This blog: NAKED CAPITALISM, is from an ex-Wall Street whistle-blower. It’s very fair and informative – Ed.
“2010: Foreseeable and Unforeseeable Risks ~ The Room For Policy Error is Enormous”
Posted: 28 Dec 2009 11:27 PM PST
By John Bougearel, author of Riding the Storm Out and Director of Financial and Equity Research for Structural Logic
Policymakers managed to extinguish a financial panic in 2008-09 by March 2009. This rescue operation allowed the broad U.S. stock market as measured by the SP500 to rally nearly 70%. Extinguishing the panic was to be expected. What I have questioned throughout the year are the measures that policymakers took to extinguish the panic and effect a stock market rescue. In particular, I wonder if the measures taken are only masking over serious unresolved issues within our financial atmosphere.
U.S. Treasury Secretary Timothy Geithner in a December 22, 2009, All Things Considered interview with Michele Norris claimed that 2009 is ending on the road to recovery.
The economy’s growing again. The policies the president put in place are helping lay the foundation for growth and job creation…American’s “can be more confident about their financial future, financial security. Growth looks like its accelerating in the 4th quarter.
NPR queried Timothy about a second wave of systemic crisis coming from commercial real estate or some other seen or unforeseen or unintended time bomb. Many experts remain quite concerned this credit crisis will be back-end loaded with second-round effects and positive feedback loops that spirals us further into the rabbit hole the economy entered in 2008-09. Geithner adamantly replied,
We’re not going to have a second wave of financial crisis. We will do what is necessary to prevent that. We can not afford to let the country live again with the risks of another series of events like we had last year. That’s not something that is acceptable and we will prevent that. And that is something completely within our capacity to prevent… When you have the will to act we have substantial ability to prevent that and we will do what is necessary.
Much of the Treasury Secretary’s positive forecast for 2010 and beyond is predicated on the political will to act and anecdotal signs of Q4 GDP growth, incremental increases in business confidence and consumer spending, and the stabilization of the housing and jobs markets. Never again will America be plunged into the 2008-09 rabbit hole because the Treasury Secretary asserts “that is something completely within our capacity to prevent,” and they have the political “will to act.” Throughout the crisis, we saw policymakers displaying the political will to act in a manner that best served the interests of financial lobbyists, not that of the American public. That was transparent enough. Less apparent was how well policymakers served the short and long term interests of their constituents, the highest authority to which politicians’ should have been appealing.
I do not share Treasury Secretary Geithner’s confidence in the policies the Obama administration “put in place” to effect this recovery, and I will not champion them. In fact, many of the policies put in place only mask unresolved issues. So, I am quite concerned about the secondary effects resulting from this global financial meltdown. There are significant unrealized losses still in the pipeline. The full effects of this global financial meltdown have not been felt yet.
Nor do I share Mr. Geithner’s peculiar brand of optimism which is seemingly reminiscent of Chance the Gardener played by Peter Sellers in Being There “As long as the roots are not severed, all is well, and will be well, in the garden.” Policy measures and legislation passed to date to stabilize the financial crisis in 2008-09 have primarily been aimed at saving the dysfunctional big banks and preserving the OTC Debt and Derivatives markets. In short, the aim has been to restore the tentacled and tightly coupled roots in the big banks Financial Garden of Eden. The fact that lawmakers on Capitol Hill helped big banks preserve their Financial Garden of Eden in 2008-009 as much as possible should come as no surprise, because these same lawmakers had previously played such a large role helping banks create their garden in the first place which made possible the big banks fall and subsequent global financial meltdown.
I do have a great deal of reservations and skepticism about America’s financial future and more specifically about American’s financial security. As 2009 comes to a close, we are in the eye of the hurricane. We have yet to be hit by the backside of this financial storm. This credit-collapse is not your typical Post WWII recovery from recession as economist David Rosenberg and others like Paul Volker so often and thankfully remind us. Paul Volcker in a December 2009 Der Spiegel Interview titled America Must Reassert Stability and Leadership:
What complicates this [crisis] as compared to the ordinary garden variety recession is that we have this financial collapse on top of an economic disequilibrium…We have not been on a sustainable track and that has to be changed….those changes don’t come…in a quarter [or] in a year. If we don’t make that adjustment and if we pump up consumption, we will just walk into another crisis. We have not yet achieved self-reinforcing recovery. We are heavily dependent upon government support so far…both in the financial markets and in the economy.
