow even the most conservative institutional investors, those mandated by law to hold only investment-grade securities, to participate in the debt bubble by holding the supposedly safest, low-risk senior debt instruments. But the real world safety of these high-rated AAA, allegedly low risk senior instruments is merely derived from the unrealistically expected low-default rate of their riskier components. As the default rate of the high-risk, subprime mortgages rose from the bursting of the debt bubble of easy money created by an indulgent Fed, the safety of the supposedly low-risk, high credit-rated senior debt vanished.

With runaway "supply-side" voodoo economics keeping wage income in check during the boom phase in corporate profits, the resultant overcapacity from demand lag, resulting from stagnant low wages, shut off investment opportunities for productive expansion of the economy and forced the excess money supplied by an accommodating Fed into speculative manipulation of debt. This gave birth to structured finance that permitted the disguise of debt proceeds as revenue, providing a false sense of security by transferring unit risks into systemic risk hidden from unit balance sheets, and through sophisticated, circular risk hedging schemes. The nonexistence of a systemic balance sheet made systemic imbalances legally invisible. This was supported by free-market fundamentalism ideology, notwithstanding challenges from a few lonely independent voices that were routinely shut off from the mainstream media and authoritative academic journals. There were a few clear minds that refused to buy into the grand self-delusion, but their voices were kept in the intellectual wilderness.

Credit oversupply and neo-liberal finance capitalism

Two decades of excessive money creation produced a Fed-induced credit oversupply, which led to a system-wide under-pricing of risk, a lowering of credit worthiness standards, and the generation of a whole category of so-called subprime borrowers, whose credit rating and income stream did not meet conventional lending criteria. While subprime mortgages were at first merely a housing sector problem, the derivative effects of failure in structured finance quickly infested the entire global financial system.

The interconnected factors that fueled the spectacular formation of serial bubbles at an unprecedented rate and on an unprecedented scale provided support for the false claim of neo-liberal finance capitalism to be the most effective and efficient economic system in history. This unsubstantiated myth lasted more than four decades. The same factors behind the boom also brought the entire global finance capitalist system, built on debt, crashing down in July 2007.

The first weak link in the global network of under-priced risk to fail began in London on August 9, 2007 when the London Interbank Offer Rate (LIBOR) and related funding rates jumped sharply higher after the French bank BNP Paribas announced that it was halting redemptions for three of its high-flying investment funds to avoid forced liquidation.

The Bernanke Fed tried to clam jittery markets on August 10 by repeating the famous Greenspan announcement that had successfully calmed market jitters in the1987 crisis: "The Federal Reserve is providing liquidity to facilitating the orderly functioning of the financial markets," adding: "as always, the discount window is available as a source of funding."

A week later, on August 17, with the credit market still frozen, the Federal Reserve Board of Governors voted to reduce the primary discount rate by 50 basis points to 5.75% from the 6.25% set since June 2006. It also extended the maximum term of the discount widow to 30 days. The Fed also invited banks not yet visibly in distress to borrow from the discount window to try to remove the traditional stigma associated with discount borrowing for distressed borrowers.

Starting in September 2007, the Fed Open Market Committee (FOMC) lowered its target for the Fed funds rate in the first of many cuts, three cuts in 2007 totaling 100 basis points (one percentage point), and seven cuts in 2008 totaling 425 basis points (4.25 percentage points) that ended at essentially zero by December 2008 and has kept it there for 16 months so far at this writing (April 2010). The penalty of such long period of near zero interest rate will have to be reckoned with in future years.

At no other time has the Fed kept the Fed funds rate target near zero for so long. The visible result so far has been massive carry-trades through interest rate arbitrage by institutional speculators and hedge funds borrowing in low interest markets to invest in high interest markets for easy profit, exposing their trades to exchange-rate risks. The discount rate followed suit, falling 0.5% on December 16, 2008, and staying there for 15 months until February 19, 2010, when it was raised 25 basis points to 0.75% to calm inflation expectations.

Financial strain reemerged in November 2007 despite the August 17 cut in the Fed funds rate target and the discount rate three months earlier. On December 12, 2007, the Fed had to arrange a currency swap with the European Central Bank (ECB) and the Swiss National Bank to provide a source of dollar funding to European financial markets. Over the following 10 months, the Fed arranged currency swaps with 14 other central banks.

On the same day, the Fed also created the Term Auction Facility (TAF) to lend directly to banks for fixed terms to overcome the low volume of discount window lending on account of the traditional stigma associated with discount window borrowing, despite persistent stress in interbank funding markets.

By December 28, 2009, the Fed had provided $3.48 trillion of new bank reserves through TAF auctions. Under fractional reserve in normal times, at a reserve rate of 10%, the maximum amount of new deposits that can be created by $3.48 trillion of new bank reserves would be $34.8 trillion and the maximum increase in the money supply would be $27.84 trillion. This was a massive injection by any standard. The money supply expanded by nearly twice the size of the GDP. It produced the equity market rally of the spring of 2010 - but did little for the real economy.

Next: The Fed's no-exit strategy

Henry C K Liu is chairman of a New York-based private investment group. His website is at http://www.henryckliu.com.

Copyright 2010 Asia Times Online (Holdings) Ltd.

http://www.atimes.com/atimes/Global_Eco ... 4Dj03.html

THE POST-CRISIS OUTLOOK - Part 3
The Fed's no-exit strategy


By Henry CK Liu
Asia Times
April 21, 2010


This is the third article in a series.

Part 1: The crisis of wealth destruction
Part 2: Banks in crisis: 1929 and 2007


In testimony before the committee on financial services of the US House of Representatives in Washington, DC, on February 10, 2010, regarding the "Federal Reserve's Exit Strategy" from the extraordinary lending and monetary policies that it implemented to combat the financial crisis and support economic activity, Federal Reserve chairman Ben S Bernanke said the Fed's response to the crisis and the recession can be divided into two parts.

First, the financial system during the past two-and-a-half years experienced periods of intense panic and dysfunction, during which private short-term funding became difficult or impossible to obtain for many borrowers, even those with good credit standing in normal times. The pulling back of private liquidity at times threatened the stability of major financial institutions and markets and severely disrupted normal channels of credit.

Yet Bernanke skirted over the fact that for several large institutions, the liquidity crunch was inseparable from an insolvency problem. What these distressed institutions needed was more than a liquidity tie over; they required an injection of capital.

In response, performing its role as liquidity provider of last resort, the Federal Reserve developed a number of programs to provide supposedly well-secured, mostly short-term credit directly to the financial system. These programs, which Bernanke alleged rather simplistically as imposing no cost on the taxpayer, were a critical part of the government's efforts to stabilize the financial system and restart the flow of credit.

As noted in Part 2 of this series, the tax exemption granted to distressed institutions had cost the Internal Revenue Service tax revenue in amounts that exceeded the estimated positive returns from disposing of distressed assets the Treasury had acquired. Yet, the true cost of Fed intervention to the integrity of the market system cannot be fully evaluated until the unintended consequences surface years later. Free-market capitalism may well be history after government intervention in this crisis, as the Fed exit strategy may never be completely carried out or Fed direct intervention will be expected in all future crises.

What Bernanke did not say in his testimony was that these programs were not macro monetary measures addressed at the overall capitalist financial market system, but direct micro intervention into selected wayward distressed financial firms deemed to big to fail. The approach has set a pattern of fearlessness among gigantic financial institutions. Yet the net result of the government approach to the banking crisis is to impose on the market an oligarchy of a small number of large surviving banks.

The Fed was providing more than liquidity to the financial system. It took over toxic assets from distressed banks and bank-holding companies which had ventured into the non-bank financial sector and the shadow banking sector. The Fed acted as the white knight to save a market failure in the entire global debt securitization arena. It took on the role of protector of miscreants from market disciplinary penalties, straying from its official mandate as protector of the faith on financial market fundamentalism.

Economist Randall Wray wrote in the website of Roosevelt Institute's New Deal 2.0 Project:

But in those areas in which the government believes markets do work, there should never be any intervention to subvert market forces that want to punish miscreants. Treasury secretaries [Robert] Rubin, [Henry] Paulson, and [Timothy] Geithner's repeated claim that we cannot allow market forces to operate on the downside is logically nonsensical.
Markets cannot work if downside risks are removed. In any area in which the downside is going to be socialized, the upside MUST also be socialized - that is, removed from the market. If the market is to work on the upside, it must be allowed to operate also on the downside.

What about systemic risk? Yes, if government had allowed markets to operate as Bear [Stearns] and Lehman [Brothers] went down, all of the big financial institutions would also have been brought down. As Bernanke now apparently realizes, that would have been a good thing. The market would have accomplished what Bernanke now professes to desire: resolving the problem of "too big to fail". We would have been left only with smallish institutions - those not too big to fail. And as [Roger] Lowenstein forcefully argues, those big financial institutions do very little that is desirable from a public purpose perspective. Whatever good they do accomplish can just as easily be done by small institutions or directly by government where the market fails.

After all, this ain't rocket science. It is just finance: determine who is credit-worthy, provide a loan financed by issuing insured deposits, and then hold the loan to maturity. If the underwriting is poor, the institution will fail and the government will protect only the insured depositors. No individual institution will have an incentive to grow quickly (rapid growth is almost always associated with reducing underwriting standards, and fraud) since once it reaches a one percent share of deposits its access to more insured and cheap deposits is cut-off. Small institutions would not have to compete against the large "systemically dangerous" institutions that now enjoy a huge advantage because even their uninsured liabilities are thought to have the Treasury standing behind them. With a level playing field, even "average skill and average good fortune will be enough", as J M Keynes put it.

Bernanke asserted that as financial conditions have improved, the Fed has substantially phased out these lending programs. What Bernanke failed to tell congress was that while the phasing out in this case meant only that the transfer of troubled debt from the private sector into the public sector had been a one-time measure that was not expected to be repeated with more Fed funds, the return of the troubled debt from the public sector back to the private sector remains on an open schedule. No matter how carefully the Fed intends to carry out this return of liabilities from the public sector to the private sector, it will unavoidably cause a head wind for the seriously impaired economy.

Bernanke said the second part of the Fed's response, after reducing the short-term interest rate target nearly to zero, involved the Federal Open Market Committee (FOMC) providing additional monetary policy stimulus through large-scale purchases of Treasury and government sponsored enterprise securities.

Bernanke claimed correctly that these asset purchases had the additional effect of substantially increasing the reserves that depository institutions hold with the Federal Reserve Banks, and had helped lower interest rates and spreads in the mortgage market and other key credit markets. But his claim that thereby these purchases promoted economic growth is subject to debate and not supported by actual data. What Bernanke did not acknowledge was that the effect of Fed purchases of government debt instruments had not alleviated the rise of unemployment or foreclosures, much less promoted economic growth.

While admitting that at present the US economy continues to require the support of highly accommodative monetary policies, Bernanke warned congress that at some point the Fed will need to tighten financial conditions by raising short-term interest rates and reducing the quantity of bank reserves outstanding.

"We have spent considerable effort in developing the tools we will need to remove policy accommodation, and we are fully confident that at the appropriate time we will be able to do so effectively," he said. He only glossed over the details on these tools and gave no indication on when the appropriate time might be. The fact remains the Fed's tool box is very limited as monetary policy is generally understood as a very blunt instrument for affecting economic trends.

Yet the market is keenly aware that the date of a Fed exit from the financial markets may well be followed by the date for a double dip in a nervous market that would add more weight to the already impaired economy. Meanwhile, the exchange value of the dollar is kept up only by other currencies falling faster as the result of looming sovereign debt crises worldwide, not by the strength of the dollar's purchasing power.

The Fed's liquidity programs

Bernanke told congress that with the onset of the crisis in the late summer and autumn of 2007, the Fed aimed tactically to ensure that sound financial institutions had sufficient access to short-term credit to remain sufficiently liquid and able to lend to creditworthy customers, even as private sources of liquidity began to dry up.

Yet what the Fed actually did was to ensure the survival of unsound institutions on the verge of insolvency that were deemed too big to fail. The funds that went to these institutions failed to reach even the dwindling number of creditworthy borrowers. Instead of lending more, much of the bailout money was used by recipient financial institutions for de-leveraging to shrink their liabilities.

Bernanke said that to improve the access of banks to backup liquidity, the Fed reduced the spread of the target federal funds rate over the discount rate - the rate at which the Fed lends to depository institutions through its discount window - from 100 basis points to 25 basis points, and extended the maximum maturity of discount window loans, which had generally been limited to overnight, to 90 days. A basis point is 0.01 percentage point.

Many banks, however, were evidently concerned that if they borrowed from the discount window they would be perceived in the market as weak, and consequently might come under further pressure from creditors.

To address this so-called stigma problem, the Fed created a new discount window program, the Term Auction Facility (TAF). Under the TAF, the Fed regularly auctioned large blocks of credit to depository institutions. For many reasons, including the competitive format of the auctions and the fact that practically all institutions were in distress, albeit at different degrees, the TAF has not suffered the stigma of conventional discount window lending and has proved effective for injecting liquidity into the financial system. Another possible reason that the TAF did not suffer from stigma was that auctions were not settled for several days, which signaled to the market that auction participants did not face an imminent shortage of funds. On the other hand, it showed that serious market failure could still emerge in a matter of days, a possibility that Bernanke did not mention.

Liquidity pressures in financial markets were not limited to the United States, and intense strains in the global dollar funding markets began to spill over back on US markets. In response, the Fed had to enter into temporary currency swap agreements with major foreign central banks. Under these agreements, the Fed provided dollars to foreign central banks in exchange for an equally valued quantity of foreign currency. The foreign central banks, in turn, lent the dollars to banks in their own national jurisdictions.

The currency swaps helped reduce stresses in global dollar funding markets, which in turn helped to stabilize US markets. Bernanke said, importantly, the swaps were structured so that the Fed bore no foreign exchange risk or credit risk due to dollar hegemony. In particular, foreign central banks, not the Fed, bore the credit risk associated with the foreign central banks' dollar-denominated loans to financial institutions in their respective financial system. Left unspoken was that in protecting the Fed from exchange rate risks, the Fed in effect neutralized the equilibrium function of the exchange markets by manipulating the global supply of dollars.

Thus it is ironic that some US politicians, unversed in monetary economics and urged on by economist-turned-propagandist Paul Krugman, accused China of manipulating the exchange value of its currency by keeping its peg to the dollar. When one currency is pegged by policy to another over a long period, the manipulator can only be the issuer of the currency to which the peg has been set for a decade.

The only way to maintain stability in the exchange rate market is for the US Treasury, supported by the Fed, to give weight to the slogan that a strong dollar is in the US national interest. Unfortunately, the strong dollar slogan will remain an empty one for a long time to come, as the prospect of US economic policy giving the dollar strong support is highly unlikely. On the positive side, the Obama administration is at least soft-peddling the irrational push toward a destructive trade war with China over the yuan exchange rate issue. A trade war is the last thing the impaired US economy needs at this precarious juncture.

As the financial crisis spread, the continuing pullback of private funding contributed to illiquid and even chaotic conditions in wholesale financial markets and prompted runs on various types of financial institutions, including primary dealers and money market mutual funds. To arrest these runs and help stabilize the broader financial system, the Fed had to invoke a seldom-used emergency lending authority under Section 13 (3) of the 1932 Federal Reserve Act (as amended by the Banking Act of 1935 and the FDIC Improvement Act of 1991), not used since the Great Depression, to provide short-term backup funding to select non-depository institutions through a number of temporary facilities.

In March 2008, invoking Section 13 (3), the Fed created the Primary Dealer Credit Facility (PDCF), which lent to primary dealers on an overnight, over-collateralized basis. Subsequently, the Fed created facilities to help to stabilize other key institutions and markets, including money market mutual funds, the commercial paper market, and the asset-backed securities market.

The Fed reports that use of many of its lending facilities has declined sharply as financial conditions stabilized. In designing its facilities, the Fed in many cases incorporated features, such as pricing that was unattractive under normal financial conditions, aimed at encouraging borrowers to reduce their use of the facilities as financial conditions returned to normal. In the case of other facilities, particularly those that made available fixed amounts of credit through auctions, the Fed has gradually reduced offered amounts.

Some facilities were closed over the course of 2009, and most other facilities expired at the beginning of February 2010. At the time of this writing, the only facilities still in operation that offer credit to multiple institutions, other than the regular discount window, are the Term Auction Facility (TAF - the auction facility for depository institutions) and the Term Asset-Backed Securities Loan Facility (TALF), which has supported the market for asset-backed securities, such as those that are backed by auto loans, credit card loans, small business loans, and student loans. Bernanke told congress that these two facilities are expected to be phased out soon. The final TAF auction was conducted on March 8, and the TALF was closed on March 31, 2010, for loans backed by all types of collateral except newly issued commercial mortgage-backed securities (CMBS) and scheduled for June 30, 2010, for loans backed by newly issued CMBS.

The TALF extends three- and five-year loans, which will remain outstanding after the facility closes for new loans. The extension of the CMBS portion of the facility reflects the Fed's assessment that conditions in that sector will remain highly stressed, as well as the fact that CMBS securitizations are more complex and take longer to arrange than other types. Many in the market expect commercial real estate loan defaults to be the next crisis faced by banks. Some are describing it as a slow train wreck.

In addition, Bernanke told congress that the Fed was in the process of normalizing the terms of regular discount window loans. It has reduced the maximum maturity of discount window loans to 28 days, from 90 days set in the fall of 2007 and is considering whether further reductions in the maximum loan maturity are warranted.

Also, Bernanke told congress that the Fed expected to consider a modest increase in the spread between the discount rate and the target federal funds rate. These changes, like the closure of a number of lending facilities earlier in February 2010, should be viewed as further normalization of the Fed's lending facilities in light of the improving conditions in financial markets; they are not expected to lead to tighter financial conditions for households and businesses and should not be interpreted as signaling any change in the outlook for monetary policy, which remains about as it was at the time of the January 2010 meeting of the FOMC.

Bernanke maintained that to help stabilize financial markets and to mitigate the effects of the crisis on the economy, the Fed established a number of temporary lending programs. Under nearly all of the programs, only short-term credit, with maturities of 90 days or less, was extended, and under all of the programs credit was over-collateralized or otherwise secured as required by law. Bernanke told Congress that the Fed believes that these programs were effective in supporting the functioning of financial markets and in helping to promote a resumption of economic growth. The Fed has borne no loss on these operations thus far and anticipates no loss in the future. The exit from these programs is substantially complete: total credit outstanding under all programs, including the regular discount window, has fallen sharply from a peak of $1.5 trillion around year-end 2008 to about $110 billion by February 2010.

Separately, Bernanke told congress that to prevent potentially catastrophic effects on the US financial system and economy, and with the support of the Treasury Department, the Fed also used its emergency lending powers to help avoid the disorderly failure of two "systemically important" financial institutions, Bear Stearns and American International Group, for which economist Bill Black suggests "systemically dangerous" as a more appropriate description. Why Lehman was allowed to go bankrupt was conveniently skirted over by Bernanke.

