Chorafas sovereign debt crisis; the new normal and the newly poor (2011)

Palgrave Macmillan Studies in Banking and Financial Institutions

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Roberto Bottiglia, Elisabetta Gualandri and Gian Nereo Mazzocco (editors)CONSOLIDATION IN THE EUROPEAN FINANCIAL INDUSTRY

Dimitris N. ChorafasSOVEREIGN DEBT CRISISThe New Normal and the Newly Poor

Dimitris N. ChorafasCAPITALISM WITHOUT CAPITAL

Dimitris N. ChorafasFINANCIAL BOOM AND GLOOMThe Credit and Banking Crisis of 2007–2009 and Beyond

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Özlem Olgu EUROPEAN BANKINGEnlargement, Structural Changes and Recent Developments

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Yasushi SuzukiJAPAN’S FINANCIAL SLUMPCollapse of the Monitoring System under Institutional and Transition Failures

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Sovereign Debt CrisisThe New Normal and the Newly Poor

Dimitris N. Chorafas

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© Dimitris N. Chorafas 2011

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A slave is he who cannot speak his thought.

Euripides

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vii

List of Tables and Figures x

Preface xi

PART I FINANCIAL RISKS WHICH KEPT PILING UP

1 The World’s New Normal Economic System 3 Five forces promoting the next economic landscape 3 Cause and effect 6 The new normal defined 9 A historical precedent: the new normal at the end of World War I 12 Living at the edge of chaos 14 The importance of knowing the ‘normal’ conditions 17

2 The Newly Poor 22 Poor people’s recipe: falling deeper into debt 22 Property-owning democracies versus debt-laden democracies 24 Debt operates like a tax 27 ‘I will be gone/you will be gone’ 29 Runaway public liabilities and the day of reckoning 32 Nobody is in charge of debt policy 35 Wealth in western nations dropped like a bribed boxer 38

3 The Salient Problem is Rights Without Responsibilities 41 The many heads of a debt hydra 41 What is meant by rights without responsibilities? 44 Entitlements 46 Pensions and the new normal 50 The middle classes’ broken dreams 53 What may follow the debt hydra? 56

PART II LOOSE MONETARY AND FISCAL POLICIES LEAD TO THE DESTRUCTION OF WEALTH

4 Japanification 61 Japanification defined 61 Japanification’s after-effect: precarious public finances 64 Money thrown at the problem brings nearer the next big crisis 67 Financial discipline requires more than leadership 70 Governments, central banks and the 2010 Jackson Hole

Symposium 72 Correlation risk: Greece/Bear Stearns and X/Lehman 75

Contents

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5 Conventional and Unconventional Weapons in a Central Bank’s Arsenal 79

Souk means both market and chaos 79 Black swans and the need for a new economic theory 82 Price stability and the central bank 84 The wall of liquidity 87 Quantitative easing 90 QE and competitive currency devaluations 92 ‘Bad banks’, the Volcker rule and living wills 94

6 Fiscal Policies, Spending Policies and Conflicting Aims 99 The government takes its money out of its citizens’ pockets 99 The best solution is fiscal consolidation 102 Impact of fiscal policies on the financial system 105 Current account deficits 108 Sovereign debt and its consequences for the banking industry 111 Financial stability is one of democracy’s pillars 114

7 Restructuring Sovereign Balance Sheets 117 Deleveraging 117 Deflationary or inflationary risk? 120 Putting the carriage before the horses 122 Austerity is not that bad, after all 125 Budget cuts and B/S restructuring 128 ‘Long-haired’ ‘solutions’ and monetary illusions 131

PART III EUROLAND’S FINANCIAL INTEGRATION AND SOVEREIGN RISK

8 Woes of Euroland’s Financial Integration 137 Strong core and a weak periphery 137 Financial stability and economic integration 139 One-size-fits-all monetary policies are a dangerous game 142 The aftermath of asymmetries on the euro 145 Is a weak euro or a strong euro the better choice? 148 The message by credit default swaps should not be ignored 151

9 Sovereign Risk: Case Study on Greece 154 The Greek crisis is just the first episode 154 Wall Street helped the big spenders to hide debt 157 Textbook economics have no prescription for the current crisis 160 Events which led to the rescue 162 Going on strike against one’s own interest 165 As with swallows, EU money alone will not bring spring 168

10 Germany, France, Britain, Ireland and ‘Club Med’ 171 The German economy 171 The French economy 175

viii Contents

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The British economy 177 The Irish economy 180 Ireland, Iceland, Portugal and the uncle of Dubai 183 Down the Club Med way: Italy and Spain 187

PART IV THE NEW NORMAL’S EFFECT ON THE WESTERN ECONOMY

11 The North Atlantic Similarities are Greater than you Think 193 Tales of the unexpected 193 Big deficits resemble a classic tragedy 196 QE2: poison or cure? 199 What went wrong with monetary policy and the

bank rescues? 201 American middle class and missing employment opportunities 205 The Dodd–Frank Wall Street Reform and Consumer

Protection Act 208

12 The EU’s Banking Industry and its Stress Testing 212 Profile of large and complex banking groups 212 Ultimately economies advance because their

institutions are strong 214 Banks do not know the risks they take with derivatives

and their IT is unhelpful 217 Stress tests permit crossing the river while feeling the stones 221 How different experts evaluated the stress tests by the

Committee of European Banking Supervisors 225 November 2010: four months after the test results

have been released 228

13 The Global Systemic Risk has been Programmed for 2014 232 Not only the economy, but also democracy is at a crossroads 232 The way to global financial stability is uncharted 234 Sovereign risks and contagion effects 237 European banks, American banks and the fight for

long-term funding 241 The former ‘poor’ are better off than the former ‘rich’ 245 Financial seismology and the slow-motion train wreck 248

Epilog 252

Notes 255

Index 269

Contents ix

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x

List of Tables and Figures

Tables

8.1 Cost of social contribution to social security as a percentage of salary 145

Figures

1.1 Expected events and unexpected events are characterized by two different distributions 18

10.1 German industrial output rebounded leaving other western countries in the dust 172

12.1 The unbearable truth of a thermonuclear option with derivative financial instruments 220

12.2 The normal distribution is a proxy valid only in connection with low-impact events – the distribution of high-impact events is not normal 223

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xi

Preface

The history of economics and finance is littered with the debris of once-sacred theories. The ‘new economy’, whose promise of wealth and prosper-ity was supposed to be the only possible course, is now in shambles. The belief that theoreticians know so well how to manage the economy that crises are banned forever is another fallen idol. And the hypothesis that leveraging rescues people, companies and states from an existence of limited dimensions proved to be an unmitigated disaster:

This book is about sovereign debt, fiscal deficits, the newly poor and the deceit of the ‘State Supermarket’, with its endowments and cradle-to-grave care. The issues confronting the global economy – and most particularly America, Europe and Japan – are inseparable from the current lack of social and politi-cal leadership as well as of a credible plan to deal with the mountains of debt amassed by sovereigns, households and companies, particularly banks.

The text is written for people who need to know what the problem is with the mountains of public debt, families’ deep indebtedness and finan-cial institutions superleverage. It is not written for economists, analysts and other technicians of the ‘dismal science’, to use John Maynard Keynes’ words. The many practical examples which it includes expose the situation by which western society has cornered itself. Its constructive criticism gives advice on how to come up from under, even if this means slaughtering:

unaffordable endowments, unwarranted government rescues, andother proliferating but unsustainable big-spending projects.

Largely due to weak governance, the United States and European Union fell on parlous days. Public confidence is lost. Breaking trust can be done very quickly; re-establishing it can take a long time. The aim of this book is to provide an adult conversation on the risks of losing sight of past failures and our society’s ability to solve its problems, with debt heading the list.

Nowadays, with all liabilities taken into account, for every $1 of assets there is $4 of debt. It is pure folly to think that such a huge amount of debt will disappear on its own, or even be partially repaid if current policies continue to prevail. Liabilities have the nasty habit of increasing with time, particularly when people and companies have lost their individual initiative and put all their hopes for the future in rescues by leviathan sovereigns.

•••

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Western sovereigns are struggling with colossal debt. Peacetime prec-edents are lacking, the difficulties are so great and the debt hydra so fertile that those supposed to know better are approaching the most vital issues in ignorance. Certainty about the right thing to do in this most challenging economic and financial situation is only expressed by people who either dwell in a world of fantasy or do anything that hits their fancy, while the economy around them falls apart.

‘We are living with an unsustainable hangout between our commit-ments and our resources,’ said Timothy Geithner, US Treasury secretary on October 13, 2010 in a Charlie Rose interview broadcast by Bloomberg News. Geithner evidently knows what he is talking about because, together with the Federal Reserve, the Treasury has become the big banks’ safety net and universal fire brigade.

This is by no means a US phenomenon. Signs of distress are easily seen all over the global economic landscape, but most particularly in the western countries. From entitlements to the salvage of bankrupt institutions, the State Supermarket – a creation of infantile leftism – has taken on respon-sibilities which are unaffordable. Critics are right when they say that the biggest deficit the West has is in the fact that there is not enough leadership around, and also those who govern either don’t know how or don’t care to help the common citizen understand what the issues are.

Yet, in a democracy the people have the right to know why the economic and financial conditions are so grim, what has engineered the most recent deterioration and what kind of measures are needed to prune the system and put it on a growth course; also, why the sovereign debt is on an explosive path and what the next act of the drama will be if nothing radical is done to bend the curve. Which leads to three other questions: what lies behind the evolving economic environment known as the ‘new normal’ (Chapter 1) and who are the ‘new poor’ (Chapter 2), and how can this trend be stopped before it becomes irresponsible?

The book the reader has to hand examines these issues and explains why nothing has changed so far – in spite of the deep economic and financial crisis created by big banks through gambling with novel (and little under-stood) novel financial instruments. The gamblers continue their good work; the regulators are timid; and this means that conflicts of interest have not stopped running down the state’s finances.

On June 25, 2010 CNBC, the financial network, revealed that derivatives trades by American banks alone stood at 90 times the level of US gross domestic product (GDP). This was no number picked out of a hat. A couple of weeks earlier, a combined estimate of exposure by the US Senate and House of Representatives had put the market valuation of existing deriva-tives contracts at $1.2 quadrillion.

* * *

xii Preface

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Unprecedented sovereign debt in peacetime and a quadrillion in derivatives is bad news for the economy of the USA, the EU and the global economy as well. Ultimately economies advance because their institutions are strong. Today they are on the sick list while governments are running after the facts, doing what Montagu Norman, the governor of the Bank of England in the 1920s and 1930s said about the central bank action which preceded the First Great Depression: ‘We collected money from a lot of poor devils and gave it to the four winds.’

As the case of Ireland and of its ‘Anglo-Toxic’ Bank (Anglo-Irish) docu-ments, the mismanagement of credit institutions and poor governance of sovereigns strongly correlate. High risk, descent into the abyss and a fire brigade approach is the course typically taken by the ‘unable’, who have been asked by other incapables to do the unnecessary.

Like the First Great Depression, the economic and financial crisis in which we are living – probably on our way to the Second Great Depression – has not been an act of God. It is the direct outcome of dismal governance by chiefs of state, monetary policy-makers, investment bankers and the com-mon man in the street. In terms of cause and effect, some of the worst deci-sions date back to the 1990s, while others saw the light in the first decade of this century. The people who took these decisions:

were singularly unqualified to be at the helm of great nations and of their central banks, could not decide by themselves on what to do and therefore consulted others who had conflicts of interest, andgiving in to social pressure, they crash-landed the western economies through high leverage and unpayable debt.

Against all logic, large and complex banking groups (LCBGs) have been offered, since late 2008, an unlimited line of credit by sovereigns, at tax-payers’ expense. But the LCBGs’ wounds, due to their high gearing and misdirected decisions, have been so deep that their financial performance did not strengthen. Whatever money they got from central banks they used to bolster their capital rather than lend.

In spite of trillions thrown at the problem, the American, British, euroland and Japanese economies remained anemic. The result of throwing trillions to the four winds was a disaster. Credit is the oxygen of business activity, but sovereigns did not oblige banks that benefited from public money to extend credit. Without credit companies cannot function, and this has become also true of households. If banks cannot or will not lend, then the economy is falling off a cliff.

It is wrong to believe that central banks can continue forever accumulat-ing useless collateral while printing money non-stop. The Federal Reserve, Bank of England and the European Central Bank (ECB) have been doing

•

•

•

Preface xiii

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so for more than a couple of years, but it cannot become permanent. Mid-November 2010 the ECB indicated that there were limits to the short-term assistance it could give to Ireland’s banks, which account for around a quarter of the total liquidity offered by the ECB to all eurozone banks. The same applies to Portuguese, Spanish and other banks.

Things got out of hand because there is a symbiosis in debt characterizing relations between big banks and sovereigns. This is creating serious risks for the longer-term sustainability of public finances. Together with entitle-ments, it sees to it that efforts associated to the reduction of government debt are half-baked. Tightening the belt has been always unpopular, and politicians think of their re-election when deciding about measures that need to be taken, forgetting that when the crisis becomes longer term tough-ness is required as well as competence, and that the party that deserves to win must craft a narrative and policy that creates opportunity out of disap-pointment and chaos.

* * *

The book divides into four parts. Part I brings to the reader’s attention the financial risks which have been piling up for nearly 30 years, as well as their aftermath. It outlines the succession of errors which has lead to a situation known as the new normal, the economic, financial and social conditions which (by all likelihood) will characterize the next two decades.

The text brings the reader’s attention to the fact that western societies are no more the globe’s wealthy inhabitants. Their overleveraging and poor growth prospects have turned them into new poor, while less developing economies are moving up the ladder at a fast pace – aiming to be the new rich.

Part II provides documentation on the loose monetary and fiscal policies in the West, those followed over too many years on both sides of the North Atlantic. In recent times, such misdirected decisions were first made by Japan in the early 1990s, and they brought the former industrial dynamo to a state of coma. Hence, the term ‘Japanification’, describing where America, Britain and continental Europe are heading.

This thesis is supported by both qualitative and quantitative evidence. It is proper to inform the reader that in using statistics to document statements being made emphasis has been placed on accuracy and not on precision. It has been a deliberate choice to employ only the two or three most significant digits of numbers and ratios (depending on the issue) with emphasis placed on trend and on order of magnitude.

The theme of Part III is case studies in economic failure, starting with euroland’s lack of success in financial integration, as well as its reasons. This is followed by a discussion on what went wrong in the case of Greece. Germany, France, Britain, Ireland and the so-called ‘Club Med’ provide

xiv Preface

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some other interesting examples on how economies are being managed by sovereigns.

By way of conclusion, Part IV brings to the reader’s attention the new normal’s effect on the western economies – including the one which used to be the most vibrant: the United States. Several financial analysts said that Greece is like Bear Stearns, the investment bank whose failure preceded Lehman Brothers’ bankruptcy. By late November 2010 Ireland became Bear Stearns ‘bis’. In search of a candidate for the Lehman role, some experts mentioned America, while others said Britain.

* * *

What we forget today is to learn lessons from history – economic, financial, political and social. If we don’t understand what has been behind the suc-cesses and failures of our predecessors, then we condemn ourselves to repeat the same mistakes. Decisions leading to misdirected risks are often taken as a result of misquoting and misinterpreting what people of better knowledge have said or done.

John Maynard Keynes, for example, is often used by leftist economists as the patriarch of big-spending policies by the State Supermarket. Apart from the fact that this is less than half true, Keynes had the power to express his opinions without compromises, and he is quoted as having said: ‘When the capital development of a country becomes the byproduct of the activities of a casino, the job is likely to be ill-done.’

* * *

I am indebted to a long list of knowledgeable people, and of organizations, for their contribution to the research which made this book feasible; also to several senior executives and experts for constructive criticism during the preparation of the manuscript. Dr Heinrich Steinmann and Dr Nelson Mohler have been among the most important contributors.

Let me take this opportunity to thank Lisa von Fircks, for suggesting this project, Renee Takken, for seeing it all the way to publication, and Keith Povey and Joy Tucker for editing the manuscript. To Eva-Maria Binder goes the credit for compiling the research results, typing the text, compiling the index and making valuable suggestions.

DIMITRIS N. CHORAFAS Valmer and Entlebuch

Preface xv

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Part IFinancial Risks Which Kept Piling Up

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3

1The World’s New Normal Economic System

Five forces promoting the next economic landscape

In the ‘go-go’ years which followed the 1994 crisis of debt instruments, Alan Greenspan, then chairman of the Federal Reserve, coined the term ‘New Economy’. This he defined as defying the laws of gravity by producing more and more wealth, practically forever. We now know that such talk was a chimera, while the tandem of bubbles it produced in 2000 and 2007 were real. Their origin was not difficult to detect:

a highly accommodating monetary policy,free reign to leverage and other excesses, andscant attention by supervisory authorities paid to watch over systemic risk.

These causes of economic and financial troubles tend to correlate among themselves, amplifying their impact. Therefore, the disaster which followed was not totally unexpected. One of the outstanding consequences of the major global downturn, which started in 2007 and whose effects are still widely seen, has been the enormous increase in government debt in western countries. Spending by sovereigns rose very rapidly to both keep alive big banks and other ‘strategic’ companies, some of which were zombies, and offset the contraction in private sector spending, as millions of households confronted unemployment as well as uncertainty about the future.1

In the USA the public deficit jumped from 2.8 per cent in 2007, first year of the most recent economic and banking crisis, to 11.2 per cent in 2009. In the EU government deficits varied widely: from over 14 per cent in Greece to a little less than that in Ireland, 11 per cent in Britain, 9 per cent in France and 6 per cent in Germany. The big spenders at the governments’ ivory towers have had a ball – and that’s anathema to public confidence.

•••


4 Financial Risks Which Kept Piling Up

As Demosthenes, the ancient Greek orator, said: Business is built on confidence. Any waning of it, particularly at the time economic fortunes seem to start timidly rising, is counterproductive. Consumer confidence is crucial to western economies as it represents up to 70 per cent of spending; a figure amplified by industrial production which nearly always cruises along. ‘The real devils today are the states not the bankers,’ says Dr Heinrich Steinmann, a former vice chairman of UBS.

Scared of the long-lasting effect on the economy of these deep red numbers, by the second quarter of 2010 several western governments – including Britain, France, Germany, Italy, Spain and Greece but not the USA – announced rather significant austerity measures to reign in their dete-riorating fiscal situation. This led some economists to express concern that an austerity policy amid an ongoing recession will make matters worse, warning how fragile the early signs of an upturn still are (see also Chapters 5 and 7).

Other economists, however, have taken precisely the opposite stand, pointing out that the unprecedented 2008–11 economic easing – which went in full swing with the Lehman Brothers’ bankruptcy and near bankruptcies of AIG, Fannie Mae, Freddie Mac – has turned western economic history on its head by creating an unsustainable flood of money (see Chapter 4 on the many heads of the debt hydra). These economists also emphasized that business confidence will wane if the market sees no signs of restraint in keeping the printing presses busy.

While the two aforementioned economic theories are diametrically opposed to one another, they also share the same basic weakness. No economist, on either side of this gulf of opinions, has come up with a clear and well- documented definition of the cause and effect that characterized the ongoing crisis (see the next section). Which is the primary cause? Is the salient issue:

1. the accumulated huge amount of debt per se?2. or, is debt the consequence of the current structure of world finance and

its institutions?3. or, is the structure of world finance the consequence of entitlements and

globalization, and therefore of unsustainable policies?4. or, is it the classically poor regulation at government levels, which allows

greed and irrationality to carry the day?5. or, are these reasons closely intertwined, and therefore acting on one of

them affects all the others with dismal results?

In my opinion, the most likely fundamental reason for the current malaise is the fifth alternative which integrates all others, making both the problem and any serious approach to its solution tremendously complex. Yet, our efforts must be focused. Searching for a holistic approach which simultaneously attacks every cause will be like trying to unscramble scrambled eggs.


The World’s New Normal Economic System 5

We might, but only might, have a better chance by establishing priorities and subsequently attacking these causes indidually – provided we don’t lose sight of the total picture, or forget the underlying interdependencies among the causes of the current state of world affairs and their effects (see below). In addition, to untie the threads of this knot we would need to use practica-ble rules like those we employ to organize our lives, promote our businesses and confront our obligations.

Talking of priorities, the overriding obligation at this moment is to control the exploding debt at all levels of society. And because it is famously hard to govern debt, this is going to be the issue to which the present book addresses itself. It is not normal that every $1 in production corresponds to $4 in debt. Such an ‘unstoppable’ debt inflation has to stop before it becomes irreversible.

But the other causes should not be forgotten. Looking at them in reverse order to that presented in the preceding list, there has been, indeed, a huge amount of greed which amplified the economic and financial debacle of 2007 and the ensuing years significantly. In a Charlie Rose interview broad-cast by Bloomberg News on April 26, 2010, Michael Lewis, the author, put the blame on both the market players and the instruments they have been using, stating that:

Real corruption is behind new financial instrument design.This problem is widespread; Goldman Sachs cannot be the only bank which designs debt-based securities aimed to fail.All sorts of tricks embedded in instruments have been accompanied by misrepresentation to clients – which under current laws is illegal.

Regarding the structure of international finance and its contribution to the crisis we have been going through, its reorganization and control was thought to be the mission of the G-20 heads of state. But international tour-ism aside, the G-20 meetings have so far been met with no real success and it is a deliberate decision not to dwell on their remit in this book.

Allow me also to add that, as if to make matters worse, within each jurisdiction the prospects for a significant and deep-rooted regulatory initiative are not good. The slimmed-down Dodd-Frank Act in the USA is a lightweight (see Chapter 12). In his deposition to Congress, Paul Volcker, the respected former chairman of the Federal Reserve, insisted that the essential flaw in regulatory proposals and measures being adopted is that they leave the structure of banking unchanged. This is a pity, because if culture and structure remain the same, then so does the ultimate systemic risk.

Risk-taking is a basic ingredient of progress but it must be matched by risk control. Watching one’s exposure is not an option; it is a requirement of sound governance of a person’s, company’s or state’s fortunes – while

••

•



paternalism towards the homegrown banking industry is a most serious error.

Cause and effect

Virgil, the Roman poet, said: ‘You must know the causes, to draw the right conclusions.’ What are the causes of the crisis we are going through in 2007–11? The answers most often heard in my research have been lax lend-ing practices, the real estate bubble and subprime mortgages. While these have been, indeed, important factors, they were the triggers of the debacle rather than fundamental reasons. The real causes are:

massive increase in debt, at all levels of society,excessive risk appetite, amplified by exposures risk-takers don’t under-stand,a shadow banking system, with its dubious debt instruments, still fund-ing risks,limitations of financial engineering and serious mistakes in model-based estimates, andtotally substandard risk management at all levels, totally inappropriate in a world where derivatives are the most popular and lucrative trading instrument.2

Largely engineered through leverage, and therefore by ‘funny money’, this massive increase in debt has become a western culture. By no means a random event, it is the culture of ‘borrow now, pay later (maybe)’ which pervades all levels of western society – and which must now change to: save now, so as not to starve later on, for an improvement in fortunes of peo-ples and states. There have been many false prophets who prompted public spending through misplaced statements, and helped in creating this attitude to spending.

‘The future appears brilliant,’ wrote Thomas Lamont of JPMorgan a short while prior to the ‘Black Tuesday’ of late October 1929, moreover assuring that ‘air holes’ due to a ‘technical condition’ had developed in the market but that the situation was ‘susceptible to betterment’.3 With hindsight we do know what followed in the decade after the First Great Depression.

Clear minds expressed the opposite opinion. ‘We have involved our-selves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand,’ John Maynard Keynes wrote in December 1930 in his article ‘The Great Slump of 1930’. The same words can be used today without changing a syllable in regard to what the Federal Reserve, Bank of England and (to a slightly lesser extent) European Central Bank have done to the western economies in the 2008–11 timeframe.

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Other warnings, too, were unheeded and relegated to the wastebasket of economic history, even if they came from people who could see further than most. Friedrich Engels (1820–1895) – whose work and foresight extended beyond economics – identified in the mid-nineteenth century certain social happenings that lead to a dismal future:

people tending to live beyond their means,4 rapid urbanization under stressful conditions, andshort-term policies of governments, adopted because of their lack of cour-age to lead in shaping society’s future.

Engels wrote, in 1844, that the centralization of the population in great cities (the cause) exercises of itself an unfavorable influence (the effect): ‘All putrefying vegetable and animal substances give off gases decidedly injurious to health, and if these gases have no free way of escape, they inevitably poison the atmosphere.’5

Urban dwellings in crowded cities, which are rapidly replacing rural life for large chunks of the world’s population, may range from palaces to shanty towns, but what they have in common is the strained way of life – full of uncertainty and anguish. This is the new normal, in social terms, and Engels described it in a prophetic way nearly 17 decades ago. (The definition of the new normal in terms of the economy is given in the next section.)

In cause and effect, there are similarities between the social and economic definitions. The way people live and work (the cause) has a great deal to do with economic after-effects because – from autos and house appliances to exotic vacations – the twenty-first century’s proletarians have been enjoying an increasing standard of living paid through debt. The mountains of leverage were supposed to be taken care of by the ‘future generations’ but, as the deep crisis of 2007–11 has shown, they have already become unsupportable and unsustainable by this generation.

The easy way for politicians is to promise what they know they cannot deliver and make the people pay for it. George W. Bush came to office in 2001 and engineered the largest ever US peacetime deficit (the cause) – promising security and plenty of other goodies in exchange. In terms of security the effect has been practically nil. Instead, what the American peo-ple got is another layer of bureaucracy in Washington and an explosion of public deficit.

Barack Obama compounded all of the Bush mistakes. Among them, the two conceivably worst presidents in the history of the American Republic brought another calamity which will haunt the USA in the coming decades: the new poor (Chapter 2).

For reasons quite similar to one another, two megarisk events are likely to compete with one another during the coming years. One is that the economy implodes as sovereigns, companies and families restructure their

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balance sheets. The other megarisk is that the economy explodes as debt reaches for the stars. (Both the reasons and the consequences will be brought into perspective in the last chapter of this book.)

A preview of events to come would see the specter of horribly indebted countries which scare the hell out of their partners. For all the brave talk about solidarity among euroland’s member states, their taxpayers don’t wish to put on the table the money which might keep their badly behaved and undisciplined neighbors afloat. Not without reason, they believe that this is not their cause and that the nations which misbehaved should pay for the effects by themselves.

This has been behind an overwhelming 69 to two vote by the Slovakian parliament, in the week of August 8, 2010. A crashing majority of Slovak deputies rejected taking part in a European Union aid package for the trou-bled Greek economy (Chapter 9) – and they had good reasons not to care if both the Brussels-based European Commission and the German government criticized the Slovak parliament’s decision.

‘All member states committed themselves politically to assistance for Greece,’ said a spokesman for Chancellor Angela Merkel. ‘Every member relies on solidarity; solidarity is no one-way street.’6 That’s true, but the prerequisite to solidarity is self-discipline.

The Slovaks, who said they would not pay for other peoples’ ‘twenty-first-century lifestyle’, know that their country has a gross domestic product (GDP) per capita of $21,200 at purchasing power parity (PPP), while Greece has a per capita GDP of $32,000 – nearly one and a half times greater. Slovak taxpayers have been asked to put a4.4 billion on the table ($5.9 billion) for something they say was not their fault. Moreover:

Slovakia embarked on a bout of painful economic reforms in 1998, that transformed it into one of the EU’s top economic performers.By contrast, Greece, Spain, Portugal and other EU countries piled new debt over old debt, rather than taking the tough decisions necessary to restructure their economy and labor market.

This cause and effect, the most significant cross-border difference in economic management, is another way of showing that the accumulated huge amount of debt is, per se, a real and present danger. The recent crisis made it highly visible, and one cannot blame those people who don’t wish to pay for other peoples’ mistakes, even if they belong to the same community.

The bigger countries in euroland had additional reasons for those of Slovakia, when they decided to salvage Greece.7 In fact, for these reasons, in June 2010 they put together a war chest of a750 billion (about $1 trillion), enhanced by a unique supply of liquidity from the ECB and aimed at arrest-ing the Damoclean sword of a reignited financial crisis.

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But, in the EU and the USA, the issue of too many entitlements having been granted without proper study of their effects is still dominant (Chapter 3). What speculators now do is to accumulate liquidity and bide their time. With Greece’s financial crisis, they shook the euro and were ready to attack, first, euroland’s financial system and, next, that of the glo-bal economy – if Greece had gone broke. While they are waiting, powerful forces are shaping the economy’s new normal.

The new normal defined

Two people are at the origin of the term ‘new normal’: Mohamed El-Erian, Pimco’s8 CEO, and Bill Gross, its chief investment officer (CIO). According to their judgment, while the markets may rise from their current depth, the next five years will not resemble those preceding the crisis. Some of the changes brought by the financial earthquake we have been through may be reversed, but not all. For the world economy, the ‘normal’ situation will be different than that we knew prior to this crisis.

In the way El-Erian defines the future landscape, growth will be subdued, unemployment will remain high and the banking system will be a shadow of its former self (more on this later). As for securitization markets, which buy and sell marketable bundles of debt, they will most likely be the shadow of a shadow – while the stock of physical capital will erode.

Another of the worries associated with the new business landscape (according to this brief definition) is that state capitalism may become the name of the game, with free enterprise in the decline. In addition, as the financial system remains weak, its role of intermediation will wane, while the cost of capital will rise. Consequently, companies will use less of it per unit of output (the cause), resulting in a lower ceiling on production, as well as lower expected returns and higher implied volatility.

Pimco is by no means alone in this projection on the after-effects of the deep economic and financial crisis which, in a way, resembles the First Great Depression of 1929–33. Plenty of other experts say that, in their opinion, we are set for a long period of slow growth, as a number of global imbalances are worked through. That process will take time.

Higher taxation will, in all likelihood, be the rule as governments (rather unsuccessfully) try to restructure their balance sheets. But taxation will also have an alter ego: austerity measures (Chapter 7), accompanied by an increasingly deeper re-evaluation and downsizing of all sorts of entitlements (Chapter 3).

Business will be confronted by loss of power because its classical recovery drivers will no longer function the way they previously have. As for the helping hand of central banks and governments, they will lack money for extravagances like quantitative easing (Chapter 5) and stimuluses. Equities will suffer because they are prospering in risk-on events, and (save for speculators)



the new economic climate will be largely risk-off. To confront this novel set of challenges, investors will, most likely, place a much greater emphasis on:

diversification of assets, in the real sense of the term,directed cash flows, cross-border and within markets, andshifts in credit risks expressed by spread positions in corporate and sovereign debt, with the latter weaker than the former.

According to expert opinion, another characteristic of the new normal will be that sovereign risk will attract as much attention as that of banks, which have been known for decades to overleverage themselves and gamble with derivative financial instruments. The way a news item on CNBC had it on July 23, 2010, a strong correlation exists between credit default swaps (CDSs) of banks and sovereigns.

To be taken seriously in their effort to change course from high leverage to dependable balance sheets, sovereigns will have to come up with firm plans for a turnaround, not just with words and intentions. Their quality of governance will be judged by whether the action being taken is convincing, and by how effective it proves to be in reducing the country’s huge public debt and current account deficits (Chapter 6).

These are, indeed, tall orders, and success is by no means a foregone conclusion since precise longer-term plans are missing. For instance, in the opinion of British political analysts the ‘fiscal responsibility bill’ in the 2010 Queen’s Speech was a headline, not a plan. Yet, with the new normal it matters greatly that governments set clear, more longer-term objectives, have financial credibility and have the know-how to implement the plans they make.

The same is true of central banks, which, by and large, are lacking a longer-term monetary and interest rates policy, which (in the majority of cases) is part of their charter. Nearly zero interest rates have been a short-term game plan, before becoming a long-term drift (Chapter 5). Made to serve the self-harmed big banks, they penalized the common citizen. For the weaker members of society this has been a triple whammy:

the interest households get for their savings is below inflation; hence their capital wanes, small as it might be,their private pension plans find near zero interest rates as an excuse to speculate, since they earn nothing from money in the bank, andthe way to bet is that taxpayers, the common people, will eventually be asked to foot another king-size bill, while near zero interest rates feed the next bubble.

As we will see in greater detail in Part II, the hidden costs of very low interest rates may well be greater than their visible benefits. Authorities with a long

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tradition of speaking their minds say so. In its 2009 Annual Report, the Bank for International Settlements (BIS, the central bank for central banks) brings to attention plenty of ills connected with the too-low interest rates prevail-ing in western countries:

excessive risk taking,lop-sided balance sheets,creation of delays in cleaning out bad debts,surges in global cash flows which are destabilizing, anddistorted allocation of capital, as well as of the labor force.

These are among the reasons propelling the new normal. The question is: When will its day really come? Current thought is that with the forthcoming new big bubble (Chapter 13), which for any practical purpose has been already programmed, the post-World War II party of greater and greater leverage will be over. As for the new economic situation, it will be characterized by what Ben Bernanke called an ‘unusually uncertain’ economy.9 There is no point in denying that the western economy is weak and its players are uncertain about the future, because the measures taken so far have been poorly studied in terms of after-effects and the jury is still out on whether they made eco-nomic sense, even if unexpected consequences are not accounted for.

What is more or less sure is the stress these measures inflicted on the economy, and the hits suffered by common people and businesses alike. We all know that unstoppable leverage and speculation cannot last forever, but the medicine of trying to lower the huge indebtedness of the banking industry by creating mountains of debt at sovereign level may be worse than the disease.

In the eye of the storm are the very expensive but ineffective stimuli and quantitative easing gimmicks (Chapter 5), respectively engineered by gov-ernments and central banks. Some economists involve Ricardian10 equiva-lence in trying to explain why the US economy does not take off in spite of the stimuluses. This arises when:

consumers are forward-looking and save the proceeds from a debt-financed fiscal stimulus, andthey are doing so in anticipation of future tax increases needed to repay the extra government debt.

Plenty of factors impact on how the economy and its players react to meas-ures taken by governments and central banks. Costs head the list. The IMF’s World Economic Outlook counted the cost of 88 banking crises over the past 40 years. On average, seven years after a bust, an economy’s level of output has been almost 10 per cent lower than the level it would have attained without the crisis; that’s a big gap. If replicated in the years to come, this 10 per cent difference would: make the public debt harder to sustain, offer little hope for

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higher unemployment, diminish the fortunes of those in work and create conditions leading to further financial breakdown.

Even when the economy begins to expand, it may not regain the same pace as before, therefore eroding national income. In conclusion, the new normal shapes up as the antimatter of the go-go environment of the 1990s and earlier years of this century. Apart from the astronomical leverage found at all levels of western society, the wounds created by huge financial losses require a rela-tively long period in which to heal; healing is not doable at short notice.

A historical precedent: the new normal at the end of World War I

Mayer Amschel Rothschild (1744–1812) is rumored to have said: ‘Let me issue and control a nation’s money and I care not who writes the laws.’ The dictum fits hand in glove with the statutes and policies of central banks. By keeping the printing presses busy and spending money in quite inordinate amounts as compared with a nation’s productive capacity, they can destabi-lize the currency, penalize businesses and households and, eventually, lead to the collapse of both the currency and the banking system.

The creation of the Federal Reserve at end of the first decade of the twenti-eth century and the subsequent independence given to many central banks after World War II (the Bank of England got its independence under Tony Blair and Gordon Brown) were heralded as the start of a new epoch. Developing countries were advised by westerners to do the same – but this ‘ independence’ proved to be fata morgana, as subsequent events demonstrated.

Near zero interest rates and quantitative easing were moves by politically-minded people, in step with their governments. They were not acts by inde-pendent central bankers, whose No. 1 mission is monetary policy sustaining financial stability. This has been a very dangerous deviation from primary duties, and there is no better example of cause and effect than the collapse of the British, French and German economies after World War I. (This also applied following World War II, but the former example is the better.)

The World War I lesson sets the precedent for what currently happens with the mismanagement of monetary policy as well as currencies, and it is also very instructive because, among other events, it includes the run on the French franc and hyperinflation in Germany. Another interesting incident of that epoch was the rift between the United States and Britain, due to the controversy over repayment of wartime loans.

One of the outstanding similarities between 1918–23 and 2007–11 is that both politicians and monetary policy leaders were running out of ideas on what to do with a mammoth debt; and they were in total disagreement about who, in the last analysis, should pay what to whom.11 They were also in a bind because they could understand that unsolved debt problems would destabilize currencies, lead to bank panics and create other serious financial problems.



‘Victory’ at the end of World War I was an illusion, since millions of soldiers and civilians had died for nothing, while economic disaster spread all over Europe. As for the international financial system – which, prior to 1914, had brought prosperity to all the combatant nations, it was in a sham-bles. The unraveling had started with the panic liquidation of securities in London, on July 30, 1914, while stock exchanges in Berlin, Vienna and St Petersburg were closed by the authorities. The first days after the Great War saw the first glimpses of what was then a new normal.

Another similarity between ‘then’ and ‘now’ is that chiefs of state, includ-ing the central European royals, who in the early part of the twentieth century ran the political show, had shown a curious incapacity to distinguish between what they called a punitive action (against Serbia for the Sarajevo murders) and setting the world on fire. Subsequently, historians found it difficult to understand what World War I was all about and who really pushed whom into that gigantic hecatomb.

By the end of World War I, the spotlight fell on economists, bankers and other financial experts who proved unable to put straight the ‘IOUs’ signed by the British, French and Imperial Russian governments among themselves and (in the case of Britain and France), with the United States. Both prior to America’s entry into the war and during its intervention, the USA had acted as banker and armaments factory for the Allies. During World War I, the British government spent the equivalent of $43 billion, including $11 billion, in loans principally to France and Russia (but also to 15 other countries).

In counterpart, it owed the United States $5 billion, which took a long time to negotiate and settle after the war ended. The deal was struck in 1923 by the then British finance minister, against the advice of John Maynard Keynes – who said it was better to hold out for better terms since time worked in the debtor’s favor. London paid Washington 80 cents to the dollar. For their part, the French chose to wait and by so doing they proved Keynes was right. In 1926, they settled their American loans at 40 cents to the dollar.12

Three years later, the Italians settled their war loans by paying a mere 24 cents to the dollar, a better term than Argentina imposed on its debtors with its December 2001 (unjustified) bankruptcy. Of course, it is not only the loans which generated the condition for the economic and financial new normal in the first quarter of the twentieth century. The money the Bank of England and Banque de France printed during the war overwhelmed the mar-kets, distorted financial stability and had a strong negative effect on prices.

In Britain the currency in circulation doubled, and prices made the same jump.In France it tripled, and prices also increased by 300 per cent.In Germany it quadrupled, and so did the prices initially,13 thereafter leading to hyperinflation.

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That’s a lesson central bankers (particularly Bernanke and King) have forgotten. While the currency in circulation in all European countries rose by leaps and bounds during the fights, the end of the war changed none of the politicians’ bad habits. No government altered the wrong policy of throwing money at the problem. Instead, that unwise practice accelerated.

In Germany, throughout 1919, the monetary base rose by 50 per cent, and in 1920 by another 60 per cent. The Reichsbank warned that the volume of short-term debt was a dangerous threat, but it still kept the presses running. Germany faced, among other financial challenges, the huge and illogical reparations demanded by World War I victors, which were way beyond the ability of its ruined economy to pay, even if stretched over many years. In 1921, the German government made the first reparations payment by sell-ing marks for dollars, and this transaction contributed to a sharp decline in the mark’s value, while at home social unrest and strikes worsened.

Politicians, economists and central bankers are often fooled by the fact that the debt hydra takes some time to raise its heads. In 1921, money in circulation in the German republic rose by the ‘usual’ 50 per cent to 120 billion marks, but in 1922 the situation significantly worsened. With paper money being printed round the clock, inflation ran at 1300 per cent. The following year, 1923, was one of despair with newly minted Reichsmark flooding the market, as well as the mark’s decline against the dollar continu-ing relentlessly.

By mid-1923, the Reichsbank was throwing cash at the market at the rate of 60 trillion marks per day, much of it in big denominations. By November 1923, the currency in circulation was heading for an astronomical 400,000,000 trillion. Something significant had, however, changed. The Reichsbank had a new boss, Hjalmar Schacht, who was a no-nonsense banker.

With hyperinflation still carrying the day, on November 20, 1923 a new currency was introduced, the Rentenmark, to replace the old imperial Reichsmark. The conversion rate to the new currency was set at one tril-lionth of a mark;14 at that time the exchange rate of the old currency to the dollar had hit 4.2 trillion, which made the rate of the Rentenmark to the dollar 4.2. This was the ratio prevailing before World War I between the German and American currencies.15

This 4.2 exchange rate was fine-tuned to affect the market’s psychology, but in itself the change of currency would have been pure cosmetics without fiscal discipline. Schacht, the Reichsbank’s new president, insisted that the only way to financial salvation was through balanced budgets. It was true then; it is true now.

Living at the edge of chaos

The new normal which characterized post-World War I Europe did not affect only economics and finance. It also meant the disappearance of the



old social order, a fact which preceded the major upheaval of populations and economies because, for any practical purpose, a new normal con-stitutes a major inflection point. This change started during the World War I years and continued unabated.16 Then, as now, governments were not really in charge; they just drifted. Or, alternatively, the challenges they were confronted with overwhelmed the second raters who were in charge.

Yet, everyone knew that it would not be possible to turn back the clock. People and organizations, including government bureaucracies, had to adapt to the new conditions. Not the least among them was the need to gain citizens’ confidence by bringing all economic and financial excesses under control. They failed in that mission then, as they fail in that mission now.

What happened in 1923 in economic, financial and social terms is so interesting because of its striking similarities to what has taken place in recent years. In the early 1920s in Germany, tax revenues accounted for no more than 10 per cent of government expenditure. The difference was covered by deficit financing.

As far as western sovereigns are concerned, this 90 per cent deficit is not the case today,17 but even persistent deficits of 10 per cent or more can reek havoc. Interviewed on August 18, 2010 by Bloomberg News, an American economist said that much when he commented that a US Treasury bubble is building up rapidly. One of the examples he gave was that the Obama Administration’s $1.4 trillion deficit in 2010, which is over 10 per cent of US GDP (see also Chapter 12), may be the last drop which makes the glass overflow.

Western economists must also cope with the continuing high leveraging of the banking industry. Unprecedented increases in the use of structured instruments and securitizations, across the globe but most particularly in the USA, have been a seemingly unstoppable trend, with the trading of credit risk at its core. The tool is credit derivatives, which initially sup-plemented then overtook traditional forms of transferring credit risk, like syndication of loans. Lust and greed aside, factors which contributed to this development include the globalization of financial markets and information technology, especially networks and pricing models.

These developments produced significant changes in the financial struc-ture of western countries and in the role of banks therein, but they also had a major effect on sovereign debt. The changed role of banks developed from originating and holding to originating, repackaging and selling, thereby altering loan dynamics.

The impact on sovereigns can be briefly described as the alchemy of their budgets, enacted by hiding the effect of ever-greater public deficits. As the ‘help’ Goldman Sachs gave to different governments (the Greek among them) demonstrates, the use of novel derivative instruments produced a



mystical transformation of state debt, much of it highly shaky, yet good enough for a prolonged denial of a red ink torrent.

The 80th Annual Report by the Bank for International Settlements put this issue from a different perspective when it stated that: ‘By the end of 2011, public debt/GDP ratios in industrial countries are projected to be on average about 30 percentage points higher than in 2007 – a rise of about two fifths. But the increase for countries that have been hit particularly hard by the crisis will be even greater.’ The United States, Britain, Ireland, Greece, Portugal and Spain are evident examples.

Worst of all is the fact that the rapid increase in public debt in the wake of the 2007–11 economic and banking crisis is unlikely to be halted within the near future. As was the case after World War I (as well as after World War II), sharp declines in tax revenues will be used as an excuse for more deficit financing. In addition, nowadays sovereigns cover their lack of financial discipline behind expenditures such as income support and other entitle-ments (Chapter 3).

It is most instructive to note that, with the possible exception of the United States, fairly similar conditions of lack of fiscal discipline prevailed in the early 1920s for all former belligerents. If anyone thinks that hyperinflation befell Germany because it had lost the war, then he or she is fairly misguided. Neighboring France won the war but, in the early to mid-1920s, its currency was just as much the plaything of speculators and its recovery of economic wellbeing was just as tedious as Germany’s.

As 1923 was coming to a close, a very short time after the German mark had turned to dust, the value of the French franc fell by about 50 per cent against the dollar. In January 1924, the French Ministry of Finance asked for expert advice on how to redress the situation and salvage the franc. Frank Altschul, the principal of Lazard Brothers New York office, came to Paris at the French government’s request.

One of Altschul’s strengths was thinking out of the box. He proposed to the French government what he called an ‘experiment,’18 which essentially was a way of teaching speculators a lesson – something missing today from the toolkit of sovereigns and central bankers. ‘This would involve arranging credits for the government in the United States and perhaps England, in round amounts,’ he told the French.19

The new loan of $100 million (big money at the time) was provided by the Morgan Bank, which evidently required appropriate guarantees. (At that point the French had not yet repaid their World War I loans to the USA.) Morgan was going to lend money to a government which, five years after World War I had ended was still borrowing $1 billion a year to close its budgetary holes. The conditions for the loan included:

reduction of expenditures,abstaining from asking for new loans,

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concrete steps to balance the budget of the republic, anda rumored secret clause that the French government bound itself to accepting whatever plan the Dawes Commission came up with.20

The members of the Dawes Commission were no novices.21 They were well aware that a large part of the projected fiscal deficit in the 1924–5 timeframe was likely to persist even in the event of recovery in output. The financial crisis had permanently reduced the level of future potential output for Britain, France, Germany, Italy and other countries, and therefore the tax base. Sound familiar?

In spite of these negatives, Altschul’s trick worked. By taking on the speculators with the $100 million war chest, the French government bid the franc from nearly 30 to 18 to the dollar in a couple of weeks. (The salvage of the French franc was, however, temporary. Three years later, in 1926, the franc fell to a new low, then fluctuated while the Banque de France intervened to hold it at 25 to the dollar; an exchange rate which favored French industry.)

Up to a point, but only up to a point, this was the road taken in 2010 by euroland and the IMF to salvage Greece from bankruptcy. If Greece had had the drachma and not the euro as a currency, it is quite likely that its value would have been halved against the dollar (Markezinis, the then finance minister, did just that in 1953). But with the euro, the country could not devalue. In other words, its financial problems significantly weakened the euro against the dollar, and it had to pay over 9 per cent for short-term loans, 600 base points more than loans by Germany.

Greece does not seem to have comprehended that, in the decision- making process of nations, forthcoming ‘battles’ will not be fought by tanks and super-sonic jets but by financial instruments. This will be a permanent feature – the outcome being decided by financial staying power. Overindebted nations, and this reference includes the United States and Britain, would do well to notice that there is nothing new in the message conveyed by the preceding sentences. (In the early eighteenth century, Louis XIV had said that the last Louis (the golden sovereign) wins the war – in other words, he who has the financial staying power.)

In conclusion, massively printed money represents unsupportable govern-ment leverage, and therefore debt, which unsettles investors and makes them run for their money. It was not for nothing that, in the 1920s, Hjalmar Schacht believed the real problem in post-World War I Europe (not just in Germany) was the prevalence of government debt – and this was bound to lead to a general European bankruptcy. It was true in 1920s and it is true today, with the differ-ence that, in the coming years, general bankruptcy might be truly global.

The importance of knowing the ‘normal’ conditions

Let’s start with statisticians. They love the normal curve of events and meas-urements because it reflects the degree of calculability of an event occurring.

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Besides that, there exist excellent statistical tests and tables based on normal distribution. The nasty fact is that many distributions of real-life events are not normal. Some are skew, others have long legs – and the further a meas-urement falls from the bell-shaped curve, the higher is the degree of com-plexity of the problem, its interconnections and its aftermath. The so-called ‘normal’ situation is easily calculable and presents a simple structure. But, as Figure 1.1 shows, outliers alter these conditions and harbor great challenges, not the least being that they involve too many unknowns.

As far as the ‘not normal’ distribution of events is concerned, a major contribution has been made by Benoit Mandelbrot, a mathematician, who developed the fractals theory – which has interesting applications in economics. Mandelbrot believed that the market behavior of financial movements has fractal forms.22 It does not follow the familiar bell shape of the normal distribution. Therefore, trading practices and financial models based on the assumption of a normal distribution are fundamentally wrong. The 2007–11 economic and financial earthquake proved that Mandelbrot was right. Plenty of models were written by people who were good at mathematics but knew little or nothing about finance, and the economy was turned on its head. Banks using these models paid dearly for this error.

The misconception derives from the fact that typically, though by no means always, the distribution of measurements associated with events which are ‘normal’ and understood tends to approximate the bell-shaped curve. By contrast, with skew, leptokyrtotic, long-legged, fractal and other

Expected events based on known conditions

Unexpected events involving too many unknowns

Fre

quen

cy

Long legof distribution

A distribution approximatingthe normal curve

Figure 1.1 Expected events and unexpected events are characterized by two different distributions



distributions the area under the curve is never stable, and what are thought to be outliers may become frequent daily occurrences. Therefore, extreme events and their likelihood must always be taken into account and, while their cause is far from being clear, their effect may be significant.

As different occurrences outside the bell-shaped curve multiply, the area under it changes its shape, or it translates itself to the left (or to the right). As the frequency of what used to be extreme events increases, they become a part of a new normal. It needs no explaining that this is not only relevant today. It has been occurring all the time in both natural and man-made sys-tems – as they move from stability to chaos and back to stability following an inflection point.

During the last quarter of a century there has been: the 1987 stock market crash (a 14.5 standard deviations event); descent to the abyss by Japanese banks and breaking of the British pound by Soros and Steinhart, both in early 1990s; the 1994 hecatomb of debt instruments; the 1997 East Asia crisis; the 1998 Russian bankruptcy and near bankruptcy of LTCM; the 2000 stock market crash (with dotcoms at the epicenter); and the 2007–11 deep economic crisis – which included the bankruptcy of Lehman Brothers, as well as near-bankruptcy of AIG, Fannie Mae, Freddie Mac, the Royal Bank of Scotland and plenty of other mismanaged mammoth institutions.

The fact that these have been (unwisely) saved, through torrents of red ink, by central banks and governments has ushered in the new normal. It is in this sense that El-Erian/Gross’s insight about coming events in finance and the economy, as well as their aftermath, should be interpreted. Crises which used to be outliers are now becoming mainstream, and their impact weighs heavily on the daily lives of people, business activities and the global economy as a whole.

For instance, according to Goldman Sachs, in just two years, from early 2008 to early 2010, the economic and financial crisis knocked $30 trillion off the value of global shares (owned by people and companies) and another $11 tril-lion off the value of homes. Another statistic to remember is that these losses amounted to over 0.75 per cent of the world’s GDP.

Notice that this cumulative $41 trillion represents an amount of money in fairly popular markets – exchanges and housing – where players can win and lose all at the same time. If there is even a mild turnaround, as the new nor-mal theory suggests, some (though probably not much) of this lost money will be recovered and will help to start redressing balance sheets.

What will not be recovered, at least by many of the players, is money lost with games involving derivative financial instruments. To appreciate this statement, the reader should know that over 95 per cent of derivatives trading is proprietary between financial institutions, particularly the big ones. Trading transactions undertaken for clients represents a meager part of the total.

To understand what this means in terms of ‘silly business’, it is as if General Motors were to sell 95 per cent of its auto production to Ford, and



Ford were to return the compliment by selling 95 per cent of the motor vehicles it manufactures to GM. In addition, the large majority of these derivatives transactions contribute nothing to the national economy and involve ‘imaginary’ money, such as 30-year interest rate swaps.

How a banker or trader can know what the interest rates will be three decades down the line mystifies me, and also those people to whom I posed that question. To the contrary, what is not appreciated enough (by the gam-blers) is that one party is bound to lose and it will not recover its money, even if the economy returns to stellar performance.

The only way the loser can try to get his money back is to get even deeper involved in gambling, going further into the red. In a way, it is worse than in a casino, because the players gamble against each other to total destruc-tion and they can all go bust because of their superleveraging. Look at the fall not only of Lehman Brothers, but also of Citigroup, Bear Stearns, Merrill Lynch and plenty of others.

While in the short term superleveraging might deliver fat profits, in the medium term it leads straight to the precipice. A message the new normal gives to those who care to listen regards what happens after the day of financial reckoning has arrived. When the gambling casino goes bust, people and com-panies discover that the so-called ‘assets’ (of most doubtful value) are accom-panied by vast debts, which are due with interest. In a crisis, these ‘assets’ are shattered, but, short of outright bankruptcy, the liabilities always stand.

As in the case of Japan and its ‘two lost decades’, from 1992 to 2011, western financial institutions and households confront a balance sheet recession. And, because this is happening on a massive scale, nobody really has a clue about how to handle it, let alone how to get the economy out of the long tunnel which it has entered.

The curious medicine of throwing massive amounts of money at the problem, first practised by the Japanese government and then followed blindly by the American, British and continental European governments, is a medicine whose longer-term effects are anybody’s guess. All sorts of portfolios have been left with liabilities that far exceed their assets.

Some economists believe that the world’s economy will be pulled up from its crisis by the developing nations – which, relatively speaking, are in better shape, while demand in developed countries remains weak. But other economists question the thesis that the emerging nations will be able to compensate. There is an even more basic bifurcation in expert opinions:

Some economists say that many governments will have to keep their stimulus packages going for longer than expected, or face entrenched unemployment.To the contrary, others believe that public debt cannot rise any more without disastrous after-effects for everybody, common citizens companies and the state itself included.

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Last but not least, opinions are divided as to whether the current system of global currencies can continue functioning under the preposterous weight of debt and liabilities on some countries and their currencies. As it stands, the situation is attracting cruising sharks whose business is the blood of the mighty.

There is, indeed, a currency puzzle which has found its way into the new normal but which is still (by all likelihood) living on borrowed time. International transactions and central bank reserves are being denominated mainly by three currencies: the dollar, the euro and the yen, which is rather funny because none is supported by first-class fundamentals. The Japanese economy has been in a coma for 20 years. The finances of euroland resemble those of a traveling provincial circus. And as for the US dollar, its investment bankers, mortgage ‘bodybuilders on steroids’,23 credit-rating agencies and big spenders at sovereign level have killed the goose that laid the golden egg.


22

2The Newly Poor

Poor people’s recipe: falling deeper into debt

In 1966, the Daily Express ran a competition in which one should select, in order of importance, what one considered to be the essential attributes to become a self-made millionaire. Plenty of people participated in it. According to Robina Lund, Paul Getty, one of the oil industry’s pioneers, assessed his own most important attributes as:

single-mindedness ability to work long hours1

elastic use of time2

attention to detail knowledge of a particular business unpredictability3

ability to make good use of professional advice4

What Getty chose as the seven top characteristics of success are the per-sonality traits of men who make history in any profession – from politics to business and science. These qualities are rare, possessed by exceptional people, most of whom are self-made. What the large majority of men and women choose as their guiding light in planning their life (if they plan it at all) is the exact antithesis of Paul Getty’s guidelines. Quite surprisingly, this antithesis prevails even among so-called ‘experts’.

The basic qualities characterizing the doers of society are not limited to the seven just discussed. An eighth all-important characteristic of success, which Getty did not spell out explicitly but implicitly used throughout his life, is thriftiness and the avoidance of debt. Costs matter. Wealth provides economic freedom, gained by living within one’s assets, acquired through hard work, rather than amassing liabilities and becoming slave to them, and to the creditor(s).

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The Newly Poor 23

The ninth principle guiding the life and work of people who are in charge of their destiny is their aversion to the welfare state – today’s State Supermarket. Getty’s thesis was that those who deserve social support don’t get it. By contrast, the lazy good-for-nothing scroungers who live on rent are encouraged in their idleness. His motto was: ‘People only appreciate what they pay for. If it’s free, they waste it.’ Look at the State Supermarket’s free medical care ‘for all’ to find the evidence.

The tenth principle (which really belongs at the top of the list) is personal responsibility. Everybody has his or her duties and dues to society. Forgetting about them, or having them waived due to the pressure of the masses and being led by a lightheaded leadership, is the worst that can be done in terms of building up character. ‘In a profession, waiving your dues may be a question of conscience; in a businessman it’s proof of weakness,’ Paul Getty pointed out.5

The disregard of personal responsibilities, so well described by these ten principles of behavior, has brought our society to the edge of social, ethical and economic bankruptcy.6 In the course of the last 50 years, whether we talk of Europe or of America, the absence of personal responsibilities has become proof of social organization’s weakness. This is true all the way from the sovereign state to the smallest social unit. It is also the most fundamen-tal reason for déclinisme of the West.7

As we will see in the next section, the western countries that wrongly think themselves as ‘the rich world’ are becoming poorer and poorer – and this is a self-inflicted wound. Their sovereigns, their companies (particularly their banks) and their citizens are living on debt and, therefore, on borrowed time.

The newly rich are the so-called BRICs (Brazil, Russia, India, China), the bigger countries of the developing world. How far apart the newly rich and the newly poor are in terms of policy is dramatized by the annual meeting of the International Monetary Fund and World Bank, held in Washington, on October 8 to 10, 2010 – which was dominated by the Damocles sword of global currency wars hanging over the global monetary system.

The newly poor countries, especially America, focused on China’s unwill-ingness to allow the yuan to rise. In response to this, China’s officials argued that the biggest distortion came from the (formerly) rich world’s extra-loose economic policies, particularly the expectation that the Federal Reserve would soon reactivate its deplorable strategy of massively printing money to buy government bonds and to devalue the dollar (see Chapters 5 and 12 on quantitative easing (QE)).

Steady current account and fiscal deficits reveal a roadmap to financial catastrophe. Even worse than the doctrine is the thoughtless way in which it was deployed. The force behind the creation of newly poor nations, precisely those who in the nineteenth century were the mighty world powers, have been the twentieth century’s devastating European wars.



We have reached the end of an epoch in terms of democracy, wellbeing and trust. Few people really appreciate that breaking trust can be done very quickly, while re-establishing it takes a long time and a huge amount of effort. By lowering its ethical values, ignoring the fact that liabilities lead to poverty, forgetting about each person’s responsibilities and falling deeper into debt, our society no longer trusts itself.

Property-owning democracies versus debt-laden democracies

The most stark contrast between ancient times, when democracy saw the light under the sky of Athens, and the twenty-first century is that the base of people who have the privilege of voting has radically changed. ‘A people that values the privileges above its principles, soon loses both,’ said Dwight D. Eisenhower in his Inaugural Address, January 20, 1953. It is difficult to find a dozen words which encapsulated better the current status of our society.

The citizens of ancient Athens who exercised the right to vote were own-ers of something – even if this was only the (far from being widely avail-able) privilege8 of being the city’s citizen. Such an ownership principle also prevailed in nineteenth-century England at the time modern parliamentary democracy was born. It makes a great deal of difference whether we talk of an electorate belonging to a property-owning democracy or to a debt-laden democracy, subservient to the power of those controlling its liabilities.

Human nature being what it is, even the more ethical voters will also think of their own interests in casting their votes. But when the majority (indeed, the large majority) of voters are debt-laden, the way to bet is that people will vote for politicians and governments who enhance and perpetuate their way of dealing: debt is enshrined in the system, till the day of reckoning.

Falling deeper into debt is toxic for democracy and its citizens because it becomes a vicious cycle; one in which society finds itself cast with cement around its feet. There exists a great deal of difference between the state having a beneficial role to the citizenry and having as its raison d’ètre the survival of the State Supermarket.

Democracy pays the greater price, as the state becomes too dominant and intrudes too far into its citizens’ privacy. Both personal freedom and efficiency are at stake. Basic human liberties are abandoned as the State Supermarket not only buys and distributes goods and services it cannot afford, but also looks over the shoulders of every citizen. Furthermore, the goods and services a debt-laden ‘democracy’ provides are mediocre. By contrast, the iron-clad police state that accompanies a debt-laden society is effective.

All this is bad news for the West, where the State Supermarket has chosen its domicile. Paraphrasing Albert Einstein, the significant problems we face cannot be solved by the same way of thinking we followed when we created


The Newly Poor 25

them. Not many western leaders have read Einstein’s words on the need for cultural change, or, if they read them, they did not appreciate them. Yet, the great physicist was right. The problems of a debt-laden society will not disap-pear by ignoring them. Time is of essence as the West finds itself at an inflec-tion point, with past wealth in rapid decline, while new wealth is created by the major developing nations which work to become property-owning.

According to current projections, by 2012 the G-79 countries will account for less than 50 per cent of the world’s GDP. This sharp drop in the share of wealth is the result of déclinisme, which started in the post-World War II years, and which accelerated during the last couple of decades.

In a way that is absolutely disastrous for its economic and financial health, the West continues printing a great deal of ‘funny money,’ while the more prosperous developing countries are in the process of accumulating potentially useless paper. In 2002, developing countries’ currency reserves were just over $1 trillion, of which China’s coffers held about 20 per cent and the other developing countries shared the balance.

In 2011, this hoard of western currencies, particularly dollars, is expected to be about $7 trillion, up by nearly 700 per cent. China will probably have $3 trillion (up from $2.6 trillion in 2010), with the remaining $4 trillion shared by the other BRICs and other formerly poor countries which are now the world’s newly rich. This raises some soul-searching questions on:

the fate to which the newly poor have condemned themselves,ways and means to stop competitive devaluations leading to capital controls and trade wars, andthe necessary rebalancing of the global monetary system to save it from collapse.

There is no better example of the tragedy in store for the newly poor than the noisy strikes which shook France in September, October and early November 2010. They were supposedly motivated by the government’s decision to increase the retirement age from 60 to 62 – a rather trivial change. In reality, they were a noisy attempt to avoid redimensioning of entitlements in a last-ditch effort to salvage a bankrupt State Supermarket from going bust.10

On repeated occasions, an estimated 3.5 million people took to the streets,11 with banners and loudspeakers. This was a record turnout of teen-agers (many half a century away from their pension), railway men, bus driv-ers, postmen, dockers and teachers, joined by housewives on one side and by hoodlums on the other.

Young people from over 300 lycées (pupils and students have their own labor unions) participated in this carnival. Pupils and students added their voices to the cacophony raised by people who marched through the streets of French cities with slogans protesting against their own future. In reality, these demonstrators were not afraid of two more years of working till they get their

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pension; they were afraid of losing some of the unaffordable and unsustain-able privileges the bankrupt State Supermarket had thrust upon them.

Behind such a savage showcase of a spoiled mass society lay the toughest test of French labor unions’ ability to force the government to back down. Useful as they might have been in the nineteenth century, in the twenty-first century featherbedded labor unions have become the front window of chaos and disorder; the No. 1 agent of disruption, regression and déclinisme – a state within the state.

The most depressing statistic about this circus of the State Supermarket’s spoiled young and old is that in French opinion polls some 70 per cent of respondents said that they backed the strikes. This was far more than the 54–62 per cent in favor of social strikes against government measures, in late 1995, which forced the then French government to back down and lick its wounds.

As if to document how destabilized the State Supermarket’s spoiled masses have become, their answers to the pollsters’ queries were inconsist-ent. Because, finally, they began to understand that the newly poor western nations will eventually have to waive many current social privileges, in the same poll which backed the strikers, 70 per cent said that raising the retire-ment age was ‘responsible towards future generations’. Hence, taken indi-vidually, the people know that tightening the belt is inevitable; however, in the most undemocratic way, they still go down the street to topple the government which tries to keep the boat afloat.

In contrast to this behavior of men and women against themselves, sev-eral developing countries are improving their prosperity because they hit the nail on the head, in terms of mindset, and are working hard to come up from under. They keep clear of the strange political netherworld of the newly poor, its coterie of nineteenth-century socialists, corrupt labor unions and tunnel-vision ideologies of guilt which the dysfunctional system entails. The questions to answer to turn the situation around, Dr Nelson Mohler com-mented during a personal meeting with the author, are:

What must we do today to properly shape tomorrow? What kinds of challenges are already visible in our society, our politics and our economy?How different is the society we now live in from that ahead, which we perceive somewhat unclearly but don’t seem to accept?

Mohler adds that a crucial question sovereigns and common citizens should ask themselves (and provide the answers for) is whether the new normal eco-nomic system works in synergy with the forces that are creating tomorrow’s society. Are these forces promoting discontinuity in our social, political and economic landscape? If yes, are we able to position ourselves against them, or are we overrun by them by default?

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The Newly Poor 27

Debt operates like a tax

The more extraordinary the event, the greater the need of it being supported by strong proofs, according to Pierre Simon de Laplace, the late eighteenth-century French physicist, mathematician and astronomer. To obtain strong proof, we must strip away the surface of events and phenomena to reveal, examine and test their deeper realities, as well as their connections.

This is the basis of the scientific method, which applies, though only up to a point, to economics and finance. The limitation comes from the fact that, unlike the laws of nature, the laws of man, his tools and the rules he uses are subjective. In consequence, to gain a level of objectiveness, good practice in economic analysis is to study and scrutinize past events, and to listen to the advice of learned people who have delivered results in their lives, and also to avoid engaging in a voyage of fantasy, following different monetary theories and macroeconomic or microeconomic models.

The rapid multiplication in models and simulators12 without an accompa-nying increase in skills, which take years to develop, has resulted in dismal accuracy in their projections (evidently including VaR). Furthermore, some mathematical models seem to be written just to prove a theory, gain status, or justify high fees. The result is that, quite often, following a model is no different than chasing a myth.

Errors in monetary and fiscal policies, on one hand and in algorithmic arti-facts, on the other, correlate, if for no other reason than because they both use one or more false assumptions regarding the behavior of the economy, the market, or financial instruments – including the limited appreciation of the after-effects of policy decisions. Nowadays, frequent examples of the latter are:

zero interest rates, endless increase of the monetary base, andinterminable leveraging, in disregard of the fact that debt is toxic.

One of the persons judging, in an able manner, the risks of the third bullet point is Andrew Haldane, head of Financial Stability at the Bank of England. In 2010, he pointed out that debt operates like a tax, with higher servicing charges on it reducing disposable income. Not all policy-makers appreciate the impact of this reference. Yet, they should understand that liabilities become a triple whammy, damaging the capacity of the economy, negatively affecting its sub-sequent growth rate and inducing creditors to run after the money owed to them by their debtors when an economic financial and/or banking crisis hits.

Like all liabilities, sovereign debt must be serviced and repaid, raising the question of where to find the money. The ill-advised massive bail-out, in 2008–10, of self-harmed big banks and accompanying sharp recession, which led to collapse in tax revenues, have pushed several western countries into budgetary deficits of more than 10 per cent of GDP.

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Among industrial nations such massive deficits, unprecedented in peace time, have become a mill-stone as far as budgetary discipline is concerned. Current figures suggest that, in debt-to-GDP ratio, the leading 20 developed nations are already twice as exposed as the top 20 emerging nations;13 by 2014 the ratio will be three times as high, putting the developed nations at a huge disadvantage in the global market.14

As these references document, there are good reasons why the executive director of Financial Stability at the Bank of England made reference to a disaster myopia. Even speculators are known to exercise greater caution after a disaster, but among politicians it does not seem to happen that way. Admittedly, it does not take long for speculators to once again become reck-less, piling up ever riskier securities and creating asset bubbles – but should the people leading western countries behave in the same way?

Haldane knows full well what he is talking about. As we have seen in Chapter 1 with the case study on the post-World War I years, debt is no manna from heaven. It represents an obligation for the debtor to pay a sum of money at a given currency and at some fixed future time and place. Typically that money has been taken as a loan, or is an obligation derived from a bond15 being issued, at a rate of interest which is also due.

Theoretically, loans are given to, and bonds are bought, from entities with no or very low moral risk. Practically, the scrutiny of creditworthiness is not always what it should be, particularly when a banker or investor is try-ing to maintain yield at a time of low interest rates. Both at sovereign and corporate level, creditworthiness means that the attitude towards previous obligations reflects willingness as well as ability to repay debt. Beyond the financial underpinnings, the moral risk is measured by character; character is an important factor in determining a debtor’s ability to obtain credit.

But, here again, practice does not always conform to underlying theory. Typically, overleveraged entities – families, companies, sovereigns – do not lack character; but they overplay their hand. As debt enthusiasts, they don’t take notice of Haldane’s attention to the negative effects of debt. Therefore, time and again, they repeat the same mistakes of high leveraging.

This might even work, up to a point but, eventually, the evidence is that an economic policy based on growing sovereign debt leads to serious com-parative disadvantages and eventually to a downfall. In peacetime, such situations are often created by hopeless social-policy entanglements, and they result in an acute, long-term threat to the country’s economic well-being. In the aftermath, there is, first, an inevitable relative loss of prosper-ity, though people and those who govern them are slow to look at this side of the facts; then, an absolute loss of prosperity becomes unavoidable, as there are no more funds for productive investments – the only ones able to lift the standard of living.

In addition, when debt exceeds assets, an entity – be it a household, com-pany or the state – is insolvent. It is unable to meet its obligations such as


The Newly Poor 29

interest cost for its loans, repayment schedules, purchasing or trading com-mitments, guarantees, salaries, pensions and other assumed engagements in the present and in the longer term.

Getting out of debt is not at all easy because, financial reasons aside, debt becomes a culture. In 2008, the American consumer debt reached a mas-sive $12.6 trillion. The crisis led to belt tightening and economists spoke of households rebuilding their balance sheets. American consumer debt dropped over seven quarters, reaching $11.7 trillion at end of September 2010. But, of this $900 billion difference, $812 billion were due to bank write-downs of mortgages and other personal debt.16

‘Debt capital’, a term often used by entities nearing the edge of bank-ruptcy to crow about their ‘resources’, gives a false message. It does not mean capital but liabilities, which come due. The entity is leveraged, and it may even be highly so. Inability or unwillingness to meet requirements associated with assumed liabilities leads creditors to take legal action; and the next step is default. It follows logically that the more debt there is, the more problems there are; such problems grow exponentially as debt soars, whether the victims are countries, businesses or common people.

Most recent deep economic crises find their origins in the use of indebt-edness for fat profits. An example from this century has been the use of subprimes.17 By all evidence, this massive policy started in the 1970s, when global banks recycled the vast amounts of petrodollars. Eventually, this led to convulsions like those the Greek economy went through (Chapter 9).

No matter what the theorists of leverage (and some socialists whose mind is stuck in the nineteenth century) say, nobody has yet produced a body of theory to explain the social benefits of extreme indebtedness (if any). Yet, practically every politician, so-called Keynesian economist18 or ‘social scientist’ preaches the merits of debt and, through them, he or she promises Eden. Instead, what the public gets is Hell.

‘I will be gone/you will be gone’

In June 2010, Didier Migaud, the president of the French Cour des Comptes, the government auditor roughly equivalent to the US Government Accountability Office (GAO), said that his country’s public debt was reach-ing unprecedented levels. He also pointed out that the bigger part of the government deficit was not due to the recent economic and financial crisis. Two-thirds of it was structural.19

There seems to be a competition to use the most red ink. The French deficit for 2010 was projected to be 9 per cent, under best conditions. A similar forecast was made across the Atlantic for the US economy, while a comparable figure for Britain has been over 10 per cent. Then it was learned that, by August 2010, the US budget would also have a deficit in excess of 10 per cent.



Even before the latter forecast was made, in July 2010 Allstate’s CEO stated that US government borrowing was out of control.20 A week prior to this statement, the Congressional Budget Office (CBO) had produced a gloomy long-term outlook for America’s budget, projecting that, under current law, publicly held federal debt would rise from an estimated 62 per cent of GDP in 2010 and keep on rising. Under the CBO’s alternative fiscal scenario, US public debt could reach 185 per cent of GDP in 2035.21 The CBO stated that the government should account for costs that are expected to accrue but are not presently considered, such as increases in Medicare payments to doc-tors. One might think what happens in 2035 is of no interest to those who govern because they will be long gone. That’s true. But the American public will still be there, and it will suffer.

In addition, some American economists believe that the aforementioned figures will be reached well before 2035, using as evidence that in 2010 the US budget deficit exceeded $1.4 trillion rather than staying below the $1 trillion originally projected. They suggest that the Congressional Budget Office had exercised restraint, even if its deficit projections were worse than the government’s.

Sovereigns’ attitudes towards debt at the beginning of this second dec-ade of the twenty-first century has a disquieting similitude to the early eighteenth century and the early 1920s (Chapter 1), because it shows some common trends with those troubled periods. Personal responsibility has taken leave, and good governance went along. Whether in Europe or in America today, the prevailing principle is: ‘I will be gone, you will be gone’ (IBG/YBG).22 Those making the wrong decisions will not be here when their consequences hit hard. Therefore, they feel free to say anything they please, collect the votes and political contributions, as well as other good-ies, upfront. They don’t worry if heaven breaks loose thereafter. Louis XIV of France had the motto: ‘Après moi le deluge.’23 His grandson, Louis XVI, paid for it with his head.

A more recent example is that of France, after World War I, which could not control its finances; for eight years, from 1918 till 1926, it ran a budget deficit equivalent to $1 billion per year (big money at that time). Today’s America has copied that (almost) century-old French policy by running a budget deficit of over $1 trillion for several years which, everything counted, is not that different from the aforementioned case of the 1920s.

Several American economists have not made a secret of their disdain for this way of doing things, but both Republican (Bush Administration) and Democratic (Obama Administration) politicians have a deaf ear. If the runaway public debt continues along that road, the day will come when America, France and all the members of the so-called ‘Club Med’24 (Italy, Spain, Portugal, Greece) will be espousing Argentina’s scenario.

