Page 1 of 3 Obama's green shoots all too frail
By Hossein Askari and Noureddine Krichene
United States President Barack Obama's administration has publicized and
recycled every shred of good news, otherwise known as green shoots, about the
US economy that it can muster. It claims credit for avoiding a depression,
ending the recession, stabilizing financial markets and achieving a decline in
the number of job losses. It points to a low inflationary environment, it has
received repayment of some bank bailouts, and is cautiously optimistic about
the future of the economy.
Yet all of this, even if multiplied by a factor of two, affords little comfort
to realists looking through a crystal ball.
The story of how we got here has become a standard one and pretty much
universally accepted, with differences only of emphasis. Wholesale deregulation
and blind faith in financial
markets under the Bill Clinton administration was followed by the US Federal
Reserve's loose monetary policy from 2001.
The low interest-rate environment and cheap credit fueled speculation (more
profitable), including propriety trading (on their own account) by large banks,
pushing loans to subprime markets, leveraging, and Ponzi finance. This was
accompanied, in a deregulated environment with blind faith in the market, by a
massive expansion in derivative trading, especially in the expansion of
(underpriced) credit default swaps (CDS) - giving banks (speculators) comfort
against default and further fueling speculation.
Large banks and investment banks were further emboldened by their belief in the
federal guarantee, although unspoken, of "too big to fail". Speculation, in
turn, led to a rapid run-up in asset prices, including commodity prices, such
as oil, gold, metals, food, and to volatility in exchange rates. All the while,
it seemed that regulators and supervisors were asleep to the signs of asset
bubbles, erosion of bank capital, and the developing risk of a pending
financial collapse that were developing around them.
The US-manufactured crisis was spread to the rest of the world through a number
of channels. The US economic expansion was accompanied by large and growing
current account deficits; that is, the high level of private sector consumption
(or low level of private sector savings) and large government fiscal deficits
had their counterpart in current account deficits, matched by heavy external
financing (especially from China, Europe and surplus-strong and oil-rich
members of the Organization of Petroleum Exporting Countries).
The financing of the US current-account deficit led to foreigners acquiring a
growing position in US equity and, especially, in debt-market instruments.
Given low US interest rates and returns, foreigners turned to higher-yielding
mortgage-backed securities and other toxic debt-based instruments packaged in
the US.
Like their American counterparts, foreigners (especially foreign banks) in many
instances simultaneously bought credit-default swaps from US institutions, such
as the American Insurance Group (AIG), that were, in retrospect, grossly
under-priced to cover the risk of acquiring high-yielding assets (the return on
these assets minus the cost of the CDSs was still higher than comparable "less
risky" assets, a clear indication that CDSs were under-priced).
At the same time, hedging and speculation in interest-rate exposure resulted in
the same underlying assets being swapped as interest rate and currency swaps
numerous times around the world, with the gross value of the swaps being many
times their net value, and making default in one market infectious to markets
around the world.
What started as an American crisis became global through the cross-border
transmission of interest rates, hedging and speculating through interest-rate
swaps, capital flows, and acquisition of toxic assets and credit-default swaps.
Specifically, the expansionary policies in the reserve-currency country, the
US, had led to lower interest rates and foreigners financing the US
current-account deficit turned to toxic-debt instruments which gave a higher
yield. At the same time, as mentioned earlier, in the footsteps of US expansion
and rising prices, arbitrage affected commodity prices everywhere, resulting in
a global boom in commodities, most noticeably in oil and food.
The US policy response
In the wake of the financial collapse, highlighted by the demise of Lehman
Brothers, the US adopted policies to stabilize financial markets and to revive
the economy - specifically emergency bailouts of large financial institutions,
commercial banks, investment banks and insurance companies, and a massive
stimulus plan to increase economic activity. At the same time, the White House
and Congress agreed to look into reforms that would prevent a similar financial
catastrophe in the future.
