James K. Galbraith, who holds the Lloyd M. Bentsen, Jr. Chair of Government/Business Relations at the Lyndon B. Johnson School of Public Affairs at the University of Texas in Austin, is the son of the legendary economist John Kenneth Galbraith. He is a frequent speaker on matters related to the financial and economic crisis and has been a witness before Congress on several recent occasions. Mr. Galbraith is the author of seven books. His two most recent books are: “Unbearable Cost: Bush, Greenspan and the Economics of Empire” (published by Palgrave-MacMillan in late 2006), and “The Predator State: How Conservatives Abandoned the Free Market and Why Liberals Should Too” (published by Free Press in August 2008 – for more information visit: http://predatorstate.com). Robert B. Reich, Professor of Public Policy, University of California at Berkeley, wrote about “The Predator State”:

"James Galbraith elegantly and effectively counters the economic fundamentalism that has captured public discourse in recent years, and offers a cogent guide to the real political economy. Myth-busting, far-ranging, and eye-opening."

Moreover, Mr. Galbraith has written several hundred scholarly and policy articles, including columns in Mother Jones and articles / op-ed’s in The American Prospect, the Nation, and the Washington Post. He studied economics as a Marshall Scholar at King's College, Cambridge in 1974-1975 and holds degrees from Harvard and Yale (Ph.D. in Economics, 1981). Later he served on the staff of the U.S. Congress as Executive Director of the Joint Economic Committee before joining the faculty of the University of Texas in 1985. In public life, he organized congressional oversight of the Federal Reserve (the Humphrey-Hawkins hearings) and worked on financial crises including the Third World debt crisis of the 1980s. In the 1990s he served for four years as Chief Technical Adviser for macroeconomic reform to the State Planning Commission of China. He was called to advise the House of Representatives on the TARP legislation in September 2008 and on recovery strategy in December of the same year. He was also invited to Congress to give his point of view about the “Audit the Fed” initiative of Congressman Ron Paul (House Resolution 1207 Federal Reserve Transparency Act of 2009 – to see Mr. Galbraith’s testimony on Capitol Hill follow this link: http://www.youtube.com/watch?v=oxAt-Un1k7I).

As an outspoken critic of the free market consensus, especially the monetarist version of Milton Friedman,[i] Mr. Galbraith argues that Keynesian economics offers a solution to the current financial crisis, whereas monetarist policies would deepen it.

Mr. Galbraith’s scholarly research has focused on the measurement and understanding of inequality in the world economy, under the rubric of the University of Texas Inequality Project, UTIP (for more information on that topic visit the web-site of UTIP at http://utip.gov.utexas.edu). His policy writing ranges from monetary policy to the economics of warfare, with forays into politics and history, especially the history of the Vietnam War. He is a Senior Scholar with the Levy Economics Institute of Bard College, and Chair of the Board of Economists for Peace and Security, an international association of professional economists (www.epsusa.org). His papers on macroeconomic topics can be found on the Levy web-site at www.levy.org. An archive of his writings can be also found at http://www.utexas.edu/lbj/faculty/galbraith.html.

The following exclusive interview with James K. Galbraith is a Joint Venture between New Deal 2.0 in the USA (www.newdeal20.org) and MMNews in Germany (www.mmnews.de).

Professor Galbraith, in July of 2009 you have signed an initiative of the Franklin and Eleanor Roosevelt Institute that wants an answer to the question: What Caused the Crisis?[ii] May I ask for your personal answer?

Yes, you may. (laughs.) – The principal cause of the crisis was the dismantling of the system of regulation and supervision in the financial sector which had for much of the post-war period kept the most dangerous elements of that sector in check. In the absence of an appropriate system of effective supervision and regulation, what happens is that the actors in the system, who are intent upon taking the greatest degree of risk -- including actors who are intent upon using fraudulent methods to increase their returns -- come to dominate parts of the system. As they do that, the general methods of assessing performance in the market, specifically stock-market valuations, become counter-productive. That is to say, they  invariably reward the worst actors, while they force more traditional actors, who are still respecting the old norms of conduct, into a competitively disadvantaged position. Thus the bad actors, the fraudulent actors, and the speculative extremists quickly take over.

That is what happened specifically in the origination of mortgages in the United States in the middle part of the last decade. You had a transition from a traditional method of issuing mortgages to people who could be reasonably expected to service them, to a method of originating mortgages that were sold off immediately, that were rated in a way that permitted them to be bundled and sold to fiduciaries, and where the issuer had no interest in whether the borrowers could pay or not. In fact, in some ways the lenders actively preferred people who did not intend to pay, because they could then inflate the value of the loan and earn a larger fee upfront for doing it. And in this way, not only was there a large segment of the market that was explicitly corrupt, but the equity value of homes all across the country was compromised. When these practices collapsed, so too did the home values not only of people who had bad mortgages, but also those for many people who had good mortgages, good incomes and perfectly good credit.

The result of that was a general slump in activity. The wealth and financial security of much of the American middle class disappeared. So far about a quarter of the measured wealth of the American middle class has disappeared – about $15 trillion of $60 trillion.  That’s bound to have a fantastically traumatic effect on people’s consumption behaviour and on their ability to get new good credit. Even if they wish to continue to extend the past pattern of borrowing in order to finance activity, they can’t do it.  So, this is a very big problem. It starts with a failure to supervise and regulate the financial system, and flows on to the reaction of the broader population, which is to protect their remaining assets, to become extremely adverse to taking ordinary business and consumer risks.

How much of this crisis is related to what you call “the Economics of Empire” during the presidency of George W. Bush?

I think at the end of the day that’s not the primary factor. There was reason, good reason, to be concerned at the start of the Iraq War, that the war would be vastly more costly than was predicted, that it would be a much more difficult war than was predicted, and that it would damage the strength of America’s position in the world. All of that has certainly happened. But the war itself was not a strong enough fiscal stimulus to bring the economy out of the recession of 2000/2001, at least not in a decisive way, and it’s partly for that reason that the Bush Administration 2004/2005 set about actively encouraging the use of these credit mechanisms in the housing market. Out of that, they got a higher level of economic activity than they otherwise would have had, they avoided a period of stagnation that otherwise would have been worse --  was until the whole business collapsed completely in 2007/2008.

Marshall Auerback stated in an interview that I had with him this:

“In all important respects we managed to recreate the exact same conditions of 1929 and history repeated itself with the exact same results. Take John Kenneth Galbraith’s The Great Crash,[iii] change the dates and some of the names and you’ve got the post mortem of our current calamity.”[iv]

Do you agree with Mr. Auerback?

Of course, and so does the book-buying public which took an enormous interest in “The Great Crash” over the last couple of years.

So you believe that your father’s “The Great Crash 1929,” which was first published in 1954, is still of relevance today?

It describes behaviour and psychology in the financial markets very effectively. There are a couple of important things that have changed. One is the existence and continued vitality of some of the institutions that were created in the New Deal and the Great Society, giving us a much larger public sector as well as a very large non-profit sector, neither of which existed in the 1920’s. The capacity of the public sector to move to run very large deficits very quickly and practically automatically, is a saving grace; it’s the reason that we have a 10% unemployment rate and not a 25% unemployment rate in the wake of this crash. That’s an extremely important and valuable difference between now and the 1930’s.

My father he does not give the same weight to the element of outright fraud, back in 1929, that I would regard as a truly dominant factor in this crisis. There certainly was fraud in the 1920’s, there was a great epidemic of what we would call bucket-shops in the stock-market, there was a lot of fraud in Florida real-estate in the mid-1920’s. But this was overshadowed by a general euphoria about economic prospects. People who went into the stock-market, at least in my father’s depiction of this period, were doing so out of a great deal of authentic enthusiasm. From that point of view the period resembles the late 1990’s more than it does the middle 2000’s. During the middle 2000’s the economy was being propelled by predatory activity directed at a very vulnerable segment of the American population, people who had been renters all their lives, who really couldn’t afford to be moved into houses, who were aggressively moved into them by unscrupulous lenders. The lenders basically pushed loans on to borrowers that the lenders knew, or who ought to have known, could never have been serviced in full.

