Next New Deal

Troubles in the EuroZone: Will the Contagion affect the U.S.?

Apr 20, 2010Marshall Auerback

Could euro devaluation increase the size of the U.S. deficit? Marshall Auerback explores the possibility, and what it means if deficit hysteria continues unchecked.

A recent poll by Douglas Schoen and Patrick Caddell suggests that swing voters in the US, who are key to the fate of the Democratic Party, care most about three things: reigniting the economy, reducing the deficit and creating jobs.

But the latter two goals are generally incompatible, especially during major recessions.

In times of high unemployment, government deficits are required to underwrite growth, given that the private sector shift to non-government surpluses has left a huge spending gap and firms responded to the failing sales by cutting back production. Employment falls and unemployment rises. Then investment growth declines because the pessimism spreads. Before too long you have a recession. Without any discretionary change in fiscal policy (now referred to in the public media as "stimulus packages") the government balance will head towards and typically into deficit, unless the US miraculously becomes an export powerhouse along emerging Asia lines, and runs persistent current account surpluses, to a degree which allows the governments to run budget surpluses.

This is not going to happen, particularly when the largest current account surplus nations, notably Germany, cling to a mercantilist export led growth model, an inevitable consequence of that country's aversion to increased government deficit spending. The German government's reticence to counter any kind of shift in regard to its current account surplus is particularly significant in light of the ongoing and intensifying strains developing in the EMU nations (see here) . Last week's Greek "rescue" is Europe's "Bear Stearns event". The Lehman moment has yet to come. One possible outcome of this could well be significantly larger budget deficits in the US and a substantial increase in America's external deficit, given the unlikelihood of America becoming an export super power again. Let me elaborate below.

In the euro zone, I now see one of two possible outcomes. Scenario 1: the problem of Greece is not contained, and the contagion effect extends to the other "PIIGS" countries, leading to a cascade of defaults and corresponding devaluations as countries exit the EMU. Interestingly enough, the country which could well be affected most adversely in this situation is France, as the country's industrial base competes largely against countries like Italy and the corresponding competitive devaluation of the Italian currency in the event of a euro zone break-up could well destroy the French economy (by contrast, as a capital goods exporter with few euro zone competitors, Germany's industrial base will be less adversely affected in our view).

In Scenario 2 (more likely in my opinion) we get some greater fears about other PIIGS nations (discussion is now turning to Spain, Portugal and Ireland). The EMU might well hold together but the corresponding fear of contagion might well provoke capital flight and drive the euro down to parity (or lower) with the dollar. Of course, the euro's weakness creates other problems: when the euro was strengthening last year due to portfolio shifts out of the dollar, many of those buyers of euro bought euro denominated national government paper (including Greece). The resultant portfolio shifts helped fund the national EMU governments at lower rates during that period. That portfolio shifting has largely come to an end, making national government funding within the euro zone more problematic, as the Greek situation now illustrates.

The weakening euro and rising oil prices raises the risk of 'inflation' flooding in through the import and export channels. With a weak economy and national government credit worthiness particularly sensitive to rising interest rates, the European Central Bank (ECB) may find itself in a bind, as it will tend to favor rate hikes as prices firm, yet recognize rate hikes could cause a financial collapse. And should a government like Greece be allowed to default, the next realization could be that Greek depositors will take losses, and, therefore, the entire euro deposit insurance lose credibility, causing depositors to take their funds elsewhere.

It all could get very ugly for the ECB. The only scenario that theoretically helps the value of the euro is a national government default, which does eliminate the euro denominated financial assets of that nation, but of course can trigger a euro wide deflationary debt collapse. The 'support' scenarios all weaken the euro as they support the expansion of euro denominated financial assets, to the point of triggering the inflationary 'race to the bottom' of accelerating debt expansion.

So timing is very problematic. A rapid decline of the euro would facilitate a competitive advantage in the euro zone's external sector, but it could also set alarm bells off at the ECB if such a rapid devaluation creates perceived incipient inflationary strains within the euro zone.

What about the US? In the latter scenario, we can envisage a situation in which the combination of panic and corresponding flight to safety to the dollar and US Treasuries, concomitant with the increased accumulation of US financial assets (which arises as the inevitable accounting correlative of increased Euro zone exports) means that America's external deficits inexorably increase. There will almost certainly be increased protectionist strains, a possible backlash against both Europe and Asia, especially if the deficit hawks begin sounding the alarm on the inexorable rise of the US government deficit (which will almost certainly rise in the scenario we have sketched out).

Assuming that the US does not wish to sustain further job losses, the budget deficit will inevitably deteriorate further, either "virtuously" (via proactive government spending which promotes a full employment policy), or in a bad way , whereby a contracting economy and rising unemployment, produce larger deficits via the automatic stabilisers moving to shore up demand as the economy falters.

How big can these deficits go? Easily to around 10-12% of GDP or higher (versus the current 8% of GDP) should a euro devaluation be of a sufficient magnitude to induce a sharp deterioration of America's trade deficit. Possibly even higher.

What will be the response of the Obama Administration? America can sustain economic growth with a private domestic surplus and government surplus if the external surplus is large enough. So a growth strategy can still be consistent with a public surplus. But this becomes virtually impossible if the euro zone's problems continue, as we suspect that they will.

President Obama, however, has long decried our "out of control" government spending. He clearly gets this nonsense from the manic deficit terrorists who do not understand these accounting relationships that we've sketched out. As a result he continues to advocate that the government leads the charge by introducing austerity packages - just when the state of private demand is still stagnant or fragile. By perpetuating these myths, then, the President himself becomes part of the problem. He should be using his position of influence, and his considerable powers of oratory, to change public perceptions and explain why these deficits are not only necessary, but highly desirable in terms of sustaining a full employment economy.

Governments that issue debt in their own currency and do not promise to convert their currency into anything else can always "afford" to run deficits. Indeed, in this context government spending financially helps the private sector by injecting cash flows, providing liquid assets and raising the net worth of some or all private economic agents. In contrast to today's budget deficit "Chicken Littles", we maintain that speaking of government budget deficits as far as the eye can see is ludicrous for the simple reason that as the economy recovers, tax revenue rises, the deficit automatically reduces. That's the whole reason for engaging in deficit spending in the first place. Any projections that show the deficit continuing to climb without limit is misguided -- the Pete Peterson projections, for example, will never come to pass. As we near and exceed full employment, inflation will pick-up, which reduces transfer payments and increases tax revenues, automatically pushing the budget toward surpluses.

In the 220 year experience of the United States there have only been a few years when we've not had deficits and each time the surpluses were immediately followed by a depression or a recession. History shows that we can run nearly permanent deficits and that when we do, it's better for the economy. The challenge for our side of the debate is to expose these voluntary constraints for what they are and explain why the US is not a Weimar Germany waiting to happen.

Roosevelt Institute Senior Fellow Marshall Auerback is a market analyst and commentator.

Two Different Banking Crises - 1929 and 2007

Apr 13, 2010Henry Liu

Henry C.K. Liu continues his analysis of the global post-crisis economy by examining how the banking industry of the 1920s became the byzantine financial sector of today.

The 1929 banking crisis that launched the Great Depression was caused by stressed banks whose highly leveraged retail borrowers were unable to meet margin calls on their stock market losses, resulting in bank runs from panicky depositors who were not protected by government insurance on their deposits.

In the 1920s, there were very few traders beside professional technical types. The typical retail investors were long-term investors, trading only infrequently, albeit buying on high margin. They bought mostly to hold based on expectations that prices would rise endlessly.

By contrast, the two decades of the 1990s and 2000s were decades of the day trader and big time institutional traders. New powerful traders in major investment banking houses overwhelmed old fashion investment bankers and gained control of these institutions with their high profit performance. They turned the financial industry from a funding service to the economy into a frenzy independent trading machine. Many of the investing public aspired to be the Master of the Universe, as caricatured in Tom Wolf's Bonfire of the Vanity, which was turned into a movie starring Tom Hanks. Derivative trading by hedge funds was routinely financed through broker dealers funded by banks at astronomically high leverage.

Greenspan - the Wizard of Bubble Land

But the debt joyride was by no means all smooth sailing in a calm sea. Repeated mini crises were purposely ignored by regulators who should have known better. Greenspan, notwithstanding his denial of responsibility in helping throughout the 1990s to unleash serial equity bubbles, had this to say in 2004, three year before the 2007 tsunami of a century, in hindsight after the bubble burst in 2000: "Instead of trying to contain a putative bubble by drastic actions with largely unpredictable consequences, we chose, as we noted in our mid-1999 congressional testimony, to focus on policies to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion." The Greenspan Fed adopted the role of a clean-up crew of otherwise avoidable financial debris rather than that of a preventive guardian of public financial health. Greenspan's one-note monetary melody throughout his 18-yesr-long tenure as the nation's central banker had been when in doubt, ease.

