Perils of the Debt-Propelled Economy

Henry C K Liu


This article appeared in Asia Times Online on September 14, 2002

Economics is a complex subject. Any subject, however complex, if looked at in the right way, will become even more complex. This fact baffles many experts who tend to avoid small errors meticulously while sweeping on to grand fallacy.

One of the shortcomings of economics is the inadequate attention paid to it as a behavioral science. The problem can be traced to the neoclassical concept of the economic man who is supposed to act rationally in his own interest which in a money economy is generally defined rather simplistically as financial gain. Economics is obviously more than finance, and economic well-being is not synonymous with financial gain. Modern economics of course deals with the problem of human behavior with some sophistication, albeit always through the back door, and always equating self-interest with rational individual response to pricing. A market economy is coordinated through the price system operating on the principle of marginal utility.

Economists construct indifference curves to show consumer preferences. In economics, the effect on consumption of a pure change in price is shown in an income-compensated demand curve (also known as a Hicksian demand curve after economist John Hicks - 1904-89). A Marshallian demand curve (after economist Alfred Marshall - 1842-1924) is based on the concept of marginal utility. Marginal utility is observed only through choices. Marginal utility in consumption is simply a problem of choosing the bundle of goods that maximizes a buyer's utility, subject to the income constraint - the requirement that the bundle the consumer chooses costs no more than the buyer's disposable income.

Yet the demand for goods is affected by human behavior. A good whose consumption increases when its price goes up is called a Giffen good, after Robert Giffen, a 19th-century English statistician, who noted that Irish peasants bought more potatoes when the price of potatoes rose. This contradicted the law of demand, one of the basic laws of economics. For the poor Irish peasants, potatoes, as the main staple, took up a huge share of their income. If the price of potatoes went up, the share of their income available to purchase other foods would shrink markedly, forcing them to consume more potatoes to make up the difference.

Giffen goods are also necessary for conspicuous consumption. When high-price items go up further in price regularly, such as art objects, more buyers will enter the market, bidding up prices even more. Tulip bulbs during the speculative bubble in Holland in the 17th century were overpriced Giffen goods. The stock market is full of Giffen goods. When a share price goes up, it attracts more buyers. Real estate is often a Giffen good, particularly in places like Hong Kong where the real-estate market is fundamentally controlled by the government through control of the supply of land.

When housing prices rise over long periods, more buyers enter the housing market. The increased demand created by anticipated price appreciation more than offsets the fall in demand caused by price increases. And price deflation in housing creates a downward spiral of shrinking demand, a phenomenon easily observed in recent years all over Asia, from Tokyo to Hong Kong to Singapore. Public health and commercial medicine have characteristics of Giffen goods. When the price of medicine rises, more people tend to get ill due to less preventive use of medicine, causing aggregate demand for medicine to rise.

An inferior good is a good that one buys less of when one's income rises, because one can afford a superior good by comparison, even if the inferior good may also rise in price. During periods of prosperity, when income rises generally faster than prices, inferior goods are separated from Giffen goods. During periods of recession, when income falls generally while prices remain the same or continue to rise, inferior goods and Giffen goods tend to merge. A Giffen good must be an inferior good, but most inferior goods are not Giffen goods.

Credit drives the economy, not debt. Debt is the mirror reflection of credit. Even the most accurate mirror does violence to the symmetry of its reflection. Why does a mirror turn an image right to left and not upside down as the lens of a camera does? The scientific answer is that a mirror image transforms front to back rather than left to right as commonly assumed. Yet we often accept this aberrant mirror distortion as uncolored truth and we unthinkingly consider the flawed reflection in the mirror as a perfect representation.

Similarly, we reflexively accept as exact fidelity the encrypted labels assigned to our thoughts by the distorting mirror of language. Such habitual faulty acceptance is consequential because it is through language that ideas are transmitted and around language that culture develops.

In the language of economics, credit and debt are related but not the same. In fact, credit and debt operate in reverse relations. Credit requires a positive net worth and debt does not. One can have good credit and no debt. Too much debt lowers credit rating. When one understands credit, one understands the main force behind the modern economy, which is driven by credit and stalled by debt. Behaviorally, debt distorts marginal utility calculations and rearranges disposable income. Thus debt turns more commodities into Giffen goods and creates what US Federal Reserve Board chairman Alan Greenspan calls "irrational exuberance", the economic man gone mad.

Human behavior is complex beyond the measurement of price. Price alone is not sufficient to influence market behavior. Karl Marx dealt with the concept of fetish as a factor in demand as expressed in price.

Education is a classic dilemma. Economics literature has never dealt satisfactorily with education, being unable to decide whether it is consumption or investment or both. It has done similarly with health care and environmental preservation. If these endeavors are consumption, the law of scarcity dictates that society cannot afford too much of them. If they are investment, then supply-side theory would conclude the more the better. If they are both consumption and investment, there should be a limitless upward spiraling supply/demand symbiosis. One could not possibly have an over-educated society or over-healthy population or an over-clean environment, if being more educated, more healthy and more clean is deemed economically productive and thus financially profitable.