Chapter 1 brought to the reader’s attention to the fact that, for an econ-omy where everything is interlinked, there appears to be no clear distinction


The Newly Poor 31

between cause and effects. The interplay among the main players and inter-connection between different instruments sees to it that cause may become effect and effect cause. Even so, something is the origin, and something else follows as a result.

What the aforementioned countries, plus Britain and Ireland, have in common with Argentina is not only that they have been spending well beyond their means, hoping that somebody else will pick up the bill. They are also (like Argentina) characterized by:

exceptionally weak growth prospects,erosion of global competitiveness,high unemployment rates, and more.

Worse still, by using the IBG/YBG principle they share virtually no finan-cial discipline with Argentina and, as justification, they present arguments whose particular feature is to weaken investors’ confidence in the govern-ment’s creditworthiness. The erosion of confidence is accelerated when it becomes clear that heads of state don’t have the courage to implement radi-cal measures able to consolidate public finances and improve the prospects for economic growth in the years ahead.

This leads to adverse debt dynamics taking hold in countries whose econ-omy, till a few years ago, was sound, but which have been hit by persistent budget deficits, negative current accounts, low savings relative to invest-ment and other ills. The result is that non-residents hold a substantial part of the public debt not just in the Club Med, but also in the United States.

At no other time than in the two major wars of the twentieth century was the American government so overindebted. Prior to World War I, the public debt was less than 10 per cent of GDP; it tripled during the years of that war, rose again with the New Deal (but still kept below 50 per cent of GDP), then soared during World War II to nearly 130 per cent of GDP. But this unafford-able government deficit was sharply cut in the following decades to around 30 per cent of GDP. It is, therefore, a pity that prudence took leave and, since the 1970s, the big spenders have run the show.

Over the course of the twenty-first century, the reasons for overindebted-ness on both sides of the North Atlantic have not been the same. In America, the IBG/YBG background developed hand-in-hand with crazy budget defi-cits and widening negative current account balances (see Chapter 11) under the watch of George W. Bush. This was followed by the Fed’s printing presses working overtime to:

salvage self-harmed big banks and mortgage companies,25 launch the dubious policy of quantitative easing (Chapter 5), andfinance the Obama Administration’s stimulus, which aimed to jump-start the economy but failed to do so.

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One of the ironies has been that state governments in America are, in their way, to become much more serious debtors than the Federal administration. With only one exception (Vermont), legislation in all US states now requires that annual operating budgets are balanced. This limits the racking up of debt over time. Moreover, many state constitutions also enforce repayment of debt. In euroland, only Germany has had the courage to pass such legislation.

By contrast, France, Italy, Spain, Portugal and Greece have persistently failed to enact structural reforms leading to balanced budgets, higher growth and employment, improved competitiveness, and the policy of allowing wages to adjust appropriately to the unemployment situation. Another ‘must’ is to stop making matters worse through the increases in entitle-ments. In addition, in spite of talk to the contrary, all western sovereigns have failed to proceed with the appropriate restructuring of the banking industry, including much more effective supervision.26

Runaway public liabilities and the day of reckoning

According to the 80th Annual Report by the Bank for International Settl-ements, the continued deterioration of fiscal balances and rapidly mounting sovereign debt ‘heightens the temptation to tolerate an unexpected rise in inflation to reduce the real value of the debt, particularly when a large part of the outstanding domestic currency debt is long-term and a large share is foreign-owned’. In other words, inflation will be the name of the game on the day of reckoning and governments will be better off if inflation wipes out the wealth of their citizens.

The BIS 80th Annual Report adds that another reason why ‘high and ris-ing debts may lead to higher inflation is that the public, confronted with the continued failure of government to close the fiscal gap, may eventually become unwilling to hold government bonds’. Hence, the sovereigns will retaliate. This said, governments and, evidently, voters have two options in dealing with the toxic debt that has invaded the economy: pay what it costs now, or pay a higher price later. The first option is the best, and it can be enacted by letting the economy settle down, stopping feeding it with debt and allowing it to find its course. Propelling the second option is the current policy of supposedly helping banks and people by throwing big money at the problem. This greatly delays the required restructuring of balance sheets of governments, banks and other companies, as well as of households.

It looks as if the idol and guiding light of Ben Bernanke has been von Havenstein. Rudolf von Havenstein was the (in)famous president of the imperial Reichsbank, who stayed at this job after the war ended and under whose watch, in late 1923, Germany’s mark turned to ashes in a wave of hyperinflation. Eight and a half decades later, in 2008 (little over a year after the 2007–11 crisis started), Bernanke started hyperleveraging the American economy. This was a total miscalculation in the early 1920s, as it is now.


The Newly Poor 33

Von Havenstein I and von Havenstein II failed to recognize that inflation-ary experiments with the currency can be explosive and end by setting the country’s economy on fire. Martin Feldstein, of Harvard University, was much more serious when, offered the chairmanship of the Federal Reserve by Ronald Reagan, he said he would accept it on condition there was a balanced budget. This did not please the politicians, who chose ‘double bubble’ Alan Greenspan27 instead. After him came Bernanke who, like von Havenstein, has not learned that:

even a moderate degree of inflation can turn into a nightmare if it continues being fed by the printing press, andat some point down the line, the market and the public lose confidence in the central bank’s and the government’s will, let alone power, to maintain money’s value.

This is precisely the time when the descent to the abyss starts. The deeper this descent gets, the more governments try to micromanage the economy, typically making the wrong decisions. In his 1944 classic, The Road to Serfdom, Friedrich Hayek argued that markets were the most efficient mechanism for allocating resources – but he also outlined certain conditions for this to be true.

In Hayek’s opinion, a free market (a rare species these days) represented the individual decisions of consumers and producers – millions of them – rather than the decisions of a few politicians and bureaucrats. This does not mean that there should be no regulation. Nowadays, the free market has been killed by the State Supermarket, which started life in the late nine-teenth century and has become an elephant in the glass house through:

government health care, government pensions,28

free university education,government car companies,government banks, andgovernment ‘this’ and ‘that.’

With all these goodies supposedly for free at the State Supermarket, private initiative does not feature. Everybody learns that he or she does not have to work or get tired. The State Supermarket will take care of all personal needs. What members of society need to do to get ‘more’ from the sovereign is to demonstrate in the streets – or simply go on strike.29

This means that the government has to pay for everything the State Supermarket has put on display. But the government (any government) does not have money. The assets in its treasury come from its citizens’ pockets through taxes and inflation (precisely from the very same people protesting in the streets).

•

•

••••••



For starters, the government’s financial assets mainly include currency, loans granted, securities like bonds, shares and other equity, gold reserves, technical reserves and accounts receivable. The government’s liabilities are its debts (to other governments, banks and bondholders), as well as its commitments – many of them in the form of entitlements. In mismanaged countries (and there are plenty), the market value of government financial liabilities is more than twice as large as that of its financial assets.30

Therefore, the concept is loading with debt, also known as high leverag-ing, and is against the common citizen’s best interests. In the mind of the public, the national debt – which represents an accumulation of budget deficits, entitlements, war bonds, salvage of big banks or other entities, and all of the more mundane State Supermarket goodies – is not supposed to be repaid, at least not wholly. This is a misunderstanding because, on the contrary, short of bankruptcy, the loans taken and bonds issued by the state to finance deficits have to be repaid, a fact which also brings the need for rollovers, new loans and bonds issues to pay past debts. Also, the interest on the whole budget deficit has to be regularly budgeted for, thereby adding to the budget deficit and absorbing financial resources that might have gone to infrastructural, educational and other projects.

In France, for example, the cost of servicing the public debt is roughly equal to all the money taken by the state through personal taxation. As for Greece, according to an article in The Economist: ‘[the country] would not have had such a problem with higher bond yields if it had not borrowed so much money in the first place’.31 For a relatively small economy like that of Greece, a sovereign debt of a300 billion ($400 billion) was simply unaffordable and unsustainable.

But it was not unusual for euroland’s Club Med: Spain, Portugal, Greece and Italy (with Ireland a northern member). Neither was it in total con-tradiction of conditions prevailing in Britain and the United States, which feature the higher debt mountains of the West financed by, and putting in peril, their own commercial banks and their own central banks (as well as the wealthier emerging markets).

An example of how fast a capital error by the sovereign can have unim-aginable consequences is provided by Ireland (see also, in Chapter 10, a more detailed description of the cause and effect of events in Ireland). The Irish government erred in providing blanket coverage for the country’s over-leveraged main banks; no matter what the official communiqués say, this brought the country near to bankruptcy.

Prior to the events of 2008/09, Ireland had a prosperous economy. But lingering concerns about the health of the banking sector and its potential impact on the public finances kept Ireland in the spotlight, as one of euro-land’s major financial and economic problems.

Given the size of Ireland’s economy, the estimated bailout of its failed banking industry corresponds to a staggering $4.3 trillion in the US


The Newly Poor 35

economy. That is far more than American taxpayers have been obliged to contribute to the salvage of US financial institutions by the Bush and Obama administrations. As 2010 approached its end, the news was that Ireland was hovering on the edge of a double-dip recession, with an unsupportable pub-lic debt, GDP having shrunk in the second quarter and the market having been confronted with heightened fears that the government’s fiscal policy may also tip Britain into one.32

The multiple effects of an original error can best be appreciated by return-ing to the time just before the crisis. In 2006 and the first half of 2007, Ireland’s public debt stood at 23 per cent of GDP – one of the best in Europe. This, however, rose to 42 per cent in 2008; 62 per cent in 2009; and an esti-mated 78 per cent or more in 2010.

In fact, if the current prognosis of an increase in the public debt-to-GDP ratio in 2010 materialized (Chapter 10), Ireland would have closed the year with more than a 350 per cent rise in public indebtedness between 2006 and 2010. Not even Japan, whose economy has been in a bad way for two decades, has had such a score.

Nobody is in charge of debt policy

The deep economic crisis of 2007–11, which started with subprimes and the banking industry’s illiquidity, turned into a crisis of sovereigns. Its course and its amplitude have much to do with spreading indebtedness at all levels of society, all the way to sovereign risk. To deal effectively with it and come out ahead of the curve requires a different policy than the parochial ‘fire brigade’ approach, the results of which have proven to be both very costly and highly ineffective.

‘Regulating monetary policy and regulating debt is not the same thing,’ said George Soros, on January 28, 2010, at the World Economic Forum in Davos, Switzerland. ‘If you allow debt to accumulate in the economy you sink the economy.’33 That is precisely what has taken place under the watch of Bush, Greenspan and Bernanke in America; Blair, Brown and King in Britain; and many other chiefs of state not only in Europe, but also in Japan.

It is bad enough that the regulation of debt has been absent from the list of critical government activities. This is made worse by the fact that monetary policy and fiscal policy are not working in unison – which is an error shared by developed and developing countries. First, monetary policy involves the control of short-term interest rates and the supply of money – including the irrational extension of this to include a ‘printing press exercise’ without lim-its through quantitative easing (Chapter 5). Second, the realm of fiscal policy is the balance between government spending and tax revenue. Sovereigns try to hide their trickery but, in the end, this becomes visible through budgetary deficits (and, in rare cases, surpluses).



With the main western central banks – the Federal Reserve, Bank of England and European Central Bank (ECB) – theoretically independent but practically ready to print tons of money, the regulation of debt has been the least of sovereigns’ worries, as exemplified by von Havenstein, as detailed above. Then, as now, the money supply ballooned under the leadership of the ‘money generals’: chiefs of state, ministers of finance and central bank governors.

While the reasons for high inflation lay in the lack of a debt policy, not only in financial but also in social terms, nobody really bothered about after-effects. Starting with Greece, the sovereign crisis hit governments and central banks, and many common citizens suddenly woke up to something they had chosen not to talk about. In the aftermath, authorities have to control, contemporaneously:

family overindebtedness,banks still haunted by bankruptcy risk,major currencies (first the dollar, then the euro) on the verge of crumbling, andwestern sovereign countries close to the precipice and wondering what comes next.

Not only investors, but also all those who can read statistics and bear the bad news are increasingly nervous about public sector debt levels in the United States, Europe and Japan. Combined, these are in excess of $30 trillion. Big but empty words aside, there is not even a hint about when these might be siphoned out of the system, how this will be done, at what cost and who will pay the price.

One reason why a debt policy has not been undertaken is that it will impede the governments’ spending habits through guidelines and a road-map. Another is that sovereigns don’t want one, simply because it is bound to be unpopular.

Without a debt policy limiting big spending, sovereigns continue claim-ing that their superleveraged balance sheets (B/S) will relaunch the econ-omy. This is utterly untrue because stimuli have failed in the past, they fail today and nothing is going to change in the future – except that debt, both absolutely and relatively, becomes even greater and more unaffordable.

When Didier Migaud, the president of the French Cour des Comptes, said that two-thirds of his country’s budget is structural (see above), what he meant is that all sorts of entitlements – state pensions, universal health care, higher education for all and an ever-widening range of other social services – are state commitments met through debt financing. Deficits widen because there is volatility in the state’s income from taxes, there are too many structural requests for ‘more money,’ and fewer and fewer projects of a productive nature to create new wealth.

•••

•


The Newly Poor 37

Time, however, is pressing. Not only is it important to balance the budget, but also there should be a surplus to serve in progressively retiring the mountains of debt. The only way this can be done is by means of a debt policy which politicians have the courage to explain to the public, explain-ing its urgency and rationale.

Integral to such explanation is the fact that enormous cuts to services provided by the State Supermarket – or, alternatively, massive tax rises – are needed to save western sovereigns from bankruptcy. Leaders should not be too scared to say so publicly, for fear of losing the ‘next election’, because this is what brought us to the current mess. The common man needs to be told the truth and then prepare for the new normal. Political parties should be able and willing to set out the precise cuts, even if their opponents attack them for bringing an ‘age of austerity’ (see also Chapter 7).

Failure to do so is tantamount to lying to the public because not one but all political parties have been responsible for the ‘age of profligacy and waste’, which lasted for several decades but could not continue forever. This is precisely what led to the age of austerity which is now upon us. The people responsible at sovereign level, should, at long last, take charge of regulating debt and shrinking the vast leverage ratio which weighs upon and distorts the economic system.

No matter what its origin, and how many layers it is crystallized in, debt is toxic for the economy. True enough, deleveraging and debt regulation are not going to be an easy business; though necessary, they will not be popular because people like to spend more than they have.

There are also technical difficulties, in an economic and financial sense; according to some analysts, even if the authorities want to pull part of the large amount of printed money out of the financial system, there would be difficulties in doing so due to the complex means by which it was injected.

For instance, in the USA this has included buying asset-backed securities (ABSs), which have been largely designed as complex and opaque derivative instruments. Structured instruments would be hard to sell if deleveraging was put in motion. Sovereigns (and central bankers) also have to decide to raise interest rates, in spite of the widely spread misconception that near-zero interest rates help the economy. In fact, they do so only for some sectors of the economy at the expense of others, stealing money out of the pockets of savers and providing excuses for pension funds to take unwarranted risks.

There are also conflicts of interest and collusion between sovereigns and monetary policy-makers because nearly zero interest rates help the former to finance their mountains of debt, pushing the bankruptcy date a little further away. At the same time, however, with the passage of time the complexity of what can be found in this mountain of debt (and, by extension, in the vaults of central banks and treasuries) keeps on increasing.

Nowadays, trading with subprime securities (which brought the unmiti-gated disaster of 2007) has been replaced by proprietary trading, which also



involves unknowns and major risks – and, moreover, is largely done with taxpayers’ money. This does not really make things better.

Last, but not least, when, in 2008, Ben Bernanke, the Fed chairman, decided single-handed to become the Robin Hood of self-harmed big banks, and found imitators in Britain and continental Europe, he utterly forgot to establish an exit strategy. This proved to be a grave mistake, because an exit strategy has to be carefully worked out a priori; improvisation after the event, when the wealth of citizens is being looted and most exit doors are shut, makes no sense whatsoever.

Many governments are reluctant to allow their economic, monetary and fiscal policies to be characterized by an exit strategy, seeing it as not in their interests. Yet, ‘the way out’ is more important than ‘the way in’ – and it is integral to requirements posed by the new normal, just like stock market crashes and banking panics were integral to the old normal. It is high time to appreciate that a debt policy and its exit clauses are a ‘must’ and not an option in the economic system in which we live.

Wealth in western nations dropped like a bribed boxer

The final section of Chapter 1 underlined the importance of knowing ‘ normal’ conditions in order to make factual decisions, starting with the con-cept of the normal distribution of events. Another reason why it is important to know ‘normal’ conditions is to be able to make financial projections capi-talizing on the fact that democracies are not proactive. Their political system works backwards, trying to capitalize on what has been done already.

There is, however, an old saying that in the land of the blind the one-eyed man is king. Being reactive to events is an asset, and most particularly amid financial turbulence. To be able to sustain, let alone grow, the economy, and therefore the standard of living, governments should look forward to anything that might happen and take a priori rather than a posteriori deci-sions, albeit at a certain level of risk. Evidently this is not happening on any appreciable scale. The measures taken during this crisis by sovereigns and their central banks call forth a sense of déjà vu. But the shortfall is somewhat eased when the new normal conditions are properly understood – and the measures adapted to take advantage of them.

The old normal has been: tax, print money and throw that money at the problem no matter what the result may be. Since the end of World War I, which means for nearly a century, governments have been profligate in their spending, with no questions asked about what the effect will be on the economy, whether big spending is affordable, or if the expected results can be sustainable.

Indeed, this sums up the love of debt discussed in this chapter. It was doable with the old normal because reactive policies took some time to desta-bilize the system. But it can lead to a catastrophe with the new normal, given


The Newly Poor 39

that debt is already overflowing, and in many countries taxation has hit the limits – while, day to day, the idea that western countries are ‘rich nations’ looks highly misplaced.

Western countries are getting poorer and, by consequence, financial and monetary policy have to be fine-tuned. If they aren’t, the gap between the public and the politicians will widen, with the former losing faith in the latter.

In America, opinion polls suggest that 75 per cent of the electorate thinks the stimulus, which cost billions, was mismanaged. The country’s working people and their children are being strung with debt. Add to this torrent of red ink the huge cost of health care reform, and what you get is evidence that politicians have no clear policy of what to do next. While they were dysfunctional in regard to the old normal, they are agnostic about the new normal. As a result, they don’t even have a rudimentary roadmap; neither can they perceive the boundaries between conflicting economic aims, even if these are as important as the goals themselves.

The wealth of western nations has been described by a critic of the tax-and-spend policies of sovereigns on both sides of the North Atlantic as drop-ping ‘like a bribed boxer’. Throughout the 1980s, 1990s and first seven years of the twenty-first century, the rise in debt levels was almost unstoppable, while economic growth was subdued.

Debt increased on every side of the economic equation, from households to companies to banks to whole countries. According to statistics from the European Central Bank, the debt ratio of non-financial companies to GDP, in Europe, went from 53 per cent in January 1999 to 83 per cent in January 200934 – an increase of more than 57 per cent in just ten years.

A survey by the McKinsey Global Institute found that, on average, the debt of private and public sectors in ten mature economies rose from 200 per cent of GDP in 1995 to 300 per cent in 2008. There have been even more startling rises in Iceland and Ireland (Chapter 10), where debt-to-GDP ratios reached 1,200 per cent and 700 per cent, respectively.35

That’s not the work of the rogue traders or speculators. It is the dismal result of sovereign policies which relied on superleverage without a thought to the fact that all this debt had to be serviced and repaid. Sovereigns do this through taxation – but this, too, reaches its limits. Still, in spite of so much money being taken out of taxpayers’ pockets and thrown to the wind, gov-ernment balance sheets in the USA, Japan, Britain and continental Europe have been deteriorating as liabilities rise rapidly in response to ill-studied measures and inability to comprehend factors underpinning the economic and financial crisis.

Ill-studied measures included a great deal of money being spread around, either going down the drain or to serve special interests. It is no accident that, in the first quarter of 2010, the American financial services, insurance and property industries spent nearly $125 million on lobbying, up by over



11 per cent from 2009. The Center of Public Integrity36 says the financial industry alone hired more than 3,000 lobbyists to impact upon the financial reform bill (Dodd-Frank) before Congress (Chapter 11).

Influence peddling has been doing its best to water down the new regu-lations, even if senators and congressmen knew that taxpayers, who are repeatedly put to the task, wanted to see some house cleaning. On June 14, 2010 it was announced that the Office of Congressional Ethics launched a probe into the fund-raising activities of eight lawmakers. All of them sit on the House Financial Services or Ways and Means committees.37

The wealth of western nations has not been helped by the fact that money in politics has become pervasive. In an article in the International Herald Tribune, Thomas L. Friedman was to comment that while political instability was a phrase normally reserved for developing countries, now people ask him about political instability in America. ‘Banks, multinationals and hedge funds,’ Friedman wrote, ‘often hire policy experts to do “political risk analy-sis” before they invest in places like, say, Kazakhstan or Argentina … [but] they may soon have to add the United States to their watch lists’.38

Thomas Friedman did not say in his article whether all this is part of the new normal theory, or of the last and dying convulsions of the old normal. One can only hope that, in the evolving economic and financial landscape, it will be possible to distinguish between private interest and public respon-sibilities, doing so in a better-documented and more consistent way than has been possible so far. On the contrary, a reversal of the factors negatively affecting the wealth of western nations seems less likely, because sovereigns and their people are far from eager to fulfill the preconditions.


41

3The Salient Problem is Rights Without Responsibilities

The many heads of a debt hydra

‘One day suffices to rise or dampen all human fortunes,’ said Athena, goddess of wisdom, in Sophocles’ Ajax. The message conveyed by these ten words by the Goddess of Wisdom could not be stated in clearer terms, and it gets to the real root of the evil that has plagued the American and European economies for the last two and a half decades.

This is the avenue leading to oblivion, and the only way out is to do what Heracles (Hercules) did in Greek mythology. He cut the Hydra’s heads and burned their throats so that they did not rise again. In restructuring our economy, the aim should be to get rid of structures that have proved to be dangerous and assumptions that are plainly illusory – if not outright destructive.

In democracies the need for this, and for a radical change in course, must be explained to the public in the clearest terms. When light falls suddenly on a subject which has been, for a long time, wrapped up in an envelope of obscurity, its effect is comparable to that of a revolution. And a revolution in thinking and in culture (see the following section) is necessary to ensure that the debt habit is kicked and the road is opened up in a new direction, based on ownership of real assets.

Indebtedness as a way of life did not start suddenly. For private citizens, the era of personal debt by means of loans peddled by banks to households began in May 1928, in New York, when City Bank accepted 500 applica-tions. The next three days brought 2,500 more applicants, and the following years brought millions.1

Sovereigns have had a longer and more checkered history in leveraging and defaults. Bardi, the great Florentine banking house, went bust because of its loans to England’s Henry VIII. The reason, in the late nineteenth century, that Barings Bank brought itself to the edge of bankruptcy (but was saved by the Bank of England at the 11th hour) was its loans to Latin-American states and US municipalities.



Precisely because banks speculate with other people’s money, in the wake of the First Great Depression, which started in 1929, when it came to power the Roosevelt Administration instituted the Glass–Steagall Act which divided commercial from investment banking. But, in 1999, the big banks convinced Bill Clinton to scrap the Glass–Steagall Act2 – thereby preparing their descent to the abyss in 2007–8.

Having stated that, between 2000 and 2007, Wall Street created $1.8 trillion of subprime mortgages (within a grand total of $13.4 trillion of mortgage-backed securities sold by Lehman, Merrill Lynch, Morgan Stanley and the rest), Lawrence G. McDonald, a former trader of Lehman Brothers, looked at this issue of abuse of public confidence and depositors money: ‘The repeal of Glass–Steagall had heralded a devastating new era, where the huge deposits in the commercial banks had enabled them to get into our game simply by buying and owing an investment bank.’3

With the repeal of the Glass–Steagall Act, the debt hydra’s heads multiplied. With minimal supervision and free reign granted by the Bush Administration, US commercial and investment banks expanded their activ-ities to include all sorts of gambling, with special purpose vehicles (SPVs) and a horde of structural products of dubious creditworthiness.4 Combined with very low premiums for refinancing, engineered by Greenspan’s Fed, this made it feasible to decrease the transparency of proprietary trading banks’ activities radically and to chart a road whereby the banking industry has been steaming full speed ahead towards the icebergs.

The banks were not alone in this rush to disaster. Common citizens also took a similar road through overindebtedness, while at the same time they used all available political levers to get more and more entitlements. We will look into this issue in subsequent sections, but, first, let’s complete the picture on how hard the banking industry labored against the economy, against itself and against financial stability.

The debt hydra got the elixir of life because of the close connections prevailing between the big banks and supervisory authorities. With Basel II,5 capital rules were constructed so that supposedly low-risk business could be loaded onto the balance sheet in virtually unrestricted amounts without triggering capital requirements. This became a huge loophole nearly all banks were quick to exploit.

Step by step, the debt hydra got from governments, central banks and regulatory authorities the right to raise ever more ugly heads. They have been called special investment vehicles (SIVs) and were fed by selling off securitized tranches of the balance sheet – such as collateralized debt obli-gations (CDOs) and asset-backed securities (ABSs) – to all sorts of financial market players, but mainly to other banks.

Debt piled upon debt in the books of the banking system at highly inflated prices. The fact that the man at the helm of the Fed, Alan Greenspan, and his team kept interest rates rock bottom emboldened the speculators.6


The Salient Problem is Rights Without Responsibilities 43

Rather than being too lenient, Greenspan at the Fed, Cox at the SEC and other regulators should have followed the advice of an Athenian senator in Shakespeare’s Timon of Athens: ‘Nothing emboldens sin so much as mercy.’

Instead, they did everything in their power to ensure that the catastro-phe waiting to happen would be delayed. With the blessing of the central bank and of the supervisory authorities, the debt hydra had a ball. Events followed rapidly, one after another, as Athena had predicted in Sophocles’ Ajax.

2007 was the year of the financial earthquake, 2008 the year of the banking meltdown, 2009 the year of the impotent stimulus package, 2010 the year when the sovereign crises in the West began.

One catastrophe led to another, the only constant being continuing and massive waste of money by governments and monetary authorities. Yet, for central bankers and administrations, systemic collapse resulting from insol-vencies is a vision of horror. Some experts suggest that all this was assisted by derivative financial instruments which blurred the distinction between illiquidity and insolvency due to overindebtedness.

As the debt hydra’s heads clamored for more and more money, whether real or fake, ‘too big to fail’ companies – from banks to insurance and mort-gage companies – were not allowed to go bust. On both sides of the North Atlantic, they were provided with an unlimited blanket of protection by already bankrupt sovereigns who acted as lenders of last resort.

In America, this became known as the ‘Greenspan put’,7 which set the stage for a very curious and highly expensive zero-accident policy. Little attention was paid to the fact that this was practically bankrupting the nation. It did not matter either, since the debt hydra liked it and gave birth to even more heads, fed by very cheap taxpayers’ money handed over by the state. Big financial conglomerates rapidly expanded their off-balance sheet business, and deficits in most western countries increased so much that governments did not even dare to tackle them.

Today, judging from the after-effects, many economists say that the medicine which was applied was worse than the illness. It is also more or less generally agreed that deficits of 10 per cent or more of GDP exhibited by the USA, Britain, Ireland, Spain, Portugal, Greece and other sovereigns, cannot be sustained over several years. If they are, they will poison the economy and push nervous markets to drive up the cost of servicing the growing debt, till it reaches stratospheric levels.

It does not take a genius to understand that such a simultaneous mis-management of monetary policy, sovereign debt and the economy leads investors to question even the major countries’ ability to roll over their debt. Prior to the recent deep crisis, there was a sort of consensus that rich

••••



countries could safely have public debts worth 60 per cent of GDP. Optimists put this percentage much higher, citing as an example that Japan’s debt has exceeded 200 per cent of its GDP. But this argument forgets that, as Japan’s economic crisis lingers on, the debt hydra has turned the country into a hall of mirrors. Even in the world’s largest economy, the United States, public debt is too high relative to the economy’s size and year-on-year increase in GDP.

In the meantime, with the exception of Bernie Madoff, who supposedly swindled $65 billion in a giga-Ponzi game, none of the wrongdoers have been brought to court. Most were allowed to keep running the institutions they ruined, and those who were retired did so in great comfort, having amassed enough millions through fat salaries and bonuses for a comfort-able life. In the total absence of any responsibility, there have been golden parachutes instead of punishment.

What is meant by rights without responsibilities?

As far as life in a modern economy is concerned, these are truly changing times. Although it would be presumptuous to say that ours is a new condition in the flow of human affairs, the definition of the new normal in Chapter 1 brought to the reader’s attention that, because of government actions and inactions, business opportunities and a swarm of unexpected risks, we are at crossroads. History will record the first decades of this century – and most likely a longer time period – as living on debt rather than living on assets.

The present and the next generation will find it difficult to kick the deep debt habit, but there is no alternative. The inherent weakness of this system of enjoying more and more for less and less work is the hypothesis that there exists a bottomless pit from which to pull out riches. This is an illusion partly created by the fact that the danger of public finances drying up, with the next stop being bankruptcy, does not show up immediately; instead, it hits hardest at the most inopportune moment.

Debt, debt and more debt unraveled what historians consider to be the golden age of Pericles in ancient Athens. It lasted a mere 30 years – more or less the same time as the ‘more and more’ current prosperity. In old times, like now, with spending for welfare far exceeding the state’s income, the advantages of economic prosperity waned at the same time that profits from far away expeditions ebbed. Pericles’ Athens was living on borrowed time, at the expense of those it professed to protect; almost by necessity, Pericles’ democracy turned to imperialism, which led to the 30-year Peloponnesian War that devastated ancient Greece.

In modern times, the love of debt started to gain supremacy in the 1970s, becoming even more popular in the 1980s partly, though not wholly, because the mantra of every pressure group became its call for its ‘rights’. Theoretically, a higher standard of living in the West has been promoted by a revolution



in technology and applied science: space research, computers, robotics, com-munications, networks and biotechnology. This theory, however, is highly simplistic. Science is amoral,8 and has no interest, let alone objective, in guar-anteeing ‘a better life for all’. Indeed, it is not science per se but the profound change in society which accompanied the deification of debt from sovereigns to families that radically changed the way our generation behaves. As the first two chapters have explained, piling up and consolidating debt is, in reality, a curse – even if, curiously enough, it is being looked upon as the solution. It is a ‘solution’ for people ready to discard their responsibilities because they think that they only have rights fulfilled by amassing more debt – since it is so much more difficult to amass assets.

‘[Modern] Greece seems to be a typical example for the degeneration of the modern social state. A state, in which life shall be better year on year. In which less and less work will be done, but social protection constantly improves and privileges as well as benefits are extended,’ according to an article ‘Patient Greece’ in Rzeczpospolita, the Polish newspaper.9

As that same article points out, our disdain for assuming responsibilities has gone so far that ‘risk is eliminated, and the next generation believes they have a right to a comfortable and sorrow-less life’. Part of the blame, of course, falls on the previous generations. We should not forget that, since the end of World War II, the ‘next generation’ has been featherbedded by its parents and by society to the point of believing that one does not need to take care of oneself. Deus ex machina will do what it takes.10

Over the years, this disastrous philosophy has become typical of Europe, and it has now invaded America. Personal irresponsibility, associated with passivity or plain absence of hard work (the best way to come up from under), has sapped energy out of people who have been brought up to believe that they can have whatever takes their fancy, and they will fight anyone who tries to take that non-existent ‘right’ away from them.

As the Rzeczpospolita article aptly pointed out: ‘The furious demonstrations in Athens were not for fear of hunger or endangerment of health and life. The Greeks protested, because they thought they have a right to prosperity’ – and no politician of the left, center or right wing had the wisdom and cour-age to stand up and explain that the ‘right to prosperity’ – indeed, the right to anything else – are myths and that they are a fata morgana which no sensible people would take for real.

This is by no means singling out the Greeks for criticism. What Rzeczpospolita has written applies to all western nations without exception. The article under discussion has correctly characterized this philosophy of ‘rights without responsibilities’ as alarming, disquieting and troublesome. It is precisely the sort of personal and social attitude which identifies societies in decline, and it is propagated through the biased mentality that wealth is not a consequence of one’s own effort and work, but should be guaranteed through the state to everybody – and forever.11



As in the years of the decline of ancient Greece and of Rome, work starts being seen as something ‘good for slaves’; the moral code itself also changes for the worse. In America, bankruptcy has become one of these ‘rights’. People who persistently spend beyond their means go bankrupt, and this unethical behavior is no longer stigmatized but simply regarded as ‘bad luck’. When consumers borrow or go on shopping safaris with their credit cards, the blame is laid on lax lending practices; in reality, however, the wrong is 50:50, the other 50 per cent being irresponsible borrowing and spending. Governments have contributed to this drift in society’s values. For instance, they have encouraged more and more people to become homeowners when they can hardly afford the mortgage payments. Taking on more debt is now seen as a ‘right’, without any responsibilities attached to it.

In being so lenient in awarding entitlements which are unaffordable and unsustainable, the politicians have, most evidently, a conflict of interest. Money makes the world go round and, up to a point, debt is seen as real money – though in a society that allows unlimited leverage that ‘privilege’ turns to dust. Debt is the instrument par excellence of the virtual economy and of run-away finance, propelled by greed, lust and fake social models.

The 2007–11 economic, financial and banking crisis has demonstrated that, unlike the real economy which we know how to manage at a certain level of depth (albeit not very profound), the virtual economy is an unknown entity with opaque deals. It involves gearing, unprecedented risks and requirements for human expertise well beyond what is generally available. This new and little-understood debt-ridden financial environment has sur-vived through a stream of:

new financial products, difficult to price and untangle, novel processes of financial alchemy created by means of derivatives, and globalized markets whose whims are poorly understood and which are regulated by nobody.

Taken together, the notions of unlimited debt, deregulation, technology and globalization have created limitless opportunities for misbehavior. Control requires the highest caliber of management experience and skill – which, we should admit, is very tough to find. As for the loudly heralded ‘age of democracy’ that the West wants to export to developing countries, its critics say that it has turned into an age of cleptocracy – and this not only by politicians, speculators and smart bankers. The whole population participates in it through its entitlements and by living beyond its means by getting into debt.

Entitlements

Starting in the years after the First Great Depression, and after World War II, proceeding at an accelerated pace, society assumed obligations way beyond

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those it had the means to fulfill. In the West, an aging population has made this policy of paying by debt – and therefore by mortgaging the new generation’s future – much worse than it might otherwise have been. Both socially and economically, what now happens is destabilizing. In France, entitlements are called ‘les acquis sociaux’ (acquired social benefits); they have been lavishly given by successive governments and greatly contributed to the fact that sovereign debt is overflowing from all sides.

Entitlements range from state pensions and health care for all, to a long roster of goodies the State Supermarket delivers. Among the most worrying issues are the massive demands all this makes on the common purse. From cradle to grave, people are entitled to ‘something’, while social pressures and weak sovereigns see to it that this ‘something’ balloons.

All this did not happen by accident. It is a consequence of the fact that people have learned how to use the levers of democracy. They exercise political pressure, which allows them to get what they want. They vote for politicians ready to satisfy citizens’ wishes with something out of dreamland. By exploiting the politicians’ fear that they might lose the next election, citizens have obtained concessions from the government on an unprecedented scale.

Everybody is entitled to health coverage, which teaches people not to care for their health (widespread obesity being an example).Mothers and fathers get subsidies for their newborn, allowing them to substitute income from work by income from procreation.Youths get more benefits from being unemployed than they would if they worked, hence it is better for them not to look for a job.Those who have a job are entitled to all kinds of protection through structural barriers, essentially taking as hostage those who have no job. Bus drivers, railroad personnel and plenty of others are entitled to retire at age 55, because they are doing a tough job putting their health in peril.12

Every person has the right to three, four or five weeks of vacations; and foreign travel to exotic places, once a rare privilege, has become com-monplace.Big banks, whose managers have been inept or self-gratifying, are entitled to a rescue, by massively throwing good public money after bad.Lawyers are enjoying good business, as the expanding wave of consumer protection has led to class actions against a number of companies for reasons ranging from real to imaginary.

One of the most ‘silly’ entitlements is the so-called ‘13th and 14th month’. Under public pressure, and for the purely populist reason of being re-elected, weak governments first legislated for the payment to employees of an addi-tional month’s wage for Christmas. Then, they added a further month’s wage in

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cash payments – half for Easter and the other half for vacation.13 The calendar year still has 12 months, but, in the process of leading the sovereign to bank-ruptcy, the State Supermarket invented a 13th and 14th.

While many of the goodies in the list of entitlements were irrational to start with, an extra problem that arises with the new normal is that nobody knows for certain, ahead of time, what current solutions will be worth some years down the line – or what kind of social costs might be needed in exchange for future benefits associated with entitlements. One way to find out is to play the devil’s advocate:

How far will the wealth remaining in western nations guarantee even a slimmed-down version of entitlements? What will be the impact of conservation measures – taking into account high volatility in financial markets and greater appreciation of risk – on pension and health care systems – and their financial staying power?Will families have to retrench their spending attitudes? In which area of the economy will this be mostly felt? Will it take the form of less reliance rather than of entitlements?How will sovereigns and central banks deal with the long-term consequences of their policy of rescuing every self-harmed big bank with zillions thrown to the four winds?

Answers to these and similar questions are non-linear, because there are no reliable means of predicting economic growth after the years of superlever-aging and subsequent upheaval we have gone through. It is possible that, when it comes, recovery will lead to rapid increase in tax revenues and the deficit will be reduced without great pain. This, however, is not likely.

On the other hand, it is possible that a loss of business confidence will oblige sovereigns to proceed with deep cuts in public expenditure as well as much higher taxes – a painful way of gaining control over current deficits. ‘Anyone confident in predicting either outcome is a fool,’ wrote John Kay in a feature article in the Financial Times, adding that ‘The basic issue is the need to restore confidence in what government tells us.’14

The deep economic and financial crisis of 2007–11 has posed tough questions that self-respecting politicians will not be able to avoid answering forever. But to do so in an able manner they should involve all citizens, because in the end they will be asked to pay the bill. Even if the twenty-first century’s problems are complex, the co-involvement of common citizens can be beneficial in finding suitable solutions to problems such as:

How should government debts be reduced without overly impacting on economic development?What’s the risk on continuing with loose monetary policies? At what point will these create runaway inflation?

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How can we find more efficient ways to allocate capital commensurate with the risks embedded in financial investments and trades?How should the clean-up costs of the recent crisis be distributed between current and future generations, and how should that solution be sold to the public?

A major gain from co-involving the common citizen in the search for a soft landing is the better understanding they gain that the current system of entitlements is falling apart. Precisely because of lavish and growing entitlements, as well as of their own softness, western societies face serious challenges:

high percentage of unemployed or underemployed, falling educational standards, disintegrating families, major income inequalities, lack of trust in public institutions, andfailure to deal fully with social change.

The reason for this sharp contradiction between the ‘you never had it so good’ promised by entitlements and the negatives summed up in the preceding bullet points is human nature and the distortion of handouts (even of their meaning) by the mass effect. Many problems have become too big to manage and their complexities are way beyond the abilities of those people in charge.

In addition, some chapters of social expenditure can be effectively tackled only through open, well-informed public debate, which does not happen. Instead, opacity promotes all sorts of fraud as people try to take advantage of the system.

Governments are not vigilant in tackling fraud, an example being health-related cases. ‘The largest federal health-care fraud takedown in our nation’s history,’ was how Eric Holder, the US Attorney General, described a recent case. On July 16, 2010 authorities in five American cities charged 94 people with a $25 million plot to defraud the federal agency that manages health care programs for the poor and elderly.15

In France, about 50 million people have the right to health insurance supported by the State Supermarket. But, according to wide reports, there are 60 million individual chip-in-card health IDs in circulation, giving a right to doctors’ visits, medicines and hospital care. Worse yet, because government support is graduated; the most widely copied IDs are the sort providing full protection.

Contrary to this policy of State Supermarket health coverage, which more or less prevails in all western states (with the exception of Switzerland which has made private health insurance mandatory for all residents), everybody

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should be responsible for his/her health. The best contribution by the state is one akin to the role played by an insurance company.

Pensions and the new normal16

Entitlements are not just granted by politicians at times of prosperity. Back in 1921, at the depth of its bleak economic problems right after World War I, while a bankrupt Germany was trying to negotiate relief from the huge weight of reparations and was unable to control its finances, the government took upon itself enormous new social obligations:

eight-hour workdays,health and welfare payments for the poor,insurance for the unemployed, and other goodies, over and above pensions to veterans and widows.

These became entitlements and, because they are largely paid through debt contracted by the state, they raise the question of who will finally foot the bill. Classical measures of public debt only record the legacy of past commit-ments and associated past borrowing. By contrast, a new approach, known as generational accounting, looks far into the future and may well become part of the new normal. The concept underpinning this approach is that of quantifying how much a government can expect to spend on its citizens now and in the future, and how much it can expect to collect from present and future generations, through all sorts of taxes.

The financial deficit between these two estimates expresses the amount a sovereign would have to set aside today to fill future holes in the state budget. This is an eye-opening paradigm because, in many countries, such a gap is a millstone around the government’s neck, doing away with any hope that income could exceed expenditure. While education and the defense budget are huge expense items, those of particular concern to generational accounting are pensions and the ever-rising amount of money thrown into health care.17

Proponents of generational accounting suggest that its results help to identify the fact that the way entitlements are currently structured allows all members of society, and most particularly the elderly, to make outsize claims on the young, which may include their own children and grandchildren. This statement has far-reaching consequences because it is shows entitlements not as an instrument of social cohesion, but one of abuse.

Pensions are a case in point. In 1889, when state pensions were introduced by Otto von Bismarck, the German chancellor, life expectancy was 45. Bismarck’s concept was to provide an income for those who simply could not work any longer. In France today, people typically live 26 years after retirement.18

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Allow me to repeat the references I have made, to impress their message on the reader’s mind. Debt and entitlement policies see to it that the greatest cultural challenge for this and the coming generations is to change the mentality of common citizens and political leaders alike from borrow now, pay later to save now, rather than starve and be hopelessly ill later. The mention of starving is no exaggeration because a surprising majority of people are unprepared for retirement. According to available information, an estimated 47 per cent of British women of working age do not have a pension plan, and this is also true for 22 per cent of all adults aged between 55 and 64. The nasty surprise awaiting them is that the state’s pension system is already nearly bankrupt and may well be unable to honor its past promises in the not too distant future.

Self-reliance is the only way to avoid the whims (and eventual bank-ruptcy) of the State Supermarket, as well as those of different company pension plans. Millions of workers could be poorer when they retire because of a government plan that would allow the terms of their pension schemes to be rewritten, according to a news item in The Times. Behind it was the fact that the British Pensions minister confirmed he is considering legislation that would make it easier for the trustees of private sector-defined benefit schemes to water down crucial member safeguards.19

Aging being a rather widespread practice, one of the challenges for the new normal is thoroughly to rethink the whole issue of pensions. In addi-tion, while the currently prevailing system of public pensions (which largely rests on ideas of the mid-1930s) is bankrupt, and gets deeper in debt every year, private pensions schemes are quite frequently mismanaged.

Indeed, not only are private pension funds far from being well-run, but also western central banks have added to their mismanagement woes by keeping interest rates at 1 per cent or less. In the aftermath, pension funds, which earn nothing through bank deposits, put much of their pensioners’ money in equities – and, even worse, in alternative investments.20

The company favored by British pension funds has been BP, because of its high dividend and supposedly solid business. But following the well-known accident in the Gulf of Mexico early in 2010 and the unprecedented cost of environmental salvage, in mid-2010 BP did not pay a dividend and the British pension funds have been in a bind: BP’s dividend represented one sixth of their revenue21 and, as an equity investment, BP shares lost more than 50 per cent of their value, reducing pension funds’ assets considerably.

Not all private pension funds are properly provisioned. In mid-March 2010, in connection with a three-day strike by its cabin crew, British Airways announced that it had reached agreement with unions to tackle its £3.7 billion ($5.7 billion) pension deficit. Companies are also changing the basis of pensions they sponsor from defined-benefit to defined-contribution schemes, with uncertain benefits. The difference in cost may be as much as 30 per cent of the payroll.



This swarm of uncertainties is part of established pensions schemes’ new normal. On September 22, 2010 the Financial Times commented on a study which had documented that people employed across the European Union need to save a1.9 trillion ($2.5 trillion) more each year to retire with pen-sions that can maintain their standard of living. (The pensions gap is worst in Britain and in Germany, where total additional savings required each year are at the level of a380 billion and a470 billion, respectively.)22

Individual savings are the answer and should be part of the new normal, though it is unlikely that an electorate accustomed to 65 years of unlimited handouts by the State Supermarket will relish following that course. (When I suggested to a cousin of mine that this is a ‘must’, she answered: ‘I don’t earn enough; how can I afford to set money aside?’). Compounding this social and political adversity are the possibility that any individual invest-ment’s returns are not those expected, as the likelihood of a shortfall is always present, and also the existence of so-called pure longevity risk, which cannot be discounted. Therefore, the possibility of outliving resources must be faced ex-ante.23

Stoics could say that as long as individuals are healthy enough to pursue remunerated activities they are less affected by the aforementioned risks, because they have a fall-back option to deal with any shortcomings in public social security and in their savings. This is only half true and, moreover, does not include sudden devastation of their portfolio through a deep financial crisis. But the big if is whether they can find jobs as 60-year-olds, and it is likely that, at some point, this might no longer be the case. To make matters worse:

the legislation may change, health costs might significantly rise, andlonger-term care solutions might become too expensive, defying the idea of any old-age security system.

In conclusion, entitlements might be dying of natural causes. With public sector deficits reaching for the stars, the usual game of the State Supermarket to be everything to everybody is no longer viable. Therefore, under the new normal there will be a rigorous need for household-based mechanisms to cover pensions and health care – and the aforementioned figures from Britain and Germany show how much these will probably cost each citizen for pensions alone.

To avoid being trapped in another high debt crisis they can hardly afford, sovereigns should promote pensions and health care individual savings tar-gets, in a way similar to their approach to carbon emissions, for example. It needs no explaining that this requires a well-studied long-term policy to avoid dismal failure – the result of, Tony Blair’s (and others’) idea of taxing carbon emissions, which was politically untenable.

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The middle classes’ broken dreams

One of the reasons for overdependence on the State Supermarket is that, in the minds of most people – including those who govern – there is much confusion about the nature of wealth. Theoretically, wealth consists of goods people use or consume, as well as more permanent assets: land, factories, machinery – which provide the ability to produce goods and earn an income from them. Services could be seen as part of goods, and therefore of wealth, insofar as they help in its production, distribution and sales.

By this definition, financial assets are not wealth in the established sense. This is particularly true when these ‘assets’ are based on debt, hence on someone else’s obligations. By contrast, financial services could fall under the definition of wealth production, as long as they assist in the creation of real wealth through loans financing the companies’ investments and operating expenses.

Financial assets can, however, be a claim on real wealth even if their exist-ence per se neither increases nor decreases the level of wealth. For instance, the lack of a mechanism for recycling money can handicap the production and distribution process by making capital a scarce commodity.

Leverage used to increase one’s impact and expected profits beyond that which one’s current wealth permits is not wealth – and the preserva-tion of wealth is not promoted through leverage. The banking industry, as well as governments and households who inflate the value of their financial assets relative to their real wealth, are doing a great disservice to themselves and to the economy. The gearing of debt sees to it that real wealth takes a hit and eventually everyone suffers. This also holds true for ill- conceived geared investments. People who buy overvalued and/or speculative assets with borrowed money do not make themselves richer but poorer – particularly when adversity hits, as it does from time to time. Similar principles prevail with oversized (and often ill-studied) salvage operations and rescue packages. Economists challenging the ‘greater leveraging’ concept ask:

Is a policy of gearing financial assets boosting the amount of goods the economy produces in the long run? Or, is it having consequences that eventually restrict economic activity because of loss of business confidence?

Though different experts tend to respond to these queries in diametrically opposing ways, experience teaches that the second alternative is likely to happen more frequently than the first. This is important inasmuch as governments and central banks have been repeatedly intervening to rescue financial institutions (and the markets) by keeping the printing presses busy without thoroughly examining the downside.

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At the end of the day, those who foot the bill are the common citizens, through unemployment, higher prices, more taxes and diminution of their investment wealth. All this is poison for the middle class, and it is absurd to promote such practices because, however it may be counted, the middle class is the pillar of the modern state.

In addition, households are leveraged twice, though it is difficult to appre-ciate this issue by looking at it superficially. They are leveraged both through their own debt habits and because of unaffordable entitlements which see to it that a big chunk of public debt burden is eventually falling in their back yard to be paid through higher taxes and inflation; these ‘claims on the collective’ are ever rising and nobody bothers to ask the all-important question about how they will be financed.

To make matters worse, society now tends to penalize the very concept of enterprise which has been fundamental to the rise of the middle class; the people widely considered as the bedrock of modern western society. This is true even if the exact definition of the term ‘middle class’ is far from being clear. In Britain, it means better-off people; by contrast, the meaning in America is that of rather less well-off.24

Under either definition, as with all other parts of society, the population characterized as middle class has handsomely benefited from the generous welfare state, whose credo is ‘wellbeing for all’. In the longer run, however, this ‘wellbeing for all’ is financed through higher taxation of those working, while at the same time personal initiative – which has created the wealth – is regarded with suspicion.

As a thought-provoking commentary by Wegelin, a private bank based in St Gallen, Switzerland, pointed out, ‘wellbeing for all’ has become so embedded in western citizens’ thinking that the modern economy’s zeitgeist is unwilling to recognize misfortune and strokes of fate; while hard work, good fortune and success are regarded as a sort of evil (although also a source of tax income):

The industrious and productive are met with envy. The Greek past is forgotten, in whose mythology the Orestaea spelled out the inevitability of misfortune; forgotten too, the Old Testament story of Job, in which misfortune afflicts the innocent and the guilty triumph. Europe has lost the roots of its cultural history.25

This is true not only in Europe, of course, but also in America and Japan. Rightly or wrongly, plenty of nations collectively known as ‘the West’ are poorly equipped for global competition, particularly when confronted by emerging countries which don’t ‘take it easy’, don’t have an elaborate (and costly) ‘social net’ and are relatively unfamiliar with the entitlement mentality and all sorts of ‘guarantees’ lavishly provided by the State Supermarket.



Traveling with light luggage and working hard to come up from under, China, India, Brazil and a few other nations have been outperforming the West’s tired approach. They do not face this never-ending spiral of debt burden, which has a distorting effect on economic policy and is still being practiced on a large scale.

The way western governments are currently operating in monetary and fiscal matters far from constitutes sound management of the economy and, without doubt, has nothing to do with fiscal discipline. They are just kicking the can down the road, and through the G-20 meetings they invite the big emerging economies to join them in this self-destructive pastime.

The leaders of developing countries – who find no reason not to take part in these high-profile G-20 events (organized and paid for by the West) – are, however, careful. They don’t see the attraction in bringing their nascent middle class a boulevard of broken dreams, as the West has done with its own middle class. Rather, they use the Socratic method – the art of asking:

What exactly are they (the western leaders and hosts) trying to do?Are the West’s goals colliding with the developing countries’ own?Or are they allowing them to fill the vacuum left by the retreating West?

It is as if western leaders are not in their right minds any more. By ‘right’ I mean the way Sam Walton, one of the most successful businessmen of the post-World War II years, described the way his mind worked: ‘When I decide that I am wrong, I am ready to move to something else.’ A project or proc-ess may prove unable to deliver what was promised, or the man in charge may be unable to get results. As Walton aptly remarked on such an occasion: ‘One should never underwrite somebody else’s inefficiencies.’26

Efficiency and effectiveness correlate. ‘Effectiveness is a habit,’ Peter Drucker once said, but people today are not being taught how to be efficient and effective – let alone how to get that habit. They don’t even know how to plan, or if they make a plan they keep it static even if the world around has changed.

One does not plan and then try to make the circumstances fit those plans, according to General George Patton. One tries to make plans fit the circum-stances; the difference between success and failure in high command depends on the ability, or lack of it, to do just that. Flexibility, however, takes leave when people have ‘rights’ but no responsibilities.

Remember this when, in Chapter 4, we speak of Japanification. Remember, also, what Lord Melbourne, a former British prime minister, said when Queen Victoria came to the throne: ‘What all the wise men said would hap-pen, has not happened. And what all the damned fools predicted has come to pass.’27

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What may follow the debt hydra?

In mid-August 2010, the Federal Reserve said that America’s economic recovery was ‘more modest’ than had been anticipated. Therefore it maintained its policy of quantitative easing (Chapter 5). The debt hydra responded to the Fed’s statement with a ‘Thank you’, and the Dow Jones Industrial Average fell by 2.5 per cent the next day.28

The economy does not want to move because business confidence is lacking. After the Fed, the Bank of England lowered its growth forecasts. The given reasons were tight credit conditions, government spending cuts and the projection that inflation would probably remain above target in 2011. The reference to the debt hydra was forgotten.

The subtle admission that the largest economy in the world, and one of the largest in Europe, were unwell confirmed that the debt hydra did not achieve the miracle expected of her. Instead, the economic troubles created have been visible – a combination of shocks from the cocktail of new and risky financial instruments, fake credit ratings, plenty of greed, weak risk management and lax supervision.

It did not help that central banks bent backwards to permit commercial and investment banks to survive by decreeing bottom-rate interest rates and engaging in novel and untested monetary policy exercises. The early blossoms Ben Bernanke, the chairman of Federal Reserve, was dreaming of had a short season in late 2009. In the week of July 19, 2010, he told Congress that the US outlook was ‘unusually uncertain’.

According to critics these two words – ‘unusually uncertain’ – threw oil on the fire. Around the western countries, different government initiatives to stimulate the economy by keeping the printing presses running had the same effect. Consumers, and to a certain extent the financial industry, tried to rebuild their balance sheets, but still remained overleveraged.

With official unemployment figures just shy of 10 per cent, American consumers have emerged from the whirlwind of ‘buy now pay later’, which characterized many of Alan Greenspan’s years at the Fed. As for talk about another stimulus, on July 28, 2010, Bill Gross, the chief investment officer of Pimco, equated spending to boost production to flushing money down the toilet.

No wonder that Nouriel Roubini, the New York University economist, argued that ‘avoiding double-dip recession will be difficult’.29 For his part, Lawrence Summers, (then) chief economic advisor to President Barack Obama, described the world’s leading economies as ‘in or near liquidity trap conditions’,30 which is practically implying that they are so weak that lower interest rates and other monetary policy tools are ineffective stimu-lants. Economists, however, disagreed on whether the disaster scenario of sovereign defaults was a real and present challenge or only a tail risk. The difference is significant because a tail risk can bring totally unexpected



conditions, including a slide to the edge of the abyss. By contrast, viewing the debt hydra’s presence as a challenge means finding the money to pay for increasing debt in timely fashion. If creditors lose faith in their borrowers, they will significantly increase the interest rate they demand, call for repay-ment of existing debt or refuse to roll over old loans. The same principle exists in business. When debt is secured against assets, then the borrower is often forced to sell; a number of forced sales causes asset prices to fall, mak-ing creditors much less willing to extend loans, let alone offer new ones.

Many bank industry executives may look kindly on the debt hydra, since it means business; but alert ones will do so only up to a point. They will not wait for the house to burn till they call in their money. Jamie Dimon, Morgan Chase’s CEO, is said to have called a senior manager of his bank in the middle of the Rwanda jungle, ordering him to get the institution out of subprime mortgages – having sensed the upcoming disaster. Made in October 2006, nine months before hell broke loose, Dimon’s prognostication proved right.

That was not the case of Richard Fuld, Lehman’s CEO, who continued taking misdirected risks with all sorts of rotten mortgages till he loaded his bank with $660 billion in highly doubtful ‘assets’ in commercial and residential real estate, subprime and other mortgages, leveraged buyout debt, commercial paper and credit default swaps. As the bank was sinking in a sea of red ink, its employees posted a giant photo of Fuld and Gregory (the bank’s president, who was fired at the 11th hour) in the offices, arm in arm in tuxedos with the caption ‘Dumb and Dumber’.31

By contrast, creditors become willing to accept risk for their capital if they sense that personal, corporate or government financial policies are sound. This means that, at sovereign level, fiscal as well as monetary discipline has become an established practice. Creditors are keen to check if such a sound financial policy is well-established because, time and again, all sorts of developments, including political, reveal weaknesses in prevailing rules. All sorts of lenders, except those employing usury, will dump unsafe borrowers – for instance, when crucial aspects of the fiscal framework are far from being retightened, or incentives for encouraging a general responsibil-ity to safeguard sound finances are non-existent.

As far as sovereign debt is concerned, it is no secret that the large majority of politicians don’t have the stomach for tough decisions regarding a comprehensive consolidation of public finances. Yet, to get out of economic troubles, a country has no option other than to downplay debt and return to a sound budgetary position.

To put it bluntly, confidence in stable and reliable underlying conditions is fundamental to the recovery of the economy, particularly in countries where the debt hydra had free reign. The best policy in a globalized economy is concerted common action but, G-20 or no G-20, this is not in the works, as governments which should have been coordinating their policies are



heading in different directions in an attempt to keep their country’s voters ‘satisfied’.

If the chief executive of an organization and his financial officer are upset when analysts raise valid questions (to which the CEO and FO don’t have answers), then the crisis climate does not lift. This is one of the criteria ana-lysts (and some economists) use to make up their mind about future pros-pects. The US economy faces a painful period through 2015, an executive of Berkshire said on August 16, 2000.32 Just imagine … more of the 2007–11 economic and financial crisis for another four years and, even then, who can guarantee that, in the meantime, a second dip does not send ‘recovery day’ to 2020 or beyond?

There are very difficult choices ahead and a consensus is difficult to find, even if everyone recognized that all sorts of benefits, from health care to pensions and other entitlements, are unaffordable and unsustainable; there-fore, they have to be trimmed for spending in order for governments to be in control. What has ruined the western economies is the State Supermarket, which is running on deficits – while no government is keen to apply fiscal and economic discipline.


Part II Loose Monetary and Fiscal Policies Lead to the Destruction of Wealth


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4Japanification

Japanification defined

As a term of economic plight which is neither outright bankruptcy nor much better than a hall of mirrors, ‘Japanification’ is derived from the events which led to, as well as resulted from, the two lost decades of Japan’s economy. This unraveling process has involved a terrible destruction of wealth. It defied a horde of stimuli, which cost more than 150 per cent of the country’s GDP but delivered no results; led to a deflationary environ-ment and a moribund stock market; and crystallized business activity, leav-ing it unable to lift itself from the hecatomb into which it was thrown by the crisis.

Given the dreadful after-effects of these misdirected policies followed by the Japanese government, it is quite evident that America and western Europe did not need to copy that bad example. Yet, that’s where their poli-cies seem to be leading. By mid-2010, financial analysts in New York were saying that Japanification has the following in store for the US investor:

a Fed funds rate below 0.5 per cent until at least 2020,average annual real GDP growth of roughly 1 per cent over the next 20 years, a Dow Jones Industrial Average below 4000, and a drop in average US house prices to around $100,000 (from $184,000 today) before 2030.’1

Such a grim assessment (hopefully) might not be highly probable, but nei-ther is it impossible that things will turn out that way. Action in the right direction is the only means to avoid the economic and financial environ-ment described by the above four bullet points, which will be worst than the stagflation of the 1970s.2 So far, however, US, UK and continental European policies – including the salvaging of big ‘zombie’ banks – point towards Japanification. But what is the right direction?

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62 Loose Monetary and Fiscal Policies

If this is the wrong way, then what is the right direction? American economic history provides an excellent example, albeit eight decades old.

Shaken by the First Great Depression (which was already old news), in 1931 and 1932 the US banking industry stonewalled. It was not lending to enterprises or to the public, even if the government and Federal Reserve of New York provided abundant available liquidity. Instead, banks used the federal money to add to their own reserves.3 In this environment:

about one quarter of the working population was unemployed,roughly one quarter of US banks had collapsed,‘bank holidays’ were common currency, andthe credit engine of the nation was no longer functioning.

Then, as now, inside and outside the government the luminaries were short of ideas about what to do next. But in early March 1933, right after he took command, Franklin D. Roosevelt and his advisors (the so-called Brains Trust) thought out of the box and the measures they adopted turned the situation around.

William Woodin, FDR’s secretary of the Treasury, recognized he did not have the experience to revive America’s economic power single-handed. The president’s weight was indispensable; Roosevelt and his economic advisors (George Warren and Henry Morgenthau) were ready to act. The (then) new president’s personality tipped the balance because he knew how to make tough decisions against all odds – decisions on which he staked his author-ity and his prestige – and how to communicate with the American public to gain its understanding and support during a difficult period.

On Sunday evening, March 12, 1933 FDR started his ‘fireside chats’ over the radio (which as a communications medium is more effective than the ‘one-eyed cyclops’ [known as television] because the listener’s attention is not distracted by images). Neither George W. Bush, the father of the Second Great Depression, nor Barack Obama, who inherited it (and failed to keep his promises about righting the balances), know how to reach the hearts and minds of people – and this counts a great deal.

Roosevelt’s fireside chats, and his way of addressing the problems of the common citizen, acted like magic. Instead of the (by then) customary run on the banks, on Monday, March 13, 1933, the queues of people outside branch offices were there to deposit money rather than asking for their savings back. A week later, prodded by FDR, Congress passed the Economy Act, followed by other important legislation and, in June 1933, by the Glass–Steagall Act.4

The answer to critical problems demanding immediate and forceful action cannot be given by economic theories because they are abstract, often detached from reality. Even theories which have found more general acceptance, like so-called Keynesianism, were made for different economic

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Japanification 63

conditions than those we are confronting. The past is of course a good teacher, but decisions are made for the future, not for the past.

This is not written as the critique of just one theory, but of economic and social theories at large. Contrary to the laws of physics, economic and social theories have so many subjective biases in them that the word ‘theory’ is simply a misnomer. The free market theory, too, is suspect because in the middle of this century’s first decade the markets have failed in some important ways. One of the reasons has been over-reliance on the ‘efficient market hypothesis’; another is that the financial system has both grown exponentially and become more complex. A third is that derivative financial instruments, over-the-counter deals and shadow banking have killed the free market hypothesis. A fourth, even more critical, is that the ‘efficient market’ theory does not account for human lust and greed.

Regarding economic theories and their after-effects, Larry McDonald quotes Mike Gelbank, saying: ‘Many US economists are completely out of touch. They don’t understand derivatives in the property business and how these derivatives provide a huge and totally unacceptable stimulus to the economy. Unacceptable because they are demonstrably false.’5

According to expert opinion, if derivatives are regulated and over-the-counter trades channeled through exchanges, investment bankers and trad-ers will find other (non-regulated) ways to make fast profits. Therefore, the ability to apply discipline based on financial laws and regulations is most crucial. Regulators must do so steadily.

It should not be forgotten that those who govern are under steady pres-sure from special interests to turn a blind eye. Japanification is an example of unwanted consequences as Japanese politicians and the Liberal Democratic Party tried to be all things to all people and therefore took plenty of ill-advised decisions.

Looking back to the Roosevelt years, the fact that, in the 1930s, there were no lobbyists with huge budgets to put the government under pressure was an evident advantage to decision-makers which is currently unavail-able. Today, lobbyists have so much elbowroom that they can turn not only economic theories but even the toughest regulations on their head. The Sarbanes–Oxley Act is an example, because over the George W. Bush years it was not really applied.

By contrast, there is no evidence that Franklin Roosevelt was burdened by the lobbyists when he decided on the abandonment of the gold standard (essentially largely devaluing the dollar against gold), even if the USA had the largest gold reserves in the world. ‘Congratulate me. We are off the gold standard,’ Roosevelt said to his economic advisors6 on April 18, 1933.

That was his decision. He took the initiative rather than waiting to see infighting and hear a cacophony from his economic advisors – as Obama did in 2010 when Larry Summers and Christina Romer allegedly clashed and the latter quit as chairwoman of the Council of Economic Advisors.7



FDR’s way was leadership, and that’s the right way, though inevitably it involves risks.

When crisis is the keyword of the day, the man in charge has to be bold. He cannot succeed by making compromises. When, at the beginning of World War I, the German army was approaching Paris, Ferdinand Foch, the French commander at the front, reportedly said: ‘My left wing lost contact with the enemy, my right wing is in retreat, my center hardly holds. The situation is excellent. I attack.’ This was at the famous Battle of the Marne. Foch’s decision took the Germans by surprise and changed the fortunes of World War I.

But bold decisions are not what the Japanese government took in the early 1990s, or that the American and European governments are taking today. Instead, the policy is one of compromises and half-baked plans leading nowhere other than to Japanification.

Japanification’s after-effect: precarious public finances

One of the lessons taught by Japanification is that the worse can continue to worsen, and it can do so fairly fast, with after-effects spanning a long period of time. Two decades after the crash of its banking industry and accompa-nying evaporation of public confidence, Japan continues to have precarious public finances.

Every so often an uplift looks to be on the horizon. Economists ask: Can the recovery be sustained? The answer is that many things may look like being good news but they do not last very long. Cyclical upturns are unlikely to be sustainable when there exist deep-seated economic problems – such as Japan’s huge public debt, poor demographics and a vital lack of decisiveness among policy-makers about how to deal with the ‘next challenge’.

Economic and social problems have a nasty habit of not going away when leadership is at its lowest. Precisely for this reason, Japan has been experi-encing sapping growth for 20 years and most likely will continue doing so for years to come – with disastrous consequences. The country is in a dire fiscal situation: as a percentage of GDP, the budget deficit is over 10 per cent; and gross debt has passed the 220 per cent of GDP mark.

The real and present danger is that the negatives reach a tipping point as the government escalates its issuance of bonds to finance ambitious new spending policies; meanwhile, like the Federal Reserve, the Bank of Japan inflates away debt. ‘Misfortunes’, as such, don’t just come along. The gov-ernment is unable to take bold action, leading many analysts to the forecast of a ‘triple-sell’ –the Nikkei, the Japanese bond market and the yen – all starting to decline together.8

One of the visible after-effects of Japanification is that the country’s main stock market index is a shadow of its former self. As for government bonds, for years the state relied on domestic savers to buy them. This policy,


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however, unraveled: first, because an aging population no longer has a high savings ratio and, second, because of the mass effect – Japan’s public debt may exceed gross household assets by 2015 and Japan might have to rely on foreigners to finance its debt, except that foreign investors seem to be positioning themselves for a meltdown rather than being ready to assume ‘Japan risk’.

A triple whammy of the Nikkei caving in, coupled with investors going on strike in the Japanese bond market and the yen declining – all at the same time – would be a nightmare scenario, making Japan the Lehman Brothers of the global economy (see the final section of this chapter). But such an eventuality should not be totally unexpected. For years the Japanese econ-omy gave warning that the combination of economic stagnation and rising public debt was explosive, though this warning fell on deaf ears.

The country which, in the 1970s and 1980s, was on its way to conquer the world financially through superleverage, slipped down the global league and amassed the largest gross public debt-to-GDP ratio ever recorded in peace-time. The puzzle (as far as economic theories are concerned) is that this has happened while government-bond yields have remained unreason-ably low – as if kept so deliberately to feed speculation and promote the carry trade.

The passive attitude Japan adopted in regard to its future is a far cry from the policies it followed in the second half of the twentieth century. The 1970s, and most particularly the 1980s have been a time of ascendancy. In the latter decade, the country’s industrial production rose by nearly 50 per cent. The problem was that such a rapid growth was driven by unprec-edented financial leverage and overinvestment, both at home and abroad. This led to a real estate and stock market bubble, with equity prices rising as much as 600 per cent. The bubble’s collapse started in December 1989 and, a little over a year later, in 1991, it was followed by the aforementioned two decades of economic contraction.

Today, Japan’s economy continues operating way below capacity. The output gap is estimated at about 7 per cent, three times bigger than it has been in the interval since Japan’s asset-price bubble burst two decades ago.9 Economists think consumer prices have further to fall, while at the same time fiscal problems are also pressing.

In an effort to explain Japanification, economists say that cracks appear when the rate of interest paid on government debt is higher than the econo-my’s growth rate – not only in the event of public revenues being insuffi-cient to cover the government’s financing charges. When this happens, the fiscal position becomes unstable and the debt spirals upwards.

The deeper challenge confronting America and Europe at the present time is that their woes are not so different to those of Japan. While the recovery is theoretically continuing, practically its pace is moderating as the support from the global inventory cycle and fiscal policy stimuli wanes. Moreover,



different surveys suggest that global growth might weaken, as, in the third quarter of 2010, international trade started to slow down from rather buoy-ant rates recorded in the first quarter of 2010.

This is highly relevant to our discussion because, as far as America and Europe are concerned, a bad situation is made worse by a global financial crisis which inter alia obliges governments to borrow at ever-shorter maturities while their obligations are longer-term. This has been one of the key reasons that led to the Russian bankruptcy of August 1998 (as well as to the banking crisis in America, in 2007, because of structured investment vehicles and subprimes).

Japan’s persistent deflation is not a good omen for the future. (In financial circles, it is said that the Japanese government is unable to understand it.) Unlike Roosevelt’s forceful action in March 1933, which led to dollar devalu-ation (against gold, see above) and a rise in prices, leaving deflation behind, no Japanese chief of state has had the courage to take a bold step and reverse a situation which continues to be out of control.

Economic theories on what ‘should’ or ‘should not’ be done abound – but none presents much by way of a realistic course of action. Some economists, for instance, suggest decisive action before deflation and negative psychol-ogy become deeply embedded. They do so, however, without explaining how can this materialize under prevailing twenty-first-century circumstances.

Another piece of economic advice making the rounds is to use capital injections (read: another discredited stimulus) and then ‘ensure’ the econ-omy is on a sustained healing path before exiting the stimulus (which may mean never exit). This runs contrary to yet more advice from a different group of economists: that it is time to exit the stimulus once and for all.

No economic creed takes, or even tries to take, a well-rounded approach. Therefore, it comes as no surprise that in Japan – as well as in America and in Britain – economic policies are drifting along by default. That’s another characteristic of Japanification which also illustrates that keeping interest rates near zero, à la Bank of Japan, is far from being a brilliant idea (see also Chapter 5).

It is suggested that Japan’s scarcity of yield translated into scarcity of growth, a pattern often repeated in the USA and Britain – and it may last for years. Some economists believe that, should this happen, it will cause secular bull markets in investment grade bonds (which, in a way is already taking place) and also promote the so-called Venti stocks (the term ‘Venti’ means global firms with capitalization of at least $20 billion – vingt in French).

According to opinions which, a couple of years ago, were few but now reflect the majority, the risk of Japanification will end the day the Federal Reserve hikes. When this happens bond prices bend and the clouds will be lifted from what Bank of America Merrill Lynch financial analysts call the ‘three Ds’: debt, deflation and deleveraging.

For some time, however, there is no indication that monetary policy authorities intend to move in that direction. Therefore, doing away with


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the ‘three Ds’ is not yet around the corner. Even if the cloud of debt lifts, if that of deflation remains, the economy will be in the doldrums. In addition, deleveraging means catharsis – and both policy-makers and com-mon citizens have to accept that, because after so many excesses catharsis is inescapable.

In conclusion, the Damoclean sword of Japanification still hangs over our heads. What is rather astonishing is that western politicians don’t position their countries’ economies against the forces of the new normal, which mis-directed government policies and the big banks created, by learning critical lessons about the ways and means through which Japanification creeps in and then finds a home.

Money thrown at the problem brings the next big crisis nearer

Japan has two decades of experience of throwing money at the problem and getting deeper in debt. In spite of this waste, if not because of it, year-in and year-out prospects for stronger economic growth are being overshadowed by a market which simply refuses to get into higher gear. In the USA, the experience with massive quantitative easing is no better (though there may be political reasons behind it, as we will see in Chapter 13).

Another similitude between Japan and western countries is that politicians and central bankers are split on the nature of mechanisms, and timing, of an exit from the exceptional economic and financial measures taken at the peak of the crisis. That exit should lead to a more normal monetary policy framework – which is a natural aim. It would have been a grave mistake, and admission of Japanification, if the measures which were adopted, particularly those that were non-standard, were not designed with their phasing-out in mind.

According to learned opinions, such an exit strategy has not been one of Ben Bernanke’s and Mervyn King’s worries. Instead, the spirit was that most of the measures unwind naturally in the absence of an explicit decision to prolong them (which is absurd). Some experts add that, anyway, central banks have the ability to act whenever this is deemed necessary because of their institutional independence.

It does not need explaining that in times of crisis institutional independ-ence is a fiction. The mammoth bureaucracy of an administration leaves a large footprint on central bank decisions, and politicians know full well which levers to pull to steer monetary policy their way. Central bankers appreciate that in a clash with the government, when push comes to shove, they have three options:

follow the political winds,openly express the deeper reasons for their opposition, orsimply quit.

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That is precisely what Hjalmar Schacht did in March 1930 after confront-ing a hostile reaction by the Brüning government because of his pub-licly declared opposition to a punitive clause of the Young Plan (which substituted the better Dawes Plan of 1926, weeding out its escape clause regarding reparations).

There is little doubt that documented improvements in financial condi-tions allow central banks to begin performing part of their ‘normal’ role in the market. But what exactly is meant by ‘documented improvements’? The answer is more subjective than objective. Central banks do appreciate that keeping all or most of the non-standard monetary measures in place for a long time induces distortions such as:

excessive reliance on exceptional central bank liquidity,the belief by market players there will always be a deus ex machina, weak financial incentives to restructure banks’ balance sheets and other delays in necessary adjustments, andthe inescapable moral hazard associated with enhanced support for credit institutions.

