Sunday, November 23, 2008

Time to change the rules

Barack Obama has time to consider how his administration will minister to the ailing auto companies, as their demise will be protracted. In the real economy, failure takes time. Sixty days from now GM will still be there.

But the same cannot be said of Citibank.

Today, after investing almost half of the $700 billion appropriated by Congress to buttress the capital reserves of the banking system, the evidence suggests that the Treasury and the Federal Reserve have not achieved their goal of easing the cost or availability of capital. Instead, the major banks are cutting back credit, increasing fees and looking for ways to further solidify their balance sheets. Unless these trends are reversed, the concerted federal action will have been for naught, the recession will deepen and recovery will be forestalled.

More capital alone is not sufficient to fix the commercial banking sector, and a new injection of funds into Citibank will not allay the fear the continues to grip the system. Like Citibank, all of the commercial banks have problem loans and problem business lines, and, traditionally, new injections of capital would provide banks with the resources necessary to work out those issues. But today, the risks are different, and more dire.

The collapse of AIG two months ago highlighted for all market participants the risks presented by derivative contracts on the books of financial institutions. AIG’s demise came in a matter of days––if not hours––once its credit ratings were downgraded from the double-A level to the single-A level. On Friday, September 13th, AIG was in business. On Monday the 15th, AIG was downgraded. On Tuesday the 16th, the global insurance giant was effectively bankrupt.

In the case of AIG, the rating downgrades resulted from write-downs in its holdings of mortgage-backed securities––to comply with mark-to-market accounting rules––which depleted its capital reserves. The downgrades triggered collateralization requirements under the terms of its $450 billion portfolio of credit default swaps. Faced with demands for collateral that exceeded its financial resources, AIG was insolvent.

The lesson for the major commercial banks that face similar risks was simple: Do everything in your power to rebuild your financial strength and stabilize your credit ratings. Cut back lending, reduce outstanding credit facilities, increase fees, conserve capital, and rebuild your balance sheets. In sum, the lesson for the commercial banks is that if you want to survive––if you don't want to be the next AIG––you should not do any of the things--such as increase lending--that the Treasury is trying to get you to do.

Today, Citibank is rated AA-, which by any measure is a strong credit rating. But the markets are anticipating Citibank’s demise. On Friday, Citibank shares fell 20% to $3.77 and its total market value fell to $20.5 billion, a decline of 90% from a year ago, and less than the $25 billion that the US government gave Citibank just last month. In the credit default swap market, the cost of insuring against a Citibank default rose 20% on Friday.

In normal times, a downgrade to A+ would not be a catastrophic event for a commercial bank, but these are not normal times. While there has been no public indication from Citibank of what the financial consequences of a credit rating downgrade to single-A would be, Citibank is currently the guarantor on $1.6 trillion of credit default swap contracts––almost four times the size of AIG’s portfolio––and it is not unreasonable to imagine that those contracts have comparable collateralization terms. If this is AIG all over again, a downgrade of Citibank’s ratings would lead to the swift collapse of what one year ago was the nation’s largest bank.

But this is not just about Citibank. Over the next several days, the Treasury may announce its plans to pour billions more into Citibank. But even if Citibank survives, the Treasury will not have addressed the fear that is gripping the banks. For this, the Treasury and the Fed need to change the rules of the game: They have to tackle head-on the two issues that conspired to lead to AIG's swift collapse.

First, they should change the mark-to-market rules that have made the balance sheets of financial institutions captive of swings in asset market prices. These rules exaggerate the importance of unrealized gains and losses, and exacerbate economic volatility by undermining stability in the banking sector. Instead, consideration should be given to rules that allow for the smoothing of unrealized gains and losses over time, as is the case in pension fund accounting, to mitigate market volatility by recognizing gains and losses over a multi-year period.

Second, immediate regulatory action should be implemented, vitiating the linkage between changes in credit ratings and collateralization requirements under outstanding swap agreements. While changes in bond ratings have always had effect on an entity’s cost of capital over time, the rating agencies never intended for rating actions to trigger cataclysmic events. In fact, until the collapse of AIG, the collective impact of the collateralization triggers in swap contracts was barely recognized as a material risk factor for financial institutions. Any counterparty who objects to this change should be free to void the agreement to which they are a party.

With the implementation of these two steps––changes in the mark-to-market rules and removing the collateralization provisions from existing derivatives contracts––the Treasury can immediately reduce the pressure on Citibank and on other financial institutions. Then they can focus on the real job of recapitalizing the banking system, and perhaps the banks will get back to the business of lending.

Thursday, November 20, 2008

Bailouts. All the rage.

The debate over the bailout rages on.

On the one hand, the companies involved have only themselves to blame. No one denies that they brought this on themselves. The nation watches incredulous as the wealthy CEOs fly into the nation’s capital on their private jets and claim that it was not their fault––and begrudge anyone who suggests that their compensation should limited if they receive federal aid.

It is hard not to want to let them face the rigors of bankruptcy. Let others in their industry who did not make bad decisions reap the rewards of their strategic wisdom and take market share from those made bad choices. That is the way it is. That is the way it’s supposed to be.

Those arguing for the bailout question whether the economy can sustain the wreckage and havoc that will ensue if the companies are allowed to fail. They argue that rather than risk the widespread repercussions of a collapse, we should invest in the companies, shore up their financial condition, and hope they make better decisions going forward.

So we held a national debate and in the end, after the cajoling of Wise Men from across the Capitol, Congress and the President approved the $700 billion bailout for the finance industry.

We had a referendum on pain and our willingness to walk the walk of our capitalist principles, and we decided we just weren’t up to it.

Now come the automakers. It is like deja vu all over again. Once again, the companies have brought this on themselves. Once again, the wealthy CEOs fly in on their private jets, and show nothing approaching accountability for their circumstances.

And once again the fundamental question is whether the companies and their stakeholders will suffer for their own bad judgments, and whether their competitors who have demonstrated strategic wisdom will be allowed to take market share from those who made bad choices. The way it is supposed to be.

Those arguing for the Detroit bailout question whether the economy can sustain the wreckage and havoc that will ensue if the companies are allowed to fail. But this time, the resistance is fierce.

The hypocrisy of the moment is profound. This is not an argument for or against aid to Detroit, but against the hubris that now surrounds the debate. Would a debtor-in-possession bankruptcy process be a better choice over the long term to secure a better future for GM and Ford? Perhaps. Are other American automakers that are highly successful in the marketplace—Toyota, Honda, Nissan, BMW et al—disadvantaged by a government bailout? Sure.

And each of these arguments could have been made in the financial bailout. Like the automakers, the best efforts of Hank Paulson may just be delaying the day when Citibank succumbs, and newer, foreign-owned banks with a growing presence—Toronto Dominion, Banco Santander, FirstBank—emerge from the middle market to replace those at the top who fall under the weight of their bureaucratic indifference to the customer and their derivative-laden balance sheets.

As Joseph Schumpeter famously wrote, the process of Creative Destruction is the essential fact about capitalism. It is the driving force of innovation and growth. But as we are now witnessing, there is destruction and collateral damage along the way. Sometimes the damage is small and incidental, and sometimes the damage is cataclysmic.

We already chose not to face head-on the consequences of failure on Wall Street. Now, as the economy is coming undone, one has to question whether this is the moment to let GM and others fall under the weight of their legacy cost structures. The arguments for bankruptcy and the urgency of finally having Detroit make the real changes that are essential to its future are valid. But bailout opponents should not kid themselves into thinking that the process will be smooth or without collateral damage.

All of the obligations that GM will walk away from in bankruptcy—retiree healthcare, support for redundant dealerships, bond and lease payments for redundant facilities—are payments that someone else receives. Our essential challenge as we address the economic recession is to sustain economic activity and demand in the marketplace as consumers and companies reduce their spending. A GM bankruptcy will exacerbate this challenge and increase the costs to government at all levels to sustain economic activity and mitigate the collateral damage.

In many ways, our response to the auto industry is shaped by our response to the financial collapse. We rose to the urgency of that challenge, and now watch incredulous at the apparently arbitrary allocation of those billions of dollars of our money. Why has $150 billion been allocated to secure the interest of counterparties to AIG derivatives rather than simply to secure the policyholders? Why have we given tens of billions to the largest commercial banks only to see them cut back lending and increase banking fees? Why are we giving money to American Express––the lender to the richest Americans––while little is done for homeowners? Why have we rewarded failure and not instead mitigated collateral damage and allowed those who have been successful in the marketplace to win?

We have watched one bailout unfold, and we have not been impressed. We heeded the Wise Men, and now we feel violated.

But how do we now hold failing auto companies to a higher standard? And why now, when money is being tossed around the Street like confetti? Is it because this time the beneficiaries would be autoworkers and retirees rather than well-heeled moneymen, who to this day have yet to apologize to the nation for the destruction they have wrought?

Tuesday, November 18, 2008

Building US foreign policy in a networked world

Faced with a choice for Secretary of State between Hillary Clinton, Chuck Hagel and Bill Richardson, President-elect Obama’s choice should be clear. While all of them have strengths to serve the new president well, only Governor Richardson brings both a depth of experience and a philosophical commitment to Barack Obama leadership style.

Each of the candidates brings great strengths to the position. Hillary Clinton would bring unrivaled superstar status to the position, and provide unmatched energy and focus to push ahead the Obama foreign policy agenda. Like her husband, she is a pragmatist who will quickly grasp the nuances of every issue, and she will bring––as she does to all things––a tremendous motivation to succeed.

