Obama’s Politics of Change and US Policy on China
Henry C.K. Liu

Part I: The Song Stays the Same
Part II:  US Domestic Politics and China Policy
Part: III: The New Deal Dollar and the Obama Dollar

Part IV: Brzezinski’s G2 Grand Strategy

This article appeared in AToL on April 22, 2009

The proposal by Larry Summers, former Clinton Treasury Secretary and now Obama’s top economic advisor and Director of the White House National Economic Council, of a multilateral approach with a new group larger than the G-7 rich countries with advanced economies to deal with multilateral global economic problems moves in the opposition direction of the geopolitical call by Zbigniew Brzezinski for Washington and Beijing to set up a new informal Group of Two (G2 – US and China) in a leadership bid to jointly address a wide range of global challenges of bilateral interests.
Brzezinski made his proposal for a US-China G2 in a speech delivered during a conference in Beijing on January 13, 2009, a week before Obama was scheduled to be inaugurated as president, to commemorate the 30th anniversary of the establishment of diplomatic relations between the US and China. The conference was sponsored by the Chinese People’s Institute of Foreign Affairs and the Kissinger Institute on China and the United States, and co-sponsored by the National Committee on US-China Relations, with support from both the US Embassy in Beijing and the Chinese Ministry of Foreign Affairs. Led by former president Jimmy Carter during whose administration diplomatic relations was established, the large US delegation included key figures such as former Republican Secretary of State Henry Kissinger, and former Republican and Democratic National Security Advisers Brent Snowcroft and Brzezinski, who were formally received by Chinese leaders President Hu Jintao, Vice President Xi Jinping and Premier Wen Jiabao.
Unbalanced Relationship
Perhaps reflective of the unbalanced state of relationship between the two countries, the Beijing memorial conference was a mostly unilateral affair on the Chinese side, with no official counterpart observation in the US. The New York Times buried the story in a report on the conference deep in page A8 of its New York edition. Reflective of the depressed state of international trade, the event was cosponsored by Mary Kay, the US direct sale cosmetics maker active in the emerging Chinese market, with attendees each receiving a pink cosmetics bag filled with promotional samples. General Motor, for whom the China car market was the distressed global automaker’s only profitable operation, who normally would have been an eager sponsor, was notably absent, busy fending off bankruptcy with government aid. Also absent were transnational financial giants, such as GE, Citibank, AIG, Goldman Sachs, Morgan Stanley, all mere shadows of their former grandeur, whose luxurious corporate jets would have normally carried their top executives to Beijing in style for events of much less historical and political significance. 
In his speech, Chinese State Counselor Tang Jiaxuan, former foreign minister, recalled the NATO bombing of the Chinese Embassy in Belgrade in 1999 not as evidence of ominous undercurrent, but as proof of how relations between the two countries have survived provocative tension. He also noted some of the still unresolved longstanding obstacles to better relations between the two nations, saying the two sides need to “properly handle issues that concern China’s core interests such as those related to Taiwan and Tibet so as to safeguard the larger interests of China-U.S. relations”, in contrast to US intransigence on the need for China to adjust its policy on both Taiwan and Tibet to met US requirements of moral imperialism.
Brzezinski outlined a well-worn laundry list of international problems for which he thinks China could help the US find solutions, such as the global financial crisis, the challenges of climate change, North Korea and Iran nuclear ambitions, India and Pakistan tension and the Israeli-Palestinian conflict.
The Group of Two that could change the world
Rescuing the Beijing memorial conference from the fate of a nonevent in the US, Brzezinski attracted worldwide attention by elaborating his G2 idea with an article in the Financial Times entitled: The Group of Two that could change the world.
In the article, Brzezinski asserts that normalization of relations between the US and China “precipitated almost from the start security co-operation that has been of genuine benefit both to the US and China. The effect was to change the Cold War’s global chessboard – to the disadvantage of the Soviet Union. Indirectly, the normalization facilitated Chairman Deng Xiaoping’s decision to undertake a comprehensive economic reform. China’s growth would have been much harder without the expansion in US-Chinese trade and financial relations that followed normalization.”
