Global Post-Crisis Economic Outlook
 
By 
Henry C.K. Liu

Part I: Crisis of Wealth Destruction 
 
Part II: Two Different Banking Crises - 1929 and 2007

This article appeared in AToL on April 14, 2010
 
 
The 1929 banking crisis that launched the Great Depression was caused by stressed banks whose highly leveraged retail borrowers were unable to meet margin calls on their stock market losses, resulting in bank runs from panicky depositors who were not protected by government insurance on their deposits.
 
In the 1920s, there were very few traders beside professional technical types. The typical retail investors were long-term investors, trading only infrequently, albeit buying on high margin. They bought mostly to hold based on expectations that prices would rise endlessly.
 
By contrast, the two decades of the 1990s and 2000s were decades of the day trader and big time institutional traders. New powerful traders in major investment banking houses overwhelmed old-fashion investment bankers and gained control of these institutions with their high profit performance. They turned the financial industry from a funding service to the economy into a frenzy independent trading machine. Many of the investing public aspired to be the Master of the Universe, as caricatured in Tom Wolf’s Bonfire of the Vanity, which was turned into a movie starring Tom Hanks. Derivative trading by hedge funds was routinely financed through broker dealers funded by banks at astronomically high leverage.
 
Greenspan – the Wizard of Bubble Land
 
But the debt joyride was by no means all smooth sailing in a calm sea. Repeated mini crises were purposely ignored by regulators who should have known better. Greenspan, notwithstanding his denial of responsibility in helping throughout the 1990s to unleash serial equity bubbles, had this to say in 2004, three year before the 2007 tsunami of a century, 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.” The Greenspan Fed adopted the role of a clean-up crew of otherwise avoidable financial debris rather than that of a preventive guardian of public financial health. Greenspan’s one-note monetary melody throughout his 18-yesr-long tenure as the nation’s central banker had been when in doubt, ease.
 
LTCM – the Crisis that the Fed Papered Over
 
In the 1920s, there were no derivative markets. In the case of Long Term Capital Management, the hedge fund that failed in 1998, the firm had equity of $4.72 billion and had borrowed over $124.5 billion to acquire assets of around $129 billion, for a debt-equity ratio of about 25 to 1. But even that it was conservative when compared to the 40 to 1 ratio used by investment banks in the 2000s.  
 
LTCM had off-balance-sheet derivative positions with a notional value of approximately $1.25 trillion, most of which were in interest rate derivatives such as interest rate swaps, equaling to 5% of the entire global market.  LTCM also invested in other derivatives such as equity options. LTCM was bailed out by its counterparty creditors under the guidance of the NY Fed. (Please see my December 3, 2009 series: Reform of the OTC Derivative Market - Part One: The Folly of Deregulation)
 
The Enron Fraud
 
In the 1920s, there was no structured finance or securitization of debt. The case of Enron, a large brave new energy trader, and its spectacular bankruptcy marked the high watermark of legalized financial fraud. The evidence is undeniable that the Enron scandal exposed critical flaws in the entire financial system and the ineffective policing of US capital markets and corporate governance. In a December 18, 2001 Senate Commerce Committee hearing on the Enron collapse, Arthur Levitt, former Democratic head of the Securities and Exchange Commission (SEC), characterized corporate financial statements as “a Potemkin village of deceit”. Senator Ernest Hollings, a Democrat from South Carolina, characterized Enron Chairman Kenneth Lay’s political prowess as “cash and carry government”. Embarrassingly, the New York Times reported the following day that Hollings had received campaign contributions from Enron and its auditor Arthur Andersen dating from 1989.

Until Enron filed for bankruptcy in 2001, the system’s top law firms and accounting firms were providing professional opinion that what went on in Enron was "technically" legal. The international dealings of Enron received unfailing support from the US government. Many of the schemes undertaken by Enron and other companies were devised by investment bankers who collected fat fees advising their clients and who profited handsomely from providing financing for schemes they knew were towers of mirage. It was known in the industry as "finance engineering" and the vehicle was structured finance or derivatives. (Please see my August 1, 2002 article: Capitalism’s bad apples: It's the barrel that's rotten)
 
Greenspan – Enron Prize Recipient
 
Chairman of the Federal Reserve since 1988, Alan Greenspan gave a lecture at Stude Concert Hall sponsored by the James A. Baker III Institute for Public Policy on November 13, 2001. Following his lecture, he received the Baker Institute’s Enron Prize for Distinguished Public Service. The prize, made possible through a generous and highly appreciated gift from the Enron Corporation, recognizes outstanding individuals for their contributions to public service.
 
Greenspan’s speech offered an assessment of what lies ahead for the energy industry to an admiring audience. In the wake of the September 11 attacks and the then weakened state of the economy, Greenspan stressed the need for policies that ensure long-term economic growth. “One of the most important objectives of those policies should be an assured availability of energy,” he said.
 
Greenspan said that this imperative has taken on added significance in light of heightened tensions in the Middle East, where two-thirds of the world’s proven oil reserves reside. He noted that the Baker Institute is conducting major research on energy supply and security issues.
 
Looking back at the dominant role played by the United States in world oil markets for most of the industry’s first century, Greenspan cited John D. Rockefeller and Standard Oil as the origin of US pricing power, notwithstanding the nation saw fit to break up the Rockefeller/Standard Oil trust. Following the breakup of Standard Oil in 1911, he said this power remained with American oil companies and later with the Texas Railroad Commission. This control ended in 1971 when remaining excess capacity in the US and oil pricing power shifted to the Persian Gulf. Greenspan was saying better Standard Oil than OPEC. He seemed oblivious to the development since the 1973 oil embargo that US oil companies have been working hand in glove with OPEC producers to keep oil prices high.
 