Chuck Hagel is a very different choice. He is a serious student of foreign policy and military affairs, with a deeply grounded understanding of the international world. Unique among the Washington crowd, Hagel understands and has spoken on the most serious foreign policy challenge that we face, which remains our relationship with Russia. Our ability to address all other international issues—Iran, Iraq, the Middle East, nuclear proliferation, drug trafficking, and financial integration and regulation—will be either facilitated or undermined by our relationship with our former adversary. Hagel understood immediately our error in embracing the Kosovar declaration of independence, which undermined the primacy and principles of international law, and the far-reaching consequences of that action, which continue to unfold. Hagel recognizes the importance of American leadership that embraces the world in all its complexity, particularly after years of hubris and empty threats that have eroded our credibility and capacity to lead.

But in Bill Richardson, President-elect Obama can choose a seasoned international diplomat and negotiator who truly embraces the core of Obama’s worldview. Like Obama, Richardson understands and has practiced a style of diplomacy and leadership that begins with listening, and that is grounded in the view that even as disparate parties may have widely differing agendas, the most complex and intractable conflicts can be addressed if differences are acknowledged and respected, as a first step toward identifying and achieving common goals.

In addition, Richardson would bring to the administration a broad network of relationships across the international community and an ability to take on the portfolio of State with no learning curve. From his time as UN Ambassador, to his range of assignments as an international negotiator during both Democrat and Republican administration, Richardson has built an international reputation for diplomatic skill, integrity and credibility.

Much has been made of this being a time of transition from a uni-polar to a multi-polar world. But this is not an accurate reflection of the world that President-elect will inherit. The US will remain the dominant military and financial power for decades to come. However, the significance of that status is what people expected it to be, and the world has not, and will not in the future, march to our tune on account of that power. The emergence of asynchronous warfare and strategy has proven to be an effective counterpoint to US military dominance, and years of US deficits have led to the emergence of China and other countries as powerful financial players, even if the dollar remains dominant in times of crisis. Today, our power gives us the capacity to lead, but will not compel others to follow.

The celebrations around the world that greeted the election of Barack Obama reflect the hope that positive and effective US leadership will reemerge in the world. But that leadership must reflect a new world of struggling and emerging democratic nations that will each need to chart their own politics and path forward. This is a world that will need American support, encouragement and direction, but will not respond well to hubris or dictates from foreign soil.

The world today is defined by overlapping networks. National identity remains elemental, but in almost every conflict across the globe, we are witnessing the influence of transnational linkages and networks that put a claim on community identity. Afghanistan, Georgia, Kenya, Kosovo, Indonesia, Iran, Iraq, Lebanon, Palestine, Russia, Sri Lanka, Syria, Timor, Ukraine, Zimbabwe. All of these nations are facing conflicts where religious, ethnic, tribal and family identities are threatening the primacy national identity as a unifying force. These challenges will be exacerbated rather than solved by democratic reforms––national unity was easier to maintain at the point of a gun––and demand the development of national and transnational institutions to create legal, political and regulatory frameworks for the new century.

In this world, US leadership and policy will need to focus on multiple levels and strategies. At the highest level, the US must define and focus on its core strategic interests. This is and will always be its primary priority. At the same time, the US must implement policies that encourage and support regional networks and leadership to engage regional conflicts and issues. The world of emerging and evolving democratic states must, under American leadership, learn new skills in conflict resolution. And all roads will no longer lead to Rome.

This is a world that is ready for the leadership of Barack Obama, who built a political campaign based on a philosophy of uniting people with vastly differing identities toward common purpose. This is the world in which Bill Richardson has been immersed for decades. A world he understands from extensive personal experience, and one where, like Barack Obama, he is greeted warmly wherever he goes as one who has the knowledge, understanding and philosophical stance that can enable him to bring together even the most entrenched adversaries.

Saturday, November 15, 2008

Farther down the rabbit hole

The longer this goes on, the more absurd it is becoming.

Hank Paulson may know what he is doing. He may have insight that is lost on the rest of us. But then again, he might not.

It is not easy to suggest that a man with the pedigree and swagger of a former chairman of Goldman Sachs does not know what he is doing. But there it is.

Over the past few weeks, in the name of recapitalizing the banking system, we have witnessed the largest concentration of financial power and privilege in a century. Three of the new titans of the banking world––JPMorgan, Bank of America and Citibank––have emerged far larger and more powerful than before the financial crisis began. Their assets have ballooned. Regulation W has been waived, and FDIC deposits are now unfettered by restrictions put in place almost a century ago. And they have new infusions of taxpayer capital that some have unabashedly suggested will be used to acquire regional middle market banks and future expand their dominance in the marketplace.

Not to lose out on a good thing, American Express this week sought and received Fed approval to convert itself into a bank, so that they could get in on the action.

This, Hank Paulson suggested, marked the Government’s initiative to unlock the consumer credit market.

The irony, of course, is that these are not the institutions that will pull us out of the recession. These are not the institutions to which small businesses turn to finance the great American engine of job creation and growth. Those would be the community banks and middle market banks, that have largely eschewed the risks of derivatives and securitized obligations that have brought the larger institutions and hedge funds to their knees. And those are the institutions whose plight has been largely overlooked by the bailout strategies that Hank Paulson has pursued. Far from being helped, those institutions have been placed at a competitive disadvantage by the aggressive steps that the Treasury and the Fed have taken to concentrate financial power in a handful of dominant institutions.

We are now in the Alice in Wonderland phase of the financial bailout. The world of public policy has disappeared into the rabbit hole, and we have no idea where we are going to end up. But it is now clear that Hank Paulson has no idea either.

The greatest failure of the bailout has been in not letting institutions that did stupid things fail, and to focus public policy on how to mitigate the public and systemic consequences of that failure. In the case of Lehman Brothers, we failed to anticipate and prepare for the downstream consequences. But instead of learning the lesson that we must look down the road and anticipate systemic consequences, we turned our back on the core principle that failure is essential in competitive markets and exacerbated our problems in our approach to AIG.

The collapse of AIG came as a result of its exposure to the collateralization provisions of its credit default swap (CDS) business. To date, the bulk of the $150 billion federal cost of bailing out AIG has gone to making good on the collateralization obligations under those CDS contracts. Essentially, instead of protecting the AIG policyholders and otherwise letting AIG fail, and reaffirming the principle that stakeholders––from bondholders to CDS counterparties––are at risk in the marketplace, the Treasury chose to protect the rights of CDS counterparties with public dollars.

Halfway through the $700 billion, we are still facing two central problems. First, Paulson, Bernanke and Congress have yet to find a way to unravel the mortgage-backed securities market. The central issue here is that once mortgages are pledged in a pool to multiple investors, the terms of any individual mortgage cannot be renegotiated without impairing the contract rights of some of those investors. As a result, while mortgages held in whole by a single institution can be renegotiated, those that have been securitized may not be able to be fixed. This means that for a subset of mortgages, a foreclosure process may not be avoidable. If this is the case, federal policy should address the affects of foreclosures on families and communities, and let the process of unwinding the CDO market work itself out.

Second, the risk that credit default swap contracts present to the financial system has to be recognized and addressed. CDS contracts are essentially insurance policies against financial loss on bonds, where one party pays a premium to the other party, who agrees to make them whole in the event of a bond default. The issues are twofold. First, there is no regulatory framework that regulates the capital reserves that an institution must hold to write this type of insurance. Second, there is no requirement that the purchaser of the insurance actually own the bond in question, and there is no limit to the amount of insurance that can be written against any given bond. As such, the CDS market has become a purely speculative market that––as Michael Lewis suggested in his magnificent epilogue to Liar’s Poker––allows investors to make side bets in the bond market without actually investing any money. It is, simply state, a market with infinite leverage.

JPMorgan, BofA and Citi have approximately $13.7 trillion of credit derivatives outstanding, in compared to total combined assets of $3.9 trillion, while JPMorgan alone has approximately $7.9 trillion outstanding, in compared to total assets of $1.4 trillion. These banks will argue that their derivatives “book” is evenly balanced between long and short positions. But this ignores the fact that AIG did not collapse because of its exposure to the credit events in its CDS portfolio, but rather because of the collateralization requirements that ensued in the wake if its bonds being downgraded below “AA.”

Today, these three banks are rated "AA," with at least two of them facing downward pressure on their ratings. However, it is likely that even JPMorgan CEO Jamie Dimon––the reigning superstar of the financial firmament––does not know how much collateral JPMorgan would be forced to post to their CDS counterparties in the event they were to be downgraded. But suffice it to say that each of these banks have CDS books that are several times larger than that of AIG, and any such downgrade would likely wipe out their capital reserves.

Even as Congress and the Treasury look for solutions to the mortgage foreclosure problem, they should act immediately on credit derivatives. Three steps are warranted. First, a complete industry database must be created to track contracts, exposure and collateral terms. Second, a regulatory framework must be created to establish capitalization and reserve standards. And third, similar to the insurance industry regulatory framework, the federal government should immediately levy the equivalent of an insurance premium tax on credit derivatives to fund the public costs of financial protections and regulation.

Today, insurance premium taxes are levied in the range of 5% of premium volume. If CDS pricing averages 200 basis points on the outstanding $62 trillion, a similar fee on the annual CDS payments would generate approximately $62 billion, and provide a reasonable start at amortizing the costs of the federal bailout. And perhaps, if the industry complained that the cost was too high, it would serve the higher purpose of providing an incentive to unwind the most highly leveraged sector of our financial system.