LTCM - the Crisis that the Fed Papered Over

In the 1920s, there were no derivative markets. In the case of Long Term Capital Management, the hedge fund that failed in 1998, the firm had equity of $4.72 billion and had borrowed over $124.5 billion to acquire assets of around $129 billion, for a debt-equity ratio of about 25 to 1. But even that it was conservative when compared to the 40 to 1 ratio used by investment banks in the 2000s.

LTCM had off-balance-sheet derivative positions with a notional value of approximately $1.25 trillion, most of which were in interest rate derivatives such as interest rate swaps, equaling to 5% of the entire global market. LTCM also invested in other derivatives such as equity options. LTCM was bailed out by its counterparty creditors under the guidance of the NY Fed. (Please see my December 3, 2009 series: Reform of the OTC Derivative Market - Part One: The Folly of Deregulation)

The Enron Fraud

In the 1920s, there was no structured finance or securitization of debt. The case of Enron, a large brave new energy trader, and its spectacular bankruptcy marked the high watermark of legalized financial fraud. The evidence is undeniable that the Enron scandal exposed critical flaws in the entire financial system and the ineffective policing of US capital markets and corporate governance. In a December 18, 2001 Senate Commerce Committee hearing on the Enron collapse, Arthur Levitt, former Democratic head of the Securities and Exchange Commission (SEC), characterizes corporate financial statements as "a Potemkin village of deceit". Senator Ernest Hollings, a Democrat from South Carolina, characterized Enron Chairman Kenneth Lay's political prowess as "cash and carry government". Embarrassingly, the New York Times reported the following day that Hollings had received campaign contributions from Enron and its auditor Arthur Andersen dating from 1989.

Until Enron filed for bankruptcy in 2001, the system's top law firms and accounting firms were providing professional opinion that what went on in Enron was "technically" legal. The international dealings of Enron received unfailing support from the US government. Many of the schemes undertaken by Enron and other companies were devised by investment bankers who collected fat fees advising their clients and who profited handsomely from providing financing for schemes they knew were towers of mirage. It was known in the industry as "finance engineering" and the vehicle was structured finance or derivatives. (Please see my August 1, 2002 article: Capitalism's bad apples: It's the barrel that's rotten)

Greenspan - Enron Prize Recipient

Chairman of the Federal Reserve since 1988, Alan Greenspan gave a lecture at Stude Concert Hall sponsored by the James A. Baker III Institute for Public Policy on November 13, 2001. Following his lecture, he received the Baker Institute's Enron Prize for Distinguished Public Service. The prize, made possible through a generous and highly appreciated gift from the Enron Corporation, recognizes outstanding individuals for their contributions to public service.

Greenspan's speech offered an assessment of what lies ahead for the energy industry to an admiring audience. In the wake of the September 11 attacks and the then weakened state of the economy, Greenspan stressed the need for policies that ensure long-term economic growth. "One of the most important objectives of those policies should be an assured availability of energy," he said.

Greenspan said that this imperative has taken on added significance in light of heightened tensions in the Middle East, where two-thirds of the world's proven oil reserves reside. He noted that the Baker Institute is conducting major research on energy supply and security issues.

Looking back at the dominant role played by the United States in world oil markets for most of the industry's first century, Greenspan cited John D. Rockefeller and Standard Oil as the origin of US pricing power, notwithstanding the nation saw fit to break up the Rockefeller/Standard Oil trust. Following the breakup of Standard Oil in 1911, he said this power remained with American oil companies and later with the Texas Railroad Commission. This control ended in 1971 when remaining excess capacity in the US and oil pricing power shifted to the Persian Gulf. Greenspan was saying better Standard Oil than OPEC. He seemed oblivious to the development since the 1973 oil embargo that US oil companies have been working hand in glove with OPEC producers to keep oil prices high.

The Power of Markets against Market Power

"The story since 1973 has been more one of the power of markets than one of market power," Greenspan said. He noted that the projection that rationing would be the only solution to the gap between supply and demand in the 1970s did not happen. While government-mandated standards for fuel efficiency eased gasoline demand, he said that observers believe market forces alone would have driven increased fuel efficiency. Greenspan appeared to be the only one who sincerely believed that a free market existed or could exit for the trading of oil. All oil traders know that the price of oil is one of the most manipulated components in world trade.

"It is encouraging that, in market economies, well-publicized forecasts of crises more often than not fail to develop, or at least not with the frequency and intensity proclaimed by headline writers," Greenspan credited free markets with mitigating the oil crisis.

As it turned out, the California energy crisis of rolling blackouts was not caused by Middle East geopolitics. It was the handy work of Enron fraudulent trading strategies.

Greenspan against Reform

All though the 1990s and early 2000s, there were much talk of reform that led nowhere near what was actually needed. Less than a decade later, a financial crisis that Greenspan characterized as the market failure of a century imploded with a big bang.

On Greenspan's 18-year watch at the Fed, government-sponsored enterprises (GSE) assets ballooned 830%, from $346 billion to $2.872 trillion. GSEs, namely Fannie Mae and Freddie Mac, are financing entities created by the US Congress to fund subsidized loans to certain groups of borrowers such as middle- and low-income homeowners, farmers and students. Agency MBSs (mortgage-backed securities) surged 670% to $3.55 trillion. Outstanding ABSs (asset-backed securities) exploded from $75 billion to more than $2.7 trillion.

Greenspan presided over the greatest expansion of speculative finance in history, including a trillion-dollar hedge-fund industry, bloated Wall Street firm balance sheets approaching $2 trillion, a $3.3 trillion daily repo (repurchase agreement) market, and a global derivatives market with notional values surpassing an unfathomable $220 trillion. Granted, notional values are not true risk exposures. But a swing of 1% in interest rate on a notional value of $220 trillion is $2.2 trillion, approximately 20% of US gross domestic product (GDP). Grated that much of the derivative trades were hedged, meaning the risks are mutually canceling. But the hedges would only hold without counterparty default. All that was needed to unleash a systemic failure was for the weakest link to fail. Greenspan created a monetary situation that permitted the market to speculate on risks that it could not afford.

Having released synthetic credit of dangerously high notional value, Greenspan raised the Fed funds rate target to 5.25% on June 29, 2006 from its lowest point of 1% set on June 23, 2003, to dampen inflation expectations, adding aggregate interest payments to the financial system greater than US GDP in 2006. That was like striking a match to like a candle in a dark kitchen filled with leaked gas. Under such fragile and explosive conditions, there was little wonder that the market collapsed a year later. (Please see my March 16, 2007 article: Why the US sub-prime mortgage bust will spread to the global finance system, written at a time when mainstream opinion was that the housing market, being geographically disaggregated, would not spread.)

Much of the precautionary measures instituted during the New Deal to prevent a reply of the 1929 crash, such as the separation of investment banking from commercial banking, requiring banks to be neutral intermediary of capital funds rather than profit-seeking market makers, in the form of the Banking Act of 1933 (Glass-Steagall), were repealed, as a result of bank lobbying. Glass-Steagall was replaced by the Financial Services Modernization Act of 1999, (Pub.L. 106-102, 113 Stat. 1338, enacted November 12, 1999), aka the Gramm, Leach-Bliley Act (GLBA).

Wholesale Credit Market Failure

Yet with the benefit of deposit insurance instituted during the New Deal remaining operative, the current financial crisis that began in mid-2007 was caused not by bank runs from depositors, but by a melt down of the wholesale credit market when risk-averse sophisticated institutional investors of short-term debt instruments shied away en mass.

The wholesale credit market failure left banks in a precarious state of being unable to roll over their short-term debt to support their long-term loans. Even though the market meltdown had a liquidity dimension, the real cause of system-wide counterparty default was imminent insolvency resulting from banks holding collateral whose values fell below liability levels in a matter of days. For many large, public-listed banks, proprietary trading losses also reduced their capital to insolvency levels, causing sharp falls in their share prices.

To read the full article, please visit HenryCKLiu.com.

Roosevelt Institute Braintruster Henry C.K. Liu is an independent commentator on culture, economics and politics.

The PIIGS Problem: Maginot Line Economics

Apr 12, 2010Marshall Auerback

Marshall Auerback warns that Germany's obsession with a defense against the external threat of inflation is blinding them to the real risks facing Europe.

The Maginot Line, named after French Minister of Defense André Maginot, was a line of defenses which France constructed along its borders with Germany and Italy after suffering appalling damage and casualties during World War I. The French thought they were now protected from a repeat, and believed the defenses impenetrable.

Chatting to a number of German participants at last week's Institute for New Economic Thinking (INET) conference, we couldn't help getting a sense of the economic parallel in regard to Germany's deep resistance to greater fiscal expansion as means of dealing with the problem of the "PIIGS".

The Problem:

Germany's fiscal deficit fetishism is largely a product of that country's own hyperinflation experience during the Weimar Republic. As deeply ingrained as that trauma remains in the German psyche, it is now taking on an almost hysterically irrational quality as evidenced by the latest "rescue package" for Greece. Its EMU "partners", led by Greece and soon to be followed by Portugal, Spain, Ireland and Italy, are increasingly being forced to embrace Germanic-style hair shirt economics, because the obvious fiscal response is constrained via self-imposed rules inherent in the rules governing the European Monetary Union. These rules are regarded, almost to a man, as "sound economics" by Germany's policy makers and the vast majority of its citizens (if one is to measure this via the national polls, which continue to indicate visceral hostility to "bailouts" for "lazy Greek scroungers and tax dodgers"). We wonder if they'll still be feeling that way if the contagion extends to Berlin and Paris.

