With the London meeting behind the G20, and the Pittsburgh summit looming, Roosevelt Institute Braintruster Henry C.K. Liu looks at the politics and wisdom behind the a basic principle of banking: debt-to-capital ratios. 

World financial leaders meeting in London on September 3, 2009 announced the first steps toward withdrawing emergency support for the global economy even though they warned that the global crisis was far from being over. The US, UK, France and Germany called for work to start “on exit strategies to be implemented in a coordinated manner as soon as the crisis has ended.”  It is a call for exit from state capitalism back into market capitalism.

U.S. Treasury Secretary Tim Geithner said finance ministers should start to spell out how the “very successful policy response” to the economic crisis could be reversed, presumably without also reversing their alleged success. Speaking in the Treasury press room before flying to London for a meeting of finance ministers of the G20 nations, Geithner said these exit strategies were “very important to confidence” in the financial markets, with the unintended implication that the allegedly “very successful policy responses” would undermine market confidence if not reversed soon. 

Writing in the Financial Times on September 3, Geithner explained that American regulation requires financial institutions to maintain reserves and capital buffers in proportion to their risk so that they can absorb losses at their own expense, and not at the taxpayer’s.  Then he acknowledge what we've all seen and felt: “Regulatory framework failed last year.”   Geithner's version of what happened boils down to this: "Major global financial institutions maintained capital levels that were too low, relied too heavily on unstable short-term funding, and their compensation plans rewarded excessive risk-taking. Larger banks often held less capital relative to their risks and used more leverage than smaller banks."

How five big investment banks remade finance -- and regulation -- in their favor

Such practices did not evolve innocently. The net capital rule created by the Security Exchange Commission (SEC) in 1975 required broker-dealers to limit their debt-to-net-capital ratio to 12-to-1, and such firms must issue early warnings if they begin approaching this limit, or stop trading if they exceeded it, so broker-dealers often kept their debt-to-net capital ratios much lower than 12-1. The rule allowed the SEC to oversee broker-dealers, and required firms to value all of their tradable assets at market prices. The rule applied a haircut, or a discount, to account for the assets’ market risk. Equities, for example, had a haircut of 15%, while a 30-year Treasury bill, because it is less risky, had a 6% haircut. But a 2004 SEC exemption -- given only to five big firms which lobbied intensively for the exemption -- allowed them to lever up 30 and even 40 to 1. 

The five big investment banking firms wanted for their brokerage units an exemption from the 1975 regulation that had limited the amount of debt they could take on to $12 for every dollar of equity. The debt-to-net-capital ratio exemption would -- and did -- unshackle billions of dollars held in reserve as a cushion against potential losses on their investments and trades. The released equity funds from higher leverage allowance could then flow up to the parent company, enabling it to speculate in the fast growing but opaque world of mortgage-backed securities, credit derivatives, and credit default swaps (a form of insurance against counterparty default in order to maintain top credit rating), and other exotic structured finance instruments that only highly-trained mathematicians understand, based on models that are beyond the comprehensive of most traders. 

This brave new approach, which all five qualifying broker-dealers -- Bear Stearns, Lehman Brothers, Merrill Lynch, Goldman Sachs, and Morgan Stanley -- voluntarily adopted, altered the way the SEC measured their capital. The five big firms, three of which became insolvent in 2009, led the charge for the net capital rule change to promote financial innovation, spearheaded by Goldman Sachs -- then headed by Henry Paulson, who became Treasury Secretary under George W. Bush two years later.

By 2009, Lehman Brothers had gone bankrupt, Bear Stearns and Merrill Lynch had been sold to big commercial banks with access to Fed money and Goldman and Morgan Stanley have turned themselves into regulated bank-holding companies to avail themselves the benefit of access to Fed money. The age of independent stand-alone investment banks came to an end in the US. 