In a recent interview for MMNews, Hans-Olaf Henkel, who was once the head of the Federation of German Industries as well as IBM Europe, said two things that I would like to confront you with because Mr. Henkel is an influential opinion-maker here in Germany.[v] The first thing he said was that basically no one saw this crisis coming and that he laughs himself to death whenever someone says that this crisis was foreseen. Can you give Mr. Henkel some names in this respect? How about Dean Baker for example?

I’ve written a long article on not just the individual economists, but groups of economists who saw the crisis coming very clearly.[vi] Dean is one certainly with a strong claim. Dean follows a very simple method.  He looks at critical ratios, such as the ratio of house prices to rental rates. When these deviated very far from their historical norms, that generates an expectation that they would revert. People should have been looking at that evidence and taking Dean’s predictions far more seriously than they did. But on the other hand,  what Dean is pursuing is a very simple method and couldn’t be described as a school of economic analysis.

There are at least three traditions in economics that were warning about what was coming in ways which were very coherently related to a formal analytical program.

There is a group associated with the Levy Economics Institute and led by Wynne Godley,  former senior advisor to the British Treasury. This group was working with national balance sheets -- with the national income accounts -- and warning very emphatically that the debt-burden of the household sector was unsustainable..

There are people working in the tradition of Hyman Minsky, who of course were  trained to expect financial instability. They were making similar points from a substantially different conceptual basis.

And then there are people working broadly in the tradition of my father, who look at the structures of economic power, and who were warning that the supervision of the banking system was going to cause an epidemic of fraud. There was a group of what we call “white-collar criminologists”, who were examining these issues, and they are developing a new political economy of crime.

This group had the experience of what happened in the Savings and Loan crisis of the 1980’s, when certain patterns of behaviour, which are relatively standard in criminal financial activity, were very clearly present. These patterns re-emerged in the early 2000’s in the Enron, Worldcom, and Tyco scandals, and they were re-emerging again in the housing sector. To these people it was entirely obvious that a massive problem was developing.

So, Mr. Henkel needs to read a little bit more, He needs to broaden his definition of what constitutes economic analysis, and needs to recognize that the problem is precisely a group of people who insist that nobody outside of their very narrow circle has any insight worth paying attention to. That’s a preposterous position. It’s a completely indefensible position. It reflects fundamental narrowed-mindedness and, as I may say, incompetence which is really on display for anybody to see. So I do not need to hammer the point too hard.

The other thing that I want to know with regard to Mr. Henkel’s statements is this: He said that this crisis was caused by a certain type of “do-goodism” among American politicians who wanted to make sure that every American citizen would have a home of her/his own. What do you think when you hear such a thing?

It is an amusing interpretation of the motives of someone like George W. Bush, who represented one of the most aggressively predatory tendencies in American politics ever to reach the White House. This was a president who turned over regulation -- not just in finance but in everything he got his hands on -- to the most reactionary elements of the business community, to the most anti-regulation elements, so that regulatory structures were run down everywhere. They were run down in consumer protection, they were run down in worker protection, they were run down in trade, they were run down in ways which have significantly degraded the quality of life in the United States.

So, to suggest that this was some naïve altruism on the part of that extraordinarily reactionary Republican administration is, I must say, a view that no one who has actually lived through this period in the United States would recognize.

Now, Mr. Henkel is probably thinking about institutions like Fannie Mae and Freddie Mac which were, in fact, private firms. Fannie Mae had been privatized for forty years, and it had, indeed, become a bastion of Washington cronyism. I think that’s fair to say. Those institutions were drastically mismanaged by the overpaid appointees who were running them, no doubt about that. Ginnie Mae, the Government National Mortgage Association, which was not privatized, did not have the same problems.

But the truth is: this crisis emerged largely first of all in the private-label mortgage sector, that is to say in purely private entities like Countrywide, Washington Mutual, or IndyMac. The loans were securitized through private banks, vetted by private ratings agencies. The point here was not to put people in homes. It was clear to the lenders that the people that they were putting in homes would not be able to stay there.

The point was obviously to do two things. One was to create an enormous stream of revenue for these financial firms -- who were in many cases friends and political supporters of the administration. Second, it was to create a temporary burst of economic activity  that would be to the political benefit of the Bush administration. So, to the extent that you had political forces that were explicitly driving the process, those were the motivations. It was certainly not some broad altruism toward a part of the population in which the political leadership of the country at the time never had any interest whatever.

Is there such a thing like “do-goodism” in Washington?

There is “do-wellism.”

What is this?

Large parts of the process are driven by a very strong desire to increase one’s income and wealth. I’m not saying that everybody in Washington is a crook. I’m not saying that there aren’t principled public servants even now. But to say that they were dominating housing policy in the last decade is a very silly view.

But does at least Goldman Sachs do “God’s Work” here on earth?[vii]

Well, I think you have to ask Mr. Blankfein that question. (laughs) The reality is: these firms have enormously increased their share of American economic activity in the last twenty to thirty years. At the peak they were making, or perhaps even still, 40 % or more of total corporate profits. They were paying 10 % of total wages. This is vastly out of proportion of the need for financial services in any economy and in a substantially predatory relationship with the rest of economic activity.

So, the task facing us is to figure out how to bring this sector under control, how to shrink it  and how to restructure it, so that it is formed of firms which actually compete with each other rather of operating essentially as a large informal cartel with an implicit government guarantee for the most wealthy and powerful operations in the business.

Let me give you a parallel. In many countries, in modern times, one had a large state-owned airline which provided rather poor service and did not exploit the potential of that industry. An extreme example of that was in China, where you had one large, socialist airline. The Chinese did not privatize that firm. Rather they broke it up into many smaller airlines and allowed new companies to enter the market. Some were owned by the state, some by provinces and some by municipalities. It created an environment of enormous competitiveness between companies, and it enormously improved the service and forced a great modernization of the industry. (As an aside, I’ve heard on good authority that the Chinese got the idea for this from one of the 20^th centuries greatest physicists, the American John Archibald Wheeler.)

That is the kind of thing that we need to do with the banking industry. Banks are private-public partnerships. It can be structured in a number of different ways. And the idea that you need to have a sector which is dominated, with 60 % of the industry in a handful of multinational firms --  whose business models are highly speculative, who are involved in the avoidance of taxes and regulation on a multi-national basis -- this is absurd. It’s a very poor way to run a modern economy, and to the extent that we don’t deal with this structural problem, we are going to continually run into problems of instability into the future.

With regard to the trickle-up bailouts from autumn of 2008 – that you opposed[viii] – and onward: those trillions of dollars spent were not spent by “do-gooders” in the interest of protecting bank depositors or the general public; they went to protect bank bondholders, is this right?

Yes, that is essentially correct. But it was not just bondholders who were protected. Shareholders and holders of subordinated debt, which is risk capital, were also protected; in a resolution they would have been left out. That’s a serious problem. There was no real reason to do that. In a normal work-regulatory intervention in a bank which is insolvent or at risk of insolvency, the historical effective practice of the regulatory agencies was to ensure that shareholders and subordinated debt-holders, who were after all putting their money at risk in order to earn a higher return in good times, were wiped out. They should have been. That is first of all necessary to preserve the basic hierarchy of returns and risks in the financial markets, and necessary to establish in a credible and decisive way the need for changing practices in the financial sector.

Isn’t it the case that almost by definition, money given, like via these bailouts, to corporations or banks will show up most quickly as improvements in corporate earnings, and then slightly later, as executive compensation?

