Tuesday, March 31, 2009

Obama's Economic Policies Are Not About Big Government

Below is an excellent op/ed piece in the WSJ by Robert Reich discussing Obama's overall economic policy. An economy only has two components to drive economic growth capital and labor. The only thing that is uniquely American is labor. Capital can move any where in the world at the push of a button. Obama's economic policy concentrates on improving human capital. Text in bold is my emphasis.

Twenty-eight years ago, Ronald Reagan used the severe economic downturn of 1980-82 to implement an economic philosophy that not only gave force and meaning to a wide range of initiatives but also offered a way back to sustained economic growth. Is there a similarly powerful animating idea behind Obamanomics?

I believe there is -- and it's not a return to big government.

The expansive and expensive forays of the Treasury and the Federal Reserve Board into Wall Street notwithstanding, President Barack Obama's 10-year budget (whose projections may prove wildly optimistic if the economy fails to rebound by early next year) presents a remarkably conservative picture. In 10 years, taxes are expected to fall to around 19% of GDP, a lower level than the late 1990s. Spending is expected to drop to around 22.5% of GDP, about where it was under Ronald Reagan -- including nondefense discretionary spending at about 3.6% of GDP, its lowest since data on this were first collected in 1962.

The real distinction between Obamanomics and Reaganomics involves government's role in achieving growth and broad-based prosperity. The animating idea of Reaganomics was that the economy grows best from the top down. Lower taxes on the wealthy prompts them to work harder and invest more. When they do so, everyone benefits. Neither Reagan nor the apostles of supply-side economics explicitly promised that such benefits would "trickle down" to everyone else but this was broadly understood to be the justification.

Reaganomics surely marked the beginning of one of the longest bull markets in American history and generated enormous gains at the top. But its benefits were not widely shared. After the Reagan tax cuts, growth in the median wage slowed, adjusted for inflation. After George W. Bush's tax cuts in 2001 and 2003, the median wage dropped. Meanwhile, an increasing share of total income went to the top 1% of income earners. In 1980, before Reagan took office, the highest-paid 1% took home 9% of total national income. By 2007, before the economy melted down, the richest 1% was taking home 22%.

Obamanomics, by contrast, holds that an economy grows best from the bottom up. The president proposes to increase taxes on the highest 2% of income earners starting in 2011.

Those tax increases will fund more Pell grants allowing lower-income children to attend college, better pay for teachers that show they're worth it, broader access to health care, improved infrastructure, and more basic research. These and related expenditures are designed to help Americans become more productive. You might think of it as "trickle up" economics.

The key is public investment. Reaganomics did not view any public spending as an investment in the future except when it came to spending on the military. Hence, since 1980, federal spending on education, job training, infrastructure and basic research and development (apart from defense-related R&D) have all shrunk as a proportion of GDP. And apart from a modest expansion of health insurance available to poor children, there has been no significant attempt to make health insurance broadly affordable to Americans.

Obamanomics is premised on the central importance of public investments in the productivity of Americans. The logic is straightforward. Capital no longer remains within the borders of a nation where it is saved. It moves to wherever around the globe it can get the best return. Some of it flows as highly liquid investments that slosh across borders at the slightest provocation, as we're witnessing in the current financial crisis. But much takes the form of direct investments in new plants and equipment, telecommunications systems, laboratories, offices and -- most important of all -- jobs. Such capital goes to nations that can deliver high returns either because labor is cheap and taxes and regulations low or because labor is highly productive: well educated, healthy and supported by modern infrastructure.

In this way, every nation faces an implicit choice of whether its strategic advantage will lie in low costs or high productivity. For the better part of the last three decades America's job strategy has tended toward the former. But this inevitably exerts downward pressure on the real wages of a larger and larger portion of our population.

Only those Americans whose parents can afford to give them a high-quality private education and health care, and who can situate themselves in locations with excellent infrastructures of telecommunication, transportation, public health and safety, have been able to link up with global capital on more positive terms. But not even they are entirely secure economically, because they face growing shortages of talented people they can rely on within easy reach, and can't entirely avoid the disadvantages of a deteriorating public infrastructure, such as ever more congested roads and airports.

Obamanomics recognizes that the only resource uniquely rooted in a national economy is its people -- their skills, insights, capacities to collaborate, and the transportation and communication systems that link them together. Public investment is the key to attracting long-term private investment so that a nation's people can prosper.

Bill Clinton understood this but failed to do much about America's deteriorating public investments because he came to office during an economic expansion, when the major worry was excessive government spending leading to inflation. Mr. Obama comes to office during the biggest downturn since the Great Depression, and his plan represents the largest commitment to public investment in 30 years.

Regulation, done correctly, is also a form of public investment because it enables consumers and investors to be confident about what they're receiving, and ensures that the side-effects of trades don't harm the public. Reaganomics assumed that deregulated markets always function better. They do in many respects. But when they don't, all hell can break loose, retarding economic growth.

Energy markets were deregulated and we wound up with Enron. Food and drug safety has been neglected, resulting in contaminated products that have endangered consumers and threatened whole industries. Financial markets were deregulated and we now have a global meltdown. Obamanomics, by contrast, views appropriate regulation as an essential precondition for sustainable growth.

Under Reaganomics, government was the problem. It can still be a problem. But a central tenet of Obamanomics is that there are even bigger problems out there which cannot be solved without government. By building the economy from the bottom up, enhancing public investment, and instituting reasonable regulation, Obamanomics marks a reversal of the economic philosophy that has dominated America since 1981.
China and the IMF

I am no expert on China, but it is clear to me that China is interested in playing a larger role in international economics and finance. It is now interested to playing a larger role in the IMF, which will re-direct the institution and its policies. The Americans and Europeans better get used to the fact that the world is not going to go back to way it was and other people now want a seat at the table. Text in bold is my emphasis. From the WSJ:

China is showing more willingness to aid organizations like the International Monetary Fund, reflecting its desire for a stronger voice in global economic affairs. But as leading economies prepare for a summit, Beijing's push for clout to match its financial resources is creating friction with rich countries.

The European Union's commissioner for external relations, Benita Ferrero-Waldner, said Monday during a visit to Beijing that the G-20 summit is "not the right moment" to negotiate IMF votes, which are set to be updated by January 2011. She also called China's proposals for dealing with the global financial crisis "imprecise."

Over the past week, Beijing officials have said China, with nearly $2 trillion in foreign-exchange reserves, is willing to add funding for the IMF to increase the lender's ability to help countries hurt by the crisis. An agreement on putting more money into the IMF could be one of the most concrete achievements of this week's summit of the Group of 20, a gathering of the world's major economies.

The IMF is aiming to boost its war chest to at least $500 billion from $250 billion, and is already close to that goal. Japan has lent $100 billion, and the EU has committed €75 billion ($100 billion). Countries such as China and Saudi Arabia are being asked to help come up with tens of billions of dollars more to make up the difference. The U.S. is looking to chip in nearly $100 billion, but wants it as part of a separate kitty the IMF can tap in emergencies.

Beijing wants something in return for new funding. "China sees this as a good opportunity to increase its influence," said Jun Ma, China economist for Deutsche Bank. China doesn't want to miss out on the chance to help rewrite the rules that will govern global finance for coming decades. "China is more actively contributing their thoughts. This is very different from 10 years ago, when China was much quieter and more low profile," said Mr. Ma, who previously worked for both the IMF and the Chinese government.
China wants more IMF voting rights in exchange for any new funding, which most countries agree makes sense given its weight in the global economy. Chinese officials have also said the country could contribute in ways that don't require an immediate overhaul of the organization, for instance by buying bonds issued by the IMF.

An increase in China's IMF voting power would likely come at the expense of smaller European nations.

A stronger Chinese role at the IMF could also mean the institution might start going along less frequently with the U.S. and Europe. Because the current crisis originated in developed countries, China says the IMF should be able to more openly criticize their policies. "Under the current situation, we feel that the IMF particularly needs to strengthen its surveillance of the economic and financial policies of the major reserve-currency-issuing nations," deputy central bank governor Hu Xiaolian said last week.

China seems to want to strengthen and redirect the IMF, not undermine it. Central bank governor Zhou Xiaochuan's proposal last week for a new global reserve currency would give the IMF even greater clout. Mr. Zhou was a member of an outside panel of current and former officials who last week called for a "re-energized" IMF, concluding that "the world needs a multilateral institution at the center of the world economy to help anchor global financial stability."

The interest in bolstering the IMF is perhaps surprising given the sometimes rocky relationship China has had with the fund. The organization's reputation within Asia is poor, as many governments say the IMF gave bad advice during the regional financial crisis of 1997-98. Though China hasn't had to borrow from the IMF, many within China see the IMF as a tool the U.S. has used to criticize Beijing's currency and economic policies.

China has stepped up its participation in other international agencies. In January, China formally joined the Inter-American Development Bank, contributing $350 million to fund the agency's lending in Latin America and the Caribbean.

Incorporating China into institutions that have long been dominated by the U.S., Europe and Japan is bound to alter what has been "the fairly predictable context" for decisions on international economic policy, said Angel Gurria, secretary-general of the Organization for Economic Cooperation and Development. "We have been producing consensus among ourselves in a generally like-minded community of countries which are very used to working with each other and talking to each other," he said in an interview in Beijing.

But China's positions have gained more credibility internationally because of its aggressive response to the economic downturn: Its stimulus plan is one of the biggest in the world.

Obama and the Auto Industry - More Details

Below is an article from today's WSJ outlining the position that bankruptcy could play with GM and Chrysler. I find it very interesting that the Obama Administration has really taken the bull by the horns on this issue and demonstrated considerable leadership. If I were an executive at a bank or on Wall Street I would be nervous.

I don't know if you have noticed but so far this month the Fed agreed to buy US Treasury securities, the Treasury outlined a plan to buy toxic mortgage assets, and China warned the US about the value of the dollar. Now the government is in the auto industry in a big way. Forget the stimulus package and bail-out plan, they are not the big news. Text in bold is my emphasis.

The Obama administration, wading deeply into the U.S. auto industry, is weighing a fix for General Motors Corp. and Chrysler LLC that would divide their "good" and "bad" assets and send the auto makers into bankruptcy to purge their biggest problems.

The potential move would transform two companies that have helped define U.S. industrial power over the past century. Following the ouster of GM Chief Executive Rick Wagoner, it would represent one of the biggest-ever government incursions into private enterprise.

And it would be fraught with political risk and controversy for the Obama administration, now that it is becoming clear that government involvement in the operations of GM and Chrysler will dwarf that of any other company receiving U.S. aid.

Among other things, a bankruptcy filing could hurt GM's unionized work force, angering a key Democratic constituency. The plan also exposes the administration to criticism that it is being tougher on GM and Chrysler than the banks that have repeatedly gotten government cash.

Sending GM and Chrysler into bankruptcy isn't a done deal. But both the government and the auto makers are planning for such an eventuality, barring dramatic, 11th-hour concessions from bondholders, unions and others.

The administration would like to see the "good" GM, comprising brands such as Chevrolet and Cadillac, remain an independent company, according to an administration official. Equity in the "good" Chrysler, meantime, would be sold to Fiat SpA, assuming that proposed deal goes forward, this person said.

President Barack Obama on Monday warned GM and Chrysler that they couldn't depend on unending taxpayer loans and gave the companies a brief window to craft plans -- 60 days for GM and 30 for Chrysler -- that would justify fresh government support. But he also pledged to do all he could to save the industry.

"We cannot, we must not, and we will not let our auto industry simply vanish," Mr. Obama said at the White House.

The remarks came a day after the administration forced Mr. Wagoner's departure and rejected the restructuring plans that GM and Chrysler had hoped would lead to another infusion of government loans. The administration also is set to remove the majority of GM's board of directors. One senior administration official said the aim was to restart GM "with a clean sheet of paper."

GM's stock fell 25% on the news, down 92 cents to $2.70 in 4 p.m. New York Stock Exchange composite trading.

The administration's interventions struck a new tone of seriousness amid the recent uproar over executive bonuses at financial companies receiving big government loans. With the auto makers, the government has laid down stringent terms for new support and raised, in the case of Chrysler, the possibility the company could be left to collapse.

All the same, the administration's new plan is sure to ignite a battle over the government's role in the economy, what sacrifices will be required of labor unions, and whether it makes sense for U.S. taxpayers to assist a foreign company, Fiat, in an alliance with a U.S. company, Chrysler.

As part of their proposed pact, Fiat and Chrysler agreed over the weekend to scale down the Italian auto maker's initial stake in Chrysler to 20% as a condition of the Treasury Department's bailout. Fiat earlier this year struck an agreement to take a 35% stake in Chrysler initially, and up to an additional 20% at a later date.

Many hot-button issues remain unresolved, above all the fortunes of about 140,000 members of the United Auto Workers union and the health-care plan for the group's hundreds of thousands of retirees.

President Obama argued Monday that the U.S. auto industry -- and, by default, its largest component, GM -- was unique in its centrality to the U.S. economy. "This industry is, like no other, an emblem of the American spirit," he said. "It is a pillar of our economy." He went on to insist that the government had no intention of running GM.

His auto team's dissection of what ails GM, on the other hand, underscores how deeply the administration plans to plunge into the finer points of the company's business plan. In a five-page analysis of GM's viability, the team critiqued GM's marquee next-generation project, the electric-powered Chevy Volt, as "too expensive to be commercially successful in the short-term." It notes that much work needs to be done to boost the overall fuel-efficiency of GM's fleet of cars and trucks.

With GM, the Obama administration is interested not just in preserving jobs, but in pushing other policy prescriptions, in particular creating a "company of the future" with clean and energy-efficient vehicles, a frequent campaign theme during Mr. Obama's quest for the presidency.

The auto plan came packaged with several new government initiatives whose price tags remain unclear. The government said it would guarantee the warranties for all new GM and Chrysler cars until the two companies return to health. It also plans to speed up government fleet purchases, and to support a congressional bid to offer large tax incentives for new-car purchases, with money for the program coming out of the $787 billion stimulus package. Mr. Obama also said that the Internal Revenue Service was creating a new tax benefit for car buyers.

Auto executives and Obama aides cautioned that the bankruptcy route is not preferred or in anyway preordained. The two car makers could avoid that outcome if they manage in coming weeks to strike tough bargains with debtholders, creditors and the union. But concessions on that front have so far proved largely elusive, giving the bankruptcy option a much higher likelihood of success.

"We have significant challenges ahead of us, and a very tight timeline," said new GM Chief Executive Fritz Henderson. In a conference call with reporters, Mr. Henderson acknowledged that bankruptcy was very much a possibility. "There are ways to do this out of court, but we're getting ready to do in court if necessary," he said.

The Journal's John Stoll says that with billions in taxpayer money on the line, the Obama administration needs to work closely with GM to forge a more dramatic restructuring.

GM and Chrysler have had bankruptcy attorneys devising plans to split their companies in two for several months. Mr. Obama's task force has told both companies that the administration prefers this route as a way to reorganize the two auto makers, rather than the prolonged out-of-court process that has so far frustrated administration officials, people familiar with the discussions said.

GM looks increasingly like it will be forced into filing for bankruptcy protection, sometime in mid-to-late May, and that the surviving "new GM" will retain select brands and some international operations, said several people familiar with the situation.

Stakes in this new GM could be given to creditors. It is also possible the new company could be sold whole or in parts to investors or its shares sold in an initial public offering. The UAW's retiree health-care fund would likely get either some shares or proceeds from the sale of the stock.

A key ingredient in acting on this plan is getting the UAW to agree to an entirely new contract, including major reductions in health-care benefits, said several people involved in the matter. "That's the No.1 wild card here," one of these people said Monday.

Under the plan, the "good" GM wouldn't be expected to hold the tens of billions of dollars in retiree and health-care obligations that hurt the auto maker in recent decades. Instead, those obligations would be transferred to an "old GM," made up of less-desirable brands such as Hummer and Saturn, and underperforming plants and other assets.

This part of GM would likely sit in bankruptcy much longer while a buyer is sought for the parts or it is wound down. Proceeds from the sale of old GM would go back to pay claims to various creditors.

"That is the plan, to the extent it comports with the bankruptcy laws," said one person familiar with the matter.

On the first day in bankruptcy, people familiar with the matter said, GM would transfer the valued assets to new GM. Then it would launch a marketing and advertising campaign, aiming to comfort consumers about warranties on new and existing vehicles, the resale value of their vehicles and the ability to buy replacement parts.

The "new GM" would have a less-burdened balance sheet than GM currently has. But one debt that would stay with new GM is the $20 billion or so the federal government has lent to it, say these people.

Mr. Wagoner had participated in the plan's development, along with Mr. Henderson, turnaround veteran Jay Alix and prominent bankruptcy attorney Martin Bienenstock. GM also has veteran bankruptcy lawyer Harvey Miller working for it.

At Chrysler, where Jones Day lawyers have been working on a plan, bankruptcy would be used to force new labor contracts and rework debt deals with secured creditors. People working on Chrysler's behalf say the approach is risky, because the company is still unsure it could survive even a short-term bankruptcy. Bankruptcy might be pursued to meet the Obama administration's demand that Chrysler's creditors agree to huge reductions in their expected recoveries on Chrysler debt.

GM and Chrysler's bankruptcy financing, called debtor-in-possession, would have to be funded by the government at a cost of tens of billions of dollars, say people familiar with the matter.

Democratic Rep. John Dingell of Michigan praised the package, but voiced one worry: "I have some concern that if these companies get into bankruptcy, how do they get out? I'm an old bankruptcy lawyer, and bankruptcies have a life of their own."

Monday, March 30, 2009

AIG Finances and the Health of the Insurance Industry

Below is an article on the finances of AIG and the health of the insurance industry as a whole. Most people do not understand the the average investment portfolio for an insurance company took quite a pounding last year so many of these companies could be weak. YOu may want to think this thorugh before signing up for an insurance company or an annuity. Text in bold is my emphasis. From the LA Times:

When insurance giant American International Group Inc. imploded last fall, the firm's problems were quickly blamed not on its core insurance business but on an obscure operation that traded exotic mortgage securities.

But as the economic crisis deepens, it has become clear that AIG's problems extend across most of its business lines, including its massive life insurance and retirement services operations, which reported a staggering $18-billion quarterly loss this month.

The company's situation is emblematic of problems across the life insurance industry, which is suffering deep losses on investments that underlie policies for millions of American families.

So far, some of the biggest companies have suffered sharp drops in their stock prices, and many of them are asking for federal assistance.

Industry conditions last year were the worst in memory and are expected to grow deeper this year amid credit rating downgrades, declining revenue and investment losses, according to credit rating firm A.M. Best Co.

The worst-case scenario is that a second financial crisis is looming if these life insurance companies come under too much stress.

"It was essentially a house of cards at AIG," said Donn Vickrey, a forensic accountant and co-founder of Gradient Analytics in Scottsdale, Ariz. "I would characterize other life insurers as suffering varying degrees of risk."

The financial problems, Vickrey said, may not be as serious as the disaster that swept over some parts of the banking industry, but insurers have not been subject to the same level of scrutiny as banks, and some experts say much remains unknown about their condition.

When the life insurance industry ultimately stabilizes, the financial landscape will be different, along with the once-dominant AIG.

Two key pieces of AIG's life insurance and retirement products operations are Los Angeles-based SunAmerica Inc., which sells retirement annuities, and Houston-based American General Life.

Last fall, AIG tried to sell off its life insurance and retirement products units with the idea of preserving its core business of property and casualty insurance.

But by March 2, AIG retirement services chief Jay Wintrob wrote to employees in an internal message that the sales were more or less on the back burner.

Wintrob is now considering a consolidation of SunAmerica and American General. Both operations say they are well capitalized and have many times the minimum required level of reserves to meet their obligations to their 17 million customers.

Credit rating agencies have cut their assessments of the firms, though they remain well above levels that would indicate vulnerability.

The companies' survival is due to a unique advantage: AIG is the only insurance company that is a major recipient of taxpayer bailout funds. The company has received commitments from the Treasury Department for $70 billion and lines of credit for tens of billions more.

"With the support and cooperation of the U.S. Treasury and Federal Reserve, AIG now has a new set of tools to reduce its debt, strengthen its capital base and enhance the value of its core business," Wintrob wrote in his message to employees.

Without that lifeline, all of AIG's operations -- and the welfare of its customers -- could be in a lot more trouble, according to securities analysts, insurance industry experts and credit rating agencies.

Other insurers are now asking the federal government for bailout packages, arguing that AIG has an unfair competitive advantage.

The Treasury Department and various oversight boards are uncertain how much of the taxpayer assistance went to AIG's retirement and life insurance operations. But credit rating firms say that without that assistance, there would have been a substantial downgrade to AIG's ratings.

Its current ratings reflect "our view that the U.S. Treasury and the Federal Reserve will continue their financial support of and commitment to AIG," said Kevin Ahern, an analyst who follows the company for Standard & Poor's Rating Services.

Ahern said the federal bailout of AIG kept the credit rating for AIG's holding company six notches higher than it would be otherwise, and without that support the company's credit would sink below investment grade.

AIG's loss of $18 billion in its life insurance and retirement businesses in the fourth quarter was about the same amount that the company lost in its financial services operation, which was trading in credit default swaps and other risky instruments.

The losses for the retirement and life insurance operations came on the falling value of investments that were being furiously sold and marked down as the stock market collapsed last year. The company said that if not for those investment losses, the operations would have been profitable.

SunAmerica, which has operations in Century City and Woodland Hills, sells variable annuities, which are retirement policies that provide a stream of payments, generally based on how well securities markets perform. The company has assets of $158 billion and nearly 6 million customers.

But those policies often have embedded guarantees, meaning that benefits can only drop so low before the company has to take a hit, said Joseph Belth, a nationally known insurance expert and retired Indiana University professor.

"Different variables have different embedded guarantees," Belth said. "But they all have one thing in common: The company takes on a risk if there is a dramatic decline in the stock market. And they no doubt never dreamed of the kind of stock market collapse like we have had.

"It seems to me that if AIG had not gotten the federal money, they would have had to declare bankruptcy," Belth said.

Belth said in a bankruptcy, state regulators would continue to operate the subsidiaries and maintain existing insurance policies.

Critics say the company brought some of its troubles on itself by engaging in risky securities practices. In some cases, it was betting against its own long-term interests.

"AIG investments were more aggressive, relative to other insurers, across all of their business, including life and casualty insurance," said Paul Newsome, an insurance analyst at investment banking firm Sandler O'Neill & Partners.

In a statement, AIG disputed that, saying their products carry about the average amount of risk for the industry.

"This claim is misleading and inaccurate," AIG spokesman John Pluhowski said. "The company has maintained a generally conservative, middle-of-the-road stance on living benefits for many years."

But other analysts go much further in criticizing the company's practices.

Overall, AIG made "the most egregious investment decisions I have ever seen," Vickrey said. "It was extremely high risk with very high levels of leverage and insufficient hedging."

AIG, along with others, began offering in recent years specialized variable annuities with guaranteed minimum death benefits, Vickrey said. The assumptions underlying these contracts turned out to be wildly optimistic, he said.

As a result, AIG is on the hook to deliver guaranteed benefits despite the fact that, even if it had invested prudently, it would not have earned a sufficient return to make good on the obligation, he added.

Sen. Richard C. Shelby of Alabama, the senior Republican on the Senate Banking Committee, said AIG's life insurance companies also played a very risky game of lending out long-term securities and investing cash collateral for those loans in securities backed by subprime mortgages.

When the mortgage market collapsed, AIG life insurance firms took a $21-billion loss, Shelby said at a Senate hearing this month. Only because those AIG life insurers were able to tap $17 billion in federal assistance were they able to meet policyholder claims, he said.
The Risk of Deflation

The debate about whether or not we will get inflation or deflation in the future continues with good arguments on both sides of the issue. Below is summary of a research note published by the Fed that argues against a deflationary spiral. It is short and easy to read. From the WSJ Real Time Economics:

Unemployment is rising, asset values are plummeting and some of the economy's most common products (beyond food and energy) have seen their prices tumble. The stage is set for a deflationary spiral. So why do professional forecasters put such low odds on a deflation scenario?

The Federal Reserve Bank of San Francisco,
in a research note released today, concludes that forecasters are betting on aggressive central bank action. "Forecasters appear to be convinced that the Federal Reserve would not be content with sustained deflation and would take policy actions to restore a positive rate of inflation," writes John Williams, the San Francisco Fed's director of research. "This contrasts with the 1970s, when forecasters were concerned that the Fed would tolerate high rates of inflation."

Give the Fed a win (so far) for a successful communication policy on that front.
The Survey of Professional Forecasters puts the chance of core price deflation this year or next year at 1 in 20. The SPF sees core inflation (based on the price index for personal consumption expenditures, excluding energy and food) at 1.1% this year and 1.5% in 2010.

Mr. Williams dissects Phillips curve models of inflation and finds that one of them (based on the historical relationship between inflation and unemployment from 1961 to 2008) puts core PCE inflation at 0.3% in 2009 and a deflation rate of 0.8% in 2010.That puts the probability of deflation at 30% in 2009 and 85% in 2010.

The central bank can fight deflation by stemming slack in the economy and communicating its commitment to positive (but low) inflation rates, he writes. And the Fed is doing just that through its recent statements and its long-run inflation forecasts. "Such words, backed by appropriate actions, reinforce the anchoring of inflation expectations and reduce the chances of a deflationary spiral," Mr. Williams says.

George Soros on the Potential Global Economic Meltdown

Below are some comments about and from George Soros concerning the possibility of an economic meltdown. Text in bold is my emphasis. From the UK Times:

George Soros was 13 when the Nazis invaded his homeland of Hungary. As a Jew, he was forced to adopt a false identity and live separately from his parents in Budapest. Instead of being traumatised by the experience, though, he found the danger exhilarating. “It was high adventure,” he says, “like living through Raiders of the Lost Ark.”

Sixty-five years later, he still thrives on danger. He famously made $1 billion on Black Wednesday by shorting the pound, earning him the label of “the man who broke the Bank of England”. Last year, as the world tipped into financial chaos, Mr Soros pocketed another $1.1 billion by correctly predicting the downturn. “I’m an expert in crises,” he says.

The man who has a phobia about math has made his name as the philosopher king of economics – his book The Crash of 2008, out in paper-back next week, has been a bestseller on both sides of the Atlantic. Since 1944 he has believed in what he calls “reflexivity” – the idea that people base their decisions on their own perception of a situation rather than on the reality.

He has applied this both to investment and to politics: his skill has been to predict moments of seismic change by identifying a disjunction between perception and reality.

When everyone else was convinced that the markets would automatically correct themselves, the 78-year-old “old fogey”, as he calls himself, was one of the few warning of recession. He put all his chips on “the Barack guy” early on when all around him were still gunning for Hillary Clinton. It’s almost as if he has been waiting for the Great Recession for the past ten years. When we ask whether he prefers booms or busts, he replies: “I have to admit that actually I flourish, I’m more stimulated by the bust.”

This recession, he explains, is a “once-in-a-lifetime event”, particularly in Britain. “This is a crisis unlike any other. It’s a total collapse of the financial system with tremendous implications for everyday life. On previous occasions when you had a crisis that was threatening the system the authorities intervened and did whatever was necessary to protect the system. This time they failed.”

The financial oracle does not know how long it will last. “That depends on how it’s handled. Allowing Lehman Brothers to fail was the game-changing event. That’s when the financial crisis went over the brink.” We could end up with a depression. “Unless we handle it well then I think we would. The size of the problem is actually bigger than in the 1930s.”

The problem in Britain, he believes, is in many ways worse than in America or Germany. “American memory is seared by the Depression, the German memory is seared by hyperinfla-tion but Britain has a pretty serious problem in many ways worse than America because the financial sector looms bigger and the overvaluation of real estate is bigger than in America.”

He is not worried that an auction of government bonds failed this week – “that was a blip”, he says. He would still buy British bonds – “it depends on the price” – but he agrees with Mervyn King, the Governor of the Bank of England, that debt is a real problem. It will, he says, put people off investing in Britain. “I think it will have an effect, yes. It is a matter of worry because effectively the hole in the banking system is replaced by increasing the national debt.” There has been some talk that Britain might have to go cap in hand to the International Monetary Fund. “It’s conceivable,” Mr Soros says. “You have a problem that the banking system is bigger than the economy . . . so for Britain to absorb it alone would really pile up the debt . . . if the banking system continued to collapse, it’s a possibility but it’s not a likelihood.”

He refuses to say whether sterling has yet hit its lowest point. Has he shorted the pound recently? “I had shorted it last year, but I’m not shorting the pound now.” Is the euro under threat? “There is stress in the euro because of the differential in the interest rate that the different countries have to pay,” he replies.

Mr Soros is critical of the tripartite regulatory system set up when the Bank of England gained independence. “I have a different view on how the market operates than the prevailing view. I believe that the authorities have the responsibility to forestall, to counter the mood of the markets . . . I think that the problem was that the Bank of England didn’t have the supervisory authority.”

He does not, however, blame Gordon Brown. “He underestimated the severity of the problem, but then so did most people. Part of the perceived role of a leader is to cheerlead, so you can’t really blame him for that.”

From the day he was born, Mr Soros says, he was attracted to crisis. “It precedes me. I inherited it from my father.” His father had lived through the Russian Revolution and every day after school he would take his son swimming and talk about his experiences. “I sucked it in that way. And then when I was not yet 14, the Germans occupied Hungary, and I would have been deported to Auschwitz if my father hadn’t arranged for false papers. So that was a pretty profound crisis. I had to assume a false identity and live a different life.” He was separated from his parents. “We met occasionally in the swimming pool. But imagine you are 14 years old, you like adventure, and you have a father who seems to understand the situation better than others. It’s very exciting.”

He feels a similar thrill in an economic crisis. “On the one hand there’s tremendous human suffering, which is very distressing. On the other hand, to be able to handle the situation is exhilarating.”

He has always been something of an outsider. He thinks that this makes it easier for him to see through conventional wisdom. “I have always understood how normal rules may not apply at all times,” he says. In recent years he has been arguing against “market fundamentalism” – “the accepted theory was that markets tend to equilibrium”. He believes that the credit crunch has proved him right. “It reminds me of the collapse of the Soviet system, events are always exceeding people’s understanding. The situation is out of control. There’s a shortage of time to adjust to the change. Change is accelerating.”

Like Warren Buffett, he thinks that the complex financial instruments used by the banks were economic weapons of mass destruction. If anything he expected the tipping point to come earlier. “Everybody who realised that this was unsustainable expected it to collapse much sooner,” he says. “It is so devastating exactly because it took so long.”

The urgent task now, he says, is to realise that the system that collapsed was flawed. “Therefore you can’t restore it. You have to reform it.” He worries that politicians have not yet accepted the need for fundamental change and that “a lot of bankers have their head in the sand”.

H e was cast as the villain when Britain was forced out of the exchange-rate mechanism. “I didn’t speculate against sterling to benefit the public. I did it to make money,” he says.

He tells us that he has psycho-somatic illnesses – backaches and pains – that tip him off to changes in the market. “It’s as if you’re a jungle animal, and you see another animal facing you. You have to make a decision: fight or flight? Your hair stands up and you growl and you decide, ‘Am I going to attack because I’m stronger or am I going to run away because otherwise he’s going to eat me?’ You are very tense. And that’s the tension that gives you the backache.”

The G20 summit in London next week is, he says, the last chance to avert disaster. “The odds would favour that it fails because there are such differences of opinion. It’s difficult enough to get it right in your own country let alone with 20 governments coming together, but if it’s a failure I think then the global financial and trading system falls apart.”

If the G20 is nothing but a talking shop then he thinks we are heading for meltdown. “That could push the world into depression. It’s really a make-or-break occasion. That’s why it’s so important.” The chances of a depression are, he says, “quite high” – even if that is averted, the recession will last a long time. “Look, we are not going back to where we came from. In that sense it’s going to last for ever.”

Obama Makes Some Big Unprecedented Moves in the Auto Industry

As everyone knows President Obama made some big moves today in the auto industry. However, even with these big changes his popularity ratings did not change much. I suspect moves like this will become a pattern in the future. "If everyone could just please sit down and fasten your seat belts" will become a common expression going forward. Text in bold is my emphasis. From Yahoo News:

Some frustrated U.S. taxpayers cheered President Barack Obama's tough steps to shore up the reeling auto industry on Monday but critics called his decision to fire General Motors' chief a heavy-handed power grab.

Obama forced out General Motors chief executive Rick Wagoner, pushed Chrysler LLC toward a merger with Italy's Fiat SpA, and threatened bankruptcy for both, marking an escalation in Washington's involvement in rescuing the faltering economy.

Skeptics asked whether it was an early sign of a more activist administration or an isolated example. GM shares tumbled 30 percent on the news and the Dow Jones Industrial average sank nearly 4 percent.

Experts called it potentially the most significant presidential intervention in the private sector since Harry Truman tried to seize the steel industry during the Korean War in 1952, only to be rebuffed by the Supreme Court.

"I don't think the president should be running the economy. They should have let the company go bankrupt. The guy would have lost his job anyway," said Edward Prescott, a 2004 Nobel laureate in economic sciences.

As a candidate last year, Obama supported rescuing the financial sector, and since then he has shifted to attacking the bonuses and corporate jets for companies taking taxpayer money to pushing out a CEO and replacing members of the board of directors.

"Politics is certainly entering the process. GM should have gone into bankruptcy in the fall. We would be much further along with the workout by now," added Randall Filer, a professor of economics at Hunter College in New York.

Stephen Schork, editor of an industry report on the energy and shipping markets, feared Obama was trying to engineer a hasty conversion to green energy. "They are expressing abject hostility toward the hydrocarbon industry," Schork said.

At the same time, Obama's approval ratings have held firm above 60 percent in most public opinion polls. In a Cincinnati coffee shop, retiree Sharon Schmidt, 74, said she supported the decision to push Wagoner out.

"If GM is going to take a big bailout from the federal government, the people who brought it to this state should probably go," Schmidt said. "These bankers and so on are making million dollar bonuses? They should be gone, too."

In a Dallas suburb, accountant John Shaffer, 47, also approved. "I feel he was fired to force the unions and bond holders to seriously negotiate with the company. So I think it was good," he said.

Stephen Hess, a presidential scholar at the Brookings Institution, said Obama's action lacked any historical parallel because the circumstances of the financial crisis were unique and he could succeed because he seemed to have a good "internal gyroscope" on reading the mood of the public.

"So far people are with him," Hess said. "There will be a lot of people who say: At last somebody is doing something."

Opposition from Republicans in Congress was fast and fierce.

"With sweeping new power the White House will be deciding which plants will survive and which won't, so in essence, this administration has decided they know better than our courts and our free market process how to deal with these companies," said Republican Senator Bob Corker of Tennessee.

But in a sign Obama may find some support from the Republican minority, Representative Darrell Issa of California said Obama has "struck the right chord in seeking balance between supporting the American auto industry and calling for a much-needed restructuring."

Uemployment Rate by State

The Labor Department issued its state unemployment report for February, and the data underlined a continuing deterioration in the jobs market.

The unemployment rate increased in February from the previous month in every state except Nebraska. But every state has seen significant increases in joblessness since the beginning of the recession in 2007.

Earlier this month, the Labor Department reported that the national unemployment rate for February stood at 8.1%. Overall, 13 states and Washington, DC, had significantly higher jobless rates than the national figure, with seven states showing double-digit numbers. (Double click to enlarge.)

Sunday, March 29, 2009

Ever Heard of "A New Way Forward"?

Ever heard of A New Way Forward.org? This is a group of people that are trying to arrange a rally on April 11 to protest the current attempts to "fix" the financial system. Below is a statement of their Plan. Before you disregard this group out of hand, if memory serves me right the anti-war protests in the late 1960s started with anti-war demonstrations at the University of Wisconsin in 1964 with about 20 protesters and virtually no press coverage.

Just maybe the time has come for people to speak out. Trust me it is way overdue.

The Plan

DECENTRALIZE: Any bank that's "too big to fail" means that it's too big for a free market to function. The financial corporations that caused this mess must be broken up and sold back to the private market with new antitrust rules in place -- new banks, managed by new people.

As Wall St. corporations grew bigger and bigger until they were “too big to fail,” they also became so politically powerful that they led to distorted and unfair policies that served companies, not citizens.

Its not enough to try to patch up the current system. We demand serious reform that fixes the root problems in our political and economic system: excessive influence of banks, dangerous compensation systems, and massive consolidation. And we demand that the reform happen in an open and transparent manner.

This Weekend's Contemplation - Krugman's Market Mystique

Even if you just dropped in from Mars you would notice that there are at least 1,000 opinions out there on how to handle the economy and what to do next. Below is the opinion of Paul Krugman, which is worth a read. Please remember one thing the world is NOT going back to normal like it was 3 years ago. It is to early to tell what it is going to become, but the old world is gone and we should not try to re-establish it. From the NY Times:

On Monday, Lawrence Summers, the head of the National Economic Council, responded to criticisms of the Obama administration’s plan to subsidize private purchases of toxic assets. “I don’t know of any economist,” he declared, “who doesn’t believe that better functioning capital markets in which assets can be traded are a good idea.”

Leave aside for a moment the question of whether a market in which buyers have to be bribed to participate can really be described as “better functioning.” Even so, Mr. Summers needs to get out more. Quite a few economists have reconsidered their favorable opinion of capital markets and asset trading in the light of the current crisis.

But it has become increasingly clear over the past few days that top officials in the Obama administration are still in the grip of the market mystique. They still believe in the magic of the financial marketplace and in the prowess of the wizards who perform that magic.

The market mystique didn’t always rule financial policy. America emerged from the Great Depression with a tightly regulated banking system, which made finance a staid, even boring business. Banks attracted depositors by providing convenient branch locations and maybe a free toaster or two; they used the money thus attracted to make loans, and that was that.

And the financial system wasn’t just boring. It was also, by today’s standards, small. Even during the “go-go years,” the bull market of the 1960s, finance and insurance together accounted for less than 4 percent of G.D.P. The relative unimportance of finance was reflected in the list of stocks making up the Dow Jones Industrial Average, which until 1982 contained not a single financial company.

It all sounds primitive by today’s standards. Yet that boring, primitive financial system serviced an economy that doubled living standards over the course of a generation.

After 1980, of course, a very different financial system emerged. In the deregulation-minded Reagan era, old-fashioned banking was increasingly replaced by wheeling and dealing on a grand scale. The new system was much bigger than the old regime: On the eve of the current crisis, finance and insurance accounted for 8 percent of G.D.P., more than twice their share in the 1960s. By early last year, the Dow contained five financial companies — giants like A.I.G., Citigroup and Bank of America.

And finance became anything but boring. It attracted many of our sharpest minds and made a select few immensely rich.

Underlying the glamorous new world of finance was the process of securitization. Loans no longer stayed with the lender. Instead, they were sold on to others, who sliced, diced and puréed individual debts to synthesize new assets. Subprime mortgages, credit card debts, car loans — all went into the financial system’s juicer. Out the other end, supposedly, came sweet-tasting AAA investments. And financial wizards were lavishly rewarded for overseeing the process.

But the wizards were frauds, whether they knew it or not, and their magic turned out to be no more than a collection of cheap stage tricks. Above all, the key promise of securitization — that it would make the financial system more robust by spreading risk more widely — turned out to be a lie. Banks used securitization to increase their risk, not reduce it, and in the process they made the economy more, not less, vulnerable to financial disruption.

Sooner or later, things were bound to go wrong, and eventually they did. Bear Stearns failed; Lehman failed; but most of all, securitization failed.

Which brings us back to the Obama administration’s approach to the financial crisis.

Much discussion of the toxic-asset plan has focused on the details and the arithmetic, and rightly so. Beyond that, however, what’s striking is the vision expressed both in the content of the financial plan and in statements by administration officials. In essence, the administration seems to believe that once investors calm down, securitization — and the business of finance — can resume where it left off a year or two ago.

To be fair, officials are calling for more regulation. Indeed, on Thursday Tim Geithner, the Treasury secretary, laid out plans for enhanced regulation that would have been considered radical not long ago.

But the underlying vision remains that of a financial system more or less the same as it was two years ago, albeit somewhat tamed by new rules.

As you can guess, I don’t share that vision. I don’t think this is just a financial panic; I believe that it represents the failure of a whole model of banking, of an overgrown financial sector that did more harm than good. I don’t think the Obama administration can bring securitization back to life, and I don’t believe it should try.

Thursday, March 26, 2009

More Regulation of the Financial Markets is on the Way

I don't if you have have noticed, but the last few weeks has seen a flurry of new proposed legislation, regulation, etc. Whether we like it or not the US and the world is going to change significantly over the next few years. Below is a summary of the regulatory changes expected in the next round of legislation. Text in bold is my emphasis. From Yahoo News:

The Obama administration is proposing an extensive overhaul of financial regulations in an effort to prevent a repeat of the banking crisis last fall that toppled once-mighty institutions and wiped out trillions of dollars in investor wealth.