Historians all know how effective the Maginot Line ultimately proved for the French in terms of defending a German occupation of their country during the Second World War: the Germans were able to avoid a direct assault on the Maginot Line by violating the neutrality of Belgium, Luxemburg and the Netherlands, whilst the Luftwaffe simply flew over it.

Likewise, we think Germany's "Weimar 2.0" phobia is based on similarly flawed "Maginot Line" thinking, thereby generating a correspondingly ineffectual response to the EMU crisis. It's becoming a story of intellectual hubris, defending "good economics", Germanic-style, over common sense.

Judging from the market's reaction to the 45m euro rescue package of Greece, it appears that the EMU and, by extension, the euro, have dodged a bullet for now. But the PIIGS problems remain. The terms and conditions include IMF 'austerity' measures, which will act to slow the economy of Greece and the entire EU -- which is already dangerously weak to the point of promoting higher budget deficits through low tax revenues and high transfer payments. All of which serves to further weaken the creditworthiness of all the member nations.

It also increases the euro debts of the other contributing nations because they are being forced to contribute to this funding package for Greece. The implication of the same type of 'rescue' for the larger euro nations is not pretty. Expect much higher levels of stress for the remaining euro member nations presumed to be 'strong' as the same kind of forced austerity appears in store for other "violators" of the Maastricht Convergence Criteria. Think about Spain, which now has 20% unemployment, or Ireland, which has a classic Iceland problem, given that the liabilities of its banking system vastly exceed the country's overall GDP.

The underlying assumption of the rescue package is not sound. The stronger nations still think by offering a big enough "guarantee" the markets will take up the slack and finance Greece for them. But the markets now want to see the cash and, more importantly, they want a firm demonstration that the funding guarantees provided will help to sustain the ability of nations like Greece to service its debt without turning the nation into an industrial wasteland. The markets no longer believe in a "contingent liability" model, which is something akin to indicating that you have a rich relative who can help you out if needed. The EMU's "rich relative" has already indicated that this is verboten, but it has denied Greece and the other PIIGS nations the means to grow adequately to service debt going forward.

The Prognosis:

The euro should therefore fundamentally remain on the weak side after a temporary bout of short-covering, as the high levels of euro national government deficits are adding the non government sectors' holding of euro denominated financial assets. And the austerity measures are likely to increase euro government deficits and thereby exacerbates potential national insolvency problems amongst the euro zone nations.

The common Germanic retort to this line of thinking is that a default in, say, California, would no more threaten the viability of the dollar than a Greek default would endanger the euro. Perhaps, although the Lehman experience should have taught us all that the negative externalities of such an event can seldom be determined in advance, given the opacity of today's funding mechanisms. Additionally, the United States of America is an existing NATIONAL fiscal authority which can respond to the growing problem of state insolvency via dollar creation and corresponding revenue sharing with the states. No such comparable fiscal entity yet exists in the euro zone.

Although we have hitherto characterized Greece as the EMU's "Lehman" problem, the rescue package announced on Monday makes us that think that the better parallel for Greece might well be Bear Stearns. Bear's "rescue" in March 2008, initially looked like it enabled the global financial markets to avert a growing crisis in the asset backed securities markets. What it did in reality was kick the can down the road, as the underlying structural problems which created the crisis in the first place remained unresolved. The credit crisis that began in August 2007 involved failure of both the liquidity and the solvency risk systems. The consequent freeze-up arose because the subsequent bankruptcy of Lehman and collapse of AIG destroyed the markets' expectations (built up by years of bailouts) of their being an ultimate market maker, which would always be able to deal in these securitized instruments.

By the same token, the creation of a common currency via monetary union has created market expectations that one country's paper is as good as another, which explains why, for so many years, "fiscally profligate" nations such as Italy were able to borrow at Germanic level interest rates. But the decision a few months ago by the European Central Bank to block a basic "repo" function -- namely, the purchases of a number of European commercial banks of Greek government debt and exchanging this debt via repos with the ECB for German and French government paper is what appears to have initially triggered the Greek crisis and raised issues of Athens's potential insolvency.

From what we understand, the cessation of this repo function was largely done at the behest of the Germans, who saw this activity as a kind of "back door monetization" which would lead inevitably to inflation. This, despite the fact that the entire euro zone is characterized by huge unemployment , high output gaps, and collapsing domestic consumption. All of this at the core is being driven by Germany's pathological fear of inflation which they see as the inevitable consequence of excessive government budget deficits.

But Germany's irrational fears of inflation are storing up the conditions for a far greater crisis down the line. The euro contagion could now very well spread to Italy Portugal Spain and Ireland, all of which (under the terms of this package) have to lend to Greece, at around 5%. So what happens to their funding costs? They go north of 5% as a next step. In the US, when good banks took over bad banks, they became bad banks themselves (see Bank of America and Countrywide). And what about the seniority structure of these loans? Do they subordinate Greek Government Bond holders? One assumes yes, but this is not made clear by the rescue package. In short, this appears to be a cobbled together solution, and it won't work for a Spain or an Italy. There's no clarity even on how it gets ratified. The EU says it's done, but Germany and Holland say they need Parliamentary approval (which can easily be delayed).

Let's be clear: in the aftermath of World War I, German production capacity was either significantly damaged, or redirected toward output required by the military. The Allied blockade further restricted imports well into 1919, and in 1923, French and Belgian troops occupied the Ruhr valley which held a good deal of Germany's manufacturing base. All of these measures significantly restricted Germany's capacity to produce, fueling the distributional conflict that fed the hyperinflation.

There is nothing like that today in Germany, yet "Weimar 2.0" thinking predominates in much the same way that "Maginot Line" thinking dominated French thinking in its defense establishment. The obsession with a"defense" against the "external" threat of inflation, is blinding Germany. It doesn't see the risk that the collapse of aggregate demand within the European Monetary Union will ultimately lead to a collapse in Germany's export sector (a large chunk of which is the product of intra-European trade), and the corresponding extension of the "PIIGS" disease of slow growth and high unemployment to the heartland of the euro zone. We know how it ended for France, once the Maginot Line proved to be a defense more apparent than real.

We hope that Germany's similarly "successful" defense of inflation does not lead to a comparably disastrous result for Europe today.

Roosevelt Institute Braintruster Marshall Auerback is a market analyst and commentator.

The Coming European Debt Wars

Apr 8, 2010Michael Hudson

Fasten your seatbelts. The world is in for a bumpy ride on the debt default trail.

Government debt in Greece is just the first in a series of European debt bombs that are set to explode. The mortgage debts in post-Soviet economies and Iceland are more explosive. Although these countries are not in the Eurozone, most of their debts are denominated in euros. Some 87% of Latvia's debts are in euros or other foreign currencies, and are owed mainly to Swedish banks, while Hungary and Romania owe euro-debts mainly to Austrian banks. So their government borrowing by non-euro members has been to support exchange rates to pay these private-sector debts to foreign banks, not to finance a domestic budget deficit as in Greece.

All these debts are unpayably high because most of these countries are running deepening trade deficits and are sinking into depression. Now that real estate prices are plunging, trade deficits are no longer financed by an inflow of foreign-currency mortgage lending and property buyouts. There is no visible means of support to stabilize currencies (e.g., healthy economies). For the past year, these countries have supported their exchange rates by borrowing from the EU and IMF. The terms of this borrowing are politically unsustainable: sharp public sector budget cuts, higher tax rates on already over-taxed labor, and austerity plans that shrink economies and drive more labor to emigrate.

Bankers in Sweden and Austria, Germany and Britain are about to discover that extending credit to nations that can't (or won't) pay may be their problem, not that of their debtors. No one wants to accept the fact that debts that can't be paid, won't be. Someone must bear the cost as debts go into default or are written down, to be paid in sharply depreciated currencies, but many legal experts find debt agreements calling for repayment in euros unenforceable. Every sovereign nation has the right to legislate its own debt terms, and the coming currency re-alignments and debt write-downs will be much more than mere "haircuts."

There is no point in devaluing, unless "to excess" - that is, by enough to actually change trade and production patterns. That is why Franklin Roosevelt devalued the US dollar by 75% against gold in 1933, raising its official price from $20 to $35 an ounce. And to avoid raising the U.S. debt burden proportionally, he annulled the "gold clause" indexing payment of bank loans to the price of gold. This is where the political fight will occur today - over the payment of debt in currencies that are devalued.

Another byproduct of the Great Depression in the United States and Canada was to free mortgage debtors from personal liability, making it possible to recover from bankruptcy. Foreclosing banks can take possession of collateral real estate, but do not have any further claim on the mortgagees. This practice -- grounded in common law -- shows how North America has freed itself from the legacy of feudal-style creditor power and the debtors' prisons that made earlier European debt laws so harsh.

