Special Reports
 
 


RECOVERY 

OR THE 

BLACK HOLE 
________________
  

   

"FEAR HAS REPLACED TRUST IN OUR APPROACH TO THE ECONOMY"

"The great economic thinkers of the 20th Century, Keynes and Galbraith, knew that left to their own devices, the bankers and financiers would bring the roof in on the whole system. Banking as we have known it has totally failed and must be replaced by a new and preferably more democratically structured global format".  

"The mind-boggling global financial derivatives market, including interest rate and credit default swaps at the end of 2007, had a gross value of an estimated $393 trillion. Ignorance plays a large role here. The truth is that even now nobody knows exactly how bad things are and how many trillions of uncollected derivative debts are still out there. More than $200 trillion in open derivative contracts were not on the balance sheets because so many of the derivatives were zero sum contracts where one liability was set off against another credit elsewhere.  

“What is called for in this global economic crisis is an entirely new economic order”.
 

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The economic outlook which confronts the Obama Presidency on January 20th is truly daunting. The world appears to be heading towards a full-scale depression. Every day we read and hear about rising unemployment, falling production, collapsing banks and corporations, and overall negative growth rates. 

Unless Obama succeeds in pulling America out of its downwardly spiralling vortex the rest of the world cannot start to recover. Obama has gathered together what seems to be the best available team of experts, to advise him on the fresh course upon which to embark.  It has been said that generals design their armies to fight the last war. Regulators, by analogy, design rules to prevent the last crisis. Obama knows that he must look both forwards and back to the crisis in which President Franklin Delano Roosevelt pulled the United States out of economic paralysis in 1933.  

A major part of any turn-around will have to be a psychological one as well. Fear is a driving factor in forcing shares, markets, currencies, employment and consumption down. The world’s bankers have always been prey to the social contagion of market ideas. Like all economic bubbles since the Dutch Tulip crisis in the 17th Century, the sparks set off by the sub-prime crisis last year were at source, psychological ones.  

In halting this trend, Obama’s optimism and determination, modelled in good part on FDR’s, could make a decisive difference.  

The Obama Presidency is likely to redraw the line between government and markets.  The efforts to combat the chaos of the markets this autumn have been characterized by ad-hoc bail-outs rather than any systematic plan. The forthcoming enormous federal stimulus packages and continued federal fundings will be tied to tangible and structured goals, such as the immediate creation of jobs, spending more on the infrastructure of repairing roads and bridges, building new schools, funding new passenger rail facilities, as well as on a broader alternative energy program ranging from wind, geo-thermal, solar and tidal, to thermo-nuclear power. It has been calculated that every billion dollars in stimulus will result in 40,000 new jobs. Such efforts are patterned on the highly successful National Recovery Administration of FDR back in the 1930’s. Roosevelt’s CCC (Civilian Conservation Corps) employed three million people to plant trees, stop soil erosion and channel waterways. 

Capitalism as a weapon of mass destruction. 
What President Obama, with his careful and more thought-out approach, is not likely to tackle in his inaugural address is the economic basis of the current crisis: that powerful weapon of mass destruction of both the environment and the global economy, namely Capitalism. Five years ago, in “Dollars or Democracy” I suggested that the capitalist era of greed, consumption and excess was choking this planet with its toxic by-products. 

It seemed obvious that eventually the corporate structure of the economy, which gave priority to the interest of the shareholders and the greed of the managers, would have to be replaced with a more responsible and less competitive social and financial architecture.

Getting our priorities right is of the essence in any fundamental reassessment of our economic predicament:- 

* People are more important than money. 

* Saving the planet is more important than higher rates of either consumption or production. 

* The long term is every bit as important, if not more so, than the short term. 

Could such sane and fundamental declarations really be adopted? Capitalism denied them. 

Is “Boom and Bust,” the trade-mark of capitalism, truly the best economic scenario available to us? It is a popular myth that there is no alternative to Capitalism when in reality there are a number. 

In “Dollars or Democracy” I presented the broad outlines of an alternative economic structure based on the “Mutualism,” first expounded by Robert Owen in the 19th Century. In brief, this would transform corporations into cooperatives and mutual societies, such as United Parcel Service in the US, John Lewis Partnership in the UK and Mondragon in Spain, which are all owned and operated by the employees themselves.
  

What is evident is that globally, electorates are reluctant to face up to the hard facts of economic life which includes that there is no obvious engine to drive a recovery:

1. The computer/internet age is altering such fundamentals as accountability and trust. Derivative trading in trillions of dollars and astronomic sums in plastic indebtedness would have been unimaginable thirty years ago.  