Commenting on “the current geostrategic status of the US-China relationship”, Brzezinski cites an article in Liaowang magazine (July 14, 2008) published by the official Xinhua News Agency, which describes the relationship as one of “complex interdependence”, in which both sides evaluate each other in pragmatic and moderate terms and in which “the two sides can compete and consult within existing international rules”. Yet the reality of US-China relations is one of unending US provocation and hostility on a compliant China.
China faces surging protests and riots in 2009
In its January 6, 2009 edition, a week before the conference, Liaowang ran a story that China faces surging protests and riots in 2009 as rising unemployment stokes popular discontent, in a blunt warning of possible tarnish of the image of effectiveness of Communist Party governance from a sharp economic downturn. The uncharacteristically stark report warned that stalled growth could spark latent anger among millions of migrant workers and university graduates left jobless.
Huang Huo, a senior Xinhua reporter and bureau chief in the southwest city of Chongqing, was quoted in the Liaowang report: “In 2009, Chinese society may face even more conflicts and clashes that will test even more the governing capacity of all levels of the Party and government.” Including students who graduated in 2008 and had not found work, there would be more than 7 million university/college graduates hunting for jobs in 2009, Huang calculated, adding that the government’s goal of annual GDP growth for 2009 of 8% would generate only 8 million new jobs for the whole country. “If in 2009 there are large numbers of unemployed rural migrant laborers who cannot find work for half a year or longer, milling around in cities with no income, the problem will be even more serious,” said Huang. By the end of 2008, there were reportedly 20 million unemployed migrant workers in the export sector located in the coastal regions.
President Hu Jintao has set a goal of building in China a “harmonious society”, but the goal is being tested by rising tension over shrinking jobs opportunities and income disparity, as well as simmering public anger over headlines of official corruption and illegal farm land seizures by private developers, all part of the structural social ills that came with three decades of market economy. Chinese Foreign Ministry spokesman Qin Gang asserted that the government was confident it would be able to handle the difficult times. “We have the ability and the confidence to ensure the Chinese economy’s stable and relatively fast growth and to ensure social stability,” he said repeatedly in recent news briefings.
The Goal of 8% GDP Growth
Yet the problem is less on of sustaining a floor of 8% GDP growth, but where and how the benefits of growth are being distributed.  Xu Shanda, former vice director of the State Administration of Taxation, and a member of the National Committee of the Chinese People’s Political Consultative Conference (CPPCC) told a March 8, 2009 plenary meeting of the country’s top political advisory body that China’s consumer spending has been declining over the past ten years, both when the economy was either overheating or contracting and that more than economic cycles are behind the falling consumer spending. 
Xu said the market economy would lead to a structural income gap that suppresses spending, as high-income people tend to invest rather than consume, while low-income people do not have spare purchasing power to spend. The decline in new jobs and consumer spending, which was coupled with increases in the society’s wealth in China over the past 10 years, is another testimony to the trend, Xu explained, urging the government to address such structural imbalances inherent in a market-oriented economy.
Xu called on China to narrow the country’s income gap to stimulate consumer spending. He advised the government to compile income statistics of different groups and routinely announce these figures, making such figures as important as targeted GDP growth and energy efficiency in evaluation of local governments. He also suggested changing the strategy of “keeping prices of farm produce stable” into “working to moderately increase prices of farm produce in the long run” to enhance farmers income and to narrow income disparity generally. Without saying so explicitly, Xu is advocating a much needed income policy for China.
Xu proposed that China should raised the ratio of social security taxes to GDP up to over 10%, to be exclusively dedicated to the social security fund. In the US, the annual cost of Social Security benefits represented 4.3% of GDP in 2007 and is projected to increase to 6.1 percent of GDP in 2035, and then decline to 5.8% of GDP by 2048 and remain at that level. US Medicare’s annual costs were 3.2% of GDP in 2007, or nearly three quarters of Social Security’s. They are projected to surpass Social Security expenditures in 2028 to reach 10.8% of GDP. Together, Social Security and Medicare would take up to 18% of GDP within a decade. And the US is not a socialist economy.
