James K. Galbraith
belongs to the most distinguished economists in the United States
today. In the following exclusive interview that was conducted for New
Deal 2.0 in the USA and MMNews in Germany, he talks about the financial
/ economic crisis and the phenomenon of Peak Oil, points at future
tasks and explains why he supports the Audit the Fed bill.
K. Galbraith, who holds the Lloyd M.
Bentsen, Jr. Chair of Government/Business Relations at the Lyndon B.
School of Public Affairs at the University
of Texas in Austin, is the son of the legendary
economist John Kenneth Galbraith. He
on matters related to the financial and economic crisis and has been a
Congress on several recent occasions. Mr. Galbraith is the author of
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
2008 – for more information visit: http://predatorstate.com).
Professor of Public Policy, University
of California at Berkeley, wrote about “The Predator State”:
Galbraith elegantly and effectively
counters the economic fundamentalism that has captured public discourse
recent years, and offers a cogent guide to the real political economy.
Myth-busting, far-ranging, and eye-opening."
Mr. Galbraith has written several
hundred scholarly and policy articles, including columns in Mother
articles / op-ed’s in The American Prospect, the Nation, and the
Post. He studied economics as a Marshall Scholar at King's College,
Cambridge in 1974-1975 and
degrees from Harvard and Yale
(Ph.D. in Economics, 1981). Later he served on the staff of the U.S.
as Executive Director of the Joint Economic Committee before joining
faculty of the University
of Texas in 1985. In
public life, he organized congressional oversight of the Federal
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
the State Planning Commission of China. He was called to advise the
Representatives on the TARP legislation in September 2008 and on
strategy in December of the same year. He was also invited to Congress
his point of view about the “Audit the Fed” initiative of Congressman
Federal Reserve Transparency Act of 2009 – to see Mr. Galbraith’s
Capitol Hill follow this link: http://www.youtube.com/watch?v=oxAt-Un1k7I).
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
financial crisis, whereas monetarist policies would deepen it.
Galbraith’s scholarly research has focused
on the measurement and understanding of inequality in the world
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).
writing ranges from monetary policy to the economics of warfare, with
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
the Board of Economists for Peace and Security, an international
professional economists (www.epsusa.org).
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.
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).
Galbraith, in July
of 2009 you have signed an initiative of the Franklin
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
for much of the post-war period kept the most dangerous elements of
in check. In the absence of an appropriate system of effective
regulation, what happens is that the actors in the system, who are
taking the greatest degree of risk -- including actors who are intent
using fraudulent methods to increase their returns -- come to dominate
the system. As they do that, the general methods of assessing
the market, specifically stock-market valuations, become
That is to say, they invariably reward
the worst actors, while they force more traditional actors, who are
respecting the old norms of conduct, into a competitively disadvantaged
position. Thus the bad actors, the fraudulent actors, and the
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
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
had no interest in whether the borrowers could pay or not. In fact, in
ways the lenders actively preferred people who did not intend to pay,
they could then inflate the value of the loan and earn a larger fee
doing it. And in this way, not only was there a large segment of the
that was explicitly corrupt, but the equity value of homes all across
country was compromised. When these practices collapsed, so too did the
values not only of people who had bad mortgages, but also those for
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
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
ability to get new good credit. Even if they wish to continue to extend
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
assets, to become extremely adverse to taking ordinary business and
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
War, that the war would be vastly more costly than was predicted, that
be a much more difficult war than was predicted, and that it would
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
the economy out of the recession of 2000/2001, at least not in a
and it’s partly for that reason that the Bush Administration 2004/2005
about actively encouraging the use of these credit mechanisms in the
market. Out of that, they got a higher level of economic activity than
otherwise would have had, they avoided a period of stagnation that
would have been worse -- was until the
whole business collapsed completely in 2007/2008.
in an interview that I had with him this:
“In all important
respects we managed to recreate the exact same conditions of 1929 and
repeated itself with the exact same results. Take John Kenneth
change the dates and some of the names and you’ve got the post
our current calamity.”[iv]
agree with Mr.
