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Federal Reserve Power Unsupported
by Credibility
By
Henry C.K. Liu
Part I: No Exit
Part II: Facing a
Lost Decade Ahead
Part III: The Politics of Financial Crisis
This article appeared in AToL
on September 17, 2009
United States Federal Reserve chairman Ben S.
Bernanke is visibly frustrated that many in Congress do not
give the Fed what he believes is enough credit for what it has
accomplished in
responding to the economic crisis even as Wall Street heaps praise on
his bold
actions and steady hand in pulling the financial system out of an
impending
meltdown.
Bernanke’s second term is far from smooth sailing through
calmer seas. All the structural weaknesses that caused the economy to
implode
two years ago are still in the financial system, albeit swept under the
rug
into the Fed’s balance sheet and masked by massive amount of new money
and
public debt not backed by any new wealth creation. Even if all goes
according
to the seemingly chaotic plan, the prognosis is that recovery will be
anemic
and will stretch out in several years if not decades. Eroded by events,
Bernanke’s
falling popular approval and low credibility could in themselves add to
further
loss of confidence in the market at a time when the Fed is trying its
utmost to
restore confidence.
Bernanke Faces Outsized Challenges in the Coming Years.
On the employment front, Fed dogmatic monetarism renders it
operationally
impotence in reducing unemployment except through trickling down from
corporate
profit, which cannot recovery without consumer demand, which in turn
cannot
recover without full employment.
On the financial front, the Fed faces a dilemma of deciding
when to implement an exit strategy. Fed exit strategy is dependent on
an
economic recovery, but recovery will be aborted by a Fed exit. Yet the
future
of the dollar requires the Fed to implement an exit at the earlier
possible
time. The Fed has a Hobson’s choice between a robust recovery, low
interest
rate, low inflation, or a strong dollar, but not all. Unfortunately,
Bernanke,
by trying to balance on a high wire, may end up losing all and fall
flat on his
caution.
On the political front, Bernanke is trying to protect the
Fed’s regulatory power and independence as the White House and Congress
debate
plans to overhaul the financial regulatory regime. Critics of the Fed
asserts
that making the Fed or any other unit of government
a super regulator will lead to bank
consolidation and monopoly that will increase systemic risk.
Democrats such as Senate Banking Committee chairman
Christopher Dodd of Connecticut and House
Financial Services Committee chairman Barney Frank of Massachusetts
contend
that the Fed’s incestuous relationship with big banks and Wall Street
firms was
a systemic cause of the mortgage crisis, and that the Fed already has
too much
power to merit getting more.
Bernanke and his predecessor Alan Greenspan now concede that
the Fed failed to anticipate the full danger posed by the explosion of
subprime
mortgage lending made possible by their loose monetary policy. As
recently as
the spring of 2007, Bernanke still insisted that the problems of the
housing
market were largely “contained” to subprime mortgages. Even when panic
over
mortgage-backed securities began spreading through the broader credit
markets
in late July 2007, the Bernanke Fed still refused to cut interest rates
to ward
off an impending systemic collapse.
Even as late as the end of 2007, five months after the credit
crunch first began, the Fed was still unable to reach a consensus
internally on
a decisive policy response and decided to leave interest rate
unchanged. Bernanke
as captain of the monetary ship was ordering steady as she goes
directly into a
perfect financial storm.
Only in the January 21, 2008
FMOC meeting did the Fed belatedly slashed the benchmark
federal funds rate by 75 basis points to 3.5%, the biggest one-time
reduction
in decades. Nine days later, The Fed cut the rate again down to 3%. By
then the
panic was spreading full speed to all markets.
As the credit crisis paralyzed the financial markets,
Bernanke led the Fed to devise unprecedented but controversial bailout
measures
without fully understanding or at least concern for long-range
implications. Underneath
of all the complex technicality of financial ballistics, Bernanke’s gun
power
was an old-fashion creation of massive amounts of money by expanding
the Fed’s
balance sheet to $2 trillion from $900 billion a year ago.
The Hard Half of the Game
But that was only half the game. The other half, the end
game, is how to withdraw all the public money from the financial system
without
throwing the economy into a protracted depression. The Fed’s “exit
strategy” as
outlined by Bernanke is based on a groundless hope that financial
recovery will
bail the Fed out of its oversized balance sheet, reversing the logic
that the
Fed is supposed to bail out the economy out with an engineered
sustainable
financial recovery. The fed has bailed out the debt-infested financial
system
by transferring its toxic debt to its balance sheet and the Fed’s exit
strategy
is to unload the same toxic debt back on the financial system as it
recovers without
causing it collapse again. The game is
for the Fed to give more money to the banks to buy back the toxic debt
from the
Fed’s balance sheet, and call it a recovery. Throughout this circular
exercise,
the economy is left to rot with rising unemployment and a damaged
dollar.
The Treasury Department’s $700 billion TARP bailout has
stabilized a handful of banks deemed too big to fail, but it has not
saved the critically
impaired banking system as a whole. Small banks continue to fail,
burdening the
FDIC with having to ask the Treasury for more money which the Tresasury
in turn
has to ask the Fed to provide by buying more treasury bills to add to
its
balance sheet. That critical observation is the essence of the COP
report.
TARP was initially designed to buy troubled and illiquid
mortgage-backed
securities from banks. But by accepting Krugman’s public recommendation
via the
New York Times, the Treasury never actually used the appropriated funds
to buy troubled
assets, in part because it was simpler to invest money directly into
the
nation’s banks and in part because banks were reluctant to sell their
toxic loans
at a loss.
“The nation’s banks continue to hold on their books billions
of dollars in assets about whose proper valuation there is a dispute
and that
are very difficult to sell,” the COP report said. As
a result, the COP report warned, many banks
could find themselves short of capital if the economy suffered another
market downturn
and their losses on troubled loans soared. What the report did not say
was that
the prospect of further bank crisis itself will bring about another
market
meltdown.