Credit extended under these arrangements currently totals about $116 billion, or about 5% of the Fed's balance sheet. The Fed expects these exposures to decline gradually. The Federal Reserve board continues to anticipate that the Fed will ultimately incur no loss on these loans as well. Bernanke admitted to congress that these loans were made with great reluctance under extreme conditions and in the absence of an appropriate alternative legal framework. To preclude any future need for the Federal Reserve to lend in similar circumstances, Bernanke said that the Fed strongly supports the establishment of a statutory regime for the safe resolution of failing, systemically important non-bank financial institutions.

Fed monetary policy and troubled asset purchases

In addition to supporting the smooth functioning of financial markets, the Fed also applied an extraordinary degree of monetary policy stimulus to help counter the adverse effects of the financial crisis on the economy. In September 2007, the Fed began in a number of steps to reduce the target for federal funds rate from an initial level of 5-1/4% to near zero.

By late 2008, this target reached a range of 0 to 0.25%, essentially the lowest feasible level, since that rate cannot go below zero. With its conventional policy arsenal depleted and the economy remaining under severe stress, the Fed decided to override the limits of monetary measures to provide additional stimulus through large-scale purchases of federal agency debt and mortgage-backed securities (MBS) that are supposed to be fully guaranteed by federal agencies, though not by the Treasury. In March 2009, the Fed vastly expanded its purchases of agency securities and began to purchase longer-term Treasury securities as well. All told, the Fed purchased $300 billion of Treasury securities and purchased $1.25 trillion of agency MBS and $175 billion of agency debt securities at the end of March 2010.

The Fed's purchases have had the effect of leaving the banking system in a highly liquid condition, with US banks now holding more than $1.1 trillion of reserves with Federal Reserve Banks. Bernanke claimed that a range of evidence suggests that these purchases and the associated creation of bank reserves have helped improve conditions in private credit markets and put downward pressure on longer-term private borrowing rates and spreads.

As part of its quantitative easing (QE), the Fed first announced in November 2008 "large-scale asset purchases" (LSAPs) of government-sponsored enterprises (GSE) debt, mortgage-backed securities (MBS) and US Treasuries, expanded it in March 2009 and concluded it in March 2010.

The objective behind the purchases of MBS ($1.25 trillion) and GSE debt ($200 billion), was clearly stated at the November 2008 Fed statement: "to reduce the cost and increase the availability of credit for the purchase of houses, which in turn should support housing markets."

The Fed in effect provided massive support to the collapsed housing sector, deemed important in its effort to "improve conditions in financial markets more generally". This approach distorted the market's normal function in credit allocation. The Fed's purchase of MBS bid up prices and lowered yields at a time when prices should fall and yields rise, not only to attract buyers but to reflect true values. Similarly, houses continue to face slow sales despite low mortgage rates because house prices are still artificially held up by Fed subsidy while potential buyers know prices are still at bubble levels. As a result, the housing market has remained lifeless while foreclosures continue nationwide. In some regions, such as California and Florida, the housing market stay in deep depression.

But the Fed's QE has also been designed with the systemic objective of combating general price deflation. It hoped to achieve that systemic objective by intervening in the housing credit market and boosting equity and bond prices through the portfolio balance effect. New York Fed executive vice president Brian Sack explained in a speech on The Fed's expanded balance sheet, at New York University on December 2, 2009:
The [Fed] purchases bid up the price of the [housing credit] asset and hence lower its yield. These effects [of the purchases] would be expected to spill over into other [non-housing] assets that are similar in nature, to the extent that investors are willing to substitute between the assets. ... With lower prospective returns on Treasury securities and mortgage-backed securities, investors would naturally bid up the prices of other investments, including riskier assets such as corporate bonds and equities. These effects are all part of the portfolio balance channel.
But the problem with the above statement is that agency MBS and Treasuries are not assets that are "similar in nature" with corporate bonds and equities, as a 2004 paper ("Quantitative Monetary Easing and Risk in Financial Asset Markets") by Takeshi Kimura of the Bank of Japan and David Small of the Federal Reserve Board, showed:

... the portfolio-rebalancing effects were beneficial in that they reduced risk premiums on assets with counter-cyclical returns, such as government and high-grade corporate bonds. But, they may have generated the adverse effects of increasing risk premiums on assets with pro-cyclical returns, such as equities and low-grade corporate bonds.
QE operations that withdraw "safer" assets such as Treasuries or agency MBS from the market turn optimally balanced portfolios into ones heavily "overweighted" with pro-cyclical assets such as equities and high-yield corporate bonds, the market values of which depend on a strong economic recovery. In a protracted recession, portfolio managers will respond by shedding pro-cyclical assets to rebalance and raise their risk premium. The Fed's LSAPs during 2008-2010 actually produced the opposite spillover effects from what the Fed had wanted to achieve, which was "to reduce the cost and increase the availability of credit for the purchase of houses, which in turn should support housing markets".

Low interest rates and inflationary pressures

The Fed Open Market Committee (FOMC), which sets the Fed funds rate target, anticipates that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period going forward from 2010. In due course, however, as the expansion matures, the Fed will need to begin to tighten monetary conditions to prevent the development of inflationary pressures and expectations. Bernanke, as the nation's central banker, assured congress that the Fed has a number of tools that will enable it to firm the stance of policy at the appropriate time. Yet Bernanke, as an economist, must know that the Fed does not have a reliable way to predetermine when it is the appropriate time to firm its policy stance.

More importantly, in October 2008 congress gave the Federal Reserve statutory authority to pay interest on banks' holdings of reserve balances at Federal Reserve Banks. By increasing the interest rate on reserves, the Fed will be able to put significant upward pressure on all short-term interest rates, as banks will not supply short-term funds to the money markets at rates significantly below what they can earn by holding reserves at the Federal Reserve Banks. Actual and prospective increases in short-term interest rates will be reflected in turn in longer-term interest rates and in financial conditions more generally.

While this is the accepted theoretical correlation, in recent years Alan Greenspan had been baffled by what he called the "Interest Rate Conundrum". Greenspan's February 2005 testimony to congress referred to the behavior of low long-term rates as a "conundrum":

In this environment, long-term interest rates have trended lower in recent months even as the Federal Reserve has raised the level of the target federal funds rate by 150 basis points. This development contrasts with most experience, which suggests that, other things being equal, increasing short-term interest rates are normally accompanied by a rise in longer-term yields. The simple mathematics of the yield curve governs the relationship between short- and long-term interest rates. Ten-year yields, for example, can be thought of as an average of 10 consecutive one-year forward rates. A rise in the first-year forward rate, which correlates closely with the federal funds rate, would increase the yield on 10-year US Treasury notes even if the more-distant forward rates remain unchanged. Historically, though, even these distant forward rates have tended to rise in association with monetary policy tightening.

Greenspan was referring to the expectations theory of interest rates where long rates are the geometric average of expected future short rates plus a risk premium that would usually increase with duration of the instrument. This theory assumes that arbitrage between instruments of different durations will set the price. It is also possible for the risk premium to change over time. As an example, changes in the perceptions of the Fed's credibility on fighting inflation will change the risk premium.

Increases in the interest rate paid on reserves are unlikely to prove a net subsidy to banks, as the higher return on reserve balances will be offset by similar increases in banks' funding costs. On balance, banks' net interest margins will likely continue to decline when short-term rates rise.

Reverse repos as a tool to reduce bank reserves

Bernanke told congress the Fed has also been developing a number of additional tools it will be able to use to reduce the large quantity of reserves held by the banking system when needed. Reducing the quantity of reserves will lower the net supply of funds to the money markets, which will improve the Fed's control of financial conditions by leading to a tighter relationship between the interest rate on reserves and other short-term interest rates.

One such tool is reverse repurchase agreements (reverse repos), a method that the Fed has used historically as a means of absorbing reserves from the banking system. In reverse repos, the Fed sells securities to counterparties with an agreement to repurchase the security at some date in the future. The counterparties' payments to the Fed have the effect of draining an equal quantity of reserves from the banking system.

Recently, by developing the capacity to conduct such reverse repos transactions in the tri-party repo market, the Fed has enhanced its ability to use reverse repos to absorb very large quantities of reserves. The capability to carry out these transactions with primary dealers, using the Fed's large holdings of Treasury and agency debt securities, has already been tested and is currently available, according to Bernanke. To further increase its capacity to drain reserves through reverse repos, the Fed is reportedly also in the process of expanding the set of counterparties with which it can transact and developing the infrastructure necessary to use its MBS holdings as collateral in these transactions.

As a second means of draining reserves, Bernanke said the Fed is also developing plans to offer to depository institutions term deposits, which are roughly analogous to certificates of deposit that the institutions offer to their customers. The Fed would likely auction large blocks of such deposits, thus converting a portion of depository institutions' reserve balances into deposits that could not be used to meet their very short-term liquidity needs and could not be counted as reserves.

A proposal describing a term deposit facility was recently published in the Federal Register, and the Fed is currently analyzing the public comments that have been received. After a revised proposal is reviewed by the board, the Fed expects to be able to conduct test transactions in the spring of 2010 and to have the facility available if necessary shortly thereafter.

Bernanke said reverse repos and the deposit facility would together allow the Fed to drain hundreds of billions of dollars of reserves from the banking system quite quickly. The question has been left unanswered as to under what economic conditions the Fed would choose to do so. If the conditions include good employment figures, the Fed's need to use this new option to drain reserves from the banking system may not arise for a long time.

In the meantime, the scars of the financial crisis remain highly visible in a key part of the US fixed income universe - the repo market. As a barometer of borrowing by the financial sector, the size of the repo market peaked in early 2008 at nearly $4.3 trillion, before the demise of Bear Stearns revealed how much major investment banks had depended on this short-term funding market to finance their balance sheets.

In April 2010, the overall use of repo at about $2.5 trillion remains more than 40% below its peak. This is evidence showing how, in the wake of the Lehman failure in September 2008, large dealers have cut back their balance sheets and are now less reliant on short-term leverage. Instead, they are funding themselves with long-term debt outside the repo sector. A reluctance by repo lenders to accept lower-quality assets as collateral has also hit the market.

At the peak of repo activity in 2007 and early 2008, a sizeable portion of collateral involved securitized mortgages and structured credit securities, which subsequently collapsed in marked-to-market value as the mortgage and credit bubble burst and credit markets imploded. The subsequent large drop in repo usage partly reflects how credit standards have tightened, with only super good-quality collateral being accepted by short-term lenders of cash.

The current lack of appetite for extending money to lower-quality collateral via repo helps explain why the use of securitization among banks has not come roaring back. Another factor limiting the use of repo financing is the current low level of interest rates, which has resulted in some investors not lending their holdings of bonds as the potential returns are too low. (See The repo time bomb redux, Asia Times Online, December 5, 2009.)

Aside from the uncertainty of potential regulatory changes, the repo market faces new challenges. Before the financial crisis, US investment banks ended their financial years in November. That meant that the big repo dealers were divided into two groups, with primary dealers reporting quarterly results one month behind the big US investment banks. This split in reporting periods meant that quarterly window dressing by financial institutions, whereby banks cut borrowings and often buy Treasury bills and notes to shore up their balance sheets, was spread out over several weeks.

Now, with all banks reporting on the same quarterly schedule, uniform window dressing by financial institutions has led to a pronounced and coordinated drop in the use of repo during these periods.

This potentially has big implications for financial markets and institutions in the future as the financial crisis subsides. As all large banks now operate on the same reporting schedule, it could leave investors withholding funds and institutions scrambling for funds, as liquidity declines at the end of each quarter. This may result in a mini liquidity crunch every three months.

The Fed's other tools

The Fed also has the option of redeeming or selling securities as a means of applying monetary restraint. A reduction in securities holdings would have the effect of further reducing the quantity of reserves in the banking system as well as reducing the overall size of the Fed's balance sheet. But that would reduce the money supply through quantitative tightening and drain liquidity.

Bernanke admitted that the sequencing of steps and the combination of tools that the Fed uses as it exits from its currently very accommodative policy stance will depend on economic and financial developments.

One possible sequence would involve the Fed continuing to test its tools for draining reserves on a limited basis, in order to further ensure preparedness and to give market participants a period of time to become familiar with their operation. As the time for the removal of policy accommodation draws near, those operations could be scaled up to drain more significant volumes of reserve balances to provide tighter control over short-term interest rates. The actual firming of policy would then be implemented through an increase in the interest rate paid on reserves.

If economic and financial developments, such as expectations of rising inflation, were to require a more rapid exit from the current highly accommodative policy, however, the Fed could increase the interest rate paid on reserves at about the same time it commences significant draining operations. But Bernanke did not sketch out to congress a scenario that covered how the Fed would handle stagflation, a very likely prospect in a jobless recovery.

Bernanke told congress he currently did not anticipate that the Fed would sell any of its security holdings in the near term, at least until after policy tightening has gotten under way and he claimed optimistically that the economy is clearly in a sustainable recovery. However, to help reduce the size of the Fed's balance sheet and the quantity of reserves, the Fed is allowing agency debt and MBS to run off as these instruments mature or are prepaid over time, Bernanke said. The Fed is currently rolling over all maturing Treasury securities, but in the future it may choose not to do so in all cases. Left unsaid is that while this policy will reduce the Fed's balance sheet, it does this by adding to the national debt.

Bernanke said that, in the long run, the Fed anticipates that its balance sheet will shrink toward more historically normal levels and that most or all of its security holdings will be Treasury securities. Although passively redeeming agency debt and MBS as they mature or are prepaid will move the Fed in that direction, Bernanke said he may also choose to sell securities in the future when the economic recovery is sufficiently advanced and the FOMC has determined that the associated financial tightening is warranted. Any such sales would be at a gradual pace, would be clearly communicated to market participants, and would entail appropriate consideration of economic conditions. All things considered, the fragile economy is expected to be under the intensive care of the Fed for a long time.

Bernanke reported to congress that as a result of the very large volume of reserves in the banking system, the level of activity and liquidity in the federal funds market has declined considerably, raising the possibility that the federal funds rate could for a time become a less reliable indicator than usual of conditions in short-term money markets.

Accordingly, the Fed is reported to be considering the utility, during the transition to a more normal policy configuration, of communicating the stance of policy in terms of another operating target, such as an alternative short-term interest rate. In particular, it is possible that the Federal Reserve could for a time use the interest rate paid on reserves, in combination with targets for reserve quantities, as a guide to its policy stance, while simultaneously monitoring a range of market rates.

The Fed has long advocated the payment of interest on the reserves that banks maintain at Federal Reserve banks. But such a step would have to be approved by congress, which traditionally has been opposed to the idea because of the revenue loss that would result to the US Treasury. Each year the Treasury receives the Fed's revenue that is in excess of its expenses. The payment of interest on bank reserves would, of course, be an additional expense to the Fed and less revenue for the Treasury.

No decision has been made on this issue; the Fed says it will be guided in part by the evolution of the federal funds market as policy accommodation is withdrawn. The Fed anticipates that it will eventually return to an operating framework with much lower reserve balances than at present and with the federal funds rate as the operating target for policy.

Yet the structural echo of a long duration of high reserve balance coupled with a zero interest rate will so condition dependency on monetary accommodation that real recovery may not emerge for decades.

Bernanke told congress that the authority to pay interest on reserves is likely to be an important component of the future operating framework for monetary policy. For example, one approach is for the Fed to bracket its target for the federal funds rate with the discount rate above and the interest rate on excess reserves below. Under this so-called corridor system, the ability of banks to borrow at the discount rate would tend to limit upward spikes in the federal funds rate, and the ability of banks to earn interest at the excess reserves rate would tend to contain downward movements.

Other approaches are also possible. Given the very high level of reserve balances currently in the banking system, the Fed has ample time to consider the best long-run framework for policy implementation. The Fed believes it is possible that, ultimately, its operating framework will allow the elimination of minimum reserve requirements, which impose costs and distortions on the banking system.

As market conditions and the economic outlook improve, the series of special lending facilities to stabilize the financial system and encourage the resumption of private credit flows have been terminated or are being phased out. The Fed also aimed to promote economic recovery through sharp reductions in its target for the federal funds rate and through purchases of distressed securities.

Yet the economy continues to require the support of accommodative monetary policies after 30 months of recession. The Fed claims it has the tools to reverse, at the appropriate time, the currently very high degree of monetary stimulus. Sounds a bit like Samuel Beckett's Waiting for Godot.

Next: The Fed's extraordinary Section 13 (3) programs

Henry C K Liu is chairman of a New York-based private investment group. His website is at http://www.henryckliu.com.

Copyright 2010 Asia Times Online (Holdings) Ltd.

http://www.atimes.com/atimes/Global_Eco ... 1Dj01.html

THE POST-CRISIS OUTLOOK - Part 4
Fed's double-edged rescue


Henry C K Liu
Asia Times
April 23, 2010


This is the fourth article in a series.

Part 1: The crisis of wealth destruction
Part 2: Banks in crisis: 1929 and 2007
Part 3: The Fed's no-exit strategy


During the financial crisis that started in late 2007, the US Federal Reserve resorted to extraordinary meta-monetary measures. On March 11, 2008, the Fed announced an expansion of its securities lending program and arranged the Term Security Lending Facility (TSLF) to provide secured loans collateralized with Treasury securities to the 18 primary dealers for 28-day terms.

On the same day, the Federal Open Market Committee (FOMC) authorized increases in its existing temporary reciprocal currency arrangements (swap lines) with the European Central Bank (ECB) and the Swiss National Bank (SNB). These arrangements would now provide dollars in amounts of up to US$30 billion and $6 billion to the ECB and the SNB, respectively, representing increases of $10 billion and $2 billion. The FOMC extended the term of these swap lines through September 30, 2008

Under this new TSLF, the Fed would lend up to $200 billion of Treasury securities to primary dealers secured for a term of 28 days (rather than overnight, as in the existing program) by a pledge of other securities, including federal agency debt, federal agency residential-mortgage-backed securities (MBS), and non-agency AAA/Aaa-rated private-label residential MBS. The TSLF was intended to promote liquidity in the financing markets for Treasury and other collateral and thus to foster the functioning of financial markets more generally. As was the case with the then current securities lending program, securities would be made available through an auction process. Auctions were held on a weekly basis, beginning on March 27, 2008. The Fed consulted with primary dealers on technical design features of the TSLF to fit their funding needs.

TSLF was a weekly loan facility that promoted liquidity in Treasury and other supposedly high-rated collateral markets and thus fostered the functioning of financial markets more generally. The program offered Treasury securities held by the System Open Market Account (SOMA) for loan over a one-month term against other program-eligible general collateral.

Yet the qualifying credit ratings of the acceptable collaterals were mostly based on mark-to-model, since primary dealers holding of high-rated collaterals mark-to-market had no need to borrow from TSLF. Securities loans were awarded to primary dealers based on a competitive single-price auction. Obviously, primary dealers in deepest stress would bid the highest single-price for loans.

The first TSLF auction was conducted on March 27, 2008. The TSLF was closed almost two years later on February 1, 2010, but the Fed said it may resume if market conditions warrant. By market conditions, the Fed meant when a gap again develops between mark-to-market values and mark-to-model values that creates distress for primary dealers. Thus TSLF was really a facility to support primary dealers on more than liquidity distress.

The SOMA Securities Lending program offers specific Treasury securities held by SOMA for loan against Treasury GC (general collateral repos) on an overnight basis. Dealers bid competitively in a multiple-price auction held every day at noon. The TSLF would offer Treasury GC held by SOMA for a 28-day term. Dealers would bid competitively in single-price auctions held weekly and borrowers would pledge program-eligible collateral.