Central bankers also know that the market’s trust in their steering of the economy may bend. Breaking trust is usually done very quickly, while gain-ing it and re-establishing it (if at all doable) take a long time. On the other hand, uncertainty in regard to government policies propagates the message that a sovereign has adopted Japanification by default.

The fact that major nations continue along a one-way road, and the deci-sions they are taking are not far-sighted, leads many observers into thinking that, even if the more recent chapter of the crisis revolved around Greece, this may probably be just a starting point. Everybody knows that the United States is heavily indebted. It is essentially euroland’s sovereign troubles which enhanced the allure of US government bonds, deemed comparably safer.

Still, despite short-term benefits to the USA from the debacle or near- debacle of Club Med’s sovereigns, investors have reason to be worried. A renewed credit crunch could set off a chain reaction, undoing much of what has been achieved through emergency lending by central banks around the world.

There are visible strains in money markets, where inter-bank lending has become costlier, as the market players are still fearful about sovereigns resolving to solve their debt crisis. Something similar happened with Japan in the 1990s which led global lenders to demand higher interest when lend-ing to Japanese institutions – a policy which became known as the Japan premium.

Investors and lenders have not forgotten that the inter-bank market, which is an important source of funding for nearly all financial institu-tions, froze in the aftermath of the Lehman bankruptcy. Alarm bells ring

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because the inter-bank market makes banks highly interconnected, facilitat-ing the spread of crises from one credit institution to the next and creating conditions whereby the insolvency of one institution can materially harm others.

Against the backdrop of non-ebbing market turbulence, uncertainty about the sustainability of the global economic recovery could lead to a self- fulfilling prophecy of a double dip, while overindebted sovereigns are no longer left with a margin of error. Investors cannot fail to be aware of the number of eco-nomic errors in the past – such as injecting massive liquidity into the market and taking over, or otherwise rescuing, self-harmed big firms.

In fact, global banks, insurance companies and car manufacturers were by no means the only parties to benefit from plenty of money being thrown at the problem. In Britain, the Labour government embarked on a parallel (and irrational) spending binge, increasing funding of the (already overburdened and inefficient) National Health Service (NHS) by 6 per cent per year in real terms, and boosting spending on education.

This misdirected policy was not only motivated by the desire to overcome the economic and banking crisis. During Labour’s 13 years in power (up to the 2010 elections), two thirds of all the new jobs created were driven by the pub-lic sector. As if this we not enough, pay has grown faster there than in the pri-vate sector. In the first decade of the twenty-first century, British government expenditure soared from about 40 per cent of GDP to 54 per cent – a whisker below 55 per cent in France but still high compared to 41 per cent in the US, 43 per cent in Canada and 47 per cent in Germany.

Just like Japanification, when the sovereign’s spending spree gets out of control the situation is dangerous and contagious. Not to be left behind, in America, George W. Bush adopted a ‘guns-and-butter’ strategy whose after-effect became the biggest expansion in the US budget since Lyndon Johnson’s in the mid-1960s. Bush:

created the biggest new bureaucracy since World War II – the Department of Homeland Security,added a huge new drug entitlement for Medicare, andexpanded federal government control over the states and over education.

Instead of focusing on the reduction of public debt, it kept on rising as Barack Obama also expanded government-sponsored and -financed health care, without first cleaning up the system and cutting costs. According to critics, this has ominous implications for the future, as the demand for social services soars because of an aging population.

The reader should notice that this is a global problem, as well as one of the pillars of Japanification. According to a United Nations study, the propor-tion of the world’s population that is over 60 will rise from 11 per cent today

•

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to 22 per cent in 2050. Much worse off will be western countries where, if no radical changes in pension schemes are made, by 2050, one in three people will be pensioners and one in ten will be over 80, fully eligible not only for pension but also for full medical care every day and every hour.10

Let me conclude with this thought. There is cause and effect in Japanification. While the foregoing projections talk of events which are some years away, across western countries today’s budget deficits have already ballooned to almost 10 per cent of GDP. The more governments bol-ster their health care schemes, their pensions and their damaged banks – as well as the more they provide fiscal stimulus – the worse becomes the prog-nostication in terms of the next big crisis.

Financial discipline requires more than leadership

Japanification is not an act of God; it is an act of man. Whether we talk of entitlements, stimuluses or other big money obligations assumed by the State Supermarket, spending more money than the sovereign gets in taxes cannot go on indefinitely; it is high time to apply financial discipline. Working against discipline is the fact that political leadership nowadays is weak and it does not have the force required for change in economic and social priorities.

Instead of positioning themselves and their economies against the forces of the new normal, politicians have adopted an attitude of self-defense, delaying the tougher decisions associated with longer-term fiscal steps – as well as the all-important re-evaluation of commitments. For instance, adopt-ing policies leading to reduction of entitlement spending, which most econ-omists now see as a necessity in order to rein in public sector expenditures.

This attitude engenders significant risks. Mike Mullen, who as chairman of the Joint Chiefs of Staff, is America’s most senior officer, said publicly that the US national debt posed the biggest threat to the country’s national security – bigger even than that presented by al-Qaeda or weapons of mass destruction.11 This is another example of failed leadership in western countries.

Thomas L. Friedman, the political analyst, put the issue of what is wrong with ‘things as usual’ in proper focus:

The standard answer is that we need better leaders. The real answer is that we need better citizens. We need citizens who will convey to their leaders that they are ready to sacrifice, even pay, yes, higher taxes, and will not punish politicians who ask them to do the hard things. Otherwise, folks, we’re in trouble.12

If there is a prescription for Japanification – with all this means in déclinisme and decadence – then this is the citizens’ policy to take more out of the state than they contribute to it. In present-day western society, such a widespread


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pressure to grab the most out of the common purse is pure greed. It is also coupled with the incorrect belief that the state and its institutions are respon-sible for bringing ‘prosperity’ to everyone. The policy is that, to get the most out of the government, one has to intimidate its agents and constantly put them under pressure through demonstrations and by any other means.

Such an undemocratic attitude counts on the fact that the second-raters who are in charge of public affairs will get scared and bend, doing what the street demonstrators ask them to do. Fear of losing the next election is democracy’s soft spot – and such a fear is enough to scare those who gov-ern into submission to the will of the masses. De Gaulle once said about Pétain,13 to paraphrase, that he thought too much of the voters and not enough of the country.

Lack of financial discipline at every level – most particularly government – is the root of the crisis which started in 2009 in the aftermath of the economic and financial hecatomb opened by the crisis in self-harmed banks in 2007. As was the case in Japan in 1991, to avert the likelihood of systemic risk created by extravaganzas like speculative trading, high leverage and irresponsible lending, governments took it upon themselves to right the balances, forgetting that:

the governments themselves are markedly overleveraged,they have assumed obligations well beyond their income, and their agencies are far from being characterized by the fiscal discipline so necessary in tough times.

As central banks injected a lot of newly minted money into the economy, credit markets and stock markets rebounded from their March 2009 lows. Optimists saw this as evidence that central banks and fiscal authorities were taking decisive measures to stabilize the markets and the real economy. Because of this, they thought that a recovery was taking hold, allowing companies to raise additional capital. Ben Bernanke spoke about having seen ‘green shoots’.

The old normal was supposed to be back, albeit at great cost to the economy. This optimism was misguided. Some countries resumed growth not because of improved prospects but as a result of the government’s being maladroit with taxpayers’ money, essentially showing that fiscal discipline was still on leave.

All but forgotten has been the principle, brought to the reader’s attention in the preceding chapters, that fiscal discipline requires both leadership and a change in culture. People have to take responsibility for it, as well as accept the credits and debits which will be necessarily created by major financial adjustments in income and in spending policy.

Avoidance of Japanification requires restructuring, and the act of restruc-turing calls for deleveraging. From this, there is no escape. Because nearly all western economies have been in such a derelict state, monetary and fiscal

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adjustment are bound to be painful. Whoever takes responsibility for them will be exposed to plenty of criticism from people who fail to appreciate that:

entitlements have to be cut,all sorts of expenses need to be revisited, andwhole chapters of the sovereign budget have to be axed, especially those adopted because of populist policies.

In addition, if a recovery to sound economic conditions is to be sustained and the challenges presented by the new normal faced in an able manner, monetary and fiscal discipline should become the order of the day. There is no evidence that this is understood, because political leaders don’t have the stomach for difficult choices. Rather than keeping some powder dry for action in the future, they do what central banks have done, slashing interest rates to almost zero and dramatically expanding balance sheets. The pros say that this unprecedented activism:

injected new life to the financial system, countered the collapse in private demand, and heralded the message that governments and central banks are ready to take action.

Critics answer that this high-handed interference with the markets is simply repeating Japan’s mistakes over the last two decades on a grand scale. The risk of Japanification has been brought so much closer, and the result has been that, already, the finances of highly indebted sovereigns are cracking under the weight of new debt. But, all the while, the economy is worryingly fragile, as demand is still dependent on government support; property prices are still falling in more places than they are rising; and public largesse, papering over old problems, is creating new sources of worries and volatility.

As long as the rebound in demand is due to the public purse in the form of stimulus spending and other tricks, any celebration of coming out of the tunnel is premature. Not without reason, economic forecasts press the point that demand in the western world will remain weak, especially in countries with broken banking systems and with over-indebted households.14

Governments, central banks and the 2010 Jackson Hole Symposium

Many economists and nearly all investors are fretting that another crisis is coming because the sovereigns’ profligacy cannot last forever and debts will have to be paid. The IMF reckons the gross government debt of the western world’s big economies will reach an average of 115 per cent of GDP by 2014

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Japanification 73

and continue to rise thereafter, particularly so in America and in Europe’s Club Med:

pushing up interest rates, crowding out private investment, sapping economic growth, andleading to outright default of some sovereigns (see below).

Transforming current social norms which characterize the State Supermarket, the politicians’ and, increasingly, the common peoples’ sense of responsibili-ties are key to fighting the notion of living on debt. Asking the state to provide all sorts of goodies and, over and above that, abusing the system, as happens universally with health care, is worse than cheating. It is covert corruption.

Covert corruption is difficult to uproot because it has taken hold. On the other hand, plenty of evidence demonstrates that as long as it is around there is no way to diminish the mountain of public debt. Added to this is the fact that economic and financial crises leave plenty of muddle behind them, making corruption and overspending of public money symptoms of an increasingly profound Japanification.

Sovereigns and central banks are, in fact, running out of options. The more they try to stimulate the economy and salvage damaged entities through debt financing, the less they get in return. According to an article in the Financial Times: ‘To the fearful crowd, potentially overvalued debt sits on the world’s balance sheet like a flammable compound in a creaky old tank. A spark is a spark, wherever it comes from.’15

As the previous chapters brought to the reader’s attention, the current weak-nesses of the economy will not be resolved as long as total debt levels are high and interest rates are near zero, which practically means that central banks must stop taking more risks with the economy and that government budgetary deficits, as well as current account deficits, must be put under lock and key.

What is now happening is dynamite. One can hope the powder will not ignite while the room is full of TNT. Jean-Claude Trichet, the European Central Bank’s president, had very good reasons when he warned at the Jackson Hole Symposium – the central banks’ top annual event organized by the Kansas City Fed16 – that postponing cuts in public and private sec-tor debts would be very dangerous and risk a Japanese-style lost decade. In his opinion, dealing with economic imbalances was not simply a duty to be completed after an economic recovery, it was, and still is, an important precondition for sustaining a durable recovery.

Trichet also pressed the point that economic growth could be threatened by high public indebtedness, stating that as long as it is unclear when the adjustment will occur and who will bear what fraction of the adjustment’s costs, firms and households may delay their investment and consumption decisions. This will slow down the economic recovery.

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By contrast, in the course of the same event Ben Bernanke said that he stood ready to administer more of the same medicine – namely to boost the flagging American economy through unconventional means – adding that he had the tools to do so.17 The only issue, Bernanke added, was whether the benefits of each tool, in terms of additional stimulus, outweighed the associated costs or risks of using it. (But he did not elaborate on ‘pluses’ and minuses’.)

This did not go down well with the audience. To Bernanke’s statement that the Fed would do ‘all it can to stimulate the US economy’ (albeit with-out providing any specifics), Nouriel Roubini answered that, as far as stimu-lating the economy was concerned, the Federal Reserve was running out of bullets.18 Roubini is right. By overreacting in the wake of the September 2008 banking crisis, the central bank has not kept any dry powder.

At the 2010 Jackson Hole Symposium, Bernanke went through some of the advantages and disadvantages of the Fed’s remaining policy options. He thought that the policy of asset purchases had worked by reducing the amount of Treasury- and mortgage-backed securities available to investors (though no mention was made of the fact this also raised bond prices, push-ing them into other assets such as commercial bonds). The Fed chairman, however, acknowledged there are two risks with asset purchases: first, find-ing it hard to judge how much to buy and, second, that the sight of the Fed creating money to buy assets may unnerve the public and cause them to expect more inflation in the future.

Of course, not only the public, but also the whole financial market will be unnerved. Economists, financial experts and investors question the Bernanke Fed’s judgment of superleveraging the central bank’s balance sheet – and most particularly the fact of continuing doing so for what the market perceives as uncertain benefits.

Boosting from $2 trillion to $4 trillion to $6 trillion, with whatever ‘ benefits’, is outweighed by the costs and risks of doing so, commented an article in the Financial Times.19 To his critics, Bernanke lost the Fed’s independence by having the central banks policies follow politics – which should have never been the case.

Critics moreover suggest that Bernanke will not be remembered as a great chairman if he rescues the economy from a financial crisis, only for it to suf-fer lost decades due to Japanification. A senior executive’s legacy is, indeed, the quality and endurance of the structures he leaves behind.

The pros say that Ben Bernanke was obliged to do what he did because he did not want to be the Fed chairman who let the economy deteriorate – and, in addition, his options have been very limited. He could promise to keep rates close to zero for longer than the market expects; but then his hands would be tied if he wanted to raise rates within that period if inflation sud-denly rose.

Alternatively, always according to the pros, he could raise the Fed’s long-term goal for inflation above levels consistent with price stability. But this


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could make sense only if a prolonged period of deflation greatly weakened public confidence in the ability of the central bank to achieve price stability.

Another course might have been to cut the interest the Fed pays on reserves deposited with it by commercial banks towards zero (from 0.25 per cent), in order to encourage them to lend more. In regard to this option, the pros say the effects would be small while what is really needed is central bank action capable of calming the market’s concerns over both the likeli-hood of deflation and sovereign debt, as well as market uncertainty (caused first, by banking, then by the sovereign debt crisis, which is far from over).

These twin problems are as challenging as squaring the circle, but the argument they make works both ways. Until an effective and convincing policy is found, the central bank’s independence is compromised by the pol-iticians’ relentless push to continue flooding the market with liquidity. At the same time, however, it is an illusion to think that a monetary authority would continue to be independent when public trust in it has been lost.

Correlation risk: Greece/Bear Stearns and X/Lehman

An unavoidable presence in the mind of central bankers, government offi-cials and economists at the 2010 Jackson Hole Symposium has been the wall of credibility sovereigns have to climb to avoid repeating the Greek scenario of earlier that same year. Or, more precisely, the possible correlation between Bear Stearns, the American investment bank, and sovereign Greece. History knows that economic and financial weakness is provocative; as exposure to amassed liabilities gets bigger and bigger, there comes a time when debt is no longer sustainable.

The exceptional measures taken by the Greek government in the second quarter of 2010 to redress a situation which had gotten out of control are discussed in (Chapter 9). In retrospect, there are two ways of looking at them and their consequences: first, that the sovereign acted under pres-sure, and as a condition for the multibillion dollar loan; second, that the was actions were most courageous, presenting the only way left to save the country from Japanification.

When the Greek crisis broke, in January 2010, an opinion often heard among economists and financial analysts was that Greece was like the Bear Stearns of sovereigns. So far, there has been no evidence to refute such hypothesis. To the contrary, several knowledgeable people now think that, over the next few years, the world could see another country or two, much bigger than Greece, going the same way (Chapter 13). That will evidently cause significant concerns and a massive flight to financial safety. Even the likelihood of a Greek bankruptcy has caused a minor earthquake in euroland, with the euro sinking against the dollar, although the country’s economy is just a small part of the European Union. What is disquieting is the potential parallel to Bear Stearns. Analysts noted that, when the



American investment bank imploded in the spring of 2008, it also repre-sented a small part of the US financial system as a whole. But, its impact went well beyond its size; with Lehman’s bankruptcy immediately followed by the fall of AIG,20 Bear’s downfall reached potentially global dimensions. The root of this knock-on effect lay in the fact that Bear Stearns was linked with a web of other financial entities, through a complex network of deal-ings and interdependences.

Therefore, the ripple effect from Bear’s implosion was significant, scaring regulators and investors – with investors rushing through the exit door. The fear that a Greek bankruptcy might lead to that of a sovereign the size of Lehman Brothers in investment banking became pervasive. There has been speculation that a Greek bankruptcy may take along with it euroland’s Club Med or one of the world’s larger economies.

‘Club Med Plus’ is the more likely emulation of Lehman Brothers. If all of them fall down the precipice at once – Portugal, Spain, Italy and (why not) Finland – this will be the proverbial sword of Damocles for the global economy. Like Ireland, Finland has been seen as one of euroland’s go-go economies, but what is often forgotten is that it has gone through a severe economic winter after the fall of the Soviet Union.

Much of Finland’s resurgence was due to the strength of a couple of its global companies, foremost among them Nokia. But on February 9, 2011, a leaked memo by Nokia’s chief executive delivered a blunt assessment of its predicament, likening it to a man standing on a platform on fire, torn between burning alive and jumping into icy waters.21

The nightmare scenario of sovereigns at the edge is magnified by the big global banks’ continuing misfortunes. French and German banks (among others) will be badly damaged by a Greek, Irish or other bankruptcy, which explains why euroland’s governments thought that a huge package to shore up Greek and Irish financial defenses was urgently needed to reassure the markets. A political commentator in France put it in this way: ‘Sarkozy has two options: put up billions to shore up Greece, and never see them again. Or do nothing, and come up with billions to save from bankruptcy the big French banks22 – money he will not see again either.’23

Merkel was confronted with the same predicament. In addition, euro-land’s governments had good reason to be afraid of psychological effects. By an interesting coincidence, in early May 2010, Jimmy Cayne, the former chief executive of Bear Stearns, told a US financial crisis inquiry commis-sion that the blame for his bank’s bankruptcy lay with the market’s loss of confidence. Cayne blamed market rumors for the demise of his investment bank in 200824 – the event which started the dramatic phase in the deep financial and economic crisis.

Several companies who had made investments in Greece, particularly those who gave loans to the government and its agencies, started counting their beans. At end of July 2010, Munich Re, the giant German reinsurer,


Japanification 77

said that it held a2.1 billion ($2.8 billion) of Greek debt, but that was only 1 per cent of its asset portfolio; hence such a loss was affordable.

That sort of counting makes sense. An exposure at 1 per cent of assets is, indeed, an affordable level, provided that one has made a good return on it and that similar conditions don’t prevail with chunks of the other 99 per cent of the investor’s or entity’s portfolio. (Warren Buffet practiced this 1 per cent exposure rule when, with American Re, he reinsured policies protecting against earthquakes in California. In his words, if worst comes to worst, Berkshire could easily afford 1 per cent damage, profiting in the meantime from a hefty income from reinsurance.)

Other financial services companies, however, had not done their home-work as Munich Re had and, therefore, their exposure to a Greek bankruptcy was substantial. Boardrooms were shaken because they knew full well that euroland’s billion, matched by IMF funds (Chapter 9), might prove inad-equate. They were not the ‘nuclear option’ – the last big weapon in the armory of euroland’s sovereigns – though they proved good enough to keep the markets quiet. George Soros, Paolo Pellegrini and John Paulson, the three hedge fund managers who hoped to become trillionaires by shorting Greece, thought it safer not to challenged the package – at least for the time being. Instead, they probably lost money, as evidenced by the fact that, in late August 2010, Pellegrini closed down his fund, returning investors’ money.

Having said this, however, both euroland’s sovereigns and the European Central Bank continue to be concerned about a rekindling of the debt figures as well as the contagion of the banking sector, carefully watching spreads in credit default swaps (CDSs). The CDS spreads of the eight banks with the most exposure to Greece – BNP Paribas, Barclays, Crédit Agricole, Deutsche Bank, Dexia, Fortis, ING and Société Générale – rose to year highs at the peak of the Greek crisis.

The likelihood of a Greece/Bear Stearns correlation in financial woes should always be seen in the context of globalization. While the aforemen-tioned banks could still access inter-bank markets, the fact that CDS spreads widened alarmed investors and made them sell more peripheral euroland government bonds. Concomitant to this, financial analysts reminded their audience that, while Bear Stearns heralded the descent of investment banks into the abyss, the big drama came with the bankruptcy of Lehman Brothers,25 and that’s why the spread of sovereign risk after Greece is a mat-ter to watch most carefully.

Surprisingly enough, Lehman and many of the sovereigns who are thought to be on the sick list share another curious distinction. Their accounts are in a state of disorder and it is difficult to get a reliable picture of assets and liabilities. ‘Lehman’s derivatives records were a mess,’ Barclays Bank’s repre-sentative said on August 30, 2010 in an ongoing US trial.26

At the time these words were spoken, nobody was really certain which one of the big economies might be cast into the role of Lehman Brothers.



But several hypotheses were heard and, if this happens, the bigger sover-eign’s insolvency will severely aggravate the global economic picture – well beyond tensions in the money market and the inter-bank market.

Uncertainty about the extent of sovereign liquidity and capital shortages greatly amplifies the importance being attached to credit risk in the inter-national financial market. In Lehman’s case, commercial banks and other financial institutions responded by clearly reducing longer-term lending in the inter-bank market in a wave of risk aversion, which meant that:

maturing loans were not easily rolled over,there were new interest rate highs for unsecured longer-term money mar-ket transactions, andthe impairing of the inter-bank money market redistribution mechanism for funds obliged governments to act as lenders of last resort by getting deeper in debt.

Though the name of ‘X’, the country which might play Lehman Brothers’ role in an emulation of the Greece/Bear Stearns sequel, is not exactly known, guesses about ‘X’ abound. The same is true of hypotheses regarding the trigger for such a mega-event.

The editorial to the October issue of Research Monthly, by Crédit Suisse, put it in these terms:

Today, the nuclear weapon of the United States is protectionism, and China’s equivalent is the ability to sell its vast holdings of US government debt. Large-scale use of these weapons would trigger a global depression in which both sides would be major losers, so they don’t get used … But … markets may suffer a bout of panic over the seemingly inexorable expansion of US public debt.27

Anecdotal evidence suggests that, at G-20 gatherings of ministers of finance and central bankers, the prevailing psychology resembles that of board-rooms of financial institutions – particularly those uncertain about their own liquidity requirements and concerned that they will not receive suf-ficient liquidity from central banks, or from the market, at affordable rates.

The nervousness prevailing among debtors – whether sovereigns or credit institutions – significantly increases the spread between the bid rate on main refinancing operations and the marginal allotment rate. With sover-eigns, the market differentiates between creditors and debtors. Those with ambitious funding schedules, as well as those that have to make significant improvement in their balance sheet but fail to do so, are penalized. There is a parallel in what happens today with well-known entities, and it does not matter if they are banks or sovereigns.

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5Conventional and Unconventional Weapons in a Central Bank’s Arsenal

Souk means both market and chaos

Souk is an Arab word with a double meaning: it means market; but also con-fusion, chaos, instability. Inherent to this second definition are a significant number of unknown factors and doubtful outcomes – which evidently rep-resent risk; and they can reach critical proportions when market confidence wanes which, quite evidently, does not happen just by accident.

Like any other scientific discipline based on or reflecting scientific princi-ples, chaos theory1 teaches that there is always cause and effect (Chapter 1). The cause might be much smaller than the effect, and we can usually (but not always) identify the cause. A frequent reason for souk in the market is the blowing up of a bubble. Financial bubbles build up when prices get way above the fair value of assets and, typically, this happens because of exuber-ance, greed and the rush for quick profits.

The American subprime bubble was, in large measure, due to interest rates being kept too low for too long by the Fed, supposedly to aid recovery from the dotcom crash of year 2000. Cheap money awakened the never-sleeping lust of big business dealers and their accompanying ultra-sized bonuses.

Greed and low interest rates were also the cause of the dotcom bubble. Excessive interest rate cuts between 1997 and 1999 to counter the Asian crisis of 1997, as well as the Russian crisis and LTCM meltdown of August/September 1998, were the causes of a rush by speculators and investors to the new Eldorado – and we know the results: a bubble based on debt which wrecked the stock market.

This is exactly the kind of thing no economy needs, and it is most surprising that sovereigns changed clothes – from regulators to speculators – condoning (and even creating) situations which they knew were wrong. Here is another example. In its late 2010 ‘Global Financial Stability Report’, the IMF notes that some 24 per cent of Japanese banks’ assets consist of government bonds. In addition, Japan borrows inordinately through short-term debt. If creditors suddenly lose confidence in government debt, the



result could be a global systemic banking crisis, as well as a deep funding crisis for the Japanese government, ravaging the country’s economy.

This is souk at its best. While, in the last analysis, even the most careful debt management cannot stop a country’s solvency coming into question if its deficits keep rising, as Ireland has been recently finding with investors deserting its bonds, conveying the message that going downhill is not an option can have invaluable results.

Too much debt and frequent bubbles are the right recipe for sorrows. Economists who care for the proper functioning of the economy and of the financial system maintain that central banks and governments must inter-vene to prick asset-price bubbles. Bubbles are easy to pinpoint in hindsight, but highly-paid individuals who have the responsibility of watching over the health of the economy are expected both to exercise foresight and have the courage to identify them as they arise, then taking action to deflate them when they are still of manageable proportions. There is no excuse for the fact that the chairman of the Fed, or governor of any other central bank, is not more knowledgeable and better informed than the speculators and any other market player. Short of having foresight and decision-making expertise, central bank governors are part of the souk.

It would be most interesting to know how Ben Bernanke, who missed the housing bubble of 2004–07, or his predecessor, who perhaps inadvertently created the stock market bubble of 2000, feel about their inability to bend the curve of such economically destructive events which have taken place under their watch. Critics say that Greenspan and Bernanke not only failed as guardians, they were also at the origin of both big bubbles.

Having made the same mistake twice in a row within less than a decade (the first being the 2004 debt instruments bubble), Alan Greenspan and his monetary policy advisors created the souk. Then Bernanke repeated the same mistake. Since late 2007, interest rates have been kept ultra-low, supposedly to counter the aftermath of the credit crisis – without studying the negative effects. It is no wonder, therefore, that another bubble is brewing up, even if it is the remit of monetary policy-makers to try to avoid the causes creating bubbles and it is the mission of regulators to take timely action to stop bankers, investors and speculators from exploiting (and inflating) a nascent bubble.

In an interview he gave to CNN on April 9, 2010, George Soros said: ‘When I see a bubble I join it, because that’s how I make my money.’ But then he added that regulators should act in exactly the opposite way – deflating the bubble before it booms and busts. Otherwise, they are not performing their duties.

Soros rejected the usual excuse by Alan Greenspan, Ben Bernanke and the US regulators that they did not see the bubbles coming. Instead, he pointed out that if he could see the bubble then they, too, could see the bubble. (Notice also that Dr Paul Volcker, the respected former chairman of the Fed,


Conventional and Unconventional Weapons 81

saw the coming bubble, but Greenspan and Bernanke, who were in charge, didn’t.)

A similar argument is valid for commercial and investment bankers. Why did the West’s top bankers, considered to be masters of such an astute indus-try, not see the bubble created by their wheeling/dealing and their trades? Particularly in the United States such questions are daunting, because there is the added fact that, even after the economic and financial cataclysm, existing laws have not been applied.

Most precisely, the Sarbanes–Oxley (SOX) Act of 2002, enacted in the aftermath of the Enron and WorldCom scams, was mothballed by the Bush Administration and its regulators. Reportedly, the top brass of Lehman Brothers misrepresented the sum of $50 billion in the bank’s annual finan-cial accounts. According to SOX provisions, Lehman’s CEO and CFO were first in line of responsibility, but the fact is that none of them was brought to justice.

It does not need explaining that, both for reasons of effectiveness and of moral hazard, timely and decisive action by regulatory authorities is at a premium. Bursting bubbles presents a major risk to the economy. It is no secret that all asset-price bubbles are inflated with easy credit, and when that happens souk is the next stop.

Every major market collapse, like that of 2007–11, poses a serious sys-temic risk. It also brings the economy into a perilous state, which further discourages central bankers from exercising control. The cost of a souk is high. Beyond the waste of public money, bursting bubbles damage the balance sheets of states, companies and households, creating plenty of victims.

Because sovereigns and their regulators don’t do their job, taxpayers are asked to underwrite the speculators’ excesses. At the same time, these same taxpayers face foreclosure on their houses, lose their jobs, suffer a depletion of their savings and often see their pensions evaporate. The problem for economists who know enough to worry, is that, simultaneously, asset valu-ations are too high by historic standards and a combination of high asset prices, low interest rates and massive fiscal deficits is a prescription for trouble.

As if to support the thesis that central banks lack political independence, in recent years few monetary policy executives have given proof that they know how to be ahead of brewing trouble. South Korean central bankers, for example, have been too slow to grapple with the need to act in a timely manner against excessive asset-price movements. (The problem originated in Seoul, where, in some districts, house prices have been near or at record highs.)

Sound management would do what it takes to change this unaccept-able state of affairs. In late 2009, Lee Seong-tae, the governor of the Bank of Korea, said that the central bank would have to be increasingly alert to



the risk of speculative bubbles. At a conference in late 2009, he expressed his thoughts thus: ‘We must exercise greater vigilance over asset-price movements than we did in the past.’ But then he added: ‘I don’t think the central bank can accomplish price stability by itself.’2 In a way this is true. The whole government machinery must work in synergy.

Black swans and the need for a new economic theory

The essence of what is called a ‘black swan’ is that its occurrence calls every-thing else into question. This is generally considered to be an extraordinary outlier; an ‘unknown unknown’, to use Donald Rumsfeld’s definition. Examples include the crises which demolished several of the better-known big banks and other financial conglomerates – events that shook the global financial system, as well as the slide towards bankruptcy of Greece, which hit the euro, and the subprime crisis, which unraveled the trust placed on securitization as well as on the dependability of independent rating agencies.

Theoretically at least, one of the characteristics of financial markets over recent years is that of starting to accommodate extreme events. The practical challenge is that events which, in earlier times, were considered as rare outliers are now occurring much more frequently, beyond the margins of probability models. This leads to the assumption that finance is becom-ing more fragile. Markets and their complex instruments are prone to an unpredictable randomness and black swans are showing up in the economic landscape with much greater likelihood than originally suggested.

This change in the frequency of causes, as well as amplitude of effects, is very important because, nowadays, finance is leveraged and major upsets, even rare ones, are more significant than the sum of several smaller and better understood ‘classical meltdowns’. Examples of such higher- magnitude events include the stock market crash of 1987; Japan’s descent into the abyss of 1990–01; the interest-rate turmoil of 1994; the East Asian economic earth-quake of 1997; Russia’s bankruptcy and LTCM near-bankruptcy of 1998; the stock market crash of 2000; the 2007–11 deep economic and banking crisis.

In the short time of slightly over two decades there have been eight spikes in the long leg of the risk distribution – black swans. By all evidence, the old economic theories, with which we are still living, no longer hold water. Newly established extreme conditions may not be ‘extreme’ after all but part of the new normal – turning on their heads many of the principles of traditional economic thinking.

A new, up-to-date economic theory is needed to incorporate and reflect on risks associated with domesticated black swans, including the risks and opportunities they may bring to financial markets. Most definitely, this should also incorporate the after-effects of globalization and the rapid financial instruments innovation promoted by high technology. According



to a growing body of opinion, both the souk of globalization and the novelty, as well as opaqueness, of new financial tools contributed most significantly to the magnitude of the 2007–11 crisis. Working in unison, these three forces – domesticated swans, globalization and novelty of financials – had an unprecedented impact. While the bubble was punctured by the US subprime crisis, casino capitalism and the internationalization of interdependent financial services spread the souk worldwide, and this fed back into real economies which, geographically, are far away from one another.

In the aftermath, the rules of the game have changed. As an example of what used to be regarded as ‘normal’, diversification across multiple asset classes is today of little help. One has to be prepared for the worst all the way, including having financial staying power (own capital and liquidity) and a holistic, knowledge engineering-enriched and fine-tuned risk control system, with no sacred cows in its way. Put differently the socialization of black swans is changing the patterns of risks. Therefore, the way financial entities manage exposure should also change.3 Before the 2007–11 crisis, bankers, investors and regulators looked at exposure as a rather exogenous factor to be tackled case by case. The events which followed have shown that they now have to turn their attention to risks originating from within the enterprise and the system, being, to a significant extent, amplified by correlations which, in the past, were largely unexpected.

According to expert opinion, beyond leverage, novelty and complexity, the homogeneity of formerly diverse instruments and markets has cre-ated new financial dynamics. Banks, insurance firms, hedge funds, pen-sion funds, endowments and other financial entities, as well as individual investors, have been structuring their portfolios in a way that promotes concentration, not diversification. Therefore, risk, too, gets concentrated.

Individually and in unison, a bewildering array of entities, supposedly with diverse objectives, bought a befuddled array of structured debt securities. They did so hoping to kill two birds with one well-placed stone: fat profits (hence, bonuses) and diversification. The ingredients, however, were very similar – leveraged loans as well as subprimes and other mortgages: from each individual firm’s perspective this looked smart, but for the system as a whole it put everyone’s eggs in practically the same basket – and the eggs became scrambled.

Poor governance at sovereign and corporate levels further contributed to the frequency of black swans’ appearance, and to deepening of the crisis. Both during the inflation of the bubble and after it burst, risk management was reliant on poor models, together with lack of due diligence by bank supervisors, the banks themselves and investors. Also, there has been aston-ishing ignorance of the fundamentals, greed for money and poor incentiv-izing of remuneration.

Greater exposure ruled the day, leaving the common citizen’s finances in poor shape. In the United States, for example, private sector debt alone



rose from 50 per cent of GDP in 1950 to nearly 300 per cent at its 2008–09 peak, accounting for huge changes in family attitudes and in society at large. A century ago in America, defaulting borrowers were sent to prison and the generation that lived through the First Great Depression learned to save. However, the wide diffusion of credit cards in the 1960s and 1970s created a spending society; default became a lifestyle choice rather than shame, with a culture of reckless lenders and imprudent debtors.

This is another reason why a new economic theory is necessary at all levels of society: private, corporate and sovereign. Its goal should not only be positioning risk and opportunity against unexpected consequences of leveraging, globalization and novelty in financial instruments; it should tackle also the avoidance of moral risk – which evidently requires an upgrade of ethics.

The aftermath of obsolete, worn-out economic theories and methods has been the unprecedented indebtedness of western sovereigns and their economies. According to conservative estimates, overall write-downs in the US alone amounted to $1.5 trillion, or 11 per cent of GDP – much of it covered by taxpayers’ money. In 2008 (latest available statistics) the cost in euroland was about 18 per cent of GDP. Continuing on the same path is the worst possible solution. The new economic theory should:

internalize systemic risk,provide the basis for contingency planning, andguarantee a framework for solvent asset transfers from wrongdoers to the lender(s) of last resort.4

Anything short of this promotes moral hazard. Crisis resolution, too, should be revamped to include mechanisms for loss absorption like shareholder dilution, as well as ways and means for taking hold of cross-border chal-lenges.5 Given its novelty and the fact it can lead to cross-border con-troversies, such a plan should be tested with set-out actions aimed at guaranteeing that it can handle even the most complex financial groups, their global operations and disposition of their assets – anywhere, at any time.

Price stability and the central bank

The charter of the European Central Bank specifies that its first and foremost mission is price stability. In America, the Federal Reserve Act of 1913 gave the central bank a dual objective: price stability and high employment. These two goals are evidently contradictory to one another. Inflation of credit is a frequently used but uncertain way to promote employment, but it is the opposite of what is needed for economic and financial stability, eventually landing on the shores of greater trouble.

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An orderly credit system helps households, companies and the economy at large.6 It also implies that, in the longer run, people, businesses and gov-ernments have to live within their means, rather than being continuously strapped for cash. To fulfill its mission of price stability, the central bank must be able to control inflation in parallel with its efforts to avoid financial booms and busts.

The Monthly Bulletin of the European Central Bank explained the mon-etary policy decisions reached by its governing body in connection to the 2007–11 deep economic crisis:

Empirical evidence clearly suggests that monetary policy regimes oriented towards the maintenance of price stability contribute to stable macroeconomic environments. By firmly anchoring inflation expecta-tions … [they] help to reduce both inflation volatility and macroeconomic uncertainty, thus improving the resilience of the economy to adverse shocks … [This] is clearly demonstrated through a comparison of the macroeconomic performance of most advanced countries during the Great Inflation of the 1970s and that of recent years.7

Economies which wrongly label themselves as ‘Keynesian’ argue that exactly the opposite policy is the best way for getting out of the current mess. They justify their position as being singularly able to avoid deflation. Other economists, however, maintain that the determination by some central banks to avoid deflation could result in galloping inflation (Chapter 7).

The Fed’s pledge to keep interest rates low for ‘an extended period’ suggests that it thinks the US economy will remain underemployed for that extended period. This is simply pessimism and, if it spreads, it may become a self-fulfilling prophecy. It is exactly the policy which led to Japanification (Chapter 4). The Bank of Japan, over the last 20 years, and the Fed, in last three years, could cut rates to practically zero, and did not raise them because inflation was rather low. Just like the Bank of Japan, however, the Federal Reserve prolonged the slump, sowing the seeds of the next crisis at the same time.

Theoretically, low interest rates are helping the economy mobilize its resources; practically, they are misallocating them by generating excessive growth in sectors that rely on either fixed-asset investment or credit. There is plenty of evidence that years of loose monetary policy have unwelcome side effects and critics suggest that policy-makers should look for antidotes to stagnation beyond macroeconomics.

The Bank for International Settlements and Organisation for Economic Co-operation and Development (OECD) have warned that a prolonged period of ultra-low interest rates risks, resurgent risk-taking and inflation is the worst scenario possible. Having unwisely misused the monetary policy tools at their disposal by keeping no dry powder, central bankers in the



West now see themselves as committed to significantly extending their easy monetary policy and expanding their balance sheet, which is already over-blown.

Interest rate decisions are at the core of monetary policy-makers’ respon-sibilities – particularly short-term rates. The interest rates reflected by the yield curve8 for a period ranging from five to ten and up to 30 years down the line are practically set by the market. The central bank decides the current interest rates, which gives it the ability to regulate the process of credit and the means for determining the velocity of circulation of money, hence how much flows through the economy.9

Other things being equal, when the quantity of money circulating dou-bles, the result will be that of doubling prices. Admittedly, ‘other things’ may not be equal because; for instance, financial conditions may be awful and the economy subdued. But when this veil lifts, inflation comes at its heels. Excess liquidity strikes back (see below). At end of the first quarter of 2010, a Merrill Lynch report put it in these terms: ‘Central bankers cannot be generous forever.’

Investors know this and they carefully watch for signs of a policy change, as well as the behavior of the yield curve implied by the market, which tends to be quite a good economic indicator. Investors also demand a higher yield on longer-dated bonds, to compensate them for tying up their money for longer. This is inverted in the case of ‘backwardization’, but it does not often happen that there are periods when the yield curve is inverted with short rates above long ones.

Backwardization often occurs when the central bank raises short rates to slow the economy and head off inflation. Hence, it is an early warning of the probability of a recession.

Plenty of evidence suggests that central banks are not so successful in fighting inflation, partly because of political pressures and partly because their tools are imperfect. This sees to it that inflation has persistence, defined as its tendency to deviate from a long-term equilibrium in prices rather than quickly reverting to it.

The fight against inflation is at its worse when the policy of the central bank is adjusted to head off a recession. When a loose monetary policy is in place for a long period, such as the latter half of the twentieth century and nowadays, price stability takes leave while inflation emerges and re-emerges as a threat scenario.

Ultra-low interest rates kept over a longer term and other sorts of mon-etary stimulus engineered by sovereigns by no means offer a free lunch. On September 29, 2010 rising expectations that at least some western central banks would step up monetary stimulus to support fragile economies drove the dollar to a five-month low against the euro.

Mounting speculation suggests that the Federal Reserve will engage in another round of quantitative easing (QE, see below) by buying up bonds



and other assets to throw new cash into the economy. ‘The dollar currently is in a lose–lose situation, where if US data is disappointing it increases the prospects of Fed easing and that weighs on US rates and the dollar,’ said Brian Dolan of Forew.com10

Opponents of the need for maintenance of price stability say that a tightening of monetary policy would result in higher lending rates, reducing the demand for loans from firms and households and leading to lower aggregate demand. This is not a monetary policy but a political argument – and the risk to the economy because of brewing inflation lies precisely in this conflict of interest. The ability of, and incentives for, commercial and retail banks to supply loans through the credit channel is composed of two parts: bank lending, with monetary policy rates affecting the liability side of credit institutions’ balance sheets; and monetary policy transmission, which essentially affects changes to the quality of borrowers, principally in terms of their creditworthiness.

Interest rates aside, other monetary policy instruments used by central banks include main refinancing operations, longer-term financing, deposit facilities, marginal lending facilities, discounting of commercial paper, repur-chase agreements (repos), swaps, absorbing operations and more. Through an array of tools, a sane monetary policy aims to do all that is needed to maintain financial and price stability over the medium to longer term.

This is not to deny that, in the shorter term, certain non-standard meas-ures need to be taken during a period of acute financial market tensions (see below). Referred to as ‘enhanced credit support’, these ensure that monetary policy accommodates an overall provision of liquidity – which, if extended over longer time, might become a liquidity wall (see below).

Therefore, central bankers who want to be ahead of the curve try to forecast inflation, which should be done in a pragmatic way, free of bias. It is utterly wrong to take inflationary effects lightly.11 This is the wrong approach and it is illustrated by the fact that, over the twentieth century, the US dollar lost about 95 per cent of its spending power as a result of inflation.

In fact, there is no better answer to the different ‘inflation is good for you’ arguments than the one John Maynard Keynes (then at the British Treasury) gave to David Lloyd George, then Chancellor of the Exchequer (minister of finance) and shortly thereafter prime minister: ‘With the utmost respect, I must, if asked my opinion, tell you that I regard your account as rubbish.’12

The wall of liquidity

In the opinion of economist Nouriel Roubini, a new financial crisis is brew-ing because of persistent excessive liquidity. This has taken its strength from the 2008–09 anti-crisis measures by western central banks and governments, which put huge amounts of newly minted money into the market – though



without reaping the beneficial effects they expected from having the print-ing presses work overtime. That money was supposed to pull the big banks out of the abyss and, at the same time, relaunch the western economies. But the appropriate homework was not done and the necessary rules were not put in place, which allowed bankers and speculators to take on crazy risks.

The result should not have been unexpected. It came in the form of a new financial bubble-in-the-making which will not take long to explode. The wall of liquidity did not solve the market’s confidence problem. If anything, it made it worse because:

banks have over a trillion dollars in excess reserves, companies have plenty of cash and easy access to capital markets, andinterest rates are extremely low for most borrowers.

Still, there is a notable lack of confidence (not a lack of liquidity), which seems to be the main problem holding back the western economies – and most particularly that of the USA. It looks as if there is a bad set of policy options for the Fed. According to a growing body of economists, current Fed policy may cause a bubble in the credit markets. The market is hot, with bond, equity and gold prices rising at the same time. This flooding of the market with newly minted money through quantitative easing has come over and above the policy of very low interest rates, a more classical way of central bank intervention. Critics press the point that the real costs of over-swamping interest rates – at the zero to 1 per cent range – are overlooked, and the same is true of the wall of a vast liquidity’s after-effects.

Those economists who believe that western monetary policy is misguided, challenge the view of Ben Bernanke, Mervyn King and other central bank-ers that nobody gets hurt by a runaway monetary policy. Among other authorities who think that enough is enough is the Bank for International Settlements (BIS). In its 80th Annual Report, it asks whether the hidden costs of low interest rates might be greater than the visible benefits, and identifies several dangers from too low interest rates, including excessive risk-taking by market participants.

BIS says that keeping interest rates low comes at a cost that is growing with time, and it gives as an example lopsided balance sheets, distorted allocation of labor and capital, as well as destabilizing surges in capital flows. It also suggests that pumping more money into the economy increases inflation expectations. For instance, in Britain inflation has been above the government’s 2 per cent target for most of the past four years.

Injecting a great deal of liquidity for liquidity’s sake is also counterproductive for another reason: social commitments. It is projected that by 2050 several western countries will be devoting more than 30 per cent of their GDP to age-related spending (the median western country will be spending 27 per cent of GDP), while state expenditures altogether will absorb around 70 per cent

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of GDP. That’s very bad news. To avoid an era of ‘new communism’, western countries will have to choose between two forms of default: breaking their promises to their creditors by default, or breaking their promises to their pen-sioners and the growing army of citizens benefiting from free health care.

Theoretically, bankers might come to the rescue by inventing new and unconventional financial instruments, just as Goldman Sachs allegedly used to help Greece (over several years) to hide its galloping budget deficits. Practically, the events of the first decade of this century make it highly ques-tionable whether this is a welcome strategy. Finding buyers for ‘novel’ and tricky financial products is not that difficult: what is difficult is being able to pay for their disastrous effects in the longer run.

In monetary and fiscal policy, longer-term sustainability is much more important than short-term effects. It should not be forgotten that, in the period 2002–04 which followed the great stock market bubble of 2000, low short-term interest rates were instrumental in boosting house prices, diverting capital and workers to house construction – as well as common citizens into property gambles, all the way into the subprimes and Alt-As folly.13 But the cocktail of subprimes, Alt-As, fake credit rating, loose lend-ing standards and huge bonuses brought about the 2007–11 economic hecatomb. As long as people and companies can gamble on easy credit, ample liquidity and low servicing costs, they will gamble in a big way. As long as banks can pretend that the principal and interest might one day be repaid, their balance sheet will remain muddy – the sort of thing found at the origin of Japanification (Chapter 4).

High liquidity and low rates keep zombie companies, mismanaged banks and other bankrupt entities alive at great expense to taxpayers and to the more efficient competitors. The damage can be global because, all things considered, the Federal Reserve, Bank of England and European Central Bank determine the world’s short-term interest rates and (particularly so the Fed) they flood the global market with money – while emerging countries’ central banks find themselves obliged to raise rates and try to cool their economies.

Raising rates encourages more speculative inflows of short-term money, creating a crazy financial merry-go-round in which industrial economies send capital elsewhere in search of higher yields. Critics of this state of affairs say that, when monetary conditions in the western countries are loose, the price is paid by the emerging countries, which become prone to asset bubbles.

Liquidity and leverage correlate with negative effects, and the same is true about credit quality and leverage. In the 1980s, according to Henry Kaufman, the corporate leveraging explosion was accompanied by a severe drop in corporate credit quality: ‘Among other things I believe that highly leveraged firms ran a good chance of reporting higher-than-normal losses during the cyclical downturn in the economy.’14

It is essentially against this background that current and potential misdirected monetary policies should be judged. To make matters worse,



central banks are by no means the only providers of excessive liquidity. The problem of too much money in search of speculative profits is compounded by the proliferation of short-term debt to support illiquid long-term assets. Much of it is issued by the highly-leveraged shadow banking system, an example being structured investment vehicles (SIVs) and, when markets freeze, the SIVs’ sponsoring entities, typically banks, find it difficult if not outright impossible to absorb their losses.15

Through their daily activities the commercial banks, too, contribute to the expansion of money supply: ‘There is no limit to the amount of money that can be created by the banking system,’ warned Marrinner Eccles, the Federal Reserve chairman in the Franklin Roosevelt years, ‘but there are limits to our productive facilities and our labor supply, which can only slowly be increased.’16

Quantitative easing

A jurisdiction’s money supply is affected in a most significant way by quantitative easing (QE), originally invented by a desperate Bank of Japan, which became the West’s misdirected risk and great novelty of the 2007–10 economic and financial crisis. QE became a policy the Federal Reserve and Bank of England chose as a way to make monetary policy effective after interest rates were already (unwisely) close to zero. Put simply, the central bank uses its prerogatives of money creation, as a monetary institution, and it floods the market with it, in the (often vain) hope that excess liquidity will make the economy move again, bankruptcies will be avoided and there will be manna from heaven.

It needs no explaining that these are hypotheses bordering on wild dreams. Moreover, QE is done without establishing a priori an exit strategy. Critics say that it is characterized by lack of confidence in one’s wisdom brought on by too much improvisation. Policy-makers enter a tunnel with-out ensuring the exit is clear – yet, how to get away from a beaten path is a basic principle in sound management. In technical terms, with QE the cen-tral bank uses newly created money to purchase assets, such as government bonds, and this new money makes a full circle, ending up as bank reserves at the central bank.

To appreciate the smoke and mirrors behind QE, let’s start with its inven-tion. While it is generally believed that the Federal Reserve and Bank of England have been the first to implement QE aggressively, in reality they did not discover it. Historically, QE was invented by the Bank of Japan between 2001 and 2006, when it massively boosted the reserves that commercial banks held in their vaults.

The results have been negligible, making many economists skeptical that the benefits Japan derived from QE offer a useful yardstick. Other economists, however, tend to like this policy of monetary merry-go-round



because of its effects on the money supply, which they consider to be beneficial at practically no cost – a misconception. Excess liquidity from the Fed may lighten asset prices, but it will also increase market volatility, and have other unexpected consequences.

Therefore, economists who carefully examined cause and effect are of the opinion that QE is a double-edged knife. It impacts on asset prices – government bonds, corporate bonds and municipals bought by the Fed – as well as on liquidity.17 But it also creates significant worries about inflationary money printing and the fact that too little attention is paid to the flow of credit – while not dealing with structural problems.

Critics say that, while QE policies might have propped up creaking bank-ing systems in Japan, America, Britain and euroland, they did not really improve the economy of these countries; neither did they change the pre-vailing mindset. They also add that, inflation expectation aside, QE does not reach the most damaged parts of the credit system. For instance, in the year to January 2010 lending to the private non-financial sector in Britain shrank by 2.7 per cent.

The pros answer that QE is a beautiful, flexible policy adaptable to the pre-vailing circumstances, therefore standing a good chance of being beneficial. Without much conviction, they give as examples Japan’s form of QE and the credit easing the Fed is engaged in, but more than anything else what they do is to quote other pros who have a conflict of interest: in January 2010, Ben Bernanke said that the Fed’s approach was focused on buying up loans and securities – hence on the asset side of its balance sheet.18

This fired up QE proponents, who looked at QE as a great innovation recommended by the high priest. Critics however point out that, to the contrary, Japan’s approach looked backwards, focused on the quantity of commercial and other banks reserves held at the central bank – therefore the liability side of its balance sheet.

The latter was the opinion of none other than Masaaki Shiratsuka, the governor of the Bank of Japan, who also sees striking similarities between these US and Japanese QE approaches, because the asset and liability sides of the central banks’ balance sheets interact so closely.19

QE is not the only financial tool to support this instant metamorphosis. Derivatives have the same effect on every bank’s and every other company’s balance sheet.

A middle ground between the critics and the pros is that the use of a central bank’s balance sheet to restore liquidity to financial markets simply buys time until banks restructure their own balance sheets (if they are able to do so). In a way, this is another form of bailout through public money – and the evidence available from Ireland, Britain, the USA and Japan is not very positive in terms of the outcome.20

In spite of central banks’ zero interest rates and QEs, western economies are hardly in good health. While sovereigns are overindebted, growth is still



heavily dependent on government stimulants. In addition, the experienced massive intervention in private markets by America’s and Britain’s central banks distorts those same markets and, the longer QE persists, the more such distortions become apparent.

That may explain why, in the early days of February 2010, the Bank of England decided to halt its program of QE; though by October 2010 it changed heart and said it would repeat it. But even with that February restraint, since March 2009 it had injected £200 billion ($320 billion) of newly minted money into the British economy by buying assets, mainly government bonds (gilts). As for the exit strategy, if there is one, it is wrapped in a thick veil which can be lifted only by answering four critical questions:

When should monetary and fiscal tightening begin?Is it more important to raise interest rates or to cut budget deficits?How will the bloated balance sheets of central banks return to normal conditions?Will a serious effort at cutting deficits boost business confidence?

While answers to these questions are pending, there is little doubt that central banks will have to re-establish their name in the market, and governments will have to practice real fiscal restraint. It is important to avoid QE’s negative effects – which were not properly studied when QE policies were adopted. This means that QE’s future path runs into dilemmas, some of which are akin to those associated with fiscal stimulus.

Governments inject large amounts of money into the economy by increasing the public debt by a certain amount. Central banks inject funds into the monetary system by purchasing assets such as mortgages and gov-ernment bonds. As far as future inflation pressures are concerned, the risk is high that the two processes may work in unison.

QE and competitive currency devaluations

Up to mid-2010, the pros and cons of QE mainly revolved around its merits and demerits, along the lines discussed in the previous section. Then, sud-denly, something significant changed: QE was recast as the modern tool for currency debasing.

Using the central banks’ power to devalue currency is a different ballgame, and understanding it requires political skills to appreciate decisions taken at top government level. In a globalized economy, many voices are raised to discourage this type of behavior, which can have the most severe unexpected consequences on world trade.

QE is, by all evidence, unable to get the economy moving again. Instead, what is happening is more debasing, followed by devaluing and depreciating the nation’s currency in the vain hope of making ends meet. As critics have

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it: debasing, devaluing and depreciating are the keywords in the mind of central bankers, who are printing money like there is no tomorrow, and call it QE. Debasing a country’s currency is synonymous with undertaking competitive devaluation to stimulate exports; this implies a beggar-thy-neighbor policy, precisely the sort of stuff which led to the First Great Depression (see above).

The pros argue that, with taxes at their highest and therefore with fiscal policy practically out of the picture, the entire burden of stimulating demand falls on the central bank and QE is the last weapon in its arsenal. For instance, after lowering short-term interest rates to zero in late 2008, the Fed bought $1.7 trillion-worth of Treasury and mortgage bonds with newly created money to release liquidity and bring down long-term rates (all that in the vain hope of reducing unemployment).

Debasing is engineered through competitive QE – a race: ‘I can print more money than you can.’ In all likelihood, what forced the Federal Reserve into another round of QE in November 2010 was not just the ‘growth recession’. GDP growth in the USA, while positive, was not strong enough to sustain jobs growth, which increasingly depends on decreasing exports, while imports continue to soar.

There has been plenty of talk of currency war, and this escalated as an IMF meeting of finance ministers and central bankers (partly aimed at soothing currency tensions) failed to deliver a resolution. The gap between the two main protagonists in the dispute, America and China, appeared as intractable as ever. America accused China of an artificially cheap yuan; China accused America of destabilizing developing countries’ economies by running a lax monetary policy.

Other countries, too, have been involved in this currency dispute, to the point that, on September 27, 2010, Guido Mantega, Brazil’s Finance Minister, declared that an international currency war had broken out.21 The fuzzy, and ill-documented, rhetoric about cooperation to boost global growth is old news. Nowadays, a more combative tone has taken hold with countries blaming each other for:

distorting global demand, using QE as a weapon for debasing, andpracticing currency intervention and capital controls.

The pros also argue that currency debasing is not a new practice, but an ancient one. It started in days of yore when governments would reduce the precious metal content of coins by shaving or adding cheap alloys. The result was that, like devalued money, the same coin was worth less in exchange for goods and services.

This awkward justification of sovereign monetary policy malpractices forgets that after debasing came galloping inflation, often followed by bankruptcy and a wide financial crisis. There is no better example than the

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downfall of the French Banque Royale and the Mississippi Bubble of 1720, engineered by the policies of John Law. Misdirected, short-term measures can have long-term negative results.

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With the complexity of global as well as national economic and financial challenges continuing to increase, half-baked measures are no solution. The need for overhauling economics as a discipline is becoming increas-ingly evident. Several people argue, with plenty of reason, that much of the research in macroeconomics and finance has been of little value, and part of it was even counterproductive – essentially limited to stereotypes like ‘Keynes said that …’.

John Maynard Keynes was a great mind, and his legacy rests on the fact that he was a challenger of the status quo in the economics of his time. To the contrary, today’s self-named ‘Keynesians’ are the status quo – which, far from being eliminated by the crisis, has spread wider now than prior to 2007.

The macroeconomists who dominate leading universities, ministries of finance and central banks are theorists with a troubling lack of real-life experience. This puts them, and their approaches, in stark contrast to industrial economists and investment analysts, who work close to businesses and know what makes them tick. Other theorists, at the height of absurdity, claim that ‘markets are always right,’ or ‘they will automatically correct their own errors’. Stereotypes of many sorts have led to fallacious assumptions about conflicting solutions, such as:

deficit financing, rational expectations, efficient markets, and misplaced certainties about ‘this’ or ‘that’.

The deep economic and financial crisis we are going through also has proven that the modeling craze must come to an end. Plenty of mathematical models are written either by people who know math but understand nothing about economics and business, or by economists whose mathematical skills are wanting at best. In this misdirected risk lies the fact that, for reasons of mod-ernizing (and of tenure), for over 30 years all serious economic ideas had to be expressed in equations, not by means of well-structured cause-and-effect relationships backed up by real-life events.

‘Bad banks’, the Volcker rule and living wills

Bad banks are entities set up and backed by governments to facilitate the removal of ‘bad assets’ from their balance sheets. ‘Bad assets’ are loosely

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defined as those that are at risk of severe impairment; are difficult to value; or, when valued, are worth very little in comparison with their purchase price. Among other reasons, bad banks are created to:

assist in the resolution of a financial crisis, permit refloating of the damaged bank by relieving it of its worst ‘assets’, including holdings and non-performing loans, andtry to recover the most of what may be seen as lost money, by avoiding a fire sale of those damaged ‘assets’.

Whether or not, and how well, these aims will be reached depends a great deal on the nature of these ‘bad assets’ and the quality of management at the bad bank level. Professionalism is a plus. The eldest such entity on record has been Securum,22 engineered by the Swedish government, which put in charge people capable of restructuring loans, and negotiating the sale of holdings and participations.

However, though Securum is the first practical example, the concept underpinning a bad bank preceded it by a few years. It first arose in 1988, when the Mellon Bank spun off its energy and property loans, which had turned sour, into Grant Street National Bank, financed with junk bonds and private equity.

As the Mellon, Securum and present-day derelict bad banks demonstrate, this whole idea is quite flexible, and it can be given different interpreta-tions at different times by different people. Economist Josef Stiglitz criticizes the ‘bad bank’ idea as ‘swapping cash for trash’, but the pros say such an approach has advantages: first, management can focus on the job of recov-ering the fair value of damaged assets; and, second, taking toxic assets off the balance sheet of banks teetering on bankruptcy leaves behind a cleaner credit institution, which should find it easier to raise capital or attract a buyer.

Finding a buyer at fair value price is a pipe dream, but the real problem with bad banks is that, as usual, the taxpayer will be asked to foot the bill. Someone has to pay for the assets transferred by the damaged bank to a new equity, or to a buyer, at deep discount.

Simply stated, the transfer of big chunks of a loan portfolio (specifically non-performing loans and similar ‘assets’) from a credit institution to a specially set up vehicle will take the form of the former selling them to the government, or its agent, at large discount. Superficially, this is similar to a securitization transaction but in reality it is not, as it raises the questions of proper classification, reasonable valuation and treatment of transferred assets.

Because write-downs are not considered financial transactions, the result will be a decline in the volume of outstanding loans of the pruned bank which exceeds the recorded flow. At the same time, the impact of the

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write- down will be reflected in a decline in the stock of capital and reserves. Moreover, it may be required, for reasons of financial analysis of assets and liabilities, to treat the impact of such transactions in a way similar to corrections for derecognition of loans.

The positive side of this issue is that, with able management, bad banks may present positive surprises. Securum was able to recover over 85 per cent of the value of damaged assets it was entrusted with, doing so within six years. Had these assets been sold at the time of transfer they would have fetched less than 50 per cent of that amount.

An example of a bad bank becoming profitable comes from Britain. As will be recalled, Northern Rock was the first European credit institution to be salvaged by taxpayers’ money and to be nationalized in the first year of the 2007–11 severe economic and banking crisis.23 From it was split a bad bank, which, in mid-2010, reported a first semester profit, while its sister ‘good bank’ did not.

Nevertheless, not only Northern Rock’s ‘good bank’ and ‘bad bank,’ but also many others, like the Royal Bank of Scotland, are still on the British government’s life support and the next few years will quite likely be tough. This is particularly true as the economic crisis continues unabated and many more loans may go bad in 2011 while banks struggle to raise new finance as their existing inter-bank and other loans fall due (Chapter 13).

It follows that, though the bad bank idea may have some merits, if its management is first class, it is far better to take proactive measures which see to it that banks are not being salvaged by public money because they are ‘too big to fail’ (or, for that matter, for any other reason). This has three prerequisites:

a system of merits and demerits,Volcker’s rule, andliving wills written when the bank is still in good financial health.

One of the less frequently discussed issues with the banking debacle of 2007–11 and measures taken to redress the balance, is that the current system’s players have only rights to merits, but no obligation for failures. Bankers get fat bonuses – but they don’t pay for plain mismanagement or even for malfeasance under their watch.

Yet, behavior should have consequences. The Sarbanes–Oxley Act of 2002 says so, but, as the careful reader will recall, politicians have seen to it that it has not been applied, under the reign of George W. Bush or thereafter. Big financial institutions have tremendous power – and, if they misuse it, there must be consequences. A system of demerits should be in place to ensure that personal responsibility does not remain on permanent leave of absence.

The second prerequisite is re-establishing the Glass–Steagall Act, or instituting a modern version of it. The Volcker rule, named after Dr Paul

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Vokcker, the former Federal Reserve chairman who proposed it, calls for deposit-taking institutions to be banned from propriety trading24 in capital markets, as well as from investing in hedge funds and private equity. From the moment this was proposed, it was welcomed by the Financial Stability Board (FSB), a Basel-based entity spearheading the international reform drive. FSB also stressed that such a move would need to be combined with tougher capital and liquidity standards together with other regulatory meas-ures to make it effective.

It is, however, important to notice that, unlike Glass–Steagall, the Volcker rule does not seek a full separation of commercial banking and investment banking. Neither is it targeting those banks generally assumed to be ‘too big to fail’. Its goal is to limit further growth of non-deposit liabilities, which become the weakest link in the banking industry’s chain.25

Banks have generally opposed the Volcker rule, which was finally voted by Congress as part of the 2010 financial regulation (FINREG), but with many modifications which weakened its impact. Fat profits are at stake. Goldman Sachs derives 10 per cent or more of its revenues from proprietary trading; Morgan Stanley and Citigroup derive half as much, but these figures say nothing about the magnitude of the risks assumed by banks.

A great deal of the objection to banning proprietary trading from the activities of deposit-taking institutions is a reflection of the sacrosanct status of financial innovation. This has become a sacred cow. Yet, in his testimony to Congress on February 2, 2010, Paul Volcker is quoted as having suggested that there is no evidence financial innovation has contributed anything to the wealth of the United States. By contrast, the risks are high, opaque and widespread, and common citizens are being asked to pay for all the damage when the gamblers’ bets turn sour.

Interestingly enough, the attitude of investment bankers to the Volcker rule has changed. Morgan Stanley has agreed to jettison its big trading desk, and many of the banks that complained the Volcker rule would harm profits are complying years ahead of the 2014 deadline. It looks as if the banks’ CEOs have decided that proprietary trading is not mission-critical, while the choice to dump it could earn valuable credibility with regulators. Some experts are, however, saying that opposition to the Volcker rule was, in large part, a negotiating tactic and that there exist many other ways to speculate, make profits, distribute fat bonuses or engineer a bank’s demise.26

All sorts of speculators, some masquerading as bankers, are still making wild bets, developing and trading among themselves in new derivatives and piling on debt. With the Fed keeping interest rates at nearly zero, big banks have access to money very cheaply, and bonuses are as generous as ever. On the other side of the equation, millions of people have lost their jobs, homes and savings, and nobody answers their questions about why giant banks are so important to the economy and to the public.



This raises the issue of living wills. The term stands for a special resolution regime to be established in advance and target the case of a bank’s near-bankruptcy or partial bankruptcy. There has been much talk about such regimes for failing banks: big, medium and small – which could be seen as contingency planning. In short, living wills set up procedures for creditors to unwind a failed bank.

The Basel Committee on Banking Supervision outlined the need for living wills in the following terms:

Although certain large financial institutions provide functions that are systemically relevant … their business continuity and contingency plan-ning arrangements have not typically been required to include resolution contingencies … [hence the need to] address the practical and concrete steps that could be taken in a crisis or wind-down to preserve functional resiliency of essential business operations.27

By drawing up a living will, bank management explains to stakeholders and supervisors how the bank will be unwound in case of bankruptcy. The lead-ing thought is that it should be implemented along the insolvency regime, helping to speed the return of client assets. (Today, to a significant extent, the aim is to address problems uncovered by Lehman’s collapse.)

Critics say that giving a resolution authority the right to beat up all creditors would ensure that any credit institution at risk of falling under its auspices would face a run. The pros answer that a living will serves to ring-fence the deposit-taking parts of a credit institution and offer its depositors a full guarantee.28 There may also be other benefits.

The alternative to a living will is to force banks to issue bonds that would automatically suffer partial losses in the event of a rescue through state intervention. This, too, is contemplated with the objective of guarantee-ing sufficient of an institution’s balance sheet to repay depositors, while at the same time leaving a good part of it free of such a guarantee to protect taxpayers from having to foot big bills, as with the events which followed the 2007 debacle.

In the last analysis, however, there exists no fail-safe procedure. Much depends on ethics and human behavior; and, because a proactive approach is the better alternative, regulatory authorities should be free to act rather than have to limit their action in the narrow terrain permitted by political will, as happened in the George W. Bush years.


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6Fiscal Policies, Spending Policies and Conflicting Aims

The government takes its money out of its citizens’ pockets

Few people really appreciate that the state has no money of its own. The money it has in its Treasury comes from two sources: taxation and the central bank’s printing press – in other words, inflation. The first is the object of the government’s fiscal policies; the second, that of the central bank’s monetary policies, as well as of the politicians’ pressures. The two correlate because the difference between the money the government gets through a reason-able level of citizen taxation and its unwisely assumed huge commitments – from entitlements to foreign aid and military expenditures – is made up by the printing press, as well as by increases in all sorts of taxes. ‘We must tax the poor,’ André Tardieu, a French radical socialist prime minister, said in 1930. ‘They are the most numerous.’ Indeed, so it is. Value added tax (VAT) picks up a hefty share of private money for the government and it is paid by both rich and poor.

As Chapter 5 brought to the reader’s attention, inflation’s impact on the value of the money belonging to the citizen is more subtle but just as deadly. To show the American public what inflation means, in a televised address he gave after being elected president, Ronald Reagan held, in one hand, a $10 bill and in the other three dollars, a couple of dimes and a nickel. That’s what is left, he said (in 1981), of what $10 was worth at the end of World War II.

That’s the catch. The more money flows into an economy through the central banks’ printing presses, through derelict government budgets, twisted fiscal policies, quantitative easing and other measures to (theoretically) jump-start the economy, the more this policy contributes to the inflation of the sovereigns’ deficit spending. These loans must be serviced. Western gov-ernments have printed trillions of dollars to pay off their debts, but with the rising likelihood of sovereign bankruptcies has come the day of truth.

One of the most vicious after-effects of having the central banks’ print-ing presses working overtime since 2008, while interests rates are kept at



rock- bottom, is the emergence of sovereign credit risk among the indus-trialized economies. This is a great destabilizer because the virus of huge government deficits moves through a number of hazardous contagion channels and adverse feedback loops interlinking financial systems, which negatively affects public and private balance sheets.

Steady leverage creates adverse market dynamics. It also reflects conflicts of interest on the part of governments. When an inflation psychology takes hold, the prices of assets become detached from underlying fundamentals and sovereigns can pay back their debts at a fraction of the value of the money for which they contracted them. At the same time, however, there is a pass-through of higher sovereign funding costs, reflecting an inflation psychology’s growing concerns, which sees to it that the functioning of some markets is impaired and also that monetary policy becomes blurred as governments fail to implement fiscal consolidation, ensuring the sustain-ability of their policies.

The situation gets out of hand when governments behave as if they are afraid of taking a firm grip of their public finances. More than anything else, the reason is a lack of backbone in those who govern. There are posi-tive examples of sustainable fiscal and financial policies. In this century, Germany and the Conservative/Liberal Democrat government in Britain have been rewarded for doing so.

While the monetary policy of the majority of developed countries is want-ing, the greater risks are posed by runaway fiscal policies. In 2010, America provided an example, where anxiety about public debt made businesses and consumers tighten their purse strings, with negative effects on the US economy. Economists who favor sound public finances maintain that being in charge of budget deficits reduces uncertainty and has a liberating effect on private spending.

This, however, is not the normal course of events. Many governments responded to the 2007–11 economic crisis by taking the debt burden off the private sector’s balance sheets and putting it on their own. The result has been a huge gap in government finances, as taxes are no longer able to close these ever-greater imbalances. In addition, there are other classical symptoms of souk (Chapter 5), such as rapid growth in private sector debt, particularly the households, and an outbreak of enthusiasm for financial assets, which are not so well understood and harbor major opaque risks.

It is an irony of our time that, with a shortfall in taxes and difficulties in making ends meet, many governments, particularly city and county, started investing in derivative financial instruments1 which they don’t understand. Not only have the complexities of derivatives and structured instruments escaped them, but they also introduced new wildcards in their finances.

All that leads to skyrocketing debt at all levels of government – city, country, state and federal – along with a legacy of excessive debt contrib-uting to the economy’s mismanagement. Unsupportable gearing aside, an


Fiscal Policies, Spending Policies and Conflicting Aims 101

after-effect is misallocation of resources which, in turn, acts as a drag on economic growth. Another legacy is asset-price inflation, which redistrib-utes wealth in an arbitrary way between those who ride the bubble (a small minority) and those suffering from it as it inflates and after it bursts (the large majority).

Even where there exist plans for fiscal consolidation (and the better example among western nations is Germany), the sizeable near-term fund-ing requirements of the sovereign can crowd the issuance of bonds by companies. The risk that this implies for funding costs also raises the pos-sibility of a setback to the recovery in the private sector’s profitability, while concerns remain about pockets of vulnerability within specific industries such as banking.

Adding to the souk is the fact that doubts are raised about the willingness of some featherbedded countries (for instance, like Spain and Portugal) to push through the required austerity measures. As the example of Greece demonstrated, electorates react negatively to the cost of downsizing public deficits.2

In addition, because politicians don’t really explain to the citizen that the money they themselves overspend by abusing health care, pensions and other entitlements is their money, people want to have ‘more and more’ and don’t seem to understand that they will pay for it, in one way or another. In a democracy, the absence of public debate on ‘who pays’ discourages rigor-ous action at government level, even if those in charge understand that:

the country cannot afford to let debt build up until it reaches strat-ospheric levels,rolling over one’s rising debt may be increasingly difficult or outright impossible, short of paying outrageous interest, andlike companies and households, countries have a debt limit that is a func-tion partly of their own history of fiscal consolidation and partly of their conceived ability to repay.

Repaying by governments means that, once again, they will take the money out of their citizens’ pockets through taxation and inflation. It is a vicious cycle. A better policy is sovereign budgets for the current year, and budget-ary plans for the coming years reflect a strong commitment to implement-ing credible consolidation policies aimed at restoring fiscal sustainability when it is lost and creating room for budgetary flexibility within the realm of sound finances.

This evidently requires that a public administration’s budgetary targets comply with fiscal consolidation requirements, rather than deficit procedures. Ambitious budget control targets are necessary but inapplicable when current plans fall short of meeting the objective of halting and reversing the increase in government debt ratios. Affirmative financial action becomes believable

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only when administrations adopt credible fiscal adjustment measures – and put them into effect.

The best solution is fiscal consolidation

A basic economic principle, albeit contested by big spenders, is that, despite any illusions, government deficit cannot boost demand. Consumers, par-ticularly those who pay for public debt, cut their own expenditure in antici-pation of higher taxes ahead. Moreover, when governments are heavily geared, fiscal stimulus becomes less effective and the market’s confidence deteriorates.

This has been the case in the 2008–11 environment in which western markets have seen public debt rise so fast, skewed so strongly towards ‘spend now pay later’, that it has weighed heavily on market psychology. In devel-oped countries, the average ratio of public debt to GDP has jumped from below 80 per cent to nearly 100 per cent in two years, and the IMF believes it will approach 120 per cent by 2014.3 And yet, governments are still bent on spending huge volumes of public money.

Available evidence suggests that countries that live with higher debt burdens grow more slowly than those exercising fiscal discipline. Big spend-ing by governments gives a semblance, but only a semblance, of economic growth; this makes the politicians’ lives much easier because they don’t need to take tough decisions. Economic growth reduces deficits by increas-ing tax revenues, thereby making debts more sustainable and lightening the adjustment burden.

Governments (and more recently even the central banks) should not be as quick as they have become to invent different ways to spend taxpayers’ money. Policy-makers should appreciate that the effect of a monetary stimu-lus (for instance) lasts only as long as it is ‘on’, and it can become addictive.

Living on ‘stimuli’ is like living on steroids. The irony with these different ineffective initiatives is that withdrawal of even small parts of the package can send an economy back into doldrums.4 In December 2009 and January 2010 in America, new home sales slowed sharply after an initial end-of-November 2009 deadline for the expiry of a buyers’ tax credit. By September 2010, sales of old and new homes were most disappointing.

