Deaf frogs and the Pied Piper
By Chan Akya
A truly horrible joke from the days when vivisection was still permitted has it that a scientist took to the lab a trained frog that could jump whenever it heard the command "jump". In that respect, the amphibian was quite similar to communist party members around the world, but anyway let's carry on with the story.
In the lab, the scientist placed the frog on a table and swiftly sundered one limb. He then said "jump" and the frog complied with some difficulty. He then proceeded to do the same to the limb on the opposite side and said the same thing - and the frog miraculously managed to jump again. Then the third limb and the frog defied all odds by still jumping with just one limb. Finally, the last limb was split and of course this time the frog could not jump.
The scientist wrote his conclusion in the journal, "When it lost all four limbs, the frog became DEAF."
With all apologies to animal lovers, the story resonated with me
last week not so much because I happened to pass a French restaurant or two, but rather the triumphant signaling of the end of market capitalism that is being heralded by leftist newspapers and other media outlets globally. Across Asia, the decline of American banks and government-sponsored intervention in financial markets is being seen as the reason for everyone to return to Japanese-style interventionist policies.
Asian bloggers have come to provide faint praise to the state intervention policies of Henry Paulson and Ben Bernanke, as their moves somehow "prove" anti-market policies, such as fixed currency pegs, state restrictions on bank lending, restrictions on investing instruments such as short selling and the like. Much like the "deaf" frog, a number of these conclusions are patently erroneous and more to the point, downright dangerous for Asian policymakers.
To be sure, this is a bad time for anyone to be seen to be defending the ideals of market capitalism and its supposed superiority, which appears rather weak in the face of the most recent collapse of confidence globally. Fair weather friends though are easy to find, perhaps what Asia needs now more than ever is sensible debate on the subject. It is not the question of whether what is touted as the Beijing Consensus is somehow superior to the Washington version, it is whether either can serve the needs of the hundreds of millions Asians still mired in poverty.
My defense of market capitalism is based on three aspects:
1. The ongoing crisis is due to state interventions, not despite them.
2. There is a secular change in global power structures underway.
3. Asia has more to lose from a return to communism or socialism than from a renewed adherence to global market capitalism.
Doublespeak and the Pied Piper
Perhaps the bit of criticism about the current market collapse that really got me chewing the leather is the one that involves the role of greedy bankers and the like who created billions in unsafe securities that eventually piled on the pain to their capital bases and let these institutions fail on a spectacular level. The diagnosis, while correct in its observation of symptoms, fails to nail the root cause of such excess, which was the availability of financing for these ventures.
As I wrote last year, (see Asia and the vicious cycle of bank bailouts, Asia Times Online, August 11, 2007), the main source of such funding was the billions of dollars gathering dust in the vaults of Asian central banks. That was in turn coming from the rise of trade surpluses with the US and other Western countries as Asian central banks refused to make their currency regimes more flexible.
This lack of flexibility on currency movements was epochal state-driven intervention; and something that every commentator today with an axe to grind against market capitalism seems, quite conveniently, to forget. Then again, doublespeak is de rigueur for communists around the world, so there is little reason to labor that point.
Perhaps what made matters worse for the billions of savings entrusted to these central banks was the quality of fund management that in turn arose from the kind of mandates handed out. With the typical Asian central banks being rule-bound, traditionally oriented fund managers with a mandate to preserve capital rather than purchasing power, it soon became a bit too easy for former Federal Reserve chairman Alan Greenspan and co to unleash untold miseries on the global financial system.
There are two separate aspects to that previous paragraph, albeit interlinked. The first is the mandate for Asian central bankers to capital preservation, that is, if they were entrusted with US$100 billion in 2000, then they would be expected to have slightly over $100 billion in 2001 of that money remaining. This is very different from someone whose mandate is to preserve $100 billion of purchasing power (for example of oil, steel, food grains, singing frogs or anything else a growing economy like those in Asia need) in the years after they were entrusted with that mandate. The first mandate is a typical "communist" one; the second is a market-oriented capitalist one. No prizes here for guessing which particular mandate the Asian central banks held.
