Nightmares at hyper-speed
By The Mogambo Guru
The astonishing news to me was that the US Federal Reserve has pledged to plow US$540 billion into the money market, which is composed of very short-term debt, which is, as I already said, pretty astonishing since the total money market is about $3.5 trillion, and which has had (according to Doug Noland in his Credit Bubble Bulletin) "a year-to-date expansion of $423 billion, or 16.8% annualized". And in an odd bit of symmetry to the just-pledged $540 billion, he goes on to report that "Money Fund assets have posted a one-year increase of $566 billion (19.1%)." And now they need half a trillion dollars? Half a freaking trillion?
And since we are talking about things that are astonishing, get this: Total Fed Credit jumped by another $63.2 billion last week! I was going to try and add up the astonishing amounts of credit that the Fed has cooked up in the past month or so, but I am so Scared Out Of My Freaking Mind (SOOMFM) at what I might find that my hands are shaking too much to handle a calculator. That's my excuse, anyway, and it's a lot of work, besides.
Naturally, being the lazy little coward that I am, I decide to simply abandon the task and instead run like a scared little rabbit to the Mogambo Bunker Of Invincibility (MBOI) while I still have enough coordination in my hands to lock and bolt the door, adjust the Security Settings to "Repel Boarders" and put a slice of pizza in the microwave with which to calm my Frazzled Freaking Nerves (FFN) at all this monetary expansion.
Afterward, I remembered that I had intended to add up all the credit that those filthy bastards at the Federal Reserve have created lately, and I shuddered anew at the prospect of the work involved, and of what I would find.
But there is something in the Cosmic Force that wants me to see this, as Doug Noland's Credit Bubble Bulletin was still on my computer, and there, big as life, I read not only that "Federal Reserve Credit expanded another $63.2 billion to a record $1,803 billion", but that this latest whopping glop of credit from the Fed has reached "a historic six-week increase of $915 billion." Yow!
Almost a trillion dollars of new credit in six weeks! Gaaaahhhh! My hands now mysteriously clenched into Mogambo Fists Of Outrage (MFOO), I am forced to clutch a pencil between my teeth and try to laboriously calculate that if $1,803 billion in Federal Reserve credit is up $915 billion in six weeks, then the percentage change is, ummm, wait a minute, ummm, carry the one, ummmm, well, the percentage change is, ummm, well, who the hell cares what the damned stupid exact percentage is when you can just freaking LOOK at the problem to see that TFC has about doubled? Yow! A 100% gain! In six weeks!
My brain is staggered! In six lousy weeks, all of the total credit in the banking system created by the Fed since 1913 was almost instantly (poof!) doubled! Gaaaahhhh! We're freaking doomed!
This is the second worst news possible, right behind finding out that getting married and registering your marriage at the county clerk's office makes it some kind of a binding deal that has ramifications and duties far, far beyond what I was prepared for, and I thought she would work and I would stay at home and watch TV all day. Maybe play a little golf and do some "social" drinking. That kind of thing.
It sure as hell didn't work out that way, and when the kids started coming it got a lot worse, which is ALSO something that nobody tells you about beforehand!
But this monetary expansion thing is the stuff of nightmares, too, and one day soon you will wake up screaming in the middle of the night, bathed in sweat, jolted out of a nightmare of financial misery and suffering that is all but unimaginable even to Dante, and you finally realize, "Hey! These morons at the Fed and Congress with their ridiculous neo-Keynesian, permanent-stimulus theories and econometric stupidities are killing me by killing my money by creating so much of it! What is the only correct economic theory and who can I sue to get my money back?"
The correct theory is, since you asked, the Austrian Business Cycle Theory, as perfectly explained at Mises.org, and reinforced by Milton Friedman, who perfectly explained that "Inflation is always and everywhere a monetary phenomenon", which means that you, as the citizen who is forced to use an abused fiat currency, is doubly screwed; prices are going up faster than wages, particularly food, and you can't sue anyone.
In fact, an argument can be made that inflation in food prices is already here, as from Florida we get the news that the Department of Families and Children handled 1.3 million calls about getting food stamps last year, and already this year the number of calls has doubled!
And don't get me started on foreclosures, falling earnings, falling employment, insane levels of money and credit creation, or the horrors of inflation, because then I will also get started yammering about how gold, silver and oil have got to be the biggest bargains out there right now, and trust me when I tell you that you do not want to get me started!
Richard Daughty is general partner and COO for Smith Consultant Group, serving the financial and medical communities, and the editor of The Mogambo Guru economic newsletter - an avocational exercise to heap disrespect on those who desperately deserve it.
Monday, November 3, 2008
Wednesday, October 29, 2008
Asia's passing pleasure moment
Asia's passing pleasure moment
By R Taggart Murphy
The boardrooms and finance ministries of Seoul, Bangkok, Jakarta and Kuala Lumpur are today filled with a fair degree of schadenfreude at America's troubles. Schadenfreude is not a very nice emotion; Theodor Adorno once defined it as "unanticipated delight in the sufferings of another". But asking Asia's business and governing elites to repress shivers of pleasure at the meltdown of the American financial system is probably demanding more than flesh and blood can bear.
The spectacle of the politicians, pundits and academics of Washington and Chicago thrashing about in attempts to justify the vast amounts of money being shoveled at their, um, cronies on Wall Street is just a little too rich. That is particularly so since much of the money will have to be borrowed from the very people who a decade ago at the time of the so-called Asian financial
crisis were being pooh-poohed for their "crony capitalism," "opaque" banking systems, "incestuous" government-business relations, not to mention their supposed absence of transparent financial reporting, good corporate governance, or accountable executives and regulators.
But the glee in seeing the United States hoisted by its own petard must surely be mixed with a good deal of apprehension. Not only because Asia cannot escape this crisis unmarked, but because the crisis could conceivably force Asia's elites to engage in the open political discussions they have largely avoided until now - discussions about the kinds of economies they expect to shape in the wake of the American debacle; discussions that carry with them all kinds of risks.
The economic and financial dangers to Asia of the crisis need not detain us long for they are obvious. The region's stock markets are caught in the global downdraft. Asia's financial institutions are just as closely linked as those in every other part of the world to Lehman Brothers, AIG, Merrill Lynch and their devil's spawn of credit default swaps and "toxic waste" assets. We have already seen bank runs in Hong Kong and widespread layoffs by some of the regions' leading financial institutions. We are likely to see more of these troubles in Asia before the crisis plays itself out.
The United States appears headed into a recession that may be as bad as anything the country has faced since the 1930s. That in itself will spell trouble for a region that directly or indirectly relies on the United States as the final engine of demand. Japan last month, for example, ran its first trade deficit since 1982, something that is widely attributed to falling demand from the US.
But while this is all generally understood and prudent business and financial leaders in the region are already battening down the proverbial hatches, there is more going on here than simply the shrinking of the region's most important external market. For what we are seeing strikes at the heart of the entire process by which the region transformed itself over the past 50 years.
To be sure, Asia had little to do with the "subprime" mortgages, the slicing and dicing of rotten credits, the heads-I-win, tails-you-lose ethos on Wall Street that form the immediate causes of this catastrophe. But as Charles Kindleberger pointed out in his classic Manias, Panics, and Crashes, manias of the type that have just ended so spectacularly on Wall Street cannot occur in the absence of rapid credit creation. That credit creation in the present case stems directly from the ability of the United States to pawn off on the rest of the world an endless flood of dollar obligations, obligations that for a good 40 years now have never been presented for redemption with anything other than more US government paper.
It has been so long now that the United States had to obtain the money to service its debts by the usual means - selling more goods and services abroad than are bought; borrowing in a currency controlled by the lender rather than the borrower - that its politicians no longer have any institutional memory of what it all implies: the hard trade-offs of falling living standards and forced savings.
Like an alcoholic's wife who furtively keeps her husband plied with booze while managing to avoid thinking about exactly what she is doing, Asia has long facilitated the US addiction to drowning its problems in endless dollar cocktails. But the current crisis suggests that the days of cirrhosis of the American liver and delirium tremens are upon us. Without a clear grasp of the ways in which Asia's economic methods have facilitated American political pathologies, without a plan to replace Asia's reflexive reliance on exports to the United States with another economic driver, Asia too will be drawn into the economic and political maelstrom that now engulfs Washington.
Asia did not set out to become America's pusher; it happened through historical accident and the logic of the situation rather than any thought-through strategy. To see this, we have to go back to the circumstances of the late 1940s. The United States had emerged from World War ll with something over half the intact production capacity of the entire planet. But Washington was haunted by two fears: that the end of the pumped-up demand of the war years would mean the return of the Great Depression, and that a militant, monolithic communism would capitalize on the war's devastation to bring much of the world under its control. The so-called Iron Curtain had descended to divide Europe and Korea, Mao Zedong's Communist Party had driven the American-allied Kuomintang out of mainland China, while communist-led anti-colonialist insurgencies were emerging in French Indochina and British Malaya.