China needs Full Employment with an Income Policy Financed by Sovereign Credit
In public lectures in Beijing in September 2008 and March 2009, I proposed for China to adopt a full employment objective and an income policy financed by sovereign credit to develop a vibrant domestic market to absorb the sharp shrinkage of its export sector resulting form the global financial crisis. The way for China to use sovereign credit to finance domestic economic development is to free China from dollar hegemony by demanding settlement of its export trade to be denominated in RMB.
Brzezinski Mistakes China as a Revisionist Power
Brzezinski observes that “a globally ascending China is a revisionist power in that it desires important changes in the international system but it seeks them in a patient, prudent and peaceful fashion. Americans who deal with foreign affairs especially appreciate the fact that Chinese strategic thinking has moved away from notions of a global class conflict and violent revolution, emphasizing instead China’s ‘peaceful rising’ in global influence while seeking a ‘harmonious world’. Such common perspectives also make it easier for both sides to cope with residual or potential disagreements and to co-operate on such challenges as those posed by North Korea’s nuclear program. If we at all times keep in mind the centrality of our interdependence, we will be able to cope with other contentious issues.”
It would be hard put to find any responsible Chinese government official who would describe China today as a revisionist power. Rather, China has been trying to find a path to engage a largely capitalistic world without compromising its socialist principles. It is reasonable to assume that with the bankrupt of the global market economy, China, as with many other countries, even including the US, is beginning to recognize the limits of the market economy to revert back to a balanced application of institutional economics principles.
Brzezinski’s G2 Logic
Brzezinski asserts that the shared grand goal is to expand bilateral relationship “to widen and deepen our geostrategic cooperation, beyond the immediate need for close collaboration in coping with the economic crisis.”  He sees China as needing to be a direct participant in the US dialogue with Iran; close US-China consultations regarding India and Pakistan, to become actively involved in helping to resolve the Isreael-Palestinian conflict to reduce risk of a radicalized and unstable Middle East. He sees the need for US-China cooperation in dealing with climate change; exploring the possibility of creating a larger standby UN peacekeeping force for deployment in failed states; on an international initiative towards a global adoption of the zero-nuclear weapons option; on the need to collaborate closely in expanding the current Group of Eight leading industrial nations to a G14 or G16, in order to widen the global circle of decision-makers and to develop a more inclusive response to the economic crisis.
Brzezinski sees the need for an informal G2 composed of the US and China, a comprehensive partnership, paralleling US and Chinese relations with Europe and Japan. Chinese and US top leaders “should therefore meet informally on a regular schedule for personal in-depth discussions not just about our bilateral relations but about the world in general.”
Rejecting Bush neoconservative foreign policy, Brzezinski, sees the Chinese emphasis on “harmony” as serving as a useful point of departure for future US-Chinese summits. “In an era in which the risks of a massively destructive ‘clash of civilizations’ are rising, the deliberate promotion of a genuine conciliation of civilizations is urgently needed. It is a task that President-elect Barack Obama – who is a conciliator at heart – should find congenial, and which President Hu Jintao – who devised the concept of ‘a harmonious world’ – should welcome. It is a mission worthy of the two countries with the most extraordinary potential for shaping our collective future.”
Brzezinski is acknowledged as a key adviser to President Obama on foreign policies during and since the presidential election, while acting as foreign policy advisor to Hillary Clinton during the primaries. Many analysts consider Brzesinski as the spokesman for previously anti-Soviet, now anti-Russia hawk faction in the US foreign policy establishment. Brzezinski’s speech in Beijing was addressed to Washington through talking to Beijing. The message is for the US not to waste financial, political and military resources confronting a China destined to process enormous and rising economic, political and military strength and potentials that will surge further over time unstoppably. US national interests globally would be better served by a strategy of making friends with China by sharing power globally because eventually the US will need the support of the world’s most populous country to preserve and shore up its own global dominance. By contrast, conflicts with China will drain US capacity to maintain its global dominance.