The Room For Policy Error is Enormous
Thus, the room for error in Mr. Geithner’s optimistic forecast is enormous. His outlook ignores the fact that an incredible, wide array of uncertainties can blind-side both domestic and global policymakers in a post credit-bubble collapse environment. In particular, I will add, the room for downside risks to the Treasury Secretary’s optimism is significantly heightened by the policy measures implemented to stabilize the big banks, precisely because these policies masked the effects of so many underlying issues. If the stabilization of the big banks and the financial system becomes unhinged again, in spite of what Mr. Geithner insists must be and can be prevented from ever happening again, we will walk right back into crisis and Irving Fisher’s debt-deflation spiral will resume.
Charles Kindleberger tells us financial crises are “hardy perennials.” That is true, but traditional remedies for extinguishing panics in the financial system over the past two hundred years have more or less always followed Walter Bagehot’s prescript that you “lend freely and early, to solvent firms, against good collateral, and at high rates.” This is what the bank of England did to avert the Panic of 1825. It is exactly what JP Morgan did to avert the Rich Man’s Panic of 1907 ~ he liquidated the bad banks and recapped the good ones. This is roughly what FDR did in 1933 and what Sweden did in the 1990s. They all separated the good banks and good collateral from the bad banks and bad collateral, letting the bad banks fail, and backstopping the still solvent banks. The broader aim was always the same, to save the financial system rather than the bad banks and their shaky collateral. To do this, they let the under-collateralized banks fail, and lent freely to solvent banks against good collateral at a high rate.
The financial panic of 2008-09 stands in stark contrast to the extinguishing of previous financial panics. The most outstanding features to the financial panic of 2008-09 was that the policies set in place were to save the bad banks loaded with toxic collateral on and off its balance sheets rather than to save the financial system itself. Lawmakers effected this change in March 2009 when they eliminated the fair value accounting rule to allow insolvent banks to mark their toxic assets at full value rather than at market value. Effectively, they swept the toxic asset under the rug. They masked their toxic effect, but unresolved issues remain. These toxic assets are now being stored on the Federal Reserves and other off-balance sheets, loaded with unrealized losses. The Basel Committee and FASB are now allowing banks until 2012-2013 to put these assets back onto their balance sheets. This explosive timetable has been reset to 2012, the end of the Mayan Calendar. For those with an eschatological bent, this date with destiny might be the End Days of our financial system as we knew it.
This is a first-ever occurrence in 200 years of banking history that losses stemming from bad collateral were not realized early on. They are time bombs with delayed fuses. To partially offset this day of reckoning in 2012, the Federal Reserve adopted a Zero Interest Rate Policy (ZIRP) to help the very same insolvent banks lever up the yield curve borrowing short and lending long to earn their way out of insolvency. But rather than letting these profits restore the banks impaired balance sheets, bank executives are redistributing these profits in the form of bonuses. Worse yet, ZIRP is a financial hardship that hurts millions of saving Americans plowing their hard earned dollars into CDs and money market funds. In this way, a zero interest rate policy serves to undermine the financial security of millions of Americans. And still, the unanswered question is whether insolvent banks can successfully recap themselves before these Bouncing-Betty’s detonate. In a race against the clock, policymakers are simply buying banks time, hoping they can avoid mutually assured destruction when their eschatological date with destiny arrives.
Global Warming Trends Serve as a Model for the Global Financial Meltdown
Financial innovation over the past thirty years led to a huge growth spurt in the OTC Debt and Derivatives markets. One could say that innovation led to a revolution within the financial industry. This revolution has created vast sums of toxic assets now being stored on the Federal Reserves and other off-balance sheet vehicles. By way of analogy, these man-made toxic assets can be likened to man-made greenhouse gases being created by the industrial revolution and fossil-fuel industries which are now contributing to accelerating global-warming trends. The meltdown in the global financial markets has many dangerous parallels to global-warming trends to consider.
