Graffiti: Ruminations on political and economic life.

Insurance. Or not.

2012-02-20T19:58:00.009-05:00

If you have ever wanted to see what a scam looks like in process, check out the budding Russian insurance industry. Standard & Poor's released last week an interview between an Associate Director of their Financial Services Team and a Russia-based Senior Insurance Analyst.

The video clip, entitled Russian Insurance: High Country Risk and Frail Market Framework is instructive. It describes an insurance sector in Russia that is growing rapidly, faster than GDP growth, in a market where insurance penetration is one-tenth the norm in Europe.

But it is the details that are interesting. Russian insurers are facing high country risk is the theme. The industry is not profitable, largely because 40% of premium costs are paid out to agents and brokers. The industry, the analyst goes on, is highly concentrated and therefore there is significant price competition—note that this is not an inherently logical statement, as high concentration generally offers greater pricing control, but be that as it may.

And at the end of the day, the high up front costs, coupled with price pressures create an industry that has very low capitalization. And this is a risk for the industry. This is the conclusion of the report.

A risk for the industry? How about for the insured consumers? What the S&P analyst is describing is essentially a scam. There are high up front payouts to the salepeople, and very little capital—the reserves from which claims would be paid. Yet nowhere do either of the representatives of S&P suggest that this is a problematic situation, an industry constructed to take money up front and have very real risks of never paying out the claims that are supposed to be insured.

Now, it might be unfair, but this is a rating agency that was, along with Moody's, highly culpable for ignoring key risks related to the structuring and sale of mortgage backed securities and collateralized debt obligations. This report, like the AAA ratings awarded to multi-tiered CDOs without regard to cascading risk, seems to miss a salient point that could be a valid conclusion of the Russian industry as they describe it: That, like sellers of credit default swaps, the sale of insurance without the careful construction of actuarial risk reserve is a business that borders on fraud. And with 40% paid out up front, it might be a lucrative fraud at that.

Chumps.

2012-02-17T17:24:00.033-05:00

This week, four years after the collapse of Bear Stearns, the two hedge fund managers who helped bring about its demise, Ralph Cioffi and Matthew Tannin, agreed to pay $1 million to settle a civil suit brought by the Securities and Exchange Commission. No doubt Cioffi and Tannin made many, many times the amount of their pending restitution during those heady years before the 2008 collapse, and even the presiding U.S. District Court Judge Frederick Block suggested that the settlement amounted to “chump change.” But chump change was the bid on the table, and it looks like the SEC will take what it can get. And as has become customary in these arrangements, Cioffi and Tannin will walk away without any admission of wrongdoing.

The world of finance is indeed a rigged game. As the world of finance came crashing down four years ago, aggregate losses on Wall Street and in the banking sector totaled in the trillions, exceeding the combined profitability of the industry over the previous century. That the Fed made over $7 trillion available to restore our financial system, as tabulated by Bloomberg, was only made more obscene by the fact that billions were restored to the balance sheets of our banks—including Goldman and Morgan Stanley who essentially became banks just so they could benefit from Fed largesse—filtered through a risk-free carry trade from which massive bonuses were deducted before flowing to bank capital accounts.

Americans are not stupid. They know a rigged game when they see it. But if the past four years have proven nothing else, it is that the tightly interwoven relationship between Washington and Wall Street has survived the collapse as strong as ever. From the outset of the crisis—when the banks succeeded in stonewalling the sale of toxic assets and instead got the public dollars for free—the major banks have succeeded at almost every turn in defending their interests. Four years later, the industry is more concentrated than ever, trillions of dollars of derivatives trading remains opaque and the industry culture of privatized profits and socialized risk has been codified into law.

Like the Cioffi-Tannin case, last week’s “settlement” with mortgage brokers, whose patent fraud contributed to the housing bubble and ensuing collapse, was embarrassing—whether one believes it was supposed to constitute compensation for damages, restitution for conduct, or deterrence against future abuse. That settlement, approved by 49 participating states' attorneys general, was one more example of a resurgent finance industry that has walked away largely unscathed from the havoc it wrought.

Late last year, another U.S. District Judge, Jed Rakoff, stood up for the dignity of society—someone had to—when he rejected a Securities and Exchange Commission settlement with Citigroup. It was one of those many cases floating around these days where one of our leading banks sold bundles of mortgage-backed securities to investors, while secretly betting against those same securities. Rakoff rejected the proposed settlement as “pocket change,” and “neither fair, nor reasonable, nor adequate, nor in the public interest.” But the real source of Rakoff’s wrath, like Block’s this week, was that the Citi settlement included no admission of wrongdoing.

And so the game goes on. No one admits to any wrongdoing, and four years later almost nothing has changed.

Last month, the Brits demonstrated the old school way of handling these matters when Sir Fred Goodwin, the head of British banking giant Royal Bank of Scotland was stripped of his knighthood by the Queen. Sir Fred—now just Fred—led RBS from the pinnacle of success—it was the largest bank in the world for a time prior to the 2008 collapse—to total collapse, and an ensuing bailout by the British government.

The Queen's action to restore the honor of the realm came upon the advice of a secretive Whitehall star chamber “responsible for maintaining the integrity of the honors system” after Goodwin and the RBS board were collectively exculpated of any responsibility for the collapse by British bank regulators. To put the gravity of de-knighting in context, others who have been similarly judged to have “brought the honours system into disrepute” and shared Fred's fate include the famous British mole Anthony Blunt and dictators Nicolae Ceausescu and Robert Mugabe.

We, of course, have no queen, no honor system, and certainly no humility among our financial titans.

This week, our finance industry is on the attack again. The industry target now is the Volcker rule—the proposed rule that would limit the ability of banks to trade for their own account. Leading the attack has been JPMorgan CEO Jamie Dimon, who has turned to thinly veiled derision of Paul Volcker, as Dimon continues to make the case for scale and opacity in banking.

For his part, Paul Volcker views the eponymous rule is a political compromise at best, as he has long advocated a return to the Glass-Steagall restrictions that would fully segregate commercial and investment banking. And for good reason. Concentration and risk in the banking system has grown steadily since Clinton-era deregulation, and only increased since 2008. Today, the four largest U.S. banks hold over 50% of the assets of the banking system and the four banks most active in the largely unregulated and opaque derivatives market hold 94% of the $250 trillion volume of financial derivatives in the U.S. banking system.

Since the financial collapse, the industry has won nearly every round as it has sought to protect its privileges and power. While many might complain about the dizzying complexity of Dodd-Frank legislation, the truth is that the industry beat back the most substantive restrictions on derivatives trading as well as any constraints on size or leverage. If it can minimize the effect of the Volcker rule, the industry will have protected the two greatest sources of profitability for the big banks—derivatives and proprietary trading—despite those being the greatest sources of risk to the public and the farthest away from the public purpose of the banking system.

This Friday, in an assault on the Volcker rule that might on the surface seem to have been in support of Dimon, the Wall Street Journal editorial board ultimately made the case instead for breaking up the large banks. The Journal editorial rightly argued that Dodd-Frank promotes the illusion that an increasingly complex regulatory apparatus can prevent systemic failure. It is simply not reasonable to imagine that regulators can begin to track and monitor, much less regulate, the complex risks embedded on bank balance sheets—hidden away in collateral rules, language arbitrage and collateral valuation.

While the Journal rails against the extent to which the banking industry problem stem from monetary policy and Congressional meddling, in its penultimate paragraph, the Journal concludes that a real solution requires "a Congressional plan either for allowing large banks to fail or for breaking them up."

But too-big-to-fail is a product of the size and systemic importance of banks such as JPMorgan. This is not a question of Dodd-Frank or public disdain for bailouts. It is simply the truth. Given that truth, the remaining option, as the wisdom of the Journal editorial board suggests, is that the banks should be broken up. Then, perhaps, the Volcker rule, as half-baked and problematic as Jamie Dimon insists it is, would not be necessary, and once again we can have a banking system that serves the public interest, instead of the other way around.

The Apple-Foxconn affair.

2012-02-11T15:26:00.041-05:00

Apple aficionados suffered a blow a couple of weeks ago. All of those beautiful products, it turns out, are the product of an industrial complex that is nothing if not one step removed from slave labor.

But of course there is nothing new here. Walmart has long prospered as a company that found ways to drive down the cost of stuff that Americans want. And China has long been the place where companies to go to drive down cost.

For several decades, dating back to the post World War II years, relatively unfettered access to the American consumer has been the means for pulling Asian workers out of deep poverty. Japan emerged as an industrial colossus under the tutelage of Edward Deming. The Asian tigers came next. Vietnam and Sri Lanka have nibbled around the edges, while China embraced the export-led economic development model under Deng Xiaoping.

While Apple users have been beating their breasts over the revelations of labor conditions and suicides that sullied their glass screens, the truth is that Foxconn is just the most recent incarnation of outsourced manufacturing plants—textiles and Nike shoes come to mind—where working conditions are below American standards.

While the Apple-Foxcomm story has focused attention on the plight of workers living in dormitories who can be summoned to their work stations in a manner of minutes, the story has also become part of the debate about whether the U.S. should seek to bring back manufacturing jobs or should instead accept the conclusions reached by some economists that not only does America not need manufacturing jobs, but it can no longer expect to have them.

Nobel laureate Joseph Stiglitz argued recently that our difficulties recovering from the 2008 collapse are a function of our migration from a manufacturing to a service economy. While this migration has been ongoing for years, Stiglitz has concluded that the trend is irreversible. His historical metaphor is the Great Depression, which he suggests was prolonged because the nation was in the midst of a permanent transition from an agrarian economy to manufacturing, as a revolution in farm productivity required a large segment of the labor force to leave the farm.

The problem with this deterministic conclusion that America can no longer support a manufacturing sector is that it seems to ignore the facts surrounding the decline that we have experienced. In his recent article, Stiglitz notes that at the beginning of the Great Depression, one-fifth of all Americans worked on farms, while today “2 percent of Americans produce more food than we can consume.” This is a stark contrast with trends in the U.S. manufacturing sector. Manufacturing employment, which approximated 18.7 million in 1980 has declined by 37%, or 7 million jobs, in the ensuing years. However, the increase in labor productivity over that timeframe—8% in real terms—explains little of the decline. Unlike the comparison with agriculture, where we continue to produce more than we consume, most of the decline in manufacturing jobs correlated with the steady increase in our imports of manufactured goods and our steadily growing merchandise trade deficit.

The chart below, based on data from the Bureau of Economic Analysis, illustrates the growth in personal spending on manufactured goods in the United States over the past three decades, and the parallel growth in the share of that spending that is on imported goods. These changes happened over a fifty-year period. Going back to the 1960s, we imported about 10% of the stuff we buy. By the end of the 1970s—a period of significant declines in core industries such as steel and automobiles—this number grew to over 25%. As illustrated here, the trend continued to the current day, and we now import around 60% of the stuff we buy.

Over the same timeframe, as illustrated below, the merchandise trade deficit—the value of goods we import less the value we export—exploded. By the time of the 2008 collapse, the trade deficit in manufactured goods translated into 3.5 million “lost” jobs, if one applies a constant metric of labor productivity to the value of that trade deficit.

This is where Stiglitz’ comparison with the Depression era migration from an agrarian economy breaks down. As he duly notes, the economics of food production has changed, and today America’s agricultural sector feeds the nation and sustains a healthy trade surplus as well, with a far smaller share of the American workforce. In contrast, the decline in manufacturing jobs reflects the opening of world labor markets. Unlike agriculture, we are not self-supporting in manufactured goods, we have simply decided to buy abroad what we once made at home.

This shift has been embraced across our society. For private industry, outsourcing to Asia has been driven by profit maximizing behavior and the pressures of surviving in competitive markets. For consumers, innovations in retail from Walmart to Amazon.com have fed the urge to get the greatest value for the lowest price. And for politicians—Democrats and Republicans alike—embracing globalization was part of the post-Cold War tradeoff: We open our markets, and the world competes economically and reduces the threat of nuclear conflict.

The notion that American industry, consumers and politicians were co-conspiring in the destruction of the American working class was a discussion relegated to the margins of public discourse, championed among others by union leaders, Dennis Kucinich on the left, Pat Buchanan on the right and Ross Perot, while largely dismissed by the mainstream media.

While Apple has been pilloried from National Public Radio to the New York Times for its effective support of a slave economy, most electronics consumer goods are now imported. The irony of the Apple story is that the Chinese labor content may well not be the cost driver that we presume it to be. As in many other industries, the costs of what is in the box can be a relatively small share of total costs, when product development, marketing, packaging and profits are taken into account.

This, of course, is why China is not particularly happy with their role in the Apple supply chain. When the profits of Apple products are divided up, far more of it flows to Cupertino than to Chengdu. And that is the reality of modern manufacturing. Based on National Science Foundation data on the value chain of the iPad, for example, final assembly in China captures only $8 of the $424 wholesale price. The U.S. captures $150 for product design and marketing, as well as $12 for manufactured components, while other nations, including Japan, Korea and the Taiwan, capture $76 for other manufactured components.

If anything, the NSF data—and China's chagrine—reflect a world in which the economic returns to design and innovation far exceed the benefits that accrue to the line workers who manufacture the product. This is one part of the phenomenon of growing inequality, and would seem to mitigate the complaint that is often made that America no longer "makes things." We may not make things, but we think them up and as the NSF data suggests, to the designers go the spoils.

Yet there is no fundamental reason that the decline in manufacturing jobs in America should be deemed inevitable and permanent. For all the talk about the number of engineers in China, the fundamental issue remains price. As a friend who is a consulting engineer who works with Apple in China has commented, “Yeah, they have engineers, but the driver is cost, cost, cost. And the labor quality is awful. We lose a lot of product and have to stay on top of everything, but at $27 per day, you can afford a lot of management.”

This argument conflicts with Stiglitz deterministic thesis. Just as manufacturing jobs left the United States, they can come back as economic conditions change. As wage rates rise in other countries, one competitive advantage of outsourcing shrinks. And if nations—from China to Taiwan—migrate away from their practice of pegging their currencies to the dollar, foreign currency risk exposure will offset some of the cost advantages of outsourcing. And today, as newly industrialized nations like Brazil have seen their own manufacturing sectors ravaged by mercantilist competitors, there is a growing understanding for the need for order and fair rules to govern the forces of globalization.

The Apple-Foxconn affair spooked consumers of Apple products—at least for a news cycle or two. Like Claude Rains in Rick’s Cabaret, we were shocked to confront the reality of labor conditions in China. But the story was less about China than about us. That Foxconn could put eight thousand workers to work within thirty minutes to accommodate a last minute design change by Steve Jobs was not—as Jobs suggested in a meeting with President Obama—an argument for why those jobs could never come back to America, but rather it was illustrative of the astonishing narcissism of the Apple world.

It is true, no American factory could deliver for Apple as Foxconn did. But on the other hand, there really was no need to. That story was less about what Foxconn could deliver than what Foxconn’s customer had the audacity to demand.

This story raised the question of whether we care where our products are made. The answer is unclear, however many Americans have long cared about purchasing cars made in this country, and Clint Eastwood's Super Bowl ad has raised awareness of this question. What is clear is that if Americans care about where their products are made, companies will care. Therefore, even as the President promoted tax credits for insourcing—the new word for bringing those jobs back—perhaps another step would be to build on the power of choice. Perhaps not all Americans care where their products are made, but many certainly do. But even if one does care, it tends to be difficult to find out.

Perhaps a simple step would be for companies to provide that information to consumers. Even if it was voluntary labeling, knowing who chose to provide information to their customers would tell many of us all we need to know. Then we could find out whether the Apple story really changed anything, and whether consumers might be willing to take more into account that the last dollar saved if it enables us to sustain a diversified economy into the future.

Speaking Greek.

2012-02-05T15:14:00.020-05:00

“The pace and composition of the deleveraging process needs to be consistent with the macroeconomic scenario of the adjustment program and should not jeopardize the provision of adequate levels of credit to the economy.”

Thus spoke one European finance official this weekend, as one more confab of ministers from the eurohood gathered to assure the world that all is proceeding apace toward “a more balanced monetary union governance model and effective firewalls.”

The tendency to speak in finance jargon—one is reminded of the incomprehensible utterances of Alan Greenspan—may suggest to some that they have the problem under control. However, the lack of frank discussion of the underlying issues suggests instead that they have a tiger by the tail and are making it up as they go along.

Each week now brings new assurances that a deal is imminent, and yet as the weeks go by it is becoming harder and harder to imagine that after all of the complex negotiations, the end will not be more straightforward: Greece defaults and exits the eurozone.

It may be inevitable, and it may be for the best. Maybe not for Germany, maybe not for the banks, but for Greece.

The United States began as poorly structured fiscal union. The debts of the nation and the debts of the states were comingled and the boundaries of responsibility poorly defined. Like Europe, the United States is a federation with a single currency and centralized monetary policy, but with fiscal authority retained at the state level. And early on, there were periods of fiscal crisis that were first resolved with the federal government assuming the debts of the states. But it was only after state defaults on their own debts that long-term stability was achieved, as new working rules—established under state constitutions—were established that clearly delineated the responsibilities of the states and of the central government.

Europe—or more precisely the eurozone—was created with similar failures to define boundaries of responsibility. It is not surprising that nations bound together with a common currency, but each retaining spending authority, would find themselves subject to fiscal pressure. This problem was exacerbated by the implied debt guarantees that allowed each state to borrow freely, while giving the banks and other investors little incentive to make credit decisions reflective of each country's management of its fiscal affairs.

The European experience mirrors the experience of nations that have pegged their currency to the dollar. There are benefits of maintaining a common currency, but the peg cannot be sustained if a nation fails to manage their affairs—such as was the case of Argentina—or if they outperform the nation to which they have pegged their currency—such as Taiwan and Singapore. In either cases, market forces will exert pressure over time to move away from the peg and allow their currency to depreciate or appreciate until a new balance is achieved.

Greece is the Argentina of Europe, and enjoyed the benefits that access to a common currency offered, until it was no longer able to pay its bills. Argentina finally defaulted a decade ago, but not before its families of means squirreled their pesos away in dollars stashed in foreign banks—much as Greeks are doing today.

There was no impediment to Argentina’s ultimate default. The currency market did for Argentina all of those things that are being demanded of Greece today. Everything was adjusted downward in real terms. Salaries and pensions—public sector and private alike—funding public services. The population became poorer, their futures cast into doubt, but unlike Greece, no public official had to cast a ballot.

Each week, the Germans—along with their junior partners in France—are putting the hammer to the Greeks. Cut public sector spending. Cut worker salaries. Cut pensions. Sell the airports and trains. And this week demands to cut private sector salaries by 25%. Now, German ministers have taken the final, inevitable step and suggested that Greece must have a fiscal overlord to set budgets and spending levels.

While the world has focused on Greece's failures—with the implication that it was German beneficence that allowed Greek participation in the euro in the first place—it is easy to loose sight of the fact that Germany has been the greatest beneficiary of the creation of the eurozone. The advent of the common currency eurozone with 330 million people created a massive, captive market for the German export machine. After China and ahead of the United States, Germany is the second largest exporting nation on earth, and the bulk of what it sells is to other European countries. There are no innocents in this morality tale. All those Greek bonds and Italian bonds and Spanish bonds and other bonds that are now at risk were issued to sustain an economic bubble of consumerism from which German exporters were among the largest beneficiaries. If Greece lied on its application for admission, the Germans had good reason to look the other way.

Those who have benefited from the euro want it to survive this crisis. Failure is not an option—insisted European Central Bank member this weekend. It is not an option for Germany, whose currency would skyrocket if the eurozone nations went their separate ways, punishing its export-dependent economy. It is not an option for France, for whom the euro is the key both to containing the German colossus with which it has fought several wars and to creating a counterweight to U.S. global power and prestige. It is not an option for China, that badly needs an alternative currency to the dollar for its massive foreign currency holdings.

And then there are the financial imperatives of achieving an orderly unwinding of the exposure of the European banks to Greek default risk. Each week, we are assured, a deal to restructure Greek debt—theoretically averting a default—is almost done. The parameters of such a deal are not in question. The banks holding Greek bonds would write off more than half of the value of their bonds against their fictitious capital reserves—fictitious because those reserves have been invested in sovereign euro-denominated bonds, among which are these very same Greek bonds. Hedge funds will be strong-armed into accepting the same deal, though their write-offs will be against their own—rather than other people’s—money.

But essential to the suggested resolution would be the forbearance by the ISDA—the International Swap Dealers Association—in pronouncing that no "credit event" has taken place, such that those same banks will not have to pay out on credit event losses as the sellers of credit default swaps against those same Greek bonds. Such an outcome would seem to be unlikely based on the merits, but in a world that has dangerously comingled the financial and the political, anything is possible.

For all of this—to sustain the illusions that are Europe and the stability of its banks—all that is asked of Greece is that it voluntary cede its powers of democracy and self-determination. Yes, Greeks can still elect their leaders, but those leaders will no longer control the destiny of the nation.

But even if a default by Greece on its March 20th bond payment is diverted, nothing will actually have been solved. At best, a new package of loans will be arranged, and the default will be delayed until some later date.

This solution is backwards. Instead of affirming Greece's responsibility for its own choices, it will have been stripped of its sovereignty. Instead of having to face up to the challenge of building its own future with real rules—as ultimately each nation must—it will move forward instead as a vassal state to its Franco-German overlords.

Perhaps it is time to gather those ministers and elected leaders into a room and tell them to go home. For all of their sakes, perhaps it is time that they open their eyes and let Greece be Greece. Better now than later, because all is not proceeding according to plan.

Because there is no plan. They are just making it up as they go along.

Rage against the machine.

2012-01-29T15:38:00.019-05:00

Mitt Romney was a good governor of Massachusetts.

That alone should disqualify him from being the Republican nominee. Like Bill Weld and Frank Sargent before him, he was part of the cyclical antidote to the deeply rooted Democrat machine politics of the state, the periodic salve to the status quo.

And he could be a good president, but the longer this goes on, the less likely it is that we will ever find out. Newt Gingrich—a man more in love with his own voice than any in memory—can smell blood. Who knows if it is Romney’s blood, or the blood seeping from dying Republican dreams of taking over the nation’s capitol.

Romney’s weaknesses are well known—his pro-choice past and creation of Obamneycare—but these are failings that could be turned to positives in the suburban Pennsylvania and Ohio suburbs that loom to be ground zero in the battle for the White House. The choice for Republicans always looked to be nominating from the right and going to war with a motivated base, or accepting Romney—liberal warts and all—and fighting for the independent center.

The world is different now from a decade ago when W. strategists Karl Rove and Matthew Dowd crafted a political strategy in a world with no center. Today, the center looms, and whatever the illusions of Rick Santorum, Republican chances are zero if they cannot win the suburbs.

But Newt's campaign is not about a political position. It is about Newt, and what he chooses to say at any given moment in time.

To hear Gingrich attack Romney for paying an income tax rate of 15%, one forgets for a moment that there is no hint of impropriety in Romney’s tax returns. It is all legal. He paid what he owed. He did not write the tax code. He never served in Congress, and thus cannot even be accused of sanctioning those inequities. He is just the Republican version of Warren Buffett, a very rich guy who benefits from how we tax investment income.

To hear Gingrich attack Romney for earning his fortune in private equity, one could easily disregard the fact that private equity—like venture capital—is one of the best functioning sectors of our capital market. Private equity groups raise money privately, they invest in real companies—either nurturing young, emerging ones, or redeploying the assets of failing ones—their funds have no real or implied public guarantees and investors fully accept that their money is at risk. He was not a hedge fund trader, simply making money from money, or from the part of Wall Street that took the world financial system down.

It has been odd to watch these attacks coming from Gingrich. Without doubt, the Obama campaign was poised to raise exactly those arguments against Romney in the fall, and just as assuredly, Republicans would have dismissed those attacks as reflective of Democrat ignorance of how the real world works. Now, by choosing to attack Romney from the left, Gingrich has essentially endorsed that line of attack and undermined one more of Romney’s potential defenses.

Romney was badly hurt in the wake of those attacks. As shown in the graph below from Intrade—a prediction market website that allows individuals to take positions on political events in the form of traded futures contracts—the price of a contract betting that Romney will be the Republican nominee plummeted from its peak at $92—comparable to a 92% chance—on January 18^th to $65 six days later in the face of Gingrich’s withering assault.

Romney was bruised by the assault, but recovered, as illustrated in the graph showing his bounce back to $88. He finally acceded to demands and published his tax returns, and within days Republicans came to their senses and realized that, in fact, they are Republicans, and making money is not supposed to be a disqualifier.

But the damage was done. While Romney has bounded back to nearly $90, the beneficiary of the Gingrich scorched earth strategy has been the President, whose odds ticked upwards at the same time as the Romney crash, and now remain at $55, and solidly above 50-50 threshold for the first time in months.

Gingrich insists that he is in it for the long haul. Campaigning in Florida he asserted that he will remain in the race through the convention. “Romney’s got a very real challenge in trying to get a majority at the convention. This party is not going to nominate somebody who is a pro-abortion, pro-gun control, pro-tax increase liberal. Look, it’s not going to happen.”

Grand Old Party stalwarts Bob Dole and John McCain see the damage that is being done as the party has moved farther away from its orderly and disciplined past, but their efforts to return order to the process and avert the train wreck that they fear have been to no avail. Speaking for the grass roots this weekend, Sarah Palin—who has a way with words like no other—said it best. “You’ve got to rage against the machine at this point in order to defend our republic and save what is good and secure and prosperous about our nation. So, if for no other reason, rage against the machine. Vote for Newt, annoy a liberal, vote Newt, keep this vetting process going, keep the debate going.”

Unless Newt comes to his senses, or—more likely—lightening strikes, David Plouffe and the President will continue to watch as the campaign that once loomed to be an uphill battle becomes easier every day.

The worm turns.

2012-01-22T17:29:00.017-05:00

Negotiations to avert a default by Greece continue to move haltingly. The closer the parties get to a resolution—presumably replacing existing short-term debt with new, long-term bonds with a reduced coupon—the clearer it is becoming that a solution may require 100% participation of bondholders while sustaining the illusion of “voluntary” investor participation.

The holders of the Greek debt range from European banks to hedge funds. The European banks—for decades among the titans of the world financial system and the envy of U.S. banks—have been a shadow of their former selves since 2008. Many were essentially insolvent in the wake of the 2008 collapse, and only survived through a combination of sovereign guarantees, public injections of capital and actions by the U.S. Federal Reserve Bank.

Those banks are the largest holders of Euro-denominated sovereign debt of Eurozone members, in large part because they viewed that debt as carrying an implied guaranty—much as U.S. banks viewed the mortgage-backed securities that were their undoing—and because those bonds were eligible collateral for their borrowing from the European Central Bank. In a larger sense, however, those purchases reflected the extent to which the banks have become an integrated part of the public policy apparatus of the new Europe, where the boundaries between the public and private sectors have becoming increasingly blurred.

Hedge funds, on the other hand, live with no such ambiguity. Hedge fund buyers of Greek bonds are in it for financial gain. If a fund trader buys a medium-term Greek bond, they do so in anticipation of being able to sell that bond in the future at a higher price or in the extreme case holding the bond until it matures at 100% of its par value. To effectively protect against downside risk, they might concurrently enter into a credit default swap that would pay off in the event Greece were to default on its payment obligation. Ideally, a well-structured trade provides an upside to the hedge fund regardless of the outcome for Greece. Heads they win, tails they win, and only the math would tell you which way they would win more.

But in the new world order, things are not so simple. There are many participants involved, and each has their own set of metrics for a successful outcome of the Greece workout. The proposed resolution would provide for a swap of currently outstanding Greece bonds for new bonds that would pay out over a longer term, at lower rates. In theory participation is voluntary, but clearly some are kicking and screaming as they seem to be voluntarily coming to the table.

For the banks, the proposed swap is not such a bad outcome. First, because their holdings are of both short and long-term bonds, and based on the complex portfolio accounting, what they lose on swapping their short-term bonds in the deal, they make up in part at the long end. Second, as part of the complex public-private Euro-policy apparatus they have been told by their new political masters to play ball. But finally, and of critical importance, the European banks want to avoid an official default—or any outcome that could be defined as a “credit event” by ISDA, the International Swap Dealers Association—on Greek debt, as those banks are the primary providers of the credit default swap insurance purchased by the hedge fund community, and they want very much not to have to pay out on those derivative contracts.

For Greece, the objective is clearly to survive the restructuring with a balance sheet that causes as little domestic pain as possible, and to retain access to new borrowing going forward. To any rational observer, this outcome seems counter-productive, as it is hard to imagine that such continued market access for new borrowing will not lead all of the parties back to the table for a new workout down the road. Same script, another year.

For the hedge funds, this may be, to use that paternalistic cliché—a teachable moment. The banks seem to be getting out of the deal what they need—putting off a hit on their capital and avoiding a credit event under their credit default swap exposure. For its part, Greece seems to have garnered increasing leverage the longer the negotiations drag on, at least in part through its threat to recast the terms of the bonds. The bonds were sold under Greek law, and someone seemed to have realized that the Greek parliament could have the power to unilaterally change the terms of the outstanding obligations. It is hard to fathom that such an action would be legal, but no doubt Greek legislators would be only too eager to vote on the matter. It is the hedge funds that seem to have ignored the extent to which rules in the financial markets are increasingly subject to political intervention, and they may find themselves to be the odd man out.

The deal on the table is evidence of the growing interplay between the financial markets and political forces. Like the GM bondholders, the hedge funds are finding themselves subject to massive political and coercive pressures to consent to a workout that takes away both the upside that they thought they owned and the downside protection that was their fallback. In the most ironic of twists, hedge fund managers have threatened to sue in the European Court of Human Rights to prevent the usurpation of their economic rights through the proposed “voluntary” restructuring. Perhaps they are right on the merits, but it may be that trading and making a profit on the life and death of nations is not going to be as easy as it once seemed.

Early on, the new, dynamic interaction between the private financial markets and the political world was evident in the enormous pressure felt by Greek politicians to vote to cut public sector salaries, pensions and services. Now, the worm seems to have turned and the politicians have the upper hand and are turning the screws on the hedge funds.

Somehow, this Greek saga that was once front page news has drifted into the background, though its outcome may yet rock the financial markets. But the roles are shifting, and it is now apparent that the Greek politicians are not as dumb as they seemed, nor the hedge fund traders as smart as they thought.

Veering from the playbook.

2011-12-24T15:37:00.003-05:00

House Republicans, just days after standing their ground, decided instead to head home for Christmas dinner.

So much for the principles that brought them to power in 2010. So much for ending business as usual in the nation’s capital.

But their language changed by the end. Gone was the moral outrage, the appeals to end the mindless spending that was bankrupting the nation. This week, the House Republican talking points led with the insistence that America’s working men and women deserved more than a two-month payroll tax holiday. Somehow, the Tea Party-spawned House Republicans had morphed into demagoguing Proletarian heroes.

But this was an important moment. After all, when the current House majority seized the reins, they were clear that their mission was to curtail spending as the singular path to curbing massive fiscal deficits, while not impeding the morally righteous task of cutting taxes. Specifically, the House Republicans changed “Paygo” rules that had been in effect for many years—whereby tax and spending measures must be budget-neutral over a 10-year period, as scored by the Congressional Budget Office—to provide instead that such constraints should not apply to tax cuts.

This perspective—that deficits are not a function of the mix of revenues and expenditures but rather a function of spending alone—is a odd vestige of the Reagan era, when cutting taxes emerged as the sine qua non of the modern Republican Party and liberated the GOP from its stodgy traditions of fiscal prudence and school marmishness. At the time of the Reagan revolution, when marginal tax rates where high, one could make a fairly reasoned argument of the supply-side premise, that cutting taxes would increase revenues. But that argument was bound up in the facts and economics of that era, and only attained that status of a moral imperative in the ensuing years.

But in the debate regarding extending the payroll tax cut, for reasons that are unclear, the House Republican did not merely forsake their rule that tax reductions are morally self-justifying, they went to the mattresses to demand that they be paid for like any other legislation of Democrat-inspired spending.

Then, suddenly, they got up off the mattresses, changed their votes and went home.

Fast forward to late next year and the implications of the House action looms large. At the end of 2012, the Bush-era tax cuts are set to expire just like the payroll tax cut that was just extended. Under the House Paygo rules, Republicans would no problem demanding that such tax cuts remain permanent, despite the $4 trillion of projected costs over ten-years. But the payroll tax debate should cast the stance of the House Republicans in a new light. This month, for the first time in recent memory, the Republicans took a stand against tax cuts because of the fiscal implications of those cuts.

