Creative Accounting and Destructive Risk

Henry C K Liu

This article appeared in AToL on April 3, 2002

Note: This article was written more than five years before the credit market crisis of August 2007 and four months after Enron filed for bankruptcy protection on December 2, 2001.  The analysis has survived the test of time. Greenspan bought time by unleashing the housing bubble.  Today, the problem is essentially the same except the scale has multiplied. The next bubble will be hyperinflation. Perhaps central bankers will recognize that it is finally time to go cold turkey to stop this debt addiction.

Alan Greenspan, chairman of the US Federal Reserve Board, frequently credits US growth in the 1990s to a rise in productivity made possible by advances in technology. Yet studies have shown that computerization did not stimulate much rise in industrial productivity in the 1990s. Industrial computerization was essentially in place long before 1995. The 1990s boom in the US was not an industrial boom but a financial boom. This was made possible by three developments: the deregulation of financial markets, the computerization of trading of financial instruments, and globalization, particularly financial globalization.

The entire structured finance (derivatives) phenomenon would not be possible without any one of the above mentioned developments. Structured finance in essence allowed an unprecedented explosion of credit, by unbundling risks for a wide range of risk-takers who sought corresponding compensatory returns. While hedging initially provided protection against volatility to individual market participants, it soon became a profit center for financial institutions. This led to the institutionalization of volatility as a market opportunity. Financial institutions actually sought volatility in the system to provide a continuous profit stream.

Creative accounting, whose peculiar logic evolved from structured finance, also made the traditional debt/equity ratio immaterial. Ways were devised for the large market participants to structure debt as hedges, through swaps that avoided taxes and balance-sheet liabilities. Swaps enabled borrowers legally to book loan proceeds as current operating income and loan liabilities as future capital expenditure that could be kept off the balance sheet, inflating current earnings. Circular counterparty risks suddenly became neutralized risk, and cash flow from swaps became net revenue. These practices are now known as Enronitis.

On the macro level, the global finance game has become a sure win for those who use dollars, especially those whose government issues dollars by fiat. The world market has become a place where the United States makes dollars and the rest of the world makes what dollars can buy. But after the Asian financial crisis of 1997, the whole world essentially adopted dollarization, if not directly, at least through hedges, albeit sometimes at prohibitive cost.

At that point, the US economy suddenly began to lose its exclusive dollar hegemony advantage because US entities were no longer the only ones with access to dollars nor could US transnationals avoid non-dollar revenue. To maintain the "strong dollar" monetary policy instituted by US treasury secretary Robert Rubin at the beginning of the Bill Clinton presidency, the US Federal Reserve progressively tightened dollar money supply throughout most of the 1990s. But this did not slow the US economy because structured finance permitted debt to expand without a corresponding expansion of equity. A strong dollar gave the US economy a boom in low-cost imports, while the US trade deficit merely forced foreign exporters to hold dollar reserves to finance the US debt bubble through a US capital account surplus. Japan did this for a whole decade, pushing its own economy into permanent recession while its dollar reserves mounted. Mainland China, Hong Kong and Taiwan took up the slack from Japan by 1995 and the three Chinese economies together now hold more dollar reserves than Japan does. China, starved for capital for domestic development, thus finds itself stuck with US$200 billion in US Treasury bills that pay 5 percent while it is forced to offer foreign direct investment high double-digit returns. The annual interest gap alone is in excess of $20 billion, which amounts to half of China's current annual foreign-capital inflow.

Growth in the 1990s came from a structural shift of the US economy from industrial capitalism to finance capitalism. Through financial globalization, the US shifted labor intensive manufacturing off US soil to low-wage locations, thus lowering the cost of manufactured products. Financial products and services and intellectual property valuation constituted most of the growth, making the US a consumer market of last resort for the whole world. London, Frankfurt, Paris, Tokyo, Hong Kong and Singapore became financial outposts of New York, sucking up dollar reserves to support the US debt bubble.

This game is ending, as the US consumer market becomes saturated and condemned to low single-digit growth, regardless of business cycles. The wealth effect from a tripling of equity value did not double consumption in the US, because aggregate demand is constrained by a widening income disparity. The rich have bought all the manufactured products they need and the working poor cannot afford to buy all they want. The wealth effect did double investment globally, reflected in the phenomenal rise in market capitalization of US transnationals and financial institutions, particularly in the so-called New Economy. The competition for credit favored double-digit growth markets in the developing countries, but the US continued to dominate global finance through its sophistication and innovation in finance and through dollar hegemony.

The problem is that all unregulated markets eventually self-destruct. Weak competitors are naturally forced off the market, leading to monopolies that are the result of market failure of competition. Yet regulation cannot cure the problem preemptively because remedial regulation only makes sense after disasters, never before.

There is increasing evidence that the real threat to China is not democracy or the market economy per se but the peculiar US version of these institutions. The 19th-century industrial capitalism that Marx observed no longer exists. Finance capitalism is a system in which capital is only a notional value upon which to build a gigantic mountain of hidden debt. Representative democracy and unregulated market fundamentalism in the US mode now work as legalized constitutional devices to disfranchise the poor and weak, both locally and globally.

Greenspan acknowledged this in his semiannual monetary policy report to the US Congress, before the Committee on Financial Services on February 27: "From one perspective, the ever-increasing proportion of our GDP [gross domestic product] that represents conceptual as distinct from physical value-added may actually have lessened cyclical volatility. In particular, the fact that concepts cannot be held as inventories means a greater share of GDP is not subject to a type of dynamics that amplifies cyclical swings. But an economy in which concepts form an important share of valuation has its own vulnerabilities." He was of course referring to Enronitis.

Greenspan's observation about the vulnerabilities of conceptual valuation was on target, although his warning of vulnerability was disproportionately misplaced. Even after the Enron and Global Crossing controversies, Greenspan continues to resist regulation, preferring to rely on market discipline. The risk is much higher than he admits.

Past records do not reliably project future vulnerability risk. Any risk manager knows that accidents are always waiting to happen. The fact that it has not happened in the past does not mean it will not happen in the future. In fact, with each passing day without an accident, the risk of borrowed time increases. Low probability is only a source of comfort if the impact is not fatal.

Also, what Greenspan did not say, but admitted by implication, was that finance capitalism is operating with less and less reliance on capital. Capital has become a notional value in structured finance. Credit is no longer anchored by equity but by circular hedges. Debt-to-equity ratio is no longer a relevant consideration. Practically all US major businesses nowadays, with their high debt leverage, would have negative real equity if the price/earning (P/E) ratio were to return to historical norms. Blue chips are being shut out of the unsecured short-term commercial paper market. Corporate credit ratings are inflated by exorbitant market capitalization value, which in turn reflects irrational P/E ratios. Even now, during what many on Wall Street contend to be a savage bear market, the Standard & Poor's 500 Index yields 25 times earnings. It would have to fall by another 41 percent to reach the median valuation prevailing since 1957.

Such a decline can happen in a period of days in this age of program trading and socialized risk, even with circuit breakers and trading curbs. When that happens, structured finance will be a sea of dead and wounded in counterparty casualties, regardless of who won and who lost.