The Power of Markets against Market Power
 
“The story since 1973 has been more one of the power of markets than one of market power,” Greenspan said. He noted that the projection that rationing would be the only solution to the gap between supply and demand in the 1970s did not happen. While government-mandated standards for fuel efficiency eased gasoline demand, he said that observers believe market forces alone would have driven increased fuel efficiency.  Greenspan appeared to be the only one who sincerely believed that a free market existed or could exit for the trading of oil. All oil traders know that the price of oil is one of the most manipulated components in world trade.
 
“It is encouraging that, in market economies, well-publicized forecasts of crises more often than not fail to develop, or at least not with the frequency and intensity proclaimed by headline writers,” Greenspan credited free markets with mitigating the oil crisis.
 
As it turned out, the California energy crisis of rolling blackouts was not caused by Middle East geopolitics. It was the handy work of Enron fraudulent trading strategies.
 
Greenspan against Reform
 
All though the 1990s and early 2000s, there were much talk of reform that led nowhere near what was actually needed. Less than a decade later, a financial crisis that Greenspan characterized as the market failure of a century imploded with a big bang.
 
On Greenspan’s 18-year watch at the Fed, government-sponsored enterprises (GSE) assets ballooned 830%, from $346 billion to $2.872 trillion. GSEs, namely Fannie Mae and Freddie Mac, are financing entities created by the US Congress to fund subsidized loans to certain groups of borrowers such as middle- and low-income homeowners, farmers and students. Agency MBSs (mortgage-backed securities) surged 670% to $3.55 trillion. Outstanding ABSs (asset-backed securities) exploded from $75 billion to more than $2.7 trillion.
 
Greenspan presided over the greatest expansion of speculative finance in history, including a trillion-dollar hedge-fund industry, bloated Wall Street firm balance sheets approaching $2 trillion, a $3.3 trillion daily repo (repurchase agreement) market, and a global derivatives market with notional values surpassing an unfathomable $220 trillion. Granted, notional values are not true risk exposures. But a swing of 1% in interest rate on a notional value of $220 trillion is $2.2 trillion, approximately 20% of US gross domestic product (GDP). Grated that much of the derivative trades were hedged, meaning the risks are mutually canceling. But the hedges would only hold without counterparty default. All that was needed to unleash a systemic failure was for the weakest link to fail. Greenspan created a monetary situation that permitted the market to speculate on risks that it could not afford. 
 
Having released synthetic credit of dangerously high notional value, Greenspan raised the Fed funds rate target  from its lowest point of 1% set on June 23, 2003, to 4.50% on January 31, 2006, to dampen inflation expectations, before retiring as chairman the following month. Ben Bernanke, his successor as of February 1, 2006, continued increasing the Fed funds rate target  in three more steps to 5.25% on June 29, 2006, the cumulative effect adding aggregate interest payments to the financial system greater than US GDP in 2006.

That was like striking a match to light a candle in a dark kitchen filled with leaked gas. Under such fragile and explosive conditions, there was little wonder that the market collapsed a year later. (Please see my March 16, 2007 article: Why the US sub-prime mortgage bust will spread to the global finance system, written at a time when mainstream opinion was that the housing market, being geographically disaggregated, would not spread.)
 
Much of the precautionary measures instituted during the New Deal to prevent a replay of the 1929 crash, such as the separation of investment banking from commercial banking, requiring banks to be neutral intermediary of capital funds rather than profit-seeking market makers, in the form of the Banking Act of 1933 (Glass-Steagall), were repealed, as a result of bank lobbying. Glass-Steagall was replaced by the Financial Services Modernization Act of 1999, (Pub.L. 106-102, 113 Stat. 1338, enacted November 12, 1999), aka the Gramm, Leach-Bliley Act (GLBA).
 
Wholesale Credit Market Failure
 
Yet with the benefit of deposit insurance instituted during the New Deal remaining operative, the current financial crisis that began in mid-2007 was caused not by bank runs from depositors, but by a melt down of the wholesale credit market when risk-averse sophisticated institutional investors of short-term debt instruments shied away en mass.
 
The wholesale credit market failure left banks in a precarious state of being unable to roll over their short-term debt to support their long-term loans. Even though the market meltdown had a liquidity dimension, the real cause of system-wide counterparty default was imminent insolvency resulting from banks holding collateral whose values fell below liability levels in a matter of days. For many large, public-listed banks, proprietary trading losses also reduced their capital to insolvency levels, causing sharp falls in their share prices.
 
Bank Bailouts
 
Citi Group shares fell from $70.80 in July 31, 2007 to $1.02 on March 4, 2009. CitiGroup market capitalization dropped to $6 billion from $300 billion two years prior.
 
CitiGroup shares were trading at $4.54 on April 2010 after having received $320 billion of bailout help from the Treasury in November 2008. Citigroup and Federal regulators negotiated a plan to stabilize the bank-holding company with the Treasury guaranteeing about $306 billion in loans and securities and investing about $20 billion directly in the company. The assets remain on Citigroup’s balance sheet; the technical term for this arrangement is “ring fencing” or hypothecation, the dedication of the revenue of a specific tax for a specific expenditure purpose. In a New York Times op-ed, author Michael Lewis and hedge fund manager David Einhorn described the $306 billion guarantee as “an undisguised gift” without any real crisis motivating it.
 
