Let’s call it what it is

(2 pm. – promoted by ek hornbeck)

 Famous investor George Soros warned the other day of very severe consequences if the Euro wasn’t saved.

 “It seems to me that one still doesn’t understand what would happen if the euro collapsed,” Soros told the Swiss magazine in an e-mailed pre-release of tomorrow’s edition. “It would lead to a banking crisis that would be totally out of control.”

He even used the term “new Great Depression”. It sounds serious, especially since many have come out and said that the cost of saving the Euro is too high. Some say the chances of the Euro’s survival is 50-50, and that the Euro-bond plan would be nothing more than a band-aid.

So while everyone worries about a Great Depression 2.0, we overlook the fundamental reasons why the economy remains so weak.

 Allow me to present Exhibit A: The treasury bond market.

 Panic flight to safety has pushed the yield on 10-year US Treasuries below 2pc for the first time in modern American history, exceeding the extremes of the Lehman crisis and the banking crash of the 1930s.

We aren’t talking about the weeks after the Lehman collapse, when the Bush Administration did a full-court press to save Wall Street. We aren’t even talking about the spring of 1933, when many states in America didn’t have a single functioning bank and the unemployment rate was above 20%.

We are talking about right now, when we are supposedly two years into a “recovery”, that the bond market is more afraid now than any time since records have been kept.

“Markets are in a fearful state right now, and data like this gives them plenty of excuses to panic.”

Andrew Roberts, credit strategist at RBS, said investors are haunted by fears that European banks may have lost full access to America’s $7 trillion markets, leaving them at imminent risk of a dollar squeeze…

The Bank for International Settlements said German, Dutch, Swiss and British banks together have a US dollar funding gap of around $1 trillion. The global dollar gap is $5 trillion, reflecting the continued use of the greenback as the base for international finance. This means that severe market stress sets off a scramble for dollars, akin to a global margin call.

“It won’t take much for the interbank market to collapse,” said Lars Frisell from Sweden’s Riksbank.

There is something being said here that need explaining. The rush to treasuries aren’t so much a sign of confidence in treasuries as a sign of fear that European banks won’t be able to get dollars to cover their dollar-based debts.

Interbank lending might collapse because of fears of the return of the zombie banks of 2008. No one wants to lend to an insolvent bank.

European banks have historically leveraged themselves to even greater levels than American banks. This has raised the fear that many European banks are about to collapse.

“Open our eyes: the euro and Europe are on the brink of the abyss.”

– Jacques Delors, the ex-president of the European Commission

The problem for Europe’s banks is two-fold.

First of all, they are major holders of government debt. When the government bonds of Greece, Spain and Italy (and lately France) dropped dramatically a few weeks ago, it meant the capital worth of Europe’s major banks also dropped dramatically.

Many economists have been quick to point out that this is not 2008 again, mostly because corporate balance sheets are so much stronger now. However, few have acknowledged the obvious problems we have now that we didn’t have then.

Fiscal policy currently is a drag on economic growth in both the eurozone and the UK. Even in the US, state and local governments, and now the federal government, are cutting expenditure and reducing transfer payments. Soon enough, they will be raising taxes.

Another round of bank bailouts is politically unacceptable and economically unfeasible: most governments, especially in Europe, are so distressed that bailouts are unaffordable; indeed, their sovereign risk is actually fuelling concern about the health of Europe’s banks, which hold most of the increasingly shaky government paper.

Nor could monetary policy help very much. Quantitative easing is constrained by above-target inflation in the eurozone and UK. The US Federal Reserve will likely start a third round of quantitative easing (QE3), but it will be too little too late. Last year’s $600bn QE2 and $1tn in tax cuts and transfers delivered growth of barely three per cent for one quarter. Then growth slumped to below one per cent in the first half of 2011. QE3 will be much smaller, and will do much less to reflate asset prices and restore growth.

To put it simply: Unlike 2008, if the banks get in trouble again then there is little that the governments and central banks can do to help this time.

