Federal Reserve Power Unsupported by Credibility
Henry C.K. Liu

Part I: No Exit
Part II: Facing a Lost Decade Ahead


Part III: The Politics of Financial Crisis
This article appeared in AToL on September 17, 2009


United States Federal Reserve chairman  Ben S. Bernanke is visibly frustrated that many in Congress do not give the Fed what he believes is enough credit for what it has accomplished in responding to the economic crisis even as Wall Street heaps praise on his bold actions and steady hand in pulling the financial system out of an impending meltdown.
Bernanke’s second term is far from smooth sailing through calmer seas. All the structural weaknesses that caused the economy to implode two years ago are still in the financial system, albeit swept under the rug into the Fed’s balance sheet and masked by massive amount of new money and public debt not backed by any new wealth creation. Even if all goes according to the seemingly chaotic plan, the prognosis is that recovery will be anemic and will stretch out in several years if not decades. Eroded by events, Bernanke’s falling popular approval and low credibility could in themselves add to further loss of confidence in the market at a time when the Fed is trying its utmost to restore confidence.
Bernanke Faces Outsized Challenges in the Coming Years.
On the employment front, Fed dogmatic monetarism renders it operationally impotence in reducing unemployment except through trickling down from corporate profit, which cannot recovery without consumer demand, which in turn cannot recover without full employment.
On the financial front, the Fed faces a dilemma of deciding when to implement an exit strategy. Fed exit strategy is dependent on an economic recovery, but recovery will be aborted by a Fed exit. Yet the future of the dollar requires the Fed to implement an exit at the earlier possible time. The Fed has a Hobson’s choice between a robust recovery, low interest rate, low inflation, or a strong dollar, but not all. Unfortunately, Bernanke, by trying to balance on a high wire, may end up losing all and fall flat on his caution.
On the political front, Bernanke is trying to protect the Fed’s regulatory power and independence as the White House and Congress debate plans to overhaul the financial regulatory regime. Critics of the Fed asserts that making the Fed or any other unit of government  a super regulator will lead to bank consolidation and monopoly that will increase systemic risk.
Democrats such as Senate Banking Committee  chairman Christopher Dodd of Connecticut and House Financial Services Committee chairman Barney Frank of Massachusetts contend that the Fed’s incestuous relationship with big banks and Wall Street firms was a systemic cause of the mortgage crisis, and that the Fed already has too much power to merit getting more.
Bernanke and his predecessor Alan Greenspan now concede that the Fed failed to anticipate the full danger posed by the explosion of subprime mortgage lending made possible by their loose monetary policy. As recently as the spring of 2007, Bernanke still insisted that the problems of the housing market were largely “contained” to subprime mortgages. Even when panic over mortgage-backed securities began spreading through the broader credit markets in late July 2007, the Bernanke Fed still refused to cut interest rates to ward off an impending systemic collapse.
Even as late as the end of 2007, five months after the credit crunch first began, the Fed was still unable to reach a consensus internally on a decisive policy response and decided to leave interest rate unchanged. Bernanke as captain of the monetary ship was ordering steady as she goes directly into a perfect financial storm.
Only in the January 21, 2008 FMOC meeting did the Fed belatedly slashed the benchmark federal funds rate by 75 basis points to 3.5%, the biggest one-time reduction in decades. Nine days later, The Fed cut the rate again down to 3%. By then the panic was spreading full speed to all markets.
As the credit crisis paralyzed the financial markets, Bernanke led the Fed to devise unprecedented but controversial bailout measures without fully understanding or at least concern for long-range implications. Underneath of all the complex technicality of financial ballistics, Bernanke’s gun power was an old-fashion creation of massive amounts of money by expanding the Fed’s balance sheet to $2 trillion from $900 billion a year ago.
The Hard Half of the Game
But that was only half the game. The other half, the end game, is how to withdraw all the public money from the financial system without throwing the economy into a protracted depression. The Fed’s “exit strategy” as outlined by Bernanke is based on a groundless hope that financial recovery will bail the Fed out of its oversized balance sheet, reversing the logic that the Fed is supposed to bail out the economy out with an engineered sustainable financial recovery. The fed has bailed out the debt-infested financial system by transferring its toxic debt to its balance sheet and the Fed’s exit strategy is to unload the same toxic debt back on the financial system as it recovers without causing it collapse again.  The game is for the Fed to give more money to the banks to buy back the toxic debt from the Fed’s balance sheet, and call it a recovery. Throughout this circular exercise, the economy is left to rot with rising unemployment and a damaged dollar.
The Treasury Department’s $700 billion TARP bailout has stabilized a handful of banks deemed too big to fail, but it has not saved the critically impaired banking system as a whole. Small banks continue to fail, burdening the FDIC with having to ask the Treasury for more money which the Tresasury in turn has to ask the Fed to provide by buying more treasury bills to add to its balance sheet. That critical observation is the essence of the COP report.
TARP was initially designed to buy troubled and illiquid mortgage-backed securities from banks. But by accepting Krugman’s public recommendation via the New York Times, the Treasury never actually used the appropriated funds to buy troubled assets, in part because it was simpler to invest money directly into the nation’s banks and in part because banks were reluctant to sell their toxic loans at a loss.
“The nation’s banks continue to hold on their books billions of dollars in assets about whose proper valuation there is a dispute and that are very difficult to sell,” the COP report said.  As a result, the COP report warned, many banks could find themselves short of capital if the economy suffered another market downturn and their losses on troubled loans soared. What the report did not say was that the prospect of further bank crisis itself will bring about another market meltdown.