The US economic response was two-fold. First, at home, the United States adopted the new-fangled tools of Keynesian demand management to keep the country from sliding back into Depression. Meanwhile, abroad, the United States through such measures as the Marshall Plan and aid to occupied Japan, essentially offered to finance on very easy terms the transfer of production capacity to war-devastated nations. The US then agreed to accept the exports manufactured thereby without reciprocal demands for imports of American products. The notion that places like Japan could ever pose a serious economic threat to American industry did not occur to anyone on either side of the Pacific. What Washington cared about was that Japan and Western Europe not follow China and Poland into what was seen then as Moscow's orbit.
But the Keynesian synthesis that so electrified economists and policy makers of the time in the United States seemed to have little relevance to the challenges faced by an Asia emerging from colonialism and war. Keynes had addressed himself to the problems of a highly developed economy finding itself stuck in a trough of structural unemployment and idle production capacity; in 1946, Japan and Korea did not have production capacity to idle. Instead, there were two alternative models of development on offer. One was the Marxist-Leninist; the other went under the rubric of import substitution or dependency theory - that is, that the goal of development ought to be the freeing of a country from dependence on foreign financing and imported capital equipment. Both called for state-directed capital accumulation and autarkic development, although the latter did allow for market mechanisms to function at the local level. Both boasted an extensive theoretical literature. In early postwar Asia, China would be the champion of the former, India of the latter.
Japan, however, adopted neither. With the United States providing the initial wherewithal to rebuild its economy (albeit at the price of aligning its foreign policy with Washington's and ensuring that leftists were kept away from the levers of power), Japan chose instead to engineer an economic structure that focused on the rapid accumulation of dollars so that it could buy the capital equipment it needed. This meant the deliberate channeling of scarce domestic savings into externally competitive export industries. It is here that we see the origins of the distinctive Asian model of export-led growth.
The distinction between this and the import substitution model then being championed by India's Mahatma Gandhi and, subsequently, Jawaharlal Nehru may appear a semantic one in that both called for the development of domestic industry behind protectionist walls. But they differed crucially in their stance towards the existing global financial order. India sought to eliminate its dependence on that order; Japan to accumulate sufficient dollars in order to exploit it for its own domestic needs. Largely for geopolitical reasons, the architect and designated care-taker of that order - the United States - was perfectly willing and even happy to see Japan use it to cement postwar recovery and join the ranks of the non-Communist developed nations.
I wrote above that Japan "chose" its postwar path of development, but this is not quite correct. It happened not, as in Beijing or New Delhi, through any deliberate choice of an overarching theoretical model, but because the pressures and opportunities of the time made it seem inevitable to Japan's decision makers. The priority of recovery from the war's devastation was so obvious that it required no political discussion to give it legitimacy. The war years had left Tokyo with an intact institutional apparatus that could be used to channel scarce financing into targeted industries - it was easy enough to redirect the flows from munitions makers to promising export industries. With the fortuitous (for Japan) outbreak of the Korean War, the United States suddenly began placing large orders for Japanese goods needed to equip its military. Thus through a process more akin to biological evolution than conscious political choice, Japan found itself in a niche that functioned well-nigh perfectly for the country in the economic ecology of the era.
The results exceeded anyone's expectations. Between 1955 when the final elements of the postwar Japanese system were put into place and 1969 when its growth began to alter the global economic ecology which had fostered it, Japan boasted the highest growth rates that had ever been recorded by any economy in human history. But the circumstances of its birth - its coming into being without any real debate on the matter or generally accepted theoretical foundation - help explain what is happening today.
The late 1960s provided the first evidence that things could not keep on going as they had without adjustment. The rigid international financial architecture of the time, labeled the Bretton Woods system for the small New Hampshire resort town where it had been hammered out in 1944, could not accommodate the emergence of Japan's export surpluses - joined to a lesser extent by those of West Germany - and their mirror images, the first substantial trade deficits run by the United States for a century or more. Attempts to rework the formal arrangements of the Bretton Woods system collapsed in the political chaos surrounding the Watergate scandals and the American defeat in Vietnam.
The world economy limped through the rest of the 1970s until Paul Volcker was appointed chairman of the Federal Reserve in 1979 with a mandate to do what it took to halt the inflation that threatened to destroy the dollar as a store of value. Japan's vote of confidence in Volcker's policies - snapping up US dollar securities - permitted the rebuilding of the organizing principle of Bretton Woods: the dollar's central role in the international financial system. But instead of Bretton Wood's formal arrangements that required the United States to back the dollar with gold while other participants maintained fixed exchange rates with the dollar, the Asia's passing pleasure moment
By R Taggart Murphy
new system was predicated purely on the willingness and ability of the likes of Japan to continue to accumulate and hold stores of dollars.
Meanwhile, Japan's 25-year sprint from devastation to the front ranks of the world's industrial powers provided an overwhelming example to the region. South Korea, Taiwan and Malaysia all pro-actively adopted export-led growth strategies with concomitant suppression of domestic demand, undervalued currencies, and savings channeled into the development of internationally competitive industries.
With the coming to power in 1977 of Deng Xiaoping and Beijing's tacit adoption of the Japanese economic model, the region turned decisively away from autarkic development models. Vietnam
would arrive at the party in the late 1980s, and in 2000 India would formally abandon Nehru's legacy of import substitution to join in the scramble to build industries for export.
But not only did most Asian countries emulate Japan in making the highest national priority the building of internationally competitive export industries, they followed Japan in accumulating reserves in dollars - a trend that accelerated after the crisis of a decade ago. Most countries in the region, whether they had suffered badly (Thailand and South Korea), or largely escaped the worst effects (Malaysia and China) resolved they would never again be in a position where emissaries from Washington - or anywhere else, for that matter - would be in a position to dictate their macroeconomic policies or how they ought to structure their banking systems. They redoubled their efforts to build impregnable fortresses of international reserves against the slings and arrows of future balance of payments crises.
That effectively meant accumulating reserves in US dollars. Aggregate two-way trade and investment flows between Europe and Asia are not large enough to permit the euro to circulate yet in sufficient quantities in the region to see the euro substitute for the dollar as the region's reserve currency, even if the region's businesses were willing to switch from dollars to euros as their primary cross-border settlements currency.
As for the yen, neither Japan nor China for separate reasons want to see the Japanese currency supplant the dollar in the region. China is not prepared to cede that kind of economic leadership to Japan, while the wrenching changes that the emergence of the yen as a major international currency would pose to the Japanese economic and political order insure that Tokyo will move to bring that about only when there is no alternative.
But when a country accumulates reserves in dollars, it is effectively leaving its export earnings inside the American banking system where they can be used, among other things, to finance the building of houses for people who do not earn enough to afford those houses. The result is seven-figure salaries for gamblers with other people's money and tax cuts enacted while spending soars on entitlements and wars of choice.
The latest surge of dollar holdings in Asia on top of a generation of dollar accumulation in countries such as Japan and Korea coincided with the coming to power of the most fiscally irresponsible administration in American history. Not only did Asia's soaring dollar holdings help the George W Bush administration avoid the usual financial consequences in ripping open the sutures its predecessor had stitched up between America's taxes and government spending. They also facilitated a horrendous asset bubble in American housing while Alan Greenspan's Federal Reserve watched idly from the sidelines.
The era of American "deficits without tears," in the famous phrase of the French economist Jacques Rueff, has ended with the Panic of 2008. The core institutions of American finance are collapsing. The United States is still - and will remain for some time to come - the world's largest and most productive economy. But it can no longer act as the world's engine of demand, no matter how many dollars Asia throws at it.
For while those dollars may be "owned" by Asian central banks and businesses, they reside inside a ruined financial system whose panicked participants will not lend to those who need credit to keep their businesses running. As the Japanese can explain from their own experience of the mid-1990s, you can pour all the money you want into tottering banks and brokers, but when they are paralyzed by fear and will do nothing but lend back to the government, it does little for your economy.
The days of export-led growth for Asia are over, or at least exports outside the region. Intra-regional trade is another matter provided importers in the region can be found to equal exporters and the final demand is in Asia; that is, exports of parts and supplies from one Asian country to another for finished products headed for the US market don't count.