For the first time in recent memory, Milton Friedman and the Republican Party of my grandfather were redeemed. This was a significant point that should not be lost.

Because the simple truth is that to extend the Bush tax cuts is wrong.

Little if anything has been said in the public debate over those tax cuts to remind the public about why they had an expiration date to begin with. After all, changes in the tax code tend to be eternal, and ability to rely on the rules of the tax system is a bedrock principle of our economy. But the Bush-era tax cuts had to expire if they were going to comply with the fiscal rules in place when the cuts were enacted into law. To meet the ten-year Paygo scoring rules, the Bush-era tax cut legislation provided for rates to return to the levels in effect in 2001 after seven years in order to pay for the largesse that was bestowed upon taxpayers over the period the cuts were to be in effect.

Oddly, in the debate over extending those tax cuts, up until now the Democrats and Republican essentially had to act under different political rules. Democrats, because they are the party of wanton over-spending and fiscal profligacy, had to justify how extending the tax cuts would be somehow fiscally justifiable. Republicans, because their brand includes the long-defunct notion that they are the party of fiscal prudence, felt no such constraint, and they have felt free to argue that the cuts be made permanent, whatever the fiscal impact might be.

The argument in Congress that the Bush-era tax cuts should be extended has given the lie to the notion that Congress is subject to any rules, even the ones it places on itself. The argument that tax rates should not be increased in the face of a recession is utterly disingenuous. Those arguing to gut the 2001 and 2003 tax bills now would be doing so regardless of our economic condition.

Look back at the historical record. Even as the Bush-era tax cut legislation was being considered, Republican leaders assured their base that by 2010 those cuts would be made permanent, as the Republicans pledged from the outset to attack as taxers any who would let the cuts expired. That is to say, even at the moment of the original legislation, those who supported those tax cuts eschewed any intention of adhering to the fiscal rules that Congress had imposed on itself. At the time, the cynicism was breathtaking. But as political calculation, it was prescient.

This month, House Republicans veered from the Republican orthodoxy on cutting taxes without offsets in favor of their Tea Party anti-deficit principles when they demanded spending cuts if the payroll tax cut was to be extended. For the first time in recent memory, Republicans returned to pre-Reagan principles and demanded that tax cuts be paid for.

A cynic might argue that this was not a change from the Republican playbook. They might suggest instead that we have seen the emergence of a codicil to the principle that tax cuts are morally self-justifying that suggests that such cuts must be paid for if the benefit accrues to working class Americans. Or perhaps the House leadership simply got caught up in needing to oppose anything that Democrats supported, and lost sight of the fact that they were in the odd position of opposing a tax cut.

In acting to demand that the payroll tax cut extension be paid for, will the House Republicans apply the same rule to extending the Bush-era tax cuts? That would be a game changer. But it is more likely that the House Republicans will get their act together, and once again the $4 trillion cost—and profound hypocrisy—of extending the Bush-era tax cuts will be subordinate to the higher moral principle of cutting taxes—without regard to cost.

Neoconservative denouement.

2011-12-18T13:34:00.015-05:00

With the end of the war in Iraq, one chapter of the Neoconservative history is ended. Its outcome will not be known for decades to come.

In his famous 2003 interview in Vanity Fair magazine, then-Deputy Secretary of Defense Paul Wolfowitz was forthright in explaining that while their public case for going to war in Iraq was based on weapons of mass destruction, they chose the WMD argument because it was the most salable. It was the rationale for the war, but not the reason.

Some, such as Dick Cheney, saw the war in Iraq was a means to achieve American control over oil fields whose development Saddam was ceding to Russian, Chinese and French companies, and putting boots on the ground within striking distance of both Saudi and Kuwait oil fields, to deter future threats to America’s interests in the region.

Others, such as Donald Rumsfeld, saw Saddam as a proven threat to the region, who would be increasingly allied with international terrorism as a strategic threat to America’s interests. That group—that garnered sympathy in the outgoing Clinton administration—viewed action in Iraq as imperative both to forestall further aggression by Saddam, and to prevent an alliance with terrorist groups that had declared war on America and the west years earlier.

For Wolfowitz and his Neocon brothers-in-arms, however, the motivation was more idealistic. Iraq was an opportunity to bring a reformation to the Arab world—to end centuries of oppression and dictatorship dating back through the Ottoman Empire and the Caliphates, and set it on a path toward modernization, democracy and freedom.

It is ironic that a decade later—after a cost of thousands of American and Iraqi lives and trillions of dollars of total projected costs—the argument that was chosen to sell the war was the easiest to have been proven wrong. For Wolfowitz and his brethren that is OK, because WMD was never really the reason. It was simply the rationale.

Today, as winter sets in following the Arab Spring, it is hard not to reflect on the Neoconservative casus belli. One cannot point to the evolving democracy in Iraq and suggest a direct cause for democratically inspired movements that have shaken the Arab world. The contemporaneous evolution of communications technologies that have been so evident in media coverage of the Arab Spring certainly suggests a range of changes in the world that might have been causal factors. Yet images of Iraqis exercising their new-found rights of suffrage had to have an effect.

The devolution of the Arab Spring as the early excitement gave way to the increasing violence in Iraq should have been anticipated. Even as the commentariat pronounced a new world order, real world factors were bound to counter the idealism of the moment—whether the military in Egypt or the tribalism in Libya, or the Algerian history of one man-one vote-one time that looms in the background as the Muslim Brotherhood and other Islamist parties loom to seize power in a matter of months through the ballot that they failed to achieve after decades of armed struggle.

This is a dissatisfying outcome. In an era of instant news and communication, the notion that it may take generations for new political and social dynamics to evolve is hard to accept. Through the Iraq war, we have created turmoil in the region. We have let the jinni out of the bottle and when things begin to look worse for it—when new regimes become hostile, when women’s rights are suppressed, when all those leaders across the Muslim crescent who graduated from American universities take power and rail against us to play to their local electorate—there will be little we can do.

But we already know that living in a world of increased freedom can pose difficult challenges. We have been down this road before.

If our experiment in spreading democratic freedom across the Muslim world seems like it may have rough moments, we need only look back at our now-decades old experiment in spreading economic freedom, known as free trade.

Just as the Neoconservative vision held that building democratic institutions across the Muslim world was critical to addressing the long-term threats that emanated from that region, Richard Nixon’s openings to China and the Soviet Union began a process of bridging the west and the Communist world through economic engagement as a strategy to mute the risks of military—and ultimately nuclear—conflict.

While we may have to wait fifty or a hundred years to see how the Neocon strategy of democratization of the Muslim world pans out, we are beginning to see the impact of our free trade strategy.

By and large, free trade has worked. At least with respect to the muting of military and nuclear conflict. Russians are now deeply engaged in their own economic and political development, even as they struggle to migrate toward a system based on laws in lieu of tsars and commissars. China, meanwhile, has embraced free trade with a vengeance—or a free trade world to be more specific. A quarter century ago, according to U.S. Census data, our trade with China was negligible. Since that time, through an unrelenting mercantilist strategy China has seized the advantages available to a provider of low-cost labor to become our largest trading partner—and each year our trade deficit and job losses have grown.

The price of our free trade policy on the American worker and middle class was not unanticipated. Most famously, 1992 Presidential candidate Ross Perot described the “giant sucking sound” of jobs that would be drained from this country with the advent of free trade agreements supported by Democrats and Republicans alike. And the economics of his statement were unarguable. Lower labor costs, lower regulation and reduced enforcement of environmental laws had been the basis of the rise of the Sunbelt and the decline of the industrial Midwest domestically, and Perot was suggesting nothing other than the same dynamics would lead to the internationalization of the deindustrialization of America.

But few warned the American people. Across the punditocracy of the time Ross Perot was roundly derided as a crank and a scold. But Perot's followers, the political antecedents of the Tea Party, knew a con job when they heard one.

Many may not care for Paul Wolfowitz and his friends that imposed a bloody and costly war upon the Iraqi and American people. But in his ideological fervor Wolfowitz is part of a uniquely American tradition. Few empires have offered their lives and treasure that other nations might be lifted up. And in that sense, the Neoconservative aspirations were an outgrowth of the highest rhetoric of John F. Kennedy.

With the advent of free trade, America willingly and deliberately sacrificed the livelihoods of its working class as the price of raising people out of poverty from Xinjiang to Sochi. With the Iraq war young American men and women gave their lives that future generations from Mosul to Tunis might see their lives transformed. But like free trade, there will likely be more pain yet to come, and the next chapters of the story will play out over decades. A remarkably unsatisfying outcome.

The missing voice on Wall Street.

2011-10-08T20:07:00.007-04:00

Whatever one’s view of Occupy Wall Street—and how quickly those on the right and those on the left have gone to their respective corners and hammered out their talking points—it is a positive step that there might be some thought given to where we are and where we are going. But so far, one group has been fairly quiet, if the point is to address the undue political clout and financial power—to say nothing of economic risk—now manifest in our leading banks. It is the voice of the American banker.

Not Jamie Dimon, the CEO of JP Morgan, who continues his reign as the doyen of US banking—nor Goldman Sachs CEO Lloyd Blankfein, who occupies a very different role in the public imagination—but rather the leaders of 7,500 other banks across the country. These are the banks that continue to play the critical role of commercial banking in our economy—they take deposits and make loans.

As a result of two decades of consolidation, the commercial banking industry in the U.S. has become increasing concentrated. Today, the four largest banks, JP Morgan, Citibank, Bank of America and Wells Fargo, comprise just over 40% of the total assets of the U.S. commercial banking system.

Contemporaneous with this consolidation was the integration of investment banking and commercial banking, with the final removal of Depression-era restrictions two decades ago. Legislated changes in 1999 and 2000 paved the way for the new focus on trading within the commercial banking world, and the explosive growth in derivatives.

But the purpose and rationale for a publicly-supported commercial banking system remains its depository and lending functions. Banks take deposits, which are federally guaranteed, and they use a combination of these deposits, equity and debt capital, and loans from the Federal Reserve Bank to make loans—to judiciously allocate capital across the productive sectors of the economy.

A quick scan of the list of highest loan/deposit ratios among bank holding companies published by American Banker illustrates the richness of the banking sector, with institutions ranging from Bank of America to Big Sandy Holding Company, the owner of Mile High Banks in Colorado that boasts 160 shareholders. The ratio of loans to deposits may not be the most appropriate metric for assessing bank performance in their public mission, but to a lay person it seems to be a reasonable start. Wells Fargo and Bank of America, both commercial banks with deep roots on Main Street, are among the top 200 banks in that ranking, while neither JP Morgan nor Citibank, both banks culturally rooted in Wall Street, appear on the American Banker list.

JP Morgan and Citibank are at the top of another list—this from the Bank Trading and Derivatives report published by the Office of the Comptroller of the Currency, the lead federal regulator of the commercial banking system. JP Morgan and Citibank are ranked one and two here, with a combined $134.2 trillion of total outstanding derivatives contracts, or 54% of the total $249.3 trillion of derivatives in the commercial banking system. Add the third and fourth ranked banks, Bank of America and Goldman Sachs, and those top four hold $191.1 trillion, or 77% of the total derivatives exposure in the banking system. By comparison, those four banks hold 46% of the total risk-based equity of all banks that participate in the derivatives market.

Without doubt, certain derivative products play a valuable role in commerce, trade and commercial risk management. Commercial, industrial and agricultural clients—the traditional clientele of the commercial banking sector—reasonably need to hedge interest rate exposure, foreign currency risk and commodity prices. But the $134.2 trillion of contracts for JP Morgan and Citi alone far exceeds the levels of economic activity that one might imagine being hedged—the $89.6 trillion of interest rate hedges is six and one-half times our national GDP, the $10.4 trillion of foreign exchange hedges are five times the dollar value of the imported goods and services that domestic firms might conceivably want to hedge in a given year, and JP Morgan’s $6.1 trillion book of credit derivatives approximates the total value of corporate debt outstanding in the U.S. economy.

Does this matter? Beyond the shock value, are there valid reasons to reassess the appropriateness of this volume of derivatives business and the potential financial risks that it entails? Does the fact that one-quarter of commercial banks do no derivatives business at all, and only one percent of US banks have enough derivatives exposure to warrant public concern, suggest that the extent of the derivatives exposure of the top banks is not necessary for assuring effective and efficient client service? This is not a question of government meddling in private affairs. Quite the contrary, the commercial banking system has been constructed based on a system of deposit insurance and access to loan capital from the Federal Reserve. Accordingly, these banks are engaged in businesses that are directly supported by public resources and guarantees, and therefore can expect public scrutiny.

The argument JP Morgan would make is that their “derivatives book” is fully balanced, with every positive exposure balanced by a negative exposure. That is to say that for all their long positions in a given currency, or interest rate movement or General Motors bond, they have an offsetting negative position. They are not “net long” or “net short.”

Similarly, their derivatives book is balanced with respect to counterparty credit exposure. For every position where they might be taking, for example, Deutsche Bank risk, they have a balanced and opposite position that theoretically keeps them neutral and protected against counterparty credit events.

Thus, in the case of JP Morgan, as reported to the OCC, its total $78.1 trillion derivatives portfolio actually leaves it with total net credit exposure of $361.0 billion, or just 2.71 times their risk-based capital. So, the theory goes, despite the eye-popping numbers, JP Morgan, and by extension other banks active in the derivatives business, are managing their affairs. And, they would submit, the risks are manageable.

But the theory seems to miss two salient points.

The first point reflects the corruption of the culture of commercial lending as banks embrace the trading culture that is central to the derivatives world. The mission and purpose of the commercial banking system is the efficient allocation of capital across society. Commercial banking has been seen as a sleepy world of bankers with green eyeshades, pouring over financial statements, even as Jimmy Stewart, playing George Bailey in Frank Capra’s 1946 movie “It’s a Wonderful Life,” portrayed the iconic Main Street banker, who made America work.

And that remains the mission of America’s commercial banks. They invest in Main Street businesses, small businesses that grow from the dreams of their founders, businesses too small to issue stock or access the bond market, and they partner with them from one decade to the next.

Commercial banking is a slow business that takes time. This is a sharp contrast with the world of derivatives trading. Derivatives trading is a form of securities trading with magnified, and in certain cases unlimited, leverage. As noted above, derivatives contracts have two primary risk attributes, event risk—did interest rates move against your bet, or did GM go belly up—and counterparty risk—this was the AIG problem, where AIG could not perform on its end of the derivative contracts and there was a scramble among counterparties to get what they could.

As in the AIG episode, the collateralization provisions of the standard derivatives contracts now constitute the largest area of risk exposure. With the downgrades of Bank of America and Wells Fargo this month, and the turmoil in the European banking system, it is easy to imagine an AIG-type event on the horizon. Many have forgotten that AIG did not collapse because of housing bond defaults. It collapsed because it was downgraded from double-A to single-A, and that downgrade triggered a collateralization event that required AIG to post $180 billion of collateral.

Unlike a hypothetical loan to a local restaurant that is collateralized by their real estate and equipment, AIG did not pledge specific collateral to its counterparties. Like every financial institution, AIG was highly leveraged and its outstanding obligations were many times its available capital resources. Accordingly, as—Goldman Sachs demonstrated when it pulled $7 billion out of AIG in advance of other creditors—in a derivatives credit event, time is not your friend and counterparties have to move quickly to protect your interests.

This stands in stark contrast to the commercial lending world. If that restaurant were to have a cashflow problem, the bankers from Mechanics Bank would not come crashing in—You, grab the pans, I got the Fryolator—to get a jump on Mission National Bank or Union Bank. Rather, the rules governing commercial lending, foreclosure and lender liability result in the need for a senior lender to exercise prudence and carefully consider the impact of its actions on the borrower—as well as dealing with competing interests of other creditors, equity holders and management—even as it seeks to protect its financial interests. This results in a slower process that is more deliberative and enables the workout of complex situations. In contrast, in a derivatives event everything has to be done over a weekend, to avoid spooking the markets. To put it simply, in the derivatives world, you grab the Fryolator first, and ask questions later.

The second point builds on the first. If commercial banking is an operational business that takes time and attention, investment banking and trading are transactional worlds of urgency and short attention spans. Profits and bonuses are the immediate imperative, and relationships and character—the core of commercial banking—are relatively unimportant. In the past two decades, the culture of investment banking—the culture of Wall Street—imposed itself on the world of commercial banking. Dating back to Salomon Brothers merger with Philipp Brothers and culminating in Sandy Weill’s assault on Citicorp, Wall Street’s pursuit of capital created the world today, where a handful of leading commercial banks are imbued with the culture of Wall Street and increasingly largely diverted from the traditional, slow function of commercial lending.

Which leads to the question that should be addressed: Why?

Why should American banking be captive of the political clout and financial interests of four or six or eight firms? It simply is not in the interest of the overwhelming majority of commercial banks to let federal policy be driven by the political power of or risks related to that handful of firms. Two of those firms, Goldman and Morgan Stanley, only became commercial banks in the wake of the financial collapse in 2008 in order to gain access to the resources of the Federal Reserve Bank, and have no business remaining bank holding companies now that the crisis has ebbed. Whatever one believes about the fairness of public dollars and protection being used to support those two large investment banks, that time is past and the linkages with the public purse should be firmly severed.

This is a question that is not being asked, but that must be asked. As our political parties fight for access to Wall Street money, the ability to make sound policy that serves the larger interest of assuring a sound and effective commercial banking system has been undermined. Nor is Occupy Wall Street raising the questions that must be asked in a way that will reach the wide range of legislators the need to take notice.

What is missing from the new focus on Wall Street is the voices of the American banking community. Through consolidation and crisis we have gone down a path that has undermined the effectiveness and stability of our commercial banking system. Derivatives trading—now central to the profitability of those largest banks—entails uncharted and unknowable risks to the financial system, and it is part of a cultural shift that has impaired the effectiveness of those banks in serving their primary function of commercial lending. The Dodd-Frank and Sarbanes-Oxley laws were created at moments of crisis in response to the egregious practices of a small number of market participants, but now constitute enormously expensive regulatory regimes that constrain and impair the effectiveness of thousands of banks that simply have not heretofore been part of the problem.

Occupy Wall Street might make good media, but if we are to address the serious challenges that confront us about the structure and direction of our commercial banking system, the voices that must be heard above the din are those of Main Street bankers across the country whose future success is critical to our long-term economic recovery.

So little, too late.

2011-10-05T00:27:00.025-04:00

Three years ago, it all fell apart. A decade of borrowing and greed finally culminated in the collapse of Wall Street, and it has taken three years for any visible protests to bubble to the surface. Occupy Wall Street, as they call themselves, is just now making it onto the news.

How is it that after Americans have watched their retirement savings disappear, after a 31% decline in housing values and an estimated $7 trillion of lost assets on the balance sheets of American homeowners, only a couple of hundred people manage to show up and protest what Wall Street power and arrogance has done to America, and how little has been done to exact retribution on behalf of a bewildered nation.

One casualty of our political wars has been the absolute loss of accountability for the excesses and the collapse. Reasonable regulation of the financial sector has long since given way to the imperative of political fundraising. During the Clinton years, Democrats gleefully won over Wall Street money—traditionally a Republican entitlement—as the Rubin-Summers cabal trampled thoughtful opposition and engineered the 1999 and 2000 laws that loosened regulation of financial services and gave the green light to unchecked derivatives trading. Today, Republicans have won back Wall Street’s affections through their opposition to the Dodd-Frank regulation, while disingenuously trumpeting to the world that they oppose too-big-to-fail.

The simple fact is that through unbridled financial largesse—the financial services sector was unmatched in its level of political contributions over the past decade—concentration of power and market share in the financial industry has continued to grow, even as little has been done to alleviate the risk of future financial crises.

Few across the political landscape would actually let our large banks fail. That is not a political argument or observation, it is simply a fact of the world that we live in. Since 2008, as our major financial institutions became insolvent, our Government has bent over backward to assure that the public’s money was poured onto the balance sheets of the private banks. While TARP has become the piñata for the right, that program’s $700 billion authorization paled beside the $16 trillion in loans made by the Federal Reserve Bank—to American and foreign banks alike—to sustain the liquidity of the global financial system.

In another era—perhaps on another planet—insolvent banks would be allowed to fail. Their assets would be sold off, depositors in insured accounts would be protected, and bank bondholders and equity holders would lose out. It was called capitalism. The paramount responsibility of investors was to assess risk and make investments. Those who were astute evaluators of risk would do well. Those who were not, would not. It was the way it was supposed to be. And the benefit to society was an efficient allocation of capital and economic growth.

Not so today. Barely 20 years after the fall of the Berlin Wall—the supposed triumph of the capitalist west—capitalism has been reduced to a shell of its former self. In today’s world, investors are protected from the risks they assume. In today’s world, the largest financial institutions are insulated from the consequences of their own worst behavior, and even in the wake of the global financial collapse engineered by their own excesses, the political parties continue to vie for their dollars—even as they continue to utter pious obeisance to such notions as accountability and responsibility. In today’s world, millions of American households lost trillions of dollars of equity in their homes as values collapsed, while at the same time the Federal Government has engineered the restoration of trillions of dollars of bank capital in the name of restoring confidence in the financial system.

Last week, London-based trader Alessio Rastani stunned the world by pronouncing that he prays for another recession. “As a human being,” Rastani pronounced, “I don’t want a recession, but as a trader it creates good conditions to make money.” Anyone who has been paying attention might have noticed that traders tend to find ways to benefit from the world's ills, yet for some reason, Mr. Rastini’s comments were deemed to be news.

Last month, Vermont Senator Bernie Sanders was excoriated for publishing oil trading data from the Commodity Futures Trading Commission that detailed the trades of leading Wall Street firms that participated in the speculative trading frenzy that pushed oil prices through the roof in advance of the 2008 election. Sanders was derided by industry figures for actions that would “have a chilling effect on derivatives trading in the U.S.” and the ensuing news stories focused on whether Sanders had broken any laws, while largely ignoring that the data Sanders released confirmed what had previously only been conjecture: It was Wall Street traders rather than Chinese demand and other market forces that led to the spike in energy prices in 2007-08, which drained American checkbooks and dominated the early debate in the run-up to the 2008 presidential primaries.

In our digital world, Occupy Wall Street’s protests have been rendered quaint. The earnest youth chanting slogans are an artifact of decades past as they hunker down in lower Manhattan. They seem to miss the point that Wall Street is no longer a physical place, but has ascended into metaphor. Wall Street is no longer the buildings that line Wall and Broad, or even the gleaming new Goldman Sachs edifice across the way. Rather, it is the mind set of banks and hedge funds, the traders and derivatives architects, that seek competitive advantage and lucre as they move from one target to the next where a windfall might be had, with little or no regard for the havoc and destruction that increasingly lie in their wake.

For months we have followed the morality play of Greece, a nation and a people that must be brought to their knees for their willful profligacy in order to protect the balance sheets of the European banks that have been the major buyers of Greek debt. Now, the story line has evolved, it is about Contagion, a public health metaphor that aptly labels the seriousness of the risk, while at the same time seemingly suggesting an unknown cause. This week, Moody’s Investors Service downgraded Italy by three notches, from the pristine Aa2 to the pedestrian A. Unlike the Greece saga, this downgrade did not suggest poor fiscal management on Italy’s part—indeed, Italy is a country that heretofore has balanced its budgets—rather, Moody’s action reflected its fear that “financial market shocks” could undermine Italy’s fiscal position.

So we have come full circle. Once, as in the case of Greece, it was poor fiscal management that led to deteriorating financial position and ultimately drew traders like sharks smelling blood in the water. But now, as Moody's highlighted in its downgrade of Italy, it is the financial assault itself that Moody's suggests would undermine the ability of a major global power to manage its fiscal affairs.

Financial market shocks. Contagion. These are not natural phenomenon, but the cumulative actions of an industry run amok, an industry now preying upon the world that that has nurtured its growth.

Early on in the financial crisis, we debated the question of moral hazard and the consequence that if we did not let banks fail, bad behavior would be rewarded. But we are way past that stage. Now, the greater risk is understood to be the interconnectedness of each bank to the others. This is the lesson we took from Lehman Brothers and AIG: Where once failure was important to the effective functioning of capitalism, now it is deemed to be unacceptable. The global financial system is now an organic whole, daisy chains of hundreds of trillions of dollars of linked derivatives that could come tumbling down and crater the world financial system if even one major bank were to be held accountable for its own financial and risk management decisions.

It has been three years, and what have we learned? Perilously little.

Nothing that Mr. Rastani said should have surprised anyone. As Moody's made clear this week, the continuing, unfettered conduct of Wall Street now directly threatens the stability of major industrial countries. It has undermined the core principles of our economic system and corrupted our democracy. The question facing Occupy Wall Street is whether anyone in America is paying attention anymore.

A man of joy.

2011-08-30T15:26:00.002-04:00

Peter Terpeluk was my friend. And he died last week.

Like gay lovers in an earlier era, Peter and I kept our relationship quiet. He was a big Republican muckety-muck, fundraiser and lobbyist extraordinaire, former Republican National Committee finance chairman. I was, he liked to tell me, his favorite Liberal.

Peter was among the most unfailingly joyful people I have ever known. An odd thing to say about a D.C. insider—it not being a place where joy would jump out of a word cloud. To watch Peter pacing in his office, however, bouncing from one call to the next to the next, was to watch a person completely and profoundly in his element. How he kept the pieces sorted out was a mystery to me. But he would laugh as he reflected on the world of his choosing. The world of his making.

Peter was appointed Ambassador to Luxembourg by W. It was the culmination of his life. From borough manager in Pennsylvania, he worked his way through the Republican ranks, until the final honorific was his for life.

Ambassador Terpeluk. It was, he assured me, a great gig. “You gotta do it,” he insisted, seemingly oblivious to the realities of the world that precluded the rest of us from applying to be, for example, Ambassador to Iceland.

Peter was a giver. He was a bundler. He knew who to call and when to call them. He introduced people. He had a sense about people. As Wayne Berman—a peer and collaborator at the peak of the Republican money world—assured me years ago, Peter was the best. Along with Bill Timmons, the best lobbyist in DC.

Peter believed in the Republican Party. Though not on any particular issue I can think of. He was a party man, not an issue man. Like most Democrats. This nation is split in half by party people, more so than issues. Don’t ask me why, I don’t get it. But Peter was unfailingly friendly. While I heard him disparage Democrats to no end—Clinton was white trash. Obama was a joke—on a personal level, I never heard him utter a mean word. It was never personal, it was strictly business. Or rather, it was strictly politics.

But there was something that mystified me about Peter jumping on early with Rick Perry. George H.W. Bush and W. were both unfailingly amiable people. And Ronald Reagan as well. They each in their own way radiated an optimism and embrace of the nation beyond its political borders. These were the people who brought Peter to politics and to the seat of power. And like Peter, their politics was played hard, but not with a mean or harsh tone.

Not so with Rick Perry. If he has a weak spot, it is not intelligence—the great Democrat blind spot—but his apparent meanness. Not meanness of policy, but of attitude. Of affect.

Among Peter’s last words to me of Perry—It could be a movement. Won't know for a long while—indicated that he saw Perry to be of Reaganesque potential, but that he was not sold yet. I suspect that it was the lack of joy, the meanness of spirit in Perry’s public demeanor that had give him pause. Perry can connect with the anger of the Tea Party and may yet, as Peter predicted, run the table in the primary season, but to win the Presidency, Perry will have to show something more, something better. America does not vote mean. Or if it does, that is when it will be time to fear for our nation.

Optimism is the touchstone of leadership. It brings out a sense of hope, and from hope comes joy. Even in the face of adversity.

And joy—deep down beneath that Republican exterior, with the tie pins and those starched, French-cuff shirts—was the defining wellspring of Peter Terpeluk’s character. I will miss him.

And so it starts.

2011-08-17T12:13:00.020-04:00

I watched Texas Governor Rick Perry over the weekend. Gotta say, great start. Perry should rip Mitt Romney apart. He delivers a great vision speech. And the primaries lay out well for him. Iowa and South Carolina should be easy, and New Hampshire will be discounted, because even if Romney wins there, he will be viewed as a favorite son.

A Republican friend, close to Perry, demurs. "We will win New Hampshire. I have never been with a political person like this in my life. He is the best guy working a room ever. Better than Reagan. That speech went right into the living rooms like RR used to do."

My son reads this, and has the perfect new age response: "I should put some Intrade money on him while it's cheap." But the Perry contract is not cheap. He just announced and he is already at 38, eight points over Romney.

I have had two reactions. I listened to Perry's stump speech. He is delivers a great speech. He has a very strong voice. Clear vision on opportunity and the future. As my friend said, it goes right through the medium—radio, TV—to the person. Visceral. He has a power and passion that elude Romney, who is the epitome of Just Words. Seemed apparent to me that Perry can run away with the nomination.

Then I took a look at Perry's other words. Not his record—as that really matters little, ironically, despite how it will be spun and debated—but his temperament. And boy is he out there. There is a reason Karl Rove and the Bush family have fought this guy. He is the opposite of their notion of a conservative Republican. W worked hard to convey a sense of being a unifying figure, the Compassionate Conservative and all that. In that regard, Dick Cheney really was his undoing, the Sith Lord who brought him under his wing, taught him the arts of war—domestic and international. In contrast, Perry just either says what he wants with no regard for outcomes, or says what he wants with full regard for outcomes. I suspect it's the latter.

The bit about Texas and secession is notable. When Texas joined the union, it had the right to choose to divide up into six states—to have more senators. It did not have the right to exit. Yet secessionism remains such a visceral touchstone of American Nativism, something that Perry has played well. Does it matter that Texas has no such right? Does it matter that we fought a long civil war over the this issue? Of course not. This is politics, not political science.

Playing the secession card is directly linked to Perry's comments on the Fed. "If this guy [Bernanke] prints more money between now and the election, I don't know what y'all would do to him in Iowa, but we—we would treat him pretty ugly down in Texas." His unwillingness to acknowledge those comments as grossly inappropriate—and instead to simply retort "Look, I'm just passionate about the issue"—tells you exactly why he is cut from a different bolt of cloth than the Bush clan. He also knows that they—Karl Rove and others—have no choice but to come around. Perry knows well that, in the famous words of Toby Ziegler, "They'll like us when we win."

I had my own personal, visceral reaction to Perry's attack on Ben Bernanke, rooted in my own family history in Alabama, where by grandmother taught me that the rules by day were different than the rules by night. Filtered through my own rendering of family and national history "I don't know what y'all would do to him in Iowa, but we—we would treat him pretty ugly down in Texas," translated into "I don't know about y'all —but we know how to handle Jew bankers down in Texas."

I know, I need to have my filters cleaned. But even if this reaction was unfair and unreasonable, it reflected my larger reading of Perry. As a politician who can reach out and grab his audience by the jugular, he is head and shoulders above the rest of the pack.

So, if my first reaction was that he can run away with the nomination, my second reaction is that he may well run away with it. At 38, the Perry contract on Intrade may still be cheap.

Never before could I imagine that monetary policy could generate such heat. I mean, does any politician really understand the workings of monetary policy and the mechanics of money creation in a digital age? I don't think many people do. But Perry's words, like his words on secession, had nothing to do with the facts of the matter, but rather the roots of popular distrust of federal institutions, to say nothing of Wall Street and bankers.

And never before could I imagine that a leading presidential contender could verbally threaten a high public official—much less a thoroughly decent man of his own political party. Virginia Governor Bob McDonnell—who governs a state where one must understand history and language and code, provided an understated assessment of Perry's words—"I thought the remarks probably were something that could have been said differently."

But McDonnell was speaking to a different time, before Tea Party anger swept away the Republican Establishment as it was, and before all notions of temperance and self-restraint were swept out of the public square. Today, Rick Perry is in perfect alignment with his audience. His words are pitch perfect. He will not be admonished by Bob McDonnell or Karl Rove for intemperance. Intemperance is his brand.

It is particularly odd to see Karl Rove and the Bush loyalists so far outside the mainstream of their own party, unable to channel the currents of conservative opinion in a direction of their choosing. But this is indeed a different time, and so far they have found themselves powerless to stop it.

Questions of character.