From October 2008 to January 2009, the US Treasury provided Citigroup with three rounds of financial aid worth $45 billion. Citibank has to pay back $20 billion of the aid as the US government acquired 34 percent of Citigroup’s capital. The government also imposed executive pay restrictions which the bank was eager to dodge fearing the exodus of “talented” employees. Even though the bank was optimistic about the plan, offering $15 billion in common stock, there were some within the bank who questioned whether the aid should be paid back so soon. Some government officials also voiced concerns that the US economy might head back into recession causing consumer credit losses and commercial real estate losses.

"The basic objective is to make sure as we exit ... we’re leaving the capital position of the institutions stronger, not weaker," said US Treasury Secretary Timothy Geithner, as if merely stating the goal is as good as achieving it.
 
Tax Deduction Stealth Bailout
 
Under the Bush Administration, the IRS, an arm of the Treasury Department, changed a number of rules during the financial crisis to reduce the tax burden on financial firms and to encourage mergers, letting Wells Fargo cut billions of dollars from its tax bill by buying the ailing Wachovia. The government was consciously forfeiting future tax revenues from these companies as another form of assistance.
 
On December 16, 2009, the Bush administration government quietly agreed to forgo billions of dollars in potential tax payments from Citigroup as part of the deal to help wean the company from the massive taxpayer bailout that enable it to survive its blunders that helped cause the financial crisis. The Internal Revenue Service issued an unusual exception to long-standing tax rules for the benefit of Citigroup and a few other companies that had been partially acquired by the government.
 
As a result of the exception, Citigroup will be allowed to retain billions of dollars worth of tax breaks that otherwise would decline in value when the government sells back its Citigroup stake to private investors. The Obama administration, in updating the exceptions, has said taxpayers are likely to profit from the sale of the Citigroup shares. Many accounting experts, however, are of the opinion that the lost tax revenue could easily outstrip those profits.
 
Treasury officials said the most recent change was part of a broader decision initially made to shelter companies that accepted federal aid under the Troubled Assets Relief Program from the normal consequences of such an investment. Officials also said the ruling benefited taxpayers because it made shares in Citigroup more valuable and asserted that without the ruling, Citigroup could not have repaid the government at this time.
 
“This rule was designed to stop corporate raiders from using loss corporations to evade taxes, and was never intended to address the unprecedented situation where the government owned shares in banks,” Treasury spokeswoman Nayyera Haq said. “And it was certainly not written to prevent the government from selling its shares for a profit.”
 
When working as spokeswoman for Representative John Salazar, Democrat of Colorado Nayyera Haq joined with 22 other Muslims aides on Capitol Hill to form the Congressional Muslim Staffers Association, after hearing a radio interview in which Tom Tancredo, a Colorado Republican, in response to a question on what should be done if Muslim terrorists attacked the United States, suggested bombing Islam's holy sites, including Mecca. “That's when I realized there was something really wrong,” said Ms Haq. “Not just with members of Congress, but as Americans and our approach to dealing with ‘others’.”
 
Byzantine Partisan Politics
 
The Democrat-controlled Congress, concerned that lame-duck Bush Treasury was bypassing Congress to rewrite tax laws, passed legislation early in 2009 that reversed the ruling that benefited Wells Fargo in 2008 and restricted the ability of the IRS to make further changes. A Democratic aide to the Senate Finance Committee, which oversees federal tax policy, said the Obama administration, just as the Bush administration did, has the legal authority to issue the new exception, but now Republican aides to the committee say they are reviewing the issue.
 
A senior Republican staffer now questions the Obama administation’s echo of the Bush rationale. “You’re manipulating tax rules so that the market value of the stock is higher than it would be under current law,” said the aide, speaking on the condition of anonymity. “It inflates the returns that they're showing from TARP and that looks good for them.” Never mind that  TARP had first been initiated by Republican Treasury Secretary Henry Paulson.
 
The Obama administration and some of the nation’s largest banks have hastened to file for separation in recent months. Bank of America, followed by Citigroup and Wells Fargo, agreed to repay federal aid. While the healthiest banks had already escaped earlier this year, the new round of departures involves banks still facing serious financial problems. It seems obvious that executive pay restriction has much to do with the mad rush to independence.
 
The banks say the strings attached to the bailout, including limits on executive compensation, have restricted their ability to compete and return to health. Executives also have chafed under the stigma of living on the federal dole. President Obama chided 13 of the nation’s top bankers at the White House for not trying hard enough to make small-business loans.
 
The Obama administration also is eager to close out a bailout program that has become a major political liabilities in this season of populist discontent. Administration officials defend the program as necessary and effective under emergency conditions, but the president has acknowledged that the bailout is “wildly unpopular” and officials have pointed out at every chance they do not relish helping banks that seem to be milking the crisis for narrow advantage.
 
The Root Cause of Excess Debt for Both Crises
 
Both crises, though 80 years apart, have the same root cause of excess debt, but the contours of the crises are quite different. In both crisis, the function of the stock market as a venue for raising capital was distorted to one where most of the investing population expects to make unearned fortunes by speculating on stock prices. Capital formed from savings became dissatisfied with fair return from sound, long-term investment based on economic fundamentals. Instead, highly leverage capital began to seek outsized returns from risky assets technically-driven to high prices in debt-financed bubbles in hope of selling them to latecomer investors for spectacular profit before inflated prices expectedly returned to normal levels.  Prices continued to rise in an expanding bubble as a result of escalating mass speculation, creating an unrealistic expectation that prices could only rise higher from artificially generated high demand over limited supply.
 
