Friday, September 26, 2008

Credit Crisis: What We Haven't Been Told

"The danger was that the system was fundamentally unstable. Almost overnight it could go from working well to collapsing. If any one of the Asian countries piling up dollars (and most were doing so) began to suspect that any other was about to unload them, all the countries would have an incentive to sell dollars as fast as possible, before they got stuck with worthless currency."

James Fallows, "Countdown to a Meltdown",
Atlantic Monthly, July 2005
Even Princeton economist Paul Krugman has expressed puzzlement over why the Bush administration went into panic mode over the economy so quickly and without much warning a week and a half ago. And where did the number of $700 billion come from?

After all, FED chairman Bernanke and Treasury Secretary Paulson spent most of this year and last reassuring everyone who asked that the economy was strong and the derivative mortgage meltdown was "contained." Suddenly, last week they changed their tune and demanded $700 billion with no strings attached, no oversight, and no clear explanation of how they planned to spend it.

What explanations they offered publicly have puzzled everyone. Vague statements about diminishing confidence in our financial institutions; true but insufficient descriptions about the burden on the books of banking institutions posed by unmarketable mortgage derivative assets; the threat of uncollectible CDOs; broad descriptions of concern that the credit markets are freezing up.

On one level, we are just as puzzled as you may be about the three largest mysteries hanging over the financial crisis:
  • How did this crisis come upon us so suddenly?
  • Why are FED chairman and Secretary of Treasury so spooked?
  • Why won't Bernanke and Paulson come clean in public?
We hasten to add that we have no inside information. We weren't involved, and have not spoken to anyone who was, in those private meetings where Bernanke and Paulson scared the bejesus out of key administration and congressional leaders. And, of course, we didn't personally witness Secretary Paulson fall to his knees last night and beg Democrats to save the nation from Republicans.

So, what we are about to say is purely the product of what education we have, what we have read, and thinking about those three mysteries. Here is what we have come to believe the facts strongly suggest:

Bernanke and Paulson anticipate the U.S. economy is on the verge of a meltdown because one or all of China, Japan, the United Arab Emirates, and/or Russia have signaled they are pulling the plug on the U.S. dollar.

In all the credit crisis reporting, there has been almost no mention of this possibility. Conventional news sources cover the issue as if it were exclusively a domestic matter between the greedy crooks on Wall Street and the taxpayers from Main Street.

But what if we're right? What if the triggering factor is the imminent collapse of the American economy because foreign nations are no longer willing to fund our profligate ways?

This would explain the vagueness of the explanations offered in public, the seeming suddenness of the crisis, and why those in the know -- like Bernanke, Paulson, and a tight circle of others -- are scared witless. To publicly place the blame on foreign countries -- even if we're the ones who put ourselves in hostage to them -- is to invite the same kind of wrath against "the other" that Americans now feel about Wall Street brokers.

Judging by comments one hears from average Americans, most of us want to jail the Wall Street crooks. But you can't jail another country. You can only make war against it.

The most useful linkable sources we can point to as support for our theory are two little-noticed articles by James Fallows in the The Atlantic Monthly. The first appeared in the July, 2005 issue. The title was "Countdown to a Meltdown." The second article, in January of 2008, was titled: "The $1.4 Trillion Question."

"Meltdown ... $1.4 trillion." Do those words sound familiar?

Fallows long has been a highly respected American author and magazine editor. He's been living in China the past few years, after having had an even longer sojourn in Japan before that. From that distance, he has had a unique opportunity to objectively see how the U.S. economy fits into and relates to the larger world economy. That has led him for some time to become very worried over the prospect of a world-wide financial crisis -- one that easily could be the very thing that is terrifying Paulson and Bernanke.

Fallows' 2005 article was written as if it were penned in the year 2016 and the writer was looking back on this very time. It is scarily prescient, except that he thought the credit crisis would fall upon us in 2009, not 2008.