Of course, and so does
the book-buying public
which took an enormous interest in “The
Great Crash” over the last couple of years.
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
have changed. One is the existence and continued vitality of some of
institutions that were created in the New Deal and the Great Society,
a much larger public sector as well as a very large non-profit sector,
of which existed in the 1920’s. The capacity of the public sector to
run very large deficits very quickly and practically automatically, is
grace; it’s the reason that we have a 10% unemployment rate and not a
unemployment rate in the wake of this crash. That’s an extremely
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
dominant factor in this crisis. There certainly was fraud in the
was a great epidemic of what we would call bucket-shops in the
there was a lot of fraud in Florida
real-estate in the mid-1920’s. But this was overshadowed by a general
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
1990’s more than it does the middle 2000’s. During the middle 2000’s
economy was being propelled by predatory activity directed at a very
segment of the American population, people who had been renters all
lives, who really couldn’t afford to be moved into houses, who were
aggressively moved into them by unscrupulous lenders. The lenders
pushed loans on to borrowers that the lenders knew, or who ought to
could never have been serviced in full.
for MMNews, Hans-Olaf Henkel, who was once the head of the Federation
Industries as well as IBM Europe, said two things that I would like to
you with because Mr. Henkel is an influential opinion-maker here in
The first thing he
said was that basically no one saw this crisis coming and that he
himself to death whenever someone says that this crisis was foreseen.
give Mr. Henkel some names in this respect? How about Dean Baker for
I’ve written a long
article on not just the
individual economists, but groups of economists who saw the crisis
clearly.[vi] Dean is one certainly with a
Dean follows a very simple method. He
looks at critical ratios, such as the ratio of house prices to rental
When these deviated very far from their historical norms, that
expectation that they would revert. People should have been looking at
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
There are at least
three traditions in
economics that were warning about what was coming in ways which were
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
with national balance sheets -- with the national income accounts --
warning very emphatically that the debt-burden of the household sector
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
who were warning that the supervision of the banking system was going
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
very clearly present. These patterns re-emerged in the early 2000’s in
Enron, Worldcom, and Tyco scandals, and they were re-emerging again in
housing sector. To these people it was entirely obvious that a massive
So, Mr. Henkel needs
to read a little bit more,
He needs to broaden his definition of what constitutes economic
needs to recognize that the problem is precisely a group of people who
that nobody outside of their very narrow circle has any insight worth
attention to. That’s a preposterous position. It’s a completely
position. It reflects fundamental narrowed-mindedness and, as I may
incompetence which is really on display for anybody to see. So I do not
hammer the point too hard.
thing that I want to know with regard to Mr. Henkel’s statements is
said that this crisis was caused by a certain type of “do-goodism”
American politicians who wanted to make sure that every American
have a home of her/his own. What do you think when you hear such a
It is an amusing
interpretation of the motives
of someone like George W. Bush, who represented one of the most
predatory tendencies in American politics ever to reach the White
was a president who turned over regulation -- not just in finance but
everything he got his hands on -- to the most reactionary elements of
business community, to the most anti-regulation elements, so that
structures were run down everywhere. They were run down in consumer
they were run down in worker protection, they were run down in trade,
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
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,
firms. Fannie Mae had been privatized for forty years, and it had,
become a bastion of Washington
cronyism. I think that’s fair to say. Those institutions were
mismanaged by the overpaid appointees who were running them, no doubt
that. Ginnie Mae, the Government National Mortgage Association, which
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
private entities like Countrywide, Washington Mutual, or IndyMac. The
were securitized through private banks, vetted by private ratings
point here was not to put people in homes. It was clear to the lenders
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
were in many cases friends and political supporters of the
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
explicitly driving the process, those were the motivations. It was
not some broad altruism toward a part of the population in which the
leadership of the country at the time never had any interest whatever.
such a thing like “do-goodism” in Washington?