It is obvious that debt changes human behavior. A little debt reinforces responsibility. The US social system of private property is built on the notion that homeowners with a life-long mortgage are better citizens than renters. People tend to take better care of their homes and plant roots in their communities if they "own" their homes, even though 90 percent of the purchase value is in debt that is not expected to be paid off until three decades later.

On the other hand, it is clear that excessive debt encourages irresponsibility. The borrower may develop an irresistible incentive to walk away from his debt if he perceives the debt to be beyond his ability to repay, or the cost of the debt to exceed its benefits. Even a central bank, which is the domestic lender of last resort, is wary of the problem of moral hazard, that commercial banks within its system would lend irresponsibly if they knew that their lending errors would be bailed out by the central bank.

The US bankruptcy regime is designed to give trapped debtors a fresh start from distressed debt to reestablish credit. Unlike European precedents, one cannot be jailed in the United States for failing to pay one's debt, unless criminal fraud is involved. In fact, there is a legal concept of lender liability, based on which a distressed debtor can sue the lender for damages for lending money irresponsibly that led the debtor into financial trouble.

Lender liability is embodied in common and statutory law covering a broad spectrum of claims surrounding predatory lending. It is a key concept in environmental-cleanup litigation. If a lender knowingly lends to a borrower who is obviously unable to make reasonable beneficial gain from the use of the funds, or causes the borrower to assume responsibilities that are obviously beyond the borrower's capacity, the lender not only risks losing the loan without recourse but is also liable for the financial damage to the borrower caused by such loans. For example, if a bank lends to a trust client who is a minor, or someone who had no business experience, to start a risky business that resulted in the loss not only of the loan but of the client trust account, the bank may well be required by the court to make whole the client.

In the United States, although predatory lending is not defined by federal law, and various states define abusive lending differently, it usually involves practices that strip equity away from a homeowner, or equity from a company, or condemn the debtor into perpetual indenture. Predatory or abusive lending practices can include making a loan to a borrower without regard to the borrower's ability to repay, repeatedly refinancing a loan within a short period of time and charging high points and fees with each refinance, charging excessive rates and fees to a borrower who qualifies for lower rates and/or fees offered by the lender, or imposing new unjustifiably harsh terms for rolling over existing debt. Predation breaks the links between an economy's aggregate resource endowment and aggregate consumption and between the interpersonal distribution of endowments and the interpersonal distribution of consumption.

The choice by some to be predators decreases aggregate consumption, both because the predators' resources are wasted and because producers sacrifice production by allocating resources to guarding against predators. Much of welfare economics is based on the concept of Pareto Optimum, which asserts that resources are optimally distributed when an individual cannot move into a better position without putting someone else into a worse position. In an unjust global society, the Pareto Optimum will perpetuate injustice.

Now, there is a close parallel in most Third World debts and International Monetary Fund (IMF) rescue packages to the above predation examples where sophisticated international bankers knowingly lend to dubious schemes in developing economies merely to get their fees and high interest, knowing that "countries don't go bankrupt", as Walter Wriston of Citibank famously proclaimed. The argument for Third World debt forgiveness contains large measures of lender liability and predatory lending. Debt securitization allows these bankers to pass the risk to the credit markets, socializing the potential damage after skimming off the privatized profits.

Credit is reserved financial resources ready for deployment. Debt basically is unearned money secured with a promise to repay the principal sum plus interest with optimistically anticipated earned money in the future, assuming, for example, that the borrower will not become unemployed through no fault of his own or a business will not be adversely affect by unanticipated shifts in business paradigm, or an economy will not be destroyed by global financial contagion.

Paying down debt with new debt is a Ponzi scheme - the likelihood of its exposure is inversely proportional to its scale of operation. More and more critics are calling the Enron debacle a Ponzi scheme, in that the company filed for bankruptcy even though, for almost a decade up to a few weeks before its bankruptcy filing, many in high places were hailing Enron as the new innovative business model.

Neoliberal economist Paul Krugman publicly hailed Enron as a shining example of free-market entrepreneurship in what he called "a love letter to free markets". He served on its prestigious advisory board for a annual fee of US$50,000. Neoconservative Weekly Standard editor Bill Kristol received $100,000 from the same Enron advisory board, while contributing editor Irwin Stelzer praised Enron for "leading the fight for competition".

On November 13, 2001, two weeks before Enron filed bankruptcy on December 2, the Baker Institute honored Greenspan with its Enron Prize, which the official press release said "gives recognition to outstanding individuals for their contributions to public service. The prize is made possible by a generous gift from the Enron Corp ... one of the world's leading electricity, natural-gas and communications companies. Among the previous recipients of the Enron Prize are Colin Powell, current US secretary of state; Mikhail Gorbachev, former president of the Soviet Union; Nelson Mandela, the first black president of South Africa; and Georgian President Eduard Shevardnadze."

