According to WaPo, next week's DNC will be a blame-Bush-apalooza, at least in between updates on the war on women (i.e., the wholly irrational and unfair refusal of people to willingly and fully fund Sandra Fluke's sex life).
At any rate, expect to hear the following mindless mantras repeated ad infinitum next week:
- Do we "want to return to the very same policies that brought on the crisis in the first place?".
and
- "Wall Street greed"
and
- "Deregulation"
The Romney response to them should be simple - if Obama and the left are right about the causes of our economic problems, then their solutions should have righted our economy by now, or at least have us on a clear path to recovery, just like in every other recession we have had in the past 65 years. Yet, instead of recovery, we are circling the drain.
And of course, if Romney feels the need to elaborate any more, he can point to any of the following. IBD opined yesterday, "the Obama recovery can only be graded as a tremendous failure — as it has produced the worst rate of economic growth of any recovery in the past 65 years." And as the Economist noted this week, "three million more Americans are out of work than four years ago, and [our] national debt is $5 trillion bigger." And there is no relief in sight. On the horizon are hundreds of billions in tax increases to fund Obamacare, an explosion in regulations between Dodd Frank and an EPA at war with our energy sector. Then there is the biggie, the combination of Medicare and Social Security that will swallow our economy in a decade or so if not reformed.
Just keep the responses simple and loud. Let no repetition of the mantras go unanswered. Do that and by any measure, this should be Republicans election to lose.
The Euro is the official currency of the "eurozone," adopted as the national currency by 17 of 27 of the member states of the European Union. It is the world's second largest reserve currency as well as the second most traded currency behind the dollar. All monetary policy for the Euro is set by the European Central Bank (ECB).
The Euro officially became an "accounting currency" subject to ECB control in 1992, with members of the Eurozone normalizing the value of their currency to a "Euro" standard. The euro as an actual physical currency didn't occur until 2002.
Nominally, the adoption of a single currency was sold on several theoretical benefits. It would eliminate the currency exchange fees from the cost of doing business between the European states. It would encourage competition by allowing quick comparison of prices. And by encouraging stability and efficiency, the hope was that the euro would stimulate economic growth, reduce the unemployment rates in the eurozone, and encourage international investment.
The reality has proven that the downsides were not sufficiently examined. Because all monetary power, including the power to set EU wide interest rates, resides with the ECB, this poses a huge problem for nations with weaker economies during times of economic downturn. One way in which weak nations have been able to survive such problems is to intentionally devalue their currency by speeding up the printing presses. While such a move brings inflation, it gives the nation a window in which to pay off its debts. The flip side of such a drastic action is that, if there is not enough discipline in the government to carefully limit the presses and pay off the debts, you end up with Zimbabwe.
It also poses a problem for nations that need to stimulate growth. Normally, a sovereign nation that wants to stimulate growth will lower its prime interest rate. But again, that is not something that the individual member states of the EU can do. They are stuck with whatever ECB decides for the eurozone as a whole - and the ECB is avoiding inflation like the plague. That leaves only tax policy to stimulate growth among the troubled eurozone members, but at this point, each is being pressured - and indeed, has agreed - to raise taxes in an effort to lower its sovereign debt.
Several people, such as Robert Samuelson, have painted the Eurozone crisis as simply a failure of the European welfare state model. Others, on the left, such as Paul Krugman, have claimed that the crisis has nothing to do with the welfare state model. Setting that argument aside for a separate post, it seems clear that the high cost of the welfare state has played a role. But there are also systemic issues, mentioned above, that are combining with a host of issues unique to individual countries such that at least five Eurozone member countries sit on the brink of fiscal ruin. Greece, Italy, Spain, Portugal and Ireland are all in danger of defaulting on their sovereign debt. The general rule of thumb is that, when a country cannot sell 10 yr. bonds with a rate of return below 7%, the likelihood of an eventual default becomes real. With the exception of Spain, all of the troubled EU nations have crossed the 7% level. Spain is flirting with it.
In the cases of Greece and Italy, deficit spending on a bloated public sector and overgenerous welfare state drove their national debt significantly above 100% of GDP (Greece - 142%; Italy 119%). Ultimately, this drove their cost of borrowing above the magic line - 7% on 10 year bonds.
Portugal is Greece without the international press. It has a debt to GDP ratio of 93%, much of it coming from deficit spending over the past decade on the welfare state. Their cost of borrowing reached a high this month of 13.47% on ten year bonds. That said, Portugal is in the midst of cutting public sector benefits and increasing taxes.