But prices could not continue to rise without fundamental growth and fundamental growth cannot take place without sound long-term investment to increase productivity that keeps income rising. As soon as asset prices began to fall from correction on an overbought market, a large number of highly leveraged institutional speculators were forced to liquidate with high losses. Bankers and brokers continued to act as market cheerleaders, calling every decline as merely market corrections that were in fact windows of buying opportunity, while the smart money was unloading their excess risk onto unsuspecting and less informed speculators worldwide. Structured finance also allowed conservative institutional investors to invest in highly rated derivatives of subprime loans.
 
Worse still, in the 2007 crisis, much of the institutional money came from pension funds of the working population whose savings were seeking high returns from risky speculative financial derivatives of the population’s own highly leveraged debts, mainly in bloated housing and consumer credit sectors that were not supported by stagnant debtor income.
 
Loss of Market Confidence over High Leverage
 
Both crises, though 80 years apart, involved banking system failures brought on by an abrupt loss of confidence in a market infested with excessive leverage. But the 1929 crisis manifested itself first in the retail markets while the 2007 crisis began in the wholesale markets. Yet the leverage was much higher in 2007 and the face amount of exposure much bigger. In 1920, the average leverage was 10 times. To put it another way, the margin set at was 10% which meant $10 of equity for every $100 of speculative trade. In 2007, the going leverage has risen to 40 times, or $10 of equity for every $400 of speculative trade.
 
Liquidity and Insolvency
 
Both crises, though 80 year apart, involved problems of sudden illiquidity, but due to finance globalization and electronic trading developed in recent decades, the 2007 banking crisis was faced with an additional problem of fast paced global contagion triggered by insolvency in financial institutions that were “too big to fail” without triggering serious global systemic consequences, a problem that remains unsolved as post-crisis regulatory reform is watered down in a Congress highly influenced by special interests financed lobbying.
 
Bank Capital Ratio
 
Conspicuously missing from the House regulatory reform bill (Wall Street Reform and Consumer Protection Act of 2009 - H. R. 4173) is required capital ratio, the minimum level of capital that banks should be required to hold for every dollar they lend.  The bill also does not define what can be counted as capital, or how much of that capital should be readily available to provide adequate liquidity. Those important questions are being left to the new regulators to sort out later, without any assurance of adequate technical capability for the challenging task.
 
Rating Agencies Immunity
 
Rhode Island Democrat Senator Jack Reed criticized Standard & Poor’s for its “cynical” attempt to resist regulatory reform by asking Republican members of Congress to oppose legislation that would make it easier for market victims to sue credit-rating firms for misleading rating. “The same companies that helped cause the financial crisis are now trying to block reform,” Reed, who drafted the litigation provision, said in a statement on April 6, 2010. “This cynical attempt by Wall Street lobbyists to kill Wall Street reform before it has a chance to see the light of day must be resoundingly rejected.”
 
Legislative Tactics
 
The Senate Banking Committee under Democrat Chairman Christopher Dodd on March 23 approved landmark financial regulatory reform legislation, pushing the fight over the issue to the full Senate in April. The Democrat-controlled committee voted 13-10 along party lines to pass a 1,336-page bill, which will need 60 votes to move for a vote on the Senate floor, a calculation that was key to Republicans’ acquiescence to a quick committee decision. All Republican committee members voted against the Democratic measure at a working session that lasted only 30 minutes.
 
In the full Senate, the Democrats will need to pick up some Republican support to win passage. Democrats control only 59 votes out of 100 in the chamber since it lost the critical seat of the late Senator Teddy Kennedy to Scott Brown, a Massachusetts Republican. The Dems would need to muster 60 votes to overcome procedural roadblocks, such as a filibuster, that Republicans are likely to throw up to stall a vote.
 
Just hours before voting, the Committee dropped plans for a weeklong debate of 400 amendments that were to be offered by both Republicans and Democrats to a bill unveiled in the previous week by the Chairman Dodd.
 
The shift came after Republicans decided not to offer their 300 amendments, opting instead to take their fight to the Senate floor, where they have a better chance at blocking reforms that are opposed by their party, the banks they represent and Wall Street interests that fund their campaign costs.
 
“Republicans will not offer hundreds of amendments that would only be defeated at the committee level,” said Richard Shelby, the top Republican on the Committee. The tactical adjustment followed a narrow win on Sunday, March 21 in the House of Representatives for the Democrats and the White House on healthcare reform -- another top priority on the Obama agenda.
 
The Dodd bill would set up a council of regulators to oversee financial risk, create an orderly process for liquidating distressed financial firms, regulate derivatives markets, and take other steps meant to avert another financial crisis caused by the too-big-to-failed syndrome.
 
President Barack Obama welcomed the Dodd Committee vote. “We are now one step closer to passing real financial reform that will bring oversight and accountability to our financial system and help ensure that the American taxpayer never again pays the price for the irresponsibility of our largest banks and financial institutions,” the President said. Obama vowed in a statement to fight to strengthen the measure and urged senators on the floor to resist efforts to water it down. The bipartisan appeal fell on deaf ears.
 