The question is, who will bear the loss? Keeping debts denominated in euros would bankrupt much local business and real estate. Conversely, re-denominating these debts in local depreciated currency will wipe out the capital of many euro-based banks. But these banks are foreigners, after all -- and in the end, governments must represent their own home electorates. Foreign banks do not vote.

Foreign dollar holders have lost 29/30th of the gold value of their holdings since the United States stopped settling its balance-of-payments deficits in gold in 1971. They now receive less than a thirtieth of this, as the price has risen to $1,100 an ounce. If the world can take that, why shouldn't it take the coming European debt write-downs in stride?

There is growing recognition that the post-Soviet economies were structured from the start to benefit foreign interests, not local economies. For example, Latvian labor is taxed at over 50% (labor, employer, and social tax) -- so high as to make it noncompetitive, while property taxes are less than 1%, providing an incentive toward rampant speculation. This skewed tax philosophy made the "Baltic Tigers" and central Europe prime loan markets for Swedish and Austrian banks, but their labor could not find well-paying work at home. Nothing like this (or their abysmal workplace protection laws) is found in the Western European, North American or Asian economies.

It seems unreasonable and unrealistic to expect that large sectors of the New European population can be made subject to salary garnishment throughout their lives, reducing them to a lifetime of debt peonage. Future relations between Old and New Europe will depend on the Eurozone's willingness to re-design the post-Soviet economies on more solvent lines -- with more productive credit and a less rentier-biased tax system that promotes employment rather than asset-price inflation that drives labor to emigrate. In addition to currency realignments to deal with unaffordable debt, the indicated line of solution for these countries is a major shift of taxes off labor onto land, making them more like Western Europe. There is no just alternative. Otherwise, the age-old conflict-of-interest between creditors and debtors threatens to split Europe into opposing political camps, with Iceland the dress rehearsal.

Until this debt problem is resolved - and the only way to resolve it is to negotiate a debt write-off -- European expansion (the absorption of New Europe into Old Europe) seems over. But the transition to this future solution will not be easy. Financial interests still wield dominant power over the EU, and will resist the inevitable. Gordon Brown already has shown his colors in his threats against Iceland to illegally and improperly use the IMF as a collection agent for debts that Iceland doesn't legally owe, and to blackball Icelandic membership in the EU.

Confronted with Mr. Brown's bullying -- and that of Britain's Dutch poodles -- 97% of Icelandic voters opposed the debt settlement that Britain and the Netherlands sought to force down the throat of Allthing members last month. This high a vote has not been seen in the world since the old Stalinist era.

It is only a foretaste. The choice that Europe ends up making will likely drive millions into the streets. Political and economic alliances will shift, currencies will crumble and governments will fall. The European Union and indeed, the international financial system will change in ways yet to be seen. This will be especially the case if nations adopt the Argentina model and refuse to make payment until steep discounts are made.

Paying in euros -- for real estate and personal income streams in negative equity, where the debts exceed the current value of income flows available to pay mortgages or for that matter, personal debts -- is impossible for nations that hope to maintain a modicum of civil society. "Austerity plans" IMF and EU style is an antiseptic, technocratic jargon for life-shortening and killing impact of gutting income, social services, spending on health on hospitals, education and other basic needs, and selling off public infrastructure for buyers to turn nations into "tollbooth economies" where everyone is obliged to pay access prices for roads, education, medical care and other costs of living and doing business that have long been subsidized by progressive taxation in North America and Western Europe.

The battle lines are being drawn regarding how private and public debts are to be repaid. For nations that balk at repayment in euros, the creditor nations have their "muscle" waiting in the wings: the credit rating agencies. At the first sign a nation is balking in paying in hard currency, or even at the first hint of it questioning a foreign debt as improper, the agencies will move in to reduce a nation's credit rating. This will increase the cost of borrowing and threaten to paralyze the economy by starving it for credit.

The most recent shot was fired n April 6 when Moody's downgraded Iceland's debt from stable to negative: "Moody's acknowledged that Iceland might still achieve a better deal in renewed negotiations, but said the current uncertainty was hurting the country's short-term economic and financial prospects."

The fight is on. It should be an interesting decade.

Prof. Michael Hudson is Chief Economic Advisor to the Reform Task Force Latvia (RTFL). His website is michael-hudson.com.

The Crisis of Wealth Destruction

Apr 7, 2010Henry Liu

Henry C.K. Liu argues that the poorly targeted stimulus and bailouts have caused long-lasting damage to global wealth.

The financial crisis that first broke out in the US around the summer of 2007 and crested around the autumn of 2008 had destroyed $34.4 trillion of wealth globally by March 2009, when the equity markets hit their lowest points. On October 31, 2007, the total market value of publicly-traded companies around the world reached a high of $63 trillion. A year and four months later, by early March 2009, the value had dropped more than half to $28.6 trillion. The lost wealth, $34.4 trillion, is more than the 2008 annual gross domestic product (GDP) of the US, the European Union and Japan combined. This wealth deficit effect would take at least a decade to replenish even if these advanced economies were to grow at mid single digit rate after inflation and only if no double dip materializes in the markets. At an optimistic componded annual growth rate of 5%, it would take over 10 years to replenish the lost wealth in the US economy.

In the US where the crisis originated in mid-2007 after two decades of monetary excess that encouraged serial debt bubbles, the NYSE Euronext (US) market capitalization was $16.6 trillion in June 2007, more than concurrent US GDP of $13.8 trillion. The market cap fell by almost half to $7.9 trillion by March 2009. US households lost almost $8 trillion of wealth in the stock market on top of the $6 trillion loss in the market value of their homes. The total wealth loss of $14 trillion by US households in 2009 was equal to the entire 2008 US GDP.

As the financial crisis broke out first in the US in July 2007, world market capitalization took some time to feel the full impact of contagion radiating from New York which did not register fully globally until after October 2007. In 2008 alone, market capitalization in EAME (Europe – Africa – Middle East) economies lost $10 trillion and Asian shares lost around $9.6 trillion.

Government Bailouts, Stimulus Packages and Jobless Recovery

As a result of over $20 trillion of government bailout/stimulus commitments/spending that began in 2008 worldwide, the critically impaired global equity markets finally began to show tenuous signs of stabilization only two years later by the end of 2009. Yet total world market capitalization was still only $46.6 trillion by the end of January 2010, $16.4 trillion below its peak in October 2007. The amount of wealth lost worldwide in 2009 still exceeded 2009 US GDP of $14.2 trillion by $2.2 trillion. The NYSE Euronext (US) market capitalization was $12.2 trillion in January 2010, recovering from its low at $7.9 trillion in March 2009, but still $4.4 trillion below its peak at $16.6 trillion in June 2007.

US GDP in first quarter 2009 fell 6.3% annualized rate while fourth quarter of 2009 surged 5.7% mostly as a result of public sector spending equaling over 60% of annual GDP. The US government bailout and stimulus package to respond to the financial crisis added up to $9.7 trillion, enough to pay off more than 90% of the nation’s home mortgages, calculated at $10.5 trillion by the Federal Reserve. Yet home foreclosure rate continued to climb because only distressed financial institutions were bailed out, but not distressed homeowners. Take away public sector spending, US GDP would fall by over 50%. This is the reason why no exit strategy can be expected to be implemented soon in the US.

It took $20 trillion of public funds over a period of two and a half years to lift the total world market capitalization of listed companies by $16.4 trillion. This means some $3.6 trillion, or 17.5%, had been burned up by transmission friction. Government intervention failed to produce a dollar-for-dollar break-even impact on battered markets, let alone generating any multiplier effect which in normal time could be expected to generate a multiplying effect of between 9 and 11 times. In the mean time, the real global economy, detached from the equity markets, with the exception of China’s, continues to slide downward, with rising unemployment and underemployment.

This massive government injection of new money managed to stabilize world equity markets by January 2010, but only at 73.5% of its peak value in October 2007. Still it left the credit markets around the world dangerously anemic and the real economy operating on intensive care and life support measures from government. This is because the bailout and stimulus money failed to land on the demand side of the economy which has been plagued by overcapacity fueled by inadequate workers income masked by excessive debt, and by a drastic reversal of the wealth effect on consumer demand from the bursting of the debt bubble. The burst of the debt bubble had destroyed the wealth it buoyed, but it left the debt that had fueled the bubble standing as liability in the economy.

Much of the new government money came from adding to the national debt, for which taxpayers would still have to pay back in future years. This money went to bail out distressed banks and financial institutions which used it to profit from global “carry trade” speculation, as hot money that exploited interest rate arbitrage trades between economies. The toxic debts have remained in the global economy at face value, having only been transformed from private debts to public debts to prevent total collapse of the private sector. The debt bubble has been turned into a dense debt black hole of intense financial gravity the traps all lights from appearing at the end of the recovery tunnel.

