rigorousintuition.ca

"The Global Economic Crisis: The Great Depression of the Twenty-First Century" with Michel Chossudovsky. Discussion of the new anthology; the deepening global economic crisis; financial speculation; fiscal crisis; poverty; drug trade; savings and credit crisis; the long war; big brother state.

Nordic wrote:We talk a lot here about "transnational elites". Most of us, it seems, have realized that these are the people who really run things.

This is a portrait of one of them.

You really gotta click on the link to read it, because this guy is the master of hyperlinking. I'm c&p'ing it here just for reference.

http://www.washingtonsblog.com/2010/06/ ... ional.html
(Article reproduced here under fair-use provisions, with original link given, solely for non-commercial purposes of archiving, education and discussion.)

Chairman of Goldman Sachs International Was - Until Last Year - Also Chairman of BP

Janine Wedel has written extensively on how the "shadow elite" rule the world and about the "flexians" - the movers and shakers of the shadow elite who glide across borders, and structure overlapping (and not fully revealed) roles in government, business, media, and think tanks to serve their own agendas.

Wedel says that flexians wear many hats both within and outside of government, and use their networks of contacts to influence policy - are warping our democracy and the rule of law.

Peter Sutherland is the quintessential flexian.

According to his September 2009 bio:

Peter Sutherland is chairman of BP plc (1997 - current). He is also chairman of Goldman Sachs International (1995 - current). He was appointed chairman of the London School of Economics in 2008.... Before these appointments, he was the founding director-general of the World Trade Organisation. He had previously served as director general of GATT since July 1993 [and was] chairman of the Board of Governors of the European Institute of Public Administration (Maastricht) 1991-1996.

Sutherland resigned as BP's chairman in 2009, but apparently still serves in various key capacities.

Sutherland is managing director - as well as chairman - of Goldman Sachs International (Goldman Sachs International is the very powerful subsidiary of the Goldman Sachs Group, of which Lloyd Blankfein is CEO). Sutherland is also an Advisory Director of the Goldman Sachs Group itself.

And he was is European Chairman for the Trilateral Commission.

He has, at various times, attended meetings of the Bilderberg group.

He is also one of the chief financial advisers to the Vatican.

As if that is not enough, Sutherland also serves in the following capacities (click on "Read Full Background"):

Mr. Sutherland served as an Attorney General of Ireland and also served as European Commissioner from 1985 to 1989 where he was responsible for competition policy.... He serves as the Chairman of British Petroleum, BP Amoco PLC and United Kingdom. From 1989 to 1993, he served as the Chairman of Allied Irish Bank. .... He serves as a Non-Executive Director of Telefonaktiebolaget LM Ericsson. He serves as a Director of Goldman Sachs International. He has been Member of Supervisory Board at Allianz SE since January 2010 and serves as its Member of International Advisory Board .... Mr. Sutherland served as a Non Executive Director of BP Plc since July 1995. He serves as a Member of Foundation Board of World Economic Forum. He served as an Independent Non Executive Director of National Westminster Bank PLC since January 2001. He served as an Independent Non Executive Director of The Royal Bank Of Scotland Plc from January 2001 to February 6, 2009.... In addition, he serves on the board of Allianz, Koc Holding A.S. and is a member of the advisory board of Eli Lilly.... He served as a Director of LM Ericsson Telephone Co since 1996, Ericsson SPA since 1996 and Investor AB since 1995. He served as a Non Executive Director of Royal Bank of Scotland Group plc from January 2001 to February 6, 2009.

Sutherland is - literally - like Lloyd Blankfein and Tony Hayward rolled into one. But unlike Blankfein and Hayward, he has also held numerous powerful governmental and quasi-governmental positions.

I give this one three

The First HuffPost Book Club Pick of 2010: Shadow Elite by Janine Wedel

My first HuffPost Book Club selection of 2010 is Janine Wedel's Shadow Elite: How the World's New Power Brokers Undermine Democracy, Government, and the Free Market. It's a gripping, disquieting book that exposes and explains why it's been so hard to bring about any real change in our country -- why Washington no longer seems capable of addressing the problems our nation faces. Fingers have been pointed at everything from gerrymandering to partisan polarization to the misuse of the filibuster. But, according to Wedel, the real problem is much deeper -- and more disturbing -- than any of these.

As she writes in Shadow Elite, a new "transnational" class of elites has taken over our country: "The mover and shaker who serves at one and the same time as business consultant, think-tanker, TV pundit, and government adviser glides in and around the organizations that enlist his services. It is not just his time that is divided. His loyalties, too, are often flexible."

Wedel dubs this new class of influencers "flexians," and the closed system they've created for themselves the "flex net." She attributes their power, among other factors, to the "embrace of 'truthiness,' which allows people to play with how they present themselves to the world, regardless of fact or track record."

Wedel cites retired Gen. Barry McCaffrey as one example of this new international super-class -- a member of the shadow elite that serves in government posts, moves to the private sector, goes on TV, and collects a healthy paycheck from companies that benefit when the power broker's advice is taken. McCaffrey was one of the Pentagon-pundits-for-pay exposed by two Pulitzer-winning front-page stories in the New York Times last year. Yet even as I write this, he's on TV giving us his wisdom on how to fight terrorism. Because, as Wedel points out again and again, members of the shadow elite keep morphing into their next incarnation no matter how often their conflicts of interest and their undermining of the public interest are revealed.

Another key flexian, former Treasury Secretary Robert Rubin, is on full display right now in Newsweek's special "Issues 2010" edition, in which he pens a lengthy essay on "Getting the Economy Back on Track," failing, in a very flexian way, to explain or acknowledge -- let alone apologize for -- the key role he played in getting the economy off track in the first place.

Rubin's resume is the personification of the flex net in action, as he seamlessly moved between political positions (Director of the National Economic Council, Treasury Secretary), private positions (as a board member and senior counselor at Citigroup, he received over $126 million in cash and stock), advisory positions (including serving on the President's Advisory Committee for Trade Negotiations and the SEC's Market Oversight and Financial Services Advisory Committee), and stints on a World Bank task force on Growth and Development, work as an unofficial economic advisor to President Obama, and his current position as co-chairman of the Council on Foreign Relations.

You can read Rubin's 2,500+ word Newsweek piece here. But I was much more interested in the 28-word bio at the end of it: "Rubin is a former secretary of the Treasury (1995-99). He now serves as co-chairman of the Council on Foreign Relations and is a fellow of the Harvard Corporation." Given that the piece is about the economic meltdown, it's telling that the bio doesn't include his nearly ten years at Citibank -- during the very time that ended with the bank having to be saved by the American taxpayers.

But that's how the flex net works: you are able to wreak destruction, bank a tidy profit, then go along your merry way, pontificating about how "markets have an inherent and inevitable tendency -- probably rooted in human nature -- to go to excess, both on the upside and the downside." And how many people remember key details in Rubin's career like his vociferous opposition, during the Clinton years, to the regulation of derivatives -- a key factor in the meltdown? Or his lobbying the Treasury during the Bush years to prevent the downgrading of the credit rating of Enron -- a debtor of Citigroup?

Last month, Janine Wedel came to HuffPost's D.C. office to talk about her book. Our team was riveted as she painted a portrait of our political culture not from the perspective of a political scientist but from that of a social anthropologist. As a professor of public policy and social anthropology at George Mason, Wedel spent years studying what happened in Eastern Europe after the fall of communism, and sees a similar co-mingling of state power and private power at work here.

Take the health care fight. Though Wedel completed her book before the most recent twists and turns in the legislative process, reading Shadow Elite you get the feeling you are being given a peek at the how-to manual the insurance and drug companies -- and their water-carriers in Congress -- used to ensure that what may well have started out as a push for real reform ended up as an industry windfall.

After all, the final Senate bill (which looks like it will be the base for the final bill sent to Obama), is essentially the same bill that was drawn up months ago in Max Baucus' office by Baucus staffers who used to be health care executives, and by health care lobbyists who used to be Baucus staffers.

The shadow elite clearly knew that the months and months of so-called debate over the issue was nothing more than a charade -- the ultimate outcome never in doubt. The bill was created in the shadows. The public process since then has essentially been like a Hollywood adaptation -- complete with the requisite third act happy ending (or, in the words of our elected officials, a "historic" ending).

"The new breed of players," writes Wedel, "who operate at the nexus of official and private power, cannot only co-opt public policy agendas, crafting policy with their own purposes in mind. They test the time-honored principles of both the canons of accountability of the modern state and the codes of competition of the free market. In so doing, they reorganize relations between bureaucracy and business to their advantage, and challenge the walls erected to separate them. As these walls erode, players are better able to use official power and resources without public oversight."

That's a spot-on description of what happened with health care -- as well as a spot-on description of the totally-lacking-in-transparency bailout of the financial system. Remember how the bailout was supposed to take care of not just Wall Street but Main Street? Well, the former ended up with record profits and bonuses while the latter is looking at double-digit unemployment -- and millions of foreclosures and bankruptcies -- for the rest of the year.

As for the "embrace of truthiness" Wedel writes about, witness this exchange from This Week between Jake Tapper and White House spokesman Robert Gibbs. Tapper asked Gibbs about Obama's broken promise to televise health care negotiations on C-SPAN and whether Obama will at least push for transparency for the final reconciliation process. Gibbs' response:
Well, Jake, first of all, let's take a step back and understand that this is a process legislatively that has played out over the course of nine months. There have been a countless number of public hearings. The Senate did a lot of their voting at 1:00 and 2:00 in the morning on C-SPAN. A lot of this debate -- I think what the president promised and pledged was so that you could see who was fighting for their constituents and who was fighting for drug and insurance companies...

Talk about being flexible -- Gibbs is a world-class rhetorical yogi. So all that talk during the campaign about transparency now just comes down to Congressional votes being shown on C-SPAN -- as they've always been?

The worst part is that Gibbs' posturing about being on the side of constituents rather than the drug and insurance industries sounds so normal. Gibbs knows all too well that he's supposed to shake his fist at the insurance companies, just as Larry Summers and Tim Geithner -- who both feature prominently in Shadow Elite -- know they're supposed to talk tough to the banks and vow to end "too-big-to-fail." But, as Wedel writes, they've rigged the system so they can "institutionalize their subversion of it."

And in the same way that our regulatory structure was outmoded and unable to deal with the complex new financial instruments devised by Wall Street, the rhetoric we use today to describe what's happening to our system is not up to the task. According to Wedel, terms like "lobbyist," "interest group," "corruption," and "conflict of interest" no longer suffice.

The new flexians are, as HuffPost's Arthur Delaney dubbed them, "influence launderers." That's why a flexian like Tom Daschle never needed to bother registering as a lobbyist. He could do the same things, selling off the public trust to the highest bidder, and then go around bragging about how he's never sullied himself with actual lobbying.

With our capitalist version of what Wedel describes as the "merging of state and private power that characterized both communism and postcommunism," we're getting to the point where the only difference between senior congressional staffers and the lobbyists and influence launderers whose ranks they'll soon join is the size of their paychecks. They just have to do a few years in Congress before joining their former bosses. It's a kind of grad school: put in a few semesters getting your Masters of Influence and you won't have to worry about paying off those school loans.

So how can we wrest control of our government from the Shadow Elite?

As Wedel says, the first step is to understand. "Merely exposing certain activities is not enough," she writes, "framing them is essential." We need to reframe how we look at and think about and respond to what is being done in our name and with our resources.

Reading -- and talking about -- Shadow Elite is a great first step in that reframing process. And don't miss Janine Wedel's blog post about her book, coming tomorrow. Let's get the conversation going.

Get your copy of Janine Wedel's Shadow Elite at Amazon.com

vanlose kid wrote: One thing that bother's me when I read this type of stuff is the way they're framed, e.g. "Back in the day the X was working for America and democracy and yadda yadda" or "America used to stand for yadda yadda yadda" – and yet these people know, presumably, that this is false. Or they should know because they write about like instances of activity that date back way before "America was all momma's apple pie".

In her piece on the BIA: CIA and Wall Street Wedel writes:

During the Cold War, we took it for granted that officers of the Central Intelligence Agency worked solely for the good of the USA -- or at least their version of the good. They were loyal first, last, and always only to one institution, the CIA. Americans assumed that they had one boss, and one boss alone: the CIA director. But this week came a revelation that shakes that longstanding belief to the core. Today, CIA officers are allowed to moonlight, and ply their espionage skills elsewhere in their free time.

As if this was something new. It's not. What's "new" if anything is that a lot of what counts for "knowledge" – what you get taught in school, through media, etc. – is nothing but "longstanding belief".

When has the CIA not been part of Wall Street? There never was a question of "dual" loyalties. And there isn't.

*

edit: What I mean to say is that the term "modern" in the Op can only mean "contemporary". Not "new".

•

I think it's a disastrous strategy, one that contributes to the historical and systemic blindness that is one of the most important conditions for maintaining the status quo. It serves to reinforce a false "national identity" that needs to be challenged.

I want to point out how often you will see the reverse strategy in action: bad things are what "we" did in the past, before we learned better. Gunboat interventions and child labor are part of more benighted times, although you shouldn't blame past actors for being "products of their time." These past examples bear no relation to the modern counterterrorist drone-strike interventions, which were forced on us, or "our" trade with Bangladesh clothing mills, which is the price of free enterprise and anyway the best the Bangladeshis can do in improving their lives.

I bring up this other strategy because it relies on a concept of progress or historical discontinuity, just like Wedel's myth of earlier times when the motives of the power-holders were supposedly nobler. I think not understanding the continuity of history reduces our power to know what to do about it today.

The real problem is in the "we." The apologists for today's conditions and critics like Janine Wedel both think their readers are going to identify with the history of "our country" as represented by the actions of past power-holders, presidents, "founding fathers," generals and robber barons. By treating it that way, they reinforce it. Far better would be to acknowledge the historical continuity and seek to engender identification with the popular actors of past times - the abolitionists, the workers' movement, the war resisters, the populists, the people who refused to go along with the Commie witchhunts and the Cold War hysteria, all of whom are equally "products of their time": These should be more "we" than the likes of past CIA directors. It occurs to me that Wedel's strategic avoidance of the past reality (if it really is mere avoidance) would have us believe that the post-1963 CIA was still just an agency seeking to promote "American interests," which is an extreme distortion that disserves us.

Nevertheless, I'm going to assimilate the OP into the Wall Street thread, if you don't mind!

How Markets Fail: The Logic of Economic Calamities

John Cassidy , Joanne J. Myers


December 2, 2009


Introduction
Remarks
Questions and Answers

Introduction
JOANNE MYERS: Good afternoon. I'm Joanne Myers, Director of Public Affairs Programs. On behalf of the Carnegie Council, I would like to thank you all for joining us.

Today I'm delighted to welcome John Cassidy to participate in our ongoing discussions on the recent financial crises.

If you want to fully understand the rise and fall of free-market ideology and economic thinking over the last three centuries, from Adam Smith to Ben Bernanke, How Markets Fail: The Logic of Economic Calamity is the book for you. In this illuminating work, our speaker combines not only economics, but the history of ideas, a narrative of the financial crisis, and a call to arms.

As America and the world's economy slowly crawl from the decline of 2007 and the depths to which they had fallen in the autumn of 2008, questions about how we got into this difficulty, along with the commentaries offered to explain the debacle, have fallen rather short—that is, until the publication of this book. As Mr. Cassidy clearly indicates, the crisis which engulfed the global financial system was not just a function of greed on Wall Street, poor regulation, or even property bubbles which got out of control. It was far more significant. It was a failure of the ideology of the free market, which is to say the belief that markets left to themselves will self-correct without the need for government intervention or regulatory control.

In writing this book, Mr. Cassidy says that he wanted to address the underlying economics of the crisis and to explain how the rational pursuit of self-interest created and prolonged it. In doing so, he talks about "Rational Irrationality," the title of an article which many of you may have read in The New Yorker, which was recently published, in which he defines people pursuing their own interest in the market, but the market somehow aggregates their actions into a collectively disastrous outcome. He warns that in the current economic fiasco, conforming to the antiquated orthodoxies isn't just misguided; it is downright dangerous. Accordingly, he offers a new way to understand the consequences of decisions taken by private firms in an environment of minimal regulation.

John Cassidy has been writing about Wall Street and finance since 1987. Before coming to New York, he was the business editor of The Sunday Times in London, where he was known for his brilliance as an economic historian. Now based in America, still considered as brilliant as ever, today he is recognized even more so for his astute and insightful analysis of business and financial journalism. If you follow his writings in The New Yorker or read his articles which frequently appear in The New York Review of Books, you will know this to be quite accurate.

Our speaker is also the author of the widely admired book Dot.con: How America Lost Its Mind and Money in the Internet Era. This afternoon Mr. Cassidy invites us to move beyond the daily headlines and think about the way modern capitalism operates and about the theories that informed economic policy.

Now I invite you to join me in welcoming him to the Carnegie Council.

Remarks
JOHN CASSIDY: After that introduction, I haven't really got much left to say. Perhaps we should just go straight to questions.

There are two books out at the moment, as you know probably, about the financial crisis with "fail" in the title, my book How Markets Fail and Andrew Ross Sorkin's book Too Big to Fail. I look on these two books as complementary in many ways. If you're looking for a book about Hank Paulson retching and Tim Geithner running around Wall Street at 6:00 a.m. worrying about what he's going to have for breakfast, then you should read Andrew's book, which is a very good narrative. When people ask me what the difference is between the two books, I say Andrew's is the fly-on-the-wall account; mine is the view from the orbiting satellite.

What I try to do in this book is explain how the various elements of the crisis fit together. It seems to me there have been three, possibly four, theories of what happened put forward so far:
The first one, which probably the man on the street subscribes to, is that it was all a matter of greed. It was basically "Bernie Madoffism" writ large.

The second theory, which quite a few behavioral economists, such as Bob Shiller and George Akerlof, have put forward, is that this was basically an instant of the madness of crowds, that we had sort of collective irrationality, disaster myopia. People thought the housing market was going to go up forever. They sort of lost their minds and the traders lost their minds temporarily. I saw Bob Shiller giving a speech a couple of weeks ago, and he said it's all about the stories people were telling each other. That's the second theory.

The third story, which is very common on the right, is that this was a government failure. It comes in various guises, mostly to do with Fannie Mae, Freddie Mac, and the Community Reinvestment Act. Basically, the government caused the problem by encouraging people to invest in subprime—banks to lend to people who otherwise wouldn't have got their loans, Fannie Mae and Freddie Mac propping up the subprime market, et cetera. As I say, quite a few people take it all the way back to the Community Reinvestment Act of 1979.

I don't believe any of those theories. I think there's an element of truth in each of them. But I really see this as an example of market failure writ large.

What does market failure mean? It means that markets fail to act in the way they are supposed to according to the free-market theories going all the way back to Adam Smith. The basic theory of the free market is that if you add individual rationality to competition, you get a good outcome. The market aggregates people's actions and produces an overall socially beneficial outcome. That's the theory of the invisible hand. Of course, it was applied to financial markets in this case.

My argument is that ultimately this is not a failure of the government—although the government, as I'll speak about a bit later, did make some mistakes— and it's not just greed; greed is a perennial on Wall Street. Probably a lot of people in the audience work on Wall Street, so I don't want to be too insulting.

But there is an element of self-selection. If you want to make a lot of money, you go to Wall Street, so it's not surprising that we find some greed there. The third one, mass stupidity—again, I think there was some stupidity, but my argument, which again I'll lay out in a bit more length in a while, is that this was more to do with rational self-interest rather than irrational self-interest.

So the way I structured the book is in three parts. As I say, I ultimately see this crisis as a crisis of ideas, and misapplied ideas. For the first third of the book I try to explain where this idea of the free market as a self-regulating device comes from. I go all the way back to Adam Smith. I probably am the only person in the room who has actually read The Wealth of Nations. Even though I have been writing about economics for 20 years, I can honestly say I had never read it front to back before, although I have frequently referred to it. It's a very long book. In this case I did actually go back and read it all.

I ultimately see this crisis as a crisis of ideas, and misapplied ideas.

So I take it back to Smith. I'm not making a wholesale critique of the free market. As I say in the introduction, I'm not saying we should resurrect Gosplan or switch to some other system completely.

My argument is that free markets are all good in their own place. I try to point out in the first third of the book what the strength of the free markets is. It has been elucidated in all sorts of ways since Smith, but I think the basics are there in Smith.

One is the division of labor. People specialize in what they do best, going back to Adam Smith's famous pin factory, where if you have one guy trying to make pins by himself, he may make one or two in a week; if you have ten people, each doing specialized tasks—one cutting the metal, one sharpening, one attaching the heads—they can churn out thousands in a week. Free markets encourage specialization. That leads to big productivity growth.

The second very desirable aspect of free markets is that they encourage innovation. If you innovate and produce something which people want to buy, you generally make a profit, at least for a while. If you produce shoddy products or bad products, people don't want to buy and you go out of business. So there is a feedback mechanism: If you do well, you're rewarded; if you do badly, you're punished. Most other economic systems, like feudalism and communism, lacked that basic feedback mechanism.

If you add those two things together, the division of labor and this feedback mechanism, you basically have a machine for productivity growth. That's incredibly important. The other person I went back and read was Malthus. If you go back to when Smith was writing and just after that, people really thought—Malthus wasn't an outlier—a lot of people thought, like him, that there was going to be mass starvation with mass population growth. Why didn't it happen? Because productivity grew faster than the labor force, and it's based on specialization and innovation in the free market.

The third very desirable aspect of free markets is that you don't need a central planner. The market is a coordination mechanism. When you think about that, we take it for granted, but if you think about the tens of millions, hundreds of millions, of people just in the U.S., billions of people around the world, each going out to work every day, producing goods and services, who tells them what to make? Who tells them how much to make? It's the market that tells them. There's a price system. They react to the price system.

Attempts have been made to supplant that with sort of indicative planning in Europe, with straightforward planning in the Eastern Bloc. None of them worked very long.

They can work in the early stages of industrialization.

You get sort of Stalin's five-year plans. They can ramp up steel production or grain production. But it's not a very effective mechanism for advanced economies. It can't produce the product differentiation and all the different goods and services we want to buy.