The bailout of financial institutions was implemented on a case-by-case basis,
a method that is slow, unfair to the public and does not address the issue of
too big to fail. How do we ensure a good deal for the public in negotiated
bailouts, especially given the revolving-door culture of Wall Street? Bailouts
lead to more bailouts because they give an incentive to bankers to take
excessive risks in pursuit of extraordinary rewards in the future. Most
importantly, after bailing out the big financial firms, we find ourselves
saddled with firms that are still too big to fail and with no easy solution.
In fact, because of the mergers and takeovers that the government supported,
our financial institutions are now even bigger than before and with more
influence on politicians. We have done very little to avoid a worse catastrophe
in the future.
The other way to rescue the financial system would have been to nationalize all
threatened institutions that were too big to fail, break them up, so that they
are no longer too big to fail, and auction the pieces one by one to get the
best price for the public. This would have saved the financial system, restored
financial stability in quick order and resolved the problem of "too big to
fail" once and for all, as long as we adopt financial regulations to avoid such
an eventuality in the future - regulations to keep size in check. We are still
burdened with the same problem - "too big to fail" institutions - institutions
that have the power, which they use freely, to block meaningful reform.
The second prong of the economic revival plan was a massive stimulus plan.
Because of strongly expansionary demand policies under the George W Bush
administration, US national savings became very low or even negative. Low
savings invalidate a basic assumption for a Keynesian expansionary fiscal
policy and make the financing of the deficit from real domestic savings
unfeasible.
The only sound financing option would have been foreign financing as in
previous fiscal deficits. On the one hand and under this assumption, the US
fiscal deficit will have a negligible impact on US real gross domestic product
(GDP); it will mainly increase domestic consumption; and as experience in the
recent years has shown, it will end up stimulating, through classical
multiplier effect, China, Japan, and commodity-producing countries.
In other words, Obama's plan will end up creating most of the 3.5 million jobs
outside the US, and far fewer jobs domestically, something that we have
witnessed with the unemployment rate rising significantly above anything that
the administration had expected. The administration's senior advisors had
predicted a maximum unemployment rate of about 8%, while we predicted
double-digit unemployment, cresting in the 11-12% range. The unemployment rate
has already hit 10.2%, falling back to 10%, and most economists predict that it
will go up again.
On the other hand, if foreign financing were discouraged by ridiculously low
interest rates and fears of an expected further depreciation of the US dollar,
the fiscal deficit would have to be financed through monetization. This
scenario is the most likely and the most detrimental. If it materializes, it
will trigger inflationary dynamics that will be difficult to control, with a
depreciating US dollar and a rapidly falling real economy.
The third policy to tackle the economic crisis was financial reform. The White
House adopted a limited range of reforms, including a new agency to protect
borrowers from abuse by lenders, granting the Fed extensive new powers to
monitor the financial sector, enabling the Federal Deposit Insurance
Corporation to deal with non-bank as well as bank financial failures, requiring
financial brokers to act in the interest of their clients, and new reporting
requirements for derivative trading.
On December 11, the US House of Representatives by a narrow margin adopted most
of these proposals on a watered-down basis. It is unlikely that the Senate will
go even this far. Moreover, it should be noted that little has been done to
break up the firms that are too big to fail, to revamp the board of directors
of financial institutions to eliminate conflicts of interest, to separate the
position of chairman and CEO, to afford stockholders a vote on executive pay,
and most importantly to close the revolving door between Wall Street and the
government.
As long as Wall Street executives dominate the federal financial
decision-making process and contribute vast sums to election campaigns, the
needed reforms will not be adopted. The large firms were rescued. They were not
penalized. They have amassed fortunes - just look at what has happened to the
equity of the partners in Goldman Sachs since the firm went public. They will
just keep repeating their risk taking activities at our expense.
G-20 and IMF policies
While the US has travelled the path outlined above, others have adopted some of
the same policies as indicated by the stand of the Group of 20 (G-20)
countries. Most strikingly, with a view to inflating their way out of debt and
precluding price deflation, money creation has been proceeding at unprecedented
rates in the major countries: 18% in the US, 14% in the euro zone, 14% in the
UK, and 29% in China. Only Japan has been cautious, at less than 1%.
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