The phrase “money given” is a little bit vague. What was done in this case primarily was a purchase of preferred equity in the banks and that does not show up as earnings. The best way to think of a capital injection, technically, is as a form of regulatory forbearance. It was a way of saying to the banks, “we are not going to impose upon you the restructuring of your balance sheets that would have been required by recognition that your capital had been diminished to the extent that it had actually been diminished.” From a regulatory standpoint, buying preferred shares is essentially the same thing as reducing a capital requirement.

Two other things then happened.  The Federal Reserve reduced the cost of funds to the bank existent to zero, and the Treasury made it clear that the large institutions were not going to be permitted to fail. This was the message of the stress tests, which were clearly, I’d say, one of the most successful public relations exercises of recent times. They didn’t persuade people that the banks were sound. They simply persuaded people that the government would not let them fail. The government was not going to allow the banks’ unsoundness to trigger the normal actions that would have brought them into conservatorship and ultimately to resolution.

As a result, the banks were able to begin borrowing extensively. Some of these funds apparently found their way, by what channels is not entirely clear, right back into speculative asset markets. This meant that the stock market recovered and that commodity markets recovered and people who were investing in those markets at the bottom with speculative hopes have been very, very greatly rewarded. I think that’s where the bank profits partly come from. That, plus an enormous amount of interest arbitrage which is to say, borrowing from the central bank at zero and then lending back to the treasury or similar, very secure, non risk-taking entities at 3 or 4 %, is also a way of making a lot of money if you do it on a sufficiently large scale. Those things have given the banks very good earnings and enabled them to resume paying bonuses.

And what do you think about the plan of the Securities and Exchange Commission (SEC) to abolish the legal right to redeem money market accounts?[ix]

Do I have a comment on it? I’m not on top of that one.

At the end of “The Predator State” you are explaining the consequences of the breakdown of the Bretton Woods agreement by Richard Nixon in 1971. May I summarize my reading of it?

Sure.

Well, in the chapter “Paying For It” you explain that according to the system established in 1944, the U.S. current account deficit – and by extension its public budget deficit – was limited by an obligation to exchange foreign-held dollars for gold. Richard Nixon abolished that arrangement. You are arguing now that since the early 1980s, the world has held the T-bonds that the U.S. chose to issue. You acknowledge that the system is neither robust nor just, but you insist that so long as it lasts, it doesn't discipline the U.S. budget and therefore doesn't constrain U.S. government spending in any way. Is this right so far?

Correct, sure.

I mention this because this is basically, at least as far as I understand it, the financial backbone of the stimulus package you want to see taken place? And if this is the case how would then a stimulus package look like if you could have it your way?

First of all, it’s very clear that the United States government is not constrained externally, and it’s clear that quite apart from the stimulus package, the automatic stabilizers and the financial rescue, which greatly ballooned the public debt of the United States, have had no effect on the ability of the United States government to fund itself and no effect on the interest rates that the government pays. So, it, I think, follows from that logically and straight-forwardly that we have nothing to fear from additional efforts as long as they are necessary. And they’re obviously very clearly necessary. So the question is: what should be the structure of those efforts?

I’ve always taken exception to the constant reference to “stimulus” as the policy objective, because implied in that word is the idea that all one needs to do is to undertake one or more relatively short term spending sprees, on whatever happens to be available at the moment, and that this will somehow return the economy to its pre-crisis state, putting it on a path of what economists like to call “self-sustaining growth.” I maintain that in the present environment there is no such thing as a return to self-sustaining growth. There will be no return to the supposedly normal conditions, which were in fact, from a historical point of view, highly abnormal, of the 1990s and 2000s.

What one needs is to set a strategic direction for renewal of economic activity. We need to create the institutions that will support that direction.  Those institutions are public institutions, which create a framework for private activity. This is the way it is done. It is the way countries have always developed in the past and, to the extent that they are successful, they will always do so in the future or they won’t succeed. Seventy years ago when we were in the Great Depression, they built a national infrastructure: roads, airfields, schools, power-grids – this kind of thing was the priority. In the post-war period, the creation and maintenance of a large middle class with social security, with medical care, with housing programs, universities – these were the priorities of the post-war period.

Now we clearly face an enormous challenge with energy and climate. It’s a challenge that requires us to think in very creative ways, in very ambitious ways about how to change how we live, so as to make life on the planet tolerable a century or two centuries hence. This is a huge challenge. It requires design, planning, implementation, something with enormous potential for providing employment because things have to be done, enormous potential for guiding new public and private investment because one has to provide people with the means of making it realistic for individual activity to support this larger objective. And that is the way to move toward a renewed economic  expansion. This strikes me very far from being a stimulus proposal. It is a proposal for setting a new strategic direction for the economy and doing so over a relatively long time horizon with a view that you’re sustaining effort for 15, 20, 30 years. That’s the way I think you need to think about this.

Just to wrap up a long answer to a short question: Why can’t we go back to the pre-crisis period? The answer is that restructuring of the private household debts is an enormous task which necessarily takes a very long period of time. During that time, the pre-crisis pattern of increasing debt will not resume. The asset against which the American household sector collateralized its debt for 15 to 20 years, its housing, has radically fallen in financial value. The houses are still there but you can’t sell them for nearly as much as you could have three years ago. And that is a structural impediment to returning to the previous pattern of economic expansion. And that impediment isn’t going to be removed in any short period of time for the simple reason that the houses remain there as an excess supply on the market and they remain therefore as a drag on housing prices.

Do you see a bit of a problem in the fact that the Federal Reserve bought approximately 80 percent of the U.S. Treasury securities issued in 2009?[x]

No.

Why not?

Well, say what problem are you hinting at here, then I’ll explain.

Some people might say that this does fulfil the requirements for a Ponzi Scheme.

It certainly isn’t remotely related to a Ponzi Scheme. To be very clear, a Ponzi Scheme is a scheme in which a private party is issuing debts which can only be serviced by issuing more debts to cover the interest. This is not a constraint on a sovereign government which controls its own currency. Never is, never will be. There is a lot of loose rhetoric about things like Ponzi Schemes and national bankruptcy which is typically the work of people who neither know nor care much about what they’re talking about.

You already said that energy should be part of a stimulus package or a larger plan. What do you think like for example about the immediate implementation in the U.S. of a national Feed-in Tariff mandating that electric utilities pay 3 % above market rates for all surplus electricity generated from renewable sources, as Mike Ruppert suggests in his new book “Confronting Collapse”?[xi] In Germany, the Feed-in Tariff was quite a success story that created a huge amount of new jobs. Would you support this implementation?

I would need to study it, so I’m not sufficiently familiar to say. But it does sound, as you just described, like a promising line of attack.

With regard to the energy problem, I would like to know if you take the phenomenon of Peak Oil seriously, and if so: why do you think that the financial, economic and political establishment around the globe wants to keep quiet about it or dismiss it as “nonsense”[xii] even though there seems to be a good amount of evidence that the world soon won't be able to meet energy demands anymore?

I have read a fair amount on Peak Oil and I do think that the argument in its favor is qualitatively different from, and more serious than, earlier alarmist warnings about the supply of oil. The peak oil proposition relates to supplies of conventional oil, and it relates to the idea that there is a normal (bell) curve associated with discovery and production over time. That strikes me as a plausible hypothesis, and as one that back in 1956, successfully predicted he peak in conventional oil production in the United States in 1970. So it’s been around for a long time. So, I do think that it’s a proposition which needs to be taken seriously. As to your characterization of the actions and motives of large and powerful interests, I don’t have a theory on that.

As Chair of the Board of Economists for Peace and Security: isn’t the whole ongoing “War on Terror” a fraud that is really driven by the geopolitical competition for oil?

That’s a compound question. First part, is the “War on Terror” a fraud? I have always found that the concept of war on a method to be a very dangerous way of arguing because it basically covers anything the speaker wants to cover. It is something which can have no end, no limit, no success. It’s a construct which justifies the permanent commitment of resources to an exercise in futility at best, and at worst a cover for all kinds of other purposes. And your suggestion is that one of those purposes is the struggle for the control of oil.

