Greed Exposed : The 'Naked Credit Default Swap'

"Greed" (2006). Mixed media from natalie.org.
What they are and why they should be banned:
Naked Credit Default Swaps

By Ted McLaughlin / The Rag Blog / May 21, 2010

Don't let your eyes glaze over and stop reading this post because you don't know what a "naked credit default swap" is. This is very important and I'll try to make it easily understandable. It is important because these "naked credit default swaps" are one of the major reasons for Wall Street troubles that kicked off this recession, and if nothing is done about them, we could easily see a repeat of these problems in the near future.

First, let us examine what a "credit default swap" (CDS) is, and then what a "naked credit default swap" (NCDS) is. Say a company needs to raise some money, so they create some bonds and sell them. A second company (or individual) buys those bonds, but gets to thinking that they'd like some protection in case of the bond-seller failing to redeem the bonds. They buy an insurance policy that protects them if the bond-seller defaults on the bonds. This insurance policy is called a CDS.

Now I don't really have a problem with CDS's, since the buyer of the bonds should have the right to protect their investment. The problem starts with the NCDS's. These are insurance policies on those bonds that are bought by someone who didn't buy any of the bonds. They would not lose a single penny if the seller defaulted (failed to redeem) the bonds, because they don't own any of the bonds.

Those who buy a NCDS are not trying to protect any investment they made (because they didn't make any investment). They are simply making a cheap bet that the bonds will default. If the bond-seller doesn't default, they are out a small fee, but if the default happens then they stand to make many millions of dollars. To put it bluntly, they are betting against the economy.

And this actually happened during the failure of the financial institutions on Wall Street. Many people who did not have an interest in those institutions made millions of dollars (sometimes hundreds of millions) because they had bet against the financial institutions (and our economy) by buying NCDS's. While these people got rich over other's misfortunes, the NCDS's just made the whole economic situation worse for everyone else (including the people on Main Street who had no interest in Wall Street).

Let me use an analogy. If you own a house, laws prevent me from buying insurance on your house. That's because I don't have a legitimate interest in your house. If your house burns down, I won't be out any money. You are the only person who will lose if your house burns down, and that is why you are the only person who can buy insurance on that house (to protect your investment). That's just common sense. I shouldn't have the right to get rich off your misfortune, while you just get reimbursed for your loss.

But the same rules that apply to you and me don't apply to Wall Street. Why? That's simple -- GREED! They have fixed the rules so they make money regardless of what happens to the economy. Even worse, they make money off the misery of others without any danger of losing their own money (as would happen if they actually had to make an investment). And the Wall Street financial gurus let this happen because they get fees on the sale of these NCDS's, which increases their own salaries and bonuses.

Why should you care about this? Because it is your tax dollars that bail out the financial and insurance giants when it all comes crashing down (just like last time). Consider this. There is currently, according to Senator Byron Dorgan (D-North Dakota), about $10 trillion (yes, I said trillion) worth of CDS's bet on the performance of Wall Street's giant banks, and the holdings of these banks are guaranteed by the taxpayers (just like your community bank).

The problem is that 80% of these CDS's are NCDS's -- people betting they can get rich off the failure of these banks (or at least the failure of their bonds). And if that happens, it is the taxpayers who will get stuck with the bill. And while the taxpayer is footing the bill to make these people rich, our economy takes another nosedive -- perhaps even worse than the one we are currently in. It cost us 12 million jobs this time. Can we survive the next one?

This is a problem that has a simple solution. The solution is simply to outlaw NCDS's. Limit the "credit default swaps" to the people or companies that actually have an interest in protecting themselves from a default -- that is, the buyers who would be hurt by a default. But don't let those without a legitimate interest purchase a "naked credit default swap." Don't let them bet against our economy.

Sadly, the current financial reform bill being considered by the Senate does not ban the NCDS's. Senator Dorgan has proposed an amendment that would do this, but he cannot get the Senate to even consider his amendment. He is being ignored by both Democrats and Republicans. It looks like the $1 million a day that Wall Street has sunk into lobbying is paying off for them.

The financial reform bill does contain some good things, but it doesn't get down to the real reform that would keep the Wall Street disaster which caused our country's economic disaster from happening again. A good start on this would be to ban NCDS's. But at this point it doesn't look like that will happen.

It would be nice if our senators cared as much about Main Street as they do about Wall Street, but it doesn't look like that's a possibility either.

[Rag Blog contributor Ted McLaughlin also posts at jobsanger.]

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Psychology of Greed : Protecting the People from Wall Street

A rebuttal of sorts:
Protecting the people from Wall Street

By Steven Porter / The Rag Blog / April 23, 2010

[On April 21, The Rag Blog published an article by Sherman DeBrosse entitled Republican Jujitsu : Protecting Wall Street from the People.]

To argue that the abuses of Wall Street lie at the feet of one political party or another really avoids a deeper issue with which our nation must eventually come to grips. The issue is the psychology of greed which is the progenitor of the abuses. And it is a psychology which is part of our entire nation.

Greed is a neurosis which is not characterized by party label, gender, religion, age, sexual orientation, or any of the other considerations of which the pundits often talk. It is a cultural phenomenon whose roots are in the child-rearing practices and sociological landscape of the society. Both Freud and Karen Horney discuss the process, Horney most eloquently in her book The Neurotic Personality of our Time.

The lies and manipulations which often accompany greed cannot really be legislated. Morality and immorality are not determined by what laws are passed. In fact, given a sufficient lust for the immoral, laws are more often simply things to circumvent rather than statutes to obey.

That said, if immorality cannot be halted by law, it can certainly be prosecuted by law, and that seems to be the great weakness of our government. It is a weakness because Congress is also one of the foxes guarding the chicken coop of finance.

The foxes on Wall Street and those in Congress have been allies for years, as anyone who looks at the record will see. The alliance has taken two traditional paths: campaign contributions from the financial industry to candidates for Congress (by the billions -- see www.opensecrets.org) and a revolving door between top financial executives and top government officials.

Goldman Sachs, the focus of our current dilemma, is a particularly egregious offender in this regard having placed more than 45 of its top people in government (including both Rubin and Paulson who went from GS CEO positions to Secretary of the Treasury).

The appearance of President Obama on Wall Street as a spokesperson for a greater fiscal morality is simply laughable. It is part of a charade being played out by all parties to make it seem like the interests of the people are being looked after. Let us remember that it was Obama who eschewed the 2008 campaign spending limits he once proclaimed he would uphold. Let us remember that it was Obama who took $1 million in contributions from Goldman Sachs in the 2008 campaign.

Not that I am saying anything about Obama which is not true of the other candidates. The system has been rigged to aggrandize the greed of special interests, and candidates in both major parties are willing participants.

The question of what we do to protect ourselves against the abuses of the finance industry is thus a far more complex one than the passage of any single piece of legislation. It involves the psychological metamorphosis of our culture from one of spendthrift instant gratification to one of what psychologist Eric Berne called "more Adult behavior."

To rail against the fiscal and governmental corruptors is to miss the real point. To quote Mr. Shakespeare yet again, "The fault is not in our stars, but in ourselves."

[Dr. Steven Porter holds BS, MA, PhD, and PD degrees in fine arts and educational administration. He was the Democratic Party candidate for Congress in Pennsylvania's third district in both 2004 and 2006. His new book is entitled Preserving America: ten things we must change to survive.]