While recommending further stress tests for the too-big-to-fail banks, the COP report warned that thousands of small and medium-size banks, which it defines as those with assets of $600 million to $100 billion, might find themselves short a total of $21 billion in capital if the conditions match its worst-case assumptions.
The report noted that other institutions had already estimated the amount of troubled assets on bank balance sheets that had yet to be written down. The Federal Reserve estimated in May that banks in the US still had about $599 billion in assets to write down. Goldman Sachs and the International Monetary Fund estimated the total at about $1 trillion. And RGE Economics, headed by doom guru Nouriel Roubini, has estimated the total at $1.27 trillion.
The report urged the Treasury to either expand its Public-Private Investment Program (PPIP) to soak up troubled assets, “or consider a different strategy”, without identifying one.
Seizing on sales report of existing homes rising 7.2% in July, the biggest jump this decade, albeit from very low base, Bernanke declared what may become another set of famous last words: “The prospects for a return to growth in the near term appear good.” He did not mention at what distressed prices the sales were make.
Meanwhile, Meredith Whitney, who commands more credibility in the market than Bernanke based on her accurate analyses of the precarious position of Citigroup as the credit crisis was building up, observed: “There will be over 300 bank closures.”  European Central Bank president Jean-Claude Trichet cautioned against assuming that the world was back to normal.
Some critics think the August 2009 COP report makes the false assumption that when a bank is insolvent that it automatically ceases operations. This is not necessarily true. Receivership is the way that a bank’s liabilities are restructured when that institution is insolvent. The restructured bank’s debts are reduced but depositors can still access 100% of their deposits without interruption up to the $250,000 limit insured by the FDIC.
In most cases, the failed bank’s management will be replaced, some liabilities to creditors are reduced, and one of the healthy competitors of the failed bank takes over the branches of the failed bank to continue operation. Much of the time, receivership means that bank shareholder equity is wiped out, but the branches remain open for business, making loans the very next business day.
It is not clear that the Fed buying toxic assets from small banks would be a good idea. In two papers: The Put Problem with Toxic Assets and A Binomial Model of Geithner’s Toxic Asset Plan, University of Louisiana Professor Linus Wilson shows that the government must overpay for toxic assets to get banks that have not entered receivership to part with these trash loans and securities. Wilson’s research shows that troubled banks, which are not yet in receivership, will be most reluctant to part with their toxic loans. That is because most of their stock price is derived from the volatility of the market value of toxic assets. FDIC receivership allows the FDIC to write down bank debts so failed banks can emerge from restructuring healthier than they entered. But Wilson’s paper: Debt Overhang and Bank Bailouts, shows that toxic assets are the biggest problem when banks are poorly capitalized.
There are over 8000 FDIC insured banks in the United States serving communities of all sizes. Most of them are not large enough to pose systemic risk to the financial system. Wilson’s research shows that Geithner’s plan to sell toxic assets through the Public Private Investment Partnership (PPIP) is most likely to be effective if it is used on banks that are in receivership, rather than to keep banks out of receivership. It would be a misguided subsidy, which would hurt the deposit insurance fund, if the Legacy Loans Program part of the PPIP is used on undercapitalized small banks to keep them out of receivership to preserve shareholder value.
Using the PPIP to bailout every community bank’s shareholders and non-deposit creditors is a waste of taxpayer’s funds and will hurt healthy community banks because they have to compete with zombie banks kept upright with taxpayer money. A much more efficient use of taxpayer funds would be to shore up the deposit insurance fund so the FDIC can afford to restructure banks before their losses mount uncontrollably.
Yet the Congressional Oversight Panel’s August 2009 report seems to be advocating propping up zombie banks. That is very expensive, and does not help otherwise good borrowers get good credit rating.
International Exit Coordination
World leaders on September 3, 2009 announced the first steps toward withdrawing emergency support for the global economy even though they warned that the crisis was far from being over. The US, UK, France and Germany called for work to start “on exit strategies to be implemented in a coordinated manner as soon as the crisis is over”.
US Treasury secretary Tim Geithner said finance ministers should start to spell out how the “very successful policy response” to the economic crisis could be reversed, presumably without also reversing their alleged success. Speaking at the US Treasury press room before flying to London for a meeting of finance ministers of the G20 nations, Geithner said these exit strategies were “very important to confidence” of the financial markets, with the unintended implication that the allegedly “very successful policy responses” would undermine market confidence if not reversed soon.
Writing in the Financial Times on September 3, Geithner said that safety net that governments have put in place to limit the fallout from instability resulting from excessive leverage have a cost, because they insulate financial institutions from the full consequences of their actions and can diminish market discipline. Such moral hazard needs to be contained through regulation that requires financial institutions to maintain reserves and capital buffers in proportion to their risk so that they can absorb losses at their own expense, and not at the taxpayer’s.
Geithner acknowledged that the “regulatory framework failed last year [2008].” In the benign atmosphere before the crisis, government supervisors and those in the market underestimated risks building in the system. Major global financial institutions maintained capital levels that were too low, relied too heavily on unstable short-term funding, and their compensation plans rewarded excessive risk-taking. Larger banks often held less capital relative to their risks and used more leverage than smaller banks.  
The resulting distortions helped make our global financial system dangerously fragile. As that system grew in size and complexity, it became more interconnected and vulnerable to contagion when trouble occurred, Geithner said.