Enron officials have since acknowledged that the company has purposely overstated its profits by billions of dollars since 1997 and has disguised billions in debt as revenue through structured finance via offshore special-purpose vehicles. Top Enron executives cashed out more than $1 billion in company stocks when they were near their peak price of more than $80. In addition, nearly 600 employees deemed critical to Enron's operations received more than $100 million in bonuses in November 2001 while the company was on the brink of bankruptcy. Some commitment to public service.

On the corporate level, debt inevitably alters management behavior. Leverage increases profit margin on successful business plans. As Henry Kravis, king of the leveraged buyout, famously said: "Debt can be an asset. Debt tightens a company." To less creative minds, debt is still a liability, not an asset. But debt also exaggerates losses when business plans fail. In the US financial system, bankruptcy is a legal if not painless way to refute debt. The comfort to lenders is that equity investors are wiped out first before the lenders' various collateralized positions are endangered.

Banks used to be the sole intermediaries of debt. For this reason, a central bank was formed to supervise and provide liquidity to the banking system. Thus a central bank came into existence in the United States in 1913 on the assumption that the existence of a healthy banking system is in the national interest. And to protect the national interest, the central bank, which in the US version is a government institution privately owned by the banks in the Federal Reserve system, is allowed to act as lender of last resort to the nation's commercial banks with public money, or more accurately, through government authority to create fiat money.

Thus regulation on banks is a fair quid pro quo, a social contract. Bank deregulation without corresponding raising of the threshold for central-bank bailout is a direct breach of this social contract. If for the good of the nation banks cannot be allowed to fail, they should also not be allowed to deregulate.

More ominous, the US credit system has broken through the banking system - the bulk of debt now is intermediated through the unregulated credit markets by debt securitization. Securitization acts as more than just providing a vehicle for investment in debt instruments. It restructures simple debt into complex, hybrid instruments sliced infinite ways until the original debt is beyond recognition.

Debt securitization is guerrilla warfare against a sound credit system. Debt proceeds can be disguised as current income, distorting the financial performance of the debtor. In these brave new credit markets, the government is generally only an interested bystander, so far quite unwilling to regulate even over-the-counter (OTC) derivative trading by banks, which are suppose to be regulated, with an "if I don't smoke, someone else will" mentality.

OTC derivatives are traded off exchanges, directly between counterparties, and as such are not subject to disclosure rules. Adding estimated data from the Bank for International Settlements for OTC derivatives to published figures for exchange-traded derivatives, the total notional principal balance of the reported derivatives market in June 2001 was $119 trillion, about four times the gross domestic product (GDP) of the Organization of Economic Cooperation and Development (OECD) countries and twice the value of global trade. The amount unreported remains unknown.

This shows that derivatives performed more than a hedge function, as apologists claim. Derivative trading has become a profit center for banks and non-bank financial institutions. True, the notional principal amount is never at risk, because no principal payments are exchanged. The interest payments that are linked to that notional principal amount are at risk. A loss on a derivative contract becomes possible when (a) interest rates or commodity prices move in a direction that makes the contract more or less valuable, and (b) the counterparty on the other side of the contract defaults. Derivatives credit exposure is the present value of the cost of restoring the economic value of a contract should a counterparty default.

All kinds of street rumors are flying at this very moment that one of the world's biggest banks is exposed to derivative trades that would cause serious counterparty credit problems if the market capitalization of this bank should fall below a triggering level, or the price of commodities or interest rates should move against its derivative positions. Because there is no way to dispel or confirm such rumors, and the bank involved remains tight-lipped about its true financial conditions, the uncertainties weigh down on the economy.

There is ample evidence that the level of interest rates does not always control the aggregate level of debt in an economy, popular expectations notwithstanding. When interest rates are high, they often merely reflect the systemic credit-unworthiness of borrowers as a group or the high risk assumed by lenders collectively. High interest rates in fact create more incentive for both lenders and borrowers to take higher risk to shoot for the higher returns needed to meet higher interest cost. High interest rates also direct money to more desperate borrowers. As William Zeckendorf, the bankrupt real-estate tycoon, once said: "I'd rather be alive at 30 percent interest than be dead at 3 percent."

However, interest rates do affect the distribution of credit in the economy. When rationed by interest rates, debt actually puts money to work for those who need it most desperately, and not necessarily the highest and best use in the economy, or where it is socially needed most. Debts at high interest rates can only be justified by high risk, which tends to destabilize the economy. Debt securitization actually lowers systemic credit quality by socializing risk across the whole system rather than concentrating it on singular, isolatable defaults.