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Republicans : Choosing Wall Street Over Main Street

Graphic from USA Today.
The Republicans and financial regulation:
Choosing Wall Street over Main Street

By Ted McLaughlin / The Rag Blog / April 22, 2010

It's no secret to anyone what kicked off the current recession in America. It was the financial industry and Wall Street that were so greedy that they were willing to throw the entire country under the bus as long as they could keep making their fees and bonuses. They were so concerned with making their own money they even put their own companies at risk to make a fast buck.

Of course, this couldn't go on forever. Wall Street had convinced Americans that rules were in place that would prevent a financial meltdown like what happened in 1929 and led to the Great Depression. To hear them talk, land and housing values would keep rising forever, the stock market could not bottom out and lose billions of dollars, and the financial industry was too big and smart to fail. None of that was true.

Their greed finally caught up with them. Some companies folded (like Lehman Bros.) and others would have folded if they hadn't been bailed out by Republican President George Bush creating a $700 billion bailout to keep them afloat. This huge failure by Wall Street banks, brokerages and insurance companies led us into the worst recession since the 1930s. Over 12 million jobs were lost and the economy's failure was felt in every state and city throughout the country.

After the $700 billion of taxpayer money was pumped into Wall Street, they are now back to their old ways. The stock market is going up, outrageous salaries and bonuses are being paid to the executives, and we are probably well on our way to another financial meltdown in the future because nothing has been changed. And that seems to be the way Wall Street wants it, because they're pumping over a million dollars a day into lobbying against any changes or new regulations.

But the American people know better. They know that changes on Wall Street must be made and the financial industry must be more closely regulated, because they have shown that they are clearly incapable of controlling their own greed or policing their own industry. This is even true of the teabaggers. While it is true that they are unhappy with government, they are equally unhappy with Wall Street and unhappy that while the financial companies have recovered, ordinary Americans are still mired in the recession.

That's why I am so puzzled that congressional Republicans are now siding with Wall Street against the ordinary citizens on Main Street. President Obama is trying to get some new regulations passed to rein in some of the most egregious abuses on Wall Street. I think he should do even more than he is proposing, but his proposals will make a good start and bring at least a modicum of sanity back to Wall Street.

But the president may be unable to get his new financial regulations through Congress. This is because the Republicans have decided they are against any reform of Wall Street. That should tell any observer where most of that lobbyist money is going.

Senator Chris Dodd (D-Connecticut) is chairman of the Senate Banking Committee and one of those pushing for new regulations on the financial industry. However, he has received a letter from the Senate Minority Leader (who receives more funds from Wall Street than any other senator) telling him that the Republicans have 41 votes to oppose regulating the financial industry. In fact, he claims they can even prevent Democrats from debating financial reform.

I think the Republicans, while they may be filling their campaign coffers off of Wall Street, are making a big mistake. They are underestimating the rage that the average American feels toward Wall Street and the financial giants. Maybe they think the next election will be fought over health care reform, and they can keep the public's mind off of Wall Street and our jobless economy caused by Wall Street. They are wrong.

The health care reform is old news, and the more people learn about it, the more they will like it -- or at least accept it. The next election will be fought over the economy, and the bill that will be freshest in the minds of voters will be the effort to regulate Wall Street and rein in some of their greed. They are not going to be happy with the protectors of Wall Street.

I think the Republicans are giving the Democrats a great campaign issue. I hope the Republicans continue their efforts to protect Wall Street greed, because it gives Democrats an issue to pound them on. Democrats should repeat over and over again that it is the Republican Party that opposes financial reform. They should make it clear that the Republicans are the ones blocking help for ordinary Americans and acting to protect the rich Wall Street corporations. The issue for Democrats should be simple:

THE REPUBLICANS HAVE CHOSEN WALL STREET OVER MAIN STREET!!!

[Rag Blog contributor Ted McLaughlin also posts at jobsanger.]

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State of the Union : What Obama Must Do

Obama's State of the Union must address:

• Creating jobs
• Reducing the deficit
• Re-regulating the banks

By Sherman DeBrosse / The Rag Blog / January 25, 2010

People are enraged by the bonuses the banks are handing out, and many think the Obama administration is too cozy with Wall Street. Many believe Obama has not done enough to address unemployment.

The State of the Union message will give President Barack Obama an opportunity to redirect the nation’s political discourse. He should focus on job creation, propose tougher regulations on the financial sector, and suggest means of cutting costs and raising needed revenue.

Creating jobs

A jobs package should center on New Deal-style work relief projects and tax incentives for small businesses to hire more people.

Tax incentives should be created to reward small businesses for creating new jobs. They could be partly based upon total increases in payroll so that firms would not be rewarded for firing one person and hiring someone else.

Credit has dried up for small business. The banks are unlikely to do much to remedy this situation. Many must amass cash to cover bad assets, and others are more interested in investing in other banks or in complex financial instruments . The administration must find ways to recycle recovered TARP money into Small Business Administration loans. SBA procedures must be streamlined, and it might be necessary to find ways for the SBA to make the loans directly.

Work relief projects could resemble the New Deal’s Civilian Conservation Corps and National Youth Administration projects. Some could work through states and municipalities as did the more recent CETA operations.

Manufacturing employment preservation

This is the time to propose repealing legislation that held out incentives to export jobs. Such legislation has been on the books since the post-World War II years when we were trying to fight communism by building up economies abroad. The last serious effort to repeal this legislation was the Hartke Bill, which Gerald Ford vetoed shortly after becoming president.

Raising funds

Obama’s coming State of the Union address will disappoint many if he does not deal with obscene bonuses in the financial community. For one thing, they soak up funds that will be needed to keep lending and absorb losses. The president should propose legislation taxing bonuses at a higher level. Present tax law treats bonus income the same way capital gains are handled. At the very least, that provision should be repealed so that these people no longer get that very low tax rate. Even better would be to tax the bonuses at a 50% rate.

So far, it appears that the administration is thinking about applying the Medicare payroll tax to investment income. That is a good idea as long as it does not penalize ordinary retirees living off their investments. Perhaps the tax should kick in at the $60,000 level.

Another means of raising funds to reduce the deficit is to levy excess profits taxes on all sectors of the health care industry, including health insurance providers. Excess profits taxes should also be enacted for the petroleum and natural gas industries.

German Finance Minister Peer Steinbruck has proposed a global financial transaction tax of .05 % ( half a percent) that would be applied by all the G20 countries. It should be applied whether or not the transactions occur on recognized exchanges. Some have estimated that it would raise for the Treasury over $600 billion annually. This would include derivatives.

It is unlikely that all 20 nations will agree to it. The Obama Administration seems to prefer a fee on the liabilities of banks and investment companies. It should apply across the board to institutions that took TARP money and those that did not. The president says this should only cover losses from the TARP program. The tax would discourage excessive leveraging in the future. He should consider making the fee permanent.

Moreover, we need to recover more of that money lost through the TARP program. The collapse of the financial system triggered a deep recession, which made necessary a large stimulus package. In addition, bank bailouts since 1980 have cost about $14 trillion in obligations undertaken by the Fed and Treasury. It is high time we begin to recover some of that money.

Obama should make it clear that he will not accept an extension of the Bush tax cuts, which run out this year. He should call for reenactment of an inheritance tax with large carve-outs for family farms and small, family owned businesses.

Fixing Medicare

By all accounts Medicare is fast approaching collapse. One reason is that we lose about $60 billion in fraudulent claims every year. Another reason is that Medicare Advantage, essentially a subsidy to the health insurance industry, is too great a burden.

The president should propose legislation allowing Medicare providers to negotiate for drug prices and establish a formulary with approved medicines. Since this legislation involves the spending of federal funds, it should go through the Senate via the budget reconciliation process to avoid a filibuster.