The Economist actually said this book provides a strong argument for free markets. I think it's true for the first third of the book, in which I take Smith and I then go through more advanced derivations of it, bringing you up through the Chicago School and general equilibrium theory and lots of other subdisciplines, which are probably only of interest to economists. But the basic ideas were all there in Smith. Most of the stuff since then—actually, Milton Friedman, to give him his due, was very explicit about this. If you go back and read Capitalism and Freedom or Free to Choose, he says that most of this is in Smith, "I'm just sort of updating it and producing some new examples."

So that's the first third of the book. I call that "Utopian Economics" because I think the basic good ideas have been misapplied. I'll explain why in a minute. I think the Chicago School, in particular, when they sort of applied these to financial markets, through the rational-expectations hypothesis associated with Bob Lucas and the efficient-market hypothesis associated with Gene Fama and others—they took these ideas about free markets and applied them to financial markets. In my opinion, because of the speculative aspect of financial markets, you can't apply these theories. When you do, you get into big trouble, as I'll explain in a couple of minutes.

So that's the first third of the book.

In the second third of the book I try and explain something called "reality-based economics," which is just a sort of fancy phrase for—not even, really, heterodox economics—what I would call mainstream Keynesian economics, as I was taught it 20 years ago, 25 years ago, in Oxford and at Harvard. I start off with Keynes himself. I was going to say he is unfashionable. He's actually becoming very fashionable. Even some of the Chicago School, including Judge Posner, have come out as Keynesians recently. Until recently, unfashionable Keynes.

I think Keynes's great contribution was this idea that a financially driven economy is different to just a sort of agrarian economy. There's something about a financial system which adds a level of complexity and potential instability to the economy.

I spend a lot of time on the so-called beauty contest analogy, which I think is very instructive. That's the idea that investors, instead of investing on ultimate value, basically try and outguess each other. In the 1930s in England, there were beauty contests. It's a bit sexist, this story, but I'm afraid that's how it was in the 1930s. They would have a page given over to pretty girls, and the readers had to write in and you won a prize if you picked the prettiest—except it's not quite that simple, because you win a prize if you pick the prettiest girl, the one who comes at the top of the opinion poll.

So what are you trying to do when you are trying to win a contest like that? You are not trying to say who the prettiest is. You are trying to figure out the girl whom average opinion will think the prettiest. Keynes figured that out. Then he said, actually, if you get clever, then there's a second degree. You don't think about what the average opinion thinks the prettiest girl will be; you have to think about what the average opinion thinks the average opinion thinks the prettiest girl is going to be. And there are third, fourth, and fifth derivations, as he said.

Actually, a lot of what happens in financial markets is this sort of approach. If you work on a hedge fund, most of the hedge funds have got momentum funds, they have got value funds. But even the value funds tend to be driven by how they think the analysts are going to react to various statistics. It's very much trying to outguess everybody else.

So I take you back to Keynes. It's not just about financial markets. The idea of market failure is much broader than just finance. I have a chapter about spillovers, externalities, global warming, taking you back to Pigou, the other famous British economist—not as famous as he should be—of the early 20th century, which I actually wrote up in The Wall Street Journal a couple days ago. Pigou's idea, which again is now a mainstream idea—there's a Pigou Club for Republicans, which Greg Mankiw at Harvard set up—his great contribution was this idea of spillovers or externalities, that the market is very good at measuring private benefits and private costs, but very poor at measuring social costs and social benefits. Pigou's example is a train, a new rail service which sets up, say, between New York and Boston. That clearly provides a lot of value for the customers. They can go faster. That's all good. The prices reflect what people are willing to pay.

But what about if—he was writing in the steam age—there are lots of sparks emitted from these engines and pieces of fire coming out of the engine? What about if it sets the surrounding woods ablaze? Who pays for that? It's the owner of the field. The market mechanism doesn't give the railway company any incentive to pay that.

If you think about global warming for a second, it's exactly analogous. The people who produce the greenhouse gases—the power stations or the SUV drivers or anybody else who burns a lot of carbon fuel—don't take into account the costs they are creating for, in this case, future generations, usually—or maybe some people who are young; maybe global warming will be so serious by 2050. But they don't take into account the ultimate social consequences of their actions.

What Pigou said is, to make them take account of it, we need a tax system—what he called extraordinary restraints. So that's the sort of underlying basis of the argument for carbon taxes, which is not a controversial idea in economics anymore. As I say, even Republican economists agree with that, or quite a few of them do. It's just incredibly politically unpopular, so nobody wants to put it forward.

So that's another example of market failure.

I had better speed up a bit, because I promised not to speak for more than half an hour.

The other examples which I run through are sort of informational problems. If you think about health care, for example, another very topical aspect, the problem with the health-care system is another form of market failure. The private insurers—there's a big informational problem there. If you try to buy private insurance, the private health-care insurers don't know your medical history, obviously. So they tend to assume, if you are out on the open market looking for insurance, you have probably been bumped by somebody else and you may be chronically ill. So they are very reluctant to offer individual coverage at reasonable rates. They will offer you a very extortionate rate. That's why, unless you have employer coverage, it's just very expensive.

That's an informational asymmetry, as economists would call it in the jargon. It's very difficult to deal with.

There's another form of market failure called moral hazard, which is, if you're insured, you then have no incentive to reduce your costs. Everybody knows that. We get a cold; we say, "Oh, I need a brain scan. I may have cancer." We're not paying the cost of the brain scan. The insurers are paying it. That's moral hazard. Again, it turns out to be quite important in financial markets, too.

So those are two big examples, not to do with finance—health care and global warming—both of them very topical, which are ultimately forms of market failure.

So I run through them and various forms of what I call reality-based economics, including some behavioral economics, some of the theories that Shiller and Akerlof and people have come through. There have been other books on that. Some of you may have read those. I won't dwell on that. But there are chapters in there about that.

In the final third of the book, which is sort of the meat of it in a narrative sense, I try and apply these ideas to what happened in the financial crisis. As I say, I have dismissed greed, I have dismissed stupidity, I have dismissed the government, so I had better have something else to say.

What do I have to say? What I have ultimately to say is that this is an incentive problem. As I said in the first part of the book, the market's great defense is that it provides good incentives in some areas. In financial markets, though, as we saw, it provides bad incentives. Friedrich Hayek called the market mechanism a telecommunications system. He said the prices are signals. That's exactly right. What Hayek didn't realize or was reluctant to admit was that the signals the market can send out, especially in a speculative bubble, can be the wrong ones. Once you get speculation started, prices depart from fundamentals and then the incentive structure gets completely out of whack.

In the book, if you think of the subprime mortgage, which obviously underlies all this, I take you through the chain from the people who are buying the houses, the people who are issuing the mortgages, the mortgage brokers, the mortgage lenders, the people on Wall Street who are securitizing the mortgages, the investors, the hedge funds and banks that are buying the subprime mortgage securities, and the credit-rating agencies who are rating the bonds.

It seems to me, in every one of these cases, the incentive structure was misaligned. Just think of—I won't go through them all, but let's just focus on a couple of them—the mortgage brokers and the people issuing the mortgages. Why would they conceivably give $300,000 to some guy out of work in East L.A., who is buying a house maybe ten times his income, if he had a job?

There are two answers. Number one, because of securitization, they didn't think they would be holding the mortgages. Obviously, in the old days, if you issued a mortgage and you were a mortgage lender, you kept it on your books for 30 years. If the guy defaulted, you were in trouble. If you had issued that mortgage, you had to explain to your boss why you did.

In this case, because of securitization, firms like AMERITRADE and Countrywide and all the others really didn't give a damn who they were giving the mortgages to, as long as Wall Street was willing to buy them, and for a long time it was. So the mortgage standards completely evaporated—the famous NINJA loans, "no income, no job, no assets." As long as you could stand up and sign your name, you could get $250,000 to buy a house. It got to the stage where we are not even sure if you bought it, because they were issuing these things so quickly that a lot of the paperwork was never put through. So in a lot of cases —there are famous cases in Ohio where the judge is throwing out the foreclosure judgments because the bank can't prove that the guy owned the house, because they were too busy issuing mortgages to actually fill in the paperwork.

That's an example.

On Wall Street, then. Most of the attention has been focused on Wall Street. Why did the banks, all these smart people, get involved in this thing? This is where my theory of what I call "rational irrationality" comes in. The idea basically is that it was rational for them to do things which they knew, ultimately, could well turn out to be irrational. The example I use in the book is Chuck Prince, chairman of Citigroup, who obviously has been pilloried from A to Z since the whole thing blew up.

Actually, if you go and look at the history of Citigroup, they were far from the worst offender. From 2000 to 2005, they had a home mortgage department, a sort of housing finance for lower-income people, but it wasn't one of the big securitization machines. They were lagging behind Merrill Lynch and Countrywide and various others, so much so that in the start of 2005, the board of directors, including Bob Rubin, the former Treasury secretary, came to Prince and said, "Look, we're falling behind our competitors. We need to do something to catch them up. We need to increase our risk profile. We're not taking enough risks."

What should Prince have said? Well, obviously, in retrospect, he should have said, "You're crazy. An august institution like Citigroup doesn't want to bet its future on people who can't afford their mortgages. It's all going to blow up." But there were very few people saying that at the time. Given the incentive structure Prince faced, given the enormous short-term stock options he had, given that he was judged on a quarterly or an annual basis, and given that he was already under pressure for not doing what everybody else was going, he would have probably lost his job if he had said the sensible thing and said, "Look, we shouldn't get involved in this."

Is this my theory of what happened or is it Prince's theory? I think Prince himself understood the logic of this very well. Actually, the one thing I would like to read from the book, very quickly, is a reference to an interview with Prince in 2007. This was in July of 2007, when the market was already starting to crack. One of their best hedge funds had got into trouble, I think. Citi was big in subprime at that stage. They were also big in LBOs [leveraged buyouts], which was also starting to crack.

Prince went to Japan. He must have been outside his usual security cordon or something, because the Financial Times managed to catch up with him, and they asked him a question. I should say two weeks before this, in fact, the Bear Stearns hedge funds had lost $3.2 billion, I think it was. In June 2007, just a few weeks before Prince's Financial Times interview, as I say, the Bear Stearns hedge funds had blown up.

Prince conceded that a full-scale blow-up in subprime could cause liquidity to dry up in other asset-backed securities markets, leaving Citi and other banks saddled with numerous loans of questionable value. Still, he insisted, Citi had no intention of pulling back.

He said, "The depth of pools of liquidity is so much stronger now than it used to be, and a destructive event now needs to be much more destructive than it used to be. At some point, the destructive event will be so significant that its liquidity, instead of filling in, will go the other way. I don't think we're at that point. As long as the music is playing, you've got to get up and dance."

That now I think will go down as one of the quotes of the decade. As I say, whether he knew it or not, Prince was channeling Keynes, who, in Chapter 12 of The General Theory, pointed to the inconvenient fact that there's no such thing as liquidity of investment for the community as a whole. Whatever the asset may be, stocks, bonds, real estate, or anything else, if everybody tries to sell it at the same time, prices will collapse and the market will seize up.

Given this possibility, Keynes said, financiers were forced to keep a close eye on the mass psychology of the market, which could change at any moment. He said, "This is the inevitable result of investment markets organized with a view to so-called liquidity," referring back to the quote there. "For it is, so to speak, a game of Snap, of Old Maid, of Musical Chairs, a pastime in which he is a victor who says, "Snap," neither too soon nor too late, who passes the Old Maid to his neighbor before the game is over, who secures a chair for himself before the music stops. These games can be played with zest and enjoyment, though all the players know that it is the Old Maid which is circulating or that when the music stops, some of the players will find themselves unseated."

It seems to me, if you compare those two quotes, they are very similar. It seems to me Prince knew exactly what he was doing, and he was just responding to the incentive structure quite rationally, from his narrow point of view. But, of course, when everybody does that, you get a blow-up. That's my theory of rational irrationality.

A secondary piece of evidence to support this, which actually comes from Andrew Ross Sorkin. He was telling me the other day that he was talking to John Mack, the head of Morgan Stanley, and Mack was basically saying, "Look, we can't regulate ourselves. Somebody else has got to come in. The government has got to come in and impose some rules. You can't leave it to Wall Street because, given where I sit"—he's the chairman of Morgan Stanley—"there's no incentive for me to draw back from risky situations."

I think the smart people on Wall Street know what happened. They know it wasn't just greed. That's why I think they are so angry at being pilloried all the time. Of course, some of them are greedy, so they deserve some criticism. But I don't think that was the primary force at fault here.

So that's my theory of the crisis. In the final chapter or two, I just try and take us up to where we are now. I'll just spend a minute on that, and maybe if anybody has questions, they can ask me more detail on that.

It seems to me that the government did a pretty good job preventing a return to the 1930s. I think the Fed did a terrible job in getting us into this mess by keeping interest rates too long and provoking a speculative bubble. But I think, once they realized, at the end of 2007, that things were really serious, they shifted to pumping money into the markets, reducing interest rates to zero. I think they did a good job.

I think Hank Paulson, for all the criticism he gets, did what needed to be done. He screwed it up by first going to this sort of complicated TARP [Troubled Asset Relief Program] structure, where they were going to buy back the bonds. But they pretty quickly realized that that wouldn't float and then they decided to recapitalize the banks. A very unpopular thing to do, still very unpopular. But I think it did avert a catastrophe.

So if you add those two things together, and maybe a bit of kudos to Obama for introducing the stimulus package, which has had, I think, some impact, we have successfully avoided the mistakes of the 1930s, when the Fed basically let the banks go under. That was Milton Friedman's great insight, and he was right on that. You can't just let the banking system collapse, much as some of Friedman's actual followers in Chicago would like to now. They say, just let it collapse and everything will come back in a few weeks. As I say, I think we tried that in the 1930s. I think that didn't work.

So short-term, I think the government did a good job.

Long-term, I'm a lot less sanguine. I think the administration has made a strategic error in not trying to reform Wall Street first and then focusing on health care. Now we have the situation where the market is coming back, the banks are making a lot of money, they are a lot more cocky, lobbyists are empowered again, and the sort of political imperative to do something about Wall Street has sort of diminished. It looks like health care is going to take the next two or three months. It's going to be at least the start of the year, possibly the spring, before we get on to financial regulation. By then you are sort of into midterm election season. That means politicians need to raise a lot of money. Who do they raise the money from? They raise it from the banks on Wall Street.

So it seems to me that even the administration's pretty moderate ideas for reregulation, which I'll address in questions and answers—I don't think they go far enough—even those relatively modest reforms, it seems to me, are by no means certain to be put through. Obviously, nobody asked my opinion, but if they had done that, I would have done it the other way around and exploited the great sort of revulsion at Wall Street in the public at the start of the year, to try and put some reforms through quickly and to keep a laser focus on the economy, then, when you get that through, switch to health care.

So I think that was a political error on the part of the White House. I can understand why they did it. He had obviously campaigned on health care. But I think they should have pirouetted and gone for financial regulation first. I think it was probably a political economy error, and we may live to regret it.

So that's pretty much all I have to say, and in half an hour, I think. I'm happy to answer questions on any aspect of that or anything else I didn't cover.

JOANNE MYERS: I thank you very much for making the irrational rational. It was a terrific discussion.

Questions and Answers

QUESTION: You said that you didn't think that the proposals so far being considered for financial regulatory reform go far enough. What other steps would you propose?

JOHN CASSIDY: I'm sort of in the Volcker camp on this, Paul Volcker, the former chairman of the Fed. I think regulation is good. I think all the ideas the administration has put forward are good ones—increasing capital regulations, forcing the banks to hold some of the securities that they securitize, setting up a consumer financial products commission, having some sort of systemic risk regulator, whether that be the Fed or whether it be some new institution, as in the House bill. They are all good ideas.

I don't think they necessarily go far enough, because if you do all that, you are still going to have these enormous, too-big-to-fail financial institutions, like Citi, like Bank of America, like Wells Fargo, Barclays—you know the names—Goldman Sachs, et cetera. They are still going to face the same incentive structures which got us into this mess. You can't just proscribe rational irrationality. It's part of the logic of the situation. That's the whole point. It's intrinsic in the market.

I think the only way you can deal with that—regulators will do their best, but ultimately they will be out-gamed—

I think the only way you can do it is to try and split up the banking system in some way, so that you have a safe sector, the so-called utility sector, which is banks which take in customer deposits, maybe brokerage deposits. They have a pretty much explicit government guarantee. If they get into trouble, we're going to bail them out. But they also face high capital requirements, large restictions on their activities, and a complete ban on proprietary trading and some of the riskier sort of derivatives trading. So you should have the safe, the utility sector.

Goldman Sachs or Morgan Stanley or maybe Citigroup might say, "We don't want to do that."

That's fine. You can go and be a casino—the sort of casino aspect. You can do as much proprietary trading as you want. But explicitly—I don't know if we would need a constitutional amendment or whatever—there would be an explicit law that we are not going to bail you out if you get into trouble; you will be allowed to go under.

People say that wouldn't be realistic. I'm not so sure. I think what would happen is that if you did introduce that split, the capital markets themselves would start to introduce and enforce—and they would start to charge these banks a lot more for the loans. Goldman Sachs without a government guarantee is going to find it difficult to raise money. We saw that last year. That's why the FDIC [Federal Deposit Insurance Corporation] had to ensure the debt, which was the big giveaway of the whole crisis.

So I think by splitting them in two, you would not only separate the utility aspects, sort of bank clearing—money market accounts are complicated. They would have to be in that sector somehow. You would also encourage the market to put some more restrictions on the risk takers. Once the system is up and running, it doesn't really need regulating that much. It's just a set of laws on the books, similar to Glass-Steagall. People say it's Glass-Steagall. It's not Glass-Steagall. Glass-Steagall was investment banking and commercial banking. Under this system, the banks in the regulated sector would still be allowed to underwrite securities for their clients, because that's not, actually, a risky thing. They're just providing a service for their clients.

The risk comes in when they start expanding their balance sheets exponentially, on their own account. If you go back and look—I wrote a big thing on Merrill Lynch a couple years ago—if you go back and look at firms like Merrill from 2002 to 2008, the balance sheets went up 150 percent or something. When you see that sort of balance sheet growth, there's something going wrong. It's always a telling sign of a problem.

As I say, if there is explicitly no guarantee, the markets will restrict the banks' ability to raise capital and to raise funds. They'll just charge them a lot more. That's my argument. As I say, it's not original. It's Volcker's argument.

QUESTION: You didn't mention the Community Redevelopment Act and what role that probably played in the subprime—and that's government regulation.

JOHN CASSIDY: I think I did mention it. Maybe I misnamed it.

There is this argument that the Community Reinvestment Act of, I think, 1979, which then developed under various administrations—Cisneros in the Clinton Administration, Bush, the "homeownership society"— that was ultimately to blame. I think it played some role. Whenever I speak, people stand up and say it was all the government's fault, that it was the Community Reinvestment Act. But if you go and look at the research and see how much of the bonds that were issued were linked to the Community Reinvestment Act, how much of the subprime bonds, it's very small. It's about 10 percent of the market. So 90 percent of the subprime bonds have nothing to do with Fannie Mae and Freddie Mac and nothing to do with the government. They didn't have any guarantees.

So I think it played a role in persuading banks like Citi or Chase or whoever that they should set up consumer finance departments, because the regulators, especially in the Clinton and Bush administrations, were saying you can't redline areas anymore. But I don't think it can be held responsible. It's only a 10 percent contribution, I think.

QUESTION: What do you think the prospects are for some sort of coordination in terms of regulation globally? One of the obvious problems is, if in the United States we try to regulate the banks more heavily, where we make it more costly or have additional capital requirements, if they are out of the business there are plenty of other banks globally that would be probably happy to step into their shoes.

JOHN CASSIDY: I may be completely wrong, but I actually think this one is a bit of a red herring. I think the banks use it as an argument to avoid regulation. It seems to me these big banks need to be active in New York. They need to be active in London. I agree, if the U.S. does something and London doesn't do it, that's a big problem. It may be with Tokyo, too. But if the big Asian, European, and U.S. markets agree on a set of rules, I think they could then call Wall Street's bluff and say, "Look, if you want to bank in the U.S., if you want clearing by the Fed, you have to abide by these rules. If you want to go to Bermuda or Curaçao or Panama, good luck to you."

I think it will be very difficult for them to do it because they can't get access to the funds in the U.S. unless they can clear through the Fed. So I think the government has stronger bargaining leverage than it appears. Wall Street always uses this argument: "Oh, we can't regulate stricter in the U.S. because Citigroup will relocate to China," or something. I actually don't think that. Alot of the money is here. A lot of the infrastructure is here. If it's imposed on everybody so there is not this sort of rational irrationality problem, where one is trying to beat the other, if everybody has to agree to the regulations at the same time so no individual can get a competitive advantage if they want access to the U.S. and U.K. markets, I think the government can do quite a lot.

The U.S. and the U.K., for some reason, don't seem to be on the same—they are on the general same page in terms of capital requirements, et cetera. But the British—it's interesting, actually. As you can probably tell, I'm British, but I have been here 20, 25 years. But I was actually in the U.K. last week. The political climate there is different. The political climate there is still where it was here six or 12 months ago. People loathe the banks in London. You can't admit you're a banker or people give you abuse in a restaurant. Banks are seen as primarily responsible for the crisis.

Because of that, Brown, the government, is under strong pressure to take as tough a line as possible. That's why they are pushing—Brown floated the idea of a Tobin tax on international financial transactions. The British floated the idea of stricter limits on CEO pay, even stronger capital requirements.

The Obama Administration is ultimately still pretty much in bed with Wall Street. As I say, a lot of intelligent people on Wall Street realize the need for reform, but they are not willing to go as far as the Brits. They are not motivated. If I was Obama, I would go populist on this. But for some reason, he doesn't appear willing to do that. The Treasury is basically still running the show, rather than the White House political advisers, and the Treasury is strongly opposed to most of the British ideas.

QUESTION: I saw a little breaking news. I think Bank of America just jumped out of bed with the government. At 5:00, they announced they were repaying the TARP. You have to raise a lot of money to do that.

If you had to say there was one common denominator of financial crises over centuries, would it be a four-letter word, "debt"?

JOHN CASSIDY: Ken Rogoff, who I think was here a few weeks ago, would probably be able to answer this better. Sure, the common denominator is almost always very rapid credit growth in various forms. That's why the old monetarists, I think, had it right, to some extent. They used to look at broad measures of the money supply, which include a lot of these debts. If you look at the financial ratios, what happened here was that the Fed basically stopped—M3 was discontinued about four years ago, which was very convenient, because it was starting to go through the roof because it included a lot of the short-term debt instruments.