(Though the credit had been extended until April 2010, December 2009 home sales were just 342,000, compared with 329,000 in January 2009, at the height of the crisis. The pros said that the stimulus might have pre-vented an even worse real estate market. But this argument is just an ‘if’.)

The fact is that economic growth does not happen on command, and the best way to be in charge of deficits is to use a sharp knife to cut government spending by increasing statutory pension ages, cutting the public sector’s fat (such as guaranteed increases in salaries and pensions based on years of serv-ice rather than performance). While shrinking the number of bureaucrats



and rolling back comfortable retirements may be an unpopular medicine, the private sector and households should by no means be the only parties paying for the government’s follies.

Other social measures, too, are important, such as reforms that make labor markets more flexible and which, in most western countries, are overdue anyway. The fact that measures necessary to redress the balances skewed by debt are unpopular is not surprising. What is surprising is the western gov-ernments’ inertia in reinforcing sustainable growth through job creation – which cannot be done without fiscal and structural reforms – including the promotion of a policy of sound balance sheets.

Optimistic GDP forecasts have often been used by governments as a way of avoiding decisive action, but fake good news is unsustainable. In March 2010, economists projected that the American economy would experience growth of 2.8 per cent in 2011. Six months later, in September 2010, this forecast was reduced to 2.3 per cent.5

Governments lie when they say that they are laying the foundations for long-term growth, while they continue loading themselves with debt. There is, therefore, no surprise when the actual GDP figures are a lot feebler than projected. Galloping budgetary deficits by sovereigns and the fallout of the 2007–11 financial crisis weighs heavily on the private sector’s spending and the way the economy tries to recover.

‘In the short term, fiscal consolidation reduces aggregate demand and thus has a negative impact on economic activity,’ states the September 2010 Monthly Bulletin by the European Central Bank. ‘At the same time, credible and ambitious consolidation raises expectations of future economic growth and induces economic reactions, which may offset the demand effect in the short term.’6

Fiscal consolidation is not achieved by wishful thinking, just as damaged balance sheets and stiff labor markets are not repaired by words. Laying the foundations for sustainable financial stability, and acting in this direction, are often regarded as unpopular activities by part of the population – often the sector which benefits from the current casino society and its bonuses; hence it involves conflicts of interest.

Governments run ‘by the seat of their pants’ do not really know where all the money is going. In early June 2010, months after the debt earthquake shook the euro, it was announced that Greece would do an inventory of staff on its public sector payroll and establish an agency to monitor public sector pay. The aim of this action, taken in the wake of the economic and financial crisis, was to improve public sector administration and promote a more efficient use of public money.7

That’s good. But the measure also reveals that the government is lacking accurate and readily available data on how many people work for the wider state sector, including local government and state firms – which is evidently bad. This is much more of a reflection on previous governments than on the



current Greek one; the country’s fortunes have been set without a compass, or a sense of responsibility.

In addition, taxpayers should no longer be asked to pay for the misdeeds of bankers and politicians, who have been feeding the debt hydra’s appetite and saddling future generations with a growth-sapping burden of higher taxes. The best way to squeeze the beast is to explain to the common man what the problems are and what is required for sound solutions – including the cost and the risk of leaving the problems unsolved.

Governments never really feel the economy is strong enough to stop throwing money at the problem, particularly if an election campaign is about to begin. Very few politicians learn from past mistakes or are ready to admit them. Jim Callaghan, the then British Labour prime minister, did precisely that when he declared to a party conference in the 1970s that:

We used to think that you could spend your way out of recession and increase employment, cutting taxes and boosting government spending. I tell you in all candour that that option no longer exists and that in so far as it ever did exist, it only worked on each occasion since the war by injecting a bigger dose of inflation into the economy, followed by a higher level of unemployment as the next step.8

Not only is it followed by unemployment, but also by higher taxes. ‘Too much tax kills the tax,’ said Jacques Chirac before being elected president of France. After his election, however, he changed his mind. With a mis-managed economy where the large majority of people expect the State Supermarket to take care of all their needs, taxes increased and Chirac sim-ply forgot that taxpayers deserve a break.

Germany provides another example of what is meant by this reference. A single person earning an average income pays more of his wages in income tax and social security contributions than in any other country among developed nations, except Sweden. Taxpayers earning just 1.3 times the average income, pay a rate of 42 per cent and there is an even higher rate for top income earners. All this works to discourage rather than encourage people to work harder.

That is precisely the sort of policy western citizens do not need. Gover-nments are wrong to take the common man as utterly stupid. According to an article in The Economist, white voters in America have changed their view of Barack Obama; not because of his skin color but because of what he has done – and what he has failed to do – since he took office. White men, The Economist’s article says, are disproportionately skeptical of Obama’s proposed solutions. Seven out of ten prefer small government to big government. ‘I don’t like the way they are giving away all that money,’ suggested Steve Roberts, a welder in Arkansas. ‘I think you should work for your money.’9



Impact of fiscal policies on the financial system

There is both a direct and an indirect interaction between a government, its fiscal policies and the financial system. Indirect channels between fis-cal policies and the financial system exist via households and industrial firms. Tension along these channels may have important consequences for financial stability, even more so than direct links, because of potential impli-cations for a government’s balance sheet.

Another indirect channel is provided by financial and economic globali-zation. It makes itself felt through the impact of current account deficits (see the next section), which bring into the picture cross-border contagion effects. Cross-border contagion comes from, or has an impact on, other countries because of spillovers. Spillovers and tensions are particularly dangerous to tightly connected economic systems, like euroland’s, whose members share a monetary union but do not have political union, with a plethora of incompatible, if not outright contradictory, fiscal policies.

Small economies like those of Greece or Portugal will not do irreparable damage to euroland if they default. They also gain relatively little from looser fiscal policy, because a lot of its effects spill abroad. However, they will suffer heavily when investors lose confidence.

Countries with heavy debt burdens (like Italy) or whose tax base has collapsed (for instance, Spain), would create considerable financial and economic upheaval if they were to collapse. For this reason, they should be greatly concerned about a sudden loss of investors’ confidence – whether this is the result of uncontrollable deficit procedures or other events casting doubt on the government’s ability to be in charge of its fortunes.

Sovereigns also interact directly with the financial system. They do so when financing their fiscal deficits and when managing their debts. Important parameters in this direct channel connection are the amount and maturity of public debt held by financial institutions, and shares of intra-bank lend-ing covered by government securities as collateral. Other important fac-tors include the proportion of government debt insured via credit default swaps and downgrades to sovereign credit ratings, which in the globalized economy immediately become public knowledge.

Plenty of information on direct channel patterns and behavior can be obtained by assessing relationships between fiscal policies, monetary policies, and financial stability. Furthermore, valuable information is avail-able through the role the government plays as tax authority, affecting the behavior of financial industry participants through tax rates and tax structures.

In the best cases, tax rates and tax structures are fine-tuned. This is not universally the case, and they do go wrong. They practically always do so with persistent budget deficits. The wrong interaction between a government and its fiscal policies, on one hand, and the economy and financial system,



on the other, could lead to ominous consequences. Persistent unemploy-ment is a case in point.

The most recent events connected to the 2007–11 deep economic and financial crisis illustrate this statement. In western countries (with the exception of Germany, where employment figures have been improving) unemployment is still widespread, with little hope of a pick-up. Business confidence oscillates. And, in spite of massive stimuli as well as rock-bottom interest rates, the economies of western nations remain under repair, even if some seem to have recovered to some degree. Two of the most important background reasons are: first, that the stock of debt that sovereigns, banks and households carry will take many years to absorb; and, second, that the holes in sovereign and other balance sheets must be repaired before the economy can get moving again.

Tibor Vamos of the Hungarian Academy of Sciences commented as fol-lows in recent correspondence with the author: ‘The Ponzi-game of over-spending was a crazy cooperation of greedy people, politicians and banks.’ Greed was not the whole reason for the debacle. The financial firms had too much (unjustified) faith in their own foresight, believing themselves capa-ble of modeling and containing the risks they were running. In so doing, they neglected the basic quality of resilience and assumed that, at a pinch, they could always borrow funds or ask for government bailouts.

In his book The Creation and Destruction of Value, Harold James argues that the events most closely related to the present crisis may be the huge bank failures in Austria and Germany in 1931.10 Then, as now, uncertainty about asset values in a big bank led to an earthquake throughout the banking sec-tor. In 1931, the German government responded by injecting huge amounts of public money into the banks and creating a separate entity (a forerunner of a bad bank, see Chapter 5) for the assets that could not be priced.

Sound familiar? That’s precisely what the American and British govern-ments repeated in the first decade of this century. In 1931, the German authorities also founded a new institution that allowed the Reichsbank to discount bills from those banks that found it difficult or outright impossible to trade then because the inter-bank market had seized up. That’s precisely the policy followed by the Fed, Bank of England and European Central Bank after 2008, except that they did so directly, without a bad bank intermedi-ary, and, by so doing, they filled up the western central banks’ vaults with useless financial and commercial paper. The net result has been more newly minted money and higher sovereign debt. Another curious and ominous similarity is that, in 1931 and these days, the politics of bank bailouts have been both too complex and too controversial. Politicians meddled with economic decisions that had enormous consequences on the economy, but lacked the necessary experience to enlighten their moves. In his book, James shows how seemingly novel crises and debates about ‘the way out’ are vari-ants of past crises; the debates among politicians, economists, bankers and



whoever else joins them, make no contribution of new ideas on ways and means to come out of the hole we find ourselves in.

In reality, when financial crisis struck no one seemed to have a clue about how to react; statistics that have emerged since have been devastating. Following the crash of 1929, for instance, America’s economy shrank by one quarter and the unemployment rate hit 25 per cent – and nobody today can ensure that this will not be repeated, despite all the quantitative earnings.

According to some opinions, ‘this time around it is different’ because the Fed and other western central bankers, as well as governments, have not been thrifty (with other people’s money). But this is only a theoretical state-ment based on an illusion because big banks are wrapped in cotton wool, extremely low interest rates devastate savers and pension funds, and big public spending packages create the impression that economic distress has been much less than it really is. In spite (or because) of this, the deep reces-sion has still been extremely painful and the common man’s perception is that nothing is really different from the events that followed the First Great Depression.

Some people may, however, say that there is a difference. In January 1932, Wright Patman, a Congressman, opened impeachment hearings for high crimes and misdemeanors against Andrew Mellon, a former banker and Treasury secretary under three presidents. The investigations that followed did prove a number of misdemeanors by Mellon, including his use of ficti-tious gifts to avoid taxes, and the employment of Treasury tax experts to trim his personal tax bill.11

The same policy prevailed towards those who ran the banking system into the ground. Because the management of big banks messed up badly, their shareholders have been severely penalized. But only a small minority of credit institutions ejected their CEOs in anything like disgrace, let alone brought them to court.

This is even true of cases such as Citigroup, Merrill Lynch, Royal Bank of Scotland, Société Générale and Crédit Agricole, whose CEOs left but were not accused of wrongdoing. Boards have been ultra-lenient – and the same is true of public prosecutors, even if the failed CEOs destroyed swathes of property.

Instead, western governments and central banks bend over backwards to salvage the self-harmed mammoth financial institutions – through an ill-stud-ied policy of saving banks ‘too big to fail’, at great cost to the economy. In its 2009 Annual Report, the Bank for International Settlements (BIS), arguably the central bank of central banks, had some good advice on this matter:

Institutions that are too big to fail – those that created intolerable systemic risk by themselves because others are exposed to them – pose a significant challenge … Mergers and acquisitions that have formed a part of the crisis response … may have increased the number of such institutions … [and officials] realize that [this] creates an unsustainable structure.12



Again and again, the throwing of an inordinate amount of taxpayers’ money at the problem has created the false impression of having escaped the worst. This, however, masks a lack of necessary change in the system of finance itself. With the exception of Lehman’s, no big firms have been allowed to file for bankruptcy, which would have happened without the lavish (and irrational) supply of taxpayers’ money. The law for big firms today is that which the film Wall Street dubbed ‘survival of the unfittest’.

Its alter ego is the mountain of debt which turns on its head the western governments’ fiscal policies. Because of widespread debt in America, Britain, France and Spain (to name but a few), consumers cannot start, let alone, lead a sustained recovery. They themselves have to repair their balance sheets. Exports could help, but with the exception of Germany, developed countries find that their peers, as well as emerging countries, are not ready to absorb them.

Current account deficits

A country’s current account is a balance of payments (BOP) ledger covering all transactions in goods and services, as well as income and currency transfers between residents and non-residents. The balance of payments bill is a sta-tistical statement which, for a specific period of time, summarizes the finan-cial/economic transactions of an economy with the rest of the world.

The current account definition presented in the preceding paragraph is that of the European Central Bank. Other central banks define BOP in somewhat different terms. For instance, the Deutsche Bundesbank states that the current account balance corresponds to the difference between aggregate savings, including the balance on the capital account, and over-all net investment, equal to gross investment less depreciation, of a given country. If aggregate savings are lower than investment, a current account deficit shows the aggregate savings gap that has to be bridged by lowering balances or by borrowing abroad. At this point of reference, the afore-mentioned two current account definitions tend to merge into a common concept.

Unavoidably, because of international trade, at any given time period (for instance, a year) some countries will have a positive current account and other countries a negative one – which they need to finance by borrowing abroad. This shorter-term measure of ‘�’ or ‘�’ tells an interesting story. By itself, the one-year reference is neither good nor bad. It becomes bad and perilous if:

the ‘minus’ persists year after year, foreign debt accumulates, andthe government is unable or unwilling to turn around the situation to the ‘plus’ side.

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Taking a longer-term view, a country’s current account position provides vital information about its economy and its global trade (most particularly in regard to its macroeconomic factors). In terms of the conduct of the econ-omy, it makes a difference whether increasing external debt is driven chiefly by productive investments or whether too little import discipline, too few exports and a declining savings rate propel the current account deficits.

It does not need explaining that, in general, surpluses and an improve-ment in the net external position are welcome – particularly for countries faced with an aging population, because they help to absorb future demo-graphically induced burdens. All else being equal, channeling savings abroad permits domestic savers to diversify the risks of their assets and benefit from higher yields in growing economies having a different demo-graphic profile.

Internal government debt and current account deficits do not necessarily need to correlate, though they tend to do so because they both represent imbalances and the fact that those in positions of authority are not really in charge. They are signals of an economic drift, and a similar statement is true about deficits in sectors of the economy that lack competitiveness.

For instance, in western countries today both the household and public sectors have become permanent and significant borrowers, but in some countries their deficits are partly offset by surpluses in the corporate sector. In addition, over time there may be significant changes in some sectoral net borrowing/lending positions. If the current account surpluses become yearly affairs, then the reason may be that the government has been able to address some of the legacy imbalances in the economy.

An example to the contrary, when the government exacerbates the imbal-ances, is the merchandise deficit. A widening trade gap is created when imports grow faster than exports.

A case in point is America’s economic slowdown in the second quarter of 2010, which saw imports grow three times faster than exports, producing a big drag on the current account. Christina Romer, who was at the time Obama’s chairwoman of the Council of Economic Advisers, lamented: ‘A bit of you keeps saying that if only those were American products, think of how high GDP growth would have been.’13

The problem confronting the USA and the dollar is not just the current account deficit because of global trade, which acquired its own dynamics, but also that of being policeman of the world – which, in terms of expen-ditures, makes an already bad situation worse. In the early 1970s, when the gold reserves at Fort Knox were melting away because of the convertibility of dollars into gold as warranted by Bretton Woods, President Nixon realized that the USA did not have the resources to hold the world’s banner of gold standard and this policy ended with the Smithsonian Agreement. The dif-ference between what ‘could be’ and ‘what is’ in global trade and other deals has an unquestionable impact on the country’s current account. When the



foreign currencies’ deficit continues to grow, its impact on the economy and on foreign debt can be devastating.

Sometimes a cumulative presentation of current account figures hides important differences behind the reasons propelling imbalances. These rea-sons cannot be confronted in summary manner. They should be examined individually – each on its own merits. The often-heard statement that the current account balance of euroland in the aggregate fluctuated only a little between deficits and moderate surpluses since the launch of the euro masks the fact that Germany has had huge surpluses, while France has had mostly deficit figures, and the current accounts of Italy, Spain, Portugal and Greece have regularly been in the red.

A more accurate statement about BOP imbalances is to say that, with its high surpluses from trading with non-euroland countries, Germany made a major contribution to the health of the euro by sustaining a largely positive current account position. Had Germany been factored out of the calcula-tions, euroland would have had to bear current account deficits of between a160 billion or 2.6 per cent of GDP (which occurred in 2006) and a320 billion or 4.7 per cent of GDP (observed in 2008).14

If Germany falters as a major exporter, then the euro will face hard times. There is plenty of evidence of unsustainable developments in current account balances in euroland’s peripheral countries. These current account deficits, and their funding, have been accelerated by the disappearance of the exchange rate risk because of monetary union. In addition, country default risk in euroland’s bond markets was rated very low in the years prior to the 2007–11 crisis.

Prior to membership of euroland’s monetary union, some countries’ persist-ent current account deficits led to the market’s dumping of their currencies. Their currencies were devalued and the silver lining was that they were (at least partly) compensated by the resulting difference in foreign exchange rates. The common currency did away with such an adjustment mechanism.

With or without the existence of special factors like monetary union, the study of divergences in current account balances provides a good deal of insight on how an economy works. Another basic criterion is that of a coun-try’s inflation rate. Inflation is ravaging euroland’s peripheral countries, mainly driven by sharp rises in unit labor costs. This slows down exports in real terms and boosts growth in imports, by weakening the position of domestic suppliers on their home market.

An important input in any model of current account balances, and factors underpinning them, is price competitiveness of industry sectors compared with their peers in other countries. This is usually calculated on the basis of the deflators of total sales. At the core of redressing current account imbal-ances, however, is always the will of governments, industries and common citizens to turn around an unfavorable situation.

A successful effort in this direction includes the proper identification of the origin of trade deficits and of prevailing trends, which may be negative.



For instance, America’s bilateral trade deficit with China grew by nearly $4 billion from May to June 2010, while China’s July trade surplus swelled to $28.7 billion (the highest level for one-and-a half years).

In a globalized economy, the banking industry is clearly concerned about persistent current account balances in countries where it operates, as well as what underpinning them. Trade is by no means the only issue. International loans is another, and it is fast growing in importance, leading to bad debts in foreign currency loans.15

An example is provided by Hungary, where about 6.5 per cent of house-hold debt is in foreign currencies, particularly in Swiss francs. In mid-2010, the steep rise in the value of the Swiss franc against local currencies (as well as against the euro and the dollar) has significantly increased the burden of debt on Hungarian borrowers; the strains have been made worse by the general economic crisis and collapsing housing markets. Economies hit by the double whammy of persistent current account deficits and credit woes, as banks call in their foreign currency loans, find it tough to recover. The lenders, too, are suffering.

Many loans in Eastern Europe have been made by western European banks, which will be paralyzed if lenders are weighed down simultane-ously with bad debts. The way Piroska Nagy, of the European Bank for Reconstruction and Development sees it: ‘The risk is of a Japanese-type frozen situation.’16

Sovereign debt and its consequences for the banking industry

Banks and other financial firms from countries with excessive deficits are typically large holders of government debt securities. One of the results is that a fall in the value of government bonds has an adverse impact on the banks’ securities portfolio. Over and above this exposure, banks also have a sizeable lending activity with governments; therefore, sovereign bankrupt-cies severely erode their capital buffers.

Governments are wrong when they press the country’s banks to lend to them because they may well put their liquidity and solvency in jeopardy. An actual, or even perceived, decline in the quality of government bonds in a financial institution’s portfolio, which is often used as collateral for covered inter-bank loans, has an adverse effect on its access to financial resources and may ultimately reduce the inter-bank market’s liquidity itself.

Moreover, as far as the bank’s capital requirements are concerned, down-grades of sovereign ratings may also lead to a potential increase in capital risk weights on the bank’s holdings of government bonds. Inter alia, the interde-pendency of players in the globalized economy is illustrated. Traditionally, the increase of sovereign risks has been observed in the falling price of government bonds. A more recent, and highly potent, measure is the spike in sovereign credit default swaps (CDSs). Spreads over AAA-rated sovereigns widen most



in countries where fiscal imbalances are high; investors become proactive by pushing the spreads of damaged sovereign issuers to higher and higher levels.

In late October 2010, this happened with Greek and Irish bonds. Critics say that the role of CDSs, and most particularly of sovereign CDSs, as a way of judging the likelihood of an entity’s failure to pay interest and repay the money it has borrowed, is controversial. The pros answer that CDSs repre-sent community intelligence – and, as such, they have shown the market’s ability to judge creditworthiness better and in a more steady manner than credit ratings.17

CDSs did play a role during the Greek crisis of early 2010 by promoting investor vigilance. At the same time, speculation saw to it that liquidity in several sovereign bond markets evaporated. The market doubted that other Club Med (Spain, Portugal, Italy, and eventually France) member states have really decided to put their economic and financial houses in order.

The volatility of sovereign bond spreads also focused market attention more generally on interest rate risk – even if, over the months preceding the second quarter of 2010, interest rate volatility had remained relatively low. In the event, a steep yield curve attracted investors into building up size-able yield curve carry-trade positions which were leveraged and their abrupt unwinding would have disrupted market functioning.

One issue on which many experts now seem to agree is that the descent of the banking industry into the abyss, compounded with crushing amounts of sovereign debt, changed the rules of the game. As Chapter 1 explained in connection with the new normal, since the 2007–11 crisis the business model which has been, for over two decades, characterized by:

zero cash,maximum leverage,large derivatives exposure, andunrealistic return on equity (ROE)

is no longer sustainable. In fact, one of the basic premises underpinning the new normal is that this model has come to an end. Against this position of several economies works the fact that such an outcome implies a radical change in the behavior of politicians, governments, central bankers and regulators. Resistance in changing mental models sees to it that practical evidence of this happening is scant at best. Such evidence would involve:

an end to lax monetary policies,regulators taking and maintaining a tough stance, abandonment of policies of easy credit and quantitative easing,break-up of the big, unmanageable financial conglomerates, andappreciation of the fact that financial risks are not isolated, while their severity critically increases when they become correlated.

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In democratic regimes, it is up to the public to elect politicians that will enact radical changes (see the next section). Abandoning past practices requires a great deal of leadership. The hope is that the 2007–11 deep economic and financial crisis has created conditions which may have the momentum to force a change.

Precious lessons can be learned from recent events such as the credit crunch, and skyrocketing public debt. The credit crunch has led to an eco-nomic slowdown. In economies accustomed to feed on debt, restrictions on the supply of credit created a negative pattern with important consequences for economic activity and employment.

For its part, the deterioration of public debt has brought some crucial issues into perspective. Worsening sovereign financial problems had, and continue to have, a large adverse impact on industry a whole, and on the banking sector in particular. Hence, they imply further adverse consequences for the economy. Evidence of this has been that the banking industry’s (almost) unconditional support by euroland governments led to both bank and sov-ereign CDS spreads becoming increasingly correlated and an accompanying credit rating spillover, as in fiscally troubled countries rising sovereign risk induces rating agencies to review their ratings. These notions correlate. Credit rating agencies are increasingly using CDS patterns to derive market-implied probabilities of default. In addition, a marked discrepancy between current ratings and market-implied ratings now serves as an early warning for detecting companies that may warrant a critical review.

An irony with the destabilization of sovereign debt, as it reaches strat-ospheric levels, is that corporate bonds and credit default swaps are being priced using a so-called ‘risk-free’ rate as a benchmark. This originally derived from an AAA sovereign debt security with a corresponding maturity. High-rated government bond yields generally set a floor for corporate bond yields in the same country, but the question now becomes: Do sovereign bonds justify the assumption they are credit risk-free?

Like big banks, sovereigns have only themselves to blame for this dete-riorating situation: the former, because they invented instruments backed by blue sky and took many of households and ordinary investors to the cleaners; the latter, because they turned a blind eye on the banks’ wrongdo-ing, as the party running the government was ‘pro business’. Here is a short chronological list of major shocks during the last few years:

subprimes, special purpose vehicles (SPVs), structured investment vehicles (SIVs), conduits: February to October 2007liquidity crisis: November 2007 to August 2008Fannie Mae, Freddie Mac, AIG, Lehman Brothers: September 2008 lasting to February 2009zero and near-zero interest rates plus the printing press of quantitative easing: late 2008 to 2011

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sovereign debt bubble expected during the next three to four years (Chapter 13), with nobody knowing how to stop the clock from ticking.

Over and above the economic and business weaknesses promoted by these bullets has been the complete absence of bringing wrongdoers to justice. Politicians and central bankers rushed to spend public money as if they were firefighters, not the persons entrusted with their nation’s wealth. This gave the message to speculators and bankers (running after fat bonuses), that, quite unexpectedly, their wrongdoing has been rewarded by a win–win situation – which is highly undemocratic.

Financial stability is one of democracy’s pillars

In the early 1970s, Raymond Aron, a French author, journalist and political analyst, wrote an inspiring article18 in which he stated that the year-on-year 2–3 per cent improvement in the standard of living was a post-World War II pillar of democracy. For all the destruction of World War II, the reconstruc-tion which followed provided plenty of work and a better living standard, fulfilling Aaron’s criterion.

This is now a faded memory. Western democracies, and their econo-mies, are no more able to provide a steady increase in standard of living, while their citizens want to experience jumps of 5 per cent or 10 per cent per year – and the gap which followed has been filled by endowments (Chapter 3) and torrents of debt. This has been deadly for financial stability, which is now being also challenged by two other principal factors. First, the American democracy, which after World War I became the financier of the West, is presently borrowing too much abroad for its own good. Second, the progressing destruction of the middle class is making the economy of western nations ungovernable because the gap between rich and poor tends to become an abyss. The huge discrepancy in pay is a dramatic example of this second point. Research investigating pay at Wall Street firms found that bonuses rose by 17 per cent in 2009, amid a deep economic and banking cri-sis, to $20.3 billion. Compensation at Goldman Sachs, Morgan Stanley and JPMorgan Chase jumped by a whapping 31 per cent;19 at that same time, 10 per cent of the American labor force was unemployed.

While big banks were (wrongly) salvaged by lavish amounts of taxpayers’ money, fat cat bonuses bounced back to be higher than ever. In 2009, the average Wall Street employee took home nearly $124,000 on top of his base salary, one quarter more than in 2008, while the American economy was still at the edge of the abyss.

There is, indeed, a very good reason why Bair and Shapiro, respectively the chief executives of Federal Deposit Insurance Corp (FDIC) and the Securities and Exchange Commission (SEC), were quoted by Bloomberg News on January 14, 2010 as having said that the banks’ bonus practices spur the

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economic debacle of America. This is true of every other country – and most particularly of Britain.

The destruction of democracy through wage ratios of 400:1 is by no means only a Wall Street phenomenon. At the five biggest British banks, execu-tives’ pay exceeded £50 million ($80 million) over the 2005–09 timeframe, according to a report by the Labor Research Department. Fred Goodwin, the CEO of Royal Bank of Scotland (RBS) who brought the institution to near bankruptcy under his watch, was paid a basic salary of £3.5 million ($5.6 million, an ultra-big salary in Europe) while RBS was falling apart and being rescued by the government.

There seem to be some very curious rules when it comes to determining a ‘disaster-to-pay-out’ ratio: the greater the disaster, the more lavish the CEO’s benefits, all the way to the golden handshake. BP’s CEO Tony Hayward prof-ited handsomely from that. After the huge engineering mistake and ecological catastrophe in the Gulf of Mexico, which will probably cost BP shareholders upwards of $30 billion, his severance package was (inevitably) outrageous.20

These are not cases reflecting high ethical standards, let alone endearing the leaders of big business to public opinion. Times have changed since the late nineteenth century, when Lord Salisbury, and other conservatives, feared that democracy would lead to the overthrow of private property rights because debtors tend to outnumber creditors and, therefore, can out-vote them. Today, debtors and creditors are cut from the same cloth, charac-terized by the habit of spending way beyond one’s means at state, corporate and family levels. Still, the ultra-high salaries, superbonuses and other extravagant self-awards remind everyone of unjustifiably large inequalities, which, inevitably, are common knowledge. This has disastrous effects on financial discipline, pushing the less well-off segments of society to emulate the richer by loading themselves with liabilities way beyond their means.

Democracy is at risk because financial stability and a Republican regime are the two sides of the same coin. Public discontent translated into a debt frenzy becomes self-feeding (and self-defeating). The peril of destabilization is a global problem, to a large measure created by the fact that politicians and governments turn a blind eye to practices which should never have been condoned.

As we saw in Chapter 3, to hide the growing discrepancy between rich and poor, successive governments have handed out many entitlements without examining whether the country’s economy can afford them. This ranges from universal health care from cradle to grave, to early retirement with a generous pension and unemployment benefits higher than the salary a person makes when working. The total bill means spending beyond the economy’s means and it results in structural deficits which are unsustain-able, while further inciting people to use debt as money of the mind.

This issue is hugely topical and important. In part, the educational system itself is to blame because, while the subjects it teaches might have been great



in the nineteenth century, they fall short of elementary literacy for future citizens of the twenty-first.21 Nowhere is the concept of savings and being in charge of one’s own future being taught.

This is a pity because saving for a rainy day is a mindset necessary to ensure a person’s independence. According to Henry Ford, small savings made in big numbers represent a large sum of money. Take care of the smallest penny, Andrew Carnegie, the king of steel, used to say, and the pen-nies will take care of themselves. For his part, John Rockefeller applied two principles to his success: first, to be ruthlessly competitive with his competi-tors; and, second, to control the whole chain of production, which further allowed him to compress costs. (Carnegie had done the same.)

The principle of being watchful of costs and adherent to a savings policy is applicable not only through the whole chain of industry, but also all the way from household to government expenditure. Low cost, however, should not mean low quality. Ingvar Kamprad, who built Ikea, says that diminish-ing the quality to cut costs is not a solution; it’s a trap.

Another trap is to put assets on the block, in a desperate effort to close the gap between income and expenditures – rather than cutting expenditures to below income level. In 2010, highly-indebted western governments decided to sell some of their remaining (lower-quality) assets, while, in former times, their predecessors had already sold state-owned telecoms, gas and electricity outfits, as well as everything else that mastered a good market price. In Britain, George Osborne, the Chancellor, listed four candidates for privatiza-tion, none of them exciting as an investment:

Tote, a state-owned bookie,the student-loans book,the National Air Traffic Control Service, and High Speed 1, the new name for the Channel Tunnel Rail Link, which also happens to be the country’s only high-speed rail line.

These are largely fire sales, but the British government does not have much of anything else left that can master a market price. (A 30-year concession to run High Speed 1 was put up for sale on June 21, 2010, and experts reckon the final price will be around £1.5 billion [$2.2 billion] just a quarter of the £6 billion the track cost to build.)

With practically every saleable asset gone, at stake is not just the govern-ment’s ability to keep expenditures below income, but also to solve the prob-lem of great indebtedness relegated to future generations. Because financial stability is one of democracy’s pillars, taxing future generations with debt for which they are not responsible is sure to have severe political consequences.

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117

7Restructuring Sovereign Balance Sheets

Deleveraging

Japan’s example of an economy which has been, for two long decades, in a coma should give western governments plenty of food for thought. As Chapter 4 on Japanification brought to the reader’s attention, since the early 1990s a prolonged banking crisis, sluggish growth and the failure to prune balance sheets led to deflation, and from there to free fall. Numerous unsuccessful stimulus plans drove up Japan’s debt ratio dramatically, but their effect on the economy has been practically zero; yet, this misdirected policy has found imitators in the USA and Britain.

Lack of leadership and the beaten path of easy ‘solutions’ saw to it that the Japanese economy got the worst of two worlds: continuing leveraging and permanent residence in a deflationary status quo. This is, once more, evidence that throwing money at the problem and taking half-way measures don’t work and it is silly to try them all over again in America and in Europe, as certain governments are doing, with stimuli, quantitative easing and other nonsense. If the Japanese economy sank under mountains of debt, then there is no reason to try an unsuccessful formula all over again.

Yet, all things considered, on both sides of the North Atlantic the delever-aging that many economists suggested as the best possible course to end the economic crisis has not really begun. Government debt has simply s ubstituted for banking sector and household debt. This makes plenty of western econo-mies very reliant on continuing misdirected action by central banks and gov-ernments, while the opinion that these mismanaged economies will slump once that support is taken away is very hard to disprove.

It is as if Japanification’s dismal results, documented through statistics, have had no effect on western decision-makers. Lip service is paid to the urgent need for sovereign deleveraging, but there is little evidence that governments properly appreciate their big underlying budget gaps. These, and most particularly the structural gaps, will not be filled by economic recovery. Rising pension and health care spending puts relentless pressure



on government debts and, if western economies return to economic growth, public borrowing will crowd out private investment and harm the prospect of further recovery. Therefore, the time for deleveraging is now – not at some unspecified date in the future. This requires well thought-out exit strategies, a term used to describe the necessary monetary policies to be used by central banks to disengage themselves from their (often unwise) leveraging of the preceding year or years.

As has been the case with the Bank of Japan, it will not be easy, let alone painless, for the Federal Reserve, Bank of England and ECB to establish valid exit strategies. Governments object to raising interest rates for fear of weak-ening the economy, even if ultra-low interest rates and a great deal of newly minted money increase the risk of inflation. In addition, absolutely nobody has had any experience of how to undo the damage created by quantitative easing.

Reductions in government debt, particularly a large one,1 require a firm longer-term commitment to fiscal consolidation, along with a strong focus on the reduction of spending and structural reforms. Both are doable, but neither is every jurisdiction’s cup of tea. Among positive examples, Belgium, Finland, Holland and Ireland have, in the past, implemented substantial budgetary adjustments, complemented by structural reforms; their after-effects were instrumental in reducing each country’s government debt-to-GDP ratio.

Fiscal consolidation, however, gives rise to certain negative short-term effects on sharing the weight of the reforms between the different sectors of the economy. Negative reaction to consolidation because of these effects unduly delays fiscal discipline and ultimately results in even greater adjust-ments. This is not properly explained to the public when it mobilizes against austerity measures (see below).

The increase in retirement age, aimed to account for demographics, lon-gevity and a bankrupt government-sponsored social security system, is an example of a domain in which fiscal consolidation is urgently needed. The plan advanced in 2010 by President Sarkozy of France was to raise the legal retirement age from 60 to 62, which is necessary, though far from being adequate. But it met fierce popular opposition promoted by labor unions and the Socialist Party, who wanted to hike taxes on ‘the rich’ – the usual left-wing snake oil.

Millions of demonstrators paraded time and again in the streets of Paris and other French cities with whistles and banners (Chapter 8). They showed their anger against a minor deleveraging – only by two additional years – of an entitlement which, because of demographics and mismanagement, has become unaffordable and unsustainable. Increasingly bleak economic figures from the western economies do not help in turning the system around.

On the other side of the North Atlantic, at end of August 2010, the Congressional Budget Office (CBO) released a baseline budget forecast based on two hypotheses. The first assumed that tax cuts enacted in 2000 by


Restructuring Sovereign Balance Sheets 119

George W. Bush would expire as planned; with this, the deficit could fall from 9.1 per cent of GDP in 2010 to 3.8 per cent in 2014, but rise to 6 per cent in 2020; clearly, too high a level. The alternative hypothesis of exten-sion of the Bush tax cuts would increase the shortfall in 2014 to over 6 per cent of GDP and to over 11 per cent of GDP in 2020 essentially ruining the American economy.

As these references demonstrate, fiscal tightening has many aspects and there is no way of avoiding the pain of budgetary repairs. But it is not easy to explain to the public that this negative attitude damages everybody’s future prospects and standard of living. Yet, in the medium to longer run the benefits of budget pruning and fiscal consolidation become evident. A reduction in government financing needs leads to lower long-term interest rates, due to lower demand and declining risk premia, and frees up revenues to finance productive expenditure as well as growth-enhancing tax cuts.

Because of its positive results but negative public response to necessary measures, deleveraging is a fine balancing act. Therefore, it is the art of masters who are in short supply. While, in financial history, severe financial crises are usually followed by long periods of debt reduction, the rapid rise of liabilities in the first decade of this century – family, corporate and sovereign – does not benefit from precedents on how to handle the new normal. This makes more complex the process of reducing leverage by:

convincing the public that deleveraging is a ‘must’, not an option,finding open-minded, agenda-free economists able to work with dili-gence, andmaking plenty of walkthroughs and post-mortems to fine-tune measures and document progress, because success can only be judged through deliverables.

Early signs are important; it is just as critical to see if they are sustained. Judged by ratios of total debt to GDP, in November 2010, at the time of writ-ing, deleveraging has barely started in any western country. Theoretically, consumer credit in the USA has fallen for nearly a year, but not by much in real terms. What is evident is that the composition of debt has shifted as government borrowing has soared and the curve of private debt bent somewhat.

This sharp rise in sovereign debt on both sides of North Atlantic (with the possible exception of Canada) lead several economists to the belief that, under current conditions, deleveraging will be more protracted than in previous cases. The scale of indebtedness is higher and the fact that almost all major western countries are simultaneously afflicted by high sovereign debt will have global consequences. Deleveraging is made still more complex by the fact that rising amounts of public debt have

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increased the overall debt reduction that will be needed and a simultane-ous private–public sector deleveraging adds to the aftermath of cause and effect.

Economists suggest that pivotal to reducing high debt ratios of sov-ereigns is the creation of significant primary surpluses2 through fiscal consolidation – particularly based on the reform of state expenditure and promotion of output growth. Working against this option is the fact that, where tax burdens are high, a revenue-based consolidation provides rather limited results.

Most helpful in creating a deleveraging psychology is the early announce-ment and implementation of credible ambitions and decisions on con-solidation, particularly when they focus on matters of expenditure. Such a strategy can be instrumental in reducing risk premia in interest rates and in providing the market with a message of sustained commitment by the government.

In conclusion, the complexity of the deleveraging process and the unknowns it involves see to it that it is not well understood by those who govern, let alone by the public. Doing a neat job requires a great amount of skill, and involves plenty of risks, some of which are cropping up for the first time.

While the French and American economies have been taken as an example, several other western countries are currently confronting similar challenges from the perspective of budgetary discipline and need for deleveraging. There are also issues connected to the quality of debt, which call into question the creditworthiness of governments supposed to be risk-free borrowers. What is more, many present risks are of asymmetric nature in the sense that the upside is limited but there is plenty of downside. Inflation and deflation are examples.

Deflationary or inflationary risk?

Deflation is a persistent, generalized and self-reinforcing decline in a broad set of prices, usually resulting from a decrease in aggregate demand. At the same time, deflation can turn into a market psychology and become entrenched in expectations. Contrasted to this, disinflation characterizes a process of decelerating inflation that may lead to negative inflation rates (hence deflation) of a temporary nature.

The definition of inflation is more twisted, and therefore more ambiguous. Webster’s New Universal Dictionary describes it as an increase in the amount of currency in circulation resulting in price rises, and a relatively sharp and sudden fall in the currency’s value. Webster’s also assigns inflation’s causes to supply of goods failing to meet demand and/or an increase in volume of paper money issued.

While this definition looks crisp, economists as well as statisticians of the government and of central banks make it less straightforward by



distinguishing between ‘headline inflation’, ‘core inflation’, ‘imported inflation’, ‘implicit inflation expectations’ and other terms invented to enrich the technical jargon which, at the end of the day, means different things to different people. To make matters worse, with the exception of Paul Volcker’s successful fight against inflation in the early 1980s in the USA, monetary policy has little to offer by way of proven achievements in swamping inflation – or, for that matter, deflation.

To make matters more complex, there exists as well the process of ‘ strategic inflation’, used as a tool by governments to avoid paying the full value of their debts. Strategic inflation is heralded as being socially friendly (which is absolutely untrue), and some economists (particularly the pseudo-Keynesians) look at it with a sympathetic eye. They are wrong to do so.

In the longer run, the net result of inflation hurts people more than a dose of deflation. Economists, contrary to the supposedly liberal thinking about inflation ‘benefits,’ doubt that a period of deflation would be catastrophic, as some of their colleagues have been warning. The non-believers in the destructive power of deflation put their thoughts in this way: ‘Will the sky fall in if deflation happens? The sun still rises over Tokyo.’

By contrast, the school of thought promoting inflationary policies maintains that deflation is more dangerous than most forms of inflation, particularly if it becomes entrenched, as in Japan. This argument is wholly one-sided, forgetting the dramatic after-effects of inflation – and, even worse, of hyperinflation, which devastated Germany in 1923 and Zimbabwe in 2008/10, under the watch of Robert Mugabe’s regime.

Theoretically, but only theoretically, one might feel more comfortable with zero inflation and zero deflation. But nothing walks in a straight line, advises the Heisenberg principle. These two zeros are not a realistic target. With zero inflation, part of the time prices will be in deflationary territory. An inflation rate of up to 1 or 1.5 per cent is taken by many economists as acceptable, but it is unrealistic when sovereigns’ huge budget deficits, coupled with a very accommodating policy, flooding the market with money from central banks feed the fires of inflation. Economists who press for more stimulus in spite of the fact that the sovereigns’ debt runs in torrents, do so because they fear a large oversupply in goods, as governments struggle to fund the bur-geoning budget deficit. To this, they say, should be added a disappointing consumer attitude (in terms of spending money by falling deeper into debt). The result is an increasing likelihood that the economy relapses, particularly so if credit is still restrained and the residential real estate market looks dead in the water. Under the regime of so-called inflationists, prices rapidly rise, including labor costs, making exports uncompetitive and public confidence in the value of money is lost; therefore, the road to economic recovery becomes even more problematic.

In an article he published in the Financial Times, Edward Gottesman took the opposite stance to that of the inflationists: ‘From 1865 to 1895, the US



had persistent deflation,’ Gottesman wrote, noting that ‘During that period industry flourished … [while] businesses produced real output from innova-tion, capital investment and human resources, without illusory gains from currency depreciation.’3 He also contrasted this result to four decades of inflation in America and Britain, which led to damaging imbalances.

Some of these imbalances were created by the massive and very low-cost central bank financing in 2008–11, which, moreover, proved to be no real cure for illiquidity and decay of bank assets, or for the credit squeeze (an effect partly due to disrupted credit channels and rising defaults in western economies). Five years into the global financial crisis and, in spite of unprecedented public sector support for banks’ capital, the financial industry is still on the sick list, says Gottesman.

Deflationary risk, therefore, is far from being the one and only challenge confronting monetary and fiscal policy-makers. There is also a wall of cred-ibility western governments and their ‘too big to fail banks’ have to climb in order to prove that the measures taken by sovereigns have been sound, and the big banks’ recovery has been successful.

Still, the risk of embedded deflation should not be taken lightly, as it has the nasty habit of perpetuating itself. By so doing, it condemns the economy to a vicious cycle of weak spending and sliding prices. In short, the elephant in the china shop can be both inflation and deflation.

As with all other issues, both costs and deliverables count. The expensive and ill-studied stimulus programs through which western governments substantially increased the sovereign debt are an example of the costs.4 The often-heard argument that ‘the hole was simply deeper than it appeared’ and, therefore, is very difficult to plug, is not acceptable. As for the after-effects of superleveraging, nobody bothered to explain the negatives to the US or British public, and no political leader asked for sweat and tears5 – as Churchill did in World War II – to prepare the citizen for confronting the challenges lying ahead.

Putting the carriage before the horses

One of the paradoxes of the years 2008, 2009 and 2010 was that, while China, India, Brazil and the companies there were vaunting their sales-driven, consumer-centric growth to achieve first-class efficiency, most European countries, as well as the USA, were on the defensive. Their lead-ers are apologetic, timid and constrained by conflicts of interest, as well as by the sacred cows which put themselves in the way, such as ill-conceived ‘social’ spending, which inhibits bold decisions commanded by a sound economic policy and leads to the oxymoron that sovereigns and their folk want to have their cake and eat it, too.

France boasts more Fortune 500 companies than Germany; but the French public behaves as if the country is exploited by the multinationals.



It also presses for wealth distribution. ‘Elsewhere, material success is readily admired … billionaires are applauded (and envied), bosses are acclaimed, self-made men celebrated,’ writes Alain Duhamel, a French political commentator. ‘In France, not at all. Wealth embodies evil, money the devil.’6

Copains d’abord7 used to be a French slogan, but, as of recently, the United States has fallen into precisely this same trap of putting the cart before the horse. This speaks volumes about cultural reversal. In the eighteenth cen-tury, Jean-Jacques Rousseau believed that society enslaved man to vanity and ambition. By contrast, Adam Smith argued that society’s impact was positive. The US economy was tuned to Adam Smith’s principles, but today it has become an ardent follower of Jean-Jacques Rousseau.

In his first book, The Theory of Moral Sentiments, Smith turned the tables on Rousseau, but the argument underpinning their cultural difference did not die out with the passage of time. The theory espoused nowadays by many people, that the state should indefinitely continue playing nanny to society by means of a monstrous State Supermarket, has taken root.

This turns the principles of able governance on their head. Sound management requires that when a crisis hits an institution, the task of handling that crisis falls mainly to the institution itself, its bosses and its agents. Managers must regroup and restructure the resources. If they do not, then the institution fails and eventually collapses.

This is precisely what Latvia did in 2009 and 2010 (to its credit), and by so doing its government defied social gravity. In spite of the severe economic and financial crisis it went through, the country kept its currency pegged to the euro and regained competitiveness through an internal devaluation, with large cuts in wages and public spending, and a fiscal adjustment roughly equivalent to between 14 and 18 per cent of GDP.

It is a measure of the Latvian voters’ maturity and understanding that the coalition which saw through such tough measures won the parliamentary election on October 2, 2010 with 58.6 per cent of votes cast. The common citizen did not punish the government; they rewarded it for holding firm.

Because the public have been so poorly informed about the need to reverse the profligate policies of the last three decades, in other parts of Europe it has reacted negatively to austerity measures. On September 29, 2010 there was labor unrest in Spain and other EU countries in response to recent rather timid austerity measures taken by their governments.

Spanish industry and parts of the country’s transport network were brought to a standstill by a general strike, with thousands taking to the streets to protest against spending cuts and new labor rules that make it easier to fire workers. In Brussels, an estimated 50,000 workers from across the EU converged on the Schuman area, where many European Union insti-tutions are located. They gathered to decry the measures aimed at dealing with the aftermath of the financial crisis and the European Commission’s



proposal to impose semi-automatic fines on countries that share the euro currency, but fail to improve their finances and balance their budgets.

Belgium, France and Spain are not alone in experiencing this ‘anti- democracy’ through street power. In Athens, public transport employees stopped work for several hours to protest about job cuts; the debt-ridden national railroad was hit by a 24-hour strike to protest plans to downsize and privatize the company; and truck drivers were in the third week of a strike because the government (correctly, though belatedly) decided to lib-eralize the truck drivers’ market.

This is, in a few words, the real challenge confronting western society and its sovereigns today many of the other arguments raised are pure theory. Clear decisions have to be made on economic priorities, otherwise overind-ebted governments, companies and households are heading straight for the wall. If deflation and higher interest rates are the medicine to save society and the economy from a hecatomb, then so be it.

The silver lining of having gone to the edge of the abyss is that economic policy is being increasingly constrained by deflationary tendencies as they limit the government’s capacity to inflate debt away. Austerity measures are not the enemy of society, as we will see in the next section.

This is by no means a call for deflation Japanese style, but for a policy of austerity aimed at facilitating the long-delayed restructuring of sovereigns’ and households’ balance sheets. Failure to do so is precisely what led to Japanification (Chapter 4). Deflation was a symptom, not the disease in Japan. Internal rigidities and demographic trends were primarily responsible for Japan’s long-term structural damage.

But misdirected monetary and fiscal policies, implemented after the bursting of the Japanese economy’s bubble,8 have made a bad situation much worse. Carmen and Vincent Reinhart presented evidence at the Jackson Hole Symposium of late August 2010 for appropriate policies. They have shown that, in the wake of financial crises, deleveraging can be an exit road.

The real problem with engineering a recovery after deleveraging is that, in practically all countries, fiscal policy is deeply politicized, characterized by an absence of or only rudimentary, defined goals, as well as haphazard methods, largely due to a lack of precedents.

Politicians sometimes use deflationary tendencies as a counterweight to the need for fiscal restraint, following a sharp rise in public debt. Political squabbling and the absence of an exit strategy are key reasons why a deflation which should be short-lived lingers on. As it is prolonged, it turns into outright deflation and can have a severe impact because it raises the real value of outstanding debt, with negative implications for the valuation of liabilities.

Summing up the themes above and in the present section, the cornering of monetary and fiscal policies between rationality and the easy way out has led many economists, central bankers, commercial bankers and investors



to debate whether inflation or deflation is the greater danger for the economy. This issue is still unsettled,9 which matters a great deal because inflation and deflation require almost totally different responses from households, companies, investors and government policy-makers.

Inflate, deflate, stagnate, default; all seem equally grim. The better solution for countries is to work off their debts through economic growth – but economic growth has proved to be an elusive concept, particularly for western countries, as, with globalization, jobs moved abroad (and money, too).10 Therefore, it is all the more important for countries to pursue deep structural reforms that will open up new opportunities for market entry, free the labor market and, hopefully, make it vibrant once more.

Austerity is not that bad, after all

In March 1933, in the very early months of the Roosevelt Administration, the US Congress passed the Economy Act, which cut the public employees’ salaries by 15 per cent, as well as department budgets by up to nearly one billion dollars in various public expenditures. This was followed by the crea-tion of the Civilian Conservation Corps which aimed to provide jobs for young men in areas such as fire prevention, flood control, maintenance of roads, bridges and other constructions. Franklin Roosevelt had a talent for finding solutions to complex and urgent problems; the austerity measures which he took should have been a guiding light to the Bush and Obama administrations.

Decisions about austerity policy are tough and can be taken by leaders – not by second-raters in government. More often than not, the choice is that of the lesser evil. When, in 1930, Brüning became chancellor of Germany, he imposed austerity measures aimed to stop the torrent of red ink in the government’s budget:

salaries of all officials11 were cut by 20 per cent,unemployment benefits were restricted, andother measures were taken to balance the budget.

Memories of Germany’s hyperinflation disaster of 1923 were still fresh, and the government did not want to finance the sovereign deficit through the central bank’s printing presses. Now, as then, the tough decisions on austerity are a test of a statesman’s legacy and of the quality of the economic structure he leaves behind.

Austerity measures enacted by the Greek government, in early 2010, in spite of wide public opposition, helped in the improvement of market psychology towards the country’s outstanding debts. It should, however, be remembered that in this, as in all other cases of national overindebtedness and restructuring of the state’s balance sheet, the most important factors

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are the composition of austerity measures and the will to see them through. Persistence will determine whether or not fiscal retrenchment is successful. There exist payoffs: outside infrastructure, spending cuts are effective in stimulating growth by reducing public sector employment and wages, and when the government cuts public spending, households perceive the likelihood of lower future taxation and they increase consumption.

Like any other project, an austerity program has to be managed. It would be a mistake to think that EU-IMF loans and associated austerity measures will succeed no matter how the program is run. But they had to be enacted. Failing to try is to miss an opportunity to restructure the Greek economy that might have been. Short of rigorous measures, the effects of a deep economic crisis can be wide. In terms of money alone, the emergency loans exclude neither that Greece might default (at least in an organized, pre-arranged way), nor that other sovereign defaults will not happen because governments will be in charge of their finances.

In the opinion of Wegelin, the oldest and one of the best-managed Swiss private banks: ‘Greece corresponds to the non-bankruptcy of Bear Stearns in spring 2008; we shall be surprised if a Lehman Brothers for the eurozone does not follow relatively rapidly, and put an abrupt end to the midsummer night’s dream.’12 (See also the discussion on this issue in Chapter 4.)

This risk looms on the horizon of every indebted nation and makes it absolutely imperative that the sovereign put its financial house in order. The faster this is done, the better is the government’s ability to confront the next shock. As for the argument that austerity measures swamp growth, it stands on thin grounds. Under certain conditions of good governance, austerity can improve growth prospects; this is another example of cause and effect.

Looking at 112 cases of serious fiscal retrenchment, the London-based European Economic Research team found that sizeable and swift austerity, delivered primarily through expenditure cuts, was successful in supporting growth as well as (often) reducing the debt to GDP ratio. A most interesting finding has been that, on average, in the year of fiscal tightening and the two following years GDP grew by 2.8 per cent per year.13

While the Merrill Lynch statistics contradict other findings by economists, the opinions they document tend to converge with evidence supporting the fact that tightening and expenditure cuts open up the way to GDP growth. This is also the conclusion of a new analysis by the International Monetary Fund, which suggests that fiscal austerity, coupled with structural reforms, yields far higher growth than austerity alone.

Such a synergy should, indeed, be the overriding objective of an economic austerity plan. Neither households nor governments can continue to oper-ate with wide budget gaps without running the risk of funding costs esca-lating. America’s deep crisis suggests that even the largest economy in the world cannot afford the spend, spend, spend attitude which has prevailed



since the early George W. Bush years. A similar concept is found in the 80th Annual Report of the Bank for International Settlements:

Financial and economic recovery is under way, but it is both incomplete and fragile, at least in the major advanced economies. Monetary policy is still highly stimulative almost everywhere, despite first steps towards a more neutral policy stance in some economies. Fiscal policy remained expansionary, causing government debt levels to rise at an alarming pace.14

Because every country has idiosyncratic problems, trying to develop one solution which fits them all would be the wrong approach. Instead, the cause and effect method discussed in Chapter 1 should be preferred, assisted by a search to uncover the deeper causes of the imbalances found in domes-tic economy factors.

The aim of such a study should be to unearth the half a dozen deeper causes, then examine how to go from ‘here’ to ‘there’. How can an economy which is skidding to the edge of the abyss get back on a sustainable path? It is enough to proceed by consolidating public budgets? Which structural reforms have priority? Which other adjustments are required – for instance, in areas of the industrial base and wage growth? (More on this later.)

It is self-evident that the higher-deficit countries will bear the brunt of the adjustment burden; still, an important question is whether the costs of redressing a bad situation will be distributed symmetrically or asymmetrically between sections of the population. Socialist claims that ‘taxation ought to be based on a person’s ability to pay’ are reminiscent of failed communist doctrines, and therefore unacceptable.

Another issue requiring careful study is the case of countries sharing a common currency, like euroland member states. Corrective measures should focus on an extensive reduction of negative current account balances and the control of inflation – since relative prices can no longer be adjusted through exchange rate changes.

The way a monthly bulletin of the European Central Bank puts it:

Major reforms are particularly needed in those countries that have expe-rienced competitiveness losses in the past or that are suffering from high fiscal and external deficits. Measures should ensure a wage bargaining process that allows wages to adjust flexibility to the unemployment situ-ation and losses in competitiveness.15

Identification of economic sectors which contributed the most to a country’s total debt and leverage is the next most important requirement. Taking as an example the United States, focusing on four main sectors and using order of magnitude figures, in 1970 the largest debtors were non-financial



companies, followed by households and the government. In comparison, only a tiny amount of debt belonged to financial firms. At that time, total US debt stood at a relatively large, but still manageable, 145 per cent of GDP. In 1980, the same pecking order prevailed, but government debt had shrunk somewhat, while the financial industry’s debt had more than doubled.

By then, total US debt approached 160 per cent of GDP; a 10 per cent increase in ten years. In 1990, following the Reagan years, the largest debtor was the government, with the financial industry rapidly catching up as it leveraged itself more than in any previous time.

In 1990, the total US debt ratio passed the 230 per cent mark – a destabilizing increase of nearly 44 per cent in a decade. In 2000, the financial industry’s debt alone represented 85 per cent of GDP, making it by far the greatest debtor, while (thanks to the Clinton years of balancing the federal budget) government debt had fallen to fourth position.

An austerity program at that time should have been squarely applied to the financial industry, because it was that sector of the economy that brought total US debt to 260 per cent of GDP. Unfortunately, no austerity measures were put in place. Instead, the financial industry was allowed, as an industry sector, to increase its debt figures at will, while the government and supervisory authorities turned a blind eye.

A year after the bubble burst, in 2008, the largest US debtor was the financial industry, having reached, all by itself, a debt level of 120 per cent of GDP. Capitalizing on the banking industry’s superleverage and low credit standards, households were not far behind; their debts amounted to another 100 per cent of GDP.

By 2008, the cumulative mountain of debt in the US economy had reached 360 per cent of GDP.16 As the above statistics demonstrate, the financial industry should have been the first to be subjected to austerity measures, while there was still time. Instead, the bubble burst and private sector debt was taken over by the government in the most unwarranted manner – suggesting policies established by inflation rather than propo-nents of financial stability and balanced budgets.

Budget cuts and B/S restructuring

One of the first senior executives to quit the Obama Administration, and most particularly its economic policy team, has been Peter Orszag, who headed the Office of Management and Budget (OMB).17 The wider opin-ion has been that he resigned partly in frustration over the absence of a tough plan to address America’s oversize national debt, which continues to soar.

Reportedly, Orszag clashed with Larry Summers,18 the head of Obama’s National Economic Council, over when fiscal consolidation should start and how far it should go. Political analysts have suggested that this dispute



arose after the head of OMB asked government agencies to prepare two budgets: one with a minor spending freeze requested by the Administration; and the other with the aim of cutting spending by 5 per cent, which he saw as a first step towards restructuring of the government’s balance sheet.

Another reason for divergence of opinions within Obama’s economic team seems to have been the battle over health reform. Orszag’s thesis was that getting health care under control was essential if America’s large deficits and mountain of debt were ever to be controlled. But the Administration’s bill fell far short of his cost control expectations.

Congress balked at measures designed to hold down costs over the longer term, a move which has a great deal to do with the politicians’ fear of a backlash from downsizing entitlements. Both America and the European Union are confronted with public claims and entitlements which have got out of control, but there is no political leadership able to downsize them to make ends meet. The sovereign budget is loaded with unsupportable claims whose financial requests multiply like the heads of the hydra:

old age pensions,unemployment subsidies,a growing pallet of health care services, social wealth redistribution requirements, and more.

These go way beyond the demographic problem which has hit the West (particularly western Europe). Politicians seem to be overwhelmed by legislating the proliferating claims and entitlements, and governments are evidently unable to manage them. Both the political leadership and the general public are living in a world of monetary illusions.

The public’s adverse reaction to measures aimed at putting the debt-to-assets balance right is often promoted by the fact the sovereigns find no difficulty in finding good money to throw after ‘silly money’. In Ireland, the ill-advised decision taken by the government to save the self-harmed banks at any cost saw to it that, by October 2010, the cost of bailing out the Allied Irish and Anglo-Irish banks had soared close to a massive a50 billion ($74 billion) and the Irish budget deficit was revised up to 11.9 per cent of GDP, plus the banks bailout costs, which, when added, raise the sovereign’s deficit for 2010 to an eye-watering 32 per cent of GDP.

If one looks for a definition of what is meant by a dramatically unbalanced budget, this is it. No wonder, therefore, that after three years of austerity in which household wealth fell by almost one third, most of the Irish public remain deeply pessimistic. A cool 70 per cent of respondents to an opinion poll said they felt the worst was yet to come for their country’s economy.19

In neighboring Britain, the Conservative/Liberal Democrat coalition led by David Cameron and Nick Clegg, with George Osborne at the Exchequer, is in the middle of an initiative to balance the budget. It enacted the

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industrial world’s biggest collective budget cuts for about four decades. The newly elected government is pushing ahead with plans to overhaul the British state: schools, the police and some forms of welfare all face a sharp knife.

This, however, is not true of the National Health Service (NHS), the sacred cow with an insatiable appetite for taxpayers’ money. There is even talk of the Bank of England offsetting the pain of the budgetary cuts by printing more money to buy more government bonds (see Chapter 5 on quantita-tive easing). On the positive side of the Cameron/Clegg budgetary cuts is the fact that 75 per cent of the savings will come from spending cuts. Many government departments will shrink by 25 per cent. On the negative side is the massive budget deficit of 11 per cent of GDP inherited from the Labour government and the lack of political will to trim the budget of the biggest spender of them all, the NHS, as if it were untouchable.

Peter Orszag in the USA and George Osborne in Britain have been absolutely right in their emphasis on taking tough fiscal action. This is an urgent task before, under relentless pressure, the markets force Washington and London to do anything else by default. Governments don’t necessarily appreciate that unplanned or poorly planned deleveraging causes low growth and has other unexpected effects – like scarce investment themes.

An example of well-studied, planned action is provided by the restruc-turing of the Swiss fiscal framework. In the 1990s, after a period of rising budget deficits and growing debt, the Swiss people voted to implement a debt-brake mechanism. Constitutionally inscribed and enforced since 2003, this mechanism aims at achieving a structurally balanced budget, sets annual expenditure ceilings government officials must observe and prevents excessive accumulation of debt via future expenditure corrections. This has had, quite evidently, a positive effect on the Swiss economy and the citizens. To compete internationally, Switzerland must focus on producing high value-added goods and services whose costs are kept in check. Inflation, too, must be low so as not to erode competitiveness.

To help in meeting these goals, public expenditure for new social projects has been kept low, as compared with other western countries, at less than 0.5 per cent of GDP. This is a meaningful percentage when inflation is swamped – which, at the end of the day, benefits workers and employees because unemployment, too, is low. In contrast, measures taken by other governments have simply been too weak and too indecisive, while more and more common citizens and business people have a feeling that trouble lies ahead.

This negative public feeling is further promoted by the fact that, in spite of the different stimuluses and salvage of self-harmed banks, concerns remain relating to the emergence of renewed tensions in financial markets, increases in commodity prices, growing protectionist pressures and the possibility of a disorderly correction of global imbalances.20



Because they are more eager to get re-elected, than to do a neat job, politicians avoid taking radical but necessary measures, including the reorganization of government itself. Peter Drucker argued that if politicians were serious about really reinventing government they would go back to first principles and ask if large parts of government services, and budgets allocated to them, need to be there in the first place. In Drucker’s opinion, in many cases the evident answer is they don’t; but it takes political courage to be an organizer and innovator.

Restructuring the government’s balance sheet should make use of the fact that not only have many departments become obsolete, but also public services are characterized by an appalling amount of waste, as successive parliamentary inquiries have revealed.21 Margaret Thatcher first tried to cut dead wood and increase efficiency, but in the end her successive governments built overly elaborate, bureaucratic structures and made it harder for people to do their job or to serve the public.

In the USA, Barack Obama created a new bureaucratic structure of ‘chief performance officer’, with no evidence his government’s performance got a boost, especially in terms of spending taxpayers’ money more efficiently. If the health care bill ‘for everybody at any price’ is taken as an example initiative, financial performance was hit by paying no attention to the attainment of greater efficiency in public health.

Yet, greater performance is a bonus in the government’s balance sheet restructuring. Therefore, the absence of evidence that governments care about efficiency comes as a surprise.

‘Long-haired’ ‘solutions’ and monetary illusions

So-called Keynesian economists (an incorrect label) argue that big budget cuts will fell a fragile recovery and condemn the western countries to deflation. Paul Krugman has stated that this is utter folly of madmen in authority – but he failed to pay due attention to the fact that, with unlimited spending policies, public debt is heading for 120 per cent of GDP and beyond, which is an even greater disaster than two decades of Japanification.

Krugman is not alone in his preference for fiscal irresponsibility. J. K. Galbraith also promotes government stimuli without limits, no matter the consequences. One of his famous remarks on spend-and-spend policies was that: ‘there is no operational limit. The federal government can spend what it wants.’22 Really? A government that ‘spends what it wants’ is utterly irresponsible; it is indeed regrettable that some politicians and ‘long-haired’ economists make the mistake of confusing ‘do’ and ‘can afford’.

While fiscal responses to the crisis differ notably across countries, the multiplication of the debt hydra’s heads is very bad news for everybody, and most particularly for those nations featuring the larger budget deficits. The need to balance receipts and expenditures is no abstract notion, but one



targeting the sustainability of public finances, taking care of imbalances and allowing the stabilizers to operate in order to improve economic activity. Measures are needed to:

reduce government expenditure by downsizing administrative costs,lower public wages and trim the number of public employees, andrethink entitlements, with the aim of cutting back the unlimited spend-ing of public money.

The alternative is the widening of the tax base through both direct and indi-rect taxation. ‘More taxes’ are anathema to economic activity, but they have come into the picture in a big way as governments have deliberately taken on the debts of the private sector, incorrectly assuming that their capacity to carry such burdens is almost unlimited. In reality, these have been national Ponzi schemes in which governments grant all sorts of benefits and take on spending responsibilities way beyond their tax income. As the evidence presented so far demonstrates, this leveraging of the government’s balance sheet through more and more debt is a dirty trick because everybody knows that somebody will have to pick up the bill – it will be the next generation.

Globally, particularly among western nations, the number of deficit countries is growing and their condition has become chronic. Not unexpectedly, this has led to a public debate on the strategies required to achieve a sustainable reduction of macroeconomic imbalances; for instance, in euroland, by using the credit of surplus countries.

This argument, which has been joined by Barack Obama with no success whatsoever, is based on a monetary illusion. The recommendation that surplus economies should reduce external discrepancies by increasing domestic demand and by being, in economic terms, irresponsible, falls on deaf ears and for good reason – it leads to fiscal catastrophe.

The Obama Administration has been pressing Angela Merkel to increase her country’s imports through higher government expenditure or wage acceleration, and therefore inflation. This poor advice is supposed to lower Germany’s current account surplus and help deficit countries – including the USA – by providing an expansionary stimulus. China is under the same pressure from a so-called symmetrical adjustment scenario where its surplus would work towards reducing the huge trade deficit of America.

Critics say that a symmetrical adjustment scenario is based on assumptions which, when analyzed in greater detail, prove to be invalid. A case in point is the theory that surplus countries actually have a notable impact on deficit countries. Statistics show this is not true. If German imports were to rise by 10 per cent, then the first-round effect would be that the current account balances in Spain, Portugal and Greece would improve by only a 0.25 percentage point, while in the case of Ireland the effect would be more pronounced, amounting to 1 percentage point.23

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Proposals for so-called symmetrical adjustments often center on wages, prices and collateral damage to the surplus country’s economy, with a second thought that, after the damage, output will shift to the market(s) benefiting from the deal. That’s plain nonsense. The problem of large, persistent current account deficits can only be solved by the affected coun-tries themselves (Chapter 6).

The fact that symmetric adjustments are unsustainable, has also been illustrated by events in America; successive governments have tried it for some time without success. The current account deficit is not the only worry. Any western economy is full of government-sponsored and government-controlled entities, which have been used for decades as gar-bage bins for nearly worthless loans, particularly mortgages, or, to provide well-paid jobs distributed by political patronage to people who know little or nothing about how to run a company.

This being widespread among industrial nations, it is not far-fetched to assume that, even with nominal budget cuts and budget restructuring, the deeper healing of western economies still has a long way to go. Economists who lean towards the side of optimism suggest ‘this’ or ‘that’ course for the recovery, which pays minor attention to market fundamentals, and could produce stronger expectations. Needless to say, these half-baked solutions do not work.

Other economists with an optimistic outlook think that inflation will not rise, as spare capacity remains high; and, against a backdrop of a weak recov-ery and stable or falling inflation, most global central banks will remain on hold. Adherents to that school of thought are usually (but not always) younger people whose experience of inflation is limited to what they read in books.

To the contrary, more mature economists who went through the stagflation of the 1970s and galloping inflation of the 1980s do not believe in such fairytales. According to their judgment, the gaping fiscal deficits in western nations cannot be sustained forever. Eventually, the debt bubble will burst.

Beyond these differences in the appreciation of the risks present in the current economic situation, and projections made about the future, lies the fact that there are no fundamental studies to document which level of public debt to GDP governments should aim for. We have spoken about this issue. The limit of 60 per cent enshrined in the Maastricht Treaty, which governs membership of the euroland,24 was a political decision. It is also one that no member state in euroland cares to observe. What can be stated with assurance is that debt, and therefore leverage, makes the economy fragile, as it does with a company’s or a household’s balance sheet; even if the figure shown as national debt is not to be repaid in its entirety, the part of it in foreign loans will have to be repaid – while the total debt has to be serviced, with new receipts running to cover the damage created by old spending follies.



In conclusion, governments have the responsibility of ensuring that higher debt does not crowd the economy, resulting in lower future growth. Some economists also reckon that a public debt rising from 60 per cent of GDP to 100 per cent of GDP could increase a country’s borrowing costs by 2 percentage points. Therefore, it is important not only to avoid re- emergence of debt increases and imbalances, but also to ensure a sustainable process of bringing the public debt to GDP ratio below pre-crisis levels.


Part IIIEuroland’s Financial Integration and Sovereign Risk


137

8Woes of Euroland’s Financial Integration

Strong core and a weak periphery

As these lines are written at the end of 2010, Germany is leading euroland’s rebound, helped by the global manufacturing cycle, a restructured economy and (till mid-2010) a less overvalued euro. France and Italy have strength-ened, but the financial crisis in euroland’s periphery has been worsening and continues unabated. Ireland ruined its economy by providing unquali-fied support to its mismanaged banks; Spain and Portugal are falling back into stagnation; and Greece is suffering a recession.

The good news is that Greece is staging a fiscal turnaround, while the risk that Spain may soon fall into euroland’s economic safety net has receded. The optimistic view is that euroland can (and probably will) get its internal problems under control, even if the sovereign debt crisis and domestic fiscal responses restrain the pace of growth. Pessimists – and, along with them, speculators – are betting on the opposite outcome.

The common currency’s weak periphery and its woes evidently weigh on the euro. A decade after having been born, the monetary union itself is not in the best of health, which is bad news because the euro had been seen as a symbol of successful financial integration. It was originally thought that the challenge of a common currency was to provide stability for all of its members, but economic and financial laxity at government level saw to it that overspending policies and budget deficits undermined both discipline and economic growth.

This has evident consequences for the European Union as a whole. Euroland is divided between a group of countries determined to save the currency’s value through budgetary discipline and a bloc that wants to continue feeding the monster of the State Supermarket which devours the economy’s flesh. The latter press for transfers from ‘richer’ to ‘poorer’ (in terms of discipline) members.

Mismanagers advocate ‘solidarity’, accusing the more productive and disciplined euroland members of selfishness. By so doing, they even brush


138 Euroland’s Financial Integration and Sovereign Risk

aside one of the pillars of democracy: for voters to consent to a transfer of wealth, they must feel that the recipients are fully responsible and accountable to them – which is far from being the case.

The flaws in the agreements which led to establishment of the euro ensure that, so far as action taken by its member states to redress the balances is con-cerned, alarm bells only ring when danger is imminent. Ireland has made the most serious effort. Greece has been obliged to slash spending and raise taxes significantly. Spain and Portugal have also been tightening their belts some-what, but one can see no enthusiasm for austerity elsewhere in euroland.

An example of a mismanaged economy is provided by Spain, which ben-efited lavishly (and still does so) from euroland’s and the EU’s financial help, and, on the surface, appeared to be a model of fiscal discipline. Compared with those of the other countries, its public debt was relatively low at 43 per cent of GDP in 2007; it had good bank regulation and it was running budget surpluses. This, however, was only superficial.

Fundamentally, the Spanish economy was overleveraged by a huge and poorly controlled housing boom, whose financing mainly came from out-side the country. Large and unsustainable inflows of capital from the rest of Europe (Germany in particular) fed rapid growth of the Spanish economy, as well as significant inflation. As a result, Spanish exports became increasingly uncompetitive, while it seemed that jobs stayed strong, society was polar-ized; then the housing bubble burst with the economic crisis.

With this, the Spanish economy turned on its head and unemployment soared to over 20 per cent, while the budget went into deep deficit. What the reader should appreciate is that the torrent of red ink which followed was the result – not the cause – of the ‘Spanish miracle’s’ end. After the bubble bursts, it is not easy to recover.

Spain is not the only example of lack of economic and financial discipline. In retrospect, Ireland seems to have done almost all it could to become vulner-able. The overexposure of its three main banks (which escaped the attention of its regulators), and the flood of money thrown at them by the government to save them from bankruptcy, make the recovery of the Irish economy quite a worrying prospect. (More on this in Chapter 9.) The old proverb goes, ‘the time to fix your roof is when the sun is shining’: for Greece, Ireland, Portugal and Spain, joining the euro was the sunshine – but they failed to take advan-tage of it and instead increased their sovereign debt.

Because economic and financial discipline has been absent, the common currency helped Ireland, Spain, Portugal and Greece to overleverage them-selves. All four have handsomely benefited from the euro, but they were not ready for it. Indeed, well before the single currency came into being, econo-mists warned that many sovereigns who wanted to join had a good deal of homework to do before joining the club. These warnings were ignored and the fact the crisis came is not really a surprise. If euroland’s strains increase past a certain point, there will be two options and neither is easy. One option


Woes of Euroland’s Financial Integration 139

is the break-up of euroland (which is not unthinkable), allowing undisci-plined member states to reintroduce their national currency – though they would face a mountain of problems, not least high interest rates and de facto increases in debt repayments.1 The alternative is to make the euro work bet-ter through a euroland-wide fiscal policy and near-zero budget deficits to be carefully policed by the ECB or a new transnational authority. This means moving towards political union and tightening belts along the way.

Whichever option is chosen, its implementation has to be holistic, not half-baked. Recent talk of ‘coordinating’ fiscal policies among euroland’s members, but without political union, does not make sense. Calculating and coordinating changes in fiscal stance among 17 independent nations would be a tricky business, even if the different chiefs of state could agree on a core fiscal balance to act as baseline.