A great deal more must be invested in hiring people and creating mechanisms to detect Medicare fraud.

If health care reform does not pass, the president should pledge to use administrative means to reduce losses through Medicare Advantage. The current health reform plans have provisions to gradually trim Medicare Advantage.

Even if health care reform somehow passes, it will be in a form that does too little to control costs. Obama should propose legislation that will do more to control medical expenses that are ultimately funded by the federal government. This should include repealing the exemptions from anti-trust legislation now enjoyed by the medical insurance and medical liability insurance industries.

Financial system reform

Senator Dick Durbin said that the banks own Congress, but there is now enough public anger at the banks to enable Congress to pass some reforms.

At the very least, banks that are federally insured or hold our savings should not be permitted to export our money or use it for speculation in stocks, complex financial instruments, and hedge funds. President Obama should reverse his position on creating a Financial Consumer Services Protection Agency, even though Congress might lack the spine to follow his lead.

No doubt Obama will endorse financial regulatory legislation now going through Congress. As the economy improves, there will be more pressure to derail it. He needs to press for rapid passage. Above all, it must include provisions for rapidly placing commercial and investment banks into federal receivership when they face failure. Reregulation should include a ban on ordinary commercial banks gambling with our savings. Much of Glass-Steagall should be restored.

President Obama must urge the independent regulatory agencies to be more vigilant and vigorous in enforcing existing regulatory legislation. He should promise that the Justice Department will focus upon finding and prosecuting those who are guilty of fraud

We must begin to regulate derivatives trading. They should be handled in an open market and there should be no “dark market” where some are traded out of sight, and no entities should be allowed to continue dealing with them in unregulated over the counter trades. The legislation now going through Congress has too many loopholes and invites more abuses and future crashes.

The President’s allies in Congress should begin investigating why Goldman Sachs received 100% compensation for its exposure while AIG had to liquidate many assets under the worst possible circumstances.

Political implications

These steps represent good beginnings for reregulating the financial sector, containing medical care costs, bringing in more revenue, and creating jobs. They will not completely stem the perfect political storm that was building all last year and became obvious to all with the recent election of Senator Scott Brown in the Bay State.

The reregulation of banks will give the GOP still another advantage -- full campaign war chests for the coming by-elections.

Progressives need to appeal to economic populism while beginning the slow and difficult process of explaining to voters how our economy and financial system became so fragile. This is a long-term process, and they need to learn a great deal about message management and cognitive science. Republicans are light years ahead in these areas, and their task is so much easier because their success rests on playing to impatience -- and to the independents with their disinclination to examine anything closely.

The November elections will not be a happy time for Democrats, but they face great long term challenges. The GOP could produce a favorable political realignment by 1) continuing to reenergize its base, 2) continuing to promote what sociologists call a crisis of legitimacy, and 3) continuing to insist that our economic woes are the result of Democratic policy. If you insist on anything long enough, people will believe it.

Continual obstructionism has created the impression that government cannot produce desired results, and a legitimacy crisis usually hurts those in power. A long-term realignment is possible because, at some level, voters are beginning to realize that the long term prospects for the middle class are not good. When that finally sinks in, someone will pay the price.

[Sherman DeBrosse is a retired history teacher and a regular contributor to The Rag Blog.]

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Fixing the Economy? Like Filling a Leaky Bucket

"Old tin bucket." Photo by {JO} / Flickr.
Bucket's got a hole in it:
Can we revive the U.S. economy?

By Roger Baker / The Rag Blog / December 13, 2009

Is trying to fix the U.S. economy like trying to fill a leaky bucket? So it seems. The money the U.S. government is printing is not getting down to the grassroots to create jobs. The lack of liquidity and credit is creating a deflationary spiral, a self-perpetuating economic contraction.

The financial tools being used to revive the domestic economy are having little effect. The main tools being tried are the Keynesian stimulus aimed at creating domestic jobs; the guaranteeing of existing commitments like bad home loans and social security; and the very low prime rate accessible to major bank lenders for both domestic and international loans.

Keynesian stimulation is primarily a domestic stimulus effort, a policy which by itself and used alone on a large scale could be quite effective in doing things that need to be done. However, the Congressional Republicans are trying to block more stimulus at a time when much more is needed to stop the deflationary spiral. Here is how Nobel prize winning economist Joseph Stiglitz sees the current situation:

Nobel Prize-winning economist Joseph Stiglitz urged U.S. lawmakers to use “overwhelming force” to cut a 10 percent unemployment rate that is forecast to rise...“Unless action is taken, we risk facing a vicious cycle: unemployment contributing to a weak economy, more mortgage foreclosures, more bad debts, lower demand, and possibly more, but certainly not less, unemployment.” Stiglitz said priorities for spending should include extending unemployment benefits, aiding states facing revenue shortfalls, giving tax credits for weatherizing homes, government jobs programs and research and technology initiatives...

The Keynesian stimulus package is at the same time dwarfed by a much bigger pot of money: the global finance system, largely managed by the bankers who got us into trouble. Here is what Stiglitz goes on to say about that:

...Stiglitz, 66, also said the Federal Reserve contributed to the financial crisis by failing to supervise banks or stem the housing bubble. He questioned proposals to give the central bank more authority to supervise firms whose failure might threaten the financial system. “Giving more power to an institution which has failed so miserably, with results that have imposed such costs on all of us, cannot be the right solution unless there are deep and fundamental reforms in the institution, of a kind that are beyond those currently being discussed,” he said.

In other words, the net effect of the amount of Keynesian stimulus we are likely to get is unlikely to do much good if we are not also reforming the banking system. All the money the U.S. government obligates should be pulling in the same direction. At least the immediate prospects for deep reform of the financial system are not good. Matt Taibbi, who just wrote a devastating critique in Rolling Stone titled "Obama's Big Sellout,” documents the incestuous relationships between the bankers and their government regulators, who are now increasingly associated with the Obama administration.

Why aren’t the bank failures being followed by reform, with bank nationalization as an option? The problem is more one of politics than of economics. The U.S. government through its bailout policies is in real control of the banks through our legal system. This Atlantic article explains the same situation from a slightly different perspective.

And here's an overview of the economic situation by an IMF banker. It explains how the U.S. adopted a system of political control by the banking oligarchs; the U.S. is beginning to resemble a third world country in its pattern of entrenched corruption. The thesis is that the current entrenched banker-ocracy will do anything to block reform. The bankers and their political allies are unwilling to step aside, thus blocking adoption of a rational economic cooperation policy based on the needs and desires of the vast majority of the public.

Why do we not take full charge of their management in the public interest? Do we want to keep pretending the banks are solvent using phony profits and non-transparent financing? Or do we have the courage to face reality, to declare the likely bankrupt banks like Citibank insolvent, and then get to the heart of fixing the problem with strict controls, much as prominent Keynesians like Krugman and Galbraith advocate?

The TARP bank bailouts greatly favored the banks while obligating future taxpayers to bear the burden, but there as little reform to benefit the taxpayers in return. The policy of cheap and easy Federal Reserve credit remains, with a prime lending rate down around zero percent. Bernanke says he is going to try to keep this going. Meanwhile, the U.S. government, the big investment banks, and the multinational corporations are first in line for low interest rate loans. This is the Wall Street Journal complaining about the situation:

The Federal Reserve implemented an emergency monetary policy after the 2008 Lehman bankruptcy to salvage the world financial system. In his testimony yesterday... Ben Bernanke said, 'We must be prepared to withdraw the extraordinary policy support in a smooth and timely way as markets and the economy recover.' This leaves all-out emergency monetary stimulus in place, but with a different, much weaker justification.