2. Capitalism depends on perpetual growth – which is both a mathematical and physical impossibility. Living on a restricted planet with rapidly diminishing resources imposes limits. Economic performance for the advanced nations has deteriorated overall over the past 30 years, whether one judges it by employment, wages, investment or even by profitability. Despite all the major technological innovations, wages of three-quarters of the US population have not risen since Ronald Reagan became President.  

3. The corporate system developed by capitalism works for the enrichment of shareholders and places competition, greed and individual advancement above such demands of society as health and education.  

4. Capitalism pushes inequality at all levels: between rich and poor, between men and women, between races, communities, nations and continents. 

5. Capitalism’s rapacious demand for resources is proving increasingly destructive of the environment, with visible and potentially devastating consequences.  
What this amounts to is that we are facing a critical turning point in our thinking about the economy. With business failures surging, unemployment rising at a record pace and retail and auto sales plummeting, major economic indicators in 2009 will be flashing RED. All this may prompt Obama to call for a new economic order to counter free-market disorder. It is of comfort for the world to know that we shall hear little more of ‘market solutions’ for health care, education, or prisons in the United States.

The State of Free-Market Disorder
The scope of the economic problems facing not only the President elect of the United States but the leaders of the entire world is staggering. Over the past decade, the leaders of the developed nations so frequently asserted that their economic system could sustain itself through borrowing, that they came to believe this as a mantra. When the bubble burst, all were caught off guard. 

When Obama assumes office, US government and private debts are more than four times the Gross Domestic Product- or around $40 trillion. And there is no doubt that in 2009 the bail-outs will continue and add substantially to this colossal sum. The United States as well as China, the UK, France, Germany, Italy, Poland and others have underwritten ever greater debts in their efforts to stave off growing unemployment as well as the banking crises.  

Obama rejects that there is a choice between saving the environment and saving the national economies. They are inexorably intertwined. However, it is to be expected that in most countries economic resources will go first to tackling the financial crisis. Convulsions in the financial markets mean that all are looking to shift their money out of potentially risky currencies and assets into safer ones. Even the formerly stable Swiss Franc is now being battered. Surprisingly, downward pressure on the dollar has been eased because of the deep US cuts in imports (i.e. consumers have stopped buying) which has helped decrease the long-running balance of payments deficit.  

Because shares and corporate bonds have been plunging, nervous investors are eagerly buying up government bonds which are yielding historically low rates of return. How long will the appetite of the buyers continue? S & P analysts believe that the stock markets will have to drop another third to approach the lows of past bear markets. In addition, default rates on junk-bonds are likely to soar in 2009. 

There is growing concern however, that Washington and London are going to issue so much debt that they will struggle to pay the interest on the bonds. Such problems have occurred in other countries in the post WWII era. “Credit default spreads” (which are a form of insurance on bonds) are now at record levels. London has issued £150 billion in Treasury gilts (bonds) this year. With US budget deficits almost certainly going well over the trillion dollar a year mark (not to count the $ 8 trillions in bank debt coverage and guarantees to mortgage holders), might confidence in the world’s premier reserve currency collapse with melt-down consequences? Will soup kitchens in London and New York again become a necessity?  

Alas, for nearly a third of the world’s population, soup is not available. Many are already experiencing the worldwide crisis of water and food shortages. The rising cost of food in the less developed world, whose inhabitants now spend up to 2/3rds of their $2 a day income on food, has been devastating. The World Bank suggests that 2.5 billion people live on less than $2 a day. Robert Zoellick, the Bank’s President, reckons that food inflation pushed at least 100 million people into poverty in 2008-thus wiping out the gains the poorest billion people made in the past decade. The Bank itself has had few measurable results or success in reducing poverty, hunger or disease. The poor in the developing countries do not have the resources, such as savings, insurance or welfare provisions from the state to tide them over. Living in slum cities, they do not have the possibility to survive by what the countryside offers. Their “no option deal” is to starve, or get sick and die. 

New Directions 
President Obama’s first moves when he assumes office will be to unveil a truly gigantic stimulus package to try and get the US economy out of its downward spiral. This is most likely around one trillion dollars and will make a mockery of all the free-market talk about “getting government spending under control.”  

On the revenue side, it is most likely that capital gains taxes will be drastically cut if not entirely abolished. There is no reason why those making money from investment should pay lower taxes on their gains, than those working for a salary. 

There has been considerable debate within the economic team set up by Obama on whether to immediately repeal the Bush tax cuts for those in the top tax brackets. This tax law is due to expire in 2010 in any case, and the thinking is that abolishing it would distract from the impact the new administration wants to make with its stimulus package. On the other hand, abolishing the Bush tax cuts would ultimately generate an increase in consumer spending because the added revenue collected would go to those who would spend it at once. 