As the Koreans and Thais can easily testify given their own recent traumas, the United States cannot recover from the mess it is in without more savings - another way of saying less consumption. That in turn means the US after 40 years of profligacy will have to export more than it imports. For this to happen, much of the production capacity that has been steadily transferred to Asia over the last 50 years will have to be repatriated back to the United States so that Americans will have enough factories again in which to go to work to pay off the debts that their politicians and bankers so recklessly ran up. Otherwise, all those dollars Asia holds will quickly be worth very little. What, after all, is a dollar other than a claim on the output of an American? The Americans will have to have the means to create that output if the dollar is to have value.
Meanwhile, what of Asia? How is Asia going to wean itself from its dependence on the US market? One lesson the world may finally learn from this crisis is that genuine, long-term prosperity comes not from continuously shoveling money at distant foreigners so they can keep buying your stuff, and certainly not from games-playing and speculation by would-be plutocrats. Rather, prosperity comes from a large, economically secure middle class - a middle class with the means to purchase the output of a nation's factories, farms, and service providers.
Here is where we see a connection between the meltdown of American finance and the political turmoil that has been wracking practically every country in the region. Each specific example has it own local causes and flavors: the struggle in Thailand over former prime minister Thaksin Shinawatra's buy-rural-votes-populism; the political insurrection led by Anwar Ibrahim in Malaysia against the entrenched UMNO elite; the seemingly out-of-proportion demonstrations in South Korea over beef imports; the palpable rage in China at the inability of the government to enforce safety standards in construction and food provision; the challenge posed by Japan's first serious, united opposition in 50 years to the Liberal Democratic Party's control of that country's formal political institutions.
Behind these varied struggles one can hear a common theme: a demand for accountable, responsible government that puts the interests of the middle class first. I wrote at the beginning of this piece that the political discussion necessary to restructure the region's economies carries with it all kinds of risks. We have been seeing those played out in the streets of Bangkok and Seoul or on-line behind the firewalls that Beijing builds in its attempts to contain and control discussion of China's future.
These struggles threaten, among other things, the workings of essential economic machinery, as Thailand's tourist-related businesses can readily testify. The struggles provide a profound challenge to elites that are accustomed to effecting minor corrections behind closed cockpit doors to national trajectories that have long been taken for granted.
But the meltdown of American finance has closed the destination of an economy humming with industries for export. Whether Asia's economies have the political will and ability to chart a new course will determine how they ride out the present storm.
R Taggart Murphy, a former investment banker, is professor in the MBA Program in International Business at the University of Tsukuba's Tokyo campus and a Japan Focus associate. He is the author of The Weight of the Yen (Norton, 1996) and, with Akio Mikuni, of Japan's Policy Trap (Brookings, 2002).
This is a substantially expanded version of an article that appeared in The Brief. Magazine of the British Chamber of Commerce Thailand. It was posted at Japan Focus on October 24, 2008.
By R Taggart Murphy
The boardrooms and finance ministries of Seoul, Bangkok, Jakarta and Kuala Lumpur are today filled with a fair degree of schadenfreude at America's troubles. Schadenfreude is not a very nice emotion; Theodor Adorno once defined it as "unanticipated delight in the sufferings of another". But asking Asia's business and governing elites to repress shivers of pleasure at the meltdown of the American financial system is probably demanding more than flesh and blood can bear.
The spectacle of the politicians, pundits and academics of Washington and Chicago thrashing about in attempts to justify the vast amounts of money being shoveled at their, um, cronies on Wall Street is just a little too rich. That is particularly so since much of the money will have to be borrowed from the very people who a decade ago at the time of the so-called Asian financial
crisis were being pooh-poohed for their "crony capitalism," "opaque" banking systems, "incestuous" government-business relations, not to mention their supposed absence of transparent financial reporting, good corporate governance, or accountable executives and regulators.
But the glee in seeing the United States hoisted by its own petard must surely be mixed with a good deal of apprehension. Not only because Asia cannot escape this crisis unmarked, but because the crisis could conceivably force Asia's elites to engage in the open political discussions they have largely avoided until now - discussions about the kinds of economies they expect to shape in the wake of the American debacle; discussions that carry with them all kinds of risks.
The economic and financial dangers to Asia of the crisis need not detain us long for they are obvious. The region's stock markets are caught in the global downdraft. Asia's financial institutions are just as closely linked as those in every other part of the world to Lehman Brothers, AIG, Merrill Lynch and their devil's spawn of credit default swaps and "toxic waste" assets. We have already seen bank runs in Hong Kong and widespread layoffs by some of the regions' leading financial institutions. We are likely to see more of these troubles in Asia before the crisis plays itself out.
The United States appears headed into a recession that may be as bad as anything the country has faced since the 1930s. That in itself will spell trouble for a region that directly or indirectly relies on the United States as the final engine of demand. Japan last month, for example, ran its first trade deficit since 1982, something that is widely attributed to falling demand from the US.
But while this is all generally understood and prudent business and financial leaders in the region are already battening down the proverbial hatches, there is more going on here than simply the shrinking of the region's most important external market. For what we are seeing strikes at the heart of the entire process by which the region transformed itself over the past 50 years.
To be sure, Asia had little to do with the "subprime" mortgages, the slicing and dicing of rotten credits, the heads-I-win, tails-you-lose ethos on Wall Street that form the immediate causes of this catastrophe. But as Charles Kindleberger pointed out in his classic Manias, Panics, and Crashes, manias of the type that have just ended so spectacularly on Wall Street cannot occur in the absence of rapid credit creation. That credit creation in the present case stems directly from the ability of the United States to pawn off on the rest of the world an endless flood of dollar obligations, obligations that for a good 40 years now have never been presented for redemption with anything other than more US government paper.
It has been so long now that the United States had to obtain the money to service its debts by the usual means - selling more goods and services abroad than are bought; borrowing in a currency controlled by the lender rather than the borrower - that its politicians no longer have any institutional memory of what it all implies: the hard trade-offs of falling living standards and forced savings.
Like an alcoholic's wife who furtively keeps her husband plied with booze while managing to avoid thinking about exactly what she is doing, Asia has long facilitated the US addiction to drowning its problems in endless dollar cocktails. But the current crisis suggests that the days of cirrhosis of the American liver and delirium tremens are upon us. Without a clear grasp of the ways in which Asia's economic methods have facilitated American political pathologies, without a plan to replace Asia's reflexive reliance on exports to the United States with another economic driver, Asia too will be drawn into the economic and political maelstrom that now engulfs Washington.
Asia did not set out to become America's pusher; it happened through historical accident and the logic of the situation rather than any thought-through strategy. To see this, we have to go back to the circumstances of the late 1940s. The United States had emerged from World War ll with something over half the intact production capacity of the entire planet. But Washington was haunted by two fears: that the end of the pumped-up demand of the war years would mean the return of the Great Depression, and that a militant, monolithic communism would capitalize on the war's devastation to bring much of the world under its control. The so-called Iron Curtain had descended to divide Europe and Korea, Mao Zedong's Communist Party had driven the American-allied Kuomintang out of mainland China, while communist-led anti-colonialist insurgencies were emerging in French Indochina and British Malaya.
The US economic response was two-fold. First, at home, the United States adopted the new-fangled tools of Keynesian demand management to keep the country from sliding back into Depression. Meanwhile, abroad, the United States through such measures as the Marshall Plan and aid to occupied Japan, essentially offered to finance on very easy terms the transfer of production capacity to war-devastated nations. The US then agreed to accept the exports manufactured thereby without reciprocal demands for imports of American products. The notion that places like Japan could ever pose a serious economic threat to American industry did not occur to anyone on either side of the Pacific. What Washington cared about was that Japan and Western Europe not follow China and Poland into what was seen then as Moscow's orbit.
But the Keynesian synthesis that so electrified economists and policy makers of the time in the United States seemed to have little relevance to the challenges faced by an Asia emerging from colonialism and war. Keynes had addressed himself to the problems of a highly developed economy finding itself stuck in a trough of structural unemployment and idle production capacity; in 1946, Japan and Korea did not have production capacity to idle. Instead, there were two alternative models of development on offer. One was the Marxist-Leninist; the other went under the rubric of import substitution or dependency theory - that is, that the goal of development ought to be the freeing of a country from dependence on foreign financing and imported capital equipment. Both called for state-directed capital accumulation and autarkic development, although the latter did allow for market mechanisms to function at the local level. Both boasted an extensive theoretical literature. In early postwar Asia, China would be the champion of the former, India of the latter.
Japan, however, adopted neither. With the United States providing the initial wherewithal to rebuild its economy (albeit at the price of aligning its foreign policy with Washington's and ensuring that leftists were kept away from the levers of power), Japan chose instead to engineer an economic structure that focused on the rapid accumulation of dollars so that it could buy the capital equipment it needed. This meant the deliberate channeling of scarce domestic savings into externally competitive export industries. It is here that we see the origins of the distinctive Asian model of export-led growth.