He begins with what was known when the article was written: Bush's massive tax cut plan for the wealthy. "Everything changed" on 9/11? No, it changed the day those tax cuts were enacted -- June 7, 2001.
[H]ere is what really mattered about that June day in 2001: from that point on the U.S. government had less money to work with than it had under the previous eight presidents. Through four decades and through administrations as diverse as Lyndon Johnson's and Ronald Reagan's, federal tax revenue had stayed within a fairly narrow band. The tax cuts of 2001 pushed it out of that safety zone, reducing it to its lowest level as a share of the economy in the modern era.
What followed were escalating U.S. trade deficits... a "plummeting" U.S. dollar ... hugely increasing U.S. budget deficits... and inappropriately low interest rates... a "jobless recovery"... and "the evaporation of personal savings."
Americans saved about eight percent of their disposable income through the 1950s and 1960s, slightly more in the 1970s and 1980s, slightly less and then a lot less in the 1990s. At the beginning of this century they were saving, on average, just about nothing.

The possible reasons for this failure to save — credit-card debt? a false sense of wealth thanks to the real-estate bubble? stagnant real earnings for much of the population?—mattered less than the results. The country needed money to run its government, and Americans themselves weren't about to provide it. This is where the final, secret element of the gun-cocking process came into play: the unspoken deal with China.

The terms of the deal are obvious in retrospect. Even at the time, economists discussed the arrangement endlessly in their journals. The oddity was that so few politicians picked up on what they said. The heart of the matter, as we now know, was this simple equation: each time Congress raised benefits, reduced taxes, or encouraged more borrowing by consumers, it shifted part of the U.S. manufacturing base to China.

In Fallows' own version of Looking Backward, Fallows then projected an "oil shock" followed by loss of confidence on the part of foreign countries in the value of the dollar. What he predicted is what we're seeing right now, before our eyes:
As the dollar headed down, assets denominated in dollars suddenly looked like losers. Most Americans had no choice but to stay in the dollar economy (their houses were priced in dollars, as were their savings and their paychecks), but those who had a choice unloaded their dollar holdings fast.

The people with choices were the very richest Americans, and foreigners of every sort. The two kinds of assets they least wanted to hold were shares in U.S.-based companies, since the plummeting dollar would wipe out any conceivable market gains, and dollar-based bonds, including U.S. Treasury debt.

Thus we had twin, reinforcing panics: a sudden decline in share prices plus a sudden sell off of bonds and Treasury holdings. The T-note sell off forced interest rates up, which forced stock prices further down, and the race to the bottom was on.
Fallows issued a second, even more explicit warning, in the January 2008 issue. As he explained:

Through the quarter-century in which China has been opening to world trade, Chinese leaders have deliberately held down living standards for their own people and propped them up in the United States. This is the real meaning of the vast trade surplus—$1.4 trillion and counting, going up by about $1 billion per day—that the Chinese government has mostly parked in U.S. Treasury notes. In effect, every person in the (rich) United States has over the past 10 years or so borrowed about $4,000 from someone in the (poor) People’s Republic of China. Like so many imbalances in economics, this one can’t go on indefinitely, and therefore won’t. But the way it ends—suddenly versus gradually, for predictable reasons versus during a panic—will make an enormous difference to the U.S. and Chinese economies over the next few years, to say nothing of bystanders in Europe and elsewhere.
* * *
Neither government likes to draw attention to this arrangement, because it has been so convenient on both sides. For China, it has helped the regime guide development in the way it would like—and keep the domestic economy’s growth rate from crossing the thin line that separates “unbelievably fast” from “uncontrollably inflationary.” For America, it has meant cheaper iPods, lower interest rates, reduced mortgage payments, a lighter tax burden. But because of political tensions in both countries, and because of the huge and growing size of the imbalance, the arrangement now shows signs of cracking apart.
Remember, this was written nine months ago, when the Bush administration was assuring everyone that things were hunky-dory and, indeed, the only economic need on the horizon was to make permanent the Bush tax cuts for the wealthy -- just as John McCain urges now.