In contrast to the Term Auction Facility (TAF), which offered term funding to depository institutions via a bi-weekly competitive auction, the TSLF offered Treasury GC to the New York Fed's primary dealers in exchange for other program-eligible collateral. The New York Fed term repo operations are designed to temporarily add reserves to the banking system via term repos with the primary dealers. These agreements are cash-for-bond agreements and have an impact on the aggregate level of reserves available in the banking system. The security-for-security lending of the TSLF, however, would have no impact on reserve levels since the loans were collateralized with other securities.

Primary Dealer Credit Facility

On March 16, 2008, invoking authority under the rarely used Section 13(3) of the 1932 Federal Reserve Act, the Fed established temporarily the Primary Dealer Credit Facility (PDCF) to provide allegedly fully secured overnight loans to primary dealers. Primary dealers are banks and securities brokerages that trade in US government securities with the Federal Reserve System. As of September 2008, there were 19 primary dealers. Daily average trading volume in US government securities by primary dealers was approximately $570 billion during 2007. PDCF was an overnight loan facility that provided funding to primary dealers in exchange for any tri-party-eligible collateral and was intended to foster the functioning of financial markets more generally.

PDCF differed from other Fed facilities in the following ways. The Term Auction Facility program offered term funding to depository institutions via a bi-weekly auction, for fixed amounts of credit. The Term Securities Lending Facility was an auction for a fixed amount of lending of Treasury general collateral in exchange for open market operations (OMO)-eligible and investment grade (AAA) corporate securities, municipal securities, mortgage-backed securities, and asset-backed securities.

Fed credit advanced to the primary dealers under the PDCF increased the total amount of bank reserves in the financial system, in much the same way that discount window loans do. To offset this increase, the OMO desk utilized a number of tools, including, but not necessarily limited to, outright sales of Treasury securities, reverse repurchase agreements (reverse repos), redemptions of Treasury securities and changes in the sizes of conventional reverse repo transactions.

But PDCF credit differed from discount window lending to depository institutions in a number of ways. The discount window primary credit facility offers overnight as well as term funding for up to 90 calendar days at the primary credit rate secured by discount window collateral to eligible depository institutions. The primary credit facility at the discount window, as revised by the Federal Reserve in 2003, offered credit to financially sound banks at a rate 100 basis points above the Federal Open Market Committee's target federal funds rate (the primary credit rate).

Primary credit was made available to depository institutions at an above-market rate but with very few administrative restrictions and no limits on the use of proceeds. Because the interest rate charged on primary credit was above the market price of funds, it replaced the rationing mechanism for obtaining funds from the central bank and eliminated the need for administrative review by the Federal Reserve.

Amid the onset of the liquidity crisis in August 2007, the Federal Reserve lowered the spread between the primary credit rate and the target funds rate from 100 basis points to 50 basis points and extended the maximum term of loans to 30 days.

In March 2008, the Fed once again narrowed the spread, this time to 25 basis points, and extended the loan term to 90 days. The moves were motivated by the desire to make discount window credit more accessible to depository institutions.

The Fed's actions led to an increase in the volume of discount window borrowing during the crisis. While the massive increase in the volume of borrowing supports the argument that the stigma of borrowing had been eliminated, one should be cautious when interpreting this result. Despite the expansion in borrowing, some trades in the funds market took place at rates above the primary credit rate.

Reluctance of banks to borrow from the Fed discount window has several components. The non-price mechanism is the component attributable to the Fed's implementation of discount lending. This component declined significantly after the establishment of the revised facility in 2003.

Meanwhile, a second type of stigma arises from the asymmetric information problems associated with discount window borrowing. Specifically, while most banks borrow from the discount window, the facility is also used by troubled or failing institutions. Because market participants cannot fully differentiate sound from troubled borrowers, they may view borrowing as a potential sign of weakness of any bank that visits the discount window. If this type of stigma increases at the early stages of a financial crisis, when institutions are trying to signal their good health, it could explain the spikes in the funds rate over the primary credit rate. In addition, it is plausible that the capital crunch during the financial crisis left some institutions without sufficient collateral to apply for primary credit loans and thus forced them to bid for higher rates in the federal funds market, which is un-securitized.

The PDCF, by contrast, was an overnight facility available to primary dealers (rather than depository institutions). PDCF expired on February 1, 2010.

Since not all primary dealers are depository institutions, the Fed, to provide credit assistance to them, had to invoke authority under Section 13(3) of the 1932 Federal Reserve Act, as amended by the Banking Act of 1935 and the FDIC Improvement Act of 1991, which permits the Fed to lend to any individual, partnership, or corporation "in unusual and exigent circumstances if the borrower is "unable to secure adequate credit accommodations from other banking institutions".

Section 13(3) was enacted in 1932 out of concern that widespread bank failures would make it impossible for many firms to obtain loans, thus depressing the economy. In the four years after the section was added, the Fed made a total of 123 loans totaling just $1.5 million. Section 13 (3) was not used again until 2008, 76 years later.

In addition to applying Section 13(3) to PDCF, the Fed also invoked it to authorize the New York Fed to lend $29 billion to a newly created special limited liability corporation named Maiden Lane, LLC, to exclusively facilitate the Fed/Treasury-sponsored JPMorgan Chase acquisition of Bear Stearns, which faced imminent insolvency from bad investments in subprime mortgage securities extensively funded by overnight repos that were unable to rollover.

The PDCF and the Maiden Lane loan departed significantly from the Fed's normal practice of lending only to financial sound institutions against top-rated collaterals. The departure was again made when the NY Fed was granted authority to lend to mortgage guarantors Fannie Mae and Freddie Mac to supplement the Treasury's moves to stabilize these government-sponsored enterprises (GSEs). As it turned out, the Treasury had to place both GSEs under conservatorship in September 2008.

Nevertheless, a brave new world of central banking began with these new authorities by the Fed to make unconventional loans against toxic assets. Besides TARP programs, mortgage financiers Fannie Mae and Freddie Mac have received more than $125 billion in federal aid. There is no indication that either firm will be able to repay the government anytime soon, if ever.

In March 2008, JPMorgan Chase had been provided with a $29 billion credit line from the Fed discount window in its purchase of Bear Stearns arranged by the Treasury. In early September, the Treasury seized control of Fannie Mae and Freddie Mac with a $200 billion capital injection against a $4.5 trillion liability, concurrent with another government arranged "shotgun marriage" that induced Bank of America to acquire Merrill Lynch at a fire sale price of $50 billion.

The Henry Paulson-led Treasury had been criticized and had become sensitive to criticism of bailing out private Wall Street firms that should have been allowed to fail from irresponsible market misjudgments, and Treasury secretary Paulson was eager to show that going forward it was not government policy to increase moral hazard.

Lehman bankruptcy

Lehman Brothers' bankruptcy filing on September 15, 2008, was the result of failure of the coordinated efforts by the Ben Bernanke Fed and the Paulson Treasury to find a qualified buyer for the failing firm. At the end, the refusal of the Bank of England to approve the participation of Barclays was a bridge too far in a desperate campaign to save Lehman. Secretary Paulson, sensitive to criticism that he helped to distort markets by bailing out Merrill Lynch, resisted pressure to rescue Lehman. Alan Meltzer, professor of political economy at Carnegie Mellon University and the respected author of A History of the Federal Reserve, argued that allowing Lehman to fail was "a major error that deepened and lengthen the current recession".

Fed chairman Bernanke, while defending the Fed's inaction by citing a technical legal restraint on Fed lending without adequate collateral, which Lehman did not have in relation to its funding needs, admitted on public television afterwards that "Lehman proved that you cannot let a large internationally active firm fail in the middle of a financial crisis".

He might as well have added you also cannot bailout a large internationally active firm without long-term effects on market operations with penalties for the economy. By now, it is becoming clear that the difference between government bailouts and no-bailouts is not different levels of economic pain, but how the pain will be borne over time and by whom - those who were responsible for the crisis, or innocent taxpayers. Once those responsible for the crisis are allowed to escape with no penalty, no reform can prevent replays of the crisis.

Within hours of the Lehman bankruptcy filing, the Fed was confronted with the imminent failure of the American International Group (AIG) from exposure to the failure of the subprime mortgage market through its underwriting of credit default swaps insurance and other derivative contracts and portfolio holdings of mortgage-backed securities. All concerns of moral hazard went out the window as the Fed and Treasury panicked and opened the door to save dysfunctional market capitalism by replacing it with state capitalism. The pain was relieved by putting the patient in a coma.

AIG bailout

Determining that AIG was too big to fail, the Federal Reserve Board on September 16 announced that "in current circumstances, a disorderly failure of AIG could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth and materially weaker economic performance", to justify invoking Section 13(3) of the Federal Reserve Act to make an $85 billion loan to AIG, secured by the assets of AIG and its subsidiaries.

In the course of two days, the Fed took different approaches in dealing with imminent failure of two major institutions, neither of which was a depository institution and therefore not qualified for funding support through the Fed's normal lending programs.

In Lehman, the Fed determined it did not have the legal authority to prevent its failure and also, even if with legal authority, Lehman's net assets were inadequate collateral for its funding needs. The Fed then concentrated on limiting the impact on other financial firms and markets. It was able to protect some large institutions that were counterparties to Lehman positions, but it did nothing to protect the general public around the world who invested in allegedly high-rated Lehman bonds without the benefit of full disclosure.

In AIG, the Fed deemed a rescue to protect the financial system and the economy necessary enough to invoke Section 13(3). The Fed has been widely criticized for not rescuing Lehman when efforts to find a buyer for it failed, allegedly resulting in a deepening and lengthening the consequent recession. Yet the bailout of subsequent distressed firms did not prevent the recession.

Reserve Primary Fund breaks the buck

The Lehman bankruptcy did produce immediate fallouts. On September 16, 2008, one day after the bankruptcy filing, a major money market fund, Reserve Primary Fund, with $62 billion under management, announced that the net asset value of its unit share had fallen below the required $1 level because of losses incurred to the fund's holdings of Lehman commercial paper and medium-term notes. Money market funds are supposed to be super safe. They can yield near-zero returns but they are not supposed to lose principal.

The news of Reserve Primary Fund "breaking the buck" triggered widespread withdrawal from other money market funds, creating a system-wide run on the money markets. This prompted the Treasury to announce a temporary program to guarantee investment in participating money market funds.

The Fed responded to the run of money market funds by again invoking Section 13(3) to establish the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF) to extend non-recourse loan to US depository institutions and bank-holding companies to finance purchases of asset-backed commercial paper from money market mutual funds. A non-recourse loan is ultimately guaranteed only by the collateral pledged for the loan and not other assets of the borrower.

On September 21, 2008, the Fed approved the applications of Goldman Sachs and Morgan Stanley, both non-deposit-taking institutions, to become bank-holding companies and authorized the New York Fed to extend credit to the broke-dealer subsidiaries of both firms.

A few days later, the Fed increased its swap lines with the European Central Bank and several other central banks to supply additional dollar liquidity in the international market.

Yet financial market turmoil continued in the ensuing weeks despite the massive bailout programs. To revive the stalled commercial paper market, the Fed again invoked Section 13(3) to introduce the Commercial Paper Funding Facility (CPFF) on October 7, 2008. This facility provided financing for a special-purpose vehicle established to purchase three-month unsecured and asset-backed commercial paper directly from eligible issuers.

In recent decades, the commercial paper (CP) market has become an important part of the financial system as an alternative source to bank loans for lower-cost short-term financing. In recent years, the CP market has become dominated by financial issuers rather than industrial issuers. Large investors purchase CP directly while small investors purchase through money market mutual funds (MMMFs), which intermediate between large denomination CP and the liquid, small-denomination share issued to retail investors. The CP market is now larger than the Treasury bills market.

Large companies, such as GE, can issue their unsecured CP directly through finance subsidiaries such as GE Capital, or via an agent or dealer known as a single-seller conduit. Small firms, to save costs, prefer to borrow through a multi-seller conduit in which a small firm sells its debt to a bank-advised special purpose vehicle (SPV), which in turn sells asset-backed commercial paper (ABCP) to many investors.

The ABCP SPV purchases the debt, mostly collateralized debt obligations (CDO), at a discount from its face value to maintain an over-collateralization position (a haircut to the seller of the debt) to provide an equity cushion for the investors. CDOs are securitized instruments which derive cash flow from ongoing payments of consumer debt, such as credit-card, car-finance or other installment-payment obligations.

Because the maturity of the CP is shorter than the maturity on the underlying loan, the ABCP conduit will roll over the maturing CP to pay old investors with money from new investors. Liquidity providers will provide funds for a fee in case some CP is not rolled over. To assure investors, additional program-wide credit enhancement in the form of a bank letter of credit at higher interest rate is arranged, but is only drawn upon if needed. Dealers charge clients a fee that is less than one eighth of 1 percentage point, which in 2008 translated into roughly $150 million in daily fees on $120 billion new CP issued daily.

Asset-backed commercial paper

Asset-backed commercial paper is CP with specific assets attached, issued as security by "conduits" that are structured to be bankruptcy remote and limited in purpose. Each conduit includes a special purpose vehicle that is the legal entity at the center of the program and a financial advisor (usually a commercial or investment bank) that manages the program and determines the assets to be purchased and the ABCP to be issued. The owner of the conduit receives nominal dividend payments. Since the SPV does not generally have any employees, fees are paid to an administrator (normally a bank) to manage CP rollovers and the flow of funds.

SPVs, especially the more complex ones, are opaque entities that hold assets undisclosed to the purchaser of their ABCP. For this lack of transparency, ABCP generally yield some 75 basis points more than traditional unsecured CP. The market calculates the spread using rates on AA-rated CP reported in the Fed volume statistics on CP issuance. The spread changes depending on the issue type, financial or non-financial, and maturity chosen.

The spread is a mysterious outcome. Why should CP with specific attached assets as collateral pay a higher yield than CP with only general collateral? Moody's attributed the yield premium to lack of transparency. As financial intermediaries, CP conduits purchased financial assets and issued ABCP under their own name, performing the task of risk and rate spread arbitrage between assets they purchased and the liabilities they issued. To insure against risk, the conduits bought credit default swaps (CDS) from a highly rated insurer such as AIG, which collected profitable fees against defaults that were not expected to happen.

AIG Financial Products (AIGFP), based in London, where the regulatory regime was less restrictive, took advantage of AIG's statute categorization as an insurance company, which meant it was not subject to the same burdensome rules on capital reserves as banks imposed by the Fed or the Federal Deposit Insurance Corporation (FDIC).

AIG would need to set aside only a tiny sliver of capital to insure the super-senior risk tranches of CDOs in its holdings. Nor was AIG likely to face hard questions from its own regulators in New York because AIG Financial Securities Corp (AIGFS), which operated as a subsidiary of AIGFP to offer securities underwriting and brokerage services, had largely fallen through the interagency cracks of oversight. AIGFS operations in the US were regulated by the US Office for Thrift Supervision, whose staff had inadequate expertise in the field of cutting-edge structured finance products.

AIGFP insured bank-held super-senior risk CDOs in the broad CDS market. AIG would earn a relatively trifling fee for providing this coverage - just 0.02 cents for each dollar insured per year. For the buyer of such insurance, the cost is insignificant for the critical benefit, particularly in the financial advantage associated with a good credit rating, which the buyer receives not because the instruments are "safe" but only that the risk was insured by AIGFP. For AIG, with 0.02 cents multiplied a few hundred billion times, it adds up to an appreciable income stream, particularly if no reserves are required to cover the supposedly non-existent risk. Regulators were told by the banks that a way had been found to remove all credit risk from their CDO deals.

Credit default swaps

The Office of the Comptroller of the Currency and the Federal Reserve jointly allowed banks with credit default swaps insurance to keep super-senior risk assets on their books without adding capital because the risk was insured. Normally, if the banks held the super-senior risk on their books, they would need to post capital at 8% of the liability. But capital could be reduced to one-fifth the normal amount (20% of 8%, meaning $160 for every $10,000 of risk on the books) if banks could prove to the regulators that the risk of default on the super-senior portion of the deals was truly negligible, and if the securities being issued via a collateral debt obligation (CDO) structure carried a triple-A credit rating from a "nationally recognized credit rating agency", such as Standard & Poor's rating on AIG.

With CDS insurance, banks then could cut the normal $800 million capital for every $10 billion of corporate loans on their books to just $160 million, meaning banks with CDS insurance can lend up to five times more on the same capital. The CDS-insured CDO deals could then bypass international banking rules on capital.

To correct this bypass was a key reason why the government wanted to conduct stress tests on banks in 2009 to see if banks needed to raise new capital in a downward loss given default. Moody's defines loss given default as the sum of the discounted present values of the periodic interest shortfalls and principal losses experienced by a defaulted tranche. The coupon rate of the tranche is used as the discount rate.

CDS contracts are generally subject to mark-to-market accounting that introduces regular periodic income statements to show balance sheet volatility that would not be present in a regulated insurance contract. Further, the buyer of a CDS does not even need to own the underlying security or other form of credit exposure. In fact, the buyer does not even have to suffer an actual loss from the default event, only a virtual loss would suffice for collection of the insured notional amount.

So, at 0.02 cents to a dollar (1 to 10,000 odds), speculators could place bets to collect astronomical payouts in billions with affordable losses. A $10,000 bet on a CDS default could stand to win $100,000,000 within a year. That was exactly what many hedge funds did because they could recoup all their lost bets even if they only won once in 10,000 years.

As it turns out, many only had to wait a couple of years before winning a huge windfall and driving AIG into insolvency in the process. But until AIG was bailed out by the Fed, these winning hedge funds were not sure they could collect their winnings. Luckily for the winning hedge funds, the Fed, by bailing out AIG, paid them in full. (See False profits and prophecies , Asia Times Online, June 24, 2009).

On October 7, 2008, Section 13(3) was also invoked by the Fed to create the Money Market Investor Funding Facility (MMIFF) under which the Fed offered to provide loans to series of special-purpose vehicles that purchased assets from money market mutual funds and other eligible investors. Special-purpose vehicles were the venue that the likes of Enron and Lehman used to hide liabilities from their balance sheets. (See No exit for emergency nationalization, Asia Times Online, January 23, 2009.)

CitiGroup bailout

Within a month, on November 23, 2008, Citigroup was the next too-big-to-fail institution requiring assistance from the government. The Fed participated with the Treasury and the FDIC in a financial assistance package to provide a non-recourse loan to support a government guarantee of $300 billion of real estate loans and securities held by Citigroup, although the Fed has yet to be called upon by Citigroup to make a loan under the agreement.

Two days later, on November 25, 2008, the Fed again invoked Section 13(3) to create the Term Asset-Backed Security Lending Facility (TALF) under which the New York Fed provided non-recourse loans to holders of triple-A-rated asset-backed securities and recently originated consumer and small business loans. The TALF was launched on March 3, 2009. The types of eligible collateral were subsequently expanded on March 19 and May 19, 2009.