Man-made greenhouse gases like carbon dioxide that have been released into the earth’s atmosphere are being partially absorbed by the ocean and then stored there. However, the carbon dioxides that have been absorbed into the ocean are not passively sitting there; they are actively destroying the ocean’s corral reefs and shellfish. These gases being stored in the ocean have yet to be re-released into the earth’s atmosphere. The ocean creates a lagged effect on global warming trends. When they are re-released into the earth’s atmosphere, this will create negative second-round effects thereby accelerating global-warming trends in the decades ahead.
Today, the Federal Reserve acts much like the ocean for greenhouse gases, absorbing and storing the toxic assets and shaky collateral [OTC Debt and Derivative products] created and released by the big banks. These financial carbon dioxides being stored on and eating away at the Fed’s balance sheets have yet to be re-released into the global financial system. When these financial carbon dioxides are re-released into the global financial system, this will create negative second-round effects that will broaden the reach of the global financial meltdown in the immediate years ahead [2011-2013]. Do you see where I am going now?
Jim Hansen, a leading global warming scientist has shown us that global warming trends in the earth’s atmosphere do not respond instantaneously to increases in greenhouse gases. There is a “substantial amount of what Jim calls ‘unrealized warming’ or warming that was still ‘in the pipeline’ – we hadn’t felt it yet.” What Jim Hansen is describing are the feedback loops and secondary effects that are still in the pipeline. “And feedbacks are inherently slow to unfold.” One of the most important examples of feedback is the melting of permafrost in Alaska, northern Canada and Siberia. “Plants that have been frozen for thousands of years are now supplementing the greenhouse effect as they decompose and send prodigious quantities of carbon dioxide and methane into the air.” The artic tundra stores more than 500 billion tons of carbon which is twice that of all the rainforests on the planet and 20 times the amount of fossil fuels emitted in a year. The secondary and lag effects with respect to global warming, Jim Hansen notes “obviously complicates the tasks of decision-makers.”
To the extent that the policy measures put in place in 2009 to “mask” “store” and “freeze” the financial dioxides embedded in the financial system rather than having them purged them from the system, most American’s financial futures and their financial security will be at risk for several years to come. I see no room for complacency. Moreover, American’s financial security will be further compromised in the coming decades as and when Social Security and Medicare pass their tipping points as well. Will the U.S. government default on their social obligations to meet their financial obligations in the years to come?
So what happens as and when the frozen and unrealized losses still in the pipeline and being stored on off-balance sheets are allowed to decompose over the course of the next three years? What will be the cost to millions of American’s financial security once the full effect of this financial meltdown is felt? And I speak as if this were only an American problem. But in point of fact, this is a global problem, particularly in those countries running large deficits. The financial security and well being of hundreds of millions of global citizens remain vulnerable.
Mr. Geithner’s reassurances to Americans aside, the lagged consequences of the global financial meltdown remain considerable. While some of these risks are transparent, many of the risks are opaque and remain hidden. Final outcomes are imaginable yet highly uncertain and largely unquantifiable. No one person can possibly get their arms around all of the risks. Below I attempt to highlight some of the foreseeable uncertainties, risks, and challenge that lie ahead between 2010 and 2013. The list is by no means comprehensive.
Domestic Risks and Uncertainties
1. The Bulk of the Option Arm resets trigger in 2010-2011 – “The reality is that these loans were never meant to survive the reset. Unless an alternative is created, the human pain and loss will be massive.” Institutional Risk Analyst Chris Whalen
2. The Black Holes at FNM and FRE and other GSEs continue to grow
3. Bank hoarding in 2009, with no end in sight until those option arm resets trigger and all toxic assets have been brought back onto their balance sheets by 2013
4. State and local governments defaulting on financial obligations. To meet financial obligations, austerity measures will be required, social obligations will suffer, meaning more unemployment and less teachers, firemen, and policemen. This burden will be another source of drag on the U.S. economy.
5. Credibility of the Fed and U.S. Treasury and White House Administration will be on the forefront on Investors minds in 2010 and beyond. If their credibility suffers, there will be negative ramifications in the financial markets
6. Stock Market Rescue Operations like the one that got underway in March 2009 tend to last roughly two years, and are followed by bear market resumptions. My models indicate the 2009 bear market rally may end sometime in 2H 2010 followed by a resumption of the secular bear market into 2012-2013.