Sunday, November 02, 2008

The prospect of hanging concentrates the mind

“The prospect of hanging concentrates the mind.” Samuel Johnson.

After decades of fretting over the low American savings rate, Americans are putting away their credit cards and hunkering down for a long, cold winter. And the rest of the world is trembling at the thought.

The anticipation phase of this financial crisis is coming to an end. In a world of six-hour news cycles, people are beginning to realize that nothing is going to be fixed quickly. Last week’s god, Hank Paulson, is this week’s afterthought.

No, he did not fix it. No, he does not know what we should do with the $700 billion. No, he does not know what AIG did with the $100 billion. And no, he does not know what to do next.

Soon, people will turn off the cable news circus. The election will be over, and there will only be the uncertainty of what lies ahead.

For a president Obama—willing to turn the page on the Neoconservative rhetoric that has dominated American foreign policy of late—the financial crisis will offer a dramatic opportunity to reshape international relations, in positive and constructive ways. After all, the denouement of the crisis that is slowly placing a vice grip on nations across the world has brought a new clarity to international relations. And as each nation now looks out over the precipice, the hubris that has characterized the past few years may give way to a new willingness to build bridges.

In the early moments of the financial debacle, our allies in Europe—to say nothing of those across the world resentful of our new militarism—could barely conceal their satisfaction as the dollar fell, the price of oil rose and the end of the era of US dominance loomed. But that moment was fleeting before the interconnectedness of the 21st century economy became the dominant fact of the new world order.

Within a few short weeks, new realities emerged. As stock markets around the world plummeted—from 40% across Europe to 60% across Asia to over 70% in Russia, Ireland and Iceland—the interdependence and integration of national economies, and the ease of migration of capital, undermined newfound notions of prosperity from Ireland to Russia.

In European capitals, the ascendant notion of an economic decoupling from the United States fell by the wayside as nations quickly sought to protect their own interests and the euro crashed. In Russia, the collapse of energy prices demonstrated the fragility of an economy that has failed to build legal institutions and will soon show what little protection Russia’s new financial reserves can provide in the face of an international recession.

At the same time, for the United States, two dominant doctrines of the post-Cold War era have been discredited. First, the consuming conflicts in Iraq and Afghanistan have demonstrated the limits of overwhelming military power to force change and democratization. Second, the financial crisis and final capitulation of Alan Greenspan have demonstrated the limits of unfettered free markets and the power of uncontrolled ambition and greed to foment global chaos.

Today, the reality of economic interdependence can transform political relationships, as evidenced by our relationship with China. Two years ago, as Europe was trumpeting the emerging decoupling, China demurred. China’s communist leaders grasped the implications of the integrated international economy better than her European counterparts, and understood—as good Marxists—that economic imperatives trump traditional political arguments. China tightly linked her currency to the dollar and, after decades of saber rattling, has now tempered her threats to take back Taiwan by force.

Our relations with China are a marked contrast to our relations with Russia. For years, we have dealt with China quietly and respectfully—despite domestic protests regarding Tibet and religious persecution. With Russia, nothing has been quiet or respectful, but rather our policy has been long on hubris and trapped in Cold War rhetoric, if not ideology.

In early October, Chancellor Angela Merkel visited Moscow, where she announced that Germany would oppose efforts to admit Ukraine and Georgia into NATO. Her announcement has offered the US an opportunity to step back and reframe our relations with Russia. A new administration will now have the ability to rebuild our relationships with Russia, as with many other countries, on principles that reflect the new economic realism of international economic integration and our own understanding of the limits of military power. Simply stated, Russia—as China has accepted—can no longer impose her will at the point of the gun, while we must lead with a tempered rhetoric in a world where tanks alone cannot achieve our goals.

The strength of the dollar in a time of global crisis has reaffirmed the critical role of American leadership—to say nothing of the importance to the rest of the world of a vibrant American economy—to others. At the same time, an end to American hubris and a touch of the humility that George W. Bush once embraced, may allow us to provide the leadership that the world now desperately needs.

For a new president who grasps how dramatically the world has changed in the past month, and who appreciates both the complexity of international economic integration and national identity, this will be a time of unprecedented opportunity.

Monday, October 13, 2008

The twilight of John McCain

The fact that Bill Kristol’s advice to John McCain is being taken seriously is itself nothing short of comical.

When McCain secured the Republican nomination in the spring, many patriotic Americans sighed felt a sense of relief. While John McCain could not be counted on the bring balance to a Supreme Court heavily weighted with Republican nominees, he was a men of integrity and credibility as a national politician who would stand against the most partisan forces, and act in the broad national interest.

That is to say, he would be a departure from the last eight years. Eight years that have greatly damaged our nation. Economically we are deep in debt and our financial system is teetering on the brink of collapse. Militarily we are overstretched and hamstrung in our ability to respond to new threats. Internationally, we have lost much of our credibility in the world and our capacity to lead—at a time when centered leadership is badly needed and hard to find. And morally, our embrace of torture as a tool of national policy has undermined the national character that has been part of our strength in the world.

But it was John McCain himself, not some Washington cabal as Kristol suggests, who brought McCain’s candidacy to its current state of affairs. Despite his attack ads accusing Barack Obama of Unbridled Ambition, it is John McCain who cast his faith in the American people to the wind, and tried to remake himself in the mold of George W. Bush.

It is John McCain who cast aside his principled opposition to torture as a tool of public policy in an effort to reach out to the Party base.

It is John McCain who cast aside his opposition to tax cuts that benefited the rich and drained the national treasury in a time of war, to embrace new and deeper tax cuts in an effort to gain the affection of the Party base.

It was John McCain who reached out to evangelical leaders—not just evangelical voters—and muted his opposition to their contribution to the destruction of civil discourse in our society and in our politics.

It is John McCain who cast aside his long-time political advisors––who had help craft the McCain Brand that stood for integrity and straight talk that was critical to his success as a national candidate—and hired in their place his current team of Bush era and Rove-trained advisors, who have cut him off from the press and done much to destroy the essential character that—we thought—set John McCain apart from other candidates.

And finally, it is John McCain who failed to stand up to his new campaign team and select the centrist vice-presidential candidate of his choosing—Joe Lieberman or Tom Ridge—and elevated in their stead a candidate who lacked any of the core attributes of experience and wisdom that he valued above all else.

Above all else but winning, it seemed.

John McCain is a man driven by his political instincts, and by a sense of decency in the public square. But he has proven in this campaign—despite the profound irony of the Country First slogan—that this time around, he was going to do what it takes to win.

Many supporters looked at the Palin nomination as the final moment when McCain himself could pivot toward the center. Palin would be sent out to placate the base, while McCain would return to the ground on which he is most comfortable. Openness. Candor. The politics of the center over the braying of the extremes.

But this is not the choice that John McCain made. Not this time. Instead, McCain lost his bearings. Perhaps it the roar of the supporters who turned out to see Sarah Palin. Perhaps it was the anger at being upstaged by young, stoic and unflappable Obama. But rather than veering to the center, McCain embraced a new populism and raged against the machine.

His campaign strategy changed week to week. Day to day. His rhetoric has become shrill and pandering, disconnected to any core message or program.

I’ll get Osama bin Laden… I know how to do it.

I will lower gasoline prices.

I know how to lower food prices.

I can fix this financial crisis. I know how to do it.

I know how to fix Wall Street.

This race is about Main Street vs. Wall Street.

There have been hints of old McCain from time to time, as he has shown discomfort with the quality of the campaign rhetoric, and has balked at elements of his newfound strategy. But as much as Bill Kristol would like to deflect the responsibility from his candidate, the failure of the McCain campaign rests firmly with the candidate.

Now, as the Barack Obama as un-American Terrorist Sympathizer strategy has failed, the McCain campaign is making a belated effort to return to the McCain Brand: John McCain as courageous and measured centrist, who will bring balance to the Democratic majorities in Congress and steady leadership to a the nation in its hour of need. Finally, John McCain will reach out to the large political center, where once he found succor and support, and which in the sunset of the Bush era has once again emerged as the key to electoral success.

But it is too late for that. John McCain chose personal ambition over principle and trust in the American people. He took his beloved brand and tossed it to the gutter. His integrity and credibility—all one has in politics—have been destroyed. Instead of centered and wise, he has proven to be fickle and petulant and impetuous.

We will never know which is the real John McCain. But he alone is responsible for where he finds himself today. All he has left is to consider his legacy.

Saturday, October 11, 2008

Credit default swaps and the crisis of confidence

Five years ago, billionaire investor and American icon Warren Buffett suggested that financial derivative products were “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”

Five years ago, few people were paying attention, and even fewer understood what he meant. Even today, as the term credit default swap (CDS) is migrating from the financial cable networks to CNN, MSNBC and the mainstream media, the critical role of these arcane derivative products in the undoing of the financial markets is not well understood.

The term derivative product is a general term for a contractual agreement between two parties whereby the counterparties exchange––or swap—payments based some underlying benchmarks, applied against a contract notional amount.

The most widely used derivatives are interest rate swaps, which account for more than 75% of the global $530 trillion derivatives market, compared to the 10% that comprise credit default swaps. In its most basic structure, an interest rate swap provides that Party A will pay Party B an amount equal to a fixed interest rate times the contract notional amount, and receive an amount equal to a variable interest rate times that same amount. Many businesses that borrow money from commercial banks at the variable prime rate use interest rate swaps to fix their annual cost of borrowing and avoid interest rate risk.