Brzezinski’s statement aims at preserving US dominance in an existing world order that is facing fast and fundamental changes by drawing China into regions previously laid beyond a weak modern China’s sphere of influence. If adopted by the Obama administration, a likely possibility as US foreign policy of the past three decades reflects an increasing acceptance of a scenario of a future world described in Brzezinski’s 1997 book, written six years after the dissolution of the Soviet Union in 1991, The Grand Chessboard: American Primacy And Its Geostrategic Imperatives: “A geostrategic issue of crucial importance is posed by China’s emergence as a major power.” (page 54) “China’s growing economic presence in the region [Central Asia] and its political stake in the area’s independence are also congruent with America’s interests.” (p.149) “Potentially, the most dangerous scenario [for the US] would be a grand coalition of China, Russia, and perhaps Iran, an ‘anti-hegemonic’ coalition united not by ideology but by complementary grievances.”
Brzezinski, the grand master of geopolitical chess, plots his strategy several moves ahead of the game. Geopolitical pluralism must first be promoted to defuse challenges to US superpower, followed by encouraging compatible key partners to cooperate under US leadership, and finally the pragmatic sharing of global geopolitical responsibility can be rewarded with a sharing of power. The twin poles of this strategy are a united Europe in the West and strong China in the East; with the problematic central regions stabilized within a new balance of power.
With the idea of forming a G-2, Brzezinski concedes that the days are numbered for a unipolar world order dominated by a single superpower that had emerged since the dissolution of the Soviet Union in 1991. The US, in view of the self-inflicted damage to its freewheeling market economy that can be expected to leave the US in a protracted depression, will need a trade partner with high growth potential to absorb its overcapacity. China emerges in the 21st century as the ideal candidate for the new ally with a special relationship with the US. From the US security perspective, an alliance with China will spare the US from again involve directly in a war in Asia, a role the US alliance with Japan had repeatedly failed to accomplish. From the US economic perspective, US-China economic interdependence has the potential of a win-win symbiosis.   

Brzezinski anticipates that a G-2 would be more effective in dealing with multilateral global issues than the G-5 (France, Germany, Italy, UK, US) or G6 (G5+Japan) or G7 (G6+Canada) or G8 (G7+ Russia) or even the G-20 (G7+Developing countries including China).
Brzezinski’s G2 Vision not Shared by All in US
Brzezinski’s vision of harmony with China is not shared by all in the US. Within days after Hillary Clinton’s maiden foreign visit to Beijing as Secretary of State, in which she declared US-China cooperation as imperative for enhancing the national interests of both countries and for pulling the world from the current financial crisis, the US Navy staged a provocative intrusion into Chinese territorial waters by a US low-frequency sonar surveillance ship near China’s submarine base on Hainan Island in the South China Sea, mapping deep-sea routes for submarines leaving and entering their base.
Press reports on computer hackers allegedly associated with the governments of Russia and China having embedded software in the US electricity grid and other infrastructure that could potentially disrupt service or damage equipment are suddenly appearing even though such concerns have been simmering for years within government security establishment. President Obama reportedly has started a 60-day review of all the nation’s efforts at cyber security that is expected to be completed by April 17.
Chinese Foreign Ministry spokeswoman Jiang Yu at a regular press conference on April 8 denied China had any involvement with mapping or hacking into the US electrical grid to leave behind software programs that could be used to disrupt the system, noting that the White House had denied the media reports.

Meanwhile, the omnipotent US Navy appears to be helpless in dealing with a handful of enterprising pirates highjacking US merchant ships for money of the coast of Salia in the Gulf of Aden, inducing the New York Times to headline: Navy’s Standoff with Pirates Shows Limits of Military Might. (Please see my April 5, 2003 AToL article: The War that may end the Age of Superpower)

G2 Concept Requires Fundamental Adjustment in US Foreign Policy
For the idea of G2 to work, the US has to adjust fundamentally its foreign policy since the end of WWII away from neo-imperialism toward Wilsonian/FDR liberalism and give up its aim of peaceful evolution of Chinese society toward market capitalism. G2 would have to be a leading force in building a new world order of social justice and economic equity.
China Not Likely to Play Brzezinski’s New Great Game
The big question is whether China will play Brzesinski’s geopolitical chess game. There is a sizable pro-US faction in China’s foreign policy establishment who would welcome Brzesinski proposal. Formal US recognition of great power status for China will strengthen the influence of this pro-US faction in internal Chinese politics and policy deliberation.  Yet, not withstanding Brzezinski’s assertion, China is not a “revisionist” power, but a non-expansionist revolutionary state aiming at restoring its natural historical status before the arrival of Western imperialism in Asia. China is not interested in bringing back a pre-WWII world order of imperialist exploitative expansion. China is not Japan who as a defeated nation has been willing to play the role of a submissive ally with a benevolent victor.