The second aspect of that paragraph is the role of Greenspan when chairman of the Federal Reserve, who shrewdly bet that the lack of available alternatives globally (because Asian savings were growing faster than the bond markets of developed markets) meant that a herd of bankers would follow him wherever he went.
Thus when interest rates were cut sharply in the early part of this decade well below prudential levels, in turn driving bond yields far below what would have been required to maintain purchasing power, Asian central banks did not flinch but simply accepted the new yields. They even congratulated themselves on the billions of profits on US government bond and agency holdings as rates fell, much like a rat praises the cheese that got it into a trap.
In effect, what the US exploited was a closed system of bondholders with specific mandates and constraints that were completely different from the principles of market capitalism - that is, the mandate to maintain purchasing power that I laid out above. Back to the subject: Greenspan was thus able to play the Pied Piper, taking Asian savers with him to the river with his beautiful phrases like "conundrum of long-term rates", "global savings glut" and "marked reduction in inflation expectations". When yields on US Treasury securities fell below inflation rates, the search was on for securities with "similar" security characteristics, which in the world of bonds means credit ratings; that is, the much-vaunted triple-A rating that bond managers are trained to respect.
The genius of free markets shone through here. On the one hand, a few billion dollars of demand existed for securities that could be rated triple-A but paid more than the US government did. On the other, there was the giant US mortgage market that had the benefit of recording low payment defaults in its history. Wall Street engineers soon started putting the two together and creating in their wake billions in enhanced value financial products - triple A mortgages of every variety (prime, agency-backed, subprime, alt-A and what have you), other securitized products with triple As (asset-backed securities, or ABS), corporate equivalents of triple A securities (collateralized debt obligations - CDOs; collateralized loan obligations - CLOs; and the like) and so on. Some folks even tried to create triple-A rated securities on stock markets, but even the rating agencies thought that would be too difficult to rate at that level with any shred of conscience.
The other side of genius is of course greed. Wall Street banks that absorbed the billions of profits from selling these securities soon took to eating their own cooking, with comical results for their employees and shareholders, as shown in the past few weeks. Yes, a few folks in Wall Street are indeed my friends, but that doesn't mean I do not take a certain amount of pleasure in watching these fancy white-shoe folks eating dust.
Just so we are clear though - the entire charade can be traced to the decision of Asian central bankers (or more importantly their governments) not to float Asian currencies. In a free-floating system, Asian currencies would have appreciated sharply, rendering returns on US government securities too low to bother. This would have shifted up meaningfully the US yield curve, destroyed the basic mortgage math of a few million Americans (that is, made mortgages too expensive for them), and thus failed to create the hundreds of billions in mortgage-backed securities that now swirl around the world.
The Ponzi in my cradle
Pretty much the worst gift that you can give a newborn child now is a 50-year bond issued by a European country like Italy, France, Germany or Britain. Forget principal repayment after half a century of demographic decline; it is unlikely that coupon payments will be made (or worth anything in terms of purchasing power) by the time the kid turns 20.
Unprecedented losses in the financial crisis around the world expose not so much the distinction between market capitalism and other forms of economic organization - as the previous part of this article makes clear - but instead highlight deeper structural flaws that have become apparent and therefore priced into market calculations.
As I argued last week (see Terminal velocity, Asia Times Online, September 23, 2008), demographic, productivity and other changes mean that the Group of Eight (G-8) leading industrial countries is spent and it is really up to Asian economies to take up the mantle of the sole economically viable region of the world. This is an argument made from two fronts: firstly, the profit generation potential of G-8 economies and secondly the long-term demographic disadvantage of these countries.
The first point is relatively easy to make by looking at the contribution of profits to total gross domestic product for G-8 economies and within that, the share of the financial sector. This approached in 2007 over half of all profits in the case of the US economy, even as profits peaked historically. While the share was lower for Western Europe, Japan and Russia, tying back export-oriented profits to the US economy (which was finance driven) makes all these economies part of the same ball game.