2011-08-13T12:22:00.037-04:00

One week after the downgrade of the United States bond rating, the markets have returned a verdict of sorts. In a week of staggering volatility, stocks declined by 2% while money flooded into the downgraded U.S. Treasury market, reducing yields on the 10-year by 0.30%. While the S&P action certainly amped up the already-white hot political climate, the actual report offered little new insight. By the end of the week it was evident that the correction in the equity markets that had been underway since July was continuing, as was the global flight to quality that continues to favor U.S. Treasury bonds.

The dramatic rally in bonds was more notable than the stock market decline. After all, S&P's pronouncement was supposed to cast a pall over U.S. Treasuries and send investors scurrying to the sidelines. Of course, if global investors have learned nothing else, it is that there are no sidelines. The near-death experience of the world financial system in 2008 showed that in a pinch the United States Federal Reserve remains the back-stop and liquidity source of first and last resort, and since 2008 the universe of "risk-free" investment alternatives has dwindled. The very concept of a united Europe is under assault, much less the notion that the euro would emerge as the reserve currency alternative to the dollar. Even keeping holding cash in a bank has become problematic for institutional investors, as banks are beginning to charge fees for accepting large deposits rather than paying interest.

At the end of the day, the markets shrugged off the S&P downgrade because it was a non-event. Is the United States facing significant financial challenges? Certainly. Was this news? Certainly not. Does U.S. sovereign debt now rated AA+ constitute a greater default risk that any number of triple-A rated corporate bonds? That would seem to be a silly question, yet S&P seemed to be saying yes, while the markets this week said no. In the world today—a world where risks abound—the U.S. Treasury remains the benchmark for very simple reasons. In a crunch, there is nowhere else to go.

But in S&P's view, there was a material change. In the old rating agency adage, bond ratings reflect both an issuer's ability to pay and its willingness to pay. What had changed was the casual willingness of some debt ceiling combatants to embrace default as an acceptable outcome, even as others wielded the threat of default for leverage. This Friday, a senior director for S&P confirmed that the factor that led to the downgrade of the U.S. credit rating was not a material change in the financial circumstances as much as evident changes in the willingness to pay, or, more frankly, the willingness to not pay. “People in the political arena were even talking about a potential default... That a country even has such voices, albeit a minority, is something notable. This kind of rhetoric is not common amongst AAA sovereigns.”

It did not used to be this way. In fact, until recently such rhetoric was inconceivable—in old Yankee terms, credit was a point of moral character. This dramatic shift in acceptable political speech emerged earlier this year when Newt Gingrich advocated the use of bankruptcy by states as a strategic option. Gingrich's argument—which sent the municipal bond market reeling—established the principle that it is now acceptable for national political figures to disavow our moral and legal obligation to pay our debts, if it serves the interest of the pursuit of partisan political advantage.

A lingering question about our political system has been whether we are able to face up to long-term fiscal challenges and make needed changes in advance of market pressures forcing the issue. In some respects, we would seem to be making progress. After all, for the first time in the twenty years since the creation of the Concord Coalition, the issues of the long-term fiscal health of the United States and the affordability of entitlement programs are now active subjects of debate in the public square. The problem evidenced by the debt ceiling debate, however, is that for all of the debate and sense of urgency, there appears to be almost no willingness in Congress to taking the next step: Owning the problem, and doing something about it.

The debt ceiling bill that finally emerged—with the oxymoronic title The Budget Control Act of 2011—was a perfect Congressional compromise: It cut no spending and raised no revenues. For the only fiscal year over which this Congress has authority, Fiscal Year 2012, it reduced the deficit by a grand total of $21 billion. After talk of $4 trillion here and $2 trillion there, the final legislation—with apologies to Everett Dirksen—did not even add up to real money. The rest was in the out-years. Or kicked over to a debt commission which may or may not achieve its purpose—time will tell.

Congress has a well-established tradition of being long on rhetoric and short on action when it comes to dealing with budget issues. Dating back to the Gramm-Rudman-Hollings Act a quarter century ago, Congress prefers to set out-year targets but never actually specify what and how to cut. It is notable that Gramm-Rudman had the same 50-50 automatic cuts in defense and non-defense programs in the event targeted cuts were not achieved. It is also notable that none of those spending cuts ever materialized.

Now, once again, the arguments are high on rhetoric and devoid of substance. As a follow-up to the debt ceiling debate, John Boehner and Eric Cantor are pushing for a balanced budget amendment. Yet—like so many demagogues before them—neither Boehner nor Cantor have proposed how they would balance the budget—which, it is important to point out, the Paul Ryan Plan did not do. And this week, at the Republican presidential debate, Michele Bachman reasserted her stance in opposition to raising the debt ceiling, but none of the moderators saw fit to ask how Bachman would have proposed to allocate the limited federal resources if the debt ceiling bill had not passed.

At the Republican debate, only Ron Paul made a substantive point on this issue, when he advocated ending our war policy and spending. But every candidate, particularly if they choose to ride the balanced budget amendment wave, should be obligated to describe the specific choices they would make to actually balance the budget. It is not hard to do, as there is abundant data about choices and trade-offs readily available. The Congressional Budget Office provides detailed data for evaluating alternative policy choices, and weighing the long-term budget impacts. And earlier this year, this easy online tool was created that allows anyone to build their own budget solution.

We now have a window of several months before the commission created by the debt ceiling bill is obligated to put its recommendations on the table—and Congress is obligated to vote up or down—or automatic cuts are supposed to go into effect. The question is whether we ever get there, as both political parties are itching to make 2012 the showdown election, and both believe that they will be in a better negotiating position after that election. Republicans believe that Obama is beatable, and they can win the Senate with a continuation of the 2010 election trend. Democrats believe that the younger, more diverse electorate of 2008 will turn the tide away from the 2010 turnout that was uniformly older, whiter and richer. Therefore, both parties will be willing to kick the can a few more years down the road, and avoid once again making those choices that Congress has proven, time and time again, that it is loath to make.

The question remains whether this is our political system working as it should—as the more optimistic observers have concluded—or whether S&P's observation is correct, that our political rhetoric is evidence of a deeper weakness—that political imperatives now trump all other considerations—and that Congress is no longer be capable of making serious budgetary choices that are necessary for the long-term well-being of the nation.

Big time bluff.

2011-07-31T14:54:00.019-04:00

Granted, the tea party came to Washington and changed the nature of the debate. Last December, two debt commissions reported out long-term solutions to the issue of chronic budgetary reliance on debt. Both commission reports recommended a balance of actions affecting expenditure and revenues. Both commissions projected long-term moderation in debt levels. President Obama could have embraced his debt commission, and as Senator Judd Gregg noted on one senior RNC official, had Obama endorsed his commission, Senate Republicans would have been hard-pressed not to fall in line.

But last December was eons ago in the life of Washington, and while that path not taken might have seemed immoderate at the time for the President and Democrats, it is a stark reminder of how far the tea party has moved the debate in a few short months.

But for the tea party—the House radicals and their fellow travelers—the end of Debt Ceiling Crisis of 2011 may loom as the great opportunity lost. Their goals were not to move the debate or incrementally shift the culture, but rather to make radical change, to stop the spending and impose a balanced budget on the nation. Rhetorically at least, they have been unmoved by arguments that rapidly curtailing federal spending would send an already weak economy into a tailspin. Instead, their stance has ranged from the moralistic—that the accumulation of debt must stop—to the contrarian—that based on their own economic calculus a cut-back in federal spending would have curative powers on the private sector and stimulate economic growth.

This week, pointing to the risks of credit downgrades and sovereign default, John Boehner finally brought his caucus into line behind a debt ceiling bill, and it now appears that before the August 2nd deadline, the political parties will agree on some deal that purports to reduce the trajectory of national spending by some trillions of dollars over ten years. But as the numbers are crunched, the reality will look increasingly marginal. And the House radicals find themselves complicit in a process that was closer to business as usual than to radical change.

As the denouement approaches, and a resolution to the debt crisis appears to be at hand, one has to ask how many of the participants continue to believe that a default on U.S. Treasury obligations was ever at risk. Yet that was the hammer held over the heads of the House radicals.

The meaning of a default U.S. Treasury bonds is narrow and specific: It means that principal on maturing Treasury bonds or interest due on any outstanding bonds is not paid when due. A default on our Treasury bonds has been the hammer hanging over negotiations, yet such a default would not be caused by a failure to raise the debt ceiling.

While there appears to have been little public discussion of the process by which default would be averted, it is actually not complicated. First, all maturing Treasury bonds would be rolled over (refinanced) into new bonds, as is currently the practice with all maturing Treasury securities. Refinancing the principal amount of maturing obligations does not impact the par amount of bonds outstanding subject to the debt ceiling, it simply replaces old maturing bonds with new bonds on a dollar for dollar basis. Second, unlike current practice, interest due on such obligations would have to be paid from resources other than the issuance of new bonds. Whether through Federal Reserve credits—effectively the creation of new money—or the utilization of tax receipts flowing into the Treasury, the approximately $15 billion per month of interest payable on outstanding Treasury obligations—a relative pittance—would be prioritized over other uses of funds, as both common sense and the 14th Amendment would dictate.

Two months ago, Tim Geithner made clear that the default argument was a ruse.

I think there are some people who are pretending not to understand it, who think there's leverage for them in threatening a default. I don't understand it as a negotiating position

Ironically, notwithstanding Geithner's assertion that there would not be a circumstance leading to a default, and lack of any risk premium priced into U.S. securities in the Treasury bond or credit default swap markets, for the past two months the debate over the debt ceiling has continued under the specific pretense—the leverage suggested by the fear of default—that Geithner dismisses.

Default has not been at issue in the current debacle in Washington, DC. Rather, it is the fear of default that has been used so effectively as the hammer by the so-called "adults" in the political establishment. Why the language of default risk persists is itself an interesting question, as a bi-partisan spectrum of Congressional leaders and pundits continue to push the default crisis paradigm. More curious still is why it continues to hold sway.

This week, that leverage was brought to bear in full force on the radical members of the House Republican caucus, as those House members finally cow-towed to their elders. Just at the moment of their greatest power, the recalcitrant House members were brought to heel by the John McCains and Mitch McConnells who knew well that a rapid deceleration of federal spending would hurt Republican constituencies as well as Democrat, and who had much to fear of a failure to raise the spending cap. If the House radicals had held firm for one more week—and no default transpired—the Washington debate would have been turned on its head. Instead of raising the debt ceiling to resolve a purported crisis, in such a post-August 2nd world with no threats of default and bond market calamities, raising the debt ceiling would only be done once there was explicit agreement on what actually spending warranted incurring new debt.

In such a post-August 2nd world—where no default had occurred—the debate would return to a debate on spending—which has always been the central issue. But in that new world, the debt ceiling would remain in place, effectively forcing a balancing of revenues and outlays unless the votes could be cobbled together to specifically authorize new debt.

And what an odd world that would be—and we already began to see hints of the arguments that would be made: Soldiers in Afghanistan are worried they may not get their paychecks. The first argument for "patriotic" spending. Then it will be the Medicare recipients. Then Medicaid. And the farmers. Mortgage brokers. Defense contractors. Voting blocks. Major contributors.

What would that world look like, when every tax cut, every tax expenditure, every spending program and every military venture was on the table. Each one with a voting block, each one with a constituency, but each one having to be justified in the full light of day: Are we willing to pay for this? Or are we willing to vote to borrow money for this?

That is the world no one wants to see. And when the House radicals wake up on Wednesday, and see the rare opportunity that passed them by—and that it was their own leadership that sold them out—there should be hell to pay.

Full faith and credit.

2011-07-15T19:56:00.029-04:00

Everyone wants in on this act. Particularly the bond rating agencies. Having been caught asleep at the switch in the run-up to crises past, Moody's and Standard & Poor's are loath to let it happen again. Going back to the Drexel Burham/Michael Milken affair, they affirmed the strong ratings on Executive Life just before the junk bond world collapsed. Same with Orange County, California, before losses in its investment pool drove it into bankruptcy. They threatened the bond insurance companies with downgrades if they did not bulk up their balance sheets with housing bonds, and we are all know how that ended up...

Now, Moody's and S&P want to play in the Treasury bond/debt ceiling game of high stakes poker in Washington. This week, both rating agencies piled on, threatening the United States with downgrades on its bonds if the debt ceiling matter is not promptly resolved. These pronouncements tend to have consequences, as the leadership of united Europe has found out. Greece has become yesterday's news, as over the past two weeks Portugal and Italy have seen their bond prices tumble and interest rates skyrocket as the markets responded to rating agency comments on their fiscal fortunes. Outraged European central bankers, struggling to find an effective solution to the crumbling of the Eurozone, attacked the bond rating firms for hidden political motivations and threatened to take action to "break the oligopoly."

And what of the Treasury market? How did U.S. Treasury bond market respond to the threatened downgrades?

Not even a whimper. Actually, a rally of sorts. Yields on the benchmark 10-year Treasury declined by four basis points this week. As buyers bid up the prices, yields fell from 2.95% to 2.91% today, down from just over 3% a week ago. Europe's pain—much to their undying chagrine—continues to be our gain. From the bond market perspective, the debt ceiling debate seems almost to be a sideshow against the backdrop of the disintegration of Europe, even with only two weeks to go until Armageddon.

It's the new reality TV. Everyone is watching, everyone is talking about it, but if the markets are a measure of the real world, this most important and urgent of matters seems to have become part of the entertainment-cable-Internet-popular culture other-world that consumes our lives, but isn't really part of our lives.

Perhaps it is because we tend to believe that an actual default on U.S. Treasury obligations is simply beyond of the realm of possibility. We see all the actors yelling and screaming in Washington, playing their assigned roles, but we know deep inside that they cannot actually let the world unravel around them. Just because they are scared of Grover Norquist?

There is another point of view, which is that this is not about our debt at all, but a tug of war for which the debt ceiling is just a dramatic point of leverage. It is not about debt, because some would argue—though few appear to be listening—that constitutionally there is no crisis. The 14th Amendment would seem to be quite clear—to a lay-person—that the full faith and credit of the United States obligations cannot be questioned—and therefore cannot be undermined even by Congress. The counter-argument that has been offered is that the Constitution gives only to Congress the power to borrow. But the simple fact is that all of the bonds on which people suggest that we might default were borrowed with the full authority of Congress. And once authorized and issued, the obligation to repay cannot be questioned—or so it would seem.

Perhaps the bondholders who are lining up at the Fed window in D.C.—even as they are running from the same in capitals across Europe—know what seems to have eluded the bond rating agencies, which is that the debt will be paid and that the market—as is its wont—has already priced in the risk of default on our bonds, and it is a small price indeed. From a practical standpoint, the principal due on maturing Treasury bonds can be "rolled over" into newly issued Treasuries, with no debt ceiling impact. It is all the other "obligations" that are at risk. All of those obligations—the ones that impact the lives and livelihoods of all but the holders of our bonds—that are only valid if each Congress chooses to make good on the commitments of some prior Congress. And those obligations are indeed at risk, for the simple reason that as a nation we have consistently determined that we are not willing to tax ourselves for the goods and services that we seem to want, and with no action on the debt ceiling we will have neither the tax revenues nor the bond proceeds to pay for all of them.

The issue is not default. The issue is spending. In the view of House Republicans and Tea Party activists, spending should come down dramatically. Sacred cows should be slaughtered. Entitlements should be reconceived. The New Deal and the Great Society have run their course. But for the Senate Republicans the motivations are more complex. The plan put forward by Senator Mitch McConnell skillfully serves a larger set of interests and would allow the status quo ante so dear to Senators to survive. His plan would essentially would take Congress out of the debt ceiling game, and give his colleagues the best of all outcomes: The spending would continue while someone else—the President—would take the blame.

Right now, both the President and Senate leaders believe that the fear of default should provide enough motivation to get something done—along with the cover each side needs to take steps that might otherwise be unthinkable: Cutting entitlements, raising taxes, trimming the military. But so far, the House leadership is not biting. For the Democrats, the McConnell proposal may well emerge as a middle ground of sorts. But for the House Republicans and the Tea Party—those who truly want to reduce the size of government—McConnell's success would constitute a stinging defeat, an historic moment lost, and a movement scorned.

The ultimate question is what the President plans to do on August 2nd if there is no agreement. One must presume that there is a plan in place: The 14th Amendment will be upheld, the bonds will be paid, the full faith and credit of the nation will be reaffirmed—and massive cuts and sequesters will be put into effect.

As great as the fear of default might be, both the President and Mitch McConnell must fear even more what would happen next. If the markets are right, and no default ensues, the motivation to reach a middle ground or face-saving solution will dissipate, and each side will once again be captive to their base. Caught in a lie—that he knew there would be no default—the President would lose the high ground. Vindicated for their obstinance, the House leadership will have even less reason to negotiate.

That may well be the endgame that true believers among the new breed of House Republicans have in mind. And it does not make them crazy, just strategic. If they believe that default will not be allowed to occur—as a matter of Constitutional obligation and proven bi-partisan deference to the bond markets—then reaching August 3rd with no agreement might reasonably be their goal. In three weeks, they can achieve their objective of an America forced to live within her means. And ironically, from that perspective the only thing the President could do to stop them would be to allow a default to occur even when it is within his power and authority to prevent it.

Jerry Brown's challenge.

2011-06-19T14:36:00.016-04:00

On the streets of Greece and in the legislative chambers of Sacramento, people are grappling with the same issues: Are we willing to pay for those things that we want. And what are the consequences if we don’t.

This week, Governor Jerry Brown vetoed the budget sent to him by the Democrat majority of the California legislature. In his incoming State of the State speech five months ago, Brown suggested that it was time to address the State’s long-standing fiscal problems and produce a balanced budget. Brown proposed a Solomonic solution of sorts to close the $25 billion gap in the State’s budget: Half the budget gap would be closed by budget cuts, the other half through revenue actions which would be submitted to the public for a vote. Specifically, he proposed to ask voters to approve the extension of existing taxes that are set to expire.

The Golden State has now endured literally decades of budgetary trials and gimmickry, and seen its credit rating decline along with its fiscal resources. But for all the rhetoric about decline and bankruptcy, California’s problems are political, not economic. Yes, its economy has suffered as high costs have pushed industry inland and off-shore, but it remains a vibrant economy that is home to several of the nation’s strongest economic drivers and export industries: entertainment, technology, aerospace and agriculture.

The chart below illustrates the budget situation in California. Interestingly, the data suggest that California’s history is not a story of government spending run amok. The General Fund budget, which funds core services—including public safety, transportation, support for public and higher education, transfers to local governments and bond debt service—has declined relative to State personal income and GDP growth. As this graph shows, the steady growth of the State economy has not been matched by growth in the budget, and General Fund spending has dropped significantly in recent years. The dotted lines across the top indicate the impact on taxpayers, as General Fund expenditures per $100 of personal income declined 32% over the past three decades, from $7.43 per $100 of personal income in 1980 to approximately $5.05 this coming year.

Jerry Brown is providing a test case to see if our political establishment is—just this once—capable of setting aside party interest in favor of a broader and essential urgency. While the Democrat majority agreed to significant budget cuts, thus far, Republicans in Sacramento have declined to meet him halfway. Brown’s effort to find partners willing to seize the opportunity to chart a course toward real fiscal solvency and responsibility have been stymied by Grover Norquist, the anti-tax Jeremiah of the Republic establishment, who flew to California early on to pronounce that even a vote to put the revenue measures on the ballot would constitute a violation of the Republican anti-tax shibboleth.

Our political challenge, in California and nationally, is that too many people see more opportunity in exacerbating our problems than in solving them. It is too easy to rail against the debt and decry raising the debt ceiling, all the while conveniently ignoring one’s own complicity in the problem.

Over the past 30 years, Americans have become used to not having to pay for the government services we expect and desire—like the Greeks whose profligacy we so easily disdain. And this is a universal affliction, indifferent to political party. As illustrated below, federal personal income taxes paid—the purple line—have not kept pace with the growth of national income and GDP since 1980, while federal outlays have grown steadily. Like Californians, Americans have seen personal income taxes decline modestly as a share of national income. From 2009-2011, personal income taxes have ranged from 9-10% of personal income, slightly below the average level since 1980.

Of course, the difference between California and the nation is that national spending is not constrained by actual tax collections, but only by the political will to borrow and investors’ willingness to lend. Accordingly, as this graph illustrates by the divergence and convergence of the green and purple lines, instead of constraining spending, declines in tax receipts (the purple line) have simply led to increasing levels of public debt (the green line) and conversely, increases in tax receipts have led to moderating debt levels. Over the past twenty-five years, we have not had to weigh priorities, but instead have chosen as a matter of course to borrow rather than pay out of pocket for those things that we want. Year after year, we choose not to raise taxes to fund growing military, healthcare and other program costs, or to reduce spending to offset the impact of tax cuts.

It is in the proclivity to borrow rather face up to the limited nature of financial resources that America is more like Greece than California. And it is the ready availability of capital from foreign investors that makes our national problem differ from both.

Imported capital—that funds the "current account" deficit that comprises our budget and trade deficits—has supported economic activity in much the same way borrowing on credit cards allows households to live beyond their means. And like households that allowed increasing debt to mask the reality of their economic condition, U.S. economic growth has become dependent upon borrowed funds. As illustrated in the graph below, U.S. GDP growth has been 4% or greater for much of the past three decades, however, the share of that growth that has been supported by borrowed resources has grown.

While our economic growth has become more tenuous and entitlement costs have accelerated, Americans have abdicated their personal responsibility for our predicament. We will willingly vote for those who promise to cut our taxes or to expand our entitlements, but have shown no serious interest in addressing the the imbalances that have built up in our name. And lest one be fooled by the rhetoric, the Tea Party caucus of House Republicans have proven themselves no different, as they imposed pay-go rules on spending increases but not on tax cuts.

In California, Jerry Brown has proposed putting the question of the funding and size of state government to the voters. Voting for pain is simply not part of the democratic bargain. Yet that is what Jerry Brown is demanding. Let the voters choose. Treat us like grownups, and insist that we bear the consequences.

On the other side of the pond, as they seek to resolve the Greece situation, European leaders have come to believe that the Greek polity will never willingly take the steps to reduce spending and increase taxes that European bankers are demanding. What remains to be seen is what the consequences of that unwillingness will be, for Greece and for the concept of European union.

And for us. Because in our unwillingness to accept collective responsibility for the economic situation of our own making, we may have more in common with Greece than the grownups of Jerry Brown's imagination.

Housing market blues.

2011-06-10T12:50:00.010-04:00

Last week was but one more setback in hopes for a robust economic recovery. For two years now, economists, pundits and politicians have been looking for evidence that we have put the economic collapse behind us. Yet just last week, the sharp decline in the Case-Shiller Home Price Index and poor jobs report pointed to a stalling in any meaningful economic recovery.

The Case-Shiller index history, shown below in a graphic from the New York Times, illustrates the extent of the asset bubble in residential real estate that we experienced over the past decade, and how far prices still have to fall to be within historical ranges.

Even with the sharp contraction in prices that we have realized since the unraveling of the mortgage bond market almost three years ago, housing prices remain high by historical standards, and thus it is curious that this week Standard & Poor's would express puzzlement at the lack of a sustainable recovery. Its report "Global Housing Still Faces a Puzzling Future," begins: "Since the first-time homebuyer tax credit ended last year, the recovery of the U.S. housing market has been something of a tease." Unfortunately, that S&P should be puzzled is itself more of a puzzle than the housing market.

In fact, with the expiration of the first-time homebuyer tax credit and looming end to the quantitative easing efforts by the Federal Reserve to hold down long-term interest rates, the housing market is only now being left to face the brunt of post-crisis market forces without those two forms of federal support. As that support falls away, it is hard to be optimistic about the direction of the housing market, and if a rebound in housing is a prerequisite for a sustained economic recovery, we could have a hard road ahead.

In their write-up, S&P projects that when all is said and done, home prices will fall 35% from their pre-crisis peak, meaning that we have another 15% downside to go. Yet by historical standards, this will not produce "cheap" prices as S&P suggests, but rather return prices to within historical norms. But whatever bottom is ultimately reached in housing prices, a resurgent housing market will also require an environment that provides reasonable expectations for asset price stability, if not appreciation. And this appears unlikely to happen any time soon.

Over the past 30 years, the housing sector benefitted from declining interest rates and liberalizing standards for residential real estate lending. Just 30 years ago, my wife and I purchased our first house in Philadelphia. A 2,400 square foot twin, we purchased it for $37,000. 30-year mortgage rates at the time were 19% the day our offer was accepted. We were required to put down 20% and the result was a monthly payment just under $500.

Real estate is a peculiar market. While people talk mostly about the sale price, what matters most to the buyer is the monthly carrying cost of the mortgage, as well as the down payment. That is to say that affordability is only partially related to the sale price.

This was evident in the growth in property values in that Philadelphia neighborhood over the ensuing three decades. Since that day when we purchased our first home, long-term mortgage rates have declined fairly steadily. There were bumps and plateaus along the way, but the decline in mortgage rates led to a long-term, explosive uptick in home prices.

Five years after we purchased our home, with mortgage rates down to 10%, we sold it for $86,000. While the price was well over twice what we paid for it, the new owner's monthly payment of $600 was only slightly more than our $500 in real terms (adjusted for inflation). And the value of the homes on our block continued to increase as long-term rates continued downward. Over the ensuing years, as mortgage rates fell to 8%, the selling price of twins on that street increased to over three times their value in 1982. And by the time we reached the pre-crash years, and mortgage rates fell to the 6% range, the price of those homes topped out over $220,000, or six times what we paid, yet the monthly carrying cost of required to by a home at that price was only $1,200 per month, still almost the same as our $50o per month payment in 1982, adjusted for inflation over the ensuing quarter century.

As mortgage interest rates continued to decline from their 1982 peak, the market grew a fevered pitch. As a real estate broker said to my wife and I when we moved to California in 1990, "You just have to get on the escalator." Prices would go up, they would never go down. Americans borrowed more as rates declined, and, believing that prices could only go up, they committed more of their income to buying bigger homes: From 1982 to 2007, the median size of a new American home grew by approximately 50% and the percentage of household disposable income Americans spent on mortgages increased by 30%.

This was the phenomenon we lived through. As interest rates fell, lower cost mortgages allowed home values to skyrocket, even as homes remained affordable at the higher prices. The graphic below illustrates the trends that conspired to support the price escalation captured in the Case-Shiller Home Price Index (shown here as the green solid line). As mortgage rates fell (blue dashed line plotted against the right axis), the mortgage value that could be supported for a constant payment grew (solid red line, left axis), while at the same time the percent of household income families used to pay their mortgages increased (purple dotted line, right axis).

The financial crisis was built on the conclusions people drew from this decades long trend in price appreciation. Many--Standard & Poor's famously among them according Michael Lewis in The Big Short--concluded that home values would never decline across the board. The mortgage lending markets bought into this notion, as down payments--the traditional protection for lenders agains declining values--all but disappeared.

But if declining rates were the driver of price appreciation, what does this portend for the housing market if we have reached the floor in long-term interest rates? The factors that could drive interest rates and mortgage carrying costs upward--economic growth, a domestic debt crisis, waning international buyer interest in our securities, sunsetting of QE2--seem more likely to transpire than those that would push rates lower--reduced U.S. borrowing, depression, deflation, renewed global economic collapse. As such, if a driver of the housing market has been steadily declining long-term interest rates, perhaps it is no longer reasonable to expect the housing market to be a driver of our economy for the simple reason that it is no longer reasonable to expect interest rates to continue to fall.

Standard & Poor's should not be puzzled. We are on the downside of the bubble now, and that should have a fundamental impact on the prospects for recovery of the housing market. If prices can fall, the psychology of home buying is very different, and for all the reasons that prices rose over the past decades, they could well continue to fall going forward if interest rates trend upward. Today, a $200,000 mortgage at 4.5% costs just over $800 per month. An increase in mortgage rates by just 1.5% to 6% increases that monthly payment by 33%, while a return of mortgage rates to the 8% level of the mid-1990s increases the monthly payment by 45%. Accordingly, rising rates would reduce home affordability and assert downward pressure on prices--just as falling rates pushed home values upward over the past several decades--and even just the risk of future price uncertainty should affect buyer confidence.

And there are other reasons home ownership may have lost its patina, further suppressing demand. Babyboomers, downsizing now that the kids are gone, may rationally choose to rent rather than own, if price appreciation will no longer be a given. And for them and their children in today's workforce, mobility may be of greater value than the rootedness of owning one's home. You only have to ask the residents of Michigan, who found themselves unable to move to pursue opportunity, tied down by the equity they hope still remained in their homes.

Home ownership is part of our identity. For some it is a rite of passage to adulthood, while for others it is what binds a family and neighborhood together. Those are attributes without financial measure. As such each spring, homes will be spruced up for sale, and buyers at a Sunday open house will find the place of their hopes and dreams. That is not going to change. But the interest rate driven growth in values of the past quarter century is behind us, and those looking for a sustained rebirth of the housing sector--waiting for the escalator to start once again--may have a while to wait.

Dominican Daydream

2011-05-26T20:27:00.008-04:00

Rashi, our Australian Shepherd, followed me dutifully in to the kitchen, looking up expectantly as I opened my laptop to check the scores before we went out. The Red Sox had clobbered Cleveland. The Phillies, after Halladay gave up a 3-1 lead, were in extra innings with Cincinnati. Each team had just scored in the 10th to leave the scored tied at 4-4.

That is when Rashi's long night started. That is when Wilson Valdez earned himself a permanent place in Phillies, and baseball, lore. Perhaps it is too soon to speak the name Dave Roberts--the journeyman outfielder whose stolen base in the bottom of the ninth inning of an elimination game launched the Red Sox to the championship in 2004--but Wednesday night's game was the stuff kid's dreams are made of.

The game wore on. Inning after inning, the late relievers for each side handled their opponents with little threat of a resolution to the contest. By the end of the 18th inning, the Phillies last pitcher, Dennys Baez was spent, and there was no one left in the bullpen.

Enter Wilson Valdez. A 33-year old utility infielder from the Dominican Republic, Valdez had never pitched an inning as a professional baseball player. Not in the major leagues. Not in the minor leagues. But he was game to give it a shot, and Phillies manager Charlie Manuel had nowhere else to go.

Valdez proceeded to live a dream. The game was six hours hold, but the Philly faithful were hanging in. Fans--including many who clearly were going to be tired in school the next day--chanted his name as he faced the heart of the Reds line up.

And he looked the part. He looked like an infielder who had been handed the ball. One of his first pitches went wide to the backstop--he was not crisp. But he settled in, and one could slowly see the kid emerge, as the fantasy that happened to be real unfolded. He became the Dominican youth channelling Pedro Martinez, the Dominican legend who himself spent a few fading months in a Phillies uniform. Wilson and Pedro. Similar slight build. Right handers.

OK. Maybe that is the end of the comparison. One a slam dunk Hall-of-Famer. One, not so much. But on Wednesday night--or make that Thursday morning--Wilson Valdez channelled Pedro in his imagination. He was dealing.

He had clearly practiced the moves. Standing on the mound, right foot on the rubber, peering in for the sign. Like he had done it a thousand times before--just not for real.

He was a bit shaky at first, facing reigning National League MVP Joey Votto. His first batter as a major league pitcher. But Valdez was inhaling the wonder of the moment. A few pitches in, he shakes off the sign from Dane Sardinha. Hard to imagine what he was shaking off, actually. The 86 mile an hour fastball or the 88 mile an hour fastball. Perhaps he was clearing his head, checking to see if he was really there.

No. He was shaking off Sardinha because that is what a kid does, living out that moment. Top of the 19th. Facing the heart of the order. It is a mind game, me vs. the batter... Votto, perhaps not quite believing the situation, flied out lazily to center.

Then Valdez faced Scott Rolen, stirring the fans into a greater pique of frenzy. Go Wilson Go!

Scott Rolen! The scriptwriter made a great choice. Rolen came up in the Phillies organization. A powerful third basemen, heir to the hot corner legacy of Michael Jack Schmidt. Heir now as well to the boos that rained down on Rolen, the player who abandoned the city and the team, back in the days before the parade.

Valdez, still fighting for control of his pitches, located a fastball on Rolen's shin, and located him on first base.

But then, Valdez settled in. The outcome was never in doubt. It never is in those situations. Who misses that shot at the buzzer when you are a kid?

Valdez showed no fear. He was facing the heart of the order. He gave in to his inner Pedro, ceded his Dominican soul to his childhood hero. He peered in to Jay Bruce. Bruce, the powerful slugger, leading the National League in home runs.