But such practices did not evolve innocently. The net capital rule created by the Security Exchange Commission (SEC) in 1975 required broker-dealers to limit their debt-to-net-capital ratio to 12-to-1, and such firms must issue early warnings if they began approaching this limit, and were forced to stop trading if they exceeded it, so broker-dealers often kept their debt-to-net capital ratios much lower than 12-1. The rule allowed the SEC to oversee broker-dealers, and required firms to value all of their tradable assets at market prices. The rule applied a haircut, or a discount, to account for the assets’ market risk. Equities, for example, had a haircut of 15%, while a 30-year Treasury bill, because it is less risky, had a 6% haircut. But a 2004 SEC exemption -- given only to five big firms which lobbied intensively for the exemption -- allowed them to lever up 30 and even 40 to 1.
The five big investment banking firms wanted for their brokerage units an exemption from the 1975 regulation that had limited the amount of debt they could take on to $12 for every dollar of equity. The debt-to-net-capital ratio exemption would unshackle billions of dollars held in reserve as a cushion against potential losses on their investments and trades. The released equity funds from higher leverage allowance could then flow up to the parent company, enabling it to speculate in the fast growing but opaque world of mortgage-backed securities, credit derivatives, and credit default swaps (a form of insurance against counterparty default in order to maintain top credit rating), and other exotic structured finance instruments that only highly-trained mathematicians understand, based on models that are beyond the comprehensive of most traders.

This brave new approach, which all five qualifying broker-dealers - Bear Stearns, Lehman Brothers, Merrill Lynch, Goldman Sachs, and Morgan Stanley - voluntarily adopted, altered the way the SEC measured their capital. The five big firms, three of which became insolvent in 2009, led the charge for the net capital rule change to promote financial innovation, spearheaded by Goldman Sachs, then headed by Henry Paulson, who two years later, would leave Goldman to become Treasury Secretary and until the departure of the George W Bush administration on January 20, 2009 had to deal with the global mess he helped create. Lehman Brothers had gone bankrupt, Bear Stearns and Merrill Lynch had been sold to big commercial banks with access to Fed money and Goldman and Morgan Stanley have turned themselves into regulated bank-holding companies to avail themselves the benefit of access to Fed money. The age of independent stand-alone investment banks came to an end in the US. (Please see my January 22, 2009 AToL article: The Folly of Intervention – Part One)
Treasury White Paper: Financial Regulatory Reform: A New Foundation spells out five key objectives of reform:

(1) Promote robust supervision and regulation of financial firms
A new Financial Services Oversight Council of financial regulators to identify emerging systemic risks and improve interagency cooperation.
New authority for the Federal Reserve to supervise all firms that could pose a threat to financial stability, even those that do not own banks.
Stronger capital and other prudential standards for all financial firms, and even higher standards for large, interconnected firms.
A new National Bank Supervisor to supervise all federally chartered banks.
Elimination of the federal thrift charter and other loopholes that allowed some depository institutions to avoid bank holding company regulation by the Federal Reserve.
The registration of advisers of hedge funds and other private pools of capital with the SEC.

(2) Establish comprehensive supervision of financial markets
Enhanced regulation of securitization markets, including new requirements for market transparency, stronger regulation of credit rating agencies, and a requirement that issuers and originators retain a financial interest in securitized loans.
Comprehensive regulation of all over-the-counter derivatives.
New authority for the Federal Reserve to oversee payment, clearing, and settlement systems.

(3) Protect consumers and investors from financial abuse
A new Consumer Financial Protection Agency to protect consumers across the financial sector from unfair, deceptive, and abusive practices.
Stronger regulations to improve the transparency, fairness, and appropriateness of consumer and investor products and services.
A level playing field and higher standards for providers of consumer financial products and services, whether or not they are part of a bank.
(4) Provide the government with the tools it needs to manage financial crises with:
A new regime to resolve nonbank financial institutions whose failure could have serious systemic effects.
Revisions to the Federal Reserve’s emergency lending authority to improve accountability.

(5) Raise international regulatory standards and improve international cooperation with:
International reforms to support our efforts at home, including strengthening the capital framework; improving oversight of global financial markets; coordinating supervision of internationally active firms; and enhancing crisis management tools.
To promote national coordination in the insurance sector, which is regulated by a state insurance commission in each state, the report proposes the creation of an Office of National Insurance within Treasury.
Under the report’s proposal, the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC) would maintain their respective roles in the supervision and regulation of state chartered banks, and the National Credit Union Administration (NCUA) would maintain its authorities with regard to credit unions. The Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) would maintain their current responsibilities and authorities as market regulators, though the Treasury proposes to harmonize the statutory and regulatory frameworks for futures and securities.
The September 4, 2009 G20 ministers meeting in London set its aim to move forward on reforms to put the global financial system on firmer ground. In his June 17, 2009 remarks on 21ST CENTURY FINANCIAL REGULATORY REFORM, President Obama outlined a new regulatory framework that promotes stronger protections for consumers and investors and greater financial stability. Making the system safer requires a comprehensive approach including tougher regulation of derivatives, securitization markets and credit rating agencies, new executive compensation standards and, critically, more powerful tools for governments to wind down firms that fail. Geithner said the Obama administration is working with foreign partners to ensure similar reforms are put in place by governments around the world.
Geithner set out eight principles for regulatory reform, including one that would force banks to raise far more capital by issuing new shares. It would also set absolute limits on the amount of money a bank could borrow relative to its capital cushion. The proposal has received broad support from UK chancellor of exchange Alistair Darling.
However, the proposals have caused disquiet in Paris. French finance minister Christine Lagarde told a press conference in London that changes proposed to existing capital rules for banks – known as Basel II – should be enough to ensure lenders hold a satisfactory level of capital. “We need to have a good and sound explanation among ourselves concerning what Basel II is about. It has been significantly improved, amended over time ... and, as revised, I would have thought that addressed the issue,” she said. Instead, Ms Lagarde added, France would like to see the debate on bankers’ bonuses at the heart of discussions about reforms.