Chinese Foreign Policy Legacy 
Foreign policy of the People’s Republic since its founding in 1949 has a long legacy of nonalignment. Mao Zedong had made repeated overtures to Washington for peaceful and friendly relations with the new socialist China but such overtures were categorically rejected by a US caught up in anti-communist phobia during the Cold War. Nixon’s opening to the China in 1972 was partly driven by US perception of China’s concern for imminent threat from Soviet imperialism. Specifically, Nixon’s opening to China was aimed more at forcing the USSR into the US strategy of Détente. In fact, China would have accepted Nixon’s overture even without a Soviet threat, as evidenced by the fact the Chinese attitude towards the US remain positive even after the collapse of the Soviet Union. China was not naïve enough to think the US would risk a nuclear exchange with the USSR merely to save China from a nuclear attack by the USSR. Mao’s vision of US-China relations transcends fleeting geopolitical tactics of balance of power, towards a long-range peaceful coexistence of two of the world’s largest nations.
China as Protector of Developing Countries
China’s view of itself is one of a natural member of what during the Cold War was called the Third World, now generally known as developing countries, in the struggle against Western imperialism, now known as neoliberalism, but not as its leader either by design or by default, as each country must seek its own way of struggle according to its historical conditions. Nor does China maintain a foreign policy of exporting revolution to other countries that do not want a revolutionary path. China has formally declared its determination never to seek hegemony and has openly declared a policy of no-first-use of nuclear weapons. Brzezinski’s G2 strategy runs counter to Deng Xiaoping’s strategy of “hide capacity, bide time” (韜光養晦 tao guang yan hui), a strategy of keeping a low profile to avoid attracting unnecessary hostility in a period when the world’s sole remaining super power was intoxicated with imposing its will on other countries by its overwhelming military power. A G2 regime will inflict on China the side effects of rising anti-US sentiments from around the world at a time when US power is declining from self-inflicted wounds.
If G2 is patterned after G5, then there is no geopolitical purpose for China to become a member, because G5 is a tool of US hegemony and neoliberal imperialism. Unless G2 is based on true equality between the partners, which is unlikely as the power disparity between the US and China is still too wide and at any rate not possible without a new just world order, then the cost for China from being a member of G2 is too high and the benefits negative. By being a member of the proposed G2, China would be necessarily saddled with the burdens of being a special ally of a superpower without the benefits or even the need of being a superpower itself.
China and Asia
In the long run, Chinese foreign policy should stay on track with nonalignment and be on the side of developing countries and oppressed peoples. A G2 will create unavoidable geopolitical problems for China in Asia, and also relating to the US global war on terrorism. It will exacerbate China’s problem with Islamic separatists, who if devoid of US instigation and support, would be a problem of infinitely less complexity than the US global war on terrorism. China’s first priority should be to secure her position as the leading protector of Asian interests against neo-imperialism from the G5. Anti-imperialism does not need to be associated with anti-Western zenophobia if the West would abandon residual imperialist policies. A strong China needs also a strong, independent Asia free from undue manipulation by external forces. China must not make the same mistakes as Japan did in allying itself first with imperialist Britain and then fascist Germany against other Asian countries that led eventually to World War II.
China and Japan
China needs to do everything it can to improve Chinese-Japanese relations, even to the extent of appeasing Japanese national interests. China should reverse the past policy of tilting toward the US with undignified concessions while adopting antagonistic posture toward Japan. China should tilt towards Japan as a friendly neighbor and not fantasize about unrealistic US friendship with a socialist China. It France and Germany can be members of the EU to their mutual benefit, there is no reason why China and Japan cannot be symbiotic partners in a united Asia.