Again, one way is just looking at the aggregate monetary ratios. Another way is to look at the balance sheets of the individual financial institutions, because they are the guys who are issuing all this debt. If their balance sheets are expanding at 20, 30 percent a year, as they always do in a credit bubble, that's an almost certain sign of trouble ahead.

Everybody knew this in developing economies. That's why the IMF and the World Bank monitor this stuff on a day-to-day basis in the developing world. But, unfortunately, the U.K. and the U.S. basically turned into developing economies in the last ten years, as far as the financial sector goes.

QUESTION: [Not at microphone] There's always the problem of excessive risk and excessive regulation, which can stifle [inaudible] industry. Could you comment on the advantage of having IMF, through the Group of 20, impose minimum reserve requirements on all the financial banks and the transactions and maximum leverage requirements on the same things, and also to avoid this consumer [inaudible] bureaucracy, simply restore the old usury and bankruptcy regulations that we used to have?

JOHN CASSIDY: You mean put a regulation queue back in or something? I hadn't thought of that one.

On the IMF, again you need coordination. I'm not saying you don't need international coordination. You do need some international coordination. So it would be a good idea. It's never going to work through the IMF, I don't think.

QUESTIONER: [Not at microphone]

JOHN CASSIDY: The Group of 20? It's like Stalin said about the pope: How many divisions do they have? Nobody takes any notice of the Group of 20. Unless the U.S. Treasury is behind it, nothing will happen. Brown tried to float these ideas at the G-20. He actually tried to sue the G-20 as cover for sort of doing an end run around the Americans. But you can't do an end run around the Americans. They run these institutions, and they run the IMF, too. So unless the U.S. government signs on for anything, it is not going to happen.

The consumer bureaucracy thing—it may turn into a terrible bureaucracy. I don't know. It seems to me a reasonable idea. There were large sectors of the mortgage market, for example, which just weren't regulated, because they are regulated at the state level. In California, where all these enormous financial institutions, like AMERITRADE and Ameriquest, et cetera, were all based, there were, like, ten regulators in an office in Sacramento looking after 20,000 loan offices. That's why they incorporated at the state level, because they knew they could out-game the local regulators. At least if you have a national level of regulation, I think it's harder for these institutions to game them.

I know what you are saying. It may degenerate into just another bureaucracy. But I think the idea of regulating at the federal level has got something to be said for it, because it just avoids people going to different states.

QUESTIONER: Wouldn't simple criminal prosecution for violating the usury laws and bankruptcy laws solve the problem?

JOHN CASSIDY: The FBI would need another 200,000 agents, wouldn't they?

It's a federal crime to lie about your income on a mortgage application form. If we had enforced that in the last five years, I would have said, at a rough guess, probably 30 million, 40 million, 50 million Americans would have been found guilty of a felony.

It's easy to say to enforce this stuff, but it's sort of a social norm issue, I think. The FBI were issuing warnings back in 2004-2005 about the growth of mortgage fraud, but nobody would listen. It's easy to say to just prosecute them, but you are going to have to build a lot of jails if you're going to start prosecuting people for lying on their mortgage statements.

QUESTION: There's a hypothesis that I heard recently which was that if it hadn't been for Y2K and the sort of reconciling and rebuilding of all of the computer systems in the financial services industry, the velocity of transactions would have been a lot less, the interconnectedness would have been a lot less, and it might have been a lot less dangerous. I wondered if anything like that had—

JOHN CASSIDY: You mean it was all the computers' fault and they were boosted enormously by Y2K? I'm really not qualified to answer that question. It seems to me it's a convenient excuse for the bankers.

Certainly I think technology played a role, in that a lot of the risk models which the Wall Street banks were relying on were based on computer simulations. That is certainly true. They used computer simulations to price a lot of the CDOs [collaterized debt obligation] and the CDOs-squared, et cetera. Guys like Chuck Prince clearly had no idea what was going on in these sort of "quant" departments. But I think it's too easy to just blame the computers. Somebody programs these computers, right? I would tend to blame them.

QUESTION: I wonder if you could talk a little bit about how you approach efficient-market theory. I ask because a lot of these large portfolios had values put on them, and it strikes me that a lot of the valuations were disseminated more widely than they should have been, based on limited data and limited models, through daisy chains of markets.

JOHN CASSIDY: It's a fascinating question. Actually, I'm writing something for The New Yorker at the moment about the efficient-market hypothesis. I've just been out in Chicago to talk to the sort of high priests a year after, including Gene Fama, who was the founder of efficient markets.

I'm pretty critical of it, to be honest. I think there are two versions of the efficient-market hypothesis. One I'm willing to go along with: That it's difficult to beat the market, that it is efficient enough to make it difficult for an individual or a firm to beat the market. I think there are 30 years of research showing that. There are some sort of anomalies which you can exploit from time to time. But the market is efficient enough that once one person learns them, somebody else learns, and it gets eliminated pretty quickly. If that's where the efficient-market hypothesis is, you can sign me up; I agree.

But the idea that markets never depart from economic fundamentals and that the market price is always right, in some sense, I think has been completely discredited by what we have seen. These credit products were chronically mispriced for years. Fifty basis points above Treasuries? They should have been trading at 1,500 basis points above Treasuries or something.

Gene Fama and people have got a very convoluted argument for why the market wasn't failing, which I'm trying to convert into English. If you keep reading The New Yorker, you should get a version of it.

But it seems to me it's a bit like when Hubble discovered that the universe was expanding. There were some guys who said, "Well, actually, he's got the results wrong. If you reinterpret these results, the universe is actually still stable," which Einstein believed. I think that's all nonsense. This was clearly an example of chronic inefficiency in the capital markets for years on end.

We had another example of that ten years ago in the stock market. We probably had an example of it in the commodities market last year. Financial markets are prone to speculative bubbles. That seems to me to be fundamentally—they are not always, but periodically they are prone to it. That seems to me to be very difficult to reconcile with the efficient-market hypothesis.

QUESTION: I'm very concerned about the fact that the banks, especially the big banks, are still sitting on all of these toxic assets, so-called. Until those toxic assets get written down—and, of course, the Fed has a whole heap of them, too, now—they are not going to lend. The question is, what do you do? How do you force them to—they eliminated mark-to-market rules. So they are just going to sit there for ten years waiting for the rising tide.

JOHN CASSIDY: I get the argument. It's a very good question. I was on a panel, actually, with Carmen Reinhart, who is Ken Rogoff's co-author, the other day, and she was pointing to this and saying she thinks the U.S. is turning into Japan, that we're on the Japanese timetable.

She thinks the most important thing that happened last year was the FASB ruling [Financial Accounting Standards Board], which is that you don't have to mark these things to market anymore. So the banks are basically putting whatever prices on them they want.

I'm a bit more optimistic than that. I'm not massively optimistic, but I'm a bit more optimistic than that. In a recession, the banks always get criticized. I'm not a big fan of the banks, as you probably gathered.

But in a recession, the main reason they stop lending is because there's not a massive demand, I think. So I think the test will come when the economy starts to grow again, if it's still difficult to find credit.

Maybe I'm wrong, but I haven't seen big lists of industrial corporations who are having difficulty getting access to credit. They are obviously not getting it as cheaply as they used to do. But they were getting it too cheaply. The market was mispricing credit.

The second aspect of it is that there is a covert recapitalization of the banking system going on, through monetary policy. The Fed is giving these guys money at zero and they invest at 4 percent. That might be morally terrible, but it's economically quite effective. They are making enormous profits, so their capital ratios are coming back up. As I say, it's not something you like to see, but it's clearly a covert recapitalization. If their capital ratios all come back up, they make so much profit. When the economy ticks up again, they shouldn't be capital-constrained; they should be able to lend more.

I'm not saying that's definitely going to happen, but I'm not willing to totally buy into the Japanese argument as yet. If the economy starts recovering over the next year, if the recovery picks up a bit, and there are lots of stories about how small businesses and big businesses can't get any money from the banks, then I may reappraise my optimism.

JOANNE MYERS: I think after listening to you speak today, if you're not a subscriber to The New Yorker, you would probably want to become one in order not to miss any of your articles. I thank you very much for your presentation.

JOHN CASSIDY: Thank you. Thank you, everybody.

Copyright © 2010 Carnegie Council for Ethics in International Affairs

THE FOOD BUBBLE
How Wall Street Starved Millions and Got Away with It

By Frederick Kaufman
Frederick Kaufman is a contributing editor of Harper’s Magazine. His last article for the magazine, “Let Them Eat Cash,” appeared in the June 2009 issue.

The history of food took an ominous turn in 1991, at a time when no one was paying much attention. That was the year Goldman Sachs decided our daily bread might make an excellent investment. Agriculture, rooted as it is in the rhythms of reaping and sowing, had not traditionally engaged the attention of Wall Street bankers, whose riches did not come from the sale of real things like wheat or bread but from the manipulation of ethereal concepts like risk and collateralized debt. But in 1991 nearly everything else that could be recast as a fi nancial abstraction had already been considered. Food was pretty much all that was left. And so with accustomed care and precision, Goldman’s analysts went about transforming food into a concept. They selected eighteen commodifi able ingredients and contrived a fi nancial elixir that included cattle, coffee, cocoa, corn, hogs, and a variety or two of wheat. They weighted the investment value of each element, blended and commingled the parts into sums, then reduced what had been a complicated collection of real things into a mathematical formula that could be expressed as a single manifestation, to be known thenceforward as the Goldman Sachs Commodity Index. Then they began to offer shares.

As was usually the case, Goldman’s product fl ourished. The prices of cattle, coffee, cocoa, corn, and wheat began to rise, slowly at fi rst, and then rapidly. And as more people sank money into Goldman’s food index, other bankers took note and created their own food indexes for their own clients. Investors were delighted to see the value of their venture increase, but the rising price of breakfast, lunch, and dinner did not align with the interests of those of us who eat. And so the commodity index funds began to cause problems. Wheat was a case in point. North America, the Saudi Arabia of cereal, sends nearly half its wheat production overseas, and an obscure syndicate known as the Minneapolis Grain Exchange remains the supreme price-setter for the continent’s most widely exported wheat, a highprotein variety called hard red spring. Other varieties of wheat make cake and cookies, but only hard red spring makes bread. Its price informs the cost of virtually every loaf on earth.

As far as most people who eat bread were concerned, the Minneapolis Grain Exchange had done a pretty good job: for more than a century the real price of wheat had steadily declined. Then, in 2005, that price began to rise, along with the prices of rice and corn and soy and oats and cooking oil. Hard red spring had long traded between $3 and $6 per sixtypound bushel, but for three years Minneapolis wheat broke record after record as its price doubled and then doubled again. No one was surprised when in the fi rst quarter of 2008 transnational wheat giant Cargill attributed its 86 percent jump in annual profi ts to commodity trading. And no one was surprised when packaged- food maker ConAgra sold its trading arm to a hedge fund for $2.8 billion. Nor when The Economist announced that the real price of food had reached its highest level since 1845, the year the magazine fi rst calculated the number. Nothing had changed about the wheat, but something had changed about the wheat market. Since Goldman’s innovation, hundreds of billions of new dollars had overwhelmed the actual supply of and actual demand for wheat, and rumors began to emerge that someone, somewhere, had cornered the market. Robber barons, gold bugs, and fi nanciers of every stripe had long dreamed of controlling all of something everybody needed or desired, then holding back the supply as demand drove up prices. But there was plenty of real wheat, and American farmers were delivering it as fast as they always had, if not even a bit faster. It was as if the price itself had begun to generate its own demand—the more hard red spring cost, the more investors wanted to pay for it.

“It’s absolutely mind-boggling,” one grain trader told the Wall Street Journal. “You don’t ever want to trade wheat again,” another told the Chicago Tribune. “We have never seen anything like this before,” Jeff Voge, chairman of the Kansas City Board of Trade, told the Washington Post. “This isn’t just any commodity,” continued Voge. “It is food, and people need to eat.” The global speculative frenzy sparked riots in more than thirty countries and drove the number of the world’s “food insecure” to more than a billion. In 2008, for the fi rst time since such statistics have been kept, the proportion of the world’s population without enough to eat ratcheted upward. The ranks of the hungry had increased by 250 million in a single year, the most abysmal increase in all of human history.

Then, like all speculative bubbles, the food bubble popped. By late 2008, the price of Minneapolis hard red spring had toppled back to normal levels, and trading volume quickly followed. Of course, the prices world consumers pay for food have not come down so fast, as manufacturers and retailers continue to make up for their own heavy losses.

The gratuitous damage of the food bubble struck me as not merely a disgrace but a disgrace that might easily be repeated. And so I traveled to Minneapolis—where the reality of hard red spring and the price of hard red spring fi rst went their separate ways—to discover how such a thing could have happened, and if and when it would happen again.

The name of the Minneapolis Grain Exchange may conjure images of an immense concrete silo towering over the prairie, but the exchange is in fact a rather severe neoclassical steelframe building that shares the downtown corner of Fourth Street and Fourth Avenue with City Hall, the courthouse, and the jail. I walked through its vestibule of granite and Italian marble, past renderings of wheat molded into the terra-cotta cartouches, and as I waited for the wheatembossed elevator I tried not to gawk at the gold-plated mail chute. For more than a century, the trading fl oor of the Minneapolis Grain Exchange had been the place where wheat acquired a price, but as I stepped out of the elevator the opening bell tolled and echoed across a vast, silent, and chilly chamber. The place was abandoned, the phones ripped out of the walls, the octagonal grain pits littered with snakes of tangled wire. I wandered across the wooden planks of the old pits, scarred by the boots of countless grain traders, and I peered into the dark and narrow recesses of the phone booths where those traders had scribbled down their orders. Beyond the booths loomed the massive cash-grain tables, starkly illuminated by rays of sunlight. In the old days, when brokers and traders looked into one another’s faces, not computer screens, they liked to examine the grain before they bought it.

Now an electronic board began to populate with green, red, and yellow numbers that told the price of barley, canola, cattle, coffee, copper, cotton, gold, hogs, lumber, milk, oats, oil, platinum, rice, and silver. Beneath them shimmered the indices: the Dow, the S&P 500, and, at the very bottom, the Goldman Sachs Commodity Index. Even the video technology was quaint, a relic from the Carter years, when trade with the Soviet Union was the fi nal frontier, long before that moment in 2008 when the chief executive offi cer of the Minneapolis Grain Exchange, Mark Bagan, decided that the future of wheat was not on a table in Minneapolis but within the digital infi nitude of the Internet.

As a courtesy to the speculators who for decades had spent their workdays executing trades in the grain pits, the exchange had set up a new space a few stories above the old trading fl oor, a gray-carpeted room in which a few dozen beige cubicles were available to rent, some featuring a view of a parking lot. I had expected shouting, panic, confusion, and chaos, but no more than half the cubicles were occupied, and the room was silent. One of the grain traders was reading his email, another checking ESPN for the weekend scores, another playing solitaire, another shopping on eBay for antique Japanese vases.

IT WAS AS IF THE PRICE OF WHEAT
WAS GENERATING ITS OWN
DEMAND. THE MORE IT COST, THE
MORE INVESTORS WANTED TO PAY

“We’re trading wheat, but it’s wheat we’re never going to see,” Austin Damiani, a twenty-eight-year-old wheat broker, would tell me later that afternoon. “It’s a cerebral experience.” Today’s action consisted of a grayhaired man padding from cubicle to cubicle, greeting colleagues, sucking hard candy. The veteran eventually ambled off to a corner, to a battered cash-grain table that had been moved up from the old trading fl oor. A dozen aluminum pans sat on the table, each holding a different sample of grain. The old man brought a pan to his face and took a deep breath. Then he held a single grain in his palm, turned it over, and found the crease.

“The crease will tell you the variety,” he told me. “That’s a lost art.” His name was Mike Mullin, he had been trading wheat for fifty years, and he was the fi rst Minneapolis wheat trader I had seen touch a grain of the stuff. Back in the day, buyers and sellers might have spent hours insulting, cajoling, bullying, and pleading with one another across this table—anything to get the right price for hard red spring—but Mullin was not buying real wheat today, nor was anybody here selling it.

Above us, three monitors flickered prices from America’s primary grain exchanges: Chicago, Kansas City, and Minneapolis. Such geographic specifi cities struck me as archaic, but there remain essential differences among these wheat markets, vestiges of old-fashioned concerns such as latitude and proximity to the Erie Canal.

Mullin stared at the screens and asked me what I knew about wheat futures, and I told him that whereas Minneapolis traded the contract in hard red spring, Kansas City traded in hard red winter and Chicago in soft red winter, both of which have a lower protein content than Minneapolis wheat, are less expensive, and are more likely to be incorporated into a brownie mix than into a baguette. High protein content makes Minneapolis wheat elite, I told Mullin.

He nodded his head, and we stood in silence and watched the desultory movement of corn and soy, soft red winter and hard red spring. It was a slow trading day even if commodities, as Mullin told me, were overpriced 10 percent across the board. Mullin fi gured he knew the real worth of a bushel and had bet the price would soon head south. “Am I short?” he asked. “Yes I am.” I asked him what he knew about the commodity indexes, like the one Goldman Sachs created in 1991. “It’s a brainless entity,” Mullin said. His eyes did not move from the screen. “You look at a chart. You hit a number. You buy.”

Grain trading was not always brainless. Joseph parsed Pharaoh’s dream of cattle and crops, discerned that drought loomed, and diligently went about storing immense amounts of grain. By the time famine descended, Joseph had cornered the market—an accomplishment that brought nations to their knees and made Joseph an extremely rich man.

In 1730, enlightened bureaucrats of Japan’s Edo shogunate perceived that a stable rice price would protect those who produced their country’s sacred grain. Up to that time, all the farmers in Japan would bring their rice to market after the September harvest, at which point warehouses would overfl ow, prices would plummet, and, for all their hard work, Japan’s rice farmers would remain impoverished. Instead of suffering through the Osaka market’s perennial volatility, the bureaucrats preferred to set a price that would ensure a living for farmers, grain warehousemen, the samurai (who were paid in rice), and the general population—a price not at the mercy of the annual cycle of scarcity and plenty but a smooth line, gently fl uctuating within a reasonable range.

While Japan had relied on the authority of the government to avoid deadly volatility, the United States trusted in free enterprise. After the combined credit crunch, real estate wreck, and stock-market meltdown now known as the Panic of 1857, U.S. grain merchants conceived a new stabilizing force: In return for a cash commitment today, farmers would sign a forward contract to deliver grain a few months down the line, on the expiration date of the contract. Since buyers could never be certain what the price of wheat would be on the date of delivery, the price of a future bushel of wheat was usually a few cents less than that of a present bushel of wheat. And while farmers had to accept less for future wheat than for real and present wheat, the guaranteed future sale protected them from plummeting prices and enabled them to use the promised payment as, say, collateral for a bank loan. These contracts let both producers and consumers hedge their risks, and in so doing reduced volatility.

But the forward contract was a primitive fi nancial tool, and when demand for wheat exploded after the Civil War, and ever more grain merchants took to reselling and trading these agreements on a fastgrowing secondary market, it became impossible to fi gure out who owed whom what and when. At which point the great grain merchants of Chicago, Kansas City, and Minneapolis set about creating a new kind of institution less like a medieval county fair and more like a modern clearinghouse. In place of myriad individually negotiated and fulfi lled forward contracts, the merchants established exchanges that would regulate both the quality of grain and the expiration dates of all forward contracts—eventually limiting those dates to fi ve each year, in March, May, July, September, and December. Whereas under the old system each buyer and each seller vetted whoever might stand at the opposite end of each deal, the grain exchange now served as the counterparty for everyone.

The exchanges soon attracted a new species of merchant interested in numbers, not grain. This was the speculator. As the price of futures contracts fl uctuated in daily trading, the speculator sought to cash in through strategic buying and selling. And since the speculator had neither real wheat to sell nor a place to store any he might purchase, for every “long” position he took (a promise to buy future wheat), he would eventually need to place an equal and opposite “short” position (a promise to sell). Farmers and millers welcomed the speculator to their market, for his perpetual stream of buy and sell orders gave them the freedom to sell and buy their actual wheat just as they pleased.

Under the new system, farmers and millers could hedge, speculators could speculate, the market remained liquid, and yet the speculative futures price could never move too far from the “spot” (or actual) price: every ten weeks or so, when the delivery date of the contract approached, the two prices would converge, as everyone who had not cleared his position with an equal and opposite position would be obligated to do just that. The virtuality of wheat futures would settle up with the reality of cash wheat, and then, as the contract expired, the price of an ideal bushel would be “discovered” by hedger and speculator alike.

No less an economist than John Maynard Keynes applied himself to studying this miraculous interplay of supply and demand, buyers and sellers, real wheat and virtual wheat, and he gave the standard futures-pricing model its own special name. He called it “normal backwardation,” because in a normal market for real goods, he found, futures prices (for things that did not yet exist) generally stayed in back of spot prices (for things that actually existed).

Normal backwardation created the occasion for so many people to make so much money in so many ways that numerous other futures exchanges soon emerged, featuring contracts for everything from butter, cottonseed oil, and hay to plywood, poultry, and cat pelts. Speculators traded molasses futures on the New York Coffee and Sugar Exchange, and if they lost their shirts they could head over to the New York Burlap and Jute Exchange or the New York Hide Exchange. And despite the occasional market collapse (onions in 1957, Maine potatoes in 1976), for more than a century the basic strategy and tactics of futures trading remained the same, the price of wheat remained stable, and increasing numbers of people had plenty to eat.

The decline of volatility, good news for the rest of us, drove bankers up the wall. I put in a call to Steven Rothbart, who traded commodities for Cargill way back in the 1980s. I asked him what he knew about the birth of commodity index funds, and he began to laugh. “Commodities had died,” he told me. “We sat there every day and the market wouldn’t move. People left. They couldn’t make a living anymore.”

