Tuesday, October 28, 2008

The gig is up. World starting to call the US on its shell game.

In America we distrust

The crisis of the U.S. financial system is the crisis of its imperial system, after it managed to defeat the U.S.S.R. and start a huge technological revolution. It might be the end of a period, but last century the United States came back twice from similar problems

by Francesco Sisci


In these days the U.S. dollar is no longer what it used to be. For decades, concrete sign of power and wealth, it is now beleaguered, despite the recent rallies that have boosted its value against the European competitor – the euro. The American financial system in fact is crumbling day after day, and nobody knows when the fall of this extremely volatile market will stop or how much money it will have to burn before it can start all over again. At the moment nobody trusts the U.S. financial system, heart if not mind of the (formerly?) almighty American empire. So the once proud motto on the greenback “in God we trust” sounds now like the prayer of the despairing who cast their lot with God because everything else has failed.

Yet it did not begin yesterday, and it did not start with the financial derivatives, which now have become almost byword for deceit and trickery.


These two sets of data reveal the problem that, according to many economists, is at root of the present financial crisis: At the end of September, the overgrowth of the U.S. deficit reached the extraordinary total of U.S. $10.2 trillion—and it keeps growing!

The growth of public debt was an intentional policy started during the Ronald Reagan administration, and it was coupled with wide-ranging deregulation intended to boost America’s economy after the doldrums of the Vietnam War and the failures of the Carter administration. And, indeed, it did do so.

These policies worked miracles. They were a strategic weapon, as they provided the funds to engage the U.S.S.R. in an armament race that eventually bankrupted and thus defeated the Soviet enemy.

They also provided cheap credit that allowed America's stillborn computer industry to engage and defeat the competing Japanese computer giants then poised to surpass the United States.

Furthermore, the strategies endowed the American people with cheap money to start a spending spree, which proved to them U.S. affluence and guaranteed consensus for the ruling parties. The psychological depression of the Vietnam War and the former fear of being defeated by the communists were all gone.

It was a God-send all around. Besides, the largest part of this debt was domestic, and thus not influenced by the vagaries or blackmail of foreign governments. For many years, it was well below 60 percent of the GDP, the golden mark fixed by the European countries during the pact on the euro in the early 1990s as a standard of public discipline and well-being.


However, there were snags in this process. The debt was sold to the open market as bonds, and it was also monetized. That is, the Federal Reserve created an entry on its books to credit the U.S. Fractional Reserve Banking, this new checkbook money was treated as an asset to lend against for an amount equal to the dollar amount of the bonds the Federal Reserve was acquiring. The money created in this process not only included the new dollars that came into existence just to purchase the bonds, but also much more because this new money was now sitting in the form of checkbook money at the Federal Reserve.

The expansion of the money supply was many times the initial money created. That exact amount ended up being a function of the percentage of deposits banks must set aside as "reserves."[2]

The monetization of U.S. debt expanded the money supply, which tended to dilute the value of dollars already in circulation, put downward pressure on the dollar for short-term interest rates (thus, the banks had more to lend), and put upward pressure on inflation. Typically, this situation causes an inflationary boom that ends in a deflationary bust to complete the business cycle. However, the debt soared and inflation ultimately stayed relatively low in the 1990s, partly because China, Japan, and other Asian exporters were willing to sell America cheap products and get paid with money accumulated in reserves denominated in U.S. dollars.

Monetization might not be the core of the problem, as Spengler argues in a private exchange:

“Robert Mundell's groundbreaking paper in 1965 argued that an expansion of government debt relative to GDP could represent an increase in market efficiency, if it were issued in context of tax cuts that increased growth (market efficiency measured by the portion of total future income streams that could be discounted by the market). That was the foundation of what later became known as supply-side economics. In that sense the growth of debt was not necessarily a bad thing. As for monetization, the growth rate of the monetary base between 2001 and 2008 fell gradually to zero before spiking during the last few weeks due to massive intervention by the Fed. I don't believe that issuing public debt and monetizing it was the root cause of the crisis, although the deficit certainly was too large during much of this period. Rather, the massive increase in effective leverage by the banks due to use of derivatives created vulnerabilities that blew up starting in July 2007… Once the prospective returns to high-quality U.S. agency-backed mortgage-backed securities collapsed during the mid-2000s due to massive buying from Asia and Europe, the banks turned to manufacturing structured credit instead. The structured credit leverage machine in the banks, in turn, absorbed almost all the financing for corporate leverage (leveraged buyouts), and so forth.”

However, from abroad it is easier to see the continuity of the faults of a 25-year-old ballooning public debt sold abroad, and in times of crisis, the whole strategy is put under scrutiny. As the U.S. financial system asks for money, support, and understanding from foreign countries, it is hard to imagine that foreign creditors will be willing to carry on with a policy of buying bonds while accepting relatively minor fixing of the problem. A major overhaul and rethinking is due, and this can’t avoid issue of the American public debt.