The US Federal Reserve's fixation on interest-rate policy as the sole tool of regulating monetary policy is increasingly taking on the look of shadow boxing, with declining effect on the economy. As chairman Greenspan is fond of saying: "Bad loans are made in good times." As interest rates are artificially raised by Fed action to tighten money supply, distressed borrowers with bad loans made in good times will need to borrow more, thus enlarging the credit pool, defeating the Fed's purpose of a tight monetary policy. As interest rates are artificially lowered by Fed action to stimulate a slowing economy, banks raise their credit threshold to compensate for the narrowing of rate spread, thus reducing the number of qualified borrowers and shrinking aggregate loan volume. This is known as the Fed pushing on a credit string.

Credit rationed by interest rates also discourages economic democracy, since the poor generally find it much harder to obtain or afford credit. The poor also do not have the sophistication to participate in structured finance. There is much truth is the saying that it is not how much you own, it is how much you owe that measures how rich or financially powerful you are.

Debt also encourages carelessness with money, since lending implies faith in the borrower's ability to repay in the future. People tend to be more careful with money they earned in the past in the form of savings because they remember how hard they had to work for it. In contrast, debt is based on future earnings, which is deemed easier money by the existence of debt itself. High interest rates also encourage high risks to justify the high cost of money.

The problem with debt is that it needs to be serviced regularly (except zero coupons, which are discounted from the principal sum at the outset and cost more and are monitored with bond covenants and triggers to activate automatic foreclosure). Unlike a credit-driven economy, a debt-propelled economy will inevitably reach a point where its ability to service the growing debt is exceeded, unless inflation stays ahead of interest charges, in which case the banking system will fail. Thus runaway systemic debt frequently leads to hyperinflation.

Bankruptcy only relieves the debtor, not the economy. If, as economist Hyman Minsky claimed, money is created whenever credit is extended, then the erasure of debt destroys money and shrinks the economy.

There is a circular link among deregulation, debt, overcapacity and bankruptcy. Deregulation has created a havoc of bankruptcy in the airline, health-care, communication, energy and finance sectors. Deregulation permits predatory pricing in the name of competition, which often leads to monopolistic consolidation within industries. The surviving giants then take on massive debt to acquire vanquished competitors and to expand capacity in anticipation of increased demand and soon reach a point where increased sales do not increase net revenue to offset low margin. Once a company is trapped in the whirlpool of debt, a downward spiral of low prices and shrinking revenue will push the cost of debt beyond sustainability, leading to bankruptcy. This is known as the bursting of the debt bubble.

In March 1980, the Depository Institutions Deregulation and Monetary Control Act (DIDMCA) was enacted in the United States. It was a deregulation initiative by the administration of president Jimmy Carter aimed at eliminating many of the distinctions among different types of depository institutions and ultimately removing interest rate ceiling on deposit accounts. Authority for federal savings and loan associations to make risky ADC (acquisition, development, construction) loans was expanded, which ended up with the savings and loan (S&L) crisis five years later. Deregulation of airlines also began under Carter, leading to recurring waves of bankruptcy.

Conventional wisdom suggests that a good credit rating is necessary to borrow. But the financial world works differently in reality. A good credit rating is first necessary to issue credit. Without the ability of some entity to issue credit, no one can borrow. And since no modern financial institution lends its own money, lenders must first secure funds wholesale to lend to retail borrowers. For that, a lender must maintain a good credit rating.

Banks are protected from this requirement by their discount window at the central bank, which is backed by the full faith and credit of the nation, and by Federal Deposit Insurance Corp (FDIC) insurance. Still, central banks and the Bank of International Settlement (BIS) set capital and reserve requirements for commercial banks to assure risk prudence.

GE, the world's largest non-bank financial conglomerate that incidentally also manufactures, issues credit at the retail level through vendor financing, to capture sales for GE products. It gets its funds wholesale from the commercial paper market, which GE dominates because it has a good credit rating. When GE credit rating was downgraded recently, it faced being frozen out of the commercial paper market, and had to revert back to costly bank credit lines that adversely affected its interest rate spread and profitability.

When a government issues currency and circulates money through the banking system, it is in essence issuing credit to the economy that it is entitled to receive back in taxes. Government then spends the tax money on goods and services that the public provides. The surplus money that is not returned by taxes is government credit floating around the economy to keep it operating financially.

It is important to understand that money issued by the government, unlike private money, is not IOUs from the issuer. Money, when issued by government as a legal tender, is a credit from the government good for the payment of taxes, and for settling "all debts, public and private", as printed plainly on all Federal Reserve notes. A US dollar is a Federal Reserve note that entitles its holder to exchange it at any of the six Federal Reserve Banks for another Federal Reserve note of the same face value, no more and no less, at least since 1971 when the late president Richard Nixon took the dollar off the gold standard.

Even before 1971, while an ounce of gold was officially pegged at $35 by president Franklin Roosevelt on January 31, 1931, a domestic holder of a dollar note could only exchange it at a Federal Reserve Bank for another dollar note, since US citizens were forbidden by law to own gold. Only foreigners could demand gold for dollar up to 1971.