Throughout the autumn of 2008, the Fed approved more large financial firms to become bank holding companies, including American Express, CIT Group, and General Motors Acceptance Corporation (GMAC), which generated some 60% of General Motors revenue by financing car installment purchases and leases, although its main profit in pre-crisis years had been financing subprime mortgages. Despite government help, CIT Group eventually filed bankruptcy protection while GMAC had to be bailed out by the Treasury.

CIT Group, a commercial and consumer finance company, filed for Chapter 11 bankruptcy protection on November 1, 2009, in an effort to restructure its debt while trying to keep loans flowing to thousands of mid-sized and small businesses.

CIT bankruptcy would wipe out current holders of its common and preferred stock, likely meaning the US government and taxpayers would lose the $2.3 billion sunk into CIT in 2008 to prop up the ailing company. Goldman Sachs, however, would gain $1 billion because of CIT's bankruptcy, according to a report published October 2009 by the Financial Times:

The payment stems from the structure of a $3 billion rescue finance package that Goldman extended to CIT on June 6, 2008, about five months before the Treasury bought $2.3 billion in CIT preferred shares to prop it up at the height of the crisis ... While Goldman is entitled to demand the full amount, it is likely to agree to postpone payment on a part of that sum, these people added. A CIT filing last week said that it was in negotiations with Goldman "concerning an amendment to this facility".

The $2.3 billion lost in taxpayer funds in efforts to keep the company afloat was the largest amount lost since the government began infusing banks with capital, according to the Financial Times.

CIT made the filing in New York bankruptcy court on a Sunday, after a debt-exchange offer to bondholders failed. CIT said in a statement that its bondholders overwhelmingly approved a prepackaged reorganization plan which would reduce total debt by $10 billion "while allowing the company to continue to do business to provide funding to our small business and middle market customers, two sectors that remain vitally important to the US economy".

The CIT Chapter 11 bankruptcy filing was one of the biggest in recent US corporate history. Only Lehman Brothers, Washington Mutual, Worldcom and General Motors had more in assets when they filed for protection. CIT's bankruptcy filing showed $71 billion in finance and leasing assets against total debt of $64.9 billion.

CIT said all existing common and preferred stock would be cancelled upon emergence from bankruptcy protection. That would likely include preferred stock from the $2.3 billion in funding from the government's Troubled Asset Relief Program (TARP) the company received in its efforts to stay afloat.

CIT sought a second federal bailout in July 2009 but the request was rejected. It was then able to get a $3 billion loan from bondholders in order to stave off bankruptcy temporarily. It has struggled to find funding as sources it previously relied on, such as short-term debt from the repo market, evaporated during the credit crisis.

CIT had received $4.5 billion in credit from its own lenders and bondholders a week before filing for bankruptcy, reportedly made a deal with Goldman Sachs to lower debt payments, and negotiated a $1 billion line of credit from billionaire investor and bondholder Carl Icahn. But the company failed to convince bondholders to support a debt-exchange offer, a step that would have trimmed at least $5.7 billion from its debt burden and give CIT more time to pay off what it owed.

The bankruptcy filing was bad news for small businesses, many of which looked to CIT for loans to cover expenses at a time when other credit is hard to come by. CIT served as the short-term financier for about 2,000 vendors that supply merchandise to more than 300,000 consumer retail stores.

Oversight panel criticizes Fed handling of GMAC

On March 10, 2010, the Congressional Oversight Panel (COP) under Elizabeth Warren released a new report: "The Unique Treatment of GMAC Under the TARP", which also criticizes the handling of GMAC under TALF.

The Term Asset-Backed Securities Loan Facility (TALF) was the program created by the Fed in November 25, 2008 to support to the market for asset-backed securities, such as those that are backed by auto loans, credit card loans, small business loans, and student loans. TALF was closed on March 31, 2010, for loans backed by all types of collateral except newly issued commercial mortgage-backed securities (CMBS) and scheduled for closure on June 30, 2010, for loans backed by newly issued commercial mortgage-backed securities.

The panel said it remained unconvinced that bankruptcy was not a viable option in 2008. In connection with the Chrysler and GM bankruptcies, Treasury might have been able to orchestrate a strategic bankruptcy for GMAC. This bankruptcy could have preserved GMAC's automotive lending functions while winding down its other, less significant operations dealing with the ongoing liabilities of the mortgage-lending operations and putting the company on sounder economic footing.

The federal government has so far spent $17.2 billion to bail out GMAC and now owns 56.3% of the company. Both GMAC and Treasury insist that the company is solvent and will not require any additional bailout funds, but taxpayers already bear significant exposure to the company, and the Office of Management and Budget (OMB) currently estimates that $6.3 billion or more may never be repaid.

Although the panel took no position on whether the Treasury should have rescued GMAC, it found that the Treasury missed opportunities to increase accountability and better protect taxpayers' money. Treasury did not, for example, condition GMAC access to TARP money on the same sweeping changes that it required from GM and Chrysler: it did not wipe out GMAC's equity holders; nor did it require GMAC to create a viable plan for returning to profitability; nor did it require a detailed, public explanation of how the company would use taxpayer funds to increase consumer lending.

In light of the scale of these potential losses, the panel's report expressed deep concern that the Treasury had not required GMAC to lay out a clear path to viability or a strategy for fully repaying taxpayers. Moving forward, it said, the Treasury should clearly articulate its exit strategy from GMAC. More than a year has elapsed since the government first bailed out GMAC, and it is long past time for taxpayers to have a clear view of the road ahead.

The panel's recommendations include:

Treasury should insist that GMAC produce a viable business plan showing a path toward profitability and a resolution of the problems caused by ResCap, GMAC's mortgage-lending unit .

Treasury should formulate, and clearly articulate, a near-term exit strategy with respect to GMAC and articulate how that exit will or should be coordinated with exit from Treasury's holdings in GM and Chrysler.

To preserve market discipline and protect taxpayer interests, Treasury should go to greater lengths to explain its approach to the treatment of legacy shareholders, in conjunction with both initial and ongoing government assistance.

This fits with the earlier discussions on the stress tests since GMAC was on the "Stress Test 19" - that is, the list of 19 institutions that underwent examination by regulators for financial viability. It probably would have cost the taxpayers far less to have GMAC file bankruptcy than the current situation.

Takeover of government-sponsored enterprises

On September 7, 2008, Treasury officials unveiled an extraordinary takeover of government sponsored enterprises Fannie Mae and Freddie Mac, putting the government in charge of the twin mortgage giants and the $5 trillion in home loans on the GSE's back.

The move, which extended as much as $200 billion in Treasury support to the two companies, marked the government's most dramatic attempt yet to shore up the nation's collapsed housing market to try to stop record foreclosures and falling prices. The sweeping plan, announced by Treasury secretary Henry Paulson and James Lockhart, director of the Federal Housing Finance Agency (FHFA), placed the two government sponsored enterprises into a "conservatorship" to be overseen by the Federal Housing Finance Agency. Under conservatorship, the government would temporarily run Fannie and Freddie until they are on stronger footing.

Fannie and Freddie, which were created by the US government, were badly hurt by the sharp decline in home prices as well as rising mortgage delinquencies and foreclosures. The two firms racked up about $12 billion in losses as the crisis developed from the summer of 2007.

Dividends on both common and preferred shares of Fannie and Freddie were to be eliminated in an effort to conserve about $2 billion annually. All lobbying and political activities by the GSEs were to be halted immediately and charitable activities reviewed.

In addition, the Treasury Department announced a series of moves targeted at providing relief to both housing and financial markets. Paulson said the Treasury would boost housing by purchasing mortgage-backed securities from Fannie and Freddie, as well as offering to lend money to the companies and the 12 Federal Home Loan Banks. The home loan banks advance funds to more than 8,000 member banks. The Treasury, with fellow regulator the FHFA, was also to buy preferred stock in Fannie and Freddie to provide security to the companies' debt holders and bolster housing finance. The government, in agreeing to backstop the firms, said it would receive $1 billion in each company's senior preferred stock. The government was also to receive a quarterly dividend payment and the right to own 79.9% of each company.

Shares of Fannie and Freddie were hammered in the summer of 2008 among concerns they would need to raise additional funds to cover future losses or need to be taken over by the federal regulator. Investors feared that either step would reduce or wipe out the value of current shareholders' stakes.

In mid-July, 2008 the Treasury Department and Federal Reserve announced steps to make funds available to the firms if necessary and congress approved the sweeping proposals later that month. Shortly thereafter, regulators stepped up their review of Fannie and Freddie. Secretary Paulson announced in August that he had tapped Wall Street firm Morgan Stanley to help him examine the firms. Morgan Stanley had determined that both Freddie and Fannie faced "meaningful" capital issues before deciding that government intervention was necessary. Officials ruled out a capital infusion - a less drastic option than convervatorship - after considering questions such as whether the government would have to keep putting money in and how best Treasury officials could protect taxpayers. In the end, the route taken amounted to "a timeout, not a liquidation". Conservatorship left all options open for the administration that would follow the presidential elections that November.

Following an exhaustive review, FHFA's Lockhart said that the two companies could not continue to operate without taking "significant action". Fannie and Freddie had become virtually the only source of funding for banks and other home lenders looking to make home loans. Their ability to do so is crucial to the recovery of the battered home market and the broader US economy.

The two firms buy loans, attach a guarantee, then sell securities backed by the loans' income stream. All told, they own or back $5.4 trillion worth of home debt - half the mortgage debt in the country.

The Treasury-FHFA plan drew praise from regulators, lawmakers and some market experts. President George W Bush called the move "critical" to the housing market recovery. "Americans should be confident that the actions taken today will strengthen our ability to weather the housing correction and are critical to returning the economy to stronger sustained growth in the future," he said.

Fed chairman Ben Bernanke, who along with Paulson led efforts to help get the US housing market and the broader economy back on track, endorsed the move by Lockhart and Paulson. "These necessary steps will help to strengthen the US housing market and promote stability in our financial markets," Bernanke said in a statement.

Democrat Senator Charles Schumer, a member of the Senate Banking Committee, said that Paulson had "threaded the needle just right" with the plan. Pimco's Bill Gross, a widely followed bond fund manager, said the Freddie-Fannie plan was the right move. "This is a significant step and almost exactly what we had hoped for," Gross told CNNMoney.com.

In addition to confirming the government's sovereign credit rating, Standard & Poor's on the news affirmed its sterling AAA rating on both Fannie and Freddie, adding that its outlook for the two firms to be stable.

At first blush, Wall Street seemed encouraged by the news, although the true test came when financial markets around the globe failed to rally. The cost of the government intervention remained unclear. Experts argued that it will depend in large part on the structure of the rescue, the direction of home prices and mortgage default rates. Still it seemed almost certain it would run into the billions and will most likely eclipse such other high-profile government bailouts including the Fed's $29 billion backing of Bear Stearns assets when it was taken over by JPMorgan Chase.

Paulson said that the cost to taxpayers would largely depend on the future financial performance of Fannie and Freddie. But he stopped short of saying that the future appeared rosy. The problem would be handed over to his Democrat successor, Timothy F Geithner.

One concern was the possibly unintended yet unavoidable consequence on the nation's troubled banks. Some of the nation's largest financial institutions, including JPMorgan Chase and Sovereign Bancorp, owned a big chunk of the estimated $36 billion in preferred shares of Fannie and Freddie. Those stakes were at risk of being wiped out.

Top banking regulators, including the Federal Reserve as well as the FDIC, said in a joint statement that a limited number of smaller institutions had significant preferred share holdings in Fannie and Freddie. They added that they were prepared to work with these institutions to come up with a plan should they need to raise capital.

The government rescue of Fannie and Freddie has so far fallen short of its intended aim - bringing stability to the housing market while making it easier for consumers to obtain affordable mortgages. The foreclosure rate has not dropped and home sales have remained stagnant.

The issue of interest rates

After the market closed on Thursday, February 16, 2010, the Fed raised the discount rate, the rate which banks are charged when they borrow from the Fed, by 25 basis points to 0.75%, making it 50 to 100 basis points higher than the Fed Funds rate at 0 to 0.25% set 14 months earlier on December 15, 2008.

The Fed took pains to draw attention to the distinction between the discount rate and its target for overnight interbank rates, called the Fed Funds rate, its main monetary policy tool. The Fed Funds rate target remains unchanged near zero percent, while a still fragile US economy strains to gain recovery traction to lower unemployment and to increase consumer demand. The Fed appears powerless in getting banks, which are receiving practically free loans form the Fed, to lend into the market, particularly to small and medium-sized businesses through which most new jobs are expected to be created.

The Fed statement read: "Like the closure of a number of extraordinary credit programs earlier this month, these changes [of the discount rate] are intended as a further normalization of the Federal Reserve's lending facilities. The modifications are not expected to lead to tighter financial conditions for households and businesses and do not signal any change in the outlook for the economy or for monetary policy."

What the Fed statement conveniently left out was that the higher discount rate is also not expected to ease still tight financial conditions for household and businesses. In other words, raising the discount rate is largely an empty gesture to impress the market that the Fed has not forgotten the need to protect the exchange value and purchasing power of the dollar. Yet, historical data suggest that a return to normalcy of Fed lending facilities can only mean a return to the decades of monetary excess represented by the free-money regime of the past two years.

The discount rate is the interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank's lending facility - the discount window. The Federal Reserve Banks offer three discount window programs to depository institutions: primary credit, secondary credit, and seasonal credit, each with its own interest rate. All discount window loans are fully secured.

Under the primary credit discount program, loans are extended for a very short term (usually overnight) to depository institutions in generally sound financial condition. Depository institutions that are not eligible for primary credit may apply for secondary credit to meet short-term liquidity needs or to resolve severe financial difficulties. Seasonal credit is extended to relatively small depository institutions that have recurring intra-year fluctuations in funding needs, such as banks in agricultural or seasonal resort communities.

The discount rate charged for primary credit (the primary credit rate) is set sometimes above and sometimes below the level of short-term market interest rates, depending on the Fed judgment on market conditions. Because primary credit is the Federal Reserve's main discount window program, the Federal Reserve at times uses the term "discount rate" to mean the primary credit rate. The discount rate on secondary credit is generally above the rate on primary credit. The discount rate for seasonal credit is an average of selected market rates.

The term "discount rate", although widely used, is actually an anachronism. Since 1971, Reserve Bank loans to depository institutions have been secured by advances. Interest is computed on an accrual basis and paid to the Fed at the time of loan repayment. The discount rate is important for two reasons: (1) it affects the cost of reserves borrowed from the Federal Reserve, and (2) changes in the rate can be interpreted as an indicator of monetary policy. Increases in the discount rate generally reflect the Federal Reserve's concern over inflationary pressures, while decreases often reflect a concern over economic weakness or, in recent times, deflation.

Discount-window lending, open market operations to effect changes in reserves to set Fed funds rates, and bank reserve requirements are the three main monetary policy tools of the Federal Reserve System. Together, they influence the cost and supply of money and credit, a major component in macroeconomics.

Normally, the discount rate is set lower than the Federal Funds and other money-market interest rates. However, the Fed does not allow banks to borrow at the discount window for profit. Thus, it monitors discount-window and Federal Funds activity to make sure that banks are not borrowing from the Fed in order to lend at a higher rate in the Federal Funds market.

During periods of monetary easing, the spread between the Federal Funds and discount rates may narrow or even disappear briefly because depository institutions have less of a need to borrow reserves in the money market. Under these conditions, the Fed may adjust the discount rate in order to reestablish the accustomed spread.

Discount window loans are granted only after Reserve Banks are convinced that borrowers have fully used reasonably available alternative sources of funds, such as the Federal Funds market and loans from correspondents and other institutional sources. The latter sources include the credit programs that the Federal Home Loan Banks and the Central Liquidity Facility of the National Credit Union Administration provide for their members.

Usually, relatively few depository institutions borrow at the discount window in any one week. Consequently, such lending provides only a small fraction of the banking system's total reserves. All depository institutions that maintain reservable transaction accounts or nonpersonal time deposits are entitled to borrow at the discount window. This includes commercial banks, thrift institutions, and United States branches and agencies of foreign banks.

Prior to the passage of the Depository Institutions Deregulation and Monetary Control Act of 1980, discount window borrowing generally had been restricted to commercial banks that were members of the Federal Reserve System. In the course of the current financial crisis, the Fed has allowed financial firms, such as Goldman Sachs, to declare themselves as bank holding companies to qualify as borrowers at the Fed discount window.

Changes in the discount rate generally have been infrequent. In the decades from 1980 through 1990, for example, there were 29 discount rate changes, and the duration of the periods between adjustments ranged from two weeks to 22 months. However, following those 22 months without a change, the Fed cut the discount rate seven times in the period of economic sluggishness from December 1990 to July 1992 - from 7.0% at the start of the period to 3.0% at the end. From May 1994 to February 1995, when the Fed was concerned about the threat of inflation, it raised the discount rate four times - from 3.0 to 5.25%.

Changes in the discount rate often lag changes in market rates. Thus, even though the Fed pushed the Fed Funds rate down 25 basis points in July 1995, as of December that same year it had not cut the discount rate. Since 1980, the changes in the discount rate have been by either 50 or 100 basis points (one half or a full percentage point), although mostly quarter-point changes were made in earlier years. This reflects the insensitivity of the money market to discount rate levels. The lowest discount rate charged by the New York Fed was 0.5%, which was in effect from 1942 through 1946; the highest rate was 14%, which lasted from May to November 1981 when the Fed Funds rate was at 20%.

Starting in mid-July 1971, the discount rate had been set below the Fed Funds rate, with a spread of 300 basis points on August 13, 1973 at 7.5% against a Fed Funds rate at 10.5%.

On February 4, 1975, the Fed reversed the pattern to set the discount rate at 6.75%, 50 basis points above the Fed Funds rate target at 6.5%. Generally, when the discount rate is set above the Fed Funds rate target, the Fed is punishing banks that borrow from the discount level, with the aim of slowing the supply of high-power money from the Fed.

On August 29, 1977, the Fed again reversed the pattern to set the discount rate at 5.75%, 25 basis points below the Fed Funds rate at 6%. The pattern was reversed again on May 28, 1980, with the discount rate set at 12%, 225 basis points above the Fed Funds rate at 9.75%, until September 25 in the same year, when the discount rate was set at 11%, 100 basis points below the Fed Funds rate at 12%. Since January 25, 2003, when the Federal Reserve System implemented a "penalty" discount rate policy, the discount rate has been about 1 percentage point, or 100 basis points, above the effective (market) Fed Funds rate.

This history showed the high volatility of the money supply and the unusual swing of the Fed's intervention in market interest rates. This was a departure form the Fed's traditional preference for gradualism in interest rate fluctuation. It told the market that the Fed was repeatedly over-compensating its earlier overcompensation to produce damagingly high volatility in the money supply.

Discount rates are established by the boards of directors of each of the six Reserve Banks, subject to the review and determination of the board of governors of the Federal Reserve System. The discount rates for the three lending programs are the same across all Reserve Banks except on days around a change in the rate. The discount rate is not set by the Fed Open Market Committee (FOMC), which has the authority to set the Fed Funds rate target to be implemented exclusively by the New York Fed through buying and selling treasury instruments in the repo market. The other 11 regional Reserve Banks do not participate in open market operations.