Italy, unlike Greece and Portugal, has a strong manufacturing base and a relatively frugal population. Nonetheless, Italy "suffers from an overall failure to implement reforms needed to boost productivity and growth," which, when combined with the size of their national debt, is proving toxic.
Ireland is also in dire straights. Ireland's welfare state was not overlarge, and indeed, Ireland was running a budget surplus through 2005. But today, Ireland has a debt to GDP ratio of 94.9% and is having to borrow over 40% of every Euro to finance its government spending. What drove Ireland into its hole was an ill advised easing of credit standards and a housing bubble that burst in 2007. The Irish government than stepped in and nationalized the bad debts being held by the banks, causing a massive increase in publicly held debt. Ireland's cost of borrowing is today 7.74% on ten year bonds.
As to Spain, it's national debt was a comparatively paltry 61% as of last year, though much of that has come with recent increase in deficit spending. Spain's true problems are massive privately held debt and a horrendous economic outlook. Unemployment at or near 20% combined with both a housing bubble that makes the U.S.'s look small by comparison and a country that, because it does not produce any domestic energy, is subject to extreme shock when the price of oil jumps as it did in 2008, have all combined to make Spain's economy look extremely weak. All that has driven Spain's cost of borrowing rising, recently to a high of 6.7%:
In many ways, the economic situation in Spain is now even worse than the economic situation in Greece. Spain's unemployment was already above 20 percent even before this recent crisis. There are now 4.6 million people without jobs in Spain. There are 1.6 million unsold properties in Spain, six times the level per capita in the United States. Total public/private debt in Spain has reached 270 percent of GDP.
The BBC has a very good article on Spain's deep economic troubles and how its problems do not fit the mold of profligate welfare state spending.
It is safe to say that, in each of these countries, the fact that they cannot manipulate their currency or make monetary policy has removed the traditional tools of the sovereign for saving their countries from economic disaster. To explain in greater detail, this from Edward Harrison:
Now that crisis is upon us, the currency trilemma of a currency union that is the Impossible Trinity of fixed exchange rates, independent monetary policy and free movement of capital has reared its head. Hands are tied; in a currency union, there is no devaluation to recoup competitiveness, no room for fiscal freedom, and no control over monetary policy. This leaves so-called internal devaluation and/or sovereign default as the remaining ways to escape crisis. The political will to go through this is impaired because internal devaluation (across the board wage and price cuts) leads to a long and arduous depression . . . And default leads to massive creditor losses – not just in Ireland but also in Germany. So the Eurozone is trying to figure out how to keep its union together while minimizing costs – with the ECB and IMF integrally involved.
On the flip side of the coin, there is no central authority overseeing individual nation's budgets or taxes, as if the EU were a true sovereign. So, essentially, the Eurozone presents the worst of all worlds.
In an effort to save the Euro, those five nations in trouble are being forced to adopt significant "austerity" measures. Those measures, across the board, mean a significant reduction in the size of government and their welfare programs. For example, in Greece, the public sector is set to be reduced in size by and all public sector wages are being cut by almost a third. Collective bargaining is limited. The pensions of public sector workers are being sliced by 20% to 40%.
Further, all nations in the EU, led by Germany (the rise of the Fifth Reich), are meeting to consider systemic changes to the eurozone in an effort to save the Euro. This from Reuters:
Germany - Europe's biggest economy - was intent on changing the European Union's treaty to enshrine stricter budget discipline and penalties for countries that failed to adhere to them, to ensure there could be no repeat of the current crisis. From the German perspective, only by reforming economies, cutting social benefits and working longer would the indebted members of the euro zone and the single currency project itself emerge from the turmoil. Printing money would buy only a temporary respite and would remove the incentive to reform.
As to whether the Euro can be saved, the general consensus seems to be that it cannot. That said, a detailed analysis from Goldman Sachs concludes that the Euro may be salvagable, but that all ways forward are problematic. Ultimately, the eurozone countries must either come together in a much tighter economic union with a structure much like the U.S., or Germany and other core nations are going to have to weaken their economies in favor of the "peripheral" nations. In any event, Goldman Sachs paints the consquences of the failure of the Euro as dire - with the seizing up of credit and equity markets as the first step.
But the Euro crisis is also having another, much more insidious impact. The European Union is anti-democratic, and that this monetary crisis has been the springboard for actions that are direct assaults by the EU on democracy in the European states. Indeed, both Italy and Greece have been subject to coups at the direction of the EU.
At City Journal, The Free Marketeers Strike Back. It is a long and probing look from the perspective of conservative economists at free markets, regulation, and the origins of our current fiscal crisis. I highly recommend the entire article. To summarize the conclusions:
- Keynes was demonstrably wrong.
