World on the Brink- Depression or Hyperinflation
In August 2007, an obscure bank in Germany disclosed that it had suffered crippling losses on some financial instruments it held, which were based on a pool of sub-prime mortgages in the United States. Within days, traders in financial markets around the world were panicking as they found it nearly impossible to determine which other banks might be having the same problem, and just how large that problem was. Central banks around the world poured in money to calm troubled financial markets, and U.S. Treasury Secretary Henry Paulson made a show of declaring that the problems of the U.S. subprime mortgage market had been “contained.”
Either Paulson lied, or he did not know what he was talking about. By November, financial markets around the world were roiled with worries, and a number of analysts and economists were warning that the problems in the U.S. subprime mortgage market were just the tip of an iceburg buckling and ripping the metal plates of the world financial system. In the week before Christmas, a coordinated intervention by the U.S. Federal Reserve, the European Central Bank, the National Bank of Canada, the National Bank of Switzerland, and the Bank of England poured an estimated $1 trillion (that’s with a t not a b) into financial markets in just three days.
In an article on December 29, 2007, entitled, Crisis may make 1929 look a 'walk in the park' The London Telegraph reported that central bankers are quietly reviewing a 2004 U.S. Federal Reserve Bank study on how far the Fed’s powers can be extended in an emergency. The gist of the Telegraph article is that the world’s central banks have about two months to stop the collapse of the credit and derivatives markets before the Atlantic economies are pushed into depression. The article includes some very notable quotes from various central bankers around the world:
The Bank of England knows the risk. Markets director Paul Tucker says the crisis has moved beyond the collapse of mortgage securities, and is now eating into the bedrock of banking capital. "We must try to avoid the vicious circle in which tighter liquidity conditions, lower asset values, impaired capital resources, reduced credit supply, and slower aggregate demand feed back on each other," he says.
New York's Federal Reserve chief Tim Geithner echoed the words, warning of an "adverse self-reinforcing dynamic", banker-speak for a downward spiral. The Fed has broken decades of practice by inviting all US depositary banks to its lending window, bringing dodgy mortgage securities as collateral. . . .
"The kind of upheaval observed in the international money markets over the past few months has never been witnessed in history," says Thomas Jordan, a Swiss central bank governor. "The sub-prime mortgage crisis hit a vital nerve of the international financial system," he says.
In the United States, the economy had turned so far south so fast that it has become the dominant issue in the Presidential primaries. Sales statistics for the holiday season in the United States were very grim, and pointed to a very rapid collapse of what economists call “aggregate demand generation” (basically, the public’s purchasing power).
According to Barry Ritholtz, president of a hedge fund and a specialist in the analysis of macroeconomic trends and the capital markets,
Total sales gains from Thanksgiving to Christmas Eve were a nominal gain of 3.6%, according to data gathered by MasterCard’s SpendingPulse. Taking apart that data, we find that sales actually had a 0.0% gain over 2006 levels.
This was despite the fact that there were an extra eight days in the shopping spree season since Thanksgiving fell on November 30th in 2006 compared to November 22 in 2007, and Christmas Eve was Sunday evening in 2006 versus Monday in 2007. But it was even worse, according to Ritholtz:
That sales data includes Food & Energy. It's before we make any adjustments for inflation. It's worth noting that MasterCard’s SpendingPulse data is based on purchases made by more than 300 million MasterCard debit and credit card users; it covers not just store purchases, internet buys and gift cards: It also includes gasoline and meals at restaurants, both of which had seen significant price increases this year.
Excluding just the gas purchases, holiday sales rose a lackluster 2.4%. If we back out restaurants (and their price increases), then I ballpark sales at approximately 2% -- or a bit below the core rate of inflation. In other words, Real Sales may have reflected an actual loss over last year. This was despite the longer holiday shopping season. (Emphasis in original.)
Ritholtz ended by noting another very disturbing indication: the day before Christmas, Newsweek reported that
The value of credit card accounts at least 30 days late jumped 26 percent to $17.3 billion in October from a year earlier at 17 large credit card trusts examined by the AP. That represented more than 4 percent of the total outstanding principal balances owed to the trusts on credit cards that were issued by banks such as Bank of America and Capital One and for retailers like Home Depot and Wal-Mart.