Asymmetrical Observance
The celebration of the 30th Anniversary of US-China diplomatic relations was held only in Beijing. In the US, no one cared. Obama’s inauguration speech is indicative of deep-rooted US national psyche in which he sees the US as a holy defender of the world against Fascism and Communism, as if the two were one equal evil. China needs to be prepared for the penchant on the part of US Democrats for tough China-bashing policies in trade and human rights. Early indications suggest that the Obama team will likely not be able to revive the US economy within the four years of its first term and China may become the convenient scapegoat for US policy failure. Chinese policymakers will be disappointed if they are not realistic about deep-rooted US hostility toward China. China must avoid open conflict with the US, but Chinese policymakers must understand that the US will never be China’s friend as long as the Chinese Communist Party is in control of China. 
New US Realpolitik on China
Obama administration Secretary of State Hillary Clinton’s current overture of peace and cooperation to China is merely an emergency measure in response to a collapsed economy and exhaustion from undeclared foreign wars. China should welcome this pragmatic gesture of realpolitik friendship from the US but not be lured into geopolitical complacency about a fundamental change in US foreign policy.
Just as China had been lured into market capitalism at a time when market capitalism was rushing towards its final phase of self destruction, China now needs to carefully consider any disingenuous invitation to join and save the precarious US-constructed and dominated world system at a time when conditions around the world are making the prospect of a new, just world order on the horizon a welcome possibility. It is true that the current financial/economic crisis is a global problem and can only be solved with global cooperation. It is also true that the crisis was created by the US. It is however, far from clear that the solution can come from discredited US leadership to restore a broken world order to its pre-crisis ways.
Obama’s Change
The Obama policies on economic recovery and foreign relations have so far been more business-as-usual than real change, despite the President’s populist and optimistic rhetoric of hope and change. Even Lawrence Summers, director of the White House’s National Economic Council, admits the economy will be in for a rough time for a while and that unemployment will continue to rise even with the massive stimulus package. Treasury Secretary Tim Geithner has failed so far to exert any bold leadership. There are reports that the Treasury Department is having difficulty staffing up key positions because of the Obama administration’s strict vetting procedures.
Geithner’s Failing Rescue
Geithner’s three-part program for tackling the credit crisis: 1) Inject fresh government capital into some of the country’s biggest financial institutions; 2) Start a program of up to $1 trillion to promote new lending to consumers and businesses; and 3) Establish a toxic-debt fund, appeared stalled for details as the Treasury Department suffers from vacant offices at the Undersecretary and Assistant Secretary levels. 
Details of the toxic debt fund are still not been fully released to the public, leaving unresolved a key challenge in the competing incentives in the proposed partnership between the public and private sectors. Distressed-asset investors typically want the cheapest possible price to protect their returns on investment. However, sales at such low prices would result in further large write-downs for banks and potential failure of some, something the administration wants to avoid. Many economists are pointing out that the Obama bailout plan for distressed banks is too small for the scale of the problem, that taxpayer money is being misdirected to save banks without adequate control on the banks as to how to use the money to help the injured public, and that it is a hybrid solution that combines the worst aspects of nationalization and the worst aspect of private enterprise without the benefits of either.
Government efforts to buy toxic assets and spur bank lending may not work, according to a study by three economists. The study, titled ‘The Pricing of Investment Grade Credit Risk during the Financial Crisis’ by Joshua Coval and Erik Stafford of Harvard University and Jakub Jurik of Princeton University suggests that recent credit market prices are “actually highly consistent with fundamentals,” and that bonds and credit derivatives should have experienced a “significant repricing in 2008 as the economic outlook darkened and volatility increased.”

The analysis also confirmed that the “severe mispricing existed in the structured credit tranches prior to the crisis and that a large part of the dramatic rise in spreads has been the elimination of this mispricing.” The authors conclude that any use of taxpayer money to buy toxic assets “will simply transfer wealth to the current owners of these securities.” This conclusion has been independently reached by a large number of market participants in the past two years.
As part of Treasury’s wide-ranging effort to restore stability to a banking sector hit by huge mortgage-related losses, coupled with a public-private program to buy toxic assets from banks to clear the way for banks to attract private capital, 19 of the country’s largest banks will be subjected to stress tests by regulators to determine whether they can weather aftershocks and future shocks. The Treasury is planning to delay the release of any completed bank stress test results until the first-quarter earnings reporting after April 24, 2009 to avoid complicating stock market reaction. Discussions are reportedly on-going about how the results of the regulatory stress tests on the 19 largest US banks will be released, possibly as summary results that are not institution-specific.