In effect, the subsidized availability of finance from the rest of the world and especially Asia was the primary engine of growth for the US and its G-8 colleagues. What has happened now from a portfolio management perspective is that Asian central banks and other investors will find it immensely difficult if not well nigh impossible to find enough "safe" investment choices to lend to; and even fewer to trust on a longer-term basis.
Losses for European and Japanese banks in the latest US financial crisis rival those of American institutions and in most cases far surpass them. For example, the list of the biggest lenders to Lehman Brothers, the failed investment bank, is entirely Asian; billions of dollars worth of bonds that the company
defaulted on in the Japanese market (so-called Samurai bond market) have now helped to shutter the whole market itself.
This means that going forward, deleveraging of the American and European economies is a structural necessity that calls for the shedding of billions of dollars in assets across their banking systems as well as the ramping up of substantial capital levels. Without willing lenders from the saving pockets of the world, these banks will have to make do with leverage of 2:1 rather than 20:1. That in turn means fewer opportunities for speculative positioning within those economies, greater reliance on expensive term funding and in general a reduction of wasteful consumption.
(On a side note, this deleveraging of the US and other G-8
economies will mean a sharp decline in the consumption of oil, shipping of goods half way around the world at throwaway prices, the use of raw materials such as steel in the manufacture of motor vehicles and perhaps even a reduction in food waste. In effect, these economies will see their global carbon footprints shrink dramatically in years to come. By design or otherwise, the financial crisis will do wonders for the environment.)
The alternative to the above, which is now being considered in earnest across the US and other G-8 countries (see the next section for more on that subject) is the nationalization of financial institutions with the idea that government-owned and guaranteed institutions will fare better in the new world financial order. The trouble with that logic though is that the long-term prognosis for those economies needs to be positive, and unfortunately for the G-8 this is simply not the case.
This is where the second point raised at the beginning of this section comes in, as it concerns the demographic decline of the US as well as other G-8 countries. Leaving aside immigration from countries such as Mexico (which is now in sharp decline due to the destruction, ironically enough, of the construction industry) - US population characteristics are similar to those of major European countries.
This means that the reduction of the profit potential of those economies will also cause a situation of net emigration rather than net immigration - in other words, more people will leave than will arrive in these countries.
Already, we have seen evidence of this in the parts of the US that benefited the most from the expansion of illegal employment, for example the construction industry - which has now imploded. There are anecdotal reports, such as one from California, that point to strawberries rotting on the plants as not enough migrant labor to pluck the fruits can be found.
The slowdown of net migration will impose substantial hardships on the European economies. Many of these, like Italy and Britain, rely on the flow of migrants to pay government taxes; this modern version of a Ponzi scheme depends on the flow of increasing numbers of new players to keep up the cash flows of existing members (citizens). The relative calm on the surface for European economies thus hides a wider panic, namely that the replacement engine for growth is being lost, and in most cases, inexorably so.
Market capitalism - better than the alternatives
Former British prime minister Winston Churchill, defending democracy, made a point that is quite similar to the one I am about to make on market capitalism: "Democracy is the worst form of government, except for all those other forms that have been tried from time to time".
The major aspect of global capitalism's supposed decline of late that has to be debunked pertains to the notion that interventionist Europeans somehow did better than the laissez faire Americans. This is patently untrue when we examine the record of declines in the European zone:
1. Firstly the massive liquidity support being provided by the European Central Bank averaging well over 400 billion euros (daily) (US$574 billion) since the beginning of last summer, that is, more than 13 months already; this is vastly higher than the assistance provided by American authorities over the equivalent period. This alone highlights the scale of investment exposure of these institutions to troubled assets as well as the rather obvious point that other banks aren't willing to lend to them anymore.