My answer to that is: the interest of major oil producers can be served without, and has been historically served without physical access to production fields. The oil majors’ interests haven’t depended on owning oil fields for many decades. So, when you ask what were the interests of energy producers in the Iraq War -- and without saying that they played the dominant role, which I think is very, very uncertain, in the decision to undertake that war -- there’s no evidence whatever that their interest was to go over and produce the Iraqi fields. Quite the contrary, since the war they’ve not made a very serious effort to do that.

There’s been very little new international investment in Iraq in the post-war period. Very little certainly in the traditional oil-producing regions of Iraq. So, I think that their interests are served perhaps by preventing excess supply that might otherwise have come on-line from Iraq from doing so, because that would have undermined the markets for oil produced in places where costs are much higher. One could make an argument along those lines. It strikes me as being economically more coherent, but I’m not going to get into the position of trying to interpret the entire exercise in Iraq along those lines because I think, in point of fact, that other factors, including power politics in the Middle East, and including domestic politics in the United States, also played extremely important roles.

And there are people, who have studied George W. Bush, who write that he believed that you can’t be a successful president of the United States without a war. Perhaps the whole matter was as simple as that. I don’t know if that’s true or not, but one has to be, as a historical matter, very open-minded about the reasons why a particular government of the United States takes a particular action of this kind.

The biggest “treasure”, I believe, that the Bush Administration left, are the records of the National Energy Policy Development Group, NEPDG, run by Vice-President Richard Cheney in Spring of 2001. Those records are kept secret even though the American public did pay for it – and not Mr. Cheney himself. Given the fact, that we can strongly assume that those records must be very precise when it comes to oil reserve numbers, and given the fact, that we have for years now all this debate about reserve estimates, wouldn’t it be time to open this “safe deposit box” in order to let the world see how much oil there is really left?

Again, a question with a number of predicates that I can’t speak to with authority. I don’t know what is in those files.

Well, they’re secret.

Yes. I do agree that files of this type should be made public. If there is an argument, which undoubtedly some people will make, for a national security reason not to make them public, then an appropriate procedure, which we have followed in this country in the past, is to appoint a panel of independent outsiders, not previously connected to the government, to review the documents and to make them public unless there is a compelling reason not to, with arguments about what is compelling and not-compelling ultimately resolved by the president himself. That’s a model that has been applied successfully in the past in the United States on a matter of this kind. I think it would be very useful to do it in this and other instances on the conduct of the Bush administration.

Two questions on Ron Paul’s bill to audit the Fed, or more precisely the House Resolution 1207 Federal Reserve Transparency Act of 2009, a bill requiring that an audit of both the Fed's Board of Governors and the Federal Reserve Banks be completed and reported to Congress before the end of 2010. You support this bill.

Yes.

Why?

The transparency of the Federal Reserve is an old battle between the Federal Reserve and Congress which I have been a party to since my days on the staff of what was then the Banking Committee of the House of Representatives in the mid-1970s. The bill to audit the Fed at that time was a project of the great Texas Congressman Wright Patman who, up until 1975, had been Chair of the Banking Committee and had served in Congress from 1929 until his death in the late 1970’s. I also worked on the development of a regular reporting procedure for the Federal Reserve, the Humphrey-Hawkins hearings on monetary policy, which has been in place ever since. After my days on that Committee, Chairman Henry B. Gonzales worked to expand the transparency of the Federal Reserve, particularly with respect to making its archives open after a certain period of time.

In every case, systematically, the pattern is the same. The Federal Reserve always resists having its operations investigated. But when it cannot resist any longer, it adjusts. And people quickly realize that the agency actually functions better under transparency than under the previous regime of secrecy. This is perfectly normal. Secrecy, in almost all aspects of federal government, is a cover for inadequacy and inability to explain yourself in public. The Congress itself went through major reforms of this kind in the 1970’s and everybody agrees, I think, that they led to very significant improvements in the way Congress did business at least for a time. That’s point number one.

Point number two is that in the crisis that we are just going through, the Federal Reserve went to extraordinary steps to support the financial sector. Extraordinary steps, steps which it has persistently refused to present a full accounting of to the Congress. The Chairman of the Federal Reserve has arrogated to himself a power that he does not have in law, to withhold information from the Congress. The Federal Reserve is not the European central bank. It’s not a constitutionally separate part of the governing structure. The Federal Reserve is an agency of the United States government, created by an act of Congress. The Congress has unquestionable oversight authority of the Federal Reserve and a presumptive right to any information it wants. The Congress is a constitutional branch of government, the Federal Reserve is not. So this is a fundamental issue in the American system.

My view is that information requested by Congress or by the Government Accountability Office, which is the auditing arm of the Congress, should be provided. The issue of whether that information should be kept confidential or not is a matter for Congress to decide, not for the Federal Reserve. There is ample practice in other parts of the government where this works very well. There has never, so far as I know, been a significant leak of national security information from Congress. Congress is briefed, and leadership of the intelligence committees is briefed on sensitive covert operations carried out by the national intelligence agencies. Security on that has been remarkably good. Nothing that the Federal Reserve does has remotely that degree of national security sensitivity.

The justification for secrecy is only about money and to some degree about – so they argue --the reputation of particular firms, whether they are going to the discount window and whether this signals that they may be in some kind of difficulty. These are concerns of some importance in normal times. They are concerns that are totally overridden in a moment of crisis, when every financial firm was in severe difficulties, and everybody knows this fact.

 The issue before us, is to ensure that actions of the Federal Reserve were conducted in a way consistent with the public interest and with the detachment that one would normally expect of a public official from purely private financial considerations, especially favouritism to one firm as opposed to another. Those are issues which are legitimate to investigate, in fact it’s imperative to do so. Absent a full investigation, most people are going, rightly, to be very suspicious.

The point of an audit is to get to the bottom of that matter. It’s a bipartisan bill. Ron Paul picked up the idea from his fellow Texan on the other side of the spectrum, Wright Patman, and he’s been joined by progressive member from Florida, Alan Grayson, who is a very competent fellow, knows what he’s doing. It’s something which needs to be treated with great seriousness. It’s also something that has a lot of popular support, but it is not a demagogical “populist” measure. It’s a measure that gets to the heart of the correct relationship between the Congress and the central bank in the constitutional structure of the government of the United States.         

Is it any surprise to you that most of those economists who oppose the audit the Fed bill are actually on the payroll of the Fed?[xiii]

This is a fact which has been well documented by a close colleague of mine here at the LBJ School, Robert Auerbach. The Federal Reserve engages in a very wide-spread practice of consulting contracts to economists who repay the Federal Reserve with loyalty. Since this is now well-known, it’s not surprising that no one takes the position of an economist on a matter like this very seriously.

Do you agree with Ron Paul that the “Fed will self destruct when it destroys the dollar”?[xiv] Is the Fed indeed destroying the dollar? And do you see signs that a run on the dollar might start soon?[xv]

No, no, and no. I’ve spoken favourably of Ron Paul about this question of the audit. He is in other respects a very strange person to have captured the mantle of populism because, while the populists were in favour of an elastic currency and their great cause was free silver (the use of silver as a monetary metal), Ron Paul is a hard money man. To the extent that he has a clear vision of a monetary system, it’s a vision that would have been comfortable in the board room of a New York bank in the late 19^th century -- that the dollar has to be good as gold, etc., etc. He has held this view for many years. As a very young man, I remember debating him on  radio in Washington D. C. about this and this was in the mid 1970’s.