Banking Reform 
Saving the banking system from collapse is not the same as halting the credit crunch facing consumers. But then the twin problems afflicting the banks, solvency and liquidity, are not necessarily harmonious. Changes to banking must be directed at reforming the broken financial system so that it can function smoothly again. Financial sector activities are to be kept on a tight rein with both lending and the generation of credit likely to face far greater controls merely as stop-gap measures.  

Many banks in the US and the UK, as well as others in the G8, remain open today only thanks to the taxpayers, but banks still prefer to hoard their money to lending it to those in need. The immediate first step is likely to be to separate commercial banks from investment banks. Indeed Obama has called for the creation of a separate “infrastructure bank” which would operate on the basis of need and merit of particular state projects and not on pork-barrel congressional politics. 

But this too will not be enough. Bankers and politicians still lack an exit strategy from the awkward position in which they find themselves. Six giant banks currently control 75% of America’s $14 trillion in banking assets. As Ben Bernanke, the Fed’s chairman acknowledged this autumn: “We have developed… a very serious too-big-to-fail problem.” These institutions are betting that the US government will not let them fail if they get into further trouble. And investors assume that the government will find further billions to bail them out because the alternative could bring down the entire system. 

The great economic thinkers of the 20th Century Keynes and Galbraith knew that left to their own devices, the bankers and financiers would bring the roof in on the whole system. Banking as we have known it has totally failed and must be replaced by a new and preferably more democratically structured global format. 

In the computer age, the control of capital could be managed with the efficiency which groups like VISA and MC run in their global debt servicing businesses. Some economists believe that nationalizing all banks would be a true recognition of what is already happening: governments in Washington and London and the European capitals are swiftly becoming the largest shareholders and players in the financial system. The state is already the only one that can print money and its handling of government securities is larger than that of any bank. In the long-run, such nationalization would be far less expensive than trillion dollar and hundreds of billions of pounds sterling or euro payouts. 

A WFO (World Financial Organization)
What is called for in this global economic crisis is an entirely new economic order.
 

The world is already facing a huge gap between a global system for economics and a generally fractured state system in politics. Two generations ago at Bretton Woods the world leaders were forced to confront a similarly critical situation facing a post WW II economy. The new financial architecture of the time involved the creation of the IMF and the World Bank. 

Keynes had envisioned a supernational bank in which trading accounts would not be settled in gold but in a kind of overdraft facility structured around each nation’s share of world trade. He was defeated on this with tragic results for the global economy. Today we need an institution of this scale but based on far more democratic principles than those dictated by the U.S. in 1944.  

After Bretton Woods all currencies were pegged against the dollar and could fluctuate narrowly within a set parity. More important, the dollar could be exchanged for gold. Acting on behalf of Washington, the IMF imposed conditions on third world countries that America would never have tolerated for itself. The IMF insisted on reducing government spending on everything except debt repayments, in impoverished countries seeking aid. It also demanded the privatization of all national assets which could be sold to foreign investors. Things started to turn around in unexpected ways when Nixon took the dollar off the gold standard in 1971. This allowed the U.S. to become the world’s largest debtor as the IMF insisted that foreign exchange reserves maintained by other nations be in dollars. Brazil’s President Lula pointed out this fall that those who bear the heaviest burden for the collapse of the global economy are those who were least responsible, and that the one who benefited most from this absurd global financial system was the US.  

As the noted economist Joseph Stiglitz has shown in his many books, the IMF forced countries like Argentina into debt and recession, it wrecked public services throughout the world, destabilized exchange rates, and created enormous balance of payments problems for third world nations. Of course it could be argued that it also had its successes, but with such a dismal record is it any longer trustworthy? The time has obviously come to replace it with a new system which does not rely exclusively on the dollar, nor on American economic power. Its very creation could mark the beginning of a better multilateral economic system. Early on in his administration President Obama will have to take a clear position on this in order to decrease the risks of future meltdowns, to lessen the drastic fluctuation in the price of all commodities, and to create a global lender of last resort. 