Clearly, some innovation was in order. In the midst of this dead market, Goldman Sachs envisioned a new form of commodities investment, a product for investors who had no taste for the complexities of corn or soy or wheat, no interest in weather and weevils, and no desire for getting into and out of shorts and longs—investors who wanted nothing more than to park a great deal of money somewhere, then sit back and watch that pile grow. The managers of this new product would acquire and hold long positions, and nothing but long positions, on a range of commodities futures. They would not hedge their futures with the actual sale or purchase of real wheat (like a bona-fide hedger), nor would they cover their positions by buying low and selling high (in the grand old fashion of commodities speculators). In fact, the structure of commodity index funds ran counter to our normal understanding of economic theory, requiring that index-fund managers not buy low and sell high but buy at any price and keep buying at any price. No matter what lofty highs long wheat futures might attain, the managers would transfer their long positions into the next long futures contract, due to expire a few months later, and repeat the roll when that contract, in turn, was about to expire— thus accumulating an everlasting, ever-growing long position, unremittingly regenerated.

“You’ve got to be out of your freaking mind to be long only,” Rothbart said. “Commodities are the riskiest things in the world.” But Goldman had its own way to offset the risks of commodities trading—if not for their clients, then at least for themselves. The strategy, standard practice for most index funds, relied on “replication,” which meant that for every dollar a client invested in the index fund, Goldman would buy a dollar’s worth of the underlying commodities futures (minus management fees). Of course, in order to purchase commodities futures, the bankers had only to make a “good-faith deposit” of something like 5 percent. Which meant that they could stash the other 95 percent of their investors’ money in a pool of Treasury bills, or some other equally innocuous financial cranny, which they could subsequently leverage into ever greater amounts of capital to utilize to their own ends, whatever they might be. If the price of wheat went up, Goldman made money. And if the price of wheat fell, Goldman still made money—not only from management fees, but from the profi ts the bank pulled down by investing 95 percent of its clients’ money in less risky ventures. Goldman even made money from the roll into each new long contract, every instance of which required clients to pay a new set of transaction costs. The bankers had fi gured out how to extract profi t from the commodities market without taking on any of the risks they themselves had introduced by flooding that same market with long orders. Unlike the wheat producers and the wheat speculators, or even Goldman’s own customers, Goldman had no vested interest in a stable commodities market. As one index trader told me, “Commodity funds have historically made money—and kept most of it for themselves.”

No surprise, then, that other banks soon recognized the rightness of this approach. In 1994, J.P. Morgan established its own commodity index fund, and soon thereafter other players entered the scene, including the AIG Commodity Index and the Chase Physical Commodity Index, along with initial offerings from Bear Stearns, Oppenheimer, and Pimco. Barclays joined the group with eight index funds and, in just over a year, raised close to $3 billion. Government regulators, far from preventing this strange new way of accumulating futures, actively encouraged it. Congress had in 1936 created a commission that curbed “excessive speculation” by limiting large holdings of futures contracts to bona-fide hedgers. Years later, the modern-day Commodity Futures Trading Commission continued to set absolute limits on the amount of wheat-futures contracts that could be held by speculators. In 1991, that limit was 5,000 contracts. But after the invention of the commodity index fund, bankers convinced the commission that they, too, were bona-fide hedgers. As a result, the commission issued a position-limit exemption to six commodity index traders, and within a decade those funds would be permitted to hold as many as 130,000 wheat-futures contracts at any one time.

“We have not seen U.S. agriculture rely this much on the market for almost seventy years,” was how Joseph Dial, the head of the commission, assessed his agency’s regulatory handiwork in 1997. “This paradigm shift in the government’s farm policy has created a new era for agriculture.”

Goldman and all the other banks that followed them into commodity index funds had fi gured out how to safeguard themselves, but there was a lot more money to be made if the banks could somehow convince everyone else that an inherently risky product designed to protect the banks—and only the banks—was in fact also safe for investors. Good news came on February 28, 2005, when Gary Gorton, of the University of Pennsylvania, and K. Geert Rouwenhorst, of the Yale School of Management, published a working paper called “Facts and Fantasies About Commodities Futures.” In forty graph-and-equationfilled pages, the authors demonstrated that between 1959 and 2004, a hypothetical investment in a broad range of commodities— such as an index—would have been no more risky than an investment in a broad range of stocks. What’s more, commodities showed a negative correlation with equities and a positive correlation with infl ation. Food was always a good investment, and even better in bad times. Money managers could hardly wait to spread the news.

“Since this discovery,” reported the Financial Times, investors had become attracted to commodities “in the hope that returns will differ from equities and bonds and be strong in case of infl ation.” Another study noted as well that commodity index funds offered “an inherent or natural return that is not conditioned on skill.” And so the longawaited legion of new investors began buying into commodity index funds, and the food bubble truly began to infl ate.

A few years after “Facts and Fantasies” appeared, and almost as if to prove Gorton and Rouwenhorst’s point, the financial crisis hit mortgage, credit, and real estate markets— and, just as the scholars had predicted, those who had invested in commodities prospered. Money managers had to decide where to park what remained of their endowment, hedge, and pension funds, and the bankers were ready with something that looked very safe: in 2003, commodity index holdings amounted to a not particularly aweinspiring $13 billion, but by 2008, $317 billion had poured into the funds. As long as the commodities brokers kept rolling over their futures, it looked as though the day of reckoning might never come. If no one contemplated the effects that this accumulation of long-only futures would eventually have on grain markets, perhaps it was because no one had never seen such a massive pile of long-only futures.

From one perspective, a complicated chain of cause and effect had infl ated the food bubble. But there were those who understood what was happening to the wheat markets in simpler terms. “I don’t have to pay anybody for anything, basically,” one long-only indexer told me. “That’s the beauty of it.”

Mark Bagan, CEO of the Minneapolis Grain Exchange, invited me to his offi ce for a talk. A self-proclaimed “grain brat,” Bagan grew up among bales, combines, and concrete silos all across the United States before attending Minnesota State to play football. As I settled into his oversize couch, admired his neatly tailored pinstriped suit, and listened to his soft voice, it occurred to me that if the grain markets were a casino, Mark Bagan was the biggest bookie. Without him, there could be no bets on hard red spring.

“From our perspective, we’re price neutral, value neutral,” Bagan said. I asked him about the commodity index funds and whether they had transformed the traditional wheat market into something wholly speculative, artificial, and hidden. Why did anyone except bankers even need this new market?

“There are plenty of markets out there that have yet to be thought of and will be very successful,” Bagan said. Then he veered into the intricacies of running a commodities exchange. “With our old system, we could clear forty-eight products,” he said. “Now we can have more than fi fty thousand products traded. It’s a big number, building derivatives on top of derivatives, but we’ve got to be prepared for that: the fi nancial world is evolving so quickly, there will always be a need for new riskmanagement products.”

Bagan had not answered my question about the funds, so I asked again, as directly as I could: What did he make of the fact that speculation in commodity index funds had caused a global run on hard red spring? Bagan slowly shook his head, as though he were an elementaryschool teacher trying to explain a basic concept—subtraction? ice?— to a particularly dense child. The Goldman Sachs Commodity Index did not include a single hard red spring future, he told me. Minneapolis wheat may have set records in 2008 and led global food prices into the stratosphere, but it had nothing to do with Goldman’s fund. There just wasn’t enough speculation in the hard red spring market to satisfy the bankers. Not enough liquidity. Bagan smiled. Was there anything else I wanted to know?

Plenty, but there was nothing more Bagan was about to disclose. As I left the offi ce, I remembered the rumors I’d heard at a grain-crisis conference in Washington, D.C., a few months earlier. Between interminable speeches about price ceilings and grain reserves, more than one wheat expert had confi ded, strictly on background, that at the height of the bubble, Minneapolis wheat had been cornered. No one could say whether the culprit had been Cargill or the Canadian Wheat Board or any other party, but the consensus was that as the world had cried for food, someone, somewhere, had been hoarding wheat.

Imaginary wheat bought anywhere affects real wheat bought everywhere. But as it turned out, index traders had purchased the majority of their long wheat futures on the oldest and largest grain clearinghouse in America, the Chicago Mercantile Exchange. And so I found myself pushing through the frigid blasts of the LaSalle Street canyon. If I could figure out precisely how and when wheat futures traded in Chicago had driven up the price of actual wheat in Minneapolis, I would know why a billion people on the planet could not afford bread. The man who had agreed to escort me to the fl oor of the exchange traded grain for a transnational corporation, and he told me several times that he could not talk to the press, and that if I were to mention his name in print he would lose his job. So I will call him Mr. Silver.

In the basement cafeteria of the exchange I bought Mr. Silver a breakfast of bacon and eggs and asked whether he could explain how index funds that held long-only Chicago soft red winter wheat futures could have come to dictate the spot price of Minneapolis hard red spring. Had the world starved because of a corner in Chicago? Mr. Silver looked into his scrambled eggs and said nothing. So I began to tell him everything I knew, hoping he would eventually be inspired to fi ll in the blanks. I told him about Joseph in Egypt, Osaka in 1730, the Panic of 1857, and futures contracts for cat pelts, molasses, and onions. I told him about Goldman’s replication strategy, Gorton and Rouwenhorst’s 2005 paper, and the rise and rise of index funds. I told him that at least one analyst had estimated that investments in commodity index funds could easily increase to as much as $1 trillion, which would result in yet another global food catastrophe, much worse than the one before.

And I told Mr. Silver something else I had discovered: About two thirds of the Goldman index remains devoted to crude oil, gasoline, heating oil, natural gas, and other energybased commodities. Wheat was nothing but an indexical afterthought, accounting for less than 6.5 percent of Goldman’s fund.

Mr. Silver sipped his coffee. Even 6.5 percent of the Goldman Sachs Commodity Index made for a historically unprecedented pile of long wheat futures, I went on. Especially when those index funds kept rolling over the contracts they already had—all of them long, only a smattering bought in Kansas City, none in Minneapolis.

And then it occurred to me: It was neither an individual nor a corporation that had cornered the wheat market. The index funds may never have held a single bushel of wheat, but they were hoarding staggering quantities of wheat futures, billions of promises to buy, not one of them ever to be fulfi lled. The dreaded market corner had emerged not from a shortage in the wheat supply but from a much rarer economic occurrence, a shock inspired by the ceaseless call of index funds for wheat that did not exist and would never need to exist: a demand shock. Instead of a hidden mastermind committing a dastardly deed, it was old Mike Mullin’s “brainless entity,” the investment instrument itself, that had taken over and created the effects of a traditional corner.

Mr. Silver had stopped eating his eggs. I said that I understood how the index funds’ unprecedented accumulation of Chicago futures could create the appearance of a market corner in Chicago. But there was still something I didn’t get. Why had the wheat market in Minneapolis begun to act as though it too had been cornered when none of the index funds held hard red spring? Why had the world’s most widely exported wheat experienced a sudden surge in price, a surge that caused a billion people—

At which point Mr. Silver interrupted my monologue.

Index-fund buying had pushed up the price of the Chicago contract, he said, until the price of a wheat future had come to equal the spot price of wheat on the Chicago Mercantile Exchange—and still, the futures price surged. The result was contango.

I gave Mr. Silver a blank look. Contango, he explained, describes a market in which future prices rise above current prices. Rather than being stable and steady, contango markets tend to be overheated and hysterical, with spot prices rising to match the most outrageously escalated futures prices. Indeed, between 2006 and 2008, the spot price of Chicago soft red winter shot up from $3 per bushel to $11 per bushel. The ever-escalating price of wheat and the newfound strength of grain markets were excellent news for the new investors who had fl ooded commodity index funds. No matter that the mechanism created to stabilize grain prices had been reassembled into a mechanism to inflate grain prices, or that the stubbornly growing discrepancy between futures and spot prices meant that farmers and merchants no longer could use these markets to price crops and manage risks. No matter that contango in Chicago had disrupted the operations of the nation’s grain markets to the extent that the Senate Committee on Homeland Security and Governmental Affairs had begun an investigation into whether speculation in the wheat markets might pose a threat to interstate commerce. And then there was the question of the millers and the warehousers—those who needed actual wheat to sell, actual bread that might feed actual people.

Mr. Silver lowered his voice as he informed me that as the price of Chicago wheat had bubbled up, commercial buyers had turned elsewhere—to places like Minneapolis. Although hard red spring historically had been more expensive than soft red winter, it had begun to look like a bargain. So brokers bought hard red spring and left it to the chemists at General Mills or Sara Lee or Domino’s to rejigger their dough recipes for a higher-protein variety. The grain merchants purchased Minneapolis hard red spring much earlier in the annual cycle than usual, and they purchased more of it than ever before, as real demand began to chase the ever-growing, everlasting long. By the time the normal buying season began, drought had hit Australia, fl oods had inundated northern Europe, and a vogue for biofuels had enticed U.S. farmers to grow less wheat and more corn. And so, when nations across the globe called for their annual hit of hard red spring, they discovered that the so-called visible supply was far lower than usual. At which point the markets veered into insanity.

Bankers had taken control of the world’s food, money chased money, and a billion people went hungry. Mr. Silver fi nished his bacon and eggs and I followed him upstairs, beyond two sets of metal detectors, dozens of security staff, and a gaudy stained-glass image of Hermes, god of commerce, luck, and thievery. Through the colored glass that outlined the deity I caught my first glimpse of the immense trading fl oor of the Chicago Mercantile Exchange. The electronic board had already begun to populate with green, yellow, and red numbers.

The wheat harvest of 2008 turned out to be the most bountiful the world had ever seen, so plentiful that even as hundreds of millions slowly starved, 200 million bushels were sold for animal feed. Livestock owners could afford the wheat; poor people could not. Rather belatedly, real wheat had shown up again—and lots of it. U.S. Department of Agriculture statistics eventually revealed that 657 million bushels of 2008 wheat remained in U.S. silos after the buying season, a record-breaking “carryover.” Soon after that bounteous oversupply had been discovered, grain prices plummeted and the wheat markets returned to business as usual.

The worldwide price of food had risen by 80 percent between 2005 and 2008, and unlike other food catastrophes of the past half century or so, the United States was not insulated from this one, as 49 million Americans found themselves unable to put a full meal on the table. Across the country demand for food stamps reached an all-time high, and one in fi ve kids came to depend on food kitchens. In Los Angeles nearly a million people went hungry. In Detroit armed guards stood watch over grocery stores. Rising prices, mused the New York Times, “might have played a role.”

On the plane to Minneapolis I had read a startling prediction: “It may be hard to imagine commodity prices advancing another 460 percent above their mid-2008 price peaks,” hedge-fund manager John Hummel wrote in a letter to clients of AIS Capital Management. “But the fundamentals argue strongly,” he continued, that “these sectors have signifi cant upside potential.” I made a quick calculation: 460 percent above 2008 peaks meant hamburger meat priced at $20 a pound.

On the ground in Minneapolis I put the question to Michael Ricks, chairman of the Minneapolis Grain Exchange. Could 2008 happen again? Could prices rise even higher? “Absolutely,” said Ricks. “We’re in a volatile world.” I put the same question to Layne Carlson, corporate secretary and treasurer of the Minneapolis Grain Exchange. “Yes,” said Carlson, who then told me the two principles that govern the movement of grain markets: “fear and greed.”

But wasn’t it part of a grain exchange’s responsibility to ensure a stable valuation of our daily bread? “I view what we’re working with as widgets,” said Todd Posthuma, the exchange’s associate director of market operations and information technology, the man responsible for clearing $100 million worth of trades every day. “I think being an employee at an exchange is different from adding value to the food system.” Above Mark Bagan’s oversize desk hangs a jagged chart of futures prices for the hard red spring wheat contract, mapping every peak and valley from 1973 to 2006. The highs on Bagan’s chart reached $7.50. Of course, had 2008 been included, the spikes would have, literally, gone through the roof. Would the price of wheat rise again?

“The fl ow of money into commodities has changed signifi cantly in the last decade,” explained Bagan. “Wheat, corn, soft commodities—I don’t see these dollars going away. It already has happened,” he said. “It’s inevitable.”

To Hell With the Free Market
In the Service of the Rich
June 14, 2010

By DEAN BAKER

The supposed free market fundamentalists are once again running to get a helping hand from Big Government. Apparently, the Republicans are outraged over the fact that many homeowners are now "strategically defaulting" on their mortgages. They have stopped paying a mortgage even though they can still afford the payment because they decided that they would be better off just giving the house back to the bank. There have been some press accounts talking about strategic defaulters who have used their savings to buy a new car or even take a trip to Europe.

This has outraged Republicans in Congress. They have now proposed a bill to have the government punish strategic defaulters by denying them the option to receive a loan insured by the Federal Housing Authority (FHA).

It is important to get some perspective on the issue here. Strategic defaulters are following the terms of their contracts to the letter.

The mortgage contract requires a homeowner to pay a mortgage in order to stay in possession of the house. The penalty for not paying the mortgage is that the bank gets to retake the house.

Banks know (or are supposed to know) when they issue a mortgage that there is some probability that the homeowner will not repay the mortgage. One of the reasons that homeowners may not repay the mortgage, and cause the banks to lose money, is that the home falls in value. Banks should have incorporated this risk into the interest rate they charged on the mortgage.

Since nationwide house prices have fallen 30 percent since the peak of the bubble, and much more in some areas, there are millions of homeowners who would do better by turning over their home to the bank than by continuing to pay their mortgage. Now many homeowners are taking advantage of this option to the detriment of the banks or other holders of the mortgage.

Rather than respecting the sanctity of contract, the Republicans want to punish homeowners who look out for their own best interest and strategically default. Hence they want to prohibit them from later getting a loan that is insured by the FHA. Who knows what other sanction they may look to impose. Maybe they will also prohibit strategically defaulters from getting a loan through the Small Business Administration or allowing their children to getting a government guaranteed student loan.

It is worth noting that strategic default is a standard business practice. There was recently an incident in which Morgan Stanley strategically defaulted on the mortgage of a large property in its possession, deciding it was better just to turn it back to the lenders. There haven't been any calls by the Republicans in Congress for punishing Morgan Stanley - say by banning them it from government contracts.

We also have to look at this issue from the other side. Do we think that bankers are too stupid to understand contracts? Do Citigroup and J.P. Morgan need the government to hold their hand when they issue a mortgage, making sure that these banks fully understand the terms of the contract that they have issued? Maybe the government should require that all mortgage contracts are written in big type and simple language so that highly paid bank executives will understand the terms of the mortgages that they are selling.

Actually, the Republicans are doing the country a valuable service by showing us in the clearest possible terms that they couldn't give flying f*** about the "free market." They are about redistributing income upward. If they can rig the rules of the market to get the income flowing upward, that's great. But, if it takes the big hand of big government to make sure that the money goes to their friends, then they have no qualms about going this route also.

The truly remarkable part of the story is that so many progressives feel obligated to do the Republicans' work by attacking them as "free market fundamentalists." People who want to use the government to change the terms of a contract after the fact to help banks have no interest in the free market. These people are about taking money from everyone else and giving it to the rich: end of story.

Progressives do these Republicans an enormous favor by calling them "free market fundamentalists." It is far better to be acting in the name of a belief in the free market than to be acting in the service of the rich. The Republicans are clearly doing the latter, progressives should stop telling people that their actions have anything to do with a principled commitment to market outcomes.

Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of Plunder and Blunder: The Rise and Fall of the Bubble Economy and False Profits: Recoverying From the Bubble Economy.

This column was originally published by TMP Café .

CHAIRMAN ERSKINE BOWLES (D, investment banker, current board member of Morgan Stanley and NC Mutual Life Insurance, former Clinton Chief of Staff, failed NC Senate candidate) : Everybody has left their partisanship at the door and hopefully we can get something done… But first we’re going to have a chance to hear from Prof. Carmen Reinhart from the center of International Economics at Maryland… She has vast experience in public and private sectors of the economy as well as at the academy, including a period as head researcher at the IMF. She just co-authored a book entitled This Time Is Different: Eight Centuries of Financial Folly…

PROF. CARMEN REINHART: It’s a real honor. I’d like to have the interaction as we go along rather than prepare remarks and then questions at the end so please feel free to chime in at any point in time. What I’d like to do is divide my presentation into four parts. The first two very, very short. One is the global setting and say a little about… the stages of crises, how we progress from one problem to another, that’s the negative way to put it. Then talk a little about the antecedents of crises but very little just as to the point where it’s relevant to where we are today. Most of my talk is going to be devoted to the aftermath of crises. I’ll say very little about the aftermaths as regards to the typical post-crisis experiences in housing and employment but the main thrust of my remarks is about debt, government debt. And there’s two themes. One is, when does a severe financial crisis end up being a debt crisis, as it is in Europe as we speak. And the second is what are the implications of high public debts for growth and inflation based on a very broad historic study that I have done with my co-author Ken Rogoff of Harvard University.

REINHART: So in the handout starting with where we are in a global context if we could just move to the first chart…



REINHART: What is shown in that chart is basically the incidence of crises from 1900 to 2008, everything else that I talk about will be through 2010. But the focus is to highlight that we’ve seen in recent years and what we see now is really pre-[World War II], that post-World War II we haven’t really seen anything quite like this. So the chart… takes five types of crises. Severe banking crises. (1) Government internal debt crises. (2) Government external debt crises. (3) Right now Europe is having both because the solvency issue is affecting both internal debts and external debts alike. Inflation crises (4) and currency crises. (5) Currency crises is what we saw for example in the UK pound in 2008 and what we’re seeing in the euro right now. So it takes those five crises and it weighs them according to world GDP. So a US financial crisis carries a lot more weight than an equivalent financial crisis in Costa Rica.

REINHART: The red line takes those five severe crises and adds stock market crashes, defined as severe declines in equity prices of more than 25 percent… The bottom line of my showing this chart at the outset of my remarks is really to highlight that we haven’t seen since World War II something of this order of magnitude. You might note that we have similar readings in the 1950s but that’s the lingering part of World War II. That’s because not forget that Japan, Germany, Italy were in a state of default, some of them since the Great Depression, some of them since World War II, and those defaults were not resolved until 1952. Greece, the subject of so much public interest, was in a state of default until 1964… Greece has been in a state default roughly 50 percent of the time since independence in 1830, so [the current Greek crisis] is unprecedented by recent standards but certainly not by historic standards. The second point that I want to highlight from this chart before moving on is that the post-World War II period, the 50s 60s early 70s up to the oil crisis…

REINHART: …was really quite an unusual period of calm, not just for the States but worldwide, and we’ve taken that for granted.