Geithner asserted that “at the core of our endeavor must be making capital standards for financial institutions stronger.” He referred to a recent paper sent to G20 finance ministers expressing his views on the principles that should shape a new international accord on capital standards. The fundamental principle is that capital and other regulatory requirements should be designed to ensure the stability of the system, not just the solvency of individual institutions. Such an approach requires a broad shift in the way capital and related regulations are designed.
Geithner said strengthening capital requirements is an essential part of a broader effort to modernize the regulatory framework so that the financial system is strong enough to withstand the failure of large, complex institutions. That is the most effective way to prevent the world from re-living the events of last autumn. And that is the challenge G20 financial ministers must tackle in London, Pittsburgh and beyond, added Geithner.
But the capital inadequacy did not evolved by itself. It was created by policy by the Federal Reserve. Geithner seems to have forgotten the stated official views of the Fed under Alan Greenspan who said in a 1998 testimony before Congress:
We should note that were banks required by the market, or their regulator, to hold 40% capital against assets as they did after the Civil War, there would, of course, be far less moral hazard and far fewer instances of fire-sale market disruptions. At the same time, far fewer banks would be profitable, the degree of financial intermediation less, capital would be more costly, and the level of output and standards of living decidedly lower. Our current economy, with its wide financial safety net, fiat money, and highly leveraged financial institutions, has been a conscious choice of the American people since the 1930s. We do not have the choice of accepting the benefits of the current system without its costs.
The risk of systemic market failure was a conscious choice of Fed monetary policy that the American people did not have much say in. Greenspan, notwithstanding his denial of responsibility in helping throughout the 1990s to unleash the equity bubble, had this to say in 2004 in hindsight after the bubble burst in 2000: “Instead of trying to contain a putative bubble by drastic actions with largely unpredictable consequences, we chose, as we noted in our mid-1999 congressional testimony, to focus on policies to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion.” By the next expansion, Greenspan meant the next bubble which manifested itself in housing. He did not heed the dire warnings in 2000. The “wide financial safety net” that Greenspan relied on had holes big enough to drive a Mack truck through. By 2008, Greenspan was forced to admit to Congress that he erred in his faith in the self-regulatory regime of banks.
There was no clear G7 support, let alone G20, for a US proposal for increasing the capital that banks hold in order to prevent a rerun of the crisis that led to the collapse of some of the world’s biggest banks.
While G20 finance ministers agree that banks need more money set aside in reserves to cushion against losses, how much is needed and how that is calculated appears to be in dispute.
Washington’s proposal has raised concerns that the United States is pulling back from the G20’s April 2008 pledge to tackle the issue within the existing framework, known as Basel II, the second accord on recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision, an institution created by the central bank Governors of the Group of 10 nations (G7 + Belgium, Netherlands, Sweden, Switzerland). It was created in 1974 and meets regularly four times a year.
One difficult aspect of implementing an international agreement is the need to accommodate differing histories and cultures, varying structural models, and the complexities of public policy and existing regulation.
FDIC Chairman Sheila Bair criticized the Basel II standards in June 2007: “There are strong reasons for believing that banks left to their own devices would maintain less capital -- not more -- than would be prudent. The fact is, banks do benefit from implicit and explicit government safety nets. Investing in a bank is perceived as a safe bet. Without proper capital regulation, banks can operate in the marketplace with little or no capital. And governments and deposit insurers end up holding the bag, bearing much of the risk and cost of failure. History shows this problem is very real … as we saw with the U.S. banking and S & L crisis in the late 1980s and 1990s. The final bill for inadequate capital regulation can be very heavy. In short, regulators can’t leave capital decisions totally to the banks. We wouldn't be doing our jobs or serving the public interest if we did.
On July 16, 2008 The federal banking and thrift agencies (The Board of Governors of the Federal Reserve System; the Federal Deposit Insurance Corporation; the Office of the Comptroller of the Currency, and; the Office of Thrift Supervision) issued a final guidance outlining the supervisory review process for the banking institutions that are implementing the new advanced capital adequacy framework (Basel II). The final guidance, relating to the supervisory review, is aimed at helping banking institutions meet certain qualification requirements in the advanced approaches rule, which took effect on April 1, 2008
French finance minister Christine Lagarde said on September 4, 2009 in London she could not see the point of scrapping that framework, saying changes already made to it had dealt with the biggest issues.
High on the list of priority topics for September 4-6, 2009 G20 finance minister meeting in London will be ‘when’ and ‘how’ to unwind the massive and unprecedented fiscal, monetary and financial sector stimulus that has been put in place by governments around the world since 2008.  For the US, the ‘how’ has been answered by Bernanke, the ‘when’ will have to wait and see.  
The UK delegation who hosted the London meeting said that there is widespread agreement that although there are signs of a nascent recovery in the UK, Europe, Asia and the US, it is still far too early to begin rolling back stimuli on any grand scale. Nevertheless, it is clear the high levels of government support are not sustainable and will need to be rolled back eventually.
The Organization for Economic Cooperation and Development (OECD) said while a recovery in the world economy looked likely to come earlier than expected just a few months ago, the return to normal conditions was likely to be slow and protracted. In its interim assessment of the economic outlook for this year, the OECD warned that considerable headwinds would hit the recovery.