The concept underpinning one of the approaches under discussion is that the actual deficit of a euroland member country may vary, depending on a cyclical component and the change in its interest burden. Only bureaucrats, whose lives revolve around long discussions and zero results, could think of something like that.

Somewhat more promising is the fact that on May 9/10, 2010 Ecofin (the EU Council of finance ministers and CEOs of member states) agreed to estab-lish a comprehensive package of measures to preserve financial stability in Europe (including a European Financial Stabilization Mechanism). The fund is subject to strong conditionality; it still constitutes an interesting back-stop financing arrangement which will have up to a500 billion ($615 billion) in funds to be provided by euroland members. The IMF will participate in the financing arrangements and is expected to provide at least half as much as the contributions – hence the talk about a $1 trillion fund.

How effective this financial stabilization mechanism will be can only be judged after the next couple of crises of euroland member states have been tackled. Also, all member states, and most particularly the economically weaker, will need to exercise self-discipline in financial matters and imple-ment deep cuts in their expenditures, which has often been required but only partly done.

In addition, if the European Union, not just euroland, wants to institute budgetary discipline, it will be well-advised to start doing so with its own bureaucrats in Brussels, who are overpaid. Over 1,000 European Union officials earn more than Britain’s prime minister. The EU is a ‘racket’, thundered one of the members of the European Parliament who sits in for the British Independence Party (UKIP).2

Financial stability and economic integration

According to the European Central Bank, financial stability can be defined as a condition in which financial intermediaries, markets and market



infrastructures (which comprise the financial system) are able to withstand shocks as well as the aggravation of financial imbalances. Implicit in this definition is their ability to sustain the continuing allocation of capital to profitable investment opportunities and mitigate the probability of disruptions in financial intermediation.

To fulfill such requirements, it is important to identify (and continue identifying) the main sources of vulnerability, as well as the risks which they pose. Also, to ensure transparency and monitor financial stability in a forward-looking way, evidently the likelihood of imbalances and instability and reasons to worry about their effects should be included, particularly those interfering with the normal behavior of economic processes, or those having a potentially disruptive impact.

Theoretically, financial stability should be examined independently of economic integration in a wider area, which includes independent states. Practically this is not so, because it is too optimistic to expect that formerly independent economic entities will effectively merge their financial affairs by adopting a common currency – as the euro’s experience demonstrates.

Also, theoretically, this expectation is not unreasonable because an integrated financial market offers economies of scale, potentially greater efficiency and a rather smooth monetary policy. Practically, when such statements are heard you can bet that those making them pay little atten-tion to the fact that there are also drawbacks – such as the easier spread of economic and financial crises occurring in one of the members of the inte-grated financial market and possible cross-border spillover.

This spillover hits both the public and the private sectors. Companies within a monetary union tend to engage more strongly in cross-border investment activities as they continue increasing their foreign investments. They do so because, apart from waiving foreign exchange risk, they expect that the single currency promotes harmonization of the institutional framework, providing additional impetus to financial market integration among the participating countries.

Not all of these expectations are, however, fulfilled. While statistics on industrial activity in Germany reflect the strength of its exports and renewed demand for German cars and machine tools, the main drive of German exports is in Asia, while France and Italy have not experienced the same surge and the weaker periphery countries of euroland remain subdued.

The Germans have applied a much greater economic discipline than other euroland members. The country’s industrial and economic data reflect the rigorous restructuring the economy has been through, which, practically, means that even with economic integration the results may be asymmetric. Other euroland countries did not benefit much from the rebound in world trade.

Such real-life examples provide good reasons to back up the opinion of a number of economists that, as far as economic integration is concerned, the



experiment of a monetary union without political union has failed. Even the simpler mechanics required by an integrative approach to finance and the economy are not in place; for instance:

euroland-wide control of budgetary deficits damaging the common cur-rency,a supranational crisis resolution system with authority over all members states, andpolicies to reduce intra-euroland current account imbalances through corrective measures.

Therefore, both economists and political analysts suggest that not only euroland, but also the EU confronts a historic choice between integration and break-up unless real economic convergence is put in motion. This should include the smoothing of national consumption and spending paths, followed by centralized taxes, as well as a common level of reasonable and sustainable social benefits.

It does not need explaining that diverging paths of income, taxation, consumption and social benefits (from health care to pensions and beyond) create conflicts between member countries. A stabilization mechanism on entitlements is most critical in an aging society, where capital for social ends becomes scarce, given so many demands, while the state’s catchment area is shrinking.

The ‘sharing of risk’, often considered to be one of the characteristics of an integrated economy, makes no sense at all when some jurisdictions lack discipline while others work hard to improve their standard of living. The market sees that and votes with money. Sovereigns lacking fiscal discipline pay steadily higher yields.

During the last couple of decades, investors have set new rules in the flow of funds, as sovereign debt problems have an enormous impact on their decisions. Financial stability has taken a primary role in investment choices, way above that of a theoretical economic integration based on a common currency. When a euroland member country spends in an unsustainable way, the specter of Lehman’s collapse comes to every investor’s or banker’s mind.

In terms of risk appetite, 2011 is a world apart from the earlier years of this century, when the wide expansion of securitization and off-balance sheet instruments enhanced the ability of banks to transfer credit risk, and led to an excessive risk-taking behavior. There is an ongoing transformation in the financial system in appreciation of the fact that policies and instruments that leveraged the banking industry and the economy brought them to the edge of chaos.

From the perspective of a common currency, matters become more complex by the fact that the government of each individual country is more

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concerned with pleasing its voters than with righting the balances. In turn, this leads investors to the conclusion that cutting the deficit and striving for positive current account balances are not top priorities.

The after-effects are seen in bond auctions whose results should be fairly uniform if euroland were characterized by economic integration and financial stability. Governments with outsized borrowing, which offers numerous opportunities for something to go wrong, are penalized by having to pay a high level of interest for their bonds and banking loans.

This situation cannot continue unchecked. In mid-December 2009, as the Greek crisis was still brewing, Joaquin Almunia, then the European Union’s economic and monetary affairs commissioner, told Spanish newspaper El Pais that Greece could not rely only on the eurozone to come to its rescue: ‘If Greece does not take the necessary measures to overcome its problems, the eurozone won’t be able to take them in the name of Greece.’3

With political and market warnings becoming common currency, as 2009 came to a close Greece urgently needed to restore its international credibility. This became particularly urgent following a downgrade by Fitch to BBB+ and a warning by Standard & Poor’s of a possible downgrade – while the country’s public debt was set to rise in 2010 to the highest in euroland. A year later, in November 2010, Portugal and Ireland are the sick men of euroland.

In a way not dissimilar to that of Greece, Portugal, Spain and Ireland, Uncle Sam had taken some hefty risks, with some of its bonds failing to raise as much money as planned, sending shock waves through global financial markets. What will a government do when there is a confidence shock to its name? Will it borrow at astronomical interest rates or finally decide that austerity is the better way to take hold of one’s economic and financial fortunes?

Today, America is still the world’s strongest borrower, thanks to two centuries of timely debt repayment,4 plus its size, wealth, legal and political stability. But Britain, too, was in the same position prior to World War I (and somewhat less so between the two world wars). However, in early 2009, in a public auction it failed to raise as much money as the government had planned.

One-size-fits-all monetary policies are a dangerous game

Short of political, social, fiscal and economic rules common to all of euroland’s member states, a one-size-fits-all monetary policy creates an unstable system prone to flip over. The idea that a common currency will, all by itself, correct the asymmetries characterizing the different jurisdictions if euroland has been tested and failed.

Up to a point, but only up to a point, the common currency benefited countries like Greece, Portugal, Spain and Ireland in obtaining cheaper



money. This, however, also led to looser economic policies and greater inflation, making the Club Med countries uncompetitive while the traditional escape route of devaluation was no longer available.

Euroland’s peripheral countries have also suffered from another flaw which comes with cheaper money and scant attention paid to credit: a very low national savings rate. Club Med citizens have become big spenders. In turn, negative savings have not permitted governments to emulate Japan, which financed the unprecedented expansion of its public debt over two decades by means of its citizens’ traditionally high savings habits.

Furthermore, scant attention has been paid by the governments of peripheral euroland member states to the fact that countries with low savings tend to grow slowly, and their dependence on external sources of funds increases over time. In turn, this negatively affected fiscal sustainability, as the citizen started to believe that someone else would foot the bill.

As if the structural deficiencies have not been enough, ‘under the plans being developed by former Internal Market Commissioner, Mario Monti, at the behest of European Commission President, José Manuel Barroso, Europe will be saddled with a tax harmonization scheme that will stifle growth and erode global competitiveness’, says Investment Commentary No. 269 by Wegelin, the eldest Swiss private bank.5 The counterparty adds that ‘the European Union in its current form would not survive such restructuring – collapse or compulsion will result’.

This is almost always the result of half-baked measures. One of the weaknesses of studies done not only by bureaucrats, but also by economists and central bankers up to the crisis of 2007–11 is that, in their estimates of the amount of fiscal consolidation, they have focused on aggregates. Aggregates lack detail because they abstract from the existing heterogeneity among the different countries sharing the euro. Yet, the asymmetry of this heterogeneity has been most significant and its impact is felt both in inaccuracy of the models and on necessary precision of exit strategies from an economic crisis.

Had the common currency been confined to the majority of the original members of the 1957 Common Market – Germany, France, Holland, Belgium and Luxembourg (Italy was not ready to join the euro6) – the hypothesis of relative homogeneity might have been sustained.7 As it was, both the mem-bership of the common currency and the models used to manage it were poorly chosen. To make matters worse, management control was totally absent. On more than one occasion, the Stability and Growth Pact was watered down and not taken seriously; inspections of fiscal policies and debt strategies by member states, if they were ever exercised, brought up none of the anomalies which prevailed among euroland’s members – which is curi-ous because these anomalies have been legion. To take just one example, between 2006 and 2009 the average increase in Greek sovereign debt was an estimated 40 per cent.



Other public debts in euroland’s periphery also grew significantly during the same period, as did those of the USA, Britain and Japan, increasing by so much sovereign credit vulnerability. In the past, this was typical of countries with embedded entitlements cultures and oversized governments, but it is now rapidly expanding in western countries.

Such a deteriorating fiscal and economic outlook cannot change on a dime or on its own will. It takes a strong will to bend the debt curve, and even the best efforts can be undermined by the negative underlying economic trend. There is also spillover, with the result that a growing number of countries suffer from serious fiscal issues and find it difficult to refinance their debt.

Financial analysts have singled out France as the euroland country of greater vulnerability outside the Club Med, as well as Ireland, because the share of public spending in the economy is the highest. Cuts in the state’s bureaucracy and in entitlements, not tax increases, would be the best remedy for balancing the national budget, but under public pressure successive governments have done just the opposite. Public psychology and habits acquired from long-held (albeit wrong) practices are the political rea-son why one-size-fits-all monetary policies do not work.

Another important area where one-size-fits-all hypotheses are extremely wrong is that of labor relations. Generally speaking, individual countries in euroland need radically to revise their labor practices to facilitate flexibil-ity and promote profitability, but some member states have to do a much deeper restructuring than others. Rigid labor laws and practices are seen as a sacred cow; the cost of hiring and firing is so high in continental Europe that it forms substitute capital for labor when expanding production.

In all European countries, big labor, big business and big government hold the keys to the future of economic policy. Many sovereigns are run by coali-tions of several parties whose goals conflict with one another. Coalitions are too weak to attack the rigidities of the social system.8 Businesses may want to modify labor laws, but they lack the votes. Labor unions launch crippling strikes to preserve the status quo.

The result is that reform comes very slowly, or not at all. Even a strong personality like Margaret Thatcher could not accomplish everything she wanted by way of labor restructuring. In Germany, Gerhard Schröder did a good job in restructuring the labor market, but it may take bankruptcy to wake up France and the Club Med to the fact that high unemployment and a still labor market are highly correlated.

The frequent ‘easy strikes’ policies followed by labor unions in some euroland countries make matters worse. According to statistics published by The Economist, the annual average number of days lost to strikes per 1,000 workers in the period 2000–08 has been:

130 in Spain, 92 in Italy,

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62 in Finland, but only four in Germany.9

Huge discrepancies also exist in social security contributions, which add a great deal to the cost of labor. Table 8.1 compares contributions by workers and employees in three euroland countries to those prevailing in three non-euroland jurisdictions. Notice that, in the sample of France, Italy and Ireland, the contribution by companies varies from maximum to minimum by a factor of more than 440 per cent.

Correction of such discrepancies is no matter-of-course issue because most governments follow the path of least political resistance. This means that the wide gap in social cost continues to penalize some economies severely. Even worse, the path of easier resistance means still more spending and widening continuing fiscal deficits – thereby feeding an economy’s vicious cycle.

The aftermath of asymmetries on the euro

The euro has been the fourth, not the first monetary union in the old continent. The previous three date back to the nineteenth century, with the first on record being the German Monetary Union (GMU), which lasted for 78 years. The GMU was formed in 1838 when the currencies of the North German Confederation, Kingdom of Bavaria and Austro-Hungarian empire were linked together; and it collapsed in World War I.

The second attempt at establishing a common currency among independ-ent states was the so-called Latin Monetary Union (LMU), formed by (in alphabetic order) Belgium, France, Greece, Italy and Switzerland in 1865. It lasted for 61 years.

It is interesting to notice that the LMU included only gold and silver coins. Each country maintained its own currency but with a fixed 1:1 exchange rate. Discipline, however, was not at its best. Italy issued an excessive amount of paper money, which led to strains, and this increased with World War I. The LMU broke down in 1926.

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Table 8.1 Cost of social contribution to social security as a percentage of salary

By companies By workers

France 57 19Italy 38 8Ireland 13 6Britain 13 11USA 10 10Japan 16 14

Source: Statistics based on working meeting of financial and economic analysts.



The third attempt was the Scandinavian Monetary Union (SMU), which lasted for 42 years. It was formed in 1872 on the basis of 1:1 exchange rates between the currencies of Denmark, Sweden and Norway – and it collapsed in 1914 at the start of World War I.

None of these past events gives a clue as to how long the euro can last. Averages are meaningless; looking at budgetary deficits can be more reveal-ing about a future trend.

All 17 members of euroland now breach the 3 per cent deficit threshold of the Stability and Growth Pact; three out of four also violate the 60 per cent debt limit. The fact is that there is an escape clause permitting them to avoid penalties if Europe faces a general shock such as a financial crisis. At the same time, details about how monitoring should take place are, at best, sketchy. All this casts doubt over eurocrats who promote the monitoring of imbalances and exercising of scrutiny by a new financial regulator who could spot the problems.

Management control is weakened by the fact that official statistics tend to lie. Hence, imbalances are identified after a bust; practically never during a boom. As for self-discipline, its absence has been noteworthy. Too many governments believe that, once in euroland, they could worry less about balanced budgets, or even creditworthiness or competitiveness.

What all this adds up to is that there has been simply no point in estab-lishing a common currency without political union, or, as a bare minimum, common monetary and fiscal policies to be followed without deviations by all member states under the control of a transnational authority.

Just the same, there is no benefit from outlining some supposedly common economic rules in a stability pact without real and immediate sanctions. Paper tigers are feared by nobody.

Because the necessary preconditions for a successful common currency were not fulfilled, the euro has turned into a dangerous project. Every one of its members has fiscal and spending policies which conflict with those of its neighbors.10

Precisely because of this diversity in fiscal policies, spending policies and debt levels, euroland’s economy is pulled apart by conflicting inter-ests – which make economic integration problematic at best. The worst can worsen because of the expansion of euroland’s membership, while management planning and control is wanting.

As an investment letter pointed out:

Membership of the eurozone was also sweetened by unrealistic conversion rates; subsequently, the marginal member states enjoyed financing condi-tions on the capital markets that had previously only been available to the soundest economies, such as Germany or Holland. The absurdity of this implicit solidarity lay (and still lies) in its incentive for the weaker countries to pile on still more debt.11



Quite to the contrary of what this undesirable policy promoted, profligate governments had to be told to become more prudent. Uncompetitive labor unions had to be shaken up. Countries that were classically running current account deficits had to make far-reaching changes through strategic product and market plans. Instead, incompetence and impotence have been rewarded, as in the case of Spain, and all sorts of problems were allowed to build momentum till they dragged down the economy of euroland.

In addition, unwisely, the member states of the common currency lost their chance to profit from it. Their political leadership relied too much on the hope that euro membership alone would generate favorable economic conditions, and did too little to turn this into a reality. Scant attention was paid to macroeconomic imbalances, which were apparent in large current account deficits, persistent fiscal deficits and eroding price competitiveness.

Euroland’s chiefs of state could have improved their performance by operating in unison, but, being politicians, this is not what they did. Instead, inflation in the peripheral countries and fiscal irresponsibility destroyed the euro’s two pillars: price stability and financial stability (in terms of market perception). The basic economic principle, which was put on the backburner, was that countries with enormous fiscal deficits, like those of the Club Med, never really had a stable currency. Rather than betting on stability, every member state tried to improve its standard of liv-ing by getting deeper into debt.

With this economic background, the euro has suffered progressively as the recession has followed its course. For some of euroland’s peripheral countries – Ireland, Portugal, Spain and Greece – the initial slump in gross domestic product was weak due to lower dependence on exports. But as the crisis developed, it became clear that home-grown problems were being added to global recessionary forces.

One of the worst omens for Club Med’s economic future is that, over the years, the countries in question allowed their industrial base to decay. Part of the reason was competition from cheaper Asian products; another reason was that as internal demand for goods increased it exceeded domestic production capacity and created a vicious cycle whereby imported goods displaced those produced at home.

Inflation, too, played a negative role. For instance, Portugal was not able to halt the rise in unit labor costs while fiscal policy was charting a course that was unsustainable in the long term. Greece did the same and this ultimately plunged the country into the current crisis created by a mountain of debt.

There is an irony in this real-life scenario because the euro was supposed to make the member countries more virtuous. It did not happen that way, because no attention was paid to the fact that there exist centrifugal forces and, under the conditions of a common currency, persistent national



imbalances generate internal tensions, with rising current account deficits, and contagion effects on other member states, which strain the economic prospects of national economies as well as the stability of the common monetary framework.

Under these conditions, draconian measures are needed to establish long-term, not just short-term, stability of the euro. This policy, however, has two enemies: public reaction to austerity measures and forces promoting a scenario of chain reaction, which starts with the deep economic and financial troubles of one of the common currency countries and spills over. As for the option that Greece, Spain, Portugal, and maybe Ireland, leave the euro, this is one of unprecedented dangers and complexity. Such a move would shake the banking system to its roots, or at least a big part of it; the weaker countries themselves would sink further into the red as, short of outright bankruptcy, the obligations they assumed in the euro’s first decade would be payable in euros. All this leads some experts to the belief that – as economist Martin Wolf said in an interview with Charlie Rose12 – it is more likely that Germany might leave the euro. The Germans have had enough of the economic weaknesses of other euroland member states and they will probably decide to establish their own strong currency. If this happens, before too long the euro will turn to ashes.

Is a weak euro or a strong euro the better choice?

During most of the first half of 2010, prior to and after the temporary rescue of Greece by euroland’s and the IMF’s intervention, the euro has been buffeted by uncertainty about a resolution to the ongoing crisis and looming bad news in euroland’s weak periphery. Reactions have been uneven: in Germany the majority of people wanted the deutschmark back and, in mid-February 2010, one poll in France found that 69 per cent regretted losing the franc, up from 39 per cent in 2002.13

Economists and financial analysts came up with plenty of reasons why the destiny of the euro was to continue to weaken. Some foresaw that it would reach parity to the dollar; others said it might even fall below that. Both proved wrong: still in the background of such projections was the opinion that the world’s smartest investors were convinced that, given the debt problems confronting Club Med countries, the euro has only one way to go: down.

Proof that the argument was overdone was provided by the market. After breaking 1.20 to the dollar, the euro bounced back to 1.30 and from there to 1.40 (breaking it in early November 2010). Forecasting is by no means an exact science.

Financial analysts who still bet on the euro during the crisis pointed out that the Federal Reserve and Bank of England were inflating themselves out of their debt, while the European Central Bank held a firmer stance. They



did add, however, that investors, and the market at large, were concerned about what would happen to the euroland beyond Greece. Does it risk:

one or more sovereign meltdowns?private sector depression concentrated heavily on the Mediterranean shore? leading to euroland’s break-up at some point in time?the euro taking all the hits and surviving a major devaluation?

Because so many factors enter into these what if queries, no a priori answers could or should be given. The speculators are always at play, seeing to it that the exchange rate of a currency and its volatility are in themselves an interesting theme.

According to some economists, Germany’s manufacturing industry has suffered in global competition from the strong euro, particularly during the period when the dollar, yen and renminbi were relatively weak. Others, however, and among them many German manufacturers, have been of the opinion that a strong currency has advantages – provided a country puts its house in order.

The problem is that, in different euroland countries, politicians inter-pret this statement in diverse ways. When German politicians talk about euroland’s rigor they mean extending fiscal discipline for all. By contrast, the French want more state intervention and abolition of flexible economic tools in other countries, like weaker labor laws and market liberalization.

All of the aforementioned factors see to it that the answer to the question ‘Is a weak euro or a strong euro the better choice?’ is not linear. It is subject to a long list of economic, social and political constraints and also to little expected reaction from labor and business, since the exchange rate of a currency affects competitiveness in the global market and has a significant impact on imports and exports.

Dieter Zetsche, chairman of Daimler, told the Financial Times that the strengthening of the dollar against the euro was helping exporters in the short term, adding that ‘in the long term, I always say two things: the strong euro has been a good training ground for companies. It has made the weak weaker. The second thing is that a strong currency is a sign of a strong economy.’14

Furthermore, a strong euro or a weak euro cannot be judged in the abstract. It has to be measured against something else. That ‘something else’ is the dollar, which, since the end of World War II, has been the international currency. It has a status no other currency ever attained in recent times. Dollar denomination is used in:15

86 per cent of foreign exchange transactions,62 per cent of international reserves,

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nearly 60 per cent of bank deposits,53 per cent of bank loans,48 per cent of sales of debt securities.

The dollar’s status has persisted over 65 years independently of macroeconomic factors, and often in spite of them. The euro is a currency without a country. In Germany and Holland, taxpayers worry that the corollary of giving weaker euroland governments unqualified support to cut their deficits is a weak euro. They look at the French ‘compassion for the euroland members who find themselves in difficulty’ as an invitation to avoid the hard decisions that lie ahead. In the longer term, collective insurance which includes the profligate is a recipe for collapse. Carte blanche solutions do not promote collective discipline; it would be impossible to stop reserve funds from being abused. The fact that both fiscal/financial discipline and compassion for neighbors were absent at the same time is not surprising. They go together like a horse and carriage. Financial discipline cannot just be enforced when things have already gone wrong, as the Stability and Growth Pact stipulates.

The whole logic of the euro’s stability pact was questionable. To threaten a deficit-ridden country at the edge of an economic precipice with huge fines is the worst possible way to make the need for fiscal discipline credible. Aside from that, too many countries, including the euroland’s biggest econ-omies, were repeatedly allowed to break the rules. How are sinners going to bring to reason profligate governments? Where is the Stability and Growth Pact’s mechanism for dealing with impending failure, and an orderly sys-tem for sovereign-debt restructuring? Were the clauses of the Stability Pact, invented at Maastricht by François Mitterrand and Guilio Andreotti to kill the Deutschmark, intended from the start to be a paper tiger? Behind these questions lies the hypothesis that the euro might have been invented sim-ply as a currency to emulate the successive devaluations of the French franc and Italian lira, rather than one able to promote financial stability, like the Deutschmark. The Mitterrand/Andreotti coup, which trapped Helmut Kohl at Maastricht, has been continued by Jacques Chirac, by his trimming of the Stability Pact’s clauses during negotiations in Dublin and by pushing the Germans to abandon it altogether through a new version which is a shadow of the original – and is simply meaningless.

Things being what they are, the European Central Bank should be given the task of studying each country in euroland – both in the core and in the periphery – to determine what it needs to do to meet its commitments. Consider what would happen if this is not successful in balancing its total fiscal budget and current account16 (in less than three years); and evaluate the fallout if the member country suspends debt payments, offering instead a take-it-or-leave-it deal, as Argentina did.

In redressing this bad situation, approaches to be chosen should not just brush aside existing rules, because otherwise the setting of economic

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rules becomes a meaningless exercise. For instance, euroland’s 2010 loan to Greece has violated the no bailout rule in the treaty setting up monetary union. It also contravened a decision by the German Constitutional Court. In a 1993 judgment it was ruled that, once monetary union had come into force, it had continuously to satisfy the full conditions of the Stability and Growth Pact concluded when the single currency was agreed. If it did not, the court ruled that Germany would be obliged to leave euroland, which it did not.

Stopping Greece from falling into the abyss was both a political and financial act. The euro would not only have weakened with an inorderly Greek bank-ruptcy. It would have fallen off the cliff – with trillions of investments wiped out, aside from the major crisis of French, German, British and American big banks, which had given the Green sovereign a windfall of loans.

There is a precedent to this from the 1930s, when the British government abandoned the gold standard because gold reserves in the Bank of England had become ultra thin. The Banque de France at that time had $350 million in sterling deposits, as sterling sank when Britain went off-gold, and it ended up losing close to $125 million, a cool 700 per cent of its equity capital.17

The message by credit default swaps should not be ignored

‘Considering the high indebtedness in Europe, I am in favor of a Schuldenbremse,’18 said Josef Pröll, Austria’s finance minister.19 Nicolas Sarkozy, the French president, also expressed himself in favor of some form of balanced-budget rule which serves as a roadmap for judging the survivability of indebted sovereigns. The problem is that, by allowing ‘this’ or ‘that’ exception to fiscal discipline, pretty soon there are many. Objective tools are necessary to ensure that the trickery associated with the cocktail of politics-and-the-economy is taken out of the system.

Which are the metrics that should be used? A rather good way for measuring debt exposure is employed by the financial industry. Known as debt-adjusted cash flow (DACF), this is one of the tools which shows why companies which, in classical accounting terms, look alike, should be judged differently.

The tools we use should be uniform and invariable. However, reasons can always be found for exceptions: for instance, ‘weak growth’ (whatever that means) has often been an argument which did away with observance of the Stability and Growth Pact. No attention was paid to the fact that financial markets vote with their money and don’t look at ‘weak growth’ as being an excuse.

Prior to the 2007–11 deep economic crisis, credit ratings were taken as being an objective metric. But they were discredited because of massive misrepre-sentations of creditworthiness in connection with securitized instruments based on subprimes and Alt-As.20 Today, the way to track default likelihood



of nations and companies is credit default swaps (CDSs).21 They are based on cumulative intelligence, which is in no way perfect; and for countries, they reflect the market’s estimate of creditworthiness – for countries, that of sov-ereign risk.

First, credit default swaps transfer credit risk between two counterparties. In a transaction, the buyer receives credit protection, while the seller guar-antees the creditworthiness of a fixed-income instrument – like a corporate bond or asset-backed security (CDSs are over-the-counter (OTC) derivatives, and payouts vary according to the specifics of the contract).

As the credit default swaps culture soared, at the beginning of this century, they have been compared with an insurance, because the buyer of a CDS contract pays a periodic fee to the seller in exchange for his guarantee. But since the credit default swap buyer does not have to suffer a loss to receive a payout from the CDS, such contracts can also be used for speculation purposes.

The upside is that, because CDS contracts are steadily marked-to-market (which is not the case for insurance contracts), they serve as metrics of a counterparty’s creditworthiness. This is precisely the role discussed in this section, and has a great deal to do with the fact that investors are no longer willing to regard the debt of governments, including western governments, as risk-free.

As the preceding chapters have brought to the reader’s attention, many sovereigns have taken on not only huge public debts because of ill-advised fiscal policies, but (most recently) they have also assumed major private sector debts (particularly those of banks and of some big companies like GM). CDSs are expected to reflect the sovereign credit risk associated with such policies.

In practical terms, widening CDS gaps indicate that there is no free lunch; the debtor is far from being ‘credit risk-free’. Among sovereigns, this is attested by the fact that, in many countries, government bond yields are higher than some corporates. Taking Germany as a basic reference for the CDS gap, at the beginning of January 2010, the gap of CDS spreads for Greece was 236 base points (bp),22 for Ireland 114, for Spain 84, for Portugal 75 and for Italy 73.23

These were way up from corporate CDS, which rated Unilever at about the same risk as Germany, France Telecom 10 bp higher, Deutsche Post 11 bp higher, Total 13 bp, Siemens 30 bp and Axa 36 bp – with the default risk of Greece being 655 per cent higher than Axa’s. Four months later, in early May 2010, the gap of CDS spreads for Greece (compared with Germany) was past 750 bp (though it subsequently fell lower), for Portugal was approach-ing 400 bp, for Spain was past 200 bp (almost at par with Hungary) and for Italy was past 150 bp.24

The volatility of CDSs connected to countries where there exist doubts in terms of creditworthiness tends to be high. By contrast, the CDSs of



Germany, Norway, Sweden and Switzerland (the best of them all) tend to cluster together. All these references dramatize the fact that market differen-tiation between sovereign debtors is growing, and the result is quantitatively expressed through CDSs.

Critics say that CDSs are purely speculators’ tools. As a general statement this is false, though there is no denying that where there is money there is also speculation. Without any passion or pre-established positions, as the ‘central bank of central banks’, the Bank for International Settlements (BIS) should take a close look at the validity and reliability of sovereign credit default swaps. CDSs are derivative instruments, but in their role of reflecting creditworthiness they should not be confused with the use of derivatives to bet on positions. The fact that western governments might default primarily because of mismanagement and, secondarily, because of the deep economic crisis is not something to be examined from a nationalistic viewpoint.

The CDS market for debt instruments – resembling a ‘cat among the pigeons’, as a Barclays Capital executive once suggested – is more suitable for a comic strip than for financial professionals. This does not mean that some players may not be deliberately pushing CDS prices around to make fat profits – as long as they can afford to do so. This is, nevertheless, some-thing that carries enormous risks. The Hunt brothers tried to corner the silver market in the early 1980s and, from being billionaires, they ended up owing billions.

At the peak of the Greek crisis, there were rumors that Soros, Pelegrini and Paulson had joined forces to drive down the value of the euro, as part of a trading bet. In much the same way, Soros and Robertson had profitably attacked sterling in the early 1990s. The way the rumor had it, the attack on the euro was using CDSs, but by September 2010 Paolo Pelegrini and John Paulson were losing money.

Sovereigns and central bankers should use measurements provided by CDSs to hit speculators where it counts, in their pocketbook. The best way to avoid the CDS fever is not to play the fool with unstoppable budget deficits and current account deficits – neither is it to kill the messenger. Granted, reality is never quite as tidy or as chaotic as a measurement (any measurement) might show. But when countries come perilously close to declaring bankruptcy and when their pleas for a rescue are loud and clear, the measuring instrument must show that they are unable to pay their debts.


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9Sovereign Risk: Case Study on Greece

The Greek crisis is just the first episode

Though it has caused widespread tremors in euroland and, to a lesser extent worldwide, Greece is just the first episode of a sovereign crisis scheduled to assume important dimensions. The real problem underlying this crisis is much more fundamental than profligate policies and budget deficits; it is, further, underestimated by chiefs of state, finance ministers and central bankers.

‘Concerns about Greece’s long-term solvency have fast evolved into a new global capital markets shock,’ said Lena Komileva, head of G7 market economics at Trullet Prebon.1 About Greece only? This is a global problem, particularly when one accounts for calculations of fiscal frugality – made by the IMF, needed for countries to bring their government debt levels down to a more sustainable 60 per cent of GDP. For instance, the USA would have to run a primary budget surplus (prior to financing charges) of 4.5 per cent of GDP per year for 15 consecutive years to bring the national debt down to an affordable level; Japan would have to run a fiscal surplus of some 15 per cent of GDP for 13 years to reach the aforementioned goal; and plenty of other countries would have to apply strict discipline in govern-ment spending.

As it cannot be repeated too often, the problem confronting the devel-oped countries, from the United States to Japan and the European Union – generally known as the West – lies not in one but in a horde of more or less serious comparative disadvantages vis-à-vis the developing countries. To a substantial extent, though not exclusively, these disadvantages derive from:

nineteenth-century social policy entanglements, which are unsustain-able in a modern economy but difficult to drop because the public loves them;an anemic economy overburdened with unaffordable entitlements which, instead of being trimmed, increase every year;

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Sovereign Risk: Case Study on Greece 155

long-standing threats to competitiveness by developing nations, because of the West’s structural flaws, high labor costs and inflexibilities;an overburdening bureaucracy active at all levels of the economy, mixed with intensive lobbying at every hub of authority, gratification and greed.

The roots of the current social malaise are found in these four bullet points. A bad situation is made worse by the fact that the real problems confront-ing the ‘new poor’ (Chapter 2) are being concealed, distorted and glossed over. Nobody seems to appreciate that, as Judge Louis Brandeis once said: ‘Sunshine is the best disinfectant.’

Avoidance of grappling with the crucial question of governance is wide-spread among western nations, and there is simply nobody around who will accept responsibility for change. Yet, change will come – either by design or by default; in the latter case, adjustments become necessary in order to survive, which will be so much more painful. Over and above that, changes which are too timid and made too late will fail.

A poorly planned – or, even worse, unplanned – revamping of economic and social policies, aimed at wiping debt out of the system, is by no means workable. This is particularly true when, for several decades, weak govern-ments have adopted the unfortunate policy of bending to pressure – when the government budget alone is half or more the country’s gross national product. In the case of Greece, the public function and retirement benefits constitute 51 per cent of GDP. This fact alone should have induced the last few governments to reduce the number of personnel in public functions. Quite to the contrary, in 2009 an estimated 29,000 people were hired to replace the 14,000 taking their retirement.

Since Greek independence in 1830, the effort to set the country on its feet has been interrupted by an never-ending series of wars. These saw to it that, in roughly 50 per cent of the subsequent 180 years, the country has endured poor economic conditions. Therefore, entry into the EU, and subsequently the euro, should have been a golden opportunity to recover.

Instead, successive governments adopted a profligate policy.2 They have also failed to crack down on corruption, not bringing well-connected tax evaders to justice, wrapped themselves up in scandals and losing popular support – which made their leadership questionable. In practically all Club Med countries, one of the key underlying problems looks like a carbon copy of the subprime crisis in the USA: easy credit and governments turning a blind eye to problems.

There is no excuse for governments to show tolerance to those who break the law. Together with the hydra of debt came the hydra of corruption. Just as it is in many other countries, the policy was that of enjoying the present and forgetting about tomorrow.

With rare exceptions, like those of Scandinavian countries, corruption has become widespread. In Slovakia, one of the two more recent euroland mem-bers, a campaign called Replace the Politicians, run by a group of public-spirited

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experts, has focused voters’ wrath on some of the worst offenders; a cartel between political parties has brought worrying deals between businessmen and politicians, and dirty money has found its way into the system in a stream of scandals involving the courts and police.

In America, New Jersey citizens have seen curious state slogans with entries such as ‘New Jersey: Not all our elected officials have been indicted’ and ‘New Jersey: We hate you, too.’ ‘Corruption is rampant at high levels, and at low levels,’ said an FBI agent, before adding, ‘and all levels in between.’3

In China, its political leaders seem to recognize that the main threat to their authority is corruption, but even so their power rests on a system that makes it almost inevitable. Corruption has become a sort of ‘transaction tax that distributes ill-gotten gains among the ruling class … It becomes the glue that keeps the system together,’ says Richard McGregor.4

All this has a great deal to do with the origins of economic crises because it destroys the authority of the state, and it creates the perfect climate for all other ills. The message from these references is that the crumbling of the economy is by no means an overnight affair. It starts with nepotism, cor-ruption, spending well beyond one’s means (by the state, companies and households) and getting deeper into debt by trying to emulate the ‘million-aires’ and the ‘oligarchs’.

Measures must be taken to bend the curve, and they have to be properly studied as well as clearly explained to the citizen in regard to their rationale, urgency and inevitability. This is not being done, as politicians (and to a large extent the public, too) hope that things will take care of themselves – though everybody knows that they don’t. Greece is by no means alone in this predicament. As the title of this section states, it is just the first episode. Others will follow. In terms of a hole in the budget in 2009:

Greece (13 per cent budget deficit)5 was joined by Britain (14 per cent) and Ireland (12 per cent). Spain (11 per cent) and the United States (10 per cent) came next.Portugal, India, France, Japan and Russia (in that order) clustered together at around 8 per cent.By contrast, in countries with better budgetary discipline – Germany, Canada, Brazil, China – deficits revolved around 3–5 per cent.

Given the aforementioned statistics, it is not unreasonable to expect that if Greece were the first episode, the second will come from countries listed in the first two bullet points. The trouble is that these include a couple of economic heavyweights. If Britain, and even more so the USA, plays the role of Lehman Brothers in the investment banks scenario (Chapter 4), then a global financial tsunami is sure to follow.

More than 200 years ago, Alexander Hamilton, the first US Treasury secre-tary, warned of the extravagant premium countries must pay if their credit

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were questionable. In 2010, Greece, Ireland and Portugal proved Hamilton right. America and Britain have not yet lost their AAA rating, but among financial experts their credit stars are being severely questioned.

Wall Street helped the big spenders to hide debt

The governments of many countries are walking a tightrope between getting serious about putting their economic house in order and what they (incor-rectly) believe to be a course for maintaining domestic growth. Wall Street has been ready to help them out of the dilemma created by contradictory aims through creative accounting. The case of Goldman Sachs forays in Greece is an example.

Fears about soaring public deficits and debt have been (at least temporar-ily) appeased through derivative financial instruments. In February 2010, it was revealed that, with Wall Street’s help, Greece engaged in a decade-long effort to evade European debt limits. Created by Goldman Sachs, one deal helped obscure billions in debt from the European Union executive and the EU’s budget watchers. Worse yet, while the crisis was nearing explosion point, the investment bank was searching for ways to help the Greek gov-ernment delay, if not outright evade, the day of reckoning. This is a most curious case of deception on a long-term basis.

For instance, in November 2009, only a few months before Athens became the epicenter of global financial turmoil, a team from Goldman Sachs reportedly arrived in Athens with a new proposition for a government struggling to pay its bills. The bankers outlined a novel derivative instru-ment that would have pushed debt from Greece’s public health care entity far into the future, relieving the country’s budget significantly.

November 2009 was far from being the first time investment bankers had offered sovereigns the chance to tamper with their books. Anecdotal evi-dence suggests that, in Greece, the unlawful use of derivative instruments to enable the government to lie with statistics started in 2001. US investment advisers helped the government to treat its borrowing of billions as a cur-rency trade rather than a loan, thereby evading euroland’s deficit rules and enabling the politicians to continue spending beyond the country’s means.

There have been other precedents to this scam of using derivatives for ille-gal purposes, such as to disguise debt and bypass proper financial reporting standards. An even earlier incident dates back to the 1990s, when Japanese companies used derivatives to hide losses – or, as it was stated in local jar-gon, ‘to make them fly away’.

By employing their own ‘invented’ off-market interest rates and currency rates, unscrupulous traders made it possible to create differences in value between payments and receipts. By manipulating the value of future pay-ments at a level lower than future receipts, the party benefiting from this transaction receives an upfront payment reflecting the supposedly ‘ positive’



value of its contract. It is a sort of modern alchemy crooks love to use. These are shocking cases of malfeasance and, in an economic sense, they do double harm because they lead to inappropriate management decisions and damage reputations.

Another example of deception from creative accounting practices comes from the middle of this century’s first decade. It has been widely used by American banks, and most particularly mortgage houses, specializing in fake profits and big bonuses. Securitized junk, conveniently rated as AAA, was employed to deceive the banks’ customers – including other banks.6

The interesting thing about all this is that, while such cases are pure fraud, nobody in the USA, Japan or Greece has been brought to justice. Yet, there has been no difficulty in identifying prime ministers, ministers of finance, company presidents, treasurers and investment bankers who engaged in such scams. Nothing has happened to them except some mild verbal con-demnation, and even this was an exception.

A few politicians have shown more courage than others. For instance, on February 17, 2010 Angela Merkel, the German chancellor, criticized global investment banks which may have helped successive Greek governments disguise mounting budgetary deficits in past years. She called it a disgrace, if it turned out to be true that banks, which already pushed the world economy to the edge of the abyss, were also party to falsifying official gov-ernment financial reports and statistics.

A disgrace indeed it was, but not only a disgrace. Unpunished, it leaves the door open to other even greater deceptions at all levels of government. Some countries are more seriously affected by these swindles. In Milan and other Italian cities, investment banks convinced administrators to use derivatives for window dressing, as a way to meet their city’s obligations. As prices toppled, that practice left these cities deeply in the red. In the case of financial losses incurred by Italian municipalities, prosecutors brought to justice a swarm of well-known banks and bankers implicated in the scams. But in the much greater creative accounting scandals and other malfeasance set up for sovereigns who wanted to hide their debts, there has been no specific action taken; therefore no house cleaning.

Creative accounting is pervasive. In December 1996, the Italian govern-ment itself used a currency swap against an existing $1.6 billion bond (in yen) to lock in profits from depreciation of the yen. In reality, this was a loan mas-querading as a swap where Italy accepted an unfavorable exchange rate and received cash which it employed to reduce its deficit and meet budget targets of less than 3 per cent of GDP – another avoidance of euroland’s rules.

All these examples should be written down as shameful and carry with them huge reputational damage for those engaged in financial deception. It is also bad business. What the sovereign cheats and their manipulators do not realize is that such ‘arrangements’ have wide social ramifications because they incite the common citizen to cheat too.



Under conditions of creative accounting, with or without derivatives, con-trol over state finances is practically unworkable; because of the absence of well-kept and reliable books, proper disclosure of derivative transactions is all but impossible. Opacity is what unethical professionals and their clients are after.

Goldman Sachs is not alone in the novel business of using derivative financial instruments developed to hide debt. JPMorgan Chase is rumored to have been Goldman’s competitor in enabling politicians to mask addi-tional borrowing in Greece, Italy and (quite likely) elsewhere. Corruption, too, played a role (see above). Reportedly, in dozens of deals across conti-nental Europe, banks provided cash upfront in return for government pay-ments in the future.7 Liabilities were left off the books, but fat profits were pocketed.

The fact that this treachery, in which big banks got involved with some governments to cheat other governments of euroland, is now in the public eye could be a turning point. To show that it is still in charge, in mid-February 2010 the European Commission told Greece to provide details by the end of that month about derivative transactions it carried out with Goldman Sachs and other banks. No such details have so far been published, partly because complex derivative deals are opaque, having no ‘details’; also, untangling transactions based on sophisticated financial instruments is an unknown art even to the bankers who designed them.

Complex derivatives are purposely designed in a way which is novel and complex, so that they cannot be re-engineered.8 It is also part of the plan that they are not well-documented or disclosed, since secrecy adds to the uncertainty over how deep the troubles go. Moreover, we don’t even know how many euroland governments have used off-balance sheet accounting. What we do know is that many countries entered the monetary union with bigger deficits than those permitted under the treaty that created the euro. What these governments should have done was to raise taxes or reduce spending. Instead, they colluded with the bankers to reduce their deficits artificially by means of derivative financial instruments.

The only way to get an insight into what has happened is to bring to justice the bankers and politicians who were involved in such dirty deals, and let them accuse each other to save their skins. That is a ‘must’ for both ethical and disciplinary purposes, and it may provide elements necessary to reconstruct the scenarios of malfeasance.

It is also quite surprising that Wall Street’s handiwork in Europe has received little attention in the United States. Yet, it should have interested the Securities and Exchange Commission (SEC) intensely. While the big investment banks did not create the debt problems of Greece, Italy and other euroland member states, bankers enabled them to borrow and spend beyond their means, in deals that were presumably legal9 even though they were unethical. The conclusion is that, if bankers and governments want to cheat,



they have the tools to do so. This provided them with the ground for a most lucrative symbiosis with speculators and free-spending governments.

Last but not least, the scams with creative accounting have not been lim-ited only to deals with sovereigns and municipalities. Banks also corrupted other banks. Allegedly, in 2005, Goldman Sachs sold an interest rate swap to the National Bank of Greece, the country’s largest credit institution. Three years later, in 2008, Goldman helped the bank put the swap into a legal entity called Titlos, retaining the bonds Titlos issued for use as collateral to borrow from the European Central Bank.10

Textbook economics have no prescription for the current crisis

The scams of hiding deficits by a number of Greek governments left no doubt that something was very wrong with the economy and the budget. Hiding deep red ink behind derivative instruments could not last forever. Something had to give, or the next stop was bankruptcy.

The staggering sovereign debt of Greece and of the other Club Med coun-tries has, by no means, been the result of the financial and economic crisis which started in 2007. Rather, it is the result of chronic mismanagement, as well as the inability to correct structural problems which are widespread in euroland. Loose financial discipline is another background reason.

Because these problems are widespread, and they include the United States in their realm, Wegelin, the Swiss private bank, is right when it says that: ‘Greece is just an episode; the real problem lies deeper, and its importance cannot be overestimated. The role of the state as a debtor, the ultimate sheet anchor of stability in the system … is now fundamentally challenged.’11

With some sovereigns until recently considered to be, like the Rock of Gibraltar, not far from bankruptcy, it is clear that risk-free interest rates are a fiction. As such, they may turn out to be a trap in which many investors are being caught. Ironically, the chronic very low interest rates to which Ben Bernanke has condemned the dollar may be the silver lining, because they drive investors away from government debt.

Investors would be well-advised to examine carefully whether an econo-my’s gearing is oversized, as in the case of the USA, Ireland and Greece, prior to committing themselves. When the crisis erupted in late 2009/early 2010, the Greek government’s outstanding debt securities of a300 billion ($400 billion) dwarfed the amount Lehman Brothers owed bondholders at the time of its collapse. Of these huge sovereign liabilities, Greek banks held about a40 billion, roughly equivalent to the amount of capital they had. The other 60 per cent of Greek government bonds issued in the twenty-first century were sold to non-Greek buyers; roughly half of them banks.

As these numbers suggest, any restructuring of Greek debt could result in lender banks having to take massive write-offs – and the majority of these were European credit institutions. On a percentage basis, US banks were less



exposed to Greece, though, according to some estimates, the ten biggest American banks had exposures to Ireland, Portugal, Spain (and Greece) of nearly $180 billion.

Spain, Portugal, Greece and Ireland (as well as Italy) had borrowed so much during the boom years that, when bad times arrived some of them were not far from having exhausted their credit lines. The capital markets were still available but interest rates soon started rising. But for how long? As the case of all aforementioned countries demonstrates, loose common currency agree-ments are not able to stop reckless financial behavior, and a simple currency without a common economic and fiscal policy is a prescription for trouble.

For Greece, the economic troubles, brewing for several years, hit the news shortly after October 4, 2009, when PASOK (a center-left party calling itself socialist) won the elections. With the new government, the projected public deficit figures for 2009 were reviewed upwards: the budget deficit rose to 12.7 per cent and the national debt to 113.3 per cent of GDP. (Both sub-sequently moved to yet higher levels.) No action was taken immediately thereafter to bend the curve of public spending; this was a lost opportunity, because a new government can turn the tables on the one preceding it, tight-ening the budget and putting the blame on the outgoing prime minister.

Subsequently, in December 2009, Standard & Poor’s and Fitch, followed by Moody’s Investors Service – the three independent credit rating agencies – cut the rating of Greece. The Athens stock exchange plunged. On Christmas Eve 2009, the parliament adopted the 2010 budget, targeting a deficit of 9.1 per cent – but without measures being taken to make that happen.

In January 2010, experts of the European Commission and the European Central Bank (belatedly) went to Athens to examine the government’s accounts. The International Monetary Fund also sent a mission. In mid-January 2010, the government revealed a very mild austerity budget. The market was unconvinced and, at end of the month, interest rates on longer-rated Greek debt surged to 7.15 per cent.

Following January’s mild measures, in early February 2010 George Papandreou, the prime minister, announced a freezing of salaries in the public sector of those earning more than a2,000 per month. As far as reduc-tion in government expenditures was concerned, this was peanuts. It was followed by a strike of public employees, and immediately afterwards by a general strike – as if the strikers wanted to make matters worse (see below).

For their part, European member states were discussing whether and how to assist Greece. Confronted with elections which were destined to be close, on March 17, 2010 Angela Merkel said that she did not exclude the possibil-ity of a euroland member state leaving if it did not fulfill the prerequisite conditions (if this were the case, Greece would have been joined by Spain, Portugal, Ireland and maybe Italy).

Euroland’s ministers of finance met on April 11 to discuss a loan to Greece of a30 billion (peanuts once again) at an interest rate of 5 per cent.



According to what were then considered to be reliable estimates, Greece needed a150 billion just to roll over debt for the next three years; and about half of that amount, even as a starting point, to make an impact. For the first time, there were no evident givers.

Not everything was, however, negative. That same day (April 11, 2010) it was officially announced that euroland’s member states were collectively committed to provide that loan of up to a30 billion ($40 billion) to Greece over 2011, to stem a debt crisis that had rocked financial markets and posed the most serious challenge to the euro so far. The funds were to be supplemented by money from the International Monetary Fund that could yield an additional $15 billion ($20 billion, at the then-prevailing exchange rate).

It does not take a genius to appreciate that, for a country which owed a300 billion, albeit over a longer term, this 15 per cent breathing space was no more than temporary relief. Martin Feldstein, economics professor at Harvard, suggested that Greece take a ‘euro holiday’ before rejoining at a more competitive rate. Leon Brittan, Chancellor of the Exchequer under Thatcher, was of the opinion Greece could operate parallel domestic and international currencies.

Critics said that neither approach made much sense, and the same was true of still another suggestion: that Greece should reintroduce the drachma and peg it immediately to another big currency. It was further stated that the only real option might be to choose the dollar for pegging, but the politics of such a move ruled it out. That was not the only reason why this was bad advice. Argentina had pegged the peso to the dollar. But its financial disci-pline was dismal and (at end of 2001) the country went bankrupt.

Events which led to the rescue

A serious piece of advice advanced by some economists has been that Greece should aim at fiscal consolidation. As the careful reader will recall, the effort involved in a properly planned fiscal consolidation can reduce the risk of mutually reinforcing but largely negative links between government finances, the financial industry and the rest of the economy.

The problem has been that, in an emergency and amid a budgetary disas-ter, nobody has the mindset necessary for a successful fiscal consolidation. The political will is missing, let alone that the necessary skills and reliable accounts may also be absent or incomplete. Delays, however, can be deadly and euroland governments understood that immediate action was needed to stop the crisis from spreading.

There is no doubt that the Greek crisis has been a defining moment for euroland, and particularly so for the European Central Bank. The calls to employ its printing presses to solve sovereign debt problems were growing louder. But this was not the ECB’s mission.



It was good that euroland’s ministers of finance were looking for money that might provide at least a temporary a solution to the Greek crisis. This solution, however, should under no circumstance compromise the ECB’s independence. By mid-April 2010, Athens had not yet asked for a loan.

The case was further complicated by the fact that Greece understated the degree to which it was borrowing money, a practice Jean-Claude Trichet, the president of the ECB, called ‘intolerable’.12 The Greek government must carry out its responsibilities ‘with extreme vigor’, Trichet commented, but no action was taken at that time. While the country was not yet thought to be in imminent danger of default, refinancing its debts was very difficult without action to restore confidence, analysts said.

On April 14, the Greek parliament adopted a fiscal restructuring law to reduce the public deficit and to fight against corruption. A week later, serious discussions started between the government, European Commission, ECB and IMF. Reliable statistics came up as a problem. Over the next couple of days:

Eurostat, euroland’s statistical outfit, said that the Greek public deficit stood at 13.6 per cent,the markets reacted, with interest rates for Greek ten-year bonds hitting 8.8 per cent,the euro fell to its lowest level against the dollar for more than a year, andPapandreou asked for activation of a plan of financial assistance from the European Union and the IMF.

On April 26, Angela Merkel took a major political risk by promising that Germany would help Greece. One day later, Standard & Poor’s lowered the damaged country’s creditworthiness by three notches to BBB+. The next day, Herman Van Rompuy, the EU’s president, convoked a euroland summit (to take place mid-May) to discuss the Greek crisis.

This became superfluous as a result of an April 30, 2010 announcement of an imminent assistance package of a45 billion (with two thirds contrib-uted by euroland and one third by the IMF), which could rise to a120 in three years. It settled at the level of a110 billion.13 Concluded on May 2 and named the ‘Greek bailout’, the agreement foresaw that:

the (then) 16 euroland countries were supposed to provide a80 billion in bilateral loans, coordinated by the European Commission, with up to a30 billion available in the first year,loans by the IMF would make up the balance, with the euro equivalent of $15 billion in the first year, and a rolling quarterly review process was instituted to observe what had been done by Greece, and judge what needed to be done before the installments were paid out.

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All euroland countries were supposed to contribute to the loan package according to a European Central Bank ratio, with interest at 5.5 per cent. Many financial analysts said that this was hilarious. How could overind-ebted Ireland, Spain and Portugal – which were themselves near the edge of the abyss – loan money to Greece? The contribution of nearly bankrupt Portugal amounted to a1.4 billion; that of Spain, to a6.5 billion; but by far the biggest contributor was Germany.

For its part, the European Central Bank decided to prolong the exceptional collateral regime, which allowed banks that own Greek bonds to exchange their assets for cheap central bank funds. This announcement provided Greece and its creditors with additional financial support.

Greece was supposed to contribute a $30 billion package of spending cuts and tax increases, with its economy projected to shrink by at least 4 per cent in 2010 and another 1 per cent in 2011 (an underestimate). The aim was to reduce its budget deficit by 5 percentage points of gross domestic product in 2010 and another 4 points in 2011. It has been unavoidable that the main burden would fall where the red ink was thickest, on:

public sector workers facing salary cuts and a three-year salary freeze, further cuts in different allowances, and the abolition of the 13th and 14th monthly salaries, which were, in any case, outrageous.

Indirect taxation also rose to boost revenues. All three value added tax tiers were raised for an overall increase of 10 percentage points. Private compa-nies had to pay a one-off tax on 2009 profits, on top of a similar levy on profits from six months of the previous year. Anyone who thought that coming ‘out of the cold’ would be a painless exercise was proved wrong.

The prime minister, George Papandreou, told an emergency cabinet meet-ing: ‘Our priority is to avoid bankruptcy … That is a red line that cannot be crossed.’14 He was perfectly right. Following decades of high spending, Athens had to implement a massive fiscal tightening equal to about 15 per cent of gross domestic product by 2015 – and that assumes the eurozone and IMF are willing to roll over their lending to Greece indefinitely at low rates – which is in no way self-evident.15

There are good reasons why many economists say that, when the worst comes to the worst, re-equilibrating a sovereign’s budget is like walking a tightrope. With inflation higher and GDP lower than in a more dynamic economy, Greece had to meet binding fiscal targets while expecting under-performance at sovereign level, as well as the level of local government, health care and social security funds.

There have been, in addition, downside fiscal risks stemming from the expected catch-up of expenditure for that made in past budgetary alloca-tions, a projected revenue shortfall and negative cash-accrual adjustments.

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To compensate for these risks and ensure that fiscal targets were met, the government agreed to a plan of action in the context of the joint EC/ECB/IMF intervention.16 The bad news was that tax collection also faced a short-fall, lagging behind budget targets.

Shortly after the package was announced and analysts had had time to absorb the salvage operation, the market’s opinion was that, in the short term, the effect of the EC/ECB/IMF move would be to stave off a Greek debt restructuring for some years. Briefly, the extremely high yields on short-term Greek debt fell, and there was some kind of market optimism.

Indeed, in mid-September 2010 Greece managed to raise a1.2 billion ($1.6 billion) in six months’ bills in its second foray into the markets since its May bailout. This sum was 4.5 times oversubscribed, but investors demanded a 4.82 per cent yield versus 4.65 per cent paid in the pension auction two months earlier (July 2010). The problem has been that short-term loans are dangerous because they need to be frequently rolled over; if investors buy only short-term debt, this means that their business confidence has not yet been restored.

In addition, the economic problems of Ireland and Portugal keep the wound open. The longer term might be a different story than that of mid-2010. Analysts have not been convinced that measures have been sufficient to avoid a Greek bankruptcy.

Some economists distinguish between a near-term insolvency (as a result of the failure to roll over existing debt) and long-term solvency of Greece – coming to the conclusion that, while it will not default in 2010 or 2011, the sovereign will eventually default because, overall, the situation of Greek finances does not look at all good. The same is true of all other members of Club Med.

Going on strike against one’s own interest

As far as the Greek public is concerned, swarms of people reacted negatively to the government’s measures, even if both inside and outside the country experts remained skeptical about them, thinking they didn’t go far enough. ‘It’s hard to see how Greece can avoid a further tightening of fiscal policy,’ said a senior Athens banker, quoted by the Financial Times.17

Athens has not been the only city where demonstrations against the first measures taken by the government became the order of the day. The aim of bringing some sense of relative financial stability, in contrast to the prof-ligacy of previous years, was not generally appreciated, and public opinion has been divided about the need for the measures.

Finding themselves at the eye of the austerity measures storm, public serv-ants were first demoralized; then they took to the streets to protest against them. It was as if nothing worked any more. Independent observers, how-ever, were not convinced about the strikers’ arguments. As a foreign reporter said, after closely watching a couple of demonstrations in central Athens, if



these people were hungry, then one would have had compassion for them; but they looked to be well-fed. Probably, the reason for their anger was that they would lose some of their privileges, including part of their vacations.

‘Say farewell to the Greece you knew,’ said a front-page headline in Eleftherotypia, a left-wing Athens newspaper, warning of the impact of new measures on tax evasion and an end to early retirement. Public opinion did not seem to like the idea of a farewell, and social unrest increased. To its credit, the Greek government stuck to its guns.

With roughly half of Greek citizens feeling let down, the implication of interminable strikes and demonstrations was that either those in the government needed to change, or the strikers themselves had to alter their reaction and their way of dealing with the problem. It was the mission and responsibility of those who governed to explain to the people, in the most convincing way, that the alternative to austerity was bankruptcy – and with bankruptcy everybody would be hurt, particularly the younger generation. At the same time, however, as happened in Germany in 1930, America in 1933 and Ireland in 2009:

the prime minister, ministers and members of parliament should have taken a bigger salary cut than the one they voted for common citizens (see Chapter 10 on the Irish example), the government should have got into a high gear to stamp out not only tax evasion but also the ‘fakelakia’,18 and the whole machinery of the state should have moved to root out cor-ruption, especially where it was embedded the most: in health care and defense.

In times of crisis, it is the duty of those who govern to set an example and establish a process of recovery which is predictable. Back in December 2009, at a summit, George Papandreou sought to regain the confidence of his European Union colleagues by acknowledging corruption. Since then, how-ever, corruption is still alive and well, while ‘fakelakia’ decided what is to be done next in health care and elsewhere.

Among the strikers were tax collectors and taxi drivers. The latter were furious over plans to make them issue receipts.19 On March 11, 2010, serious street clashes erupted in central Athens between rioting youths and police, as some 30,000 people demonstrated during a nationwide strike against the austerity measures. Hundreds of masked and hooded youths20 punched and kicked motorcycle police: and riot police responded with volleys of tear gas and stun grenades.

The violence spread after the end of the march to a nearby square, where police faced stone-throwing anarchists. Rioters used sledgehammers to smash the glass fronts of more than a dozen shops, banks, jewelers and a cinema. April 2010 did not bring any better news in regard to public discontent.

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In early May 2010, new demonstrations took place against the govern-ment’s austerity plans; three people died, provoking an angry reaction from strikers. Anti-austerity demonstrators stormed up to the steps of the parlia-ment building, where the austerity plan was about to be debated, calling the parliamentarians ‘thieves’ and goading them to come out, reportedly chanting: ‘Burn it down, that brothel parliament!’

The protesters also set fire to a bank. In reality, however, all this commo-tion was to bid farewell to two decades in which money flowed extrava-gantly, including expenditure on the 2004 Olympics. As long as the show was on, swarms of legal and illegal immigrants came to work in restaurants, clean the streets and harvest agricultural produce.

By June 2010, labor unions were calling for a sixth general strike in a row for July 8, to protest once again against the government’s austerity measures. It was planned to take place on the same day the parliament was expected to vote on the pension bill. Among the measures being taken, the government, was, quite correctly, attempting to reform the state-run pension system by raising the retirement age to 65 years for all Greek employees and by taxing pensions above a1,400 a month. In the meantime, public opinion began to shift towards acceptance of the measures. A public poll showed that about half of Greeks thought pension reform was needed; this was also the per-centage of Greek people who, though hurt by the austerity plan, thought that there was a need to redress the country’s finances and its economy.

It comes as no surprise that resistance to change dies slowly. In mid-October 2010, riot police used tear gas to disperse dozens of Culture Ministry employees blocking access to the Acropolis monument. They occupied the historical monument in reaction to a government plan to make some 300 Culture Ministry workers redundant by the end of the month under cost-cutting measures, targeting rolling short-term contracts for public sector employees.

For their part, employees at OSE, the state railway company which was the biggest public sector loss-maker,21 staged a 24-hour strike against a draft law cutting 2,500 jobs. As the finance minister commented in the course of the negotiations which led to the EC/ECB/IMF loan, Greek public servants are not paid very highly, but there are so many of them that the state budget cannot cope any more. That’s a problem most western economies are cur-rently facing.

Correctly, among the measures taken by the Papandreou government was to open up the closed shop of many professions – whereby those who had a job took as hostage those who had not. This included very diverse groups of people: from truckers to lawyers, pharmacists and civil engineers.

Under the conditions of the bailout by the European Union and the IMF, the law liberalizing all closed-shop professions was due to pass parliament in December 2010 – months earlier than was agreed. From lawyers to under-takers, more than 150,000 people work in about 70 closed-shop professions



with a vested interest keeping the cost of services high. According to some estimates, liberalizing the labor market could boost Greek GDP by over 13 per cent in a timeframe estimated between three and four years.22

Greece is by no means the only euroland country in dire need of structural reforms – another reason why what has taken place in early to mid-2010 is just the first episode in a long series of events bringing forward the new normal. To its credit, the government stood up to 33,000 owner-drivers who, in early August 2010, at the height of the tourist season, went on strike in protest against plans to double the number of truck licenses and allow citi-zens to set up long-haulage companies. This eight-day strike caused a severe petrol shortage, kept tens of thousands of Greeks and foreign tourists off the road and further harmed the already damaged economy. But the govern-ment stuck to its guns and its stance constituted a defining moment in the country’s struggle to reshape its outdated economy.

As with swallows, EU money alone will not bring spring

‘Greece’, wrote Thomas L. Friedman in a feature article, ‘became the General Motors of countries.’23 Like GM’s management, since membership of the Common Market, Greek politicians used the easy money and subsidies that came along not to make the country more competitive in a globalized world, but in Friedman’s words: ‘more corrupt, less willing to collect taxes and uncompetitive’.

This is a tough indictment. Unfortunately it is true. Friedman could also have written that, like mismanagement in the old General Motors, where the cost of workers’ health care embedded in a car exceeded that of steel, the cost of health care, unemployment benefits and pensions in Greece shattered the economy. (At the beginning of this century, a change of US accounting rules saw to it that, out of $24.5 billion losses in one year in GM, $23.5 billion were due to accumulated health care expenses, and only $1 billion to operations.)

In addition, like the de-industrialization of the United States and of Britain, Greece allowed its industries to decay. When I was young, in the immediate post-World War II years, there was a first-class textile industry; a very good mechanical industry; and an average, but still acceptable, electri-cal industry in Greece. All of them have been wiped out by cheaper Asian competition; nowadays, all that is left is a huge but ever-growing govern-ment bureaucracy which produces nothing.24

In fact, all that it does, when it is not asking for fakelakia, is to try to ‘bleed’ those who are still productive. It is no wonder, therefore, that, in such a depressing landscape, to save the ship from sinking, the government had to cut public sector expenditures, freeze benefits and slash jobs. It will also have to abolish plenty of welfare entitlements and take the axe to pro-grams which lead nowhere in terms of wealth creation for the economy.



With Greek industry flat and foreign income mainly depending on tour-ism (which, because of global economic woes and Greek strikers is down), the country’s economy cannot recover within a reasonable time – even with the measures voted by parliament. A default of some type is inevitable in the medium-term future, and it is likely that the earlier this happens the more orderly is likely to be.

One of the many reasons why Greece is just the first episode in the unraveling of the old system and its replacement by the new normal is that sovereigns – including the USA, Japan and Britain – don’t have the money to pay for a social system based on ‘guarantees’ that simply cannot be met in social, economic and financial terms.

As with Spain and Portugal, the problem Greece faces is not just explicit debt, but also the implicit miserable economic prospects of developed coun-tries whose industry, wherever it still exists, is uncompetitive. Because of this fact, the billions earmarked as a loan by the other euroland countries and by the IMF are nothing more than seed money for a change – money which may be wisely used or simply wasted – but, left to its own devices, the EC/ECB/IMF financial package will change nothing.

There has been a hope, at least by those of us who wanted to see Greece take its future in its hands and recover, that there will be a movement of national resurgence. Unfortunately, this hope does not stand up to scrutiny. What is left is the bailout, which was certainly bigger than the markets had expected; all it can do, however, alone, is to eliminate the risk of default for a year or two while Greece still faces a deep medium-term solvency crisis. The question then is: What comes next? If euroland’s and the IMF’s a110 billion are used in conjunction with an orderly Greek default, and if there is a national resurgence, then Greece may recover. If these two ifs don’t materialize, then the country will continue suffering, banks will be crippled, the Greek Treasury frozen out of capital markets and the govern-ment will fall.

An alternative might be that Greece uses euroland/IMF money to buy, at deep discount, its longer-term bonds, at rates currently fluctuating around 65 per cent. This could significantly reduce the country’s debt load, while the 65 cents to the euro is also what an orderly default will likely target.

The risk is that, if the percentage of loans forgiveness is significant, then Ireland, Portugal and Spain will immediately line up for the same treat-ment. Among them, Spain and Portugal owe 400 per cent of what is owed by Greece – a huge a1.2 trillion. Add to this a1.5 trillion, which is Italy’s exposure, and the question ‘Who is to advance all that money?’ is simply answered: nobody.

On the other hand, if the orderly default is delayed and becomes disor-derly (which is highly likely), then it will greatly damage the euro, the Greek economy and the banks25 – all in one go. This does not mean that an orderly



recovery after prearranged bankruptcy is a garden of roses. It requires serious discipline and pain, in implementing:

enormous fiscal tightening,unprecedented deleveraging, andshrinkage of GDP by roughly 15 per cent, as was the case in Latvia in 2009.

Still, without an orderly bankruptcy and disciplined recovery, which will greatly depend on the general public’s attitude, Greece will not able to hold its place among developed nations in the near future. And if the EC/ECB/IMF loan is only a short-term measure, then the Greece/Bear Stearns and X/Lehman hypothesis, of which we spoke in Chapter 4, comes back with a vengeance. To search for an answer to ‘Who might be X?’, one has to return to the fundamentals. The way a Wegelin Investment Commentary puts it:

What was the trigger for the financial (and economic) crisis? The over-indebtedness of the banks.Why were they overindebted? Because they had engaged in supposedly risk-free own-account trading.Why was this trading regarded as risk-free? Because it was based on sup-posedly risk-free mortgages.Why were the mortgages regarded as risk-free? Because they were ‘guaran-teed’ by the quasi-state agencies Fannie Mae and Freddie Mac.26

This is a Socratic method at its best. At stake now is our ability to identify ‘X’ by following the same logic with sovereign indebtedness.

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10Germany, France, Britain, Ireland and ‘Club Med’

The German economy

As Figure 10.1 brings to the reader’s attention, after falling off a cliff in late 2008 in the wake of the dip in the severe economic crisis, in the second quarter of 2009 Germany’s export- and investment-driven economy started to expand again. Part of the reason was that the global manufacturing cycle turned around, but the bigger reason was that workers and companies were ready to capture the rebound without destabilizing claims.

The surge in growth was driven by exports, investments and invento-ries, leaving the effects of the ongoing global financial crisis behind. There were no strikes (as in neighboring euroland countries) and the economy moved forward, even if German consumers raised their savings rate from 10.5 per cent in 2006 to 11.6 per cent in early 2010.

Through the synergy which developed in the economy, Germany headed for neither a deflationary spiral nor a major rise in inflation. Production capacities were still idle. Demand recovered at stable prices and unemploy-ment fell, with economists projecting that this would continue for some time. Such an orderly progression, however, did not characterize other euro-land countries. Taking credit rating as a criterion:

In 2000, Greece’s rating was A�, rose to A� in 2003, dropped to BB� in 2010 and to B� in early 2011.Portugal entered the euro with AA; by 2010 it had become A�.Spain’s AA+ in 2000 rose to AAA in 2005 and dropped to AA in 2010.Ireland’s rating went from AAA in 2010 to AA in 2011 – which is curious, because its sovereign finances are not much better than those of Greece, albeit for different reasons.

In none of these four countries did the politicians share the spirit which led to Germany’s social and economic synergy. To better appreciate it, the reader should know that these positive results were achieved despite the

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fact that Germany entered the common currency handicapped by a strong Deutschmark and the cost of unification (which was just a decade old) was still lingering on. But, unlike in other euroland countries, employers and labor unions cooperated to keep the lid on labor costs.1 The government contributed to this surge by liberalizing the jobs market and cutting social security contributions, partly making up the shortfall with higher VAT.

Behind this resurgence in Germany’s industrial spirit is the work of German executives, workers and employees. Therefore, the German public can be excused for its reluctance to sign up to a financial rescue package. The upswing we see here is a totally different story from those presented in the following sections on Germany’s neighboring countries and fellow European Union members.

German voters have grown weary with the idea that they should pay for bailouts – be it loans to Greece or to any other euroland (let alone EU) member country which is approaching an economic precipice because it mismanaged its finances. In rejecting a bailout for several weeks, Angela Merkel was reflecting the political conviction of her own party and its allies, as well as fear of what the German constitutional court in Karlsruhe might decide on the legality of such a move.

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Figure 10.1 German industrial output rebounded leaving other western countries in the dust


Germany, France, Britain, Ireland and ‘Club Med’ 173

Economic discipline and economic solidarity go hand-in-hand. Merkel was consistent from Day 1 in saying the bailout of a euroland member could only be justified under three conditions: if the stability of the eurozone as a whole was endangered; if rescue was a ‘last resort’; and if the country receiv-ing euroland’s loan had decided to do what it takes to implement sweeping budget cuts, start economic and labor reforms right away and increase the competitiveness of its economy.

Unavoidably, there were also political motives, as the German chancel-lor knew full well that a rescue reinforced public unhappiness about having adopted the euro and given up the Deutschmark. This is not just a German phenomenon. Public opinion polls in other countries too, such as Holland, point to weak support for the EU through ‘No’ votes in various referendums.2

Indeed, the greatest mistrust of the EU is in Britain where, according to 2010 statistics, only 30 per cent of the population thinks the EU is ‘a good thing’ and just 22 per cent tend to trust it. This rises, respectively, to 48 per cent and 42 per cent in France; 48 per cent and 52 per cent in Italy; 44 per cent and nearly 60 per cent in Germany.3 Why only 44 per cent think the EU is ‘a good thing’, but 60 per cent tend to trust it, is a mystery.

The early 2010 German mistrust of bailouts in euroland has been vindi-cated by the facts six months down the line. With interest rates on Ireland’s and Portugal’s bonds reaching for the stars, by mid-November 2010 euro-land’s debt crisis was reaching a new phase. Concerns grew that the EU peripheral economies may have to restructure their debt and, while it is the right decision to ask bondholders to share the pain, its prospects turned Ireland and Portugal out of capital markets.

Not only the general public, and therefore the politicians, but also euro-land’s economists and financial analysts (who understand the need for eco-nomic and financial discipline) now say that the governments which signed the Maastricht Treaty (two decades ago) did so without understanding what they had signed into law. Now they are finding out that the price they have to pay for that failure can be steep and is totally unwarranted.

The German economy is strong, but not so strong as to be able to carry on its shoulders the entire debt of euroland. If money is given to a profligate neighbor for no other reason than ‘just to be nice’, then plenty of other countries will queue up, cap in hand. They can always find the excuse that if they don’t get money from heaven, they would fall like dominoes.

For German policy-makers, as well as for other euroland chiefs of state, Greece has not been an isolated case of budgetary indiscipline and dete-riorating competitiveness. It is common knowledge that even if Germany, France and other euroland countries presented Greece with a loan without any conditions attached to it, then Spain, Portugal, Ireland and who knows who else would come up with similar requests.

In all transactions between states, as well as between companies and between people, sound management principles require that the recipient



must prove that it can live within its means after restructuring. Unless and until it does so, the yields of its bond will carry a risk premium reflecting a higher default likelihood and the market’s disbelief that big spending has been replaced by financial discipline.

It is only normal that lenders ask for assurances. Money does not grow on trees. Apart from anything else, the lender – for instance, Germany – has to deal with its own problems. Government debt has risen almost continuously since the Federal Republic was founded, with three spikes:

following the 1973 and 1979 oil price shocks,in the aftermath of German unification up to 1996, andbecause of the recent economic and financial crisis, particularly from 2008 onward.

It is interesting to note t from 1950 to the early 1970s, in financially dis-ciplined Germany the debt to GDP ratio remained relatively stable at just under 20 per cent. But, by the end of the 1980s, the national debt reached almost 40 per cent of GDP – oil crisis and stagflation having had their effect. A further spike due to German reunification placed considerable strains on public finances.4 It needs no explaining that the negatives of higher public debt and continuing borrowing include:

distortions arising from future increases in taxes and social security con-tributions,potential crowding out of private investment and associated uncertainties,limited effectiveness of debt-financed measures aimed at averting crises,danger of conflicts between fiscal and monetary policy causing macro-economic costs, andrisk premiums on capital markets because of growing concerns about the government’s solvency.