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
now. But to say that they were dominating housing policy in the last
a very silly view.
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
activity in the last twenty to thirty years. At the peak they were
perhaps even still, 40 % or more of total corporate profits. They were
10 % of total wages. This is vastly out of proportion of the need for
services in any economy and in a substantially predatory relationship
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
essentially as a large informal cartel with an implicit government
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
service and did not exploit the potential of that industry. An extreme
of that was in China,
where you had one large, socialist airline. The Chinese did not
firm. Rather they broke it up into many smaller airlines and allowed
companies to enter the market. Some were owned by the state, some by
and some by municipalities. It created an environment of enormous
competitiveness between companies, and it enormously improved the
forced a great modernization of the industry. (As an aside, I’ve heard
authority that the Chinese got the idea for this from one of the 20th
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
structured in a number of different ways. And the idea that you need to
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
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
problem, we are going to continually run into problems of instability
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
of protecting bank depositors or the general public; they went to
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
they would have been left out. That’s a serious problem. There was no
reason to do that. In a normal work-regulatory intervention in a bank
insolvent or at risk of insolvency, the historical effective practice
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
financial markets, and necessary to establish in a credible and
the need for changing practices in the financial sector.
the case that
almost by definition, money given, like via these bailouts, to
banks will show up most quickly as improvements in corporate earnings,
slightly later, as executive compensation?
phrase “money given” is a
little bit vague. What was done in this case primarily was a purchase
preferred equity in the banks and that does not show up as earnings.
way to think of a capital injection, technically, is as a form of
forbearance. It was a way of saying to the banks, “we are not going to
upon you the restructuring of your balance sheets that would have been
by recognition that your capital had been diminished to the extent that
actually been diminished.” From a regulatory standpoint, buying
shares is essentially the same thing as reducing a capital requirement.
other things then
happened. The Federal Reserve reduced
the cost of funds to the bank existent to zero, and the Treasury made
that the large institutions were not going to be permitted to fail.
the message of the stress tests, which were clearly, I’d say, one of
successful public relations exercises of recent times. They didn’t
people that the banks were sound. They simply persuaded people that the
government would not let them fail. The government was not going to
banks’ unsoundness to trigger the normal actions that would have
into conservatorship and ultimately to resolution.
result, the banks were able to
begin borrowing extensively. Some of these funds apparently found their
what channels is not entirely clear, right back into speculative asset
This meant that the stock market recovered and that commodity markets
and people who were investing in those markets at the bottom with
hopes have been very, very greatly rewarded. I think that’s where the
profits partly come from. That, plus an enormous amount of interest
which is to say, borrowing from the central bank at zero and then
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
scale. Those things have given the banks very good earnings and enabled
resume paying bonuses.
do you think about the plan of the Securities and
abolish the legal right to redeem money
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
agreement by Richard Nixon in 1971. May I summarize my reading of
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 –
limited by an obligation to exchange foreign-held dollars for gold.
Nixon abolished that arrangement. You are arguing now that since the
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
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?
this because this is basically, at least as far as I understand it, the
backbone of the stimulus package you want to see taken place? And if
the case how would then a stimulus package look like if you could have
all, it’s very clear that
the United States government is not constrained externally, and it’s
quite apart from the stimulus package, the automatic stabilizers and
financial rescue, which greatly ballooned the public debt of the United
have had no effect on the ability of the United States government to
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
to fear from additional efforts as long as they are necessary. And
obviously very clearly necessary. So the question is: what should be
structure of those efforts?
always taken exception to the
constant reference to “stimulus” as the policy objective, because
that word is the idea that all one needs to do is to undertake one or
relatively short term spending sprees, on whatever happens to be
the moment, and that this will somehow return the economy to its
state, putting it on a path of what economists like to call
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
normal conditions, which were in fact, from a historical point of view,
abnormal, of the 1990s and 2000s.
needs is to set a
strategic direction for renewal of economic activity. We need to create
institutions that will support that direction.