Much criticism by mainstream economists in the US has been focused on the controversial bailout of “too-big-to-fail” financial institutions that have continued to effectively resist critically needed regulatory reform by holding the seriously impaired economy hostage. Some critics have complained that government stimulus packages are too small for the task at hand. Only a few lonely voices have focused on public spending being directed at wrong targets. Yet such massive public spending has left many economies around the world with looming sovereign debt crises.

For more, please visit HenryCKLiu.com.

Roosevelt Institute Braintruster Henry C.K. Liu is an independent commentator on culture, economics and politics.

Sybil Economy

Apr 7, 2010Joe Costello

The Sibyl, with frenzied mouth uttering things not to be laughed at, unadorned and unperfumed, yet reaches to a thousand years with her voice by aid of the god.

-- Heraclitus

Sibyls were the oracles of ancient Greece. You'd go to them when you had a heavy decision, but the problem was their advise was never straight forward and prone to misinterpretation. Not quite as bad as a modern pollster, but they could get you in serious trouble. For example, Croesus, a great king of ancient Greece, went to the Delphic Oracle seeking advise about attacking Persia. She replied, "If you attack Persia, a great empire will fall." He did, and a great empire fell. Unfortunately for Croesus, it was his. Looking at the global economy today, one can't help but think you'd get a better view of the future from any Sibyl.

Global financial markets are so manipulated and pumped full of discount dollars, they are relatively useless in divining. The US stock market on p/e value is approaching historical highs, while a metal like copper sits near historic highs, despite a global economy that sits well below its peak of two years ago. Now, there's no denying Asian economies led by China started growing again, but how sustainable that growth is, considering the faults of over-indulging history has revealed with any command and control economy, is truly an important question. The question of over-capacity in China is an important one, and the Chinese have announced they are beginning to shutter smaller steel and electricity plants.

Now, if you look at China, India, Australia and the other Asian economies minus Japan, they are a little over 20% of the global economy. Nothing to sneeze at; however, a great chunk of that is tied to exporting to what we can call the old global economy -- that is the US, Japan, and the EU, which still comprise almost half the global economy. Now the old global economy is drowning in debt, and depending on who you ask, that either matters or it doesn't. Right now for the Greeks, who need a trip up to Delphi, it matters. For the EU as a whole, it seems to matter too, as growth seems at best spotty. The Japanese remain entrenched in deflation and the American economy appears little better than flat.

The most interesting oracle for the modern world is the price of oil, which, despite the greatest global slow-down in post-war history, managed to stay above $70 a barrel and today sits around $87, which in no way helps the global economy as presently structured. Begging the question, what if the global economy gets back to its 2007 peak, where then the price of oil?

Joe Costello was communications director for Jerry Brown’s 1992 presidential campaign and was a senior adviser for Howard Dean’s effort in 2004.

Greece and the EuroZone: Angie, Ain't it Time to Say Goodbye?

Mar 30, 2010Marshall Auerback

Time for Greece to exit the Eurozone? Marshall Auerback argues that as painful as it might be, the alternative of wage-cutting is worse.

Arthur Conan Doyle's literary creation, Sherlock Holmes, once solved a murder by noting the dog that didn't bark. It doesn't take Holmes's ingenuity to see that the plan on offer for Greece is clearly a rescue package which doesn't rescue. It's a dog's breakfast.

Greece indeed is being offered a financial aid package of around 22 billion euro, but no funding will be made available until the country fails to find funding elsewhere, entirely obviating the point of the bailout. Greece, like all borrowers, simply offers securities at ever higher rates until it finds the needed buyers. Failure, in theory, is defined as the rate reaching infinity with no buyers. At that time, the euro members would step in with a loan offer at a non concessional rate which would then presumably be infinity. As George Friedman of Stratfor has noted, "That is akin to offering a homeowner, who is about to default on a mortgage, a refinancing offer that equals or increases his mortgage rates above the rate he already cannot pay."

This makes no sense at all, of course. In reality, it's a statement that says Greece is on its own. It means that the EMU nations will stand by without taking action as observers of the standard market default process of Greek funding rates going into double and then triple digits as happens to all failed borrowers of externally managed currencies, including nations with fixed exchange rates.

So much for European solidarity. Even worse, German Chancellor, Angela Merkel has managed to secure the backing of France for her proposal for a joint International Monetary Fund and bilateral aid package from euro-zone countries should Greece need help, which is a shame, given that recent remarks by French Finance Minister Christine Lagarde suggested that Paris better understood the nature of the current crisis.

An interesting question which has hitherto been unanswered by the mainstream media: why did the Greek debt crisis erupt with such sudden ferocity in the past month or so? As many observers have noted, if these countries had their own national currencies, they could allow their currencies to float, which would potentially allow some stimulus via the external sector. More significantly, they are unable to use the expansionary fiscal policies that would help pull their economies out of recession. Of course, both France and Germany also violated these rules and were never punished for their transgressions. Indeed, the selective applications of the rule in EMU have made it more apparent that this is nothing more than a liquidationist gambit on the part of Berlin and now, it appears, Paris.

A liquidationist gambit is the removal, by power, of government from the society. Liquidation occurs when society has ceased to be a center of power, and has become a center of weakness. It therefore becomes far more prone to corporate predation. It does not mean that government becomes either smaller or less intrusive, but that government's traditional role of mobilizing resources for broader public purpose is impaired. These are some of the instruments which are characteristic of liquidation gambits:

1. Looting

2. Corporatism and cartelization

3. Brow-beating (societal interest above self interest, power as power, cooptation and betrayal) particularly via manufactured bankrupcties

4. Shams and accounting frauds

The unseemly side of the Franco-German power play came to the fore last week: ECB President Jean-Claude Trichet ostensibly took some pressure off Greece by extending emergency lending rules, saying its bonds won't be cut off from ECB refinancing operations next year in case Moody's Investors Service lowers its rating to a level comparable with other companies. Of course, this occurred only after the Greeks cried "Uncle".

Why were these lending rules threatened to be removed in the first place? This has never been adequately explored. Trichet's statements marked a reversal for the ECB, which said in January that it wouldn't soften its collateral policy for the sake of a single country. The bank was scheduled to reintroduce pre-crisis rules at the end of 2010.

This basically confirmed my earlier suspicions that this entire crisis was triggered by the ECB at the behest of the Germans. The ECB closed the lending window to Greece, which had been dealing with the inherent operational constraints of the EMU by buying Greek government debt, repo-ing it to ECB, and then taking the reserves from that and buying more government debt. The Germans surely took offense to that, since it is Weimar 2.0 from their paranoid perspective. Ireland has also been using this loophole. Of course, that Germany and France were serial violators of these EMU imposed constraints (when they routinely ran budget deficits in excess of 3% of GDP) never seemed exorcise the President of the ECB to the same degree.

Given the loss of Greece's independent currency creating function, the repo mechanism was likely the only way to get "vertical money" into Greece, once ECB stopped expanding its balance sheet as the crisis died down. So various European central bankers started mentioning in front of microphones that ECB rule waiver would be up at year end, (the one that lets ECB hold and repo lower quality rated euro zone government debt) and, presto, a fully-fledged crisis emerges in Greece.

How convenient, especially as it finally gave Berlin the leverage to fully impose its version of hair shirt economics on those allegedly lazy southern Mediterranean scroungers. Left conveniently unstated is the idea that the longer the PIIGS are forced to wallow in stagnant growth, the more persistent will be the very budget deficits and the larger the public debt to GDP ratios for which they are now being punished. It's akin to someone having a high temperature because he/she is suffering from influenza and therefore denying that person medicine on those grounds. Trying to work against the automatic stabilizers with austerity programs will be futile unless you start dismantling some of the automatic capacity, which gives rise to these stabilizers.

Which is exactly what is happening at present. As Bill Mitchell has noted:

"European countries have stronger automatic stabilisers than most other nations because they have historically given better protection to their workers and retirees etc. The push for austerity is seeking to undermine these provisions in part and in my view that is one of the hidden agendas in all of this."

We would agree with Mitchell and go further by noting the hypocritical nature of the cuts demanded here. As is the case in the US, fiscal austerity seems only to apply when dealing with "wasteful" social spending, because at the same time France and Germany were imposing harsh austerity conditions on the Greeks in exchange for their "support", Berlin and Paris are using the leverage created by the debt crisis to force Athens to buy their weaponry and warplanes even as they urge those "profligate" Greeks to cut public spending and curb its budget deficit. France is pushing to sell six frigates, 15 helicopters and up to 40 top-of-the-range Rafale fighter aircraft. Greek and French officials said President Nicolas Sarkozy was personally involved and had broached the matter when Papandreou visited France last month to seek support in the financial crisis, according to The Economic Times.

Talk about gunboat "diplomacy"! The Germans like to argue that nations such as Greece, Portugal, Spain, Ireland and Italy blew the opportunity that interest rates converging down gave them to get labor productivity up with new investment. In Berlin's eyes, it is all their fault they can't "achtung baby" and get their lazy work forces in line, with lower unit labor costs, like the Germans themselves managed after 7 years of deflating their own country into the ground following on from reunification (of course, this conveniently in the days before the creation of the Stability and Growth Pact).