Still, before rebutting the issue of public debt, one has to make clear that it was part of a complex program that brought many positive results.

Benefits of the snags

This practice immensely expanded the money in circulation, and this money was seminal for the growth of the computer and telecommunication industry, which revolutionized the world in the 1990s. It contributed to the risk funds that placed their bets with small-garage enterprises: One of them could succeed and 20 could fail, but the initial investor would still be rewarded with 100 times returns. Google, Yahoo, and many other present giants were engendered by this wealth of money supply and generosity of conditions. If interest rates had been higher and lending conditions stricter, this revolution might have not taken off.

Moreover, the technological and productivity boost contributed by the advances in computers created major economic growth that rewarded the easy money supply.

However, in the late 1990s, the Internet was already a bubble. Returns were not that great, and the public and advertising industry did not move from traditional media to the Internet fast enough to justify expectations from lenders and investors. Still, this could be dealt with. Asians, and especially the thrifty Chinese, were willing to save money and lend it to squandering Americans, building a virtuous chain linking the two economies. Americans would invest in China, upgrading the local technology and know-how. American and Chinese factories, which had learned the American ways, would send cheap exports to the U.S. This kept down world inflation and aided in the growth of the American service industry, which was selling more Asian products to Americans and shifting away from manufacturing. Part of the profit was returned to China, which in turn invested in U.S. debt to finance new American spending.

Yet, to pay off the interest on the bonds and keep alive this virtuous circle of Asian money looking for great returns in America, the U.S. had to provide grand new growth venues similar to the computer and Internet industries in the 1980s and 1990s. First of all, the money supply had to be kept abundant for it to move around looking for investment opportunities, such as new technologies that could replicate the computer revolution in other areas. A money crunch or a spike in interest rates in America would make the U.S. pay high interests on its bonds and could also sap Asian confidence in continuous economic growth in the United States and thus could push investors away from the golden sidewalks of Wall Street and its neighborhood.

With so much cheap money and investment flourishing, the only task for banks was to allocate the funds, without paying too much attention on the solidity of the assets financed. In the late 1990s, there was this crunch.

As the Washington Post reported:

“The Clinton administration, supported by then-Federal Reserve Chairman Alan Greenspan, refused to tighten regulations on financial derivatives, memorably dubbed ‘financial weapons of mass destruction’ by Warren Buffett. The 1999 repeal of the Glass-Steagall Act, a Depression-era law separating commercial banking and investment banking, passed with overwhelming bipartisan support in Congress and was signed into law by President Bill Clinton.”[3]

But this did not change the overall economic situation because technological revolutions do not turn up every day, and technological improvements do not deliver the same returns as a new product. An electric lamp that illuminates the night or a computer providing fast computation tools and instant, free telecommunication can promise immense returns. Improved brighter lamps and faster communication and computation facilities provide only incremental returns. These returns would not justify the massive amount of public debt in America in the first years of this century. Therefore, the George W. Bush administration, then in power, could choose to either (1) carry on with the Clinton policy of managed decrease of the public debt, (2) let the existing Internet bubble burst open and allow the market start afresh after the explosion, or (3) look for new expansion drives and bet on them.

In a way, there was no choice: Bush had to go for option (3) if he wanted to try to be reelected. If he chose option (1), he would have imposed harsher discipline on Americans who were looking for signs of recovery and welfare after the meager Clinton years, and he therefore might have lost votes. If he had chosen the purely liberal recipe (2), he could have opened a Pandora's box of social tensions that might have toppled him. The safest course was option (3), which could keep the growth going until reelection time, and then, in the following four years, he could assess the situation and recalibrate it, if necessary.

Politicians are no saints, and their political survival is the precondition for any policy. Therefore, Bush de facto had only option (3). Besides, the "war on terror" could have been a golden opportunity. The computer industry and Internet developed as spin-offs of military research in the 1980s—a new military campaign could have provided the same momentum for a technology revolution as the Cold War in the 1980s had done before.

War in Central Asia and the Middle East could have been a good thing. It gave the U.S. several things that were necessary at the time. (1) It had an inspirational ideological drive (the fight against Islam fundamentalism-terrorism) that was as real a threat to the world as communism had been before. (2) It promised to deliver cheap oil supplies that would grease the rusty clogs of American capitalism and help restart it. (3) It would democratize and stabilize the region, thus making it a part of the “Western world” market value system. This shift would definitively defeat the OPEC oil-producing cartel. It would also open a world of new consumers and producers and brush up the old continental Silk Road, which linked the Mediterranean to the Far East, placing it under American influence.

It was a promise of bonanza that—if it worked—would have more than justified the continuous growth of the U.S. debt, which Asians, in turn, would have been more than willing to keep financing just to be part of the game led by America. By the time this was over, new technologies and investment opportunities might have sprung up to reignite the whole process.