7. My models also indicate the 2009 bear market rally in the Dow Jones may peak at 11,750-to 12,000, near the bull market crest in 2000. That leaves maybe 12% further upside in 2010 and implies that most of the gains from this bear market rally are already in place. As David Rosenberg pointed out throughout 2009, this is a rally for investors to ‘rent.’ What reallocations can they make as and when the rally ends?
8. Advanced Economies in America and Europe all face Pension liability nightmares with shrinking workforces to support the retiring population, recent examples are GM and YRC pension nightmares. Are taxpayers going to be obligated to fund all private and public pensions of bankrupt companies and state governments?
9. Risk Aversion, saving more versus spending more will be a drag on the economy
10. U.S. government mandate requiring 30 million uninsured Americans to buy health insurance will curb consumer spending and act as a tax on the economy. It will also curb hiring plans amongst U.S. employers further prolonging Americans sidelined from employment opportunities and exacerbating the unemployment rate issues.
11. Will the kindness of foreigners continue to fund the U.S. deficit spending? Eric Sprott and David Franklin noted in their December 2009 missive titled “Is it all just a Ponzi Scheme?” that the “household sector” bought $528 billion of the $1.88 trillion of U.S. debt that was issued to them. This sector only bought $15 billion of treasuries in 2008, where would this group find the wherewithal to buy 35 times more than then bought in the previous year. Sprott concludes that makes no sense with accelerating unemployment and foreclosures, so the household sector must be a “phantom. They don’t exist. They merely serve to balance the ledger in the Federal Reserve’s Flow of Funds report.”
Global Risks and Uncertainties
12. Sovereign Risks of Default are increasing as is their fiscal credibility in countries with large debts
13. Asymmetries within the EMU could precipitate a possible breakup of the EMU. The solidification of the countries in the EMU may break-up like ice sheets in the Artic tundra as the global financial meltdown puts further stress on the EMU. Incentives to remain in the EMU, for many EU countries it might be better to leave the EMU than stick around for its constraints and austerity measures
14. The One-size fits-all monetary policy in the EMU may be derailed by this crisis
15. Germany may not want to subsidize weaker countries in the EMU if their exports to those weaker euro countries are falling off a cliff as the crisis rolls on
16. The ECB may not be able to accept sovereign collateral and assets from countries in the EMU that have a negative credit outlook and are later hit with further downgrades. That could have spillover effects into the banks-at-large, including the ones the U.S. government sought so frantically to save.
17. The PIIGS (Portugal, Ireland, Italy, Greece, and Spain) debt ratios are all expected to exceed the 3% GDP 1992 Maastricht Treaty requirement.
18. PIIGs negative 2009 GDP resulting from global export decline leaves them with little incentive to stay strapped to an expensive Euro.
19. Italy is expected to be the first country that will first kiss the EMU good riddance. Greece and Spain might not be far behind as a domino-effect takes hold.
“What’s in Store for 2010?
Posted: 28 Dec 2009 10:16 PM PST
By Bruce Krasting, a former foreign exchange and derivatives trader and hedge fund manager.
Mohammad said, “One cannot foretell the future”. I think he was on to something. What looks predictable rarely happens. There are always surprises. I have been tripped up so many times. The following are not predictions of things that will happen. Just some thoughts on what might happen in 2010.
-Tim Geithner will resign as Treasury Secretary. Sheila Bair will replace him.
-AIG will be dismantled. What is good will be sold, what is bad will be shuttered. The end result will be a loss to the US of $40 billion.
-The Mid term elections will go to the Republicans. A surprising number of independents will be elected. The Democrats will still have a narrow majority. The end result will be legislative deadlock.
-Gold prices will trade as low as $900 and as high as $1,400. $1,400 will come first.
-Fourth quarter GDP will be at -1%.
-Unemployment will fall from 10% as the 800,000 census workers are hired. Outside of that there will be no growth in employment. Ex the census impact and other government hiring, job creation will be negative.
-Fiat/Chrysler will introduce some sexy new fuel-efficient cars. They will sell well. GM’s Volt will not be in full production. Demand will not be there.
-Boeing will finish a few Dreamliners but they will face many delays and problems.
-Apple will trade at $300 (tablet) and Google at $750. Amazon’s stock will be lower over the full year.