The dollar is the national currency of a very large economy, and it is also the transactions and reserves currency of a very large share of world trade. The reasons for this are that the US is a very big place, and the US government does not have any problem, never will have any problem servicing its own debts in dollars. So, the US has a great advantage in the world of being the target of flights to quality, and we provide a service to the world economy, which does not cost us very much to provide. It’s fundamentally a matter of existing institutions and reputation and scale of American economic activity. This is not going to go away in my view, and it’s not threatened by reserve holdings of Japan or China either. It is much more likely that Greece, Portugal, or Spain will be forced from the euro than it is that Texas or even California would be forced from the dollar. Much more likely.

For this reason, everything in world currency terms has to be assessed in relative terms. The institutions that support the dollar, the public institutions, the Federal Reserve and the US Treasury, are much more flexible and better-adapted to economic management, generally, and the crisis in particular, than is the euro system. The Europan system is a system managed by a rigidly constrained central bank and by a loose network of finance ministers who are ridden by ideological differences and unable to turn to bring the power of the European economy to the assistance of the economies on the periphery of the euro zone that had been most severely effected in fiscal terms by the crisis.

The world investment communities are well aware that what happened in  November 2008 was that the dollar rescued the euro, not the other way around. This was done by a massive extension of swap of currencies from the Federal Reserve to the euro zone to alleviate a massive shortage of dollars caused by banks and others hoarding dollar assets and dumping dollar liabilities. It’s true that the euro has gone up and the dollar has gone down since then, but the basic asymmetry in these institutional arrangements and capacities remains.

So, I think Mr. Paul is really, first of all, wrong, alarmist and to some extent politically motivated. In spite of everything that’s gone wrong in the American economy it’s quite unwarranted to start talking as though there’s an imminent collapse of the dollar. All reserve systems are fragile. All monetary regimes can collapse. It’s not excluded that something very bad could happen. The costs of something like this are however very large, and the most likely thing is that the existing system, the existing role of the dollar, will continue and as I say for the reasons that I’ve just given, the euro is in no position to replace the dollar.

Thank you very much for taking your time, Professor Galbraith!

SOURCES:

---

[i] compare James K. Galbraith: “The Collapse of Monetarism and the Irrelevance of the New Monetary Consensus”, 25th Annual Milton Friedman Distinguished Lecture at Marietta College, Marietta, Ohio, March 31, 2008, published at: http://utip.gov.utexas.edu/papers/CollapseofMonetarismdelivered.pdf

[ii] compare http://www.whatcausedthecrisis.com/

[iii] John Kenneth Galbraith: “The Great Crash 1929”, Houghton Mifflin Company, Boston, 1954.

[iv] Lars Schall: “Marshall Auerback: ‘Many years of economic stagnation’”, published at MMNews on September 7, 2009 under: http://www.mmnews.de

[v] Michael Mross: “Henkel: Politik wrackt ab”, published at MMNews on November 27, 2009 under: http://www.mmnews.de

[vi] compare James K. Galbraith: “Who Are These Economists, Anyway?”, published in Thought & Action, the journal of the National Education Association on October 11, 2009 and hosted under: http://www.levy.org/pubs/Thought_Action.pdf

[vii] compare John Arlidge: “I'm doing 'God's work'. Meet Mr Goldman Sachs”, published at The Sunday Times on November 8, 2009 under: http://www.timesonline.co.uk/

[viii] compare for example James K. Galbraith: “A Bailout We Don't Need”, published at The Washington Post on September 25, 2009 under:

http://www.washingtonpost.com

In this op-ed, Professor Galbraith said the bailout plan of September 2008 wasn’t necessary, and any rescue could have been handled by expanding existing programs: “Now that all five big investment banks — Bear Stearns, Merrill Lynch, Lehman Brothers, Goldman Sachs and Morgan Stanley — have disappeared or morphed into regular banks, a question arises.

The point of the bailout is to buy assets that are illiquid but not worthless. But regular banks hold assets like that all the time. They’re called “loans.”

With banks, runs occur only when depositors panic, because they fear the loan book is bad. Deposit insurance takes care of that. So why not eliminate the pointless $100,000 cap on federal deposit insurance and go take inventory? If a bank is solvent, money market funds would flow in, eliminating the need to insure those separately. If it isn’t, the FDIC has the bridge bank facility to take care of that.

Next, put half a trillion dollars into the Federal Deposit Insurance Corp. fund — a cosmetic gesture — and as much money into that agency and the FBI as is needed for examiners, auditors and investigators. Keep $200 billion or more in reserve, so the Treasury can recapitalize banks by buying preferred shares if necessary — as Warren Buffett did this week with Goldman Sachs. Review the situation in three months, when Congress comes back. Hedge funds should be left on their own. You can’t save everyone, and those investors aren’t poor.

With this solution, the systemic financial threat should go away. Does that mean the economy would quickly recover? No. Sadly, it does not. Two vast economic problems will confront the next president immediately. First, the underlying housing crisis….The second great crisis is in state and local government.”

[ix] Geoffrey Batt: “This Is The Government: Your Legal Right To Redeem Your Money Market Account Has Been Denied”, published at Zero Hedge on January 3, 2010 under: http://www.zerohedge.com

Batt writes: (N)ew regulations proposed by the administration, and specifically by the ever-incompetent Securities and Exchange Commission, seek to pull one of these three core pillars from the foundation of the entire money market industry, by changing the primary assumptions of the key Money Market Rule 2a-7. A key proposal in the overhaul of money market regulation suggests that money market fund managers will have the option to "suspend redemptions to allow for the orderly liquidation of fund assets." You read that right: this does not refer to the charter of procyclical, leveraged, risk-ridden, transsexual (allegedly) portfolio manager-infested hedge funds like SAC, Citadel, Glenview or even Bridgewater (which in light of ADIA's latest batch of problems, may well be wishing this was in fact the case), but the heart of heretofore assumed safest and most liquid of investment options: Money Market funds, which account for nearly 40% of all investment company assets. The next time there is a market crash, and you try to withdraw what you thought was "absolutely" safe money, a back office person will get back to you saying, "Sorry - your money is now frozen. Bank runs have become illegal." This is precisely the regulation now proposed by the administration. In essence, the entire US capital market is now a hedge fund, where even presumably the safest investment tranche can be locked out from within your control when the ubiquitous "extraordinary circumstances" arise. The second the game of constant offer-lifting ends, and money markets are exposed for the ponzi investment proxies they are, courtesy of their massive holdings of Treasury Bills, Reverse Repos, Commercial Paper, Agency Paper, CD, finance company MTNs and, of course, other money markets, and you decide to take your money out, well - sorry, you are out of luck. It's the law.

A brief primer on money markets

A very succinct explanation of what money markets are was provided by none other than SEC's Luis Aguilar on June 24, 2009, when he was presenting the case for making even the possibility of money market runs a thing of the past. To wit:

Money market funds were founded nearly 40 years ago. And, as is well known, one of the hallmarks of money market funds is their ability to maintain a stable net asset value — typically at a dollar per share.

In the time they have been around, money market funds have grown enormously — from $180 billion in 1983 (when Rule 2a-7 was first adopted), to $1.4 trillion at the end of 1998, to approximately $3.8 trillion at the end of 2008, just ten years later. The Release in front of us sets forth a number of informative statistics but a few that are of particular interest are the following: today, money market funds account for approximately 39% of all investment company assets; about 80% of all U.S. companies use money market funds in managing their cash balances; and about 20% of the cash balances of all U.S. households are held in money market funds. Clearly, money market funds have become part of the fabric by which families, and companies manage their financial affairs.

When the Reserve fund broke the buck, and it seemed like an all-out rout of money markets was inevitable, the result would have been a virtual elimination of capital access by everyone: from households to companies. This reverberated for months, as the also presumably extremely safe Commercial Paper market was the next to freeze up, side by side with all traditional forms of credit. Only after the Fed stepped in an guaranteed money markets, and turned on the liquidity stabilization first, then quantitative easing spigot second, did things go back to some sort of new normal. However, it is only a matter of time before the patchwork of band aids holding the dam together is once again exposed, and a new, stronger and, well, "improved" run on the electronic bank materializes. It is precisely this contingency that the SEC and the administration are preparing for by "empowering money market fund boards of directors to suspend redemptions in extraordinary circumstances to protect the interests of fund shareholders."