Were there any warning signs the Bush administration missed? In that January article, Fallows answers with a resounding "yes."
In the past six months, relative nobodies in China’s establishment were able to cause brief panics in the foreign-exchange markets merely by hinting that China might stop supplying so much money to the United States. In August, an economic researcher named He Fan, who works at the Chinese Academy of Social Sciences and did part of his doctoral research at Harvard, suggested in an op-ed piece in China Daily that if the U.S. dollar kept collapsing in value, China might move some of its holdings into stronger currencies. This was presented not as a threat but as a statement of the obvious, like saying that during a market panic, lots of people sell. The column quickly provoked alarmist stories in Europe and America suggesting that China was considering the “nuclear option”—unloading its dollars.
Again, speaking for ourselves, we don't know for a fact that China -- or Japan for that matter, or the Arab Emirates, or Russia or any other creditor nations holding dollar-denominated U.S. Treasury bills -- actually has threatened the "nuclear option." But, clearly, something quite sudden spooked the Treasury Secretary. And the scary scenarios James Fallows has been trying to warn us about are shockingly similar to the sort of thing we're witnessing now.

What does it all mean?

First, our own chickens are coming home to roost. Much as we might like to think otherwise, we can't blame only Wall Street or even China and the other creditor nations. We are responsible for our own past foolishness. The sooner we realize this, the quicker we can begin working on a real solution.

Second, the Bush administration isn't telling us the complete truth. Most likely, it's fearful of coming clean because this is a financial crisis that the Bush administration precipitated with its signature 2001 tax cuts that effectively wiped out the budget surpluses of the Clinton years.

Third, everyone in Washington knows the widespread sentiment of average Americans is to "string up those Wall Street criminals," as a woman told us yesterday at a local fitness center. She is so mad she actually said, "I'd be willing to go through a depression so long as I see those crooks in jail."

But Washington knows, too, that there is a very broad nativist streak in our populace. How much more ungovernable -- and dangerous -- might we become if we thought the credit crisis could be blamed on "the yellow race" or Arabs?

Fourth, if James Fallows was right in his predictions, then what Paulson and Bernanke are trying to do is calm our international creditors, not so much Wall Street. Like a home owner with a mortgage he can't pay who offers the bank part-payment in hopes of forestalling foreclosure, in just seven years the United States has become a nation with debts it can't pay. Paulson and Bernanke are asking for nearly $1 trillion to mollify our creditors in hopes they won't, in effect, 'foreclose' on the U.S. dollar.

Finally, if we're right, then what this means is whether or not Congress gives Bernanke and Paulson what they want, this is just the beginning of the credit crisis. It will take America as many, or more, years to get out of this mess as it takes for a bankrupt to re-establish good credit.


tocsin23 said...

Hey great blog! You are right. This is why the republican idea won't work. It is not about insuring banks against bad assets. That is ridiculous. It is about protecting the U.S. against a world run against the greenback.

Nick said...

Contrary to what the main stream media says, wall street as a whole (capitalism) should not be blamed for the actions and policies set forth by OUR congress. There are, in fact, corrupt men in wall street who partnered with corrupt men in government to engineer a win-win situation at the expense of the taxpayer. Capitalism (and our nation or any nation) will only survive when the good and virtuous people are running it. Which means, come this November, you must vote for good men and women who stand by principle and uphold our constitution and not just give lip service to causes that seem noble and just.

Anonymous said...

Fantastic article...for the most part. I can follow all of the cause and effect, all of the underlying reasons for failure, even the comment re nativist streak. Where the comment derails is "the budget surpluses of the Clinton years." Speaking of head in a hole. This is the same as saying if we repeal the Sarbanes-Oxley legislation, all of this will go away. It's irresponsible. Changing the rules in the middle of the game does not make the "real" score any different. It reminds me of a story I once read entitle, "The Emporer's New Clothes."
Dan, CPA