A government bond, which on the surface looks like a government debt, is merely a call on government credit previously issued, withdrawing dollars from the money supply by providing a government bond. Government bonds are the living proof that money is not an IOU from the government, otherwise when government sells or redeems bonds, it is perpetrating a Ponzi scheme of paying off old debt with new debt, rather than exchanging debt instruments (bonds) with credit instruments (dollars).

Sovereign debt is fundamentally different from corporate debt. A corporate bond entitles its holder to claim its face value in dollar notes that the bond-issuing corporation cannot create by itself. It must earn dollars with the bond proceeds to pay interest on the bonds. At the time of redemption, if the corporation already spent the bond proceeds, it must then earn back or sell assets or borrow the dollars from somewhere to redeem the bond.

In contrast, a government bond entitles its holder to claim from a Federal Reserve Bank its face value in dollars that the government can print at will, even if it already spent the bond proceeds. The interest on the bond is also paid with dollars of which the government has an unlimited supply. Part of the dollars that the government spends will come back from the public in the form of taxes. The rest will stay in the economy to finance its operations.

So if the government runs a surplus, meaning it takes in more tax money than it spends, it drains money from the economy, forcing the economy to contract. A budget deficit is in essence an injection of more government credit into the economy.

Private citizens can own assets, but whenever such assets are monetized with dollars, one trades those assets for credit from the US government that other market participants in the economy will accept because, aside from its status of legal tender as defined by law, it is good for negotiating tax liabilities.

Technically, a government never borrows. It issues tax credit in the form of money. So when former president Ronald Reagan said the government does not make any money, only the private sector does, he was merely mouthing conventional wisdom, with no clear understanding of the true nature of money and credit. In fact, money is all that government makes. Thus any government that takes on foreign-currency debt or allows its economy to do so is taking unnecessary risk.

The main function of sovereign debt is not to make up for any shortfalls in government funds. Such shortfalls cannot exist by definition. Rather, sovereign debt instruments act as fundamental collateral for the nation's credit market. The Fed Open Market Desk buys and sells government securities to maintain the Fed funds target rate set by the Federal Reserve Board. The repo (repurchase agreement) market, which provides overnight and short-term funds for banks, operates with government securities as collateral.

Thus IMF conditionalities of reducing sovereign debt by imposing budget surpluses and price deflation as a cure for a distressed credit market of excessive foreign debt is merely adding gasoline to fire.

As a sovereign bond is redeemed with cash, it is in essence replacing a call instrument on government credit with government credit. When government securities are withdrawn and cash floods the economy, the debt market shrinks because the amount of collateral shrinks and the amount of cash increases, reducing the need for credit, and the economy contracts with cash inflation, unless the cash is immediately recirculated as private debt or investment.

The reason that the market monitors the Fed funds rate as an indication of Fed policy is that the Fed funds rate closely tracks another rate, the repo rate, that the Fed Open Market Desk actively influences during most market days. Every business-day morning at 11:45 Eastern Standard Time, the Fed announces what it intends to do (buying or selling government securities with an agreement to reverse the transaction later) in the repo market to keep the repo rate close to the Fed funds target rate set by the Fed. Changes in the repo rate are normally quickly followed by changes in the Fed funds rate. Thus, indirectly, the Fed appears to influence the federal funds rate through its impact upon the repo rate.

Non-monetarists subscribe to the view that Fed easing means the Fed lowers interest rates. But they are not specific about how these rates are lowered are how the Fed should go about doing this. There are often periods (such as 1990-91) when interest rates dropped but money growth also fell. Non-monetarists (and market participants) view periods like this as Fed easing episodes, while monetarists argue that these are (implicitly) periods of Fed tightening. Thus it is clear that interest rates by themselves do not always determine the money supply.

Since all private debts in a money economy are anchored by government credit, through what economists called high-power money (money created by the Fed through the increase of the total reserves in the banking system, so called because it would be multiplied manifold through the money-creation power of commercial bank loans), credit in an economic democracy should not be rationed by interest rates to the highest bidder, but by national purposes or social needs.

Credit in fact is a financial public utility, much like air and water, and it should be equally accessible to all, not just the rich. Government loan guarantees for students and house mortgages for low- and moderate-income groups and loans to small business are based on this principle.

For example, the US National Housing Act was enacted on June 27, 1934, as one of several economic-recovery measures of the New Deal. It provided for the establishment of a Federal Housing Administration (FHA). Title II of the Act provided for the insurance of home mortgage loans made by private lenders, taking the risk in lending to low income borrowers off the private lenders. Title III of the Act provided for the chartering of national mortgage associations by the administrator. These associations were to be independent corporations regulated by the administrator, and their chief purpose was to buy and sell the mortgages to be insured by the FHA under Title II.