The myth of populist capitalism and the apostasy of Alan Greenspan

In the FT, Geithner wrote, "Strengthening capital requirements is an essential part of a broader effort to modernize the regulatory framework so that the financial system is strong enough to withstand the failure of large, complex institutions."  But the capital inadequacy did not evolve by itself. It was created by policy by the Federal Reserve. Geithner seems to have forgotten the stated official views of the Fed under Alan Greenspan, who said in a 1998 testimony before Congress: 

"[W]e should note that were banks required by the market, or their regulator, to hold 40% capital against assets as they did after the Civil War, there would, of course, be far less moral hazard and far fewer instances of fire-sale market disruptions. At the same time, far fewer banks would be profitable, the degree of financial intermediation less, capital would be more costly, and the level of output and standards of living decidedly lower. Our current economy, with its wide financial safety net, fiat money, and highly leveraged financial institutions, has been a conscious choice of the American people since the 1930s. We do not have the choice of accepting the benefits of the current system without its costs." 

The risk of systemic market failure was a conscious choice of Fed monetary policy that the American people did not have much say in. Greenspan, notwithstanding his denial of responsibility in helping throughout the 1990s to unleash the equity bubble, had this to say in 2004, in hindsight (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.”

By the next expansion, Greenspan meant the next bubble, which came in the form of  housing. He did not heed the dire warnings in 2000. The “wide financial safety net” that Greenspan relied on had holes big enough to drive a Mack truck through. By 2008, Greenspan was forced to admit to Congress that he erred in his faith in the self-regulatory regime of banks. 

The bank vaults are empty -- and they're going to stay that way

There was no clear G7 support, let alone G20, for a U.S. proposal to increase the capital holdings at banks in order to prevent a rerun of the crisis that led to the collapse of some of the world’s biggest banks. 

While G20 finance ministers agree that banks need more money set aside in reserves to cushion against losses, how much is needed and how that is calculated appears to be in dispute. 

Washington’s proposal has raised concerns that the United States is pulling back from the G20’s April 2008 pledge to tackle the issue within the existing framework, known as Basel II, a set of recommendations on banking laws and regulations.

FDIC Chair Sheila Bair criticized the Basel II standards in June 2007: “There are strong reasons for believing that banks left to their own devices would maintain less capital -- not more -- than would be prudent. The fact is, banks do benefit from implicit and explicit government safety nets. Investing in a bank is perceived as a safe bet. Without proper capital regulation, banks can operate in the marketplace with little or no capital. And governments and deposit insurers end up holding the bag, bearing much of the risk and cost of failure. History shows this problem is very real … as we saw with the U.S. banking and S & L crisis in the late 1980s and 1990s. The final bill for inadequate capital regulation can be very heavy. In short, regulators can’t leave capital decisions totally to the banks. We wouldn't be doing our jobs or serving the public interest if we did."

French Finance Minister Christine Lagarde said on September 4, 2009 in London she could not see the point of scrapping that framework, saying changes already made to it had dealt with the biggest issues. 

But earlier this year, Ben Bernanke suggested a slightly different view.  "We no longer live in a world in which central bank policies are confined to adjusting the short-term interest rate. Instead, by using their balance sheets, the Federal Reserve and other central banks are developing new tools to ease financial conditions and support economic growth."  

Bernanke holds that relieving the disruptions in credit markets and restoring the flow of credit to households and businesses are essential for the gradual resumption of sustainable economic growth.

Which means that, for the U.S. at least, the ‘how’ has been answered by Bernanke. But the ‘when’ will have to wait and see.

What does Japan's recent election tell us about the politics of bubble-popping? Roosevelt Institute Braintruster Joe Costello takes a look.

Hypocrisy and custom make their minds

The fanes of many a worship, now outworn.

They dare not devise good for man's estate,

And yet they know not that they do not dare.

-- Prometheus Unbound

In the 1980s, Japan was all the rage. In the last half of the decade, Japan's financial bubble seemed to imply the sun was yet again rising. The empire that failed to be held militarily a half century before might yet be gained economically. But then came 1990 -- the bubble popped, and Japan for the next two decades became an example of what to avoid. Yesterday saw the landslide defeat of Japan's Liberal Democrats, who held complete power, all but for a brief moment, for a half-century. Two decades on, the politics of bubble-popping still roil Japan. A professor at Columbia states in the FT:

"This election is not about a ruling party with an unpopular prime minister in a bad economy, this is about the end of the postwar party system in Japan. It's the beginning of a different party system."