2. Frequent rescues of massive financial institutions ranging from various German banks (IKB, a few of the state-owned Landesbanks and more recently Dresdner Bank) to the Swiss banking giant UBS. These activities have generally raised less headlines in the global financial press, perhaps because the average reader in the rest of the world and especially Asia is less aware of the existence of these banks in the first place.
3. In the past week alone we have seen European regulators circling their wagons around Fortis, the Belgian-Dutch financial conglomerate that appears to have come unstuck on the scale of fresh losses on its global asset-backed portfolios. Fortis, the largest Belgian financial-services firm, at the weekend received a $16.3 billion rescue from Belgium, the Netherlands and Luxembourg after investor confidence in the bank evaporated.
4. Higher losses being absorbed by the European financial institutions on the back of straight defaults and downgrades on their investment portfolio; this is even higher when we consider the potential mark-to-market hits that these banks are either not taking or not disclosing at the moment. At the very least, the numbers will probably be double what has already been disclosed.
5. None of the above observations pertains to what will happen when European banks start taking hits on their home-grown portfolios, which are often bigger than their US exposures. The cratering of home prices in Ireland, Spain, France and elsewhere all means that mortgage losses as well as those on derivative securities will be immense for these banks.
6. The experience of Britain where similar accounting practices to the US are adopted (that is, earlier recognition of losses) shows that European banks have a worse time ahead. After the nationalization of Northern Rock last year, we have seen this year the forced merger of banking giant HBOS with Lloyds TSB as well as the forced acquisition of Alliance and Leicester by a Spanish bank (which previously acquired another British bank, Abbey). British regulators also on Monday announced the nationalization of Bradford & Bingley. B&B's savings business, which represents its best assets, will be sold to Spanish bank Santander, while its mortgage book will be nationalized, the Treasury was quoted as saying.
Put simply, the European banking system didn't quite dodge the silver bullet of mortgage losses by not following the precepts of market capitalism. If anything, they have it worse due to lower capital bases supporting more speculative asset categories, as well as the lack of regulatory oversight that follows the absence of mark-to-market accounting.
Economies on a higher growth trajectory, like those of Asia, owe it to their citizens as well as global investors to provide greater transparency on profit generation. Market-friendly policies such as open capital flows and floating currencies help to soften the likely impact of market extremes by effecting ready changes in prices that help to change investment returns; thereby popping asset bubbles quickly and efficiently.
Depending on a bunch of socialists or communists to deliver would be to ask again for the sort of troubles that plagued those systems in the past: the human mind tends to forget pain quickly and hence perhaps everyone has started having nostalgic thoughts about communists. For those of you with such a problem, here are a few reminders:
# Let us recall the standard of living of Russians when the Soviet Union collapsed under the sheer weight of lies imposed by communism in the early 1990s, their long bread queues, the low fertility and longevity rates and so on.
# What about those socialists? Think of the shortages of coal and fish in Britain thanks to hare-brained socialist policies: an amazing achievement for an island country surrounded by fish and bedded on coal.
# Spare a thought for the millions of people in Zimbabwe who suffer from hyperinflation, corruption and government oppression thanks to an interventionist geriatric sporting a Hitler-style moustache and espousing Leninist nonsense.
# The income and wealth gap that opened up between India and South Korea from the 1950s to late-1980s, when the 3.5% annual growth of India left hundreds of millions in abject poverty. This is by far the greatest statistical evidence of the gap between capitalism and socialism in terms of trickle-down wealth effects.
# The opening up of the Chinese economic system to capitalist forces by Deng Xiaoping, which ushered in one of the greatest periods of economic transformation ever witnessed on the planet. As a communist state with Maoist principles, it is unlikely that the Chinese economy of today would be even one-third of the size that it is.
Any choice between the rough and tumble of the markets versus the quiet desperation of corrupt government employees sitting in smoke-filled rooms dreaming up the destinies of millions of people will inevitably lead me to choose the former.
Global market capitalism works. Every time, and any time.
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