The Committee’s approval of the Dodd bill, which critics complained as a water-downed compromise, marks the biggest concrete step yet taken by the Senate toward putting in place new rules for banks and capital markets, two years after the collapse of Bear Stearns ushered in the worst financial crisis since World War Two.
 
While Republicans have worked closely with bank lobbyists to block reforms that they think will threaten financial industry profits, some liberal Republicans concur that regulatory reform is needed up to a point. They disagree with Democrats on how fundamental reform should reach.
 
Shelby said he remains hopeful that “broad consensus” can be reached on reform as the Dodd bill moves toward the floor. The Senate began a two-week recess on Friday, March 26. When it returns in April 12, Democratic leaders will decide how and when to bring financial reform to the floor. Until then, lawmakers of either party could reshape the bill to increase or decrease its chances of passage.
 
Republican Senator Judd Gregg said in a statement that he wants to continue working with Democrats, but he criticized the Dodd bill on several fronts. Senator Bob Corker, a Republican who tried but failed to broker a bipartisan deal with Dodd, called the committee’s unexpectedly quick vote “dysfunctional”. But he added that “there is still an opportunity to produce a sound piece of legislation that will merit broad bipartisan support from the full Senate and stand the test of time.” In other words, the Republicans hope to water down fundamental reform further.
 
Failure by the Senate to produce a bill by July would hand Obama and the Democrats a defeat heading into the November mid-term congressional elections, and leave a cloud of political uncertainty hanging over the financial services industry.
 
Consumer Protection
 
The Consumer Financial Protection Agency (CFPA), much fought for by reformers, has been put under the Federal Reserve by the Senate bill. Advocates for an independent agency argue that the Federal Reserve has always had consumer protection power that it repeatedly failed to use to prevent the crisis from hurting consumers.
 
Under the Senate Bill, the Federal Reserve will oversee banks with assets of $50 billion or more, together with a vaguely defined “systemically risky [non-bank] institutions”. In other words, the same players who brought on the crisis and the bailout with tax payer money are still running the show, albeit with a new, improved script.
 
Water Downed Reform Bill
 
The Senate Bill is criticized by reformers in the following areas: 
- A new systemic risk council stuffed with the same players: the Federal Reserve, the Treasury, the FDIC and the SEC would be a sham, as a 75% majority vote on the council can overturn any rulings of the CFPA.
- Over the counter (OTC) derivatives are to be regulated but as in the House Bill. But there are enough loopholes and exemptions to render regulation meaningless.
- Shareholder vote on executive compensation will be non-binding only.
- The Volcker Rule to limit bank proprietary trading appears to be dead on arrival.
- The proposal to audit the Fed is not even mentioned, so much for oversight discovery on $2 trillion dollars in loans the Fed has given Wall Street.
- Smaller bank holding companies, if they hold a federal charter, would be overseen by a new regulator formed out of the Office of the Comptroller of the Currency, which already oversees national banks.
- The Federal Deposit Insurance Corporation (FDIC), which already oversees state-chartered banks that are not members of the Fed system, would gain oversight over those that are.
 
No-Holds-Barred Bank Lobbying
 
J P Morgan Chase and Company reportedly spent $6.2 million in 2009, up from its pre-crisis annual spending of around $4 million, on lobbying lawmakers against regulatory reform proposals that would further restrict credit-card lending and increase fees on federal depositor insurance. Citibank spent over $7 million in 2007, $6.5 million in 1908 and $4.8 million in 2009 on lobbying.
 
J P Morgan chairman, James Dimon, called proposed consumer protection measures “Un-American”. Having earlier embraced the Trouble Asset Relief Program (TARP) by receiving $25 billion in government bailout money as a “patriotic duty” even though his bank allegedly did not need the money, Dimon protested publicly against the Treasury’s requirement of banks that had received TARP money raise fresh capital from the market before they exit from TARP, as it would force banks to pay high cost for the funds.  The bank repaid the $25 billion of Tarp fund in June 1009, but continued to fight with the government on the value of warrants it needed to buy back from the Treasury Department to officially conclude the transaction. J P Morgan ultimately waived its right to buy the warrants as part of the initial TARP terms so that Treasury could hold an auction to get a higher price that netted the Treasury $936 million gain in December 2009. 
 
A request from White House Chief of Staff Rahm Emmanuel to a  high Morgan executive, former Commerce Secretary William Daley, a scion of a prominent Chicago Democratic political dynasty, asking for the bank’s support for the proposed creation of a new consumer protection agency, was vetoed by Dimon on grounds that sufficient consumer safeguards are already in place.   
 
In a recent 36-pge annual letter to shareholders, Dimon wrote: “It is critical that the reforms actually provide the important safeguard without unnecessary disrupting the health of the overall financial system.”  In other words, no fundamental reform will be accepted.
 
Post WWII Recessions and the Marshal Plan
 
While WW II ended the Great Depression, the first post-WWII recession occurred between 1948 and 1949, lasting 10 months, with a GDP decline of 1.58%, unemployment reaching 7.9% and deflation as measured by the CPI falling 2.07%. The recession ended with military spending in arming NATO as Truman launched the Cold War and millitary spending in the Korean War which also jumped started the “Asian Tigers” economies with massive US procurement in Asia. The revival of the war-torn Japanese economy began with US military spending in the Cold War in Asia, half a decade after the Marshall Plan and NATO spending jump-started the revival of war-torn Europe. Soviet rejection of the Marshall Plan marked the beginning of the Cold War.
 