You can’t cut interest rates when they are already at zero. You can’t go on a spending spree when you are priced out of the bond markets. You can’t bail out the banks again when the populace is still furious about the last bailout.

And let’s not overlook one important fact: While the Treasury Department has claimed all the money loaned to Wall Street has been paid back, the NY Times, CNNMoney, and Pro Publica have been keeping their own numbers and tell a far different story.

while the TARP bailout of Wall Street (not including the bailout of the auto industry) amounted to $330 billion, the government also quietly spent $4.4 trillion more in efforts to stave off the collapse of the financial and mortgage lending sectors. The majority of these funds ($3.9 trillion) came from the Federal Reserve, which undertook the actions citing an obscure section of its charter.”

“..$4.8 trillion went out the door to aid financial companies and repair the damage they caused to financial markets, and $1.5 trillion of that is still outstanding.”

So the legacy of the 2008 bailouts are still with us in more ways than one.

The other way that banks can build up their capital holdings is with stock shares.

However, that has been even a larger disaster of banks.

Foreign banks equities (August 3):

  • Société Générale: down 34.82% YoY, down 36.39% over 6 months, -30.28% over one month.
  • Crédit Agricole: down 30.9% YoY, down 31.66% over 6 months, -30.8% over one month.
  • Deutsche Bank: down 31% YoY,  down 17.61% over 6 months, -16.48% over one month
  • RBS: down 35.61% YoY, down 25.12% over 6 months, -17.73% over one month

Europe imposed curbs on short selling to try and stem the slaughter, but that has had little effect.

Wrong diagnosis, wrong medicine

Why are we so close to collapse again, only three years removed from the last time?

Could it be, as some have claimed, that we didn’t spend enough money?

On the contrary. The Federal Reserve alone threw $16.1 Trillion at the problem. To put that into perspective, the GDP of the U.S. economy is $14.5 Trillion. Plus, that $16.1 Trillion only measures between December 1, 2007 and July 21, 2010. The Federal Reserve started QE2, for at least another $600 Billion, after this date.

Anyone who says that we didn’t spend enough money to fix the problem is insane.

So then why are we back where we started?

To put it simply – the problem was misdiagnosed. We got plenty of medicine, but the wrong kind of medicine.

The phrase “great recession” creates the impression that the economy is following the contours of a typical recession, only more severe – something like a really bad cold. That’s why, throughout this downturn, forecasters and analysts who have tried to make analogies to past postwar U.S. recessions have got it so wrong. Moreover, too many policy-makers have relied on the belief that, at the end of the day, this is just a deep recession that can be subdued by a generous helping of conventional policy tools, whether fiscal policy or massive bailouts.

But the real problem is that the global economy is badly overleveraged, and there’s no quick escape without a scheme to transfer wealth from creditors to debtors, either through defaults, financial repression or inflation.

The “solution” so far has been to throw money at the same people that caused the problems in the first place (aka Quantitative Easing and low interests rates). Everyone was in such a panic in 2008, that no one in power questioned the strategy.

Besides the immorality of that “solution”, the fact is that it fixed nothing. One of the Fed chiefs has recently come out and said that the low interest rate policy is “counterproductive”.

An analysis of quantitative easing by the Bank of London finds that the central bank policy is directly responsible for “exacerbating already extreme income inequality”. It seems all the money wind up as profits rather than creating jobs.

He points out that real wages – adjusted for inflation – have fallen in both the US and UK, where QE has been a key tool for boosting growth. In Germany, meanwhile, where there has been no quantitative easing, real wages have risen.

What’s more, the debts were simply transferred from private hands to public hands, thus encouraging those same private hands to increase their risky speculations. What was sold to us as an expensive effort to ‘save the system’ was actually an extremely expensive effort to ‘save the status quo’.