At the same time, defaults -- when lenders essentially give up hope of ever being repaid and write off the debt -- rose 18 percent to almost $961 million in October, according to filings made by the trusts with the Securities and Exchange Commission. Serious delinquencies also are up sharply: Some of the nation's biggest lenders -- including Advanta, GE Money Bank and HSBC -- reported increases of 50 percent or more in the value of accounts that were at least 90 days delinquent when compared with the same period a year ago.
What all these numbers indicate is that people don't have enough disposable income to buy stuff. Economists call this a deficit of aggregate demand generation, and it is very, very bad. Franklin Roosevelt's Federal Reserve Chairman Marriner Eccles explained in his memoirs how this exact problem caused the Great Depression.
This is not even the worst of it. The American consumer, as Robert Reich recently noted, has reached the end of the line. But Reich apparently is not willing to admit just how bad the situation actually is, because to do so would require an acknowledgement that the present problems actually result not from just the past seven years of incomprehensible ineptitude of the Bush regime, but from a four decades’ long experiment with the “free market” “free trade” economic policies of Milton Friedman and Ronald Reagan. Unfortunately, economists call these policies “neo-liberalism” -- Reich is hardly a critic; he has been a consistent defender of free trade, for example. Wikipedia has an excellent summary of the key features of economic “neo-liberalism”:
- Fiscal rectitude, meaning that governments would cut expenditures and/or raise taxes to maintain a budget surplus
- Competitive exchange rates, whereby governments would accept market-determined exchange rates, as opposed to implemented government-fixed exchange rates, as had prevailed under the Bretton Woods System
- Free trade, which means the removal of trade barriers, like tariffs, subsidies, and regulatory trade barriers
- Privatisation, which means the transfer of previously-public-owned enterprises, goods, and services to the private sector.
- Undistorted market prices, meaning that governments would refrain from policies that would alter market prices.
- Limited intervention, with the exception of intervention designed to promote exports, some kinds of education or infrastructural development.
- Reduced capital controls, which involve removing governments laws that hinder or control the cross-border flow of finance
- Deregulation, the abolition or reduction of government-imposed restrictions on the conduct of business' decision-making
- Union busting policies, as unions are generally taken to be impediments to economic development by adherents of this worldview
- Export-led development, as opposed to a development strategy that emphasizes the protection of domestic industry
This is the underlying reality of the present crises: the abandonment of the post-World War Two Keynesian full employment industrial economy in the 1970s, and the creation of the Ronald Reagan / Milton Friedman radical "free trade" and "free market" economy that replaced it in the 1980s – economic neo-liberalism. What has happened with this basic shift in economic policies, from Keynesian full employment to “neo-liberal” “free markets,” is better captured by defining it as a switch from industrial capitalism to financial capitalism, with activity in the financial markets growing from rough parity with real economic activity as measured by GDP in the 1960s, to over 50 times larger than GDP now.
How quickly and how huge these financial markets have grown is truly mind-boggling. For example, consider the explosive growth credit default swaps, which are the financial derivatives that AMBAC and other similar companies specialized in:
Yes, the scale on the left is in increments of $5,000 billion -- that is, in increments of $5 trillion. And this is just one, small part of the financial markets. By comparison, U.S. GDP in 2006 was $13.13 trillion. Financial markets now dwarf the real economy. And that is the crux of the crises. Each financial instrument represents a potential future claim for payment that will have to met by the products of real economic activity. But what happens when the amount of payment claims is tens of times more than what the real economy produces?