The Marshall Plan was created as part of the Truman Doctrine of containment of Soviet communism. It was more than an altruistic aid program to help Europe recover from war damage. It sought to restructure Western European economies away from its prewar socialist direction and launch them on a new path towards US style market capitalism under a new monetary regime based on a gold-backed dollar worked out at Bretton Woods, and to keep budding European social democracy from mutating into populist communism through electoral politics. The strategic geopolitical purpose was to integrate Western Europe firmly into the postwar Pax Americana of free market fundamentalism and a regional anti-Soviet military alliance in the form of the North Atlantic Treaty Organization (NATO) based on collective security, having rejected the lesson of the role of interlinked alliances in igniting WWI. For the first two decades of its existence, the US supplied all of the military materiel of NATO. The Marshall Plan was the linchpin of US strategy to neutralize a perceived rising Soviet threat. It helped to trigger the Cold War which undeniably had its economic benefits for the capitalist system at the expense of the socialist system.  Truman left the national debt at 74.3% of GDP by the end of his presidency.
 
The Eisenhower Recessions
 
There were three short, mild recessions during the Eisenhower presidency (1953-61). The first occurred between 1953 and 1954, lasting 10 months, with GDP declining 2.53%, unemployment reaching 5.9% and inflation at 0.37%. The second recession under Eisenhower occurred between 1957 and 1958, lasting 8 months, with GDP declining 3.14%, unemployment reaching 7.4% and inflation of 2.12%. The third Eisenhower recession occurred between 1960 and 1961, lasting 10 months, with a slight decline of GDP of 0.53%, but unemployment reaching 6.9% and inflation of 1.02%. The standard Eisenhower cure for recessions was new military contracts to the industrial sector.  Eisenhower left the national debt at 56% of GDP. Eisenhower left office with a warning to the nation of the danger of a military-industrial complex.
 
The Kennedy/Johnson Recessions
 
The Kennedy presidency, cut short by assassination on November 22, 1963, was spared of recessions as Kennedy maintained high government spending by continuing the Cold War and the arms race with the Soviet Union, topped with the Apollo program to land a man on the moon. The Kennedy tax cut in the Revenue Act of 1964, pushed through in 1964 by Johnson, was 1.9% of the Net National Income as measured by the Net National Product, more than the Reagan tax cut of 1.4% in the Economic Recovery Act of 1981. Popular image and political rhetoric notwithstanding, Reagan was not the most aggressive tax cutter in US history, not was he the most conservative in fiscal affairs.
 
Despite heavy spending on the Vietnam War, a short recession occurred between 1969 and 1970 during the last year of the Lyndon B. Johnson presidency, lasting 11 months, with GDP declining 0.16%, unemployment reaching 5.9%, but inflation climbed to 5.04%. The economy managed to produce simultaneously for both guns and butter, but war expenditure robbed LBJ of the funds needed to finance his Great Society dream.  JBJ left the national debt at 42.5% of GDP, substantially lower than Ronald Reagan did.
 
The Nixon Recession
 
The presidency of Richard Nixon saw one recession between 1973 and 1975 as Nixon winded down the Vietnam War. The recession was the longest since the Great Depression, lasting 16 months, with a GDP decline of 3.19%, unemployment reaching 8.6% but inflation rose to an unprecedented 14.81%. It was the first stagflation recession rather than a deflationary recession. Nixon left the national debt at 37.1% of GDP at the end of his first term and Ford left the national debt at 36.3% of GDP.
 
The Carter Recession
 
Jimmy Carter had one short recession in 1980 during his presidency (1977 to 1981), lasting 6 months, with a GDP decline of 2.23%, unemployment reaching 7.8%, unacceptably high for a self-proclaimed populist president, with inflation still at 6.3% despite the Volcker Fed’s bloodletting monetarist measures to fight run-away inflation. Nevertheless, Carter left the national debt at 33.4% of GDP, the lowest since WWII.
 
The Reagan Recessions
 
Under Ronald Reagan, the country had two recessions, the first between 1981 and 1982, lasting a long 16 months to match the Nixon recession record, with GDP declining 2.64%. But unemployment reached double digit for the first time since the Great Depression, to 10.8%, with inflation hitting 6.99%. The Reagan tax cut of 1981, coupled with Reagan military budget, left the US with a national debt of 51.9% of GDP, compared to Jimmy Carter’s 33.4%.
 
The First Bush Recession
 
The 1987 crash did not produce an official recession, thanks to Greenspan’s magic wand of monetary laxative. In the 1988 presidential election, George H.W. Bush defeated Democratic challenger Michael Dukakis because the Greenspan Fed, with aggressive intervention, prevented the 1987 stock market crash from developing into a recession. But a recession occurred between 1990 and 1991 in the aftermath of the Savings and Loan Crisis, lasting 8 months, with a GDP decline of 1.36%, unemployment reaching 6.8% and inflation of 3.53%.
 
In the 1992 presidential election, Bush, appearing oblivious about the effect of the ailing economy on the voting public, lost the election to Bill Clinton (43.0% of the vote against Bush’s 37.4% of the vote), with billionaire conservation populist Ross Perot as an independent candidate spoiler (18.9% of the vote). Clinton’s campaign slogan of “it’s the economy, stupid!” took advantage of Bush’s decline in the polls which had reaching as high as 89% immediately following the Gulf War (2 August 1990 – 28 February 1991).
Bush left the national debt at 64.1% of GDP.
 