-Oil will trade at $100 by midyear, but it will be closer to $75 by year-end as the global slowdown re-emerges.
-The La Nina conditions will revert to El Nino conditions. This will result in a significant increase in Hurricane activity. Four named storms will hit the US coastlines. Total damages will approach $50 billion. There will be no CAT 5 hits on the mainland. But the Yucatan Peninsula is hit with a big one. Storm activity will interrupt Gulf gas production. Nat Gas will trade at $9 at one point in the fall.
-Typhoon activity in Asia will fall from the pace seen in 2009. The result will be a significant increase in Pacific Ocean temperatures.
-2010 will see another significant increase in ice melt. No meaningful steps will be made toward a global response to climate warming.
-Fannie and Freddie will convert their outstanding Preferred stock into common shares at a ratio of 3 to 1.
-After the Preferred conversion the shares of the Agencies will be delisted. Shareholders will be thrown a bone. They will get a beneficial interest in the REO owned by the Federal government. This could be in the form of a trust or individual transactions where old shares are tendered for individual properties. (Hotels/big stuff). The objective of this will be to remove these properties from the market for a meaningful period of time. The result will be that medium priced homes will stabilize in value. Rental costs will fall.
-High-end home prices (+$1mm) will continue to fall in value. In some areas the decline will be 20%. The absence of a viable mortgage market for these homes is the culprit for these declines. Prime defaults will rise to 8%.
-On September 1, 2010 the Federal Funds target will be at ½%. The 10-year bond will be at 4.5%. During the course of the year the ten-year will trade at 3.5% and also 5%. Interest rates will be lower at the end of the year than they will be on September 1st. There will be no meaningful reduction in the Fed’s balance sheet.
-At some point in 2010 there will be a test in the bond market for a government auction. At that time the Federal Reserve will, without hesitation or consent, re-establish a form of the QE policy. They will not permit a “failed’ auction.
-The Federal Reserve will become active in the foreign exchange markets. At different times of the year they will both buy and sell dollars. Their objective will be stability. These efforts will be referred to as “smoothing operations”.
-Volatility for all exchanges and commodities will increase from current levels. Intra-day moves greater than 2% will become common.
-The Sovereign Risk Story will continue to be a major theme. Italy and the UK will be lumped into the status of Greece, Spain and Portugal. Eastern Europe will see negative growth.
-There will be no breakup of the Euro. Greece will not pull out. The strong members will provide some relief for the weak. But the problems will not go away and the possibility of some form of two-tiered Euro will be a matter of open discussion. It is in this context that the Fed’s FX intervention takes place.
-There will be no meaningful overhaul of Social Security. This topic will be more controversial than Healthcare. It is too hot a potato for a bi-election year. As a result the SS Trust Fund will be at cash flow breakeven for all of 2010. Down from a surplus of +$200 billion in 2006. This reality will impact bond yields.
-The dollar will trade as high as 1.35 vs. the Euro. The low for the year will be at 1.60. At some point the Yen could weaken to as low as 110 to the dollar. Trade the extremes.
-China will surprise us all and revalue the Yuan by 10%. The currency will still be undervalued. China’s GDP will grow at 10% for the year. But the prospect for 2011 will be in doubt. China will not lose its rank as number 2 in global GDP.
-Mexico will devalue the Peso by 15% and Brazil will revalue the Real by the same amount. The Canadian Dollar will exceed 1 to 1 versus the US dollar.
-The Treasury will not sell the 10 billion of Citicorp shares that it holds. The argument put forth will be to maximize the value of the holdings.
-Some of the folks from Bear Sterns and Lehman will form a Boutique. It will be a success.
-The debate over Glass-Steagall will linger. It will not happen. It is not practical at this point. This creates a dilemma for Goldman Sachs. Can they go private and then just ignore all the noise?
-Fannie and Freddie will be merged. Their troubled assets will be transferred to a workout trust. There will be talk of returning the cleaned up entities to the private sector. The cost of these steps will bring the total losses to $500 billion.
-FHA will receive a $40 billion equity infusion from Congress. This capital increase will be necessary as it will be determined that the FHA model is the best approach for Government involvement in the mortgage market. FHA will use the new capital and substantially increase its lending activities. This step will avoid the necessity of a bailout of FHA. These actions will marginalize Fannie and Freddie.