- Rising costs of energy were implicated in our economic meltdown and are the looming challenge for our future economy. Our government is not moving to meet this challenge, it is moving in the opposite direction.
- Don't underestimate the importance of monetary policy. Keep interests rates high enough so that prices remain stable but sufficient currency and credit are available to finance steady growth. Interest rates set too low for too long are a major factor in causing spectacular bubbles. That is what happened with Greenspan and the housing bubble.
- Market bubbles are an inevitable part of capitalism. You can't kill bubbles without killing capitalism. It is only when bubbles are combined with a very cheap money supply that they become truly dangerous in size.
- Recessions, as a part of the business cycle, are an intregal part of capitalism. Recessions are necessary for our system to correct market imbalances. You can't stop recessions without killing capitalism.
- The much maligned derivative market brought tremendous financial benefit, particularly to the world's poor. They allow for the efficient allocation of risk, thus increasing the availability of cheap credit. Some have recommended greater transparency for the market by funneling them through a clearing house that would create a record of the swaps.
- Big banks do not bring any economy of scale and, therefore, we should consider limiting the ability of banks becoming "too big to fail."
- Big banks should not enjoy taxpayer protection because that harms free competition, putting smaller banks at a disadvantage
- Reasonable regulations are necessary to efficient markets, and that includes requiring sufficient reserves. Banks become far too overleveraged, leaving them vulnerable during the economic downturn.
- Republicans need to stand up more forcefully for markets.
- Ballooning American and European debt poses a huge threat to long-term prosperity.
- By increasing taxes and imposing the wrong regulations, Western governments are hindering entrepreneurship and hence growth, that is the path to long-term prosperity.
The one thing Guy Sorman touches upon in his article does not go into any great detail about is the dismantleing of traditional lending standards. It is critical to note that Democrats dismantled our lending standards in the 1990's on a now discredited assertion that racism was endemic in the mortgage and loan industries. Even though now fully discredited, the race based standards remain in our laws and have actually been strengthened by Obama as part of the financial regulatory overhall recently passed into law.
Sorman does make one interesting point in addressing this issue. That is that, in comparing U.S. to Canadian home ownership, the Canadians fared better because of higher down payment requirements, yet the overall home ownership percentage between the U.S. and Canada are the same, suggesting the final irony, that Democrats destroyed our credit system for nothing. Here is how Sorman addressed the issue:
. . . [E]asy money helped expand a massive credit bubble. And that credit helped fund a wild proliferation of risky subprime mortgages, often issued with little or no money down, thanks to relaxed mortgage-lending laws and to Fannie Mae and Freddie Mac, the now-infamous “government-sponsored enterprises” that busily bought mortgages from lenders to keep homeownership expanding. The bursting of the bubble in 2008 brought the U.S. banking system, which had invested extensively in the subprime mortgages, to its knees. Given the enormous scale of the crisis, Taylor says, it’s clear that the private sector could not have caused it on its own. “Distorted incentives encouraged private speculation,” he says. “Central banks should return to their former global targets against inflation and be less erratic and more predictable.”
Taylor’s analysis draws support from a comparison of the financial crisis in the U.S. and Canada. Canadian banks, it turns out, weathered the financial storm much more effectively than American banks did. The reason: Canadian mortgages, unlike American ones, legally required robust guarantees, usually a 20 percent down payment. That helped keep homeowners from running away from their mortgage payments when things turned south, as happened in the United States. Canada and the U.S., it’s worth noting, still have the same percentage of homeowners—roughly 67 percent—meaning that the American incentives that favored risky bank behavior failed to increase ownership levels.
Harvard Professor of Business Niall Ferguson is a brilliant historian and economist. He states that deregulation did not cause the financial crisis and opines that calls for more regulation of the financial markets as very ill advised. Rather, he sees the problem as being poorly designed regulations currently on the books.
This from Niall Ferguson writing at the NYT:
. . . Financial crises will happen. In the 1340s, a sovereign-debt crisis wiped out the leading Florentine banks of Bardi, Peruzzi and Acciaiuoli. Between December 1719 and December 1720, the price of shares in John Law’s Mississippi Company fell 90 percent. Such crashes can also happen to real estate: in Japan, property prices fell by more than 60 percent during the ’90s.
For reasons to do with human psychology and the failure of most educational institutions to teach financial history, we are always more amazed when such things happen than we should be. As a result, 9 times out of 10 we overreact. The usual response is to introduce a raft of new laws and regulations designed to prevent the crisis from repeating itself. In the months ahead, the world will reverberate to the sound of stable doors being shut long after the horses have bolted, and history suggests that many of the new measures will do more harm than good. The classic example is the legislation passed during the British South-Sea Bubble to restrict the formation of joint-stock companies. The so-called Bubble Act of 1720 remained a needless handicap on the British economy for more than a century.