The distinction between this and the import substitution model then being championed by India's Mahatma Gandhi and, subsequently, Jawaharlal Nehru may appear a semantic one in that both called for the development of domestic industry behind protectionist walls. But they differed crucially in their stance towards the existing global financial order. India sought to eliminate its dependence on that order; Japan to accumulate sufficient dollars in order to exploit it for its own domestic needs. Largely for geopolitical reasons, the architect and designated care-taker of that order - the United States - was perfectly willing and even happy to see Japan use it to cement postwar recovery and join the ranks of the non-Communist developed nations.
I wrote above that Japan "chose" its postwar path of development, but this is not quite correct. It happened not, as in Beijing or New Delhi, through any deliberate choice of an overarching theoretical model, but because the pressures and opportunities of the time made it seem inevitable to Japan's decision makers. The priority of recovery from the war's devastation was so obvious that it required no political discussion to give it legitimacy. The war years had left Tokyo with an intact institutional apparatus that could be used to channel scarce financing into targeted industries - it was easy enough to redirect the flows from munitions makers to promising export industries. With the fortuitous (for Japan) outbreak of the Korean War, the United States suddenly began placing large orders for Japanese goods needed to equip its military. Thus through a process more akin to biological evolution than conscious political choice, Japan found itself in a niche that functioned well-nigh perfectly for the country in the economic ecology of the era.
The results exceeded anyone's expectations. Between 1955 when the final elements of the postwar Japanese system were put into place and 1969 when its growth began to alter the global economic ecology which had fostered it, Japan boasted the highest growth rates that had ever been recorded by any economy in human history. But the circumstances of its birth - its coming into being without any real debate on the matter or generally accepted theoretical foundation - help explain what is happening today.
The late 1960s provided the first evidence that things could not keep on going as they had without adjustment. The rigid international financial architecture of the time, labeled the Bretton Woods system for the small New Hampshire resort town where it had been hammered out in 1944, could not accommodate the emergence of Japan's export surpluses - joined to a lesser extent by those of West Germany - and their mirror images, the first substantial trade deficits run by the United States for a century or more. Attempts to rework the formal arrangements of the Bretton Woods system collapsed in the political chaos surrounding the Watergate scandals and the American defeat in Vietnam.
The world economy limped through the rest of the 1970s until Paul Volcker was appointed chairman of the Federal Reserve in 1979 with a mandate to do what it took to halt the inflation that threatened to destroy the dollar as a store of value. Japan's vote of confidence in Volcker's policies - snapping up US dollar securities - permitted the rebuilding of the organizing principle of Bretton Woods: the dollar's central role in the international financial system. But instead of Bretton Wood's formal arrangements that required the United States to back the dollar with gold while other participants maintained fixed exchange rates with the dollar, the Asia's passing pleasure moment
By R Taggart Murphy
new system was predicated purely on the willingness and ability of the likes of Japan to continue to accumulate and hold stores of dollars.
Meanwhile, Japan's 25-year sprint from devastation to the front ranks of the world's industrial powers provided an overwhelming example to the region. South Korea, Taiwan and Malaysia all pro-actively adopted export-led growth strategies with concomitant suppression of domestic demand, undervalued currencies, and savings channeled into the development of internationally competitive industries.
With the coming to power in 1977 of Deng Xiaoping and Beijing's tacit adoption of the Japanese economic model, the region turned decisively away from autarkic development models. Vietnam
would arrive at the party in the late 1980s, and in 2000 India would formally abandon Nehru's legacy of import substitution to join in the scramble to build industries for export.
But not only did most Asian countries emulate Japan in making the highest national priority the building of internationally competitive export industries, they followed Japan in accumulating reserves in dollars - a trend that accelerated after the crisis of a decade ago. Most countries in the region, whether they had suffered badly (Thailand and South Korea), or largely escaped the worst effects (Malaysia and China) resolved they would never again be in a position where emissaries from Washington - or anywhere else, for that matter - would be in a position to dictate their macroeconomic policies or how they ought to structure their banking systems. They redoubled their efforts to build impregnable fortresses of international reserves against the slings and arrows of future balance of payments crises.
That effectively meant accumulating reserves in US dollars. Aggregate two-way trade and investment flows between Europe and Asia are not large enough to permit the euro to circulate yet in sufficient quantities in the region to see the euro substitute for the dollar as the region's reserve currency, even if the region's businesses were willing to switch from dollars to euros as their primary cross-border settlements currency.
As for the yen, neither Japan nor China for separate reasons want to see the Japanese currency supplant the dollar in the region. China is not prepared to cede that kind of economic leadership to Japan, while the wrenching changes that the emergence of the yen as a major international currency would pose to the Japanese economic and political order insure that Tokyo will move to bring that about only when there is no alternative.
But when a country accumulates reserves in dollars, it is effectively leaving its export earnings inside the American banking system where they can be used, among other things, to finance the building of houses for people who do not earn enough to afford those houses. The result is seven-figure salaries for gamblers with other people's money and tax cuts enacted while spending soars on entitlements and wars of choice.
The latest surge of dollar holdings in Asia on top of a generation of dollar accumulation in countries such as Japan and Korea coincided with the coming to power of the most fiscally irresponsible administration in American history. Not only did Asia's soaring dollar holdings help the George W Bush administration avoid the usual financial consequences in ripping open the sutures its predecessor had stitched up between America's taxes and government spending. They also facilitated a horrendous asset bubble in American housing while Alan Greenspan's Federal Reserve watched idly from the sidelines.
The era of American "deficits without tears," in the famous phrase of the French economist Jacques Rueff, has ended with the Panic of 2008. The core institutions of American finance are collapsing. The United States is still - and will remain for some time to come - the world's largest and most productive economy. But it can no longer act as the world's engine of demand, no matter how many dollars Asia throws at it.
For while those dollars may be "owned" by Asian central banks and businesses, they reside inside a ruined financial system whose panicked participants will not lend to those who need credit to keep their businesses running. As the Japanese can explain from their own experience of the mid-1990s, you can pour all the money you want into tottering banks and brokers, but when they are paralyzed by fear and will do nothing but lend back to the government, it does little for your economy.
The days of export-led growth for Asia are over, or at least exports outside the region. Intra-regional trade is another matter provided importers in the region can be found to equal exporters and the final demand is in Asia; that is, exports of parts and supplies from one Asian country to another for finished products headed for the US market don't count.
As the Koreans and Thais can easily testify given their own recent traumas, the United States cannot recover from the mess it is in without more savings - another way of saying less consumption. That in turn means the US after 40 years of profligacy will have to export more than it imports. For this to happen, much of the production capacity that has been steadily transferred to Asia over the last 50 years will have to be repatriated back to the United States so that Americans will have enough factories again in which to go to work to pay off the debts that their politicians and bankers so recklessly ran up. Otherwise, all those dollars Asia holds will quickly be worth very little. What, after all, is a dollar other than a claim on the output of an American? The Americans will have to have the means to create that output if the dollar is to have value.
Meanwhile, what of Asia? How is Asia going to wean itself from its dependence on the US market? One lesson the world may finally learn from this crisis is that genuine, long-term prosperity comes not from continuously shoveling money at distant foreigners so they can keep buying your stuff, and certainly not from games-playing and speculation by would-be plutocrats. Rather, prosperity comes from a large, economically secure middle class - a middle class with the means to purchase the output of a nation's factories, farms, and service providers.
Here is where we see a connection between the meltdown of American finance and the political turmoil that has been wracking practically every country in the region. Each specific example has it own local causes and flavors: the struggle in Thailand over former prime minister Thaksin Shinawatra's buy-rural-votes-populism; the political insurrection led by Anwar Ibrahim in Malaysia against the entrenched UMNO elite; the seemingly out-of-proportion demonstrations in South Korea over beef imports; the palpable rage in China at the inability of the government to enforce safety standards in construction and food provision; the challenge posed by Japan's first serious, united opposition in 50 years to the Liberal Democratic Party's control of that country's formal political institutions.
Behind these varied struggles one can hear a common theme: a demand for accountable, responsible government that puts the interests of the middle class first. I wrote at the beginning of this piece that the political discussion necessary to restructure the region's economies carries with it all kinds of risks. We have been seeing those played out in the streets of Bangkok and Seoul or on-line behind the firewalls that Beijing builds in its attempts to contain and control discussion of China's future.
These struggles threaten, among other things, the workings of essential economic machinery, as Thailand's tourist-related businesses can readily testify. The struggles provide a profound challenge to elites that are accustomed to effecting minor corrections behind closed cockpit doors to national trajectories that have long been taken for granted.
But the meltdown of American finance has closed the destination of an economy humming with industries for export. Whether Asia's economies have the political will and ability to chart a new course will determine how they ride out the present storm.