But the priority in the Reagan / Friedman "neo-liberal" economy is to allow the markets to "grow," and financial claims have morphed over and over again, into all types of instruments generically called derivatives, because they derive their value from the value of other, underlying financial instruments. The Bank for International Settlements has reported that the amount of trading in derivatives in 2006 surpassed $1,000 trillion – that is, $1 quadrillion. What effect does this mass of financial paper have on the real economy? Remember that the standard nostrum of "free market" economics is increased competition will automatically create more value for consumers, in terms of better products, and or lower prices. But under the "neo-liberal" economy: the real function of competition is to cut wages, cut benefits, put the squeeze on vendors and suppliers. And so we have seen the nasty side effects of the past four decades' experiment with Reagan / Friedman “neo-liberal” "free market" economics: wages have stagnated, benefits have actually dropped, the bottom third of the population today is poorer than it was thirty years ago, long-term investment in things like roads, bridges, and water systems has become nearly impossible (anyone in Atlanta reading this?). The only reasonable conclusion of the experiment is that Reagan / Friedman "free market" “neo-liberal” economics actually impoverishes the national economy, while enriching the few who thrive on cut-throat competition. Probably not the best economic arrangement for a society comprising more personality types than just ESTJ and ENTJ.
James Crotty of the Political Economy Research Institute at the University of Massachusetts / Amherst explains this shift very well in the book Financialization and the World Economy (a six-page summary, that just is not as good as the chapter in the book, is available here: The Neoliberal Paradox: The Impact of Destructive Product Market Competition and Impatient Finance on Nonfinancial Corporations in the Neoliberal Era). The period 1946 to the 1970s, Crotty writes, can be considered the “Golden Age” of industrial capitalism. It was
characterized by what Schumpeter called ‘correspective competition,’ inter-firm relations based on partial cooperation rather than all out war. Of particular importance, firms avoided predatory pricing and capital investment wars that destroy profits and create large-scale industry excess capacity. By placing upper limits on capacity and lower limits on price, firms generated secure oligopoly rents, which were used in part to fund the high road labor relations that were the hallmark of the dominant firms of the era. High road labor relations, in turn, helped generate high productivity growth and rapidly rising real wages. Closing the Golden Age virtuous circle, rising wages, low unemployment ' and fast-paced investment helped sustain strong private demand growth.
In the neoliberal era, by way of contrast, deregulation, increasingly open borders, and the end of a commitment by government to pursue high growth through Keynesian macro policies have destroyed the conditions necessary for corespective behavior. We have witnessed an outbreak of what I have called 'coercive competition' (Crotty 1993) based on cut-throat pricing, the destruction of secure oligopoly rents, over-investment relative to demand - creating chronic excess capacity, and fast-paced technical innovation that often renders recently constructed capital goods prematurely obsolete and the debt that financed them unpayable.
With their survival threatened by fierce competition, much of it international in character, large firms were forced to adopt shorter planning horizons. Semi-cooperative management-labor relations were now considered unviable because firms had to slash labor costs through downsizing and wage cuts to survive beyond the short run. Conflict-driven labor relations became the order of the day.
Thus, a new form, an extremist form of capitalism, began to emerge, with various unforeseen effects. One of these, already apparent in the “go-go” years of the 1960s and especially in the rise of leveraged buy-outs in the late 1970s, Crotty calls the development of a “Financial or Portfolio Conception” of the non-financial corporation (NFCs) by the financial markets and professional managers. Crotty explains that there were
two aspects of the changing relation between financial markets and large NFCs. The first is a shift in the beliefs of financial agents, from an implicit acceptance of the Chandlerian view of the large NFC as an integrated combination of illiquid real assets – that is, physical and organizational assets that cannot be sold for cash quickly and without a major loss in value – assembled to pursue long-term growth and innovation, to a “financial” conception in which the NFC is seen as a ‘portfolio’ of liquid subunits that home-office management must continually restructure to maximize the stock price at every point in time. The second is a fundamental change in management’s reward structure, from one that linked pay to the long-term success of the firm, to one that links it to short-term stock price movements.
This Portfolio Conception of industrial enterprises both complemented and abetted the creation of a new class of idiots savant -- the professional manager -- who believe that managing a company that produces semi-conductor lithographing equipment is not that much different than managing a chain of brothels in Nevada. The typical American manager with MBA in hand no longer views industrial companies as long-term enterprises in which they must carefully nurture strong commitments to long-run goals by top management, lower level management, specialized professionals, white- and blue-collar workers, and the firm's traditional suppliers. Rather the professional manager views industrial companies as units or collections of sub-units that are liquid assets which can be sold off to capital markets if they “underperform.” This demolishes any idea of long-term commitments or long-term loyalties, to anybody, to any community, even to any nation. (One great irony here is that conservatives have never noticed that this effect has seriously undermined the work Friedrich von Hayek did on the problem of intertemporal coordination of capital, commonly regarded among economists as Hayek’s most valuable contribution to economic theory.)