Only one association was ever formed under this authority on February 10, 1938, as a subsidiary of the Reconstruction Finance Corp, a government corporation. Its name was National Mortgage Association of Washington, and this was changed that same year to Federal National Mortgage Association (Fannie Mae). By amendments made in 1948, Title III became a statutory charter for Fannie Mae.

Before the Great Depression, affording a home was difficult for most people in the United States. At that time, a prospective homeowner had to make a down payment of 40 percent and pay the mortgage off in three to five years. Until the last payment, borrowers paid only interest on the loan. The entire principal was paid in one lump sum as the final "balloon" payment.

During the 1920s boom time in real estate, a rudimentary secondary mortgage market was established. The stock-market crash of 1929 ended the real-estate boom and forced many private guarantee companies into insolvency as home prices collapsed. As economic conditions worsened, more and more people defaulted on mortgages because they couldn't come up with the money for the final balloon payment or to roll over their mortgage because of low market value of their homes.

To help lift the country out of the Depression, Congress created the FHA through the National Housing Act of 1934. The FHA's insurance program protected mortgage lenders from the risk of default on long-term, fixed-rate mortgages. Because this type of mortgage was unpopular with private lenders and investors, Congress in 1938 created Fannie Mae to refinance FHA-insured mortgages.

As soldiers came home from World War II, Congress passed the Serviceman's Readjustment Act of 1944, which gave the Department of Veterans Affairs (VA) authority to guarantee veterans' loans with no down payment or insurance premium requirements. Many financial institutions considered this arrangement a more attractive investment than war bonds.

By revision of Title III in 1954, Fannie Mae was converted into a mixed-ownership corporation, its preferred stock to be held by the government and its common stock to be privately held. It was at this time that Section 312 was first enacted, giving Title III the short title of Federal National Mortgage Association Charter Act.

By amendments made in 1968, the Federal National Mortgage Association was partitioned into two separate entities, one to be known as the Government National Mortgage Association (Ginnie Mae), the other to retain the name Federal National Mortgage Association (Fannie Mae). Ginnie Mae remained in the government, and Fannie Mae became privately owned by retiring the government-held stock. Ginnie Mae has operated as a wholly owned government association since the 1968 amendments. Fannie Mae, as a private company operating with private capital on a self-sustaining basis, expanded to buy mortgages beyond traditional government loan limits, reaching out to a broader income cross-section.

By the early '70s, inflation and interest rates rose drastically. Many investors drifted away from mortgages. Ginnie Mae eased economic tension by issuing its first mortgage-backed security (MBS) guarantee in 1970. Investors found these guaranteed MBSs highly attractive. Also in 1970, under the Emergency Home Finance Act, Congress chartered the Federal Home Loan Mortgage Corp (Freddie Mac) to buy conventional mortgages from federally insured financial institutions. The legislation also authorized Fannie Mae to purchase conventional mortgages. Freddie Mac introduced its own MBS program in 1971.

In the early 1980s, the US economy spiraled into deep recession. Interest rates and housing prices were high, while income growth was stagnant. The US economy faced a dual problem of income deficiency and money devaluation. In this poor housing environment, Ginnie Mae, Fannie Mae and Freddie Mac all created programs to handle adjustable-rate mortgages. The Ginnie Mae guaranty is backed by the full faith and credit of the United States. Today, Ginnie Mae guaranteed securities are one of the most widely held and traded MBSs in the world. Ginnie Mae has guaranteed more than $1.7 trillion in MBSs. Historically, 95 percent of all FHA and VA mortgages have been securitized through Ginnie Mae. Ginnie Mae is a guarantor, a surety. Ginnie Mae does not issue, sell, or buy MBSs, or purchase mortgage loans.

Fannie Mae operates under a congressional charter that directs it to channel its efforts into increasing the availability and affordability of home ownership for low-, moderate- and middle-income Americans. Yet Fannie Mae receives no government funding or backing, and it is one of the nation's largest taxpayers as well as one of the most consistently profitable corporations in America. The company has evolved to become a shareholder-owned, privately managed corporation supporting the secondary market for conventional loans. It continues to operate under a congressional charter with oversight from the US Department of Housing and Urban Development and the US Treasury.

Fannie Mae has two primary lines of business: Portfolio Investment, in which the company buys mortgages and MBSs as investments, and funds those purchases with debt, and Credit Guaranty, which involves guaranteeing the credit performance of single-family and multi-family loans for a fee.

Its Portfolio Investment business includes mortgage loans purchased throughout the US from approved mortgage lending institutions. It also purchases MBSs, structured mortgage products and other assets in the open market. The corporation derives income from the difference between the yield on these investments and the costs to fund these investments, usually from issuing debt in the domestic and international markets. Fannie Mae has $3.46 trillion in MBSs outstanding today.

