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3 THE ROAD TO
HYPERINFLATION Fed helpless in its own
crisis By Henry C K
Liu
of money the asset commands: the higher
the asset price in money terms, the less valuable
the money. When debt pushes asset prices up, it in
effect pushes the value of money down in terms of
purchasing power. In an inflationary environment,
when prices are kept high by excess liquidity,
monetized wealth stored in the underlying asset
actually shrinks. This is the reason why
hyperinflation destroys monetized wealth.
When the central bank withdraws money from
the market by selling government securities, it in
essence reduces sovereign
credit outstanding because a
central bank never needs to borrow its own
currency, which it can issue at will, the only
constraint being the impact on inflation, which
can become a destroyer of monetized wealth when
inflation is tolerated not as a stimulant for
growth but merely to prop up an overpriced market
in a stagnant economy.
Yet debt can only
be issued if there are ready lenders and borrowers
in the credit market. And the central bank is
designed to serve as "lender of last resort" when
lenders become temporarily scarce in credit
markets. But when borrowers are scarce not due to
short-term cash flow problems but due either to
low credit rating or insufficient borrower income
to service debts, the central bank has no power to
be a "borrower of last resort".
The role
of "borrower of last resort" belongs to the
federal government, as Keynes observed when he
advocated government deficit spending to moderate
business cycles. The Bush administration, through
the Treasury, sells sovereign bonds to finance a
hefty fiscal deficit. The only problem is that it
spends both taxpayer money and proceeds from
sovereign bonds mostly on wars overseas, leaving
the domestic economy in a liquidity crisis.
To address an impending recession, the
Bush 2008 proposal of a $150 billion stimulus
package of tax relief, representing 1% of GDP,
would target $100 billion to individual taxpayers
and about $50 billion toward businesses.
Economists said a reasonable range for tax cuts in
the package might be $500 to $1,000 per tax payer,
averaging $800. Bush said the income tax relief
"would help Americans meet monthly bills and pay
for higher gas prices". The policy objective is to
keep consumers spending to stimulate the slowing
economy, as consumer spending accounts for about
70% of the US economy.
Speaking after the
president, Secretary of the Treasury Henry Paulson
said he was confident of long-term economic
strength, but that "the short-term risks are
clearly to the downside, and the potential cost of
not acting has become too high." He added that 1%
of GDP would equate to $140 billion to $150
billion, which is along the lines of what private
economists say should be sufficient to help give
the economy a short-term boost.
"There's
no silver bullet," Paulson said, "but, there's
plenty of evidence that if you give people money
quickly, they will spend it."
Yet the
Republican proposal favors a tax rebate, meaning
that only those who actually paid taxes would get
a refund. That means a family of four with an
annual income of $24,000 would receive nothing and
only those with annual income of over $100,000
would get the full $800 rebate per taxpayer, or
$1,600 for joint return households.
Further, against a total US consumer debt
(which includes installment debt, but not home
mortgage debt) of $2.46 trillion in June 2007,
which came to $19,220 per tax payer, the Bush
rebate of $800 would not be much relief even in
the short term. In 2007, US households owed an
average of $112,043 for mortgages, car loans,
credit cards and all other debt combined.
Outstanding credit default swaps is around $45
trillion, which is three times larger than US GDP
of $15 trillion and 3,000 times larger than the
Bush relief plan of $150 billion.
Bush did
not push for a permanent extension of his 2001 and
2003 tax cuts, many of which are due to expire in
2010, eliminating a potential stumbling block to
swift action by Congress, since most the
controlling Democrats oppose making the tax cuts
permanent. The 2008 tax relief proposal harks back
to the Bush 2001 and 2003 tax cuts, which were at
variance with established principles that an
effective tax stimulus package needs to maximize
the extent to which it directly stimulates new
economic activity in the short-term and minimize
the extent to which it indirectly restrains new
activity by driving up interest rates.
The
Bush tax cuts were implemented without first
adopting an overall stimulus budget; without
designing business incentives to provide reasons
for new investment, rather than windfalls for old
investment; nor designing household tax cuts to
maximize the effects on short-term spending;
without focusing on temporary (one-year) items for
businesses and households, not permanent ones.
Most significant of all, they failed to maintain
long-term fiscal discipline.