What this means, of course, is that wages, earnings and benefits in the U.S. have been under intense assault for the past three decades. The numbers, when brought down to the level of you and me, and truly startling and discomfiting. If, since Reagan took office, average weekly earnings had continued to grow at the same rate they had grown from 1964 to 1980, the typical household in the U.S. today would have had around $30,000 more in income than it does now. That's right, nearly twice the income. There would not have been a “market” for sub-prime mortgages in those circumstances, the opportunities for predatory lending would have been almost non-existent, and we would not be watching the rare spectacle of Republicans and Democrats co-operating – to pass a $150 billion “stimulus” plan that actually does not address any of these underlying problems.
This is how the deficit in “aggregate demand generation” was created. But why did it not create a financial crisis before? The answer is debt: an explosion of debt. As Van R. Hoisington and Lacy H. Hunt explained in their 2007 Third Quarter Review and Outlook from Hoisington Investment Management Co.:
at the end of the second quarter, household mortgage debt totaled $10.143 trillion, compared with $4.295 trillion in 1999. Thus, in six and a half years the household sector’s mortgage debt increased by $5.8 trillion, or 136%. While the aggregate debt figures are interesting, the relevant measure is the relationship between mortgage debt and household income. If personal income were also rising rapidly, then households would be in position to make the required interest and amortization payments. However, incomes have lagged. Consequently, mortgage debt relative to disposable personal income surged from 64.7% at the end of 1999 to 100.2% at the end of the second quarter of this year. This 35.5% rise since was greater than the rise over the 43 years leading up to 1999. Third, total household debt relative to disposable personal income also continued to move ever higher. At the end of the second quarter, this ratio jumped to a new record of 131%, up from 93.6% at the end of 1999. . .
By propping up the American consumer with an increasing load of debt (rather than simply increasing wages and earnings) a “virtuous circle” was created – for Wall Street. Issuing ever more debt, of course, makes the financial sector ever bigger, with ever more assets to leverage, trade, and churn. Essentially, the United States has been creating the illusion of growing prosperity by focusing on the creation of “paper” wealth, while the real economy has been dismantled and shipped overseas, and the wages, earnings, and benefits of ninety percent of the population have stagnated or even fallen for those on the lowest rungs. Throwing $150 billion in economic “stimulus” at this reality is like throwing toothpicks into a bonfire.
In Asia Times Online, the inestimable Henry C. K. Liu lays out where the world financial crises are now headed. In The Road To Hyperinflation, Fed Helpless In Its Own Crisis, Liu responds to former U.S. Federal Reserve chairman Alan Greenspan’s defensive but arrogant article in the December 12, 2007 edition of the Wall Street Journal, in which Greenspan blamed the current world financial crises on China and the developing world for “saving too much.” Liu harshly condemns Greenspan, explains how Greenspan helped engineer the mess during his tenure as Fed chairman, and concludes that now there are only two options left:
The Fed has a choice of accepting an economic depression to cut off stagflation, or ushering hyperinflation by flooding the market with unproductive liquidity.
The first web page of the article is rather dry, as Liu reviews the fundamentals of how the U.S. Federal Reserve functions. Along in the second web page, though, things get more interesting. First, Liu demolishes the idea that the current bi-partisan “stimulus” package in the U.S. will do any good. Next he heaps scorn on the Bush tax cuts of 2001 and 2004 as ill-conceived and implemented without preparation of proper incentives for new investment. Then Liu points directly at the underlying problem:
… for the last two decades, even in boom time, the US middle class has not been receiving its fair share of income while increasingly bearing a larger share of public expenditure. The long-term trend of income disparity is not being addressed by the bipartisan short-term stimulus package.
Liu then surveys the explosive growth of credit swaps (CDS) (now at $45 trillion, three times the size of U.S. GDP) and collateralized loan obligations (CLO), and details why and how the loan insurers like MBIA and Ambac Financial were brought to their knees, and explains how that crises is now heading toward territory outside the banking system, and will soon cause the collapse of companies other than banks.