Really, could it get any better this? First, the league MVP goes down. Next, he hits Rolen. Now he is facing down Bruce?

So he drops down, wheels in from the side. Pure Pedro. His teammates are in awe.

He is feeling it. He is dealing. Bruce takes him deep, but not deep enough. Flies out the the warning track in deep center.

Then with two outs, it comes down to Carlos Fisher. Relief pitcher. An easy out for any pitcher in the majors.

If he was facing a just any major league pitcher.

But he was facing Pedro Martinez.

It was over. As Fisher skied a pop up behind second base, Valdez was already trotting off the field as the ball landed in Placido Polanco's glove. It doesn't get any better than this.

If you weren't watching, it all ended in the bottom of the 19th. Phillies scored, and won 5-4.

The long night ended. Finally, Rashi got her walk. And Wilson Valdez became the first player since Babe Ruth to start a game in the field and win it on the mound.

Coming to grips with the price of oil.

2011-05-18T12:55:00.013-04:00

The announcer on the radio gave the news: Oil prices fell back below $100, as the dollar strengthened….

That the price of oil would be a newsworthy event was not new. Since the OPEC oil embargo and gas lines of the 1970s, periodic high oil prices have made news, as they crimped the American pocketbook, and caused cascading political consequences.

Last week, faced with the economic and political consequences of high gas prices, President Obama sidled up to the Drill, Baby, Drill camp and offered his support to measures to support domestic oil production. Increased domestic oil exploration and production is probably a good idea. After all, the U.S. is the largest consumer of oil, and both our national security and economic security would be enhanced by reduced dependency on oil imports.

This, of course, has been the bi-partisan stance of presidential administrations dating back at least to the Nixon administration. And in terms of environmental impact, opposing oil production in the United States is not necessarily a laudable stance—if one's concern is about global environmental impact—as production in Nigeria, for example, is certainly subject to lower environmental standards than would apply in South Dakota or Alaska.

But the President's call for increased domestic production and exploration did not reflect new insights on U.S. energy policy or how oil dependency affects our foreign policy and military engagement. The President, of course, was responding to the price of gasoline at the pump.

This is a cyclical political script dating back forty years, which is pulled out of the can when gas prices rise. We need more production. We need more conservation. We need alternative sources of supply. Wind. Solar. Tar sands. Horizontal drilling. Hydraulic fracturing. The stuff we learn in those moments of pump price political pandering.

The issue reached an extreme during the 2007-08 presidential primary season when oil prices surged upward. The candidates and political parties fulminated in high lather about cause and effect, supply and demand, and ultimately who was to blame for our pain. As Goldman Sachs predicted $200 oil, candidates vacillated between calls to eliminate the gas tax, to tax the speculators driving up the price or to drill, baby, drill.

Then the price collapsed.

Months before the economy came unglued in the fall of 2008, crude oil prices came back to earth. After peaking over $145 around July 4th, the price was back below $100 by Labor Day, and continued down. All the talk of drilling and T. Boone Pickens wind farms died away. This time, the storm abated before any legislation could be passed, so there was no new ethanol fiasco. No new oil shale tax credits. No new market distorting initiatives put in place by lobbyists for one industry or another seeking an opportunity to benefit from the public’s fleeting attention.

Months later, the Commodity Futures Trading Commission settled the question of whether the price spike was driven by real or speculative demand. Outside of the public view, and far from the political limelight, the CFTC concluded that speculation was indeed the major factor in the price spike, as distinct from "natural" forces of supply and demand driven by economic growth and declining reserves.

That is to say, demand for the consumption of oil was not the driver, but instead it was demand for oil contracts as a financial instrument.

This conclusion is a salient one for our nation's energy policy, and our monetary policy as well. It may seem to be a peculiar feature of the modern economy that commodity price speculation drives the welfare of families and individuals. But whether it is the American family planning a summer vacation or a fruit vendor far away in Tunisia, the prices of commodities traded in Chicago and other financial capitals do indeed touch daily life in the real world.

This is not news. And it is not a modern day phenomenon, as commodity price speculation and hoarding have afflicted daily life throughout history, and Tunisia’s was not the first government to fall due to high food prices. Just ask Marie Antoinette. What is notably today is the direct linkage between currency trading and commodity markets.

Oil prices fell back below $100, as the dollar strengthened….

As illustrated in the graph below, oil today has become the new asset class for hedging against dollar risk in global trading. Today, the U.S. dollar stands alone as the reserve currency of the world economy—the currency that nations use for investing their own reserves and for denominating commodity and other transactions. Despite efforts—such as the creation of the euro—to supplant the dominance of the dollar, no alternative has emerged. The structural flaws of the euro were exposed in the 2008 collapse, as the U.S. Federal Reserve emerged as the sole backstop for the global financial system. Japan’s economy remains weak and threatened by an aging population. The renminbi will not be a real currency for global trading purposes until China is willing to relinquish its managed peg and expose its economy to real market forces.

As shown here, oil has become a nearly perfect hedge against fluctuations in the dollar. The peak price of oil—the red dashed line—in the summer of 2008 came just after the low point of the dollar that same year. The ensuing collapse in oil prices mirrored the rise in the dollar through the early months of the financial collapse. Then the price of oil moved upward—mirroring the rally in gold—as the dollar value declined once again in the wake of Federal Reserve policy driving liquidity into the banking system and the dollar downward through early this year.

Then finally, as announced on the radio, the dollar is now rallying in anticipation of the end of QE2, and the oil price rise has abated.

The linkage between monetary policy and oil prices raises questions for how a consistent domestic energy policy can be implemented if critical energy market price signals are distorted by linkages with monetary policy. Federal energy policies are presumably designed to spur investment into energy development—oil, gas and alternatives—but the such investments rely on the reliability of market pricing as an indicator of supply and demand equilibrium. If oil pricing increasingly reflects non-supply and demand factors, and is in part influenced by Federal Reserve policies and actions, there are significant ramifications for our energy policies.

In simple terms, if the role of oil as an asset class can be expected to significantly affect the price of oil and add to price volatility over time, investors in energy industries will have to consider that volatility and those characteristics as much as actual supply and demand for energy as they consider investment decisions.

The impact of the evolution of oil from a physical to a financial commodity is far reaching, as the decline in the value of the dollar and the correlated rise in oil pricing has most adversely impacted those nations whose currency is tied to the dollar.

China is grappling with that challenge now. By adhering to a dollar peg and declining to float the renminbi, China has been forced to accept the inflationary consequences of growing energy costs. As illustrated here, cost escalation in the price of oil has been most significant for those whose currency is tied closest to the dollar. Accordingly, India and China saw major spikes in oil prices in their respective local currencies, both in 2008 and this year, as compared the modest impacts in the Euro, and negligible impacts in the Australian dollar.

It may be that with the end of QE2, the dollar will stabilize, and with it the rhetorical drumbeat for new energy policies will subside. But the lesson should be internalized into our national debate over debt and deficits, as this same oil price shock that emerged from deliberate Fed policy to depress the value of the dollar will be visited upon us with greater ferocity should global bond markets finally give up on our ability to put our fiscal house in order, and leave us with a decline in the value of the currency—and accelerating energy costs— that is out of our control.

Thoughts on NYT and Goldman.

2011-05-17T15:16:00.006-04:00

The New York Times today continued the glorification of Goldman Sachs. The article trumpeted the careers of the best and the brightest luminaries that have led Goldman in its transition from a partnership to public firm.

What is lost in this presentation of Goldman as the successful center of the world of finance is how that success has morphed. The financial meltdown caused aggregate losses to financial institutions that have yet to be tallied, though the numbers $2 to $4 trillion are bandied about. Goldman, much as their PR efforts have denied it, would itself have collapsed in the absence of the bailout of AIG counterparties and conversion to a Fed-eligible bank holding company. Why on earth Goldman fit the profile of "systemically important"—warranting extreme public actions to assure its continued life—is one thing, but to continue on with the hubris and arrogance, and ignore the fact that financial institution losses not only took down the world as we knew it, but also wiped out a century of earnings.

In the old days of Wall Street partnerships, these losses would have wiped out the Street, and the partners would have lost much—if not all—of their personal wealth. That is why it would have been unlikely to happen. Back in the day, each of those partners had the others looking over their shoulders, scrutinizing their business, their trades and their risk. It was a real market system, and the feedback was exacting. Partnership risks were assessed by those best able to understand them—unlike the well-documented, feeble efforts of under-staffed, and intellectually less capable regulators—and unreasonable risks and trades were taken off the table by those who had their own wealth at risk.

So tell me again how this works today? Heads we win, tails you lose? We are the best and the brightest when the bets turn our way, and you hold us harmless when we are wrong. Good deal for them. Bad deal for us.

Ah, what happened to the capitalism of my youth.

Same old, same old.

2011-05-11T18:42:00.004-04:00

So John Boehner wants trillions of dollars in cuts. Trillions. And everything is on the table. Except tax increases. And except for allowing expiring tax cuts to expire.

But everything is not on the table if everything isn't on the table.

This, of course, is why the President should have embraced the recommendations of his debt commission that was released last December. Because Washington is unable to even pretend to have a real discussion about the fiscal direction of the country.

And the consequences of continuing down this path will be disastrous.

Just because U.S. treasuries are trading at their lowest levels in history should not be taken as much comfort. It just means that the end is not near. Yet.

If we get past May 21st—the beginning of the end of days according to some Biblical prophesiers—the next apocalypse on the horizon will be the one when the world finally decides that currency stability and fiscal self-discipline are necessary attributes of a nation hosting the global reserve currency. Somehow, a currency that offers a yield of below 1% in interest while declining in purchasing power by 20% does not serve the long-term interests of the global community.

For Boehner to even posture as part of the solution—and not even give a nod to the irony of the moment—is in itself frightening. It is one thing to appeal to your newest voting block by embracing anti-deficit rhetoric as part of the ongoing spectacle that has become our politics. And as long as that voting block is willing to buy the absurd notion that spending causes deficits but tax cuts don't, Boehner can keep riding that wave.

But if the issue is deficits and debt, then the measure of one's words must be in the outcome one produces. Yet Boehner stands before a crowd of bankers and traders and says with a straight face that he wants trillions in deficit reduction as the price of not accelerating the pace of the nation's march down the road toward judgement day.

Accelerating because he is not serious for one minute about tacking the problem. His goal, as the leader of his party in Congress, is the pursuit of power and majority status. That means winning middle class votes and upper class political contributions. And standing before that room of bankers and traders, he postured effectively to get the latter at the expense of the future dreams of the former.

He will get the political contributions not because anyone in that room buys the notion that this is about cutting deficits, but rather because everyone in that room stands to reap great benefit from keeping the Bush-era tax cuts in place, and putting off the day when we actually pay for what we budget at the federal level.

No. Boehner is not serious about achieving trillions of dollars in cuts. His is just a rhetorical flourish. And the proof is in the budget that the House has just embraced. Paul Ryan's budget plan, as economist Bruce Bartlett has pointed out, does nothing to tackle deficits, but instead produces deficits far larger than current Congressional Budget Office projections. Current budget policy produces $3.2 trillion of deficits through 2019, while the Ryan budget projects $4.3 trillion of deficits during that same timeframe.

Of course, one of the major differences is that the Ryan budget cuts taxes, but those tax cuts are not paid for even with the significant cuts in spending that are in that budget. Therefore, the debt ceiling argument that Boehner made this week—his appeal to step back from our bi-partisan march toward the next fiscal train wreck—is contradicted by his own budget: If Congress were to pass the Boehner-Ryan budget, the debt issuance through 2019 would project to be $1,000,000,000,000 higher than the path we are on now.

My only question is whether, as Speaker Boehner stood before that Wall Street crowd, he believed his own words. Does he believe that the House budget proposal fixed the problem—if the problem is debt and deficits? Does he believe that putting half of the budget on the table makes his words ring true? And which is worse, if he does believe or if he doesn't?

This is just the same old game. Listen to my words, write your check, give me your vote, but God forbid I should be held accountable for the results I produce. This is the rhetoric that has destroyed the Republican Party brand of my youth. Fiscal responsibility and intellectual integrity. Prudence at home and tempered humility abroad.

Those were the days.

Default is not in our future.

2011-05-09T22:49:00.004-04:00

The notion of a default by the U.S. Government on outstanding Treasury securities is nonsense. This is not to say that Congress will act to raise the debt ceiling. Who knows what Congress, in its infinite wisdom, will do; but the notion that a failure to raise the debt ceiling will lead to a default by the U.S. Government on outstanding Treasury securities is nonsense.

Debt and deficits and default are thrown around loosely these days. Deficits are what we have when our budgeted revenues are less than our budgeted expenditures. Debt is what we issue from time to time to fund those deficits that result from our wanting more things from the government—services, wars, transfer payments—than we are willing to pay for in taxes.

And we also print currency.

Actually, printing currency is a concept that has largely been rendered quaint, but the concept of printing currency continues to hold a place in the public imagination for those times when the Federal Reserve funds some purchase or expenditure with money that it creates for that purpose, and is provided to the recipient through electronic transfer. There is no printing involved, and no currency either, at least in the Wikipedia definition of “physical objects generally accepted as a medium of exchange.”

In the case of the current battles over the federal budget and the raising of the debt ceiling, increasing the debt ceiling may be necessary for the issuance of new Treasury securities—which once legally issued carry the full faith and credit of the United States of America—as presumably such bonds cannot be legally issued if the debt ceiling has been reached. Therefore, failure to raise the debt ceiling would presumably constrain the ability of the Federal government to “spend beyond its means,” meaning spending in excess of current revenues within a budget year. In the absence of debt capacity under the debt ceiling, federal spending would have to be held in check, and constrained to the amount of available revenues within a budget year.

But a failure to lift the debt ceiling should have no impact on the ability—and obligation—of the Fed to pay the interest and maturing principal owed on Treasury securities. Such payments will be paid by the Fed through an electronic transfer of funds that for all intents and purposes are created at the moment of transfer, without regard to any budgetary action by the Congress or the availability of revenues in the Treasury. No budgetary action or further appropriation is required for the simple reason that any Treasury debt currently outstanding was legally issued under the debt ceiling at the time it was issued, and the full faith and credit pledge of the Government is pledged to its repayment.

And this is true of the general obligation indebtedness of any state government as well. Or Greece, for that matter.

The difference of course is the printing press. California can default on its general obligation bonds—if its politicians continue to play the games that are becoming all too easy and routine—because it must have money in the bank to pay its bonds when they come due. There does not need to be an appropriation in the budget—though there always is—but there does need to be money in the bank. Because unlike the U.S. Government, California does not have the ability to create currency to pay the debts that it has legally incurred and to which it has pledged its full faith and credit.

But the U.S. Government does have that ability. And it does have that obligation. And the Fed would act on that obligation regardless of what games Congress and the President might continue to play—whatever posturing they might find to be in their partisan interests as this charade plays out.

The fact is that U.S. Government will not default on its duly and legally authorized Treasury securities. And anyone who is paying attention understands this. Like the bondholders. Today, the yield on three-month Treasury bonds was one basis point. That is one one-hundredth of one percent. Or 0.01%. This rate has not changed in the past month. The three year rate is still below 1.00%, and the benchmark 10-year rate is 3.15%, or more than forty basis points less than one month ago.

So Democrats and Republicans can yell about debt and deficits, and manipulate as much as they like the simple fact that for decades now none of them have cared one whit about it, except for those moments that come along when it serves some partisan interest, and they can whip voters—who should be ashamed of themselves for going along with all of this—into a frenzy. But the markets have not blinked.

Because for all the debt, and for all the deficits, a default is not in our future. Because we own the printing press.

Whatever that means.

Who will tell the people.

2011-04-27T17:58:00.013-04:00

For all the yelling and screaming about the national debt, you would think that Democrats and Republicans disagree about everything, when in fact they are in almost total agreement when it comes to fiscal matters. Or at least that is what the historical data seems to suggest.

The fundamental source of agreement is that Americans should get what they want, and they should not have to pay for it. Republicans think Americans want tax cuts and a strong national defense—and they should not have to pay for it. Democrats think Americans want healthcare and roads and schools, and should not have to pay for them. And most of all, Republicans and Democrats alike think that Americans should have unlimited access to drugs and medical care the closer to death they get—and certainly no one should be asked to pay for it.

At least that is what the historical record shows.

As illustrated below, federal personal income taxes paid—the purple line—have not kept pace with the growth of national income and GDP since 1980, much less with the growth in federal spending. That is to say that with all the growth in the Federal Government since Ronald Reagan came to town to shut it down, Americans have seen personal income taxes decline modestly as a share of national income. Stated simply, for every $100 of income earned by Americans in 1980, they paid $11 in personal income taxes, and over thirty years later that number was $10. And, as illustrated here as well, since 1980, total taxes—including personal and corporate income taxes, excise taxes, social security taxes and the rest—have rarely paid for all that we want, and we have made up for it by issuing debt.

Oddly enough, however, what we seem to want—what has been funded by Democrat and Republican Congresses and Presidents—has remained more constant than one might think. Since 1980, even as how much we pay has not changed materially, what we buy has not changed much either. After decades of partisan warfare, no area of federal spending has grown as a share of national income or GDP other than healthcare. In 1980, we spent 5% of GDP on defense vs. 4% today. In 1980, we spent 5% of GDP on non-defense discretionary spending vs. 4% today. In 1980, we spent 8% of GDP on non-Medicare/Medicaid entitlement spending—stuff like veterans benefits and student loans and farm subsidies—vs. 6% today. All of the growth—and therefore arguably all of the debt incurred since the bygone era of balanced budgets—has come for Medicare and Medicaid spending, which collectively grew by almost 200%, from 2% of GDP to 5%.

As the graph above illustrates by the divergence and convergence of the green and purple lines, instead of constraining spending—one of the original theories behind the tax cuts of the 1980s—declines in tax receipts have simply led to increasing levels of public debt, and conversely increases in tax receipts have led to moderating debt levels. That is to say, for all the arguments and blame about debt levels, the simple fact is that year over year we have been making a simple choice: Do we borrow or do we pony up our own dollars to pay for the budget that our elected officials approve.

The current debate over deficits and debt has been more about political theatre and gamesmanship than about constructive solutions. As one looks at the historical data, it is hard to avoid the conclusion that for past 30 years, all rhetoric aside, the national political establishment has come to accept that we do not have to pay for that which we want to receive. And this is a universal affliction, indifferent to political party. Everyone has been willing to cut what they don’t like on the margin; but no one has been willing to either tackle—or pay for—those things that everyone seems to want.

As suggested above and illustrated below, the primary source of spending growth has been healthcare. Perhaps this is not news to anyone, but it is surprising to note that since 1980, no other area of the federal budget has grown as fast as GDP and national income.

This trend has been uniform through Republican and Democrat administrations. As illustrated below, during the Reagan-Bush years, when military spending grew faster than GDP growth, its growth, in the end, was far surpassed by Medicare and Medicaid.

During the Clinton years as well, when both military and overall discretionary spending lagged behind GDP growth—and for the only time since early in the Nixon presidency that the federal actually had a balanced budget—healthcare cost growth continued unabated.

Finally, in the George W. years, when all manner of spending surged ahead, Medicare spending once again led all areas in spending growth.

For all the outcry about debt and deficits, the story is simpler that we want to imagine. First and foremost, we lost our way thirty years ago when in both the political and personal worlds we allowed ourselves to believe that it is ok to borrow instead of pay for those things that we want. And second, it is all about healthcare.

To his credit, Congressman Paul Ryan has put the issue of Medicare spending on the table, and suggested for the first time in memory that sustaining costs will require that people pay more. For his part, President Obama did the nation and his own legacy a great disservice when he chose to walk away from, rather than embrace, the admirable work of his commission on debt and deficits. That commission produced a politically balanced and thoughtful set of recommendations. While the commission lacked the super-majority vote of support that would have mandated an up or down vote by Congress—in part due to the aforementioned Congressman Ryan—it deserved that vote.

The nation has limited time to grasp this problem. To date, we have not felt the pain of the debt that we have accumulated over the past thirty years, as the interest costs we pay have been declining steadily. The irony is that the status of the dollar as the global reserve currency has been of particular benefit to us in the wake of the financial crisis. Just as our debt has been accelerating, our interest costs have reached historic lows as each global investors and central banks have continued to pour money into the dollar as the only freely convertible safe haven.

But when the global recovery comes, our costs are likely to accelerate. As the graph below illustrates, federal interest costs will accelerate rapidly with any return to normal interest rates. The average maturity of federal debt—data on which is not readily available—has been in the four to five year range over recent years, but may well have declined with the duration impact of QE2. Accordingly, this graph suggests that if our interest costs average in a return to historical interest rate yields—our net interest costs will quickly skyrocket, and within five or six years will exceed the current costs paid for either defense or Medicare spending.

This is not a radical scenario, but just based on a normal interest rate cycle. The disaster scenario happens if the bond market turns against the dollar and the reserve currency status of the dollar comes to an end.

The challenge that we face is to address our fiscal problems while we still enjoy our privileged access to capital. It is not a crisis yet—right now it is just political theatre. Somehow, for all the talk, most politicians just do not really believe that we are at risk. If they did, would they still be content to play the same games and use our fiscal challenges as one more prop for gaining partisan advantage?

As Americans, it is time to grow up and either pay for what we want, or to formally disavow wanting it. And we must all recognize that the debt that we have built up is our debt: It is the consequence of our political choices spanning a generation.

The President should reconsider his rejection of his own commission, and embrace it now, if it is not too late. Jerry Brown has already written the words for him:

If you are a Democrat who doesn’t want to make budget reductions in programs you fought for and deeply believe in, I understand that. If you are a Republican who has taken a stand against taxes, I understand where you are coming from.

But things are different this time...

We have seen the enemy, and it is us.

The last grownup.

2011-02-28T03:25:00.015-05:00

Each time Ben Bernanke testifies before Congress, his job gets more difficult. Firmly ensconced between a rock and a hard place, Bernanke must defend the drastic measures he is taking as Chairman of the Federal Reserve Bank to support the economic recovery, all the while denying any extreme concerns that he might have, lest his words spook the bond markets and exacerbate the problems that are his to tackle.

But the extreme nature of current Fed actions—the quantitative easing strategy that essentially constitutes printing money to buy long-term bonds in an effort both to reduce long-term rates and flood the economy with liquidity—betray the depth of Bernanke’s concern. Looking back at a his seminal speech in 2002—when Bernanke laid out the extraordinary steps available to some future Fed chairman that would assure that Japan-style deflation could never happen here—one can read the full array of strategies Bernanke has now employed. However circumspect and positive he tries to be in his public commentary, his are the actions of one who believes the risks of falling back into recession, and ultimately into a deflationary spiral, are real indeed.

And he is not alone. The recently released minutes of the late January meeting of the Federal Reserve Bank Board of Governors indicate unanimous support for continuing the Fed’s QE2 strategy. Buried in the elliptical government-speak of the staff reports is the list of contingencies that the Fed Governors fear may yet drag the U.S. economy down into a deflationary spiral: Deepening financial market disarray in Europe; layoffs by stressed state and local governments; downside risks in housing prices; reversal of improving consumer sentiment; and slow job growth. And since that meeting, turmoil in the Middle East has spiked oil prices upward.

Congress, on the other hand, has largely moved on from the 2008 crisis. While Bernanke continues to warn of the risks of moving too quickly or too soon to reduce federal deficits, his words by and large are falling on deaf ears. Bernanke, a Republican Fed Chairman appointed by a Republican President, is now widely derided by new House leaders and their supporters who are in thrall of the Austrian school of economics that rejects both Keynesian theorists on the left and Monetarists on the right.

Harsher still have been the attacks from the international community. In the early months of the financial crisis, the Fed emerged as the world’s central bank, providing liquidity for U.S. and foreign banks alike to stem systemic failure. However, as the fear and panic receded into memory, protests escalated as the Fed expanded its efforts late last year. Bernanke, foreign leaders complained, was seeking to drive down the value of the dollar. He was seeking to build U.S. exports at the expense of other nations. He was seeking to export inflation and poverty.

Most shrill in its criticism was China, whose leaders and media decried Bernanke’s efforts and demanded that the Fed renounce its policies and strengthen the dollar. Yet, for all of those nations there was something far greater at stake, something that seemed to have been lost in all the noise: All of those nations—and none more so than China— depend on the strength and resilience of the United States economy for their own economic growth, and they have much to lose should the U.S. recovery fail. Instead of cries of indignation, some degree of introspection and patience should have been warranted from those foreign leaders as they consider what the future might hold should Bernanke fail.

But patience and introspection are commodities in short supply these days. Few in the United States seem to recall the turmoil in late 2008, when Hank Paulson begged Congress to act to save the financial system. Few seem to recall how the voices across the political spectrum and commentariat fell silent in the face of real and palpable fear of broad based economic collapse. The cavalier protests that Bernanke confronts these days are evidence of how quickly success in forestalling a greater crisis has engendered collective amnesia regarding that national near-death experience.

And the arrogant retorts from China strikes a similar cord. Despite the recent fanfare of China’s economy surpassing Japan in size, it remains a relatively poor country—on a per capita basis it is barely in the top 100 nations, sitting at 93 between Bosnia and El Savador according to IMF data. And the depth of China’s dependence on the U.S. consumer was laid bare following the 2008 collapse, as factories shut down and protesters quickly turned on the Communist regime, quieted only by an immediate and massive public works program.

Nowhere in the public declarations of Chinese leaders is the acknowledgement, the appreciation or the humility that might come with the recognition that without open access to the U.S. market, China has no path to becoming Japan, and the Communist Party will be hard pressed to keep its hold on power. Chinese leaders are quick to point to the excesses of U.S. consumerism—too much debt and too little savings—ignoring the paradox of their own dependence on that consumer excess.

Nowhere too is there any recognition of the unsustainability of the status quo. While the global financial collapse was precipitated by a housing asset bubble problems across the financial sector, it masked an accelerating problem at the center of the U.S. economy—the continuing erosion of the manufacturing sector that, for all the talk of the migration to a service economy, remains essential to sustaining the U.S. middle class wealth.

In the wake of the 2008 financial collapse, the U.S. manufacturing sector was in freefall, illustrated here in Federal Reserve data. The long run decline of the U.S. manufacturing economy was not news. The percent of the workforce employed in manufacturing declined steadily by decade—from 24% in 1970 to 21% in 1980 to 17% in 1990 to 14% in 2000—and this decline contributed directly to the lack of real wage growth for the middle quintile of the U.S. workforce over the past three decades.

However, despite these percentage declines, the actual number of workers employed in manufacturing was remarkably stable, declining only slightly from 19.2 million to 18.5 million from 1970 to 2000. In contrast, since 2000 manufacturing employment plummeted, as approximately 6 million jobs were lost by 2009, a decline of 33%.

The difference was China. Since 1970, U.S. manufacturers faced global competition from Germany and Japan to Singapore and Korea. Worker productivity steadily increased, as did manufacturing quality. Nonetheless, while the U.S. had negative trade balances with those countries that built their own economies through access to the U.S. market, by and large those trade balances remained manageable.

Trade with China has been another story, however. With a deep labor pool of very low cost labor and abundant capital provided through trade surpluses, the Chinese economy has grown steadily and driven manufacturing costs toward zero. Over the course of the past decade, trade with China eroded the U.S. manufacturing base. As illustrated here, as 6 million jobs were lost over the past decade, U.S. manufacturing income declined by 17% in real terms and imported Chinese goods grew in value from 6% to 20% of U.S. manufacturing income.

Perhaps most notable in this graph is the increase in the Chinese share of the total U.S. manufacturing trade deficit, which grew to 45%, or more than doubling, over the decade. For other countries that rely on free access to the U.S. market for their own economic development, this essentially meant that China, a relative new-comer to free trade, was rapidly squeezing out the rest of the world in the most important global market.

Central to China’s economic development strategy has been to peg the value of the renminbi to the dollar, and to carefully manage changes over time. Since the beginning of the Fed’s quantitative easing, the dollar has declined in value against the currency of the U.S.’s major trading partners, while the Chinese government has continued to resist pressure to open its currency to market forces.

Slowly, international opposition to Benanke’s policy has moderated, as other nations—Brazil most recently—have come to recognize that Bernanke’s fight is not with them, but with a Chinese regime whose predatory trade and currency policies will ultimately decimate their manufacturing sectors just as it has the U.S. And like Bernanke, they are beginning to realize that the future stability of their own economies depend on his success.

Last week, as oil prices moved over $100 and the Case-Shiller housing index turned downward, the hint of fear began to emerge that we are not out of the woods. But Benanke should not expect to see greater support for his efforts in Washington, as the 2012 election season is upon us. That’s just the way it is. Surely Ben Bernanke must know by now that if he succeeds there will be no acclaim or garlands, even as he understands that if he fails the consequences will be devastating.

Why now?

2011-02-08T00:01:00.016-05:00

As we watch history unfold, the events that swirl around us are interrelated in ways we never could have imagined a generation ago. And so it is that events in Tunisia and Egypt can be seen as interconnected stories emerging from a single tableau.

For all of the stories wired in from Cairo of the yearning for freedom in Tahrir Square, the question of Why Now? is rarely addressed. Surely the predations of the state visited upon Arab populations by autocrats and secret police from Morocco to the Gulf are not news—at least not to the citizenry of those countries. Yet as blogs and bylines and televised reports reach us, their central narrative remains the yearning for freedom and dignity.

But Why Now?

In Tunisia, it was Mohammed Bouazizi, a food vendor in the city of Sidi Bouzid, who, after years of taunting and abuse by the police, immolated himself in rage and frustration, and ignited the storm that subsequently erupted. But it was the price of food that had changed Mohammed Bouazizi’s world, for the beatings were a regular feature of his life. And so too in Egypt, it is the price of basic foodstuffs—that consume as much as half of a typical family’s income—rather than the denial of basic rights that marks a material change in peoples lives.

Over the second half of 2010, basic food commodity prices have skyrocketed, with wheat and sugar prices up over 90% in six months. While many have pointed to supply and demand factors—ranging from growing demand in China to floods in Australia that threaten future wheat supplies—the fact is that commodity price inflation has not been limited to food.

If there is a simple answer to Why Now, it may be that the answer is less Hosni Mubarak than Ben Bernanke. In normal economic times, broad-based commodity price inflation would increase during periods of strong economic growth. But these are not normal economic times.

In the wake of the economic meltdown of 2008, it has become clear that the recovery of the world economy depends on successful return to growth in the United States. For all of the talk of decoupling Europe from the U.S., in the wake of the global collapse the U.S. Federal Reserve emerged as the de facto central bank of the E.U. And for all the talk of China rising, the collapse of U.S. consumer spending wrecked havoc on China in a matter of months, leading to widespread civil unrest and forcing the Communist regime to spend an amount equal to 20% of its foreign exchange reserves on a stimulus program to weather the storm.

By the middle of last year, Bernanke and the Fed broadened their efforts to push liquidity (read: money) into the system to forestall a recessionary "double-dip" and accelerate domestic job creation. This effort, known by the moniker Quantitative Easing, or QE2, basically entailed printing money and buying long-term Treasury bonds.

The response of the global markets to QE2 was an immediate understanding that the Fed's intention was to push down the value of the dollar to ease trade pressures and stimulate domestic growth, even as the Fed was counting on international investment to continue to fund U.S. deficit spending. In a massive game of chicken with the Chinese—and others whose national development strategies have been nothing less than dumping cheap goods into the hands of U.S. consumers—Bernanke was counting on international dependence on the U.S. dollar as the reserve currency to assure adequate continued flow of funds in the U.S., even as the dollar traded down in value.

To date, for all the complaining, from China to the Fox commentariat, Bernanke has thus far succeeded. International holdings of U.S. Treasuries have continued to grow in the face of a weakening dollar, the U.S. stock market has boomed and the economic recovery has been sustained. Even some vocal critics of quantitative easing have softened their views, such as Kansas City Fed President Thomas Hoenig, who recently suggested that the Fed would likely consider extending the program.

But if QE2 has been provoked little adverse reaction domestically, a more concrete impact of QE2 has been felt in Tunisia, Egypt and across the Middle East, where basic food price inflation has skyrocketed.