The Fed does not set interest rates directly. The FOMC sets targets and the Federal Reserve Bank of New York estimate money supply targets needed to hit those goals by participating in the repo market. (See The repo time bomb, Asia Times Online, September 25, 2005, and Repo time bomb redux, Asia Times Online, December 5, 2009.) The repo market has been a major source of short-term funds for financing long-term investments. In recent years, it has also become the legal channel to masking institution risk exposure by moving liabilities off balance sheet to categorizing the repo transactions as sales rather than collateralized loans.

The Federal Reserve is unlikely to make any big changes to its monetary policy stance in the near-term future, though there is a chance it could make some alterations to its provision of liquidity. The Fed is likely to keep the key line of its policy guidance - in which it says it expects to keep rates at "exceptionally low levels" for an "extended period" - unchanged.

However, the Fed expectedly announced a decision to increase the discount rate at which the Fed makes emergency loans to banks, coupled with reaffirmation from the Federal Reserve Board that it would shut down many emergency liquidity programs on February 1, 2010. This move would tighten financial conditions slightly at the margin, but it should not be mistaken for a tightening of monetary policy.

As the crisis ebbs, the Fed is borrowing a page from the European Central Bank, which draws a sharp distinction between monetary policy and liquidity policy, through a so-called "separation principle". The Fed viewed this distinction as problematic mid-crisis but now it appears to believe it has relevance to the exit process. With financial markets once again buoyant but the US economy still burdened with high unemployment, normalizing monetary policy and liquidity policy can be expected to proceed at differing pace.

The approach of the unified end of the financial year caused the Fed to defer action on liquidity into 2010, which will be the first time the former investment banks that became banking holding companies and the regular deposit-taking banks share the same December 31 year-end, making it impossible for them to shift illiquid assets back and forth to show strong year-end positions. Against that accounting convergence, there are more than $1 trillion excess reserves in the system to smooth over year-end liquidity stress.

The Fed amended its key guidance on the outlook for interest rates for the first time since March 2009. It added that the conditions on which this guidance - commonly understood to mean rates near zero for at least the next six months - is based. Implicitly in doing so it indicated what might lead to rate hikes within the six-month period.

Rather than change this template, the Fed is likely to update its discussion of the economy in ways that refer to the conditions. However, the Fed will probably retain its assessment that inflation is moderate and inflation expectations stable.

Fed hawks and doves had been resting on a quiet truce in 2009 while positioning themselves for a fight in mid-2010. With unemployment still high, and congress turning hostile towards the Fed, the interest rate hawks are putting on their deficit hawk masks. Yet excess capacity does not automatically translate into lowering of prices, as firms are forced to raise prices for price-insensitive customers to offset loss of revenue from price-sensitive customers. The result is stagflation.

The risk factors that could force an earlier battle on interest rates between hawks and doves have remained subdued. The dollar's exchange rate has improved from the sovereign debt crisis in the European Union and commodity prices have stabilized. Many policymakers are paying attention to asset prices and some are uneasy that interest rate guidance is feeding speculative trades. But there is a widespread preference for using regulatory tools rather than interest rates in the first instance to curb any emerging speculative excesses.

Going forward, the Fed's extraordinary Section 13 (3) programs will pose a formidable challenge to the Fed's exit strategy. The economy may have to limp along with government help for a whole decade.

Next: Public debt, fiscal deficit and sovereign insolvency

Henry C K Liu is chairman of a New York-based private investment group. His website is at http://www.henryckliu.com

Copyright 2010 Asia Times Online (Holdings) Ltd.

http://www.atimes.com/atimes/Global_Eco ... 3Dj02.html

THE POST-CRISIS OUTLOOK - Part 5
Too big to save


By Henry CK Liu
Asia Times
April 30, 2010


This is the fifth article in a series.

Part 1: The crisis of wealth destruction
Part 2: Banks in crisis: 1929 and 2007
Part 3: The Fed's no-exit strategy
Part 4: Fed's double-edged rescue


It is sometimes said that war's legitimate child is revolution and war's bastard child is inflation. World War I was no exception. The conflict heralded the emergence of social democracy as a legitimate political institution to replace monarchism in the Europe. Among the underdeveloped colonial economies of the world, communism emerged to replace Western imperialistic colonialism.

In Europe, socialism was the platform on which democracy flowered. Outside of Europe, in the colonized world, communism was the platform on which nationalism gained state power from the feudal elite who had become compradors of Western capitalism. Nationalistic communism was the political weapon with which the oppressed masses used to combat Western colonialism.

As a result of World War I, two of the world's great nations, Russia and China, found communism to be the effective vehicle for creating a new society to carry out the revival of their past glory and to launch a new historical socio-economic-political development. But in China, Western imperialism continued to dominated the weakened nation even after the decrepit feudal monarchy was overthrown in 1911 by a social democratic revolution to establish a republic patterned after US president Abraham Lincoln's ideal of government of the people, by the people and for the people, and even as the imperialistic West evolved into liberal social democracy at home. Western imperialism continued in republican China for 38 years until Chinese communists gained state power in 1949, four years after World War II ended in Asia.

Six decades after the founding of the People's Republic of China, communism failed in the Soviet Union in 1991, while communism with Chinese characteristics continues to prosper in China. The reason Chinese communism has not failed is because socialist concepts have always been operative throughout Chinese history and the import of Marxism from the West did not replace Chinese socio-political culture of communal harmony derived from prescribed social rites and hierarchical relations.

Chinese culture has always placed community at its core, in contrast to Western post-Reformation culture of centering on individualism. The Confucian philosopher Mencius (372-289 BCE) warned that a nation that operates by profit motives will endanger its own wellbeing; a better foundation would be renyi, a Chinese concept with no exact counterpart in the West, loosely translated as observance of proper human relationship, support for justice, fidelity and humanity, as embodied in the socialist ideal. Marxism merely adds a contemporary dimension to indigenous Chinese socialist philosophy of renyi that enables China to interact with the expansionist capitalism of the West and to effectively repulse Western imperialism and resist neoliberalism.

The post-Civil War Populist movement

The Civil War was not followed by a union of mutual fraternal forgiveness and reconciliation, as Lincoln had hoped by his speech: "With malice toward none; and charity for all." The victorious North treated the defeated South as a conquered territory more harshly than the victorious US treated defeated Germany and Japan after World War II. Rather than reconstructing the war damaged South, Northerners were bent on reconstructing Southern institutions to keep the South from ever again considering rebellion.

The North was undeniably the aggressor, a role clearly evidenced by the fact that all of the fighting was on Southern territory. As a result, the Southern economy was destroyed by war while the Northern economy industrialized and prospered from war production. War debts issued by the Confederacy became worthless after the war. Not a single bank in the South was solvent as Southern savings had been spent on financing the war. After the conflict, the Federal Treasury ordered the confiscation of Confederate government property but refused to assume its war debts. Corrupt Northern agents looted the South indiscriminately. In contrast, Northern war debts were honored by taxing the whole economy, including the South.

Two years into the Civil War, Congress passed the National Banking Act in 1863. While its immediate purpose was to sell war bonds to finance military costs for the North, it served also to create a national paper currency. Banks that bought war bonds equaling up to one third of their capital were invited to apply for federal charter. Since the Jacksonian period, bank supervision was the province of the states. In 1860, more than 1,500 banks issued bank notes, many of which were accepted only with high discounts.

The new banking regime was far from perfect. The currency it provided was insufficiently elastic for the needs of the expanding economy. As the federal government redeemed it war bonds after the war, the quantity of money in circulation decreased, causing deflation that created hardship for debtors, such as Southern and Western farmers. Also, money capital tended to be concentrated in the Northeast. The farming regions in the South and the West continued to suffer from a chronic scarcity of cash and credit. This situation continued until the establishment of a central bank in 1913, in the form of the Federal Reserve.

The one remaining asset the South still possessed was the fertility of its soil. There was hope that economic recovery could begin with the first harvest of the cotton crop. But large-scale cotton production was not possible until the financial system was restored and the liberated former slaves return to work as paid labor. Hundred of thousands of former slaves had joined the Northern army and were informed that they were freed by the Civil War. They now wandered aimlessly in the North and the new territories in the West. They had interpreted the new freedom to mean they no longer had to work for their former masters. Many were disappointed that their expectation that the Union government would grant them free land to farm for themselves was mere fantasy. Illiterate and totally unprepared for survival as independent workers, many died of starvation and homeless exposure in the cold early spring of 1865 in the North.

In March, the Federal government set up the Freedmen's Bureau to provide food, shelter and medical attention to the indigent, but did not provide job opportunities for workers. White workers in the North did not want competition from Southern blacks who were willing to work for low wages. Southern attempts to put the former slaves back to work were interpreted by Northern radicals as schemes to restore slavery.

The North was divided on policy towards the South, whether to grant the South its full constitutional state rights or to take measures to prevent the recurrence of sectional conflict and future attempts of secession. The Northern radicals wanted to subdue the South permanently by destroying the traditional power structure of the plantation and by establishing racial equality. Yet while the constitutional States Rights issue was the cause of the secession, it was not the cause for the Civil War. In practice, minority sections in the Northeast, such as New England during the War of 1812, had used state rights arguments to limit federal power.

The reason for the Southern secession was distinctly different from the reason the North had for launching the Civil War. The South by its own statement seceded to maintain the institution of slavery, which was vital to its socioeconomic structure. Official Southern statements placed secession as a legitimate response to the North's violation of the rights of Southerners by excluding them from the new territories, refusing to restore fugitive slaves and threatening the institution of slavery itself.

The North resorted to prevent secession by force to preserve the Union for political and economic reasons, not to abolish slavery, even though its abolition might be the result of the war. Lincoln himself repeatedly made the distinction, and he personally was not an abolitionist. To Northern industrial interests, an independent Confederacy closely linked to Britain would deprive the North of a big part of its protected domestic market.

Congress did not meet until December 1865, nine months after the fighting ended. Until then, reconstruction was under the exclusive control of the executive branch. Andrew Johnson succeeded the assassinated Lincoln in April and continued Lincoln's conciliatory reconstruction program, which was opposed by the Republican Radicals.

Some radicals were ideologues who saw the Civil War as a war to abolish slavery. Other radicals were merely using abolition as a pretext to hold on to Republican political dominance and to strengthen the North's control of the economy. If the South were to be permitted to return to the Union on Lincoln's terms, then the pre-war dominance of the Democratic Party would be restored to win the next election to dislodge Republican control of the federal government.

Northern industries and banks were concerned that the tariff would then be lowered to allow foreign competition. Free trade would allow the South to sell more cotton to Britain and form an economic alliance with British capital to oppose the North. Northerners feared that the national debt held by Northern banks might be repudiated by a Democratic congress controlled by Southern politicians the same way Confederate debt was repudiated by the Republican congress controlled by Northerners. Congress would then be controlled again by the agrarian South and strip the North of all economic benefits of having won the war. Electoral politics required Republican support for enfranchising former slaves in order to win votes in Southern states with large black population.

Still, despite less than pure moral incentives, the Republican radicals pushed through the Fourteenth Amendment to the Constitution on July 9, 1868, a year after the Civil War ended. The amendment provides a broad definition of citizenship, vacating the Supreme Court decision in Dred Scott v Sandford (1857), which had excluded slaves and their descendants from possessing constitutional rights. The relevant question before the court was whether, at the time the constitution was ratified, former slave Scott could have been considered a citizen of any state within the meaning of Article III of the constitution.

According to the court, the authors of the constitution had viewed the "Negro" race as:

beings of an inferior order, and altogether unfit to associate with the white race, either in social or political relations, and so far inferior that they had no rights which the white man was bound to respect.

Thus strict view of the constitution held by Southern Democrats would deny blacks all constitutional and civil rights despite changing conditions. Later, Richard Nixon, as Republican president, co-opted the term and concept to described conservative Republican politics and judicial philosophy.

The amendment's "Due Process Clause" has been used to apply most of the Bill of Rights to the states. This clause has also been used to recognize substantive due process rights, such as parental and marriage rights, and procedural due process rights, which require specific legal steps before a person's right to life, liberty, or property can be infringed.

The amendment's "Equal Protection Clause" requires states to provide equal protection under the law to all people within their jurisdictions. This clause later became the basis for Brown v Board of Education (1954), the Supreme Court decision that precipitated the dismantling of racial segregation in the United States and the Civil Rights Bill of 1964.

The agrarian revolt

By the late 1880s, two decades after the Civil War ended, the small farmers of the South were beginning to organize resistance against the dominance of the landlords and industrialists from the North. The Southern farmers wanted to keep more of the wealth they produced from farming to pay for local schools, roads, and other improvements plus a more democratic political system. Farmer discontent was caused by Northern financial control and exploitation of the Southern farming economy, with manipulation of the commodities market causing cotton prices to fall by half to 5.8 cents per pound during 1894-97.

The National Farmers' Alliance, also known as the Southern Alliance, was formed in Texas in 1875, a decade after the war ended. It grew quickly to a membership of over 3 million. A separate organization, the Colored Farmers' National Alliance, had a membership of over one million. These alliances advocated measures for the benefit of farmers and sought support from Northern industrial workers. A People's (Populist) Party was formed from support of the farmer alliances.

The populist platform of the People's Party demanded a series of reforms designed to break the control of political bosses in municipal politics and to give back to the people effective control of their urban governments. It also aimed at restoring a more equitable economic system through nationalization of the railroads and communication networks, a graduated income tax, shorter work days and work weeks, and a stable currency to ward off inflation that repeatedly outpaced wage increases.

To address the problem of farm credit, the party platform proposed a "sub-treasury" plan by which the government would store non-perishable farm produce in national warehouses and give loans to farmers to whom it belonged up to but not more than 80% of its value. Populism was essentially a resurgence of the spirit of Jeffersonian agrarian democracy that had shaped American ideals and institutions at the founding of the republic.

The currency issue

The issue that aroused the most controversy was that of currency. Southern and Western farmers were convinced that the main reason for the fall of farm prices was the policy of deflation adopted by the federal government after the Civil War to punish Southern debtors. By limiting the quantity of greenbacks and silver dollars, making them redeemable in gold, the Treasury had increased the value of money held by Northern money trusts and correspondingly deflated prices of commodities produced by farmers and miners. Farmers saw the product of their labor decrease in value while their debts to Northern banks increased in value. They felt it unfair that they had to repay the loan they took out earlier when wheat was selling for $1 a bushel with money that could later buy wheat at 60 cents a bushel.

Many homeowners today also feel unfair that they have to repay loans they took out two years earlier, before the onset of the 2007-08 financial crisis, when their homes were selling for $700,000 with money that now can buy the same homes for $300,000.

The Populists demanded an increase in the quantity of money in the form of paper currency or unrestricted coinage of silver at the constant ratio of 16:1. The silver coin proposal received strong support from the silver miners. The Populists were convinced that the maintenance of the gold standard was a conspiracy of international financiers, for whom the Northeastern banks were agents, to impoverish the masses. This attitude was a foundation of isolationist sentiment in the US, particularly in the rural regions of the South, the West and the Middle West.
Today, many borrowers are upset that their pension funds are getting low returns as a result of the Federal Reserve monetary stance of keeping interest rate near zero while the old mortgages taken out two years ago keep rates fixed at high levels. They have strong incentives to default on their mortgage loans.

Populism reduced to a sectional movement

The 1892 election showed US populism reduced to mostly a sectional movement. Democratic candidate Grover Cleveland, having lost the White House in 1888 to Republican Benjamin Harrison despite a popular vote majority but a 168 to 233 loss in electoral votes, recaptured the presidency from Harrison with both a popular vote and electoral majority. People's Party candidate James B Weaver won 1,041,028 popular votes and 22 electoral votes, all from states west of the 95th meridian, with support mostly from Western farmers and miners. Populist appeal to Northern industrial labor was not successful.

The long-term impact was the growth of populist influence within the two major parties. Populist candidates ran on Democratic and Republican tickets. The most notable was John P Altgeld, a German immigrant who became Democratic governor of Illinois, giving the state a progressive administration. Shortly after the 1892 election, the country plunged into a severe and long depression in which unemployment grew to over 4 million, or 18.4%, with double-digit unemployment from 1893 to 1899. (See The Shape of US Populism, Asia Times Online, March 2008. )

Progressivism and the Federal Reserve

The Progressive Movement in US politics emerged during the first decade and a half of the 20th century out of the intellectual and political ferment of final two decades of the 19th century. It was primarily a reform movement represented in national politics by two presidents: Theodore Roosevelt and Woodrow Wilson. Progressives were against the growth of political corruption and a captured government that favored organized wealth at the expense of the general public.

Progressives of this era believed in the ideals of democratic government, individual liberty, the rule of law and the constitutional protection of private property. But they argued that the maintenance of these ideals in the new industrial era required new political procedures and governmental regulations.

Progressives emphasized traditional ethical and humanitarian values of fairness and equal opportunity. Marxist concepts of class struggle were inoperative for US conditions as the concept of class never took hold in US political discourse. American politics revolved around economic issues outside of the class context. Almost all giants of industry in the US had worked their way up as young apprentices from the factory floors or as errand boys for big banks. The American Revolution had cut European imperialism on US soil at its root at the founding of the new nation. Not being a victim of imperialism, the US as a nation did not feel oppressed by capitalism.

Most socialists in the US were later immigrants from Europe who landed in urban ghettos and never experienced first-hand conditions that naturally supported Jeffersonian democracy. In the half century between 1870 and 1920, the US absorbed 26.3 million immigrants, more than three times as much as during the whole of the previous two and a half centuries. After 1890, unlike immigrants who came earlier, who were generally economically self-sufficient and culturally advanced and educated with professional skills, the new immigrants tended to come from the lower classes of less-developed countries of Europe.

A good number of the new immigrants in urban ghettos failed to find the economic liberation they had hoped to be waiting for them in their new home. Some with more financial resources went on to rural areas in Pennsylvania and the Midwest and did better. The successful immigrants, usually ones with education or disciplined drive, qualities the lower classes in the old countries were generally deprived of, provided concrete, albeit token evidence of a classless society in the new land.

Progressives at first were mostly reformers in city politics, as their influence on the national level was limited. Reformer Tom Johnson of Cleveland had made a fortune as a streetcar owner and he became interested in the reform movement through the writings of Henry George. Johnson became mayor of Cleveland in 1901 and served until 1907 to make Cleveland the best governed city in the nation. But despite the efforts of reformists, other big cities such as New York, Chicago and Philadelphia continued to be governed by corrupt political machines.

On the state level, John P Altgeld in Illinois and Hazen S Pingree of Michigan were accomplished reformers. But the champion was Robert M LaFollette of Wisconsin, whose progressive governance came to be known as the Wisconsin idea, which influenced a block of Midwestern farm states that included Iowa, Minnesota, Kansas, Nebraska, and the Dakotas. In New York, Charles Evan Hughes won the governorship based on his investigation as attorney general of corruption in big insurance companies. Hughes' path of political success was followed by Mario Cuomo, Elliot Spitzer and possibly Andrew Cuomo, the present New York State attorney general. Hughes went on to be secretary of state and Chief Justice of the Supreme Court. In New Jersey, Woodrow Wilson went from the governorship to be the 28th President on March 4, 1913.