-In 2010 over 90% of all new mortgages will come from or be supported by the government.
-There will be spot shortages of all manner of things. Soy oil, diesel fuel, specialty steel, industrial chemicals, ball bearings, replacement parts etc. This is an inventory problem. It will result in price jumps for things. This will be a global story.
-There will be several occasions when it will appear that we are about to fall off a cliff (or soar to the moon). Beware of these conditions. It is more than likely that the markets will be oversold and over-worried (or too enthusiastic).Take profits at these points. Do not stretch a bet too far. If you have some winnings in the jar consider counter trading big market moves on the day that the issue at hand gets front page coverage in the NY Times.
-Japan will not get out of recession. They will have to confront the issue of deficit spending and their debt to GDP ratio. Their response will be to sell reserve holdings to fund the deficit. The amounts involved will be small but the change in direction will be perceived to be significant.
-We will pay significantly more for virtually everything that we consume. The CPI and COLA numbers will be modest. We will be poorer as a result.
-American’s distrust of their financial institutions and our financial leadership will deepen. The whole notion of “I Promise to Pay” will come into question. As a result, the availability of consumer credit will continue to dry up.
-There will be no curbs placed on Dark Pools or flash trading. The short sale rule will not be re-introduced. There will be no regulated futures market for CDS. The Securitized Market will not recover.Nothing will change.
-The “Flight to Quality Trade” will be a dominant theme for the markets throughout the year. At some points this topic will drive the big capital flows. A month later they will have been reversed. This instability is driven by the conclusion that there really is no ‘Quality’ that the capital is Fleeing to. It is just the constant movement of the deck chairs. This creates good trading markets. Great opportunities to make and lose money will present themselves. It should be a fun year. Enjoy it.
How not to solve a financial crisis
Posted: 28 Dec 2009 11:02 AM PST
By Edward Harrison
As we head into the New Year, I am trying to look back at the last one with some semblance of a coherent interpretation of events that leads to a strategic vision of the future. I have already touched on stimulus, kleptocracy and crony capitalism as dominant themes for the year 2009.
These posts have been critical of the economic vision presented by the Bush and Obama Administrations. I would stress that I see a lot of overlap in the two Administrations’ economic policies, which is why I use the phrase “the Bush and Obama Administrations” instead of focusing just on Obama.
But, now is the time to offer a review of alternative policy solutions. Bashing policy without pointing to an alternative doesn’t add value. I also believe quite strongly that this exercise will demonstrate that alternative policy solutions did exist – and that they were pointed out at the time. One can only assume that alternative policy solutions were rejected because the Bush and Obama Administrations preferred the solutions they crafted to these. And while, I am most concerned with outcomes, this juxtaposition between what could have been and what is points to the kleptocracy and crony capitalism I mentioned in my last two review posts.
Before I go into my spiel, I want to stress a point I made at the outset of a November post “The less optimistic view of Treasury’s handling of the crisis”:
one doesn’t have to take the view that its efforts to save the banking industry were a deliberate attempt to line bankers’ pockets by transferring money from taxpayers to the banking industry.
I will probably end up flexing my confabulatory muscles like every other pundit out there – making direct or unconscious assumptions about motives, agendas or intent. This is all just speculation – much of it false. It is outcomes that matter, not intentions. And it is the outcomes that leave me unsatisfied with the present policy course.
Change you can believe in
The key issue, in my view, is the desire for change in 2008.
For years, the U.S. had been lecturing others how to run a successful economy. The Mexicans needed to sell their banks to foreign behemoths to succeed. The Asians and the Argentines needed to take their depressionary medicine and eliminate crony capitalism. The Russians also needed to eliminate gangsterism and crony capitalism or no one would invest there. The Europeans were overly regulated and the state was too big. And so on.
Then, after a quarter-century of apparent economic success (1982-2007), the U.S. economic and financial system was close to collapse. The masters of the universe were seen to have brought the economy to its knees because there were vulnerabilities at the core of American-style capitalism. This was an ugly surprise for many – and it was humiliating, just as 9/11 had been on national defense. Change was the watch word.