Those institutions are public institutions, which create a
private activity. This is the way it is done. It is the way countries
always developed in the past and, to the extent that they are
will always do so in the future or they won’t succeed. Seventy years
we were in the Great Depression, they built a national infrastructure:
airfields, schools, power-grids – this kind of thing was the priority.
post-war period, the creation and maintenance of a large middle class
social security, with medical care, with housing programs, universities
were the priorities of the post-war period.
clearly face an enormous
challenge with energy and climate. It’s a challenge that requires us to
in very creative ways, in very ambitious ways about how to change how
so as to make life on the planet tolerable a century or two centuries
This is a huge challenge. It requires design, planning, implementation,
something with enormous potential for providing employment because
to be done, enormous potential for guiding new public and private
because one has to provide people with the means of making it realistic
individual activity to support this larger objective. And that is the
move toward a renewed economic
expansion. This strikes me very far from being a stimulus
is a proposal for setting a new strategic direction for the economy and
so over a relatively long time horizon with a view that you’re
effort for 15, 20, 30 years. That’s the way I think you need to think
wrap up a long answer to a
short question: Why can’t we go back to the pre-crisis period? The
that restructuring of the private household debts is an enormous task
necessarily takes a very long period of time. During that time, the
pattern of increasing debt will not resume. The asset against which the
American household sector collateralized its debt for 15 to 20 years,
housing, has radically fallen in financial value. The houses are still
but you can’t sell them for nearly as much as you could have three
And that is a structural impediment to returning to the previous
economic expansion. And that impediment isn’t going to be removed in
period of time for the simple reason that the houses remain there as an
supply on the market and they remain therefore as a drag on housing
Do you see
a bit of a problem in the fact that the Federal Reserve bought
percent of the U.S.
Treasury securities issued in 2009?[x]
say what problem are you
hinting at here, then I’ll explain.
people might say that this does fulfil the requirements for a Ponzi
certainly isn’t remotely related
to a Ponzi Scheme. To be very clear, a Ponzi Scheme is a scheme in
private party is issuing debts which can only be serviced by issuing
to cover the interest. This is not a constraint on a sovereign
controls its own currency. Never is, never will be. There is a lot of
rhetoric about things like Ponzi Schemes and national bankruptcy which
typically the work of people who neither know nor care much about what
already said that energy should be part of a stimulus package or a
What do you think like for example about the immediate implementation
U.S. of a national Feed-in Tariff mandating that electric utilities pay
3 % above
market rates for all surplus electricity generated from renewable
Mike Ruppert suggests in his new book “Confronting
In Germany, the Feed-in Tariff was
quite a success story that created a huge amount of new jobs. Would you
I would need to study
it, so I’m not
sufficiently familiar to say. But it does sound, as you just described,
promising line of attack.
regard to the
energy problem, I would like to know if you take the phenomenon of Peak
seriously, and if so: why do you think that the
financial, economic and
political establishment around the globe wants to keep quiet about it
dismiss it as “nonsense”[xii]
even though there
seems to be a good amount of evidence that the world soon won't be able
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,
serious than, earlier alarmist warnings about the supply of oil. The
proposition relates to supplies of conventional oil, and it relates to
that there is a normal (bell) curve associated with discovery and
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
in 1970. So it’s been around for a long time. So, I do think that it’s
proposition which needs to be taken seriously. As to your
the actions and motives of large and powerful interests, I don’t have a
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
method to be a very dangerous way of arguing because it basically
anything the speaker wants to cover. It is something which can have no
limit, no success. It’s a construct which justifies the permanent
resources to an exercise in futility at best, and at worst a cover for
kinds of other purposes. And your suggestion is that one of those
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
physical access to production fields. The oil majors’ interests haven’t
depended on owning oil fields for many decades. So, when you ask what
interests of energy producers in the Iraq War -- and without saying
played the dominant role, which I think is very, very uncertain, in the
decision to undertake that war -- there’s no evidence whatever that
interest was to go over and produce the Iraqi fields. Quite the
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
regions of Iraq.