The corporation accomplishes its mission to provide products and services that increase the availability and the affordability of housing for low-, moderate- and middle-income Americans by operating in the secondary rather than the primary mortgage market. Fannie Mae purchases mortgage loans from mortgage lenders such as mortgage companies, savings institutions, credit unions and commercial banks, thereby replenishing those institutions' supply of mortgage funds. Fannie Mae either packages these loans into MBSs, which it guarantees for full and timely payment of principal and interest, or purchases these loans for cash and retains the mortgages in its portfolio.

Fannie Mae is one of the world's largest issuers of debt securities, the leader in the $5 trillion US home-mortgage market. Fannie Mae's debt obligations are treated as US agency securities in the marketplace, which is just below US Treasuries and above AAA corporate debt. This agency status is due in part to the creation and existence of the corporation pursuant to a federal law, the public mission that it serves, and the corporation's continuing ties to the US government. It benefits from the appearance, though not the essence, of being backed by government credit.

Fannie Mae debt obligations receive favorable treatment from a regulatory perspective. Fannie Mae securities are "exempted securities" under the laws administered by the US Securities and Exchange Commission to the same extent as US government obligations. Also, Fannie Mae debt qualifies for more liberal treatment than corporate debt under US federal statutes and regulations and, to a limited extent, foreign overseas statutes and regulations.

Some of these statutes and regulations make it possible for deposit-taking institutions to invest in Fannie Mae debt more liberally than in corporate debt and mortgage-backed and asset-backed securities. Others enable certain institutions to invest in Fannie Mae debt on par with obligations of the United States and in unlimited amounts. Fannie Mae uses a variety of funding vehicles to provide investors with debt securities that meet their investment, trading, hedging, and financing needs. Fannie Mae is able to issue different debt structures at various points on the yield curve because of its large and consistent funding needs. As the Treasury retires 30-year bonds, agencies have stepped in to fill the void.

The privatization of Fannie Mae and Freddie Mac was an ideological move. It was financially unnecessary and government credit could have funded the entire low-, moderate- and middle-income housing-mortgage needs with no profit siphoned off to private investors. These agency debt instruments played a crucial role in developing and sustaining the credit markets in the US.

In fact, the funding risk of both agencies was questioned by the Wall Street Journal last February 20 in an editorial about Fannie Mae's and Freddie Mac's safety, soundness and financial management, characterizing both agencies as risky, fast-growing companies that "look like poorly run hedge funds", "unduly exposed to credit risk with large derivative positions", and that they "use all manner of derivatives" and "are exposed to unquantified counterparty risk on these positions". Such concerns would have been avoided if both agencies had been funded with government credit, and the cost of housing to low-, moderate- and middle-income Americans would have been lower.

A government credit economy is different from a private debt economy in its sustainability. The Japanese economy stagnated for more than a decade primarily because it shifted from a government credit economy to a private debt economy in the name of financial liberalization and market fundamentalism. The Japanese version of London's Big Bang started the Japanese private debt bubble that subsequently infected all Asian economies.

The Big Bang in London refers to deregulation on October 27, 1986, of London-based securities markets, an event comparable to May Day in the US, marking a major step toward a single global financial market. May Day refers to May 1, 1975, when fixed minimum brokerage commissions ended in the US, ushering in the era of discount brokerage firms and the beginning of diversification by the brokerage industry into a wide range of financial services using computerization and advanced communication systems. This started the offering of new genres of financial products and the emergence of structured finance that made possible a new private-debt economy that turned quickly into a global debt bubble. As the US reaped the fleeting benefits of dollar hegemony, a budget surplus accompanied with sovereign debt reduction merely pushed more debt on to the private sector to feed the debt bubble.

The most fundamental aspect of a private-debt economy is that it cannot sustain a slowdown, even a soft landing. If Greenspan had been better versed in debt economics, he would have understood that a debt bubble, unlike the conventional business cycle, cannot survive the slightest deflation. Inflation is the oxygen for a debt bubble.

Greenspan's attempt to engineer a soft landing by raising interest rates to fight pending inflation pre-emptively only accelerated the debt bubble's burst. His only option was to prevent the debt bubble from forming by tightening credit quality years ago, but he chose to rely on the market to exercise its discipline. He rejected the suggestion of such Wall Street gurus as Henry Kaufman to raise margin requirements. Instead of discipline, the market gave him an insatiable appetite for addictive debt, which he had previously called "irrational exuberance".

Once the bubble was on its way, Greenspan was on top of a debt tiger that he could not get off without being devoured by the beast. It was not the New Economy, it was not the unprecedented productivity that gave the US its decade-long boom. It was debt. Without debt, there would have been no New Economy, no dotcom industry, no telecom explosion, no structured finance, no budget surplus and no current account deficit or its flip side, capital account surplus.

The 1990s was the debt decade. Much of the technology was invented prior to the beginning of the decade of finance capitalism and became widely applied through debt in the form of vendor finance. The communication revolution was built on debt that had been accumulated in the last decade. The greatest invention of the 1990s was more and more sophisticated debt instruments.