Though the soundness of the German economy makes the likelihood of the last bullet point relatively small, the (unwarranted and illogical) assumption of debt belonging to other euroland members would substantially increase that exposure. No wonder, therefore, that Germany required guarantees of sound future economic policies5 prior to participating in the 2010 loan package to Greece, to the tune of a8.3 billion.

In conclusion, to anyone who thinks with his head (rather than his feet, as the various street demonstrators do), solidarity involves doing plenty of homework – each for himself. Giving in to demands for bailouts is the best prescription for indiscipline, which will make the total operation much more expensive and inefficient. As for the cries that the economies of some

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countries are devastated by speculators, as Merkel aptly stated: states with stable finances do not invite speculators.

The French economy

So far, only one of the better-known French politicians has had the cour-age to speak his mind about the status of the French economy. In 2007, François Fillon was a lone voice when he declared ‘France is bankrupt.’6 In mid-November 2010, after being reappointed as prime minister, he said that his absolute priority was to trim the deficit.

In 2010, the budget deficit of France was around 9 per cent of GDP, but the government announced a target of reducing it to 6 per cent in 2011 and 3 per cent in 2013, without embarking on fiscal austerity. It sounds more than just plain difficult to kill both of these birds with one well-placed stone, but ‘austerity’ has been taboo in French politics since 1995, when Alain Juppé’s government succumbed to public sector strikes and a long parade of noisy street protests.

Yet, Juppé’s initiative was right. What he correctly sought was to slash the budget deficit aggressively. It took the 2010 sovereign debt crisis, wreak-ing havoc in Greece and other peripheral euroland economies, to concen-trate French politicians’ minds on the need for economic and financial discipline – if France is to avoid a similar fate.

As in Greece, the public is divided 50:50 on the need for such measures. The loafers are always against. The government is betting on GDP growth to bal-ance the budget by 2013. Its projection is that growth will reach 2.5 per cent from 2011. The European Commission has already said this is optimistic, not-ing ‘substantial risks’ that the deficit in 2011–13 will be worse than forecast. In contrast to the German economy, the French economy lost some momentum in the first and second quarters of 2010 as private and public consumption was largely flat and investment declined for the eighth successive quarter, with inventories subtracted from growth for the sixth time in seven quarters.

The good news has been signs of stabilization in the job market and household savings ratio. With a background of bad news comes subdued consumer spending, at a time when the manufacturing industry needs to pick up momentum. Exports are not flourishing because labor costs are rising and the labor market has structural problems.

To pull the French economy up from under, the French government has proposed a range of consolidation measures, including a reduction in govern-ment employment, increasing retirement age, direct taxes for households and enterprises to finance the pensions, and a central government expenditure freeze. The public, however, is not ready to see its entitlements trimmed.

As the careful reader will recall, France has also seen days of demonstra-tions, in September, October and November 2010, as millions took to the streets to protest at the raising of retirement age to 62 years (from 60). This



was a last-ditch effort by the government to save the state-owned pension systems from full bankruptcy. (One of the ironies was that the majority of the demonstrators were young – it was as if they did not have the brains to understand that, when they reach retirement age, state pensions will defi-nitely be bankrupt, whether the retirement threshold is set at 60, 62 or 70.)

Established as a populist measure by François Mitterrand, a former president of the Republic, retirement age at 60 saw to it that the average Frenchman spent 24 years in retirement, against an OECD average of 18. Furthermore, French pensions are fairly generous. Civil servants, for exam-ple, get 75 per cent of their final six-months’ salary.

Not surprisingly, the result is a growing pension deficit that could reach a35 billion or more by 2030. Economists say that the only serious option is retirement at 65, but doing so would almost amount to a revolution – and might even bring one about. Therefore, the government decided to take the easy option and set its retirement goal at 62 (which is utterly inadequate). Even that will not come into full force until 2018.

Moreover, while the French government’s measures addressed some of the economy’s and budget deficit’s problems, they left intact the rigid labor laws which stifle personal initiative and the spirit of enterprise. French labor laws are based on an underlying social model whose religion is generous benefits. The economy is crushed under heavy payroll taxes, which deter job creation – the gap between what an employer pays and the employee receives, known as the tax wedge, is as much as three times bigger in France than in Ireland.

That is the very image of the welfare state, and its reincarnation as the State Supermarket. The sovereign’s budget is sinking under the weight of self-created mountains of debt. Economists sympathetic to the nanny state’s wheeling and dealing suggest that generous government outlays, a large public sector and entitlements cushioned the French economy from the more severe blows suffered by other euroland countries.7 No attention is paid to the fact that these same factors feed the huge budget deficit and work against a swift economic pick-up, when it comes.

Therefore, several French economists now believe that the rules of the game must change – even if the reforms that the state has to go through and digest to restructure its finances add to the uncertainty about the economic outlook. The French government has no alternative other than to trim spending, and this is achieved gradually by not replacing one in two retiring civil servants. But there have been no pay freezes, with most attention placed on pension reform.

The time has come for deficit problems to be tackled at their roots – including trimming entitlements, cutting public waste and rationalizing the bureaucracy. The money which allowed France to do otherwise, albeit with difficulty, has dried up.

In early February 2010, the magistrates of la Cour des Comptes – the official auditing agency of the French government – clearly stated in their annual



report that the republic’s finances were in a sorry state: beyond the eco-nomic crisis, there has been deterioration of the country’s structural deficit, and the situation of the financing of social security is impossible to main-tain. Therefore, taxes associated with entitlements should be increased.8

Not only in France, but also all over Europe and in America, the (theoreti-cally) ‘hard won’ entitlements have reached a crossroads. The time has come to move to the next stage, trimming them significantly and withdrawing some of them to make those that remain affordable and sustainable.

Measures such as imposing a nominal terms freeze on central government spending, reducing tax exemptions and ending the different ineffective eco-nomic stimulus measures to cut the deficit are welcome, but not enough. ‘It is a very good budget,’ said Laurence Boone at Barclays Capital in connec-tion with the 2011 French budget. ‘Most of the effort at reducing the deficit is structural … France should meet its target of 6 per cent of GDP.’ The key question is what happens after 2011.

One should also recall that France has not balanced its budget for over 30 years. As Charles-Amédée de Courson, a centrist deputy who campaigns for transparency, put it: ‘When there is no control, you can do what you want.’9

Some time ago, a feature article which appeared in the daily press under-lined the same concept in somewhat different terms: in troubled economic times, and with politicians enjoying handsome perks at taxpayers’ expense, remembering de Gaulle may also be a way for the French to invoke a model of integrity and modesty.10 In 1958, when he was called by popular acclaim to save the Republic from downfall, he proceeded with an austerity program and publicly stated: ‘Without an effort to regain control, without the sac-rifice it requires and the hope it entails, we will remain a country that lags behind, swinging continually between drama and mediocrity.’

Three centuries earlier, François de La Rochefoucauld, a French author, went even further in conveying his message to his readers. ‘We are so accus-tomed to disguise ourselves to others that in the end we become disguised to ourselves.’ Continental Europe, Britain and America cannot find clearer terms to describe their social and economic situation today.

The British economy

For Britain, 2009 was by far the weakest year in post-World War II history. GDP contracted by 4.9 per cent in that year alone, while over the full course of the 2007–11 deep recession output declined by over 6 per cent, more than double that in the early 1990s downturn.

In the first quarter of 2010, the British economy posted a modest 0.3 per cent quarter-to-quarter rise in GDP, and economists estimated a total of 1.2 per cent in 2010, before strengthening in 2011 with support provided by a relatively weak exchange rate,11 quantitative easing by the Bank of England and ultra-low interest rates, also from the Bank of England.



By contrast, consumer spending remained muted through much of 2010, with high unemployment, fiscal tightening and focus on balance sheet repair based on a takeoff. After the folly of spending mountains of money on saving the self-harmed big British banks, even the Labour government, in early 2010, finally decided to rein in spending to repair Britain’s sovereign balance sheet.

Bad news for Britain was the fact that inflation had taken off, its path greased by energy prices and VAT effects, while spare economic and indus-trial capacity acted as counterweight to improve economic conditions. The British economy was weakened by the fact that, like the Bush Administration in the USA, Labour spent trillions propping up banks, with the result that public deficits skyrocketed.

As 2009 came to a close, to refill the state’s coffers the Labour government was ready to raise taxes on the better-off. The then chancellor, Alistair Darling, continued his attack on high earners by reducing further the tax relief available to them on their pension contributions and unveiling a one-off tax on bank bonuses.

But as André Tardieu, the French socialist prime minister in 1930, had said, the big money for the sovereign’s treasury comes from the taxes paid by the many rather than the few. His famous advice survived for 80 years: ‘We must tax the poor. They are the more numerous.’

Writing in the Financial Times about the budget delivered by Alistair Darling, Martin Wolf said that: ‘What lies ahead is an area of harsh choices. Is there a politician to create something uplifting out of this disappoint-ment? … What stretches ahead is an epoch of diminished expectations.’12 This is true for all western nations – America included.

The Tories did not lose the opportunity to explain to the electorate that both the few and the many had to contribute the funds needed to steer the economy and restore sound public finances after the bust. Economic analysts helped in documenting this assertion, as, according to current projections, British national debt will be about 100 per cent of GDP, which is better than forecasts for the United States, where the public debt to GDP ratio has been brought to nearly 110 per cent, but worse than debt figures projected for Canada (70 per cent) and Germany (90 per cent) for 2010.

The debt hangover sovereigns inflicted upon themselves is not going to disappear because of wishful thinking, or as a result of grandiose pronounce-ments by any politician. The economy will not automatically generate the cash needed to cover past public sector extravagance. Only long years of fis-cal discipline can bring back prosperity in Britain (as well as in other western countries), and even that is not certain.

Wolf is right when he says that the crisis we are going through marks the end of an epoch, economically and politically. Other economists, too, stress the fact that future economic growth requires more radical decisions on public finances than those political parties customarily make. Britain has to



find itself again after years of mismanagement. If not, then, although it was written as a joke, a commentary read on the internet on April 23, 2010 risks becoming reality: ‘St George (whose day it is today) is also the patron of Greece and Portugal as well as England – so should we be thinking and fret-ting about “Club St George” rather than Club Med?’ This question is by no means insane. If the Greece/Bear Stearns and X/Lehman hypothesis (which we studied in Chapter 4) is right, then it would be proper to account for the fact that – if the drift continues on its present course – Britain is one of the three candidates to fill X’s shoes (the other two being the USA and Japan).

Indeed, prior to the 2010 elections it was no secret that huge deficits awaited the victor. On May 5, 2010 the European Commission said the British government will have to borrow more than it planned as ‘in the current financial year and in calendar 2010 it will have the largest budget deficit in the European Union’.13 And the Conservative Party itself had stated that restoring British public finances was a central task.

George Osborne, the new chancellor of the exchequer, aptly criticized former prime minister Gordon Brown and Alistair Darling, his predecessor at the Treasury, when he said: ‘In a nutshell, they fixed the figures to fit the Budget, when they should have fixed the Budget to fit the figures. Forecasts were fiddled in order to help the government to present the sort of Budget it wanted to present.’14

Leading British economists15 had called on the government to start cut-ting the country’s record deficit, adding that, in the absence of a credible plan, there is risk of loss of confidence in the government’s economic policy. This will contribute to currency instability and higher long-term interest rates.

It is to Osborne’s credit that he wrote his budgetary figures in a way which has shown political courage, but there are problems with the figures. One of them is that cutting down a £163 billion ($252 billion) deficit is no small business and it cannot effectively be done in small installments. Spending cuts worth roughly £6 billion in 2010–11 were announced at the end of May 2010. The other £157 billion were the theme of the budget unveiled as June 2010 came to an end. But, when everything is taken into account, the financial plan leaves plenty of red ink, and not everybody is convinced the cuts will materialize as intended without far-reaching decisions, which require: redefinition of what Britain wants to be in the future; cooperation from embedded interests hurt by the cuts; and navigation in uncharted terri-tory. All this amounts to a formidable task that will test the resolve and stay-ing power of the coalition. Two themes will haunt the budget-makers: first, avoidance of trimming the ballooning budget of public health care; and, second, the 10 per cent cut in the defense budget, without clearly stating which military commitments will be dropped and never again taken up.

Britain devotes an annual budget of about £45 billion ($72 billion) to defense, of which £4.6 billion or so is extra cash the Treasury provides for



operations in Afghanistan and Iraq. The irony is that the Labour govern-ment constantly supported American initiatives but was reluctant to meet the costs resulting from lengthy military engagements. This was an issue of contention.

Several Tory/Liberal Democrat government economists and plenty of financial analysts have criticized the decision to ring-fence the National Health Service (NHS) – in essence, continuing to raise the budget of an entity well-known for its inefficiency, run-away costs and other waste.16 Given the size of the government’s budget deficit (around 13 per cent of GDP in 2010), and the already high level of the debt to GDP ratio, cuts in the public sector workforce are inevitable.

A report by McKinsey suggested the NHS may need to cut 10 per cent of its workforce over the next five years.17 This is a problem confronting all western governments. Paying for health care in an aging society is not just a British challenge, it is at the heart of deficits of all western countries. That is precisely why many experts had expected courageous decisions by the new government, to bring the NHS’s ever-rising costs into line.

Instead, the axe fell on higher education. In early November 2010, univer-sity fees (instituted by Tony Blair) were increased by 300 per cent.18 This led to a riot in central London, which got out of hand with student demonstra-tors sacking the Conservative Party’s offices at Millbank and damaging other buildings. Whether the demonstration was justified or not by this sharp increase in fees, destroying other people’s property was a weird response, showing that at least part of the money spent on education is wasted.19

The Irish economy

Over the first decade of the common currency, the Irish economy has benefited greatly from the euro, which has been the best-ever stimulant to financial growth the Irish people could have expected. Capitalizing on what seemed to be a stable currency in a broader euroland economy (initially) rated for growth, the government engaged in a well-orchestrated campaign to get foreign firms to settle or resettle in Ireland.

For years there was practically only good news. The bad news came with the 2007–11 economic and banking crisis, in a way not too dissimilar from what has happened in Iceland (more on this later). There were some com-mon reasons as well. The Irish economy’s growth was largely propelled by the financial industry, and this created major vulnerabilities when the bub-ble of subprimes and other inflated ‘assets’ blew, and the deepest crisis since the First Great Depression hit the Irish financial industry like a hammer.

Economists are bound to debate for many years whether the Irish govern-ment was right or wrong to mortgage the Irish economy by rushing to save, first, bigger three Irish banks, then an equal number of British–Irish institu-tions, from descending into hell because of their own mistakes. (The same



is true of the Icelandic government’s action, though the conditions were somewhat different.)

As of mid-November 2010, the Irish government’s impulsive and ill- studied blanket bank bailout was estimated to have cost the sovereign a50 billion ($70 billion) – the bill became bigger and bigger. The problem con-fronting the common citizen is no different from that in Britain and in the United States: taxpayers have been condemned to underwrite the banks’ liabilities, no questions asked.

Not only Irish taxpayers have been affected, but also German, French and plenty of other Europeans, to the tune of a85 billion. With an ill-advised laissez faire attitude and substandard supervision, the Irish banks have engineered the demise of the Irish economy. Such huge damage is not only economic and financial. According to the Economic and Social Research Institute, a Dublin-based think-tank, 100,000 people are expected to leave Ireland between April 2010 and April 2012.20

Judging from the way the a85 billion of the Irish package was allocated, the government’s foremost failures have been the mismanagement of a property-induced economic boom and a huge underestimate of the scale of the crisis for Ireland’s banks. The Irish sovereign rushed to guarantee its liabilities without first studying the depth of its losses. Of the a85 billion:

a10 billion have been allocated to immediate recapitalization,a25 billion will be on a contingency basis for banking system support anda50 billion will cover the Irish government budget financing needs, largely created by the foolish underwriting of failing financial institutions.

The roadmap is that Ireland will contribute half of the banking support meas-ures (a17.5 billion) through the treasury cash buffer (a5 billion) and invest-ments of the National Pension Reserve Fund (a12.5 billion). The remaining a67.5 billion will come from external support – of which a22.5 billion will come from the solidarity fund (EFSM) and the other a22.5 billion will be made up of a17.7 billion of EFSF money and bilateral loans of a4.8 billion (a3.8 billion from Britain, a0.6 billion from Sweden and a0.4 billion from Denmark).

IMF repayments will start after 4.5 years and will end after ten years. The interest rates of the Irish package will be close to 6 per cent, based on market rates plus a spread of 300 base points. Ireland has been given an extra year, to 2015, in order to bring its budget deficit to less than 3 per cent of GDP. (Just as in Greece’s case, Ireland will be subject to quarterly assessments for the disbursement and use of funds.)

Irish banks, whose abysmal governance created the whole mess, were stress tested again in the first quarter of 2011, but the fact remains that they were the primary beneficiaries of the package. They clearly needed

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the money because they were shut out of the capital markets for almost a year, leaving them increasingly dependent on the European Central Bank for funding. (Ironically, it is the ECB that led opposition to cutting senior bondholders for fear that the reputational damage to Irish banks would close their access to the markets for far longer than the bailout.)

An opinion I have often heard in my research is that ‘Six banks were too many’ and, moreover, some of them were already too damaged, constituting an inordinate risk for the Irish Treasury. The taxpayer finally revolted when the government decided, in September 2010, to pour more good money into the Anglo-Irish Bank’s treasury, with disastrous results on the Republic’s financial health.

According to the same expert opinions, the Irish government should have selected only two or three banks out of the six it supported with lavish public money – evidently, those with lesser damages and the best chance of survival.21 But the Irish copied the policies of neighboring Britain and of the USA, where the governments rushed to extinguish the fire without first deciding which banks were worth saving and which should be left to the fate prescribed by their own mismanagement. What distinguished the Irish sovereign from the British under Labour is that the government lost no time in putting into effect austerity measures, and there was, at first, a muted public reaction, suggesting that the population understood the need for emergency measures. (This changed as the salvage bill got bigger and bigger, with one bad surprise following another.)

Fair enough, the Irish government tried to restore confidence in the republic’s banking system, but by so doing it also enriched the mismanaged banks’ shareholders at the expense of taxpayers. The blanket guarantee was unwise, and it was a major regulatory failure that Irish banks were allowed, over the good years, to run up such large losses that trying to salvage them turned into the sovereign’s ruin.

At least, once again unlike other sovereigns, after having made mistakes, the Irish government has shown courage in taking tough economic meas-ures. It would have done better if it had applied the rules and lessons origi-nated by Stefan Ingves, governor of the Riksbank (Sweden’s central bank), in the early 1990s, who, confronted with his country’s bank crisis and bailouts, prescribed an immediate write-down of all bad assets and forced recapitalization of banks, even if it meant nationalizing them.

The Ingves strategy was bank clean-up through a clean sweep. The Irish, British and American choice, by contrast, worked piecemeal. No wonder, therefore, that the situation of the Irish banks continued to worsen, and the cost of bailing them out rose. A torrent of public money went to Anglo-Irish, a deeply mismanaged specialist property lender that had to write off almost half of every euro it loaned (see below).

Analysts said that bailing out the Anglo-Irish Bank will end up costing the government much more than a25 billion ($40 billion), no matter what the



politicians might say. Several experts also pointed out that this particular institution should not have been saved in the first place. Relative to the size of the country’s economy, its salvage required a torrent of red ink, making Anglo-Irish more destructive by far than big banks in Britain and America. Anglo-Irish was expected to drain more than 12 per cent of Ireland’s GDP. In Britain, the rescue of the Royal Bank of Scotland abused ‘only’ 3.3 per cent of GDP; in America, the cost to the taxpayer of saving Citigroup stood at about 0.5 per cent of GDP, given the size of the country’s economy.

The sovereign was not even sure what to do with so much financial nuclear waste. Belatedly, in early September 2010, the Irish government announced it would split Anglo-Irish,22 which by then was already nation-alized into a ‘funding bank’ (read: good bank) to manage deposits and an ‘asset recovery bank’ (read: bad bank) for toxic debt – while some bits and pieces of the former entity were earmarked to be sold or simply closed down. This should have been done from Day 1.

According to some opinions, Ireland, Britain and America are three perfect examples of the forces creating the economic environment of the new normal. Because of the massive failure of their banks, and the fact they rushed to cover their huge shortfall without first establishing an exit strategy, the citizens of all three countries have taken a great deal of pain. Ireland, for example, was not highly indebted before this crisis; its sovereign debt was an enviable 25 per cent of GDP. But the torrent of red ink due to the banks’ astronomical liabilities radically changed the sovereign’s indebt-edness, as the government threw money at the problem.

According to reliable estimates, Ireland’s public debt will reach about 140 per cent of GDP in 2014, once Dublin’s guarantees and estimated losses are reflected in the national debt.23 This is a substantial increase of 560 per cent compared with its level prior to the crisis, reflecting what might become an integral part of the new normal – that the State Supermarket covers the real and imaginary needs of the country’s citizens through more and more debt; the financial losses of its enterprises, no matter how mismanaged they may be, fall on the shoulders of the citizens in the short, medium and longer term.

Critics say that, the way things are drifting, it might well become a new norm that the government accepts open-ended exposure to private liabilities across the banking and other sectors, which means the end of free enterprise as we know it. With this, the State Supermarket’s empire will cross the boundaries of what has been so far considered as ‘reasonable’ practice, further enhancing its already substantial power over taxpayers.

Ireland, Iceland, Portugal and the uncle of Dubai

If you default on any of your creditors, you should expect some sort of legal action; and if a deus ex machina saves you from default by using other people’s money, you should expect their anger. Instead of being arrested for



driving a cement lorry bearing the logo (in big letters) Anglo-Toxic Bank24 up to the Irish parliament’s gates, the driver should have been awarded the Irish Truth Prize of the year. He was the bearer of a message which served to wake up the parliamentarians to the urgent need to stop throwing good money after bad, and pressed the point that the best policy would arguably be to bury the ‘Anglo-Toxic’ under reinforced concrete, while bringing those responsible for its failure to court for destruction of assets.

The Anglo-Irish was long considered a mismanaged bank disastrously concentrated in two sectors – property and derivatives – with overwhelming single-client exposures25 and a great number of dangerous financial gam-bles. All this added up to a hugely troubled balance sheet – an estimated 50 per cent of the Irish economy at the outset of the crisis. To the Irish citizen, and the economy at large, this has been nothing short of dynamite. When it blew up, a bewildered government tried to draw a line under its banking crisis. This proved to be a hopeless task, raising the cost of taxpayer-funded bailouts of the country’s banking sector and lifting the country’s fiscal defi-cit for 2010 to as much as 32 per cent of gross domestic product, which is a record.

The numbers describing the crisis are not only big, they are also fuzzy. On September 29, 2010, according to a report on CNBC, Brian Lenihan, Ireland’s finance minister, said that, because of these unprecedented rescues, in 2010 the country’s deficit would exceed 30 per cent of GDP – the differ-ent toxic banks alone will call for another a29.5 billion ($40.8 billion) of new bailouts.

Ireland’s finance minister knows his figures. Experts, however, contested his comment that the country had no choice but to act, rejecting his statement that: ‘Any Anglo failure would bring down the sovereign. It is systematically important not because of any intrinsic merit in the bank … but because of its size relative to the national balance sheet.’26 What the finance minister failed to explain was why the Irish regulators allowed that to happen and how the bank got so oversized that its failure could bring down the state.

The Anglo-Irish losses were probably twice as big as the sum of its equity, subordinated debt and senior long-term debt, according to an article in The Economist: ‘The country’s financial regulators were incompetent at best, cronies at worst. And at the first sign of trouble, the government made the mistake of issuing a blanket guarantee for all its banks’ debts.’27 Taxpayers would now bear the catastrophic losses on bets made by the country’s banks and, although euroland came up with a lifesaver, this is a loan which has to be serviced and repaid, also with taxpayers’ pain.

What has happened with the Irish banks’ gambles and the government’s incompetence is not just imprudence; it is plain mismanagement at sover-eign level. A major failure was turning a blind eye to overexposure, but the sovereign’s errors do not end there. The big Irish banks also had thinner



capital requirements than most of their western competitors, thereby giving them little in the way of a buffer to fall back on in times when the going was generally tough, particularly pertinent for those who were already in difficulties with their business.

In addition, damaged banks were not the only issue hurting the Irish economy. According to economists’ opinions, even without more and more thrown at the problem banks, Irish finances will prove difficult to put right as the government tries to slash its deficit from well over 10 per cent GDP in 2010 to below 3 per cent by 2014. This is something in which Ireland is far from being alone.

Iceland is not foreign to the problems described in the preceding para-graphs; this is largely for the same reasons: its derelict banks. In November 2009, Iceland’s sovereign credit rating was cut two levels by Moody’s Investors Service to BBB (the lowest investment grade) as its banking indus-try’s failure continued to affect public finances negatively.

The Icelandic government had been relying on a $10 billion loan by the International Monetary Fund and Scandinavian countries to rebuild the economy, but this effort faced headwinds – some of them of gale force. The three main Icelandic banks had taken deposits in Britain, Holland, Switzerland and other countries, promising an exorbitant interest rate. After they went bust, deposit insurance in these countries compensated the depositors, but the British and Dutch governments wanted the Icelandic sovereign, who had turned a blind eye to the banks’ escapades, to make good the losses.

The country’s new government agreed to do so, but, on January 5, 2010, Olafur Regnar Grimsson, Iceland’s president, rejected a bill passed by parlia-ment five days earlier on a state guarantee for a3.9 billion ($5.5 billion) owed to the British and Dutch governments. That was intended to cover compen-sation paid to savers in those countries after the collapse of Landsbanki and its internet-banking link Icesave.

Iceland’s electorate was alarmed by the financial havoc created by the small minority who ran the country’s banks. People struggled to reconcile themselves to decades of debt repayment, as well as the high taxation and budget cuts that were bound to come. Britain, however, froze the assets of Icelandic banks as they got into trouble.

Iceland’s predicament was not so different than that of Latvia, whose economy reached for the stars after ascension to the European Union, then contracted severely as the government tried to extinguish the financial firestorm. In 2009, GDP plummeted by 18.4 per cent year on year – while the Latvian government slashed public spending and investment to get the budget deficit under control.

There are a couple of important lessons to be learned by Iceland’s deba-cle. According to an article in The Economist: ‘The first is that the extra cost to a country of not standing by its banks can be surprisingly small.’ Many



pundits said that Iceland definitely made the wrong decision when it let its banks fail. However, while Iceland’s GDP sank by 15 per cent, Ireland, which saved its banks through lavish use of taxpayers’ money, also saw its GDP drop by 15 per cent and is now deep in debt, rescued by IMF and euroland funds.

‘A second lesson,’ says The Economist, ‘is that the benefits to a small coun-try of being part of a big currency union are not all they were once cracked up to be.’28 Mismanaged economies like Greece, Ireland, Portugal and Spain (to name a few) can lose the confidence of markets even though they are members of euroland and they issue bonds in euros.

Like Greece and Ireland, Portugal, another of the smaller euroland coun-tries and a member of Club Med, may be obliged to do as much in the near future. On January 12, 2011, European officials drew comfort from the relative success of a closely watched debt auction from embattled Portugal, which was able to sell more than a1.2 billion in long-term debt at lower than expected interest rates. A month later, however, that situation was reversed as Portuguese debt costs rose further because there were no buyers of the country’s debt.

In the wake of the Portuguese and Spanish failure to raise money in the market, the French and German governments have tried to guide the Portuguese towards asking for IMF intervention with a loan to save it from bankruptcy. Jean-Claude Trichet, the ECB governor, said that the central bank cannot do wonders if governments don’t put their house in order. Even so, the ECB bought worthless Portuguese debt.

There are good reasons why European policy-makers would like to see Portugal opt for bailout loans, which offer rates of about 6 per cent and are considered the best way to deal with the country’s banking and economic problems. The country has been living beyond its means since joining the euro, and serious fund managers, like Pimco, are no longer prepared to buy its bonds because of fears over high debt levels.

What Ireland, Iceland, Latvia and Portugal have in common is not only deep economic and financial troubles, but also that they lack the benefit of a rich uncle next door – like Dubai’s uncle Abu Dhabi. As will be recalled, in 2008 and 2009 Dubai’s debts were ultra-heavy, amounting to about $100 billion – if the debts of both the government and the conglomerates it controlled are included.

Investors had expected Dubai World to seek forbearance from its bankers, asking them to roll over their loans – no questions asked. But many experts felt sure the emirate would make good on publicly traded financial instruments.

In February 2009, Dubai raised $10 billion from Abu Dhabi, its much wealthier neighbor. It then raised another $5 billion from two Abu Dhabi banks. These timely injected bailouts propped up the finances of Dubai Financial Support Fund, a committee which oversees the restructuring of



Dubai’s indebted companies. It helps to have an oil-rich uncle when one racks up a $100 billion debt.

Before the rich bailouts were announced, the spike on Dubai’s CDS spreads had passed 600 base points,29 Latvia’s CDS spreads were just below 600 bp, while Greece’s were still only 200 bp (though, later, the CDS spread soared). With money on the table, the riskiness on Dubai’s bonds bent.

By late 2010, the memory of November 25, 2009 – when Dubai threat-ened to default on a $4 billion subuk (Islamic bond) issued by Nakheel,30 the troubled property developer belonging to Dubai World – was gone. That announcement threw both the emirate and global credit markets into free-fall. But as the day approached, Abu Dhabi released more funds and the subuk was eventually paid on time.

This, of course, did not solve all of Dubai’s problems connected to an economy which overplayed its hand: empty buildings, falling property prices and suspended construction projects. But with money from the Abu Dhabi uncle pouring in, markets assumed that Dubai’s debts would always be covered by the richest member of the United Arab Emirates (UAE). In late 2010, Dubai returned to the markets for the first time since the Dubai World incident; the foray was successful as it managed to raise $1.25 billion in a two-part bond sale, which was heavily oversubscribed.

Dubai seems to have realized that it cannot trample on foreign investors; neither can it escape from them, because it relies on outside money. That is the first lesson all sovereigns should learn because it applies everywhere in the globalized economy. The second is that, like the Irish and Icelandic financial industry, as well as Latvia’s boom and bust, Dubai is a creature of globalization and will continue relying on open marketplaces. But, to do so, it must preserve its creditworthiness as a precious asset.

Down the Club Med way: Italy and Spain

The first five sections of this chapter provided enough evidence that a coun-try’s national debt and budgetary deficits are headwinds to recovery after an economic low. If sovereign debt continues piling up, the damage can spread cross-border because the financial services industry has become globalized and the inter-bank market itself is poisoned.

In the 1980s, Walter Wriston, Citibank’s CEO, said that governments do not go bankrupt. This is no longer true (if it ever was). The Bank of America has an exposure of $22.5 billion to the Club Med countries. If this is concen-trated in a couple of names, it will be a prescription for future sorrows.

Good news first: the financial position of Italy (the larger of Club Med countries, excluding France) has not deteriorated in an appreciable way through the financial crisis. The widening of the budget deficit from 2.7 per cent of GDP in 2008 to 5.3 per cent in 2009, which stemmed from the deep recession and some temporary support measures due to expire by



the end of 2010, is a fraction of the fiscal deficit of France or Britain. The government projects a budget deficit of 3.9 per cent of GDP in 2011 and 2.7 per cent of GDP in 2012.

A negative is the fact that Italy’s accumulated public debt is well in excess of 100 per cent of GDP. Another ‘minus’ is a negative trade balance, albeit smaller than that of Portugal, Greece, Spain and France. But a positive is that the cyclically adjusted budget balance has been stable around 3 per cent of GDP in the period 2008–10 and analysts expect a return to a primary surplus from 2011.

Italy has adopted a series of measures to restrict spending and increase taxes to confront its excessive public debt. On the spending side, the gov-ernment put a cap on staff turnover in 2009, setting it at 10 per cent of employees whose employment terminated in 2008. This was raised to 20 per cent of the previous year’s termination for 2010 and 2011, and 50 per cent for 2012.

A cut in salaries of public sector workers of 0.2 per cent of GDP was effected in 2010, raised to 0.3 per cent in 2011–12. No temporary worker can be offered a permanent job in the public sector. In the period 2009–11 there was also a cut in capital account spending by a total of a14 billion, with the strongest impact in 2010 and 2011 (approximately equal to 0.2 per cent and 0.5 per cent of GDP, respectively).

The Italian government adopted measures to streamline local bureaucracy and foster more decentralized decisions and fiscal federalism, with estimated savings of about a1.9 billion in the years 2010–12. There has been, in addi-tion, a gradual increase in retirement age of female public sector workers, as well as the introduction of a spending ceiling on pharmaceutical care to curb health expenses. The government says that better management of state real estate aims to bring rents in line with the market and reduce administra-tive costs, which are also affected by other consolidation measures.

On the revenue side, like practically all other governments, the Italian government says that it targets a stricter system of tax collection and inspec-tion by tax authorities to fight tax evasion. It also introduced an extraordi-nary duty of 5 per cent of assumed returns to convert illegal offshore assets into legal ones, while Milan and other cities charged big foreign banks with fraud and misleading city officials.31

Good news for the Italian taxpayer was the fact that big Italian banks kept themselves out of the trouble which shook American, British, Irish, German and French banks in 2007–09. The sovereign did not have to intervene to pull them out of hell.

So far so good; but Italy’s cumulative national debt remains stuck in high numbers. It was about 108 per cent of GDP in 2001, rose to 113 per cent in 2005, shrank to 103 per cent in 2007 and shot up to 117.5 per cent in 2009. It has been just a little lower than that in 2010 and there is not much hope it will fall below 106 per cent in the coming years.



As with the other European Union countries, public sector deleveraging is Italy’s biggest challenge, along with structural reforms to boost the econo-my’s potential for growth in spite of fiscal tightening. The GDP progressed by 1.1 per cent in 2010; private consumption rose about half that much; investment rose 1.2 per cent (compared with –12.5 per cent in 2008); while government expenditures fell slightly.

The economic story of Spain is not that brilliant. The list of things that need repair is extensive and, with austerity in the horizon, its socialist prime minister, José Luis Rodriguez Zapatero, has become a shadow of his former self. Spain’s economy is littered with structural faults which were long hid-den by a housing bubble, but have been glaringly exposed as the bubble burst and the economy took a dive.

From unemployment to deeply troubled savings banks damaged by the housing hecatomb, and questionable public finances, Spain’s problems con-tinue to mount. According to the central bank, loans to property developers and construction firms stood at a445 billion at the end of 2009.32 This is more than ten times the banks’ a42 billion of specific reserves and a further a16 billion of general reserves. Spain’s cajas (unlisted savings banks) are in a worse condition than its banks (Chapter 12).

In mid-2010, after the Greek sovereign crisis, the government produced a mild austerity plan to calm market fears about Spanish debt. But the meas-ures have been too little too late. There is no reform of a rigid labor market that makes most employees too costly to fire, makes Spanish industry glo-bally uncompetitive and condemns one third of workers to unemployment or unstable jobs.

The markets did not take these half measures kindly. After they were announced, the yield on ten-year Spanish government bonds rose amid speculation of a Greek-style bailout for Spain and more worries about the financial health of the country’s banks. By late 2010, these fears somewhat subsided as Ireland and Portugal took center stage.

In the years of the building bubble, Spain had a budgetary surplus. In 2009, this turned into an 11.2 per cent deficit as a percentage of GDP. The Spanish government hopes to reduce it to 6 per cent of GDP in 2011 but, as with Portugal, the measures adopted by the sovereign don’t go far enough. A tax rise, aimed at Spaniards earning over a120,000 ($168,000) will do little to help. The government does not dare raise taxes for lower earners for fear of losing support in the next election.

Precisely for the same reason, the talk about austerity is just that: talk. Unveiled at end of September 2010, Spain’s 2011 budget aims to slash spend-ing by 3 per cent, on top of some 2010 cuts (partly by freezing public service pay and some pensions). Critics say that this is far from enough and that the day is not far off when Spain will queue up for a salvage plan by euroland.

Spain also has one of the highest levels of household debt of euroland. On the positive side, it has exited recession in the first quarter of 2010, helped by



the end of inventory correction. Industrial production is starting to rise but, according to economists, domestic demand will likely contract for another year in 2010 as the legacy of a burst housing bubble and a 20 per cent peak in unemployment curtail the recovery in consumer psychology. In the opinion of financial analysts, consumer spending will remain pressured by negative wealth effects, fiscal tightening and an increase in precautionary savings as households rebuild their balance sheets.

As with Italy, Greece, Portugal and Ireland, Spain cannot use devaluation as a way out. The risk is that it will have a lost decade. The public finances are creaky and the legacy of Zapatero is also in the balance. He lacks eco-nomic expertise, and seems to be reluctant to grasp the seriousness of the Spanish economic crisis and take remedial action.


Part IV The New Normal’s Effect on the Western Economy


193

11The North Atlantic Similarities are Greater than you Think

Tales of the unexpected

The European Union’s problems of sovereign risk, which Part III brought to the reader’s attention, find their equivalents across the North Atlantic. Though the underlying reasons are not precisely the same, the EU and the United States share many of the same challenges. What is common between them is more important, and it presents itself more frequently, than what is different. Compared with the EU, the USA has two advantages: it is home to the world most liquid asset market; and the dollar acts both as reserve cur-rency1 and currency in which global commodities are denominated.

But are these two issues as important today as they used to be in previous decades? The years of the Bush and Obama administrations provide plenty of proof that the dollar’s competitive advantages are no longer enough to provide the country with financial independence. The reason is not only the rise of China and other developing nations but also, and most particularly, an unprecedented US sovereign debt build-up followed by a housing bubble and economic meltdown.

This is by no means a condition to be taken lightly. America would be shaken if the Asian central banks and sovereign wealth funds of developing nations were to dump the dollar as reserve currency by choosing a basket of currencies. While such a move may not look like an immediate option, it is a possibility which has been openly discussed (particularly by the Chinese) because of the USA’s:

huge year-on-year budgetary deficit,rapidly rising national debt, inflationary monetary policy, andpersistent (some economists say irreversible) current account deficits.

According to the Congressional Budget Office, the federal government will accumulate a deficit of $10 trillion in this decade (up to 2020). Even that

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194 The New Normal’s Effect on the Western Economy

may be an underestimate, because it depends on some optimistic assump-tions about economic growth which may not materialize. While there is nothing exceptional about optimistic assumptions (they are current cur-rency among European Union governments), the trouble is that, a short time after they are made, they are revised downwards, and the consistency of such revisions becomes depressing.

The 2007 financial crisis, which started in the USA, and subsequent eco-nomic downturn have called for policy responses by both fiscal and monetary authorities. Almost worldwide, governments and central banks had to react swiftly and decisively; but somehow, in the rush, no fundamental decision was made on whether the top aim was maintaining economic stability to the benefit of all stakeholders, or only saving the big banks from collapse.2

In America, how to get the economy going again has been both the Treasury’s and the Federal Reserve’s dilemma, as has the question of whether policymakers should give priority to the real economy or to the virtual economy. The latter carried the day and, according to learned opinions, it has been a decision made by default. The Bush Administration filled the coffers of banks and mortgage companies with an unexpected torrent of taxpayers’ money. The Fed reduced rates to levels not seen in recent decades and imple-mented a non-standard monetary policy: quantitative easing (see below).

But even these exceptional measures did not sustain financial intermedia-tion necessary to the availability of credit for households, industrial and merchandising firms. Neither was an exit strategy established so that stake-holders knew when such exceptional measures would end and a return to normal economic conditions would take their place.

This has been equally true in Europe. Indeed, there were significant simi-larities in the approaches taken by American, British and (to lesser extent) euroland authorities. Another fact that speaks volumes about the common course followed by America and Europe is that – to make matters worse – the former copied many of the big social spending habits of the latter. This was a deliberate choice despite the fact that, over a long period of time, nanny-state commitments made by European countries proved to be unaffordable and unsustainable; it was, thus, a bad idea to duplicate them by inflating the federal debt.

Aside from the taxpayers’ money thrown to the four winds after Lehman’s collapse, with the Troubled Assets Relief Program (TARP), the US govern-ment’s stimulating program was instituted at the cost of $700 billion. In fiscal year 2009, ARRA (American Recovery and Reinvestment Act of 2009) was created with US$ 800 billion; and the Fed’s balance sheet was expanded from $940 billion in 2008, to $2,370 billion in mid-2010, with the Fed buy-ing up the American government’s debt.

Critics said that people who made these decisions had too much of a theo-retical background and little by way of practical experience. The govern-ment’s team of decision-makers was woefully short of men who had had to


North Atlantic Similarities 195

meet a payroll, and the uncertainty created by two presidents – first George W. Bush, then Barack Obama – hampered the economy.

Neither of the two administrations has been able to convince the glo-bal financial market of its commitment to sound money. US taxes are 15 per cent of GDP, but, by using its Treasury and agencies as a ‘fire brigade’, the US government was spending well beyond its means. Accumulating more debt has also been a chronic European illness.

Worse yet, the lack of budgetary discipline provided evidence that rising deficits were here to stay. On both sides of the North Atlantic, western gov-ernments were not keen to take a sharp knife and cut their budgets. Neither were they ready to renegotiate, externally, all world trade agreements and, internally, all entitlements, which have been creeping up for decades.

World trade agreements hammered out after World War II under GATT and the World Trade Organization have been consistently characterized by giveaways by the West, supposedly to help less developed nations develop.3 But now, the conditions which led to those agreements have been totally reversed. The fast-growing markets are those of developing nations. The USA contributed just 13 per cent to global growth in 2010.4

Therefore, what is presently under debate is nothing less than the sustain-ability of Washington’s finances. Even if things have not reached the point of what has happened in Greece (Chapter 9), lack of financial discipline brings that day nearer. As many economists will confirm, a sovereign’s appeal as a debtor is only as strong as his last bond auction.

This is precisely the reason why several euroland governments have recently been looking for ways leading to fiscal prudence. Measures are taken (albeit rather mild) in the framework of a medium-term strategy of debt stabilization and reduction. What most governments are essentially seeking is a balance between credibility and stimulus, with emphasis on spending cuts over tax increases (because cuts are seen as less threatening to aggregate demand) and deficit reductions to be matched with supply-side reform, aimed at giving internal growth a better chance to succeed.

Such a policy can succeed only if nothing escapes the budget-cutter’s knife. According to some estimates, the United States spends as much on defense as the rest of the world combined. That was the World War II way of winning, but it is no longer what is required today for military supremacy. Critics say that the defense budget is driven by what President Eisenhower called the industrial/military complex and its politics. They also add that this is notoriously crammed with all sorts of waste.

Robert Gates, the Secretary of Defense, understands this and wants to replace a ‘culture of endless money’ with one of ‘savings and restraint’. Hence his aim to achieve savings in the military bureaucracy5 and in weap-ons whose day is past. He has to act, given the growing pressure by US citizens for broader fiscal constraint, though this has foreign policy reper-cussions; this is where the deep strategic rethinking should start.



The no-win situation and loss of life aside,6 Afghanistan has cost the American taxpayer over $100 billion per year. In nearly ten years, this makes $1 trillion. Iraq has cost another $1 trillion so far, for no practical purpose. The heralded strategy to ‘promote democracy’ turned into a nightmare. As for deliverables, in both cases, it is better not to talk about it!

A policy to put one’s economic and financial house in order must pay great attention to the fact that neither entitlements nor military gear are productive investments. Money spent on them does not multiply like money spend on infrastructure, equipment, R&D innovation and market-ing. In addition, when that money is plain red ink its cost is overwhelming. If growth is the best strategy out of the current impasse, for the USA and the EU, then all policies, including spending policies, should be geared towards growth – rather than trying to sprint in all directions and end by spinning one’s wheels in a vacuum.

As this if … then suggests, there are tough choices that have to be made, and some of them will be unpopular. But we have to make a U-turn towards growth and leave behind the policies of decline. Growth has not returned as some politicians say. The West is in a growth recession. The latest US jobs fig-ures are dismal and house repossessions continue to rise. There must be a rea-son why 60 per cent of Americans think the country is on the wrong track.7

Big deficits resemble a classic tragedy

One of the problems that has hit the West like an epidemic is that everybody – from sovereigns to local governments, companies and common citizens – is living beyond their means. A financial expert, interviewed on Bloomberg on July 2, 2010, took the US state and local governments as an example of spending well in excess of their income. Having made his case, he said that to close the gap they need to fire 1 million people.

America used to be the country whose people were accustomed to self-help and self-improvement. That’s why, during the decades after World War II, it constantly led the world in investing in new technologies, as well as provid-ing both training and support to exploit them. No other country invested so much in getting ahead of the rest, and this promoted mobility because people had confidence in themselves and their careers.

Unfortunately this has changed, as the aforementioned 1 million surplus employees in US state and local governments illustrate. While all of the causes of that change are not clear, the most important seems to be that – as practically all over Europe, but most particularly in France – people have learned to look for cradle-to-grave featherbedding, and politicians have promoted the State Supermarket supposedly to provide it.

It looks like a re-enactment of a classical ancient Greek tragedy, in which, from Aeschylus to Sophocles and Euripides, we have seen a conflict of wills characterized by the external perplexity of personalities: the traditional plot



is the rise of a leader and his fall at the most inopportune moment. The leader in this US tragedy is the spirit of free enterprise. In ancient times, typi-cally the fall was engineered by Tichi,8 which represents hazard or destiny and acts by delegation of absent gods.

But, in reality, Tichi is man-made. The leader himself has labored to set his own trap and he has dug his own grave. His actions are characterized by an anarchy of sentiments, an instability of wills, an absence of liaison with the salient problem confronting him, as well as short-termism which ends by boxing him in. Euripides expresses with pathos this self-destructive but also self-engineered destiny in Antigone in Aulis.

AGAMEMNON, King of Michinai: Mirage of power … it’s sweet only at a distance. Once conquered, nothing is more deceiving, more bitter.

MENELAUS, King of Sparta and Agamemnon’s brother: What happens to you is common among statesmen. They labor to reach the honors, then they prove incapable of serving their country’s greatness.

Menelaus continued in his description of how leaders prepare their own downfall by stating: ‘Today they say the contrary to what they stated yester-day, and the inverse of their thesis an hour ago. It is agreeable to be a general, Agamemnon. But one must also have the size for it.’ Wise words which should make all chiefs of state, central bank governors and other mortals think.

AGAMEMNON. Consoling the leaders of this Earth is forbidden. They are the slaves of their own pride and of their own majesty.

As these words suggest, Agamemnon had more self-respect than present-day politicians; and while consoling the leaders may be forbidden, this is not true when acknowledging the critical state of public finances which, having run out of control – under those leaders’ watch, led to a debt-driven meltdown. The net worth of the federal government is a negative $63 trillion9 comprised of $11 trillion total net position10 and negative $52 trillion present value of expenditures in excess of future revenue for entitlement programs.

As Menelaus might have said, leaders who forget these numbers, or do nothing about them, are not worth their salt. They are both depressive and impressive, and they become even more so when compared with the net worth of households and non-profit organizations.

According to data published by the Federal Reserve in its Z1 report in December 2009, the total net worth of the above two sectors – households and non-profit organizations – was $53 trillion. In other words, even if the US sovereign were to confiscate all of the net wealth of US households and non-profit organizations, it would still be in the red by $10 trillion.

If Euripides were alive today, his theme would not have been the War of Troy and the two kings of Argos and Sparta, but the continuing digging of



the US public deficit’s hole, and its kings: Barack Obama and Ben Bernanke. The blame also goes to their predecessors, but they are the commanders at this moment of peril. Obama has too often been absent from decisions vital to the finances of the Union, too anxious to be liked, and too ready to do the popular things now and leave the awkward stuff till later or never. Bernanke has taken an unprecedented amount of misdirected risk by putting the printing presses of the Fed to work overtime without having carefully thought out the accounts for damages done to the economy.11

In an early January 2010 speech at the annual meeting of the American Economic Association, Ben Bernanke blamed the deep economic and finan-cial crisis on weak regulatory oversight (read: the Securities and Exchange Commission) that failed to put a stop to the lax lending practices that pre-cipitated the housing bubble. This runs contrary to the widespread opinion that, while the regulators had turned a blind eye, it was Greenspan’s and Bernanke’s loose monetary policy that caused the bubble.12

There has been, as well, a loose current account policy characterizing the Bush and Obama administrations. According to the latest available statistics (Financial Times, November 10, 2010) the USA has a 3.2 per cent of GDP current account deficit, much worse than Britain (2.2 per cent) and Australia (2.4 per cent) – and evidently nothing to compare with Japan’s and Germany’s hefty current account surplus.

As if federal, state, city and other administrative red ink were not enough, over the coming years the American financial system faces a challenge of $4.2 trillion of debt, largely of speculative quality. This amounts to nearly 30 per cent of US GDP, and will manifest itself in the commercial real estate and non-investment grade debt markets. At best, it will strain credit capacity; at worst, it will restrain economic growth and prolong the credit crunch.

Barack Obama should know this is like the Titanic coasting Newfoundland, but budgets under his watch do not compel government departments to tighten their belts – with the best tightening example provided at the top. This and plenty of other uncertainties dampen business confidence because people know that they limit the flexibility to respond to future economic shocks, even if action taken in the past was not particularly brilliant.

For instance, quantitative easing aside, the Federal Reserve instituted a Money Market Investor Funding Facility (MMIFF), endowed with $600 billion, to buy certificates of deposit and other instruments from institutions; another liquidity facility (AMLF) for money market funds; and a Commercial Paper Funding Facility (CPFF) to buy commercial paper directly from eligible companies. This comes over and above the federal government’s:

$50 billion insurance program for money market funds,Troubled Asset Relief Program (TARP) legislation authorizing the Treasury to purchase up to $700 billion in assets,13

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salvage of Fannie Mae and Freddie Mac (placed into conservatorship by the Federal Housing Finance Authority and US Treasury),salvage of self-ruined AIG at great cost to taxpayers,a torrent of red ink to pull out of the abyss Citigroup and other big banks, or force their merger with healthier institutions.

All this has been financed by higher and higher deficits – essentially, bor-rowed money which passed the private sector’s indebtedness to the public. Such an unexpected transformation is no longer the America I knew. The one I encountered in the early to mid-1950s was based on ownership and responsibility. Now the economy’s function is production of debt and higher leverage is based on greater irresponsibility with high leveraging. As a recent Merrill Lynch study put it, the battle for supremacy in the US economy is fought by two forces: one is negative, known as the ‘3 Ds’, which stands for debt, deleveraging and deflation; the other is positive, called the ‘3 Ps’, for policy, positioning and production.14

Unfortunately, the 3 Ds dominate, and evidence on whether the 3 Ps can come up from under is still pending. Yet, the test of a statesman’s and central banker’s legacy is the 3 Ps and their ability to prove that the USA is not Japan. (Another proof would be the Fed’s willingness and ability to raise interest rates in 2011, or early 2012 at the latest.)

QE2: poison or cure?

The equity market has criticized the Fed’s $600 billion stimulus (better known as quantitative easing 2, or QE2), according to a news item on the Bloomberg Financial Network on November 5, 2010. And not only the equity market; plenty of dissenting voices have been raised by former cen-tral bankers, economists, investment analysts and US senators.

Gerald Corrigan, the respected former president of the New York Fed, has been critical of Bernanke’s quantitative easing and its after-effects. Experts who espoused the idea of QE1 criticized QE2 as damaging the American economy. Other central bankers have commented that QE makes life partic-ularly difficult for emerging markets because they confront huge monetary inflows which import inflation and make their economic system fragile. In an interview on Bloomberg, on November 8, 2010, Gerald O’Driscoll, senior fellow of Washington-based Cato Institute, said that there is no rationale for what Ben Bernanke is doing. Quantitative easing simply does not make sense in terms of monetary policy, while it represents a big risk with regard to US inflation.

It also runs contrary to what has been touted as (but probably is not) Barack Obama’s decision to cut the deficit – to which objective he appointed a blue ribbon commission. On November 10, 2010, Erskine Bowles and Alan Simpson, co-chairmen of the President’s deficit commission, proposed sweeping tax

•

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reforms and spending overhauls to cut the deficit to 2.2 per cent of GDP15 and stabilize the American sovereign debt at 69 per cent of GDP by 2015.16

How is this going to happen when both the Obama Administration and the Fed spend stacks of money in the vain hope of kick-starting the economy? Some experts even ask: ‘Does the US economy need a deficit-financed kick-start?’

Investment Commentary No. 273, by Wegelin, put this question in per-spective by pressing the point that stimulation packages arouse increasingly negative expectations concerning future marginal revenues. Wegelin sug-gested that innovation and investment is the answer; new torrents of red ink are counterproductive.

Whether caused by recession or technological developments, deflationary phases should be looked at as periods of restructuring. ‘Being in a deflation-ary phase with high levels of debt may end in going under,’17 says Wegelin, because the cost of servicing the debt is fixed and, therefore, the level of expenditures cannot be adjusted as the sovereigns like.

Investment Commentary No. 273 further observes that many stimulation programs are ossified structures aimed in exactly the wrong direction. As evidence to this statement, it uses the US industry’s earnings, which moved north after the 2008 hecatomb, and increased by an impressive 50 per cent in 2010. Based on this, Wegelin asks the provocative question: ‘Is this what deflation looks like?’

The opinion of Jeremy Grantham is not much different. Grantham has been a successful American investor and financial advisor, having made his name by forecasting the 1987, 1998, 2000 and 2007 crises. In an interview he gave to Maria Bartiromo of CNBC on November 11, 2010, he explained why the US and global economy are in a very difficult situation. Grantham was critical of the Fed action, most particularly of QE2, saying that the last weapon the central bank has in its arsenal is the ‘wealth effect’, and this has lost its power; QE2 will not motivate the market, while it will have after-effects on US debt and on emerging markets.

Indeed, many American economists, investors and businessmen believe that quantitative easing is setting the USA up for an inflationary surge in the long term. Bill Gross of Pimco, the huge fund management group, wrote recently that: ‘Cheque-writing in the trillions is not a bondholder’s friend; it is in fact inflationary and, if truth be told, somewhat of a Ponzi scheme.’18

In spite of this opposition by well-respected people, the Federal Reserve announced that it would go ahead with buying $600 billion in Treasuries up to June 2010 to the tune of about $75 billion per month (some experts think that the total will eventually rise to between $1.2 and $1.5 trillion, as the $600 billion deficit spending proves ineffective).

All this unprecedented inflation of money supply is done without even a glimpse of an exit strategy, and while the government knows full well that voters are against new tax hikes. During the early November 2010 elections, voters in Washington state rejected a proposal put on the ballot by Bill



Gates, Sr, the father of Microsoft’s genius, to introduce a personal income tax for wealthy people.19

The American people are also angry, and rightly so, because their savings are penalized by the zero interest rate policy of the Fed. The old tactic of cutting interest rates has been pursued almost to exhaustion. Current yields reflect the expectation that the Fed will hold short-term rates below infla-tion for the foreseeable future. If inflation averages 2.0 per cent over the next two years, and the Fed keeps short rates at 0.5 per cent or less, then the real yield on savings will be �1.5 per cent. Savers will be confronted by a negative yield, essentially losing their capital.

This common citizens’ pain offers more evidence that the Obama Administration and the Fed have paid no attention to the social impact of their decisions, from zero interest rates to QE2. Their negative after-effects don’t seem to have been anybody’s concern. Something must be wrong with this insistence in going ahead with actions that are both economically and politically toxic.

Wolfgang Schäuble, Germany’s finance minister, described the US growth model as in ‘deep crisis,’ adding that ‘it’s not right when the Americans accuse China of manipulating exchange rates and then push the dollar exchange rate lower by opening up the flood gates.’20 Those of us who remember what it took to kill the inflation of the late 1970s and early 1980s, partly created by two oil shocks, better understand Schäuble’s worries.

The competition to create more money and weaken one’s currency does not go unnoticed. Brazil’s finance minister talked of an ‘international cur-rency war’. Dominique Strauss-Kahn, the IMF president, warned against using currencies as a policy weapon.21 And, in spite of all this commotion, the results are in no way brilliant.

A report by Bank of America Merrill Lynch expressed the looming risk in the following way:

We think the economy will manage to post positive headline GDP num-bers, but this growth will not be fast enough to keep the unemployment rate from drifting higher. We expect below-trend GDP growth in each of the next four quarters, with a gradual rise in the unemployment rate above 10 percent.22

Time is running out for those who believed QE2 would be the snake oil to change their way of thinking.

What went wrong with monetary policy and the bank rescues?

On August 30, 2010, a financial expert interviewed by the Bloomberg Network said that the Fed confronts a new series of slowdowns, as well as skepticism on the effectiveness of its monetary policy tools. That same day,



Mohammed El Erian, the CEO of Pimco, stated in a different interview that he saw a lost decade for America and its economy.

Pessimistic assessments likes these are taking place in spite of trillions spent by the US government – or maybe because of them – as they leave behind an overindebted economy. As the early November 2010 mid-term US elections have shown, the common citizens have lost faith in their leaders. Theirs is a natural reaction, also to be found in the European Union. Even in regions historically statist, such as the Scandinavian and Mediterranean countries, debates are beginning to emerge about the size, cost and effective-ness of government.

In the USA, the negative public reaction started in earnest in late 2009, after a year of lavish capital spending failed to move the economy, while unemployment stubbornly remained high and a wave of foreclosures swept the country. In an interview he gave to Bloomberg Financial Network on January 6, 2010, Bill Gross, of Pimco, said: ‘America has descended into the clutches of corporatism and special interests.’

Politicians who could see more clearly than others rang the alarm bell years before the subprime time-bomb exploded in everyone’s face. Back in February 23, 2001, an article published in EIR stated: ‘The bubble that [Alan] Greenspan built up over the past 14 years – the $30 trillion debt of state, pri-vate households, and companies in the United States, the almost $20 trillion stock market bubble on Wall Street, the off-balance sheet liabilities of the US banks – is in the process of popping.’23

Some time prior to this article, Lyndon LaRouche, EIR’s editor, had emphatically stated that the Fed’s major cuts in interest rates have proven a failure in reviving the market, much less the economy, and Greenspan was simply pouring out liquidity in hopes of keeping the speculative game going as long as possible. Does this remind us of quantitative easing? Greenspan’s magic is gone, LaRouche concluded. Bernanke never had ‘magic’, but his attempt to boost the economy through monetary creation is also doomed.

Nothing has been learned from past failures. There is, today, fairly general agreement among economists that the monetary institution’s policy of hav-ing kept extremely low interest rates for too long at the beginning of this century led to the next bubble, which burst in 2007. The same mistake is being repeated once again, with practically zero interest rates set by the Fed, and the likelihood is that it will lead to the bubble of 2014 (Chapter 13).

As for using newly created money to buy debt, the QE business, this has been compared to dreaming up the South Sea Company and its huge bub-ble, which, in the early eighteenth century, wrecked the British economy. Economic history has characterized the South Sea bubble – arguably the first case of a sovereign with money on its mind – as obvious folly. It will do the same for QE.

Back in the nineteenth century, Walter Bagehot noted in his seminal book Lombard Street that, in normal tes, the central bank should observe



the gold standard. By contrast, in a financial crisis it should lend freely to uphold the public psychology rather than let it sink. Bagehot, however, put a crucial limit on the monetary institution’s bold lending: it should never lend to those that are insolvent (the big banks, in the present case) and it should advance money only to those banks facing a temporary liquidity squeeze. That’s what Gerry Corrigan, then boss of the New York Fed, did in 1987, when he said to a reticent and objecting (but new in the job) Alan Greenspan, that under certain conditions you cannot tell the difference between illiquidity and insolvency. Another case where the distinction between solvency and liquidity had become meaningless showed up on the heels of the First Great Depression.

In total contrast to Bagehot’s advice on exercising great prudence in the central bank’s dealings was the so-called Greenspan put, reincarnated into Bernanke put. It created the belief in the financial industry that the Federal Reserve would ride to the rescue with lower rates and unprecedented liquid-ity, with practically no limits.

An opinion heard on Wall Street, worth keeping in mind, is that the risks the banks themselves took were inflated by the assurance that the Greenspan put provided – if the worst came to the worst. With the taxpayers and print-ing presses brought to the task of rescuing those who gambled and failed, there has been no reason for restraint.

Among economists, Anna Scharz and Josef Stiglitz were bold enough openly to criticize this ‘put’ and speak of insolvent banks before the financial earthquake started. Other economists joined later on, when in early 2007 Bear Stearns became the first emergency case within the system. Insolvent in mid-March 2008,24 the investment bank should have been overtaken by the fate that normally awaits enterprises that fail because of imprudent business practices, lack of transparency and questionable balance sheets. Instead, the central bank, the government and even their competitors opted for a rescue operation (which essentially amounted to a rescue for the creditors and their assets). Bear Stearns was absorbed by JPMorgan, presumably under the Fed’s patronage, and this helped the financial system to survive the summer of 2008, only to encounter a far more serious crisis in September with AIG, Fannie Mae, Freddie Mac and, as a spike, Lehman Brothers.

Lehman went to the dogs, but Citigroup and several other severely self-harmed financial institutions survived. The Greenspan put – which, with the change in Fed’s chairmanship, became Bernanke put – was always there to reassure bankers and speculators that public money was ready to rescue pri-vate money when the risk became unbearable. Government or central bank guarantees are popular because, theoretically, they entail no immediate cost. But they leave the sovereign balance sheet exposed to headwinds (as the case of Ireland illustrates), and they load the sovereign with a great deal of debt.

On September 11, 2009, on CNBC a year after the Lehman bankruptcy, a group of experts evaluated the results that had, up to that point, been



obtained by the interventionist policies of the Federal Reserve and Bank of England. The consensus has been that, if the intention was to sustain the survival of big banks and feed up their balance sheets, then the actions taken by the two central banks in 2008 and 2009 were successful.

By contrast, if the objective was to improve the economy, stop the wave of foreclosures, pull it out of deep recession, avoid high unemployment and make the banks lend again, then the central banks’ intervention was a total failure. In fact, a much better policy would have been not to throw huge amounts of public money at the problem but, instead:

ring-fence them to avoid a snowball, help homeowners stay in their houses (even if they were co-responsible for the crisis), control the reasons which might feed inflation and destabilize the currency,restructure pension schemes to steer them away from bankruptcy, andbring to justice those who were truly responsible for the financial earthquake.

The government should not be concerned only with the salvage of a mis-behaving banking industry: the pension system, too, was at the edge of the abyss. To take just one example, researchers at the Kellogg School of Management at the University of Rochester estimate that, in the USA, the states’ pension shortfall may be as much as $3.4 trillion and that municipali-ties have another hole of $574 billion.25

This eye-watering $4 trillion, some of which is covered by assets, is con-tested by other economists, who note that pension schemes have not achieved good returns over the past decade of dismal stock markets and are unlikely to do so in future. Therefore, they are eating up their capital. Moreover, their liabilities do not disappear if they fail to achieve targeted returns.

A public pension promise is a debt owed by the sovereign; a private one, by the company. Experts think that, if the states of the Union pension promises are discounted by a risk-free rate, then total liabilities are $5.3 trillion, com-pared with $1.9 trillion of assets. The total shortfall for state pensions alone reaches $3.4 trillion; this is practically equal to a quarter of the US GDP.26

There must be good reasons why the proposals submitted to President Obama by the co-chairman of the commission, whom he instituted to look at ways of improving America’s fiscal situation, have included a reform of the tax system and sweeping spending cuts – as well as raising the retire-ment age, eventually, to 69.

As the reader is already aware, the government is also in the red with regard to entitlement spending. The time has come to confront the deficits produced by the growing health care costs of an aging population, limiting (at an affordable level) expenditures as a share of the economy.

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As far as liabilities are concerned, the aforementioned red ink is by no means the end to the debt tragedy. In the United States, the worst of the government’s contingent liabilities is the growing exposure to residential mortgages. Since 2008, Washington backed the debt and guarantees of Fannie Mae and Freddie Mac, as well as the Federal Housing Administration (FHA). According to some estimates, the total loans guaranteed by all three have grown to $6.1 trillion – just short of 50 per cent of US GDP.27

For their part, the common citizens are penalized by the absence of a thoroughly studied policy to roll back the carpet of bank repossessions of people’s homes. This lack of a forward-looking policy has been a major error of both the Bush and Obama administrations; it is continuing and it is inexcusable. (More on this in the next section.)

American middle class and missing employment opportunities

One of the main strengths of the United States, and of practically every other western economy, has been the middle class. However, in a way not too unlike what is happening in Europe at present, the American middle class is overleveraged, overtaxed, used as feed for Alt-As and other sub-primes, and only partly employed. Such a scenario is alarming. The US middle class is getting hammered because its standing has been jeopardized due to the appalling mismanagement of the sovereign’s finances; also, over several decades, trade agreements have been signed by the USA (and other western governments) without a thought about their effect on jobs.

After improving the standard of living at a reasonably healthy rate for sev-eral decades, from the end of World War II to the end of the twentieth cen-tury, leaner times have set in. Growth in the American economy has ceased and citizens are facing a decline in prosperity. This is documented by:

a persistent rate of unemployment at more than the two-digit level,the fact that median incomes, as well as of families’ net worth, have moved south28, andthe wave of repossessions by banks of people’s homes accelerated, hitting also prime mortgage owners.

The high unemployment figures in 2009–10 in the USA have many reasons, and the dismantling of the middle class, with its social solidarity, is one of them. It is not the multinationals who spur employment, because they find their labor force anywhere in the world. The main agents of employment are the small to medium enterprises (SMEs) whose owners do not trust the economic policies in place or being proposed, and do not like the govern-ment’s huge deficits, since those mean higher taxes down the road. To make matters worse, the ongoing recession has reinforced trends that began, some three decades ago, in regard to a polarization of the American labor market,

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creating jobs for the better educated and the low-paid but offering little in between – where, essentially, the US middle class is positioned.

This leads to an increasing debate over whether a large share of the 9.6 per cent unemployment rate is structural, rather than a result of inadequate demand. A mismatch in unemployment compared with vacancies suggests something has changed, creating the most extreme imbalance since the period 1982–03, which was also characterized by a prolonged recession.

In fact, this often-quoted 9.6 per cent unemployment statistic is only partly true. Including those working part time who are ready and willing to work full time, US unemployment is almost 20 per cent and future prospects for significantly reducing such statistics are not so brilliant. Interviewed on the Bloomberg Financial Network, Martin Feldstein, of Harvard, said that a research project at his university estimates that the real unemployment figure in America is nearer to 20 per cent. This includes:

15 million jobless,29

9 million underemployed and in precarious jobs, and6 million who gave up looking for a job because they had been on unem-ployment lists for so long.

The US household’s financial scenario is just as wanting. Having observed how financial professionals collect truckloads of money through bonuses and com-missions, plenty of middle-class families have tried to speculate using the most precious asset they had – and, in the aftermath, they have lost their home.

An estimated 2.5 million homes are in the process of repossession, and 11 million, almost one quarter of all homes with mortgages, are in negative equity – borrowers owe more on their mortgage than their houses are worth. According to a news item on Bloomberg on November 15, 2010, Citigroup reported that housing excesses in the USA may last another four years. Another depressing fact that came on the heels of this was that, in fiscal 2010, 147 pension funds failed.

The US government’s ability to initiate a resurgence has proved to be limited at best. Several reasons contribute to this, including, most evidently, the quality of politicians and the long-term dangers created by all sorts of deficits and debts. The facts are grim:

In the West, significantly higher wages prevail compared with developing countries; therefore cost of production is high in world trade terms.Even in high-tech industries, some of the developing countries have taken a lead; first, by copycats, then by large investments in research.The financial industries lobby30 is so strong in Washington, and other western capitals, that negotiators to global trade agreements paid 90 per cent of their attention to opening the doors for banking and finance trades – to the detriment of all other sectors.

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The net result has been a catastrophe for the productive middle class, which has, moreover, confronted an increased tax burden as well as social costs, further reducing the incentives for entrepreneurial activity. As if these calamities were not enough, lust and greed among the newly rich class of traders and investment bankers had a corrosive effect on the preservation of an asset-based democracy (Chapter 2).

While the middle class in the West entered a period of decline, that of developing countries rose in number and importance. The OECD studied the emerging middle class in developing countries and came to the conclu-sion that it was going to leave that of western nations in the dust. In 2009, the middle class in the West numbered about 1 billion people; that in devel-oping countries 840 million.31 The projection is that, in 2020, the western middle class will add a mere 36 million to its members; that in developing countries will increase by 260 per cent to over 2.2 billion. According to the OECD, ten years later, in 2030, the size of the western middle class will shrink back to the 1 billion level, while nearly 3.9 billion people will belong to the developing countries’ middle class.32

Another flaw hitting western society is the growing number of ‘new poor’. A recent report by the Washington-based Brookings Institution indicates that, over the past decade, the number of people below the poverty line in America’s suburbs has jumped by 37.4 per cent to 13.7 million, compared with some 12.1 million people below the poverty line in cities.33

The picture emerging from these studies and reports is that poverty rates are expected to continue to increase. The 2007–11 crisis has also hit non-profit organizations; donations dried up and about one third of them had to lay off staff, while one in five has had to reduce services.

Many economists think that the stagnant economic environment, produc-tion capacity still idle and weak labor market will continue to haunt the mid-dle class. Statistics talk of more than six unemployed Americans for every job opening, with competition for jobs getting more intense, as the growing indus-tries of health care and education can absorb only so many people per year.

Some experts are, moreover, suggesting that, because of the scale and nature of the housing and financial crisis, the labor market has become less efficient at matching supply with demand. The households themselves are saddled with mortgages and they are no longer as able or willing as in the past to move in pursuit of new jobs. If this proves to be the case, it will have long-term consequences.

Under the title ‘A Study in Paralysis’, an article in The Economist put it in this way: ‘The growing idea among influential pundits that America is “ungovernable” is being driven in large part by Barack Obama’s failure so far to pass some of the main laws he wants to. And it is, indeed, a puzzle. Here, after all, is a president who only just over a year ago won a handsome 53 percent of the popular vote.’34 But his popularity sank, and the results of the November 2010 elections probably turned him into a lame duck president.



The Dodd–Frank Wall Street Reform and Consumer Protection Act

In a panel at the 2010 World Economic Forum, in Davos, Switzerland, Barney Frank, chairman of the US House of Representatives Financial Services Committee, supported the Volcker rule for bank regulation, which limits deposit-taking banks from doing proprietary trading (Chapter 5). He said that rules are needed by which everybody abides, and also made reference to an answer given to him by Chuck Prinz, Citigroup’s CEO, during its downfall.

Frank asked Prinz why he did not write the debt of Citigroup’s SIVs into his balance sheet, and the latter answered that, had he done so, his bank would have been at a disadvantage to Goldman Sachs, which did not write the SIVs debt into its balance sheet either. There seems to be a competition among big banks about who has the more opaque and erroneous balance sheet – which the Dodd–Frank Wall Street Reform and Consumer Protection Act (FINREG), Dodd–Frank Act) was supposed to correct.

But has it done so? The Act did make some headway in regulatory over-sight, derivatives trades and dealing with troubled banks. What it was originally intended to offer, however, was watered down by lobbyists and the special interests behind them. Moreover, no law is worth much if it is not applied, a fate which hit the excellent Sarbanes–Oxley Act of 2002 on George W. Bush’s watch.

Back in November 2009, Chris Dodd, chairman of the Senate Banking Committee, had advanced a draft financial regulation bill whose provi-sions cut through the regulatory maze and reserved some slashes for the Federal Reserve’s regulatory powers. That draft bill provided for a resolution authority over large financial groups, and also pushed derivatives trading into central clearing and on to exchanges; and gave shareholders a say on executive pay.

In connection with extending the Fed’s supervisory powers, Dodd’s posi-tion was that the central bank should return to its ‘core functions’ of setting monetary policy and being the lender of last resort. But most of that has been trimmed away by intensive lobbying which turned Dodd’s original concept on its head.

Critics also say that, even if it created a council under the Treasury to advise regulators on emerging threats, the Dodd–Frank Act missed its chance to eliminate the patchwork of regulatory bodies in the USA, which is a pity. It did not succeed in putting derivatives risk under lock and key, though many novel, complex and opaque derivative financial instruments are used by banks and speculators.35 All this creates a perennial risk for the next crisis by adding leverage to the financial system. A sound proposal to stop banks trading derivatives for ‘proprietary’ reasons, meaning their own gambling largely done bank-to-bank, has been significantly scaled back. Fully applied, the Volcker rule would have limited the banks’ ability to trade on their



own account, but the creation of a ‘3 per cent exception’ opens up plenty of proprietary trading opportunities. In addition, what Congress approved in FINREG’s financial version included no provisions similar to those of Glass–Steagall36 and no forced break-ups of banks too-big-to-fail. All this is highly relevant in regard to the next bubble.

As it should never be forgotten, since the 1980s (when investment banks became global, restless and relentless seekers of risk by any means) the crises hitting the US and global financial system became much more frequent. Novel and opaque derivative deals became the instrument in wheeling and dealing par excellence, but the Dodd–Frank Act was shrunk to the point that it did nothing to alleviate the risk that high-leverage, excessive risk-tak-ing and light bank supervision would continue to promote the conditions which produced powerful but unstable global financial companies bound by no clear standards of behavior. By contrast, such entities have plenty of con-flicts of interest, including conflicts in pay practices, which in turn produce short-sighted toxic thinking – a basic ingredient of the next depression.