With the system stabilized, the Fed hopes that artificially low interest rates and its purchases of mortgage-backed securities [MBS] will spur growth. Instead they are pushing dollars abroad and wasting precious growth capital in asset and commodity bubbles... more than a year after the heart of the panic, the Fed is still promising near-zero interest rates for an extended period and buying over $3 billion per day of expensive mortgage securities... Capital is being rationed not on price but on availability and connections.

The government gets the most, foreigners second, Wall Street and big companies third, with not much left over. The irony of the zero-rate policy, coupled with Washington's preference for a weak dollar, is a glut of American capital in Asia (as corporations and investors shun the weakening U.S. currency) and a shortage at home... Much of its current stimulus is being diverted to commodities and foreign economies - hence Asia's complaint about bubbles ... Wall Street will threaten a tantrum if the Fed even thinks about damping the air-raid sirens. The Street utterly loves the Fed's largess ...

Under current unreformed and unregulated conditions, no matter how much cheap low interest rate money is available for loaning out, the banks try to seek out their highest profit. Bankers are, after all, in business to make as much money as possible on their loans. A fast return, high profit loan by a bank is always going to win out over a slow return, low-profit-anticipated loan. This will be so until banking is made to change by externally imposed laws and regulations.

The consumer spending portion of the U.S. economy is continuing to deflate with no obvious recovery stage in sight. Consumers spend most of the total U.S. GNP on personal goods, but the high unemployment and consumer debt mean that there are few profitable domestic loan opportunities in the USA anymore, especially for small businesses catering to the consumer economy.

People are only buying what they really need and not much else. Contraction in this Main Street sector is indeed holding wage inflation down, but at a high social cost in what has become an increasingly service-based U.S. economy. Cheaper U.S labor, delivered through increasing poverty and wage competition, does not translate into more profitable bank loan opportunities so long as U.S. wages remain far above Chinese wages.

A new banking reform bill has just made its way through the House of Representatives. However, on close inspection it looks like token reform, falling far short of the reforms suggested above by Stiglitz. As one example, the bill calls for an audit of the Federal Reserve system, but not for another two years. Another mismatch stems from the fact that we live in a world of international banking. A world that needs international banking reform to coordinate the global economy properly, as Financial Times points out here. The U.S. doesn’t dominate the global economy any more, nor can we fix it on our own.

The leaky bucket

Back to the leaky bucket syndrome. Since the domestic economy is no longer a lucrative source of profit, bank loans are no longer attracted toward domestic investments that might create jobs and help restrain deflation. The opportunities for banks to make much profit on traditional domestic investments involving average people are rare.

Given this situation, we can see why making easy money available through the Federal Reserve is like trying to pour money into an old tin bucket. The theory is that the dollars circulate and stimulate additional general consumer demand, called the "multiplier effect.” The problem is that the money tends to head offshore. Not enough stays to revive domestic demand alongside the relatively insufficient Keynesian stimulus.

The easy money and stimulus the government creates is tending to leak outside of the country into foreign loans, equities and commodities. The guys managing private money watch the fed and the treasury extend credit to prop up all sorts of bad investments and government entitlements. They realize that the total accumulation of U.S. treasury debt is so large that it may never be paid back by the aging population of taxpayers. It looks like U.S. debt may have to use shrunken, devalued dollars as a likely alternative to government default.

The banking investment outlook is different with regard to bank investments in foreign debt, foreign equities, and commodities. The biggest U.S. banks often make loans to corporations that then use the money for profitable investments abroad. A lot of production in the U.S. biotech industry is now relocating to China, with the parent companies evolving into domestic sales outlets. Loans to such companies tend to stimulate foreign economies rather than the domestic economy.

If you buy commodities, you are often stimulating foreign mining and manufacture in the country of production; most commodities (where are we competitive except wheat soybeans, and Boeing airliners?) are largely produced outside the USA. We are now seeing broad price inflation of many commodities since about March 2009, with a rise of about 30-40% so far in just this year.

Those who see this handwriting on the wall are clearly buying metals and commodities which tend to preserve wealth, while dumping their dollars. The rising gold prices is a fundamental sign that people don’t trust dollars to hold their value, so they buy gold, which has always held its value and preserved wealth.

This is an obvious sign that the psychology of the rich guys who run the world is shifting away from the U.S. service economy, to favor the emerging economies of Asia, etc. There is now a global asset bubble that attracts speculative investments in commodities.

This applies to oil too. With annual global oil depletion of about 5%, and a production cushion of perhaps 5 million barrels a day of spare capacity (we have to guess the number), we are probably due for another economy-crippling oil price spike within just a few years. This will happen sooner if the global economy "recovers.” However oil dependence is so basic to the global economy that a tight market and another oil price spike probably cannot be delayed much in any case.

Hope for change?

Not facing reality with regard to the finance system and turning to printing money and phony bank profits could be extremely destructive before long, probably within the next few years. This will most likely be reflected in higher federal interest rates. Why not simply mandate that the banks that get government bailouts must do the stuff that really needs to get done, like setting up nationwide medical clinics, or cooperative community gardens, or homeless relief centers?

The public is now figuring out some of the right answers on its own. People say what they want when they are asked in the polls. The fact that the politicians, who determine how the banks are regulated, are resisting making these changes points to the heart of the problem.

Americans want their government to create jobs through spending on public works, investments in alternative energy or skills training for the jobless.

They also want the deficit to come down. And most are ready to hand the bill to the wealthy.

A Bloomberg National Poll conducted December 3-7 shows two- thirds of Americans favor taxing the rich to reduce the deficit.

Even though almost 9 of 10 respondents also say they believe the middle class will have to make financial sacrifices to achieve that goal, only a little more than one-fourth support an increase in taxes on the middle class. Fewer still back cuts in entitlement programs such as Social Security and Medicare or a new national consumption tax...

If this is what most of the public wants, why is bank nationalization not an option? The problem is more one of politics than of economics.

The government through its bailout policies is in real control of the banks, so why do we not take full charge of bank management in the public interest? Do we need to keep pretending that the banks are solvent or do we have the courage to face reality? Why not declare key banks insolvent, and get to the heart of fixing the problem through strict bank controls, much as prominent Keynesians like Krugman and Galbraith advocate?

If by some political miracle progressives had been put in charge of dealing with the U.S. economic crisis in mid 2008, what might they have done differently? Probably the initial acute part of the current crisis should have been treated with an injection of liquidity and deficit spending along Keynesian stimulus lines to prevent a chain reaction banking panic. This did happen. But there was little followup in terms of fixing the policies that caused the problem.

Given a U.S. political system polarized between two parties, and one in which political influence peddling and lobbying influence plays a large and ongoing role, the bankers have been able politically to resist banking reform. This is now widening into a deep and fundamental conflict between a wealthy oligarchy, with its power centered on finance, and the broad economic interests of the American public.

Why no trials for the most culpable bankers? If Citibank cannot survive without phony profits, why not nationalize it? Unreformed, poorly regulated banks too big to fail are probably a bigger threat than foreign terrorists. I think the proper smart solution is either to break up or to nationalize too-big-to-fail banks so the money gets spent on the low profit things we need in this country. This would send a sign that the public is in charge, and not the banker-ocracy that caused the problems.

If Karl Marx were still around as an observer, I think he would see this as the historically defining class struggle of our times. A conflict between the bankers and their private but destructive interests, in opposition to the public interest of the vast majority, both domestic and globally.