Surely there was a better way? Rather than the austerity cold bath to break the back of labor and induce a private income deflation with a decidedly Fisherian debt deflation cast to it, would it not be better for current account countries to reinvest the surpluses in the deficit nations in the form of direct foreign investment, or PIIGS government bonds directed solely at public investment that will improve productivity in periphery and have ripple effects on private investment, or run it through the European Investment Bank?

Or the creation of a supranational authority, but not one which replicates the austerity ethos embodied in the Stability and Growth Pact -- rather one which emphasizes the principle that the only fiscally sustainable policy is one that promotes full employment. As we've said before, this could be done via a Government Job Guarantee program. We would need a supranational authority which is geared toward a full employment goal. Such a program would potentially be even more attractive in Europe, given that minimum wages and income support packages are far more generous in than in the US, consequently leaving less scope to use the JG program as a means to replace a strong social welfare benefits model with some form of indentured slavery, which is something one could potentially envisage developing in the US.

Acknowledging that crony capitalist politicians do have this proclivity toward supporting corporate predation and wasteful spending and giving goodies to their campaign contributors, a genuine Job Guarantee Program that automatically adjusts to insure the private sector can actually realize its desired net nominal savings position largely frees the system from political parasites while increasing the freedom of the private sector to achieve its goals. And it is consistent with the idea of re-employng the country via, say, green tech initiatives.

If the Franco-German axis proves resistant to this idea, then it might be time for the Greeks, Portuguese, Italians, Spanish, Irish, etc., to send a different message to Chancellor Angela Merkel. To quote those noted political philosophers, Keith Richards and Mick Jagger, "Angie...ain't it time to say goodbye?"

An exit from the euro zone would clearly create a short term problem because the PIIGS nations that wanted to exit would have to deal with a foreign currency debt burden. It is unclear how the transfers back into the central banking system from the ECB noted above would serve to offset the "euro exposure" upon exit. And there is also likely to be collateral damage within the remaining EMU nations' banking systems, given the amount of PIIGS debt that they likely hold. But ultimately as part of a painful adjustment process it might require the nation to default which could manifest as a negotiated settlement where the creditors accepted the local currency (or nothing). It would be painful and messy. But a long, drawn-out process of wage cutting is the other way and that will have to be a decade-long adjustment. Far more costly, other words, in the long run. And, as Keynes, noted insightfully, in the long run, we're all dead.

More on the Crisis of 2018

Mar 17, 2010Bo Cutter

Shaping the future with today's choices

As I have said in other posts, the Roosevelt Institute is starting a project we are calling "The Next American Economy: Nation-Building for our own Nation." I will be writing about aspects of the next American economy more and more. This is a small road sign on the impending fiscal crisis.

Moody's has just reconfirmed the U.S. government AAA bond rating, but it also said, "In light of the muted recovery, discretionary fiscal adjustment is now the principal means of repairing the damage the global crisis has inflicted on government balance sheets. [ed. note: This is finance talk for saying we can't grow our way out of the box we are in.] A key issue is whether governments are able and willing to implement such unprecedented adjustments."

As my friend, Joe Minarik of the CED, has observed, Allan Greenspan backed the Bush tax cuts in 2001 because he felt we should get rid of the impending budget surplus in order to maintain a U.S. government bond market. He was worried there would be no risk free securities. So the combination of the tax cuts, the out of control spending in the second Bush term, the financial crisis, the steps we had to take to deal with the crisis have brought us to the point at which there are no risk free securities anyway. But we reached this point by making the Treasury bond risky -- not a policy we want to continue to pursue.

Roosevelt Institute Senior Fellow and Braintruster Bo Cutter is formerly a managing partner of Warburg Pincus, a major global private equity firm. Recently, he served as the leader of President Obama’s Office of Management and Budget (OMB) transition team.

Coming to a Country Near You: Let a dozen Latvias bloom?

Mar 8, 2010Marshall AuerbackRob Parenteau

Marshall Auerback and Rob Parenteau explain why self-imposed political constraints on economic policy is 'neo-liberal madness' that threatens countries around the globe. Are we next?

Want to see the real consequence of smash mouth economics? Forget about Greece and take a look at Latvia. Its 25.5 per cent plunge in GDP over just the past two years (almost 20 per cent in this past year alone) is already the worst two-year drop on record. The country recently reported a 12% decline in annual wages in Q4 2009 versus Q4 2008. The IMF projects another 4 percent drop this year, and predicts that the total loss of output from peak to bottom will reach 30 percent. The magnitude of this loss of output in Latvia is more than that of the U.S. Great Depression downturn of 1929-1933.

Policies and systems built for failure

Mainstream economics insists that one path to full employment is via lower wages. If you want to sell more labor services, lower the price of them, namely wages. This is a classic fallacy of composition argument. What might work for one firm is unlikely to work for all firms. Wage cuts in the aggregate simply destroy aggregate spending power, unless the lost demand is made up for in other ways.

But even though Latvia's external balance is improving (largely through a collapse of imports as a result of the collapse of domestic demand), the country is unable to deploy fiscal policy effectively due to the external constraints of its monetary system, which is predicated on the existence of a currency board system. True, the current account is now turning positive, but to suggest that every single country can "internally deflate" its economy via wage destruction of this magnitude to achieve this state of affairs is another fallacy of composition argument. The whole world cannot run trade surpluses, especially not if policy is designed to destroy demand via massive wage destruction.

More importantly, the very structure of a currency board is wrong. It requires a nation to have sufficient foreign reserves to facilitate 100 per cent convertibility of the monetary base (reserves and cash outstanding). Under this system, the central bank stands by to guarantee this convertibility at a fixed exchange rate against the so-called anchor currency. The government is then fiscally constrained and all spending must be backed by taxation revenue or debt-issuance. Pegging one's currency, then, means that the central bank has to manage interest rates to ensure the parity is maintained and fiscal policy is hamstrung by the currency requirements (which is why organizations like the IMF love them so much; it ties governments' hands). Latvia pegs its currency at 0.71 lat per Euro and joined the ERM in 2005 with the intent of qualifying for the euro zone. It operates a system similar to Argentina in the 1990s which ultimately collapsed and led to its default in 2001 (Argentina pegged against the US dollar).

The country's debt is projected to be 74 per cent of GDP for this year, supposedly stabilizing at 89 per cent in 2014 in the best-case IMF scenario. A devaluation, however, would substantially raise the debt service ratios, given the high prevalence of foreign debt (about 89% of Latvia's debt is euro denominated). The currency peg, then, not only restricted the Latvia government's freedom of fiscal maneuver, but also created huge financial fragility because Latvians operated under the mistaken assumption that the peg was inviolable, encouraging borrowers to act with no sense of exchange rate risk. As in Argentina nearly a decade ago, a devaluation would, in all likelihood, lead to a default on external debt. Argentina did eventually manage a 25% recovery in output in the two years following Q1 2002, but only after a 190% devaluation (which was 300% at its maximum)

As Michael Hudson and Jeff Sommers have noted, "these debt levels place Latvia far outside the debt Maastricht debt limits for adopting the euro. Yet achieving entry into the euro zone has been the chief pretext of the Latvia's Central Bank for the painful austerity measures necessary to keep its currency peg." They also point out that maintaining that peg has burned through mountains of currency reserves that otherwise could have been invested in its domestic economy. It has also precluded the use of fiscal policy, since (by virtue of Latvia's peg to the euro), the country operates under the same constraints as if it were already working within the Stability and Growth Pact rules.

'Internal devaluation' is a toxic remedy

With no room to adjust the exchange rate, the only other way to make the currency lose value is to engineer a real depreciation -- that is, reduce labor costs and prices in order to make its tradable products more attractive. This is euphemistically being described as an "internal devaluation" -- a one-off coordinated reduction of wages and prices across the board. It is, in reality, more like an "infernal devaluation". It amounts to a domestic income deflation as wages are crushed in order to get the prices of tradable goods down enough so the current account balance increases sufficiently enough to carry the next wave of growth. The hidden assumption is that a debt deflation spiral does not do the host country in as domestic private incomes are deflated. The argument to justify this toxic remedy is that a reduction in nominal wages and salaries can help Latvia accomplish a boom in net exports, thereby enhancing an economic recovery which would quickly attenuate or short circuit any accompanying debt deflation dynamics that might have been set off at the inception of the internal devaluation.

Here, in a nutshell, is a country which shows us all of the misery that is enacted through the creation of self-imposed political constraints on policy. The Latvian government has voluntarily abandoned the policy tools that could make the lives of their citizens better. Policy makers have tied both their hands and their feet behind their backs so that markets could work their self-adjusting magic. They have pegged their currency; they are furiously slashing their net fiscal spending (under the IMF agreement they are due to cut their net position by 6.5 per cent of GDP -- a huge fiscal contraction), and the economy continues to deteriorate.