R Taggart Murphy, a former investment banker, is professor in the MBA Program in International Business at the University of Tsukuba's Tokyo campus and a Japan Focus associate. He is the author of The Weight of the Yen (Norton, 1996) and, with Akio Mikuni, of Japan's Policy Trap (Brookings, 2002).
This is a substantially expanded version of an article that appeared in The Brief. Magazine of the British Chamber of Commerce Thailand. It was posted at Japan Focus on October 24, 2008.
Sunday, October 26, 2008
Pretenders all of us
Pretenders all of us
By Chan Akya
I am highly inspired by the testimony provided by Alan Greenspan, former chairman of the Fed and formerly the most powerful man in financial markets, to the US House Committee of Government Oversight and Reform on Thursday. Headlines immediately captured the essence of the prepared testimony, namely that "the" Alan, as we can call him in the style of the times, had admitted some shock but hadn't really fessed up to any major mistake on his own part.
Now of course, there is the whole ego, superego and id thing; but the little matter of continuing employment wherein the former chairman derives some tidy income from consulting for the world's major financial companies in sectors such as mutual funds (PIMCO) and banking (Deutsche Bank). Then there is always the matter of book sales [1], which may be adversely affected by any notions of fallibility.
In any event, many commentators have in the past attempted to create a dictionary of what Greenspan means when he uses any particular phrase. His commentaries and numerous testimonies during his tenure were famous (or infamous, depending on how much you actually understood) for the use of code, with specific phrases designed to excite the markets but leave lay people utterly befuddled.
In the same spirit, the following few phrases that appeared in his testimony on Thursday have been translated for the benefit of Asia Times Online readers. I have also added a comment on what a certain fictitious chairman of the Fed (let us call him Paul V) might have said in the same place.
The Alan: "We are in the midst of a once-in-a century credit tsunami. Central banks and governments are being required to take unprecedented measures. You, importantly, represent those on whose behalf economic policy is made, those who are feeling the brunt of the crisis in their workplaces and homes."
What he meant: "I am really glad it's you not me doing the heavy lifting. Furthermore, my opening with the tsunami reference is designed to make this whole mess seem like an unpredictable seismological event rather than the simple effect of various policy mistakes."
What Paul might have said?: "I messed up."
The Alan: "What went wrong with global economic policies that had worked so effectively for nearly four decades? The breakdown has been most apparent in the securitization of home mortgages. The evidence strongly suggests that without the excess demand from securitizers, subprime mortgage originations (undeniably the original source of crisis) would have been far smaller and defaults accordingly far fewer. But subprime mortgages pooled and sold as securities became subject to explosive demand from investors around the world. These mortgage-backed securities being 'subprime' were originally offered at what appeared to be exceptionally high risk-adjusted market interest rates. But with US home prices still rising, delinquency and foreclosure rates were deceptively modest. Losses were minimal. To the most sophisticated investors in the world, they were wrongly viewed as a 'steal'."
What he meant: "Hey don't look at me; all my data said this sort of stuff could never happen. It's the fault of all those poor people who couldn't see that they were supposed to turn away the free money being offered to them, and the fault of all my rich buddies for trusting these poor folks in the first place."
What Paul might have said?: "Firstly, it is not true that economic policies had worked well in the past four decades, as the series of crises in the US and around the world from 1968 to the present would tell us. I should have tightened credit policy and banking supervision when the growth in higher risk mortgages appeared to increase disproportionately to actual income growth in the United States. Furthermore, the billions of dollars flowing into the US should have alerted me to potential bubbles and forced me to hike rates drastically. Or in short, I messed up."
The Alan: "It was the failure to properly price such risky assets that precipitated the crisis. In recent decades, a vast risk management and pricing system has evolved, combining the best insights of mathematicians and finance experts supported by major advances in computer and communications technology. A Nobel Prize was awarded for the discovery of the pricing model that underpins much of the advance in derivatives markets. This modern risk management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year because the data inputted into the risk management models generally covered only the past two decades, a period of euphoria. Had instead the models been fitted more appropriately to historic periods of stress, capital requirements would have been much higher and the financial world would be in far better shape today, in my judgment."
What he meant: "Nobody really knew how to price or trade these things. They even managed to confuse the idiots on the Nobel committee. So don't blame me for believing the balderdash. Also no one told me Nicholas Nassem Taleb was writing a book [2] that would point out all these model fallacies and so sell more copies than my book did."
What Paul might have said: "We had enough experience of other crises, such as the Latin America debt crisis that blew up our banks in the late '80s, to know the effect of false assumptions and poor data on the integrity of our financial system. This should have alerted us to the potential for mispricing and false profit generation; that should have forced us to intervene on the regulatory and accounting side of these transactions to make them less attractive for our banks to do. That was my job as Fed chairman, and I failed. Or in short, I messed up."
Fessing up
Having translated some of the comments for Asia Times Online readers, I will now fess up to my own mistakes in assuming that the end of the Group of Seven leading industrialized countries [3] could be hastened by the emergence of new giants such as Russia and some Asian countries.
In particular, three countries have recently performed a whole lot worse than my expectations, in effect denting any claims they can have in coming years for being considered serious (and independent) investment destinations. These three countries are Russia, South Korea and India: I have left out for now other countries that seem in greater danger of tipping over, such as Indonesia, as they were never considered anything more than exotic destinations. The three above though were talked of in some earnest as breaking their historic moulds but instead may well have been exposed as fraudsters being pulled up by the global economic prosperity.
I show below the performance of the countries' equity indices and their currencies against the US average, and for good measure those of China. While the relative equity performance is nothing to boast about for China (indeed, as equity returns are currency adjusted it means that nominal performance in China was the worst across that column), the trio of Russia, South Korea and India show some eye-popping bad numbers. The most difficult to believe is the significant decline of the Korean won against the US dollar this year; shocking for a country that showed an improving current account balance until the middle of this year.
YTD Equity
Return % YTD Currency
Return %
Russia -72 -9.10
Korea -63 -49.62
India -62 -26.34
US -38 NA
China -62 +6.33
This is however not all of the bad news - as the current crisis is very much one rooted in the credit markets, it makes sense to evaluate the relative riskiness of the various governments underpinning the economies. This we can do by looking at sovereign credit default swaps (CDS), that is, the insurance payment being demanded by a market counterparty to cover your risk of that government failing to repay its obligations. These are traditionally shown in basis points or one-hundredth of a percentage point (thus 500 basis points means 5%).
From the CDS value, the implied probability of default being assigned to that sovereign can be worked out provided we can assume a certain "loss given default", (or LGD, which is fixed here at 60%); this is shown in the column after the CDS. Note that the figure below for India pertains to its largest state-owned bank (State Bank of India) because the government itself doesn't have any externally traded obligations.
Oct 23rd 5yr
CDS spread Implied Prob of Default %
Russia 1100 61
Korea 600 41
India 750 48
US 25 2
China 235 15
From the above, it is clear that none of the pretenders and especially not the first three countries can claim to be in a position to overtake the existing global benchmark for risk-free assets, namely the United States. It is shocking and rather amazing that despite holding about US$1 trillion of reserves between them, the three countries average a default probability of 50% within five years. That one-in-two chance of default within the period shows that these countries have never truly learnt the lessons of the past few decades.
Russia
The simple matter of evaporating market confidence has belied Russia's claims to great-power status, resurgence under president and now Prime Minister Vladimir Putin and so on. For a country with more than $500 billion in reserves (itself down around $100 billion from just August this year), market signals are not so much about the government as they are about the overall level of confidence in the economy and its business representatives.
The first point of the market's loss of confidence is the mounting debt maturities of various Russian companies and the country's largest banks, all of which tapped the short-term (one- to two-year) markets to finance their expansion plans. With many of these facilities now coming due for payment, and no prospect that any investor would agree to postpone payments for another couple of years (refinancing), the Russian government has been expected to step up.
The only other alternative for investors in such nominally private
companies, namely to convert the debt into equity stakes, doesn't apply in the case of Russia, due to the high-handed behavior of the government. Thus, despite very little in the way of direct obligations, the shadow of the 1998 debt default by Russia along with a string of Kremlin-inspired malfeasance has scared investors and caused a flight from Russia. Many oligarchs are rumored to be urgently stashing away their wealth in destinations far away from Russia, adding to the pressure on the currency - this is even being cited as one reason for private companies to deny payments to foreign creditors as their owners make off with the bank balances.
It is still possible for Russia to take remedial steps that could prevent an escalation of the current crisis into a full-blown economic collapse. After underpinning the viability of Russian banks, it must undertake quick steps to improve investor confidence; for example by avoiding arbitrary closure of its stock markets whenever prices fall [4], avoiding the temptation to indulge in currency intervention and implementing steps to improve bankruptcy procedures, corporate governance and the like which can help create equilibrium much faster.