While recommending further stress tests for the
too-big-to-fail banks, the COP report warned that thousands of small
and medium-size
banks, which it defines as those with assets of $600 million to $100
billion,
might find themselves short a total of $21 billion in capital if the
conditions
match its worst-case assumptions.
The report noted that other institutions had already
estimated the amount of troubled assets on bank balance sheets that had
yet to
be written down. The Federal Reserve estimated in May that banks in the
US
still had about $599 billion in assets to write down. Goldman Sachs and
the
International Monetary Fund estimated the total at about $1 trillion.
And RGE
Economics, headed by doom guru Nouriel Roubini, has estimated the total
at
$1.27 trillion.
The report urged the Treasury to either expand its
Public-Private Investment Program (PPIP) to soak up troubled assets,
“or
consider a
different strategy”, without identifying one.
Seizing on sales report of existing homes rising 7.2% in
July, the biggest jump this decade, albeit from very low base, Bernanke
declared what may become another set of famous last words: “The
prospects for a
return to growth in the near term appear good.” He did not mention at
what distressed
prices the sales were make.
Meanwhile, Meredith Whitney, who commands more credibility
in the market than Bernanke based on her accurate analyses of the
precarious
position of Citigroup as the credit crisis was building up, observed:
“There
will be over 300 bank closures.” European
Central Bank president Jean-Claude Trichet cautioned against assuming
that the
world was back to normal.
Some critics think the August 2009 COP report makes the
false assumption that when a bank is insolvent that it automatically
ceases
operations. This is not necessarily true. Receivership is the way that
a bank’s
liabilities are restructured when that institution is insolvent. The
restructured
bank’s debts are reduced but depositors can still access 100% of their
deposits
without interruption up to the $250,000 limit insured by the FDIC.
In most cases, the failed bank’s management will be replaced,
some liabilities to creditors are reduced, and one of the healthy
competitors of
the failed bank takes over the branches of the failed bank to continue
operation.
Much of the time, receivership means that bank shareholder equity is
wiped out,
but the branches remain open for business, making loans the very next
business
day.
It is not clear that the Fed buying toxic assets from small
banks would be a good idea. In two papers: The Put Problem with Toxic
Assets
and A Binomial Model of
Geithner’s
Toxic Asset Plan, University
of Louisiana Professor Linus Wilson
shows that the government
must overpay for toxic assets to get banks that have not entered
receivership to
part with these trash loans and securities. Wilson’s
research shows that troubled banks, which are not yet in receivership,
will be most
reluctant to part with their toxic loans. That is because most of their
stock
price is derived from the volatility of the market value of toxic
assets. FDIC
receivership allows the FDIC to write down bank debts so failed banks
can
emerge from restructuring healthier than they entered. But Wilson’s
paper: Debt Overhang and
Bank
Bailouts, shows that toxic assets are the biggest problem when
banks are
poorly capitalized.
There are over 8000 FDIC insured banks in the United
States serving communities of all
sizes.
Most of them are not large enough to pose systemic risk to the
financial system. Wilson’s
research shows that
Geithner’s plan to sell toxic assets through the Public Private
Investment
Partnership (PPIP) is most likely to be effective if it is used on
banks that
are in receivership, rather than to keep banks out of receivership. It
would be
a misguided subsidy, which would hurt the deposit insurance fund, if
the Legacy
Loans Program part of the PPIP is used on undercapitalized small banks
to keep
them out of receivership to preserve shareholder value.
Using the PPIP to bailout every community bank’s
shareholders and non-deposit creditors is a waste of taxpayer’s funds
and will
hurt healthy community banks because they have to compete with zombie
banks kept
upright with taxpayer money. A much more efficient use of taxpayer
funds would
be to shore up the deposit insurance fund so the FDIC can afford to
restructure
banks before their losses mount uncontrollably.
Yet the Congressional Oversight Panel’s August 2009 report
seems to be advocating propping up zombie banks. That is very
expensive, and
does not help otherwise good borrowers get good credit rating.
International Exit Coordination
World leaders on September 3,
2009 announced the first steps toward withdrawing emergency
support for the global economy even though they warned that the crisis
was far
from being over. The US, UK,
France
and Germany
called for work to start “on exit strategies to be implemented in a
coordinated
manner as soon as the crisis is over”.
US Treasury secretary Tim Geithner said finance ministers
should start to spell out how the “very successful policy response” to
the
economic crisis could be reversed, presumably without also reversing
their alleged
success. Speaking at the US Treasury press room before flying to London
for a
meeting of finance ministers of the G20 nations, Geithner said these
exit
strategies were “very important to confidence” of the financial
markets, with
the unintended implication that the allegedly “very successful policy
responses” would undermine market confidence if not reversed soon.
Writing in the Financial Times on September 3, Geithner said
that safety net that governments have put in place to limit the fallout
from
instability resulting from excessive leverage have a cost, because they
insulate financial institutions from the full consequences of their
actions and
can diminish market discipline. Such moral hazard needs to be contained
through
regulation that requires financial institutions to maintain reserves
and
capital buffers in proportion to their risk so that they can absorb
losses at
their own expense, and not at the taxpayer’s.
Geithner acknowledged that the “regulatory framework failed
last year [2008].” In the benign atmosphere before the crisis,
government
supervisors and those in the market underestimated risks building in
the
system. Major global financial institutions maintained capital levels
that were
too low, relied too heavily on unstable short-term funding, and their
compensation plans rewarded excessive risk-taking. Larger banks often
held less
capital relative to their risks and used more leverage than smaller
banks.
The resulting distortions helped make our global financial
system dangerously fragile. As that system grew in size and complexity,
it
became more interconnected and vulnerable to contagion when trouble
occurred,
Geithner said.
But such practices did not evolve innocently. The net
capital rule created by the Security Exchange Commission (SEC) in 1975
required
broker-dealers to limit their debt-to-net-capital ratio to 12-to-1, and
such
firms must issue early warnings if they began approaching this limit,
and were
forced to stop trading if they exceeded it, so broker-dealers often
kept their
debt-to-net capital ratios much lower than 12-1. The rule allowed the
SEC to
oversee broker-dealers, and required firms to value all of their
tradable
assets at market prices. The rule applied a haircut, or a discount, to
account
for the assets’ market risk. Equities, for example, had a haircut of
15%, while
a 30-year Treasury bill, because it is less risky, had a 6% haircut.