REINHART: If I were to extend this chart back another 100 years it would look a lot more like 1900 to 1945 than like the 50s 60s and early 70s. So that’s the point I wanted to make there. Turning to the next chart…



REINHART: This is just the set-up before I get to the heart of my remarks. The flow chart basically highlights the feast-famine cycle that the United States and most of the major world economies have been through. The feast phase has been you have financial innovation, you have a liberalization in the financial industry, we’re all geniuses. And a boom in asset prices ensues, fueled by a lot of credit, and it’s important to note that leverage begins there. Private sector begins to lever up there and this quite often ends in tears, it ends with a lot of those debts becoming non-performing and you have a banking crisis.

REINHART: Banking crises have been usually associated with currency crashes as we saw for example in the UK. We really in the United States were the outlier, in that we saw a flight to the dollar in the fall of 2008. I will talk more about that towards the end of the remarks, because we’re seeing something similar right now in a somewhat different order of magnitude [a renewed "flight to the dollar" as haven]. But I will talk about the good and the bad of that. Because as most things it has the good and the bad. But the point that I want to highlight today is that often times these banking crises, whether there is fiscal stimulus or not, whether there is a large bailout or not, usualy end up with huge build-up in government debts. And that is also because revenues collapse. So even if you go to the pre-World War II experience where bailouts were very limited if you had any and counter-cyclical stimulus packages were non-existent, you’d still get a real serious deterioration in the fiscal because of prolonged severe slumps in revenues.



REINHART: Moving to the list into the antecedents, this is Slide 6, all I want to highlight is… I don’t want to dwell on this but the stages of crises, the first stage is a run-up in private debts. As the banking crisis unfolds public debts run up and this is where we are right now… I’d be happy to send you all the material, but if you go back to 1914 we have the highest level of private debt by a significant margin in the United States. This is household, non-financial and financial firms have the highest level of debt to income since the data has been kept from 1914 onwards. And so the indebtedness issue extends beyond the public sector…

REINHART: I highlight this because this is a major problem going on in Europe right now. Spain and Ireland for example did not start out with high public debts but they have been in the process of acquiring a huge stock of private debt. In crisis times private debts often become public debts. So that’s also an issue to consider.

REINHART: Let me now turn to the aftermath of crises.

REINHART: So we’re on Slide 8.



There are two comments that I’d like to make on this score. Severe banking crises are protracted affairs. In our work Ken and I have been emphasizing this pretty much since the onset of the crisis. When crises are this severe you do not get your typical recession. You do not get your typical housing market cycle or employment cycle they’re more protracted. Even when GDP recovers for example, much more quickly than the labor market. The equity market, this is not just because equity prices rebounded in 2009. The norm is that equity markets recover well before housing does. If you look at this chart, the left panel shows the magnitude of the housing market decline in the worst of all the post-war financial crises. The right panel shows the duration, the time it takes from peak to the market bottom-out. I’d like to leave you if anything with the theme that it’s a protracted process.

REINHART: It’s six years if you include Japan [1990-present], it’s five years if you exclude Japan. I mean we talk about V-shaped, W’s [i.e., chart lines], but in Japan it’s really been an L… But taking out Japan you’re still looking at about five years peak to trough. Let me highlight that in the United States the peak in housing was in the first quarter of 2006. The actual decline using Case-Schiller [the S&P home price index] which showed another decline in the most recent, it showed a 5 to 10 percent decline in the figures released this week, highlights that the slump in housing isn’t entirely behind us.



REINHART: Employment conditions also [show] a protracted recovery, on average the unemployment rate has increased in the worst of the post-WW2 crises by 7 percent. Let me say that this is not melodrama, it’s not meant to be melodramatic. If I really wanted to be melodramatic I would show the same statistics for the Depression, in which you’re talking about peak-to-trough declines that are much bigger. And the duration being much longer. So these are strictly postwar crises.



REINHART: But now I really want to get in the next slide into the heart of my presentation. And the true legacy of financial crises is more government debt. This is where we are right now. In January of 2009 Ken Rogoff and I presented this analysis at the American Economic Association meetings and it was met with a bit of incredulity. We’re basically saying, what this chart says, is that if you take the crisis year to be equal to 100, real government debt a few years later is on average 186. It means that it nearly doubles. This is not debt as a percent of GDP but real inflation-adjusted government debt [that] nearly doubles in three years following a severe financial crisis on average. And we are on track as I will highlight later to meet that near-doubling of debt, not just in the United States but in the major advanced economies.

REINHART: So in what remains of my remarks I’d like to address two issues. One is… the links between what becomes a surge in government debt to what becomes a debt crisis, a surge in insolvency. And the less dramatic, more benign, more common pattern which even absent a debt crisis, what are the implications for economic growth of high government debt.

REINHART: In Slide 12, after we go from financial crash to debt crisis… highlights since Greece has been so much in the heart of the discussion the remarks that I made earlier. But the surge in Greek debts actually is not as of recent vintage as it is for other European countries. We will see that in the next slide. The surge in Greek debts is more chronic. There is an important issue at hand in that remark, because debt crises often don’t happen overnight. They build up for some time and Greece was one of those cases where it was building over some time. However, in the inset of that slide I’d also like to highlight a theme in Greece that is as common in other parts of the European Union as it is in the United States, which is the surge in household debts at the same time. And this has implications that I will discuss later for growth. Because let me put it very bluntly, very high level of public debts is not new to the United States entirely or to Britain. Right after World War II we had a very high stock of public debts but private debts were nil at that time.

REINHART: So what is new or newer is the combination of both public and private indebtedness, this is a theme that I’ll return to.

A COMMISSIONER: Prof. Reinhart I have a question. On this chart you showed the household debt in 2008 of 49.7 for Greece. What is the corresponding number for the US now?

REINHART: It’s about double that. It’s about double that… Greece is a newcomer. Greece did not have access to debts, households did not have access [like in the] US ten years ago, twenty years ago. So the US numbers are actually more comparable to other European than Greece per se but the US number is about double that.

…and now for the most interesting chart…



REINHART: The next chart… averages public debt as a percent of GDP. That’s the blue line. And public debt as a percent of GDP for seventy countries that account for about 95 percent of world GDP. And this is not weighted by world income, so here Greek debts receive the same weight as German debts, receive the same weight as Italian debts, it’s not weighted. If we were to weight it by world income we would see that for the advance economies -- because of the surge in private debts and… in public debts have been so severe since the onset of the crisis -- for advanced economies weighted in share of world income we are the highest debt levels since the Depression. Even larger than around the time of World War II. The yellow shading… is where the link between banking crises, public indebtedness and… sovereign debt crises come in. The yellow shading is the share of countries that are in default. The percent of countries that are in default or restructuring. So for instance I’ve noted Greece was in a state of default until 1964. However since 1964 -- well Hungary was in default until 1967 but apart from that -- there have been no high-income countries in default since. So that yellow shading from the mid-1960s onward is zero if we only looked at advanced economies. The surge that you see in the 80s is of course the debt crisis, notably in Latin America but not exclusively. The point being we are seeing an advanced economy debt crisis which you’d have to go back to the 1930s.

REINHART: What are the links between the financial crises and the banking crises? … First of all let me clarify this gross government debt for all the countries. It is only central government. So it does not include things like government guarantees which also surge during crises. So in effect if we were to take a broader view of government debts that includes other levels of government and that includes guarantees, the recent surge… in debts would be that much more dramatic. And this is a global issue, not just a US issue.

GUY #1: (inaudible, question about US figure for gross central government debt to GDP)

REINHART: The US is very close to 90 percent gross, gross gross gross.

GUY #2: And that includes intergovernmental debt? Social Security and Medicare…

REINHART: Yes, that’s the gross.

GUY #1: It doesn’t have the guarantees?

REINHART: No, it does not include guarantees, only the federal government, so huge guarantees, Fannie, Freddie are not… and what I also want to highlight is that during the past three years other economies have also extended a huge level of guarantees to the financial industry, primarily but not exclusively.

GUY #2: Have you calculated a percentage with those guarantees for the US?

REINHART: No I have not but I think the IMF publishes some of the…

GUY #3: Do you know what it is?

THE GUY FROM THE IMF: No I don’t have it at the moment here.

REINHART: But let me say that the surge in debt, the solvency issues that are in the forefront of Greece are solvency issues that will also have an impact on an area that we haven’t talked about that much, which is Eastern Europe. Right now… the surprise element of having EU members such as Greece, Italy, Ireland, Spain, that has drawn a lot of the discussion, but there is a huge stock of external debts also in Eastern Europe so if I were to expect that yellow shaded percent of countries in default, right now we’re focused on the euro zone countries, the wealthy countries we thought had outgrown this but let us also not forget that… emerging Europe is still an issue as far as debt. Now debt crises come in various shadings, and one thing that I’d like to remind is that barring the most extreme case of a default or a restructuring, there’s still downgrades that have real impacts on risk premium.

REINHART: Japan which is a country that lends - lends - to the rest of the world and is now sitting at debt to GDP of close to 200 percent was downgraded several times after its financial crises as public debt soared. And let me reiterate, Japan is a country that has financed its public debts internally, through high level of domestic saving and very little external debt, it was downgraded several times.

REINHART: Slide 15 which now starts moving toward the final issue I wanted to put on the table [asks] what are the links between debt and growth. But before… this chart, which is really dated because it only goes through roughly the end of 2009, those numbers are higher for everyone, the only part that I want to highlight is that 86 percent [average per-case] increase in debt following financial crises after World War II only appears to be a high number, it actually isn’t. We are on track to see and perhaps surpass that.

REINHART: Now the exercise we did… we have put together a very large data set on public debt going back to 1800 in the case of the United States, to 1790 for Britain, about 70 countries of which 44 we have really good data for central government debt, to reiterate. Central or federal, not states or municipalities and so on. So the question that we posed was, if we were to take our historic period and break it down into periods in which government debt was (a) low, zero to 30 percent of GDP, (b) 30 to 60, (c) 60 to 90, and then (d) above 90, we’re not talking about causal relations or anything esoteric here…

REINHART: …just what was growth, and asked that simple question, what was median, what was average growth during those differen stages of indebtedness? The similar question was asked, what was average inflation performance? And we did this for advanced economies, we did this for emerging markets, we did this for pre-war and postwar, the whole period, and on page 17 I … bolded in red what the main result is. Which is when we look at these four buckets of debt, 0 to 30, 30 to 60, 60 to 90 and then above 90, surprisingly, to us, there is very little difference, it’s not statistically significant, the difference, between debts of 40 percent and debts of 20 percent. Below 90 percent there is very little statistical difference. But… it does kick in at debt levels above 90 percent, namely median growth rates are about 1 percent lower for periods of gross debt above 90 percent, while average growth rates are even lower.

GUY #3: And again, you calculate the 90 percent using both the public debt and the intergovernmental debt. You would say we are at 90 percent today.

REINHART: That’s right. And … two reasons for that. One is from the vantage point of debt servicing, debt is debt irrespective of who holds it,

REINHART: and the second is more attuned to the data that we have, in which the most reliable time set that we have for these countries over these extended periods is gross rather than netting out intergovernment.

DAVID M. COTE (CEO of Pentagon contractor Honeywell International, 2009 reported earnings $12.8 million, sits on directors board of JP Morgan Chase, advisor to KKR, and one of the few CEOs invited to Obama’s post-inauguration corporate tete-at-tete) : When you talk about that 90 percent gross debt, if you included Fannie and Freddie, what would it be?

REINHART: Well that’s the question of guarantees. All I can say it would be much higher, I’d be happy to look that up and share it with panel members… I don’t have any comparable. Guarantees are not exclusive to the current crisis. When we had the Korean crisis for example in 1997, the first thing the government did was go out and guarantee corporate external debts. So measuring actual guarantees is not, to compare apples and apples historically is not an easy comparison (sic). We just stuck to the things we could compare, which is gross government debt.

DAVID LEE CAMP (R- MI) : Are there any recommendations for making government reporting of debt more transparent so that the warning signals come more quickly?

REINHART: That is a wonderful question. I didn’t put him up to it [ha ha ha from everybody]. The issue of hidden debts. One of our big themes is the issue of hidden debts… can take many forms, and one of them is guarantees. But there’s more to the hidden debts, if you don’t mind I would like to go back to the issue at the end of my remarks, because there are many manifestations, some of them involving the… reporting of guarantees but also issues of balance sheets, issues of central bank debts and so on that… there’s a broad issue of hidden debts. And hidden debts always sort of like the Loch Ness monster, when you think it’s dead, that’s when they raise their head.

SEN. MIKE CRAPO (R-ID): You indicated the United States gross debt is over 90 percent now, our public debt if I understand if we don’t change things is projected to reach 90 percent in 2019, have you done analysis on what the impact of public debt reaching 90 percent would be?

REINHART: I have a problem with your views, which are very common, of public debt. I mean public sector. But you’re really talking about held by the public. And all the analysis that I’m presenting here is on gross debt, not held by the public [per se]. Remember, debt service is on both publicly held and non-publicly held, and is just… I’m constrained by the data that I have, and I have not broken that out. And if we broke it out it would be an exercise for the United States and that wouldn’t be enough. Because to be as candid as I can in this, if we were to look only at the US experience, we’ve only had comparable debt levels to this right after World War II which is a very special case.

CRAPO: Because it’s common here on the Hill to distinguish between public debt as opposed to intergovernmental debt, but I’m understanding you to say that the distinction is not one that is valid, in fact it may be invalid… and that as we analyze we should be looking at gross debt rather than…

REINHART: I would agree with that statement. In effect… there is a bias, not just in the United States, towards actually understating debts rather than the other way around.

REP. JEB HENSARLING (R-TX, got his start as staff to none other than Phil Gramm) : I don’t know if I missed it, but did you actually give a number north of 90 percent as far as our gross debt to GDP today or did I just hear you say… did you give a precise number… ?

REINHART: We are very close…

KENT CONRAD (D-ND, head of the Senate Budget Committee) : I just asked staff to do the calculation. As of today… we are at 89 percent, by the end of this fiscal year we’ll be over 90.

HENSARLING: One other quick question looking at your slide over here… you say that at 90 percent, gross debt to GDP the needle is hitting the red zone with respect to economic growth. You’re not necessarily saying in your roughly 200 year data set that we’re looking at negative… but that growth rates would be at least 1 percent less.

REINHART: If you look at the next slide, the average growth rate is slightly - slightly - below zero, but the median is still positive. The 1 percent difference in the median, however… remember if population is growing at 1 percent, 1 percent may not sound like a lot, but it’s the difference between rising per capita income and not at all. There’s one remark on the chart on page 18. We were expecting actually that inflation rates would be higher at higher levels of debt, but we actually did not find that… Let me say this, on inflation there is no statistical difference for the advanced economies. We did developing countries separately which I will show you time permitting… The significant differences [are] in growth, not inflation, in the advanced economies.



REINHART: In the next slide [“Emerging Markets”] the difference is both in growth and in inflation… What I’d like to make clear is this is not a causality, you have high debt therefore you have low growth. It works two ways. I think the causality is both ways. You have low growth, revenues suffer, debt builds up, as debt builds up so does risk premium. And I need to say this right now, because I think ironically the crisis which began with the subprime in the Uhited States has actually extended the life of the dollar as a reserve currency. And I’m concerned frankly that could lead to complacency. Because we studied the transition as a reserve currency from the pound to the US dollar. And it was… the writing was on the wall for many years in which countries started switching from linking to the pound, switch to the dollar, went from issuing debt in pounds (to the dollar). We were seeing that (now) with the euro. The euro was a serious contender as reserve currency to the dollar and that of course is being shattered right now. Which means that where we might have seen earlier signs of strain in debt issuance or financing, we’re getting a lot of leeway from international capital markets not because we’re doing things great but because of lack of alternatives. And I’d really like to put that on the table. I’ve taken enough time here.

CONRAD: You’re on Slide 19? And Slide 19 can you help us interpret this chart? Because this shows… Oh, it’s emerging.

REINHART: Because particularly emerging markets have hit a wall in financing that is much harder. Inflation financing becomes a much, we wanted to be clear that we looked at the two things [advanced and emerging economies] separately.

SEN. JUDD GREGG (R, NH): If your basic premise is, and I agree with it, that you can’t finance debt with debt without slowing growth, and when you finance with debt you create more debt. So you’re basically your premise is we’re in a downward spiral because it feeds off each other. How do you break it? What is a historical precedent for breaking that downward spiral of financing debt with debt, which slows growth, which leads to more debt?

REINHART: None of the replies I’m going to give are cheerful or easy, so let’s be… I’m not noted for being uplifting [ha ha ha’s all around] there have been some cases where fortuitously debt to GDP has gone down due to fast growth but they are a small number, small small. Most of the cases have involved big fiscal adjustment, have involved restructurings, so even in cases where…

OFF: Can you define restructuring?

REINHART: Restructuring is a polite way of saying partial default. Because a restructuring, what it’s intended to do, is lower interest rate costs, lengthen maturities or a combination of the two.

GREGG (with childish wonder!) : Can a world currency default? (crosstalk)

REINHART: Well, look… the United States defaulted in 1933, when it suspended the gold clause… We suspended the gold standard, let me explain why it… is considered a default. A default is anything that changes… the initial contract to terms that are less favorable to the creditor. And we had a clause, the gold clause, that said our bonds are repayable in gold. And we abrogated that clause in 1933. And said OK, this bond is payable in fiat currency. But the fiat currency had lost 33 percent approximately of its gold value. That is an abrogation of the original contract. So… a restructuring, and this is the way Standard & Poors [defines it], this is not something that I have come up with, this is the legalistic definition… A default involves a change in the contract that is less favorable to the creditor than that of the original term.

SEN. DICK DURBIN (D-IL, closest Senate ally to Obama, on the Keynesian counterattack): I hope I’m following your premise here, that a banking crisis that leads to an economic crisis involving a decline in housing and real estate values, has led in… maybe all of your examples to more government debt, and as the debt grows to GDP, the likelihood of economic growth is diminished.

REINHART: Yes.

DURBIN: If that government debt is premised not on political weakness but on a design plan that said we have to step in as a government, as the economy declines, with safety net and stimulus and guarantees, otherwise, the decline will go even deeper and further, and the debt will last longer. As you look at various countries that have approached this, have you seen, maybe this just basic Keynesian approach, have you seen that intervention by the government and incurring of debt at an early stage of the crisis has been more beneficial than the governments who did nothing?

REINHART: Let me give a very honest to that, which is there are not many examples of that. Because many of the countries that had -- forget the emerging markets… [where] even if countries wanted to act counter-cyclically, they could not because they had lost access. They couldn’t borrow. --

REINHART: Those that were not emerging markets, like the famous Nordic crises of the early 1990s, they were constrained on how much fiscal stimulus they could also do, because they were also part of the European exchange rate arrangements. The examples of more aggressive counter-cyclical policy are to be found in this [current] crisis, and in Japan [1990s to today, really]. Those are the only examples.

WOMAN #1: But isn’t there an example in the 1930s in the Depression where there was a cutback in stimulus and actually we ended up in a double-dip?

REINHART: That’s absolutely right. In the 1930s -- I actually have a Brookings paper on this issue -- there was a bouncy, real increase in spending and then a withdrawal and you had a double-dip. But in the 30s the big, huge difference was we waited a long time to leave the gold standard and we had very tight monetary policy up until 1933. Here we had a massive monetary stimulus, so that is why I avoided [that example because] the monetary side in the 1930s was completely different. What you said is absolutely right.

CAMP (apparently throwing a fit at the very idea of stimulus spending) : I just wanted to say that in the 1930s, stimulus was not the only factor. We had tarriffs, to say that government spending was the issue, frankly it was World War II that got us out of the Depression in the 1930s, and that was big, but not, I think this point needs a little more elaboration…

REINHART: To put it concretely, we had a very aggressive fiscal stimulus in the 1930s, more aggressive than the UK which actually did better, but we were very inconsistent. Namely, every time that there was the perking up of activity, we’d withdraw. So it’s a very bouncy fiscal stimulus… that’s how we describe it and quantify it in our recent work.

DURBIN: Can I follow up on that because I thought the answer to my question was that stimulus doesn’t really work, but now it seems that inconsistent stimulus doesn’t work. Which is it?

REINHART: For me it’s inconsistent stimulus that didn’t work in the 1930s.

DURBIN: I know it’s a different world today, but looking at the situation today, we have tried to stimulate the economy, we’ve seen some recovery…

REINHART: What I can honestly say is we do not observe the counterfactual. We do not know what we would have looked like had it not been for the interventions that we did, we just don’t know that. I don’t have the long list of comparitors that say, okay, this country did stimulus, this one did not. I can only take my data so far.

INAUDIBLE: Inaudible.

REINHART: No, I did not say that. I began with fiscal austerity. I have used this example because I think it’s pertinent to us: Canada in the mid-1990s faced very unpleasant debt dynamics. And… we sort of knew that it was there, and they did not come to a fiscal austerity package voluntarily, actually of all things [it came about because of] the Mexican crisis. You may wonder what the Mexican crisis had to do with Canadian austerity, but in the mid-1990s, Canadian spreads began to move in tandem with emerging markets, and that actually was a wake up call.

JAN SCHAKOWSKI (D-IL, known to our readers only because of Sibel Edmonds’s claims, you damn voyeurs) : I’m just wondering if you did any analysis of debt as it relates to unemployment, or you mentioned per capita income…

REINHART: Per capita income on average in the postwar crises, it takes four years for per capita income to go back to pre-crisis level. This is postwar. Prewar it took much longer in the United States, it took ten years…

SCHAKOWSKI: Did you break it down by short-term surges in debt versus longer term or more historical surges?

REINHART: No because… our dividing principle was any year in which debt was 60 to 90 percent or above 90… so there is no discrimination of how you got to the debt, which is what I think what you are asking. Did we get to the high level of debt because of a financial crisis or…

REINHART: but it is a very robust result precisely because our sample of observations is big.

REINHART:You see, if I actually showed you the numbers for the United States, they would actually look worse than what I’ve reported here. And it was debt that we got to mostly through war. This was right after World War II

REINHART: If we start cutting it because of high debt levels because of financial crises and high debt levels because of wars, then we’d start winnowing our sample, and how much can you extract from a handful of observations. It’s drawing big lessons from six observations for the United States or five observations for Japan is not something… uh, one last thing I’d like to highlight on the issue of hidden debts. In studying all these financial crises, actual debts are on the whole bigger than anything any of the official statistics that we measure here [say], just as I suspect that if we were right now to calculate potential domestic arrears in Greece, debts would actually be bigger than what the official statistics are. There are a lot of ways of hiding debts, this is true of the private sector as well as the public sector. So I think exercises toward greater disclosure would be [good].

