Saturday, December 19, 2009

Books: "Bad Money" by Kevin Phillips

The book's premise is that the 80s can be identified as the launching pad of a decisive financial sector takeover of the US economy, consummated by turbocharged, relentless expansion of financial debt and eventual extension of mortgage credit to subprime and unqualified buyers. Austrian school of economics taught that every boom comes from extraordinary credit expansion out of proportion to real economic growth. Forced economic deleveraging of a two decade buildup of debt and liquidity is imminent.

Political Factors

In 1960s Keynesian and progressive economics were losing credibility in the US, because of soaring government spending, inflation, and fiscal mismanagement of Vietnam War. Milton Friedman, a conservative economist whose work combined emphasis on nation’s money supply as the key to inflation with a staunch belief in the market as self-correcting mechanism, successfully sold his position within the Republican Party.

With the emergence of conservative leaning governments on both sides of the Atlantic – Margaret Thatcher in 1979 in UK and Ronald Reagan in 1980 in the US – unbridled free market ideas returned power to the finance and its allies. Contrary to the Keynesian demand-side economics Reaganites picked up 19th century Jean-Baptiste Say’s thesis that supply created its own demand by unleashing capital through tax cuts. Resulting economic growth that lasted till the mid 90s enabled the capital build-up of US military, and stock market gain that is coupled with venture capitalism and entrepreneurship. However, critics complained that tax reductions disproportionately benefited corporations, commercial real estate, stock owners, and so-called paper entrepreneurs – the designers and promoters of mergers, asset shuffling, corporate takeovers, or debt fueled corporate leveraged buyouts.

Economic Factors

As Milton Friedman’s doctrine received general acceptance in the field of economics, efficient market hypothesis (EMH) gains hold in the business schools, banks, and investment houses. With EMH high profitability finance ascended as a result of following preconditions:
1. Persistent economic deregulation
2. Debt dependent mergers, takeovers, and leveraged buy-outs
3. Economic utility of speculation
4. Usefulness and facilitation of markets provided by derivatives

Between 1987 and 2007 debt – in all flavors, from credit card and mortgage to staid
U.S. treasury and exotic Wall Street – roughly quadrupled from $11 trillion to $48 trillion. From 2001 through 2007 alone mortgage debt, financial debt, and the current account deficit all nearly rose 100%. Consequently with the increased liquidity provided by these massive debts, financial assets and homeowners’ real estate were over stimulated and similarly bond and equity markets were artificially elevated to new heights. By 2006, financial services represented 20-21% of GDP, whereas manufacturing just 12-13%.

The debt the US has been accumulating in the past few years has provided only 30-40% as much stimulus per dollar to the national economy as did the debt added 25-40 years ago, because money borrowed in the 70s or early 80s were spent on factories, jet aircrafts, teachers, or highways whereas money borrowed today were used by hedge funds to double the leverage of their various self-serving speculations.

In 2006 Bank for International Settlements in Basel declared that we have shifted from a cash-flow constrained to an asset backed economy and further issued a warning in 2007 pointing to quartet of troubling indicators: issuance of huge scale of complicated new credit instruments, reckless tolerance for risk, unprecedented household debt level, and major imbalances in the world currency system.

Consumer Price Index and Statistical Debasement:

Until 90s CPI measured the cost of a fixed basket of goods using prevailing market prices. This was changed in late 90s:

  1. Geometric weighting of now flexible basket of goods – items going up received less weight and items going down received more weight, both having reductive effect in the CPI
  2. Use of “hedonics” in order to moderate prices by reducing them for the increased satisfaction a consumer derives from some improvement
  3. Housing represents 40% of CPI but it is measured using “owners’ equivalent rent” which fails to take account for the increased expenditures of home owners such as insurance, property tax, etc.

If the old method was to be used to measure the CPI between 2005 and 2007, then the inflation would register between 5 to 7% instead of 2-4%. Statistically such difference would have dropped the US economy into recession or to its borderline.

Financial Factors

Banks and savings and loans associations gave way to mutual funds, nonbank lenders, hedge funds, federally related mortgage entities, issuers of ABS, security brokers and dealers and others. Unlike banks these latter day inventions of the financial heyday were minimally regulated by the government and yet as large as or even larger than the traditional banking institutions.

Securitization is what financial industry discovered in response to the question of whether or not if wealth can be created without manufacturing anything. Securitization as a business included two product categories – asset backed securities (ABS) and mortgage backed securities (MBS). Two products of the former that are often mentioned these days are collateralized debt obligation (CDO) and home equity loans (HELs). From $400 billion in 1995 securitization increased in size to $4 trillion by 2003. Lenders applauded the new method to sell the loans quickly, to spread the institutional risk, and to receive upfront payment so that they can issue even more loans. Wall Street jumped on the securitization issuance to make enormous profits both locally and internationally. By 2005 80% of the total securitization issuance was in US hands.