The flawed
2001 Bush tax stimulus package included five
items: 1) A permanent tax subsidy (through partial
expensing) of business investment; 2) permanent
elimination of the corporate alternative minimum
tax; 3) permanent changes in the rules applying to
net operating loss carry-backs; 4) acceleration of
some of the personal income tax reductions
scheduled for 2004 and 2006 and 5) a temporary
household tax rebate aimed at lower- and
moderate-income workers who actually paid income
taxes, a condition that reduced its effectiveness.
The 2001 Bush tax stimulus package
included permanent changes that were less
effective at stimulating the economy in the short
run than temporary changes but more expensive. And
its acceleration of the recently enacted tax cuts
for higher-income taxpayers was poorly targeted
and potentially counter-productive. A more
effective stimulus package would combine the
household rebate aimed at lower- and
moderate-income workers with a temporary incentive
for business investment. Yet for the last two
decades, even in boom time, the US middle class
has not been receiving its fair share of income
while increasingly bearing a larger share of
public expenditure. The long-term trend of income
disparity is not being addressed by the bipartisan
short-term stimulus package.
War
costs The Congressional Research Service
(CRS) report, updated November 9, 2007, shows that
with enactment of the FY2007 supplemental on May
25, 2007, Congress has approved a total of about
$609 billion for military operations, base
security, reconstruction, foreign aid, embassy
costs, and veterans’ health care for the three
operations initiated since the 9/11 attacks:
Operation Enduring Freedom (OEF) Afghanistan and
other counter terror operations; Operation Noble
Eagle (ONE), providing enhanced security at
military bases; and Operation Iraqi Freedom (OIF).
A 2006 study by Columbia University economist
Joseph E Stiglitz, the 2001 Nobel laureate in
economic, and Harvard professor Linda Bilmes,
leading expert in US budgeting and public finance
and former Assistant Secretary and Chief Financial
Officer of the US Department of Commerce,
concluded that the total costs of the Iraq war
could top $2 trillion.
Greenspan sees
no Fed cure Alan Greenspan, the former Fed
chairman, wrote in a defensive article in the
December 12, 2007 edition of the Wall Street
Journal: "In theory, central banks can expand
their balance sheets without limit. In practice,
they are constrained by the potential inflationary
impact of their actions. The ability of central
banks and their governments to join with the
International Monetary Fund in broad-based
currency stabilization is arguably long since
gone. More generally, global forces, combined with
lower international trade barriers, have
diminished the scope of national governments to
affect the paths of their economies."
In
exoteric language, Greenspan is saying that short
of moving towards hyperinflation, central banks
have no cure for a collapsed debt bubble.
Greenspan then gives his prognosis: "The
current credit crisis will come to an end when the
overhang of inventories of newly built homes is
largely liquidated and home price deflation comes
to an end ... Very large losses will, no doubt, be
taken as a consequence of the crisis. But after a
period of protracted adjustment, the US economy,
and the global economy more generally, will be
able to get back to business."
Greenspan
did not specify whether "getting back to business"
as usual means onto another bigger debt bubble as
he had repeatedly engineered during his
18-year-long tenure at the Fed. Greenspan is
advocating first a manageable amount of pain to
moderate moral hazard, then massive liquidity
injection to start a bigger bubble to get back to
business as usual. What Greenspan fails to
understand, or at least to acknowledge openly, is
that the current housing crisis is not caused by
an oversupply of homes in relation to demographic
trends. The cause lies in the astronomical rise in
home prices fueled by the debt bubble created by
an excess of cheap money.
Mortgage
crisis to corporate debt crisis Many
homeowners with zero or even negative home equity
cannot afford the reset high payments of their
mortgages with current income which has been
rising at a much slower rate than their house
payments. And as housing mortgage defaults mount,
the liquidity crisis deepens from money being
destroyed at a rapid rate, which in turn leads to
counterparty defaults in the $45 trillion of
outstanding credit swaps (CDS) and collateralized
loan obligations (CLO) backed by corporate loans
that destroy even more money, which will in turn
lead to corporate loan defaults.
Proposed
government plans to bail out distressed home
owners can slow down the destruction of money, but
it would shift the destruction of money as
expressed by falling home prices to the
destruction of wealth through inflation masking
falling home value.
Credit insurers such
as MBIA, the world's largest financial guarantor,
whose shares have dropped 81% in 2007 to $13 from
a high of $73, are on the brink of bankruptcy from
their deteriorating capital position in light of
rating agencies reviews of residential
mortgage-backed securities and collateralized debt
obligations that have been insured by MBIA, or
similar insurers, reviews that are expected to
stress claims-paying ability.
On December
10, 2007, MBIA received a $1 billion boost to its
cash reserves from private equity firm Warburg
Pincus in an effort to protect its credit rating.