In contrast, credit default swaps are financial products that allows for the transfer of the default risk related to owning a corporate bond from one party to another. For example, imagine that before the current market meltdown, CalPERS––the large California public pension fund––owned $100 million of IBM bonds, but wanted to insure against the risk of a bond default. CalPERS could accomplish this by negotiating a $100 million, five-year credit default swap with AIG––which up until a month ago was a global, triple-A rated financial institution.

Under the terms of the swap, CalPERS would make an annual swap payment to AIG equal to––for example––1% of the $100 million swap notional amount. In return, AIG would pay CalPERS the amount of any losses that CalPERS realized in the event of a default by IBM. For example, if IBM went bankrupt during the contract period, and bondholders were only repaid twenty cents on the dollar, AIG would pay CalPERS $80 million. And to secure AIG’s obligations, the swap contract would require that if AIG were downgraded from triple-A level to below double-A, AIG would post collateral equal to 20% of the notional amount of the swap contract, or $20 million.

Then came the AIG collapse.

While the general view of the AIG collapse is that it was a function of collapse of the mortgage-backed securities market, in truth it was a direct consequence of AIG’s CDS exposure. Four weeks ago, AIG was a triple-A rated insurance company. Today, it is being dismantled. If AIG had large investment losses in mortgage-backed securities, but no CDS exposure, AIG would still be in business today.

In simple terms, AIG’s collapse came as a result of the following sequence of events:

1. In the wake of the decline in real estate prices, the market value of mortgage-backed securities declined.
2. Under accounting rules that were established after the downfall of Enron––implemented to require rapid disclosure of investment losses––AIG marked down the value of its mortgage-backed securities portfolio.
3. These investment losses resulted in a reduction of AIG’s capital reserves––the core measure of its financial strength.
4. As a result of the decline in AIG’s capital reserves, Standard & Poor’s and Moody’s Investors Service downgraded AIG from triple-A to the single-A level.
5. These rating downgrades to the single-A level triggered collateralization requirements under AIG’s CDS contracts.
6. The amount of the collateral that AIG had to produce under its estimated $450 billion of CDS contracts approximated $100 billion.

And AIG did not have $100 billion in available funds.

This was the explosive event that destroyed AIG. It was not the market losses on its investments in mortgage-backed securities. It was not payouts on CDS contracts where default events had actually occurred. It was a collateral call.

The AIG story illustrates two important aspects of the current crisis of confidence within the financial markets. First, AIG’s collapse in a matter of days resulted from the collateral requirements under the terms of contracts that are opaque, unregulated and difficult to track on corporate financial statements. As Buffett and others have suggested, the risk in the AIG derivatives portfolio was explosive—and ignored until it was too late.

Second, the AIG story illustrates how a collateral call under a CDS contract can have the effect of positioning the CDS counterparty—the institution on the other side that claims rights to the collateral—senior to the AIG policy holders and bondholders.

As US and European central bankers are working to define a collective strategy to rebuild confidence in the financial system and to reinvigorate inter-bank lending, the destabilizing impact of the CDS market remains one of the central problems to be addressed.

The problem seems straightforward. After the AIG collapse, how does one institution trust its exposure to another? If CitiBank seeks a loan from JPMorgan, how does JPMorgan know whether some event might be looming that will result in a collateral call under some of the myriad derivatives contracts to which CitiBank is a party, a collateral call that in a matter of hours could bring Citibank to its knees.

The US has now signed on to the British plan to make direct investments in banks, but simply injecting liquidity and capital will not address this concern. But US officials appear to be resisting the second British proposal––which provides for direct central bank guarantees of inter-bank loans. Like guaranteeing deposits, guaranteeing inter-bank loans would transfer the risk of the unknown from the banks to the central banks.

Paulson and Bernanke may view this last British proposal as one step too far in the socialization of the financial system. But until the CDS market is brought into an effective regulatory framework and the legal rights of creditors are clearly established, do we really have any choice but to take this next step?

It seems that long ago—weeks maybe—we stared the moral hazard issue in the eye. And we blinked.

Whatever the theoretical importance of letting people and institutions fail, it seems that we have already decided that as a matter of public policy and political priorities, we just can’t take the pain.

Saturday, September 27, 2008

Deleveraging society

It remains unclear at this moment if there will be a resolution of the impasse surrounding the proposed $700 billion bank bailout bill. Since negotiations fell apart on Thursday, House Minority Leader John Boehner—with a brief cameo of John McCain—has been leading a phalanx of disgruntled House Republicans in opposition to the Main Street bailout of Wall Street.

Were that the situation was so simple.

The House Republican rerun of Pat Buchanan’s Peasants with Pitchforks routine would be charming, if it were not so off base. This financial crisis, while being billed as a Wall Street bailout, is all about Main Street. And if the House Republicans want to see the roots of this crisis, they need only look in a mirror. This crisis is all about debt. It is all about us.

Over the past quarter century—dating to the dawn of the Reagan Revolution in fact—America has become awash in debt, and sub-prime home mortgages are just the tip of the iceberg. Home mortgages. Credit cards. Auto loans. Business loans. Federal debt. As shown below, since 1980, our public debt has grown ten-fold, from $4.4 trillion to over $45 trillion

Somehow, in the early days of the Reagan years, one fundamental premise did not take root. While Reagan era luminaries such as David Stockman and Grover Norquist trumpeted about the notion that cutting revenue would lead inexorably to cutting expenditures, they underestimated the character and adaptability of the American political system. The abiding lesson of the Reagan years was not that Americans—people of thrift and hard work we were told—would embrace a government that did less for them so they could do more for themselves, but rather that there is nothing that we used to pay for with cash and hard work that we cannot instead pay for with debt—and leave for some future generation to deal with in the distant future.

Turns out, we are not as virtuous as we like to believe.

As illustrated below, our indebtedness—not just as a government but as a society—took off. As a percent of our national income, our cumulative debt burgeoned from a stable level of around 150% of GDP to 350% and counting.

As a nation, we have ceased to save, and—political rhetoric notwithstanding—we have never seriously considered that we should stop spending.

As we are getting in deeper and deeper debt, and as our national savings rate has declined to near-zero, we rely almost exclusively on foreigners to provide us with capital to fund our excessive public, private and corporate spending habits.

In addition, as the chart below illustrates, our growing debt is also increasingly owned by countries—China and Russia most notably—who are often our adversaries in international affairs. This fact was evident in the Fannie and Freddie bailout a few weeks ago, when Treasury Secretary Henry Paulson took pains to avoid any action that would diminish the value of the Fannie Mae bonds held by the Chinese, even as he wiped out the value of the preferred stock held by domestic banks.

Therefore, our growing indebtedness is quickly obliterating the dividing line between domestic fiscal policy and foreign policy. Like any debtor, we will increasingly have to temper our behavior in order to not get cross-wise with our creditors. If any of these holders of our bonds should decide to dump our paper or even move to diversify their central bank reserves out of US government securities, the dollar will fall further and our long-term interest rates will rise.

Our growing borrowing from abroad is a function of our continuing federal fiscal deficits, as well as our trade deficit—the difference between what we export and what we import. These two amounts together comprise our “current account” deficit, and generally reflect the amount of capital that we import every year to fund our public and private expenditures that we cannot pay for from governmental revenues, export earnings or out of our own annual savings.

The problem that we face is our growing addiction to debt as the driver of national income growth. The graph below presents the growth in national Gross Domestic Product over the past several decades, and illustrates the portion of that growth that can be accounted for through imported capital or financing as reflected in the current account deficit.

This data suggests that imported capital has funded an increasing share of our year-over-year GDP growth, and that since the beginning of this decade, the nation has experienced little growth in national income beyond that which has been purchased by borrowing against our future. While in all fairness, the current account deficit is not an exact proxy for imported capital—a portion of the trade deficit, for example, reflects accounting and other transactions—but the gist of the argument remains. The share of our annual GDP growth that is derived from infusions of foreign capital has been growing steadily over the course of this decade—the red line taking over the green—to the point where nearly all of our annual growth has been derived from foreign borrowing.

We are no longer a nation that is paying our own way and in control of our financial destiny, but rather have become addicted to increasing uses of debt to financing our way of life. These are not the characteristics of a great nation or a great people.

The obvious question for the next president will be how to change course. The crisis we face is not how to fix a banking crisis, but rather how to deleverage a society that has become increasingly dependent on debt and imported capital.

Historically, the traditional fix to excessive debt is inflation. As inflation grows, the borrowed dollars are paid back in a devalued currency.

And that strategy appears to be in play already. As this final graph illustrates, the decline in the dollar over the course of the decade against the Euro, and increasingly against the Chinese Renminbi will allow us to pay these countries back with a currency that will be worth far less to them then the currency they originally lent to us. If this seems a bit confusing, just consider that in 2001, oil was priced at $20 per barrel, compared to around $100 per barrel today. That illustrates the extent to which the dollars that we are using to pay back our borrowing are worth less in value—80% less in the case of oil value—than the dollars they lent to us a few years ago.

The risk, of course, is how long our international creditors will play this game with us, and when they will look to protect their own financial interests and be a bit less lenient in funding ours.

So as John Boehner and the House Republicans claim that they are looking out for Main Street, while decrying the abuses and profligacy of Wall Street, a long look in the mirror might serve them—and the rest of us—well. There are no innocents in this crisis, and the longer we refuse to look honestly at our complicity in the creation of this crisis, the steeper the cost will be of setting things right.