In the US, the spring of 1910 saw the Progressives winning a major victory in the mid-term election of the William Howard Taft presidency for seats in the House of Representatives. In the election of 1912, Democratic candidate Woodrow Wilson, a leading Progressive intellectual, won the presidency with only 43% of the popular vote, but carried 40 states due to the split of the Republicans between Progressive Theodore Roosevelt and conservative William Howard Taft.

The election also marked the greatest relative strength achieved by socialism in US political history. Socialist candidate Eugene Debs received 6% of the vote, a record not since reached by other socialist candidates. During the Cold War, socialists were officially viewed in the US as national security risks.

While Progressives wanted to reform the political regime by having government assume broader responsibility for economic affairs, they differed in how this objective could be achieved. One group as represented by Theodore Roosevelt accepted the growth of big corporation was an inevitable economic trend and that government should regulate them rather than dissolve them. Another group as represented by Woodrow Wilson laid more emphasis on prohibiting monopoly, protecting small businesses and promoting and enforcing competition and nurturing innovation. The fundamental question harks back to the Jefferson-Hamilton dispute and later in the debate over the New Deals and today on the direction of regulatory reform to prevent future financial crises.

The rise of Muckrakers, a derogatory name given to investigative journalists and reform writers by Teddy Roosevelt at one of his frequent moments of irritation, helped to drive the progressive movement. Henry Demarest Lloyd wrote in 1894 a fierce denunciation of trusts in Wealth Against Common Wealth. The popular low-price McClure's magazine ran "The Shame of the Cities" (1902), an expose on corruption in city government, "The Struggle for Self-Government" (1906) and "The Traitor State", which criticized New Jersey for patronizing incorporation, all by editor/writer Lincoln Steffens, and Ida Tarbell's articles that later was published as History of the Standard Oil. Upton Sinclair's The Jungle (1906), a report of the meat-packing industry was influential in enabling the reformers to bring about the Meat Inspection Act of 1906.

In his first term as president, Wilson helped persuade a Democratic Congress to pass the Federal Reserve Act of 1913, the Clayton Antitrust Act and the Federal Farm Loan Act. Wilson also established the Federal Trade Commission. Wilson signed the first-ever federal progressive income tax into law in the Revenue Act of 1913 to make up for revenue lost by the reduction of tariffs.

A Northern progressive Democrat, Wilson nevertheless brought many white Southern Democrats into his administration, and tolerated their expansion of segregation in many federal agencies and in Washington DC, a practice later forbidden by the Civil Rights Act of 1964, a legislation introduced by Democratic president John F Kennedy in his civil rights speech of June 11, 1963, in which he asked for legislation "giving all Americans the right to be served in facilities which are open to the public - hotels, restaurants, theaters, retail stores, and similar establishments," as well as "greater protection for the right to vote". President Lyndon B Johnson signed it into law in 1964.

The US military was segregated until after World War II when Harry S Truman signed an executive order to desegregate the army, but actual integration did not take place until the Korean War after the segregated Eighth Army suffered a disastrous setback and the field commander, in desperate need for replacements, accepted black soldiers to fight along side white ones. In the US Navy, first lady Eleanor Roosevelt's push for an integrated navy was ridiculed by navy brass as "Eleanor's folly".

The 1964 Civil Rights Act emulated the Civil Rights Act of 1875, which was introduced by Republican Senator Charles Sumner and Republican Congressman Benjamin M Butler, and signed into law of Republican president Grant but declared unconstitutional by the Supreme Court in 1883.

The first presidential task Wilson presented to congress was a revision of the high tariff policy. Yet it was not a move towards globalization. Wilson sought to use foreign competition to break up US big business from its monopolistic hold on the economy.

The Republicans in Congress passed the Morrill Tariff Act, which was signed into law by Democrat James Buchanan in March 1861, a few days before Abraham Lincoln took office. The Act marked the first increase in tariffs since 1842. During the war, there were further rises in ad valorem import duties, with the average reaching 47%. The primary purpose was to raise revenue for war spending, but the high tariffs also protected domestic industry from superior foreign competition. Domestic industries succeeded in keeping tariffs high after the war even though government revenue was no long an issue. Throughout most of its economic history, the US benefited from protectionism until the US economy became a dominant power. Free trade was not decidedly a US policy until after World War II.

The Underwood Tariff became law in October 1913, eliminating import duties on more than 100 articles and reducing the average rate of more than 1,000 others to 27% from 37%. In order to compensate for the loss of federal revenue from tariffs, an income tax was introduced. The constitutionality of an income tax had been recently authorized by the Seventeenth Amendment passed by the senate on June 12, 1911, and by the House of Representatives on May 13, 1912. It was ratified by the states by April 8, 1913.

However, the anticipated economic effect of the tariff reduction on US competitiveness could not be assessed by actual data because international trade was disrupted by the outbreak of World War I in 1914. War monopoly strengthened the US economy in manners that free-market competition could not.

The open and reform policy introduced by Deng Xiaoping in China in 1978 also included in large measure the objective of using foreign capital from advanced Western economies to break up the stagnant monopoly enjoyed by inefficient state-owned-enterprises operating under uninspired management in the context of socialist central planning, as the government struggled to revive a backward economy greatly weakened by three decades of US embargo following a century of Western imperialistic exploitation.

Over a span of three decades since 1978, the open and reform policy succeeded in energizing the Chinese socialist economy. Yet it has unleashed a host of collateral socioeconomic problems such as income disparity, developmental imbalances and environmental deterioration that may take subsequent leaders decades to correct. The current global financial crisis in market economies is also causing China to reexamine its blind rush towards a market economy.

President Woodrow Wilson fundamentally altered the monetary system of the US by establishing the Federal Reserve System when he signed into law the passage by congress of the Glass-Owen Federal Reserve Act of 1913. The main objective of establishing a central bank was to provide monetary elasticity in support of a growing economy. Prior to the establishment of the central bank, the system set up by the National Bank Act of 1863 left the money supply tied to the amount of government bonds held by banks, with no direct relationship to the monetary needs of the economy. A central bank was expected to manage the money supply to serve the needs of the economy and to control inflation by setting interest rates.

Monetary reform had long been demanded by farmers who saw the National Bank Act of 1863 as having failed to protect their interests by allowing Northeastern banks a) to keep money scarce when farmers needed loans to finance their spring planting, by keeping interest rates high in the farm belts in the South and West, and b) to keep money scarce in autumn when farmers brought their harvest to market, to keep farm produce prices low. In between, banks would ease the money supply so that general inflation would eat away the purchasing power of the sales proceeds of farm produce.

Farmers wanted a central bank not controlled by the private bankers in the Northeast along Hamiltonian lines but controlled by government along Jacksonian populist tradition, and decentralized away from the money elite of the Northeast.

Wilson set up 12 regional Reserve Banks to balance regional interests and to serve seasonal needs, to be supervised by a Federal Reserve Board in Washington in the context of a national monetary policy.

One of the outcomes of government bailout of big banks in the current financial crisis that started in 2007 may be that a large number of the more than 8,000 small community banks will be absorbed by four super banks. JPMorgan Chase is now, in 2010, reportedly holding more than $1 of every $10 on deposit in the US. The four biggest super banks (JPMorgan Chase, Bank of America, Wells Fargo and Citibank) now issue one of every two mortgages and about two of every three credit cards in the US.

Since the financial crisis began in mid-2007, these four super banks have been allowed each to hold more than 10% of the nation's deposits, having been exempted from a longstanding rule barring such market dominance by any one single bank. In several metropolitan regions, these new super banks are now permitted to take market share beyond what the Department of Justice's antitrust guidelines previously allowed.

The American banking system is now one of a handful of large global conglomerate of hedge funds pretending to be banks, taking huge profit from high-risk proprietary trades with government-backed money, instead of a bank being one of a network of small conservative local institutions serving their domicile communities merely as intermediaries of money through local deposits for nominal fees. In 2009, the 10 largest banks in the US accounted for 60% of all banking assets, up from 26% 20 years ago.

Progressive are promoting the break-up of big banks as institutions that serve no good social purpose and to prevent big banks from exploiting the too-big-to fail syndrome to hold the economy and tax payer hostage.

Latest Federal Deposit Insurance Corp data reveal that the new super banks now can borrow more cheaply than their smaller peers because creditors assume these too-big-to-fail institutions to be failsafe. This trend will leave the financial market dominated by a gigantic trust of interlocking super banks.

Such a concentration of market share will hurt consumers in two ways. It will keep the cost of credit high to borrowers for lack of competition even when the cost of funds for banks remains artificially low. It will also force regulators to push bank reserves upward, to force banks to pass on the cost to borrowers. Worse, such a gigantic monopolistic trust of large interlocking super banks will lead to a financial structure too big to save without voiding the normal characteristics of a market economy.

Next: Public debt and other issues

Henry C K Liu is chairman of a New York-based private investment group. His website is at http://www.henryckliu.com.

Copyright 2010 Asia Times Online (Holdings) Ltd.

http://www.atimes.com/atimes/Global_Eco ... 0Dj03.html

THE POST-CRISIS OUTLOOK - Part 6
Public debt - prudence and folly


By Henry C K Liu
Asia Times
May 7, 2010


This is the sixth article in a series.

Part 1: The crisis of wealth destruction
Part 2: Banks in crisis: 1929 and 2007
Part 3: The Fed's no-exit strategy
Part 4: Fed's double-edged rescue
Part 5: Too big to save


Much noise has recently been made by fiscal hawks about the danger of high fiscal deficits and national debts. Yet the purported danger comes not from the size of the deficits or debt, but on how the proceeds from them are used. In recent decades, the US economy has suffered from such proceeds being spent on programs that were not conducive to sustainable economic growth or constructive to economic health.

During the course of World War I, US national debt multiplied 27 times to finance the nation’s participation in war, from $1 billion to $27 billion. The US military drafted 4 million men and sent more than a million soldiers to France, solving the domestic unemployment problem overnight plus putting women into factories and creating a sharp rise in aggregate demand as troops had to be supported at a level of consumption exponentially higher than civilians could through market forces in peacetime. War was a blessing to the US economy as military demand put US industries humming at full capacity while the homeland was exempted from war damage.

Far from ruining the US economy, war production financed by public debt catapulted the country into the front ranks of the world’s leading economic and financial powers, because the US homeland was not affected by war damage and civilian consumption was curbed in the name of patriotism. The national debt turned out to be a blessing, because a good supply of government securities provided for a vibrant credit market and public sector spending created the rise in demand that private companies could satisfy profitably with a guaranteed market.

The truth is that the positive economic functionality of the national debt rests not so much on its level, high or low, but on how the debt is expended. When the national debt is use to expand economic production with full employment and rising wages, it will produce positive economic effects. But if the national debt is used to finance speculative profits achieved through pushing down wages via cross-border wage arbitrage, or to structure ballooning interest payments to service old debts by assuming more new debts, it will eventually drag the economy to a grinding halt by a crisis of debt implosion.

World War I raised the federal debt to about 34.5% of GDP. Nine decades later. In March 2009, the Congressional Budget Office (CBO) estimated that US gross debt will rise to 101% in 2012 from 70.2% of GDP in 2008, while the economy is expected to stay in open-ended recession with unacceptably high unemployment at over 10%. The difference is that in 1919 the federal debt was used to finance war production while in 2012 the public debt is expended to refinance the speculative debt bubble.

Less that a decade after World War I, by 1928, US gross debt fell to $18.5 billion, but the money so released was absorbed mostly by speculative profit to cause the market crash in 1929. In 1930, a year after the crash, US gross debt fell further to $16.2 billion under president Herbert Hoover's balanced budget and the Federal Reserve's tight money policy under chairman Roy Archibald Young.

During Young's term as Fed chairman there was confrontation between the Federal Reserve Board and the Federal Reserve Bank of New York under George L Harrison of how to curb speculation that led, inter alia, to the stock market boom of the late 1920s. The board was in favor of putting "direct pressure" on the lending member banks while the Federal Reserve Bank of New York wanted to raise the discount rate. The board under Young disapproved this step; however Young himself was not fully convinced that the policy of using pressure would work and refused to sign the 1929 annual report of the board because it contained parts favorable to this policy.

Eugene Isaac Meyer was appointed by Herbert Hoover to be chairman of the Fed on September 16, 1930. Meyer strongly supported government relief measures to counter the effects of the Great Depression, taking on an additional post as chief of the Reconstruction Finance Corporation (RFC), modeled after the War Finance Corporation of World War I.

The RFC gave $2 billion in aid to state and local governments and made loans to banks, railroads, farm mortgage associations, and other businesses. The loans were nearly all repaid after the Depression. RFC was continued by the New Deal and played a major role in containing the Great Depression and setting up the relief programs that were taken over by the New Deal in 1933.

Upon Franklin D Roosevelt's inauguration in 1933, Meyer resigned his government posts. Months later, he bought the Washington Post at a bankrupt auction and turned it into a respected and profitable newspaper. His daughter, Katherine Graham, was publisher of the Washington Post when it exposed the Watergate scandal that led to the resignation of president Richard Nixon on August 9, 1974. Meyer was appointed by president Harry S Truman after World War II to be the first president of the newly formed World Bank.

After the launch of the New Deal in 1933, US gross debt rose to $62.4 billion, at 52.4% of GDP. By 1950, World War II had pushed US gross debt five folds to $356.8 billion but only at 94% of GDP. After 1950, US gross debt fell steadily as a percentage of GDP to a low of 33%, with a nominal value of $909 billion in 1980 under president Jimmy Carter. Since then, US gross debt has not fallen below 56% of GDP. Projected US gross debt for 2012 is $15.7 trillion at 101% of GDP. Much of the debt money in the two years since the credit crisis has ended up in the wrong pockets of distressed financial firm but not those of thee needy public, depriving the US economy of full employment with rising wages to increase aggregate demand.

While US public debt in 1946 reached $300 billion, at 135% of GDP, the post-war years were prosperous one for the US. These data show clearly that it is not the level of the public debt, but how the debt money is spent that determines its impact on the economy.

The issue of the fiscal deficit

The federal fiscal deficit in 1919 was 16.8% of a GDP of $78.3 billion. The wartime federal deficit in 1945 was 24.1% of a GDP of $223 billion. Despite a high fiscal deficit, US GDP kept rising after World War II to $275.2 billion in 1948 with a fiscal surplus equaling 4.3% of GDP. The 2010 Federal deficit is project to be 10.6% of a GDP of $14.6 trillion.

Between 1920 and 1929, the Federal budget had a small surplus, while GDP grew to $103.6 billion in 1929. After the 1929 crash, the 1930 GDP fell $12.4 billion, about 12%, to $91.2 billion, while the Federal budget under Hoover still had a surplus of 1% of GDP.

Franklin D Roosevelt came into office in 1933, when the GDP had fallen by almost half to $56.4 billion, and the Federal deficit jumped to 3.27% of GDP in 1934. All through the New Deal years, the Federal fiscal deficit stayed below 5% with the average annual deficit at around 3% of GDP. It did not rise until after the US entered World War II and peaked at 28.1% in 1943, 22.4% in 1944 and 24.1% in 1945 before falling to 9.1% in 1946 when the GDP was $222.2 billion.

The total federal fiscal deficit for the four years of World War II was about 100% of the average annual GDP of the same period. At the same time, the US grew to be the strongest economy of the world because the fiscal deficit was used to finance war production, not to bail out distressed financial institutions and inefficient industrial firms.

US fiscal deficit for the fiscal year ending September 30, 2009 (FY2009), was more than $1.75 trillion - about 12.3% of GDP, the biggest since 1945. According the White House Budget Office, the cumulative fiscal deficit between FY2009 and FY2019 is projected to be almost $7 trillion. Total gross federal debt in 2008 was $10 trillion, projected to rise to over $23 trillion in 2019. Debt held by the public is projected to rise from $5.8 trillion in 2008 to $15.4 trillion in 2019. Interest expense in 2008 was $383 billion. Projection is expected to rise as both debt principal and interest rate are expected to rise.

The issue of inflation

Inflation is a different story. Moderate inflation is necessary for optimum economic growth, provided the burden of inflation is equally shared by all segments of the population, particularly wage earners. By the end of World War I, in 1919, US prices were rising at the rate of 15% annually, but the economy roared ahead as wages were rising in tandem with or slightly ahead of prices through wage-price control.

Income policies involving wage-price control were employed throughout history from ancient Egypt, to Babylon under Hammurabi, ancient Greece, during the American and French revolutions, the Civil War, World War I and II. A case can be made that that wage-price control has a mixed record as a way to restrain inflation, but it is irrefutable that income policies are effective in balancing supply and demand.

Yet in response to inflation, the Federal Reserve Board raised the discount rate in quick succession in 1919, from 4% to 7%, and kept it there for 18 months to try to rein in inflation by making money more expensive when banks borrowed from the Fed. The result was that in 1921, 506 banks failed.

The current financial crisis started in late-2007 and stabilized around mid-2009 after direct massive Fed intervention. It was by many measures an unprecedented phase in the history of the US banking system. In addition to the systemic stress and the stress faced by the largest investment and commercial banks, 168 depository institutions failed from 2007 through 2009. This was not the largest number of bank failures in one crisis. At the height of the savings and loan (S&L) crisis from 1987 to 1993, 1,858 banks and thrifts failed. However, the dollar value of failed banks assets in the financial crisis in 2007-2009 was $540 billion, roughly 1.5 times the bank assets that failed in the S&L crisis in 1987-1993.

A research paper funded by the Federal Deposit Insurance Corporation (FDIC), on "Bank Failures and the Cost of Systemic Risk: Evidence from 1900-1930", by Paul Kupiec and Carlos Ramireza (July 200 found that bank failures reduce subsequent economic growth. Over this period, a 0.12% (1 standard deviation) increase in the liabilities of the failed depository institutions results in a reduction of 17 percentage points in the growth rate of industrial production and a 4 percentage point decline in real gross national product (GNP) growth. The reductions occur within three quarters of the initial bank failure shock and can be interpreted as a measure of the costs of systemic risk in the banking sector. The FDIC was created by the New Deal only after 1934 to protect depositors.

In the crisis that began in mid-2007, with the discount rate falling steadily to 0.5% on December 16, 2008, from a high of 6.25% set on June 2006, 25 banks failed in 2008 and were taken over by the FDIC, while 140 banks failed in 2009 and 33 failed in just the first two months of 2010, putting the fee-financed FDIC in financial stress. Yet the Fed raised the discount rate to 0.75% on February 19, 2010. In contrast, in the five years prior to 2008, only 11 banks had failed from the debt bubble even when the discount rate stayed within a range from 2% to 6.25%.

Volcker, slayer of the inflation dragon

In the 1980s, to counter stagflation in the US economy, the Fed under Paul Volcker (August 6, 1979 - August 11, 1987), slayer of the inflation dragon, kept the discount rate in the double-digit range from July 20, 1979, to August 27, 1982, peaking at 14% on May 4, 1981. From August 1982 to its peak in August 1987, the Dow Jones Industrial Average (DJIA) grew from 776 to 2,722. The rise in market indices for the 19 largest markets in the world averaged 296% during this period.

Volcker, as chairman of the Fed before Greenspan, caused a "double-dip" recession in 1979-80 and 1981-82 to cure double-digit inflation, in the process bringing the unemployment rate into double digits for the first time since 1940. Volcker then piloted the economy through its slow, long recovery that ended with the 1987 crash. To his credit, Volcker did manage to bring unemployment below 5.5%, half a point lower than during the 1978-79 boom, and the acknowledged structural unemployment rate of 6%.