Controlling Derivatives 
A more immediate priority for the new President will be to bring the recently created phenomenon of trading in “derivatives” under control. Derivatives were supposed to spread risk, instead they increased it to levels never before contemplated. The mind-boggling global financial derivatives market, including interest rate and credit default swaps at the end of 2007, had a gross value of an estimated $393 trillion. Ignorance plays a large role here. The truth is that even now nobody knows exactly how bad things are and how many trillions of uncollected derivative debts are still out there. More than $200 trillion in open derivative contracts were not on the balance sheets because so many of the derivatives were zero sum contracts where one liability was set off against another credit elsewhere. In effect there were increasing levels of separation between debtors and creditors which left everyone uncertain of what the securities being handled actually contained. It goes without saying that packaging loans into securities substantially raised the profits of malfeasance. To be sure, Credit Default Swaps were never traded on any exchange. 
 

In theory those who bought risk could rely on rating agencies and buy insurance against default. When the crunch came, it turned out that the rating agencies had not done their homework and triple A ratings on mortgage debts turned out to be nearly worthless. As a consequence the insurers went bankrupt and the shadow banking network of off-balance sheet accounts on the computers contained gigantic opaque liabilities. 

The banks , the first to be hit when the derivative exposures became suspect, were overwhelmed by a tsunami of trillions of dollars of loan losses. 

Governments around the world must now bring derivative trading under regulatory control. Some economists have suggested that derivatives need to be moved onto an organized exchange where counter party risk would be limited. As to what must be done now, Nobel Prize winner Michael Spence has urged that “collateralized and structured assets, not trading and with uncertain values, need to be evaluated, purchased and dismantled.” This will cost untold trillions to global taxpayers. 

Re-examining Corporate Governance  
The corporate sector is a mirror image of the banking sector and the quality of assets in the banking system can be no better than the quality of liabilities in the corporate sector. To the extent that the corporate sector is fragile, over-leveraged or unprofitable, the assets of the banking sector are suspect. There is a risk that the recent re-capitalization of the banks will fail to achieve its intended objectives because the corporate side of the picture has been largely ignored. Amidst all the current discussion about how to fix the tottering world of finance, there is a gaping black hole: No one is discussing the role corporate restructuring must play to restore both the financial sector and the real economy back to health.  

We should have learned from the record of earlier crises over past decades, that corporate governance has become a burden on society. The push by corporations to increase their rates of return by holding down wages, cutting down on employment, and paring down both research and investment wherever possible, have had the overall result of reducing aggregate demand. It is easy for corporations to endorse globalisation, but how many of them are willing to honour baseline international labour and environmental standards? How many of them practice transparency in their dealings? How few are willing to abide by dispute resolution decisions, by the admittedly ineffectual World Trade Organization?

The headlines attack the corporate directors who award themselves vast bonuses for company losses and non-performance, but there is little follow-up critique of the entirely amoral structure of corporations, the short-termism of their shareholder boards, the tax evasiveness of their managements and corporate irresponsibility in general. The big multi-national corporations weaken the social structure by bidding down wages, treating workers as expendable commodities, and breaking up unions. They uprooted or shut down long-established factories on which entire communities were dependent and opened up replacements in lower-cost locations overseas.  

Over the past few decades the transnational corporations expanded their influence by creating new rules that restrict what governments can and cannot do in terms of interfering with the globalized corporate interests. Today corporations hold many of the legal rights and privileges individuals possess and use these for the purposes of avoiding US and UK taxation. No more needs to be said here but that the father of modern economics, Adam Smith, warned against the dangerously selfish power of corporations and could not accept that they had a proper role in the market. 

New Rules For New Times 
“When depression economics prevails, the usual rules of economic policy no longer apply: Virtue becomes vice, caution is risky and prudence is folly,” wrote the most recent Nobel Prize winner in economics, Paul Krugman. The message to the incoming President was clear: be bold! 

The global economic crisis offers an exceptional opportunity to develop new institutions, create new incentives and to follow moral practices. FDR wrote from the Oval Office back in January 1934: 

“Americans must forswear that conception of acquisition of wealth which, through excessive profits, creates undue private power over private affairs and, to our misfortune, over public affairs as well. In building towards this end we do not destroy ambition…but we do assert that the ambition of the individual to obtain a proper security, a reasonable leisure and a decent living throughout life is an ambition to be preferred to the appetite for great wealth and great power. 

”Those were noble words eloquently expressed. The new President, Obama, will be addressing the question of what kind of a world we want to create for our children and grandchildren and how do we work back from there? The economic crisis has affected the collective judgment on which both economic and green plans are based. Fear has replaced trust in our approach to the economy. This is small wonder in a world where, like wizards, financiers have produced an invisible, untraceable and nightmarish storm of trillions of dollars of derivatives. Fears are that the reality could be much worse than current expectations due to the lack of transparency in these complex financial dealings. The hope is that with the new President, whose sense of purpose and determination are so manifest, a measure of order and calm will return after the panic of recent months.

By Yorick Blumenfield

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