For the insurers to maintain the necessary triple-A rating, their capital reserve would have to be repeatedly increased along with the premium they charge. There will soon come a time when insurance premium will be so high as to deter bond investors. Already, the annual cost of insuring $10 million of debt against Bear Stern defaulting has risen from $40,000 in January 2007 to $234,000 by January of 2008. To buy credit default insurance on $10 million of debt issued by Countrywide, the big subprime mortgage lender, an investor must as of January 11, 2008 pay $3 million up front and $500,000 annually. A month ago, the same protection could be bought at $776,000 annually with no upfront payment.
Credit-default swaps tied to MBIA's bonds soared 10 percentage points to 26% upfront and 5% a year, according to CMA Datavision in New York. The price implies that traders are pricing in a 71% chance that MBIA will default in the next five years, according to a JPMorgan Chase & Co valuation model. Contracts on Ambac Financial, the second-biggest insurer, rose 12 percentage points to 27% upfront and 5% a year. Ambac's implied chance of default is 73%. . . .
As big as the residential subprime mortgage market is, the corporate bond market is vastly larger. There are a lot of shaky outstanding corporate loans made during the liquidity boom that probably could not be refinanced even in a normal credit market, let alone a distressed crisis. A large number of these walking-dead companies held up by easy credit of previous years are expected to default soon to cause the CLO valuations to plummet and CDS to fail.
At he begins to wrap up, Liu is not interested in taking prisoners.
The last decade has been the most profligate global credit expansion in history, made possible by a new financial architecture that moved much of the activities out of regulated institutions and into financial instruments traded in unregulated markets by hedge funds that emphasized leverage over safety. By now there are undeniable signs that the subprime mortgage crisis is not an isolated problem, but the early signal of a systemic credit crisis that will engulf the entire financial world.
Both former Fed chairman Greenspan and his successor Ben Bernanke have tried to explain the latest US debt bubble as having been created by global over-saving, particularly in Asia, rather than by Fed policy of easy credit in recent years.
Yet the so-called global savings glut is merely a nebulous euphemism for overseas workers in exporting economies being forced to save to cope with stagnant low wages and meager worker benefits that fuel high profits for US transnational corporations. This forced saving comes from the workers’ rational response to insecurity rising from the lack of an adequate social safety net. Anyone making around $1,000 a year and faced with meager pension and inadequate health insurance would be suicidal to save less than half of his/her income. And that’s for urban workers in China. Chinese rural workers make about $300 in annual income. For China to be an economic superpower, Chinese wages would have to increase by a hundredfold in current dollars. . .
Not only do Chinese and other emerging market workers lose by being denied living wages and the financial means to consume even the very products they themselves produce for export, they also lose by receiving low returns on the hard-earned money they lend to US consumers at effectively negative interest rates when measured against the price inflation of commodities that their economies must import to fuel the export sector. And that’s for the trade surplus economies in the developing world, such as China. For the trade deficit economies, which are the majority in the emerging economies, neoliberal global trade makes old-fashion 19th-century imperialism look benign. . . .
Greenspan blames "the Third World, especially China" for the so-called global savings glut, with an obscene attitude of the free-spending rich who borrowed from the helpless poor scolding the poor for being too conservative with money.
Yet Bank for International Settlements (BIS) data show exchange-traded derivatives growing 27% to a record $681 trillion in third quarter 2007, the biggest increase in three years. Compared this astronomical expansion of virtual money with China’s foreign exchange reserve of $1.4 trillion, it gives a new meaning to the term "blaming the tail for wagging the dog".
Liu’s conclusion is stunning in its brutal truth:
While the equity markets are hanging on for dear life with the Fed’s help through stealth inflation, the bond markets have collapsed worldwide, with dollar bond issuance falling to a stand still, euro bonds by 66% and emerging market bonds by 75% in Q3 2007. Lenders are simply afraid to lend and borrowers are afraid to take on more liabilities in an imminent economic slowdown. The Fed has a choice of accepting an economic depression to cut off stagflation, or ushering hyperinflation by flooding the market with unproductive liquidity. Insolvency cannot be solved by injecting liquidity without the penalty of hyperinflation.