Wednesday, September 24, 2008

Plan B

Email query from the Caribbean:

Dem bald man say, You gotta give us $700 billion by Friday.
Dem beard man say, We’ll get back to you on the rest of this.
Dem bank man say, No vote now, sky gonna fall.
Dem law men say, F--- y'all. If Monday show and we still here. Wat den?

It is, of course, all a confidence game.

Markets are a confidence game—perhaps trust is a better word—built on the belief that tomorrow will come around and it will be a lot like today. That buyers and sellers will show up. That the rules will be enforced. And most trades are completed on a handshake.

And politics is a confidence game. Despite all the appearances of a knife fight, it is not unlike a trading floor. Deals are made on a handshake, and you are only as good as your word.

Today, the two games are joined. 535 members of Congress have to take the measure of Henry Paulson and Ben Bernanke. More than anything, the members detest and resent having their backs pushed up against the wall.

Deep down, they suspect this is just a Wall Street gangbang, as the banks push to include credit card receivables and other questionable assets in the grab bag, as the lobbyists swirl around looking for the greatest payday in the history of paydays, and as the CEOs with their homes in the Hamptons call to plead their case.

More than anything, the members cannot abide being told they have forty-eight hours, and they have no choice.

But what if they demur. What if through the peculiarities of the vote, the votes aren’t there.

Perhaps the members of the Republican Study Committee hunker down and decide to vote their convictions, and demand that investors and homeowners alike pay for their bad decisions.

Perhaps Bernie Sanders and the smattering of liberals not yet co-opted by the Democratic Leadership Council put their foot down on the principle that public aid must come at the price of public ownership.

And then the broad swath of the Center, cringing in embarrassment at being upstaged by the principled fringe, heed the populist call and abandon the Paulson Plan.

What then indeed?

Congress would look for a Plan B. And perhaps Plan B would focus on the underlying mortgages that are the root of the problem, rather than simply bailing out the financial intermediaries. After all, the fundamental problem with the mortgage-backed securities market is the lack of good information. With good information—however bad the news—liquidity would return to that market. Securities would find their appropriate market level.

Under a Plan B, Congress might create an interim insurance facility that would guarantee a portion of CDO cashflows—pending a workout of the underlying mortgages. Congress could direct the HFA and state mortgage finance agencies to work with troubled homeowners to restructure the terms of their mortgages, perhaps swapping a portion of the mortgage value for an equity share in future sale proceeds, to keep people in their homes and recoup some value over time. They could give bankruptcy judges the right to recast mortgages in default. And they could score political points by directing the FBI to focus on fraud and corruption in the finance industry.

For its part, the Fed window would be flung wide open for the banks and others who did not make bad choices to grab market share from those who did. And the market would do what it is supposed to do. Those who made bad choices suffer. Those who did not do well.

And there is a lot of money to be made on the hundreds of billions of CDOs that Paulson and Bernanke proposed to purchase for $700 billion, once information on the underlying assets is confirmed and value can be determined. Under Plan B, however, these profits would flow to hedge funds and private equity groups that would move in to acquire the illiquid assets that are now being marked to market at levels well below their real value. With aggressive federal action to validate and fix the underlying mortgages, a market for these securities would reemerge, and, with the prospect of profits to be made, every incentive will be in place to find and fix the underlying mortgages.

The problem, of course, is that Plan B is purely hypothetical. And it means that Monday morning would come without a fix in place. It means facing down the two wise men and their bailout plan and playing a game of chicken. And watching to see if the sky falls.

And there could be a lot of pain in the short-term. And in this case the short-term is the forty days before 435 members of Congress get their report cards from their constituents. Better to cast a vote for $700 billion and blame the bald guy if it fails, than bet on Plan B, even if, in the long-run, Plan B might be the right choice.

After all, as Lord Keynes famously said long ago, in the long-run, we are all dead.

Tuesday, September 23, 2008

The Gordian Knot

The swift demise of American capitalism did not arrive as imagined by John Dos Passos—farmers with pitchforks linked shoulder-to-shoulder with the urban proletariat, marching on Wall Street to tear down the House of Morgan—but rather at the urgings of America’s leading financiers, who have cast aside their dog-eared copies of Atlas Shrugged and are now looking to the Government, with pleading in their eyes and fear in their hearts, in the hope that someone can clean up the mess and make things right again.

It is truly a Gordian Knot that Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke are seeking to unravel, with threads that are interconnected and entangled.

Last Thursday evening, the two men met with leaders of Congress, and by all accounts left them speechless, as they described the cataclysm that might yet unfold. Though the meeting was not public, one can imagine how the presentation might have unfolded.

Paulson and Bernanke began by offering a timeline of events as the markets spiraled out of control—perhaps using AIG as Exhibit A. They described how the housing bubble, irresponsible lending and borrowing practices, and complex mortgage securitization structures led to the issuance of billions of dollars of securities that were vulnerable to a downturn. They explained how, as the housing market deteriorated, the mortgage-backed securities lost value and became illiquid. Under accounting mark-to-market rules established after the Enron collapse, the banks recognized these losses. As losses grew, the firms lost their capital reserves, their strong bond ratings, and their access to low-cost capital. Panic ensued. Banks and other financial institutions stopped lending as they moved to conserve cash. Short-term interest rates shot up in a matter of hours.

Almost overnight, the world lending markets dried up.

Paulson and Bernanke then pointed to two non-financial events that illustrated the public panic that would ensue if action were not taken to stanch the downward spiral.

The first event was the swift run on money market funds—nearly $90 billion withdrawn in one day—that came in the wake of the Fed’s decision not to bail out Lehman Brothers. Clearly, Paulson and Bernanke failed to anticipate the impact of a failure by Lehman on money market funds that invested in its commercial paper, and the run on money market funds that ensued after one fund, the Primary Fund, “broke the buck” and passed on its losses in Lehman paper to its money market fund investors.

The second event was contemporaneous run on AIG offices in Asia, where insurance policyholders frantically sought to cash in their policies prior to the looming collapse of the insurance giant. Facing public unrest, Asian central bank officials—who happen to be the largest holders of US Treasury securities—contacted Washington with some succinct advice: Fix it.

But as harsh as these real world examples are of the unraveling that might ensue if Paulson and Bernanke are not successful, there is a more troubling scenario that might have stunned Congressional leaders into silence. Perhaps, Paulson and Bernanke then turned to the problem that surfaced just as AIG teetered on the brink, before Paulson rushed in to buy the company last week.

AIG, like Lehman and Bear Stearns, is a major participant in the credit default swap market. The CDS market links buyers and sellers of corporate default risk, and offers the holders of corporate bonds the ability to sell the default risk associated with those bonds to a counter party. And as in most derivative contracts, credit terms are agreed to pursuant to which each party agrees to collateralize its obligations to the other party with Treasury securities, should its own credit be downgraded.

According to public accounts, just before the takeover, AIG had a collateral call on $60 billion of CDS contracts that required that the company immediately post $15 billion of Treasury securities as collateral, and anticipated a similar demand under a further $380 billion of its CDS contracts.

The $15 billion collateral call would have had an immediate impact on all of AIGs creditors and policyholders, as it would give the CDS counterparties a prior claim on those funds, putting their claims ahead of the range of other AIG creditors. A comparable collateral call on the other $380 billion of CDS contracts would have increased the aggregate collateral call to $100 billion, wiping out the company’s resources.

$100 billion of US Treasuries. That's 2% of the total volume of US Treasury securities. In the world.

What Paulson and Bernanke might have pointed out to the Congressional leadership, is that there are $62 trillion of CDS contracts currently outstanding—among American and international commercial banks, investment banks, hedge funds, pension funds and others. $62 trillion of uncharted obligations with attributes of debt to one party and a high-stakes gamble to the other.

$62 trillion. An amount greater that the $54 trillion gross domestic product of the entire world, as estimate by the World Bank.

On Sunday House Minority Leader John Boehner declined to describe the words that silenced Congressional leaders at the meeting, noting that there are certain things that you don’t discuss in public. Illiquidity in the banking system is something you can discuss. A run on money funds that was staunched you can discuss.

A universe of $62 trillion CDS contracts—defaults on which can send participants scrambling to seize collateral and protect their interests—derivative products whose terms and conditions are not subject to regulation or supervision—financial obligations once described by Warren Buffet as financial weapons of mass destruction—the impact of which no one really understands.

That is something you don’t talk about on the Sunday talk shows.

It is too much to grasp, really.

Friday, September 12, 2008

God's wars

It is five in the morning and I am wide-awake.

Nothing keeps me up at night. I have always been a sound sleeper, never one to get up and read in the middle of the night. That would be my wife. But it is five in the morning and I am wide-awake.

I have not written on the Sarah Palin nomination prior to now, frankly, because I did not feel I knew enough. I have worked with many Governors, and other politicians, and I am quite comfortable that people can surprise you. You just don’t know. I did not have a sense of how she thinks, and I did not have a sense of how she carries herself.

The strongest signal to me were comments from Gary Bauer, and his enthusiasm for her based on her stance on a vary narrow set of issues. I know as a general matter that if Gary Bauer feels one way on something, I am bound to end up on the other side.

But her comments in her interview with Charles Gibson on ABC—and equally her lack of humility—on foreign policy were astonishing. She dissembled on the question of whether the Iraq War is a task from God. I had watched the whole video of her speaking before a church audience and she was not—as she suggested—arguing, as Lincoln did, that she meant only that we should hope we are on God’s side. His remark was made when considering the devastation and horror of the Civil War, and was a statement of humility in the face of horror.