DAVE COTE: An observation and a question. The observation and this is as a non-politician here

COTE: …it seemed like we were having an American world economic discussion that started to turn into a political discussion. I hope that, I may be totally incorrect and I’m not trying to be offensive in any of this but I hope we get back to where we first started the conversation.

COTE: The second one is, getting back to Sen. Durbin’s question, I thought your point at the beginning was not just the debt that the US had, but that it was in combination with all the private debt that exists that eventually turns into public debt because the economy can’t sustain it when we’ve got debt at about 100 percent of income, if I’ve understood. Is that correct?

REINHART: The hard numbers that I have are for gross central government debt. And the issue of private debt, which is a very important one… it is an additional consideration that weighs growth down, and I think, not I know. What I’m saying is right after World War II we had comparable levels of public debts but both the US and the UK had very low levels of private debt. Europe had no private debt. The point… is our study is only… about public debt. We have not done a comparable analysis of private debt. [It’s] different from the postwar experience when we had a lot of public debt. In the US, in the UK, in the Commonwealth, the issue of private indebtedness, which at any point in time can increase public indebtedness, is an additional issue to consider. I hope I’m making the distinction between the results that we do have and the issue of private debt which we haven’t looked at on a parallel basis to the public debt.

ERSKINE (me get last question!) : We’re sitting here today with a significant amount of private debt and public debt. We’ve tried to stimulate a very fragile economy and are at the very best at the beginning of a fragile recovery… Given where we are today, what would you recommend to this Commission?

REINHART: I have no positive news to give. Fiscal austerity is something nobody wants but it is the fact that it is the alternative.

REINHART: I am concerned about complacency. I am concerned that because the dollar has renewed its role as a reserve currency we may wait too long. Waiting too long doesn’t necessarily have to run out and act right now in terms of actual tightening but [to establish] a path that is sustainable. Let me also say that one of the things that happened in the 50s and 60s that cannot be denied is we had financial repression.

REINHART: And what is financial repression? That is a system in which interest rates are controlled and there more directed credit and it was a way in which governments financed high levels of debt. We’re already seeing that. I think we are going to see a return of different forms of financial repression, because it is not just our problem, it is in Europe, Japan is in a similar situation. Japan has been able to carry its debts up to 220 percent of GDP. Because of various forms of financial repression. I think we will also realistically find ways of placing government debts at lower interest rates, not worrying so much about roll-over. I think in light of the fact that it’s not just the US but all the advanced economies, I think that will be in addition to fiscal austerity. I think that will be something that is not improbable.

ERSKINE: Thank you.

(last slide)

Matt Franko wrote:
Nicholas,
I think she paints the history with too broad a brush. She treats all govt debt of the past times as the same. While ignoring facts such as whether the govt debt was denominated in a foreign currency, or whether the govt operated a convertable currency regime. These two factors (which are quite different for the current US arrangements vs much of the history she presents) are very important conditional aspects that she ignores/overlooks. (both she and co-author Rogoff).

So I dont think I have as much professional respect for her work here as you seem to Im afraid.

Matt Franko wrote:WRT her and Rogoffs book, I wish we could find out how Princeton University Press came to publish (via a grant from whom?) this work by Professors from Harvard and U of MD.

Matt Franko wrote:You know if you think about it, she and Rogoff focused on this 90% of GDP level where they push the panic button for govt deficit levels; but all of their historic examples are where you had external sources of funding due to either convertability or debt denominated in a foreign currency.

So what they really found was the level (90% of GDP) to which external funding would go before cutting them off. So any nation that would set up their system like that could expect to push it to the 90% level before they would have to shut it down.

Thanks Reinhart & Rogoff, you have stumbled upon the funding constraint of scoundrel nations!

I picked up the fact that they ignored the distinction between soverign issuers vs external funders from other MMT blogs for sure.

but their 90% threshold may be of interest if you used it for forex trading. ie, if you had a govt that had foriegn denominated debt, or external funding, and was at the 90% historic doomsday threshold they (R and R) have come up with, maybe you really short it at that point.

This Time Is Different: Eight Centuries of Financial Folly
Carmen M. Reinhart , Kenneth S. Rogoff , Joanne J. Myers



Thursday, October 22, 2009

This Time Is Different: Eight Centuries of Financial Folly

Introduction
Remarks
Questions and Answers

Introduction
JOANNE MYERS: Good afternoon. I'm Joanne Myers, Director of Public Affairs Programs. On behalf of the Carnegie Council, I'd like to thank you all for joining us.

Our discussion today is about the economy. We are delighted to have as our speakers two leading economists whose work has been influential in the policy debate concerning the current financial crisis, Carmen Reinhart and Kenneth Rogoff.

They will be talking about their book, This Time Is Different: Eight Centuries of Financial Folly, which, from all accounts, is said to provide the best empirical investigation of the financial crisis to date.

It has been a bad year for the economy. How many times have you heard, "No one was prepared for what has happened," or "It was impossible to see this coming"?

Many economists, especially those caught off-guard, have even claimed that this situation is so unusual that it bears little similarity to anything that has gone before.

Not so, say our speakers. In fact, it is just the opposite. As the ironic title of their book indicates, "This time is different" turns out to be a mantra that Professors Reinhart and Rogoff have discovered to be wrong.

How did they come to this conclusion? In researching their book, our speakers covered 66 countries across five continents, to give us a comprehensive look at the varieties of financial crises. In doing so, they guide us through eight centuries of government defaults, banking panics, and inflationary spikes, from medieval currency debasements to today's subprime catastrophe.

They provocatively argue that financial combustions are universal rites of passage for emerging and established markets. As their statistics show, financial fallouts occur in clusters and strike with surprisingly consistent frequency, duration, and ferocity. In their exhaustive research, they examine the patterns of currency crashes, high and hyperinflation, and government defaults on international and domestic debt, as well as the cycles in housing and equity prices, capital flows, unemployment, and government revenues around these crises.

Their data shows that countries do weather their financial storms, but short memories make it all too easy for crises to reoccur, and they will happen again with startling regularity everywhere.

As our guests remind us, we have been here before. If so, we might ask, is it ignorance or maybe arrogance that has prevented us from seeing that this time is no different than the past? Can we learn from history?

For the answers, please join me in welcoming our guests this afternoon, Carmen Reinhart and Ken Rogoff.

Thank you for joining us. Carmen is going to go first.
Remarks
CARMEN REINHART: I want to thank the Carnegie Council and Joanne for hosting us, and all of you for coming.

Let me begin by saying something about the title. It is meant to be an ironic title. "This time is different" is the mantra that we hear. It is universal. Crises always seem to happen to someone else at some other time; they never really happen to us. The rules of valuation don't apply to us.

So "This time is different," as Joanne pointed out, does carry very much the theme that we emphasize in our book: that these cycles of euphoria and booming asset prices and big increases in leveraging and debts that ultimately usually end in tears are nothing either unique to us in the current situation or specific to a particular region.

One of the interesting things I hope we get to talk about along the way is how certain findings that we uncovered—regions that we thought were not that crises-prone, when you delve deeper, you find that they have a long history marked by repeated crises, and there are very few reputations that are left unscathed after close inspection.

When Ken and I set out to write this book, it was when we were working together at the IMF [International Monetary Fund]. In 2001 to 2003, we worked together at the IMF, and the origins of this book date back to 2003, when we did a paper called "Debt Intolerance," which was about what we then called "the syndrome of serial default," countries that kept building up a lot of debt and then defaulting on it. One of the novelties of that research, which led us to the idea of going deeper into this and doing a book, was that some of the advanced economies of today, like France and Spain defaulted—Spain still holds the record, with 15 defaults, and France routinely defaulted every 30 years for a couple hundred years, making some of today's emerging markets look good.

A central theme of our analysis was to go beyond some other books on the history of financial crises. There is a very influential book, certainly to us, the Kindleberger book on financial panics and manias. But this literature tended to be very anecdotal, if you will, in which you got down the story of a particular bubble, be it the tulip mania or the South Sea bubble or the Roaring Twenties that ended in the Depression. What Ken and I really wanted to do was to bring a systematic analysis: What are the recurring patterns that we see before crises?

Let me just say a couple of things about that. Before the book came into being, as we were doing our research on it, we did an early piece that was called "Is the Subprime Crisis So Different? A Historical and International Comparison." We put this together in late 2007. Ken presented it at the American Economic Association in January of 2008.

What we did was to say that the then-budding subprime crisis—the stock market was still doing quite well at that time—had these patterns, this boom in real estate prices, this boom in credit. We were running large current-account deficits. We were importing a lot of capital from abroad. We were borrowing from the rest of the world.

We said, guess what? If you look at the major, severe postwar crises, they had this pattern. If we continue to follow this script, that would be followed by a series of unpleasant events—namely, sharp contractions in equity prices, sharp declines in real estate, and the unwinding of private debt.

Later on we went on to write another short piece that is also very much an integral part of the book, which is called "The Aftermath of Crises," which focused on the depth and duration of these crises.

One of the very exciting things for us was that, as we were writing this book, which really goes back and gathers data on default crises, inflation, banking crises, currency crashes—going back literally hundreds of years—we were writing this at a time in which a crisis was unfolding right here. A lot of our analysis was actually helping inform policymakers, finance ministries, central banks, not just in the U.S., but worldwide, on what to expect next.

There are recurring patterns, and one of the patterns that we emphasize in this book is the cycles of indebtedness. Usually during the feast, it's private indebtedness.

Then, as the feast turns to famine, the government steps in, and what was formerly private debt becomes public debt, and we are where we are today.

I hope we have time to uncover some of the most interesting stories of our fact finding. I know I have never personally learned so much from any research project that I have undertaken. Ken and I just, from time to time, really marveled at the things we found. I hope we have time to go over some of those highlights.

But let me pause here and turn it over to my dear coauthor, Ken Rogoff.

KEN ROGOFF: Thank you very much.

Carmen said "dear coauthor." A lot of people who have written books with someone sometimes ask us, "Are you still friends?" which we are.

I would just say, although Carmen was very prominent professionally, we actually really didn't meet until we started working together at the IMF. That wasn't an accident, actually. I was very familiar with Carmen's work. She is today one of the couple most cited people in international economics. I knew she lived in Washington and that I had some chance that I could bring her to the Fund. It was great. Our collaboration started there.

We have really been working on this book since then. During a portion of that period, we were involved in our own crises. We heard, "Argentina, this time, is different. We have it pegged to the dollar. Nothing's going to happen."

Then we were with Brazil: "This time is different. Nothing's going to happen, because we have a floating exchange. Nothing's going to happen."

Turkey collapsed when we were there: "This time is different. We don't have to worry because we're in Europe, and nothing can really happen to us."

Certainly over our professional careers we have heard this song many, many times.

I want to just give a little bit of flavor about what it is that we did. In a way, the book is a very novel data set, where we systematically collected data that one might use to think about crises quantitatively. As Carmen said, the typical crisis books—and there are some great ones, including a classic that Princeton University Press also published, by Charles Kindleberger, who was a professor of mine at MIT—are basically anecdotal: "The finance minister sweated bullets when he signed the contract with the bankers at midnight." But there is no sense of what a crisis is, what happened, how long it lasted, and how we know what to count and what not to count.

So we wanted to have a quantitative basis. It's really, as Carmen often says, an archaeological project, digging out some of this data and vetting it.

One thing that fascinated us—and we had discovered it in early papers; really, our first major paper in this area was in 2003—was this notion, as Carmen said, of serial default. Everybody thinks this is a Latin America phenomenon or a couple countries in Central Europe. It's actually nearly universal. Virtually every country, when they are going through the emerging-market stage, which is usually 200 or 300 years, defaults periodically—not every year. Venezuela is the modern-day record holder, but they still default roughly every 20 years. France back then was every 30 years, up to 1800. It may be 50 years for some countries. But it's a fairly frequent event.

We learned over time that this is something countries graduate from. But something we learned in the book that surprised us was that rich countries do not graduate from banking crises. Even before this, we had written a paper and we had a chapter in our book showing that government default—yes, that happens in emerging markets, not so often in rich countries. Not banking crises. Then we were able to show that they are quantitatively not that different.

There are whole stories about the years of collecting the data, but I'll just give you a few highlights of it. I know you probably don't think collecting data could have highlights.

One of the things that we realized was really important to have was housing price data, which was not easily available. I called Robert Shiller and asked, "Where can I get housing prices for the whole world?"

He said, "There's not. You can get it for a few years." But we needed to go back a way, so we could look around at the times of these crises.

We found a paper by someone at the Federal Reserve that cited confidential data of the Bank for International Settlements and managed to get the name of that person. We wrote to him, not really thinking we would get the data. He sent us the data. He said, "You know what? This is my last day at work. This data is not supposed to be public, but somebody ought to have it," and he sent it to us.

We since got emerging-market data and a number of others to supplement that.

Then the one which you almost can't explain to somebody who is not in the field is just plain vanilla government-debt data. You say, "Oh, wait a second. The IMF keeps that. The World Bank keeps that." No, believe me, they don't. We were there. In fact, we took great pains to get it for a small number of countries, going back ten years, much less what we have in our data sets now, 100 years.

Why do you want to know that? Does the United States have too much debt when it's 60 percent, 80 percent? When do countries default? The debt data you can get is what you owe to foreigners. But there is a lot of other debt that you owe to your own citizens—pension funds, rich individuals. In fact, one thing we discovered is that it's the same order of magnitude.

We could go off on a long tangent about that, but there are things that it's just criminal that they don't exist. I don't think it's an accident that the government debt data is hard to get. I think—I'm not being facetious—they don't want us to have this.

Here we were at the IMF, working on Argentina, working on Brazil. Are they in trouble or not? We only had what they owed to foreigners, looking at historical benchmarks. We could only look at that for sustainability exercises.

Anyway, there are other things in the data set. But having this data let us say things that nobody had been able to say before. For example, we were able to look at what happened to housing prices before a big crisis. We saw that the United States was just driving down the tracks. We were able to look at what happens to debt after a crisis. It typically nearly doubles in a relatively short period. You'll be happy to know that the United States is driving down the tracks of that, too, and a number of other things—unemployment.

It's frankly almost too much, the extent to which the crisis has tracked our projections from a couple of years ago. But I think most central banks and treasuries present it and use it, because, frankly, models just aren't that useful when you have an out-of-bounds event like this.

Let me just finish up and turn to your questions. People are saying, "No, no. This time is different because the dollar stayed really strong throughout the crisis." I think the last couple of months have put the last nail in the coffin of that argument. The fact is that in many ways this has been a very typical event that has hit the United States. If you ask us what you should do, you can't not have financial crises. You can have complete financial repression, but you also don't have healthy investment and such.

I think the thing we do find is a unifying theme is having a lot of short-term debt in the exchange-rate crises, in the sovereign-debt crises, in the banking crises. When someone is borrowing short-term, they need to constantly turn it over. When markets are confident, it seems great. You're borrowing at 2 percent, you're making money. But then when confidence runs out, what do you do? Looking at that dynamic and how it unfolds is something that we realized is a unifying theme.

There are economic models that explain that. But it is at the root of why people think things are fine, that it's so confidence-based.

Something else I would add that we also discuss is that a lot of times the data is hidden. It seems like it's good—"Oh, we owed all that?" You find out when the crisis happens that there are lots of hidden liabilities, contingent claims, private-sector debt that gets taken over that is also part of this pattern.

Finally, I said we'll always have crises. I think the issue today is, will we have one in 50 or 75 years—I guarantee you we will, just like we had or worse—or will it be in ten or 15 years because we decide that we didn't really need to pay that much attention this time? I'm not sure.

Anyway, why don't I stop there and turn to questions.

Questions and Answers

QUESTION: Most people agree that the subprime crisis triggered the overall fiscal crisis. People argue that the reason for the subprime market was because the government intervened and encouraged subprime lending. Therefore, it was the government that caused this financial crisis. Other people say it was lack of government regulation that caused this financial crisis.

Can you make any generalizations, based on your research, about the extent to which the government, by acting or by not acting, contributed to these fiscal crises?

CARMEN REINHART: I think when one looks at the central finding we have, which is that these crises are preceded by bouts of borrowing, a big pileup of debt, to the extent, of course, that big borrowing and pileup of debt occurred because supervision and regulations, in the most generous terms, were lax, and that the lending, much of it, was predicated on the expectation that housing prices would continue to rise, so you really didn't need to have a borrower that had a credit history or that had a reliable income stream—after all, you had the collateral. Yes, government policies, I think, definitely played a role in making the credit cycle what it ended up being.

But let me say also this. In our research, we also highlight that the credit cycles are also often fueled by borrowing from abroad, which we were doing liberally for many years in the United States, as other countries that had major financial crises were, at their own time, borrowing from abroad, the Asian crisis being only one example in that.

So we try not to oversimplify. But, yes, government, especially the laxity towards lending practices, no doubt contributed.

KEN ROGOFF: Let me just add, it's different in the different examples, but the thing that's unifying is, as Carmen said, when money is pouring in, it makes your stocks look good, it makes your houses look good, and it makes your interest rates seem low. It's very tough. Whatever the institutional framework is—and we look at a lot of different countries—whether it's the politicians, the regulators, the business elite, whatever it is, they don't see what's going on. It masks the hidden vulnerabilities.

With some of the crises, it's corporate debt. With some, it's the banks. But it's remarkable, the patterns that come out that are in common, despite seeming to be so different in terms of the underlying institutions.

QUESTION: I think I heard an invitation to ask this question. You mentioned that private debt builds up and public debt substitutes for it after the crisis begins to break. But you didn't talk about the unwinding of the public debt. What can we look forward to?

KEN ROGOFF: Taxes is the obvious thing. We're on a completely unsustainable fiscal trajectory. It's completely rudderless. Taxes, just at the federal level, have been about 20 percent of GDP. Now they're 15 percent. They have to go up by about a third just to get to normal, and probably further to make up for all the debt that we have accumulated.

I don't think that's going to be a very pleasant process in our political environment, and not necessarily painless. I think it could be exacerbated if we go through a period of slow growth. That seems to be the plan for getting out of this. We'll have super-fast growth for a long time and then we won't worry about it. But we could end up having inflation, trauma—not right away, but if you're looking over five or ten years, it's very, very difficult. We haven't even mentioned the aging baby boomers and all the problems with Medicare and Social Security.

I think we go through a very challenging time, and the same in Europe.

CARMEN REINHART: Let me add that we really asked precisely the question that you asked when we did an exercise: How, historically, have debt-to-GDP ratios been brought down? Is it that the numerator has to go down, the denominator goes up, and so you grow your way out? Very clearly, the answer that emerges is, in most episodes in which debt was significantly reduced, it is not through growth.

Ken mentioned that sometimes in the case of emerging markets it involves restructurings and outright defaults. In the case of the advanced economies, it has involved painful restructurings in fiscal policy, à la Canada in the 1990s, and inflation.

QUESTION: The underlying problems facing the economy are poverty, jobs, job training, relevant school training, education, and revenues, as you point out. What practical solutions do you have to address these?

CARMEN REINHART: I think speed of response is critical. We really are running out of time here. What do I mean by speed? I'm not evading at all your question.

One of the things that happens during a financial crisis of this ilk is that the credit channel becomes paralyzed. Right now there is very little lending going on. The system is not in place for the restoration of lending. Small businesses are very dependent on banks. Very labor-intensive industries, such as construction, are very dependent on credit. So if the credit channel is broken, employment conditions suffer as a consequence.

So how do you get the credit channel working? It is not by delay. Let me say that this syndrome that we are living right now is, "Oh, Japan did that, but we're going to do the same thing but get a different outcome," which is akin to Einstein's definition of lunacy.

What I mean specifically is that delay in recapitalization of banks, the forbearance, is delay of resolving the credit problem, and that could mean years of subpar growth.

KEN ROGOFF: Let me start at a narrow point. Unemployment is terrible, and if you count underemployment, it's worse. Carmen and I wrote a paper about the aftermath of crises. This was a year ago. We got projections on what typically happens to unemployment. The answer is, it goes up about 7 percent. It started at maybe 4 or 3 percent and it will end up about 6 percent more.

I think I was telling that to my spouse, Natasha, who is a filmmaker, and she said, "No, no. I'm out here. It's going to be worse. Unemployment's going to be 13 percent."

I said, "No, it's not," not really having an idea, but I had my paper with Carmen.

In some ways, she's right, because the participation rate has fallen from 68 to 65 percent. It has fallen 3 percent. You add that to the 10 percent and it looks more like 13 percent. That has very long-term consequences—psychological, people being in training, the job market. It's very serious.

I think our industrial base is likely to continue to shrink, much the way agriculture did. Many of the people who were in Detroit will eventually be taking EKGs [electrocardiograms] or doing something in the health sector, which is going to expand a lot. I don't think our industrial base is coming back. But that's not because of the crisis. I think that's a longer-term technological trend with globalization.

QUESTION: Two aspects of the current crisis are that the dollar has been for quite some time the world's reserve currency, and that globalization, since some of the last crises, has created a global interdependence, particularly between, let's say, China and the United States. What do you think of the implications of those two facts going forward? It seems as if all currencies—maybe with the exception of the renminbi—are depreciating together. What are the implications of this going forward?

CARMEN REINHART: The issue of the role of the dollar as the world reserve currency is something that Ken and I have looked at in various dimensions. It was very unusual, as Ken mentioned, that during a crisis year like 2008 the country where the crisis originates has an appreciation. We're starting to see that unwind.

I think, before we see the writing on the wall that the dollar is giving up its role as a reserve currency, there is a series of things that one sees before that. We did study the period in which the world transitioned from the U.K. pound being the world reserve currency to the dollar taking over for the pound. There are lots of things that you see before that. You begin to see that countries started pegging to the dollar instead of pegging to the pound, that countries' debts began to be issued denominated in dollars rather than pounds.

That process went on for decades before the demise of the British pound finally ended with the big bang in 1967, the sterling crisis.

We haven't seen that yet. You need a currency to replace a currency. Right now the demand from central banks is for bonds, euro bonds.