Call it what we will, there is a deep and fundamental problem that our current political institutions seem unable to resolve. This situation is unlikely to change. Not without broad public pressure and political organization generated by most of the 6 billion of us trying to survive in a world run by bankers; those taught to profit by trying to perpetuate infinite growth on our finite planet.

[Roger Baker is a long time transportation-oriented environmental activist, an amateur energy-oriented economist, an amateur scientist and science writer, and a founding member of and an advisor to the Association for the Study of Peak Oil-USA. He is active in the Green Party and the ACLU, and is a director of the Save Our Springs Association and the Save Barton Creek Association. Mostly he enjoys being an irreverent policy wonk and writing irreverent wonkish articles for The Rag Blog.]

Also see:

• Roger Baker: Can the Economy Recover? by Roger Baker / The Rag Blog / December 4, 2009
• Economy and Unemployment : Real Recovery a Long Shot by Roger Baker / The Rag Blog / December 6, 2009

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Economy and Unemployment : Real Recovery a Long Shot

Photo from OOlaah.com
Real unemployment nears depression levels;
Sustained recovery appears unlikely

By Roger Baker / The Rag Blog / December 6, 2009

It should come as no big surprise that our economy is in worse shape than the U.S. government would like to admit. Lets start out by looking at the current U.S. economic situation.

John William's Shadow Government Statistics argues that the REAL unemployment rate is about 22%, with an obvious upwards momentum that can be seen on the unemployment chart. This figure is calculated in such a way as to roughly correspond to earlier times. We had about 25% national unemployment during the great depression in 1932, when FDR was elected.

This video graphically shows the current dynamics of unemployment spreading geographically:



There are now numerous areas of high unemployment in the USA, with a severity no doubt comparable to the great depression. The portion of the population dependent on food stamps is soaring. A quarter of the children in Travis County, Texas, now receive food stamp support as this interactive map from The New York Times indicates.

From the same Times article:

With food stamp use at record highs and climbing every month, a program once scorned as a failed welfare scheme now helps feed one in eight Americans and one in four children.

Another way to view our depressed economy is in the recent contraction of the banking credit market -- a type of funding source close to small business and the average consumers who mostly drive the US economy. Look at the credit chart in this article form the Asia Times:

A 20% decline year on year does not look like a recovery. In fact, it looks like nothing we have seen since the Great Depression. C&I loan growth lags the end of recessions, to be sure, but this extreme level of credit reduction suggests profound trouble.

35% or so of Americans work for enterprises with fewer than 100 employees, and 20% work (or used to work) for firms with fewer than 20 employees. The percentages of employment in smaller firms (less than 100 employees) are much higher in real estate (46%) and construction (77%) as of the 2004 Economic Census.

It isn’t just the 17.5% broad-measure unemployment number that we should worry about, but the massacre of smaller businesses, who are concentrated in the most vulnerable sectors: real estate, construction, and retail. Retail sales may get a temporary shot in the arm from cash for clunkers, and a combination of tax credits and (de facto) subsidized mortgage rates may hold up the bottom of the housing market for a short time. But today’s data show how fragile these matters are.

In other words, the banks are not lending to support business as usual, because they realize the average American is deep in debt and thus a bad loan risk. This fact drags down other sectors. They say commercial loans will be the next sector to need a bailout. In the case of the "zombie banks," we have the remains of a vastly over-extended sector of the U.S. economy -- the byproduct of unregulated investment bankers competing to issue mountains of leveraged debt based on the capitalist credo of exponential growth forever until 2007. Yet a lot of these junk loans are still on the books.

With all these bad loans, the world of big investment banks looks objectively like a shaky house of cards, a monkey on the back of U.S. taxpayers. What to do? The answer, so far, has been to apply economic band-aids while allowing the banks to generate phony profits.

Does it ever occur to folks that the supposedly recovering banks sure are making a lot of profit on something mighty mysterious for a country that has many of its factories shut down or outsourced, and about 20% real unemployment?

Here is how the phony profit scam works. The Fed’s covert tactic of using monetary policy to recapitalize the banking system is also proving effective, perhaps too effective. By keeping short-term interest rates at or close to zero per cent, it is enabling banks to borrow at minimal cost and to invest the proceeds in higher yielding securities. The “spread” on this trade amounts to a gift from the government, and, because the Fed has promised to keep rates low for the indefinite future, it is almost risk free. Bank of America is making so much money it can afford to give the government 26.2 billion dollars in cash -- or so it says. (The other 18 billion dollars will come from a new issue of convertible stock.)

The downside is that eventually those blessed with the cash are going to take these newly abundant bank profits and try to buy something that is not equally abundant, like maybe oil. Lots of hoarded dollars, not much goods. Under these conditions, and as soon as people start spending freely again, you have a self-reinforcing tendency for commodity prices to soar.

The USA seems at this point to be willfully devaluing the dollar. To the world's many treasury bond holders, like China, this comes as bad news because they are pegged to the dollar, which means this trend degrades the value of their currency at the same time. So the Chinese are now on a global natural resource buying spree using their trillion or so of accumulated U.S. dollars, spending them on mineral deposits like oil, copper, and iron -- things calculated to give a long-term trade advantage before their dollars go bad on them.

Devaluing the dollar has several U.S. government advantages. It makes it easier to compete in trade in those areas where we are still competitive (while making key imports like oil cost more). Second, it is an easy choice for a government to, in effect, just print a bunch of money to pay off the bills. Debt for economic stimulus, bills for wars, for handling the soaring social security costs of an aging population, for paying the bills of a medical system that is impervious to cost reform, for keeping GM afloat, for bankrolling Freddie and Fannie, for backing up bad credit default swaps, for paying off the previous debt, for widespread food stamp support, bank bailouts, keeping the prime rate near zero, and the list goes on. And on.

You don't have to be a genius to see that this economic process, taken as a whole, is unlikely to get the U.S. economy back on track. What it is most likely to lead to is repaying the lenders with effectively shrunken dollars when the treasury debt comes due. As the U.S. government, you have little alternative when already debt-ridden taxpayers who provide the revenue are too far in debt to help by paying many taxes.

Dollar devaluation is a process of the marketplace expressing the supply and demand for our fiat currency. This loss of faith is already being reflected in the soaring price of gold, as central banks stock up on something that has held its value throughout history. When global lenders shun the dollar and buy gold, it really means that the buyers think the dollar is going to shrink in exchange value. Ultimately, on close examination, economics is seen to be a branch of politics. And politics, as we know, is based on psychology.

When gold soars in price like now, it means that the big players who still have dollars to lend to the U.S. government are signaling that they expect dollar devaluation, which means price inflation for internationally traded goods . Before long, lenders are likely to demand more treasury bond interest in compensation for the shrinking dollars paid back on their loans. Although the Federal Reserve is promising to keep interest rates low, there is only so long that they can defy what amounts to an economic law of gravity. Rising interest rates would of course further depress an already depressed U.S. economy.

When you are a government that can make the rules, you can get away with running heavy deficits and generating lots of Keynesian stimulation spending for years. Prominent Keynesian economists like Paul Krugman are urging heavy spending right now. However, both Krugman and most other Keynesians, like University of Texas economist Dr. James Galbraith, insist that this spending must be accompanied by banking reform. In other words, strict rules need to be imposed to stop the U.S. Treasury from becoming even more of a politicized cookie jar than it has already become.

However, the political will to reform the U.S. banking and finance system is still missing. Needless to say, this is an ominous sign. Levy Institute Scholar Galbraith recently reported on an international meeting of mostly-liberal economists, assembled a few months ago to discuss the state of the global economy. Suffice to say that the prevailing mood was not one of optimism. You can read more details of the conference notes here:

A group of experts associated with the Economists for Peace and Security and the Initiative for Rethinking the Economy met recently in Paris to discuss financial and monetary issues; their viewpoints, summarized here by Senior Scholar James K. Galbraith, are largely at odds with the global political and economic establishment.

Despite noting some success in averting a catastrophic collapse of liquidity and a decline in output, the Paris group was pessimistic that there would be sustained economic recovery and a return of high employment. There was general consensus that the pre-crisis financial system should not be restored, that reviving the financial sector first was not the way to revive the economy, and that governments should not pursue exit strategies that permit a return to the status quo. Rather, the crisis exposes the need for profound reform to meet a range of physical and social objectives.

[Roger Baker is a long time transportation-oriented environmental activist, an amateur energy-oriented economist, an amateur scientist and science writer, and a founding member of and an advisor to the Association for the Study of Peak Oil-USA. He is active in the Green Party and the ACLU, and is a director of the Save Our Springs Association and the Save Barton Creek Association. Mostly he enjoys being an irreverent policy wonk and writing irreverent wonkish articles for The Rag Blog.]

Also see:

• Roger Baker: Can the Economy Recover? by Roger Baker / The Rag Blog / December 4, 2009

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Barack Obama : Stop the Runaway Train

President Obama: Stop the runaway train of globalization.
Long range strategic innovation:

Globalization, the financial crisis, environmental planning, and getting out of Afghanistan

By Ray Reece / The Rag Blog / November 5, 2009

Call this a lesson in how to ensure your mail to the White House won't be answered. The following proposal was originally drafted in response to a call for submissions on the Obama Transition Team website. That was back in December, after Obama's election but before his inauguration. "President-elect Obama wants to hear from you," said the website. "Send us your ideas for change."

So we did -- we being the motley band of scholars, activists and free-thinkers scattered worldwide who constitute the nucleus of the organization named below. Ten months later, we're still waiting for a green light from the White House, or at least a form letter. We're not twiddling our thumbs, though. We plan to have a website of our own online by the time Obama delivers his State of the Union address next year. Stay tuned.

Like hundreds of millions of other people around the world, I'm excited by the prospect of having Barack Obama in the White House. I'm a Texas journalist currently working in Italy and Hungary. I'm also a researcher and activist in several spheres of policy and politics, including energy-environment, urban and regional planning, transportation, and, to put it bluntly, the runaway train of globalization.

I have recently joined the board of a new organization of like-minded activists in the U.S. and Europe called the World Coalition for Local and Regional Self-Reliance. In future dispatches, if you are receptive, I will spell out the specific implications of that. For now I want mainly to advance a pair of policy suggestions that arise from the premises of our coalition.

One is based on our conviction that the current approach in Washington to resolving the so-called financial crisis and "getting America back on its feet" is grounded in faulty, obsolete reasoning that will cause it to fail and even be counterproductive in the long run.

We contend that the financial crisis is functionally intertwined with other national and planetary crises, led by global climate change, or GLOCCH, and Peak Oil, the imminent depletion of the fossil fuel resources on which the entire 21st century "global economy" is based. The financial crisis is likewise inextricably bound up with the hyper-suburbanization of American cities, the egregious loss of farmland and other productive capacity, and, yes, globalization and its evil twin, international terrorism.

The latter, we argue, is nothing more or less than a violent response by the oppressed of the world -- oppressed culturally as well as economically -- to those perceived as their oppressors, meaning, above all, the purveyors of economic and cultural globalization on Wall Street and elsewhere, in league with their national governments.

The banking crisis is thus not merely a symptom of lax regulation of financial markets and greedy investors in recent years. It is systemic in nature, and a systemic crisis requires a systemic response. The trillion-dollar stimulus package recently approved by Congress is not a systemic response, since it purports merely to restart the sputtering engine of the failed larger system itself. Rather, or perhaps we must now say in addition to the stimulus package, the whole matrix of primary socioeconomic assumptions and institutions in the United States -- as a starting point and global model -- must be examined, assessed and, over time, fundamentally changed.

Toward that end, as our first policy suggestion, we urge President Obama to establish and fold into his brain trust a new Office of Long-Range Strategic Policy Innovation. This would be the place in the White House where staff would be recruited to "think outside the box," where vision, boldness and creativity would be prized over technical jargon and obeisance to America’s dying corporate mammoths and their powerful defenders in Washington. It is here that independent in-house thinkers, with appropriate input from real-world experts, would incubate the brave new concepts and paradigms the nation and world will need to survive and supercede not only the "financial crisis" but the web of corresponding metacrises mentioned above.

We dare to hope, indeed will strive to ensure, that among the big initiatives generated by a presidential Office of Policy Innovation would be the following:

1. a greatly expanded and modernized national rail system for passengers and freight alike, similar to the European system;
2. transformation of the urban/exurban population grid to a revised geography of small and mid-sized cities and towns that are largely autonomous and self-sufficient in the production of food, energy and other life-support resources;
3. promotion of small organic family and community farms as the mainstay of American agriculture;
4. at the macro level, encompassing all of the above and more, a liberation of human society from its self-defeating enslavement to the imperative of “growth” in favor of sustainability, sharing and reverence for the planet and its threatened wealth of species.

Our second policy suggestion would necessarily be implemented first, partly in order to redirect funds from the military budget to the crucial and expensive federal initiatives implied heretofore. We urge President Obama to make good on his promise to withdraw American military forces from Iraq. We further urge him NOT to nullify the positive effects of that decision by enlarging and prolonging the American-led NATO military presence in Afghanistan. Such a move, we believe, not only would not save Afghanistan from its own Islamic militants, nor strengthen the security of the U.S. and its allies.

It would have the opposite effect -- in fact might well produce a catastrophe on the scale of the wars in Iraq and Vietnam -- while diverting critical funds and other resources from the task of redesigning and rebuilding our own beleaguered society. To buttress our case, we refer you to a pair of recent articles in The New York Times, one a column by Bob Herbert, "The Afghan Quagmire," the second an essay in the Times magazine, "The Worst Pakistan Nightmare for Obama," by David E. Sanger.

Other references, to name but a few, include two books by James Howard Kunstler, The Long Emergency and World Made By Hand; Kunstler’s blog; E.F. Schumacher’s timeless classic, Small Is Beautiful; two books by Kirkpatrick Sale, Dwellers in the Land and Human Scale; Bill McKibben’s End of Nature; everything published by David Morris and the Institute for Local Self-Reliance; everything published by Pliny Fisk and Gail Vittori at the Center for Maximum Potential Building Systems; La Decrescita Felice by Maurizio Pallante and his website.

[Ray Reece is affiliated with the World Coalition for Local and Regional Self-Reliance. He is a former columnist for The Budapest Sun and author of The Sun Betrayed: A Report on the Corporate Seizure of U.S. Solar Energy Development, among other published works. His most recent book is Abigail in Gangland, a novel. He is currently based in Cagli, Italy.]

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Obama's Financial Reform: Just Plugging a Few Leaks Rather Than Repairing the Dam

US Treasury Secretary Tim Geithner told the Senate Banking Committee that he plans to reform the system of financial regulation. Photo: Bloomberg.
Only a Hint of Roosevelt in Financial Overhaul
By Joe Nocera / June 17, 2009

Three quarters of a century ago, President Franklin Roosevelt earned the undying enmity of Wall Street when he used his enormous popularity to push through a series of radical regulatory reforms that completely changed the norms of the financial industry.

Wall Street hated the reforms, of course, but Roosevelt didn’t care. Wall Street and the financial industry had engaged in practices they shouldn’t have, and had helped lead the country into the Great Depression. Those practices had to be stopped. To the president, that’s all that mattered.

On Wednesday, President Obama unveiled what he described as “a sweeping overhaul of the financial regulatory system, a transformation on a scale not seen since the reforms that followed the Great Depression.”

In terms of the sheer number of proposals, outlined in an 88-page document the administration released on Tuesday, that is undoubtedly true. But in terms of the scope and breadth of the Obama plan — and more important, in terms of its overall effect on Wall Street’s modus operandi — it’s not even close to what Roosevelt accomplished during the Great Depression.

Rather, the Obama plan is little more than an attempt to stick some new regulatory fingers into a very leaky financial dam rather than rebuild the dam itself. Without question, the latter would be more difficult, more contentious and probably more expensive. But it would also have more lasting value.

On the surface, there was no area of the financial industry the plan didn’t touch. “I was impressed by the real estate it covered,” said Daniel Alpert, the managing partner of Westwood Capital. The president’s proposal addresses derivatives, mortgages, capital, and even, in the wake of the American International Group fiasco, insurance companies. Among other things, it would give new regulatory powers to the Federal Reserve, create a new agency to help protect consumers of financial products, and make derivative-trading more transparent. It would give the government the power to take over large bank holding companies or troubled investment banks — powers it doesn’t have now — and would force banks to hold onto some of the mortgage-backed securities they create and sell to investors.

But it’s what the plan doesn’t do that is most notable.

Take, for instance, the handful of banks that are “too big to fail”— and which, in some cases, the government has had to spend tens of billions of dollars propping up. In a recent speech in China, the former Federal Reserve chairman — and current Obama adviser — Paul Volcker called on the government to limit the functions of any financial institution, like the big banks, that will always be reliant on the taxpayer should they get into trouble. Why, for instance, should they be allowed to trade for their own account — reaping huge profits and bonuses if they succeed — if the government has to bail them out if they make big mistakes, Mr. Volcker asked.

Many experts, even at the Federal Reserve, think that the country should not allow banks to become too big to fail. Some of them suggest specific economic disincentives to prevent growing too big and requirements that would break them up before reaching that point.

Yet the Obama plan accepts the notion of “too big to fail” — in the plan those institutions are labeled “Tier 1 Financial Holding Companies” — and proposes to regulate them more “robustly.” The idea of creating either market incentives or regulation that would effectively make banking safe and boring — and push risk-taking to institutions that are not too big to fail — isn’t even broached.

Or take derivatives. The Obama plan calls for plain vanilla derivatives to be traded on an exchange. But standard, plain vanilla derivatives are not what caused so much trouble for the world’s financial system. Rather it was the so-called bespoke derivatives — customized, one-of-a-kind products that generated enormous profits for institutions like A.I.G. that created them, and, in the end, generated enormous damage to the financial system. For these derivatives, the Treasury Department merely wants to set up a clearinghouse so that their price and trading activity can be more readily seen. But it doesn’t attempt to diminish the use of these bespoke derivatives.

“Derivatives should have to trade on an exchange in order to have lower capital requirements,” said Ari Bergmann, a managing principal with Penso Capital Markets. Mr. Bergmann also thought that another way to restrict the bespoke derivatives would be to strip them of their exemption from the antigambling statutes. In a recent article in The Financial Times, George Soros, the financier, wrote that “regulators ought to insist that derivatives be homogeneous, standardized and transparent.” Under the Obama plan, however, customized derivatives will remain an important part of the financial system.

Everywhere you look in the plan, you see the same thing: additional regulation on the margin, but nothing that amounts to a true overhaul. The new bank supervisor, for instance, is really nothing more than two smaller agencies combined into one. The plans calls for new regulations aimed at the ratings agencies, but offers nothing that would suggest radical revamping.

The plan places enormous trust in the judgment of the Federal Reserve — trust that critics say has not really been borne out by its actions during the Internet and housing bubbles. Firms will have to put up a little more capital, and deal with a little more oversight, but once the financial crisis is over, it will, in all likelihood, be back to business as usual.

The regulatory structure erected by Roosevelt during the Great Depression — including the creation of the Securities and Exchange Commission, the establishment of serious banking oversight, the guaranteeing of bank deposits and the passage of the Glass-Steagall Act, which separated banking from investment banking — lasted six decades before they started to crumble in the 1990s. In retrospect, it would be hard to envision even the best-constructed regulation lasting more than that. If Mr. Obama hopes to create a regulatory environment that stands for another six decades, he is going to have to do what Roosevelt did once upon a time. He is going to have make some bankers mad.

Source / New York Times

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Charlie Loving: The Banking Lobby

Cartoon by Charlie Loving / The Rag Blog

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Paul Krugman : What to Do

'Once the recovery effort is well underway, it will be time to turn to prophylactic measures: reforming the system so that the crisis doesn't happen again.'
By Paul Krugman

The following article by educator, New York Times columnist and Nobel prize winning economist Paul Krugman appears in the Dec. 18, 2008 isssue of The New York Review of Books.

What the world needs right now is a rescue operation. The global credit system is in a state of paralysis, and a global slump is building momentum as I write this. Reform of the weaknesses that made this crisis possible is essential, but it can wait a little while. First, we need to deal with the clear and present danger. To do this, policymakers around the world need to do two things: get credit flowing again and prop up spending.

The first task is the harder of the two, but it must be done, and soon. Hardly a day goes by without news of some further disaster wreaked by the freezing up of credit. As I was writing this, for example, reports were coming in of the collapse of letters of credit, the key financing method for world trade. Suddenly, buyers of imports, especially in developing countries, can't carry through on their deals, and ships are standing idle: the Baltic Dry Index, a widely used measure of shipping costs, has fallen 89 percent this year.

What lies behind the credit squeeze is the combination of reduced trust in and decimated capital at financial institutions. People and institutions, including the financial institutions, don't want to deal with anyone unless they have substantial capital to back up their promises, yet the crisis has depleted capital across the board.

The obvious solution is to put in more capital. In fact, that's a standard response in financial crises. In 1933 the Roosevelt administration used the Reconstruction Finance Corporation to recapitalize banks by buying preferred stock—stock that had priority over common stock in terms of its claims on profits. When Sweden experienced a financial crisis in the early 1990s, the government stepped in and provided the banks with additional capital equal to 4 percent of the country's GDP—the equivalent of about $600 billion for the United States today—in return for a partial ownership. When Japan moved to rescue its banks in 1998, it purchased more than $500 billion in preferred stock, the equivalent relative to GDP of around a $2 trillion capital injection in the United States. In each case, the provision of capital helped restore the ability of banks to lend, and unfroze the credit markets.

A financial rescue along similar lines is now underway in the United States and other advanced economies, although it was late in coming, thanks in part to the ideological tilt of the Bush administration. At first, after the fall of Lehman Brothers, the Treasury Department proposed buying up $700 billion in troubled assets from banks and other financial institutions. Yet it was never clear how this was supposed to help the situation. (If the Treasury paid market value, it would do little to help the banks' capital position, while if it paid above-market value it would stand accused of throwing taxpayers' money away.) Never mind: after dithering for three weeks, the United States followed the lead already set, first by Britain and then by continental European countries, and turned the plan into a recapitalization scheme.

It seems doubtful, however, that this will be enough to turn things around, for at least three reasons. First, even if the full $700 billion is used for recapitalization (so far only a fraction has been committed), it will still be small, relative to GDP, compared with the Japanese bank bailout—and it's arguable that the severity of the financial crisis in the United States and Europe now rivals that of Japan. Second, it's still not clear how much of the bailout will reach the components of the shadow banking system—largely unregulated financial organizations including investment banks and hedge funds—that are at the core of the problem. Third, it's not clear whether banks will be willing to lend out the funds, as opposed to sitting on them (a problem encountered by the New Deal seventy-five years ago).

My guess is that the recapitalization will eventually have to get bigger and broader, and that there will eventually have to be more assertion of government control—in effect, it will come closer to a full temporary nationalization of a significant part of the financial system. Just to be clear, this isn't a long-term goal, a matter of seizing the economy's commanding heights: finance should be reprivatized as soon as it's safe to do so, just as Sweden put banking back in the private sector after its big bailout in the early Nineties. But for now the important thing is to loosen up credit by any means at hand, without getting tied up in ideological knots. Nothing could be worse than failing to do what's necessary out of fear that acting to save the financial system is somehow "socialist."

The same goes for another line of approach to resolving the credit crunch: getting the Federal Reserve, temporarily, into the business of lending directly to the nonfinancial sector. The Federal Reserve's willingness to buy commercial paper is a major step in this direction, but more will probably be necessary.

All these actions should be coordinated with other advanced countries. The reason is the globalization of finance. Part of the payoff for US rescues of the financial system is that they help loosen up access to credit in Europe; part of the payoff to European rescue efforts is that they loosen up credit here. So everyone should be doing more or less the same thing; we're all in this together.

And one more thing: the spread of the financial crisis to emerging markets makes a global rescue for developing countries part of the solution to the crisis. As with recapitalization, parts of this were already in place during the autumn: the International Monetary Fund was providing loans to countries with troubled economies like Ukraine, with less of the moralizing and demands for austerity that it engaged in during the Asian crisis of the 1990s. Meanwhile, the Fed provided swap lines to several emerging-market central banks, giving them the right to borrow dollars as needed. As with recapitalization, the efforts so far look as if they're in the right direction but too small, so more will be needed.

Even if the rescue of the financial system starts to bring credit markets back to life, we'll still face a global slump that's gathering momentum. What should be done about that? The answer, almost surely, is good old Keynesian fiscal stimulus.

Now, the United States tried a fiscal stimulus in early 2008; both the Bush administration and congressional Democrats touted it as a plan to "jump-start" the economy. The actual results were, however, disappointing, for two reasons. First, the stimulus was too small, accounting for only about 1 percent of GDP. The next one should be much bigger, say, as much as 4 percent of GDP. Second, most of the money in the first package took the form of tax rebates, many of which were saved rather than spent. The next plan should focus on sustaining and expanding government spending—sustaining it by providing aid to state and local governments, expanding it with spending on roads, bridges, and other forms of infrastructure.

The usual objection to public spending as a form of economic stimulus is that it takes too long to get going—that by the time the boost to demand arrives, the slump is over. That doesn't seem to be a major worry now, however: it's very hard to see any quick economic recovery, unless some unexpected new bubble arises to replace the housing bubble. (A headline in the satirical newspaper The Onion captured the problem perfectly: "Recession-Plagued Nation Demands New Bubble to Invest In.") As long as public spending is pushed along with reasonable speed, it should arrive in plenty of time to help—and it has two great advantages over tax breaks. On one side, the money would actually be spent; on the other, something of value (e.g., bridges that don't fall down) would be created.

Some readers may object that providing a fiscal stimulus through public works spending is what Japan did in the 1990s—and it is. Even in Japan, however, public spending probably prevented a weak economy from plunging into an actual depression. There are, moreover, reasons to believe that stimulus through public spending would work better in the United States, if done promptly, than it did in Japan. For one thing, we aren't yet stuck in the trap of deflationary expectations that Japan fell into after years of insufficiently forceful policies. And Japan waited far too long to recapitalize its banking system, a mistake we hopefully won't repeat.

The point in all of this is to approach the current crisis in the spirit that we'll do whatever it takes to turn things around; if what has been done so far isn't enough, do more and do something different, until credit starts to flow and the real economy starts to recover.

And once the recovery effort is well underway, it will be time to turn to prophylactic measures: reforming the system so that the crisis doesn't happen again.

Financial Reform

"We have magneto trouble," said John Maynard Keynes at the start of the Great Depression: most of the economic engine was in good shape, but a crucial component, the financial system, wasn't working. He also said this: "We have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand." Both statements are as true now as they were then.

How did this second great colossal muddle arise? In the aftermath of the Great Depression, we redesigned the machine so that we did understand it, well enough at any rate to avoid big disasters. Banks, the piece of the system that malfunctioned so badly in the 1930s, were placed under tight regulation and supported by a strong safety net. Meanwhile, international movements of capital, which played a disruptive role in the 1930s, were also limited. The financial system became a little boring but much safer.

Then things got interesting and dangerous again. Growing international capital flows set the stage for devastating currency crises in the 1990s and for a globalized financial crisis in 2008. The growth of the shadow banking system, without any corresponding extension of regulation, set the stage for latter-day bank runs on a massive scale. These runs involved frantic mouse clicks rather than frantic mobs outside locked bank doors, but they were no less devastating.

What we're going to have to do, clearly, is relearn the lessons our grandfathers were taught by the Great Depression. I won't try to lay out the details of a new regulatory regime, but the basic principle should be clear: anything that has to be rescued during a financial crisis, because it plays an essential role in the financial mechanism, should be regulated when there isn't a crisis so that it doesn't take excessive risks. Since the 1930s commercial banks have been required to have adequate capital, hold reserves of liquid assets that can be quickly converted into cash, and limit the types of investments they make, all in return for federal guarantees when things go wrong. Now that we've seen a wide range of non-bank institutions create what amounts to a banking crisis, comparable regulation has to be extended to a much larger part of the system.

We're also going to have to think hard about how to deal with financial globalization. In the aftermath of the Asian crisis of the 1990s, there were some calls for long-term restrictions on international capital flows, not just temporary controls in times of crisis. For the most part these calls were rejected in favor of a strategy of building up large foreign exchange reserves that were supposed to stave off future crises. Now it seems that this strategy didn't work. For countries like Brazil and Korea, it must seem like a nightmare: after all that they've done, they're going through the 1990s crisis all over again. Exactly what form the next response should take isn't clear, but financial globalization has definitely turned out to be even more dangerous than we realized.

The Power of Ideas

As readers may have gathered, I believe not only that we're living in a new era of depression economics, but also that John Maynard Keynes—the economist who made sense of the Great Depression—is now more relevant than ever. Keynes concluded his masterwork, The General Theory of Employment, Interest and Money, with a famous disquisition on the importance of economic ideas: "Soon or late, it is ideas, not vested interests, which are dangerous for good or evil."

We can argue about whether that's always true, but in times like these, it definitely is. The quintessential economic sentence is supposed to be "There is no free lunch"; it says that there are limited resources, that to have more of one thing you must accept less of another, that there is no gain without pain. Depression economics, however, is the study of situations where there is a free lunch, if we can only figure out how to get our hands on it, because there are unemployed resources that could be put to work. The true scarcity in Keynes's world—and ours—was therefore not of resources, or even of virtue, but of understanding.

We will not achieve the understanding we need, however, unless we are willing to think clearly about our problems and to follow those thoughts wherever they lead. Some people say that our economic problems are structural, with no quick cure available; but I believe that the only important structural obstacles to world prosperity are the obsolete doctrines that clutter the minds of men.

November 20, 2008

Copyright © 2009, 1999 by Paul Krugman

Source / The New York Review of Books

Thanks to Dr. S. R. Keister / The Rag Blog

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