So, I think that their interests are served perhaps by preventing
that might otherwise have come on-line from Iraq from doing so, because
would have undermined the markets for oil produced in places where
much higher. One could make an argument along those lines. It strikes
being economically more coherent, but I’m not going to get into the
trying to interpret the entire exercise in Iraq along those lines
think, in point of fact, that other factors, including power politics
Middle East, and including domestic politics in the United States, also
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
the United States
without a war. Perhaps the whole matter was as simple as that. I don’t
that’s true or not, but one has to be, as a historical matter, very
about the reasons why a particular government of the United States
takes a particular
action of this kind.
“treasure”, I believe, that the Bush Administration left, are the
the National Energy Policy Development Group, NEPDG, run by
Richard Cheney in Spring of 2001. Those records are kept secret even
American public did pay for it – and not Mr. Cheney himself. Given the
that we can strongly assume that those records must be very precise
comes to oil reserve numbers, and given the fact, that we have for
all this debate about reserve estimates, wouldn’t it be time to open
deposit box” in order to let the world see how much oil there is really
Again, a question with
a number of predicates
that I can’t speak to with authority. I don’t know what is in those
Yes. I do agree that
files of this type should
be made public. If there is an argument, which undoubtedly some people
make, for a national security reason not to make them public, then an
appropriate procedure, which we have followed in this country in the
to appoint a panel of independent outsiders, not previously connected
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
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
the conduct of the Bush administration.
questions on Ron
Paul’s bill to audit the Fed, or more precisely the House Resolution
Federal Reserve Transparency Act of 2009, a bill requiring that an
both the Fed's Board of Governors and the Federal Reserve Banks be
and reported to Congress before the end of 2010. You support this bill.
The transparency of
the Federal Reserve is an
old battle between the Federal Reserve and Congress which I have been a
to since my days on the staff of what was then the Banking Committee of
House of Representatives in the mid-1970s. The bill to audit the Fed at
time was a project of the great Texas Congressman Wright Patman who, up
1975, had been Chair of the Banking Committee and had served in
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
policy, which has been in place ever since. After my days on that
Chairman Henry B. Gonzales worked to expand the transparency of the
Reserve, particularly with respect to making its archives open after a
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
quickly realize that the agency actually functions better under
than under the previous regime of secrecy. This is perfectly normal.
in almost all aspects of federal government, is a cover for inadequacy
inability to explain yourself in public. The Congress itself went
reforms of this kind in the 1970’s and everybody agrees, I think, that
to very significant improvements in the way Congress did business at
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
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
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
bank. It’s not a constitutionally separate part of the governing
Federal Reserve is an agency of the United States government, created
by an act of Congress. The Congress has unquestionable oversight
the Federal Reserve and a presumptive right to any information it
Congress is a constitutional branch of government, the Federal Reserve
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
of the Congress, should be provided. The issue of whether that
should be kept confidential or not is a matter for Congress to decide,
the Federal Reserve. There is ample practice in other parts of the
where this works very well. There has never, so far as I know, been a
significant leak of national security information from Congress.
briefed, and leadership of the intelligence committees is briefed on
covert operations carried out by the national intelligence agencies.
on that has been remarkably good. Nothing that the Federal Reserve does
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
firms, whether they are going to the discount window and whether this
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,
everybody knows this fact.
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
that one would normally expect of a public official from purely private
considerations, especially favouritism to one firm as opposed to
are issues which are legitimate to investigate, in fact it’s imperative
so. Absent a full investigation, most people are going, rightly, to be
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
fellow Texan on the other side of the spectrum, Wright Patman, and he’s
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
treated with great seriousness. It’s also something that has a lot of
support, but it is not a demagogical “populist” measure. It’s a measure
gets to the heart of the correct relationship between the Congress and
central bank in the constitutional structure of the government of the
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
consulting contracts to economists who repay the Federal Reserve with
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.