Commenting on the Dodd–Frank Wall Street Reform and Consumer Protection Act, after its many compromises and passage from Congress, Barack Obama said that it will ensure the banking debacle of 2007 will ‘never’ happen again. This is both naive and technically incorrect. More realistic was Larry Summers’ statement that it will reduce the likelihood of the same banking catastrophe repeating itself. Only time will tell if the risks have been reduced.

What we know for sure is that it has not done anything to strengthen the ethics of the banking profession, even though, by every account, this was a necessity. One example of evidence, among many, is provided by an exchange of queries and answers broadcast on Bloomberg News on April 27, 2010, directly from the US Senate hearings. A senator asked Daniel Sparks, former head of Goldman Sachs’ mortgage business, ‘How do you justify tak-ing BBB mortgages and turning them into AAA products?’

Sparks: The rating agencies have their models for rating.Senator: Do you think that makes sense?Sparks: The models made sense.Senator: Do you think the modeling was correct?Sparks: I don’t have the specifics of the models.

He ‘did not have the specifics of the models’, therefore he did not know what they were worth, but he still he stated in his deposition under oath to the US Senate that ‘the models made sense’. Anybody who does ‘not have the specifics’ but makes such an assertion is, arguably, wanting moral standards.

Senator: Did you pay for the rating?Sparks: Typically, who pays is the issuer.



This was an indirect admission of guilt because Goldman Sachs was one of the issuers, hence implicitly one of the payees to the rating agencies which, through their rating alchemy, turned any subaltern metal into gold.

Senator: Did you think that this led to conflict of interest?Sparks: (no answer)

Another colorful exchange was when the senator asked Sparks whether he told his customers these were BBB products recast into AAA. Silence was again the answer, but this also raised the question about whether bank supervisors had chastened investment banks for such practices – which, by all available evidence, they had not done.

True enough, some regulators have tried to exercise their right as exam-iners and supervisors, the best example being FDIC. But this proper action faced strong political headwinds. In the 1990s, when FDIC’s chairwoman wanted to put limits and controls on rapidly growing derivatives risks, she was fired by the Clinton Administration. Politicians always find their way to protect those who should not have been their friends.

The SEC had a similar experience under the Bush Administration. When its chairman voted to require hedge funds to register with the authority, he was thrown out, replaced by a person who had been a politician, and there-fore was more compliant to the prevailing political will.37 That was one of the incidents of George W.’s ‘reign of error’.

The trimming of the original provision of new financial regulation by Chris Dodd and Barney Frank, through the intensive action of lobbyists, was also an error. The pros say that the Dodd–Frank Wall Street Reform and Consumer Protection Act established a sound federal regulatory framework through the creation of the Financial Stability Oversight Council (FSOC), responsible for:

monitoring activities of the financial system,designating financial institutions as systematically important, andrecommending a framework for more regulation of systematically impor-tant entities.

A new Office of Financial Research (OFR) will support the FSOC with infor-mation and data-collecting powers as well as research, while the Federal Reserve Board will implement more stringent prudential regulatory stand-ards (including capital and liquidity requirements, risk management and resolution plans) – as a means for establishing a new supervisory frame-work.

Practically, however, at least according to its critics, the Dodd–Frank Act will have a rather limited effect on lust and greed – and, therefore, on systemic risk – because the Obama Administration responded to requests

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from Wall Street to kill some of the more important reform proposals from Democrats in Congress. Yet, these were vital as many American banks (European banks, too) are still fragile and having trouble raising the money they need to do business.

Indeed, as far as its jurisdiction is concerned, that is what the European Central Bank stated on September 29, 2010, in regard to credit institutions. ‘The overall outlook for EU banking sector profitability remains uncertain,’ the ECB said in its annual report on banking sector stability,38 noting that some of the increased earnings were the result of trends that might prove temporary. That’s also precisely the case for the big American banks.


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12The EU’s Banking Industry and its Stress Testing

Profile of large and complex banking groups

When the drive for more economic growth is based on leverage, every crisis is a severe setback. No other industry is more vulnerable to such change in fortunes for the worse than banking and finance which, with increasing frequency, also finds itself at the heart of the crises.

To appreciate the bearing of this statement, it is necessary briefly to describe the profile of the big European banks, better known as large and com-plex banking groups (LCBGs), which act as virtual sovereigns. This is particu-larly necessary because there is a symbiosis in debt characterizing the relations between LCBGs and governments. Big banks lend lavishly to governments, quite often with no questions asked. Governments return the compliment by salvaging the LCBGs when, because of having assumed inordinate risks and/or flagrant mismanagement, they bring themselves to the edge of the abyss.

The governments and central banks of Japan and South Korea in the 1990s, as well as the United States and Britain in connection with the 2007–11 economic crisis, have exceeded any previous record in salvaging heavily damaged banks. This in no way puts euroland to shame. During the recent crisis, the European Central Bank has provided at least a800 billion ($1.12 trillion) in loans to banks, much of it in exchange for stellar collat-eral – whether government bonds or other dubious assets.

Which of the world’s biggest banks and their cohorts can be found behind these recurring and increasingly more toxic problems? According to a clas-sification discussed in the course of a private banking meeting, the top three of the world’s top ten LCBGs are American: Bank of America,1 JPMorgan Chase and Citigroup. The next two are British: Royal Bank of Scotland and HSBC. These are followed by: Wells Fargo (US), Industrial and Commercial Bank of China (ICBC), BNP Paribas (French), Banco Santander (Spanish) and Barclays (British).

It is interesting to note that the top ten feature only one euroland-based institution: BNP Paribas. But the top ten is only the tip of the iceberg.


The EU’s Banking Industry and its Stress Testing 213

The list of global LCBGs does not end with them. Among euroland’s institutions, Société Générale and Crédit Agricole are French; Deutsche Bank, Commerzbank and Westdeutsche Landesbank (which plays investment bank, while it should not) are German. Italy’s UniCredit and Intesa San Paolo are also big banks and the same is true of Holland’s ING. There were also, formerly, ABN Amro, Spain’s BBVA (apart from Santander)2 and many more.

Being an LCBG is not synonymous with having a strong balance sheet. It might be precisely the opposite. Neither does it mean that, by being one of the world’s biggest, a bank is one of the most profitable. Global banks face a fight for long-term funding and take inordinate risks; they are not always well-managed and their fortunes vary over time.

Theoretically, with interest rates kept at nearly zero by western banks, it is cheap to borrow in debt markets. But one must have good credit stand-ing to do so, which damaged banks lack. All told, major manufacturing companies which work in the real economy have higher creditworthiness than the typical big bank, and there is a long-term shift towards companies bypassing banks and getting the money they need by issuing securities in the capital market.

Of course, it is easy to be wise about any business when one is not involved in it. But it is no less true that blindly to produce, and continue producing, structured financial instruments without regard for the further-reaching reputation of the bank (and for ethics) has been proven to be a foolish strategy more than once.

LCBGs are now paying for their past mistakes, while central bankers and regulators are in a bind. They know that they have to toughen the capital rules, prune the Tier 1 capital from hybrids and other garbage, and provide sure-fire rules for liquidity. All these are rational steps, but they also appreciate that, given the situation into which they have got themselves, banks are not able to move up the creditworthiness ladder.

But the subject has become political, as LCBGs use their governments, by intensifying their political lobbying against rules promoting good governance and better-focused supervision. The Basel Committee on Banking Supervision has been right to come up with the new Basel III3 proposals to increase the quality, quantity and transparency of capital held by banks, and to reduce the risk of another global banking crisis like the one we are still going through.

Indeed, on September 12, 2010, central bank governors and heads of the 27 most important financial economies agreed on stricter minimum capital standards by BCBS, aimed at improving the stability of the global financial system. But, under political pressure, they watered down that commitment by (unreasonably) delaying its application. Only from January 1, 2019 (!) will it come into full force. The long transitional period is proof that the world’s big banks are very badly damaged. Even the implementation of



the liquidity coverage ratio (LCR) has been delayed to January 1, 2015. Yet, liquidity was one of the main causes of the current crisis.

In essence, what big banks are trying to do with these delays is to stage a return to the go-go years which created the bubble and the deep economic crisis. They have been arguing that the new capital requirements would end up restricting their lending, at a time when their governments are asking them to finance the economy more actively. But they are not doing any significant lending despite huge injections of taxpayers’ money. They use public funds to rebuild their own balance sheets.

The irony for the LCBGs is that the crisis has dramatically changed their negotiating position. Pre-crisis they spoke with the authority and influence that their massive assets gave them. Afterwards, it was found that these assets were mostly second-class and they had turned to ashes. The result has been an industry with feet of clay that had to be bailed out. Taxpayers have been called upon to save the LCBGs, but regulators have not been permit-ted to tighten up a system that proved totally inadequate. Both at sovereign and at LCBG level, mismanagement played a major role in the failure to establish secure financial conditions and do away with crumbling structures. Part of restructuring has been the concept of a forced break-up of mammoth LCBGs, and, by extension, of the universal banking model.

A break-up of too-big-to-be-saved entities is not necessarily reserved for the banking sector. Mega motor companies, too (first GM, then Toyota), as well as other leviathan entities, have been chronically mismanaged because steering them and overseeing them has become next to impossible.

Prior to the 2007–11 economic and banking crisis, an idea making its way was ring-fencing the activities of very big banks, restricting them to institutions kept out of the economy’s vital functions. Nothing was done on that account, largely because of political lobbying. Quite to the contrary, the LCBGs fed a big chunk of taxpayers’ money into ‘dark pools’ of liquidity which are exchange trading venues free of regulatory scrutiny. As an example, in 2009 in Europe dark pools trading jumped by almost 500 per cent year on year.4

Ultimately economies advance because their institutions are strong

Back in the early 1950s, one of my professors at UCLA taught his students that, at the end of the day, economies advance because their institutions are strong. The first section of this chapter brought to the reader’s attention the fact that the West’s big financial institutions are not as strong as they should be, mismanagers have kept their jobs and corrective measures come too slowly to have a real impact.

Plenty of reasons for this statement have been brought to the reader’s attention. In addition, the basic organizational prerequisites for effective



risk management are wanting. Quite contrary to the ‘meine bank über alles’ attitude, wise governance would have established, and watched after, the risk control culture, tools and methods needed to sustain financial staying power, reputation and what it takes for longer-term survival.

Like any other organization, a credit institution does not abstain from risk-taking because, where there is no risk, there is no profit. But it must have a strong risk management culture and employ people able to identify ex ante both evident and opaque exposures, monitor their ongoing behavior by product line and transaction, and extrapolate their longer-term effect on the bank’s survivability. The tools for doing so are known but poorly used:

pricing all risks,5 and always remembering that risk is a cost,establishing statistical quality control, to track each exposure and keep it well within limits spelled out by the board, andhaving the technology to collect data in real time, computing deviations and taking immediate corrective action.

To improve the effectiveness of his work, the bank’s chief risk officer should report to the chairman of the Board’s Risk Committee, or at least directly to the chief executive officer (though, organization-wise, the former is prefer-able to the latter). Effectiveness in risk control presupposes independence of opinion – therefore, that the board’s Risk Committee is not a rubber stamp, as happened with Lehman Brothers (see also, below, the discussion on risk control with derivatives).

What has been revealed postmortem, in the case of Lehman, was that the CEO and his top management team were allegedly hiding the financial conditions of the bank for months, by manipulating its accounts. An audit by Ernst & Young brought to light that a cool $50 billion were removed from the bank’s balance sheet. An economy is condemned to slow death when trickery becomes the rule. In the short time of a decade, the Enron scam was $60 billion, Bernie Madoff’s was $65 billion and Lehman’s an estimated $150 billion. James Chanos gave these statistics when interviewed by Charlie Rose on the Bloomberg Financial Channel, on April 13, 2010. The specialty of Lehman was no different from other Wall Street banks, but at a much higher level of sophistication. Lehman was taking a bunch of illiquid derivatives, pricing them at will, having them credit-rated AAA, selling them worldwide, and claiming huge profits, which ‘unjustified’ rewarding inordinate bonuses.

That’s precisely what a mismanaged institution does. Weak and poorly managed investment and commercial banks are of no help to the economy. Such trickery saw to it that well-managed companies do not want to work with banks; for funds, they go directly to the capital market. The capital market, and non-banks generally, provide 60 per cent of the funds American companies need; in Europe, this figure is much lower, hovering at the 24 per cent level.6

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Scandals, too, are the result of poor governance, and they do not improve the standing and reputation of the banking industry. On April 16, 2010, the financial news revealed a Goldman Sachs scandal: 80 per cent of securitized subprimes did not conform to regulations.7 When cases like that get institu-tionalized, the public loses faith in the whole banking industry. According to FDIC, even among smaller banks, the number of problem institutions is more than nine times as great as in 2007, and the total assets held by such troubled banks was more than 18 times larger in 2009 compared with 2007.8

Nearly all over the West, the realm of financial institutions is further weak-ened by the rush to be in the big league of profits at any cost. Little attention is paid to the fact that risk drivers and risk factors change over time, often because of the banks’ own actions. This increases the level of exposure, while methods and tools for risk control are not significantly altered.

As far as their supervision and regulation is concerned, what is happening with big banks finds a parallel with a bad policy euroland has adopted with sovereigns. ‘Debt offenders’ encounter too much leniency for their own good as euroland finds it difficult to decide what it wants to do, if anything, with persistent budgetary deficits. While, in September 2010, the European Commission published a sweeping series of proposals to punish debt- ridden member states, it left incomplete measures to fix gaps in competitiveness that it identified as a chief reason for the crisis that threatened the euro’s existence. There is a striking similarity between leniency to sovereigns and misbehaving big banks, because management control is slow and uncertain; split personal-ity measures are absolutely counterproductive as they lead to growing uncer-tainty about financial health and cause short-term interest rate spreads to increase to abnormally high levels.

Even worse, in regard to misbehaving sovereigns, the EU bends its own rules, even those most recently created. It turns a blind eye to malpractices through improvised compromises and a ‘tit for tat’ attitude. Commission officials seek consensus on practically all regulatory issues and disciplinary decisions – and, at the same time, they are unable to overcome deep disa-greements.

A case in point is the European decision, in October 2010, to permit a tottering Spain to leverage its uncompetitive coal. Yet, no EU commissioner could claim ignorance of the fact that, in terms of financing requirements for the next three years (2011–13), Spain is way ahead of Greece by a big margin. Considering maturing debt and scheduled interest payments, plus the government’s own budget deficit, Greece comes in at just below a200 billion ($280 billion) in the red; Spain stands at an eye-watering a600 billion ($840 billion), divided almost evenly between debt servicing and sovereign red ink.9

Large and complex banking groups have been getting similar and most favorable treatmen; also, to give them a stronger helping hand, governments as well as central banks bend over backwards to increase the monetary base.



In 1994, global currency reserves were roughly $1 trillion, up from less than $300 billion in 1984. By 2003, they had reached $2 trillion, and then increased exponentially to nearly $8 trillion in 2010.10

Out of the trillions in newly minted money, which is essentially sovereign debt and leverage, hundreds of billions have been going down the drain and been used to plug the holes in LCBGs’ balance sheets. The notion of reputa-tion and of sound governance has literally broken down, with power shifted to risk-takers. It is no secret that, in the go-go years – 2004–07 – in many banks ‘chief risk officer’ had become nothing more than a glorified title: internal control was fading away and, because of political pressures, both in America and in Europe regulators were not doing their job.

In the climate produced by these anomalous facts, the threats to financial stability are being held in check less and less. To take just one example, the better-known LCBGs have been piling up non-linear bets. In spite of the deep crisis, big banks are not humbled. Instead, using political lobbying, they scramble to convince markets, regulators, politicians and the leveraged government (who freely spent taxpayers’ money to save them), that les-sons have been learned; while, in reality, nothing has changed in the LCBG ‘going for broke’ culture.

Even one of the lessons that should have been learned from the 2007–10 deep economic crisis – for instance, that quantitative finance is not a science and one should be most careful about its limits – does not seem to have left an impact. It is the people, rather than the models, who opened the gates of hell. Speaking from experience, all models are wrong, but some are useful; they have their place, but they must be coupled with more subjective approaches to risk control. Moreover, stress tests (see below) and worst-case scenarios are necessary to account for systemic liquidity shocks and the simultaneous fail-ure of two or three big banks.

The few institutions that have done honest stress tests and studied the consequences were better able to react when the crisis came. This, however, requires a CEO and board who appreciate the issue, and ‘rocket scientists’ who are as versatile in banking as in mathematics (rare birds, indeed).11 It also calls for everybody’s understanding that economies advance because their institutions are strong.

Banks do not know the risks they take with derivatives and their IT is unhelpful

In early June 2010, in the process of combining the (then) diverse versions of the new financial regulation by the US Senate and House of Representatives, it was revealed that the market valuation of existing derivatives contracts was a cool $1.2 quadrillion ($1,200,000,000,000). That number is astronomical and its growth rate was too much for comfort. Amid a deep economic crisis, derivatives contracts increased roughly by 20 per cent year on year; this



stupendous growth in highly risky financial instruments confirmed what has been stated above: that nobody was in charge of LCBGs’ logic.

The said amount of $1.2 quadrillion in derivative financial instruments defies logic. Even as an order of magnitude, it is overwhelming. Exact esti-mates are not possible because most of derivatives deals are over the counter (OTC) and bankers keep their details (in the event they know them) close to their chest. They do not stand ready to explain the depth of their losses.

As this example on unwarranted exposure demonstrates, by using high technology in designing novel financial instruments, bankers have become adept at slicing and dicing debt. The more time goes on, the more the derivatives complexity escapes their designers and their users. In addition, the bank which buys a structured instrument is often reusing it in numerous deals by slicing it again – in effect, spinning a great web of leverage associated with its trading activities. Few people appreciate that the under-lying asset base is often murky and usually surprisingly small; this provides the necessary conditions for the trading activity to crumble back into itself as a structured instrument continues changing hands.

As if to make matters worse, the collateral typically associated with securitizations is of poor quality. Subprimes and Alt-As provided examples, many being a carbon copy of one another. There is good reason to think that investors will be disappointed because, looming on the horizon, is a triple problem:

the exposure of the western economies to this sort of unstable deal continues to grow by leaps and bounds,risk control is severely handicapped by the complexity and opacity of novel derivative instruments, andtheir trading is, by a large majority, bank-to-bank; essentially, a gamblers’ deal. Only 5 per cent or less of such trades is made by banks on behalf of their clients.

In regard to the first bullet point, on June 25, 2010, according to a CNBC financial report, derivative trades by US banks amounted to 90 times the gross domestic product of the United States. If one accounts for the fact that over 95 per cent of these trades are bank-to-bank, then the inescapable conclusion is that banks hide in their vaults risky instruments to the tune of 85.5 times – or 8,550 per cent – the American economy’s GDP.

To find the amount of pure risk associated with this number, it is neces-sary to reduce it by a factor which varies with the instrument and intensity of a crisis. Focusing on the latter, evidence from the bankruptcy of the Bank of New England and the near bankruptcy of the Republic of South Korea suggest that such a divisor is between 5 and 612 – which means that, with their derivatives trades, American banks have mortgaged between 15 and 18 years of US GDP and, while similar figures for Britain and euroland are not

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available, there is no reason to believe that European LCBGs have exposed the old continent’s economy to a significantly lesser degree.

The order of magnitude of this reference is highly relevant to the stability not only of the banking industry, but also of the western economies as well, because the amount of bank-to-bank risk is rising – and it is networked. The recent deep economic and financial crisis brought attention to the role of financial linkages in the propagation of shocks because of the:

intertwined nature of the present-day financial system,consequences of interconnected complex instruments, which are very hard to predict, andintricate structure of interdependencies between LCBGs and sovereigns, leading to significant effects on sectors of the economy, as well as across economies and financial systems.

Figure 12.1 brings these facts to the reader’s attention in a nutshell. A severe shock to a systemically important financial institution – essentially, all of the LCBGs and a number of other global entities are systematically important – will upset the balance sheets of many other networked institu-tions and sovereigns. Almost instantaneously, the shock waves will propa-gate through the interlinked global economic system.

The tools which exist to monitor, analyze and assess systemic risk and contagion in financial systems have worn out. Rapid novelty in finance left them in the dust. They are rather primitive compared with the magnitude of the problem and do not take care of uncertainties concerning the behav-ior of any particular LCBG. Therefore, hypotheses being made may not be directly applicable to a specific urgent case.

The availability of relevant, accurate and timely data is another important prerequisite not being fulfilled. Highly dependable data streams are critical, both for steady oversight and as a postmortem surveillance tool. Available data on relevant exposures, however, are not necessarily reliable or timely enough.

There is also the fact that, for a large number of entities (including a wide range of financial institutions and other business enterprises, as well as government departments), the proliferation of data makes them increasingly inaccessible and therefore obscures the behavior of underlying factors. Large volumes of half-irrelevant information consume the attention of its recipients. Economist Herbert Simon brought this into perspective in 1971; he concluded that a wealth of information creates a poverty of attention.

When I present this argument in my seminars, many participating execu-tives answer that information technology (IT) takes care of making financial data timely and comprehensive. As I never tire explaining, however, this statement is very weak because old-fashioned IT is still king in the financial industry and its principle is ‘garbage-in, garbage-out’.

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The problem is also one of organization. Even the most sophisticated information technology solutions cannot correct data streams which are untimely, opaque and unreliable. In the early 1990s, Citibank had to cancel a multimillion dollar executive information system (EIS) because one third of the information it contained was wrong (false or obsolete). Contrary to generally heard statements that big banks and other institutions have first-class IT, in the large majority of cases their IT is Paleolithic.

Overexposurein derivatives

trades

90 timesthe GDP of

UnitedStates

Consequencesof

interconnectedglobal

markets

Intricateinterdependences

betweenICBGs

Intertwinednature offinancial

instruments

US and globalafter effects

from volatility,shocks

and crises

Figure 12.1 The unbearable truth of a thermonuclear option with derivative financial instruments



According to John Hasson, a former manager of Abbey National Bank:

It seems to me that all of the major forces in banking are finding their legacy systems more and more of a sea anchor in terms of agility and profit. And if they don’t do something about it they will find themselves in a declining spiral of increasing expense (therefore lower profit) and increas-ing competition which they cannot answer effectively. Every dollar that is inefficiently employed comes straight off the profit line.13

This is not something that only myself or John know from our own profes-sional practice. In mid-2010, The Economist published an excellent article under the heading ‘Big Banks Need IT Reform Almost as Badly as Regulatory Change’,14 which started with the well-known fact that the majority of banks not only still use mainframes,15 but also they continue adding to them because they believe (incorrectly) that it is too risky to change them.

Quite often, though not always, IT support given to the traders is an exception to this statement. They almost always get the best equipment and software, which means practically that they leave the risk controllers and senior managers way behind because they still depend on IT based on a plethora of incompatible mainframes – the so-called ‘big irons’.16

The aforementioned Economist article further noted that:

banks tend to operate lots of different databases producing conflicting numbers. ‘The reality was you could never be certain that anything was correct,’ [according to] a former executive at Royal Bank of Scotland. Reported numbers for the bank’s exposure were regularly billions of dollars adrift of reality, finding the source of the error was hard.17

This is by no means an atypical case, with the result that the majority of credit institutions have no single overview either of their risks or of their customers, which could allow them to be in charge of a polyvalent matrix of exposure. To make matters worse, because of the wrong IT culture of unwisely writing programs rather than buying them off the shelf, these programs must be maintained by large teams of people who were born well after the programs were written.18

Stress tests permit crossing the river while feeling the stones

In engineering, as well as in management, the principle is that whatever is done has to be tested. ‘Anything that can go wrong, will,’ states Murphy’s Law. Quality depends on specifications and the severity, as well as consistency, of tests. Many tests are done under normal operating conditions, which is not sufficient when the product is novel and/or extraordinary events happen during operations.19



Borrowing a leaf from the engineering book, some years ago the Basel Committee on Banking Supervision introduced, in conjunction with Basel II, the practice of stress tests.20 The best way of looking at stress testing is as a generic term which describes methods, techniques, tools and conditions whose origins (as already noted) are found in engineering. The exercise requires:

1. testing each component under conditions considerably more exposed and demanding than in a normal case;

2. integrating the results through statistical simulation; for instance, using the Monte Carlo method, which permits one to obtain a system perspective;

3. testing the system itself under stress conditions to establish the integrity of the whole structure; and

4. comparing the simulated results under ‘B’ with the ‘C’ outcome, to obtain a sense of the product’s or aggregate’s reliability.

In the engineering sciences, the best measure of reliability is provided by the Weibull algorithm.21 Etymologically, reliability is not an ability. It is a statistical concept denoting the probability that a system, or piece of equipment, will perform without failure over a pre-established period of time under defined operational and environmental conditions. In a nutshell, without going into detail, the results expected from a stress test address the long leg of the risk distribution, whose pattern is presented in Figure 12.2. A normal test’s results, usually (but not necessarily always) fall under the bell shape of the normal distribution curve, with more than 99.7 per cent of measurement within 3 standard deviations from the mean. Stress tests, by contrast, are made n standard deviations from the mean, and n may be equal to 5, 10, 15, 20 or 25 – depending on the level of severity in stress testing (we will return to this issue).

Five standard deviations is the lowest level of stress testing. I personally prefer 15 standard deviations; but the reader should also appreciate that it is not enough to decide only on how many standard deviations should be used in a stress test. This procedure also has prerequisites. The first of them is to identify the drivers of risk, followed by estimating for each of them:

origin,causes,background conditions,likely correlation(s), now and as volatility rises,projected frequency and amplitude, andmost likely impact, now and through the life of the instrument.

In addition, stress testing should be done at a level of confidence of at least 99 per cent; and, even better, at 99.9 per cent. It is appropriate to remember that in the 99 per cent case, 1 per cent of events will not be taken into

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account (which is superficial). By contrast, in the 99.9 per cent level of con-fidence only 1 per thousand events are not accounted for.

Not all stress tests observe these requirements; therefore, not all of them offer reliable results. Some are made to prove a point, rather than really test. In such cases, their organizer counts on the psychological effect of a good result statistic, in terms of its effect on markets.

In connection with the tests conducted by the Committee of European Banking Supervisors (CEBS)22 in 2010, several analysts questioned the use of stress methodology that failed to take into account exposure to the doomsday scenario, which is the ultimate stress test. Of particular concern were the mounting sovereign debt woes of peripheral eurozone members – and their after-effects on the banking industry. The cases of Irish and Portuguese sov-ereign debts proved the doubters right.

Market effects aside, the main purpose of stress tests is better comprehen-sion of outliers associated with unknown causes, event risk and uncertain-ty’s impact. Therefore, the emphasis, as mentioned, is placed on tail risk at 5, 10, 15, 20 or 25 standard deviation(s) from the mean. The October 1987 US stock market crash was a 14.5s event. In the aftermath of Lehman’s bankruptcy in mid-September 2008, in the big dip, economic and financial variables were observed at 20 and up to 25 standard deviations.

Precisely because it helps in the investigation of outliers and their after-effects (albeit based on both facts and hypotheses), stress tests provide a quantum leap in data analysis. The focus is at the level of what can be seen as extraordinary, unexpected conditions. Notice, however, that all tests – and, hence, the stress tests themselves – are subject to model uncertainty, data uncertainty and, even more damaging, the effect of cooking the books.

Unknownunknowns

Knownunknowns

3s 5s 10s 15s 20s 25s

Normaldistribution

can be a proxy

Stress distribution is longtail with Hurst exponent

Figure 12.2 The normal distribution is a proxy valid only in connection with low-impact events – the distribution of high-impact events is not normal



The answer to all three of these risks, and most particularly the third, is rigorous auditing. Models and data must be technically audited, before and after testing, which was not done in connection with the February 2009 tests by the Treasury and 2010 euroland tests by CEBS. The best example of a sound policy in terms of an inquiry (which essentially is the sense of testing) has been provided in Britain by the House of Lords, in late July 2010.

The reason was the market concentration of auditors PwC, Ernst & Young, KPMG and Deloitte, which together audit most of the world’s biggest companies. The July 2010 inquiry by the House of Lords’ Economic Affairs Committee was prompted by a ‘worrying lack of scepticism’ in some of the aforementioned public accountants’ audits of financial institutions in the run-up to the financial crisis. As quoted by the Financial Times, senior people from these firms said that such an inquiry should provide a forum to prove that competition was fierce and that the auditors did their duty in the run-up to the crisis.23

This is precisely what should characterize any inquiry or testing for any reason, anywhere. CEBS experimentation, with regard to the financial staying power of the 91 euroland banks that took part in this stress testing, will be examined with this approach in mind in this and the next section. Behind this statement lies the principle that, the more rigorous these tests are, the more unambiguous are their results.

Tests on the credit institutions’ creditworthiness were needed because in Europe, as in America, the financial crisis initially hit banks hardest, while other parts of the economy were not affected until later, or were affected rather indirectly. For instance, mounting risk aversion and the economic slowdown did not cause a major stock market slump until 2008, whereas the bond market benefited from portfolio shifts towards investments considered liquid and providing greater safety. Stress came from the fact that the economic and financial crisis weighed very heavily on the banking system and largely exposed its weaknesses. But, at the same time, the nature and size of its impact differed considerably from one bank to another, as well as over time, depending on the amount of their leverage.

As the financial and economic crisis deepened from the autumn of 2008 onwards, banks other than the LCBGs, with more of a domestic focus (like savings banks exposed to the real-estate bubble), were increasingly hit as well. The question, therefore, was whether the members of the European banking system were still resilient – and, if not, what kind of effect their troubles might have on the real economy.

As should be expected, a parallel goal in the mind of supervisory authorities was that of giving confidence to the market. This is true of practically all publicly held tests, even if they do not quite provide governments, central bankers and regulators with what they need to know about the weakness of the tested banks in terms of core capital, liquidity and other key factors vital to the survival of an institution.



Keeping in mind this particular objective, euroland-wide stress tests can be helpful in providing a picture of the risks still lurking in bank balance sheets. But, for these to give credible results, they must not be administered separately by each regulator under a vague set of guidelines; neither should they be subject to unwarranted constraints (see below). In due course, as experience with cross-border stress tests in the financial industry grows, they should be extended to cover what the European Central Bank calls ‘financial network analysis’, to enable better understanding of financial stability, exam-ination of contagion channels in the financial system and deeper study of financial information connected with or having an impact on systemic risk.

Tests should be designed to provide a broader set of data on financial linkages at three levels: bank-to-bank, cross-market and cross-currency – both nationally and on a cross-border basis; also, to study the market players’ behavior under normal and stress situations. This more enlarged perspective could help policy-makers in promoting safer financial struc-tures, says the European Central Bank.24

How different experts evaluated the stress tests by the Committee of European Banking Supervisors

In February 2009, five months after the Lehman bankruptcy, the US Treasury decided to conduct a stress test among the bigger American banks. The objective was to show that their balance sheets were sound, at least to some degree. As was to be expected, official announcements stated that the results met the announced objective. Not everyone was convinced, but this does not mean the stress test was totally useless. The stress tests were politi-cal, but they did give the market some reason for confidence.

As we saw above, in a way emulating the tests administered by the US Treasury to American banks in 2009, the Committee of European Banking Supervisors organized, a little more than a year later, stress tests aimed at gauging, among other things, how European Union banks would cope with sharply lower GDP growth, and shocks from credit and market risk. The critical level of Tier 1 capital that a given bank needed to pass the test was set at 6 per cent, which was inadequate.

Under the Basel I agreement of 1988, for international banks the Tier 1 ratio was set at 8 per cent; even that by no means represents a level to be had under stress conditions. In addition, the testing exercise was one-sided, because it applied only to that part of the bank’s assets that are held in the trading book.

Longer-term holdings in the banking book, deemed to be held up to maturity, were not tested. Yet, that is where exposure to sovereign risk is to be found (more on this later). As one financial analyst commented, we could rightly be critical of the regulators for erring on the side of meekness in the testing parameters.



A further criticism was the lack of stress applied to proposed cuts,25 par-ticularly in the context of some of the moves already seen in peripheral European bond markets during 2010 (Greece, Portugal, Ireland). This was regrettable. Careful watchers of this exercise pointed out that, for results to be believable, some big-name banks had to fail. If all of them passed the tests, this would prove that the questions asked were not hard enough, or that political pressure biased the results. Some sort of political pressure did show up, in the sense that the risk of sovereign defaults and their after-effects on the banking industry were not fully addressed. According to expert opinion, this issue needed to be dealt with convincingly, with each bank’s exposure to jurisdictions whose economies are on the verge of a crisis disclosed in detail.

Leaving aside such important considerations revealed a kind of conflict of interest between testing the banks’ and the governments’ balance sheets. Most likely sovereign default risk was not considered because politicians decreed it should not happen. Critics, however, stated that, without factored-in sovereign default, the tests simply were not worth their salt.

With hindsight, the critics were right, because it is better to correct faults before they hit the public eye. In the first week of September 2010, it was revealed that fresh doubts had been cast on the stress tests released in July on the 91 European lenders. The reason for such doubts was that, as some reports revealed, certain banks did not provide full disclosure of their government-debt holdings.

Other criticisms in connection with the 91 European banks stress tests centered on their very nature. John Key has pointed out (in the Financial Times) that the stress tests were self-referential. Their purpose, Key said, was to show not that the banks are sound, but that they met the requirements for regulatory capital. He added that the purpose was not to ensure depositors’ money is safe or that taxpayers will not be called on again, but, rather, to reassure banks and their shareholders that they will not be required to provide significant additional capital. Also, of course, they were designed to give the markets and the governments themselves an uplift by showing that the creditworthiness of the banks passing these tests was not in question. (In a way, this was a foregone conclusion because, if it were otherwise, the tests would have been counterproductive, in the sense that they would only have served to confirm market fears that the financial system was, indeed, in trouble.)

Another issue to which not enough attention was paid was that euroland (at the time of the tests) comprised 16 sovereigns, not just one as in the USA. The stress tests should have provided a uniform disclosure pattern, but critics say this was not the case, particularly where individual banks’ expo-sure to peripheral countries was concerned. This poses the questions: ‘Who is hiding dodgy debt?’ and ‘Why did the supervisors allow them to do so?’ Another criticism has been that the tests defined banks’ capital generously,



using the not-so-dependable (by now) Tier 1 capital rather than the more stringent measure of core equity, which Basel III rules endorse. Therefore, some analysts called them stress-test light.

Still other non-positive reaction targeted the assumptions used in different countries. For instance, Austria’s adverse scenario assumed that commercial property prices would continue to rise in 2011; while Greece accounted for only a 2 per cent decline, which compares poorly with a 10 per cent drop in real estate values in most big countries and a 30 per cent drop in Spain – the euroland country which, along with Ireland, was worst hit by the burst of the real estate bubble.26

In spite of these shortcomings, however, in terms of market psychology these tests have been useful, even if they failed (in my opinion) on two issues. First, they could be hardly called ‘stress tests’; and, second, participating banks had used taxpayers’ money to bolster their capital ratios.27 In a free economy, banks must raise capital in the capital market. Tier 1 capital should be only equity capital, because this is a pivotal risk buffer for strengthening the resilience of a bank; if need be, dividends can be deferred, but interest on loans cannot be skipped over, except in case of bankruptcy. While some banks might ingeniously hide their troubles, for the financial system as a whole, total reserve capital and liquidity requirements play a very important role – particularly when banks use risky business models.

Even if it is only temporary, loss of confidence in the solvency of crucial market players can lead to loss of confidence in the whole financial system. The credit institutions’ resilience because of appropriate liquidity and capital, at a level high enough to absorb shocks, must therefore be stress tested. Attention should also be paid to the institution’s ability to refinance in the inter-bank market, as well as its ability to confront market risks.

Another vital piece of information which alert bankers did not find in the stress test’s results regarded which of the 91 banks was ‘too big to be saved’. For instance, several months after the tests, in mid-November 2010, rumor in the financial markets had it that Westdeutsche Landesbank was so badly damaged that the German government was considering closing it down.

There is no point in continuing to feed the leviathans – a policy invented by the Japanese government in the early 1990s – wle, at the same time, being reluctant to change their management and bring wrongdoers to justice. Taken together, these policies emboldened bankers into taking huge but ill-studied risks, since they were faced with a win–win situation; they had nothing to worry about in terms of ethical fallouts, penalties or prison terms.

It is, indeed, regrettable that Japanification’s easy way to hell has been followed on a big scale by western governments unable to deal in a sensible manner with the ‘too-big-to-be-saved’ financial institutions and resorting to ill-advised bailouts. On October 20, 2009, Mervyn King, governor of the Bank of England, told businessmen that regulation is not enough to keep



banks from becoming ‘too important to fail’. Instead, he said, banks should be split up28 and that public money should underpin only those banks that operate as economically necessary utilities, such as being responsible for payments systems and intermediation activities. Risky operations, on the other hand, like proprietary trading and derivatives games – in short, ‘casino banking’ – should be spun off to entities which do not benefit from sovereign guarantees.

King is right. There is no greater moral hazard than throwing taxpayers’ money into a sea of bad debts and into the pockets of financial leviathans, which definitely need to be broken up. The challenges ahead are not limited to the fact that such oversized institutions should be required to have much higher capital levels than smaller ones. Their activities, too, must be super-vised and regulated in the most rigorous manner by a single global regulator whose authority extends across jurisdictions.

November 2010: four months after the test results have been released

In conjunction with the European Central Bank and euroland’s finance ministers, on July 23, 2010, the Committee of European Banking Supervisors released the results of stress tests it had conducted among 91 credit institu-tions of euroland’s member states. While awaiting these results, estimates for the potential amount of capital required by banks varied greatly. At the lower end of the range was a30 billion, which appeared to be quite manage-able, especially if it were dispersed among a significant number of banks and spread over a period of time, rather than an immediate cash injection.

The surprise was that, at least officially, only seven of the 91 banks failed the tests. The released information indicated that, as far as capital require-ments were concerned, even this low a30 billion guestimate was a multiple of the amount really needed.29 But was it really so? If the objective was to reassure the market about the banks’ financial health beyond doubt, then this objective was not achieved, since serious doubts persisted and, even worse, have been justified.

Plenty of analysts and economists said that test results were underwhelm-ing. Stress tests should help in building up confidence, if the results are fundamentally sound, but, as a Morgan Stanley executive commented, these did not have that effect. In the opinion of a JPMorgan senior manager, ‘The ESCB stress test result is of limited value to us.’30

This was a fairly widespread reaction, and it is a pity, because the publi-cation of test results was intended to alleviate the problem of incomplete information about the banks’ finances. If providers of funds to the bank-ing industry cannot be certain of the quality of the assets on their balance sheets, then, at best, they will require a premium to lend and, at worse, the inter-bank market will not work.



Part of the problem were the low-level requirements. As already mentioned, a 6 per cent Tier 1 capital ratio was set as the threshold for assessing the magnitude of capital shortfalls of the participating banks. But this 6 per cent ratio is not a regulatory minimum capital level and, while seven banks pub-lished Tier 1 capital ratios below the 6 per cent threshold, they did not fail the test.

It should not be forgotten that the European Union’s banking sector had benefited from public capital support amounting to a222 billion, which meant that there was plenty of taxpayers’ money in the banks’ balance sheets. It needs no explaining that the capital injected into the banks’ coffers between the end of 2009 – the starting point of the stress tests – and July 1, 2010 had lowered the aggregate capital shortfall revealed by the adverse scenario.

Another part of the problem was the basis on which these tests were conducted. There was no evidence of a universal algorithm given by regula-tors; every bank used its own models for the stress tests.31 Macroeconomic indicators were given by the Central European Banks System, but they were not that rigorous.

There have been, as well, some extraordinary surprises. For instance, Portugal’s central bank subsequently revealed that Portuguese banks borrowed a33.8 billion ($50 billion) from the European Central Bank in May 2010, double the amount in April, as euroland’s crisis made it increasingly difficult for the banks to raise funds through capital markets. Banks which had swapped ‘trash’ for cash with the monetary institution should have failed the tests de facto.

In view of the freedom – to use their own models, and other rather unsound principles, Citigroup made a full reappraisal of the Committee of European Banking Supervisors tests, restructuring the banks’ valuation of all of their sovereign debt holdings.32 As expected, this beefed-up stress test, amplifying the failure rate, showed that there were 24 failures out of 91 banks. The damaged institutions, according to Citigroup’s account, included Allied Irish Banks (which in October 2010 practically blew the Irish Treasury apart, see Chapter 10), Italy’s Monte dei Paschi, four additional Greek banks, five additional Spanish cajas and two German Landesbanken. Even so, the outcome was not that dramatic. These 24 banks showed a capital shortfall of a15.2 billion over and above what the other 67 banks required.

It would have been a laudable initiative for the CEBS if it, rather than Citigroup, had pointed out such shortfalls. Voices were also raised in the market about the need to stress test the central banks of EU countries, particularly those which, during the 2007–11 deep economic and banking crisis, have overleveraged their balance sheet.

While central banks cannot go bust in the classical sense of the term ‘bankruptcy’, because they have the printing presses on their side, they can lose a great deal of money. In a worst-case scenario, trillions in additional



capital from taxpayers may be needed to restore their credibility – shaken by the socialization of risk through the governments’ and the central banks’ balance sheets. Quantitative easing policies, foreign exchange intervention and other central bank initiatives have generated unprecedented and largely unhedgeable exposures; according to some estimates, all these initiatives taken together reach 20–25 per cent of global gross domestic product – an immense amount of money.

Anecdotal evidence suggests that the European System of Central Banks (ESCB) owns as much as 40 per cent of Greek and 20 per cent of Spanish outstanding government bonds. National debt restructurings in Greece and Spain, let alone an outright bankruptcy of either country, could generate billions in losses for the ESCB.

The Federal Reserve is in no better position, albeit for different reasons. With more than $1 trillions’ worth of US mortgages now in its hands, a minor 1 per cent increase in US interest rates could generate marking-to-market losses of $50 billion; and, if interest rates escape the Fed’s control, the result will be a huge hole in the central bank’s balance sheet.

People and companies who are active in the economy and in finance are fully justified in doubting the reliability of today’s financial system, and being skeptical about the measures being taken. They also have good reason to take with a pinch of salt what central bankers and supervisors say about stress tests and other studies they are conducting.

In the first week of November 2010, less than four months after CEBS gave the glorious results on the European banks’ financial health, the ECB again bought a lot of euroland – largely Irish – government bonds. And the Irish sovereign needed extra money because it spent foolishly to save the ‘Anglo-Toxic’ Bank from its rightful demise.

Happily for European taxpayers, the ECB’s scope for action in bond markets is limited by opposition from Axel Weber, Bundesbank’s president, who fears damaging consequences from using the ECB’s firepower for fiscal rather than monetary ends.33 Ireland is not the only euroland sovereign needing money to save its banks. On November 5, 2010, DW-TW (Deutsche Welle) revealed that a total of a809 billion ($1.53 trillion) is owed by European banks to the ECB.

No matter what the Committee of European Banking Supervisors might have said in July 2010 in connection with the outcome of the ‘stress tests’, in November of that same year it was evident that European sovereigns would need more than a1 trillion ($1.4 trillion) to recapitalize their banks. This explains why they pushed so hard to postpone phasing in parts of Basel III to 2014, 2015 and 2018.

This adds up to the fact that every sovereign, every financial institution, every country’s financial system and the global financial aggregate should be subject to real stress tests, conducted with full transparency. And the books should not be cooked prior to making their contents public. If globalization



means anything, transparent financial information should reflect universal standards applied on a global scale. Accounting for systemic exposure must include not only financial issues, but also:

government presence in the industry, the banks’ living wills, too-big-to-fail rules, rigorous risk control directives, steady supervision of global groups, andpenalties for breaking ethical standards.

This is written on the understanding that there is currently no harmonization whatsoever for banking supervision, and for associated financial reporting, under stress conditions. This means that there can be no reliance on market information, let alone on discipline – even if a transparent market requires less overt intervention by regulators, as the market participants themselves force their counterparties to hold a line of appropriate behavior.

Let me repeat this message in different words. The extent to which market discipline can be relied on for successful regulation depends on universal standards, transparency, ethics and the strength of their influence. All four have to be upgraded to obtain meaningful results and improve the chances of survival of the financial system.

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13The Global Systemic Risk has been Programmed for 2014

Not only the economy, but also democracy is at a crossroads

‘We should not be beholden to a tyrant,’ said Cato, the Roman senator; but he did not point out that this was improbable, perhaps even impossible. As the power of the Roman Senate declined, the Republic fell. Why did its power decline? Because it became passive, failed to raise its voice and gave the reins to individuals who escaped democratic scrutiny. America is in the same situation today, according to Dr Nelson Mohler, in a personal com-munication to the author.

An unexpected after-effect of the severe financial crisis is that the United States and its citizens find themselves at a crossroads: will the country remain a free economy or become another social democracy submerged in debt, à al Française? The dice is not yet cast, but the answer will be clearer over the next three or four years, by the time the second dip in the ongoing economic and financial crisis reaches its nadir.

Efforts to save America and other western democracies from this pre-dicament show the current leadership’s shortcomings. Often, two plus two results in three. Not only are these efforts timid but they also use the same failed recipe: more and more debt. It is as if western leaders want to vindicate Victor Chernomyrdin, Russian prime minister in the Yeltsin years, who said: ‘Whatever organization we try to create, it always ends up looking like the Communist Party.’1

The European and American State Supermarket, whose demerits have been sufficiently explained in the previous 12 chapters of this book, is noth-ing more than the Russian Communist Party revived and dressed in western attire. There is, however, a major difference: when the Russian Communist Party fell and left the country’s economy in shambles, the banking system was still functioning.2 The sovereign was tremendously weakened but not indebted. Military expenditure aside, government spending was low and did not overleverage the economy.3 This is not what has been happening in the West, with the State Supermarket acting like a debt hydra, and everyone


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living way beyond his means. It is no surprise, therefore, that we are living in debt-laden times, which have killed individual initiative and transformed western society – but it cannot last forever.

History will characterize the last decades of the twenty-first century as obvious folly in economic and financial management. Though the scheme is complex enough to deceive even prudent economists and analysts, fun-damentally, the ‘solution’ western central bankers found simply uses newly created money to buy old debt, with debt levels continuing to rise in every sector of the economy. As a result, there is a practically irreversible spiral into more and more liabilities; the idea that the sovereign can (and does) spend what it wants for as long as it likes is shown to be untenable.

All western governments have made the same mistakes, but the extent of them is quite different. The lesser offenders are the Germans; the worst offenders are the Japanese, British and Americans. Overloaded with debt, according to Marco Ragosta, an Italian banker, most economies resemble a Ferrari which goes at 300 mph, but the road ends and the driver is left with only two options: he can crash into a cement wall or a wall of steel. The choice is an unhappy one, but it is not clear. Quite likely the driver will do it by default, while still hoping to find a free pass for the expansion of public debt, entitlements and other individual claims. It comes, therefore, as no surprise that financial analysts warn that the United States, Britain and France may lose their AAA credit rating in the not too distant future.

Even if Washington, London and Paris were to become more prudent with sovereign finances overnight which is far from being the case (see below), it will take years for the Federal Reserve, Bank of England and European Central Bank to shrink their balance sheet significantly by containing liquidity and raising real interest rates. This is a present and real risk; it is therefore advisable to monitor it.

A chastened sovereign will also be keen to revamp and rebalance its fiscal policy. It is no secret that, due to the prolonged 2007–11 economic crisis, western government finances deteriorated dramatically and, in certain cases (Ireland, Portugal, Greece and more), confidence in their long-term sustainability has suffered. The persistence of this crisis weakened the overall economic momentum. The only thing that went up was public spending. Given the potential dangers from continuing on this track, decisive fiscal policy responses are most appropriate. This is, however, easier said than done because the crisis made apparent fundamental problems associated with the management of the economy. For example, the existing fiscal framework failed to prevent the emergency in the management of wealth in several countries. The economic and financial crisis stretched the fiscal framework to breaking point, exposing underlying structural shortcomings and reveal-ing the need for reform. Compliance with rigorous budgetary rules must now be ensured so as to obviate the need for indefinite ‘support’ measures and to ward off serious repercussions from overflowing sovereign debt.



In addition, the management of risk has to be properly regulated at sov-ereign, corporate and household levels – in a way which, as far as possible, affects only those who caused the ongoing crisis with their financial gam-bles and their indebtedness. Ironically, sovereigns, banks and households are both creditors and debtors. They are players in a clandestine redistribu-tion of wealth.

Until the problems associated with rising indebtedness and absence of personal responsibilities are fixed, and a sense of balance between income and expenditures is re-established – which can be done only by significantly downsizing the State Supermarket – democracy will be in peril. The worst-case scenario oscillates between dictatorship and collapse: it is a sad fact that generations of people have not been educated on the matter of choosing their leaders wisely.

Guillaume de Chièvres was the tutor of Charles (1500–1558, V and I), future king of Spain and head of the Holy Roman Empire. He educated him in the most direct way, from the age of 12, commenting on reports of governors, messages of ambassadors and military affairs. Young Charles thus gained truly practical wisdom and understanding from an early age.

When other members of the court criticized this educational policy, de Chièvres answered: ‘I am tutor and curator of his early years. I want him to remain a free person when I die. If he does not know his business, he must find another tutor. He who is not master of his work is obliged to rely on others.’4 This is true of every regime. A democracy only fulfills its mission when those who vote now and understand the facts can make up their minds, and are willing and able to undertake their responsibilities. A democracy whose popular vote is based on the message of the one-eyed Cyclops – the television – is a parody of a regime representing public opinion. By spending $5 billion on the election campaign for a president or a party, those who put up the money are taking millions of citizens for a ride. Unfortunately, we do not educate our kids in the way Guillaume de Chièvres did the young Charles.

The way to global financial stability is uncharted

George Soros said that the global economy has just entered Phase II of the crisis, adding that the European Union’s troubles are spreading.5 To the contrary, Ben Bernanke is of the opinion that, thanks to his decisions – long-term zero interest rates and quantitative easing – the economy is moving in the right direction. In his speech of September 2010, Barack Obama con-firmed Bernanke’s thesis. Many observers believe that Obama and Bernanke are theorists, whereas the man who knows what he is talking about is Soros.

The ‘wrong way’ and ‘right way’ to handle the current mess is an issue which divides economists the world over, though few would venture to say



that the economy (particularly in the West) is on the right track. Officially, according to current metrics, the American economy came out of recession in June 2009. But this is a joke. With structural problems unattended, unemployment stubbornly high and industrial production underutilized on both sides of North Atlantic, the newly poor western nations (Chapter 2) are still sick and only very slowly recovering. As 2010 came to a close, euroland’s industrial production was at about 87 per cent of capacity, and the same was true of Japan’s. American manufacturing, which bottomed out in June 2009, was nearly 15 per cent lower than in January 2008. By contrast, in China and India output did not fall below its level at the begin-ning of 2008, even if growth slowed. If anything, indeed, in August 2010 China’s output was more than one third higher than at the beginning of 2008 – a marked contrast to western statistics, which have been in negative territory.

Among western governments there are, as well, different perceptions of risk. The optimistic view is that central banks, regulators and the sover-eigns themselves are in charge, with risk in the system able to be offset by dispersion. The realistic view, by those economists who err on the side of prudence, is the existence of a great deal of exposure reflected in:

high volatility, low asset values, negative current account balances, andthe questionable longer-term sustainability of debt positions.

The message provided by currency policies followed by different western sovereigns is that of multiple stresses which lead to friction with developing nations. On October 11, 2010, it was announced that the IMF meeting, convened to avoid currency wars because of quantitative easing and other measures aimed at devaluing certain currencies, had failed to reach consensus. Discords and disarray preceded this failure.

The fact that each of the major economies participating in the IMF meeting has been too busy taking care of its own fires and very little inclined towards an international agreement makes a mockery of globalization. With every sovereign facing a very difficult situation at home, because of the ongoing economic and banking crisis, there is no room left for maneuvers aimed at establishing a global economic policy – whether this concerns currencies or anything else.

In practically every nation, political leadership must struggle to reclaim its credibility. The recent sovereign debt crisis in euroland illustrates how questionable the sustainability of risks confronting the different economies is. ‘Markets no longer reward instruments for complexity and opacity,’ Mario Draghi, chairman of the Financial Stability Forum and governor of the Bank of Italy, wrote in an article.6 In fact, many central bankers and

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some chiefs of state have begun to worry about four sovereign factors which could greatly destabilize the global economy:

excessive foreign debt and budget deficits by the United States,the shaky balance sheets of euroland’s peripheral countries,a globally dysfunctional supervision of financial entities ‘too big to be rescued’, andthe exact nature, amplitude and depth of the next big bubble, which has been promoted by the loose monetary policies of some central banks.

While the market has been flooded with newly minted money which runs into the coffers of undeserving, self-harmed big banks, but did not show up in loans, the wealth of US households has been slashed by $1.5 tril-lion as asset values continue to drop. Pensions, too, are at risk. No matter how they are funded, for many pensions the consequences of the crisis are significant.

This is true of both public and private pensions, as all of them require steady funding. Public pensions are at risk because Social Security is bankrupt in most western countries. Private pensions find themselves in a crisis, not only because companies have had a tough time, but also because of the cen-tral banks’ almost-zero interest rates, which penalize savers and investors, including pension funds. More money than would have been otherwise necessary has to be put aside to fill the gap. If pension schemes simply cut benefits to balance their budgets, then that would leave the pensioners with a shortfall, and greater difficulty in making ends meet.

Rates which are low, in both real and nominal terms, make it so much harder to replenish capital. And an oversupply of money carries its own dangers – because money’s worth derives from the fact that it is limited in supply (hence the gold standard which was king in previous centuries). Wegelin’s Investment Commentary No. 270 made the point that sovereigns, central bankers, investors and the market at large are confronted by two contradictory arguments.7 According to one, the most sensible course is to put out the fire of banks and other insolvent entities before it leads to more bankruptcies, particularly in the banking industry. The other, more balanced approach doubts the medium-term effectiveness of measures taken by west-ern central banks. It fears that the policy of swapping a large problem for a far larger and unmanageable one threatens everything and everybody.

These two points identify the crossroads and, therefore, choices confront-ing western sovereigns, central bankers, regulators, economists, analysts, investors and the general public. Monetary policy-makers have generally followed the course suggested by the first opinion. But, in growing num-bers, experts are now saying that this has been the wrong course, and they provide as evidence the fact that, in spite of a torrent of money, the banking crisis has become worse – not better (see below).

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In addition, the economic and banking crisis we are going through has demonstrated that, in order to safeguard financial stability, it is essential to establish a global approach to systemic risk. This involves not only the sys-temic relevance of big banks, but also the negative fallout of rapid financial innovations. New financial instruments bring into play risks which escape control because they are poorly understood and, in many cases, involve conflicts of interest between the banks and the sovereign.

Another factor which worsened the crisis was the nationalistic attitudes by all countries in connection with their banks, which made global regulation and supervision impossible. ‘A central lesson of this crisis was the lack of system-wide oversight,’ wrote Mario Draghi in his aforementioned article in the Financial Times. He is right. What is needed is not just a vague sense of ‘coordination’ during tourist happenings like the G-20, but careful watch of:

liquidity risk,credit risk, market risk, andevent risk.

This can only be done by a czar who can put limits on speculation, fine banks, suspend executives and traders, close exchanges, pull financial insti-tutions out of the system and stop central banks from printing an inordinate amount of money. This does not happen even within a nation. Who could do it globally?

Politicians will not allow a powerful global supervisor … until the next megacrisis throws them off the cliff. A 477-page report by the Inspector General of the Securities and Exchange Commission, the American supervi-sor of quoted companies, concluded that there were systematic breakdowns in the agency’s oversight of Bernard Madoff. The SEC first investigated Madoff-related funds in 1992, but took no action before the $65 billion scam was revealed to its full extent. Can it be really hoped that a global bank supervisor would be more efficient worldwide?

Realistically, anyone who believes in global governance is in cloud cuckoo land. A running joke is that Cathy Ashton, the British lady who (theoretically) has been Europe’s foreign minister, told Hillary Clinton she now has a single telephone number to ‘call Europe’. But when the American Secretary of State dialed it, all she got was a recording: ‘For French foreign policy, press 1; For British foreign policy, press 2 …’ National interests come first; the European Union’s interests take second place.

Sovereign risks and contagion effects

Western wealth has been created by enterprising people, from explorers and conquistadores to scientists and industrial tycoons. It is their brains,

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self- discipline, hard work and steady habits that originally made the old continent, then the United States, rich and prosperous.

But, during the last five decades, this wealth has been dissipated, the assets on which it was based replaced by debt, while a State Supermarket elbows out individual initiative – indeed, it punishes it through red tape and high taxation. Entrepreneurs are not assisted in improving their nation’s standard of living; they are deterred from doing their work by the mass of bureaucrats.

The phrases inscribed in the temple of Delphi, in ancient Greece, were calculated to set the mind to work. Know yourself was the first; nothing in excess was the second. Men had to think for themselves, they knew that they should not wait for the government to do it for them. The day an ancient version of the State Supermarket took over, and people wanted to take out of the common purse more than they contributed to it, marked the end of antiquity.

History is repeating itself. After nearly five centuries of western civiliza-tion, the depth of its guiding values (what Goethe called the inner universe) has been under severe, unprecedented threat. The rise of the masses and their indiscipline swept away western values. Men and women no longer think for, and do by, themselves. They expect somebody else to do for them what is first and foremost their responsibility.

Thinking has been cast out, replaced by a free ride, which became the rule of the day. The European Union provides an example. The failure to get euroland going as an integrated economic entity has as much to do with economic and financial nationalism8 as with the lack of discipline and infantile leftism. The few people who make the effort to live better are not seen as saviors but as outcasts.

The political courage to explain that to people is missing. During the first decade of this century, euroland, and the European Union at large, have been anxious to deceive themselves and their citizens. For the countries sharing the common currency, self-deception started in the late 1990s with the downsizing of the Stability and Growth Pact, which underpinned the Maastricht Treaty. By negating the need for economic discipline, euroland’s governments watered down the Pact they had signed till it became mean-ingless. Its clauses were never really fully observed by any of the member states, and the absence of the will to enforce discipline and rules seemed to be what linked every sovereign, till the Greek crisis hit.

Suddenly, euroland started focusing on the risks of Greek bankruptcy. After a great deal of hesitation, the money was put together to offer Greece a loan; but then Ireland, Portugal and Spain came under the limelight and hastily euroland put together a a440 billion ($616 billion) stabilization fund.

Not everybody was convinced this was the best way to face the crisis, or that the money was enough to hold the bursting dams of sovereign debt. On September 29, 2010, Angela Merkel, the German chancellor, criticized the



common fund intended to help struggling but misbehaving debtor nations: ‘We will need other mechanisms for crisis prevention,’ she said, in response to comments that Germany would not back an extension of the fund past 2013 and would, instead, push for changes to euroland rules.9

Merkel’s opinion has been that the Lisbon Treaty, successor to the ill-fated European Union constitution (which had followed the half-baked Maastricht, Amsterdam and Nice treaties), is no longer the club’s permanent rule book. Changes are necessary to create effective means of restructuring the debts of bust countries. The European Commission, however, was not on the same wavelength. Instead, it preferred measures that could be implemented under existing rules, which had proven to be paper tigers, such as:

intensified monitoring of member countries’ budgets,watch over economic imbalances, anda system of escalating warnings and sanctions imposed ‘semi- automatically’ – whatever this is supposed to mean.

It does not take a genius to appreciate that simply ‘reinforcing’ the rules of the failed Stability and Growth Pact, as proposed by the European Commission, is by no means enough. Both euroland and the wider European Union need a crisis resolution mechanism – essentially, an insolvency procedure in all but name – that would involve private lenders and fellow member states sharing in the costs of any debt rescheduling forced on any country in the club.

Absentee rules are the best prescription for sovereign risk, and that’s what we now have. In addition, to watch over discipline, regional economic entities, like the EU, need a transnational supreme authority able to clear and maintain the road to financial stability across-borders, without ‘ifs’, ‘buts’ and vetoes.

This is particularly important, as bad news about sovereign debt spreads like brushfire, impacting on public mood and soliciting investor reaction. Even well-intended decisions can backfire. While boosting spending and cutting taxes by the US government aimed at staving off a sharp recession was applauded amid the gloom of late 2008/early 2009, little more than one year later financial markets put pressure on nearly all governments around the world to rein in their ultra-high deficits and slash their debt levels in a significant way; something most sovereigns are unwilling to do.

Markets are highly concerned about the contagion effect. From Latin America to Asia, there is plenty of evidence on how far local contagion can go. Still, in their effort to avoid being caught in a rotten financial environment, institutional and other investors tend to overlook important distinctions between countries. They group together sovereigns whose solvency problems are proven – from the Asian Tigers in the late 1990s to Argentina and Brazil in the first years of this century.

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The most recent lumping together is in euroland, centering around Club Med and Ireland. Many banks are hugely exposed in Ireland; Lloyds, for instance, is in to the tune of £27 billion ($43 billion).10 This explains why not only euroland’s governments, but also Britain have been coming forward with new money; but it overlooks the fact that Club Med and Ireland are two different cases. It was not the public but the private sector that went haywire in Ireland. The mistake the Irish government made was to provide blanket coverage of the public sector’s (then unknown) deep debts. In contrast, in Club Med countries the misbehavior came largely from the public sector. Weak governments made it easy for the citizens to live way beyond their means.

The difference behind the message in the first and second points above is not at all surprising. As cannot be repeated too often, not only is the EU far from being an integrated economy, it also lacks almost all the charac-teristics needed for fiscal and economic discipline of its members. Far from being the world’s largest economy, the European Union is a collection of 27 small and medium-sized ones with very local agendas. The dictum applies hand-in-glove to euroland, where deficit spending has taken eco-nomic activity and public finances down a path of paralysis; it has reduced the common citizens’ patience as well as business confidence, rather than promoting them.

The only way to stop the profligate euroland members from spending other nation-states’ money is to apply debt brakes with penalties, as Angela Merkel has been demanding. But this is far from achieving unanimous support. The first to object was Italy; then, on February 11, 2011, Greece joined Italy in opposing debt-reduction benchmarks. It needs no explaining that agreements without brakes are like a run-away train – the next thing one hears about is a train crash.

These two points encapsulate not just the after-effect of politics, but also the most likely future of the European Stabilization Mechanism (ESM), the new name given to euroland’s permanent crisis resolution authority. (Contrary to today’s fire brigade approach to save member states from bankruptcy, from July 1, 2013, the ESM will distinguish between liquidity and solvability issues.)

In all likelihood (though nothing is yet sure), in the first instance the ESM may provide liquidity assistance through a loan – enjoying preferred creditor status, junior only to an IMF loan. The private sector creditors would be encouraged to maintain their exposure according to international rules (which is in line with IMF practices). In addition, standardized and identical collective action clauses (CACs) – a strange name – are projected to preserve market liquidity.

The size of the ESM is unknown at the time of writing; it is one of the key issues of the projected March 2011 meeting between euroland’s chiefs of state. What is more or less known is that the ESM will be based on a European Financial Stability Facility (EFSF) type of guarantee to be com-plemented by the European Financial Stabilization Mechanism (EFSM).11



The size of the guarantee remains open at this stage, and will be the subject of future discussions which will show how serious euroland’s politicians are about protecting the euro.

It is probable that Germany would have to increase its financial support for euroland’s bailout fund to facilitate an expansion in its activities, link-ing its consent to other countries’ willingness to adopt tough economic overhauls. That’s right and understandable. Less understandable is the fact that, rather than contemplate reintroducing the drachma, the peseta or the lire, euroland decided to expand and take in Estonia at a time that fiscal discipline is running short in most of euroland, and money committed by the better-off euroland members is not unlimited.

As the current fund aimed at salvaging poorly governed euroland countries gets exhausted, mounting public discontent in Germany will bring further negotiations to a halt. By all evidence, Berlin will not support more bailout money without draconian debt restructuring on bondholders of both banks and sovereigns – leading to unprecedented strains in euroland, probably around 2014.12

Country risk will reach for the stars. Since they are ongoing, the Greek and Irish rescue programs are unlikely to be suspended, though this is a tentative statement, as much will depend on their austerity measures and their leaders’ ability to convince the public that austerity measures must continue. By contrast, other governments in the peripheral countries will default on at least some of their debts, leading to forced debt write-downs with knock-on effects on the balance sheets of banks.

If this course of events materializes, and this is a big ‘if’, then governments in Germany, Britain, France and United States will find themselves obliged, once again, to recapitalize their banks with public money. The after-effects will be another shock of seismic proportions. In all likelihood, the European Union will become ungovernable, and perhaps break up. Global imbalances will widen again, with a wave of protectionism sweeping the globe, while currency and trade wars will become common policy.

Summit will follow summit without any hope of an arrangement to enable the world’s larger economies to absorb future economic shocks. Instead, the results of these summits will be to worsen economic imbalances. The world economy will eventually recover, but slowly and without any significant prospects for global cooperation. Instead, economists will fret about the next global economy and financial crisis.

European banks, American banks and the fight for long-term funding

A question increasingly asked in the years of the recent crisis is whether the banking system in western nations is really fulfilling its economic function. Serious doubts exist because deep red ink has proved to be a permanent



stain, in spite of a lavish amount of public money thrown into the big banks’ coffers. The overleverage of the balance sheets of sovereigns and of large and complex banking groups (LCBGs) is propelling a new bubble. In fact, it is its raw material.

The failure radically to restructure the banking industry in America and in Europe, following its descent to the abyss in 2007–08 will, in all likelihood, have dramatic consequences. It is absolutely the wrong hypothesis, but not an uncommon argument, that euroland’s banks face the ‘manageable’ task of replacing an estimated a1,300 billion ($1,820 billion) of debt finance due to be repaid over the next three to four years. This strange logic about a ‘manageable’ task forgets some important issues:

all LCBGs, whether European or American, will face increasing competi-tion for long-term debt funding,sovereign and corporate issuers are most likely to step up their own borrowing in the markets,concerns about obtaining financing from investors have dogged some euroland banks for months, with many still dependent on funding from the ECB, and the ECB provided at least a809 billion ($1.13 trillion) in loans to banks, against what is arguably very dubious collateral.

Anecdotal evidence suggests that certain banks even fabricated ‘securities specials’ to deposit with the ECB and take good money. Among euroland’s nations this is becoming current practice. Garbage collection has been one of the worst policies by western central banks, starting with the Fed. (As with all analogies, the comparison to plain garbage is not intended to be exact; it is a metaphor useful in understanding how much governments bend over to save the rotten big banks.)

On October 31, 2010, it was revealed that the ECB had extended loans against dubious collateral to Irish banks to the amount of a130 billion ($182 billion). This was a 9.2 per cent increase in one month (on September 30 private Irish banks owed the ECB a119 billion) – and it came over and above the a50 billion ($70 billion) of good money the Irish government had already committed to save them from outright bankruptcy.

Despite the lavish assistance by sovereigns and central banks, as of late 2010 LCBGs from America, Britain and euroland still have to borrow from capital markets to plug the holes created by their trading speculations and by having given more loans than deposits from their customers. In mid-November 2010, it was announced that the Bank of Ireland was in trouble because it had a ratio of loans to deposits of 160 per cent. Such aggressive lending has two effects: first, it worsens the western banks’ indebtedness (more of this later); and, second, it turns on its head prudent lending poli-cies and the traditional ratio of loans to deposits.

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Statistics sometimes contain a bitter irony. Looking at a dozen years of statistical evidence one can see that, since 2005–06, western banks made common currency the practice of excess loans over deposits; in 2008, the year of the high-water mark, the deposits deficits reached nearly $2 trillion. In contrast, emerging market banks had an excess of deposits over loans, with this excess reaching about $2 trillion in 2009.

After having compared these two statistics, it does not take a genius to conclude that a good part of this excess $2 trillion in deposits in developing countries’ banks coffers has found its way into the coffers of western banks. The practice is far from being commendable because it adds to the LCBGs’ debts in the form of bank-to-bank loans, which:

causes significant fragility in the western banking system, pushes western governments towards using taxpayers’ money to ‘save’ misbehaving banks, andprovides evidence that the light which was thought to be the end of the tunnel, in terms of western big banks’ debt, is that of an oncoming train loaded with red ink.

Economists and plenty of financial analysts are also, and most particularly, concerned by the amount of fresh finance that banks are said to need in coming months and years to replace their maturing debt. Many investors prefer to buy the debt of manufacturing companies rather than LCBGs, about whose solvency they grow nervous; and, as private money dries up while public money gets exhausted, the day of reckoning approaches.

The twentieth century’s measures for patching up the relationship between society and the banking industry, particularly after the First Great Depression, have by now lost their appeal. In the early 1930s, banks and governments backed deposit insurance; and, slowly, without any big news, banks managed to enjoy an implicit blanket guarantee of all their liabilities. This allowed them to borrow cheaply, but also it permitted the banking industry to operate with smaller buffers than in the past; the capital and liquidity shortfalls in banks’ treasuries grew by leaps and bounds relative to the economy.13

These huge refinancing needs of the banking industry will, in all likelihood, clash with the increasing supply of government bonds which continues unabated since the outbreak of the crisis. Public sector issues soared and they continue in that path. Moreover, as we will see below, in the coming years, large volumes of sovereign debt will mature and will have to be refinanced, aside of the fact that governments take up additional loans.

‘Competition from governments could quickly and significantly impair banks’ financing conditions, especially if market sentiment were to dim again, causing a shortage of liquidity in bond markets,’ says the Financial Stability Review of the Deutsche Bundesbank.14 The markets may be

••

•



unwilling to finance profligate sovereign borrowing endlessly, and the same is true of financing poorly governed banks.

It comes, therefore, as no surprise that European bank funding remains a perennial concern to sovereigns, regulators and investors – an area where many express disquiet as to whether sovereigns will always find the money to close the gap. The allaying of the market’s fears is not around the corner, as it requires a perception of stability not answered by current conditions.

Western governments have cornered themselves by assuming the role of ‘deep pocket’ financing of nearly bankrupt private banks. By trying to cut back overblown public deficits, they find it increasingly difficult to continue the foolish policy of throwing good money after bad – and this is happening at the worst possible time as banks encounter increasing uncertainty and higher rates in rolling over their debts.

Sovereigns whose finances are dubious are also watching the ascent of yields they must pay for their bonds. On November 23, 2010, Spain was forced to pay big premiums to sell new debt. The government issued a3.26 billion ($4.56 billion) in three-month and six-month bills. Such short-term borrowing is a precursor to a deep crisis at rollover time; the fact that Spain paid yields nearly double those of previous auctions speaks volumes about the growing pains of the sovereign and its banks.

Whether subscribed by banks or sovereigns these are loans and, short of outright bankruptcy, loans have to be repaid. But nobody is able to say from where the money is supposed to come. It is not just the banks of one or two countries in need of steady cash: in terms of bank debt by maturity date, euroland’s banks have an estimated:

$850 billion to repay in 2010, $750 billion in 2011,15 plus rollovers,$700 billion in 2012, plus rollovers, and over $400 billion each year in 2013 and 2014; in addition to this, there are plenty of rollovers from 2010, 2011 and 2012.16

Even without counting the rollovers, these numbers add up to a total of $3.1 trillion.17 With the debt of earlier years rolled over towards 2014–15, it is probable that, by that time, the European LCBGs will confront a huge debt crisis.

Compared with such depressing debt numbers from euroland, American banks are faring better with repayable debts of about $300 billion in 2010, $350 billion per year in 2011 and 2012, and somewhat less than $200 billion per year in 2013 and 2014. Still, this adds up to an impressive $1.4 trillion plus rollovers18 – a Damoclean sword over the head of the American taxpayer.

The figures in red are a little less depressing for British banks, with about $120 billion in 2010, $200 billion per year in 2011 and 2012, but

••••



somewhat below $100 billion per year in 2013 and 2014. In terms of order of magnitude, the sum is $700 billion. Per capita, however, the British tax-payer is more burdened than the American.

American, British and euroland’s banks, taken together, exhibit an eye-watering $5.2 billion in red ink – provided available information is accurate. Debts hidden through derivatives and other means are not included; and they will bring the aforementioned totals much higher (but there is no way of ascertaining by how much at present). If the pessimistic hypothesis pre-vails and there is a double dip, creditors are not likely to extend rollovers for more than three or (a maximum) six months at a time, bringing the day of the Second Great Depression so much closer – probably before 2014. But even with the optimistic hypothesis of slow growth, it is not likely that the economy’s rise will be enough to wipe out that huge debt (most unwisely) accumulated by the banking industry – and the day of reckoning may be 2015 or thereafter.

The rollover risk is a clear and present danger. The shorter the maturity of a debt instrument, the more frequently its issuer has to refinance it and the greater the uncertainty as to whether investors will come forward or go on strike.19 When this happens, financial stability becomes vulnerable to a combination of market illiquidity and greater credit risk.

The former ‘poor’ are better off than the former ‘rich’20

The go-go 1990s ended with a stock market bubble, and the high-flying years between 2004 and 2007 had a much more dismal finish. Both crises started in the USA and spread to Europe. Successive financial aftershocks made it painfully clear that globalization fell on parlous days and that the world’s economy is not in best of health. The banking system itself is in dire need of new international rules able to impose lending and trading discipline and guard against any temptation to re-establish weak regulatory regimes. Financial institutions, particularly the global ones, have become too big and too complex. The same is true of some megastates, their problems being compounded by low-quality political leadership. As a result, economic policies adopted by western nations are wanting, and the center of gravity shifts towards the emerging economies.