Also on the agenda of the London meeting will be reforms of international financial institutions such as the International Monetary Fund and the World Bank, as requested in a letter to the heads of state and governments signed by the leaders of Britain, Germany and France. In addition, the letter underscored the goal of achieving financial commitments for the IMF’s new arrangements of borrowing facility agreed to in principle at the previous G20 meeting on April 2 in London, but not yet confirmed.
European Central Bank president Jean-Claude Trichet outlined in the Financial Times on September 3 the principles of “enhanced credit support” under which the ECB would unwind the unconventional steps it has taken in dealing with the financial crisis. He said: “Stressing the importance of the exit strategy should not be confused with its activation: it is premature to declare the financial crisis over. Today is not the time to exit.” However, the first and foremost of four issues that will shape the ECB’s approach to existing the “non-standard measures” in exception times will be inflation. “Should the non-standard measures trigger risks to price stability, we will immediately begin to unwind them and ensure the continued solid anchoring of inflation expectations,” wrote the ECB president.
UK Prime Pinister Gordon Brown, French President Nicolas Sarkozy and German Chancellor Angela Merkel wrote in a joint letter to European Union governments: “While cyclical indicators point to economic stabilisation, the crisis is not over.”
On September 4, 2009, G20 finance ministers and central bankers pledged in London to keep economic life-support packages in place until recovery is firmly secured, but reached no agreement on financial executive compensation reform. A joint statement declares that fiscal and monetary policy would stay “expansionary” until recovery from the worst financial crisis since the Great Depression is solidly anchored. Policymakers are worried about derailing any recovery by pulling the life-support plug prematurely.
An accompanying statement: “Declaration on Further Steps to Strengthen Financial Institutions”, lists 6 points:
1. Compensation
2. Systemically important firms
3. Prudential regulation
4. Non-cooperative jurisdictions
5. Implementation of international standards for actors outside the core bank system such as credit derivatives etc.
6. Convergence of international accounting standards
The statement identifies what “more needs to be done” on:
Increasing transparency;
Global standards on pay structure, including on deferral, effective claw back, the relationship between fixed and variable remuneration, and guaranteed bonuses, to ensure compensation practices are aligned with long-term value creation and financial stability;
Request the FSB (Financial Stability Board) to explore possible limits/approaches on total variable remuneration” and
G20 governments agreeing to explore ways to address non-adherence with the FSB principles.
The populist rhetoric leading up to the meeting had been directed firmly at bankers and financial executives about their lavish tens-of-million of dollar bonuses. Yet the finance ministers could not agree on putting an actual cap on bonuses as had been advocated by some governments and NGOs. Instead, they agreed to create a global structure for imposing tighter controls on pay at financial institutions to discourage bankers from making the kind of risky bets that started the crisis back in August 2007.
These included deferring bonus payments over time and subjecting them to “clawback” in case the risks imploded. The compromise was that the Financial Stability Board, a global regulatory council headed by Bank of Italy chief Mario Draghi, would study caps and the whole issue of pay further. British Prime Minister Gordon Brown told the start of the meeting: “Pay and bonuses cannot reward failure or encourage risk taking. It is offensive to the public whose taxpayers’ money in different ways has helped many banks from collapsing and is now underpinning their recovery.”
France and Germany still favor a cap on executive bonuses or a targeted tax on excess remuneration, proposals the US and UK believe would be difficult to implement. The issue was not so much the astronomical compensation figures, but an annual bonus system that encourages long-term risk-taking to produce short-term gains in order to boost annual pay. Under current practice, executives can walk away with lucrative payments annually while leaving certain losses in future years for investors.
The draft statement showed agreement that emerging nations such as India and China should have a greater say in the running of the International Monetary Fund and World Bank but did not offer up any formula of how this should be achieved. It said only that their voice in global economic policymaking would grow ”significantly” and that it expected “substantial progress” to be made on the issue at a summit of world leaders in Pittsburgh on September 24-26
The BRIC group of leading emerging powers - Brazil, Russia India and China - had laid out concrete targets for how much movement they wanted in IMF and World Bank quotas.
When the leaders of the G20 nations in earlier semiannual meetings that first began in September 2008 in Washington, there was a unity driven by fear of world economic collapse. At the G20 finance ministers meeting in London on September 4-6, 2009, ahead of a full national leaders’ summit in Pittsburgh on September 24-26, agreement was no longer preordained regarding a whole range of issues, such as the appropriate strategy for a sustainable global recovery and an improved financial regime going forward, the reform of the IMF, the finance regulatory regime, the issue of executive bonus practices that encourage excessive risk-taking and even strategy for preventing climate change.
On the economy, G20 finance ministers are expected to agree to keeping stimulus programs for as long as needed while central bankers are expected to keep monetary policy accommodative through credit easing.
In first quarter 2009, the Group7 major industrialized economies were contracting at an annualized rate of 8.4%. Tremors from the financial crisis and the collapse in world trade volumes, which fell by 17% between September and December 2008, were felt across the world.
It is not clear how much output is being stoked up directly by government stimulus packages. As a whole, these demand-boosting packages for the G20 now total $1.06 trillion, almost 2% of its economic output in 2008. The G20 accounted for 87.3% ($53.2 trillion) of global GDP ($61 trillion) in 2008. The US comprised the largest single share in 2008 at 23.6% ($14.3 trillion) of world GDP while the total EU accounted for a further 30.2% ($18.4 trillion). Japan’s 2008 GDP was $4.9 trillion and China’s was $4.4 trillion. In Germany, private consumption was boosted by around 1% in the first half of 2009 just by its popular “cash-for-clunkers” car trade-in scheme alone. Such stimulus is clearly unsustainable.