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
No, no, and no. I’ve
spoken favourably of Ron
Paul about this question of the audit. He is in other respects a very
person to have captured the mantle of populism because, while the
in favour of an elastic currency and their great cause was free silver
of silver as a monetary metal), Ron Paul is a hard money man. To the
that he has a clear vision of a monetary system, it’s a vision that
been comfortable in the board room of a New York bank in the late 19th
century -- that the dollar has to be good as gold, etc., etc. He has
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
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
own debts in dollars. So, the US
has a great advantage in the world of being the target of flights to
and we provide a service to the world economy, which does not cost us
to provide. It’s fundamentally a matter of existing institutions and
and scale of American economic activity. This is not going to go away
view, and it’s not threatened by reserve holdings of Japan
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
dollar, the public institutions, the Federal Reserve and the US
much more flexible and better-adapted to economic management,
the crisis in particular, than is the euro system. The Europan system
system managed by a rigidly constrained central bank and by a loose
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
the periphery of the euro zone that had been most severely effected in
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
to alleviate a massive shortage of dollars caused by banks and others
dollar assets and dumping dollar liabilities. It’s true that the euro
up and the dollar has gone down since then, but the basic asymmetry in
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
systems are fragile. All monetary regimes can collapse. It’s not
something very bad could happen. The costs of something like this are
very large, and the most likely thing is that the existing system, the
role of the dollar, will continue and as I say for the reasons that
given, the euro is in no position to replace the dollar.
you very much for taking your time,
[iii] John Kenneth
Galbraith: “The Great Crash 1929”, Houghton Mifflin Company, Boston,
[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
In this op-ed,
Professor Galbraith said the bailout plan of September
2008 wasn’t necessary, and any rescue could have been handled by
existing programs: “Now that all five big
investment banks — Bear Stearns, Merrill Lynch, Lehman Brothers,
and Morgan Stanley — have disappeared or morphed into regular banks, a
The point of the
bailout is to buy assets that are illiquid but not worthless. But
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
Deposit insurance takes care of that. So why not eliminate the
$100,000 cap on federal deposit insurance and go take inventory? If a
solvent, money market funds would flow in, eliminating the need to
separately. If it isn’t, the FDIC has the bridge bank facility to take
Next, put half a
trillion dollars into the Federal Deposit Insurance Corp. fund — a
gesture — and as much money into that agency and the FBI as is needed
examiners, auditors and investigators. Keep $200 billion or more in
the Treasury can recapitalize banks by buying preferred shares if
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
can’t save everyone, and those investors aren’t poor.
With this solution,
the systemic financial threat should go away. Does that mean the
quickly recover? No. Sadly, it does not. Two vast economic problems
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
foundation of the entire money market industry, by changing
primary assumptions of the key Money Market Rule 2a-7. A key
the overhaul of money market regulation suggests that money market fund
managers will have the option to "suspend redemptions to allow
the orderly liquidation of fund assets." You read that right:
this does not refer to the charter of procyclical, leveraged,
transsexual (allegedly) portfolio manager-infested hedge funds like
Citadel, Glenview or even Bridgewater (which in light of ADIA's latest
problems, may well be wishing this was in fact the case), but the heart
heretofore assumed safest and most liquid of investment options: Money
funds, which account for nearly 40% of all investment company assets.
time there is a market crash, and you try to withdraw what you thought
"absolutely" safe money, a back office person will get back to you
saying, "Sorry - your money is now frozen. Bank runs have
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
from within your control when the ubiquitous "extraordinary
circumstances" arise. The second the game of constant offer-lifting
and money markets are exposed for the ponzi investment proxies they
courtesy of their massive holdings of Treasury Bills, Reverse Repos,
Paper, Agency Paper, CD, finance company MTNs and, of course, other
markets, and you decide to take your money out, well - sorry, you are
luck. It's the law.