Two months after Volcker left the Fed, to be succeeded by Greenspan, the high interest rate left by Volcker, inter alia, led to Black Monday, October 19, 1987, when stock markets around the world crashed mercilessly, beginning in Hong Kong, spreading west to Tokyo and Europe as markets opened across global time zones, hitting New York only after markets in other time zones had already declined by a significant margin. The DJIA dropped 22.61%, by 508 points, to 1,738.74 on Black Monday 1987.

On October 11, 2007, the DJIA hit a high of 14,198.10. On March 2, 2009, it lost almost 300 points, or 4.2%, to end at 6,763.29, its lowest point since April 25, 1997.

By the end of October 1987, stock markets in Hong Kong had fallen 45.8%, Australia 41.8%, New Zealand 60%, Spain 31%, the United Kingdom 26.4%, the United States 22.68%, and Canada 22.5%. Fundamental assumptions such as market fundamentalism, efficient market hypothesis and market equilibrium were challenged by events. Despite that dismal record in the 1980s, Volcker was appointed by President Barack Obama two decades later, on February 6, 2009, as first chair of the President's Economic Recovery Advisory Board.

The 1987 stock-market crash was unleashed by the sudden collapse of the safety dam of portfolio insurance, a hedging strategy made possible by the new option pricing theory advanced by Nobel laureates Robert C Merton and Myron S Scholes. Institutional investors found it possible to manage risk better by protecting their portfolios from unexpected losses with positions in stock-index futures. Any fall in stock prices could be compensated by selling futures bought when stock prices were higher.

This strategy, while operative for each individual portfolio, actually caused the entire market to collapse from the dynamics of automatic herd-selling of futures. Investors could afford to take greater risks in rising markets because portfolio insurance offered a disciplined way of avoiding risk in declines, albeit only individually. But the reduction in individual risk was achieved by an increase in systemic risk.

As some portfolio insurers sold and market prices fell precipitously, the computer programs of other insurers then triggered further sales, causing further declines that in turn caused the first group of insurers to sell even more shares and so on, in a high-speed downward spiral. This in turn electronically generated other computer-driven sell orders from the same sources, and the market experienced a computer-generated meltdown at high speed.

The unlearned lesson of the 1987 crash

The 1987 crash provided clear empirical evidence of the structural flaw in market fundamentalism, which is the belief that the optimum common welfare is only achievable through a market equilibrium created by the effect of countless individual decisions of all market participants, each seeking to maximize his own private gain through the efficient market hypothesis, and that such market equilibrium should not be distorted by any collective measures in the name of the common good or systemic stability.

Aggregate individual decisions and actions in unorganized unison can and often do turn into systemic crises that are detrimental to the common good. Unregulated free markets can quickly become failed markets. Markets do not simply grow naturally after a spring rain. Markets are artificial constructs designed collectively by key participants who agree to play by certain rules. All markets are planned with the aim of eliminating any characteristic of being free for all operations. Free market is as much a fantasy as free love.

In response to the 1987 crash, the US Federal Reserve under newly installed chairman Greenspan, merely nine weeks in the powerful office, immediately flooded the banking system with new reserves, by having the Fed Open Market Committee (FOMC) buy massive quantities of government securities from the repo market. He announced the day after the crash that the Fed would "serve as a source of liquidity to support the economic and financial system." Greenspan created $12 billion of new bank reserves by buying up government securities from the market, the proceeds from which would enter the banking system.

The $12 billion injection of "high-power money" in one day caused the Fed funds rate to fall by 75 basis points and halted the financial panic. It did not cure the financial problem, which caused the US economy to plunge into a recession that persisted for five subsequent years. Worst of all, the monetarist cure for systemic collapse put the financial world in a pattern of crisis every decade: the 1987 crash, the 1997 Asian financial crisis and the financial crisis of 2007.

High-power money injected into the banking system enables banks to create more bank money through multiple credit-recycling, lending repeatedly the same funds minus the amount of required bank reserves at each turn. At a 10% reserve requirement, $12 billion of new high-power money could generate in theory up to $120 billion of new bank money in the form of recycled bank loans from new deposits by borrowers.

The Brady Commission investigation of the 1987 crash showed that on October 19, 1987, portfolio insurance trades in S&P 500 Index futures and New York Exchange stocks that crashed the market amounted to only $6 billion by a few large traders, out of a market trading total of $42 billion. The Fed's injection of $120 billion was three times the market trading total and 20 times the trades executed by portfolio insurance.

Yet post-mortem analyses of the 1987 crash suggest that though portfolio insurance strategies were designed to be interest-rate-neutral, the declining Fed funds rate was actually causing financial firms that used these strategies globally to lose money from exchange-rate effects. The belated awareness of this effect caused many institutions that had not understood the full dynamics of the strategies to shut down their previously highly profitable bond arbitrage units.

The rise of hedge funds

This move later led to the migratory birth of new, stand-alone hedge funds such as Long Term Capital Management (LTCM), which continued to apply similar highly leveraged strategies for spectacular trading profit of more than 70% returns on equity that eventual led it to the edge of insolvency when Russia unexpectedly defaulted on its dollar bonds in the summer of 1998. The Fed had to orchestrate a private-sector creditor bailout of LTCM to limit systemic damage to the financial markets. The net effect was to extend the liquidity bubble further - causing it to migrate from a distressed sector to a healthy sector.

The 1987 crash reflected a stock-market bubble burst, the liquidity cure for which led to a property bubble that, when it also burst, in turn caused the savings-and-loan (S&L) crisis.

While the 1987 crash was technically induced by program trading, the falling dollar was also a major factor. Although the dollar had started to decline in exchange value by late February 1985, due to US fiscal deficit, that decline had yet to reduce the US trade deficit, causing protectionist sentiment in the US to mount as the trade deficit swelled to an annual rate of $120 billion in the summer of 1985.

The issue of exchange rates

In part to deflect protectionist legislation, US officials arranged a meeting of Group of Five officials at the Plaza Hotel in New York on September 22, 1985, with the purpose of ratifying an initiative to bring about an orderly decline in the dollar, observing that "recent shifts in fundamental economic conditions among their countries, together with policy commitments for the future, have not been fully reflected in exchange markets", and concluded that "further orderly appreciation of the main non-dollar currencies against the dollar is desirable", and that the G-5 members "stand ready to cooperate more closely to encourage this". During the seven weeks following the Plaza Accord, G-5 authorities sold nearly $9 billion, of which the US sold $3.3 billion for other currencies, while speculators profited by shorting the dollar.

The dollar had declined to seven-year lows in early 1987 amid signs of weakness in the US economy while the US trade deficit continued to grow. Demand was sustained not by income but by debt. Public statements by Reagan Administration officials were interpreted in exchange markets as indicating a lack of official concern about the ramifications of further declines in the dollar.

On February 22, 1987, officials of the G-5 plus Canada and Italy met at the Louvre in Paris to announce that the US dollar had fallen enough. But despite heavy intervention purchases of dollars following the Louvre Accord, the dollar continued to decline, particularly against the yen. Market participants perceived delays in the implementation of expansionary fiscal measures in Japan expected after the Louvre Accord, and talks of trade sanctions on some Japanese products heightened concern about tension in US-Japanese trade relations.

Following the Louvre Accord, the G-7 authorities intervened heavily in support of the US dollar throughout the episodes of dollar weakness in 1987, and sold US dollars on several occasions when the currency strengthened significantly. Net official dollar purchases by the G-7 and other major central banks effectively financed more than two-thirds of the $144 billion US current account deficit in 1987. The US share of these purchases was $8.5 billion, and the share of the other G-7 countries was $82 billion, since the non-dollar export-dependent governments wanted desperately to halt the appreciation of their currencies.

Record US trade deficits and market perceptions that the G-7 authorities were pursuing monetary measures best suited to their own separate domestic economic objectives soon sparked a further sell-off of the dollar. This contributed to a worldwide collapse of equity prices which had risen to levels unsupported by fundamentals. The dollar's decline gathered new momentum when the Federal Reserve under its new chairman, Alan Greenspan, moved more aggressively than its foreign counterparts to supply liquidity in the aftermath of the 1987 stock market crash, which had been triggered by program trading on portfolio insurance derivatives arbitraging on macroeconomic instability in exchange rates and interest rates.

Domestic accommodative monetary stance

The Federal Reserve's actions under Greenspan in 1987 led market participants to conclude that the Fed would emphasize domestic market objectives with accommodative monetary stance, if necessary at the cost of a further decline in the dollar. By year-end, the dollar's value had fallen 21% against the yen and 14% against the mark from its levels at the time of the Louvre Accord while Greenspan, the wizard of bubble-land, was on his way to being hailed as the greatest central banker in history. Two decades later, by 2007, the Greenspan put was called by the market and trillions of dollars were lost.

The issue of unemployment

Half a century before 1987, beginning in 1921, deflation had descended on the US economy like a perfect storm from Fed tight monetary policy under chairman Daniel R Grissinger, with farm commodity prices falling 50% from their 1920 peak, throwing farmers into mass bankruptcies. Business activity fell by one-third; manufacturing output fell by 42%; unemployment rose fivefold to 11.9%, adding 4 million to the jobless count.

Since mid-2007, the US has lost more than 6 million jobs, with 4.4 million jobs lost in the first year of the Barack Obama administration. Latest government estimate puts the Great Recession of 2008 as having lost 8.4 million jobs thus far and no more than 1.4 million jobs are expected to be restored by the end of 2010. Unemployment is expected to stay near double-digits for the foreseeable future. If workers who have given up looking for work are also counted, the unemployment rate is close to 14% in 2010.

Some are attempting to put a positive spin on US jobs numbers for February 2010, when the unemployment rate, though still at 9.7%, held steady. The economy shed 36,000 jobs in January, but the good news was that the pace of job loss was moderating. An average of 27,000 jobs was lost each month since November 2009, compared with 727,000 jobs a month on average over the same period in 2008. When the laws of gravity says what goes up must eventually come down, there is no law that say what goes down will eventually come back up. That is how swimmers drown; they float back up only after life has long left the body. Only dead bodies float naturally.

While the unemployment rate is rising more slowly, it seems likely to remain high. And despite the recent policy insistence that the top three priorities are jobs, jobs and jobs, neither congress nor the Obama administration are taking concrete steps to create them quickly beyond the usual lukewarm tax incentives.

By February 2010, 8.4 million jobs had been lost since the financial crisis began in July 2007. The normal 2.7 million jobs needed to absorb new workers coming into the economy were never created, leaving the economy bereft of 11.1 million jobs. To fill that cumulative employment gap while keeping a growing work force fully employed would require more than 400,000 new jobs a month for the next three years, considerably in excess of even the most optimistic projections under current job creation policies and programs. Further, healthcare reform, if it is expected to save costs, will inevitably include a reduction of jobs.

Five states reported new highs for joblessness in January 2010: California, at 12.5%; South Carolina, 12.6%; Florida, 11.9%; North Carolina, 11.1%; and Georgia, 10.4%. Michigan's unemployment rate is still the nation's highest, at 14.3%, followed by Nevada with 13% and Rhode Island at 12.7%. South Carolina and California rounded out the top five.

Employers are unlikely to make new hires until they can profitably restore their current part-time work force to full time. In the private sector, just restoring hours cut during the recession will neutralize the equivalent of 2.8 million new jobs.

Congress is taking its time debating an undersized jobs bill that is not expected to create anywhere near the jobs that the economy needs in 2010. The good news is that during the second half of 2010, the economy will get a temporary, one-time job boost from the taking of the census, which will hire about 1 million minimum-wage temporary workers. The danger is that misleading job statistics will allow both the administration and congress to avoid meaningful job-creation commitments needed for a genuine recovery. Going forward, a jobless recovery has become a given when the recovery finally comes.

The next unemployment trouble will come from the public sector. Without timely and adequate Federal aid, the states and local governments will be forced by falling tax revenue to tighten fiscal budgets, which will mean layoffs and cancelled private contracts, both of which would squeeze demand in the private sector to further reduce local government revenue in a downward spiral.

The Fed's deflationary bias

Back in 1921, when the economy came to a screeching halt, the Fed's monetary ideological perspective was that declining prices were the goal, not the problem; unemployment was necessary to restore US industry to a sound financial footing, freeing it from wage-pushed inflation. Potent medicine always came with a bitter taste, the central bankers explained. The bitterness was assigned to the worker, while the sweet success was kept for capital.

In 1913, farmers supported the establishment of a central bank because they had hoped such an institution would not be controlled by moneyed interests in the Northeast. But their hope was dashed in 1921, when a technical process inadvertently gave the New York Federal Reserve Bank, which was closely allied with internationalist banking interests, preeminent influence over the Federal Reserve Board in Washington, the composition of which had originally represented more balanced national and regional interests.

The initial operation of the Fed did not use the open-market operation of buying or selling government securities as a method of managing the money supply. Money in the banking system was created entirely through the discount window at the regional Federal Reserve banks. Instead of buying or selling government bonds, the regional Feds accepted "real bills" of trade, which when paid off would extinguish money in the banking system, making the money supply self-regulating in accordance with the "real bills" doctrine of money.

The twelve regional Feds bought government securities not to adjust money supply, but to enhance their separate operating positive cash flow by parking idle funds in interest-bearing yet super-safe government securities. While the regional Feds did not need to make a profit, they felt a need to avoid incurring negative cash flow with the effect of inflating the money supply. They viewed their mandate as providing monetary support to their respective regional economies.

Bank economists at the time did not understand that when the regional Feds independently bought government securities, the aggregate effect would result in macro-economic implications of injecting "high power" money into the banking system, with which commercial banks could create more money in multiple by lending/depositing recycles through partial reserve banking regulations.

When the Treasury sold bonds, the reverse would happen. When the Fed made open market transactions, interest rates would rise or fall accordingly in financial markets. And when the regional Feds did not act in unison, the national credit market could become confused or become disaggregated, as one regional Fed might buy while another might sell government securities in its open market operations.

Benjamin Strong, the first president of the New York Federal Reserve Bank, saw the problem and persuaded the other 11 regional Feds to let the New York Fed handle all their transactions in a coordinated manner. The regional Feds agreed to form an Open Market Investment Committee for the purpose of maximizing overall profit for the whole system, being unaware that they were signing away their separate prerogative to support their respective regional economies.

This new committee was dominated by the New York Fed, which was closely linked to big international money-center bank interests, which in turn were closely tied to international financial markets in which the New York banks were also key participants. The Federal Reserve board approved the arrangement without full understanding of its full implication: that the Fed was falling under the undue influence of the New York internationalist bankers who were more interested in the value of the currency than the health of the economy, particularly the regional economies. This fatal flaw would reveal itself in the Fed's role in causing, and its impotence in dealing with, the 1929 crash and all subsequent market crashes.

While the Fed was careful not to expand the money supply, money was created by the rising use of margin in the stock market. The deep 1920-21 depression eventually recovered into the margin-fed speculative Roaring Twenties, which, in many ways similar to the "new economy" debt bubbles of the 1990s and 2000s, left some segments of economy and the population in them lingering in a depressed state amid general prosperity.

Farmers remained victimized by depressed commodity prices, and factory workers shared in the prosperity only by working longer hours and assuming debt with the easy money that the banks provided. Unions lost 30% of their membership because of high unemployment. The prosperity was entirely fueled by the wealth effect of a speculative boom in the stock market that by the end of the decade would face the 1929 crash and land the nation and the world in the Great Depression.

The historical record showed that when New York Fed president Strong leaned on the other 11 regional Feds to ease the discount rate on an already overheated economy in 1927, the Fed lost its last window of opportunity to prevent the 1929 crash. Some historians claimed that Strong did so to fulfill his internationalist vision at the risk of endangering the national interest.

The dangerous influence of Milton Friedman

Milton Friedman, in his widely praised study of the monetary causes of the Great Depression, focused on the role of the Fed by claiming a counterfactual insight that had the Fed responded to the 1929 crash with massive monetary easing, the Depression would have been avoided.

In the decades from 1978 to 2007, Fed chairmen Alan Greenspan and Ben Bernanke, both faithful Friedmanesque doctrinaires, relied on the Friedman monetary cure to postpone the inevitable day of reckoning of debt-fueled speculation, in a market where on top of Fed easing of the money supply, money was being created without limits by the use of high leverage by financial manipulators.

Hedge funds and investment banks were routinely using leverage at 40 to1 (bypassing the regulatory limit of 12 to 1) as an industry standard for structured finance to make bets on minute market movements to produce unsustainably high returns that posed dangerous systemic risk to globalized financial markets.

When money is not backed by gold, its exchange value must be managed by government, more specifically by the monetary policies of the central banks. Yet central bankers in the 1920s tended to be attracted to the gold standard because it can relieve them of the unpleasant and thankless responsibility of unpopular monetary policies to sustain the value of money. Central bankers have been caricatured as party spoilers who take away the punch bowl just when the party gets going.

Yet even a gold standard is based on a fixed value of money to gold, set to reflect the underlying economical conditions at the time of its setting. Therein rests the inescapable need for human judgment. Instead of focusing on the appropriateness of the level of money valuation under changing economic conditions, central banks often become fixated on merely maintaining a previously set exchange rate between money and gold, doing serious damage in the process to any economy out of sync with that fixed rate. Economies that do not produce or possess a flexible supply of gold will be penalized by the inability to vary their money supply to meet the needs of their economies. Central bankers do not understand that the problem is the currency's fixed rate to gold and not the varying monetary needs of a dynamic economy.

When the exchange value of a currency falls, central bankers often feel a personal sense of failure, while they merely shrug their shoulders to refer to natural laws of finance when the economy collapses from an overvalued currency.

But the effectiveness of central bank intervention in the money markets is steadily reduced by the ability of market participants to create money through the extension of credit. The subprime mortgage syndrome was essentially a private-sector money printing press over which the Fed had no control since it ideologically placed faith in the unregulated market's inherent ability to self correct.

While this faith has now been fully discredited, regulatory reform is still stuck the political quicksand of special interest lobbying. More than two years after the outbreak of the global financial crisis, the financial markets are essentially still operating under the same regulations that brought them to a near meltdown.

Next: Global sovereign debt crises

Henry C K Liu is chairman of a New York-based private investment group. His website is at http://www.henryckliu.com.

Copyright 2010 Asia Times Online (Holdings) Ltd.

http://www.atimes.com/atimes/Global_Eco ... 7Dj02.html

THE POST-CRISIS OUTLOOK - Part 7
Global sovereign debt crisis


By Henry C K Liu
Asia Times
May 13, 2010


This is the seventh article in a series.

Part 1: The crisis of wealth destruction
Part 2: Banks in crisis: 1929 and 2007
Part 3: The Fed's no-exit strategy
Part 4: Fed's double-edged rescue
Part 5: Too big to save
Part 6: Public debt - prudence and folly


As a result of government bailouts and stimulus spending in response to the global financial crisis, gross government debts around the world have risen to unprecedented heights by 2010 and are expected to continue on an upward trend for the foreseeable future as recovery remains anemic in many regions in the world. Ironically, the list of countries with high sovereign debt is topped by Japan, notwithstanding Japan's huge foreign
currency reserve and its large export sector and persistent trade surplus.