We have Greek bonds, we have German bonds, we have Italian bonds, but those are still relatively individually small markets compared to the U.S. Treasury. Japan has never indicated the intention or interest in the yen becoming a reserve currency. And the yuan, the renminbi, is not convertible.

So at this stage, no doubt that if we continue to make policy mistakes along the lines of many that we have made, the dollar's role as a reserve currency will reflect that, accordingly. But it's too soon to put it to bed.

QUESTION: From your research, have you determined what kinds of personal or government behaviors cause these cycles to happen? If so, do you have any suggestions about how we change that?

This is the "voice for ethics in international policy" here. Are there ethical behaviors? Is greed a substantial element to all of this? Is it ignorance? What have you determined from your research?

KEN ROGOFF: I think what we emphasize from our research—and Joanne used these words in her opening remarks—is that it's about arrogance and ignorance, ignorance that these things even happen or how they happen, and the arrogance that, if you're aware of that, it's not going to happen to us.

There is a lot of blame to go around in each of these things. At some level, it's the government's responsibility to try to take a longer-term perspective and to try to regulate the system so that this doesn't happen so frequently. That did not happen in the entire run-up to this. Instead, we heard that we don't need to worry, that we're borrowing two-thirds of world net savings, which is what was happening—and totally freakish, frankly—but we don't need to worry about it, because, thanks to financial globalization, our superior regulation and political system, and the trust in the United States, there's just nothing to worry about. Our central bank is great, and our whole productivity is great.

There are all these stories. Especially given what was happening to housing prices and other things going on, we should have been suspicious.

There's a whole political economy element to this that we talk about but don't go into too deeply. Surely there is a dynamic that some sector—in our case, it was the financial sector; other times, it's the corporate sector or others—gets rich in this process, and that helps them support the dynamic politically.

There's certainly a human side.

You said, what can you do about it? At least try to strengthen your knowledge of experience. The simple data that we develop and provide doesn't tell you if you are going to have a crisis, but it says something. And if you have all the red lights blinking, somehow that should get brought into the conversation.

Also this view that I think our book shatters, that financial crises happen at other times to other people in other places—they happen in Asia. Of course, they also happen in Africa, even though you don't read about it. They happen in Europe. And they happen just about as frequently. Just some awareness of that in the public discussion, at least for a while, I think would be helpful.

QUESTION: Can you tell us how extraordinary the quantitative easing has been by the Fed and other central banks—notably, the Bank of England—during this crisis?

Is this unusual, to act in order to make funding for the banking sector essentially riskless and quite inexpensive? What about the mopping-up?

CARMEN REINHART: Let me say that quantitative easing is not new to this episode, but is a luxury that goes with having a crisis in an advanced economy. So it is a luxury. If you look at the Japanese crisis in 1992, there was massive quantitative easing, especially as fears of deflation really took hold and we saw zero interest rates and so on. It's not unprecedented.

In the crises that we analyzed in emerging markets, that's not an option. It's not an option because you lose financing, and so you have no option but to raise interest rates to try to restore confidence and to keep capital from leaving the country.

The Depression we had late, but if you look at the period after the gold clause was abrogated in 1933 and you look at what happened in the monetary base in the United States, that qualifies as quantitative easing.

But I think the one issue that I want to leave in connection with quantitative easing, highlighting again the Japanese experience, is that it can be quickly undone, if the will and wherewithal is there, which is, of course, a big "if."

KEN ROGOFF: Maybe I'll add a couple things to that. There's normal monetary policy, where you set the interest rate, and quantitative easing basically has the central bank acting like an investment bank in the economy. There is a lot of that in emerging markets, where they get involved in other ways. It can work for a while, but it also raises an awful lot of political economy issues and risks over the longer term, when you become involved in that.

It is not that easy to exit from this, because it's so extraordinary. I think the Federal Reserve will, rightly, emphasize that they have all the tools they need to unwind what they did. But then they need to add to that, "But we've never done it before." It's certainly risky.

We have some creative tension between us about things, which I think helps us think deeper about things. I tend to be a little less tough on them for these bank bailouts they did. It's horrible. The moral-hazard problems and everything are horrible. I tend to think the problem has been pushed down the road five or ten years, to when we figure out if we can pay for this. On the other hand, I must say I respect that often when we disagree, Carmen turns out to be right. I think she has a little bit darker view of the near-term risks.

QUESTIONER: Is it very optimistic to believe that when they start unwinding this and therefore selling these securities into the market that there's going to be a lot of willing buyers?

KEN ROGOFF: They can't sell them. They can sell some of it, but not the junk stuff. I don't see how they can sell them.

What ought to happen is that the government, the Treasury, ought to take it over. But we have our stupid debts, and it complicates it. So it ought to get taken over by the Treasury and then worked out over a very long period. Instead, it's in the wrong place—the Federal Reserve—because Congress wouldn't do anything in the crisis. That forced the Fed to bear this burden. At least that's my interpretation.

CARMEN REINHART: A lot of the unwinding is just by allowing maturities to expire.

KEN ROGOFF: Which could take a long time.

QUESTION: Not focusing so much on quantitative easing and how you try and mitigate or deal with the effects of a crisis, but talking more about how to avert a crisis, in your historical research, have you come across many examples of cases where governments or regulators successfully averted a crisis that would otherwise have been building up? If you did, is it your view, based on that research, that you are more likely to be successful doing it by addressing capital imbalances or by dealing with it on the regulatory end—i.e., by curbing the excesses that tend to occur when the capital imbalances build up?

CARMEN REINHART: I am actually going to give one concrete example, but you can only draw so many lessons. One country that actually had its last crisis very vivid in policymakers' minds is Chile in the early 1990s—still reeling with the memories of their massive banking and currency crisis of the early 1980s. When Chile became rediscovered in capital markets in the early 1990s, they took all kinds of measures to try to guard against an excessive borrowing cycle. It involved tighter regulations, it involved actually trying to get government spending to contract, to offset what some of the private sector was doing, and it involved reserve requirements that made it more difficult for Chilean companies to borrow abroad. It involved a lot of things. But it really took a major crisis that was vivid in their memory.

Unfortunately, in all the work that Ken and I have done, there are too few examples of that type of preemptive action.

KEN ROGOFF: Brazil did it yesterday. It's striking that Brazil did it yesterday.

QUESTION: "Woe is us" in history is fascinating. Assume that you were both benevolent dictators. I do not accept the fact that the government is going to pay any attention to it. Could you come up with systems engineering to solve the problem, not whether people will accept it? In other words, your next book: What to do?

KEN ROGOFF: A point we would underscore—we would have said we were in trouble for a long time here and something was going to happen.

By the way, I think the idea that the Lehman crisis caused this is a joke. It was a very difficult hand that the Fed and Treasury had to play at that point, with all the excesses.

But going forward, the obvious excess is government debt. What often happens in these cycles is that the debt builds up and people start charging you higher interest rates. You think, "I want to pay lower interest rates. What can I do?" So I promise that it's going to be okay. We could link the bonds to inflation. We can shorten maturity—so, instead of borrowing at ten years, borrow at three years, two years, one year. That is such a routine cycle in this. And, of course, that backs you into a corner, so that when confidence is lost, you're toast.

It's better to just face this problem up front. If I had one concrete piece of advice for our government, it would be not to yield to that temptation. These are big amounts of money. If they are borrowing longer-term on a debt that could be close to 100 percent of GDP, you are talking about an extra $150 billion a year in interest payments. That's if you moved all from one category to the other. But if at some point you don't try to play the game of trying to save money by making the debt very vulnerable, you are much better off. It forces you to tighten your belt sooner, which you don't want to do.

But if I had to say what I'm afraid the dance will be as we run into trouble, as this goes on, that will be it. Carmen studied myriads of examples of this in her early work.

CARMEN REINHART: I would just quickly add that a critical problem is, even if you were a benevolent dictator, then you had better be a benevolent dictator that has a good handle on history. It is often the governments themselves that build up the basis that this time it's different.

I think also institutions like the IMF don't have a strong hand to deal with such situations. When the times are booming—and everyone is a genius in a bull market—those are the times when the IMF influence is also at its weakest. Therefore, enforcing corrective measures has little authority.

KEN ROGOFF: I should add, when Canada had its deep crisis in the early 1990s, it had many advantages over us today, because the government was very big and it could reduce it. But one of the very smart things they did was, they had a fair amount of U.S. dollar debt and they converted a lot to Canadian debt. Carmen was following it in real time, because she was the Canada desk at the IMF at that time. That was very smart. It's exactly the opposite of what most governments do.

QUESTION: How much of the blame should, in your view, go to the Fed for its persistent low-interest policy? Did it have other options?

Secondly, is it historically so that a low-interest policy has been at the bottom also of previous crises that you have studied?

KEN ROGOFF: Yes, I think it was important, but not in itself. There was a mix—this borrowing from abroad, the easy regulation. I think it certainly was an error, and no matter what they say, if they had to do it again, they would do it differently. There was a view that you should only look at inflation and not look at the rising housing prices and leverage. I think that has, happily, been thrown out the window after this crisis.

But it's the whole system—the politicians, the regulators, the financial sector, us, the ones who are buying houses and overleveraging. The Fed certainly played a role, but I think it was hardly in this dance by itself.

CARMEN REINHART: I would add that one of the things that becomes very manifest from our research is that these crises, these booms in credit, which are so associated with borrowing from abroad, have taken place in the context of fixed exchange rates, floating exchange rates, inflation targeting. You can go down the list.

Very different monetary arrangements have been accompanying the cycles.

KEN ROGOFF: We have some sections in the book where we go through these cycles. One of the ones I like is, in the 1930s, a lot of the loans were from small bondholders. In the big Latin run-up in the 1970s, they said, "Well, we're not going to make that mistake again, because then, when there's a default, it's really hard to coordinate the creditors. We're going to have just big banks make the loans. We're not going to have a problem." Well, we saw what happened in the 1980s.

In the 1990s, people said, "Look at what happened with the big banks. It was too easy to default. The countries could go to them and renegotiate because they could coordinate too easily. So this time we're going to have all bonds."

I'm not kidding. People forgot about the 1930s, that they had been through that cycle, and the next cycle will be bank lending. The same thing with the currency: "This time we have a currency board." "This time we have inflation targeting." "This time we have the gold standard." And the fiscal problems just blow through these things.

QUESTION: I want to know, if taxes and inflation are a way out of this thing, what happens to our economic base? With people having less money to spend, what happens to our economic base at that point?

CARMEN REINHART: We went into this crisis, if you look at the postwar, with a record low in the saving rate and a record high in household debt-to-GDP. No doubt a lot of the deleveraging that's going on, perhaps, is necessary and it's overshooting, and it involves a lot of deleveraging through default on the part of households as well.

But I think, in terms of spending, one really has to go back and not use the pre-crisis level as a benchmark. That was way out of line with the postwar experience. So I think going back to pre-crisis is not what we should be focused on.

KEN ROGOFF: Absolutely. You've heard it a thousand ways: We were living beyond our means. That can't go on forever.

JOANNE MYERS: I'll ask one question, because we have time for one more. Do you think the government strategies that they are now implementing are the right strategies? Or would you have other suggestions for them?

KEN ROGOFF: When I walk the halls of Harvard or if I go to Chicago or Stanford, around the academic world—and, I grant, this is the academic world—the fairly universal consensus is, "Good job, but why didn't you have people who lent money to the banks, the big bondholders, share some of the cost? Would it really have been so hard?"

You hear contorted arguments that that was impossible. I think that was very unfortunate, because now we basically have deposit insurance writ large. Any kind of financial—anything is implicitly guaranteed. The government talks about taking that away. But who thinks that the big former investment banks will ever be allowed to go under at this point? Therefore, they can borrow practically at the government rate, and that lets them borrow too much, et cetera.

I think that was certainly unfortunate, is all I can say.

Otherwise, I have a few different ideas, but I don't want to go back and try it again to see if they would work better.

CARMEN REINHART: I have to reiterate my answer to this gentleman's questions about jobs. I think delay and coming to terms with the unpleasant, painful, and expensive fact that the financial system needs more recapitalization and this "let's wait to see what the private sector does"—we've been doing that for some time. I think delay is very costly.

I think it has also shifted a lot of the burden from the fiscal authority to the Fed. I think that is undermining the credibility of the Fed big-time.

JOANNE MYERS: Thank you very much. There's no question that this was a gold standard for financial analysis. I thank you both for being here.

Copyright © 2010 Carnegie Council for Ethics in International Affairs

The Foreclosure Spiral
The Next Housing Crisis
June 15, 2010

By MIKE WHITNEY

Did the Federal Reserve collude with the big banks to hold millions of houses off the market until the Fed finished adding $1.25 trillion to the banks reserves? Did the Fed do this to make it appear that its bond purchasing plan (quantitative easing) was stabilizing prices when, in fact, it was the reduction in supply that stopped prices from plunging? It sure looks that way. This is from Bloomberg News:

"U.S. home foreclosures reached a record for the second consecutive month in May, with increases in every state, as lenders stepped up property seizures, according to RealtyTrac.Inc.

“Bank repossessions climbed 44 per cent from May 2009 to 93,777, the Irvine, California-based data company said today in a statement. Foreclosure filings, including default and auction notices, rose about 1 per cent to 322,920. One out of every 400 U.S. households received a filing." (Bloomberg)

Inventory steadily declined during the period the Fed was exchanging cash-for-trash (toxic assets and non performing loans for reserves) with the banks. Now inventories have begun to rise again as the banks get back to business as usual, in other words, throwing people out of their homes. The sudden uptick in repossessions and property seizures coincides perfectly with the ending of the Fed's giant "no bankster left behind" program. Clearly, there must have been a quid pro quo.

What's so impressive about Bernanke's trillion dollar sleight-of-hand operation is its simplicity. We're just talking "supply and demand" here, not rocket science. The banks agreed to cut supply (by temporarily stockpiling homes) while the Fed loaded them up with a cold trillion-plus in reserves. Meanwhile, John Q. Public assumed (incorrectly) that Bernanke's program stabilized prices. It's a very ingenious deception.

Readers may remember that quantitative easing (QE) was promoted as a way to increase lending to consumers and to keep interest rates on mortgages low. But that was all public relations hype. Consumer lending contracted in the last year while interest rates on the 30-year mortgage have fallen since Bernanke's QE program ended at the end of March.

So what does it all mean? It means the public was snookered yet again. It also means that housing prices will fall further as banks dump more inventory on the market. How far prices drop will depend on how quickly the banks clear their shadow inventory which, in turn, depends on agreements they've made with the Fed and the other banks. Housing inventory is being released in drips and drabs according to an unknown plan. Some would call it price-fixing. Here's an excerpt from an article in the Wall Street Journal that says that there's a 9-year backlog of distressed homes:

"How much should we worry about a new leg down in the housing market? If the number of foreclosed homes piling up at banks is any indication, there’s ample reason for concern. As of March, banks had an inventory of about 1.1 million foreclosed homes, up 20 per cent from a year earlier....

“Another 4.8 million mortgage holders were at least 60 days behind on their payments or in the foreclosure process, meaning their homes were well on their way to the inventory pile. That “shadow inventory” was up 30 per cent from a year earlier. Based on the rate at which banks have been selling those foreclosed homes over the past few months, all that inventory, real and shadow, would take 103 months to unload. That’s nearly nine years. Of course, banks could pick up the pace of sales, but the added supply of distressed homes would weigh heavily on prices — and thus boost their losses." ("Number of the Week: 103 Months to Clear Housing Inventory" Mark Whitehouse, Wall Street Journal)

Here's a clip from Housing Wire with a slightly different perspective:

"The amount of REO property held by the banks is also known as the “shadow inventory” of foreclosures. According to Morgan Stanley, it would take 47 months for the market to clear the roughly 7.5m first-lien mortgages in danger or already in foreclosure." ("Foreclosed Properties Held by Banks Up 12.4 per cent in Q110: SNL Financial," Jon Prior, Housingwire.com)

No matter how you look at it, housing will be in a funk for the next 5 to 10 years. There's just too much product and too few buyers. Austerity measures by the Obama team will only put more pressure on sales and prices.

Now that the government's homebuyer credits, subsidies and incentives have ended, demand for housing is drying up fast. The Mortgage Bankers Association (MBA) reports that new mortgage purchase applications have tumbled nearly 40 per cent to their lowest level since April of 1997. Sales are in freefall. Prices have already slipped 30 percent from their peak in 2006. Another 10 percent could be the straw that breaks the camel’s back, as Whitney Tilson explains in a recent article titled "The Housing Non Recovery". Here's an excerpt:

"Today about 17.2 per cent of homeowners are underwater. But if home prices drop 10 per cent from here, 27 per cent of homeowners would go underwater. In other words, a 10 per cent drop in home prices would cause a 56 per cent increase in the number of people underwater…which would almost certainly lead to another surge in defaults." ("The Housing Non Recovery", The Daily Reckoning)

This excerpt deserves a second reading. The next 10 per cent plunge in prices will be more painful than the first 30 percent. The market is on a knife's edge and one false move could be deadly. More than 7 million homeowners have already stopped paying their mortgages which means that the inventory-pipeline will be bulging for years to come. The administration needs to get on top of this problem before the downward spiral begins and the next disaster becomes unavoidable.

Mike Whitney lives in Washington state. He can be reached at fergiewhitney@msn.com

Business as Usual on Capital Hill
Credit Storm in Europe

May 28 - 30, 2010


By MIKE WHITNEY

Credit market turmoil in the Eurozone has ignited frenzied trading on global markets. On Tuesday, shares tumbled nearly 300 points on the Dow Jones before launching an unconvincing 257-point late-day comeback. Wednesday the mayhem continued; all the major indexes seesawed wildly as positive news on durable goods was nixed by reports on wobbly EU banks. Erratic selling pushed the S&P down to 1,067 while the Dow slipped below 10,000 for the first time since February 7. The rise in Libor (the London Interbank Offered Rate) is increasing volatility, a red flag indicating trouble in interbank lending. Banks are wary of each other’s collateral as Greece and other underwater Club Med members appear to be headed for debt-restructuring. Libor is not yet at pre-Lehman levels, but the rate that banks charge each other for short-term loans has rocketed to a 10-month high. Improving economic data have not eased fears of another meltdown or removed the rot at the heart of the system. The banks are still loaded with loans and assets that are losing value. The credit system is breaking down.

When banks post collateral overnight for short-term loans, the collateral is effectively downgraded, limiting the banks’ access to capital. This is what triggered the financial crisis two years ago, a run on repo. Regulated "depository" institutions now rely on a funding system that operates beyond government oversight, a shadow banking system. The banks exchange collateral, in the form of bundled securities and bonds with institutional investors (aka---"shadow banks"; investment banks, hedge funds, insurers) via repurchase agreements (repo) for short-term loans. The repo market now rivals the traditional banking system in terms of size but lacks the guard rails and stop signs that make the regulated system safe. The system is inherently unstable and crisis-prone as a recently released paper by the Federal Reserve Bank of New York (FRBNY) admits. Moody's rating agency summarized the paper's findings like this: the tri-party repo market “will remain a major source of systemic risk, especially given the current market volatility and the fact that the Federal Reserve’s primary dealer emergency lending facilities are no longer in place...... the market remains structurally vulnerable to a repo run...... If cash investors pulled away in a stressed environment, the clearing banks would be faced with a choice (as they were several times in 2008) of taking on large secured credit exposure to dealers or severely constraining intra-day credit to them. Such market mechanics can exacerbate the effect of a systemic and/or a dealer-specific crisis.....Until the remaining issues in the tri-party repo market are resolved, the risk of a repo run remains in place. (Moody's, thanks to zero hedge)

It's too bad Congress doesn't take time to read Moody's analysis before gutting the derivatives and capital requirements provisions in the new reform bill. It might help them understand that by placating Wall Street they're laying the groundwork for another financial disaster.

When Lehman failed, Fed chair Ben Bernanke stepped in as lender of last resort to keep the banking system functioning. He deftly shifted from lending facilities to quantitative easing (QE)--a ploy that allowed the Fed to relieve the Wall Street behemoths of their toxic assets and non performing loans. The Fed's efforts revived the economy but transferred gigantic losses onto its own balance sheet. The EU lacks the political infrastructure to enact a similar fiscal strategy. When banks collapse in Spain or Greece, the losses must be written down, adding to deflationary pressures. That has world leaders worried that their economies will be pulled back into recession. Here's a recent post from David Rosenberg which sums up the present situation:

"The downdraft in the market in recent weeks reflects the financial risk related to the European debt crisis, the monetary tightening in China and the re-regulation of the financial sector that is currently making its way through to Congress. The next leg down in the equity market specifically and cyclical assets more generally is economic risk. Equities went into this period of turbulence priced for peak earnings in 2011 and with a tailwind of positive earnings revision and positive guidance ratios from the corporate sector. If the ECRI and the Conference Board’s own index of leading economic indicators, which dipped 0.1 per cent in April, are prescient, then they are portending a period of sub-par economic growth ahead." (Breakfast with Dave, David Rosenberg, Gluskin Sheff.)

The media characterize troubles in the EU as a "sovereign debt crisis", reflecting "deficit cutting" the political agenda of its authors. In fact, this is a straightforward banking crisis, undercapitalized banks whose downgraded assets are leading them towards default. The banks alone are responsible. In the US the problem has been resolved by the historic bank/state merger. "Too big to fail" implies that the primary function of the state is to preserve its core financial institutions. For many reasons, this remedy won't work in Europe. The individual countries will have to bailout banks at their own expense or resolve them through the bankruptcy courts.

Austerity measures in the Eurozone will derail Obama's efforts to increase exports to compensate for the slowdown in consumer spending. The administration's economic strategy, to large extent, depends on a weak dollar, a strong EU and a prosperous China. That plan vaporized earlier this week when Spanish regulators took over CajaSur one of the country's biggest mortgage lenders. Spain's property crash is intensifying the contraction and pushing banks to the brink. As credit tightens and economic activity slows, the prospects of a strong rebound become more remote. The downturn could last for years.