Human beings are as good at devising ex post facto explanations for big disasters as they are bad at anticipating those disasters. It is indeed impressive how rapidly the economists who failed to predict this crisis — or predicted the wrong crisis (a dollar crash) — have been able to produce such a satisfying story about its origins. Yes, it was all the fault of deregulation.
There are just three problems with this story. First, deregulation began quite a while ago (the Depository Institutions Deregulation and Monetary Control Act was passed in 1980). If deregulation is to blame for the recession that began in December 2007, presumably it should also get some of the credit for the intervening growth. Second, the much greater financial regulation of the 1970s failed to prevent the United States from suffering not only double-digit inflation in that decade but also a recession (between 1973 and 1975) every bit as severe and protracted as the one we’re in now. Third, the continental Europeans — who supposedly have much better-regulated financial sectors than the United States — have even worse problems in their banking sector than we do. . . .
We need to remember that much financial innovation over the past 30 years was economically beneficial, and not just to the fat cats of Wall Street. New vehicles like hedge funds gave investors like pension funds and endowments vastly more to choose from than the time-honored choice among cash, bonds and stocks. Likewise, innovations like securitization lowered borrowing costs for most consumers. And the globalization of finance played a crucial role in raising growth rates in emerging markets, particularly in Asia, propelling hundreds of millions of people out of poverty.
The reality is that crises are more often caused by bad regulation than by deregulation. For one thing, both the international rules governing bank-capital adequacy so elaborately codified in the Basel I and Basel II accords and the national rules administered by the Securities and Exchange Commission failed miserably. It was the Basel system of weighting assets by their supposed riskiness that essentially allowed the Enronization of banks’ balance sheets, so that (for example) the ratio of Citigroup’s tangible on- and off-balance-sheet assets to its common equity reached a staggering 56 to 1 last year. The good health of Canada’s banks is due to better regulation. Simply by capping leverage at 20 to 1, the Office of the Superintendent of Financial Institutions spared Canada the need for bank bailouts.
The biggest blunder of all had nothing to do with deregulation. For some reason, the Federal Reserve convinced itself that it could focus exclusively on the prices of consumer goods instead of taking asset prices into account when setting monetary policy. In July 2004, the federal funds rate was just 1.25 percent, at a time when urban property prices were rising at an annual rate of 17 percent. Negative real interest rates at this time were arguably the single most important cause of the property bubble.
All of these were sins of commission, not omission, by Washington, and some at least were not unrelated to the very considerable political contributions and lobbying expenditures of the financial sector. Taxpayers, therefore, should beware. It is more than a little convenient for America’s political class to blame deregulation for this financial crisis and the resulting excesses of the free market. Not only does that neatly pass the buck, but it also creates a justification for . . . more regulation. The old Latin question is highly apposite here: Quis custodiet ipsos custodes? — Who regulates the regulators? Until that question is answered, calls for more regulation are symptoms of the very disease they purport to cure.
Read the entire article. And someone distribute this to Barney and Barack, please.
Until recently, I was confident that our economy would weather the current storm without undue difficulty. With the fall of Bear Stearns, I am far less sanguine. The long-term policy of record low interest rates may have dug us into a hole that proves the worst recession since WWII.
Bear Stearns, one of the big five investment banks, has gone belly up and the federal reserve has stepped in. This from the WSJ:
Yesterday's combined J.P. Morgan-Federal Reserve rescue of Bear Stearns is one of those judgment calls that are easier to second guess than they are to make in the heat of a financial panic. Regulators have to balance the risks to the larger financial system of letting a big investment bank fail against the discipline of seeing bad risk management punished by the marketplace.
These columns prefer the discipline of the market, but then we don't know all of the facts that regulators confronted as they looked at Bear's troubles. Specifically, we don't know if letting Bear collapse might have had a domino effect on others in the debt and derivative markets.
The Fed and J.P. Morgan are acting in concert to give Bear short-term access to the Fed's discount lending window that Bear couldn't access on its own. A big plunger in the debt markets but not a standard commercial bank, Bear's private sources of funds had dried up. The overriding public interest at the current moment is to maintain a functioning financial system, and regulators clearly felt this was at risk from a Bear failure. Just once we'd like to see what would happen if a big bank did fail, but the current general market panic arguably isn't the best time to have that experiment. Presumably Bear will now be shopped to private buyers. . . .
Read the entire article. Dinah Lord, blogger and former trader, reflects on a similar situation she lived through during her days on Wall St., as well as including links discussing the fall of Bear Stearns.