But a 2004
SEC exemption -- given only to five big firms which lobbied intensively
for the
exemption -- allowed them to lever up 30 and even 40 to 1.
The five big investment banking firms wanted for their
brokerage units an exemption from the 1975 regulation that had limited
the
amount of debt they could take on to $12 for every dollar of equity.
The
debt-to-net-capital ratio exemption would unshackle billions of dollars
held in
reserve as a cushion against potential losses on their investments and
trades.
The released equity funds from higher leverage allowance could then
flow up to
the parent company, enabling it to speculate in the fast growing but
opaque
world of mortgage-backed securities, credit derivatives, and credit
default
swaps (a form of insurance against counterparty default in order to
maintain
top credit rating), and other exotic structured finance instruments
that only
highly-trained mathematicians understand, based on models that are
beyond the
comprehensive of most traders.
This brave new approach, which all five qualifying broker-dealers -
Bear
Stearns, Lehman Brothers, Merrill Lynch, Goldman Sachs, and Morgan
Stanley -
voluntarily adopted, altered the way the SEC measured their capital.
The five
big firms, three of which became insolvent in 2009, led the charge for
the net
capital rule change to promote financial innovation, spearheaded by
Goldman
Sachs, then headed by Henry Paulson, who two years later, would leave
Goldman
to become Treasury Secretary and until the departure of the George W
Bush
administration on January 20, 2009 had to deal with the global mess he
helped
create. Lehman Brothers had gone bankrupt, Bear Stearns and Merrill
Lynch had
been sold to big commercial banks with access to Fed money and Goldman
and
Morgan Stanley have turned themselves into regulated bank-holding
companies to
avail themselves the benefit of access to Fed money. The age of
independent stand-alone
investment banks came to an end in the US.
(Please see my January 22,
2009
AToL article: The
Folly of
Intervention – Part One)
Treasury White Paper: Financial
Regulatory Reform: A New Foundation spells out five key
objectives of
reform:
(1)
Promote robust supervision and regulation of financial firms with:
A new
Financial Services Oversight Council of financial regulators to
identify emerging
systemic risks and improve interagency cooperation.
New
authority for the Federal Reserve to supervise all firms that could
pose a threat
to financial stability, even those that do not own banks.
Stronger
capital and other prudential standards for all financial firms, and
even higher
standards for large, interconnected firms.
A new
National Bank Supervisor to supervise all federally chartered banks.
Elimination
of the federal thrift charter and other loopholes that allowed some
depository
institutions to avoid bank holding company regulation by the Federal
Reserve.
The
registration of advisers of hedge funds and other private pools of
capital with
the SEC.
(2)
Establish comprehensive supervision of financial markets with:
Enhanced
regulation of securitization markets, including new requirements for
market
transparency, stronger regulation of credit rating agencies, and a
requirement
that issuers and originators retain a financial interest in securitized
loans.
Comprehensive
regulation of all over-the-counter derivatives.
New
authority for the Federal Reserve to oversee payment, clearing, and
settlement
systems.
(3)
Protect consumers and investors from financial abuse:
A new
Consumer
Financial Protection Agency to protect consumers across the financial
sector
from unfair, deceptive, and abusive practices.
Stronger
regulations to improve the transparency, fairness, and appropriateness
of consumer
and investor products and services.
A level
playing field and higher standards for providers of consumer financial
products
and services, whether or not they are part of a bank.
(4) Provide the government with the tools
it needs to manage financial crises
with:
A new
regime to resolve nonbank financial institutions whose failure could
have serious
systemic effects.
Revisions
to the Federal Reserve’s emergency lending authority to improve
accountability.
(5) Raise
international regulatory standards and improve international cooperation with:
International
reforms to support our efforts at home, including strengthening the
capital
framework; improving oversight of global financial markets;
coordinating supervision
of internationally active firms; and enhancing crisis management tools.
To
promote national coordination in the insurance sector, which is
regulated by a
state insurance commission in each state, the report proposes the
creation of
an Office of National Insurance within Treasury.
Under
the report’s proposal, the Federal Reserve and the Federal Deposit
Insurance Corporation
(FDIC) would maintain their respective roles in the supervision and
regulation
of state chartered banks, and the National Credit Union Administration
(NCUA)
would maintain its authorities with regard to credit unions. The
Securities and
Exchange Commission (SEC) and Commodity Futures Trading Commission
(CFTC) would
maintain their current responsibilities and authorities as market
regulators,
though the Treasury proposes to harmonize the statutory and regulatory
frameworks for futures and securities.
The September 4, 2009
G20 ministers meeting in London
set its aim to move forward on reforms to put the global financial
system on
firmer ground. In his June
17, 2009
remarks on 21ST CENTURY FINANCIAL
REGULATORY REFORM, President Obama outlined a new regulatory
framework that
promotes stronger protections for consumers and investors and greater
financial
stability. Making the system safer requires a comprehensive approach
including
tougher regulation of derivatives, securitization markets and credit
rating
agencies, new executive compensation standards and, critically, more
powerful
tools for governments to wind down firms that fail. Geithner said the
Obama
administration is working with foreign partners to ensure similar
reforms are
put in place by governments around the world.
Geithner set out eight principles for regulatory reform,
including one that would force banks to raise far more capital by
issuing new
shares. It would also set absolute limits on the amount of money a bank
could
borrow relative to its capital cushion. The proposal has received broad
support
from UK
chancellor of exchange Alistair Darling.
However, the proposals have caused disquiet in Paris.
French finance minister Christine Lagarde told a press conference in London
that changes proposed to existing capital rules for banks – known as
Basel II –
should be enough to ensure lenders hold a satisfactory level of
capital. “We
need to have a good and sound explanation among ourselves concerning
what Basel
II is about. It has been significantly improved, amended over time ...
and, as
revised, I would have thought that addressed the issue,” she said.