Might we have such a hopeful outlook for the US?

Now, there are great differences between the US of 2009 and Japan of 1991, however many of them were favorable to the Japanese. Demand around the world didn't collapse with the Japanese bubble. Japan had a greater industrial base from which it could continue to export. The Japanese had a much stronger social safety net, unemployment never went over 6%, where we are already close to double that. Japan's position allowed economic stagnation for two decades, however last year's global slowdown saw the severest downturn of this post-bubble stagnation, resulting in yesterday's unprecedented election.

What politics will stagnation bring the US? What are the politics of bubble-popping? The initial drop down for the US has been more severe, thus the economy will crawl at an even slower pace. The US has a relatively smaller industrial base and a more porous safety net. The US does have the dollar, but as the global reserve currency it might prove a weight as much as a benefit. For if the weakening of the dollar continues, it will force the Reminbi down, and others to follow suit. The devaluing of the dollar may lead to an even greater deflationary environment.

In the US, the politics of bubble-popping have just begun.

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

As California confronts its own fiscal crisis, Edward Harrison says its closest analogy may be the situation in Ireland -- which, as a case study, has little to offer except company in Depression.  

For quite some time now I have been of the view that there are a number of striking similarities between the goings on in Ireland and those in California, none of them good.  Both locations have seen extraordinary rises in home prices turn to massive busts. As a result, both locales have seen depression-like collapses in consumer demand and the local economy. Unemployment and government deficits are surging in both California and Ireland.  But, both California and Ireland have zero control over monetary policy and this is the crucial connection.

Ireland

Let’s rewind a bit to 1999 when the Euro came into being.  Ireland was a founding member of Euroland. So, on January 1st of that year, the Irish fixed their currency, the Punt, to the Euro for good at a rate of 0.7876. From that time forward, Ireland effectively had no control of the monetary spigot.  By 2002, Punt ceased to exist as money in Ireland and the Euro was ushered in.

What this change meant for Ireland is that it had the many benefits that go with being part of a large single currency market. Among the many advantages of a single currency are reduced foreign exchange costs, less currency volatility, less chance of a run on the currency, and a greater certainty in business planning that results from those benefits.  And these benefits can be huge in times of crisis - just ask Iceland.

There is a problem though which I mentioned before, namely the Irish have no control over their own money.  To be sure, hard money types probably see this as a good thing as it prevents countries inflating to get out of an economic pickle. But the alternative for the Irish has been depression.

Back in February, I mentioned this problem in a post called “The European Problem.” The Eurozone members have decided to forgo independent monetary policies. Individual member nations have free capital movement and a fixed exchange rate but zero control over monetary policy. That rests with the European Central Bank (ECB) in Frankfurt.

The problems mount in recession. Some members are getting devastated. Spain, for instance, is in depression already with unemployment at 14 percent. Ireland’s national budget is imploding with estimates for deficit reaching 10-12 percent of GDP. If you are Spain or Greece, you would like to print money –- a lot of it. But that’s not happening in the Eurozone yet.

The result is a potential national bankruptcy for the likes of Ireland, and this is one reason their credit rating is suffering. Will Ireland go bankrupt?  Perhaps.  It is unclear how willing other Eurozone members would be to support the country were it to run into that kind of difficulty.  The Germans are furious for having abandoned the Deutsche Mark for the Euro, which they see as a ‘weak’ currency.  Bailing out a Eurozone member would come with many strings attached.

Then, there is the case of Austria.  They too are in the Eurozone.  They have a weak banking system because of excessive lending to Eastern Europe — reaching a full 85 percent of Austrian GDP.  (Whether the Austrians were mentally re-creating their lost Empire, stripped after World War I, is a case for the Austrian psychologist Freud.) If the Eastern Europeans run into problems, Austrian banks will fail en masse, requiring help from other Eurozone members (read France and Germany).