A Brookings Institution study released in March 2009 showed the total amount of stimulus in the G-20 amounts to be about $692 billion for 2009, which is about 1.4% of their combined GDP and a little over 1.1% of global GDP. This is a still significant amount of stimulus, but appears to fall short of what is needed to tackle a crisis of the proportion the world is currently in. The IMF, for instance, has called for stimulus equal to 2% of global GDP.
Three countries—the U.S., China and Japan—account for about $424 billion of the overall stimulus in 2009, with their shares in the overall global stimulus amounting to 39% (U.S.), 13% (China) and 10% (Japan). Measures for 2009 in the U.S. stimulus package amount to 1.9% of its 2008 GDP and the corresponding numbers for China and Japan are 2.1% and 1.4% respectively. For the remaining G-20 economies, the total fiscal stimulus amounts to 1.0% of their overall GDP.
In 2010, the U.S. is projected to account for over 60% of planned stimulus. China and Germany are the next largest contributors with China contributing 15% of G-20 stimulus and Germany contributing 11%. Measures for 2010 in the U.S. stimulus package amount to 2.9% of 2008 GDP, China’s 2.3%, and Germany’s 2.0%.
In summary, while almost all countries have signed on to the fiscal stimulus program, the size of the stimulus varies substantially across countries, with some of the stimulus packages looking downright meek (e.g., France, which has proposed measures amounting to only 0.7% of GDP in 2009).
There is considerable discussion about the relative effectiveness of tax cuts versus spending in stimulating domestic demand. Brookings highlights one regularity in the composition of packages across countries and then indicates one dimension in which the structure of the packages differs markedly across countries.
Most countries that have announced multiple waves of stimulus have increased the share of spending (compared to tax cuts) in the second round, just as the U.S. has done from January 2008 to January 2009. For example, Germany’s stimulus in November 2008 was largely composed of tax cuts. The second stimulus package announced in January 2009 was largely tilted towards spending. Similar features can be found in the stimulus measures announced in Australia in October 2008 and February 2009, and in Spain in March 2008 in November 2008.
There is a great deal of variation across countries in the share of the stimulus that is devoted to tax cuts. In the U.S., this share is about 45%. Some countries—including Brazil, Russia and the U.K.—have focused almost entirely on tax cuts. Others—including Argentina, China and India—have mostly proposed spending measures. Among the G-20 countries excluding the US, about one-third of the stimulus is accounted for by tax cuts and the remainder by spending measures.
Brookings did not analyse the difference in focus in the tax cuts of different countries. In the US, for example, the tax cut has been focused on the upper income groups because odits ideological fixation about the trickling down model of spreading prosperity.
The Brookings report observed that countries vary in the degree of frontloading of their stimulus packages—the speed with which the tax and expenditure measures hit the real economy (in terms of money reaching the pockets of firms and households, or government monies being spent on social programs or procurement). This is partially a function of the vagaries of the budget process in each country—countries may not announce stimulus for the future though they intend to enact it as part of their regular budget process.
Of the 19 countries that make up the G-20, only four countries—China, Germany, Saudi Arabia, and the US - plan to spend as much or more on stimulus (as a share of GDP) in 2010 than in 2009. In other words, there is a fair amount of frontloading in the stimulus packages of the G-20 countries, with much of the stimulus taking effect in 2009. Of course, this could reflect different beliefs about the length of the recession. It could also reflect difficulty in ramping up government expenditure quickly, especially on infrastructure and other investment projects.
The report also noted that some countries recognized the coming crisis and implemented stimulus plans at some point in 2008. This list includes Australia, China, Japan, Korea, Saudi Arabia, South Africa, Spain, U.K. and the U.S.
Fiscal stimulus has a crucial role to play in stabilizing the world economy, especially as conventional monetary policy appears to have reached its limit in many countries. By and large, policymakers in G-20 economies have acted on their leaders’ joint announcement in November 2008 to use fiscal stimulus in a concerted and coordinated manner to boost economic activity. Some countries like China and the US have responded forcefully, with impressive packages. But the execution, both in terms of size and speed, leaves much to be desired in some of the G-20 countries.
Brookings said there are legitimate questions about the effectiveness of fiscal stimulus, especially in economies where the financial system has broken down and where monetary policy can no longer play much of a supporting role. Moreover, excessive government borrowing to finance large budget deficits could itself generate instability and there are serious concerns about medium-term sustainability of fiscal positions in economies that are building up public debt at a rapid pace. Given the dire and fast-deteriorating economic situation and the lack of other tools, however, the world may have little choice but to engage in massive frontloaded fiscal expansion. Swallowing the Freidmanesque counterfactual conclusion about how the Great Depression cold have been prevented, Brookings consluded that “the consequences of timidity, as history teaches us, could be even worse.” In the absense of credible exit strategies for wholesale governmetn intervention in the market, time will tell if the worse had been avoided.
International Monetary Fund managing director Dominique Strauss-Kahn declared at the London meeting that withdrawal of stimulus will need to be handled delicately, and not before households and companies are up to the task of “taking the baton” of supporting growth from the public sector. He did not give a specific date as when that would be.
Divisions on policy have appeared among the G20: Germany and France are treading hawkish lines about cutting borrowing. The UK, in particular, is urging flexibility, arguing that governments should only withdraw stimulus as quickly as the strength of the economy allows, even if that means extending existing program without time limits. The danger is that temporary stimulus programs will become permanent fixtures in the system. The G20 appear to be seeking political cover for that outcome, by arguing that an exit plan should not be set in stone when the economic situation is so fluid. The problem is that economic conditions will always be fluid to justify the emergence of state capitalism.