This is something likely in store for Greece, which has recently introduced a new round of austerity measures in order to ensure the success of its latest bond offering. Greece and other countries now face the prospect falling private sector incomes - that is, after all, the direct and immediate result of higher taxes on businesses and households, and lower government expenditures. Euro area nominal GDP is already estimated by the OECD to have fallen over 3% in 2009. Unless the trade deficits of the nations pursuing fiscal retrenchment can swing sharply into surpluses (as lower domestic incomes lead to less import demand, and lower costs of production lead to higher exports), private debt defaults will now start to multiply and cascade through the system. Last week, as we mentioned, Moody's placed 4 Greek banks on downgrade watch. This is just the start - the fiscal retrenchment has only just begun to take effect. By taking these steps to avoid a public debt default, we would suggest these economies are now poised for more private debt defaults.

We believe private investors do not yet get this connection, but it will be made very clear in the months ahead. Latvia, with a GDP collapse of nearly 25%, will become the poster child of the region in this regard. This private debt distress will back up into higher loan losses at German banks. Germany's hard won current account surplus will continue to fade Loan growth is already dead in the water in Europe, and if the above analysis is correct, banker perceptions of private sector creditworthiness are about to go "pear shaped", as they so delightfully put it in London.

Paradox of public thrift

But that's not all. Each of these countries are about to discover what we will call the paradox of public thrift. Argentina discovered this in 2001-2. Latvia and Estonia have recently rediscovered it. Ireland is rediscovering it, and within the next three months, Greece will no doubt discover it as well. We will let Bill Mitchell's comments depict the nature of this paradox for you, because it really does capture the essence of the dilemma at hand:

From Ireland: Gov't took billions of €'s out of the economy in the form of public service pay cuts, pensions cuts, dole cuts + wave of private employees replaced by agency workers at minimum wage rates... Guess what? January tax receipts crashed yet again below projections. After two systemic budget cuts, the tax receipts keep tanking. The mainstream consensus? We need more cuts (except for bankers and top civil servants who don't have to take wage cuts)! And the international bond market is happy with Ireland. One day we shall be able to compete with China on a level wage scale, and generous tax incentives for Multinationals. In the meantime, say hello to all the Irish immigrants for me.

This is the future discovery awaiting Greece, Spain, Portugal, Italy...and the UK...possibly Japan...and perhaps the US, although it could manage to skirt the issue for another year. In each of these nations, if the private sector is retrenching already, and the public sector tries to retrench on top of that, unless a massive swing in foreign trade can be accomplished, policy makers are unwittingly inviting falling private nominal incomes and private debt distress into the picture as they reverse fiscal stimulus.

As private incomes fall, tax revenues fall. In order to hit fiscal targets promised to global bond holders, further expenditure cuts must be implemented, and further tax hikes must be rolled out. As the Irish blogger reveals above, this is not a theory -- it is already happening, but policy makers and investors are not willing to acknowledge it. Yet for those who understand the fiscal balance cannot be changed without influencing the cash flows and financial balances of the remaining sectors of the economy, the paradox of public thrift at this juncture is far too evident.

We are by no means defending the generous pension benefit levels of euro zone government workers, the early retirement ages, the corrupt tax practices, etc. These are decisions the citizens of each nation need to make on their own, preferably in full awareness of their consequences, both short and long run. It is not our place to dictate the trade-offs citizens chose in each nation.

The question we are raising, however, is whether the private leverage ratios in many of these countries will allow them to withstand the pressures of transitioning back to growth in the absence of fiscal autonomy. The now prevalent global quest for "fiscal sustainability" may place these economies on a path of private debt default, which is ultimately unsustainable for the economy as a whole. If fiscal retrenchment is to be enacted, then orderly private debt renegotiation and private asset liquidation must be accomplished at a large scale and in a timely fashion. Yet our experience is that this is no easy trick, as the near locking up of various financial channels following the Lehman debacle illustrated in no uncertain terms. Usually such a recipe delivers a financial implosion.

Even the Honorable David Walker, CEO of the Peter G. Peterson Institute, former Comptroller General, and ardent foe of government waste and reckless spending is coming to understand the precarious nature of the current situation. In a February 24th piece on Politico.com with Larry Mishel, Walker insists on the primacy of job creation at this juncture, and recognizes this may actually serve his goal of reducing fiscal deficits in the long run:

President Barack Obama is in a difficult position when it comes to deficits. Today's high deficits will have to go even higher to help address unemployment. At the same time, many Americans are increasingly concerned about escalating deficits and debt. What's a president to do?

The answer, from a policy perspective, is not that hard: A focus on jobs now is consistent with addressing our deficit problems ahead.

We have seen this movie before

That, dear readers, is the real deal, and it is not being reported or openly discussed. We have seen this movie before in Argentina almost a decade ago. They eventually got out with a massive "external" currency devaluation of 300% and an equally massive swing in the trade balance. But the costs of delay were enormous: from 1998-2001, Argentina suffered its worst recession ever and pushed 42% of its households into poverty.

And not every country can do what Argentina has done. Again, the whole world cannot run trade surpluses, the first mover has an advantage until the second mover moves, etc. Plus, Argentina had an explicit debt repudiation and a 300% "external" devaluation that was timed right with global recovery, hardly the sort of conditions that pertain today.

The US has so far managed to resist anything of this magnitude. But as the voices of fiscal retrenchment intensify, a future not unlike Latvia, Greece and Argentina could await. It has taken the people of Iceland to make the first stand against this growing neo-liberal madness. In a historic referendum, over 90 per cent of the population has rejected a proposal for the repayment of billions of pounds lent by Britain and Holland to compensate depositors in a failed Icelandic bank.

The deal would have saddled citizens of Iceland with an additional $16k in debt to compensate the UK and Holland with a $5.3 billion note for the failure of their local banks. This, in a country of a mere 300,000 citizens. The vote failure has already prompted the ratings agencies to downgrade the country to junk, as well as leaving an IMF-led loan in limbo. The "experts" are declaring this a disaster for Iceland, but they and their banking allies must secretly be dreading the result, demonstrating as it does that an international bailout watchdog is truly powerless when the people of the bailout recipient nation want to have nothing to do with a poisoned chalice of an economic "rescue", which does nothing but create a country of indentured serfs.

It is now time for the rest of us to follow the Lilliputians of Iceland: to take the rentier juggernaut down before it completes the task. Time to pry the vampire squid off our faces so we can see the light of day again. Hopefully, Iceland represents the future, not Latvia.

Roosevelt Institute Braintruster Marshall Auerback is a market analyst and commentator.

Rob Parenteau, CFA, is sole proprietor of MacroStrategy Edge, editor of The Richebacher Letter, and research associate at the Levy Economics Institute.

Memo to Greece: Make War Not Love with Goldman Sachs

Feb 22, 2010Marshall AuerbackL. Randall Wray

Marshall Auerback and Randall Wray call for an end to Wall Street's manipulation and destruction of our economies.

In recent weeks, there has been much discussion about what to do about Greece. These questions become all the more relevant as the country attempts to float a multibillion-euro bond issue later this week. The Financial Times has called this fund-raising a critical test of Greece's credibility in financial markets as it battles with a spiraling debt crisis and strikes. The "credibility" of the financial markets is an important consideration in a country which has functionally ceded its sovereign ability to create currency, and thus remains dependent on the vagaries of the very banking institutions which helped create the mess in the first place.

Maybe Greece should secede from the European Union and default on its euro debt? Or go hat-in-hand to the International Monetary Fund (IMF) to beg for loans while promising to clean up its act? Or to the stronger Euro nations, hoping for charitable acts of forgiveness? Unfortunately, all of these options are going to mean a lot of pain and suffering for an economy that is already sinking rapidly.

And it is questionable whether any of them provide long term viable answers. Polls show that given the perception of fiscal excesses of Greece and the other countries on the periphery, the public in Germany opposes a bailout of these countries at its expense by a significant margin. Periphery countries such as Ireland that have already undertaken harsh austerity measures also oppose the notion of a bailout, despite-nay, because of -- the tremendous pain already inflicted on their own respective economies (in Ireland's case, the banks are probably insolvent as well). The IMF route is also problematic, given that Greece probably doesn't qualify under normal IMF standards, and many euro zone nations would find this unpalatable from an ideological standpoint, as it would mean ceding control of EU macro policy to an external international institution with strong US influence.

The Wall Street Journal recently highlighted an article by Simon Johnson and Peter Boone, lamenting that the demands being foisted on Greece and other struggling Euronations would "massively curtail demand, lower wages and reduce the public sector workforce. The last time we saw this kind of precipitate fiscal austerity -- when nations were tied to the gold standard -- it contributed to the onset of the Great Depression in the 1930s". Where we disagree with Johnson and Boone is the suggestion that the IMF be brought in to craft a solution. Any help from this organization will come with tight strings attached -- indeed, with a noose around Greece's neck. Germany and France would be crazy to commit their scarce euros to a bail-out of Greece since they face both internal threats from their own taxpayers and external threats from financial vampires who are looking for yet another nation to attack.