South Korea
Perhaps the country that shocked me the most by its presence on this list, South Korea has failed to learn the basic lessons of asset-liability and liquidity management from its previous crisis in 1997-98. Most recently, the Korean government has had to unveil a $100 billion guarantee program for the offshore debt of its banks, taking away a rather substantial chunk of the $240 billion or so of foreign exchange
reserves that it boasts.
Given the escalating current account deficit and poor prospects for investment
inflows, it is possible (albeit very unlikely) for Korea to run out of foreign exchange by the beginning of 2010. This must be problematic for any country, and more so for one with international pretentions, as shown by the abortive global takeovers attempted by South Korean companies such as KDB [5] and Samsung in recent months.
There are numerous culprits here. Most notable is the Bank of Korea, which followed an ill-advised policy of maintaining an onshore US dollar shortage in order to deflect the potential for Korean won appreciation. In so doing, it created the conditions for greater offshore borrowings to fund the economic reliance on the export market rather than domestic consumption. In turn, this left banks and companies with the same mix of short-term liabilities against longer-term assets that marked South Korea's first descent into a balance of payments crisis in the Asian financial crisis of 1997.
Ironically, many equity index managers were finally upgrading Korea from its perch in "emerging markets" to a new "developed markets" level; instead it appears that Korea will have to negotiate to stay afloat in the emerging markets category; its most recent equity, currency and credit performance certainly put it in the same category.
India
To a number of people who bought into the BRIC - Brazil, Russia, India and China - hoopla, India's fall from grace parallels that of Russia. Here again, it is not the external borrowing practices of the sovereign itself that are to blame; funnily enough, neither are the borrowings of local companies in global markets considered to be excessive. In any event, less than $25 billion of Indian corporate and bank debt falls due by the end of next year compared with $275 billion of foreign exchange reserves that the country boasts. Even accounting for zero capital inflows and continued current account deficits, the overall cushion will remain close to $200 billion.
Achilles though still has a heel. The loss of confidence can be traced to the haphazard decision-making of the central bank, which came late to the inflation-fighting party this year in a futile attempt to prevent foreign exchange appreciation, thereby causing policy about-turns that stun even the most adept of investors.
Secondly, political noise in the country has been increasing ahead of next year's elections. This has turned investors naturally cautious, and in turn made crisis management a bit trickier for the government (in which respect there is much in common with the recent US experience).
Thirdly, there is legitimate concern both domestically and offshore about the impact of low infrastructure investments by India over the past two decades. The problems seen in the poorest parts of the country offer a closer view, albeit one that the media have been slower to latch onto compared with the markets.
Recent violence in the state of Orissa between Hindu fundamentalists and Christian missionaries showed not so much the tinderbox of religious intolerance as it did the fairly low "price" that poor Indians assigned to their centuries-old culture and religion. For the destitute and the desperate whose battle for basic sustenance is all-consuming, manna from any source is welcome. Inconveniently enough for the people who believe in an India that can outshine its recent past, the images aptly conveyed the two sub-nations (the upwardly mobile and the downwardly stale) created by communist-inspired governments in the country. [6] As in the case of Russia, the response from investors has been to sell first and ask questions later.
And in closing ...
Perhaps the one quote from Greenspan's testimony that I find myself agreeing with, and especially the last sentence: "There are additional regulatory changes that this breakdown of the central pillar of competitive markets requires in order to return to stability, particularly in the areas of fraud, settlement, and securitization. It is important to remember, however, that whatever regulatory changes are made, they will pale in comparison to the change already evident in today's markets. Those markets for an indefinite future will be far more restrained than would any currently contemplated new regulatory regime."
The fact that a market become overcautious at the drop of a hat (or a few billion dollars) is borne out by the experience of the US subprime mortgage market, as it is for countries such as Russia, South Korea and India. In all these cases, the loss of confidence that has been sparked by a combination of quantitative and qualitative factors will induce substantial behavioral shifts that will take years if not decades of patient reworking for these markets and/or countries to correct. Pretenders, whether they are government officials or market fallacies, will always be exposed.
Notes
1. The Age of Turbulence: Adventures in a New World, by Alan Greenspan. Penguin Press HC, 2007. (For review, see Reaping what is sown, October 6, 2007
2. The Black Swan: The Impact of the Highly Improbable, by Nassim Nicholas Taleb, Random House, 2007.
3. See among other Asia Times Online articles: Terminal Velocity, September 23, 2008; Deaf frogs and the Pied Piper, September 30, 2008; and A Fukuyama moment in Finance, October 18, 2008
4. A stone for Chris Cox, Asia Times Online, July 19, 2008
5. Lehman and the liars, Asia Times Online, June 14, 2008 6. India's real terrorists Asia Times Online, May 17, 2008.
(Copyright 2008 Asia Times Online (Holdings) Ltd. All rights reserved. Please contact us about sales, syndication and republishing.)
By Chan Akya
I am highly inspired by the testimony provided by Alan Greenspan, former chairman of the Fed and formerly the most powerful man in financial markets, to the US House Committee of Government Oversight and Reform on Thursday. Headlines immediately captured the essence of the prepared testimony, namely that "the" Alan, as we can call him in the style of the times, had admitted some shock but hadn't really fessed up to any major mistake on his own part.
Now of course, there is the whole ego, superego and id thing; but the little matter of continuing employment wherein the former chairman derives some tidy income from consulting for the world's major financial companies in sectors such as mutual funds (PIMCO) and banking (Deutsche Bank). Then there is always the matter of book sales [1], which may be adversely affected by any notions of fallibility.
In any event, many commentators have in the past attempted to create a dictionary of what Greenspan means when he uses any particular phrase. His commentaries and numerous testimonies during his tenure were famous (or infamous, depending on how much you actually understood) for the use of code, with specific phrases designed to excite the markets but leave lay people utterly befuddled.
In the same spirit, the following few phrases that appeared in his testimony on Thursday have been translated for the benefit of Asia Times Online readers. I have also added a comment on what a certain fictitious chairman of the Fed (let us call him Paul V) might have said in the same place.
The Alan: "We are in the midst of a once-in-a century credit tsunami. Central banks and governments are being required to take unprecedented measures. You, importantly, represent those on whose behalf economic policy is made, those who are feeling the brunt of the crisis in their workplaces and homes."
What he meant: "I am really glad it's you not me doing the heavy lifting. Furthermore, my opening with the tsunami reference is designed to make this whole mess seem like an unpredictable seismological event rather than the simple effect of various policy mistakes."
What Paul might have said?: "I messed up."
The Alan: "What went wrong with global economic policies that had worked so effectively for nearly four decades? The breakdown has been most apparent in the securitization of home mortgages. The evidence strongly suggests that without the excess demand from securitizers, subprime mortgage originations (undeniably the original source of crisis) would have been far smaller and defaults accordingly far fewer. But subprime mortgages pooled and sold as securities became subject to explosive demand from investors around the world. These mortgage-backed securities being 'subprime' were originally offered at what appeared to be exceptionally high risk-adjusted market interest rates. But with US home prices still rising, delinquency and foreclosure rates were deceptively modest. Losses were minimal. To the most sophisticated investors in the world, they were wrongly viewed as a 'steal'."
What he meant: "Hey don't look at me; all my data said this sort of stuff could never happen. It's the fault of all those poor people who couldn't see that they were supposed to turn away the free money being offered to them, and the fault of all my rich buddies for trusting these poor folks in the first place."
What Paul might have said?: "Firstly, it is not true that economic policies had worked well in the past four decades, as the series of crises in the US and around the world from 1968 to the present would tell us. I should have tightened credit policy and banking supervision when the growth in higher risk mortgages appeared to increase disproportionately to actual income growth in the United States. Furthermore, the billions of dollars flowing into the US should have alerted me to potential bubbles and forced me to hike rates drastically. Or in short, I messed up."
The Alan: "It was the failure to properly price such risky assets that precipitated the crisis. In recent decades, a vast risk management and pricing system has evolved, combining the best insights of mathematicians and finance experts supported by major advances in computer and communications technology. A Nobel Prize was awarded for the discovery of the pricing model that underpins much of the advance in derivatives markets. This modern risk management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year because the data inputted into the risk management models generally covered only the past two decades, a period of euphoria. Had instead the models been fitted more appropriately to historic periods of stress, capital requirements would have been much higher and the financial world would be in far better shape today, in my judgment."
What he meant: "Nobody really knew how to price or trade these things. They even managed to confuse the idiots on the Nobel committee. So don't blame me for believing the balderdash. Also no one told me Nicholas Nassem Taleb was writing a book [2] that would point out all these model fallacies and so sell more copies than my book did."