Instead, Ms
Lagarde added, France
would like to see the debate on bankers’ bonuses at the heart of
discussions
about reforms.
Geithner asserted that “at the core of our endeavor must be
making capital standards for financial institutions stronger.” He
referred to a
recent paper sent to G20 finance ministers expressing his views on the
principles that should shape a new international accord on capital
standards.
The fundamental principle is that capital and other regulatory
requirements
should be designed to ensure the stability of the system, not just the
solvency
of individual institutions. Such an approach requires a broad shift in
the way
capital and related regulations are designed.
Geithner said strengthening capital requirements is an
essential part of a broader effort to modernize the regulatory
framework so
that the financial system is strong enough to withstand the failure of
large,
complex institutions. That is the most effective way to prevent the
world from
re-living the events of last autumn. And that is the challenge G20
financial
ministers must tackle in London,
Pittsburgh
and beyond, added Geithner.
But the capital inadequacy did not evolved by itself. It was
created by policy by the Federal Reserve. Geithner seems to have
forgotten the
stated official views of the Fed under Alan Greenspan who said in a
1998
testimony before Congress:
We should note that were banks
required by the market, or their regulator, to hold 40% capital against
assets
as they did after the Civil War, there would, of course, be far less
moral
hazard and far fewer instances of fire-sale market disruptions. At the
same
time, far fewer banks would be profitable, the degree of financial
intermediation less, capital would be more costly, and the level of
output and
standards of living decidedly lower. Our current economy, with its wide
financial safety net, fiat money, and highly leveraged financial
institutions,
has been a conscious choice of the American people since the 1930s. We
do not
have the choice of accepting the benefits of the current system without
its
costs.
The risk of systemic market failure was a conscious choice
of Fed monetary policy that the American people did not have much say
in.
Greenspan, notwithstanding his denial of responsibility in helping
throughout
the 1990s to unleash the equity bubble, had this to say in 2004 in
hindsight
after the bubble burst in 2000: “Instead of trying to contain a
putative bubble
by drastic actions with largely unpredictable consequences, we chose,
as we
noted in our mid-1999 congressional testimony, to focus on policies to
mitigate
the fallout when it occurs and, hopefully, ease the transition to the
next
expansion.” By the next expansion, Greenspan meant the next bubble
which
manifested itself in housing. He did not heed the dire warnings in
2000. The
“wide financial safety net” that Greenspan relied on had holes big
enough to
drive a Mack truck through. By 2008, Greenspan was forced to admit to
Congress
that he erred in his faith in the self-regulatory regime of banks.
There was no clear G7 support, let alone G20, for a US
proposal for increasing the capital that banks hold in order to prevent
a rerun
of the crisis that led to the collapse of some of the world’s biggest
banks.
While G20 finance ministers agree that banks need more money
set aside in reserves to cushion against losses, how much is needed and
how
that is calculated appears to be in dispute.
Washington’s proposal has raised concerns that the United
States is pulling back from the G20’s April 2008 pledge to tackle the
issue
within the existing framework, known as Basel II, the second accord on
recommendations on banking laws and regulations issued by the Basel
Committee
on Banking Supervision, an institution created by the central bank
Governors of
the Group of 10 nations (G7 + Belgium, Netherlands, Sweden,
Switzerland). It
was created in 1974 and meets regularly four times a year.
One difficult aspect of implementing an international
agreement is the need to accommodate differing histories and cultures,
varying
structural models, and the complexities of public policy and existing
regulation.
FDIC Chairman Sheila Bair criticized the Basel II standards
in June 2007: “There are strong reasons for believing that banks left
to their
own devices would maintain less capital -- not more -- than would be
prudent.
The fact is, banks do benefit from implicit and explicit government
safety
nets. Investing in a bank is perceived as a safe bet. Without proper
capital
regulation, banks can operate in the marketplace with little or no
capital. And
governments and deposit insurers end up holding the bag, bearing much
of the
risk and cost of failure. History shows this problem is very real … as
we saw
with the U.S.
banking and S & L crisis in the late 1980s and 1990s. The final
bill for
inadequate capital regulation can be very heavy. In short, regulators
can’t
leave capital decisions totally to the banks. We wouldn't be doing our
jobs or
serving the public interest if we did.
On July 16, 2008 The federal banking and thrift agencies
(The Board of Governors of the Federal Reserve System; the Federal
Deposit
Insurance Corporation; the Office of the Comptroller of the Currency,
and; the
Office of Thrift Supervision) issued a final guidance outlining the
supervisory
review process for the banking institutions that are implementing the
new
advanced capital adequacy framework (Basel II). The final guidance,
relating to
the supervisory review, is aimed at helping banking institutions meet
certain
qualification requirements in the advanced approaches rule, which took
effect
on April 1, 2008
French finance minister Christine Lagarde said on September 4, 2009 in London
she could not see the point of scrapping that framework, saying changes
already
made to it had dealt with the biggest issues.
High on the list of priority topics for September 4-6, 2009 G20 finance minister
meeting
in London will be ‘when’
and ‘how’
to unwind the massive and unprecedented fiscal, monetary and financial
sector
stimulus that has been put in place by governments around the world
since 2008. For the US,
the ‘how’ has been answered by Bernanke, the ‘when’ will have to wait
and see.
The UK delegation who hosted the London meeting said that
there is widespread agreement that although there are signs of a
nascent
recovery in the UK, Europe, Asia and the US, it is still far too early
to begin
rolling back stimuli on any grand scale. Nevertheless, it is clear the
high levels
of government support are not sustainable and will need to be rolled
back
eventually.
The Organization for Economic Cooperation and Development
(OECD) said while a recovery in the world economy looked likely to come
earlier
than expected just a few months ago, the return to normal conditions
was likely
to be slow and protracted. In its interim assessment of the economic
outlook
for this year, the OECD warned that considerable headwinds would hit
the
recovery.