But that comment was not decisive, as none of us would like to be held to account for every public utterance.

Rather, it was her comfort with war—combined with a very simplistic view of events. Hers is a Manichean worldview, of those who are for us and those who are against us. That is what pierced through. Her answers were largely scripted, but underlying the script, her comfort with that world shone through to me.

She brings a determined fervor to her comments that suggest that war with Russia would be a fine notion, if it grew out of an obligation to Georgia. She offered no sense that Russia’s volatility was a foreign policy challenge to be managed with the goal of avoiding war.

Last week, Dick Cheney described our conflict with Russia as one that pitted them against the “Free World.” Harkening back to the days of us vs. the Communists, he spoke with the certainty of a great ideological warrior.

The problem is that we are no longer in a great ideological war. The Berlin Wall is gone, the Iron Curtain is no longer, and however imperfect their democracy, Russia's future must now be guided by the Russian people. Russia is a capitalist nation, part of the world economy, and an integral trading partner with Europe and Asia, just as we wanted them to be. Our relations with them are no longer black and white, and the challenges with them are as they are with all nations, about how we navigate power, self-interest and mutual interest.

Eight years ago, George W. Bush preached humility in the world, and it masked his sense of good and evil in the world that has informed his conduct of foreign policy. Sarah Palin came across to me as a true believer, equally comfortable with a righteous sense of good and evil, but lacking Bush’s political sense to keep it under wraps—or Lincoln’s deeply rooted understanding that even as one must fight battles, the certainty of good and evil is never so simple.

I suspect that is why she appeals to Gary Bauer, and why it is five in the morning and I am wide-awake.

Wednesday, September 10, 2008

Country first

Got some blowback from the last piece on our fiscal situation. Some have questioned my mental health for suggesting that whatever our financial mess, it is inconceivable that a Democrat could do anything but make it far worse. Whatever the cause, it is not the Republicans.

It is Congress, they pass the money bills! It is old people and the AARP! It is Democrats who love to spend!

This argument reflects the old adage that, “If you aren’t a Democrat in your 20s you have no heart. If aren’t a Republican in your 40s you have no brain.” However, while Newt Gingrich and others worked hard to change the first part, the Republican Party long ago abandoned its principles of fiscal conservatism that were the root of the second part.

In the 1970s, as the Republican Party was embracing supply-side economics and jettisoning its long-held, conservative fiscal principles, Milton Friedman cautioned his Republican colleagues not to be disingenuous. Despite the tax-cut rhetoric that was becoming the Party’s new mantra, the true size of government is measured by spending, and fiscal deficits are simply deferred tax increases. To cut taxes and keep spending is not conservative, he insisted, it is simply dishonest.

As much as McCain supporters would like to cling to the notion that the Republican Party has remained true to its long-abandoned principles, the historical evidence does not support their argument. People, of course, are unlikely to change their political views based on actual data—and no right-thinking Republican would acknowledge that Bill Clinton and Robert Rubin did a better job on the economy that either George Bush and Michael Boskin—but the argument that Republicans are either the party committed to smaller government or balanced budgets is simply specious.

As illustrated in the graph below, going back forty years to 1968—the starting date for data readily available from OMB and the Congressional Budget Office—through twenty-four years of Republican leadership and sixteen years of Democrat leadership, the overall size of the federal government, as measured by total outlays, has remained largely constant at 20% of the Gross Domestic Product—economic shorthand for the size of the US economy. Most notable during this period has been the growth of entitlement programs—primarily Social Security, Medicare and Medicaid—which have risen from 5.6% of GDP to 10.6% of GDP, and the concurrent 44% decline in discretionary spending, which largely comprises defense and domestic spending.

As this graph illustrates, the most dramatic decline in discretionary spending came under Nixon—the last Republican president elected as a traditional fiscal conservative before the Reagan Revolution—as defense spending declined significantly with the wind-down of the Vietnam War. Discretionary spending also declined under Clinton—who on fiscal matters famously pronounced “We are all Eisenhauer Republicans now"—though Republicans are always quick to take credit for Clinton's budget success, a claim that is not supported by the data presented below. And discretionary spending decreased modestly under Reagan, as defense spending rose while discretionary spending declined.

Under Jimmy Carter, overall discretionary spending was flat—defense spending rose a bit, while domestic spending fell—while discretionary spending rose as a percentage of GDP under Ford and George W. Bush.

The data shows that discretionary spending, and in particular domestic spending, fell under both Democratic presidents, while it rose under both Bush presidents. The data on the public debt is less ambiguous, as illustrated below. Here, the pattern is clear. The change in Republican Party doctrine to embrace of supply-side economics brought with it an acceptance of deficit spending and a build-up of the national debt as the price of growth—even if over the long-term the growth never brought the books back into balance.

As illustrated here, the national debt declined under Nixon—an old-time conservative Republican—as well as under Carter.

Fiscal deficits took off during the Reagan presidency, as the Reagan tax cuts were implemented without commensurate reductions in federal outlays. The public debt doubled as a percentage of GDP during the Reagan-Bush years. During the Clinton years, shrinking deficits and ultimately budget surpluses contributed to a decline in public debt. Finally, under George W. Bush, new tax cuts combined with war spending have contributed to renewed growth in the national debt.

Faced with the evidence that Republican presidents have left a trail of deficits and debt in their wake, supporters insist that deficits are the fault of Congress, and particularly of Congressional Democrats. But here again, the OMB data tells a different story. Executive budget recommendations and the impact of Congress on spending and deficits are tracked within OMB data beginning in 1982. The OMB data presents the executive budget recommendation, the actual deficit that was realized, and determines the extent to which the difference—generally a higher deficit—resulted from Congressional over-appropriation, economic conditions or technical factors.

The graph below illustrates the annual executive budget recommendation for each year, and the impact of subsequent Congressional action in red. While Congressional spending bills over-spent the executive recommendations in almost all years, the impact of this overspending was generally a fraction of the deficit starting point in the executive budget.

This data suggests that—as one would hope would be the case—that the primary driver of fiscal outcomes is the recommended administration budget, despite the desire to put our fiscal mess at the feet of Congress. During the period 1982-2007, administration budget recommendations contained average deficits of 10% of outlays, while the average impact of Congressional over-spending was 1.9% of outlays. Prior to the current administration, where the impact of Congress is overstated due to administration decision to keep war funding out of the executive budget and rely instead on supplemental appropriations, Congressional over-spending averaged just 0.8% per year.

Nor does the data support the notion that the fiscal culprit is the innate profligacy of Democrats. Congressional over-spending during years when Democrats controlled both houses of Congress averaged 0.4% of outlays, and averaged 0.6% when Democrats controlled both houses of Congress and the White House. During years when Republicans controlled both houses of Congress, overspending averaged 2.3% of outlays, and it averaged 4.6% when Republicans controlled both houses of Congress and the White House.

No doubt the McCain campaign will continue to push the time-honored attacks against the tax and spend Democrats. A visceral appeal against "Barack Reid Pelosi O'Biden." But they will offer no evidence to support their claims, because the Republicans long ago lost that high ground. The fact is that both parties spend; the difference is whether they pay for their spending, or borrow the money and push off the day of reckoning.

Then they will argue that their policies are pro-growth. And, of course, that is true. All things being equal, lower taxes are stimulative. But that is not supply-side magic, just the old school Keynesian economics that Friedman inveighed against. To argue that we must continue with the policies that have gotten us here, you have to answer the question of how and when will we stop digging ourselves into an ever-deeper hole, and why it will not be increasingly painful the longer we wait.

This is the dilemma that years of debt and deficits have left us with: there are few good choices left today.

But as our fiscal situation is weighing heavier—as each American family is now burdened with its $265,000 share of the new debts that the nation has taken on in the past seven years—it is past time that we move beyond the old rhetoric and acknowledge—as Milton Friedman suggested years ago—that continuing these fiscal policies is irresponsible.

We all know that cutting taxes is great politics, and we would all rather pay less than more, but isn't John McCain running on the principle that it is time to put the country first?

Sunday, September 07, 2008

At the precipice

Four years ago, with total aplomb, George W. Bush faced the nation and argued that if he were not reelected, all notions of “fiscal sanity” would be gone in Washington, DC. The notion of this president as the boy who held his finger in the fiscal dike would be comical if it were not so tragic.

One need only walk around New York City and see townhouses for sale with prices in dollars and euros to realize how far the mighty have fallen. One need only travel in foreign capitals to realize that while our infrastructure falls into disrepair, other nations are robustly investing in their future. Only a fool can argue as our debt burden grows and the dollar slides that we are not standing at a precipice.

Still, with an economic plan that offers more and deeper tax cuts, and no grasp of the consequences of continuing down the same path, John McCain is proving that the Republican Brand endures.

Republican: Balanced budgets. Small government. Individual liberty.

Not since George H.W. Bush almost thirty years ago attacked Ronald Reagan’s proposed tax cuts as Voodoo Economics has a national Republican leader stood up for the most basic tenets of Republican doctrine. Or what once was Republican doctrine.

In the 1980 contest between Bush and Reagan, the Republican Party formally turned away from any substantive commitment to fiscal responsibility because, as Grover Norquist—the founder of American’s for Tax Reform and one of the architects of the contemporary Republican coalition—likes to point out, the constituency that votes on the basis of balanced budgets is small—generally the old money and Wall Street set—and can be bought by a commitment to cutting taxes.