Greenspan warned in December 1996 about "irrational exuberance" when the Dow Jones Industrial Average (DJIA) was at 7,000, that inflation down the road was inevitable unless the Fed started to raise Fed funds rate pre-emptively. Yet as rates rose, the DJIA rose to 12,000 by 2000, because inflation as measured by the government failed take into account the wealth effect.

The reason for this was twofold. Inflation was kept low by imports and inflation was measured mostly by rising wages but not by rising asset value. Stock prices doubled and real-estate prices tripled, but the economy officially did not register inflation because of low wages and cheap imports. As stock prices rose, the price to earnings ratio skyrocketed. As the economy inched toward technical full employment with 4 percent unemployed, Greenspan reflexively raised the interest rate to cut off anticipated wage-pushed inflation. The high interest rate adversely affected the earnings of debt-ridden companies. To boost earnings, companies cut employees, which started the downward spiral.

Since July 1997, the risks of protracted global asset deflation caused by the aftermath of excessive private debt have become reality, first in the emerging markets and now in the United States. Neither the IMF nor the Group of Seven (G-7) have been able to deal effectively with the twin problems of the artificially strong but debt-driven dollar and the spreading manipulated devaluation of other national currencies around the globe.

For the affected nations, the combination of mountains of foreign-currency debt and massive short-term capital flight through stock-market collapses, exacerbated by IMF conditionalities of high interest rates, austerity measures that insisted on reduced government deficits and sharp currency devaluations coupled with asset deflation, have led to tragic destruction of hard-earned wealth and a severe drop of living standards.

Certainly market forces in a runaway-debt economy have not created Adam Smith's "universal opulence which extends itself to the lowest ranks of the people". The only trickling down has been poverty and misery. In a world of 6 billion people, only about 1,000 currency traders and a small circle of rich investors in their hedge funds seem to enrich themselves further through the unbridled manipulation of the free financial market. Even in advanced economies, workers are misled to accept low wages as a trade-off for stock options that become worthless when the debt bubble bursts.

Corporations seduce share owners with fantasy capital gains based on debt to replace regular dividend payouts. When market capitalization of major corporations inflated by debt can fall by 90 percent within a matter of months while top executives can cash out at peak prices and resign with severance packages worth tens of millions of dollars, there is no other way to describe the situation than reversed Robin Hood: robbing the poor to help the dishonest rich.

This view is now shared by increasing numbers across ideological spectrums. Economist John Kenneth Galbraith's famous description of trickling down prosperity was if you feed the horse enough oats, the sparrows will some day benefit from its droppings. In finance capitalism, the poor sparrows are crushed by the wheels of the carriage of debt that the horse pulls.

If debt is dilapidating, foreign-currency debt, mostly dollar debt, is deadly. Thus those governments that had been misled by neoliberals to borrow massive amounts of foreign currency unnecessarily and subsequently dutifully implemented IMF prescriptions, such as Brazil, Argentina, Turkey, South Korea and Indonesia, saw their economies destroyed to the point where recovery may now take decades, if ever, and only if the poisonous IMF medicine is quickly rejected.

The IMF has now admitted that it made a "slight mistake" in dealing with the Asian financial crisis of 1997. It might have been slight for the IMF, but the cost to the economies of Asia was horrendous. Trillions of dollars of hard-earned assets and economic capacities have been destroyed, lost forever. In fact, lives have been lost, children malnourished, families ruined, governments fallen and ethnic animosities intensified. The cooperative partnership among neighboring countries has been undermined and regions destabilized. This is the direct result of predatory lending followed by predatory IMF rescues. The operations were technically successful but the patients died.

Since World War II, the term "capitalism" has been gradually displaced by the more benign label of the free market. Capitalism ceased to be mentioned in most economic literature. In the process, economists also squeezed out of official dialogues the word "capitalism", the once-traditional name for the market system, with its subjective connotation of class struggle between owners, through their professional managers, and workers, through their trade and industrial unions, and with its legitimization of the privileges that go with various levels of wealth.

The word "capitalism" no longer appears in textbooks for Economics 101. A Harvard economist, N Gregory Mankiw, author of a popular new textbook, Principles of Economics, told the New York Times: "We make a distinction now between positive or descriptive statements that are scientifically verifiable and normative statements that reflect values and judgments." A whole new generation of economists have grown up thinking of "capitalism" only as a historical term like "slavery", unreal in the modern world of market fundamentalism.

Capital, when monetized in dollars, is in essence credit from government. Capitalism in a money economy is a system of government credits. Thus a case can be made that in a capitalistic democracy, access to capital and credit should be available equally to all in accordance with national purpose and social needs. The anti-statist posture of neoliberalism is not only logically flawed, but its glorification of a private-debt economy will inevitably lead to self-destruction.

September 14, 2002