World Leaders now face the daunting task of having to redesigning the global financial system without challenging its ideological fixation and to restore public confidence in a bankrupt credit market living on life support from government. How can recovery led largely by the public sector be sustained in a global market economy that operates on private enterprise principles? Governments in failed market economies cannot turn off the monetary and fiscal taps to start cleaning up the public sector balance sheets without causing zombie private institutions to return to the dead. How is the government to force the banks to lend when there are no credit-worthy borrowers, without leading to another debt crisis? What kind of exit strategy can emerge from rescue programs based on blocking normal fire exits in the market by holding up the collapsed ballooned values of toxic assets with taxpayer money? On the other hand, staying the course on monetary accommodation and government stimulus is also unsustainable, as inflation will result to cause the all currencies to collapse. Why is full employment with living wages not the top prerequisite of all stimulus programs? (Please see my April 14, 2009 article: G20 Summit Missed the Real Target)
Meanwhile, fundamental systemic reform is delayed, waiting for the crisis to subside from fire-fighting emergency measures, stalled by pre-game political squabbling among special interest groups over turf and advantages. Substantial amount of rescue money are being spent by banks to lobby against bank reform.
Obama Approval Rate Falling
In the meantime, President Obama who captured the White House with campaign promises of change to reform dysfunctional economy and the birth of a new political environment, has since seen his approval rating fall as Americans become more pessimistic about how long it will take the economic downturn to end. Obama’s tumbling poll numbers have dipped below those of his predecessor George W. Bush at the same point in his White House tenure, according to a national USA Today/Gallup poll released on September 1, 2009. Obama's approval rating is 55% six months into his presidency, but 56% of those polled approved of the job done by George W. Bush after six months. Only 47% of respondents said they approve of Obama's handling of the economy while 49% said they disapprove. Specifically, they disapprove of his health care policy by 50% to 44% approval.
The August 23, 2009 Rasmussen Reports daily Presidential Tracking Poll showed that only 27% of the nation’s voters ‘Strongly Approve’ of the way that Obama is performing his role as President, while 41% ‘Strongly Disapprove’, giving Obama a Presidential Approval Index rating of -14. These figures mark the lowest Approval Index rating yet recorded for this President. The previous low of -12 was reached on July 30.

The September 06, 2009 Reports improved slightly. It showed that only 29% of the nation’s voters ‘Strongly Approve’ while 40% ‘Strongly Disapprove’, giving Obama a Presidential Approval Index rating of -11. The index had started to turn negative at the end of June. The Rasmussen poll of likely voters found Obama’s approval rating dipping below 50% for the first time around the end of June 2009, after five months in office.
Some analysts attribute the approval decline to Obama’s unpopular health reform program, particularly the process he has been using to push his signature initiative--a process that many voters found arrogant, deceptive and bullying.
Obama the candidate who impressed voters as even-tempered, honest and earnest, a leader who is reflective and open to debate, who is willing to listen and relies on persuasion, seems to have disappeared in past months in Obama the president as the health care debate turned intensely ideological. Rather than being open to opposing views on a highly controversial subject, he comes across to many as a sarcastic, lecturing know-it-all on issues on which every voter holds a uniquely personal view. Rather than appearing honest and sincere, his rhetoric sounds duplicitous and slick as he answers opponent distortions with his own. Rather than sounding thorough and measured, his reform plan appears frantic and extreme. The Obama budget will incur deficits that dwarfs the record set by Ronald Reagan and the bulk of money seems to be going to Wall Street executives rather than the truly needy.
A new August 6 Quinnipiac University poll shows Obama’s approval rating among Americans has fallen seven points in July, from 57% to 50%, with just 45% of independent voters approving of the job he is doing. On specifics agenda, only 39% approve of the way Obama is handling health care; 45% approve of how he is handling the economy; 64% say they are somewhat or very dissatisfied with the way things are going in the country today; and an astonishing 93% say the economy is poor or not so good.
The Same Neo-liberal Centrist Team
The Obama administration is largely run by former Clinton neo-liberals who cannot escape sharing prime responsibility for the current financial crisis that took two decades to ferment. Obama was sent by disenchanted voters to the White House to make “changes we can believe in”. Instead of mining the rich reservoir of American progressive populism, Obama’s bipartisan centrist approach to change only provokes passionate rightwing populist outbursts in tea-party town-hall resistance.
In contrast to Franklin D, Roosevelt and his liberal brain trust to give the country a New Deal, Obama came to Washington without a general staff of progressives, but an tired discredited entourage of former Clinton neo-liberal centrists, exposing his administration to accusation from vocal conservatives such as Washington Post Op-ed columnist Charles Krauthammer of “cutting backroom deals with every manner of special interest -- from drug companies to auto unions to doctors -- in which favors worth billions were quietly and opaquely exchanged.” The practical realism of political deal-making is depriving the leader for change the loyal support from his real political base in the grass root communities. In his eagerness to get things done, Obama puts himself in danger of doing the wrong things.
Bernanke Reappointment
The reappointment of Bernanke as Chairman of the Federal Reserve in August 2009 is equivalent to Jimmy Carter’s appointment of Paul Volcker in August 1979, 15 months before Carter had to face election for a second term. On February 6, 2009, after 17 days in office, Obama also appointed Volcker as first chairman of the President’s Economic Recovery Advisory Board.
William G Miller, after only 17 months at the Fed, had been named treasury secretary as part of Carter’s desperate wholesale cabinet shakeup in 1979 in response to popular discontent and declining presidential authority. After isolating himself for 10 days of introspective agonizing at Camp David, Carter emerged on July 15, 1979 to make his speech of “crisis of the soul and confidence” to a restless nation. In response, the market dropped like a rock in free fall. Miller was a fallback choice for the Treasury, after numerous other potential appointees, including David Rockefeller, declined personal telephone offers by Carter to join a demoralized administration.