What kind of change? Last month, I said:
If you asked 1000 people in those exit polls from November 2008 – or even last week, “what would make you know America was headed in the right direction,” you probably would have gotten 700 different answers.
But, one thing is clear: Since January 20th, a lot of people are saying to themselves, “I know change when I see it and this is not it.” That’s what all polls are saying. So, whatever Obama and the Democratically-controlled Congress are doing, it’s not working.
So, people wanted fundamental change and they felt Obama could deliver it. What the specifics were was less important. The key was that whatever changes were made, it reflected a more proportional connection between economic contribution and financial gains as well as elimination of the core vulnerabilities of our system.
More of the same
So, when Tim Geithner says:
I spent most of my professional life in this building. Watching the politics of the things we did in the past financial crises in Mexico and Asia had a powerful effect on me. The surveys were 9-to-1 against almost everything that helped contain the damage. And I watched exceptionally capable people just get killed in the court of public opinion as they defended those policies on the Hill. This is a necessary part of the office, certainly in financial crises. I think this really says something important about the president, not about me. The test is whether you have people willing to do the things that are deeply unpopular, deeply hard to understand, knowing that they’re necessary to do and better than the alternatives.
this is either cynical propaganda or self-delusion. People did not elect your President to do deeply unpopular things. They elected Obama to make the fundamental change that he is not delivering. You may think this is change we can believe in, but polls show Americans do not. This quote encapsulates why you can’t have people who created the mess clean up after it. They are prone to defend their prior policies tooth and nail to vindicate their actions. As I said when reviewing a recent Matt Taibbi piece:
What happens when a company is nationalized or declared bankrupt is instructive; here, new management must be installed to prevent the old management from covering up past mistakes or perpetuating errors that led to the firms demise. The same is true in government.
And Geithner and Summers do not represent change in the least. They were at the center of many of the past decade’s policy mistakes: Lehman, OTC derivatives, and anti-regulation of money center banks.
It’s not difficult to see what’s going on. For Obama, it’s kind of hard to get change when you surround yourself with insiders who have vested interests in the status quo.
Credit Crisis Options
A quote from “America needs a pre-privatization plan” is my jumping off point because it does a good job of framing the policy choices at the time.
To my mind, there are three ways to deal with an insolvent financial institution:
§ Bankruptcy. Allow the institution to collapse (like Lehman Brothers)
§ Nationalization. Seize the assets of that institution and nationalize it (like Northern Rock, AIG, or Fannie Mae)
§ Bailout. Inject capital into the institution in order to allow it breathing room until it can meet capital adequacy levels.
As you can see, governments have tried all three solutions. However, there are vast differences between the three.
The bailout solution is the most ‘anti-free market’ choice and seems to be the favored solution of governments everywhere. It props up organizations, giving them an unfair advantage at the expense of other more prudent institutions. It also acts as a subsidy, which favors domestic institutions over foreign rivals. Bailouts increase moral hazard by rewarding risky and reckless lending practices. And they are often the result of crony capitalism due to the power of the financial services lobby. There are many other problems with bailouts. All around, bailouts are a poor solution.
As you know, the Bush and Obama Administrations chose the third option. Here are a few posts from the crisis detailing the Bush response (for which Geithner as New York Fed Chair shares responsibility). Paulson wanted to allow failed firms to fail. But, he quickly learned the same lesson that the Brits learned during the run on Northern Rock, namely this is a very risky strategy unless you have a well-thought out process to limit contagion (see the first post below).
After the post-Lehman panic, I see the policy as bailouts that are “a naked attempt to preserve status quo” as I say in the Dead on Arrival post below (and I present a coherent policy alternative there). Congress was asleep at the wheel, as usual.
§ Lehman’s bankruptcy: putting the cart before the horse? – Sep 2008
§ The $700 billion Paulson Plan is dead on arrival – Sep 2008
§ The Paulson Bailout Plan is unconstitutional crony capitalism – Sep 2008
§ The Paulson plan is not going to make it – Sep 2008
§ Congress does need to act on the Economic Patriot Act – Sep 2008
So, when Obama was elected, there was an enormous opportunity to change course. I had pointed to Paul Volcker’s presence in Team Obama as encouraging in October 2008 (Paul Volcker: Obama’s other economic advisor) and November 2008 (Volcker warns how serious things have become).