A little more on money markets:

Money market funds seek to limit exposure to losses due to credit, market, and liquidity risks. Money market funds, in the United States, are regulated by the Securities and Exchange Commission's (SEC) Investment Company Act of 1940. Rule 2a-7 of the act restricts investments in money market funds by quality, maturity and diversity. Under this act, a money fund mainly buys the highest rated debt, which matures in under 13 months. The portfolio must maintain a weighted average maturity (WAM) of 90 days or less and not invest more than 5% in any one issuer, except for government securities and repurchase agreements.

Ironically, the proposed change to Rule 2a-7 seeks to make dramatic changes to the composition of MMs: from 90 days, the WAM would get shortened to 60 days. And this is occurring at a time when the government is desperately seeking to find ways of extending maturities and durations of short-term debt instruments: by reverse rolling the $3.2 trillion industry, the impetus will be precisely the reverse of what should be happening, as more ultra-short maturity instruments are horded up, leaving a dead zone in the 60-90 day maturity window. Some other proposed changes to 2a-7 include "prohibiting the funds from investing in Second Tier securities, as defined in Rule 2a-7. Eligible securities would be redefined as securities receiving only the highest, rather than the highest two, short-term debt ratings from a requisite nationally recognized securities rating  organization. Further, money market funds would be permitted to acquire long-term unrated securities only if they have received long-term ratings in the highest two, rather than the highest three, ratings categories." In other words, let's make them so safe, that when the time comes, nobody will have access to them. Brilliant.

[x] compare “Ponzi Scheme: The Federal Reserve Bought Approximately 80 Percent Of U.S. Treasury Securities Issued In 2009”, published at The Economic Collapse under:

http://theeconomiccollapseblog.com

[xi] compare Michael C. Ruppert: “Confronting Collapse. The Crisis of Energy and Money in a Post Peak Oil World. A 25-Point Program for Action”, Chelsea Green Publishing, December 2009.

[xii] compare  Michael C. Lynch: “Nonsense, Peak Oil, and Oil Prices”, published at Business Week on December 17, 2009 under: http://bx.businessweek.com and Jeff Poor: “CNBC’s Kilduff: $100 Oil in Next Six Months.
Network contributor says China pushing prices higher; blasts the peak oil theory as dated”, published at Business & Media Institute on January 12, 2010 under:

http://www.businessandmedia.org/

Jeff Poor writes: Kudlow asked if we needed to rely on “windmills on Nantucket” as a new power source and Kilduff told Kudlow that wasn’t a good idea. But he also refuted the theory of peak oil.

“Well if we do it will be very expensive, Larry,” Kilduff said. “And I have been opponent of the peak oil theory my entire career, not for the least of which reasons was that this morning's announcement from McMoRan Exploration and several other companies who might have made the oil find of a decade in shallow Gulf waters. And it's a real game-changer for the companies involved and it’s in a neighborhood that is going to be one of the biggest finds in decades.”

Peak oil is a theory that there exists a point in time when the maximum rate of global petroleum extraction is reached. However, a recent BusinessWeek article disputed this theory and Kilduff explained that when this idea was conceived, there wasn’t the technology to confirm such a theory.

“With new technologies every day, Larry,” Kilduff said. “This was thigh problem with the peak oil theory from the beginning. How could you have the hubris to tell me that we had the knowledge and the science to help us find this oil? Our cell phones were as big as cars. Now they fit in your pocket, right? Now, the same thing goes for satellite technology that can find oil and new drills that can get to places without harming the lands anywhere near what we had in the '50s and '60s and '70s.”

[xiii] compare Mike Shedlock: “Economists Opposing Fed Audit Are On Fed Payroll”, published at MISH’S Global Economic Trend Analysis on November 19, 2009 under:

http://globaleconomicanalysis.blogspot.com/

[xiv] compare Andrew Moran: “ Ron Paul: ‘Fed will self destruct when it destroys the dollar’, published at Digital Journey on November 23, 2009 under: http://digitaljournal.com/article/282591By Andrew Moran.

[xv] compare Porter Stansberry: “A Run on the Dollar Starts Soon”, published at Daily Wealth on November 28, 2009 under: http://www.dailywealth.com/archive/2009/nov/2009_nov_28.asp

We Are So Screwed

John Mauldin | Jan. 30, 2010, 9:05 AM | 34,364 | 71

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Tags: Economy, Debt, Stocks

"Our immersion in the details of crises that have arisen over the past eight centuries and in data on them has led us to conclude that the most commonly repeated and most expensive investment

advice ever given in the boom just before a financial crisis stems from the perception that 'this time is different.'

"That advice, that the old rules of valuation no longer apply, is usually followed up with vigor. Financial professionals and, all too often, government leaders explain that we are doing things better than before, we are smarter, and we have learned from past mistakes. Each time, society convinces itself that the current boom, unlike the many booms that preceded catastrophic collapses in the past, is built on sound fundamentals, structural reforms, technological innovation, and good policy."

- This Time is Different (Carmen M. Reinhart and Kenneth Rogoff)

When does a potential crisis become an actual crisis, and how and why does it happen? Why did most everyone believe there were no problems in the US (or Japanese or European or British) economies in 2006? Yet now we are mired in a very difficult situation. "The subprime problem will be contained," said now controversially confirmed Fed Chairman Bernanke, just months before the implosion and significant Fed intervention. I have just returned from Europe, and the discussion often turned to the potential of a crisis in the Eurozone if Greece defaults. Plus, we take a look at the very positive US GDP numbers released this morning. Are we finally back to the Old Normal? There's just so much to talk about...

The Statistical Recovery Has Arrived

Before we get into the main discussion point, let me briefly comment on today's GDP numbers, which came in at an amazingly strong 5.7% growth rate. While that is stronger than I thought it would be (I said 4-5%), there are reasons to be cautious before we sound the "all clear" bell.

First, over 60% (3.7%) of the growth came from inventory rebuilding, as opposed to just 0.7% in the third quarter. If you examine the numbers, you find that inventories had dropped below sales, so a buildup was needed. Increasing inventories add to GDP, while, counterintuitively, sales from inventory decrease GDP. Businesses are just adjusting to the New Normal level of sales. I expect further inventory build-up in the next two quarters, although not at this level, and then we level off the latter half of the year.

While rebuilding inventories is a very good thing, that growth will only continue if sales grow. Otherwise inventories will find the level of the New Normal and stop growing. And if you look at consumer spending in the data, you find that it actually declined in the 4th quarter, both annually and from the previous quarter. "Domestic demand" declined from 2.3% in the third quarter to only 1.7% in the fourth quarter. Part of that is clearly the absence of "Cash for Clunkers," but even so that is not a sign of economic strength.

Second, as my friend David Rosenberg pointed out, imports fell over the 4th quarter. Usually in a heavy inventory-rebuilding cycle, imports rise because a portion of the materials businesses need to build their own products comes from foreign sources. Thus the drop in imports is most unusual. Falling imports, which is a sign of economic retrenching, also increases the statistical GDP number.

Third, I have seen no analysis (yet) on the impact of the stimulus spending, but it was 90% of the growth in the third quarter, or a little less than 2%.

Fourth (and quoting David): "... if you believe the GDP data - remember, there are more revisions to come - then you de facto must be of the view that productivity growth is soaring at over a 6% annual rate. No doubt productivity is rising - just look at the never-ending slate of layoff announcements. But we came off a cycle with no technological advance and no capital deepening, so it is hard to believe that productivity at this time is growing at a pace that is four times the historical norm. Sorry, but we're not buyers of that view. In the fourth quarter, aggregate private hours worked contracted at a 0.5% annual rate and what we can tell you is that such a decline in labor input has never before, scanning over 50 years of data, coincided with a GDP headline this good.