When Ronald Reagan took office, the public debt stood at $712 billion. Twelve years later, it had increased more than four-fold to $3.2 trillion. Under Bill Clinton’s watch, the increase was a mere $70 billion in eight years, or 2%. When George W. Bush took office, the public debt stood at $3.3 trillion. This year, it stands at $5.4 trillion, and increase of 64%.

Still today, Republicans claim the principles of fiscal responsibility as their own, and decry Democratic profligacy. But what data are they looking at? Coca Cola was once sold as a health elixir, but the evidence would prove otherwise. Where is the truth in advertising that adheres to the most basic areas of civic choice?

Today, any semblance of the historic identity of the Republican Party has been sundered. Based on Concord Coalition data, the total fiscal burden—including public debt and future unfunded entitlements—on each American totals $175,000, or $455,000 on each household. Eight years ago, these amounts were $72,500 per person, or $188,750 on each household. Therefore, the price of the past eight years—of tax cuts and massive increases in spending—has been over $100,000 per person, or $265,000 per family.

$265,000 per family. Enough to put four kids through the average public university, but instead just a burden on America's future.

Compare these numbers to per capita income of $33,250 and median family income of just over $50,000. Consider the real struggle that most families face to put kids through college, and the ease with which this new $265,000 obligation has been foisted on those same families.

This is not a theoretical debt burden, but rather the real cost of our current liabilities. It is the real world manifestation of Republican icon Milton Friedman’s wisdom—offered to contradict the economic hocus pocus of supply-siders—that a fiscal deficit is simply a commitment to raise taxes in the future. Deficit spending, as true Republicans easily grasped, is simply evidence of political opportunism and moral weakness.

The simple fact is that in 1982 the Republican Party walked away from fiscal responsibility, as it fell prey to—in the words of long-time Republican wise man Pete Peterson—the unholy alliance of tax-cutting and big spending Republicans, and their grip on the Party is as tight as ever.

Where is John McCain's political courage today? How is he putting the Country First today when he trades away his once-valued integrity for votes, even as his plans will foist an ever greater fiscal burden on the country's future?

This issue is manifest in the debate in the Presidential race over extending the 2001 and 2003 tax cuts. These tax cuts—which John McCain opposed when they were originally enacted for being skewed to the rich and inappropriate as the nation went to war—were approved in a manner of unmatched cynicism as they were set to expire within a ten-year timeframe to create a pretense of being “revenue-neutral,” even as the intention from inception was to characterize efforts to oppose extending them as a tax increase.

Today, John McCain proposes new cuts in corporate tax rates in addition to extending the 2001 and 2003 legislation as it expires. The Office of Management and Budget projects the cost of an extension of the 2001 and 2003 tax cuts, without regard to the additional corporate tax cuts, at $2 trillion. Meanwhile, McCain proposes to pay this cost through eliminating Congressional earmarks, which according to Citizens Against Government Waste peaked in 2005 at a cost of $27 billion. Therefore, even if all earmarks are eliminated, at their peak they would barely pay for one-third of the interest cost alone of extending the tax cuts.

In contrast, in 1993, Bill Clinton took the Democrat Party in the opposite direction, as he moved the party away from its roots, and embraced the very principles that the Republicans eschewed. As Bill Clinton declaimed early in his presidency, "We're all Eisenhower Republicans now. We stand for lower deficits and free trade and the bond market.” Today, Democrats propose to shift the tax burden toward the wealthiest Americans in favor of the middle class—much McCain advocated at the time of the 2001 and 2003 tax cuts—while adhering to the revenue neutral principle that was once claimed by Republicans.

Over the weeks to come, John McCain will pull the old horse out of the barn for one more run around the track. He will claim the Republican mantle of fiscal responsibility with the full-throated enthusiasm of either a naïf or a craven opportunist.

But will people notice that the horse is dead? Will the depth of the Republican brand still have enough juice to offer the voters succor one last time?

As Americans sit around the kitchen table, will they understand that the $265,000 that they have taken on in the last eight years is the price they will have to pay for failing to challenge those who prey on their optimism and their patriotism?

Will they understand that every tax cut and war and entitlement comes with a price and that none of the goodies that they are offered are ultimately paid for by anyone but themselves?

And will they understand that unless they stop accepting the easy answers, the price tag the next time around is only going to be higher?

Tuesday, September 02, 2008

A word please?

Enough with all of this.

Just ask a simple question: “Did John McCain know that Bristol was pregnant?”

There are two possible answers. Yes, he did. Or, no, he did not.

Is it really possible that the answer is yes?

Could John McCain, having realized that he could not pick his friend Joe Lieberman due to the ruthless blowback from the right wing and evangelical community, picked a woman he barely knew—that everyone barely knew—fully aware that her 17 year-old, unmarried daughter was pregnant?

That is nearly inconceivable. He would announce his selection, the attractive, strong and valiantly conservative Governor of Alaska to be his running mate right in the wake of Barack Obama’s speech. This would counter the Democrat bounce and energize the Party in the time leading up to the convention.

And what? This secret would not get out? The news would not undermine the energy he sought to build as he changed the conversation from Barack to the Republican ticket?

No. Sorry. That simply is not possible.

Therefore, the answer must be no, John McCain did not know at the time he named Sarah Palin to be his running mate.

But how could this information have slipped through the cracks? Clearly, it was not the fault of those responsible for vetting the candidate. Should they have known that she supported the Bridge to Nowhere before she opposed it? Sure. Should they have known that she supported a windfall profits tax on oil companies in Alaska? Absolutely. But no Washington lawyer would have written on the standard list of questions, “Which of your children are pregnant?” I don’t even think it would be legal.

So the answer really can only be that for reasons only known to Sarah Palin, she declined to mention it. For reasons that we may never not, either (a) it slipped her mind, or (b) she believed that it was a private matter and none of John McCain’s business, or (c) she thought it would hurt her chances, or perhaps, (d) she never really thought she was under serious consideration, so why bother?

Perhaps we will never know. I tend to go with (d). After all, even her mother-in-law thought she was kidding—and plans to vote for Obama in any event.

But just imagine how awkward it must have been. Some moments after he made his decision, and the word was going out. She thought, ‘Oh, my.’ And she turned to the presumptive Republican nominee, and in a soft voice said, “Senator, a word please…”

What is it with white people?

So, my wife and I are sitting here, and I look to her and just shake my head. What is it about these White kids that they just keep having babies? Wouldn't you know that that man makes the effort to put a White on the ticket, and a woman at that, and the next thing you know, her daughter is pregnant!

I mean really, what with all the advantages they give White people, the least you would think that they would teach their kids some values and not go around being like that. And now they say that she was the same thing, pregnant in high school and had to get married and all?

The shame of it is that this is going to set White people back another 20 years. Not going to find another presidential nominee picking a White person to be on the ticket, I don't care how badly they want to reach out and get the base motivated and whatnot. I don't care who says it's a White persons turn, or any of that. I just say enough of that. They can't show up on a a ticket for more than an hour, or day, or what, and one of them shows up being pregnant.

So I'm done, and my wife gets all up in my face. You know, Hell, she says, you don't know what our kids do, and where they do it, and with whom. So why are you getting so worked up about this poor White woman? She can't control what her daughter does. (Ain't that the truth, I manage to butt in.) So don't tell me that just because she is White, you are going to blame her for it, and tell me that because of that, you don't think she should run the country.

Why you men! You wouldn't say boo if she was a man! If she was a White man (Then she wouldn't be a she, now would she, I chime in, but she ignores me. Whatever.) you wouldn't have a word to say, except maybe for some comment about Where's was the mother at?

After all, it was a man that did this to her, but they are going to do the right thing, and get married.

Who is? I ask.

Bristol. Her daughter. The girl who's pregnant. And Levi.

Levi? Who's Levi?

He's the one who went and got her pregnant.


Figures. I knew the Jews were behind this.

Saturday, August 30, 2008

Casus belli or modus vivendi?

Since early August, when Russian tanks pierced the mountain passes of South Ossetia and rumbled into the Georgian heartland, we have found ourselves in an oddly familiar place. It is like one of those moments when you return to your old neighborhood after decades away. As you walk the streets, there is a warm feeling of familiarity. A sense of comfort, of a time when life was simpler and the rules were clear.

Oh, for the Cold War and the remembrances of things past. It was a time moral clarity, when partisanship ended at the water's edge, of the Marlboro Man and enemies in black hats.

If the Cold War ended one evening in December 1991—when then-Russian President Boris Yeltsin and his compatriots conspired to topple the Soviet state—perhaps the uni-polar world of American power that ensued ended this month. This is not to say that Russia has reemerged as a counterweight to American power, but rather that Russia’s willingness to push back against the West’s determined policy of encirclement has illuminated the limits of American power, and perhaps of American judgment.

The emergence of our new conflict with Russia has come with breathtaking swiftness and the verbal invective has been startling. Condi Rice publicly mocked Vladimir Putin and labeled Russian behavior bizarre. Zbigniew Brzezinski likened the Russian aggression to Hitler’s Germany. Across the political and media class we are assured that we are witnessing unwarranted and irrational aggression. Russian conduct has undermined US-Russian relations and threatens to plunge the world into a new Cold War.

But if there is a surprise here, it is that there is such surprise here. After all, Putin has decried NATO expansion for several years and his concerns have been largely ignored. When Russian tanks rolled into Georgia, Putin's objective was not territorial aggression, but rather to waken the West—and America in particular—to Russia's anger at the continuing policies of encirclement. Ironically, Putin's objective was not to get into a debate about the future of Georgia and South Ossetia, but rather—no doubt clumsily—to elevate bi-lateral discussions to the strategic level.