Protecting the criminals has a price

When I say ‘save the status quo’, I don’t mean just with cash. The SEC has been illegally destroying documents that expose the crimes of Wall Street. After thwarting investigations, senior SEC officials would then go to work for the same corrupt bank. In other cases, the investigation would be farmed out to private firms that were working for the same bank.

But the problems are much deeper than that. Wall Street fraud was and is widespread, but our government and news media refuses to look for it.

We’ve been betrayed by the establishment.

The problem is not limited to America. The EU’s financial watchdog has covered up for the banksters as well.

One thing a lot of people forget is that there is a price to be paid for this immoral protection of Wall Street criminals. We’ve paid this price before.

The amount of gimmickry and outright fraud dwarfs any period since the early 1970’s, when major accounting scams like Equity Funding surfaced, and the 1920’s, when rampant fraud helped cause the crash of 1929 and led to the creation of the S.E.C.

The financial media and central bank members use the term “confidence” a lot. They tend to use it in regards to “confidence in the strength of the economy”. What they overlook is the failing confidence in the legality and fairness of the financial system.

This is a really important point to understand from the point of view of our society. The legal system is supposed to be the codification of our norms and beliefs, things that we need to make our system work. If the legal system is seen as exploitative, then confidence in our whole system starts eroding. And that’s really the problem that’s going on.

When the criminals are made financially whole and even protected by the government, why should anyone have any confidence in the system? That’s like having trust in a mafia front company. It’s insanity.

We all know we are dealing with thieves. No one is under any false impressions anymore.

Helping an individual recover from a traumatic experience provides a useful analogy for understanding how to help the economy recover from its own traumatic experience, Sachs pointed out. The public will need to “hold the perpetrators of the economic disaster responsible and take what actions they can to prevent them from harming the economy again.” In addition, the public will have to see proof that government and business leaders can behave responsibly before they will trust them again, he argued.

What we are facing isn’t just an economic crisis. It’s a political crisis. The thieves who own our politicians have, in their greed, pushed things so far that the corruption of the system has become obvious even to the normally oblivious voter and citizen.

Americans confidence in the financial system is currently at a record low of 23%.

The Wharton economics found a correlation between a rise in unemployment and the loss of public confidence in banks – meaning faith may largely be a function of the economy.

And without trust, the normal business of a country starts to break down. Who would want to borrow money to expand a business or buy a home if they thought the bank would rip them off in the process? Who would have confidence to spend a little more for a luxury if they thought their savings might vanish overnight because of Wall Street fraud?

Trust … plays a key role in economic exchange and politics. In the absence of trust among trading partners, market transactions break down. In the absence of trust in a country’s institutions and leaders, political legitimacy breaks down. Much recent evidence indicates that trust contributes to economic, political and social success.

One consequence of this breakdown in trust is retail investors pulling their money out of mutual funds the moment there is a sign of trouble. It is also reflected in a higher savings rate and people buying gold.

Some want to call the gold bull market a “bubble”, when it is more accurate to call it a reaction to the bursting of a bubble of confidence in the financial system.

And let’s not forget that corporations are sitting on a huge pile of cash, rather than hiring and spending. Some people here are outraged because of it. They are simply doing what the average person would be doing right now if she/he had a job – building up reserves to protect themselves because they have lost confidence in the economic and financial system.

The problem of a collapse in trust in our institutions goes far beyond people hoarding gold and cash. It goes to the root of our entire economic system.

Being able to trust people might seem like a pleasant luxury, but economists are starting to believe that it’s rather more important than that. Trust is about more than whether you can leave your house unlocked; it is responsible for the difference between the richest countries and the poorest.

“If you take a broad enough definition of trust, then it would explain basically all the difference between the per capita income of the United States and Somalia,” ventures Steve Knack, a senior economist at the World Bank who has been studying the economics of trust for over a decade. That suggests that trust is worth $12.4 trillion dollars a year to the U.S., which, in case you are wondering, is 99.5% of this country’s income.