"Normally, GDP growth is 1.7% when hours worked is this weak, and that is exactly the trend that was depicted this week in the release of the Chicago Fed's National Activity Index, which was widely ignored. On the flip side, when we have in the past seen GDP growth come in at or near a 5.7% annual rate, what is typical is that hours worked grows at a 3.7% rate. No matter how you slice it, the GDP number today represented not just a rare but an unprecedented event, and as such, we are willing to treat the report with an entire saltshaker - a few grains won't do."

Finally, remember that third-quarter GDP was revised downward by over 30%, from 3.5% to just 2.2% only 60 days later. (There is the first release, to be followed by revisions over the next two months.) The first release is based on a lot of estimates, otherwise known as guesswork. The fourth-quarter number is likely to be revised down as well.

Unemployment rose by several hundred thousand jobs in the fourth quarter, and if you look at some surveys, it approached 500,000. That is hardly consistent with a 5.7% growth rate. Further, sales taxes and income-tax receipts are still falling. As I said last year that it would be, this is a Statistical Recovery. When unemployment is rising, it is hard to talk of real recovery. Without the stimulus in the latter half of the year, growth would be much slower.

So should we, as Paul Krugman suggests, spend another trillion in stimulus if it helps growth? No, because, as I have written for a very long time, and will focus on in future weeks, increased deficits and rising debt-to-GDP is a long-term losing proposition. It simply puts off what will be a reckoning that will be even worse, with yet higher debt levels. You cannot borrow your way out of a debt crisis.

This Time Is Different

While I was in Europe, and flying back, I had the great pleasure of reading This Time is Different, by Carmen M. Reinhart and Kenneth Rogoff, on my new Kindle, courtesy of Fred Fern.

I am going to be writing about and quoting from this book for several weeks. It is a very important work, as it gives us the first really comprehensive analysis of financial crises. I highlighted more pages than in any book in recent memory (easy to do on the Kindle, and even easier to find the highlights). Rather than offering up theories on how to deal with the current financial crisis, the authors show us what happened in over 250 historical crises in 66 countries. And they offer some very clear ideas on how this current crisis might play out. Sadly, the lesson is not a happy one. There are no good endings once you start down a deleveraging path. As I have been writing for several years, we now are faced with choosing from among several bad choices, some being worse than others. This Time is Different offers up some ideas as to which are the worst choices.

If you are a serious student of economics, you should read this book. If you want to get a sense of the problems we face, the authors conveniently summarize the situation in chapters 13-16, purposefully allowing people to get the main points without drilling into the mountain of details they provide. Get the book at a 45% discount at Amazon.com.

Buy it with the excellent book I am now reading, Wall Street Revalued, and get free shipping.

A Crisis of Confidence

Let's lead off with a few quotes from This Time is Different, and then I'll add some comments. Today I'll focus on the theme of confidence, which runs throughout the entire book.

"But highly leveraged economies, particularly those in which continual rollover of short-term debt is sustained only by confidence in relatively illiquid underlying assets, seldom survive forever, particularly if leverage continues to grow unchecked."

"If there is one common theme to the vast range of crises we consider in this book, it is that excessive debt accumulation, whether it be by the government, banks, corporations, or consumers, often poses greater systemic risks than it seems during a boom. Infusions of cash can make a government look like it is providing greater growth to its economy than it really is. Private sector borrowing binges can inflate housing and stock prices far beyond their long-run sustainable levels, and make banks seem more stable and profitable than they really are. Such large-scale debt buildups pose risks because they make an economy vulnerable to crises of confidence, particularly when debt is short term and needs to be constantly refinanced. Debt-fueled booms all too often provide false affirmation of a government's policies, a financial institution's ability to make outsized profits, or a country's standard of living. Most of these booms end badly. Of course, debt instruments are crucial to all economies, ancient and modern, but balancing the risk and opportunities of debt is always a challenge, a challenge policy makers, investors, and ordinary citizens must never forget."

And this is key. Read it twice (at least!):

"Perhaps more than anything else, failure to recognize the precariousness and fickleness of confidence-especially in cases in which large short-term debts need to be rolled over continuously-is the key factor that gives rise to the this-time-is-different syndrome. Highly indebted governments, banks, or corporations can seem to be merrily rolling along for an extended period, when bang!-confidence collapses, lenders disappear, and a crisis hits.

"Economic theory tells us that it is precisely the fickle nature of confidence, including its dependence on the public's expectation of future events, that makes it so difficult to predict the timing of debt crises. High debt levels lead, in many mathematical economics models, to "multiple equilibria" in which the debt level might be sustained - or might not be. Economists do not have a terribly good idea of what kinds of events shift confidence and of how to concretely assess confidence vulnerability. What one does see, again and again, in the history of financial crises is that when an accident is waiting to happen, it eventually does. When countries become too deeply indebted, they are headed for trouble. When debt-fueled asset price explosions seem too good to be true, they probably are. But the exact timing can be very difficult to guess, and a crisis that seems imminent can sometimes take years to ignite."

How confident was the world in October of 2006? I was writing that there would be a recession, a subprime crisis, and a credit crisis in our future. I was on Larry Kudlow's show with Nouriel Roubini, and Larry and John Rutledge were giving us a hard time about our so-called "doom and gloom." If there is going to be a recession you should get out of the stock market, was my call. I was a tad early, as the market proceeded to go up another 20% over the next 8 months.

As Reinhart and Rogoff wrote: "Highly indebted governments, banks, or corporations can seem to be merrily rolling along for an extended period, when bang! - confidence collapses, lenders disappear, and a crisis hits."

Bang is the right word. It is the nature of human beings to assume that the current trend will work out, that things can't really be that bad. Look at the bond markets only a year and then just a few months before World War I. There was no sign of an impending war. Everyone "knew" that cooler heads would prevail.

We can look back now and see where we made mistakes in the current crisis. We actually believed that this time was different, that we had better financial instruments, smarter regulators, and were so, well, modern. Times were different. We knew how to deal with leverage. Borrowing against your home was a good thing. Housing values would always go up. Etc.

Now, there are bullish voices telling us that things are headed back to normal. Mainstream forecasts for GDP growth this year are quite robust, north of 4% for the year, based on evidence from past recoveries. However, the underlying fundamentals of a banking crisis are far different from those of a typical business-cycle recession, as Reinhart and Rogoff's work so clearly reveals. It typically takes years to work off excess leverage in a banking crisis, with unemployment often rising for 4 years running. We will look at the evidence in coming weeks.

The point is that complacency almost always ends suddenly. You just don't slide gradually into a crisis, over years. It happens! All of a sudden there is a trigger event, and it is August of 2008. And the evidence in the book is that things go along fine until there is that crisis of confidence. There is no way to know when it will happen. There is no magic debt level, no magic drop in currencies, no percentage level of fiscal deficits, no single point where we can say "This is it." It is different in different crises.

One point I found fascinating, and we'll explore it in later weeks. First, when it comes to the various types of crises with the authors identify, there is very little difference between developed and emerging-market countries, especially as to the fallout. It seems that the developed world has no corner on special wisdom that would allow crises to be avoided, or allow them to be recovered from more quickly. In fact, because of their overconfidence - because they actually feel they have superior systems - developed countries can dig deeper holes for themselves than emerging markets.

Oh, and the Fed should have seen this crisis coming. The authors point to some very clear precursors to debt crises. This bears further review, and we will do so in coming weeks.

Greeks Bearing Gifts

On Monday, the government of Greece offered a "gift" to the markets of 8 billion euros worth of bonds at a rather high 6.25%. The demand was for 25 billion euros, so this offering was rather robust. Today, those same Greek bonds closed on 6.5%, more than offsetting the first year's coupon. Greek bond yields are up more than 150 basis points in the last month!