Despite all the talk about supply and demand factors pushing up food commodity prices, the recent price surge reflects the wave of speculative money flowing into commodities and gold, seeking protection against a declining U.S. dollar. As illustrated in this graph, since the implementation of QE2 in mid-2010, wheat and sugar prices—those foodstuffs most closely linked to Mohammed Bouazizi’s livelihood—have gone through the roof. While rising commodity prices have minimal impact on domestic U.S. inflation, it has a dramatic impact in less developed countries.

In Iran, fear of food riots made international news in December, as the Ahmadinejad regime sought to cut subsidies for fuel and food as commodity prices rose and further strained the national budget. And in Egypt, subsidy regimes that sought to provide low cost bread, oil, and sugar have provided little protection to the wide swath of the population—40% of whom live on less than $2.00 per day—as the price of food reportedly grew by 30% in the last six months of 2010, and the black market price of flour was 100 times the official subsidized price.

Food prices are not new as an instigating factor in popular uprisings, dating at least back to the American and French revolutions, and the price of bread can bring more people to the streets than the noblest of words. The ultimate indignity and humiliation heaped upon Mohammed Bouazizi was not the beatings that he grew to accept, but rather—faced with forces beyond his control— it was his inability to provide for his family, to fulfill that most basic responsibility.

For that humiliation, Hosni Mubarak may fall, like Tunisian President Ben Ali before him. But the story is not just about them. It also about the interconnection of the world in ways that we rarely think about, about how policies in Washington might affect traders in Zurich and, in turn, the life of Mohammed Bouazizi on a street in Sidi Bouzid. As we watch history unfold, and imagine what the next chapter might entail, the interdependence of our world should be neither ignored nor forgotten.

Once more into the breach.

2010-12-12T18:33:00.009-05:00

The word is out. Wall Street is back. Houses in the Hamptons. High end cars. Manhattan condos. After two years of nervousness, excess may once again trump discretion, or shame.

Soon we will see Goldman CEO and former gold trader Lloyd Blankfein walking the halls of Congress once again, defending his industry's largesse and lucre—though perhaps this time he will have the good grace to forego his prior suggestion that they are doing “God’s work.”

Wall Street’s revival comes even as Citibank CEO Vikram Pandit took time out of the G-20 meetings in Korea to complain about how chilly the climate was for bankers in the U.S., in contrast to the warmth he felt ensconced among his global finance brethren.

Chilly indeed.

Could America conceivably be more accommodating to its major financial institutions, as they prepare to pay out record levels of bonus compensation in the coming weeks?

The myth continues that Wall Street was bailed out with the $700 billion of TARP money. Pushed through a recalcitrant Congress in the wanting months of the Bush administration by Hank Paulson and Ben Bernanke and disbursed over the months that ensued, TARP has become the iconic whipping boy of left, right and center alike.

Ironically, little of the TARP money was actually used to purchase bank “toxic assets,” as originally intended, as most banks refused to sell—fearing the losses that they would be forced to recognize. Instead, TARP funds were provided as equity infusions and asset guarantees that nursed the banks back from the brink of collapse.

Today, the details of the whole episode are receding into memory. Even as films and books have chronicled wide-ranging stupidity, fraud and incompetence, as a matter of public policy bad conduct was occasionally noted, but never pursued. We have moved on.

The boards of the banks remain intact. The CEOs that oversaw the debacle fly off to G-20 meetings in Geneva or Korea to bemoan their fate. To hear them talk, one would think that the banks were incidental to the financial crisis. And in their revision of history, the TARP money was forced upon them. They were doing just fine on their own.

Few recall Hank Paulson and Ben Bernanke viewing the American economy on the verge of collapse. Fewer still give credit to any of the participants—Bush, Paulson, Bernanke, Obama, Geithner—for having stabilized the financial system. That is now deep in the past.

The total cost of the orgy of greed that that surrounded the packaging and trading of complex derivatives and collateralized securities has yet to be fully tallied. Last year, the IMF projected total bank losses at over $4 trillion, with $2.7 trillion of those losses at U.S. banks. Federal Reserve Bank data shows household balance sheet losses from the market collapse reached $15 trillion in 2009—almost 24% of the total net worth of American families—before ebbing to $10 trillion as the equity markets rebounded.

What is lost in the fury over TARP is that it represents only a portion of the federal intervention to support the country’s leading banks, as well as the two largest investment banks, Goldman and Morgan Stanley, which converted into bank holding companies in order to gain access to Federal Reserve support.

The most far-reaching area of federal intervention has been the sustained injection of massive amounts of liquidity (i.e. money) into the banking system by leaving the critical Fed Funds Rate—the interest rate charged on interbank loans among members of the Fed system—at or close to zero.

The effects of a 0% Fed Funds Rate are profound. In a normal time, and in a normal, cyclical recession, lowering the Fed Funds Rate ripples through the economy as a lower cost of capital on prime business loans and other loans. In the current economy, however, little new business lending is taking place.

While Fed data indicates that little commercial banking (lending) is going on, banks are taking full advantage of the availability of zero interest loans, and have borrowed trillions from the Fed. Literally trillions. Goldman: $600 billion. Morgan Stanley: $2 trillion. Citi: $1.8 trillion. Bear Stearns (now J.P. Morgan): $1 trillion. Merrill Lynch (now Bank of America) $1.5 trillion.

The term trillion makes all of this somewhat hard to grasp. But what is easy to grasp is the notion that if someone lends you money at 0%—OK, 25 basis points if you want to be picky—reinvesting it at a positive spread is not hard to imagine. Most Americans would relish the thought of replenishing their depleted retirement savings with zero interest loans, and would find any number of ways to take advantage of the opportunity. Put the money in a bank. Buy treasuries. Buy bonds. Buy commodities. Buy gold. Buy almost anything.

For the banks, free money translates into huge trading profits with no trading risk if they stick to investing in treasuries, and more if the go farther afield. And that is the point. The Fed strategy of keeping the Fed Funds Rate at or near zero provides a back door way of recapitalizing the banks, of rebuilding the balance sheets of financial institutions that lost an estimated $3 trillion and were insolvent. $700 billion of TARP funds was nowhere near enough, and the banks bridled at the constraints on compensation that came as part of the deal. In contrast, the Fed strategy was clean, and for the most part invisible. It required no vote of Congress, no authorization or appropriation of federal funds. There was no public humiliation on Capitol Hill. The only downside—for the public at least—is that before those banking profits reach the bank balance sheets, 40% or so of the trading profits will be paid out as bonuses.

But the Fed strategy has come at a high price. While the zero Fed Funds Rate is great for the banks, it has been a killer for those living off of their savings and for the nation’s pension systems. Senior citizens whose income is derived from rolling over certificates of deposit have seen their interest income decline by as much as 95% as CD yields declined from the 3% to 5% range prior to the economic collapse to recent levels of ¼ to ½ of 1%, according to Fed data.

If much of this seems incomprehensible, the message is simple: The Federal Reserve policy of keeping its target rate near zero is intended to allow banks to recapitalize, but has the effect of taking money from the elderly and others living off their savings, and transferring that money to the banks.

Over the coming weeks, Wall Street banks will pay out an estimated $30 billion in bonuses. These bonuses come on the heels of the second year in a row of record trading profits. Those record profits are not a product of great market insight, but reflect what is possible when money is free.

So when you see Lloyd Blankfein walking the corridors of power on Capitol Hill, defending the trading profits of his industry and proclaiming once again that they are doing God’s work, give your mom a call, or your great aunt or your elderly neighbor living on a fixed income. Give them a hug, and thank them for their sacrifice for God and country. Apparently, their sacrifice is necessary to rebuild our banking system and our nation.

After all, someone has to pay the price, and God knows its not going to be the people who created the mess to begin with.

Passing moment.

2010-12-10T14:44:00.001-05:00

Taken at their word, Tea Party acolytes had among their core message two principles: First, Congress should move quickly to end out of control deficit spending. Second, Congress should stop lying to the American people.

Well, so much for that election.

Over the past few weeks, in short order, Congress swept aside the recommendations of the President’s debt commission, ignored the parallel recommendations of the study committee led by Pete Domenici and Alice Rivlin, and moved to prevent the expiration of the Bush-era tax cuts that are set to expire at the end of this month.

Taken together, these actions reaffirm the principle that one ought to judge people on their actions rather than their words. For all of the words of praise directed at Erskine Bowles and Alan Simpson for putting a credible plan on the table—leading Bowles to foolishly intone that the era of deficit denial is over—Congress moved swiftly to assure jittery financial markets that such denial is still with us, and that any bold or courageous action by the 535 members of Congress to act on our long-term fiscal problems will not happen on their watch.

Or make that 534 members of Congress. Hats off to Kent Conrad, the sole member of the debt commission who will be in office in January who voted in favor of the debt commission recommendations.

To extend the Bush tax cuts is simply wrong.

Little if anything has been said in the public debate about why those tax cuts are set to expire: They expire to comply with the fiscal rules in place when the cuts were enacted into law. Back in 2001, tax legislation was required to meet a ten-year scoring rule, which required that the tax cuts be paid for over a ten-year horizon. The ten-year requirement itself was a liberalization of the earlier, less flexible, “Paygo” rules that required that changes be paid for on an ongoing basis.

These rules are not in the Constitution or some other founding document, but rather are rules Congress sets for itself, as if to guard the nation from Congress’ own penchant for reckless and inappropriate conduct. Congress does not have to approve balanced budgets—as we all know—but in the wake of Reagan-era deficits we saw the rise of legislation such as Gramm-Rudman-Hollings that sought to restrain Congress increasing disregard for fiscal prudence.

Simply stated, the Bush-era tax cut legislation provides for rates to return to the levels in effect in 2001 in order to pay for the largesse that was bestowed upon taxpayers over the ensuing years. Not just taxpayers who earn over $1 million, but all of us.

All those who are clamoring for tax rates to remain at the lower levels are giving the lie to the notion that Congress should be subject to any rules, or that such rules should be followed. The argument that tax rates should not be increased in the face of a recession is utterly disingenuous. Those arguing to gut the 2001 and 2003 tax bills now would be doing so regardless of our economic condition.

Look back at the historical record. Even as the tax cut legislation was being considered, Republican leaders assured their base that by 2010 the cuts would be made permanent, and that those who might seek to let the cuts expire would be attacked for raising taxes. That is to say, even at the moment of the original legislation, those who supported it eschewed any intention of adhering to the fiscal rules that Congress itself had imposed. At the time, the cynicism was breathtaking. But as political calculation, it was prescient.

Today, with the reversion to the pre-tax cut rates looming come January, few if any in Congress are prepared to stand on principle and remind their colleagues that those tax increase are the price that was to be paid for the prior years of reduced taxes. Instead, Congress can point to the economic situation as justification for their collective determination to undermine the fiscal rationale of the law that they are now seeking to upend.

The problem with the argument that this is not the time to “raise taxes” is that this was part of the deal. This was part of the rules—and a very limited set of rules at that—that were set in place to protect Congress from itself, and to protect the rest of the nation from Congress. And this will be no temporary action. By supporting a two-year extension, Republican strategists have made the sound bet that regardless of the financial condition two years from now, making those cuts permanent at that time will be an easy sell. After all, 2012 is an election year.

Perhaps further stimulus over the short-term is warranted, as the Domenici-Rivlin group specifically addressed. But ideally such actions would be targeted to have the greatest economic impact over the near term, while not undermining prospects for addressing the longer-term problems, such as providing a payroll tax holiday to boost domestic spending and addressing a corporate tax structure that inhibits the repatriation of foreign earnings and undermines domestic investment.

But the greatest irony is the support of eviscerating the Bush-era tax legislation coming from those who during the very same week supported the work—if not the specific recommendations—of the debt reduction commission. Both that commission and the Domenici-Rivlin group provided alternatives for balancing the short-term need for economic stimulus with long-term recommendations to address the nation’s fiscal situation. They provided our political leadership with the opportunity to stanch the momentum of a nation heading toward a fiscal train wreck. They provided a moment in which serious leaders could stand up and be counted.

How quickly that moment passed.

Representative Paul Ryan’s dissembling words in dismissing the work of the debt commission on which he served stand as evidence that for all the talk, most in Washington still do not believe that the problems we face warrant any serious consideration.

"I just don't think this thing (the work of the commission) has the ability to last in policy, and it simply buys us time. I'd rather fix the problem, with the Boomers starting to turn 65 this year, fix it once and for all so we can really get this thing fixed."

Ryan, the architect of his own fiscal reform plan, was simply unwilling to step forward and show the courage of his convictions. Imagine if he had said instead.

“I will support the Commission recommendations not because it is my preferred plan, but because it is the first step to forcing Congress—all of us who are charged to lead the American people—to make the hard choices necessary to chart a new course for our nation. I believe Congress must approve this plan. Then, those of us who believe there is a better way can propose changes to that plan that will improve our situation—bring down healthcare costs, further attack the problem of growing entitlement obligations at the federal and state level, increasing the pro-growth structure of our tax code.

“But all of those changes require first that we achieve balance—or something close to balance—and this plan does that. Those of us who believe further—and better—changes are necessary will make that case, to Congress and to the American people. But if this is the plan that gets is to a balanced starting point, we must all come together and support this as an essential first step.”

Almost 200 years ago, Alex deTocqueville commented that “The American Republic will endure until the day Congress discovers that it can bribe the public with the public’s money.” Paul Ryan, and most others in Congress, will vote soon to bribe Americans one more time, in pursuit of their own narrow political interests.

Shortly thereafter, these same politicians will clamor for deficit reduction and decry the fiscal situation of our nation—a situation that is a product of their own cynicism, self-interest and unwillingness to do the job for which they were elected.

Market distortions.

2010-11-10T00:26:00.027-05:00

It did not take long for the conflicts to emerge as Republicans struggle to make good on their commitments to reduce federal spending. In the wake of the Republican victory last Tuesday, public comments regarding how to cut the federal deficit followed a familiar line: Across the board cuts in spending, exempting Medicare, Social Security and Defense. Now, just a few short days after John Boehner’s victory lap, this strategy has been kicked to the curb.

The problem is that the math doesn’t work. Since 1980, those sacrosanct programs, Medicare, Social Security and Defense, have grown from 72% of the federal budget to 84%. Based on Congressional Budget Office data, non-defense discretionary spending for 2010 totaled $512 billion, which means that to meet Senator Jim DeMint’s threshold of $300 billion in cuts, one would have to reduce the non-defense discretionary budget by 60%. Despite the urge to point the finger at non-defense discretionary spending as the source of all that ails us, that spending category represented 3.7% of GDP in 2010, down from a quarter century peak of 3.8-3.9% in 2003-05, but up from the low of 3.2% reached in late 1990s.

Senator-elect Rand Paul has challenged the notion of sacrosanct programs, by suggesting instead that a 5% cut should be applied across the board. A 5% cut in the $3.2 trillion federal budget would translate into a $160 billion cut—still well short of DeMint’s threshold—but it puts into play those programs heretofore off limits, though still avoiding specifics of what to cut. Meanwhile, DeMint himself is mired in a battle with Mitch McConnell over the largely symbolic issue of earmarking.

Much has been written about the lack of specific proposals for spending reduction coming from Tea Party candidates during the run-up to the elections, but underlying the movement has been a call for reduced federal regulation and spending, and a return to greater reliance on free markets.

Such a call for the federal government to take its finger off the scale of competition and commerce could be a healthy change for the country, even if a painful one to achieve. Some of the pain would come in the form of economic dislocation, as industries now supported by federal subsidies or favorable tax or other treatment would have to swim in unfamiliar, competitive waters. But the greater pain would be felt by the members of Congress themselves—of every political stripe—who for decades have traded on their ability to tip the scale on behalf of those who support them.

We have all paid a price for the policies and priorities that are now deeply woven into the tapestry that constitutes the federal budget and system of regulation. Consider for a moment the role of federal spending and policies in exacerbating just a few of the problems that we continue to grapple with.

First, federal policy has directly encouraged overleveraging at the corporate and household level.

The 2008 economic collapse followed a period of massive over-leveraging at the corporate and household levels. At the corporate level, debt has been used for the past quarter century as a tool for increasing economic value, by companies, private equity funds and others. This over-leveraging of the corporate sector increases financial risk and vulnerability. Corporate over-leveraging is a specific response to the unequal treatment of debt and equity under the tax code. Simply stated, interest paid on debt is privileged by being deductible, while dividends are paid on an after tax basis. For any company seeking a $1 million investment, this unequal treatment provides a direct inducement to seek debt financing rather than equity investment.

At the household level, the inducements to borrowing are grounded in the tax-deductibility of mortgage payments vs. the payment of rent from after tax dollars, and the stimulation of consumer credit through home equity loans. Home ownership has long been touted as the cornerstone of national social policy, but of late the disadvantages of home ownership have become apparent. As we have built an increasingly dynamic national economy, labor mobility has become an increasing value, both for individuals seeking to optimize their career and educational opportunities, as well as for overall economic growth. Recently, Fed Chairman Bernanke noted the issue of labor immobility as an increasing problem for economic development. This was shorthand for people who cannot move for a job because they cannot sell their home.

Second, federal policy has directly encouraged overspending on medical procedures and pharmaceuticals.

The current structure of health insurance provides direct inducements to overspending on medical care. For example, drug insurance plans—whether private or public—that have the consumer paying a fraction of the price of a drug lead to high consumption based upon the low net price, while leaving the tax or premium paying public absorbing the rest of the cost. The impact of this incentive to overspending can be seen in the rash of commercials for new drugs for every imaginable syndrome from social anxiety disorder to overeating disorder to acne. For a $5 co-pay, there is a market for anything. At the full price of $200 per month, many consumers might choose lifestyle or nutritional solutions instead.

Third, federal policy has encouraged dependency on foreign oil.

Since the creation of CENTCOM by President Jimmy Carter, the United States has affirmed its policy priority of protecting western access to Middle East oil. After decades of failing to enact a federal energy policy, it is high time that we recognize that CENTCOM is our energy policy. If a heavy military presence in the Middle East and in other energy producing regions is part of the price of predictable access to our annual consumption of $400 billion or so of imported crude oil and petroleum products—as reported by the federal Energy Information Agency—then perhaps some share of our $600 billion defense budget should be internalized into the price consumers pay for oil products. Like overspending on drugs for which we only pay a portion of the true cost, our current energy policy has the effect of encouraging spending on oil by having consumers pay only a portion of the true price of delivering gasoline to the pump on a reliable basis.

Banks, pharma and oil are just three industries that have effectively used the federal government to enhance their competitive position and support or protect the markets for their products. And each of the practices that has been implemented to support and protect those industries—deductibility of debt, copayments for drugs and medical treatments, defense protection of oil supply lines—have encouraged patterns of over-consumption by masking the true price from the consumer and contributed directly to bubbles that we often discuss but rarely diagnose or address: Overleveraging, excessive societal spending on medical care and growing reliance on foreign oil.

In each case, addressing the incentive structure and effectively taking the federal finger off the scale could ameliorate these problems of over-consumption for which we have paid and continue to pay a heavy price: Reduce the bias toward debt in corporate finance and reduce financial risk. Increase individual incentives to make good health decisions through lifestyle changes and nutritional choices. Provide a more level playing field for non-oil based energy sources.

“The government is promoting bad behavior,” marked the opening salvo of Rick Santelli’s rant in the opening moments of the Tea Party movement. “How many of you people want to pay for your neighbor’s mortgage…?” Yet while Santelli focused on the bank bailouts, the larger problem stemmed from years of federal programs that promoted low cost mortgages—to support both home ownership and the building trades—that promoted a culture of over-borrowing and over-building.

There is no end to ways that we subsidize bad behavior, only to pick up the back end costs that ensue. To extend Santelli’s point, how many of us want to pay for agricultural subsidies and marketing programs to promote sales of cheese, corn syrup and sugar, and then pay for the skyrocketing health costs that stem from our poor nutrition habits? In Santelli's world of free markets and free choice, would not farmers live or die based on demand for their products—rather than their state's role in presidential primaries—and the customers bear the consequences of their own nutritional choices?

Today, we live in a world where prices have been distorted, often as a direct product of federal policies. And those distortions come with a price. We are now paying a high price for the collapse of an artificially induced housing boom. We pay through taxes, premiums and public debt for that portion of drug prices that are hidden from the consumer. And we pay the hidden cost of delivering oil to the pump through taxes, debt and war.

The question for Republicans as they seek to reduce the federal budget is not just whether they are prepared to cut discretionary military spending and tackle entitlement reform, but whether they are prepared to go farther and confront the complex system of subsidies, protections and regulations now built into the federal budget that distort free markets and lead to adverse outcomes that, as Rick Santelli noted, none of us want to pay for.

The free market aspirations of the Tea Party should not be silenced or dismissed, but instead should engender a much-needed reevaluation of federal fiscal, tax and regulatory policies. The question for Tea Party acolytes will be whether they are prepared to walk the walk and push to cleanse the federal budget of all manner of pork and privilege, or if theirs is a partisan battle that only aims to cut the federal budget on the backs of their political adversaries.

Shameless.

2010-10-30T15:44:00.004-04:00

In a fit of self-importance—or perhaps it is despair—the media has pounced on Jon Stewart for stepping out of the studio and into the public square. Some veil their criticism as concern for Stewart’s career. Others savage him for crossing the line between news and entertainment.

Horror!

Like some rendition of Brigadoon, one has to wonder what world these critics are living in. Twenty years ago—give or take a decade—Ted Koppel interviewed Rush Limbaugh on Nightline. In response to Koppel questioning whether he—like Steward today—was crossing a sacred line, El Rushbo retorted, Ted, let’s remember, you and I, we’re in the entertainment business now.

Religion. Politics. News. Entertainment. If the line was blurred for Rush a few decades ago, it is now gone. When Glenn Beck stood on the Washington Mall in August and pronounced the next Great Awakening, he was bringing all four together, with himself firmly placed at the epicenter. Those who suggest that Jon Stewart crossed a line should open their eyes and behold the new world.

No one questions whether Glenn Beck is in the business of entertainment. Or politics. Or news. Nor should one question the same for Sarah Palin. Beck and Palin stand at the cutting edge of a democracy that is being subsumed into popular culture, and they understand well the seamless flow between news and entertainment, religion and politics. Beck has been in the ratings game for longer than Sarah. She spins one-liners with the best of them—her riff, How’s that hopey, changey thing workin’ out for ya? is viscous and humorous at the same time—but Beck has a trained ear for when one argument has run its course and it is time to develop new material.

The ones who don’t learn and adapt are the ardent followers. Whether in the guise of Reagan Democrats of the 1980s, the Perot voters of the 1990s or the Tea Party acolytes today, disaffected American voters are easily seduced by politicians who channel their anger and provide succor through promises of lower taxes and easy fixes. The rhetoric of false prophets and entertainers alike can lure them into the public square, ready to point fingers at all the sources of their pain.

But they never want to look into the mirror.

Check the record. With promises of cutting waste, fraud and abuse, and pointing the finger at welfare cheats, Ronald Reagan offered the promise of cutting taxes and reducing the size of the federal government. The Reagan administration succeeded in cutting taxes, but never introduced a budget to Congress that reduced spending. Despite all of the familiar arguments about the revenue growth that ensued, the greatest legacy of the Reagan years was the political lesson that tax cuts buy votes, while there is no meaningful constituency for cutting budgets beyond old school Republican bankers sipping a single malt at the New York Athletic Club.

In the three decades since the Gipper recast the rules of the game, the Republican Party has become the party of tax cuts and the Democrats the party of spending increases as the key argument to their constituencies. But neither party feels any obligation to take the painful steps necessary if they are to pay for the promises that they aim to deliver.

To suggest that Republicans have abandoned their brand is not an idle claim. Since 1980, Republicans have controlled the White House for 20 of 30 years. During that time, Republicans have routinely cut taxes, while never once proposing a budget that would pay for them. The Congressional Budget Office recently observed that the Medicare Part D program passed by George W. Bush will add more to the federal deficit over the next decade than the combined cost of the stimulus, healthcare and TARP legislation—to say nothing of the wars and tax cuts—yet the power of brand still leaves Republicans as the party of fiscal conservatism.

The past three decades offer ample evidence that there are no pure players in this debate. Not the Republican Party that lost its fiscal bona fides decades ago. Not the Democrat Party that in pursuit Wall Street largesse became the handmaiden of accelerating financial deregulation that culminated in financial chaos. And certainly not the American Family, those of all faiths and political persuasions who bought into the silly shibboleths of the new economy, and chose to lever up rather than hunker down as they faced stagnating real incomes.

Yet Tea Party acolytes remain enthralled by those who are selling them a bill of goods to build their own ratings, their electoral prospects or their speaker fees—with little regard for whether they are leading America further down a path of cynicism, and contributing to the further dysfunction of a political system that seems incapable of addressing the real and deepening problems that we face. The plaintive cry “Don’t let the Government get its hands on my Medicare,” might be apocryphal, but it highlights the vacuousness of a political movement that is built on deliberate denial by Americans of their own responsibility for the straits in which we find ourselves. As Pogo said, We have met the enemy, and he is us.

Today, as the economy lies in tatters in the wake of financial crimes and misdemeanors from Wall Street to Main Street, Americans remain reluctant to confront and admit their own complicity in the mess. It was tens of millions of average Americans who violated every rule they were supposed to have learned in kindergarten about living within their means and not borrowing too much. Today, these same Americans who bought too much house and borrowed against too many cards, now want to point the finger at the politicians and decry their profligacy.

The anger and fear that Americans feel as they gather to protest the unfairness of the world should be tempered by their own complicity in buying the same bill of goods, year after year. The truth is that we did not hold our politicians accountable because we did not want to have to choose between consumption and savings. We wanted more now and more in the future.

And compounding that anger and that fear must be a healthy dose of shame for what we have wrought. But rather than facing up to our own culpability, we have become even more determined to lash out at the other that must have created this mess.

After all, it can’t be our fault, because we are Americans. We are the noble citizens of the greatest nation in history. Our ethical conduct and fiscal prudence is beyond reproach. We know this to be the true because Glenn Beck and Sarah Palin and a raft of other politicians and pundits tell us so.

And we are too happy to believe them, because to do otherwise, and to accept some measure of responsibility for the world of our making would too hard. And for that, we should feel undying shame.

Working class hero.

2010-10-23T00:28:00.003-04:00

The Delaware Senate race may not be close in the polls, but people in Delaware are nervous. Despite an apparent 15 point lead for the Democrat, Chris Coons, the palpable anger on the streets of the long-time patrician state of the Dupont family leads many to believe that the outcome of the race remains uncertain.

Delaware is a small state of less than one million people. With the industrial north and rural, agricultural south, it has its own political culture and history. While viewed by many as a Democrat, blue state, its statewide office-holders have flipped from D to R with regularity. And its politics have always had a certain genteel character—with each Election Day followed by Return Day, a public festival of reconciliation culminated by a parade honoring the winners and losers together.

But this year emotions are running high, as they are nationally. At the most recent debate, Republican Christine O’Donnell quizzed Chris Coons on the Constitutional basis of the separation of church and state. The Constitution has carried iconic status among right wing insurgencies over the years—though their affection has tended to focus on a few amendments of choice while ignoring those that less suit their purposes—and O’Donnell was quick to expand her query to whether there was any federal authority that should rightfully bind the choices of a free people. Perhaps unwittingly, her stance in defense of radical federalism recalled Delaware’s history as among the last states to abolish slavery, almost a full decade after the Emancipation Proclamation.

But despite being ridiculed in the national media for her apparent ignorance of the First Amendment, O’Donnell seemed quite pleased with her performance. Indeed, she appeared nothing short of gleeful during the exchange, as she egged Coons on, goading the Yalie into a brief discourse on the Establishment Clause.

In her view, O’Donnell won the moment—evidenced by her joy and the hoots from her supporters—as she had succeeded in stripping the veneer off of the generally unflappable Coons, exposing his essence as a high-brow elitist. You could almost read her thoughts: You see! Listen to him! Thinks he’s the smartest guy in the room, and that he can shame me with that little lecture on the Constitution. But he just doesn’t get it—this race is not about how smart he is; it is about deep and undying anger of Main Street Americans at all of those who for so long have pulled the levers of power, and seen fit to tell the rest of us how much smarter they are than we are.

O’Donnell got this far by bringing down the old school patrician Republican Mike Castle, who in her mind was not one whit better than Coons. Yet many still refuse to take her seriously and suggest that her goal is simply to garner the national stage for a bit and perhaps land a reality show on Fox. But the fact that her numbers remain north of 40% even after her First Amendment performance speaks to the depth of the anger and resentment Delawareans feel toward Washington, D.C., and support her belief that with strong turnout on Election Day she can ride that wave to public office.

O’Donnell’s rhetoric of resentment toward elites has been central to the Republican Party narrative for decades. In prior incarnations, the Party leveraged those resentments to build its base—from Nixon’s Southern Strategy, the Reagan Democrats and Pat Buchanan Peasants with Pitchforks to Lee Atwater and Karl Rove’s success in co-opting the evangelical Christian community.

But this time, the Republican Party apparatchiks have lost control of the narrative, and Tea Party leaders have wasted no words in asserting their willingness to tear the party apart if it does not follow their lead. They understand all too well that the anti-Washington movements of the past foundered quickly, and saw their leaders compromised and their energies dissipated as the rise of federal power and spending continued unabated.

The irony, of course, is that the Tea Party is a movement without any internally consistent principles. The anti-tax core of the message loses its coherence when combined with the parallel anger over deficit spending. And for all the rhetoric about deficits and healthcare reform, no serious Republican candidate who has embraced the Tea Party talking points believes that deficits were the cause of the housing bubble and ensuing collapse or that our continuing economic problems will be cured by eliminating deficits or repealing healthcare reform.

Instead, rage against the machine is the underlying theme. Christine O’Donnell is not running for office because she believes that she has a better idea about how to fix the economy, or anything else for that matter. Hers is a platform of platitudes and resentments against all those smartest-kids-in-the-class who have been running things all these years and treating the rest of the country like second-class citizens. And she hopes there are enough Delawareans who share her disdain and anger.

But while O’Donnell is unlikely to win on November 2nd, the Republican Party and House Speaker-in-Waiting John Boehner are in for a rough ride. After 40 years of service as the tip of the Republican spear on Election Day, this crowd of angry, resentful Main Street Americans may not be willing to fade away as they have in the past, as the election fades and Washington returns to business as usual. This time, the Republican Party may have to make good on its promises, and John Boehner et al will be hard pressed to construct a legislative agenda and budget that delivers on the disparate slogans they have endorsed and promises they have made.

But it sure will be interesting to watch.

They're mad as hell, but so easy to manipulate.

2010-10-10T22:35:00.003-04:00

Today’s Tea Party has a point. The political progeny of George Wallace Democrats, Richard Nixon’s Silent Majority, the Reagan Democrats, supporters of Ross Perot, and Pat Buchanan’s Peasants with Pitchforks—largely white, working and middle class—are very pissed off. And for good reason. The American middle class that was once the envy of the world has taken an economic beating.

Since 1970, the middle class’ share of national income in the United States has steadily declined. Based on U.S. Census date, over the past 40 years, the middle class—as represented by the middle quintile of households—has improved its share of nation income in only four years, 1990, 1995, 2002 and 2007, and in aggregate saw a decline of 16% over the four decades. By way of comparison, the top quintile improved its share of national income by 17% over the same time period, and the top 5% of families by 31%.

The relative and absolute economic decline of the American middle class has accelerated. Back in the Mad Men years of the 1950s and 1960s, when the American middle class was the envy of the world, real household incomes grew by 35% and 35% in the respectively. Since then, real income growth has moderated, with growth rates of 6% in the 1970s and 1980s, before a brief uptick to 10% in the 1990s. Then the hammer fell, as over the past decade, real incomes for the middle quintile of American families declined by 6%.

So it is no surprise that, in Paddy Chayefsky’s words from the 1976 film Network, middle class Americans are mad as hell and aren’t going to take it any more.

What is surprising—and disappointing—is how easily manipulated the Tea Party movement has been, and how willing its followers seem to be to have their rage channeled against the chosen targets of self-interested and opportunistic leaders.

Socialism. Deficit spending. Healthcare reform. Barack Obama.

The current plight of the middle class had unfolding—and accelerating—for four decades, and this is the best Dick Armey and Sarah Palin and Glen Beck can come up with? And the millions of people embracing the Tea Party creed are willing to accept such blatantly shallow explanations for their plight?