Also on the agenda of the London
meeting will be reforms of international financial institutions such as
the
International Monetary Fund and the World Bank, as requested in a
letter to the
heads of state and governments signed by the leaders of Britain,
Germany
and France.
In addition, the letter underscored the goal of achieving financial
commitments
for the IMF’s new arrangements of borrowing facility agreed to in
principle at
the previous G20 meeting on April 2 in London,
but not yet confirmed.
European Central Bank president Jean-Claude Trichet outlined
in the Financial Times on September 3 the principles of “enhanced
credit
support” under which the ECB would unwind the unconventional steps it
has taken
in dealing with the financial crisis. He said: “Stressing the
importance of the
exit strategy should not be confused with its activation: it is
premature to
declare the financial crisis over. Today is not the time to exit.”
However, the
first and foremost of four issues that will shape the ECB’s approach to
existing the “non-standard measures” in exception times will be
inflation.
“Should the non-standard measures trigger risks to price stability, we
will
immediately begin to unwind them and ensure the continued solid
anchoring of inflation
expectations,” wrote the ECB president.
UK Prime Pinister Gordon Brown, French President Nicolas
Sarkozy and German Chancellor Angela Merkel wrote in a joint letter to
European
Union governments: “While cyclical indicators point to economic
stabilisation,
the crisis is not over.”
On September 4, 2009,
G20 finance ministers and central bankers pledged in London
to keep economic life-support packages in place until recovery is
firmly
secured, but reached no agreement on financial executive compensation
reform. A
joint statement declares that fiscal and monetary policy would stay
“expansionary”
until recovery from the worst financial crisis since the Great
Depression is solidly
anchored. Policymakers are worried about derailing any recovery by
pulling the
life-support plug prematurely.
An accompanying statement: “Declaration on Further Steps to
Strengthen Financial Institutions”, lists 6 points:
1. Compensation
2. Systemically important firms
3. Prudential regulation
4. Non-cooperative jurisdictions
5. Implementation of international standards for actors
outside the core bank system such as credit derivatives etc.
6. Convergence of international accounting standards
The statement identifies what “more needs to be done” on:
Increasing transparency;
Global standards on pay structure, including on deferral,
effective claw back, the relationship between fixed and variable
remuneration,
and guaranteed bonuses, to ensure compensation practices are aligned
with
long-term value creation and financial stability;
Request the FSB (Financial Stability Board) to explore
possible limits/approaches on total variable remuneration” and
G20 governments agreeing to explore ways to address non-adherence
with the FSB principles.
The populist rhetoric leading up to the meeting had been
directed firmly at bankers and financial executives about their lavish
tens-of-million
of dollar bonuses. Yet the finance ministers could not agree on putting
an
actual cap on bonuses as had been advocated by some governments and
NGOs. Instead,
they agreed to create a global structure for imposing tighter controls
on pay
at financial institutions to discourage bankers from making the kind of
risky
bets that started the crisis back in August 2007.
These included deferring bonus payments over time and
subjecting them to “clawback” in case the risks imploded. The
compromise was
that the Financial Stability Board, a global regulatory council headed
by Bank
of Italy
chief
Mario Draghi, would study caps and the whole issue of pay further.
British
Prime Minister Gordon Brown told the start of the meeting: “Pay and
bonuses
cannot reward failure or encourage risk taking. It is offensive to the
public
whose taxpayers’ money in different ways has helped many banks from
collapsing
and is now underpinning their recovery.”
France
and Germany
still favor a cap on executive bonuses or a targeted tax on excess
remuneration, proposals the US
and UK
believe
would be difficult to implement. The issue was not so much the
astronomical
compensation figures, but an annual bonus system that encourages
long-term risk-taking
to produce short-term gains in order to boost annual pay. Under current
practice, executives can walk away with lucrative payments annually
while
leaving certain losses in future years for investors.
The draft statement showed agreement that emerging nations such
as India and China should have a greater say in the running of the
International Monetary Fund and World Bank but did not offer up any
formula of
how this should be achieved. It said only that their voice in global
economic
policymaking would grow ”significantly” and that it expected
“substantial
progress” to be made on the issue at a summit of world leaders in
Pittsburgh on
September 24-26
.
The BRIC group of leading emerging powers - Brazil,
Russia India and China
- had laid out concrete targets for how much movement they wanted in
IMF and
World Bank quotas.
When the leaders of the G20 nations in earlier semiannual
meetings that first began in September 2008 in Washington,
there was a unity driven by fear of world economic collapse. At the G20
finance
ministers meeting in London on September 4-6, 2009, ahead of a full
national
leaders’ summit in Pittsburgh on September 24-26, agreement was no
longer
preordained regarding a whole range of issues, such as the appropriate
strategy
for a sustainable global recovery and an improved financial regime
going
forward, the reform of the IMF, the finance regulatory regime, the
issue of
executive bonus practices that encourage excessive risk-taking and even
strategy for preventing climate change.
On the economy, G20 finance ministers are expected to agree
to keeping stimulus programs for as long as needed while central
bankers are
expected to keep monetary policy accommodative through credit easing.
In first quarter 2009, the Group7 major industrialized
economies were contracting at an annualized rate of 8.4%. Tremors from
the
financial crisis and the collapse in world trade volumes, which fell by
17%
between September and December 2008, were felt across the world.
It is not clear how much output is being stoked up directly
by government stimulus packages. As a whole, these demand-boosting
packages for
the G20 now total $1.06 trillion, almost 2% of its economic output in
2008. The
G20 accounted for 87.3% ($53.2 trillion) of global GDP ($61 trillion)
in 2008.
The US
comprised the largest single share in 2008 at 23.6% ($14.3 trillion) of
world
GDP while the total EU accounted for a further 30.2% ($18.4 trillion). Japan’s
2008 GDP was $4.9 trillion and China’s
was $4.4 trillion. In Germany,
private consumption was boosted by around 1% in the first half of 2009
just by
its popular “cash-for-clunkers” car trade-in scheme alone. Such
stimulus is
clearly unsustainable.