The Clinton Prosperity and its Costs
 
Clinton presided over the longest period of peace-time economic expansion in American history, which included balanced budgets and fiscal surpluses. But there was a price to pay. His Third Way economic approach, a centrist program of privatization, deregulation and globalization as espoused by Antony Giddens, paved the way for the crisis of the financial sector in 2007 with endless easy money provided by the Greenspan Fed. The Clinton prosperity, fueled by neoliberal market fundamentalist ideology, became the root cause of the financial crisis two decades later, even though Clinton left the national debt at 57.3% of GDP, 6.8 percentage points lower than when Bush left it, but 23.9 percentage points higher than when Carter left it..
 
The Second Bush Recession and the 2007 Market Failure
 
The dot com bust led to the recession of 2001 as George W Bush entered the White House. The recession, a parting gift from Clinton policies, was shortened by Greenspan’s monetary response to the 9/11 terrorists attacks. As a result, the recession lasted only 8 months, with a real GDP decline of 0.73%, unemployment falling to 5.5%, below the 6% structural unemployment line, lowest since WWII and with inflation at 0.68%. But the financial tsunami was building in the deregulated financial markets fueled by brave new financial innovation of derivatives and finally exploded in mid 2007 to launch a market meltdown that earned it the label of the Great Recession.  George W Bush left the national debt at 69.2% of GDP at the end of his two terms.
 
Ronald Reagan, George HW Bush and George W Bush were the only presidents who left the national debt higher than it was when they entered the White House. So much for the Republican claim of being the party of fiscal conservatism.
 
The entire Obama presidency to date has been mired in recession which started in the George W. Bush presidency. Obama’s approval rating was 50% when he took office in January 2009 and rose to 68% by April. It fell to 44% in the latest CBS News Poll in April, 2010, the lowest level of his tenure in office so far. That compares to 49% in late March, just before he signed the healthcare reform bill into law.
 
Learning the Wrong Lessons
 
Despite claims of having learned from the errors of passivity allegedly made by the Fed in the 1930s, and that the resultant, supposedly wiser measures taken by the Bernanke Fed having prevented a market freefall, the jury is still out on whether this new massive interventionist approach will save the world from another Great Depression and at what cost. As students in Econ 101 learn, there is no free lunch in economics. Free lunches are found mostly in Ponzi and pyramid schemes, even if they are concocted by governments.
 
To date, the Great Recession that began in 2007 has already lasted 30 months so far. There is no end yet in sight. Impaired markets remain anemic, still facing a possible double dip, with unemployment reaching 9.7% and expecting to stay high for a long time, consumer price index (CPI) rising 2.76%, and asset price deflation by more than half from its peak to reverse wealth effects on households. On the domestic horizon are a massive pension fund crisis, a commercial real estate loan default crisis and a crisis of state and local government fiscal insolvency. On the global horizon are a sovereign debt crisis, a foreign exchange crisis and a pending global trade war.
 
The Painful Failure of Monetarism
 
Applying the counterfactual conclusion of Milton Friedman on the errors the Fed that led to the Great Depression, the Fed under Greenspan and Bernanke signed on to Friedmanesque monetarism to make extended use of the Fed nearly unlimited power to provide liquidity to override business cycles in free markets. This approach robbed the free market economy of its self correction adjustment to produce serial bubbles in a managed market on the supply side, in opposition to the Keynesian approach of demand management. 
 
In contrast to Fed passivity after the 1929 crash, the Bernanke Fed in 2007 at first made massive funds available to distressed banks and other financial institutions. But it simultaneously used open market operation to sterilize any enlargement of the monetary base and to prevent any increase in total bank reserves in the system. While the Fed in 1929 failed to inject liquidity into the banking system, the Fed in 2007 failed to cause the massive liquidity it injected into the banking system to flow into the broader economy to increase demand. Imbalance of excess supply and inadequate demand reduced the Fed to the equivalent of pushing on the credit string.
 
The Fed as Market Maker of Last Resort in a Failed Market
 
As the crisis intensified in the second half of 2007, the Fed used Section 13 (3), a seldom used authority granted by Congress during the Great Depression, to provide emergence loan to distressed non-bank firms. The Fed also lowered the Fed funds rate target in quick succession, effectively to near zero, below which the Fed cannot go. Thus the Fed essentially ran out of its only bullet.
 
In addition, the Fed purchased large amounts of US Treasuries to inject liquidity into the credit markets, particularly in the repo and commercial paper markets. The Fed also bought distressed agency debt and toxic mortgage-backed securities at face value to provide liquidity to large financial institutions holding the most senior debts, in effect expanding to unprecedented levels the Fed’s balance sheet, the monetary base and broader monetary aggregates.
 
The 2007 financial crisis began with the collapse of the residential real estate debt bubble in the US, which had been financed by highly leveraged sub-prime mortgages that were securitized in structured finance instruments of hierarchical levels of risk and compensatory returns. These securitized instruments were sold to both institutional and retail investors worldwide who mostly bought them with highly leveraged debt. When prices of these instruments collapse from foreclosed mortgages, investors were unable to meet margin calls and defaulted en mass, causing a global chain of counterparty defaults. As the market for these securities and derivative contracts failed, the Fed acted as a market maker of last resort for these toxic instruments and contracts. The result was most of the toxic securities and liabilities ended up on the Fed’s balance sheet.
 