Who could have resisted the temptation? Yet, it did not work out. The strategy may have failed because of the deregulation of derivatives or the initial strategic approach to the war in Iraq. Still, with hindsight one can see it was ultimately because of hubris: There were too many goals (from oil to democracy) with too little thorough thinking.

Besides, after keeping the dollar exchange rate high vis-à-vis the euro, Bush let the dollar drop against the European counterpart. The objective bet was that, prompted by the cheap dollar, U.S.U.S. counterparts, abetted by the cheap dollar, simply grew lazy and did not invest in greater productivity and incremental improvements. manufacturers would bankrupt or at least beat their European competitors, who were hindered by the expensive euro, leaving American industries in globally dominant position. However, this did not occur. Prickled by the expensive euro, many European manufactures improved efficiency and productivity. Many U.S. counterparts, abetted by the cheap dollar, simply grew lazy and did not invest in greater productivity and incremental improvements.

Meanwhile, oil prices soared, clogging the arteries of the American-Asian industrial system with growing production prices and new inflationary pressures felt first in Asia and indirectly in America, too. High energy prices also boosted Russian confidence to the point that for a while the country dreamed of being an empire again and almost challenged the U.S. in Georgia.

And America, the ultimate consumer of Russian energy and Asian goods, could not find the money to foot the bill.

The sensible course of action should have been in 2007—or, even better, in 2006—to stop the run: drastically slow down money supply, import less, and cool down the economy. There were important signs that things were getting out of hand. An alarm bell should have sounded when the troubled Chinese economy, with foreign trade making up about 70 percent of its G.D.P. and exports about 40 percent of the G.D.P., was running a U.S. $300 billion surplus with America. In 2006 and 2007, China showed strong signs of economic overheating, and Beijing took steps to cool down the economy and rein in the money supply that was then going into the stock market and real estate. Because of the strong links between the two economies, if China has a fever, America will catch a cold sooner or later. But Americans did not realize it, and neither did the Chinese, who were worshipping the U.S. economy. There was greed, also. The Chinese were still hoping to get paid for their sacrifices and thriftiness through American bonds, which financed the squandering U.S. consumers. And the U.S. consumer lost track of who would pay the bill.

The paradigm of growth that had worked since Reagan was falling apart, but for months, many economists thought the worst was over and that this was a limited crisis. What had happened in America was the same as what was happening in China: There was a large money supply without rewarding returns in industry and new technologies, so investors found they could get better returns in the stock exchange and real estate. But at this point, the volumes were immense because they had multiplied the starting cash through the new derivatives.

This was not pure greed. The Clinton administration, coming to power after the fall of the Soviet empire, did not have enough money to finance the world order, which had doubled in size. The U.S. had to shoulder not just half of the world (the rest was formerly a Soviet burden) but all of it. The new derivatives and deregulation would provide the resources for new needs.

The current system worked for more than two decades, but now all of that is gone. Reaganomics, which started this whole process, does not work anymore—but what should be done?

After Reaganomics

The negative legacy of this disaster is huge. Its first victim is the reliability of the U.S. financial system, which, in turn, is the very heart of American power—Napoleon said he needed three things for war: money, money, money. Being dependable and reliable is the core of finance—it goes along with the saying “you can bank on it,” and it goes along with trading real goods and gold for banknotes, which are ultimately just sheets of paper. That was what made the world trust America in 1971, when it abandoned the gold standard, fixed in the 1944 Bretton Woods agreement, convincing everybody that the dollar greenback was as good as a bullion.

Sure, it is not the first time that America has gone under. In the 20th century, it happened twice.

In 1929, the crash of its stock exchange sunk the whole world into a depression for years. The U.S. itself seemed on the brink of disappearing, but it came back with vengeance by winning World War II and setting a new world order.

The second time was in early 1970s with the Vietnam War. The U.S. thought it was on the verge of not a local but a global defeat at the hands of the communists. That prompted Nixon to embrace the extraordinary opening of China. It was the last resort in the face of an overwhelming encroachment by an enemy threatening to take over Asia and the world. Yet, less than a decade later, the situation was reversed and the Soviets were being definitively beaten.

Will America come back after this, or is its position permanently compromised? To answer this question, one must see what was lost—or seriously dented—in this crisis: trust in the dollar (as an absolute symbol of the overall American strategy dating back to Reagan or from the 1971 drop of the gold standard) and trust in the “bankability” of its financial system.

However, after the fall of the U.S.S.R. in the 1990s, the world America took over was too big for its economy. This was unlike the situation at the end of World War II, when the U.S. economy was about half of the world economy. In 1945, America had de facto the only surviving and fully functional industrial complex. And in fact, America took over less than half of the world while the other half was under the influence of the Soviets.