Japan has been in permanent recession since the 1985 Plaza Accord pushed the exchange value of the yen up against the dollar without any significant effect on US-Japan trade imbalance in Japan's favor. Despite continuing trade surpluses, Japan's gross government debt rose from 170% of GDP in 2007 to nearly 200% in 2010 as the Japanese government revved up spending to stimulate in vain the structurally impaired export economy.

A similar fate will fall on all economies that depend excessively on export for growth as the traditional import markets in the advanced economies such as the United States and the European Union are themselves trapped in anemic growth by excessive debt for decades to come.

Yet the world, led by the US, has continued to waste money on military spending in the middle of a ruinous financial crisis. In 2008, global military spending totaled US$1.5 trillion. The US alone spent $607 billion on defense (41% of world total) while many of its citizens were defenseless against losing their homes through mortgage foreclosure due to falling income.

Stimulus packages dwarfed by military spending

In 2008, congress approved a stimulus package of $819 billion that included regressive tax cuts, with spending to begin in 2009 and to end in 2019. Taking away tax cuts, the spending amounts to $637 billion, with peak spending at $263.4 billion in 2010 - less than half of US military spending in 2008.

Meanwhile, special appropriations have been used to fund most of the costs of war and occupation in Iraq and Afghanistan so far. Much of the costs for these conflicts have not been funded through regular appropriations bills but through emergency supplemental appropriations bills. As such, most of these expenses were not included in the budget deficit calculation prior to the financial year ending in September 30, 2010.

From 2001 through February 2009, the Congressional Research Service estimates that congress approved $864 billion in war-related funding for the Departments of Defense, State and Veterans Affairs. This total is allocated as $657 billion for Iraq, $173 billion for Afghanistan, $28 billion for enhanced military base security, and $5.5 billion that cannot be categorized. Aside from normal military spending, about $900 billion of US taxpayers' funds have been spent, or approved for spending, through September 2010 for the Iraq War alone.

Growth needs to come from development, not trade

Not withstanding the fact that in 2010, despite the global financial crisis, the EU and the US still remain the world's two largest economies by gross domestic product (GDP) the EU at $16.5 trillion, the US at $14.8 trillion, about 50% of the world total of $61.8 trillion, the days are numbered when theses two economies can continue to play the role of the world's main consumption engines and act as markets of last resort for the export-dependent economies.

For sustainable growth in the world economy, all national economies will have to concentrate on developing their own domestic markets and depend on domestic consumption for economic growth.

International trade will return to playing an augmentation role to support the balanced development of domestic economies. The world can no longer be organized into two unequal halves of poor workers and rich consumers, which has been an imperialist distortion of the theory of division of labor into a theory of exploitation of labor, and of the theory of comparative advantage into a reality of absolute advantage for the rich economies.

Going forward, workers in all countries will have to receive a fair and larger share of the wealth they produce in order to sustain aggregate consumer demand globally and to conduct fair trade between trading partners. Capital is increasingly sourced from the pensions and savings of workers. Thus it is common-sense logic that returns on capital cannot be achieved at the expense of fair wages. Moreover, capital needs to be recognized as belonging to the workers, not to the financial manipulators.

The idea that workers doing the same work are paid at vastly different wages in different parts of the world is not only unjust but also uneconomic. For example, there is no economic reason or purpose, much less moral justification, why workers in the US should command wages five times more than those of workers in China doing the same work. The solution is not to push down US wages, but to push up Chinese wages to reach bilateral parity between the two trading partners.

International trade driven by cross border wage and income disparity globally will wither away from its own internal contradiction which ultimately will lead to market failure. Low-paid workers are the fundamental obstacle to growth from operative demand management at both the domestic and international levels. Pitting workers in one country against workers in another will only destroy international trade with counterproductive protectionism, which is not to be confused with economic nationalism.

Some small countries may have no easy option other than to depend on export for growth. These countries, such as the small Asian tigers, are condemned to zero growth for the coming transitional decade as the world economy shifts from export-led growth to domestic-development-led growth. They may have to seek balanced domestic growth through true comparative advantage by symbiotic integration in large super-national economic blocks, to shift export into intra-regional trade.

For example, unlike China, Japan's domestic market is simply not big enough to make up for a rapid slowdown of its huge export sector. Thus Japan will have to find ways to further boost already saturated domestic consumption while shrinking its export sector, most likely facing negative growth until the protracted restructuring of its dysfunctional export-dependent economy is completed.

One option would be for Japan to integrate its oversized national economy with that of China so that the huge Japanese export sector can be transformed into a super-national domestic sector of a Sino-Japanese common market. South Korea faces the same problem and may have to consider the option of integration into a super-national East Asian economy. However, the East Asian model needs to be different than that employed by the EU for what are by now obvious reasons.

In 2010, on a purchasing power parity basis, China's GDP is $9.7 trillion, Japan's is $4.3 trillion and South Korea's is $1.4 trillion. An integrated East Asian super-national economy will have a PPP (purchasing power parity) GDP of $15.4 trillion, bigger than that of the US of $14.8 trillion.

The availability of a large domestic market with a large population and ample land are the reasons why large countries such as the BRIC (Brazil, Russia, India, China) are going to be dominant core economies going forward with symbiotic integration with neighboring smaller countries.

Foreign holders of US sovereign debt

China's foreign reserve hit $2.5 trillion in March 2010. In April 2010, Japan's foreign reserves fell below $1 trillion. By another calculation, at the end of March 2010, China's total funds outstanding for foreign exchange were around 20 trillion yuan ($2.93 trillion at concurrent exchange rate), showing around $110 billion of growth compared to the end of 2009.

On February 16, 2010, the US Department of Treasury reported that Japan boosted its holdings of US Treasuries by $11.5 billion in December 2009, bringing the total to $768.8 billion, making Japan once again the largest creditor to the US. China, after briefly occupying top position, became once again the second-largest holder of US Treasuries, having sold $122.1 billion earlier to bring its total to $755.4 billion, down from $877.5 billion in January, relinquishing the top position creditor back to Japan.

The most US Treasuries China had held in reserve was $939.3 billion in July 2009, two years after the global financial crisis broke out in July 2007 and five months after congress approved the $787 billion stimulus package to be funded with debt.

Outside of Asia, the United Kingdom bought $24.9 billion of US sovereign debt during the same month, bringing its total to $302.5 billion. Brazil bought $3.5 billion, bringing its total to $160.6 billion. Russia sold $9.6 billion, reducing its total to $118.5 billion. Foreign creditors, nervous about US stimulus spending, of future money sold the most amount of US sovereign debt in December 2009, $53 billion, surpassing the previous record drop of $44.5 billion in April 2009. At the end of February 2010, total Treasuries outstanding were around $13 trillion; the amount held by foreigners was around $3.75 trillion.

As of March 2010, China's foreign exchange reserve totaled $2.45 trillion, about 60% of which was invested in US securities. These securities include long-term Treasury debt, long-term agency debt, long-term corporate debt, long-term equities, and short-term debt.

Hillary Clinton during her first visit to China as secretary of state in February 2009 urged China to continue to buy US Treasury securities. A month later, in March 2009, Chinese Premier Wen Jiabao responded by stating publicly that he was "a little worried" about the safety of China's holdings of US sovereign debt. In addition, some Chinese government officials have called for replacing the dollar as the world's main foreign reserve currency with International Monetary Fund special drawing rights, harking back to John Maynard Keynes' proposal of "bancors" for an international clearing union at the Bretton Woods Conference in 1943.

Foreign investors had been a mainstay of the market for US government-sponsored enterprise (GSE) debt (such as that issued by Fannie Mae and Freddie Mac), but uncertainty over the GSE mortgage financiers' capital positions and the timing and structure of an anticipated government rescue by September 2008 made investors reassess their risk exposures. Asian investors in particular became net sellers of US agency debt.

Federal Reserve custody data show that for 2008 up to July, foreign government and private investors bought a monthly average of $20 billion of US agency debt issued by GSEs such as Ginnie Mae, Freddie Mac and the Federal Home Loan banks. Foreign purchases of US Treasuries averaged $9.25 billion a month. All told, the average monthly purchase of US public debt by foreigners was around $30 billion.

From July 16 to August 20, 2008, foreign buyers sold $14.7 billion of US agency debt, trimming their overall holdings to $972 billion. They purchased $71.1 billion of Treasuries in the same period with dollars earned from trade surplus.

Bailing out GSEs to protect foreigners' exposure

In his just published memoir, On The Brink, former Treasury secretary Henry Paulson revealed that Russia made a "top-level approach" to China "that together they might sell big chunks of their GSE holdings to force the US to use its emergency authorities to prop up these companies". Paulson wrote he learned of the "disruptive scheme" while attending the Beijing Summer Olympics. "The report was deeply troubling - heavy selling could create a sudden loss of confidence in the GSEs and shake the capital markets," Paulson wrote. "I waited till I was back home and in a secure environment to inform the president."

The Bank of China, the nation's major foreign exchange bank, cut its portfolio of securities issued or guaranteed by troubled US GSE home mortgage financiers Fannie Mae and Freddie Mac by 25% since the end of June 2008. The sale by the Bank of China, which reduced its holdings of US agency debt by $4.6 billion to about $14 billion, was a sign of nervousness among foreign buyers of Fannie and Freddie's bonds and guaranteed securities. China holds about $400 billion of US agency debt in total.

A month after secretary Paulson returned from the Beijing Olympics with the disturbing message for President George W Bush, the Treasury on September 7, 2008, unveiled its extraordinary takeover of GSEs Fannie Mae and Freddie Mac, by invoking Section (14) authority under of the 1932 Federal Reserve Act, as amended by the Banking Act of 1935 and the FDIC Improvement Act of 1991.

This permits any Federal Reserve Bank to conduct open market operations under rules and regulations prescribed by the board of governors of the Federal Reserve System, to purchase and sell in the open market, at home or abroad, either from or to domestic or foreign banks, firms, corporations, or individuals, cable transfers and bankers' acceptances and bills of exchange of the kinds and maturities that were by this Act made eligible for rediscount, with or without the endorsement of a member bank, putting the government in charge of the twin mortgage giants and liable for the $5 trillion in home loans the GSEs had guaranteed.

The move, which extended as much as $200 billion in direct Treasury support to the two GSEs, marked the government's most dramatic attempt yet to shore up the nation's collapsed housing market to try to slow down record foreclosures and falling home prices. The sweeping plan, announced by Paulson and James Lockhart, director of the Federal Housing Finance Agency (FHFA), placed the two government sponsored enterprises into a "conservatorship" to be overseen by the FHFA. Under conservatorship, the government would run Fannie and Freddie "temporarily" until these entities regained stronger footing. Some analysts have suggested that the move was partly motivated by the need to reassure China and Russia of the safety of GSE debt to discourage them from selling their substantial holdings.

Economic head wind from government exit strategies

In coming years, the global business climate can be expected to face a headwind even when the initial crisis has been stabilized by government bailouts of big distressed financial institutions, as government stimulus spending ends in several major economies and governments are forced to execute exit strategies for their extraordinary bailout measures even amid weak economic conditions, in order to prevent inflationary pressure and expectation from building and to address the danger of excessive public debt.

In the US, the Fed and the Treasury are expected to gradually withdraw stimulus measures, such as the ending of government aid to the auto industry and restoring the balance sheet of central banks by shedding toxic assets taken from insolvent financial institutions. Yet the Fed and the Treasury are caught between a rock and a hard place. Stimulus cannot be exited unless employment picks up to restore demand, but stimulus packages have been ineffective in reducing unemployment. So far, the main effect of stimulus spending has been to save the insolvent financial sector from total collapse, not to create new jobs.

Central banks and finance ministries around the world would need to coordinate the timing of the ending of the near-zero interest rate regime to prevent extreme volatility and speculative arbitrage in the exchange values of their respective currencies and to dampen "carry trades" by banks eager to profit from cross-border interest rate arbitrage. This coordinated exit would be extremely difficult to manage because national economies are not likely to recovery at the same pace, and national policies tend to be governed more by domestic politics than by international coordination.

For the European Union, national GDP figures for Q4 2009 were disappointing: Germany posted zero growth even against weak expectations of 0.2%; Italy posted a 0.2% contraction against expectations of 0.1% growth; and the Netherlands posted 0.3% growth against expectations of 0.5%. Eurozone GDP grew just 0.1%, merely one third against weak expectations of 0.3%, bringing GDP contraction for the full year to negative 2.1% against expectations of only a negative 1.9%.

In France, January 2010 retail sales fell 2.4% on the month, food fell 4.4%, auto fell 5.1% autos, apparel fell 2.7%, with supermarkets falling 4.1% and hypermarkets particularly hard hit, falling 3.8%. This drop is exacerbated by a rise in inflation rate to 1% in December 2009. Given that of the 0.6% GDP growth in Q4 2009, 0.9%% stemmed from a rebound in consumption (+8% in automobiles), this hardly augurs well for GDP in 2010. GDP for the second quarter of 2010 will be worse because of the sovereign debt crisis in Eurozone.

Sovereign debt crisis

After Japan, whose government debt reaches nearly 200% of GDP in 2010, the PIIG economies (Portugal, Italy, Ireland and Greece) of the European Union (EU) all show projected 2010 public debt above or headed for 100% of GDP, with Italy leading the pack at 127%, Greece at 120%, Portugal at 90% and Ireland at 65%.

The EU as a whole was not in any better fix at the end of Q4 2009, with public debt at 80% of GDP, slightly below the US at 90% and above the UK at 75%.

The PIGS (Portugal, Ireland, Greece and Spain) are visibly in hopeless trouble. But even in other EU countries normally considered financially more solid, public debt levels are unsustainably high: Belgium's is at 105%. Banks in Austria face deep exposure to recession-hit Eastern Europe.

Normally, sovereign debt denominated in the national currency needs never default because the government can always print more money to meet public debt service requirements. While sovereign debt denominated in the national currency does not face default risk, it does face risks of currency devaluation and inflation. Excessive sovereign debt can also cause hyperinflation with the collapse of the exchange value of the denominated currency, but outright default can always be avoided by central bank quantitative easing to meet debt service of sovereign obligations. A sovereign government only faces default on sovereign debt denominated in a foreign currency that it cannot print and must earn from export or purchase through the foreign exchange market.

The US, through dollar hegemony, can print dollars without fear of inflation because low cost imports keep US inflation low and her trading partners must buy US sovereign debt with their dollar denominated trade surplus to finance the US trade deficit. (See US dollar hegemony has got to go, Asia Times Online, April 11, 2002.)

Euro preempts monetary sovereignty of EU members

EU member states are in an unusual situation - being constituents of a monetary union without a political union. Sovereign states within the EU by agreement have to denominate their sovereign debts in euros, which is a super-national currency of the EU governed by treaty conditions that prevent individual sovereign states within the union from printing euros at will to meet their separate monetary needs. At the same time, the European Central Bank (ECB) conducts its monetary policy for the benefit of the European Union, not for the needs of the constituent economies which are expected to conduct their respective fiscal policy in accordance with the rules of the European Monetary Union (EMU) to support the monetary policy of the ECB.

Many have warned that operating a monetary union without having first establishing a political union was putting the monetary cart before the geo-economic horse. By joining the EMU, a member country agrees to observe its monetary and fiscal rules regardless of what is needed by its national economy. Since EMU member states are at different stages of development with different socioeconomic conditions, EMU monetary and fiscal rules are not suitable for all members all the time.

EMU member states, such as Greece, know that adopting a stable currency that is not controlled by their own central banks implies a voluntary compromise in national sovereignty on monetary affairs. Normal sovereign options, such as devaluation of the national currency or an accommodative inflationary monetary policy are not available options for EMU member states. A single monetary policy for the euro is implemented solely by the ECB and it is the responsibility of each country to adjust its fiscal and economic policies to meet the "one size fits all" monetary criteria of the EMU.

Participation in the EMU does bring financial and economic advantages to the member states. The benefits of joining a stable large economic area with no monetary, economic and financial borders are great for the strong economies, but they are greatest for countries with historically weak economies that before joining were unable to achieve such conditions and were denied access to such a large market. Financially, adopting the euro allows previously weak economies, such as Greece, to enjoy easy access to loans at lower long-term interest rates.

Unfortunately, instead of delivering on their commitments made at the time of entry to the EMU to reduce public debt levels, many new member states have used potential benefits not to strengthen their economy but to engage in a frenzy spending of easy money.

Future of euro at stake

Monetarists point out that the crisis these economies face currently is not caused by any natural "external shock", such as an earthquake, but is the result of bad, even deceptive national policies pursued over many years masked by fraudulent data. They warn that bailing out these wayward economies, such as Greece, would reward poor behavior and create moral hazard of a dimension that will threaten the EMU itself and even the future of the euro.

According to monetarist logic, financial assistance to EMU member countries that have persistently violated the terms of their participation in the union would impair the credibility of the whole monetary framework of the EMU. By its construction, the EMU is a "no transfers" union of sovereign states. Transferring taxpayer money from sovereign member states that diligently obey EMU rules to those that regularly violate them would create antagonism towards the EMU based in Brussels and between euro area countries. For the people in the eurozone, such antagonism would undermine a necessary but still fragile sense of super-national identification with the larger aim of pan-European integration.

Financial crisis made in the USA

Yet while the current financial crisis facing the EMU was not caused by any external shock in the form a natural disaster, it has been undeniably caused by an external shock created by and originated from United States. As Nobel laureate economist Joseph Stiglitz, an American, rightly observes, the global financial crisis comes with a "Made in the USA" label. The allegedly irresponsible member states of the EMU got into financial trouble merely by acting according to the brave new rules of the neo-liberal no-holds-barred games promoted globally by US market fundamentalists and supported by easy money monetary stance of the US Federal Reserve. Destabilizing instruments of financial market innovation has been the main US export since the end of the Cold War.

The end of the Cold War removed the geopolitical gravity of a united Europe driven by a garrison mentality against communism. With the fall of the Berlin War, Europe's unification gravity came increasingly against an immovable socioeconomic wall. Necessity for doctrinal political survival was preempted by a doctrinal quest for economic growth. Yet the gap of national differences is too wide to prevent a centrifugal fracture of the virtual union in the absence of an external enemy threat. Further, the European Union has since the Cold War transformed itself from a grateful ally of the US against a threatening USSR to a potential challenger of US global economic dominance.

Germany, the magnet that has held the EU together and generated most of its dynamic growth, is now driven by domestic politics that push for a return to nationalistic insulation against the European disease of social welfare inadequately sustained by economic productivity. German public opinion is moving toward separating the disciplined nation state from nebulous European common interests.

German taxpayers are not prepared to take on the role of unconditional underwriter of credit for the EU's problematic, free-spending member economies. The potential pain of a failure of the European Union for the stronger member economies such as Germany and France is now balanced by the pain of maintaining an unwieldy union of wayward members. European Union politics is now dominated by tactical nationalist maneuvers at the expense of strategic goals towards full union.

Next: Greek tragedy

Henry C K Liu is chairman of a New York-based private investment group. His website is at http://www.henryckliu.com.

Copyright 2010 Asia Times Online (Holdings) Ltd.

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