What Paul might have said: "We had enough experience of other crises, such as the Latin America debt crisis that blew up our banks in the late '80s, to know the effect of false assumptions and poor data on the integrity of our financial system. This should have alerted us to the potential for mispricing and false profit generation; that should have forced us to intervene on the regulatory and accounting side of these transactions to make them less attractive for our banks to do. That was my job as Fed chairman, and I failed. Or in short, I messed up."
Fessing up
Having translated some of the comments for Asia Times Online readers, I will now fess up to my own mistakes in assuming that the end of the Group of Seven leading industrialized countries [3] could be hastened by the emergence of new giants such as Russia and some Asian countries.
In particular, three countries have recently performed a whole lot worse than my expectations, in effect denting any claims they can have in coming years for being considered serious (and independent) investment destinations. These three countries are Russia, South Korea and India: I have left out for now other countries that seem in greater danger of tipping over, such as Indonesia, as they were never considered anything more than exotic destinations. The three above though were talked of in some earnest as breaking their historic moulds but instead may well have been exposed as fraudsters being pulled up by the global economic prosperity.
I show below the performance of the countries' equity indices and their currencies against the US average, and for good measure those of China. While the relative equity performance is nothing to boast about for China (indeed, as equity returns are currency adjusted it means that nominal performance in China was the worst across that column), the trio of Russia, South Korea and India show some eye-popping bad numbers. The most difficult to believe is the significant decline of the Korean won against the US dollar this year; shocking for a country that showed an improving current account balance until the middle of this year.
YTD Equity
Return % YTD Currency
Return %
Russia -72 -9.10
Korea -63 -49.62
India -62 -26.34
US -38 NA
China -62 +6.33
This is however not all of the bad news - as the current crisis is very much one rooted in the credit markets, it makes sense to evaluate the relative riskiness of the various governments underpinning the economies. This we can do by looking at sovereign credit default swaps (CDS), that is, the insurance payment being demanded by a market counterparty to cover your risk of that government failing to repay its obligations. These are traditionally shown in basis points or one-hundredth of a percentage point (thus 500 basis points means 5%).
From the CDS value, the implied probability of default being assigned to that sovereign can be worked out provided we can assume a certain "loss given default", (or LGD, which is fixed here at 60%); this is shown in the column after the CDS. Note that the figure below for India pertains to its largest state-owned bank (State Bank of India) because the government itself doesn't have any externally traded obligations.
Oct 23rd 5yr
CDS spread Implied Prob of Default %
Russia 1100 61
Korea 600 41
India 750 48
US 25 2
China 235 15
From the above, it is clear that none of the pretenders and especially not the first three countries can claim to be in a position to overtake the existing global benchmark for risk-free assets, namely the United States. It is shocking and rather amazing that despite holding about US$1 trillion of reserves between them, the three countries average a default probability of 50% within five years. That one-in-two chance of default within the period shows that these countries have never truly learnt the lessons of the past few decades.
Russia
The simple matter of evaporating market confidence has belied Russia's claims to great-power status, resurgence under president and now Prime Minister Vladimir Putin and so on. For a country with more than $500 billion in reserves (itself down around $100 billion from just August this year), market signals are not so much about the government as they are about the overall level of confidence in the economy and its business representatives.
The first point of the market's loss of confidence is the mounting debt maturities of various Russian companies and the country's largest banks, all of which tapped the short-term (one- to two-year) markets to finance their expansion plans. With many of these facilities now coming due for payment, and no prospect that any investor would agree to postpone payments for another couple of years (refinancing), the Russian government has been expected to step up.
The only other alternative for investors in such nominally private
companies, namely to convert the debt into equity stakes, doesn't apply in the case of Russia, due to the high-handed behavior of the government. Thus, despite very little in the way of direct obligations, the shadow of the 1998 debt default by Russia along with a string of Kremlin-inspired malfeasance has scared investors and caused a flight from Russia. Many oligarchs are rumored to be urgently stashing away their wealth in destinations far away from Russia, adding to the pressure on the currency - this is even being cited as one reason for private companies to deny payments to foreign creditors as their owners make off with the bank balances.
It is still possible for Russia to take remedial steps that could prevent an escalation of the current crisis into a full-blown economic collapse. After underpinning the viability of Russian banks, it must undertake quick steps to improve investor confidence; for example by avoiding arbitrary closure of its stock markets whenever prices fall [4], avoiding the temptation to indulge in currency intervention and implementing steps to improve bankruptcy procedures, corporate governance and the like which can help create equilibrium much faster.
South Korea
Perhaps the country that shocked me the most by its presence on this list, South Korea has failed to learn the basic lessons of asset-liability and liquidity management from its previous crisis in 1997-98. Most recently, the Korean government has had to unveil a $100 billion guarantee program for the offshore debt of its banks, taking away a rather substantial chunk of the $240 billion or so of foreign exchange
reserves that it boasts.
Given the escalating current account deficit and poor prospects for investment
inflows, it is possible (albeit very unlikely) for Korea to run out of foreign exchange by the beginning of 2010. This must be problematic for any country, and more so for one with international pretentions, as shown by the abortive global takeovers attempted by South Korean companies such as KDB [5] and Samsung in recent months.
There are numerous culprits here. Most notable is the Bank of Korea, which followed an ill-advised policy of maintaining an onshore US dollar shortage in order to deflect the potential for Korean won appreciation. In so doing, it created the conditions for greater offshore borrowings to fund the economic reliance on the export market rather than domestic consumption. In turn, this left banks and companies with the same mix of short-term liabilities against longer-term assets that marked South Korea's first descent into a balance of payments crisis in the Asian financial crisis of 1997.
Ironically, many equity index managers were finally upgrading Korea from its perch in "emerging markets" to a new "developed markets" level; instead it appears that Korea will have to negotiate to stay afloat in the emerging markets category; its most recent equity, currency and credit performance certainly put it in the same category.
India
To a number of people who bought into the BRIC - Brazil, Russia, India and China - hoopla, India's fall from grace parallels that of Russia. Here again, it is not the external borrowing practices of the sovereign itself that are to blame; funnily enough, neither are the borrowings of local companies in global markets considered to be excessive. In any event, less than $25 billion of Indian corporate and bank debt falls due by the end of next year compared with $275 billion of foreign exchange reserves that the country boasts. Even accounting for zero capital inflows and continued current account deficits, the overall cushion will remain close to $200 billion.
Achilles though still has a heel. The loss of confidence can be traced to the haphazard decision-making of the central bank, which came late to the inflation-fighting party this year in a futile attempt to prevent foreign exchange appreciation, thereby causing policy about-turns that stun even the most adept of investors.
Secondly, political noise in the country has been increasing ahead of next year's elections. This has turned investors naturally cautious, and in turn made crisis management a bit trickier for the government (in which respect there is much in common with the recent US experience).
Thirdly, there is legitimate concern both domestically and offshore about the impact of low infrastructure investments by India over the past two decades. The problems seen in the poorest parts of the country offer a closer view, albeit one that the media have been slower to latch onto compared with the markets.
Recent violence in the state of Orissa between Hindu fundamentalists and Christian missionaries showed not so much the tinderbox of religious intolerance as it did the fairly low "price" that poor Indians assigned to their centuries-old culture and religion. For the destitute and the desperate whose battle for basic sustenance is all-consuming, manna from any source is welcome. Inconveniently enough for the people who believe in an India that can outshine its recent past, the images aptly conveyed the two sub-nations (the upwardly mobile and the downwardly stale) created by communist-inspired governments in the country. [6] As in the case of Russia, the response from investors has been to sell first and ask questions later.
And in closing ...
Perhaps the one quote from Greenspan's testimony that I find myself agreeing with, and especially the last sentence: "There are additional regulatory changes that this breakdown of the central pillar of competitive markets requires in order to return to stability, particularly in the areas of fraud, settlement, and securitization. It is important to remember, however, that whatever regulatory changes are made, they will pale in comparison to the change already evident in today's markets. Those markets for an indefinite future will be far more restrained than would any currently contemplated new regulatory regime."
The fact that a market become overcautious at the drop of a hat (or a few billion dollars) is borne out by the experience of the US subprime mortgage market, as it is for countries such as Russia, South Korea and India. In all these cases, the loss of confidence that has been sparked by a combination of quantitative and qualitative factors will induce substantial behavioral shifts that will take years if not decades of patient reworking for these markets and/or countries to correct. Pretenders, whether they are government officials or market fallacies, will always be exposed.