So Ireland, having no other choice, must cut spending…drastically, Ambrose Evans-Pritchard reports.

Events have already forced Premier Brian Cowen to carry out the harshest assault yet seen on the public services of a modern Western state. He has passed two emergency budgets to stop the deficit soaring to 15 percent of GDP. They have not been enough. The expert An Bord Snip report said last week that Dublin must cut deeper, or risk a disastrous debt compound trap.

A further 17,000 state jobs must go (think 1.25 million in the US), though unemployment is already 12 percent and heading for 16 percent next year.

Education must be cut by 8 percent. Scores of rural schools must close, and 6,900 teachers must go. "The attacks outlined in this report would represent an education disaster and light a short fuse on a social timebomb," said the Teachers Union of Ireland.

Nobody is spared. Social welfare payments must be cut 5 percent, child benefits by 20 percent. The Garda (police), already smarting from a 7 percent pay cut, may have to buy their own uniforms. Hospital visits could cost £107 a day, etc, etc.

California

I hope this sounds familiar to American readers because this is exactly the scenario faced by California.  The state does not have the option of going out to the California Federal Reserve Board’s backyard to pick a few ten billion dollar notes off the money tree. This is a privilege reserved for the U.S. Federal Government, one I would add that has the Chinese worried.  Effectively, California is to the United States as Ireland is to the Eurozone.  And that spells depression for California.  Here are a few headlines:

• California prepares to shut 220 state parks to make up budget shortfall
• California's Crisis Hits Its Prized Universities
• California closes state offices to save cash

Welcome to Reykjavik on the Pacific.  Don't think this train wreck happened overnight. It has been building for months.  I first asked in October of 2008 is the State of California bankrupt?  Technically, they are not.  But, when a state refuses to honor its bills and hands out IOUs, that’s bankruptcy to me.

It is going to get worse for California. That is for sure. The problem here again is the depressionary bust that is likely to take hold as California starts firing workers and cutting spending. Remember, people with no jobs have little income. And having little income means foreclosure, which also means a surge in housing inventory and falling prices. That’s a recipe for still more foreclosures, continued house prices declines and a deflationary spiral.  I imagine Wells Fargo and Bank of America would be rendered insolvent by such a scenario.  So why is Obama balking at lending a helping hand?

I anticipated a bust in California and a helping hand from the Obama Administration, because I figured they wanted to mitigate worst-case outcomes. As far back as January 2nd, I was already saying this was the likely scenario.  I asked “Will federal largesse be countered by state and local cutbacks?”

There has been a general outcry for economic stimulus on the part of the North American, U.K. and Eurozone federal governments to counteract the fall in private sector consumption.  In the U.S. and the U.K. in particular, this message is being heard and largesse will be delivered in spades.

But, in the United States, there is a bit of a problem: state and local governments.  They will not, and often cannot, spend.  In fact some will be cutting.  Will local government budget cuts undercut federal fiscal stimulus?

Yes. Yes. Yes.  Doesn’t the Obama administration see this?  I would argue they did not understand this in January or the stimulus bill would have been larger and more front-loaded. Perhaps they do now but have chosen not to act because every state and municipality in America would be looking for a handout if they did try to act in California.  So, we’re in bit of a pickle here.

Conclusion

The foregoing analysis can’t leave you feeling like recovery is imminent in Europe or in America.  Certainly, it is not in Ireland or California.  The problem is the Impossible Trinity of a fixed exchange rate, independent monetary policy and free movement of capital. You cannot have all three. And California and Ireland both lack the monetary escape hatch. Depression will set in.

I see only three choices to solve this problem.

1. Bailouts: Of course, we are going to see requests for transfer payments here. Will Obama bite?  Will the Germans block this, afraid that the Austrians and Spanish would be next?  Obviously, transfer payments are part and parcel of a monetary union in order to achieve economic harmonization.  In the U.S., California gets less in federal largesse than it pays in taxes. This is a fact.  However, it is looking ever less likely that this fact will help Schwarzenegger receive the help he wants.