Why such a one-week turnaround? Ambrose Evans Pritchard offers up this thought: "Marc Ostwald, from Monument Securities, said the botched bond issue of €8bn (£6.9bn) of Greek debt earlier this week has made matters worse. Many of the investors were 'hot money' funds that bought on rumors that China was emerging as a buyer, offering them a chance for quick profit. When the China story was denied by Beijing and Athens, these funds rushed for the exit."

Greece is running a budget deficit of 12.5%. Under the Maastricht Treaty, they are supposed to keep it at 3%. Their GDP was $374 billion in 2008 (about €240 billion). If they can cut their budget deficit to 10% this year, that means they will need to go into the bond market for another €25 billion or so. But they already have a problem with rising debt. Look at the following graph on the debt of various countries.

When Russia defaulted on its debt and sent the world into crisis in 1998, they had total debt of only €51 billion. Greece now has €254 billion and added another €8 billion this week, and needs to add another €24 billion (or so) later this year. That's a debt-to-GDP ratio of over 100%, well above the limit of the treaty, which is 60%.

Greece benefitted from being in the Eurozone by getting very low interest rates, up until recently. Being in the Eurozone made investors confident. Now that confidence is eroding daily. And this week's market action says rates will go higher, without some fiscal discipline. To help my US readers put this in perspective, let's assume that Greece was the size of the US. To get back to Maastricht Treaty levels, they would need to cut the deficit by 4% of GDP for the next few years. If the US did that, it would mean an equivalent budget cut of $500 billion dollars. Per year. For three years running.

That would guarantee a very deep recession. Just a 10% suggested pay cut has Greek government unions already planning strikes. Nevertheless, the government of Greece recognizes that it simply cannot continue to run such huge deficits. They have developed a plan that aims to narrow the shortfall from 12.7% of output, more than four times the EU limit, to 8.7% this year. That reduction will be achieved even though the economy will contract 0.3%, the plan says. The deficit will shrink to 5.6% next year and 2.8% in 2012.

The market is saying they don't believe that will happen. For one thing, if the Greek economy goes into recession, the amount collected in taxes will fall, meaning the shortfall will increase. Second, it is not clear that Greek voters will approve such a plan at their next elections. Riots and demonstrations are a popular pastime.

Both French and German ministers made it clear that there would be no bailout of Greece. But here's the problem. If they ignore the noncompliance, there is no meaning to the treaty. The euro will be called into question. And the other countries with serious fiscal problems will ask why they should cut back if Greece does not. If Greece does not choose deep cutbacks and recession, the markets will keep demanding hikes in interest rates, and eventually Greece will have problems meeting just its interest payments.

Can this go on for some time? The analysis of debt crises in history says yes, but there comes a time when confidence breaks. My friends from GaveKal had this thought:

"What is the next step? Having lived through the Mexican, Thai, Korean and Argentine crises, it is hard not to distinguish a common pattern. In our view, this means that investors need to confront the fact that we are at an important crossroads for Greece, best symbolized by a simple question: 'If you were a Greek saver with all of your income in a Greek bank, given what is happening to the debt of your sovereign, would you feel comfortable keeping all of your life savings in your savings institution? Or would you start thinking about opening an account in a foreign bank and/or redeeming your currency in cash?' The answer to this question will likely direct the next phase of the crisis. If we start to see bank runs in Greece, then investors will have to accept that the crisis has run out of control and that we are facing a far more bearish investment environment. However, if the Greek population does not panic and does not liquefy/transfer its savings, then European policy-makers may still have a chance to find a political solution to this growing problem.

"What could a political solution be? The answer here is simple: there is none. So if Europe wants to save Greece from hitting the wall towards which it is now heading, the European commission, the ECB and/or other institutions (IMF?) will have to bend the rules massively. In turn, this will likely lead to a further collapse in the euro. But for us, an important question is whether it could also lead to a serious political backlash. Indeed, at this stage, elected politicians are likely pondering how much appetite there is amongst their electorate for yet another bailout, and for further expansions in government debt levels. The fact that the intervention would occur on behalf of a foreign country probably makes it all the more unpalatable (it's one thing to save your domestic banking system ... but why save Greece?)."

If Greece is bailed out, Portugal and Ireland will ask "Why not us?" And Spain? Italy? If Greece is allowed to flaunt the rules, what does that say about the future of the euro? Will Germany and France insist on compliance or be willing to kick Greece out?

A few months ago, the markets assumed that not only Greece but Portugal, Italy, Spain, and Ireland would have a few years to get their houses in order. This week, the markets shortened their time horizon for Greece.

Even so, we get this quote, which may end up ranking alongside Fisher's quote in 1929, that the stock market was at a permanently high plateau, or Bernanke's quote that "The subprime debt problem will be contained."

"There is no bailout problem," Monetary Affairs Commissioner Joaquin Almunia said today at the World Economic Forum's annual meeting in Davos, Switzerland. "Greece will not default. In the euro area, default does not exist."

The evidence in This Time is Different is that default risk does in fact exist. You cannot keep borrowing past your income, whether as a family or a government, and not eventually go bankrupt.

Are we at an inflection point? Too early to say. It all depends on the willingness of the Greek people to endure what will not be a fun next few years, for the privilege of staying in the Eurozone. And on whether the bond market believes that this time is different and the Greeks will actually get their fiscal house in order.

Oh by the way, did I mention that the history of Greece is not exactly pristine in terms of default? In fact, they have been in default in one way or another for 105 out of the past 200 years. Aristotle, can you spare a dime?

And one last thought. The US is running massive deficits. If we do not get them under control, we will one day, and perhaps quite soon, face our own "Greek moment." Look at the graph below, and weep.

Obama offering to freeze spending by 17% in US discretionary-spending programs, after he ran them up over 20% in just one year, is laughable. Greece is an object lesson for the world, as Japan soon will be. You cannot cure too much debt with more debt.

Biotech, Conversations, and More

Two quick commercial notes. I mentioned a few weeks ago that I was going to start a stock-buying program for the first time in 15 years (I normally invest in managers and funds rather than specific stocks). I published an Outside the Box last week that talked about why I think biotech stocks could be at the beginning of a decade-long run, and why I wanted to participate directly. You can read that Outside the Box by clicking on this link.

Second, I offer a subscription service called Conversations with John Mauldin, where I hold conversations with people who I think have something important for us to understand. It has been very well received. We provide both audio and a transcript. I just posted my latest Conversations, in which I interviewed two gentlemen who are CEOs of companies that I think are at the very bleeding edge of the biotech revolution. Subscribers have already gotten that posting. Over the year, in addition to the usual economic Conversations we have, I will be interviewing other industry leaders who will be changing the world of medicine in the coming decade. You can subscribe at https://www.johnmauldin.com/newsletters2.html.

In addition, George Friedman and Niall Ferguson and I are exchanging emails on a time to get together for another of the series where George and I talk about geopolitics. I guarantee a lively and fascinating Conversation.

It is good to be back from Europe. While it was fun, it was mostly long days and a lot of planes, trains, and automobiles. I arrived home to find baby bottles and other baby paraphenalia around the house. Tiffani and Ryan are starting to come back to work at the house with me, and of course my granddaughter Lively will be here most days with them, along with a nanny so Mom can actually work. It has been a long time since I had a baby around. As I went to bed, I realized that I was going to get to watch this grandchild grow up on an almost daily basis. It was with a sigh of contentment that I went to sleep.

And then today, they came and brought her. She has grown so much in just the week I was gone! Once again, I get to experience the miracle of kids growing up. Only this time I don't have to change the diapers. Life is good.

Your believing my grandkids will have a better future analyst,

John Mauldin
John@FrontLineThoughts.com

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