But as the crisis deepens, as American politicians of all stripes pile on, and as Russia deepens her diplomatic isolation, one has to ask if this is the direction that we want go. Is it really in our interest to play a game of chicken with a nuclear-armed and paranoid adversary?

It did not have to come to this. In the wake of 9/11, the event that was supposed to change everything, Putin made his case for a grand alliance with America. After the planes hit, Putin was the first international leader to call George Bush and pledge his nation’s solidarity and support. Russia provided critical support to US efforts in Afghanistan—where the US had few intelligence assets on the ground—including helping the CIA build critical alliances in Afghanistan and supporting the development of US bases in the former Soviet states in Central Asia. Beyond Afghanistan, Putin proposed to be a partner in dealing with Iran, whose radical Islamism was a vital threat to Russia, within and without.

For Russia’s part, Putin asked that we recognize Russian strategic concerns along with our own. First, he asked that we temper our response to Russia’s internal struggles with Chechen terrorists. Second, he asked that we curtail the expansion of NATO into Georgia, and particularly into Ukraine. Finally, he asked that we not locate missile defense systems in Eastern Europe.

Russia’s fears of America were not irrational, despite our political and media consensus to the contrary. After all, in the wake of the dismantling of the Soviet Union, American policy remained overtly hostile to Russia. Despite assurances to the contrary from Presidents Reagan and Bush, the US supported NATO expansion to Russia's borders; Neoconservatives targeted Russia and Putin for regime change; and mainstream policy advisors argued that US policy must now promote the dismemberment of the Russia.

Putin, it should be noted, was and remains immensely popular in Russia. He has brought stability and pride to the Russian people, after the pain that ensued with the dismemberment of the Soviet empire as Russian people lived through debasement at the hands of their archrival; the destruction of their currency, personal saving and standard of living; environmental degradation through chemical and nuclear contamination; a dramatic decline in mortality; years of internal bombings and terrorism in the nation’s capital at the hands of national separatists; and the plundering of national wealth at the hands of their elected leadership.

Intelligence analyst George Friedman argues that the defining provocation by the West was the Kosovo conflict in 1999. That action—heralded as a success in the West—was implemented under the auspices of NATO after Russia blocked UN action. That event marked the ascendency of NATO—an organization in which Russia has no voice—as an international body empowered to act in support of separatist movements without preexisting legal authority to do so. That authority was vested in the United Nations, which embodied two principles. First, that borders were defined and frozen. Second, that action to change borders could not be undertaken without UN sanction.

For Russia, a country with literally hundreds of ethnic groups, regions and languages, the Kosovo issue and the negation of UN authority threatened to undermine its control of its own borders and state. The West’s support of Kosovo’s declaration of independence earlier this year marked the final step in the undermining of international institutions and rules governing international relations, borders and sovereignty. From the Russian perspective, with Kosovo, the West had laid the legal groundwork for actions not simply to contain Russia, but to begin to break it apart.

When Georgia launched its assault on South Ossetia, Putin seized the moment to raise the question: What rules are going to govern international law and sovereignty in the years ahead? Will the UN rules and the notion of fixed borders apply, as his neighbor to the Georgia claimed in justifying its invasion, or were we going to live under the new Kosovo rules, that the Americans and the West had now embraced, when might would replace right? If NATO could usurp UN authority and christen Kosovo a state, Russia could do the same.

When American Secretary of Defense Robert Gates promptly announced that under no circumstances would America come to Georgia’s aid militarily, he was simply affirming what Putin knew to be the case: In the wake of two long wars and a debased currency, the US has become long on hubris and short on stick, and would not come to Georgia's defense. The era of American uni-polar authority was pronounced to be a dead letter.

Seven years ago, when we were stronger and Russia was weaker, Putin proposed a partnership with America, but we demurred. Yet today, as we face a hostile and expansionist Iran, and a resurgent Taliban, Russia continues to share our interests in controlling Iran and Jihadism. Today, as before, Russia’s cooperation is critical to our efforts in Afghanistan. And today, Russia has become a critical source of energy to Europe and a true partner in the world economy. Today, the logic of US policy that seeks to further destabilize Russia is not apparent. Perhaps, given the challenges we face in the world, and the real threats to our national and economic security, we should consider setting aside our animus toward Russia, just for a little while.

The irony is that Putin does not want the Kosovo rules or a war with the West. The Russian leader knows well that a new arms race will undermine Russia’s future and ability to build a real economy. Sending Russian tanks into Georgia was not a provocation. Quite the contrary. Vladimir Putin was just trying to get our attention.

Perhaps it is time that someone listens.

Saturday, August 09, 2008

Ivan's ghost

I call on all governments to join with the United States and the community of law-abiding nations in prohibiting, investigating, and prosecuting all acts of torture and in undertaking to prevent other cruel and unusual punishment… Nowhere should the midnight knock foreshadow a nightmare of state-commissioned crime. The suffering of torture victims must end, and the United States calls on all governments to assume this great mission.
President George W. Bush. June 26, 2003

When Dan Levin was appointed to head the Office of Legal Counsel—the Deputy Attorney General whose legal judgments determine what is legal and what is not—in 2005, it fell to him to address the question that loomed as a brewing crisis deep inside the Bush Administration: What constituted torture, and were the interrogation practices that had come to be accepted as permissible at the CIA Black Sites and Guantanamo Bay—but which were rejected as torture by the FBI and many in the military—illegal under US and international law?

Levin, a meticulous lawyer, ultimately determined that he could only parse the meanings of suffering and pain, and offer guidance on the outer limits of suffering that agents of the United States government could legally inflict on prisoners, if he subjected himself to the interrogation practices that his opinion sought to judge. And so he did.

Levin’s actions defined the seriousness of purpose that characterized those who put their professional integrity and careers on the line to oppose the power of the Vice Presidency in the Bush Administration, and oppose the policies and practices that characterized the Dark Side of the Global War on Terror.

All Americans should read The Dark Side, Jane Mayer’s new book on the GWOT, and the battle that it depicts for the hearts, minds and soul of America that was fought between and among senior members of the Bush administration. Try as one might to view this as partisan treatise, one comes to the inescapable realization that it is about the seductive quality of retribution.

This is not a partisan issue for the simple reason—as Mayer has noted about her own post-9/11 sympathies—that in the early days following 9/11, New Yorkers—and Americans—of all political stripes, were little concerned by thoughts that our nation might overstep the bounds of legality, propriety and moral conduct in the GWOT that would unfold.

The apparent fact is that the interrogation practices at issue yielded little if any actionable intelligence. Now, we are left to look into the mirror as Americans and ponder the excesses that were done in our name, and that we condoned in the wake of the fear and moral outrage brought on by the 9/11 attacks. Excesses that were condoned and embraced as the price of fighting this new type of war that demanded extraordinary measures, even as those within the Administration with experience in these matters argued—almost to a man—the methods employed would not be effective.

This book forces the reader to consider questions far beyond the simple question of the effectiveness of torture as an intelligence tool—justified under the ticking bomb rationale and the popularity of the TV show 24. What about kidnapping and torturing an innocent bystander? Would intent or lack thereof suffice to provide protection against criminal charges or war crimes prosecution? What if the information gleaned from torture was not critical, or proved unreliable? What if years passed and the ticking bomb argument had long faded? What if at every step of the way, dissenters at senior levels argued that the actions were illegal? What if the FBI as an institution dissented and declined to participate, and the military leadership and legal counsel argued that the entire infrastructure put in place following 9/11 was a legal and moral violation of the nation’s history and purpose?

Now, as we recognize the passing of Alexander Solzhenitsyn, we have to consider where we go from here. Where do we go as a nation that willfully embraced inhumane and illegal actions not in pursuit of information, but for the satisfactions of retribution. As we recall the Life of Ivan Denisovich—the iconic symbolic of a government’s abuse of power—we must now consider our complicity in the life of Khaled el-Masri, a German citizen who was kidnapped, flown to a secret prison and tortured—his life destroyed—all while his American overseers believed him to be innocent. Not Masri because he was one person caught up in Kafka’s nightmare, but because he was but one person caught up in a system of our creation that to this day the public believes was justified.

He who does battle with monsters needs to watch out lest he in the process becomes a monster himself. And if you stare too long into the abyss, the abyss will stare right back at you.
Frederich Neitzsche. Beyond Good and Evil

Read Mayer’s book. Consider the comment of a CIA official involved in the Masri affair when George Tenet, Condi Rice and Colin Powell debated the need to tell the German government what they had done to one of their citizens, “For guys who are basically running ‘Kidnap Inc.’ they sure were pretty squeamish.”

How squeamish will we be when forced to come to grips with the events that transpired? What happens when on a trip to Europe, Dick Cheney or Alberto Gonzales or one of many others is arrested and presented with an indictment on war crimes or criminal conspiracy charges by Germany, on behalf of Khaled el-Masri, or some other nation whose citizens were caught in our web? How will the American President lead the nation through the outrage that will ensue?

For all of the talk of post-partisanship, the demands on America’s new president to lead us through the recriminations that will ensue will be trying. The true test of leadership will be how the president we select is able to temper the emotions of their own partisans, and lead us as a nation through an acceptance of the facts and a resolution of the direction forward. John McCain or Barack Obama may face challenges on the economy and the wars, but the greatest challenge may well be leading us through the miasma of emotions and politics that will ensue as we finally come to grips with what has become of us.