2.  Backdoor currency: Marshall Auerback has argued that the IOUs in California are a backdoor currency system. No, they are not legal tender.  But in a note to me, he said, “California can turn its warrants into sovereign currency by agreeing to accept them in payments to the state. Note that I AM NOT arguing that California should make them 'legal tender, payable for all debts public and private'—this is something it cannot do. But you could basically reduce the cost of CA's borrowing substantially via this device and essentially reduce the need for muni bond issuance.  In fact, the implication that flows from my analysis is that you'd want to buy every single muni bond in sight as the IOU, by giving it an intrinsic value to pay state tax, effectively eliminates the need for muni bond issuance.”  Could Ireland do the same?

3.  Immigration:  People are just going to have to move.  As jobs disappear in Ireland and California, the Irish and Californians will need to emigrate elsewhere. They have a huge market to choose from in both cases.

None of these are great options. I wish I had something more uplifting to say here. But that is the situation we face.

Edward Harrison blogs at Credit Writedowns, where this post originally appeared.

In the second of a two-part post, Roosevelt Institute Braintruster Marshall Auerback explains why the focus on China, reserve currency, and external imbalances is a red herring for our real fiscal problem.

By the end of the first quarter of 2009, it was clear that US nominal GDP had fallen. Incomes started to fall. That indicates the private sector is trying to net save more than is feasible given the shrinkage of the trade deficit and the expansion of the fiscal deficit, largely through so called automatic stabilizers, to date.  This is also reflected in a private household savings rate of almost 7 percent, the highest since 1993 (which, interestingly enough, was also the last time the US government engaged in significant deficit expenditures). 

Now, one could argue that from a US-only perspective, ideally all of the increase in the private sector net saving position would come from a reversal of the trade deficit, but this isn't going to happen.  China earns about 10 times as much on its external sector than the domestic market, so its decision to become an export juggernaut, taken in isolation, was perfectly understandable. But in a world where global trade is collapsing, in part because export dependent economies have just had the rug pulled out from underneath them as US consumers (and others) try to save, it is a fantasy to think the adjustment process can be done entirely through trade.

The only way to avoid a debt deflation outcome, as long as the private sector is trying to increase its net saving, is through an expanding fiscal deficit. And the reality is that we don't need a G20 summit to accomplish this.  The US can do this on its own.  As the government spends more than it earns in tax revenue, private sector incomes are boosted, and the private sector can earn more than it spends. They are two sides of the same coin. In fact, this is what is happening today. In that sense, if you agree that private sector deleveraging is a necessary part of the adjustment process, or at least important, it comes at the price of public sector releveraging, barring a heroic reversal in the US trade deficit (which would throw our trading partners into an even more severe recession unless they also pursued domestic demand-led polices, a la China).

To illustrate this, the current account deficit has already gone from about 6 percent of GDP to roughly 3 percent of GDP as of the end of Q1 2009. Let's say further consumer and inventory contraction gets us to 2 percent of GDP by year end. The CBO suggests the federal fiscal deficit will be out to 12 percent of GDP.  I think that's a bit high, as it incorporates TARP.  But even assuming a trailing deficit of 8 percent (which is roughly what we've got now in the US), the private sector can net save around 7-8 percent of GDP without nominal incomes falling in the economy. At the depths of the 1973-5 recession, private sector net saving hit a post WWII high of nearly 9 percent of GDP. Maybe it needs to go higher this time because of the larger shock to household balance sheets with home and equity price deflation. But at least we can say the fiscal deficit is now programmed to scale up fast enough to reduce or contain the risks of US income deflation, and hence a runaway debt deflation process. To me this is crucial to contain the worst of the credit crisis. 

So can the foreign trade and US household spending imbalances be adjusted? Yes, they can. Can that adjustment process create further challenges? Yes it can, to the extent massive fiscal deficit spending is required to allow the private sector to accomplish its net saving objective without cratering private incomes and setting off a debt deflation spiral.

Then the question really boils down to, can the massive Treasury bond issuance be placed, especially if a smaller US trade deficit means foreign investors have fewer dollars to reinvest in US assets?