A brief primer on money markets
very succinct explanation of what money
markets are was provided by none other than SEC's Luis Aguilar on June
2009, when he was presenting the case for making
possibility of money market runs a thing of the past. To wit:
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
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
just ten years later. The Release in front of us sets forth
a number of informative statistics but a few that are of particular
are the following: today, money market funds account for
39% of all investment company assets; about 80% of all U.S. companies
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
and companies manage their financial affairs.
the Reserve fund broke the buck, and it
seemed like an all-out rout of money markets was inevitable, the result
have been a virtual elimination of capital access by everyone: from
to companies. This reverberated for months, as the also presumably
safe Commercial Paper market was the next to freeze up, side by side
traditional forms of credit. Only after the Fed stepped in an
markets, and turned on the liquidity stabilization first, then
easing spigot second, did things go back to some sort of new normal.
it is only a matter of time before the patchwork of band aids holding
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
market fund boards of directors to suspend redemptions in extraordinary
circumstances to protect the interests of fund shareholders."
little more on 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
2a-7 of the act restricts investments in money market funds by quality,
maturity and diversity. Under this act, a money fund mainly
highest rated debt, which matures in under 13 months. The portfolio
maintain a weighted average maturity (WAM) of 90 days or less and not
more than 5% in any one issuer, except for government securities and
Ironically, the proposed
change to Rule 2a-7 seeks to
make dramatic changes to the composition of MMs: from 90 days, the WAM
get shortened to 60 days. And this is occurring at a time when the
is desperately seeking to find ways of extending maturities and
short-term debt instruments: by reverse rolling the $3.2 trillion
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
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
receiving only the highest, rather than the highest two, short-term
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
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
The Federal Reserve Bought Approximately 80 Percent Of U.S. Treasury
Issued In 2009”, published at The
Economic Collapse under:
Michael C. Ruppert: “Confronting Collapse. The Crisis
of Energy and Money in a Post
Peak Oil World. A
25-Point Program for Action”, Chelsea
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.
contributor says China pushing prices higher; blasts
the peak oil theory as dated”, published at Business
& Media Institute on January 12, 2010 under:
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
of peak oil.
if we do it will be very expensive, Larry,” Kilduff said. “And I have
opponent of the peak oil theory my entire career, not for the least of
reasons was that this morning's announcement from McMoRan Exploration
several other companies who might have made the oil find of a decade in
Gulf waters. And it's a real game-changer for the companies involved
in a neighborhood that is going to be one of the biggest finds in
oil is a theory that there exists a point in time when the maximum rate
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
new technologies every day, Larry,” Kilduff said. “This was thigh
the peak oil theory from the beginning. How could you have the hubris
me that we had the knowledge and the science to help us find this oil?
phones were as big as cars. Now they fit in your pocket, right? Now,
thing goes for satellite technology that can find oil and new drills
get to places without harming the lands anywhere near what we had in
and '60s and '70s.”
We Are So Screwed
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
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
- This Time is Different (Carmen M. Reinhart and
When does a potential crisis become an actual crisis, and how
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
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"
First, over 60% (3.7%) of the growth came from inventory
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
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
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
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
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,
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
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
Unemployment rose by several hundred thousand jobs in the
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
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
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
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
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
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,
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
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
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
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
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
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
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
this thought: "Marc Ostwald, from Monument Securities, said the botched
bond issue of €8bn (£6.9bn) of Greek debt earlier this week has
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
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
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
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%
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
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
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
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,
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
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
If Greece is bailed out, Portugal and Ireland will ask "Why
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
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
"There is no bailout problem," Monetary Affairs Commissioner
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
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
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
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
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).
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
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
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
It is good to be back from Europe. While it was fun, it was
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
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,
Copyright 2010 John Mauldin. All Rights Reserved
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