This is happening faster than expected, and it will continue that way because there is no reason to foresee a rapid change towards healthier economic and monetary policies in the big and powerful industrial nations. The reasons go beyond failure to restructure their economies and drastically reduce their national debt. If, however, a high debt to gross domestic product ratio is taken as criterion of poor economic management, then:

the worst of all is Zimbabwe, with 304 per cent,next comes Japan, with 204 per cent,

••



Iceland, with 146 per cent,Jamaica, with 132 per cent,Italy and Greece, each with about 130 per cent,United States, nearly 110 per cent, if federal, state and local government borrowing is included,21

Belgium, with 108 per cent, and Sudan, with 105 per cent.

This classification changes if only external debt to GEP is taken into account. Worst of all is Ireland, with an astonishingly high multiple, followed by Britain. Jamaica, which was fourth in the public debt list, is 18th in this one, while the United States is 19th.22 This persistently poor rating is, indeed, surprising.

If uncontrollable current account balances are taken as a third criterion of poor economic management, then the pack is led by the United States, with a negative balance of over $300 billion (according to a projection regarding the end of 2010 included in an IMF forecast).23 The USA is followed by the European countries (excluding Germany), with a negative balance of about $200 billion.

To the contrary, positive current account balances are evidence that somebody is in charge. For 2010, the IMF forecasts that Asia (excluding Japan), will have a current account surplus of $80 billion, Japan $100 bil-lion, Germany nearly $120 billion, oil exporting countries $120 billion and China $450 billion.

These statistics (and projections) demonstrate, as far as economic discipline and a rising standard of living are concerned, that the formerly ‘poor’ nations are in a much happier position than the formerly ‘rich’. This is further confirmed by forecasts about sovereign stress in refinancing maturing debt as a percentage of GDP. In order of magnitude, October 2010 to December 2011:24

Japan heads the list with an astonishing 25 per cent of GDP,Italy follows, with 19 per cent,the United States is next, with 18 per cent,France, with 15 per cent,Spain, with 12 per cent, andBritain, with 8 per cent.

The magnitude of the foregoing figures makes sad reading, as they identify the sorry state of western sovereigns; they compare poorly with many of the smaller, less developed countries, like Jamaica.25 Over and above that comes the leveraging by households and the banking industry (see above). On November 15, 2010, information on Bloomberg News revealed that the general leverage ratio in the West keeps on rising. American homeowners,

••••

••

••••••



for instance, are now geared up four times (400 per cent); and a gearing of 30 (3,000 per cent) is said to characterize the banking industry.

Theoretically, but only theoretically, US households continue to deleverage. A quarterly report on the state of household balance sheets released in early November 2010 by the New York Fed shows that households continue the slow process of amending their balance sheet. Since the peak, consumers have reduced their debt burden by an estimated $922 billion. This sounds like good news, except that a big part of that decline in outstanding debt reflects defaults and charge-offs – not repayments.26 To appreciate what this means for households, the banks which extended loans and the sov-ereign, the reader should know that residential mortgages make up about 80 per cent of total US consumer debt. Hence, a surge in foreclosures implies a decline in debt figures. It is, nevertheless, also true that consumers have become more frugal and less comfortable with debt.

While the reduction in consumer debt is evidently most welcome, when foreclosures are taken into the picture for the economy as a whole it is a mixed blessing. Foreclosures hit bank balance sheets like a hammer. According to available statistics, between 2007 and the fourth quarter of 2010, bank foreclosures and loss provisions stood at the level of:

$880 billion in the USA,$620 billion in euroland,$430 billion in Britain, anda ‘tiny’ $120 billion in Asia.

This is how far we know matters to be in the red. Far more opaque is the exposure in derivatives, not only by banks but also by sovereigns, municipalities, all sorts of companies, hedge funds, pensions funds, insurance companies and other investors. Derivatives are by no means a zero-sum game – as the cancellation of marking-to-market by the Obama Administration has demonstrated.27

A logical conclusion of all these important financial references is that the economic and social situation in nearly all western countries is in very bad shape. Worse yet is the fact that their citizens are dissatisfied with their standard of living. They want even more, and this at a time when more means getting deeper into debt. Such an attitude contrasts dramatically to that of citizens in less developed economies. As the 2009 Pew Global Attitudes Project documents, 94 per cent of Indians, 87 per cent of Brazilians and 85 per cent of Chinese say that they are satisfied with their lives. These are exceptionally large majorities. By contrast, the happiness barometer is very low in the West, as people have been spoiled into believing they can take more and more out of the common purse without negative after-effects.

Part, but only part, of the difference in attitude is due to the fact the formerly rich economies in the north are going south, while several economies in the

••••



formerly poor south and east are moving north. A growing number of emerg-ing countries are enjoying the most outstanding growth in recent history. At purchasing power parity (PPP), the share of global GDP of what was once called the ‘Third World’ has increased in a spectacular way: from 36 per cent in 1980, it is now approaching 50 per cent.

It should be appreciated that, in a way emulating the rapid rise of the American economy in late nineteenth and early twentieth centuries, this wealth comes from the real economy, not from financial alchemy and its seismography. In the course of the last three decades, America, Europe and Japan have been anxious to deceive themselves while moving from real to virtual wealth. It looks as if they are not far from reaching that goal.

Financial seismology and the slow-motion train wreck

Marcus Aurelius, the Roman emperor, said: ‘Remember this – that very little is needed to make a happy life.’ His words should be written in block let-ters at the entrance of all schools. Lulled by a standard of living which kept on rising in the post-World War II years, European and American citizens (including those with university education) don’t appreciate that the second word in the term ‘virtual wealth’ is a fake, because it is based on imaginary money.

This imaginary money, largely based on debt, haunts the western econo-mies. Some economists (not yet a majority) believe that the financial earth-quake is still to come, and that we have experienced since 2007 are tremors announcing the event of a lifetime. According to their judgment, the worst of the ongoing crisis is still ahead of us, along with many other problems: nearly $3 trillion of commercial mortgages fall due in the next five years28 and another $1.5 trillion of leveraged finance debt is also in the pipeline, peaking in 2014.

The world is not new to such events. America’s and Europe’s political, economic and social history has experienced many financial earthquakes, including the First Great Depression of 1929–30s. But as Dean Acheson, Secretary of State in the Truman Administration, said, capitalism will not survive another great depression.

The USA will be hit the hardest because its pattern of contractual debt maturities is front-end loaded with residential and commercial real estate; as well as back-end loaded with leveraged financial debt. As Pete Dominici, the former Republican senator and co-author (with Alice Rivlin) of a recent deficit reduction proposal, stated in regard to the ballooning public deficit: ‘America is on the threshold of potential economic devastation.’29

This does not mean that other western countries have been able to posi-tion themselves any better against the coming economic and financial earthquake. As the reader has seen repeated on many occasions in this text, in the course of the past few decades all over the western world government



debt has risen sharply, in absolute terms and relative to each country’s gross domestic product.

Since misery never travels alone, over the same period the net assets of sovereigns have been progressively depleted, turning national balance sheets upside-down. Liquid assets – that is, assets that mature within the next three months – have dried up (save for tax receipts), while medium to longer-term assets are not presented at fair value. This is as true of governments as it is of companies. One of the forces propelling this coming deeper crisis is that banks continue borrowing short to lend long – just like they did in the go-go years of this century against property that turned out to be vastly overvalued.

As an example, Portugal’s Santander Totto has a loan to deposits ratio of 203 per cent (!) and Banco Espirito Santo (BES) of 171 per cent.30 Yet, BES had the impertinence to fire Fitch, when the rating agency downgraded its credit because of its overexposure (Chapter 10).

The banks’ financial reporting is not above suspicion. Whether the alchemy of cooking the books comes from big banks or from sovereigns, the result is an exercise in creative accounting, often of a magnitude that leads to financial seismology. The reasons have become self-evident thanks to the events which took place between 2007 and 2011. Western governments generally expect the debt ratio to continue climbing, reaching a record high in peace-time. The banks know that they hold many unpleasant surprises – the very sort their massive refinancing aimed at preventing – and sovereigns are suspicious that this is the case.

Since 2008, additional strains placed on public finances by rising debt have been obscured by sharp declines in interest rates. But while nearly-zero rates continue, against all economic logic, they cannot go on indefinitely. Hence, sometime in the future, most likely between 2013 and 2015, with 2014 at the seismological epicenter, the bubble fed by zero interest rates will burst.

Economists worried about ongoing trends do not have the answers: they point out that, given the continuous rise in public debt, a rise in interest rates would lead relatively quickly to budgetary burdens amounting to bil-lions of dollars, euros and pounds. This vicious circle is fed by continuing budget deficits and the interest sovereigns have to pay. In 2000, just a dec-ade ago, the USA devoted less than 1.9 per cent of GDP to paying interest on public debt. If current spending policies continue, by 2035 this share will become about 8.7 per cent of GDP31 – a 460 per cent increase.

The interconnection between industry sectors also weighs on the ongoing crisis. American, European and Japanese insurers are major institutional investors. Life companies hold between 10 per cent and 14 per cent of total equities outstanding in their respective markets, as well as between 8 per cent and 17 per cent of outstanding bonds.32

American life insurers are at the high end of this range, owning 17 per cent of outstanding corporate bonds, many of them at relatively low interest



rates. What will be the results of a sudden inflation on the insurers’ bond portfolios, or of company bankruptcies on the solvency of life insurers?

This issue of solvency also concerns new financial instruments. Today, exchange traded funds (ETFs) are an $800 billion market (some say $1.2 trillion). The vast majority of EFTs are floated by private companies and an estimated 10 per cent are uncovered (according to other accounts, 30 per cent or more are uncovered). What will be the result of a deep finan-cial earthquake:

on the EFT’s survival?on investor confidence? on the EFT market at large?

Similar questions can be asked about sovereign defaults. The markets are not impressed by theatrical shows of solidarity. They want decisions and facts. In connection with the loan to Greece, for instance, it made no sense whatsoever for Ireland, with over a400 billion ($560 billion) in debts, to make a loan to Greece, which also has debts of over a300 billion ($420 billion). Then Greece, whose finances are held together with sticking plaster, is asked to make a loan to Ireland.

The same is true of other euroland member states known to be no better off. According to an article in the Financial Times: ‘Some 53 per cent of those polled in France think it is likely that their government will be unable to meet its financial commitments within 10 years … Just 27 per cent said it was unlikely.’33 Nouriel Roubini, of New York University, had this to say on that issue: ‘In certain essential aspects, France does not seem to be in better condition than [euroland’s] periphery.’34

As if to prove Roubini right, on November 24, 2010, the French senate’s Finance Commission approved an urgent credit of a930 million destined to pay the salaries of public employees in eight ministries including Defense, Interior, Education and the Budget (the approved deficit financing was a1.39 billion, of which a930 million would be used for personnel expenses). At the same time, the Commission expressed its doubt that the government was making the necessary effort to control salary expenditures for public servants.35

As these references illustrate, the economic and financial crisis has turned into a crisis of confidence, providing abundant evidence of the advantages of a moderate government debt level. One of the reasons why the West finds it difficult to confront its present and future challenges effectively is that its models are obsolete. The paradigms being used, and the solutions cast after them, are made for an age that has definitely passed.

Critics say that most work in macroeconomics over the past five decades has been useless at best, and harmful when employed under current conditions. A case in point is the so-called ‘efficient market theory’ (EMT).

•••



Economic nationalism, too, comes into the cocktail of twisted policies followed by sovereigns – and it needs no explaining that economic recovery and nationalism don’t mix well.

Short of providing any solutions capable of turning the economy upwards, political leaders have found the G-20 summits to be a way to let off steam. But as President Coolidge put it when his advisors promoted the merits of civil aviation: ‘What’s the use of getting there quicker if you haven’t got something better to say when you arrive?’36


252

Epilog

From research to writing, editing, typesetting, printing and distribution, a book takes about a year until it becomes available to its readers. But, as my editor Keith Povey aptly points out, developments are in train all the time. In some cases, nasty facts demolish a thesis, while in others they further document and sustain it. This is sup-ported by the statement made in Chapter 12 that the worse is still ahead of us, and that it will really become much more significant around 2014. Beyond what has been already written about rollovers of huge debts, four recent facts support this estimate:

1. interruption of manufacturing chains in Japan affecting European and American auto and other companies, in addition to the devastation of the tsunami and after-effects on nuclear technology from Fukushima;

2. destabilization of the Middle East and North Africa by an ill-advised US/French intervention,1 and political upheavals which brought the barrel of Brent to $126, and from there, most likely, to a new all-time high;

3. the ‘salvage’ of profligate Portugal – which wants to take the money without assuming any obligations – adding itself to the downfall of Greece and Ireland; plus an uncertain future for Spain and Italy with the potential of destabilizing euroland and the euro; and

4. above all, the revelation that the fiscal gap of America stands at a mind-boggling $202 trillion, or 15 times the country’s GDP – and not the $10 trillion or so the Obama Administration wants people to believe. This makes the US just as bank-rupt as Ireland, Greece and Portugal.

If radiation pollution from the Fukushima Dai-Ichi reactors remains regionally lim-ited, then the political and technological fallout will not be that great. This is, how-ever, a big if. In addition, the earthquake and tsunami caused not only a terrible loss of life and serious physical destruction, but also had global industrial ramifications. The affected areas accounted for about 7 per cent of Japanese GDP, but several local companies had prominent positions in the global market. As a result of the devasta-tion, critical just-in-time supply chains relying on Japanese imports are disrupted.2

In regard to the second issue, estimates of the effects from political instability in the Middle East and Africa on supply-related oil price increases vary. So far, there is no disruption to output from the major oil producers which have capacity to make up lost output from Libya. But dramatic political events are still unfolding, and the longer they last the faster the oil price hike will be and the longer it may stay.

The way a recent Bank of America Merrill Lynch study had it, research from its commodity team suggests that oil prices will compromise growth if they remain at $115 per barrel or above this year. Their argument is that $115/bbl would take the total energy bill to 9 per cent of US GDP, a level that has previously preceded a downturn in global growth.3 Sheik Yamani, the best authority on oil and oil pricing, recently stated that, if the Saudi royal family is destabilized oil will hit between $200 and $300 per barrel.4 This will bring the Second Great Depression to 2011–12 rather than 2014, as Chapter 12 suggested.

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Epilog 253

The US/French most unfortunate North African ‘initiative’, with implications for world stability, has come at the most inopportune moment. Apart from the curious twist of the United Nations changing from pacifier to aggressor, countries still strug-gling to recover from the financial meltdown which has followed the economic and banking crisis are put at risk from oil price spikes.

Among western countries on the sick list, Spain, Portugal, Ireland and Greece will suffer significant current account deterioration from rising oil prices – and so will the USA. Since an extraordinary increase in financial aid to euroland’s periphery is not on the cards, at best the option would be debt restructuring, and at worse outright default – which may also carry several big banks down to the abyss.

According to The Financial Times, the European big banks have a $2 trillion expo-sure to the sovereign debt of Euroland’s periphery. The IMF estimates indicate that this is roughly 10 per cent of Europe’s GDP and 80 per cent of European banks’ capi-tal. ‘It is ironic how little public discussion there has been of the ECB’s gargantuan rediscount operations to the periphery’, says a Financial Times commentary.5

As these paragraphs document, there are plenty of things to worry about, but the worst is still to come. At a conference for financial intermediaries recently organized by Wegelin & Co., the oldest Swiss private bank, Laurence Kotlikoff, an economist who teaches at Boston, calculated the US fiscal gap6 at $202 trillion7 – making the Obama Administration’s $10 trillion of explicit US debt an arbitrary figure.

An unprecedented amount of public money has been thrown to the four winds by two successive Administrations. To the words of Simon Johnson and James Kwak, the Troubled Assets Relief Program (TARP) – just one of the US government’s spending sprees – which was aimed at handovers to banks too big to be saved – had a price tag of $23.7 trillion, or nearly 170 per cent of American GDP. That mouthful of trillions was estimated by the special inspector general for TARP.8

No wonder that the self-harmed global big banks ‘emerged larger, more profit-able and even more powerful,’ morphing into the new oligarchy of America – as Johnson and Kwak describe them. As they aptly add: ‘Failure should be punished, not rewarded.’9 Punishment has not been the case with the wrong-doers of the ongoing crisis, even if reward and punishment is the way capitalism is supposed to work.

The American people expected their president to lead. By copying the (wrong) poli-cies of Bush Jr and his companions, Barack ‘Soft Wax’10 Obama and his Administration have failed the leadership test. In foreign policy, too, they have made the wrong moves, like continuing the losing war in Afghanistan, supporting the upheavals which overrun the regimes in Egypt and Tunis, and attacking Libya. This is the third Moslem country bombarded by the West in a decade – a number of the worst planned and executed military operations in history.

Ineptness has also characterized domestic policy, through the inability to put priori-ties right, and get rid of huge budget deficits and current account deficits. Continuing to spend beyond one’s means leads straight to disaster. In a Charlie Rose interview11 on April 8, 2011, Martin Wolf, the economist, was not optimistic: ‘We don’t know what the US will look like in five years from now’, he said. ‘Where is the US going?’ The questions Wolf asks are true for the whole world:

What will the world look like in five or so years from now?Where is the world going, and is there a global road map? If so, who made it, and who believes in it?

•••


254 Epilog

Within the US jurisdiction, the same question can be asked about the Federal Reserve. Where is it going with its printing presses working overtime? According to Bill Gross of Pimco, 30 per cent of the ongoing huge supply of US Treasuries is bought by for-eigners, and 70 per cent by the Fed. No American investors come forward to buy their government’s debt. ‘Who will buy our Treasury bonds?’, Gross asks (when QE2 runs dry). It’s a question of profound consequences.

Martin Wolf’s opinion about the European Union was also negative. As he pointed out, Britain is confronted by a huge deficit and there is a very divided Europe. ‘At one side are Germany, Austria, the Netherlands, Finland,’ Wolf said, ‘and in the other Greece, Ireland, Portugal. These are small economies, and much depends on where Spain goes and after Spain Italy.’ There is no experience of an economic union split the way euroland is – between the productive and thrifty on one side and the profli-gate on the other, both living under the same roof.

A house divided cannot stand (Abraham Lincoln once told his audience). That’s the drama of the West today.


255

Notes

1 The World’s New Normal Economic System 1. Over 95 per cent of American gross domestic product (GDP) growth is made up

of household consumption and government spending (statistics from the Federal Reserve Board of St Louis).

2. Some 75 per cent of Goldman Sachs’ profits come from trading. 3. Liaquat Ahamed, Lords of Finance, Windmill, London, 2010. 4. Which makes me wonder why none of the Marxists, socialists and greens today

ever advised his or her followers that they should live within their means, save and avoid debt – so as not to starve in the future.

5. In Engels’ time, this reference to overcrowded, unhealthy cities referred to the then rapidly industrializing Britain. Today, the population explosion has alt-ered the geography, with the result that in Asia, Africa and Latin America the wave of unhealthy and overcrowded megacities hits the local residents with a vengeance.

6. Financial Times, August 13, 2010. 7. Their major banks were deeply involved in the Greek economy (the cause) and

they would have lost billions if Greece defaulted (the effect). 8. Pimco is the biggest bond manager in the world, handling $850 billion on behalf

of institutional investors (pension funds, insurance companies, universities) and other clients.

9. In his late July 2010 biannual report to Congress. ‘Unusually uncertain’ were his two words, which shook economists, bankers and analysts.

10. Named after David Ricardo (1772–1823), the British economist.11. That was not only true of the punitive German reparation, but also of the inter-

locking wartime loans.12. France spent $30 billion in the World War I effort. Apart from the US loan, France

also had debts to Britain to the tune of $3 billion.13. Ahamed, Lords of Finance.14. David Marsh, The Bundesbank, Mandarin/Heinemann, London, 1992.15. Both the old and new marks continued falling for a few days, but then the rate

stabilized and the exchange of Rentenmark to the dollar reverted to 4.2.16. The same is true of the World War II years, while the force behind the current new

normal is mainly economics and financial.17. Though it may be in Zimbabwe.18. ‘Experiment’ in the sense that there is no evidence it had been done, as such,

before or after Tiberius saved the Roman Empire from financial collapse.19. William D. Cohan, The Last Tycoons, Doubleday, New York, 2007.20. Ahamed, Lords of Finance. The Dawes Commission’s role has been instrumental

in pulling Europe out of the quagmire. In a way, it can be seen (a quarter of a century earlier) as a mini-Marshall Plan.

21. What became known as the Dawes Plan was a loan of $200 million to Germany, to be raised in the international market and with a triple goal: to recapitalize the Reichsbank, build up reserves to get the domestic economy moving again and assist in paying a first year of reparations.

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256 Notes

22. D. N. Chorafas, Chaos Theory in the Financial Markets, Probus, Chicago, 1994.23. A term describing in colourful language those who destroyed the American

economy, borrowed from Lawrence G. McDonald and Patric Robinson, A Colossal Failure of Common Sense, Crown Business, New York, 2009.

2 The Newly Poor 1. Eighteen plus hours a day, seven days a week, if necessary. 2. Time should be made to adapt to the work to be accomplished, not the work to

the time available. 3. Outwitting business rivals expecting or anticipating decisions, as well as stopping

staff from getting slack. 4. Robina Lund, Getty, M&J Hobbs/Michael Joseph, London, 1977. 5. Ibid. 6. Ethical bankruptcy and economic bankruptcy correlate. 7. D. N. Chorafas, The Business of Europe is Politics, Gower, London, 2010. 8. Not the ‘right’. 9. USA, Britain, France, Germany, Italy, Canada and Japan.10. The condition of pensions’ financing is no better in the USA. The University of

Rochester estimates that the states’ pension shortfall may be $3.4 trillion and that of municipalities $574 billion (The Economist, October 16, 2010).

11. According to an interview given on October 25, 2010 by Christine Lagarde, French Minister of Finance and the Economy. In 2010, the public deficit of France was in excess of 9 per cent of GDP.

12. D. N. Chorafas, Systems and Simulation, Academic Press, New York, 1965; D. N. Chorafas, Chaos Theory in the Financial Markets, Probus, Chicago, 1994; and D. N. Chorafas, Rocket Scientists in Banking, Lafferty, London and Dublin, 1995.

13. An IMF estimate made in mid-2010 and publicly broadcast in financial news.14. As estimated by some financial analysts.15. A bond is a relatively longer-term promissory note issued by a company or a

sovereign.16. The Economist, September 25, 2010. 17. D. N. Chorafas, Financial Boom and Gloom: The Credit and Banking Crisis of

2007–2009 and Beyond, Palgrave Macmillan, Basingstoke, 2009.18. This is a misnomer because, though one of the liberals in the British Treasury,

Keynes was never an economist preaching big spending by the state. ‘What an extraordinary episode in the economic progress of man that age was which came to an end in August 1914,’ he wrote in his famous book The Economic Consequences of the Peace, Macmillan, London, 1919, pp. 10–12.

19. Le Canard Enchainé, June 30, 2010. 20. Bloomberg Financial Service, July 7, 2010.21. The Economist, July 3, 2010.22. Tony Blair was a master of IBG/YBG, with his 2050 unprecedented CO2 reduction

goals and light-hearted ‘commitments.’23. After me the flood.24. The term ‘Club Med’ has been extensively used by economists and the press to

identify euroland’s peripheral countries on the Mediterranean shore. It should not be confused with ‘Club Med’ which is also widely used as abbreviation of Club Méditerranée.

25. Chorafas, Financial Boom and Gloom. 26. A problem which also haunts the other G-20 members.


Notes 257

27. Chorafas, Financial Boom and Gloom. 28. Bankrupt, but still there.29. In France, even people on welfare go on strike, if you can imagine that.30. European Central Bank, Monthly Bulletin, June 2010. This statement is valid for

euroland, but the figures in other democratic countries are not too different.31. The Economist, June 12, 2010. 32. The Economist, October 2, 2010.33. Quote from a televised interview with Soros.34. ECB Monthly Bulletin, September 2009.35. The Economist, June 26, 2010.36. A non-partisan research group. 37. The Economist, June 19, 2010. 38. International Herald Tribune, February 1, 2010.

3 The Salient Problem is Rights Without Responsibilities 1. D. N. Chorafas, The Management of Bond Investments and Trading of Debt,

Butterworth-Heinemann, London, 2005. 2. Senator Carter Glass was Treasury Secretary in the Wilson Administration, and he

knew first hand how and how much banks speculate with depositors’ money. 3. Lawrence G. McDonald and Patrick Robinson, A Colossal Failure of Common Sense,

Crown Business, New York, 2009. 4. D. N. Chorafas, Financial Boom and Gloom: The Credit and Banking Crisis of

2007–2009 and Beyond, Palgrave Macmillan, Basingstoke, 2009. 5. D. N. Chorafas, Economic Capital Allocation with Basle II: Cost and Benefit Analysis,

Butterworth-Heinemann, London and Boston, 2004. 6. He did so as if intending to leave a template with his name on the greatest finan-

cial catastrophe to hit the United States after World War II: the Second Great Depression of 2007.

7. Which was followed by the ‘Bernanke put’. 8. Amoral does not mean immoral. Science has no ‘morals’ the way Homo sapiens

communities perceive them. 9. This quotation was printed in Frankfurter Allgemeine Zeitung, Monday, May 10,

2010. 10. Ben Bernanke, too, is (in)famous for having stated in a lecture to Wall Street fat

cats (in his bid to become Fed chairman): ‘You do what you have to do and we in the Fed will do what it takes [presumably to repair the damage].’ We have seen the results.

11. ‘Papiers à tous’ (domicile for everybody), according to a banner by illegal immi-grants parading in Paris to pressure the government for legalization, along the lines of Spain.

12. According to The New York Times, there is, in Greece, a list of over 580 jobs legally defined as ‘hazardous professions’, in which women were entitled to retire at 50 and men at 55. The ‘hazardous professions’ include ladies’ hairdressers, because they use chemicals; and the brass section of the orchestra, because too much noise can give one reflux.

13. Greece has led the way in this. Not to be left behind, however, other State Supermarkets also feature similar goodies. In Germany, it is called Weihnachtsgeld, though it does not amount to a whole 13th month.

14. Financial Times, September 22, 2010.15. The Economist, August 14, 2010.


258 Notes

16. D. N. Chorafas, The Social Cost of Business: Education and Employment in the European Union, Gower, London, 2011.

17. Ibid.18. Young and old who, in September and October 2010, paraded noisily in the

streets of Paris and other French towns against raising the retirement age from 60 to 62, were asking (through loudspeakers) to ‘spare the last few years of their lives.’ These ‘last few years’ happen to be two and a half decades long – which speaks volumes of the way people lie about their entitlements.

19. The Times, September 20, 2010.20. D. N. Chorafas, Alternative Investments and the Mismanagement of Risk, Palgrave

Macmillan, Basingstoke, 2003.21. Concentration of exposure is evidence of their mismanagement.22. Per head, the situation is worse for British citizens, who need to save an average a12,300 a year extra (Financial Times, September 22, 2010).

23. Today, in western countries, children are not inclined to take care of their parents in the way they did prior to World War II.

24. The Economist, October 9, 2010. 25. Investment Commentary No. 270, Wegelin & Co, St Gallen, Switzerland.26. Sam Walton, Made in America: My Story, Bantam, New York, 1993.27. John T. Tarbant, Drucker, Warner, New York, 1976.28. The Fed stated that it would buy Treasury debt using more than $150 billion of

maturing mortgages. This contributed to the equities tremor.29. Financial Times, July 28, 2010.30. Ibid.31. McDonald and Robinson, A Colossal Failure of Common Sense.32. Bloomberg Financial News, August 16, 2010.

4 Japanification 1. Bank of America Merrill Lynch, The RIC Report, August 10, 2010. 2. In the 1990s in Japan, banks contributed to weaknesses by rolling over the debts

of inefficient firms. 3. Sound familiar? 4. Repealed by Bill Clinton, under pressure from the big banks’ lobbies. 5. Lawrence G. McDonald and Patrick Robinson, A Colossal Failure of Common Sense,

Crown Business, New York, 2009. 6. Liaquat Ahamed, Lords of Finance, Windmill, London, 2010. 7. Shortly thereafter, Summers, too, left to return to Harvard. 8. So far, however, the yen holds the upper ground in spite of the efforts by the Bank

of Japan to lower its value. 9. The Economist, April 10, 2010.10. In the USA, the Congressional Budget Office (CBO) calculates that entitlement

spending will grow to 20 per cent of GDP in 2025.11. Financial Times, June 26/7, 2010.12. International Herald Tribune, November 23, 2009 (emphasis added).13. De Gaulle’s words were: ‘He [Pétain] thought too much of the French and not

enough of France.’14. The European Central Bank (ECB) puts household debt in euroland at 95.4 per cent

of gross disposable income versus 124 per cent for the USA. But the household sav-ings rate, which had risen from 13.6 per cent pre-Lehman to 15.7 per cent at the trough of the recession in the second quarter of 2009, fell back.


Notes 259

15. Financial Times, August 28/9, 2010. 16. Which took place at end of August 2010.17. Especially if the outlook were to deteriorate significantly.18. Bloomberg Financial News, August 27, 2010. 19. Financial Times, August 28/9, 2010.20. Both were preceded in short interval by Uncle Sam’s takeover of Fannie Mae and

Freddie Mac, the government-sponsored mortgage banks.21. Financial Times, February 10, 2011. 22. Particularly Société Générale and Crédit Agricole.23. French banks held about $75 billion in public and private sector Greek debt.

German banks were the second-highest exposure to Greek borrowers, about $45 billion (International Herald Tribune, May 6, 2010).

24. Financial Times, May 6, 2010.25. Merrill Lynch, which was bigger than Bear but smaller than Lehman, was saved

at the 11th hour by merging with Bank of America, allegedly assisted by the US Treasury and Federal Reserve.

26. Bloomberg Financial, August 30, 2010.27. Editorial by Giles Keating, Crédit Suisse, Research Monthly, October 2010.

5 Conventional and Unconventional Weapons in a Central Bank’s Arsenal

1. D. N. Chorafas, Chaos Theory in the Financial Markets, Probus, Chicago, 1994. 2. The Economist, November 14, 2009. 3. D. N. Chorafas, Risk Pricing, Harriman House, London, 2010. 4. See also the final section of this chapter on living wills. 5. Basel Committee, ‘Report and Recommendations of the Cross-Border Bank

Resolution Group’, BIS, Basel, March 2019. 6. As well as banks, which, through their lending and trading, affect the way an

economy operates. 7. ECB, Monthly Bulletin, December 2009. 8. Which draws the relationship between shorter and longer interest rates. 9. This is the money supply (MS), which in simplified terms can be expressed as the

product of monetary base (MB, how much money is printed and coined) and velocity of circulation (v): MS = v x MB.

10. International Herald Tribune, September 30, 2010. 11. It has been a deliberate choice to avoid discussion about core inflation and head-

line inflation, as the question of which is the better indicator is a subject outside the scope of this book.

12. Liaquat Ahamed, Lords of Finance, Windmill, London, 2010.13. D. N. Chorafas, Financial Boom and Gloom: The Credit and Banking Crisis of

2007–2009 and Beyond, Palgrave Macmillan, Basingstoke, 2009.14. Henry Kaufman, On Money and Markets, McGraw-Hill, New York, 2000.15. As the Bear Stearns and Lehman Brothers cases have shown, among many others.16. William Greider, Secrets of the Temple, Touchtone/Simon & Schuster, New York,

1987.17. In fact, David Miles, a member of Bank of England’s rate-setting committee,

said in September 2010 that quantitative easing was having an impact not just in financial markets in London, but also in high streets, factories and homes throughout Britain.

18. The Economist, October 17, 2009.


260 Notes

19. Ibid.20. In Ireland, the Anglo-Irish Bank, which was overexposed in derivatives for years

and had been chronically sick, was fed time and again with public money. According to financial news in September 2010, the Irish government’s throwing of good money after bad money led to a taxpayers’ revolt.

21. The Economist, October 16, 2010. 22. In the early 1990s, Securum took over the ‘bad assets’ of Nordbanken. These were

loans and holdings whose intrinsic value, however, was relatively high compared with today’s useless toxic waste in the banks’ vaults.

23. Chorafas, Financial Boom and Gloom. 24. In proprietary trading, banks bet on their own accounts rather than those of their

clients. Hence, they expose the common citizen’s deposits to major risks.25. There is already a 10 per cent cap on national market share in deposits in

the USA.26. Rather than proprietary trading, it was the investment in a $23.6 billion leveraged

takeover of property group Archstone that significantly contributed to Lehman Brothers’ bankruptcy.

27. Basel Committee, ‘Report and Recommendations of the Cross-Border Bank Resolution Group’, BIS, Basel, March 2010.

28. This could, but will not necessarily, amount to a stealthy reinstitution of the Glass–Steagall Act, which separated American commercial and investment banks.

6 Fiscal Policies, Spending Policies and Conflicting Aims 1. D. N. Chorafas, An Introduction to Derivative Financial Instruments, McGraw-Hill,

New York, 2008. 2. Especially if the main result is to repay cross-border disputes, like the one ongo-

ing between Iceland, Britain and the Netherlands over the bill for compensating depositors in Icelandic banks, which Iceland’s government unwisely assumed.

3. The Economist, February 13, 2010. 4. It had also happened in America in 1937 and Japan in 1997. 5. Other western countries, too, experienced a decline in their 2011 GDP growth

expectations. The only exception has been Germany, where projected 2011 growth went from 1.5 per cent to 1.9 per cent.

6. European Central Bank, Monthly Bulletin, September 2010. 7. Bank of America – Merrill Lynch, Economic Analysis, June 8, 2010. 8. The Economist, April 10, 2010. 9. The Economist, March 6, 2010. 10. Harold James, The Creation and Destruction of Value, Harvard University Press,

Cambridge, 2009.11. Liaquat Ahamed, Lords of Finance, Windmill, London, 2010.12. BIS, 74th Annual Report, Basel, June 29, 2009.13. The Economist, August 21, 2010. 14. Deutsche Bundesbank, Monthly Report, July 2010. 15. Such as the Swiss franc, which offered lower interest rates than local currency debt.16. The Economist, August 28, 2010. 17. As should be remembered, credit ratings have failed miserably with securitized

subprimes and the creditworthiness of some big banks, their SIVs and securitized junk.


Notes 261

18. Whose reference I have lost, but the memory remains.19. The Economist, February 27, 2010.20. The pros say that the £12 million ($19 million) settlement Hayward is likely to

receive from BP pales in comparison with those negotiated by his industry peers on the other side of the Atlantic. This is a very poor argument indeed.


7 Restructuring Sovereign Balance Sheets 1. Generally, a large government debt is in excess of a threshold situated between

77 per cent and 90 per cent of GDP, and has a negative effect on growth. The Stability and Growth Pact targeted a debt to GDP ratio of 60.

2. Balance sheets putting to one side the money needed for servicing of debt. 3. Financial Times, February 15, 2010. 4. Reportedly, these different ‘plans’ have been the subject of abuse – as evidenced

by the fact that, in 2009, the Recovery Accountability and Transparency Board (RATB), a US government body, began using network analysis software to look for fraud.

5. Which explains why the public is rather unsympathetic to measures taken to control budgetary deficits.

6. The Economist, July 24, 2010. 7. First, come the political friends. 8. The Economist, July 24, 2010. 9. Though mid-2010, policy-makers worked on the assumption that the greatest

danger is deflation, not a rise in prices.10. D. N. Chorafas, Globalization’s Limits: Conflicting National Interests in Trade and

Finance, Gower, London, 2009.11. The president’s salary, too, was cut by 20 per cent, while wages of lower-level

officials and other state employees were trimmed by 6 per cent.12. Investment Commentary No. 271, June 28, 2010 Wegelin & Co., St Gallen,

Switzerland.13. Merrill Lynch Wealth Management, Issue 151, August 2, 2010.14. BIS, 80th Annual Report, Basel 2010.15. European Central Bank, Monthly Bulletin, July 2010. 16. With the crisis, this 360 per cent high-water mark (for the time being) retreated

somewhat, but nobody can say if bending the debt curve is permanent or only temporary.

17. Prior to this appointment, Orszag was head of the Congressional Budget Office (CBO).

18. Larry Summers also quit the Obama Administration, returning to Harvard.19. And most respondents also believed that a change of government would have no

impact on economic measures. The Economist, October 9, 2010. 20. European Central Bank, Monthly Report, August 2010. 21. The Economist, January 23, 2010.22. Wegelin & Co., Investment Commentary No. 272, August 23, 2010, St Gallen,

Switzerland.23. Deutsche Bundesbank, Monthly Report, July 2010. 24. Around 60 per cent was also the average debt-to-GDP ratio among big richer

economies before the financial crisis.


262 Notes

8 Woes of Euroland’s Financial Integration 1. Legally, while the Lisbon Treaty introduced a means for states voluntarily to

withdraw from the European Union, it is silent on leaving the euro. Practically, this will present complex problems in introducing a new currency and resetting the national central bank as an independent entity.

2. The Economist, July 3, 2010. 3. Financial Times, December 14, 2009. 4. The exception being its 1933 abrogation of a promise to repay some bondholders

in gold. 5. Penned by Dr Konrad Hummler, managing partner. 6. As the then governor of the Bank of Italy had correctly insisted. 7. Finland might have been qualified to join – but not the Club Med. 8. An example is the failure of the British coalition government to trim the

mammoth budget of the National Health Service. 9. The Economist, April 24, 2010. 10. D. N. Chorafas, Globalization’s Limits: Conflicting National Interests in Trade and

Finance, Gower, London, 2009.11. Wegelin, Investment Commentary No. 269.12. Bloomberg Financial Network, May 6, 2010.13. The Economist, February 20, 2010.14. Financial Times, March 8, 2010. 15. The Economist, November 6, 2010, based on statistics by IMF.16. Not just the primary budget, which excludes interest payments.17. Liaquat Ahamed, Lords of Finance, Windmill, London, 2000.18. A break to debt issuance.19. Financial Times, May 17, 2010.20. D. N. Chorafas, Financial Boom and Gloom. The Credit and Banking Crisis of

2007–2009 and Beyond, Palgrave Macmillan, Basingstoke, 2009.21. D. N. Chorafas, An Introduction to Derivative Financial Instruments, McGraw-Hill,

New York, 2008.22. A base point is 1/100 of 1 per cent.23. Financial Times, January 13, 2010.24. Bank of America Merrill Lynch, Global Strategy Weekly, May 6, 2010.

9 Sovereign Risk: Case Study on Greece1. Financial Times, May 6, 2010.2. With the exception of George Papandreou, Jr, who must be congratulated for his

decision to try to avert the debt curve.3. The Economist, May 1, 2010. 4. Richard McGregor, The Party: The Secret World of China’s Communist Party, Allen

Lane, London, 2010. 5. Recently raised to 15.4 per cent.6. D. N. Chorafas, Financial Boom and Gloom. The Credit and Banking Crisis of

2007–2009 and Beyond, Palgrave Macmillan, Basingstoke, 2009.7. Greece is said to have traded away the rights to airport fees and lottery proceeds

in years to come.8. D. N. Chorafas, An Introduction to Derivative Financial Instruments, McGraw-Hill,

New York, 2008.9. Strictly speaking, these dirty deals were not illegal because few rules govern how

nations can borrow money.


Notes 263

10. International Herald Tribune, February 15, 2010. 11. Wegelin, Investment Commentary No. 209. 12. International Herald Tribune, February 5, 2010. 13. Requiring the IMF to provide around 40 times Greece’s quota versus 12 times for

Latvia.14. Financial Times, April 28, 2010. 15. Ibid.16. ECB Monthly Bulletin, September 2010. 17. Financial Times, February 5, 2010. 18. Envelopes with money passed under the table.19. Which is not practical, since Athens taxis take two or three clients together, but

to different destinations.20. Which happens also in France, and should not be allowed. Period.21. With posted losses of almost a1 billion and an accumulated debt (in 2009) of a10 billion.

22. By IOBE – a Greek think-tank. 23. International Herald Tribune, May 10, 2010.24. Hence the old joke: Do you know the difference between a piece of wood and a

bureaucrat? Wood works.25. In the beginning of September 2010 the National Bank of Greece (NBG)

announced plans to raise a2.8 billion ($3.8 billion) in new capital. NBG said it would use some of the money to pay back a a358 million injection from the Greek government made during the credit crisis.

26. Wegelin, Investment Commentary No. 270.

10 Germany, France, Britain, Ireland and ‘Club Med’ 1. Between 2000 and 2008, unit labor costs declined by 12.4 per cent a year in

Germany, while they rose in all other euroland countries. 2. Also strong support for extreme nationalists in Austria, France, Denmark, the

Netherlands and Sweden – though not yet in Germany. 3. The Economist, April 3, 2010. 4. A great deal of money was spent on improving the infrastructure of the former

East Germany. 5. For instance, measures to reduce the size of the bloated public sector; cuts in

public sector salaries and pensions; an increase in fuel, alcohol and tobacco taxes; and a rise in value-added tax.

6. The Economist, November 20, 2010. 7. Despite four quarters in a row of weak GDP growth, French bonds trade at a

small premium to German ones. However, the recession has battered the public finances.

8. Le Canard Enchainé, February 10, 2010. 9. The Economist, June 12, 2010. 10. Even as president, de Gaulle paid his gas and electricity bills himself.11. But high against the dollar.12. Financial Times, March 26, 2010. 13. Wall Street Journal, May 6, 2010. 14. Financial Times, May 17, 2010.15. Including former Bank of England policy-makers.16. Employment within the National Health Service expanded by 62,000 during

2009 and, at its present 1.62 million headcount, is at an all-time high.


264 Notes

17. EFG Bank, Quarter Review, Spring 2010.18. Among the goodies of the State Supermarket has been free education for all

almost from cradle to grave. Not only is this unaffordable in an aging, slow-growth society, but it also distorts the very sense of education – and it results in low standards, since the sovereign cannot afford to pay salaries commensurate to experience.


20. [email protected] 21. Bank of Ireland was in the chosen lot; Anglo-Irish Bank was out.22. Which on August 31, 2010, reported an a8.2 billion ($12.7 billion) loss for the

first half of 2010, the biggest corporate loss in Irish history.23. Financial Times, September 22, 2010. The FT projection was 136 per cent, but

some analysts suggested sovereign debt will probably exceed 140 per cent.24. On September 29, 2010, Standard & Poor’s downgraded Anglo-Irish’s

subordinated debt by three notches to CCC, the lowest possible non-investment grade, and warned there was a ‘clear and present risk’ of a restructuring of its bonds.

25. It is thought that its top ten borrowers accounted for more than half of its loans, something that only second-rate bank CEOs would ever allow to happen.

26. Financial Times, September 30, 2010. 27. The Economist, November 20, 2010.28. The Economist, December 18, 2010. 29. In February 2008, Dubai CDS spreads had hit 1,000 bp, but then had fallen to

about 300.30. One of the three government-owned conglomerates that set the pace for Dubai’s

development.31. The charges of the City of Milan are against JPMorgan Chase, UBS, Deutsche Bank

and Depfa for misleading officials in a a1.7 billion ($2.3 billion) deal. The banks all denied any wrongdoing.

32. But some a166 billion are judged as suspect.

11 The North Atlantic Similarities are Greater than you Think 1. Critics say that, in taking advantage of the dollar’s status as an international

reserve currency, the US has decided to send its domestic problems to other coun-tries, through aggressive devaluation. (Financial Times, November 10, 2010)

2. And theoretically, but only theoretically, reducing unemployment. 3. D. N. Chorafas, Globalization’s Limits: Conflicting National Interests in Trade and

Finance, Gower, London, 2009. 4. Bank of America Merrill Lynch, September 14, 2010. 5. Gates intends to close the US Joint Forces Command. The individual services are

now highly integrated, he says, making this branch of the military bureaucracy redundant.

6. The American, British and other coalition soldiers have done their duty. But was that duty well chosen by the politicians?

7. The Economist, June 12, 2010. 8. Túχη, fortune. 9. According to the 2009 Financial Report of the US Government, published by the

US Treasury.10. Assets minus liabilities.


Notes 265

11. As a result, the US public debt is set to reach a stratospheric $12 trillion by 2015, more than double its level when Obama became president.

12. Bernanke made that statement deflecting criticism from Congressmen who wanted to curb the central bank’s powers.

13. Authorized by Congress. TARP is separate from CPFF.14. Bank of America Merrill Lynch, RIC-Monthly Investment Review, September 14,

2010.15. The US budget deficit in the fiscal year that ended on September 30, 2010, stood

at $1.3 trillion – or 9 per cent of GDP.16. The deficit would be 4.3 per cent in 2015 and the debt 90 per cent in 2020 under

Obama’s most recent budget, the Congressional Budget Office reckons. The Economist, November 13, 2010. But if state and municipal deficits are added, the US deficit is already about 110 per cent of GDP.

17. Wegelin & Co., Investment Commentary No. 273, St Gallen, October 4, 2010. 18. The Economist, November 6, 2010. 19. According to political analysts, voters seem to have given way to fear, skillfully

stoked by the ‘No’ campaign, that a tax on the rich could easily become a tax on everybody.

20. Financial Times, November 10, 2010. 21. The Economist, October 9, 2010.22. Bank of America Merrill Lynch, September 10, 2010.23. Lothar Komp and Nancy Spannaus, ‘Alan Greenspan Has Lost It’, Executive

Intelligence Review (EIR), February 23, 2001.24. Postmortem, some economists are saying that the bankruptcy of Bear Stearns

would probable have been the better alternative.25. The Economist, October 16, 2010. 26. As well as equal to the whole federal debt.27. An IMF estimate is that the median industrial economy has announced guarantee

programs worth 16.4 per cent of GDP. In Europe, this figure is 200 per cent in Ireland, which guaranteed all its banks’ liabilities, 50 per cent in Britain and 34 per cent in Holland.

28. In Michigan, household median incomes shrank by 21 per cent; in Indiana by 15 per cent; in Ohio by 14 per cent. The US average is 7 per cent (The Economist, November 20, 2010).

29. Over 35 per cent of the unemployed have been out of work for 27 weeks or more, the highest rate since this record started in 1948.

30. The non-partisan Center for Responsive Politics reported on February 12, 2010, that companies and other organizations spent a record $3.5 billion on lobbying in 2009, much of it targeted on the administration’s health and energy bills. On other estimates, the total spent on lobbying in Washington is closer to $9 billion a year.

31. The Economist, February 20, 2010. 32. Numbers have been rounded to two significant digits as these are largely guesti-

mates and greater precision makes no sense.33. OECD Development Centre, Working Paper No. 265.34. The Economist, October 16, 2010.35. The Economist, February 20, 2010. 36. Not necessarily all derivatives, some of which can be useful. 37. The repeal of the Glass–Steagall Act’s separation of underwriting and investment

banking from commercial and retail banking unleashed an era of infectious greed, which led to the deep economic, financial and banking crisis of 2007–11.


266 Notes

38. There is an interesting couleur local to this affair. Alan Greenspan was reporting to the Senate and Senator Sarbanes asked if it were true that he wrote a letter to the Bush Administration stating that he was against the registration of hedge funds. The Fed chairman answered he could not remember, to which an aston-ished Sarbanes said: ‘Don’t you remember?’ (after consulting with his advisors, Greenspan remembered he had signed that letter).

39. Prepared by the Banking Supervision Committee of the European System of Central Banks and issued by the ECB.

12 The EU’s Banking Industry and its Stress Testing 1. Bank of America, which bought Merrill Lynch during the crisis, became the larg-

est bank in the world by this acquisition in 2009. 2. These have been among euroland’s credit institutions (joined by many more)

who underwent the 2010 stress tests (see below). 3. Basel II is not among the themes covered by this book. 4. Financial Times, November 2, 2009. 5. D. N. Chorafas, Risk Pricing, Harriman House, London, 2010. 6. European Central Bank, Monthly Bulletin, October 2010. 7. The Economist, February 27, 2010. 8. Ibid. 9. EFG International, Quarterly Review, Summer 2010. 10. Crédit Suisse, Research Monthly, November 2010.11. The most common policy followed by universities in producing qualitative

analysts, known as quants, is the wrong one. It is under the wing of a revamped theoretical mathematics department whose faculty understands a dry fig about finance and banking – and so do the students.

12. D. N. Chorafas, Internet Supply Chain: Its Impact on Accounting and Logistics, Palgrave Macmillan, Basingstoke, 2001.

13. Quotation from recent correspondence.14. The Economist, July 24, 2010.15. Whose cost-effectiveness is appalling; the quality of information they deliver is

even worse.16. According to the article in The Economist, when HSBC started a huge consolida-

tion project called ‘One HSBC’ in 2008, it operated 55 separate systems for core banking, 24 for credit cards and 41 for internet banking.

17. The Economist, July 24, 2010.18. D. N. Chorafas, Cloud Computing Strategies, Auerbach/CRC, New York, 2010.19. With electric lamps, for example, a risk event is significant fluctuations in voltage

which adversely affect the filament’s life. Therefore, lamp companies proceed with destructive testing of samples taken out of the production line.

20. D. N. Chorafas, Stress Testing: Risk Management Strategies for Extreme Events, Euromoney, London, 2003, and D. N. Chorafas, Stress Testing for Risk Control Under Basel II, Elsevier, Oxford and Boston, 2007.

21. D. N. Chorafas, Statistical Processes and Reliability Engineering, D. van Nostrand, Princeton, NJ, 1960.

22. The committee of euroland’s national regulators that coordinated the tests.23. Financial Times, July 28, 2010. 24. European Central Bank, Financial Stability Review, June 2010.25. To cover the risk of loan impairments.


Notes 267

26. When the real estate market is at a standstill, there is always a difference, sometimes major, between asked prices and those really paid.

27. In addition, it was a mistake to include in the tests Germany’s HypoBank, since it had failed and it was nationalized.

28. The Economist, October 24, 2009. 29. The seven banks that failed had a capital deficit of a3.5 billion ($4.65 billion), but

also those passing the test needed capital – altogether, about half the aforemen-tioned lower-end estimate.

30. Financial Times, July 27, 2010.31. CNBC, July 23, 2010. 32. Not just those held in the so-called trading book, where values are marked to

market.33. Financial Times, November 10, 2010.

13 The Global Systemic Risk has been Programmed for 2014 1. The Economist, November 6, 2010. 2. The Russian banks’ meltdown came years later, in 1998, under Yeltsin. 3. Russia’s East European satellites had followed more or less the same policies of

very low public debt. 4. Jean-Pierre Soisson, Charles Quint, Grasset, Paris, 2000. 5. Bloomberg News, June 10, 2010. 6. Financial Times, September 17, 2010. 7. Wegelin & Co., St Gallen, Switzerland, Investment Commentary No. 270. 8. D. N. Chorafas, Globalization’s Limits: Conflicting National Interests in Trade and

Finance, Gower, London, 2009. 9. Financial Times, September 30, 2010. 10. Financial Times, November 24, 2010. 11. Where bonds are issued. At the time of writing, there is one outstanding five-year

bond with nominal interest rate of 2.75 trading below par at 99.3. 12. See below the difficulties banks find in debt rollovers, the challenges confronting

sovereigns in refinancing their debts.13. Relative to the size of the economy, Britain’s banks are now ten times larger than

in 1970.14. Deutsche Bundesbank, Financial Stability Review, Frankfurt, November 2010.15. For this and following years, as well as for other LCBGs, statistics come from The

Economist, July 31, 2010. These figures are intended as order of magnitude, delib-erately limited to two significant digits.

16. The next section discusses the difficulties encountered by sovereigns in their rollovers.

17. Roughly one third from their own governments and central bank’s lending, and two thirds from banks and sovereign wealth funds of developing countries.

18. ‘Plus rollovers’ is by no means a superfluous reference. The banks are facing huge debts in 2011, 2012 etc. If they are able to refinance their debts, they will be confronted once again with payment woes as new loans mature.

19. As Ireland found to its dismay in November 2010. 20. See also, in Chapter 2, the discussion on what has turned formerly prosperous

nations and people into the ‘new poor’.21. Statistics by the OECD, and, for the USA, by The Economist, November 20, 2010.22. Ibid.


268 Notes

23. Discussed by a panel on Bloomberg News.24. The Economist, October 16, 2010.25. According to some accounts, counting all of its obligations, the US federal gov-

ernment is leveraged up to 78 times, or 7,800 per cent (Bloomberg Financial News, November 15, 2010). I hope that I have misunderstood this statistic; I therefore put it as a footnote and not in the main text!

26. Bank of America Merrill Lynch, US Economics Top Ten, November 12, 2010. 27. When the write-down by US banks connected with the garbage in their portfolios

snowballed.28. Even if peaking in 2011.29. The Economist, November 20, 2010.30. Financial Times, November 24, 2010.31. The Economist, November 20, 2010.32. Swiss Re, Sigma, No. 3, 2010. 33. Americans were only slightly less worried, with 46 per cent saying default was

likely, against 33 per cent seeing it as unlikely. Financial Times, May 17, 2010.34. Le Monde, November 11, 2010.35. www.info.dfr.fr/france/articles/des-credits-en-urgence-payer-fonctionnaires-en-

decem, accessed November 25, 2010. 36. Irwin and Debi Unger, The Guggenheims, HarperCollins, New York, 2005.

Epilog 1. Nothing seems to have been learned from the 1956 British/French Suez fiasco and

the more recent invasions of Iraq and Afghanistan. 2. As an example, the primary global supplier of microprocessor control panels for

auto manufacturers was in the area hit by the tsunami. According to anecdotal evidence, of its 10,000 employees only 3,000 have survived and just-in-time inventory policies have now turned into a liability. Western production lines risk coming to a full stop and, in business parlance, every auto not being produced will never be built again.

3. Bank of America Merrill Lynch, ‘Rocks on Stocks’, June Quarterly Outlook, April 6, 2011.

4. Bloomberg News, April 7, 2011. 5. Financial Times, April 27, 2011. 6. The fiscal gap is the difference between the present value of all future expenditure

and all future fiscal income. 7. Wegelin & Co., Investment Commentary No. 275, March 21, 2011. 8. Simon Johnson and James Kwak ‘13 Bankers’, Vintage Books, New York, 2010. 9. Ibid.10. A term used by Trotsky for Bukharin, who also allegedly found it difficult to make

up his mind and his decisions were cast upon other people’s opinions.11. On Bloomberg News.


269

Index

Abbey National Bank, 221 Adverse debt dynamics, 31 Affirmative financial action, 101 AIG, 4, 19, 199Allied Irish Banks, 129, 229 Almunia, Joaquin, 142Altschul, Frank, 16American consumer debt, 29American Economic Association, 198American Recovery and Reinvestment

Act (ARA), 194Andreotti, Guilio, 150Anglo-Irish Bank, 129, 182–4Aron, Raymond, 114Ashton, Cathy, 237Asset-backed securities (ABSs), 37, 42Asset price inflation, 101Atcheson, Dean, 248Austerity measures, 124–6, 128, 165, 167

Backwardization, 86 Bad assets, 94 Bad banks, 94–6 Balance of payments, 108 Banco Espirito. Santo, 249 Banco Santander, 212 Bank for International Settlements (BIS),

11, 32, 85, 88, 107, 127, 153 Bank of America, 187, 212 Bank of America Merrill Lynch, 66,

201 Bank of England, 6, 12, 13, 27, 28, 36,

56, 89, 90, 92, 118, 148, 177, 204, 227, 233

Bank of Ireland, 242 Bank of Italy, 235 Bank of Japan, 64, 66, 85, 90, 91, 118 Bank of Korea, 81 Bank of New England, 218 Bank to bank risk, 219Bankruptcy risk, 36 Barclays Capital, 153, 177, 212 Barings Bank, 41 Barroso, José Manuel, 143

Basel Committee on Banking Supervision (BCBS), 98, 213, 222

Basel I, 225 Basel II, 42, 222 Basel III, 213 Bear Stearns, 20, 75, 76, 126, 203 Bernanke, Ben, 11, 32, 38, 56, 67, 71,

80, 81, 160, 234 Bernanke put, 203 Bismarck, Otto von, 50 Black swan, 82, 83 Black Tuesday, 6 BNP/Paribas, 212Boone, Laurence, 177 Bowles, Erskine, 199 Brandeis, Louis, 155 Bretton Woods, 109 British national debt, 178 Brittan, Leon, 162 Budget deficits, 31 Budgetary discipline, 137, 139, 140 Buffett, Warren, 77 Bush Administration, 30, 42, 210 Bush, George W., 7, 31, 62, 96, 98, 119,

195 Business confidence, 4

Callaghan Jim, 104 Cameron, David, 129, 130 Carnegie, Andrew, 116 Carry trade, 112 Casino capitalism, 83 Cato Institute, 199 Cayne, Jimmy, 76 Center of Public Integrity, 40 Central European Bank System, 229 Chanos, James, 215 Chaos theory, 79 Charles V, 234 Chernomyrdin, Victor, 232 Chièvres, Guillaume de, 234 Chirac, Jacques, 104, 150 Citigroup, 20, 97, 183, 199, 206, 212 Clegg, Nick, 129, 130

9780230298408_17_ind.indd 2699780230298408_17_ind.indd 269 5/19/2011 2:38:25 PM5/19/2011 2:38:25 PM

270 Index

Clinton Administration, 210 Clinton, Bill, 42 Clinton, Hillary, 237 Club Med countries, 143, 148, 155, 160,

173, 187, 240 Collateralized debt obligations (CDOs), 42 Collective action clauses, 240 Commercial Paper Funding Facility, 198 Committee of European Banking

Supervisors, 223, 224, 225, 228–30 Congressional Budget Office (CBO), 30,

118, 193 Coolidge, Calvin, 251 Core inflation, 121 Corrigan, Gerald, 199, 203 Council of Economic Advisors, 63, 109 Cour des Comptes, 29, 36, 176 Courson, Charles-Amédée de, 177 Cradle to grave featherbedding, 196 Creative accounting, 158, 159 Credit default swaps, 111, 113, 151–3Credit derivatives, 15 Credit rating spillover, 113 Crédit Suisse, 78 Crisis of confidence, 250 Cross-border contagion, 105 Currency debasing, 92, 93 Currency wars, 93, 235 Current account, 108–10Current account deficits, 133, 198

Daimler-Benz, 149 Darling, Alastair, 178, 179 Data uncertainty, 223, 224 Dawes Commission, 17 Dawes Plan, 68 Debt adjusted cash flow (DACF), 151 Debt capital, 29 Debt-driven meltdown, 197 Debt financing, 36 Debt frenzy, 115 Debt hangover, 178 Debt hydra, 56, 57, 104, 232 Debt-laden democracy, 24, 25 Debt limit, 101 Debt offenders, 216 Debt reduction benchmarks, 240 Debt regulation, 37 Debt-to-GDP ratio, 28, 39, 245 Déclinisme, 25

Deep debt habit, 44 Deficit countries, 132 Deficit financing, 15, 16 Deflation, 120, 121 Deflationary risk, 122 Deflationary spiral, 171 Deification of debt, 45 De-industrialization, 168 Deleveraging, 37, 118, 119, 130 Deloitte, 224 Derivative financial instruments, 10,

43, 63 Derivatives trading, 19 Deutsche Bundesbank, 108, 230, 243 Deutschmark, 150, 173 Dimon, Jamie, 57 Disaster to payout ratio, 115 Disinflation, 120 Dodd, Chris, 210 Dodd-Frank Act, 5, 208–10 Dolan, Brian, 87 Dominici, Peter, 248 Dow Jones Industrial Average, 56, 61 Draghi, Mario, 235, 237 Drucker, Peter, 55, 131 Dubai Financial Support Fund, 186 Dubai World, 186, 187 Dubai’s debts, 187 Dubai’s CDSs, 187 Duhamel, Alain, 123

Easy money, 168 Eccles, Marrinner, 90 Economic and Social Research Institute,

181 Economic austerity plan, 126 Economic freedom, 22 Economic nationalism, 251Economist, The, 104, 185, 186, 221Efficient market hypotheses, 63 Efficient market theory (EMT), 250Einstein, Albert, 24, 25 Eisenhower, Dwight D., 24 El-Erian, Mohamed, 9, 202 Embedded deflation, 122 Engels, Friedrich, 7 Entitlements, 34, 36, 42, 46–50, 54, 132,

154, 177 Ernst & Young, 215, 224 Euro, 137, 138, 145, 149–51, 169, 180


Index 271

Euroland’s monetary union, 110 European Bank for Reconstruction and

Development, 111 European Central Bank (ECB), 6, 8, 36,

39, 73, 84, 85, 89, 103, 108, 118, 127, 139, 148, 150, 160, 161, 163, 164, 211, 212, 225, 228, 233, 242

European Commission, 8, 163, 175, 179, 239

European Economic Research, 126 European Financial Stability Facility

(EFSF), 240 European Financial Stabilization

Mechanism, 139, 240 European Stabilization Mechanism

(ESM), 240 European System of Central Banks, 230 European Union, 8, 167, 193, 234, 238 European Union debt limits, 157 Exchange-traded funds, 250 Executive information system, 220 Exit strategy, 38, 118 Extreme events, 19

Family overindebtedness, 36 Fannie Mae, 4, 19, 170, 199, 205 Federal Deposit Insurance Corporation

(FDIC), 114, 216 Federal Housing Administration, 205 Federal Housing Finance Authority, 199 Federal Reserve (Fed), 3, 5, 6, 12, 23, 33,

36, 56, 61, 62, 64, 89, 90, 118, 148, 197, 198, 204, 210, 230, 233, 242

Federal Reserve of New York, 62 Fed funds rate, 61 Feldstein, Martin, 33, 162, 206 Fillon, François, 175 Financial alchemy, 46 Financial discipline, 16 Financial engineering, 6 Financial seismology, 249 Financial stability, 12, 103, 114, 115, 141 Financial Stability Forum, 235 Financial Stability Oversight Council

(FSOC), 210 Financial Stability Review, 243 Financial Times, 73, 121, 149, 165, 178,

237 First Great Depression, 6, 9, 42, 46, 84,

107, 180, 203, 248

Fiscal consolidation, 103, 162 Fiscal discipline, 149, 240 Fiscal policy, 35, 36, 89, 165 Fiscal restructuring, 163 Fiscal risks, 164 Fiscal tightening, 119, 164, 170, 178 Fitch, 161 Foch, Ferdinand, 64 Ford, 19, 20 Ford, Henry, 116 Frank, Barney, 208, 210 Freddie Mac, 4, 19, 170, 199, 205 Friedman, Thomas L., 40, 70, 168Fuld, Richard, 57

Galbraith, J.K., 131 Gates, Robert, 195 Gearing of debt, 53, 54 Gelbank, Mike, 63 General Motors (GM), 19, 20, 168,

214 Generational accounting, 50 George, David Lloyd, 87 German Monetary Union (GMY), 145 Getty, Paul, 22, 23 Glass–Steagall Act, 42, 62, 96, 97,

209 Global downturn, 3 Gold standard, 151 Goldman Sachs, 5, 15, 19, 89, 97, 114,

157, 159, 160, 209, 210, 216 Gottesman,, Edward, 121, 122 Government Accountability Office

(GAO), 29 Grant Street National Bank, 95 Grantham, Jeremy, 200 Greece’s long term solvency, 154 Greece’s rating, 171 Greek crisis, 142, 153, 154, 238 Greek debt, 160 Greek debt restructuring, 165 Greek economy, 126 Greek sovereign debt, 144 Greenspan, Alan, 3, 33, 42, 43, 56, 80,

81, 202 Greenspan put, 203 Grimsson, Olafur Regnar, 185 G-20, 55, 78, 251 Gross, Bill, 9, 56, 200 Growth recession, 196


272 Index

Haldane, Andrew, 27, 28 Hamilton, Alexander, 156 Hasson, John, 221 Havenstein, Rudolf von, 32, 33 Hayek, Friedrich, 33 Hayward, Tony, 115 Headline inflation, 121 Health care, 47 Heisenberg principle, 121 Holder, Eric, 49 House repossessions, 196 Household debt, 111 Housing bubble, 198 HSBC, 212 Hyperinflation, 125 Hyperleveraging, 32

IBG/YBG, 29–31Icesave, 185 IKEA, 116 Implicit inflation expectations, 121 Imported inflation, 121 Industrial and Commercial Bank of

China, 212Information technology, 219–21 Ingves, Stefan, 182 Interbank loans, 111Interbank market, 68, 187, 227, 228 Internal devaluation, 123 International finance, 5International Monetary Fund (IMF), 11,

23, 72, 102, 154, 161–4, 167, 181, 185, 235, 246

Ireland’s rating, 171 Irish blanket guaranty, 182, 184 Irish budget deficit, 129 Irish Treasury, 182 Italy’s public debt, 188

Jackson Hole Symposium, 73–5, 124 James, Harold, 106 Japan premium, 67 Japan risk, 65 Japanification, 55, 61, 64–72, 75, 89,

117, 123 Johnson, Lyndon, 69 JP Morgan, 6, 16 JPMorgan Chase, 57, 114, 159, 212,

228 Juppé, Alain, 175

Kamprad, Ingvar, 116 Kaufman, Henry, 89 Kay, John, 48, 226Keynes, John Maynard, 6, 13, 87, 94 King, Mervyn, 35, 67, 88, 227, 228 Kohl, Helmut, 150 Komileva, Lena, 154 KPMG, 224 Krugman, Paul, 131

Lamont, Thomas, 6 Landsbanki, 185Laplace, Pierre Simon de, 27 Large and complex banking groups

(LCBGs), 212–14, 217–19, 224, 242–4 Larouche, Lyndon, 202 Latin Monetary Union (LMU), 145 Law, John, 94 Lax lending practices, 46 Lax supervision, 56 Lazard Brothers, 16Lehman Brothers, 19, 20, 42, 57, 77, 78,

81, 126, 156, 203, 215 Lehman’s bankruptcy, 76 Lenihan, Brian, 184 Level of confidence, 223 Leverage, 7 Lewis, Michael, 5 Liquidity coverage ratio (LCR), 214 Liquidity crisis, 113 Liquidity wall, 87, 88 Lisbon Treaty, 239 Living on debt, 44 Living wills, 98 Lloyds Bank, 240 Lobbyists, 63 Longevity risk, 52 Long-term funding, 213 Long-term sustainability, 233 Loose monetary policy, 198 LTCM, 19, 79

Maastricht Treaty, 133, 173, 238 Madoff, Bernie, 44, 215, 237 Mandelbrot, Benoit, 18 Market discipline, 231 Markus Aurelius, 248 Mathematical models, 27 McDonald, Lawrence G., 42, 63 McGregor, Richard, 156


Index 273

McKinsey Global Institute, 39 Medicare, 30 Megarisk events, 7 Mellon, Andrew, 107 Mellon Bank, 95 Merkel, Angela, 7, 76, 132, 158, 161,

163, 172, 173, 238 Merrill Lynch, 42, 86, 126, 199 Migaud, Didier, 29, 36 Mississippi Bubble, 94 Mitterrand, François, 150, 176 Model uncertainty, 223 Mohler, Nelson E., 26, 232 Monetary and fiscal policies, 27, 124 Monetary policy, 35, 87, 89 Monetary stimulus, 102 Money Market Investor Funding Facility,

198 Monte dei Paschi, 229 Monty, Mario, 143 Moody’s, 161, 185 Moral hazard, 84 Moral risk, 28 Morgan Stanley, 42, 97, 114, 228 Morgenthau, Henry, 62 Mortgage-backed securities, 74 Mountain of debt, 108 Mullen, Mike, 70 Murphy’s law, 221

Nagy, Piroska, 111 National Bank of Greece, 160 National Economic Council, 128 National Health Service (NHS), 69, 130,

180 National Pension Reserve Fund, 181 New economy, 3 New normal, 7, 9–15, 19–21, 26, 37, 38,

40, 44, 48, 50–2, 67, 70, 183New York Fed, 247 Newly poor, 7, 22, 23, 25Newly poor nations, 23 Newly rich, 25Nixon, Richard, 109 Non-linear bets, 217 Normal distribution, 18 Northern Rock, 96

Obama Administration, 30, 31, 128, 132, 200

Obama, Barack, 7, 56, 62, 104, 131, 195, 207, 234

O’Driscoll, Gerald, 199 Office of Congressional Ethics, 40 Office of Financial Research (OFR), 210 Office of Management and Budget

(OMB), 128, 129 Old normal, 38, 39, 40, 71 Orderly Greek default, 169, 170 Organisation for Economic Co-operation

and Development (OECD), 85, 176, 207

Orszag, Peter, 128–30 Osborne, George, 116, 129, 130, 179 OTC trades, 63, 152 Overburdening bureaucracy, 155

Papandreou, George, 161, 164, 166 Patient Greece, 45 Patman, Wright, 107 Patton, George, 55 Paulson, John, 77, 153 Pellegrini, Paolo, 77, 153 Pensions gap, 52 Personal irresponsibility, 45 Personal responsibilities, 23 Pew Global Attitudes Project, 247 Pimco, 9, 186, 200, 202 Portuguese debt, 186 Poverty of attention, 219 PricewaterhouseCoopers (PwC), 224 Prinz, Chuck, 208 Pröll, Josef, 151 Property-owning democracy, 24 Proprietary trading, 97 Public debt, 10, 16, 20 Public debt burden, 54 Public debt to GDP, 35 Purchasing power parity (PPP), 248

Quantitative easing (QE), 11, 12, 23, 67, 86, 90–3, 199, 200, 230, 235

Ragosta, Marco, 233 Reagan, Ronald, 99 Reichsbank, 14, 32, 106 Reichsmark, 14 Reinhart, Carmen, 124 Reinhart, Vincent, 124 Reliability, 222


274 Index

Rigid labor laws, 144, 176 Riksbank, 182 Risk management, 6 Rivlin, Alice, 248 Rockefeller, John, 116 Romer, Christina, 63, 109 Roosevelt Administration, 42, 125 Roosevelt, Franklin D., 62–4, 90, 125 Rose, Charlie, 148, 215 Rothschild, Mayer Amschel, 12Roubini, Nouriel, 56, 74, 87, 250 Rousseau, Jean-Jacques, 123 Royal Bank of Scotland, 96, 115, 183, 212 Rumsfeld, Donald, 82 Russian Communist Party, 232 Russian crisis, 79 Rzeczpospolita, 45

Sarbanes–Oxley Act (SOX), 63, 81, 96, 208

Sarkozy, Nicolas, 151 Scandinavian Monetary Union (SMU),

146 Schacht, Hjalmar, 14, 17, 68 Scharz, Anna, 203 Schäuble, Wolfgang, 201 Schröder, Gerhard, 144 Schuldenbremse, 151 Second Great Depression, 62, 245 Securities and Exchange Commission

(SEC), 42, 43, 114, 159, 198 Securitized chunk, 158 Securum, 95 Senate Banking Committee, 208 Shadow banking system, 6 Shortfall for state pensions, 204 Simon, Herbert, 219 Simpson, Alan, 199 Smith, Adam, 123 Smithsonian Agreement, 109 Socialization of risk, 230 Soros, George, 19, 35, 77, 80, 153, 234 Souk, 79–81, 100, 101 Sovereign bankruptcies, 99 Sovereign credit risk, 100 Sovereign credit vulnerability, 144 Sovereign debt, 27, 28, 34, 35, 57, 121 Sovereign debt bubble, 114 Sovereign debtors, 153 Sovereign defaults, 56

Sovereign default risk, 226 Sovereign risk, 10, 239 Spain’s public debt, 189 Sparks, Daniel, 209, 210 Special investment vehicles (SIVs), 42 Speculators, 28 Stability and Growth Pact, 146, 150,

151, 238 Standard & Poor’s, 161, 163 Standard of living, 114 State capitalism, 9 State pensions, 47 State Supermarket, 23–6, 33, 34, 37,

47–9, 52, 54, 58, 70, 104, 123, 137, 176, 183, 196, 232, 234, 238

Steinmann, Heinrich, 4 Stiglitz, Josef, 95, 203 Stimulation programs, 200 Stimulus packages, 20 Strategic inflation, 121 Strauss-Kahn, Dominique, 201 Stress-test light, 227 Stress tests, 217, 222, 223, 225–8 Structural reform, 32 Structured instruments, 37 Structured investment vehicles (SIVs),

90 Subprimes, 35, 113 Summers, Lawrence, 56, 63, 128, 209 Superleveraging, 20 Sustainability of public finances, 132 Symbiosis in debt, 212 Symmetrical adjustment scenario,

132 System liquidity shocks, 217 System-wide oversight, 237 Systemic exposure, 231

Tail risk, 56 Tardieu, André, 99, 178 Tax wedge, 176 Taxpayers’ money, 114 Thatcher, Margaret, 131, 144, 162 Tier 1 capital, 225 Too-big-to-be-saved banks, 214 Toyota, 214 Trichet, Jean-Claude, 73, 163, 186 Troubled Assets Relief Program (TARP),

194, 198 Truman Administration, 248


Index 275

UCLA, 214 Unconventional financial instruments,

89 United Arab Emirates (UAE), 187 US Treasury, 15

Value added tax (VAT), 99 Vamos, Tibor, 106 Van Rompuy, Herman, 163 Volcker, Paul, 5, 80, 121 Volcker rule, 96, 97

Warren, George, 62 Weak risk management, 56 Wealth effect, 200 Weber, Axel, 230 Wegelin, 126, 143, 160, 200

Weibull algorithm, 222 Welfare state, 23 Wells Fargo, 212 Westdeutsche Landesbank, 227 Wolf, Martin, 148, 178 Woodin, William, 62 World Bank, 23 World Economic Forum, 35, 208 World Trade Organization, 195 Wriston, Walter, 187

Yield curve, 86 Young Plan, 68

Zapatero, José Luis Rodriguez, 189 Zero interest rates, 10 Zetsche, Dieter, 149


Chorafas sovereign debt crisis; the new normal and the newly poor (2011)

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