Treasury bonds were once over 20 percent of commercial bank balance sheets. They were below 5 percent until recently. Default free securities might look attractive to banks these days, especially with a positively sloped yield curve (and there is no question of national solvency when one has a fiat currency system, as opposed to a gold standard). The Fed used to hold 70-80 percent of its assets in Treasuries, now down to 20 percent. The Fed will want to have plenty of Treasuries to sell into the market once the eventual recovery comes and private investor liquidity preferences fall.. Remember, the Fed has no budget constraint.

Does this imply an increase in liquid assets in the economy? Yes it can, but we are also undergoing a large financial sector deleveraging, and we have begun a household sector deleveraging as well for the first time in the post-WWII period. As loans are paid backed, deposits are cancelled out, shrinking conventional measures of the money supply. Much of the credit in the shadow banking system has been obliterated and will not be coming back soon.

Is there nevertheless a risk of a flight from the dollar to the extent the US is willing to be the first mover, and an aggressive one at that, down these paths of quantitative easing? Yes there is. Is there a risk investors seeing the more central banks pursing the quantitative easing path will take flight into precious metals and other real assets as prospective inflation hedges, even if product price deflation is showing up in more countries? Yes there is. Could that complicate the policy exit strategy to the extent some of these commodities, like oil, are inputs to production, and so higher commodity prices could lead to an adverse shift in supply curves (to the left in price/quantity space, as in stagflationary periods)? Yes it could. 

But I think the alternative of focusing first on the external imbalances between China and the US is the wrong way to go about it. Look at what happened to budget deficits during World War II:  at its peak, the US budget deficit as a percentage of GDP went to 30.3 percent in 1943. Yet by the end of the war, US households and the private sector were once again in a position of massive savings surplus.  This is the financial correlative to those huge government deficits on the side of the ledger.

The whole discussion about China and a new reserve currency, then, is a bit of a red herring in the current circumstances.  As economist James Galbraith has noted:

“[A] stable ratio of debt to GDP is not a normal feature of modern history.  Gradual drift in one direction or the other is normal.  There seems no great reason to fear drift in one direction or the other, so long as it is appropriate to the underlying economic conditions. 

"History has a second lesson. In a crisis, the ratio of public debt to GDP must rise.  Why?  Because a crisis – and this really is by definition – is a national emergency, and national emergencies demand government action.  That was true of the Great Depression, true of war, and true of the Great Crisis we're now in.  Moreover, we've designed the system to do much of this work automatically. As income falls and unemployment rises, we have an automatic system of progressive taxation and relief, which generates large budget deficits and rising deficits.  Hooray!  This is precisely what puts dollars in the pockets of households and private businesses, and stabilizes the economy.  Then, when the private economy recovers, the same mechanisms go to work in the opposite direction.  

For this reason, a sharp rise in the ratio of debt to GDP, reflecting the strong fiscal response to the crisis, was necessary, desirable, and a good thing.  It is not a hidden evil. It is not a secret shame, or even an embarrassment.  It does not need to be reversed in the near or even the medium term.  If and as the private economy recovers, the ratio will begin again to drift down."

And if the private economy does not recover, we will have much bigger problems to worry about, than whether we ought to have a new reserve currency. 

To quote Galbraith again:

“The only thing the scary foreign creditors can do, if they really do not like the returns available from the US, is sell their dollar assets for some other currency.  This will cause a decline in the dollar, some rise in US inflation, and an improvement in our exports.  (It will also cause shrieks of pain from European exporters, who will urge their central bank to buy the dollars that the foreigners choose to sell.)   The rise in inflation will bring up nominal GDP relative to the debt, and lower the debt-to-GDP ratio.  Thus, the crowding-out scenario Bob sketches will not occur.  

 "I'm not particularly in favor of this outcome.  But unlike Bob Reischauer's scenario, this one could possibly occur. If it did, it would lower real living standards across the board.  This is unpleasant, but it would be much fairer than focusing preemptive cuts on the low-income and vulnerable elderly, as those who keep talking about Social Security and Medicare would do."

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