In 1992, with the fall of the U.S.S.R., America was one of three main pillars of industrial production. The others were Western Europe and Japan, whose economies could challenge America’s but whose politics were subservient to the United States. They were pulled into post-Cold War efforts but dragged their feet. In fact, other countries wanted the U.S. to take the lead in many new political challenges, such as the war in Yugoslavia, during which America sent troops basically because the European powers had no stomach for a fight there or elsewhere.

In the 1990s, America tried to do too much with too little—and didn’t realize it. It overstretched its capability and economy, and this also sapped its spirit. But the U.S. still could have pulled through if the Iraqi war were better thought out and conducted or if derivatives were kept under control.

Now, the loss is not absolute, since it produced gigantic results, including the fall of the Soviet empire and the technological revolution of the Internet. Even in the face of the dramatic present crisis, it is hard to see a currency or a country replacing the dollar or the U.S. But, the present crisis proves that the dollar and the U.S. can’t answer for everything and can’t sustain the whole world alone. America's current search for support in Europe and Asia proves that America can’t do it alone. The U.S. soft power has been seriously dented, and this can’t be compensated for by the hard power of its military. If done at gunpoint, whatever the amount of money we talk about, justified earnings in financial transactions become simple highway robbery.

In a way, America has to recognize that the world has become too complex and large for the present American resources, and thus it needs to embrace some power-sharing.

On the other hand, the world can’t deny that, although no longer paramount, the dollar is still central.

This is a double challenge that likely future American President Barack Obama will have to address. The answer could be from the book of old Chinese imperial recipes: “Use foreigners against foreigners.” Or, translated in Roman imperial terms, use barbarian troops against barbarian hordes. America has been trying to do the opposite in the past two decades: doing everything itself, trusting none but its own troops and its own banks. The opposite should be true. By diluting its shares in the global stake-holding system, America could have a better grasp of the world, just like a rich man who agrees to scale down from 100 percent of a small company to 51 percent of a larger company.

This is the positive side for America, but the bitter pill is that power-sharing requires more responsible behavior. America's honor, its financial system, must be restored, as it will have to be more transparent to more stake-holders. The U.S. papers rightly complained about the scandal of the Chinese milk faked with melamine, and the world looked in horror at a history of Chinese low-quality paint for toys laced with lead and other substandard products. However, all of these scandals are dwarfed by the dimension of Wall Street's habit of producing pyramids of paper receipts leveraging 100 times the original collateral.

Let’s make no mistake, it will take years to restore America’s honor, and this restoration can’t be done in isolation, without other “stake-holding” countries. However, honor is the key for everything. Ancient China knew it.

The 4th century philosopher Wuma zi was quoted in the Mozi arguing as follows[4]:

“In the myriad things, nothing is to be valued above honor [yi, the sense of what is right].

If you tell a man ‘I’ll give you cap and shoes if you let me cut off your hands and feet,’ will he do it? Certainly he will not. Why? Because cap and shoes are less valuable than hands and feet. If you continue: ‘I’ll give you the rule of the world if you let me execute your person,’ will he do it? Certainly he will not. Why? Because the world is less valuable than one’s own person.”

However, concludes Wuma zi:

“One will fight to death over a single word, which makes honor being more valuable than one’s own person.”

Why, then, do people go to war, when they could lose their lives and benefits are very uncertain? Because for people, honor can be more valuable than one’s life.

In banking, as we saw, honor is everything. Otherwise, it is robbery, and to resist a robbery people may be willing to die or go to war. If America wants to restore its honor, it needs to thoroughly clean its financial system and have a bigger strategy for the future, together with its stakeholders. It is much more than a new Bretton Woods—it is a new world order that Obama will have to help organize. He can’t do it alone, but he could lead it. If he doesn’t, it will not be just the U.S. banks that will suffer.

I am grateful to Pansak Vinyaratn, Gianni De Michelis, Lorenzo Infantino and Enrico Colombatto for important discussions and advise.


[1] U.S. Debt from 1940 on. Red lines indicate the public debt and black lines indicate the gross debt. The difference is that the gross debt includes funds held by the government (i.e. the Social Security Trust Fund). The second chart shows debt as a percentage of the U.S. G.D.P. or dollar value of economic production per year. (Note: The two charts above do not include the recent rise of the public debt to above $10 trillion on September 30, 2008.) Data from the FY 2009 U.S. Budget historical tables is available at [whitehouse.gov/omb].
[2] See, for instance, "The Macro Economy Today" by Bradley Schiller and "Secrets of the Temple" by William Greider.
[3] Editorial, Washington Post, October 20, 2008.

[4] Mozi yinde 47/1-3, translation adapted from A.C. Graham “Disputers of the Tao” p. 62, La Salle, Illinois, 1999.

Original article posted here.

No comments: