A former chief economist of the International Monetary Fund, wrote in May 2009 about how depressingly similar the US problems are to emerging economies he has worked with. It’s a provocative article: The Quiet Coup (a few excerpts posted here).
“Anything that is too big to fail is too big to exist.”
The Quiet Coup
The problem is oligarchs who overborrow, become too powerful, and gain too much influence:
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“Wall Street ran with these opportunities [lightweight regulation, cheap money, securitization, interest rate swaps, and I would add, high frequency trading]. From 1973 to 1985, the financial sector never earned more than 16 percent of domestic corporate profits. In 1986, that figure reached 19 percent. In the 1990s, it oscillated between 21 percent and 30 percent, higher than it had ever been in the postwar period. This decade, it reached 41 percent. Pay rose just as dramatically. From 1948 to 1982, average compensation in the financial sector ranged between 99 percent and 108 percent of the average for all domestic private industries. From 1983, it shot upward, reaching 181 percent in 2007.
“The great wealth that the financial sector created and concentrated gave bankers enormous political weight—a weight not seen in the U.S. since the era of J.P. Morgan (the man)… in the banking panic of 1907…
The USA might be the most powerful economy on the planet, but the pattern is similar:
“...inevitably, emerging-market oligarchs get carried away; they waste money and build massive business empires on a mountain of debt.
“The downward spiral that follows is remarkably steep. Enormous companies teeter on the brink of default, and the local banks that have lent to them collapse. Yesterday’s “public-private partnerships” are relabeled “crony capitalism.” With credit unavailable, economic paralysis ensues, and conditions just get worse and worse. The government is forced to draw down its foreign-currency reserves to pay for imports, service debt, and cover private losses. But these reserves will eventually run out. If the country cannot right itself before that happens, it will default on its sovereign debt and become an economic pariah. The government, in its race to stop the bleeding, will typically need to wipe out some of the national champions—now hemorrhaging cash—and usually restructure a banking system that’s gone badly out of balance. It will, in other words, need to squeeze at least some of its oligarchs.
“Squeezing the oligarchs, though, is seldom the strategy of choice among emerging-market governments. Quite the contrary: at the outset of the crisis, the oligarchs are usually among the first to get extra help from the government…
“to IMF officials, all of these crises looked depressingly similar”
The thing that matters to the IMF — the most important point — is whether the government is willing to cut the oligarchs loose:
“So the IMF staff looks into the eyes of the minister of finance and decides whether the government is serious yet. The fund will give even a country like Russia a loan eventually, but first it wants to make sure Prime Minister Putin is ready, willing, and able to be tough on some of his friends. If he is not ready to throw former pals to the wolves, the fund can wait.
The oligarchs work to prevent the reforms that are needed:
“But there’s a deeper and more disturbing similarity: elite business interests—financiers, in the case of the U.S.—played a central role in creating the crisis, making ever-larger gambles, with the implicit backing of the government, until the inevitable collapse. More alarming, they are now using their influence to prevent precisely the sorts of reforms that are needed, and fast, to pull the economy out of its nosedive. The government seems helpless, or unwilling, to act against them.
The line between financial firms and the government has become blurred. It’s not just that members of financial firms are influencing the government, in some senses they are the government:
“One channel of influence was, of course, the flow of individuals between Wall Street and Washington. Robert Rubin, once the co-chairman of Goldman Sachs, served in Washington as Treasury secretary under Clinton, and later became chairman of Citigroup’s executive committee. Henry Paulson, CEO of Goldman Sachs during the long boom, became Treasury secretary under George W.Bush. John Snow, Paulson’s predecessor, left to become chairman of Cerberus Capital Management, a large private-equity firm that also counts Dan Quayle among its executives. Alan Greenspan, after leaving the Federal Reserve, became a consultant to Pimco, perhaps the biggest player in international bond markets.
“These personal connections were multiplied many times over at the lower levels of the past three presidential administrations, strengthening the ties between Washington and Wall Street. It has become something of a tradition for Goldman Sachs employees to go into public service after they leave the firm. The flow of Goldman alumni—including Jon Corzine, now the governor of New Jersey, along with Rubin and Paulson—not only placed people with Wall Street’s worldview in the halls of power; it also helped create an image of Goldman (inside the Beltway, at least) as an institution that was itself almost a form of public service.
The financial institutions get favored treatment:
“Throughout the crisis, the government has taken extreme care not to upset the interests of the financial institutions, or to question the basic outlines of the system that got us here. In September 2008, Henry Paulson asked Congress for $700 billion to buy toxic assets from banks, with no strings attached and no judicial review of his purchase decisions. Many observers suspected that the purpose was to overpay for those assets and thereby take the problem off the banks’ hands—indeed, that is the only way that buying toxic assets would have helped anything. Perhaps because there was no way to make such a blatant subsidy politically acceptable, that plan was shelved.
Instead, the money was used to recapitalize banks…
The banks were desperately ill, yet as the crisis unfolded their political strength grew.
“The IMF’s advice would be, essentially: scale up the standard Federal Deposit Insurance Corporation process. An FDIC “intervention” is basically a government-managed bankruptcy procedure for banks. It would allow the government to wipe out bank shareholders, replace failed management, clean up the balance sheets, and then sell the banks back to the private sector.
It’s well worth reading the full article. It’s rich with details that only someone who has years of experience would know. Two years on, it is still “on the money” and everyone is still waiting…
Cheap money IS the problem
My only quibble is that “cheap money” is relegated to a minor role. The root cause of the financial crisis that “started” in 2007 and rolls on with no resolution in sight, is surely debt. Lots and lots of debt. The world is drowning in debt like never before.
Because banks will always be bailed out by government, banks are no longer normal private companies that can fail, but effectively sub-branches of government — which technically they always were, because they manufacture (bank) money which looks like national currency, that is, they effectively manufacture national money on the government’s behalf. (When a bank makes a loan, it manufactures brand new money out of thin air in these days of the Basel Accord. The loan consists of the new money, and the deposits are still there. Traditional fractional reserve banking was retired around 1990. Reserves are now irrelevant, because of “retail sweep”– the bank sweeps the money from your savings account into a different type of account for a few seconds around midnight to evade the reserve requirements. The amount of money a bank can conjure out of thin air is limited by its assets according to Basel, but principally by the banks capital (the amount of money stumped up for new shares by shareholders), and to a lesser extent by deposits. Apologies for this primer on modern banks, but without that knowledge one cannot understand the cause or fix for the current financial crisis.)
Therefore the public debt of western countries really includes the debts of their banks. This is a new development. And it seems no one in western governments noticed how big those debts had become until the last year or two — experts like Rogoff at Harvard were amazed when it was pointed out to them. Ireland has debts of 25 times its annual revenues. Spain and France over 10 times. Historically, such levels of indebtedness have always led to government default, and obviously any interest rate approaching 10% is instant death.
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All this excess debt was created after 1982 due to policies of cheap money in the western countries. The central banks set the price of money (short term interest rates) by decree, and they set them as low as possible consistent with CPI not exceeding 2% or 3%. But the banks lent the new money into specific asset markets such as the housing market, so the new money did not show up in the CPI. But the money is leaking out of those markets into the general market.
So cheap money flooded the world and created an unprecedented global debt level — what brings this party to an end?
The crisis started in 2007 because the world ran out of worthy borrowers and unencumbered collateral, and private borrowing faltered. Faced with a recession or worse, governments stepped up and borrowed like crazy to replace the privates — the rate of debt/money creation had to be maintained or the system would go into reverse with disastrous political consequences (party ends with cops and bright lights, very uncool).
I don’t think any amount of regulation can make up for the temptation of cheap money. Like pumping high pressure water through a metropolis of pipes — no complex system can be leakproof. Regulations will always have loopholes. The high pressures means the water will always find all the weaknesses in the system and the leaks cause too much damage. The oligarchs feed off the cheap money. It’s the reason their power and influence expanded so fast. No one else benefits from easy loans as much as the finance industry.
So what next? Governments are losing their ability to borrow. If debt and money manufacture falters, there won’t be enough money to pay back yesterday’s debts (all of last year’s debt has to be paid with all the money, plus interest, so the total pool of money/debt must always expand to avoid widespread defaults and bank failures).
So obviously the governments must print, or else let banks and borrowers fail. One or the other.
By the way, Bernanke, a keen student of the 1930s, has made it abundantly clear he intends to print as required — he will not allow the alternative of a 1930s deflationary depression to occur on his watch, and he’s not called “Helicopter Ben” for nothing.
But then, what would I know? — Jo
Hat Tip: Pat in comments. Ta!