However, after the election, Obama immediately put Geithner and Summers in charge despite their complicity in the policies that led to crisis. I will sheepishly admit to putting a positive spin on things pre-inauguration (see Crony capitalism in U.S. banking bailout should end from January). But, Geithner and Summers consolidated power over time as infighting begins within Obama’s team forced Obama to cast his lot with Geithner-Summers or Volcker. By March, Marshall Auerback was asking Where’s Volcker? as it became obvious he was being shunted aside.
The path not chosen
So, to sum up, we had an economic and financial crisis of a lifetime. The Bush Administration and the Fed were in disbelief and failed to make enough preparations for the obvious coming failures. An almost religious belief in market mechanisms and an incoherent policy led to disaster with Lehman – after which the Bush Administration got religion about bailouts and crony capitalism.
When Obama came to town, you might have thought his policies would be substantively different. But they were not – not on regulatory reform, auto bailouts or bank bailouts. His was the neo-liberal prescription of the Clinton era – substantively the same as the Bush policies. When I wrote Seven reasons to be skeptical of Obama’s economic plans already in January, this was why.
That’s how things panned out.
Since I detailed some of the policy choices in my review post on crony capitalism, I won’t cover that ground here. I will point out just a few March 2009 posts from Credit Writedowns which I did not mention in the last review posts. They all point to problem’s with Team Obama’s solution in terms of wealth transfers and sustainable outcomes as pointed out by leading economists.
§ Is Obama considering nationalisation? – Mar 2009
§ Geithner’s Plan: one of the most regressive wealth transfers of all time – Mar 2009
§ Roubini: Nationalization “fully on the table” in Geithner’s Plan – Mar 2009
§ Krugman: Geithner Plan “won’t work” – Mar 2009
I will use this as a natural place to stress how motives and intent are irrelevant. Think Obama is a bad guy all you want. Think Larry Summers has an alternative agenda all you want. Think the perennial public servant Tim Geithner doesn’t want to do good all you want. Motives and intent don’t matter; outcomes matter.
And here are the posts I feel best represent a number of potential alternative solutions to what we have witnessed from pre-Lehman through March.
§ The Swedish banking crisis response – a model for the future? – Aug 2008
§ How to tackle systemic malaise – Sep 2008
§ The global economy has crashed: we need a comprehensive credit crisis plan – Sep 2008
§ The problem with comprehensive banking crisis solutions – Nov 2008
§ Seven reasons to be skeptical of Obama’s economic plans – Jan 2009
§ What is an economic depression? – Feb 2009
§ A conversation with Bridgewater Associates’ Ray Dalio – Feb 2009
§ Yves Smith: Nationalization is what the FDIC is doing every week – Feb 2009
§ America needs a pre-privatization plan – Feb 2009
§ Did Sweden really nationalize its banks? – Feb 2009
§ Lessons from Swedish bank resolution policy – Mar 2009
§ A few thoughts about the banking crisis response in the United States – Mar 2009
§ What would an alternative to bailouts have looked like? – Nov 2009
I’ll finish this off by quoting from my third post “The US Economy 2008” which points to over-indebtedness and a purge of malinvestment as the problem which politicians will refuse to tackle:
The global economy, now supported in the main only by the overextended U.S. consumer, finds itself at stall speed, susceptible to any number of potential exogenous shocks. Ultimately, the economic malaise created by this confluence of events will take years to unwind. A positive outcome to this process is dependent wholly on liquidation of excess credit and consumption.
This process will be extremely painful in the short term, but will lead to a healthy economy long-term. Unfortunately, experience shows that these painful steps will only be taken as a last resort. Moreover, geopolitical events become volatile in a world of economic insecurity, leading to political upheaval and protectionism. Protectionism is a natural outgrowth of nationalist economic policy as it transfers wealth from foreign producers to domestic producers by cutting off access to lower cost excess capacity in the goods in service sectors. However, this also serves to transfer wealth from domestic consumers to domestic producers by increasing the price of goods in the protected sectors, ultimately reducing consumption demand.
For these reasons, I am cautious about the long-term outlook for the global economy and the U.S. economy in particular. The likely outcome for the next decade is one of sub-par global growth with short business cycles punctuated by fits of recession.
Could it be any different?