The truth is that the plight of the middle class is a product of the triumph of capitalism, and is the direct product of deliberate national policies that have reflected the consensus of the American political and corporate establishment. Since the end of the Second World War, America has pursued national economic and foreign policies that have purchased world peace—such as it is—at a price of providing our former military and ideological adversaries with largely unfettered access to our markets. Free trade and the opening of world labor markets has supported dramatic growth in standards of living first in Japan and German in the wake of the Second World War, and then in China, the states of the former Soviet Union, India, and other smaller proxy states such as Vietnam as we “won” the Cold War.

Simply stated, we sought to create a world where the dominant world powers would compete in the economic marketplace rather than on the battlefield. Opening our markets brought billions of workers from the nations of our adversaries into direct economic competition with American workers. The impact of our integrated economic and foreign policies first emerged in the 1970s as Japan changed the landscape of the world auto industry and began an economic onslaught from which the American industrial heartland has never recovered.

The ensuing deterioration in the economic outcomes for middle class and working class Americans, and ultimately the decline in family incomes of the past decade, were masked by the steady declines in interest rates from their peak in the early 1980s and the growth in consumer and mortgage debt, which exploded over the past decade even as incomes declined in real terms. The now-familiar adage of the house-as-ATM-machine was very real, and sustained the illusion of growing disposable income until the music came to an abrupt halt in July 2008 when consumer debt peaked.

Real incomes across the American industrial heartland were doomed from the moment America chose to pursue its policy of open markets as a foreign policy tool. Competition with foreign workers depressed American real incomes as open markets pushed real wages toward a new equilibrium that would bring up living standards first in Germany, Japan and East Asia, and then across the globe. Flows of capital investment into new markets raised real incomes in these new markets, while the pressure on the American middle class continued unabated. While global economic growth ameliorated the depressing effect on wages in high-income countries, and technology and capital investment has maintained the level of productivity of American workers, it has done so at the expense of reducing employment levels, even as it increased aggregate output.

Socialism, deficits and healthcare are fine targets for bumper stickers and partisan finger pointing, but they have little to do with the plight many Americans face, but it has been capitalism, not socialism that has led to the dramatic changes in the world economy that have pressured American real incomes and brought middle class America to where it is today. And these changes have been the product of Democrat and Republican administrations alike. Similarly, while today’s deficits may loom as the next threat to our economic future, today they are neither crowding out investment in the private economy nor a plausible cause for the deterioration of middle class incomes over the past several decades.

Absent a more robust economic and political assessment of the state of our nation and the decline of the middle class, the Tea Party movement will lose its moment and leave us with nothing other than a few members of Congress who lack any meaningful platform that offers hope for a future that is different from the past. And the followers of Glen Beck, Sarah Palin and the rest will wonder what happened as they are reduced to just one more political constituency, complaining about their plight, claiming their entitlements, but doing little to build a brighter future for themselves or for the nation.

Dementia.

2010-04-17T11:38:00.016-04:00

Goldman Sachs is robustly protesting their innocence. The SEC accusations—that Goldman is guilt of fraud and duplicity—are “completely unfounded in law and in fact.”

But even if Goldman is proven right, that does not make the SEC wrong.

As the old saw goes,

When the law is against you, pound the facts.

When the facts are against you, pound the law.

When both the law and the facts are against you, pound the table.

It is table pounding time.

In essence, the SEC is raising the question as to whether Goldman created synthetic collateralized debt obligations (CDOs) for the purpose of allowing one group of investors to short the subprime market, while not disclosing this activity to other clients holding or purchasing those same bonds. The SEC is asking whether Goldman benefitted from both sides in a manner that violated their fiduciary obligation to their clients.

And the simple answer is, of course they were.

This is not a legal conclusion, but rather a systemic one. Given the size and scale of its operations, Goldman—like the rest of the financial Goliaths that have emerged from the global financial crisis—cannot help but be on both sides of almost any trade, and ultimately be in a position of advising different clients in opposite directions. But most importantly, Goldman is a trading firm, whose activities inevitably lead them to be putting their own considerable capital to bear against their client’s own interests.

Trading has become the most profitable activity in banking institutions, and derivatives trading—including synthetic CDOs and credit default swaps—has magnified potential profitability by allowing firms to realize nearly unlimited leverage as they position their bets in the global markets. While in years past, Goldman had a far smaller share of the market and prospered through a client-centric culture, that was then and this is now. Today, in a world of previously unimaginable trading profits and bonus payouts, concerns for clients and firm culture have been rendered quaint.

The blinding allure of trading profits has replaced raising and lending capital for the real economy as the singular focus of banking industry. This was evident last month when RBS—Royal Bank of Scotland, the largest bank in the world before the crisis that is now 84% owned by the British taxpayers—decried any limits on its trading activities. Trading profits, RBS asserted, were the key to rebuilding its balance sheet.

That RBS would publicly embrace the view that it intended to trade its way to prosperity begged the question of whether there aren’t any losing sides of any of these trades. Barely a year has passed since the low moments of the financial collapse—a collapse characterized by highly leveraged bets gone wrong—and dementia has truly set in.

As Congress considers major financial system reform, it is increasingly apparent that what emerges will be far from a stringent restructuring of the financial system that is warranted. Wall Street leaders have made no bones over the fact that they intend to protect their own interests in any legislation that emerges, and in particular will fight any efforts to curtail the highly profitable derivatives trading.

That we have reached a table-pounding moment should have been evident to all on February 7^th when, in a front page story in the New York Times, Wall Street publicly expressed its “buyer’s remorse” with the Democrats, and now looked to shift their political contributions to Republicans, who eagerly sought to offer Wall Street contributors a more appreciative home for their largesse.

Back in the day, political contributions in exchange for governmental action was viewed as the essence of corruption, and contributors and recipients went to great lengths to deny linkages between the money and legislative outcomes. But apparently there is no longer any shame in—or prohibition against—the buying and selling of political influence.

Today, regulatory reform is being debated publicly between the two largest recipients of banker largesse: Senators Christopher Dodd and Mitch McConnell. Accordingly, instead of focusing on issues of the size and capitalization of banks, the role of deposit insurance, and limitations on derivatives that provide no social utility, debate has focused on consumer protection and the locus of dissolution authority for failed institutions. These may be important questions, but they are predicated on doing nothing to curtail the massive aggregation of financial and political power within the banking sector. Wall Street, it would appear, has spent its money well.

While the debate among Wall Street and Congress continues, others suggest that the issues are not so complicated. One week after the story about Wall Street’s buyer’s remorse, a clique of octogenarians gathered around former Fed Chairman Paul Volker to support his call for more stringent restrictions on the trading activities of commercial banks.

Standing with Volker were former Citigroup chairman John Reed, Bush 41 Treasury Secretary and Dillon Read Chairman Nicholas Brady, Wall Street legend and former SEC Chairman Bill Donaldson, Vanguard founder John Bogle, among others. For these men, whose days in the trading pits and positions of power were behind them, the answers were simple. As Nick Brady intoned: “If you are a commercial bank and you wish the government to guarantee your deposits and bail you out if necessary, then you can’t be involved in speculative activity.”

Arguing that the lure of excessive profits and bonuses had undermined the core values of the banking system, Brady pushed back on those who argued that trading and derivatives were important to the banking system and dismissed self-serving the arguments for preserving the status quo. “You draw a line that is too tight, that doesn’t bother me a bit.”

Volker and his old friends were sending a simple message: Like it or not, we have not yet come close to a real discussion of effective, systemic financial reform. Self-interest—of bankers and politicians alike—stands firmly in the way.

The SEC charges against Goldman may or may not stick, but it should be clear to all that, as Jack Bogle observed, the system has gone badly awry and needs massive reform. That Goldman Sachs has become the poster child for all that ails us is its own fault. Like its banker brethren, Goldman has used the global financial crisis to its own advantage—gathering tens of billions of public dollars as AIG was unwound and gaining access to the Fed window—and has made effective use of political money and influence to perpetuate a system that assures Wall Street freedom to pursue massive profits, while the public continues to bear the risk.

Shame on Goldman Sachs if they have committed fraud. But shame on us if we do nothing to change the rules of the game.

Just a glimmer.

2010-02-20T10:56:00.002-05:00

For a brief moment, listening to Alan Simpson talk about the work to come of the Debt Commission, I was seized by a moment of optimism. Perhaps there is a glimmer of hope that the cascading problem of debt and entitlements might be honestly and openly discussed, and then addressed, before the weight of our collective irresponsibility collapses around us.

As Simpson noted bluntly, there is not a person within the political establishment in the nation’s capital that does not know the depth of the problem. It is notable, then, how little s actually has been done to address the problems, particularly given the amount of hubris, hot air, and sound bites that focus on the problem.

In many respects, the challenges are simple. With respect to the operations of the Federal government, we spend more than we take in. Compulsively. Collectively.

In some respects, operating deficits as an ongoing problem was exacerbated by two political moments, one by each party. Ronald Reagan fundamentally changed the relationship between the political parties with his embrace of supply side economics, and the articulation of the notion that tax cuts are a politically and morally self-justifying imperative, without little regard to fiscal consequences.

While Reagan took office at a time of very high marginal tax rates, and the salutary a affect on economic output of reductions in rates was clear, Reaganomics came to represent the view simply that economic output is improved with lower taxes—a premise that surely remains true all the way down to a tax rate of zero. But the obligation of governance remains the balancing of revenues and expenditures, and the premise argued by David Stockman, Grover Norquist and others that lower revenues will lead to lower spending proved to be manifestly false when put to its test in the ensuing quarter century.

At the end of the day, the miracle of the Reagan Revolution was that it effectively ended the power of conservatism as a force for fiscal rectitude in American politics. In the succinct words of Pete Petersen, the Republic Party fell prey to the unholy alliance of tax-cutting Republicans and big-spending Republicans.

If Ronald Reagan ended the Republican Party’s stance as a force for fiscal responsibility in the 1980s, Bill Clinton matched his contribution a decade later. Just as the large share of Republicans who admire President Reagan in unblemished terms will take umbrage at this assessment of his contribution to our problems, so too will many Democrats point to President Clinton positive contributions, as the one who left George W. Bush with balanced budgets.

But Bill Clinton also brought to the Democrat Party a commitment to build a fundraising apparatus to match the Republican Party’s fundraising prowess within corporate America. After years of watching the tireless efforts of Peter Terpeluk and Wayne Berman and the other titans of the Republican Party fundraising community develop teams of Eagles and Pioneers, with assurances of access to the top and throughout the bureaucracy, Clinton built a Democrat commitment to a kinder and gentler relationship with the for-profit community.

Clinton’s greatest success in his transformation of the Democrat Party’s relationship with corporate America came in Wall Street. Formerly the heart of the Grand Old Party, the Clintons built a foundation of support for the Democrat Party in lower Manhattan. And by the end of Clinton’s presidency, his administration matched the zeal of the Republicans in promoting the deregulation of the banking industry, ending Glass Steagall restrictions, and fending off regulation of the growing derivatives markets, even in the face of serial financial crises that would have deterred a less determined leader.

The past decade has been a golden age for corporations seeking to access the power and the purse of the federal government in the pursuit of corporate interests and the generation of private wealth. In addition to the financial reforms at the end of the Clinton Presidency, the banking industry pursued and won comprehensive bankruptcy reform several years later, with broad and bipartisan support from willing and well-compensated Congressional supporters on both sides of the aisle.

In terms of accessing the purse of the federal government, the success of the pharmaceuticals industry in passing the Medicare Part D reforms provided a nearly uncapped access to the federal treasury, and again won willing support on both sides of the aisle, with only lip service paid to the massive fiscal consequences of such an open-ended money grab.

In terms of harnessing the power of the federal government in pursuit of corporate goals, bankruptcy reform is one example, while a more interesting example was the near-decade long support of FDA regulation of tobacco products by Philip Morris. While FDA regulation was a long-held goal of health advocates, Philip Morris understood that FDA regulation—and the strict limitations on advertising that would ensue—would effectively lock in Philip Morris’ dominant market share in that industry, reducing advertising costs, increasing profitability and elevating its share price.

Alan Simpson’s challenge is to stare down his long-time Congressional colleagues, and demand that they finally accept that their overriding responsibility is to tend to the long-term health of our nation. It is not about their own reelection or the success of one political party on another. Not in this matter.

But each Senator—with the possible exception of Scott Brown, who may not have been there long enough—probably firmly believes that every vote they cast is made with conviction and integrity. They believe the spin that is wrapped artfully around each vote. Bankruptcy reform is about consumer protection and personal responsibility, not about bank power and profitability. Financial reform was about economic growth and efficiency, not about the accumulation of power and profitability on Wall Street. Medicare Part D was about improving the health and well-being of seniors—on whose comfort we can place no price—not about creating massive new markets for a dizzying array of new drugs for newly minted syndromes.

But whatever they might believe about how they vote, Alan Simpson understands what has increasingly become clear across the political spectrum—from tea partyers and CPAC members on the right to those on the left who watched their dreams of single payer healthcare swiftly subordinated to the interests of the range of corporate interests brought “inside the tent” in the early days of the Obama administration—that the main challenge facing his efforts is dealing with the very people whose votes he needs. The changes wrought by Presidents Reagan and Clinton left us with a national capital where votes can easily be bought and the core principles of fiscal prudence are little more than buzzwords and political applause lines.

But I must remain optimistic about Alan Simpson’s new challenge. If—as Simpson suggests—everyone inside the beltway understands the truth of what we face, than they must succeed, because everyone outside the beltway understands it as well.

Risk of contagion.

2010-02-15T10:02:00.003-05:00

After weeks of turmoil in the capital markets, the European Union has provided assurances that Greece will not be allowed to default on its debt. Like AIG before it, Greece has proven to be the domino that must not be allowed to fall, lest traders next take a run at Portugal, Italy and Spain, and ultimately bring the notion of a united Europe to its knees.

But those assurances, which at root suggest that Germany has agreed—behind closed doors—to serve as the de facto guarantor of the debt of Greece, would come with strings attached. Greece would have to cut its massive budget deficit, reduce public sector salaries, reduce farm price supports and restructure pension commitments. In sum, to do those things that Greece had agreed to do as conditions of joining the E.U. to begin with.

And now Prime Minister George Papandreou of the Panhellenic Socialist Party has to pick up the pieces. And he is not happy.

In an odd show of gratitude for the E.U. pledge of support, Papandreou has responded by accusing the E.U. of failing to do its homework when his conservative predecessors fudged earlier deficit numbers. But the integrity of economic data is a long-standing problem for Greece, dating to audits that showed that Greece routinely dissembled in its published data and essentially lied on its E.U. application. But whatever the history, it is Papandreou who now has to carry the bad news to the electorate.

Or he can let Greece default.

Maybe it is time for someone to stand up and stare the markets down. Maybe it is time for someone to demand that in a world of open capital markets, it is investors who must evaluate risk and take risk, and if markets are to efficiently allocate capital over time, investors must be accountable for their investment decisions.

The fact is that losing money is part of the process. Markets are supposed to weigh and price risk, and in so doing allow for the efficient transfer of information. In the case of Greece, this information is supposed to be about the long-term affordability of farm price supports and public pensions and other spending, balanced against the ability to support economic growth and wealth creation over time to pay for those politically attractive expenditures.

But we are no longer in the world of markets, we are now in the world of politics. After all, when Goldman and others took AIG counterparty risk but were let off the hook and paid out billions of dollars, that was not the markets working, that was politics. And over the past year and a half, we have watched bailout after bailout for fear of markets doing what markets are supposed to do. But risk is an essential part of the process. Risk is what free markets are supposed to be about.

And it is time that a socialist stood up and said so.

Now, of course, things will not go well for the Greeks, should Papandreou choose to take this path. The Greeks will have to pay a heavy price for the failures of their representative government. But they will make the Germans happy. Because the German people want no part of this.

But at the end of the day, Europe will work it out. After all, too much is at stake. The E.U. countries staked their futures on the idea that being part of one big country is better than being a small country. France wanted a bigger platform to steer a new foreign policy freed from the hegemony of America. Poland wanted to trade in the Zloty for the Euro, as protection against having to trade it in for the Ruble. And, coming off of a century of European wars, they both wanted institutional arrangements that would harness German might.

This appears to be the path the world has chosen. For fear of “contagion”—the notion that as Greece goes, so goes Spain, and Portugal, and perhaps Italy—the E.U. will construct an institutional “firewall” to show that Greece will not be allowed to collapse. The only firewall standing between the E.U. and its planned “firewall” may be the German people, who are scandalized that their tax dollars will be used to fix a problem of someone else’s making, and who may yet prove the last line of defense against the real contagion.

The real risk—the real contagion—as people from Main Street to the Bundestrasse understand intuitively, is the growing effort to take risk and accountability out of the financial system. It is the cascading issue of moral hazard. People—like derivatives traders—understand that risk does not go away, it just gets moved around. And they know that when the music stops, they end up paying the price.

In the U.S., the contagion is manifest in the refusal to take the steps necessary to break up the financial and political power of the largest financial institutions, to set limits on what is or is not allowable in the derivatives world, or to return risk to ownership of the financial industry. In Europe, it is the unwillingness to look at the institutional structure of the E.U. that severed currency control from national politics and fiscal policies, and made national fiscal crises all but inevitable.

For all the talk of financial reform in Washington, we are hamstrung by a system that allows affected industries with political clout to dictate policy, and in lieu of real reform we are marching down the path of more complex regulation, deluded in our fevered imagination that some team of smart regulators will ever be able to take on the political and financial power of our largest financial institutions, or match the cunning of well-incented and marginally shackled traders.

The irony is that while a socialist prime minister struggles to save his nation’s pension system and safety net, his efforts may ultimately be undermined by the E.U. efforts on his behalf. The problem that the moral hazard contagion presents to Greece—and to the rest of us— is that only a return to robust economic growth can provide the real growth in incomes and the investment returns that will be necessary for nations or states to fund their massive future pension obligations. And each new action that we take down the path that we are now on that undermines the effective pricing of risk in the capital markets, undermines our ability to return to a functioning and growing economy.

Daisy chain.

2010-02-11T11:00:00.006-05:00

It doesn’t get any better than this.

You sit down to write about the mundane corruption of our democracy, and the ease with which banks can announce on the front page of the New York Times that they are going to pull their political contributions from Democrats—who apparently are not treating them nicely—and the equal ease with which Republicans announce that they will go after those contributions, and treat the contributors with greater deference. Then you realize that that is not the pressing issue of the moment.

So you decide instead to write about the looming default of Greece on its debt, and the profound anger in Germany at waking up one morning to find that it has emerged as the defacto guarantor of not just Greece, but all of the overleveraged, profligate and unruly southern European nations that Germany tried so hard to hold under its thumb in centuries past. Indeed, the unraveling of the European Union—that great political institution created to contain the German colossus after the failure of the Maginot Line—is leaving German’s wondering how their aging nation has found itself on the hook for Greek bureaucrats who just this week marched in the streets to protest layoffs in the wake of Greek efforts to impose fiscal austerity.

But of course, the images of the righteous protests of Greeks marching in the streets, as though someone else is to blame for the overspending on the Olympics and pensions and every other matter, just foreshadows the pain that is looming across major state governments, who are just now coming to grips with the fact that the full force of the fiscal crisis is only now just about to land in the U.S., as Federal Impact Aid has been fully expended, and Republican and Democrat Governors alike are resorting to fiscal gimmickry and pension funding holidays as they struggle to avoid admitting the obvious: That if the states—and the Federal Government for that matter—are ever to return to real fiscal balance, they have to come to grips with the simple fact that they must spend less and/or take in more. And politicians, retirees and workers in many states will need to face the harsh reality that long-term pension obligations will never be fully met, and the sooner that they all come to grips with that fact, the more equitable the resolution will be.

Then, this depressing thought was sidelined by the first mention of the word quadrillion. And that seemed to trump thoughts of bank corruption, Greek bonds, German upset, state pension, and the rest of it.

Last night, I saw the $4 trillion Bailout ads on TV. And this morning, I received an email regarding the $25 trillion guarantee of financial derivatives by the Federal Reserve, sent to me not from some crackpot, but from a derivatives trader at Merrill Lynch. This email referenced a story—referring to names that will mean little to most people—about how the Depository Trust Company, the brokerage industry vehicle that handles all stock trades—$2 quadrillion annually—announced that “the Federal Reserve Board had approved its application to establish a DTCC subsidiary that is a member of the Federal Reserve System to operate the Warehouse for over the-counter credit derivatives.”

So what does this mean in English? Well, the piece argues that all credit default swaps, are now backstopped by the Fed. Because, as quoted from an Office of the Comptroller of the Currency letter, “Clearing is a form of extending credit, one of the main functions of banking institutions. A clearing agent substitutes its credit for that of its customers… and is liable to a clearinghouse for performance on all submitted contracts, and assumes, with respect to the exchange, clearinghouse, and counterparties, the risk of default.”

If there is a theme to all of this, it is that in the name of the security of the financial system, we are continuing to march down the path toward homogenization of all risk onto the books of the Federal Reserve and the U.S. Treasury. In our efforts to avoid cascading collapse in the early months of the fiscal crisis, the Fed and the Treasury merged failing investment, took over and posted collateral to avoid the failure of AIG, backed up all manner of bank obligations, swapped bad debt for cash on the books of the Fed, and took all manner of other arcane actions, all in the name of preserving the system from collapse.

But since things settled down, we have done nothing to ameliorate the massive problem of moral hazard, beyond very lame and totally unbelievable statements that banks “better not count on a bailout next time.” These statements are unbelievable exactly because every step taken so far has been to shore up and make stronger the abilities of the Fed to respond to future crises, and to have resources at its disposal to act with fewer constraints by Congress or the Executive.

Does the creation of a CDS clearinghouse within the Fed system constitute a federal guarantee of performance under those contracts? I don’t know, but every action taken so far constitutes a greater concentration of risk onto the books of the government, rather than actions that would lessen systemic risk and force risk-taking back onto the private market participants, where it belongs.

And there are no small number of viable suggestions that have been made over the past year for consideration.

· Reinstitute the separation of commercial banking and risk trading activities.

· Recognize that institution size and political influence exacerbate systemic risks.

· Reconsider the rationale, role and structure of deposit insurance.

· Reinstitute at-risk rules for trading and the partnership structure for investment banking and trading organizations.

· Eliminate collateralization provisions in derivatives contracts so that counterparties must consider and accept counterparty risk, and to prevent counterparty collateral claims from undermining senior debt holder rights.

· Regulate credit default swaps and other derivatives that undermine appropriate functioning of corporate finance and bankruptcy process.

Just to bring all of this full circle, the reason so many are rejected has to do with at least in part with the corruption of the political process referenced at the outset. Failure to chart a path that reinvigorates the private assumption of risk will surely lead us one of these days to be facing the question that many Germans are asking this morning, when the next, far bigger, crisis hits, and the U.S. Government no longer has the resources available to absorb everyone’s risks: How did we let this happen?

Losing the Kennedy seat.

2010-02-06T10:23:00.007-05:00

The Scott Brown election in Massachusetts is far less momentous than has been depicted.

To understand it simply requires holding onto two attributes of the Massachusetts electorate that might seem contradictory, but are not. First, that Massachusetts Democrats have a large registration edge over Republicans. Second that Massachusetts has close to if not the largest proportion of independent voters among states. Gallup achieves its ranking of Massachusetts as the third leading Democrat state—with a 34% edge over Republicans—only by allocating independent voters to the side to which they “lean.”

For some, the election results were touted as a bombshell because of the notion that this was Teddy Kennedy’s Senate seat. But if that Senate seat were to be an hereditary peerage, a Kennedy would have to step up and seize it. The Massachusetts election results might have been startling if Joe Kennedy had run and lost. But he chose not to run.

Despite its reputation, Massachusetts is not the Democrat bastion of national imagination. Over the past half-century, we have seen Republicans ruling the Statehouse more than Democrats—though long-time Senate President Billy Bulger would certainly protest the notion that any Governor ruled the Statehouse during Bulger’s reign. The 28 years of John Volpe, Frank Sargent, Bill Weld and Mitt Romney outstripped the 20 combined years of Mike Dukakis, Endicott Peabody and Deval Patrick. By way of comparison, in both New Jersey and Virginia, the sites of the other recent Republican gains, these numbers are reversed, with 28 years of Democrat rule compared to 20 Republican years.

A defining characteristic of top of the ticket statewide races in Massachusetts—a state with a hard earned reputation for local politics, patronage and corruption—is that they have not been dominated by old time pols, and each of these Governors—Democrats and Republicans alike—ran and won as reform candidates campaigning as much against the entrenched party establishments as embraced by them. Statehouse operative John Sasso may have greased the wheels to assure Michael Dukakis won the nomination, but the liberal Democrat from Brookline never won the hearts of party regulars. (I will leave aside for the moment the question how a half century of reform governors could have resulted in so little reform.)

If one is to draw a lesson for national politics from Massachusetts, it is less about policy—the notion that the Massachusetts electorate was voicing its opposition to federal healthcare legislation—than about politics. And in this regard, the message from Massachusetts is not particularly different than from New Jersey or Virginia. It is that the Democrat candidates lost the good will among independent voters—the voting block that was essential to the Obama victory two years earlier—as those voters leaned the other way.

Ironically, losing in Massachusetts—and losing the 60th vote in the Senate—may have been the best thing that could happen for Barack Obama. The Massachusetts loss should mark the end of Obama’s ceding the floor to Harry Reid and Nancy Pelosi—whose leadership has been anathema to the change the independent voters thought they were getting in 2008—and force a realignment of the President’s strategy. While in the first few days following the Brown election, the White House appeared to be flailing about for a message—leading to real fears that the wheels were coming off the bus—its ultimate embrace of the nationally broadcast question time with Republicans may have marked a turning point.

For the first time in many years, the public was able to witness—and our elected officials were able to participate in—real discussion over real issues. This was an astonishingly simple antidote to dangerous levels of public cynicism, at a time when Washington has been reduced to rhetoric and spin, and talk show hosts wield dangerous influence over our politics.

Every hour of every day, we are pummeled by a media that makes its living stirring us up, and exacerbating the fears and resentments that are easy enough to feel without the encouragements of Sean and Rush and Michele and Ed and the rest. And time is on their side, because most of the challenges we face take time. The economy will take time. Deleveraging takes time. The real world takes time. The only think that does not take time is the Internet and cable TV. They get faster every day.

As a nation, and as a polity, having our leaders discuss matters directly is a refreshing change. After years of debating the best format for presidential debates, we have never really gotten past various versions of gotcha questions. Yet, last week, when they put the President and Congress into a room, gave them a microphone and told them to have at it, apparently they were able to do just that. And do so intelligently and with civility.

So perhaps the message from Massachusetts is just what it should be: That the electorate—led by a growing, independent center—will continue to vote for the other guy until they see something that looks like progress. And progress does not mean a filibuster-proof majority for one party, it means injecting some degree of integrity into political debate and moving away from a system simply defined by the pursuit of partisan advantage.

And that would be a good thing.

Sauce for the goose.

2010-01-08T09:47:00.011-05:00

The Feds, the mortgage bankers, commercial banks and investors in mortgage-backed securities conspired to let people buy homes with little or no money down. One’s choice of villains in the saga that ensued based on where one sits in the political wars. Investment bankers. Mortgage bankers. Standard & Poor’s. Barney Frank. Chris Dodd. Frank Raines. Alan Greenspan. Whatever.

But now, faced with a cascading foreclosure problem, homeowners—a questionable notion for owners of a property with zero equity—are being told that the moral and ethical thing to do is to let people stay in their homes, and make good on “their” obligations. After decades of watching Donald Trump walk away from any bad deal, declare bankruptcy, and go back to the same banks for another bite at the apple, American owners of bankrupt—debt exceeds asset value—properties are being asked to stay the course, to “do the right thing.”

This, of course, is the Paulson Doctrine. On March 3, 2008, two weeks before the collapse of Bear Stearns, the Treasury Secretary set forth the principle that—unlike Mr. Trump—homeowners should stay the course.

Homeowners who can afford their payments and don't have to move, can choose to stay in their house. And let me emphasize, any homeowner who can afford his mortgage payment but chooses to walk away from an underwater property is simply a speculator – and one who is not honoring his obligations.

Today, the Paulson Doctrine has been embraced from the President on down, as the responsible course of action. For an increasingly diverse America, this is the new Protestant Ethic. Forget Donald Trump, the serial bankrupt celebrity celebrated for a decade as the face of the American economy. Forget that the banks that made all those loans—time and time again—to Donald Trump, have had those and so many other bad beds paid off by the American taxpayers.

There is no greater irony than the continuing spectacle of American taxpayers—the yet-to-be-born grandchildren of American taxpayers actually—who once thought that they had secured their piece of the American Dream, are now being told by the very bankers who they have bailed out that their moral and ethical obligation is to stay the course.

Thirty years ago, in the first day of the class “Financial Markets and Disintermediation” at the Wharton School, Professor Smith began by musing that each of the world’s great religions decry the impact of debt on the individuals and society, and are derisive of bankers and banking activities. His words were lost on the gaggle of aspiring investment bankers, who aspired to follow in the footsteps of Michael Milken and Donald Trump rather than consider WWJD.

The Koran is enlightening on the subject of debt. The principles of sharia lending suggest that debt creates an undue power relationship between the lender and the borrower, and accordingly it suggests that there should be elements of risk-sharing in lending activities. While referencing the Koran in any regard may make one suspect in American discourse today, the notion of risk-sharing in financial arrangements, and in particular in financial arrangements where the power relationship is totally skewed toward the lender as in the world of consumer and mortgage banking, is worth considering.

While Professor Smith was reflecting on moral considerations, across the hall Professor Percival was articulating the Miller Modigliani Capital Asset Pricing Model, a central tenet of the Wharton finance program. In simple terms, this model—based on the theoretical work of Nobel laureate economists Franco Modigliani and Merton Miller—demonstrated that you cannot increase the value of a business by increasing the level of debt—the approach for which Wharton grads led by Michael Milken would become famous over the ensuing decade, unless debt receives favorable treatment under the tax code relative to equity.

If the last paragraph made no sense, don’t worry. The point is that we are in the process of unwinding a massive debt crisis that has laid bare a number of fundamental flaws with our financial system, inequities in our legal system, and corruption of our political system. And a central cause of the over-leveraging is that our tax code gives everyone incentives to “lever up.”

It is easy to point out the moral hypocrisy of demanding “homeowner responsibility” in a society that for years has celebrated business icons that eschew such practices. However, it will be harder to acknowledge how—much less garner the political will to change—the rules and practices that directly contributed to the financial crisis. Democrats will decry ending the tax deductibility of mortgage interest that appears to make homeownership more affordable. Even more difficult will be changes that provide balanced treatment of debt and equity. But if we are to build a more resilient economy and address the very real problems of over-leveraging, we have to consider the extent to which the crisis that emerged was a direct consequence of the incentives that the tax code created.

Tilting at windmills.

2010-01-06T10:18:00.001-05:00

Senators Maria Cantwell (D-Wash) and John McCain (R-Ariz) have joined together to in a show of bipartisanship to promote what should be obvious: Our banking system is structurally flawed, and the changes instigated by the passage of the Financial Services Modernization Act of 1999 should be fundamentally reconsidered. Cantwell and McCain have proposed legislation to reverse the provisions of the 1999 Act that ended the Depression-era Glass Steagall Act rules that separated investment and commercial banking.

While the conventional wisdom is that Cantwell and McCain are tilting at windmills, Congress must consider three simple notions as it considers financial services reforms. First, that institutions playing with insured deposits should be limited in what they do with public money. Second, that institutional size is a threat, and therefore large banks should be broken up into smaller banks. Finally, that financial innovation and trading in financial derivatives must be evaluated and regulated with respect to risks and benefits.

Interestingly, the arguments against these notions have remained largely unproven. Paul Volker—one of the few remaining Wise Men on financial matters in Washington, with the death of Bill Seidman—has wryly argued that for all the talk, there has been no financial innovation of widespread value since the invention of the ATM. Financial derivatives—heralded by Alan Greenspan as tools that would transfer risk to those most able to afford it—have turned out, in the words of Financial Times editor Martin Wolf, to have transferred risk to those least able to understand it.

Financial derivatives, and in particular credit default swaps, were at the center of the collapse of AIG. A credit default swap (CDS) contract is in its essence an unregulated form of insurance against the risk of default on a bond, wherein the purchaser of the contract pays the counterparty—the insurer—an annual payment in exchange for protection in the event of a bond default.