By January 10, 2008, MBIA announced it would try
to raise another $1 billion in "surplus notes" at
12% yield. The next day, traders reported that the
deal was facing problems in attracting investors
and might have to raise the yield to 15%. But Bill
Ackman of Pershing Square Capital Management told
Bloomberg that regulators can be expected to block
payment to surplus note holders. Further, raising
enough new capital to retain credit ratings would
so dilute existing shareholder value as to remove
all incentive to save the enterprise.
Maintaining an AAA credit rating is of
utmost important to bond insurers like MBIA
because they need a strong credit rating in order
to guarantee debt. Moody's, Standard & Poor's
and Fitch are all reviewing the financial strength
ratings of bond insurers, which write insurance
policies and other contracts protecting lenders
from defaults.
For the insurers to
maintain the necessary triple-A rating, their
capital reserve would have to be repeatedly
increased along with the premium they charge.
There will soon come a time when insurance premium
will be so high as to deter bond investors.
Already, the annual cost of insuring $10 million
of debt against Bear Stern defaulting has risen
from $40,000 in January 2007 to $234,000 by
January of 2008. To buy credit default insurance
on $10 million of debt issued by Countrywide, the
big subprime mortgage lender, an investor must as
of January 11, 2008 pay $3 million up front and
$500,000 annually. A month ago, the same
protection could be bought at $776,000 annually
with no upfront payment.
Credit-default
swaps tied to MBIA's bonds soared 10 percentage
points to 26% upfront and 5% a year, according to
CMA Datavision in New York. The price implies that
traders are pricing in a 71% chance that MBIA will
default in the next five years, according to a
JPMorgan Chase & Co valuation model. Contracts
on Ambac Financial, the second-biggest insurer,
rose 12 percentage points to 27% upfront and 5% a
year. Ambac's implied chance of default is 73%.
MBIA and competitors such as Ambac and ACA
Capital insure mortgage-backed securitized debt
and bonds, which came under pressure as the
subprime fallout all but wiped out mortgage
credit. The credit ratings agencies have since
tried to determine whether the bond insurers'
ability to pay claims against a sudden rise in
defaulted debt has been impacted by the
deterioration of the home mortgage market. A
ratings downgrade has broad fallout, causing
billions of bonds insured by the firms to also
lose value. Banks have been major buyers of debt
insurance on the bonds they hold.
MBIA is
also facing a series of class action suits for
misrepresenting and/or failing to disclose the
true extent of MBIA exposure to losses stemming
from its insurance of residential mortgage-backed
securities (RMBS), including in particular its
exposure to so-called "CDO-squared" securities
that are backed by residential mortgage-backed
securities. Other class action suits involve
alleged violation of the Employee Retirement
Income Security Act of 1974 (ERISA) relating to
MBIA 401(k) plan.
Synthetic CDO-squared
are double-layer collateralized debt obligations
that offer investors higher spreads than
single-layer CDOs but also may present additional
risks. Their two-layer structures somewhat
increase their exposure to certain risks by
creating performance "cliffs" that cause seemingly
small changes in the performance of underlying
reference credits to produce larger changes in the
performance of a CDO-squared.
If the
actual performance of the reference credits
deviates substantially from the original modeling
assumptions, the CDO-squared can suffer unexpected
losses. On January 11, MBIA announced in a public
filing it has $9 billion of exposure to the
riskiest structures known as CDO of CDO, or
CDO-squared, $900 million more than the company
disclosed only three weeks earlier. MBIA also said
it now had $45.2 billion of exposure to overall
residential mortgage-backed securities, which
comprises 7% of MBIA’s insured portfolio, as of
September 30, 2007.
The triple-A credit
rating of the bigger bond insurers is crucial
because any demotion could lead to downgrades of
the $2.4 trillion of municipal and structured
bonds they guarantee. This could force banks to
increase the amount of capital held against bonds
and hedges with bond insurers - a worrying
prospect at a time when lenders such as Citigroup
and Merrill are scrambling to raise capital.
Significant changes in counterparty strengths of
bond insurers could lead to systemic issues.
Warren Buffett’s Berkshire Hathaway set up a new
bond insurer in December 2007 after the New York
State insurance regulator pressed him to do so.
If credit insurers turn out to have
inadequate reserves, the credit default swap (CDS)
market may well seize up the same way the
commercial paper market did in August 2007. The
$45 trillion of outstanding CDS is about five
times the $9 trillion US national
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