A Brookings
Institution study released in March 2009 showed the total amount of stimulus in the G-20 amounts to
be about $692 billion for 2009, which is about 1.4% of their combined
GDP and a
little over 1.1% of global GDP. This is a still significant amount of
stimulus,
but appears to fall short of what is needed to tackle a crisis of the
proportion the world is currently in. The IMF, for instance, has called
for
stimulus equal to 2% of global GDP.
Three countries—the
U.S., China and Japan—account for about $424 billion of the overall
stimulus in
2009, with their shares in the overall global stimulus amounting to 39%
(U.S.),
13% (China) and 10% (Japan). Measures for 2009 in the U.S. stimulus
package
amount to 1.9% of its 2008 GDP and the corresponding numbers for China
and
Japan are 2.1% and 1.4% respectively. For the remaining G-20 economies,
the
total fiscal stimulus amounts to 1.0% of their overall GDP.
In 2010, the U.S.
is projected to account for over 60% of planned stimulus. China and
Germany are
the next largest contributors with China contributing 15% of G-20
stimulus and
Germany contributing 11%. Measures for 2010 in the U.S. stimulus
package amount
to 2.9% of 2008 GDP, China’s 2.3%, and Germany’s 2.0%.
In summary, while
almost all countries have signed on to the fiscal stimulus program, the
size of
the stimulus varies substantially across countries, with some of the
stimulus
packages looking downright meek (e.g., France, which has proposed
measures amounting
to only 0.7% of GDP in 2009).
There is
considerable discussion about the relative effectiveness of tax cuts
versus
spending in stimulating domestic demand. Brookings highlights one
regularity in
the composition of packages across countries and then indicates one
dimension
in which the structure of the packages differs markedly across
countries.
Most countries
that have announced multiple waves of stimulus have increased the share
of
spending (compared to tax cuts) in the second round, just as the U.S.
has done
from January 2008 to January 2009. For example, Germany’s stimulus in
November
2008 was largely composed of tax cuts. The second stimulus package
announced in
January 2009 was largely tilted towards spending. Similar features can
be found
in the stimulus measures announced in Australia in October 2008 and
February
2009, and in Spain in March 2008 in November 2008.
There is a great
deal of variation across countries in the share of the stimulus that is
devoted
to tax cuts. In the U.S., this share is about 45%. Some
countries—including
Brazil, Russia and the U.K.—have focused almost entirely on tax cuts.
Others—including Argentina, China and India—have mostly proposed
spending
measures. Among the G-20 countries excluding the US, about one-third of
the
stimulus is accounted for by tax cuts and the remainder by spending
measures.
Brookings did not
analyse the difference in focus in the tax cuts of different countries.
In the
US, for example, the tax cut has been focused on the upper income
groups because
odits ideological fixation about the trickling down model of spreading
prosperity.
The Brookings
report observed that countries vary in the degree of frontloading of
their
stimulus packages—the speed with which the tax and expenditure measures
hit the
real economy (in terms of money reaching the pockets of firms and
households,
or government monies being spent on social programs or procurement).
This is
partially a function of the vagaries of the budget process in each
country—countries may not announce stimulus for the future though they
intend
to enact it as part of their regular budget process.
Of the 19
countries that make up the G-20, only four countries—China, Germany,
Saudi
Arabia, and the US - plan to spend as much or more on stimulus (as a
share of
GDP) in 2010 than in 2009. In other words, there is a fair amount of
frontloading in the stimulus packages of the G-20 countries, with much
of the
stimulus taking effect in 2009. Of course, this could reflect different
beliefs
about the length of the recession. It could also reflect difficulty in
ramping
up government expenditure quickly, especially on infrastructure and
other
investment projects.
The report also
noted that some countries recognized the coming crisis and implemented
stimulus
plans at some point in 2008. This list includes Australia, China,
Japan, Korea,
Saudi Arabia, South Africa, Spain, U.K. and the U.S.
Fiscal stimulus
has a crucial role to play in stabilizing the world economy, especially
as
conventional monetary policy appears to have reached its limit in many
countries. By and large, policymakers in G-20 economies have acted on
their
leaders’ joint announcement in November 2008 to use fiscal stimulus in
a
concerted and coordinated manner to boost economic activity. Some
countries
like China and the US have responded forcefully, with impressive
packages. But
the execution, both in terms of size and speed, leaves much to be
desired in
some of the G-20 countries.
Brookings said there
are legitimate questions about the effectiveness of fiscal stimulus,
especially
in economies where the financial system has broken down and where
monetary
policy can no longer play much of a supporting role. Moreover,
excessive
government borrowing to finance large budget deficits could itself
generate
instability and there are serious concerns about medium-term
sustainability of
fiscal positions in economies that are building up public debt at a
rapid pace.
Given the dire and fast-deteriorating economic situation and the lack
of other
tools, however, the world may have little choice but to engage in
massive
frontloaded fiscal expansion. Swallowing the Freidmanesque
counterfactual
conclusion about how the Great Depression cold have been prevented,
Brookings
consluded that “the consequences of timidity, as history teaches us,
could be
even worse.” In the absense of credible exit strategies for wholesale
governmetn intervention in the market, time will tell if the worse had
been
avoided.
International Monetary Fund managing director Dominique
Strauss-Kahn declared at the London meeting that withdrawal of stimulus
will
need to be handled delicately, and not before households and companies
are up
to the task of “taking the baton” of supporting growth from the public
sector. He
did not give a specific date as when that would be.
Divisions on policy have appeared among the G20: Germany
and France
are
treading hawkish lines about cutting borrowing. The UK,
in particular, is urging flexibility, arguing that governments should
only
withdraw stimulus as quickly as the strength of the economy allows,
even if
that means extending existing program without time limits. The danger
is that
temporary stimulus programs will become permanent fixtures in the
system. The
G20 appear to be seeking political cover for that outcome, by arguing
that an
exit plan should not be set in stone when the economic situation is so
fluid.