Notes
1. The Age of Turbulence: Adventures in a New World, by Alan Greenspan. Penguin Press HC, 2007. (For review, see Reaping what is sown, October 6, 2007
2. The Black Swan: The Impact of the Highly Improbable, by Nassim Nicholas Taleb, Random House, 2007.
3. See among other Asia Times Online articles: Terminal Velocity, September 23, 2008; Deaf frogs and the Pied Piper, September 30, 2008; and A Fukuyama moment in Finance, October 18, 2008
4. A stone for Chris Cox, Asia Times Online, July 19, 2008
5. Lehman and the liars, Asia Times Online, June 14, 2008 6. India's real terrorists Asia Times Online, May 17, 2008.
(Copyright 2008 Asia Times Online (Holdings) Ltd. All rights reserved. Please contact us about sales, syndication and republishing.)
Friday, October 10, 2008
Fun With Bailout Numbers
The financial pages discover the word quadrillion.
Posted Thursday, Oct. 9, 2008, at 6:50 PM ET You know the economy is in trouble when economists start bandying around numeric terms previously associated with astronomy and particle physics. You can't open a newspaper these days without seeing the phrase "trillion dollars" placed in disturbing proximity to the word losses. According to the Nexis database, these terms appeared together in 1,774 English-language news reports between July and October 2008. During the same three-month period in 2007, they appeared in only 541, and during the same period in 2006, they appeared in only 316. Those were the good old days!
You may not even remember from grade-school arithmetic what comes after trillion. It isn't kajillion. (That's just a whimsical slang term for "unimaginably high number.") It's quadrillion. The phrase "quadrillion dollars" and the word losses appeared together in only two English-language news reports between July and October 2008, so no need to panic just yet. During the same three-month periods in 2007 and 2006, they appeared in one.
After quadrillion, you get quintillion, sextillion, and septillion. I'm relieved to report that the phrases "quintillion dollars," "sextillion dollars," and "septillion dollars" have yet to appear together with the word losses in any English-language news reports that I can find in Nexis. After septillion comes octillion, nonillion, and decillion. The phrase "octillion dollars" appears only once in Nexis (in a Sept. 27 snippet from the blog the Volokh Conspiracy). The phrases "nonillion dollars" and "decillion dollars" appear not at all, which suggests that even at this late date they defy human conceptualization. According to Slate's search engine, I am the first person ever to use any numeric terms above quintillion in this magazine. (Eat my dust, Chris Suellentrop, Daniel Engber, Emily Bazelon, John Dickerson, and Dahlia Lithwick!)
What are these large numbers that the financial pages throw around as they describe the credit crisis, and what relation do they bear one another? Allow me to attempt a crude summary.
The $700 billion potential price tag on the just-passed bank bail—ahem, rescue package—constitutes roughly one-quarter of the annual total cost of operating the U.S. government, which by last year had reached $2.9 trillion. The $2.9 trillion that went out exceeded by $276 billion the $2.6 trillion that came in, mostly from income taxes. Ten months later, the Congressional Budget Office today puts the budget deficit at $438 billion. To cover the difference between spending and revenue, the Treasury borrows money, which leaves the government in debt. Right now, the national debt is $10.2 trillion. That number is so big that a National Debt Clock in Times Square had to eliminate its dollar sign last month to make room for an extra digit. The national debt is approaching the size of the entire U.S. economy. According to the Commerce Department's Bureau of Economic Analysis, the U.S. gross domestic product for 2008 is $14.3 trillion. Of that, $10.1 trillion went to personal consumption. If everybody in the United States decided that starting today they wouldn't consume anything for one year and that instead they would set all that money aside in a piggy bank the size of the Houston Astrodome, that still wouldn't be quite enough money to pay off the national debt.
(Forgive me if I'm starting to sound like the rector who describes eternity in James Joyce's Portrait of the Artist as a Young Man—"and imagine that at the end of every million years a little bird came to that mountain and carried away in its beak a tiny grain of that sand").
The U.S. economy constitutes roughly one-quarter of the world economy. That is to say, the U.S. GDP of $14.3 trillion accounts for one-fourth of the GDP of all nations, which the World Bank calculated at $54.3 trillion for 2007. Have you ever said you wouldn't do something "for all the money in the world"? What you meant literally, probably without knowing it, was that you wouldn't do that thing even if somebody paid you $54.3 trillion. Want to reconsider?
As of last month, bank losses on subprime mortgages for homes in the United States totaled $518 billion. The alchemy of finance doubled that into $1.4 trillion in losses on U.S.-based loans and securities, according to the International Monetary Fund. These losses, which may well grow—the IMF keeps recalculating as the financial crisis worsens—constitute 50 percent of the annual total cost of running the U.S. government; 10 percent of the entire U.S. economy (as expressed in GDP); and 3 percent of the entire world economy (as expressed in GDP). This mess was made in the USA, but in today's globalized economy it is now every nation's problem.
One interesting difficulty, though. As the numbers get bigger, the opportunities for misunderstanding among nations increase exponentially, because of a peculiar and most annoying cultural difference. Human civilization has advanced to the point where it can split the atom and put a man on the moon, but it hasn't advanced far enough to arrive at a common understanding of what the word billion—and therefore the words trillion, quadrillion, etc.—actually means. It's a little bit like the international split between countries that use the Metric system of weights and measures (almost everybody) and countries that stick to the English system (the United States; the United Kingdom gave up on it in 1965). In this instance, however, the confusion is greater because the same terminology is used to describe different quantities.
It all goes back to the 15th century, apparently, when the French worked out a system for describing numbers above 999,999,999. At first, they decided that 1 billion would be 1 million to the second power (i.e., what Americans today call 1 trillion); 1 trillion would be 1 million to the third power (i.e., what Americans call 1 quintillion); and so on. What I would call 1 billion they called 1 milliard. Then, two centuries later, they decided that terms like "1 thousand billion" and "1 thousand trillion" were unwieldy and therefore redefined all numbers above 999,999,999 as multiples not of 1 million but of 1,000. This was inelegant, because the actual numbers designated—billion, trillion, and so forth—were now inconsistent with their Latin roots (bi, tri, etc.). But language's loss was arithmetic's gain; the new designations were much easier to use.
Unfortunately, the earlier, inferior system had taken hold throughout Europe—with the Enlightenment due any minute numbers were getting a lot of use—and many of these countries were unwilling to submit to the inconvenience of an upgrade. Today, the antiquated system is used just about everywhere except the United States, the United Kingdom, Italy, Russia, Turkey, Greece, Portugal, and Brazil. Even France eventually reverted to the old system. In a nice reversal of the Metric system story, in which the United States plays the role of know-nothing villain, here the United States is the sensible hero trying in vain to peddle a superior quantification system to its hidebound, impractical fellow nations.
Astronomers and other big-number scientists have learned to steer around the varying-definition problem by avoiding terms like billion and trillion altogether, instead designating them as powers of 10. But economists and government officials around the world, having only recently become big-number users, still say billion and trillion and, increasingly, quadrillion. When they do so, there's no telling what they mean. This tower of arithmetic Babel has some potential to create a farcical scene when the G-7 finance ministers gather this Saturday at the White House.
Timothy Noah is a senior writer at Slate.Article URL: http://www.slate.com/id/2201961/
Wednesday, October 8, 2008
Martin Wolf: It is time for comprehensive rescues of financial systems
The time for a higgledy-piggledy, institution-by-institution and country-by-country approach is over, writes Martin Wolf. So what should be done? In a word, 'everything'. But first of all, the panic must be dealt with. It is time for comprehensive rescues of financial systems
via FT.com - Martin Wolf on 10/7/08
via FT.com - Martin Wolf on 10/7/08
Tuesday, October 7, 2008
Hockey moms and capital markets By Spengler
Asia Times Online :: Asian news and current affairs
It is true that Asian economies depend on American consumers and an American recession is bad for Asian currencies. But why don't Asians consume what they produce at home? The trouble is that rich Asians don't lend to poor Asians in their own countries. Capital markets don't work in the developing world because it is too easy to steal money. Subprime mortgages in the US have suffered from poor documentation. What kind of documentation does one encounter in countries where everyone from the clerk at the records office to the secretary who hands you a form requires a small bribe? America is litigious to a fault, but its courts are fair and hard to corrupt.
It is true that Asian economies depend on American consumers and an American recession is bad for Asian currencies. But why don't Asians consume what they produce at home? The trouble is that rich Asians don't lend to poor Asians in their own countries. Capital markets don't work in the developing world because it is too easy to steal money. Subprime mortgages in the US have suffered from poor documentation. What kind of documentation does one encounter in countries where everyone from the clerk at the records office to the secretary who hands you a form requires a small bribe? America is litigious to a fault, but its courts are fair and hard to corrupt.
Monday, October 6, 2008
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