Here's a more appropriate action: declare war on Goldman Sachs and other global financial firms that created this mess. Send the troops, the planes, the tanks, and the ships. Attack every outpost of the saboteurs on European soil. Blockade the airports and ports. Make Wall Street traders and CEOs fear for their lives, or at least for their freedom to travel. Build some Guantanamo-like facility to hold these enemy financial combatants until they can be tried, convicted, and properly punished.

Ok, if a literal armed attack on Goldman is too far-fetched, then go after the firm using the full force of the regulatory and legal systems. Close the offices and go through the files with a fine-tooth comb. Issue subpoenas to all non-clerical staff for court appearances. Make the internal emails public. Post the names of all managers and traders on Interpol. Arrest anyone who tries to board a plane, train, or boat; confiscate their passports; revoke their visas and work permits; and put a hold on their bank accounts until culpability can be assessed. Make life at least as miserable for them as it now is for Europe's tens of millions of unemployed workers.

We know that the Obama administration will not go after the banksters that created this global financial calamity. It has been thoroughly co-opted by Wall Street's fifth column-who hold most of the important posts in the administration. Europe has even more at stake and has shown somewhat more willingness to take action. Perhaps our only hope for retribution lies there.

Some might believe the term "banksters" is too mean. Surely Wall Street was just doing its job-providing the financial services wanted by the world. Yes, it all turned out a tad unfortunate but no one could have foreseen that so many of the financial innovations would turn into black swans. And hasn't Wall Street learned its lesson and changed its practices? Fat chance. We know from internal emails that everyone on Wall Street saw this coming-indeed, they sold trash assets and placed bets that they would crater. The crisis was not a mistake-it was the foregone conclusion. The FBI warned of an epidemic of fraud back in 2004-with 80% of the fraud on the part of lenders. As Bill Black has been warning since the days of the Saving and Loan crisis, the most devastating kind of fraud is the "control fraud", perpetrated by the financial institution's management. Wall Street is, and was, run by control frauds. Not only were they busy defrauding the borrowers, like Greece, but they were simultaneously defrauding the owners of the firms they ran. Now add to that list the taxpayers that bailed out the firms. And Goldman is front and center when it comes to bad apples.

Lest anyone believe that Goldman's executives were somehow unaware of bad deals done by rogue traders, William Cohan reports that top management unloaded their Goldman stocks in March 2008 when Bear crashed, and again when Lehman collapsed in September 2008. Why? Quite simple: they knew the firm was full of toxic waste that it would not be able to continue to unload on suckers-and the only protection it had came from AIG, which it knew to be a bad counterparty. Hence on March 19, Jack Levy (co-chair of M&As) sold over $5 million of Goldman's stock and bet against 60,000 more shares; Gerald Corrigan (former head of the NY Fed who was rewarded for that tenure with a position as managing director of Goldman) sold 15,000 shares in March; Jon Winkelried (Goldman's co-president) sold 20,000 shares. After the Lehman fiasco, Levy sold over $6 million of Goldman shares and Masanori Mochida (head of Goldman in Japan) sold $56 million worth. The bloodletting by top management only stopped when Goldman got Geithner's NYFed to produce a bail-out for AIG, which of course turned around and funneled government money to Goldman. With the government rescue, the control frauds decided it was safe to stop betting against their firm. So much for the "savvy businessmen" that President Obama believes to be in charge of Wall Street firms like Goldman.

From 2001 through November 2009 (note the date-a full year after Lehman) Goldman created financial instruments to hide European government debt, for example through currency trades or by pushing debt into the future. But not only did Goldman and other financial firms help and encourage Greece to take on more debt, they also brokered credit default swaps on Greece's debt-making income on bets that Greece would default. No doubt they also took positions as the financial conditions deteriorated-betting on default and driving up CDS spreads.

But it gets even worse: An article by the German newspaper, Handelsblatt, ("Die Fieberkurve der griechischen Schuldenkrise", Feb. 20, 2010) strongly indicates that AIG, everybody's favorite poster boy for financial deviancy, may have been the party which sold the credit default swaps on Greece (English translation here).

Generally, speaking, these CDSs lead to credit downgrades by ratings agencies, which drive spreads higher. In other words, Wall Street, led here by Goldman and AIG, helped to create the debt, then helped to create the hysteria about possible defaults. As CDS prices rise and Greece's credit rating collapses, the interest rate it must pay on bonds rises-fueling a death spiral because it cannot cut spending or raise taxes sufficiently to reduce its deficit.

Having been bailed out by the Obama Administration, Wall Street firms are already eyeing other victims (and for allowing these kinds of activities to continue, the US Treasury remains indirectly complicit, another good reason why one shouldn't expect any action coming out of Washington). Since the economic collapse is causing all Euronations to run larger budget deficits and at the same time is raising CDS prices and interest rates, it is easy to pick off nation after nation. This will not stop with Greece, so it is in the interest of Euroland to stop the vampires now.

With Washington unlikely to do anything to constrain Goldman, it looks like the European Union, which is launching a major audit, just might banish the bank from dealing in government debt. The problem is that CDS markets are essentially unregulated so such a ban will not prevent Wall Street from bringing down more countries-because they do not have to hold debt in order to bet against it using CDSs. These kinds of derivatives have already brought down an entire continent -- Asia -- in the late 1990s , and yet authorities are still standing by and basically doing nothing when CDSs are being used again to speculatively attack Euroland. The absence of sanctions last year, when we had a chance to deal with this problem once and for all, has simply induced even more outrageous and fundamentally anti-social behavior. It has pitted neighbor against neighbor-with, for example, Germany and Greece lobbing insults at one another (Greece has requested reparations for WWII damages; Germany has complained about subsidizing what it perceives to be excessive social spending in Greece).

Of course, as far as Greece goes, the claim now is that these types of off balance sheet transactions in which Goldman and others engaged were not strictly "illegal" under EU law. But these are precisely the kinds of "shadow banking transactions" that almost brought down the global financial system 18 months ago. Literally a year after the Lehman bankruptcy -- MONTHS after Goldman itself was saved from total ruin, it was again engaging in these kinds of deals.

And it wasn't exactly a low-level functionary or "rogue trader" who was carrying out these transactions on behalf of Goldman. Gary Cohn is Lloyd "We're doing God's work" Blankfein's number 2 man. So it's hard to believe that St. Lloyd did not sanction the activities as well in advance of collecting his "modest" $9m bonus for last year's work.

If these are examples of Obama's "savvy businessmen", then heaven help the global economy. The transaction highlighted, if reported that way in the private sector, would be accounting fraud. Fraud - "Go to jail, do not pass Go" fraud. That senior bankers had no problem in structuring/recommending/selling such deals to cash-strapped governments should probably not surprise us at this point. However, it would be interesting to know if the prop trading desks of those same investment banks, purely by coincidence of course, then took long CDS (short the credit) positions in the credit of the countries doing the hidden swaps. A proper legal investigation by the EU could reveal this and certainly help to uncover much of the financial chicanery which has done so much destruction to the global economy over the past several years.

In this country, we have had a "war on terror" and a "war on drugs" and yet we refuse to declare war on these financial weapons of mass destruction. We all remember Jimmy Carter's "MEOW"-the attempt to attack creeping inflation that was said to sap the strength of the US economy in the late 1970s. But Europe-and indeed the entire globe-faces a much more dangerous and immediate threat from Wall Street's banksters. They created this mess and are not only profiting from it, but are actively preventing recovery. They are causing unemployment, starvation, destruction of lives, and even violence and terrorism across the world. They are certainly more dangerous than the inflation of the 1970s, and arguably have disrupted more lives than Osama bin Laden-whose actions led the US to undertake military actions in at least three countries. That should provide ample justification for Greece's declaration of figurative war on Manhattan.

However, in an ironic twist of fate, it was just announced that Petros Christodoulou will take over as the head of Greece's national debt management agency. He worked as the head of derivatives at JP Morgan, and also previously worked at Goldman-the firm that got Greece into all this trouble!

Dimitri Papadimitriou has recently made what we consider to be an important plea for moderation of the hysteria about Greece's debt. Writing in the Financial Times, he complained that "The plethora of articles in your pages and others, some arguing in favour and other against a bail-out, contribute to market confusion and drive the country's financing costs to record levels. It is not yet clear that a bail-out is even needed, but this market confusion is rendering the government's ability to achieve its deficit goals ever more difficult."

Indeed, we suspect that the same financial firms that helped to get Greece into its predicament are profiting from -- and stoking the fires of -- the hysteria. He goes on, "what Greece really needs now is a holiday from further market confusion being created by contradictory, alarmist public commentary".

Greece, Euroland in general, and the rest of the world all need a holiday from the manipulation and destruction of our economies by Wall Street firms that profit from speculative bubbles, from burying firms, households, and governments under mountains and debt, and even from the crises that they create. Governments all over the globe should use all legal means at their disposal to ferret out the bad faith and even fraudulent deals that global financial behemoths are foisting on us.

Roosevelt Institute Braintruster Marshall Auerback is a market analyst and commentator.

L. Randall Wray is Professor of Economics at the University of Missouri-Kansas City.

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