By 2006 total mortgage origination was about $2.5 trillion of which ¾ were securitized into MBSs. Home equity loan which represented about 35% of all ABS in 2002 ballooned to 65-70% by 2006. US banks held record amount of mortgage related assets in their books and any housing recession combined with massive mortgage defaults would completely cripple them. By 2007 foreigners held 28% of ABS and nearly 40% of MBS of US issuance.

With the burst of the bubble CDOs and mortgage backed securities were radioactive in spreading fear among the financial institutions with prime suspect being money market funds. By mid Aug of 2007 commercial paper markets were all but frozen. President of Bundesbank stated that the Aug crisis was just like the classical bank-runs except that it was taking place in non-bank financial system.

Peak Oil

Since the emergence of Modern Europe in the wake of the Renaissance and the rise of capitalism, idiosyncratic energy regimes have been important in making the three successive world economic power: wind and water to the 17th century Dutch, coal to late 18th century Britain, and oil to the US.

In 1974, three years after the dollar lost its small tie to gold Saudis agreed that the international sale of oil would take place in dollar and further to recycle the dollar through purchases of US treasury bonds and notes.

It was generally accepted by the end of 2006 that the American attempt to open up Iraqi oil fields to drive down oil price and break the power of OPEC and its state owned companies has practically failed. During the five years after the Iraqi invasion oil price increased from $25 barrel to $100 range. Dollars long standing role as oil currency declined with the Washington’s lost credibility. As of 2007 80% of the petroleum reserves were in the hands of state owned oil companies.

Goldman Sachs posits that since 2001 $3 trillion more has been transferred to OPEC producers than would have been if the oil stayed at $20 per barrel with main beneficiaries being Russia and larger Middle East. This comes on top of late 20th century wealth transfer occasioned by surge in manufacturing export, information technology outsourcing, and huge trade surpluses China, India and Southeast Asia. The principal loser was American dollar as foreigners who sent their money to US saw sharp decline in dollars’ purchasing power of oil, metals, and other commodities. It was calculated that dollars 10% drop against other currencies would translate into some 5% drop in purchasing power of OPEC’s Persian Gulf members.

Among the major threats to dollar as a result of oil problems were: first, diversification by foreign central banks their reserve currency out of dollar into stronger currencies; second, reversal of formerly dollar pegged currencies such as those of China and Gulf countries; third, potential reversal of dollar denominated oil sale; fourth, monetary mercantilism or the reserve of huge amount of dollar by foreign central banks; fifth, vulnerability of the institutional firepower of the sovereign wealth funds being put into commission.

As a result of dollar valuation of oil, major oil exporters faced several negative effects due to depreciating dollar: reduced actual income from the oil export, increased price for imported goods from Asia and Europe, and inflationary pressure for those who pegged their currency to the dollar. In fact strong dollar pegs of Gulf countries and crawling peg of China are self trapping, because they expose their respective economies to stimulative US economic policy instead of dealing with overheating economies and rising inflation.


Derivative – Financial instrument that is derived from some other asset, index, event, value, or condition (known as the underlying)

Security – Fungible, negotiable instrument representing financial value
Debt security – banknotes, bonds
Equity security – common stocks, derivative contracts

ABS (asset-backed security) – A security whose value and income payments are derived from and collateralized by a specified pool of underlying assets.

CDO (collateralized debt obligation) – A type of structured ABS whose value and payments are derived from a portfolio of fixed income underlying assets. Usually assigned different risk classes, or tranches.

Monetary Mercantilism – The rise of sovereign wealth funds in China, Russia, Qatar, Abu Dhabi and ballooning currency reserves by their respective countries but also Japan, Taiwan, and Korea and their ability to defend their own currency or attack some other.

Energy Mercantilism – Practice of some nations – China, Russian, India, Angola, Sudan, and others – of bypassing the global marketplace and cutting oil and gas deals directly with other nations.

Financial Mercantilism – Government business collaboration calculated to suspend or stymie market forces: Washington and US financial sector seek to minimize certain unwanted marketplace forces by massive bailouts. It can also describe nation’s favoritism to its own exports through subsidies or easy financing.

Efficient Market Hypothesis – In rebuttal to Keynesian assumption that the markets were unstable, EMH held market to be inherently rational and efficient thus the fair market valuation of the shares over the long term.

Modern Portfolio Theory – It teaches that the risk is minimized by investment in whole varieties of stocks rather than in one by one basis.

No comments:

Post a Comment