“Frankly, we don’t have as accurate an assessment of the situation of a number of institutions as we’d like to because we haven’t really done the stress test against a range of scenarios,” admits  Summers, who as Treasury secretary in the Clinton administration cannot escape responsibility for the current crisis. He did not rule out the possibility that some banks might be shut down as a result of the stress tests. “When supervisors deem it appropriate, then institutions are intervened,” he added.
In other word, the administration’s top economist still does not have a handle on the scale of the banking crisis almost two years after the crisis began in July 2007. US banks have written down $758 billion in credit losses since the crisis began and have warned of more losses to come, though no one in or out of government can say how much more.
Rescue by Changing Accounting Rules
The American Bankers Association asked the Securities and Exchange Commission on October 13, 2008 to override new guidelines on mark-to-market accounting, saying they inaccurately reflect distressed asset values over the longer term. The once-obscure accounting rule that had upset bankers who blamed it for exacerbating the financial crisis, was changed April 2, 2009 to give banks more discretion in reporting the potential value of mortgage securities. The move compromised the independence of the Accounting Standards Board (FASB) which was widely viewed as having yielded to intense political pressure. Robert H. Herz, chairman of FASB, said he voted for the change because the new disclosures would help investors.
The change will allow banks to report higher profits by assuming that the securities are worth more than anyone is now willing to pay for them in the open market.  Banks are allowed by the rule changes to keep some declines in asset values off their income statements. Critics warned that the change could further damage the credibility of financial institutions by enabling them to avoid recognizing losses from bad loans they have made.
During the financial crisis, the market prices of many securities, particularly those backed by subprime home mortgages, have plunged to fractions of their marked-to-model prices, forcing banks to report huge losses because such securities must be reported at market value each three months, with the banks showing a profit or loss based on the change.
Bankers bitterly complained that current market prices were the result of distressed sales and that they should be allowed to ignore those prices and value the securities instead at their potential value in a normal market. The measure in the new guidelines that drew the most dissent will allow banks to keep part of such declines off their income statements, although the decline would still show on the institutions’ balance sheets. Since old accounting rules already allowed the fiction that all banks are well capitalized, the changes would make banks appear better capitalized than they actually are. Bank share soared in price the day the changes were announced.
FASB had resisted making the changes at first, but yielded within a few days of a Congressional hearing at which legislators from both parties demanded the FASB to act. Ironically, the erosion of integrity of rating agencies has been generally recognized as one of the causes of the financial crisis.
The application of an accounting rule had become a political issue. The International Accounting Standards Board held an emergency meeting to change its rule after such a move was demanded by the President of France. In the United States, FASB acknowledged investor criticism of its rule changes after the Congressional hearing.
While it was the banks who pressed for the new rules, the change will affect all non-blank financial institutions as well. But the FASB said it would make small changes to assure to avoid affecting accounting in mutual funds which must mark their assets to market value every day. Bank regulators already have the power to adjust accounting in computing capital, and some investor groups argued they should do that, rather than give the banks more freedom to value assets at what they think they should be worth, rather than what someone will pay for them. The FASB vote drew condemnation from the Investors Working Group headed by two former SEC chairmen, Bush appointee William H. Donaldson and Clinton appointee Arthur Levitt Jr.
Back in unusually heavily attended 2002 annual Bond Market Association meeting in New York featuring then Treasury Secretary Paul O'Neill, Securities and Exchange Committee chairman Harvey Pitt, and former Fed chairman Paul Volcker, a swarm of reporters, looking for the next Enron fiasco, turned up to ask questions about special-purpose entities (SPEs) and other means of moving risk off corporate balance sheets. One association member asked Pitt how the market could distinguish between how SPEs now were different from those used by Enron which had been deemed legally fraudulent. Pitt had no ready answer. The off-balance-sheet genie had been let out of the bottle, and there was no easy way to put it back in.