The CDS market is a huge market, with the bulk of the insurance provided by our largest banks. For those banks providing insurance, there is no requirement for setting aside capital against the risks that are undertaken, and as such the annual payment on the contracts constitute a type nearly unlimited leverage.

One question that has to be asked is what societal purpose is served by CDS contracts. Consider the two possible scenarios, using a company we will call YRC, Inc. In the first scenario, an investor holds a portfolio of YRC bonds. The bonds were purchased at a dollar price of 100, and if all goes well, the investor will receive 100 cents on the dollar at the maturity of the bonds. In this case, the investor would like to insure against the risk of YRC going bankrupt, and purchases a CDS contract that will protect it from any losses in the bonds if YRC goes belly-up. While this may sound like a fine idea, it is a socially destructive proposition, as in the event of financial problems at YRC it places that investor in a position of preferring bankruptcy to a negotiated restructuring of the company that would preserve the company but require some sacrifice on the part of the bondholders, as traditionally happens in a workout. Therefore, instead of aligning the interests of stakeholders, it undermines the alignment of interests that is necessary for navigating difficult situations.

In the second scenario, traders that do not hold YRC bonds decide to speculate on YRC’s financial condition, and purchase CDS contracts on YRC bonds in the hope of selling those contracts later at a higher price—when the likelihood of a YRC default is perceived to have increased. (Remember, the value of the CDS contract rises as perceived default risk on the bond rises, as the contract pays out upon bankruptcy).

In this scenario, the CDS contracts do not serve a fundamental societal purpose, but rather are trading instruments, or—in the words of Michael Lewis—side bets. With approximately $60 trillion of CDS contracts outstanding—an amount that far outstrips the outstanding principal amount of corporate bonds—these side bets constitute the bulk of outstanding CDS contracts.

The case against allowing such CDS contracts was made early on in the financial crisis by Lehman Brothers CEO Richard Fuld, who argued that traders at Goldman Sachs and Bear Stearns exacerbated the collapse of Lehman by shorting the stock and going long (purchasing) the Lehman CDS contract, with each trade—pushing down the stock price and pushing up the CDS price (or spread)—creating a reinforcing cycle that confirmed the market perception that the collapse of Lehman was inevitable. As the collapse neared, the traders won on both trades.

And, of course, YRC is a Fortune 500 trucking company—YRC Worldwide—that almost went the way of Lehman Brothers. As reported yesterday in the Wall Street Journal, the company almost failed to win bondholder consent for a restructuring plan, as bondholders holding CDS contracts preferred to hold out for bankruptcy to trigger a payout on those contracts. The bondholders consented only after threats of public protests by the Teamsters against institutional fund managers led in an agreement. The fundamental point regarding the destructive role of the CDS contracts was made in the WSJ article, in a comment by Mike Green of Tenex Capital, an advisor to YRC:

“It’s fundamentally improper that people can force an insurer to pay a policy when the person insured has the right to destroy his property.”

Congress appears to be ready to accept fundamental principles that must be questioned. First, institution size creates an inherent risk to the system. Arguments that institutional interconnectedness means that smaller institutions also create systemic risk does nothing to respond to the suggestion that the risk is greater with larger institution size. The problems created by institutional size include financial risk, institutional complexity that will inhibit both regulatory oversight as well as effective resolution actions, and the political power that increases with size and will mitigate against enforcement action and legislative reform over time. The latter issue should be self-evident as we watch the growing stranglehold that Wall Street has over federal policy.

Second, there should be a connection reestablished between deposit insurance and institutional role and function. Bank lending is a core function in the real economy, and this function is not augmented by institutional size or trading prowess.

Third, there should be a connection reestablished between participation in the Federal Reserve System and institutional role and function. It is hard to imagine the continuing rational for Goldman Sachs and Morgan Stanley to continue as bank holding companies.

Fourth, while the rhetoric of efficient transfer of risk sounds like an admirable principle, attention should be given to the notion that risk is an important element of lending and credit decisions. Accordingly, products that appear to mitigate transactional risk—such as credit default swaps—may exacerbate systemic risk. If CDS contracts undermine the alignment of interests between bondholders and the company, those contracts should not be allowed.

Strictly business.

2009-12-13T23:34:00.003-05:00

Just imagine how angry the American public would be if they knew the whole story.

For months, we have listened to the whining from Wall Street. U.S. banks are having a record year, and they want to be paid a lot of money. Billions and billions of dollars.

Public indignation is deep. After all, over the past year, we have watched as hundreds of billions of dollars of public money has been poured into bank balance sheets. We have—we are assured—taken steps that were necessary to bring our financial system back from the brink. We may not have liked it, but we had no choice.

But now that we have stemmed the tide, now that the Great Panic of 2008 has abated, we have been forced to watch these same institutions moan about how bad they have it. Citigroup—the one that received $45 billion in taxpayer funds, plus a couple hundred billion extra in public underwriting of bad assets—wants to wipe the slate clean by paying the money back and calling it even. So they can pay themselves billions of dollars in bonuses.

Wells Fargo, the arriviste among the financial elite, is complaining about the competitive disadvantages that they face as a consequence of federal compensation constraints. Constraints that prevent them from paying themselves billions of dollars in bonuses.

Goldman Sachs—caught in a lie by a federal Inspector General who refuted Goldman’s sanctimonious claim that even if the world had collapsed, they would have been fine—is trying to fend off accusations of unwarranted hubris and greed—which reached a pinnacle when they announced plans to pay themselves $21 billion in bonuses—by announcing that their senior partners will take their share of the billions in stock.

But what if the public understood the whole story? How is it that the banks are now having one of their most profitable years ever? Given that there is not much lending going on, and that the newly increased credit card fees have only just begun to flow into bank coffers, where is all that money coming from?

It is coming from proprietary trading. “Prop trading” is the kind of betting with the bank balance sheet that was made illegal for commercial banks back during the Great Depression, when the FDIC and deposit insurance was created. The price of having the federal government guarantee bank deposits was separating the lending and depositary functions of commercial banking from trading and risk activities of investment banking. Thus, in 1935, the commercial bank J.P. Morgan & Company was separated from the investment firm Morgan Stanley.

But this separation was undone in 1999 to facilitate the creation of the megabanks that we have today. However, while the Financial Services Modernization Act of 1999 ended the separation of activities, FDIC deposit insurance remained in place. And this year, the elite of the financial world—JP, Citi, Wells, BofA, Goldman and Morgan Stanley—have finally emerged for what they are: Gigantic hedge funds backed up by the full faith and credit of the United States of America. Wall Street bankers making big bets with our money, content in the knowledge that if they win their bets, they will pocket the cash. And if they lose, we will all pick up the mess.

But it really does get better. So exactly how did they make all that money this year?

Well, the trade of the moment has been the U.S. dollar carry trade. A foreign currency carry trade is simple in concept. Borrow money where interest rates are low, and invest where interest rates are high. Or simply stated: Short the U.S. dollar. Buy the currency of a country where interest rates are higher. The beauty part is that by continually assuring the world that U.S. interest rates will remain near zero for the foreseeable future, the Federal Reserve has assured traders that they can keep the trade in place for some time.

So the Wall Street elite, just months removed from their near-death experience, are now making a fortune shorting the U.S. dollar. One year ago, faced with the greatest financial panic in generations, the American people swallowed hard and bailed out the banks. Today, the banks have moved on, and are tearing down the currency of the nation that saved them.

But it is nothing personal. It is strictly business.

And the carry trade will work out fine. Until it doesn’t. Then the trade will unwind quickly, and those who do not get out in time will get hurt badly.

But the banks are not worried. If the unwinding of what NYU economist Nouriel Roubini has labeled “the mother of all carry trades” takes a bank or two down with it, everything will be all right. Because the bank deposits are still insured, and we now know to an absolute certainty that if one of the elite institutions fails, we will bail it out. Again.

It is time that we come to grips with the depravity of the current situation, and potential damage that continuing down this path may yet do to the financial system and to our economy.

Our commercial banks are not, and should not be, hedge funds. U.S. dollar carry trades and writing credit default swaps are not core commercial banking functions. They are not necessary to the efficient functioning of our financial system.

The U.S. dollar carry trade is destructive to our currency, and is creating asset bubbles across the world, as leverage is transferred from our markets into others. For their part, credit default swaps serve no useful purpose in proportion to the systemic risks they create.

It is time to go back to basics. Commercial banks provide essential services in our economy. They enable the Fed to control the distribution and pricing of capital to the productive sectors of the economy. They provide secure depositary and asset management services.

Unfortunately, pending Congressional legislation has done nothing to address the central risks that the new financial landscape presents to our economy. Rather than reinstitute restrictions on bank activities or restrain institution size, Congress is looking to regulatory solutions that hold little promise of success when the next crisis emerges. And rather than recognizing the problem of moral hazard, this week Congress took the first step of embracing it in statute.

This year, Wall Street has shown its true colors, but the public has yet to understand the depth of the betrayal. It is not the continuing absence of lending, or jacking up credit card fees, or hiking consumer interest rates, or even the constant refrain of complaints about limitations on executive compensation. No, the greatest betrayal is that with the American economy as weak as it has been in years, with the dollar weakness threatening to unravel the international commitment to the role of the dollar as the reserve currency, Wall Street has shown no shame about attacking the currency of the nation that came to its aid.

If this is the path that the elite commercial banks have chosen, if they have been fully seduced by the lucre of trading, Congress needs to revisit the fundamental rules of the game, and revisit the central rationale for deposit insurance and the structure of the commercial banking system.

Bankers leaving town?

2009-12-06T12:55:00.006-05:00

So what was this image from the New York Times this week?

Healthcare lobbyists coming crossing the Potomac for a meeting on the Hill?

Goldman Sachs bankers heading to the Hamptons to spend their bonus checks?

No, it turns out it was a group of uninvited guests crossing the reflecting pool on their way to a reception on the White House lawn. You can see Tareq Salahi, standing fourth from the left, in his formal hoodie.

Hell hath no fury.

2009-11-19T11:21:00.001-05:00

Just when I had convinced myself that behind the curtain, hidden from public view, Barack Obama had a plan—for Afghanistan, for the Middle East, for Iran, for Russia, for education, for energy, for financial regulation, for health care… or at least for some of them—I saw Obama Campaign Manager David Plouffe pitching his book on The Daily Show.

Plouffe was in full campaign mode, selling the successes of the first year of the Obama presidency, as well as his new book—The Audacity of Winning. Grinning and determined, he spoke with an evangelical fervor.

The Audacity of Winning. Coming from the Obama campaign manager, the title itself is at best an ironic commentary on hope as a political strategy, but at worst the title bluntly mocks the electorate that invested their hopes and dreams in the Obama campaign.

Electoral losses this month in New Jersey and Virginia provided a grim reminder to Plouffe and the Democrats of the fragility of their electoral victories of just one year ago. If 2008 was an election year when young and independent voters set their cynicism aside and embraced the hope that a different tenor might come to national politics, 2009 saw young voters abandon politics and independent voters abandon the hope briefly flickered a year earlier.

The voters in New Jersey and Virginia did not get it wrong. They were not impatient. They were not premature in their assessment. By all accounts, the hope Obama offered—the belief that Washington can shift to a new trajectory and engage the real and deep challenges that threaten our nation’s future—is, if not dead, on life support. The past year has been one of deep and unremitting partisan rancor. A year has been lost with nothing to show for it but growing evidence that national politics is indeed a rigged game.

The easy response—and we have heard it for months—is that the Republicans are responsible for the intransigence in Washington. After all, it takes two to tango. But at a defining moment in the healthcare debate, John Boehner threw down the gauntlet. Healthcare reform, he stated, would be Obama’s Waterloo. Defeat healthcare legislation and you defeat Obama. Game on.

But at that moment, President Obama failed to engage the overarching issue of politics and partisanship, and instead the healthcare debate devolved into little more than another Washington food fight. Obama abdicated his commitment to reframe political debate and ceded the field to Congressional leaders with no interest or inclination to keep hope alive.

Harry Reid and Nancy Pelosi had no interest in Obama’s pledge to young and independent voters to change the tenor of politics in Washington, because it is their politics. For Reid and Pelosi, the political price of setting aside the interests of the SEIU and the Trial Lawyers and others in favor of a bi-partisan deal was too high to pay. Instead of reaching across the aisle, Democratic leaders preferred instead to mute industry opposition to healthcare legislation by bringing the industry heavyweights—big pharma, the hospitals association and ultimately the insurance companies—inside the tent. After all, that would only cost money.

The result is legislation that makes a mockery of sensible healthcare reform. It is expensive. It continues deeply entrenched incentives to overspending. Its financing is dishonest. And it protects those industry interests—promising expanding markets and limited cost controls—along with the interests of unions and lawyers heavily invested in the status quo, proving once again the power of lobbyists and contributors to take any major piece of legislation and manipulate it to their benefit.

So was it all just words? One year in, where is the evidence that the campaign that was designed to win by building on the hopes and dreams of the electorate was something more than just tactics? Where is the courage to take the long view? Where is the courage to take on your friends and occasionally accommodate your adversaries? And where is the courage to take on the contributors and lobbyists that neuter and manipulate one legislative initiative after another.

Have we seen any of that?

This year, we have watched events unmatched perhaps since the Gilded Age a century ago, as bankers have dipped their hands deeply into our pockets and those of our children to protect and enrich themselves, and nothing but whimpers from our elected representatives who tell us that this is the way it has to be—even as they take some of that very same money for their own campaigns.

But it is not just the bankers. The pharmaceuticals and insurance industries will dig deeper into the federal trough as subsidized drugs and insurance mandates are enacted. Energy companies and traders are eagerly ogling the new carbon trading bonanza that looms under the cover of cap and trade legislation. And out in the heartland, Monsanto is rewriting the rules of the farm economy under the protection of intellectual property laws that give it greater and greater control over the agricultural economy and farm incomes.

November’s results were not haphazard. Voters have not forgotten or forgiven the Republican sins and profligacy of the Bush years. But that was then and this is now, and Dick Cheney is not on the ballot. But 2010 looms large, and 2012 not long after that, and for all the mocking of the Teaparties, Democrats are skating on thin ice, and there is real anger out there, and disgust and disappointment.

In all likelihood there will be no healthcare bill this year, and that may well be for the better. The Democrat strategy of relying on a narrow, partisan margin was undone in the House when an anti-abortion Democrats upended the political calculus and may leave Democrats to deal with their own internal battles. Then, perhaps, David Plouffe and his associates will look in the mirror. And perhaps they will not like what they see. Barack Obama is not doing well, despite what Plouffe insisted to an incredulous Jon Stewart.

If Barack Obama wants to get reelected, and win votes one more time from the young and independent voters who put him over the top, perhaps it is time he stop playing politics and govern like a president who is willing to lose. Nancy Pelosi and Harry Reid are not doing Obama any favors, and will not win a single young or independent voter to his side next time. Unless he redeems his campaign slogans about changing our politics and demonstrates the courage to do what he promised to do the first time around, Obama will lose anyway, and have nothing to show for it but words.

What are they thinking?

2009-11-01T10:49:00.004-05:00

With the announcements of record Wall Street bonus pools, and rising credit card fees, it is time to sit back and see where we go from here.

In the wake of the near collapse of the US financial sector one year ago, Hank Paulson and Ben Bernanke took extraordinary measures to avert collapse. Turning caution to the wind, they arranged shotgun mergers, decided who would live and who would die, and brought the word trillions into our every day vocabulary. By the time they were done, the landscape of American banking has been transformed. Today, the six banking organizations that received $160 billion between— JP Morgan, Bank of America, Citigroup and Wells Fargo, and the former investment banks Goldman Sachs and Morgan Stanley—are now looking to a future in which they can dominate the financial services landscape.

But perhaps the term financial services is misleading in this context. After all, as bank earnings reports were rolled out for the most recent quarter, and news headlines announced the record bonus pools that the banks were preparing to pay, it became clear that these earnings derived from trading activities, rather than traditional commercial bank lending activities. Before our eyes—and with the full support of the Federal Reserve and the US Treasury—the transformation that we have witnessed is not of the conversion of major investment banks such as Goldman Sachs and Morgan Stanley into commercial banks, but rather of each of these firms into government guaranteed hedge funds.

I readily concede that I am using the term hedge fund loosely. After all, hedge fund is a generic term for a relatively unregulated investment vehicle, that is permitted to invest in a wide range of unregulated derivatives and other investments, and whose returns are dedicated to a limited universe of investors. And certainly, the practices of JP Morgan or Goldman Sachs, who undertake massive proprietary trading activities, run huge derivatives books, and dedicate the preponderance of their earnings to senior employees, should not be lumped into the same category.

But on the other hand, if it walks like a duck…

Today, the commercial banking world is sharply divided. With over eight thousand commercial banks and savings institutions, these six firms hold less than 50% market share. Therefore, by traditional measures of market concentration, they are far from monopolistic. But as individual firms, their size dwarfs their cohorts, even considering that two of them, Goldman and Morgan Stanley are not traditional depository institutions. Together, the six boast total deposits of $2.7 trillion, or an average of $444.8 billion per firm. This compares with an average of $107.2 billion for the next six largest banks, and $76.0 billion for the following six. The fiftieth largest—well within the top 1% among all banks—Associated Bank of Wisconsin, has deposits of $16.4 billion.

At the same time, as JP Morgan and its brethren have increasingly concentrated on derivatives trading, loan securitization, securities underwriting and proprietary trading—and as these activities have contributed disproportionately to profitability—the share of bank assets dedicated to traditional commercial bank lending—the type that is most directly linked to the local economy in towns across the nation—has similarly decreased. Therefore, it is not a stretch to suggest that even as the Federal Reserve and Treasury have concentrated for the past year on addressing the risks to the financial system that largely emanated from the largest firms, these firms have at the same time migrated the farthest from the tradition public mission of the commercial banking industry.

It may be hard in the face of the drumbeat of stories about the banks and their problems and their bonuses to remember that commercial banking is an industry with a specific public mission: To take deposits and make loans. It was in the wake of the Great Depression, that the Glass-Steagall Act was passed to restore confidence in the commercial banking industry. Glass-Steagall forced the separation of commercial banking (lending) and investment banking (trading, underwriting), and created the FDIC to insure the deposits of commercial banks.

Beginning around 1980, the banking industry began a steady assault on Glass-Steagall, as investment banking firms sought access to the large pools of commercial bank deposits and commercial banks sought to expand into trading activities that would allow each type of firm larger profit and bonus opportunities. These efforts finally culminated in the Financial Services Modernization Act of 1999, which finally ended the Glass-Steagall restrictions and allowed the complete merger of investment and commercial banking organizations. However, the 1999 Act left FDIC insurance in place, resulting in the hybrid creature that emerged, able to attract government-insured deposits, and utilize those deposits across a range of lending, securities trading, and newly emerging derivatives trading activities.

Today, the financial policy brain trust of Ben Bernanke, Larry Summers and Tim Geithner have rejected calls for structural reforms to the banking system and to reinstate the Glass-Steagall restrictions. Despite the experience of the past several years, culminating in the financial crisis one year ago, they are suggesting that the concentration of power represented by these six firms is acceptable and desirable, and reform efforts should focus instead on the creation of a single systemic risk regulator to oversee those institutions deemed too big to fail.

Standing alone against Bernanke, Summers and Geithner within the Obama administration is former Fed chairman Paul Volcker. Volcker continues to call for the reinstatement of the Glass-Steagall restrictions, and recognizes the imperative of maintaining the link between deposit insurance and commercial bank lending.

It is hard to imagine what Bernanke, Summers and Geithner are thinking, and how they can look at the devastating experience of the past two years, and not conclude that something is fundamentally wrong. Financial modernization did little to help those thousands of commercial banks who have stuck to their knitting, and who now have been sorely disadvantaged by the federal bailouts of their large competitors. Proponents of financial deregulation argue that Volcker and other advocates for turning back the clock are recalcitrant Luddites, yet they have been hard pressed to demonstrate how the creation of the new class of hybrid commercial-investment banks and unregulated derivatives trading have added value to the economy.

Can Bernanke, Summers and Geithner seriously believe that a systemic risk regulator can control the risks that are embodied in these massive firms? Recent history suggests that the risks entailed in the trading strategies, quantitative models, complex derivatives and contract risks were never fully understood by the risk managers, bank CEOs and directors of their own organizations. Bank regulators were captive of the banks themselves as they sought to understand the information that was provided to them. Capital requirements other traditional tools for containing risk proved to be of only marginal value in the face of derivatives with nearly unlimited leverage, and collateralization requirements buried deep in unregistered and unregulated contracts.

Furthermore, political influence over regulators is a fact of life in Washington, and over time will undermine whatever independent structure these three wise men might have in mind. One need only point to Summers’ own success in 1998 in silencing Brooklsey Born—the head of the independent Commodity Futures Trading Commission—when she argued the inconvenient truth of the growing systemic risks presented by the unregulated derivatives market, at a time when Summers and the Clinton administration were arguing the merits of financial deregulation.

It is mind boggling that we can continue down this road. Paul Volcker must be applauded and supported for his unflagging efforts to bring attention to this issue. He is a wise man standing against smart men. And he is right.

Heads I win. Tails you lose.

2009-10-03T09:28:00.007-04:00

Thirty years ago, Salomon Brothers and Goldman Sachs were two of the “bulge bracket” underwriting firms that dominated Wall Street. Both firms with partnerships with trading cultures that characterized their organizations. It was a time when Wall Street firms were looking far and wide for ways to increase their access to capital. Trading firms make money by making bets. More capital meant bigger bets. Bigger bets meant more money.

In 1980, in pursuit of a bigger balance sheet, Salomon CEO John Gutfreund negotiated the sale of his firm to Philipp Brothers, then the largest commodity trading firm in the world. The sale was not without controversy. Within Salomon, bond traders—led by Salomon family member William Salomon—opposed the sale. How, they asked, would traders be paid what was their due in the event the new firm lost money in other far-flung commodity businesses? As partners, they had a reason to be concerned by over-expansion into business lines that they neither understood nor controlled. They did not yet appreciate the benefits of trading with Other People’s Money.

But the sale of Salomon went through—John Gutfreund pocketed his $30 million bonus—and over the next few years, the new firm, Phibro-Salomon was acquired by Travelers Insurance. Travelers, in turn, was acquired by Citibank, to create the financial supermarket that was supposed to give American banking a global dominance to match the well-capitalized Asian and European counterparts.

The Salomon story was part of the evolution of Wall Street over the past thirty years, as the storied Wall Street firms succumbed to the lure of capital to give up their partnership status and merge into commercial banks and to become publicly traded corporations. And while the Wall Street investment banks did achieve their goals of increasing their access to capital—and ultimately won back their access to the massive pools of depositor money that they lost with the passage of the Glass-Steagall Act in 1933—the cost to the rest of us has been significant.

Where, after all, was William Salomon when Lehman Brothers decided to bet the ranch on collateralized mortgage securities that would ultimately bankrupt the firm. Where was William Salomon when Bear Stearns increased its leverage to thirty times, based on financial models that few in the firm really understood. And where was William Salomon when Joseph Cassano, the head of AIG Financial Products took the insurance giant headlong into the credit default swap business.

There was a moment when Cassano made his case to the AIG Board of Directors. The credit default swap contracts that AIGFP was providing to financial giants such as Goldman Sachs had no risk to AIGFP, argued Cassano, and therefore all of the annual receipts paid to AIGFP under those credit default swap contracts could be taken as current income—and used to pay very large bonuses—rather than held as reserves against future risk. CDS contracts are essentially insurance contracts provided to guarantee against defaults on corporate bonds, but Cassano argued that the bonds were so strong that there was no credit risk, and therefore the money paid to AIGFP was essentially free money.

But there was no William Salomon on the AIG Board of Directors. Unlike the old Wall Street partnerships, directors of corporations are largely insulated from the financial consequences of their decisions. Had AIG been a partnership like the old Salomon Brothers, a William Salomon would likely have asked the logical question of Joseph Cassano:

Goldman Sachs is paying us tens of millions of dollars a year, but you are telling us there is zero risk. One of us is wrong. This is a game of poker, and there is an idiot at the table. And you are telling me that Goldman Sachs is the idiot? I don’t think so. I think we are the idiots at this table. If Goldman Sachs is paying us tens of millions of dollars a year, we are taking risk, and we sure better know what that risk is, because we are betting our future on it.

But, of course, AIG was not a partnership, and the rest is history.

But the Phibro-Salomon story had one chapter left. This summer, Citibank—the failed financial supermarket that is now a ward of the State—sought approval from the US Treasury to pay bonuses in order to keep a group of highly profitable traders from leaving the bank. The bonuses—the most famous being the $100 million for Andrew Hall—were to be for traders in its Phibro commodity trading subsidiary.

William Salomon saw the writing on the wall. The partnership trading culture that was critical to Salomon Brothers success—a culture that combined incentives and accountability—would not survive an evolution into a corporate model. What we have learned is that the incentives to make big bets and take big risks has survived, but without the accountability. Andrew Hall made $2 billion for Citigroup placing energy bets, and was due to be paid $100 million. But what of those whose bets lost Citigroup $2 billion? They have not even lost their jobs.

The trading firms gained the access to the capital that they sought in the 1980s, and they found the joy of playing with Other People’s Money. And for twenty years, the game has gone on.

Heads I win, tails you lose. Or in David Einhorn's more elegant formulation, Private Profits, Socialized Risk.

Today, the US Treasury and the Fed are trying to hold the pieces together. AIG. Citi. Bank of America. GMAC. Fannie Mae. CIT Financial. But why? Where is the evidence that large financial corporations are more efficient at allocating capital than smaller banks? Surely, they have not been sound custodians of depositor funds or of the public trust. Neither have they proven they can deliver more predictable returns on shareholder equity than smaller, more nimble financial institutions, who themselves are increasingly disadvantaged by each bailout. Whose interest has conglomeration served but that of insiders seeking greater compensation with less risk?

One central question to all of this is whether the fundamental corporate model is not central to the problem. Today, absent prosecution for fraud, the CEOs and directors of all of these failed firms will walk away with much of their wealth intact, insulated from the consequences of the decisions they made. For years now, they have been playing with our money.

New regulatory regimes will not be adequate to control this systemic risk. Controlling banker compensation might have a populist appeal, but no one should imagine it constitutes systemic reform. Regulatory bureaucracies cannot control systemic risk in massive financial corporations, because the systemic risk is the massive financial corporation.

Thirty years ago. William Salomon was suggesting a simple truth: Sound decision-making, incentives and accountability require that those who are making decisions and placing bets have their own capital at risk.

They're back.

2009-09-27T08:45:00.002-04:00

It is not clear how foreign policy strategy is being set in the Obama administration. But the execution has the appearances of a well-considered and orchestrated dance. And when the music stopped this week, standing together on the stage, united in common purpose, were the Big Four of wars gone by—the U.S., Great Britain, France and Russia.

The surprise this week was not the disclosure of a second, secret Iranian uranium enrichment site. Nor the ensuing condemnation and threats of collective action. What was surprising was the distinct voices that were heard. It was French President Sarkozy and British Prime Minister Brown whose declarations were strongest, with Russian President Medvedev joining shortly thereafter. Finally, an American President was able to speak a bit more softly—and by the demonstration of common purpose suggest a bit more stick on behalf of the international community.

For the first time in a while, Iranian President Ahmadinejad seemed caught off guard. His normal swagger was muted, perhaps with the realization that his days of manipulating Russia against the West have ended. More perhaps with cold fear that it was he that was manipulated by Russia, and that his miscalculations may weaken him considerably in his battles to retain power at home.

Perhaps American foreign policy is coalescing around some basic realities of the world. There are real threats out there, and we do not have the capacity to fight them alone. The unilateralism of the past decade was defined less by our determination to go it alone into war than by the belief that we could fight all battles and recast all nations in our own image. Almost without exception—perhaps China, as our lead banker, was the exception—we demanded fealty to our image of democratic progress from all of our antagonists.

But when you are fighting on all fronts, your ability to build enduring coalitions on any one of them is diminished. Russian Foreign Minister Sergey Lavrov has long articulated this view. Yes, as he has suggested for the better part of a decade, Russia and the United States have more issues that unite them than divide them. And yes, when presented with the top five issues of concern facing the U.S. in the international arena—perhaps including among them Afghanistan, Iran, Iraq, Islamic fundamentalism, drug trafficking, nuclear proliferation—Russia was a potentially valuable ally in all of them.

But the problem was that Russia had their own top five list, and Lavrov has long complained that if there was to be a partnership, it could not be one-sided. Russia’s concerns had to matter as well. Yes, Russia was prepared to be an ally in the Global War on Terror, but the Russian list had to be on the table. And they had a different list. Chechnya. Georgia. NATO. Missile defense. Encirclement. Status.

Russia’s list was fundamental to the continued integrity of the Russian nation. Russians may be paranoid, but the simple fact is that people are out to get them. U.S. official policy has been and continues to be one of encirclement, while many prominent voices go well beyond that—most notably Carter-era National Security Advisor Zbigniew Brzezinski—and argue that U.S. policy should be the dismemberment of the Russian state.

The dismemberment of the Russian state is not so far fetched. Before the fall of the Soviet empire, the Soviet Union claimed a population of nearly 300 million people. Today, Russia is a nation of just over 140 million, and it is shrinking rapidly. With low birth rates, high infant mortality, short life expectancy, and minimal immigration, by mid-century Russia’s population is projected to decline by more than 20%, to approximately 110 million.

The prospect of Chechen independence—and the demands for independence that would likely ensue from other minority groups should Chechnya succeed—further threatened the future of Russia. This fear explained in large measure Russia’s vociferous objection to NATO’s declaration of independence for Kosovo, and Russia’s steadfast claim that the international community can only grant nationhood through the legal powers granted to the United Nations.

Russia’s intransigence in dealings with the United States is rooted in its defense of national self-interest. For several years, Putin and Medvedev have been intent in their actions in international affairs—from supporting Iran to instigating the Ukrainian natural gas crisis—to force the United States to deal with them and their issues.

U.S. actions over the past nine months indicate that U.S. policy has evolved, and that we may finally be paying attention. The nuance is the distinction between what we say and what we do. The Bush administration talked about partnership and an alignment of interests, but took every opportunity to dismiss Russian concerns on the ground.

Now, the process seems to have been inverted. Vice President Biden—an early and vociferous backer of the Kosovo action that was so objectionable to Russia—has emerged as the voice of American support for the process of democratization and continued support for Ukraine and Georgia.

But Putin and Medvedev are realists, less moved by words than action. At the same time as Biden was talking the talk, the administration was walking a different path. During the early months of the administration, Russia threatened U.S. resupply routes into Afghanistan, and U.S. access to a key air base in Kyrgyzstan. One can imagine at that moment that the administration looked down the road at the real threats that loomed, and took a hard look at the facts on the ground. One can imagine that at that moment, they weighed the real impact on the ability of the U.S. to pursue its strategic goals and determined that Russia was—as Lavrov long suggested—better to have as an ally than face as an obstacle and an adversary.

It really was never a question. After all, for all the rhetoric—whether from Biden, Bush or Cheney—about U.S. support for Georgia or a common defense of Ukraine—neither we nor our European allies have had or likely would ever have the willingness to go to war with Russia in their Near Abroad. Our actions may have been designed to tweak them and continue the great game wherever possible—but never with the intention of real escalation.

One question this week has been how long ago did the U.S. learn of Iran’s second enrichment facility. Was it many months ago, and were the strategic moves to bring ourselves closer to an effective alliance with Russia—such as shifting our policy on strategic missile defense in Poland—in preparation for this next phase of the confrontation with the Iranian regime? Or was it simply fortuitous that the steps had been taken, and the groundwork had been laid that would allow Russia and the U.S. to stand together against a common threat?

Perhaps it doesn’t matter. But it does matter that our foreign policy may be built less on rhetoric, and more on our capacity to build effective alliances against real, and common, threats.

The grand illusion.

2009-09-13T09:54:00.010-04:00

Most of us have lived through, or will live through, the painful years of watching our parents’ health decline. Behind the ugly partisan rancor of the town halls and the healthcare debates is the simple truth of that common experience.

Whether our parents have cancer or Alzheimer’s or dementia, or are simply dying of old age, we watch as their bodies become frail and their minds fade. These are our parents, once our providers and protectors, sapped of the energy and vitality that we for so long took for granted.