Dale Franks sees the Bear Stearns situation as dire news indeed. He writes in the QandO blog:
The market took a hit today. It was a body blow. And, whether you know it or not—although, if you're reading this, you'll know now—the economy took a body blow, too. The only thing we don't know is how much damage was caused. But there was damage, and it will become apparent before too much longer.
It's all about liquidity, you see. For the last several days, there's been concern about whether Bear Stearns, one of the Big Five investment banks, was going to be able to meet its financial obligations to client and creditors because of it's exposure to bad mortgage loans. Company executives have been saying, "Yes, we will," right up to this morning, when they said, "No, we can't."
Essentially, JPMorgan Chase will step in to provide financing for 28 days, and those loans, while coming from JPMorgan's coffers, will be underwritten by the federal Reserve.
If you're a Bear Stearns stockholder, by the way, you're screwed. What will probably happen is that, to prevent the firm from going under completely, JPMorgan will acquire Bear Stearns for pennies on the dollar. At the least, the chances of Bear Stearns continuing to exist as an independent entity are probably over for good. Bear Stearns' CEO admits as much, saying the firm is seeking a "more permanent solution".
And if Bear Stearns can't make it, you have to wonder what the actual position of Merrill Lynch, which is also exposed to the Carlyle fund problems, or Thornburg Mortgage, which failed to meet some margin calls earlier this week. Countrywide Home Loans is already involved in a bailout from Bank of America, and has had foreclosure rates double.
At the heart of the problem is an ongoing liquidity crunch. As exposure to bad loans causes foreclosures to increase, huge sums of money are just being written off—basically disappearing from the economy.
The primary effects of this disappearance—the failure of the banking institutions, is bad enough.
Beyond those effects, however, there are effects on the economy as a whole, because these large write-offs not only remove money from the economy in terms of the amount of the disappearing loan assets at the institutions themselves, individuals who do business with these institutions lose the ability to borrow money. Their credit lines disappear. the institution's borrowers lose their money as well.
This money supply shrinkage usually causes people to hoard cash, because they worry that they won't have enough cash to meet their future needs. They stop investing, for example, because they lose faith in the institutions. The dearth of available loan money causes people in the building trades to lose jobs, because new housing starts decline, so they have to begin saving up their own cash, and cutting purchases. And the effect ripples outward through the economy.
We generally call this widespread hoarding of cash a "recession".
That's certainly what the National Bureau of Economic Research calls it. Is calling it, in fact. And they say it may be the worst recession since World War II.
The worst recession in my lifetime was the back-to-back recessions in 1982, when unemployment rose to almost 12%. If we're in for a worse ride than that—well, I don't even want to think about that.
But, apparently, we have to. . . .
. . . Creating a lot of liquidity does not resolve an issue of solvency, which is now the driver of credit contraction. All the Fed will achieve is a dollar that will be further debased and inflation that will be higher. It cannot stop the process of deleveraging and asset price decline...
Prime brokers and banks are reining in credit to leveraged investors. This is a direct consequence of the damage done to banks' credit capacity by the writedowns of loans in other areas, such as structured finance and mortgages. This reduces their risk-free capital (value-at-risk ratios have doubled in the last year in the U.S.). In order to maintain adequate reserves as a proportion of risk assets, lending must be cut...
Credit contraction translates through the financial system into a reduction in available credit for the non-financial corporate sector, and thus into reduced investment and growth in the real economy. The size of that contraction can be estimated from the leverage ratios of the financial sector and their impact on real GDP growth.
We estimate that nonfinancial corporate debt ultimately will have to shrink by 11%-12%. This will generate a decline of five percentage points of real U.S. GDP growth and push the U.S. into recession. Europe's real GDP growth will contract by two percentage points.
Globally, total credit losses of $1.4 trillion will cause a contraction in world GDP of 2.5 percentage points, or half the current rate of global growth. So the global economy will become a gray, dull world of semi-recession and sticky inflation that will last a long time.
What has happened is that the liquidity crunch from mortgage credit problems—too many subprime loans, too many second mortgages, plus declines in housing values—have been amplified from bank lending up through securitized debt, then again amplified in the derivatives markets.
This decline in available credit—i.e. money—is not going to be fixed by a 3% drop in short-term interest rates. And it certainly isn't going to be fixed—or even noticeably ameliorated—by a one-time rebate of $600 per taxpayer.
I'm afraid we're in for an awfully bumpy ride. The problem with Bear Stearns today is not the problem. It is the most visible symptom, though, of the real problem with the economy and one that we'll be facing soon.
Posts