Deteriorating conditions in Europe have set off alarms at the Fed. For Fed chair Ben Bernanke, the trouble in the EU money markets and commercial paper markets must seem like a recurrent nightmare, Lehman all over again. Bernanke wants to stop the repricing of bank assets that would trigger firesales and another round of deflation. So, he's reopening "swap lines" to help EU banks roll over their short-term loans. His proposal would slash rates to near-zero and make the Fed liable in the exchange of questionable loans and assets, putting both the taxpayer and the dollar at risk. Here's a clip from the Wall Street Journal:

"The Federal Reserve has a lever it can pull to help European officials combat a worsening financial crisis: Reducing the interest rate it charges on U.S. dollar loans it makes through the European Central Bank to dollar-starved commercial banks in Europe....

“The loans currently are priced one percentage point above a market rate called Overnight Indexed Swaps (OIS), which tracks the expected path of the Fed's benchmark federal funds rate. The loans are set above OIS to discourage foreign banks from using the government program too aggressively. But the Fed could reduce that penalty to encourage more borrowing and ease some of the financial strain on foreign banks in need of dollars....Many European banks, and their U.S. branches, need dollar funds because they hold U.S. dollar assets. But lenders have become more wary of extending them the cash. That's made dollar loans more costly for European borrowers and the funding they do get is has been for shorter maturities." ("Fed's Next Move Could Be Reduced Rate on Dollar-Euro Swaps", Jon Hilsenrath, Wall Street Journal)

The Fed is operating far beyond its mandate to maintain price stability and full employment. It's applying its own arbitrary pricing mechanism and usurping the authority of the EU central bank. Here's how Clifford Rossi explains the Fed's action in a recent post on Institutional Risk Analysis:

"The mechanism for the bailout of Europe is the Fed's provision of dollar credit in virtually unlimited amounts via central bank swaps lines.....the Fed swap lines help the bankrupt nations of the EU ignore their mounting fiscal problems......Fed Chairman Ben Bernanke is engaged in a little geopolitical engineering in Europe -- and the people of the EU do not yet realize that a political change in control has occurred.... the leaders of Europe now find themselves beholden to the Fed for their continued political existence.... Chairman Bernanke and the FOMC have but to terminate the Fed's swap lines with the various central banks of Europe or start selling the MBS portfolio in the US, and governments from Washington to Berlin will start to fall." ("More fed swap Lines for Europe and the End of Globalization", Clifford Rossi, Institutional Risk Analysis)

The swap lines are designed to keep asset prices artificially high, so the contagion doesn't spread to the US where accounting gimmickry helps to hide bank losses. Bernanke is perpetuating the repo scam, by assisting banks and other financial institutions to amplify crumbs of capital into huge bubbles which can take down the whole economy. The Wall Street Journal exposed a similar repo scam this week in an above-the-fold article on Wednesday. Here's an excerpt:

"Three big banks--Bank of America, Deutsche Bank, and Citigroup Inc.—are among the most active at temporarily shedding debt just before reporting their finances to the public, a Wall Street Journal analysis shows. The practice, known as end-of-quarter "window dressing" on Wall Street, suggests that the banks are carrying more risk most of the time than their investors or customers can easily see....

“Over the past 10 quarters, the three banks have lowered their net borrowings in the "repurchase," or repo, market by an average of 41 per cent at the ends of the quarters, compared with their average net repo borrowings for the entire quarter, according to an analysis of Federal Reserve data. Once a new quarter begins, they boost those levels...

“The data suggest ‘conscious balance-sheet management,’ said Robert Willens, an accounting specialist who heads Robert Willens LLC. If there are big gaps between average quarterly and quarter-end data, he said, the quarter-end numbers "are at best meaningless and at worst misleading and disingenuous." ("Banks trim Debt, Obscuring Risks", Michael Rapoport and Tom Mcginty, Wall Street Journal)

So the banks are intentionally masking their leverage to conceal their true condition to investors. And it’s all done with derivatives and repo; the lethal combo that led to the crisis of '08. Unfortunately, Wall Street's lobbying campaign has been so successful that, even now, real change is unlikely. In fact, House Financial Services Committee Chairman Barney Frank openly opposes Blanche Lincoln's comprehensive derivatives legislation saying that it "goes too far". Frank has signaled that the bill would be killed or rewritten in committee. Derivatives trading is a main profit-center for the nation's largest banks and they have spent millions to preserve the status quo.

"I don't see the need for a separate rule regarding derivatives because the restriction on banks engaging in proprietary activities would apply to derivatives as well as everything else," Frank said on Monday.

Even without Frank's support, the bill would have faced fierce resistance from a contingent of Wall Street Democrats who were planning to strip the critical provisions from the legislation.

Rep Michael McMahon (NY-D) defended the banks saying, “The House bill is based on principles on how to reduce risk and make the system more transparent, it’s not based on wiping out the system or destroying the system and that’s what the provision does."

The credit storm in the EU has had no effect on Congress. Wall Street has won this round. The window for real reform has closed, and now it's "business as usual" until the next catastrophe.
Mike Whitney lives in Washington state and can be reached at fergiewhitney@msn.com

Greek debt crisis stirs old grievances with Germans
Mon Feb 22, 2010 1:09pm GMT


(Reuters) - "Dear Greeks," the open letter began. "Over the years, we Germans have given some 9,000 euros (7,918 pounds) for each of you Greeks."

Business

"You are by far our most expensive friend," wrote German journalist Walter Wullenweber in the weekly AthensPlus, published by leading conservative Greek daily Kathimerini.

The crisis over Greece's debt mountain, and the potential threat it poses to the single European currency, has revived old resentments and stereotypes between Greeks and Germans.

Opinion polls show an overwhelming majority of Germans are hostile to the idea of bailing out Greece if Athens needs financial support from its European Union partners.

That helps explain why Chancellor Angela Merkel, whose coalition is divided on the issue, has sought to avoid turning her pledge of political support for Greece into offering money.

The mass-circulation Bild daily, a dependable barometer of ordinary Germans' gut reactions, said this month "the proud, cheating, profligate Greeks" ought to be "thrown out of the euro on their ear" because of their finances.

To that list of epithets, Wullenweber added charges of tax evasion, corruption and laziness.

Now Greeks are starting to get outraged at German outrage.

"How does Germany have the cheek to denounce us over our finances when it has still not paid compensation for Greece's war victims?" Margaritis Tzimas, of the main opposition New Democracy party, asked in parliament last week.

The conservative lawmaker reflected a belief among many Greeks that post-war West Germany paid too little to too few in compensation for the brutal 1941-44 Nazi occupation of Greece.

On the streets of Athens, a joke is doing the rounds about the government's attempt to make citizens collect receipts to flush tradesmen out of the black market: "For every VAT receipt not collected, the Germans will shoot 10 patriots."

PUBLIC CONTRITION, PRIVATE ANGER

The Socialist government that took office last October is publicly contrite about Greece's responsibility for its own fiscal mess, due to years of uncontrolled spending, poor revenue collection and dodgy statistics.

But privately, some senior officials bristle at alarmist comments by German politicians and central bankers which they say have amplified market pressure on Greek debt.

German Economics Minister Rainer Bruederle, for example, told parliament in Berlin last month that some euro zone states were showing dangerous weakness that may have "fatal effects" on all states in the currency area.

Greeks recall that Greek "Gastarbeiter" (guest workers) were among migrants who contributed to Germany's economic miracle in the 1960s and 1970s while their homeland was ruled by a military dictatorship backed by NATO, of which West Germany was a member.

They also note that Greece has been and remains a bumper export market for German goods, including tanks, since it joined the EU in 1981, as well as a playground for German tourists. Berlin profits from a large trade imbalance with Athens.

Six deputies from the small Left Coalition party last week urged the government to press Berlin over the reparations issue and blamed German banks and politicians for Greece's crisis.

"By their statements, German politicians and German financial institutions play a leading role in a wretched game of profiteering at the expense of the Greek people," they said in a written question to the government.

FOREIGN TUTELAGE

Beneath these resentments lie Greek fears, rooted in history, of once again falling under foreign tutelage.

After the first modern Greek state won independence from Ottoman Turkey in 1821, the great European powers imposed a German-speaking Bavarian, Otto, as king of Greece from 1832 until he was overthrown in a revolution in 1864.

In 1850, Foreign Secretary Lord Palmerston sent gunboats to blockade the port of Piraeus to exact compensation for a Briton whose property had been damaged in riots in Athens.

Greece defaulted four times on its debt between 1827 and 1932, but the most humiliating economic experience, seared into the national consciousness, was the imposition of International Financial Control by six great powers led by Britain in 1898.

In return for a loan, which Greece finally paid off some 80 years later, the six powers took direct control over most revenues, helping themselves to the proceeds of tax on tobacco, matchboxes, salt, oil, playing cards, stamps and customs duties.

That is one reason why talk in Brussels and Berlin of the idea of appointing an EU overseer for Greece's public finances strikes a raw nerve.

Joining the EU, with its cornucopia of agricultural and regional subsidies worth up to 4 percent of gross domestic product in the peak years, gave Greeks a feeling that they were at last on equal terms with the European great powers.

The debt crisis has suddenly thrown that into doubt.

"We are furious at the Germans," said Mahi Konstantinidou, 55, a civil servant. "We don't like their attitude -- telling a fellow European state what we have to do.

"What is Europe for? We are partners," she said.

(editing by Dominic Evans)

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€uro: the worst case scenario
by Jean-Michel Vernochet

The Greek budgetary crisis, which has become a crisis of the euro, is not the inevitable result of market self-regulation, but rather the consequence of a deliberate attack. According to Jean-Michel Vernochet, the crisis was provoked by an economic offensive directed from Washington and London that followed similar principles to those of contemporary military warfare, employing game theory and a strategy of ‘constructive chaos’. The ultimate aim is to oblige the Europeans to enter into an Atlantic bloc, i.e. an empire where Anglo-American budgetary deficits would be automatically financed through the expedient of a dollarised euro. The agreement concluded between the European Union and the IMF, giving the Fund partial oversight of Union economic policies, is a first step in this direction.


The director of the International Monetary Fund, Dominique Strauss-Kahn, and the German Chancellor, Angela Merkel. Prevented from returning to the Deutsche Mark, Germany must consent to a European loan from the IMF.

The financial attack launched against Greece because of its sovereign debt and its potential insolvency soon proved to be an offensive against the Euro and to have only a distant relationship with the flaws and structural deficits of the Greek economy itself. These ‘vices’, incidentally, are largely shared by the bulk of post-industrial countries which have acquired the bad habit of living beyond their means and on credit, hence the soaring quantum of debt, a bubble (as any other) doomed to burst.

Everything seems to indicate that behind the brutality of the attack and beyond a simple stampede to pillage some European economies loom other objectives, notably of a geopolitical character, carefully thought out. In any case, the appetites of anonymous financial predators - as sharp as they might be - cannot account for the sustained intensity of the offensive which, in the short term, threatens to shatter the Euro zone, the European Union itself, indeed even beyond …

With the proliferation of crises over the last two decades, a quick reading of the pawn movements on the Grand Eurasian Chessboard is enough to suggest that Europe is actually one battle ground within a geo-economic war (war in the proper sense), a battle that it has besides already potentially lost.

Indeed, the adoption of a European plan – at the insistence of the White House – for the bailing out of heavily indebted EU member states not only does not constitute a panacea, a durable remedy to the structural budgetary crisis that has been rapidly affecting all Western states, but points in the direction desired by the U.S. of a rapid integration of the EU, a necessary prerequisite for the constitution of a united Western bloc.

This European plan responds to a crisis of confidence and solvency (largely artificial at the outset, but which became contagious and is now snowballing) by the recapitalisation of states as if it were a matter of a simple liquidity crisis. A European plan of 750 billion euros, even greater than the 700 billion-dollar Paulson plan designed to bail out the American financial establishment with public funds after the debacle of September 2008. The deviant consequences of that solution can be seen at present in the heavy expansion of the public debt on both sides of the Atlantic.

Thus, the U.S.-born crisis, after having triggered the recession which de-activated the economic pump, has since dried up the fiscal resources of states rendering it more difficult to service an ever expanding debt. Now, the EU has just increased the existing debt by an additional 750 billion euros, which further strain member states’ national budgets (the average indebtedness of the euro zone being actually 78% of GDP), all this with the illusory plan of ‘re-establishing market confidence’.

To this end, the EU has voluntarily placed itself under the thumb of the IMF which has consented to have up to 250 billion euros at the ready. This is the same IMF, whose calling until now has been to support tottering Third World economies through crippling recipes in the guise of so-called structural adjustment plans. It is thus a supranational entity, formally ‘globalist’, which will head, indeed supervise more or less directly, the structures of economic governance which the EU will most certainly adopt if the euro zone does not spontaneously break up beforehand.

Such integrative measures have been vigourously called for by Paul Volcker, Chairman of the White House Economic Recovery Advisory Board, who, while recently in London, lambasted European leaders demanding a boosting of the euro which the Americans and British need to keep their own economies afloat.

Let us note, in passing, that it is probably with a heavy heart that the German Chancellor accepted to subscribe to this mindboggling support plan for the faltering Euro zone countries since her French counterpart – according to persistent rumours – was threatening to return to France if she did not conform. But, while it is true that ‘the worker ant is not altruistic’, a return to the Deutsche Mark would be equivalent to signing the death warrant of the German economy as a strong currency would restrain its industrial exports, at the base of its economy. Like it or not, the situation forces Berlin, under duress, to navigate the strictures drawn up by the Obama Administration.

American ukases that lead to a big open trap: capital borrowed from the markets or lent by the IMF to save the ‘PIIGS’ (Portugal, Italy, Ireland, Greece and Spain) – threatened with cessation of repayment - must rely on structures guaranteeing long term solvency of the euro. A currency whose soundness cannot be assured, however, by the type of federal institutions which Jacques Attali has been promoting in calling for “… the creation of a European Treasury, immediately authorised to borrow in the name of the EU, and of a European Budgetary Fund, given immediate mandate to control the budget expenditures of any country whose debt exceeds the 80% of the GDP.”

It essentially boils down to subjecting States to economic tutelage under the guise of saving the Euro zone from an allegedly inevitable collapse ... since the abandonment of the Euro is an inviolable taboo that nobody apparently dreams of touching.

Certain projects go even further, by prescribing that the budgets of member states should be entirely controlled and decided on by a triumvirate comprising the European Commission, the European Central Bank and the Eurogroup (the member states’ Finance Ministers). What about the popular will and the European Parliament in Strasbourg?

No one cares about denouncing the sophistry or the fallacy of equating economic integration with a return to market confidence. First of all, why should markets, and markets alone, impose their own laws? Besides, is it not time to revisit stock market capitalism, anonymous and volatile, and capable of ruining countries on a whim or from self-interest?

On this account, centralised economic control from Brussels is no more the panacea than is a flood of liquidity the solution to the current crisis. The additional indebtedness generated by the ‘plan’ is without doubt a false solution imposed from outside with the end goal of further enslaving us Europeans to capital markets and their unspeakable dictatorship.

The idea of centralised control proceeds from the same stance for it is literally a non-sense in that it ignores all the societal differences operating across all layers of the European construct: types or models of economic growth, fiscal and social systems, etc. It is basically a “non-idea”, one which is fundamentally ideological by its nature … a smokescreen concealing a whole range of ulterior motives, all in fact foreign to the economic prosperity and well being of the peoples of the EU.

Some have rightly seen that this crisis was only the means and the pretext to precipitate the introduction of a hard-core federal system [1] encompassing all twenty seven member states despite and in contempt of the popular will over which the Treaty of Lisbon has been imposed in the most underhanded fashion. A crisis which is and remains – a cardinal fact to be borne in mind – artificial, fabricated; in a word, it is the opposite of an inherent ‘inevitability’ implied by a self-regulating and disembodied market environment, supposedly steered by an ‘invisible hand’. A reputedly ‘mechanical’ process, which, despite its anonymity, is none the less constituted by corporate executives and traders made of flesh and blood that call the shots and manipulate the market.

It is for this reason that the U.S speaks with a forked tongue through two separate voices, that of its ‘market’ representatives and President Obama himself. The latter intervened to berate the Europeans and press them to stabilise their currency, or, in other words, the European economic policies, good or otherwise, which are inextricably linked to the health of their own currency. Now, don’t start imagining for one second that some kind of meddling in the affairs of Continental Europe could be involved here! Can you picture Madame Merkel and Monsieur Sarkozy asking the White House to clean up Manhattan?

The other voice belongs to those who call the shots … in short, the managers of the self-regulating order, anonymous even to the governments themselves, as French Finance Minister Christine Lagarde shamefully confessed; those who play yo-yo with the markets like a cat plays with a mouse, anticipating the lows and highs that they themselves intentionally provoke. In practice, these people are promoting a very different discourse.


For Paul Volcker, chair of the White House Economic Recovery Advisory Board, Europe must accept external control of economic policy and put the euro at parity with the dollar.

Indeed, how else to explain the evident contradiction between the concerns expressed by President Obama – legitimate by the way, for the EU needs a strong euro that penalizes European exporters, but is advantageous to American industry, a useful bonus given the record US fiscal deficit ($1400 billion for 2008-09) and above all necessary to support the ongoing war effort in Iraq, Afghanistan and Pakistan – and the radical destabilization of Western economies by the persistent attacks by the markets against the euro?

No matter how voracious, inconsistent or irrational, the ‘operators’ are nevertheless aware that the pursuit of the offensive against the euro jeopardizes the system in its totality and risks plunging the global economy into a new phase of chaos. Then why this dance on the edge of the abyss? Nobody will have us believe this nonsense that the markets have a life of their own, that they are uncontrollable and that all this is simply the result of the economic machine gone awry … In short, that it’s ‘nobody’s fault’, but the simple consequence of the impossibility of managing the agents and the irrational faux pas of the markets?

Clearly said, the risk of systemic collapse is at the very heart of the game currently being played. The big players, the cold calculators, are obvious disciples of the theory of games (since von Neumann & Morgenstern), probabilistic edifice on the foundations of which has been constructed the doctrine of nuclear deterrence … The winners are those who push the lethal bids the highest. A scenario that corresponds line for line to that which is unfolding before our eyes: increasing destabilisation of the European economies, with non-negligible effects for the U.S.

Let’s add that the financial chaos, monetary and economic, on both sides of the Atlantic is an undeniable windfall, for those who prosper in the backwash of the market’s trajectory, provoking and anticipating the cycles of panic and euphoria to play indiscriminately with the rising and falling currents of the hysterically erratic markets.

At the beginning of the Twentieth Century, the economist Werner Sombart conceived an embryonic theory of ‘creative destruction’ (subsequently taken up by Joseph Schumpeter). Since then this theory has been developed by, among others, the mathematical theory of the frenchman René Thom (‘catastrophe theory’). Amended by Benoît Mandelbrot, the theory was applied via fractal geometry to market behaviour, perceived already at that time to fall within the province of a theory of chaos, decidedly fashionable.

In the meantime, the economist Friedrich von Hayek, one of the theorists of neoliberalism, claimed to have raised the free-market economy to the status of an exact science. According to his hagiographer Guy Sorman, “… liberalism converges with the most recent theories of physics, chemistry and biology, in particular the science of chaos formalised by Ilya Prigogine. In the market economy as in nature, order is born out of chaos: the spontaneous agency of millions of decisions and pieces of information leads not to disorder, but to a superior order” … One could not say it any better, for a priori we hold there the keys to understanding the crisis.

At the end of the 1990s, the Neo-conservative disciples of Leo Strauss have carried to its logical limits the new dogma of greater disorder in making themselves the bards of ‘constructive chaos’ as a legitimation a priori for all the wars of conquest of the Twenty First Century. From this viewpoint, each is able to see this chaos at work in the Greater Middle East as s/he is able to see it at work today in Europe.

We can wager that the new regional order that the great organisers of chaos intend to see emerge from the crisis itself will be a unified Europe, centralised and federal, placed under the direct influence of the US with the aid of the Federal Reserve of which the European Central Bank will be only a branch, and under the vigilant watch of the IMF, representative or product of an emergent global power, deterritorialised yet omnipresent.

One understands quickly enough that the deification of the market associated with the idea of ‘constructive chaos’, itself complemented by an intensive application of game theory in the hands of the disciples of demolition, constitutes a mixture that promises to blow up in one’s face. An observation immediately comes to mind: ‘chaos’ (intentional) is these days a mode of government, of socio-economic transformation and of unopposed conquest. A heavy duty version of ‘divide and conquer’ even if it means nations will perish and the people with them.

For it’s a risk worth taking if in the end Europe finds itself on its knees. Greece – certainly at the soft underbelly of the euro zone but no more so than Italy, Spain, Ireland or Portugal – has been until now a sort of free electron frustrating a full integration of the Balkans in the American geostrategic orbit.

By way of a provisionary conclusion, if the EU, facing crisis, advances at forced march towards central economic control, a stage will be reached whereby quasi-discretionary power will be granted to the European Commission - for the most part composed of non-elected technocrats and recruits - for a stainless Atlanticist allegiance. To put it plainly, this will signify the obliteration of the European nation states.

In reality, nothing can prevent the integration of Europe within a trans-Atlantic Bloc. In the end, the merging of the euro with the dollar will accelerate the union of the old world and the new world. This conclusion is evidently not a matter of pure speculation but a simple projection of the architectonic tendencies visibly at work in the framework of a process of redistribution or of geopolitical recomposition of the global map. Sufficient to say that if the euro zone does not break apart, the fate of the European peoples seems definitely sealed, tied for better or worse to the manifest destiny of the United States. And this irrespective of a ‘reform’ of the global economic system.

The financiers will perhaps get their fingers burnt if the international community agrees to curb their appetites in regulating the markets, but the fact remains that the promoters of constructive chaos will have won this hand as they set out to recreate the conditions for new conflagrations.

The worse case scenario, often evoked in France by such influential men as Bernard Kouchner and Jacque Attali, happens to be the least improbable at a time when governments, backs to the wall, see themselves condemned to fleeing headlong into the unknown. In Kuwait in 1991, in Iraq in 2003 among the thinly disguised objectives of war, the boosting of the economic machinery through plans of reconstruction was high on the list. Not to mention other more flagrant and immediate interests such as fossil fuels, arms sales and all the related industries.

Whatever the accords between Turkey and Iran on uranium enrichment for medical purposes, whatever the related diplomatic annoyance for the State Department, it suffices to re-read the fabulist Jean de la Fontaine to know that the rhetoric of the wolf always prevails over that of the lamb! In a situation of extreme fragility of the global economy, one must await an end to the crisis at the harrowing door of the chaos constructor.

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