Imagine what would happen to the economy if you can no longer give out your credit card because you are afraid that the other person would steal everything from you, and he/she would suffer no consequences. Now substitute the words “credit card” with “pension”, “401k”, and “mortgage” and you can see the problem.

Without trust business grinds to a halt.

Trust is the oil in the engine of capitalism, without it, the engine seizes up.

Confidence is like the gasoline, without it the machine won’t move.

Trust is gone: there is no longer trust between counterparties in the financial system. Furthermore, confidence is at a low. Investors have lost their confidence in the ability of shares to provide decent returns (since they haven’t).

“Virtually every commercial transaction has within itself an element of trust.”

– economist Kenneth Arrow, a Nobel laureate

Besides a restoration in our political and economic systems that would be caused by prosecuting the criminals on Wall Street, there would also be the benefit of banks focusing more on traditional lending and less on financial speculation, which only benefits the wealthy.

On one hand, it seems almost too easy and simple: prosecute the Wall Street criminals (i.e. do the correct and moral thing) and the economy will start to recover.

On the other hand, the idea of the politicians doing the right things for the country seems like a pipe dream.

That’s why people need to start readjusting how they view the current economic crisis. It is as much political as economic. Both need radical reforms, and I’m afraid that the American public just isn’t ready to accept that. The real subject here isn’t “stimulus” or “austerity”. It isn’t “entitlement programs” or “taxes”.

The real subject here is “fraud and corruption” and who isn’t being punished.

Without those reforms the economy and the political system will continue to deteriorate until the vast majority of the public have nothing left to lose. When that happens things might change very fast. That day might be closer than you think.

What is even more disturbing is that a recent poll found that 64 percent of Americans would not be able to shoulder even an unexpected expense of $1,000.  If a transmission on a car goes down or additional medical expenses hit, it will cost well over $1,000.  This is simply another reflection of how the crushing collapse of the middle class will not be televised.



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    • gjohnsit on August 20, 2011 at 05:43

    I might be updating and changing this post, but its too late at night for that right now.

  1. … its certainly true that we in the US and the Europeans did not spend enough money.

    Note that in:

    Could it be, as some have claimed, that we didn’t spend enough money?

    On the contrary. The Federal Reserve alone threw $16.1 Trillion at the problem.

    … that is not spending money on products, that is spending money on financial assets.

    While spending $16.1 Trillion on financial assets, the most we spent on buying products was around $0.25 Trillion, for a $1T+ shortfall between existing demand and productive capacity.

    Meanwhile, the countries that responded to the crisis by spending on products, Australia and China, did not experience extended economic downturns, even the pace of growth may have slowed a bit.

    On the question, how to spend money when the bond markets won’t lend, the answer is that the fiscal authority of a sovereign economy spends it, and directs the monetary authority to create the money. After all, for sovereign economies, we only pretend to be financing the deficit by borrowing from the private sector ~ in reality, that is “borrowing back” what the spending injects into the private sector.

    The problem in Europe is that the part that they built in the 90’s and Two Thousandsies was built according to Wall Street Fantasy economics, and so they built their Eurozone without a fiscal authority. With no fiscal authority at the level of the currency zone, and the fiscal authorities at the national level not having sovereign economies anymore, they were pretending that we never need fiscal policy to pull the economy out of a ditch, and so left the ability to pull the economy out of the ditch out of their system.

    In the US its merely a question of political will to use the tools that are lying idle. In Europe, its a matter of mustering the political will to rebuild the system so its not broken from the outset.

    • Xanthe on August 22, 2011 at 15:41

    the “stimulus” was too small – not that the gift to the finance elites was too small – and by stimulus, he meant money in the Middle/working class pockets.  

    But your diary as usual is spot on and really depressing, as all intelligent commentary is these days.

    45 million children on food stamps – when people can’t feed their children – all bets are off.  It would only take the onset of some agricultural virus (due to the ever dimininishing regulation of any governmental agency) to cause a tsunami.    

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