Structured Finance, the Fatal Virus
 
Structured finance allows general risk normally embedded in all debts to be unbundled into structured instruments of hierarchical of credit ratings, allowing even the most conservative institutional investors, those mandated by law to hold only investment grade securities, to participate in the debt bubble by holding the supposedly safest, low-risk senior debt instruments. But the real world safety of these high-rated AAA, allegedly low risk senior instruments is merely derived from the unrealistically expected low-default rate of their riskier components. As the default rate of the high-risk, subprime mortgages rose from the bursting of the debt bubble of easy money created by an indulgent Fed, the safety of the supposedly low-risk, high credit-rated senior debt vanished.
 
With runaway “supply-side” voodoo economics keeping wage income in check during the boom phase in corporate profits, the resultant overcapacity from demand lag resulting from stagnant low wages shut off investment opportunities for productive expansion of the economy and forced the excess money supplied by an accommodating Fed into speculative manipulation of debt, giving birth to structured finance that permitted the disguise of debt proceeds as revenue, providing a false sense of security by transferring unit risks into systemic risk hidden from unit balance sheets, and through sophisticated, circular risk hedging schemes. The nonexistence of a systemic balance sheet made systemic imbalance legally invisible, supported by free market fundamentalism ideology, notwithstanding challenges from a few lonely independent voices that were routinely shut off from the mainstream media and authoritative academic journals. There were a few clear minds that refuse to buy into the grand self delusion, but their voices were kept in the intellectual wilderness.

The Fed’s Credit Oversupply – Midwife for Neoliberal Finance Capitalism

Two decades of excessive money creation produced a Fed-induced credit oversupply, which led to a system-wide under-pricing of risk and a lowering of credit worthiness standards to generate a whole category of so-called subprime borrowers whose credit rating and income stream did not meet conventional lending criteria. While subprime mortgages were at first merely a housing sector problem, the derivative effects of failure in structured finance quickly infested the entire global financial system.
 
The interconnected factors that fueled the spectacular boom in serial bubbles formation at an unprecedented rate and on an unprecedented scale provided support for the false claim of neoliberal finance capitalism to be the most effective and efficient economic system in history. This unsubstantiated myth lasted more than four decades.  It turned out that these same factors behind the boom also brought the entire global finance capitalist system, built on debt, crashing down in July 2007.
 
The Implosion of Under-priced Risk and the Fed’s Fire-Fighting Response
 
The first weak link in the global network of under-priced risk to fail began in London on August 9, 2007 when the London Inrerbank Offer Rate (LIBOR) and related funding rates jumped sharply higher after the French bank BNP Paribas announced that it was halting redemptions for three of its high-flying investment funds to avoid forced liquidation.
 
The Bernanke Fed tried to clam jittery markets on August 10 by repeating the famous Greenspan announcement that had successfully calmed market jitters in the1987 crisis: “The Federal Reserve is providing liquidity to facilitating the orderly functioning of the financial markets,” adding: “as always, the discount window is available as a source of funding.”
 
A week later, on August 17, with the credit market still frozen, the Federal Reserve Board of Governors voted to reduce the primary discount rate by 50 basis points to 5.75% from the 6.25% set since June 2006. It also extended the maximum term of the discount widow to 30 days. The Fed also invited banks not yet visibly in distress to borrow from the discount window to try to remove the traditional stigma associated with discount borrowing for distressed borrowers.
 
Starting in September 2007, the Fed Open Market Committee (FOMC) lowered its target for the Fed funds rate in the first of many cuts, three cuts in 2007 totaling 100 basis points (one percentage point), and seven cuts in 2008 totaling 425 basis points (4.25 percentage points) that ended at essentially zero by December 2008 and has kept it there for 16 months so far at this writing (April 2010).  The penalty of such long period of near zero interest rate will have to be reckoned with in future years.
 
At no other time in history had the Fed kept the Fed funds rate target near zero for so long. The visible result so far has been massive carry-trades through interest rates arbitrage by institutional speculators and hedge funds borrowing in low interest markets to invest in high interest markets for easy profit, exposing their trades to exchange rate risks. The discount rate followed suit, falling 0.5% on December 16 2008 and stayed there for 15 months until February 19, 2010 when it was raised 25 basis points to 0.75% to calm inflation expectation.
 
Still, financial strain reemerged in November 2007 despite the August 17 cut in the Fed funds rate target and the discount rate three months earlier. On December 12, 2007, the Fed had to arrange a currency swap with the European Central Bank (ECB) and the Swiss National Bank to provide a source of dollar funding to European Financial markets. Over the following 10 months, the Fed arranged currency swaps with a total of 14 other central banks around the world.
 
On the same day, the Fed also created the Term Auction Facility (TAF) to lend directly to banks for fixed terms to overcome the low volume of discount window lending on account of traditional stigma associated with discount window borrowing, despite persistent stress in interbank funding markets.
 
By December 28, 2009, the Fed had provided $3.48 trillion of new bank reserves through TAF auctions. Under fractional reserve in normal times, at a reserve rate is 10%, the maximum amount of new deposits that can be created by $3.48 trillion of new bank reserves would be $34.8 trillion and the maximum increase in the money supply would be $27.84 trillion. This was a massive injection by any standard. The money supply expanded by nearly twice the size of the GDP. It produced the equity market rally of the spring of 2010 but did little for the real economy.

April 12, 2010
 
Next: The Fed’s No-Exit Strategy