Carter felt that he needed someone like Volcker, an intelligent if not intellectual Republican, a term many liberal Democrats considered an oxymoron, who was highly respected on Wall Street, if not in academe, to be at the Fed to regenerate needed bipartisan support in his time of presidential leadership crisis. Bert Lance, Carter’s chief of staff, was reported to have told Carter that by appointing Volcker, the president was mortgaging his own re-election to a less-than-sympathetic Fed chairman. Did Rahm Emanuel warn Obama about Bernanke?

Volcker won a Pyrrhic victory against inflation by letting financial blood run all over the country and most of the world. It was a toss-up whether the cure was worse than the disease. Will Bernanke do the same as soon as recovery is at hand?
What was worse was that the temporary deregulation that had made limited sense under conditions of near hyper-inflation was kept permanent under conditions of restored normal inflation all through the Volcker tenure at the Fed.
In his March 27, 2008 campaign speech at Cooper Union in New York City Speaking at Cooper Union in New York City, Obama argued for more regulation, depicting the economic crisis as a consequence of deregulation in the financial sector. “Our free market was never meant to be a free license to take whatever you can get, however you can get it,” he said. “Unfortunately, instead of establishing a 21st century regulatory framework, we simply dismantled the old one—aided by a legal but corrupt bargain in which campaign money all too often shaped policy and watered down oversight.”
Yet Carter was the president of deregulation and Clinton sealed financial deregulation.
Senate Antitrust Subcommittee Chairman Philip A. Hart (D-Michigan 1959-76), known as the Conscience of the Senate, honored with his name on the Senate Building, held hearings in the 1970s on the concentration of economic power in the United States, and proposed expanded government regulation on oil, auto, pharmaceuticals, even professional sports. Hart was concerned that the concentration of wealth and economic power in a small number of big corporations will distort the market economy and American democracy. He argued that government regulation is needed to bring about lower prices and greater productivity and more useful innovation to serve the common good.
While efforts to deregulate began under Richard Nixon and Gerald Ford, it become reality under Jimmy Carter, who hired deregulation guru Alfred E. Kahn to head the Civil Aeronautics Board, the widely loathed agency responsible for regulating the airline industry. Young Senator Ted Kennedy and his then aide, future Supreme Court Justice Stephen Breyer, embraced deregulation as a consumer issue. With their support, Kahn quickly deregulated everything, including the elimination of his own job. The 1978 Airline Deregulation Act dissolved the CAB and removed most regulation of commercial airlines and aviation, which promptly led many airlines into habitual bankruptcies and left small communities without sir service. Carter also signed into law bills deregulating the railroads and the trucking industry.
A March 1998 FDIC paper (Number 98-05) argues that a 1978 Supreme Court decision (Marquette Nat. Bank of Minneapolis v. First of Omaha Service Corp.) fundamentally altered the market for credit card loans in a way that significantly expanded the availability of credit and increased the average risk profile of borrowers.
Robert H. Bork argued the cause for respondent First of Omaha Service Corp. in both cases.
MR. JUSTICE BRENNAN delivered the opinion of the Court: “The question for decision is whether the National Bank Act, Rev. Stat. 5197, as amended, 12 U.S.C. 85, authorizes a national bank based in one State to charge its out-of-state credit-card customers an interest rate on unpaid balances allowed by its home State, when that rate is greater than that permitted by the State of the bank's nonresident customers. The Minnesota Supreme Court held that the bank is allowed by 85 to charge the higher rate. 262 N. W. 2d 358 (1977). We affirm.”
The FDIC paper argues that Marquette ushered in deregulation of usury ceilings on consumer interest rates by allowing lenders in a state with liberal usury ceilings to export those rates to consumers residing in states with more restrictive usury ceilings. The result was a substantial expansion in credit card availability, a reduction in average credit quality, and a secular increase in personal bankruptcies.
In the Volcker era, big banks could take advantage of their access to lower-cost funds to assume higher risk and therefore play in higher-interest-rate loan markets nationally and internationally, quite the opposite of what Keynes predicted, that the abundant supply of capital would lower interest rates to bring about the “euthanasia of the rentier. Securitization of unbundled risk levels allowed high-yield, or junk, bonds with high rates to dominate the credit market, giving birth to new breeds of rentiers. (Please see my February 24, 2004 AToL article: The Presidential Election Cycle Theory and the Fed)
Deregulation, particularly of interest-rate ceilings and credit market segregation and restrictions, put an end to market diversity by killing off small independent firms in the financial sector since they could not compete with the larger institutions without the protection of regulated financial markets. Small operations had to offer increasingly higher interest rates to attract funds while their localized lending could not compete with the big volume, narrow rate-spreads of the big institutions. The rescue measures instituted by Geithner/Bernanke so favor big banks that the now some 8000 community banks in the US face the danger of being consolidated into a handful big banks that enjoy unlimited access to Fed money for no other reason aside from being too big to fail.
It is true that Obama inherited the problem of a failed market economy, albeit more from Clinton than Bush, but he also inherited the bankrupt solution. His team was the former Clinton team of neo-liberals who created the mess.
Can state capitalism be the answer to a failed market economy? Government bailout can soften the immediate pain of market failure, but there is a cost that taxpayers would have to pay in future years. Excessive debt cannot be cured with future debt. Power unsupported by credibility cannot last.

September 15, 2009