New Accounting Rules on Off-Balance-Sheet Obligations

The Financial Accounting Standards Board (FASB) adopted new rules for consolidating SPEs and disclosing off-balance-sheet activities. SPEs can no longer be all-purpose entities, especially not the kind of debt-hiding entities that Enron used and abused to puff up its profits. Interpretation No. 46, “Consolidation of Variable Interest Entities”, expands on existing rules to more precisely specify under what conditions a parent company must consolidate an off-balance-sheet SPE. Now, the question of consolidation is a matter of who takes the risks and who reaps the rewards of the enterprise.

Hundreds of US companies keep trillions of dollars in debt in off-balance-sheet subsidiaries and partnerships, skirting the consolidation rules of FASB 94, FASB 125 and FASB 140. If a company creates a legal structure, called a special-purpose entity (SPE) with a 3% minimal equity infusion, they do not have to consolidate the transaction under SEC and FASB rules. Banks arrange many of the devices and are big users themselves. JP Morgan revealed in the Enron bankruptcy that it had nearly $1 billion in potential liabilities stemming from a single 49%-owned Channel Islands entity called Mahonia that traded with Enron. Dell Computer had a joint venture with Tyco called Dell Financial Services (DFS) that originated $2.5 billion in customer financing, mentioned only as a footnote to Dell’s accounts. Dell owned 70% of DFS, but did not control it and therefore could keep DFS debts off its own balance sheet.

To move assets off its books, a company typically sells them to an SPE, funding the purchase by borrowing cash from institutional investors. As a sweetener to protect investors, many SPEs incorporate triggers that require the parent to repay loans or give them new securities if its stock falls below a certain price or credit-rating agencies downgrade its debt or other triggering events. However, the International Accounting Standards Board (IASB) resisted this type of treatment. Under pending European Union legislation, all listed companies in the EU had to report under IASB by 2005, except those that report under US GAAP, which would have to move to IASB by 2007

Moving debt off the balance sheet is more difficult in Europe than in the US under IASB rules which use the standard of whether a company participates in the risks and rewards attached to that debt in deciding whether debt can be off-balance-sheet. By contrast, US GAAP uses the standard of what legal form such an entity takes. In the post-Enron world, the rules on off-balance-sheet debt have tightened up, but new loopholes have been exploited.  Under existing accounting rules, the assets of SPEs must be consolidated when outside investors’ stakes are protected in that fashion. Yet Some 42% of off-balance-sheet debt provide guarantee for outside investors in indirect ways to get around the rules. (Please see my December 1, 2007 AToL article: PATHOLOGY OF DEBT - PART 5: Off-balance-sheet Debt)
Much of the losses came from mortgage-related investments as the housing market began to collapse. Yet the bottom appears to be a long way off. Home foreclosures in the US surged 81% in 2008 to 2.3 million, the highest on record. More than 274,000 homes received at least one foreclosure-related notice in January 2009, down 10% from December 2008, but still 18% higher than a year ago. Insolvency is spreading throughout the US and global financial systems like a wild fire beyond the housing sector to the entire economy.
The market has so far been showing disappointment after disappointment on Obama’s disjointed approach to stopping the economic hemorrhage, let alone a comprehensive strategy for recovery. Imprecise information and policy indecision continue to plague the credit market bailout, the bank bailout, the housing bailout, the auto bailout, the coming commercial real estate bailout, while a general consensus is building that the bottom is not yet in sight by a long shot. US policy initiatives presented at the G20 London summit on April 2, 2009 met with resistance from European allies.
Stalled US Economy Weakens US Diplomatic Initiatives
On her first overseas trip to Asia that included China as a final stop, Secretary of State Hilary Clinton acted like a salesperson peddling US sovereign debt to reluctant Chinese buyers and promoting joint efforts to develop clean energy as the way out of the financial crisis, an issue on which China holds fundamentally different views from the US.
The US promotion of clean energy as a way to revive the global economy rests on keeping oil prices high in order to justify investment in alternative energy while China at this stage of her development needs not just clean but also low cost energy, oil or otherwise. The US intents to use alternative renewable energy to replace its fully developed, massive fossil fuel network, while China can take advantage of alternative renewal energy to fulfill her growing energy needs without having to amortize massive sunk investment in fossil fuel network.
The global economic crisis is sapping US influence around the world and weakening the foundation of US foreign policy.
Next: G2 and SCO