The medical bills. The residential communities. The in-home care. The drugs. They drain our parents’ savings and ultimately strain our family resources. We may have thought that Medicare would suffice, until one day a bill arrives from a rehab facility or a hospital, or a new drug is prescribed. From that day, the emotional pain of end of life care is compounded by the financial strains that bleed outward, undermining sibling comity, and threatening the resources set aside for kids' education, for family vacations, or for retirement.

There is no easy solution to this. We are all living longer, and the advances of technology and science now offer us the ability to fend off diseases that years ago barely existed—largely because we used to die younger and never contracted them. As a close friend put it—a Jesuit priest with a way with words—the longer any machine works, the more the maintenance costs go up.

People like to compare Medicare with Social Security, but the challenges facing Social Security are manageable by comparison. When Franklin Roosevelt created Social Security in 1935, it was a stroke of political—if not financial—genius. Social Security offered retirement security at age 65 to American workers whose average mortality at the time was 59. Therefore, it offered an entitlement to people who—on average—would be dead before they were eligible.

But even with longer lifespans, Social Security is a controllable and predictable program. The mortality curve shifts slowly and we can—at the end of the day—choose to change the parameters of the program that affect cost: the retirement age, the cost of living adjustments, the basis of pay, and the basis of taxation.

Healthcare has no such certainties. Unlike information technology, which offers greater and greater power at less and less cost, investments in healthcare technology and pharmacology that increase longevity and cure rare diseases may be moral victories for humanity but only exacerbate the financial strain on society and families. This is the dilemma of healthcare: The better we get at it, the faster the costs will escalate.

Dr. Andrew Weil, and many others, have pointed out that the solution to our healthcare crisis lies in how we choose to live our lives, and ultimately how we choose to die. In a similar vein, Atul Gawande suggests that the solutions to the cost and quality of healthcare lie in large part in the choices and conduct of the providers themselves. If physicians turn the practice of healthcare into an exercise in profit maximization, they will do better as individuals, but their patients and the system itself will suffer.

But as in most areas of life, good choices and ethical practices cannot be compelled or overseen by government. Regulatory regimes can enforce measurable practices—such as the concentration of melamine in dog food, or rat hairs in cola. But the federal government has no capacity to regulate the quality of collaboration among and conduct of individual medical practitioners.

The person who cried out at one town hall meeting to not let the government get its hands on Medicare has been duly castigated for the irony and ignorance of the remark. But at a deeper level, the remark encapsulates the problem we face.

Medicare is a government program. While many proponents of single payer healthcare point to Medicare as a model, it is a program that pays providers far less than the cost of services, and therefore results in substantial cost-shifting that exacerbates the medical insurance costs paid across the rest of society.

But Medicare is the lifeline of the elderly, and of the families of the elderly. That person may want to believe that Medicare exists above and apart from government, but of course it does not. Each Medicare patient—and their families—are relying on Other People's Money for their care, but they feel entitled to have it with few strings attached nonetheless. But the truth is that it is one more tax-funded program. Just like the stimulus money. Just like the wars. Just like everything else.

Medicare is our cushion. It insulates us from painful decisions that otherwise would be ours. But it is an illusion.

The fear and rage evinced by the person at the town hall presages the pain to come as that illusion is laid bare. If Medicare is Other People’s Money, then those other people are surely entitled to set the rules. But even worse is the realization of what would happen if it were not there. Without Medicare, we would have to be paying those costs for our parents’ end of life care ourselves.

Based on Dartmouth research data, per patient Medicare costs for the last two years of life range from approximately $50,000 to $100,000 across the country. And this is just the part paid by Medicare, which as we all learn is only part of the puzzle. These costs stand in stark contrast to the Federal Reserve data on household finances, that indicate that the median family net worth has fallen from $120,000 in 2007 to $99,000 as of October of last year. It is not a stretch, therefore, to suggest that we are spending with other people's money far more than we could spend if it was our own.

The person who cried out at the town meeting may have been voicing a fear we all hold deep inside. What if it is all an illusion? What if Medicare is not an impenetrable wall that protects us from those decisions that are most painful?

For many years we have accepted the illusion and comfort that Medicare offers. Spending Other People's Money has changed the decisions that we make, and our assumptions and expectations about the care our loved ones receive. We now clamor to rest assured that they will receive all of the care a physician might recommend—with little consideration of the cost to the system of which we are a part.

But federal government resources are no more than the pooling of our collective family resources. In the end, we will return to the questions that for many years we have been able to avoid. How would we choose what steps to take—and what procedures to forego—if it was our limited family resources that would be drained away by each of our decisions? And what choices would our parents make if they understood the magnitude of the impact of each decision on their children and grandchildren?

The question of how we are going to spend scarce resources is with us. We confront it around the kitchen table, and it is time that we accept that it is the central question of healthcare challenge. It is the question that will consume our politics in the years ahead, because the years of free money and free choices have come to an end.

The specter.

2009-09-10T11:31:00.007-04:00

A specter is haunting America—the specter of debt.

Birthed in the dying years of the Cold War, the American polity lost its way. Public policy, as encapsulated in the Federal budget, was always about making hard choices among competing priorities and constituencies. The notion that resources were limited was a critical discipline, and the ability to navigate the process of allocating resources was the stuff of which Congressional leaders were made. Throwing arrows is easy. Building a budget in a democracy is hard stuff.

Traditionally, Democrats were the party that believed in spending more—and taxing more, while Republicans once were the grownups of the American political system, sternly cautioning against the political urges toward deficit spending and international adventurism.

But the world changed over the last quarter century. Faced with the realities of survival in a competitive world economy—and the exigencies of political fundraising—Democrats brought corporate America inside their tent and muted their hostility to the private sector. For their part, since George H.W. Bush uttered the words Voodoo Economics in his failed efforts to derail the Reagan Revolution, the unholy alliance of tax cutting Republicans and big spending Republicans marked the death knell of that party’s claim to the moral high ground in matters of fiscal propriety, while Neo-conservatives brought to the GOP an evangelical fervor to change the world that was once a Democratic credo.

The numbers are stark. Over the past twenty-five years, Democrats and Republicans alike forswore their allegiance to the central responsibility of elected legislators to make choices, balance priorities and pass budgets with integrity. Perhaps they were not to blame, after all East Asian countries led by China continued to fund our deficits by buying our bonds and offered cheap money as an alternative to the more painful options of cutting spending or raising revenues. These foreign purchases of our debt were not an act of faith in the almighty dollar as much as a simple expedient of the export-driven model of economic development that has become the norm across the world.

Over the past quarter century, China, the Asian Tigers of South Korea, Hong Kong, Taiwan and Singapore, and more recent converts such as Vietnam, pursued a successful economic development strategy built on selling manufactured goods into the U.S. consumer market. As these countries took in massive amounts of dollars, they faced two options: They could recycle those dollars back into the U.S. or watch the value of the dollar decline and their own currencies rise. There really was no choice, as the export-driven development model that was lifting the Asian nations out of poverty required that their currencies not rise in value relative to the dollar, so that their low-cost goods remained attractive in the U.S. market. Accordingly, U.S. Treasury securities became the preferred investment for Asian trade-surplus dollars, and our financial markets become flush with that kept long-term interest rates low.

What was lost in the orgy of low cost debt that ultimately engendered the securitization boom in credit card and home equity lending—and enabled growing deficit spending at the federal level—was that the American economy, like the American household, was living on a chimera of growth that belied the underlying damage that was being done to our economy.

As the table here illustrates, over the past twenty-five years, our economic growth has increasingly been driven by imported capital. In the same way that the average American household saw no real income growth during the past decade, but increased their spending through borrowing, so too the national GDP was flat, but for the growth realized through externally borrowed dollars.

Today, we are faced with stark choices. But if the healthcare debate is any measure, it is evident that our political establishment has lost much of its capacity for honest debate and real decision-making. Twenty-five years of free money and no discipline has made a mockery of the federal budget process, as we now are accustomed to avoiding choices and accepting the false notion that there are obligations that are non-negotiable.

For two decades now, we have become accustomed to justifying any manner of spending, from education to tax cuts, as an investment in our future. This rationale is a direct outgrowth of the availability of low-cost capital that has itself undermined the ability to weigh and make choices. This has undermined as well the notion of a national consensus on foreign policy, as we now go to war with little regard for the financial cost. With no fiscal consequences and no universal service, war has become a sideshow of American political life.

Today, the generation-old paradigm may well be shifting. It is with no small amount of irony that even as our Republican and Democratic representatives have lost anything but a rhetorical commitment to the traditions of responsible budget policy, it is the Chinese Communist Party—the largest holder of our debt and the most at risk for the consequences of a devalued dollar—that is becoming insistent that we pay attention to our cascading fiscal mess.

Surely, as the source of the free capital to which we have become addicted, the Chinese have little more standing to scold us than the crack dealer who declares to the destitute customer that it is time to stop. The true dividend to the Chinese is not the return on their investments, but rather the economic growth that has lifted the livelihood of hundreds of millions of Chinese out of poverty over the past two decades—paid for graciously by the American factory workers whose livelihoods were lost.

But ironies aside, we have to listen. A new economic model could be beneficial to us—over the longer-term. Increased domestic savings and a declining dollar in the short-term could make overseas manufacturing less competitive, and allow America to begin building things again. But the near-term pain will continue for some time, as the process of paying down the debts that we have accumulated will take years. And we have become a very impatient nation.

The problem, however, is not our ability to listen. The problem is that after twenty-five years, the very skills required to build a federal budget that faces up to real facts, weighs priorities and makes real choices, may be gone from our political DNA. The Death Panel debate, while fraudulent on its face, offered the first inkling of the challenges to come when capital becomes scarce once again, and we are confronted with competing priorities for limited budget dollars.

The truth is that there is a Death Panel, that is charged to sit and decide how limited resources should be allocated. To weigh the needs of the elderly against the needs of the young, the costs of healthcare against the costs of war. But it is not the faceless panel of bureaucrats of Sarah Palin's imagination. It is Congress. It is time they get used to it.

The greening of Goldman Sachs.

2009-07-15T17:47:00.002-04:00

The US economic turnaround may not be complete. The AIG turnaround may not be complete. The GM turnaround may not be complete. But Goldman Sachs is back.

“A Swift Return to Lofty Profits” proclaimed in the New York Times, as Goldman Sachs reported that it earned $3.44 billion in the second quarter, and is preparing its largest bonus payout in history. And without doubt, those lofty bonuses are well earned.

Consider how effectively Goldman has navigated the roiling waters of the global financial crisis. First, Goldman received a $10 billion injection of TARP funds to help it weather the market turmoil. Next, it swiftly converted itself into a commercial bank and member of the Federal Reserve system, gaining access to low or zero cost capital at the Fed Discount window and access to federally guaranteed borrowing through the FDIC Temporary Liquidity Guaranty Program. Finally, it garnered a $13 billion payout at one hundred cents on the dollar for its outstanding credit default swap contracts with AIG.

Now, we are told, Goldman’s profitability stems from its trading prowess in global markets. Really? A $3.44 billion profit in the second quarter could be accounted for simply by a 25% run-up in the value of the CDS portfolio from its value when AIG stood as a bankrupt counterparty.

No, Goldman may have trading prowess, but that pales against its political prowess.

Thirty years ago, most of the major Wall Street investment banks were partnerships, and those with the greatest prestige and market power—Salomon Brothers, Goldman Sachs, Lehman Brothers and Morgan Stanley—eschewed retail brokerage in favor of institutional relationships and proprietary trading. Only Merrill Lynch prided itself on retail brokerage and being a member of the New York Stock Exchange.

Then, the world changed, as investment banking firms looked far and wide for new ways to strengthen their balance sheets and access new pools of capital. One by one, the old-line partnerships fell by the wayside, casting aside their culture and independence for the lure of other people’s money. Salomon merged first with Phibro, and then was subsumed into the emerging Citibank colossus. Lehman was acquired by American Express. Morgan Stanley suffered the ignominy of merging into the Sears Roebuck/Dean Witter/Discover financial services company.

Only Goldman Sachs retained its culture and identity, even though it too tossed aside its partnership heritage in exchange for the lucre and capital offered through a public stock offering.

As one watches the evolution of Goldman, it is hard not to become a conspiracy theorist. After all, Goldman’s rise from merely the top of the heap into the stratosphere has come after years of growing influence in Washington as one Goldman partner after another were appointed to senior positions in the Cabinet or White House—John Whitehead, Robert Rubin, Josh Bolten, Hank Paulson, to name a few—and tens of millions of dollars of political contributions found their way from Goldman Sachs into the campaign war chests of members of Congress, of Senators and Presidents, Democrats and Republicans alike.

Perhaps the public interest and the private interest just happened to coincide with the passage of the Financial Services Modernization Act in 1999 and the Commodity Futures Modernization Act of 2000. Perhaps the conversion of Goldman Sachs—a non-depositary institution—into a commercial bank, with access to Fed Funds and the Discount window, and eligible for FDIC guarantees on its debt offerings was in the public interest. And perhaps the public interest was somehow served when Goldman and others jumped to the front of the line of AIG creditors and were made whole on their credit default swap contracts with a bankrupt counterparty.

Perhaps. But we must conclude—because we believe in truth, justice and the American way—that Robert Rubin, Josh Bolten and Hank Paulson influenced and guided public policy in ways that was truly in the public interest, and that there was no nefarious connection between all of those campaign dollars and the direction of our national policy in any manner that unduly benefitted Goldman Sachs over the years.

Perhaps. But this year, appearances matter. And this is the year that has seen $10 billion of TARP money and $13 billion of AIG money and who knows what amount of additional Federal Reserve funds or federal guarantee benefits flow into the coffers of Goldman Sachs.

So perhaps, this year, Goldman Sachs employees should be content with the tripling in value of their stock—surely a direct result of all of the financial largesse that has flowed Goldman’s way—and perhaps this is a year when $3.44 billion of Goldman Sachs profits should not turn into bonuses, without due consideration for how all of that was possible, and where that money came from.

From the rest of us.

After the fall.

2009-07-11T13:25:00.006-04:00

We have yet to see what the Iranian regime will be prepared to do in the face of real opposition. After all, the leaders of the opposition questioning the election results—Mir Hussein Mousavi, Mehdi Karroubi and Hashemi Rafsanjani, and others who have emerged as fellow travelers, including Ali Larijani and Mohammad Khatami—are each deeply routed in the Islamic revolution, and each served as either the leader of the parliament or the President of the Islamic republic.

More to the point, each rose to the top of Iran’s tightly controlled political apparatus, gaining personal power through a political system that excludes ex ante any candidate deemed to be a threat to the ruling regime. Therefore, one can fairly wonder why the Supreme Leader Ali Khamenei jumped the gun in declaring a winner, since the system was rigged before the vote. But apparently that was not enough.

Here in the realm of the Great Satan, we tend to view things through our own eyes. So before Michael Jackson, Mark Sanford and Sarah Palin drove Iran from our TV screens, we were fixated on the images of street protests in the wake of the Iranian election. For us, in Iran––as in Florida––the question was, “Who really won the vote.”

But as the images of Tehran have faded, debates over who won have given way to a clear understanding that the integrity of the election in Iran is not the measure of democracy there. At the same time, the Iranian regime is coming to realize that the integrity of the election, or lack thereof—whether perceived or real—may be its undoing.

From the moment the polls closed, when Supreme Leader Ayatollah Ali Khamenei declared the victory of President Ahmadinejad a “divine assessment,” Khamenei undercut his own credibility as a dispassionate ruler committed to the integrity of the electoral process. While Iranians may have come to accept limitations on what candidates are allowed on the ballot, fundamental Shia principles of fairness and justice demand that the integrity of the process be respected.

Instead of showing patience and respecting the process, Khamenei undermined his own credibility. But more important, he opened the door for the narrative that soon emerged: Those who questioned the results were guilty of apostasy. And in Islam, apostasy is a mortal sin, and such accusations have justified the most extreme incidents of Islamist violence.

Today, even though the demonstrations in the streets have disappeared from cable news, the debate in Iran has been elevated from vote counting and ballots to treason and apostasy. It doesn’t get much clearer than that.

The issue is no longer about the election results. The issue now is about the core principal of the Islamic Revolution—velayat-e faqih—that Islamic law requires that power over civil society must lie with the clerical order of Islamic jurists.

This debate is deeply rooted in the Islamic Revolution of 1979. At the time of the Revolution, Ayatollah Khomeini was the most vocal proponent among the senior Shia clerics of velayat-e faqih, while he was opposed at the time by his peer and rival Ayatollah Abul-Qassim Khoi, who disagreed with that interpretation of Islamic law, and dissented from the urge to assert clerical dominion over civil society. While Khomeini won the day and dominated the revolution against the Shah of Iran, velayat-e faqih has never been accepted across the senior Shia clerical order as settled law.

The debate over velayat-e faqih has reemerged as the central issue in Iran. Today, even as the Revolutionary Guard—the Praetorian Guard founded by Ayatollah Khomeini in 1979 to defend the clerical regime—is asserting its control over the streets of Tehran, Supreme Leader Ayatollah Ali Khamanei’s impatience in handling the election may ultimately cost the regime its legitimacy.

A central figure in the debate over velayat-e faqih will be the leading protégé of Ayatollah Khoi, Ayatollah Ali Sistani, the Iranian cleric who is demonstrating the principals of his mentor in his patient oversight of civil society and the emerging democracy in Iraq. For Iranians in the streets, as well as clerics in the holy city of Qom, Sistani is among the most revered religious figures, and a cleric of greater authority and stature than Ali Khamenei himself.

The irony is that none of the leading actors the Iranian drama, Mousavi, Karroubi, Rafsanjani, Larijani or Khatami have identified themselves with Sistani or opposition to the existing order of clerical dominion over civil society. They are each products of the existing system. And yet the principle of velayat-e faqih is what is at stake and will emerge as the issue at hand.

The prospect of change—counterrevolution by any reasonable definition—in Iran poses real dangers, as any evolution to a more open democratic process and easing of clerical dominance will yet face many hurdles, and may take many years. As Ali Khamenei loses stature due to his mishandling of the post-election period, the winner over the near term may well be President Mahmoud Ahmadinejad, whose ties to the Revolutionary Guard may allow him to assert greater power in Tehran, even as religious and legal arguments are debated in Qom. How the those debates play out in Qom may determine the long-term direction of the Iranian revolution, but how control over the Revolutionary Guard and the military evolves will likely determine whether the opposing camps in the post-election era reach a near-term accommodation, or Iran devolves instead toward a traditional dictatorship.

All in.

2009-03-01T13:34:00.007-05:00

Even as the Obama administration may be consumed by efforts to stem the depth and duration of the recession, we appear to be at a tipping point in foreign affairs that can lead to positive new directions or a new downward spiral in regional conflicts.

The opportunities at hand are complex and interconnected. And unlike the high stakes, three-hand game among Russia, China and the United States of the Nixon era, which subsumed all of the smaller countries into bit roles, the diplomatic world today involves a wide range of actors, each of whom has real interests, has signaled their readiness to play, and can each affect the potential outcomes for the others.

The historical background is important in several regards. First, the global economic collapse has illustrated the interdependence of national economies, while at the same time demonstrated the risks to individual states that flow from that interdependence. Accordingly, many national leaders find themselves at a point where they have to choose—both as a matter of policy and politics—whether they are in or out, whether they accept the rules of globalization, free trade, and interdependence, or whether they will opt for a return to economic protectionism and political self-preservation.

Second, the election of Barack Obama signaled the end of the Neoconservative era in US policy, and portends a renaissance of realism in foreign affairs and diplomacy based on national self-interest. As much as war might be the proven solution to depressions past, Americans have grown weary and cynical over calls to arms and regime change over every looming international confrontation, and the rest of the world seems ready to embrace new directions as well.

Russia, for one, has been pushing for an alignment of interests since Vladimir Putin first called George Bush to pledge Russia’s support after the 9/11 attacks. Putin sought—but ultimately failed—to build a new strategic relationship with the US around a number of specific areas of common interest—stemming the Jihadist threat emerging in Chechnya and Muslim former Soviet republics, defeating the Taliban, controlling Iran’s nuclear ambitions, and controlling drug trafficking—for which Russia could leverage the reinstatement of the Bush ‘41 and Clinton-era US commitments to curtail NATO expansion toward Russia.

Now, after several years of declining relations, and with the ruble in free-fall, Putin is signaling a desire to try again. After years of trying to swing a big stick to get our attention—cutting off natural gas supplies to Ukraine and Europe, sending arms to Iran and Venezuela, and sending tanks into Georgia—Russia is trying a bit of carrot—opening its territory for the US to resupply its troops in Afghanistan and delaying the deployment of missiles in Kaliningrad.

Iran, meanwhile, is looking to get into the carrot and stick game. Like Russia, Iran grates at being disrespected and has sought out strategies that might force the US to bargain on equal terms. Certainly, as President Obama announced his plans for withdrawing from Iraq, it was not lost on many that Iran—almost single-handedly—can determine whether those plans can succeed.

Iran has much to offer—enabling an exit from Iraq, moderating the role and conduct of Hezbollah, and, of course addressing the nuclear issue—and has much to gain—recognition of its role as a regional power, reducing the threat of American troops on both its eastern and western boarders, fears of being frozen out in a US-Russian rapproachment, and an end to American threats of regime change.

Like Russia, Iran’s economy is in shambles, and the June presidential election looms to be a critical moment. The entrance of former president Mohammad Khatami into the presidential race in early February may signal that Iranian Supreme Leader, Ayatollah Khamenei is willing to move toward a moderation of Iran’s hard line direction and rhetoric, embodied in current president Mahmoud Ahmadinejad, and substantively address the concerns of the international community.

Syria, another long-time target of US regime change, also needs to demonstrate its bona fides at this moment of political change. Just as Russia reached out to Syria over the past several years to demonstrate its continuing ability to stir the always-simmering Middle East pot, Syria can on its own significantly influence the next trajectory in the politics of the Middle East.

Like Iran, Syria controls one long border with Iraq, and can influence the outcome of President Obama’s exit strategy. Similarly, as the home of the Hamas political leadership, and as the long-time suzerain of Lebanon, the Syrian intelligence apparatus can directly control the direction and temperature of the Palestinian-Israeli conflict. Like others, Syria has its interests—in territory and regime survival—for which it will play its cards.

Achieving our foreign policy goals requires that each of these key nations change their approach to us and to others. We have tried threats of regime change and war, and we are broke and tired. Ironically, however, this has led to a moment of opportunity where each country may be motivated to move in a new and positive direction.

For Russia, Iran and Syria, this is a moment of opportunity. Their leaders, Putin, Khamenei and Assad, are rational and cunning adversaries. Each has demonstrated the ability to work with us when it served they and their country’s interests, or to resist our threats and recriminations when it did not. Each of them has a hand to play, and yet each knows that they risk being left behind if they fail to seize the moment.

For Barack Obama, as well, this is a moment of opportunity. But as he has suggested when speaking of the economic challenges we face, in the world of foreign policy, our major challenges are interconnected. He cannot put any aside for another day.

Iraq. Afghanistan. Iran. Pakistan. Al Qaeda. Israel-Palestine. Lebanon. Energy. Venezuela. For each of these, Russia, Iran and Syria—in one combination or another—can be the fulcrum for success or failure.

This is the President’s moment.

Reality bites.

2009-03-01T00:19:00.009-05:00

This Sunday, the New York Times asked a panel of economists, “When Will the Recession Be Over?” A few panelists offered hopeful words, ‘Perhaps later this year… if there are no more surprises.’ The eternally pessimistic Nuriel Roubini suggested three years… or more. One sage observer offered the wisdom of bubbles past: You don’t reach the bottom until people stop asking.

We are having a hard time accepting that recovery will take time. Leveraging, or getting into debt, is a lot of fun. For twenty years or so, as interest rates declined and lending standards loosened, America went on a debt-funded spending spree. Across the country, as housing prices rose and the home-equity lending came into vogue, Americans used their access to money to live beyond their current incomes, creating an illusion of prosperity and growth.

Deleveraging, on the other hand, is not fun. It ultimately requires reducing debt. Actually getting rid of it. For American households—whose real incomes have been flat for a decade or more—it means returning to the standard of living that they could afford before the borrowing spree started, adjusted further downward to allow them to pay off the debts they accumulated during the boom years.

So far, our public policy responses to the housing collapse and banking crisis have largely amounted to various strategies for shifting the debt burden around. In the name of stability, the TARP program socializes the losses from our financial sector. Now, in a similar vein, we are proposing to tackle the problem of home foreclosures. But unlike the TARP program that puts the bank losses on the broad shoulders of the Federal government, the strategies to boost the housing market will shift the losses experienced by current homeowner onto the next generation of homebuyers.

Consider this. In 1981, the median home price was $62,000, and the annual cost of funding the purchase of that home at the then-current 16.6% mortgage rates, and with a 20% down payment, was $8,900 per year. $8,900 was 47% of the median family income at the time of $19,000, indicating that the median priced home was not affordable for most families.

As interest rates declined through the 1980s and 90s, home prices escalated as affordability increased. By 1998, the cost of carrying an 80% mortgage on a $128,400, median priced home dipped to $8,228, or just 21% of the 1998 median family income.

By 2007, median home prices increased a further 70% to $217,800. 30-year mortgage rates only dip another 1% or so, but home priced increases were aided by the advent of all sorts of “creative” mortgages, that continued to reduce buyer monthly payments.

For more than two decades, the growth in home prices was made possible by the long-term decline in mortgage interest rates, and at the late stage of the bubble by interest only, variable rate, and teaser-rate mortgages. Despite all hopes for a revival of the real estate market, and particularly a new period of growth in home prices, this is not likely to happen.

Current Federal strategies to re-stimulate the housing market to address the foreclosure problem are ill-advised. Over the past several months, the Federal Reserve has initiated efforts to push long-term mortgage rates down toward 4.5% by purchasing mortgage-backed securities. In addition, the newly enacted stimulus package included an $8,000 first-time homebuyers tax credit.

The problem with these efforts is that they will not fix the fundamental problem, but instead will simply push the problem—the loss of home equity—onto the next generation of homebuyers.

Consider this example. Take the median US home that was worth $220,000 during the years 2005 to 2007, but which might be worth $180,000 today, reflecting a loss in value of nearly 20%. This reduced home price, with a market-rate, 6% mortgage and 80% down, would cost the new owner around $10,500 annually. However, with a 4.5% mortgage rate and the $8,000 tax credit, this new owner can afford to pay $215,000, and still owe only $10,500 annually.

This is the same game that we have watched for the better part of two decades. The buyer—who has been taught to focus on the monthly payment as the measure of “affordability”—is willing to pay the higher price for a home because of the availability of low-cost financing. The seller is happy, because they receive close to the 2005-2007 price of their home. For two decades, this logic worked, because interest rates were continuing to drop and home prices were continuing to rise.

But the situation today is different, creating two very real problems. First, these policies constitute deliberate inducements to entice homebuyers to pay over-market prices for homes, as a matter of public policy. It is reasonable to expect that once the Federal actions that induced the purchase are ceased––the artificially low mortgage rates and the tax credit—the market price of the home the buyer purchased for $215,000 in the example above will fall back to its current value of $180,000.

Therefore, the impact of these policies will be to benefit—or “bail out”—the current homeowners who are facing substantial losses, by passing those losses on to the new homebuyers.

Second, and equally important, new homebuyers should be on notice that the “great deals” that they might see in the real estate market today are only great in comparison to prices at the high point of the real estate bubble. The implied suggestion is that once the current mess is behind us, home prices will continue to rise once again. But that is not likely to be the case.

There are two simple reasons for this. First, tightened rules governing mortgage banking will end the lending practices that artificially lowered the carrying costs of purchasing a home and supported the run-up in home prices. Traditional conforming mortgages with real down payments and more conservative underwriting standards will once again tie home affordability to household incomes and long-term mortgage costs.

Second, long-term mortgage rates are more likely to rise than fall, once the Federal Reserve Bank curtails its market intervention to suppress mortgage rates, and particularly if Congressional action allows judicial rewriting of mortgage contracts, which will undermine the security of—and therefore increase the cost of—mortgage loans.

Many will argue that since we have chosen to bail out the banks, it is only fair that we bail out homeowners. That is a fair argument, and one that Hank Paulson and Ben Bernanke and Congress should have considered before we began our long walk down this path.

But Federal actions to artificially boost home values will not socialize the losses in home values, but instead will literally pass one family’s loss on to the next. Like the TARP program, the fundamental problem is that the losses are real, and try as we might to shift them around to avoid the pain, they will not go away.

Learn from Google. Make the federal budget free.

2009-02-26T17:59:00.007-05:00

Why tax people?

Really. We now know that no one likes paying taxes. The presumption was that Democrats liked taxes and that Republicans were opposed to them. But clearly that hypothesis was proven wrong. First, when the man who now sits atop the IRS, Tim Geithner, was nominated to be Treasury Secretary, it turned out that he preferred to not pay taxes.

But that failed to prove the point, as for many it was unclear whether Geithner was actually a Democrat. But Tom Daschle turned the trick. It finally was clear that Democrats, like Republicans, do not like to pay taxes.

Back in the day, taxes were not the issue. Spending was the issue. Back then, when everyone presumed that balancing budgets were among the sole tasks that our members of Congress were charged to perform––that and trashing the UN––Republicans liked to spend less and tax less. Democrats liked to spend more… and were somewhat agnostic on taxes. It was not that they liked taxes per se, but they were a necessary step to get to spend more.

Then Ronald Reagan changed everything, and all assumptions were cast to the wind. Since the Reagan Presidency, Republicans learned that spending really was not so bad, as long as taxes didn't have to pay for it. At first they voiced horror at the fiscal consequences of tax cuts, but, in time, they got over it.

And in time it really annoyed the hell out of Democrats. Ronald Reagan had led the Republican Party to the Promised Land. Cut taxes, spend money and let the chips fall where they may.

The premise was simple. It was unarguable. At any level of taxation, there is a lower level that will put more money back in the hands of taxpayers, and that will provide more resources for businesses to hire people and spur the economy onward.

It has become axiomatic. At every level of taxation, there is a lower level that if achieved will spur on the economy.

Therefore, following the logic to its natural conclusion, the optimal tax rate is zero.

Unless you need money. For stuff. Guns. Butter. You know. Stuff.

Or so we thought.

Today, we are approaching political Nirvana. In the final great leap of bipartisanship, the new administration is reaching for a new middle ground. Cut taxes in a nod to Republicans (and, it turns out, to everyone else, who also prefer to not pay taxes.) And increase spending. Because… Well. Because we can. Because we must.

And forget all those arguments about the expiring 2001 and 2003 Bush tax cuts. That is not a tax increase. That is just reality once again coming back to bite us.

Pardon the digression, but those tax cuts marked the beginning of the end of any integrity in tax policy. The scoring rules at the time required that tax legislation be budget neutral over a ten-year horizon. Congress was unable to pay for the tax cuts with other increases or spending cuts, so they paid for them by having them expire in year eight or so. So they complied with the ten-year scoring rules. Kind of. Lots of cuts for eight years. Lots of revenue to pay for them in years nine and ten.

Back in 2001, as they contemplated years of tax cuts that would suddenly expire, people jokingly referred to 2010 as “the year we push momma from the train,” because in 2011 the estate tax would rise dramatically back to its 2001 level. Well, here we are in year eight, and there is no need to worry about the estate tax. The estates were invested with Bernie Madoff.

Everyone gives lip service to debt being the problem that got us into our current mess. Not passing on to our children “a debt they cannot pay” was the great bi-partisan applause line of the President's speech the other night. They applaud fiscal responsibility. They just don’t believe in it. Or know what it is.

Look at the record over the past two decades. Our economic performance has been flat, other than the growth that we have literally purchased with debt. As a nation, we are like households whose real income has been flat for a decade, but who fund an increasing standard of living—new electronics, cruises, home improvements—through more and more borrowing. For years now, as a nation, our GDP growth has increasingly been purchased with imported capital.

Really.

Take a look at the new federal budget. $3.55 trillion of spending. A $1.75 trillion deficit. Maybe we have reached the tipping point. Finally, our revenues may become less than half our budget, and we can begin to migrate our tax rates to their optimal level.

Zero.

That does not mean we will have a 100% deficit. Far from it. We will still have cattle grazing fees.

And we will have the loan guarantee fees that the Federal Reserve charges for guaranteeing private debt. Those should be growing.

Oh. Sorry. Those aren’t in the budget.

My bad.