The problem is that economic conditions will always be fluid to justify
the
emergence of state capitalism.
World Leaders now face the daunting task of having to redesigning
the global financial system without challenging its ideological
fixation and to
restore public confidence in a bankrupt credit market living on life
support
from government. How can recovery led largely by the public sector be
sustained
in a global market economy that operates on private enterprise
principles? Governments
in failed market economies cannot turn off the monetary and fiscal taps
to
start cleaning up the public sector balance sheets without causing
zombie private
institutions to return to the dead. How is the government to force the
banks to
lend when there are no credit-worthy borrowers, without leading to
another debt
crisis? What kind of exit strategy can emerge from rescue programs
based on
blocking normal fire exits in the market by holding up the collapsed
ballooned
values of toxic assets with taxpayer money? On the other hand, staying
the
course on monetary accommodation and government stimulus is also
unsustainable,
as inflation will result to cause the all currencies to collapse. Why
is full
employment with living wages not the top prerequisite of all stimulus
programs?
(Please see my April 14, 2009
article: G20 Summit Missed the
Real Target)
Meanwhile, fundamental systemic reform is delayed, waiting
for the crisis to subside from fire-fighting emergency measures,
stalled by pre-game
political squabbling among special interest groups over turf and
advantages.
Substantial amount of rescue money are being spent by banks to lobby
against bank
reform.
Obama Approval Rate Falling
In the meantime, President Obama who captured the White
House with campaign promises of change to reform dysfunctional economy
and the
birth of a new political environment, has since seen his approval
rating fall
as Americans become more pessimistic about how long it will take the
economic
downturn to end. Obama’s tumbling poll numbers have dipped below those
of his
predecessor George W. Bush at the same point in his White House tenure,
according
to a national USA Today/Gallup poll released on September 1, 2009. Obama's approval
rating is 55% six
months into his presidency, but 56% of those polled approved of the job
done by
George W. Bush after six months. Only 47% of respondents said they
approve of Obama's
handling of the economy while 49% said they disapprove. Specifically,
they
disapprove of his health care policy by 50% to 44% approval.
The August 23, 2009 Rasmussen
Reports daily Presidential Tracking Poll showed that only 27% of
the
nation’s voters ‘Strongly Approve’ of the way that Obama is performing
his role
as President, while 41% ‘Strongly Disapprove’, giving Obama a
Presidential
Approval Index rating of -14. These figures mark the lowest Approval
Index
rating yet recorded for this President. The previous low of -12 was
reached on
July 30.
The September 06, 2009 Reports improved slightly. It showed
that only 29% of the nation’s voters ‘Strongly Approve’ while 40%
‘Strongly
Disapprove’, giving Obama a Presidential Approval Index rating of -11.
The
index had started to turn negative at the end of June. The Rasmussen
poll of likely
voters found Obama’s approval rating dipping below 50% for the first
time
around the end of June 2009, after five months in office.
Some analysts attribute the approval decline to Obama’s unpopular
health reform program, particularly the process he has been using to
push his
signature initiative--a process that many voters found arrogant,
deceptive and
bullying.
Obama the candidate who impressed voters as even-tempered,
honest and earnest, a leader who is reflective and open to debate, who
is
willing to listen and relies on persuasion, seems to have disappeared
in past
months in Obama the president as the health care debate turned
intensely
ideological. Rather than being open to opposing views on a highly
controversial
subject, he comes across to many as a sarcastic, lecturing know-it-all
on
issues on which every voter holds a uniquely personal view. Rather than
appearing
honest and sincere, his rhetoric sounds duplicitous and slick as he
answers
opponent distortions with his own. Rather than sounding thorough and
measured,
his reform plan appears frantic and extreme. The Obama budget will
incur
deficits that dwarfs the record set by Ronald Reagan and the bulk of
money seems
to be going to Wall Street executives rather than the truly needy.
A new August 6 Quinnipiac University
poll shows Obama’s
approval rating among Americans has fallen seven points in July, from
57% to 50%,
with just 45% of independent voters approving of the job he is doing. On specifics agenda, only 39%
approve of the
way Obama is handling health care; 45% approve of how he is handling
the
economy; 64% say they are somewhat or very dissatisfied with the way
things are
going in the country today; and an astonishing 93% say the economy is
poor or
not so good.
The Same Neo-liberal Centrist Team
The Obama administration is largely run by former Clinton
neo-liberals who cannot escape sharing prime responsibility for the
current
financial crisis that took two decades to ferment. Obama was sent by
disenchanted
voters to the White House to make “changes we can believe in”. Instead
of
mining the rich reservoir of American progressive populism, Obama’s
bipartisan
centrist approach to change only provokes passionate rightwing populist
outbursts
in tea-party town-hall resistance.
In contrast to Franklin D, Roosevelt and his liberal brain trust
to give the country a New Deal, Obama came to Washington without a
general
staff of progressives, but an tired discredited entourage of former
Clinton
neo-liberal centrists, exposing his administration to accusation from
vocal
conservatives such as Washington Post Op-ed columnist Charles
Krauthammer of “cutting
backroom deals with every manner of special interest -- from drug
companies to
auto unions to doctors -- in which favors worth billions were quietly
and
opaquely exchanged.” The practical realism of political deal-making is
depriving
the leader for change the loyal support from his real political base in
the
grass root communities. In his eagerness to get things done, Obama puts
himself
in danger of doing the wrong things.
Bernanke Reappointment
The reappointment of Bernanke as Chairman of the Federal
Reserve in August 2009 is equivalent to Jimmy Carter’s appointment of
Paul Volcker
in August 1979, 15 months before Carter had to face election for a
second term.
On February 6, 2009,
after
17 days in office, Obama also appointed Volcker as first chairman of
the
President’s Economic Recovery Advisory Board.
William G Miller, after only 17 months at the Fed, had been
named treasury secretary as part of Carter’s desperate wholesale
cabinet
shakeup in 1979 in response to popular discontent and declining
presidential
authority. After isolating himself for 10 days of introspective
agonizing at Camp David, Carter emerged on July 15, 1979 to make his
speech of “crisis of the soul and confidence”
to a restless nation. In response, the market dropped like a rock in
free fall.
Miller was a fallback choice for the Treasury, after numerous other
potential
appointees, including David Rockefeller, declined personal telephone
offers by
Carter to join a demoralized administration.
Carter felt that he needed someone like Volcker, an intelligent if not
intellectual Republican, a term many liberal Democrats considered an
oxymoron,
who was highly respected on Wall Street, if not in academe, to be at
the Fed to
regenerate needed bipartisan support in his time of presidential
leadership
crisis. Bert Lance, Carter’s chief of staff, was reported to have told
Carter
that by appointing Volcker, the president was mortgaging his own
re-election to
a less-than-sympathetic Fed chairman. Did Rahm Emanuel warn Obama about
Bernanke?
Volcker won a Pyrrhic victory against inflation by letting financial
blood run
all over the country and most of the world. It was a toss-up whether
the cure
was worse than the disease. Will Bernanke do the same as soon as
recovery is at
hand?
What was worse was that the temporary deregulation that had
made limited sense under conditions of near hyper-inflation was kept
permanent
under conditions of restored normal inflation all through the Volcker
tenure at
the Fed.
In his March 27, 2008
campaign speech at Cooper Union in New York City Speaking at
Cooper Union in New York City,
Obama argued for more regulation, depicting the economic crisis as a
consequence of deregulation in the financial sector. “Our free market
was never
meant to be a free license to take whatever you can get, however you
can get
it,” he said. “Unfortunately, instead of establishing a 21st century
regulatory
framework, we simply dismantled the old one—aided by a legal but
corrupt
bargain in which campaign money all too often shaped policy and watered
down
oversight.”
Yet Carter was the president of deregulation and Clinton
sealed financial deregulation.
Senate Antitrust Subcommittee Chairman Philip A. Hart
(D-Michigan 1959-76), known as the Conscience of the Senate, honored
with his
name on the Senate Building, held hearings in the 1970s on the
concentration of
economic power in the United States, and proposed expanded government
regulation on oil, auto, pharmaceuticals, even professional sports.
Hart was
concerned that the concentration of wealth and economic power in a
small number
of big corporations will distort the market economy and American
democracy. He
argued that government regulation is needed to bring about lower prices
and
greater productivity and more useful innovation to serve the common
good.
While efforts to deregulate began under Richard Nixon and
Gerald Ford, it become reality under Jimmy Carter, who hired
deregulation guru
Alfred E. Kahn to head the Civil Aeronautics Board, the widely loathed
agency
responsible for regulating the airline industry. Young Senator Ted
Kennedy and
his then aide, future Supreme Court Justice Stephen Breyer, embraced
deregulation as a consumer issue. With their support, Kahn quickly
deregulated
everything, including the elimination of his own job. The 1978 Airline
Deregulation Act dissolved the CAB and removed most regulation of
commercial
airlines and aviation, which promptly led many airlines into habitual
bankruptcies
and left small communities without sir service. Carter also signed into
law
bills deregulating the railroads and the trucking industry.
A March 1998 FDIC paper (Number 98-05) argues that a
1978 Supreme Court decision (Marquette Nat. Bank of Minneapolis
v. First of Omaha Service Corp.)
fundamentally altered the market for
credit card loans in a way that significantly expanded the availability
of
credit and increased the average risk profile of borrowers.
Robert H. Bork argued the cause for respondent First of
Omaha Service Corp. in both cases.
MR. JUSTICE BRENNAN delivered the opinion of the Court: “The
question for decision is whether the National Bank Act, Rev. Stat.
5197, as
amended, 12 U.S.C. 85, authorizes a national bank based in one State to
charge
its out-of-state credit-card customers an interest rate on unpaid
balances
allowed by its home State, when that rate is greater than that
permitted by the
State of the bank's nonresident customers. The Minnesota
Supreme Court held that the bank is allowed by 85 to charge the higher
rate.
262 N. W. 2d 358 (1977). We affirm.”
The FDIC paper
argues that Marquette ushered in deregulation of usury ceilings
on consumer interest rates by allowing lenders in a state with liberal
usury
ceilings to export those rates to consumers residing in states with
more
restrictive usury ceilings. The result was a substantial expansion in
credit
card availability, a reduction in average credit quality, and a secular
increase in personal bankruptcies.
In the Volcker era, big banks could take advantage of their
access to lower-cost funds to assume higher risk and therefore play in
higher-interest-rate loan markets nationally and internationally, quite
the
opposite of what Keynes predicted, that the abundant supply of capital
would
lower interest rates to bring about the “euthanasia of the rentier”. Securitization of unbundled risk
levels allowed high-yield, or junk, bonds with high rates to dominate
the
credit market, giving birth to new breeds of rentiers. (Please see my February 24, 2004 AToL article: The
Presidential
Election Cycle Theory and the Fed)
Deregulation, particularly of interest-rate ceilings and
credit market segregation and restrictions, put an end to market
diversity by
killing off small independent firms in the financial sector since they
could
not compete with the larger institutions without the protection of
regulated
financial markets. Small operations had to offer increasingly higher
interest
rates to attract funds while their localized lending could not compete
with the
big volume, narrow rate-spreads of the big institutions. The rescue
measures instituted
by Geithner/Bernanke so favor big banks that the now some 8000
community banks
in the US face the danger of being consolidated into a handful big
banks that
enjoy unlimited access to Fed money for no other reason aside from
being too
big to fail.
It is true that Obama inherited the problem of a failed
market economy, albeit more from Clinton
than Bush, but he also inherited the bankrupt solution. His team was
the former Clinton team of
neo-liberals who
created the mess.
Can state capitalism be the answer to a failed market
economy? Government bailout can soften the immediate pain of market
failure,
but there is a cost that taxpayers would have to pay in future years.
Excessive
debt cannot be cured with future debt. Power unsupported by credibility
cannot
last.
September 15, 2009
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