Officials said the administration will seek to regulate the market for credit default swaps and other types of derivatives and require hedge funds to register with the Securities and Exchange Commission.

Treasury Secretary Timothy Geithner was scheduled to outline the proposals in testimony Thursday before the House Financial Services Committee.

Administration officials provided details of the administration's plan before the testimony only on condition of anonymity.

The program the administration was presenting to Congress will also include a recommendation for creation of a systemic risk regulator, possibly at the Federal Reserve, to monitor risks to the entire system.

The plan also includes a measure that Geithner and Federal Reserve Chairman Ben Bernanke discussed before the committee on Tuesday to give the administration expanded powers to take over major nonbank financial institutions, such as insurance companies and hedge funds that were teetering on the brink of collapse.

That power was aimed at preventing a repeat of the problems surrounding insurance giant American International Group Inc., which sparked a furor last week when it was revealed the company had distributed $165 million in bonuses to employees of its financial products group. The unit specialized in trading credit default swaps, the instruments that drove the company to near-collapse last fall.

The administration, pushing Congress to act quickly on its reform agenda, sent Congress a 61-page bill dealing with the expanded powers to seize control of nonbank institutions late Wednesday. The House Financial Services Committee, chaired by Rep. Barney Frank, D-Mass., has indicated it could move on the measure as early as next week.

However, it was unclear how fast the rest of the financial reform agenda might move through Congress. Geithner was providing only a broad outline of the other proposals, with many thorny details remaining to be worked out.

Administration officials promised that the remaining issues would be hammered out in consultation with Congress with the goal of getting legislation approved as quickly as possible.

The administration is proposing that hedge funds and other private pools of capital, including private equity funds and venture capital funds, be required to register with the SEC if their assets exceed a certain size. The threshold amount has yet to be determined, officials said.

The proposal on credit default swaps and other derivatives would require the markets on which they are traded to be regulated for the first time, and for the buying and selling of these instruments to be conducted in ways that will foster greater oversight.

Credit default swaps, which trade in a $60 trillion global market without government oversight, are contracts to insure against the default of financial instruments like bonds and corporate debt.

They played a prominent role in the credit crisis that brought the downfall of investment banking giant Lehman Brothers Holdings Inc. last fall and nearly unraveled AIG, forcing the government to provide more than $180 billion in support.

Hedge funds, vast pools of capital holding an estimated $1.5 trillion in assets, operate mostly outside of government supervision. As the market crisis deepened last fall, hedge fund selling was widely cited as one of the reasons for increased volatility that pounded stocks and bonds. Hedge funds also suffered huge losses last year, notably from investments in securities tied to subprime mortgages.

The outline of the regulatory reform was being unveiled a week before President Barack Obama was scheduled to meet for discussions among the Group of 20 major industrialized and developing countries in London to assess what needs to be done to deal with the global financial crisis.

While the administration is pushing other nations to follow the U.S. lead in putting together sizable economic stimulus programs to jump-start global growth, many in Europe are resisting those calls and arguing that the United States needs to do more to toughen financial regulations. They believe the current troubles can be traced to lax regulation in the United States in such key areas as hedge funds and credit default swaps.

Requiring hedge funds to register would open their books to inspection by regulators. The SEC sought that authority several years ago but was stymied by a federal appeals court in 2006.
Hedge funds have grown explosively in recent years while operating secretively. They have lured an increasing number of ordinary investors, pension funds and university endowments — meaning millions of people now unwittingly invest in hedge funds indirectly.

Wednesday, March 25, 2009

China Calls for a New Currency

Many people knew that the current economic crisis would test the ability of the US dollar to remain the world reserve currency. China is calling for a new reserve currency, following in the footsteps of a proposal by Russia earlier in the month. The Bank of International Settlements (BIS) suggested the same thing several years ago. The point being that this may take a while to accomplish, but it is on its way. I personally consider this to be a news story as important as the Fed announcement last week to buy US Treasury securities. Text in bold is my emphasis. From the WSJ:

China called for the creation of a new currency to eventually replace the dollar as the world's standard, proposing a sweeping overhaul of global finance that reflects developing nations' growing unhappiness with the U.S. role in the world economy.

The unusual proposal, made by central bank governor Zhou Xiaochuan in an essay released Monday in Beijing, is part of China's increasingly assertive approach to shaping the global response to the financial crisis.

Mr. Zhou's proposal comes amid preparations for a summit of the world's industrial and developing nations, the Group of 20, in London next week. At past such meetings, developed nations have criticized China's economic and currency policies.

This time, China is on the offensive, backed by other emerging economies such as Russia in making clear they want a global economic order less dominated by the U.S. and other wealthy nations.

However, the technical and political hurdles to implementing China's recommendation are enormous, so even if backed by other nations, the proposal is unlikely to change the dollar's role in the short term. Central banks around the world hold more U.S. dollars and dollar securities than they do assets denominated in any other individual foreign currency. Such reserves can be used to stabilize the value of the central banks' domestic currencies.

Monday's proposal follows a similar one Russia made this month during preparations for the G20 meeting. Like China, Russia recommended that the International Monetary Fund might issue the currency, and emphasized the need to update "the obsolescent unipolar world economic order."

Chinese officials are frustrated at their financial dependence on the U.S., with Premier Wen Jiabao this month publicly expressing "worries" over China's significant holdings of U.S. government bonds. The size of those holdings means the value of the national rainy-day fund is mainly driven by factors China has little control over, such as fluctuations in the value of the dollar and changes in U.S. economic policies. While Chinese banks have weathered the global downturn and continue to lend, the collapse in demand for the nation's exports has shuttered factories and left millions jobless.

In his paper, published in Chinese and English on the central bank's Web site, Mr. Zhou argued for reducing the dominance of a few individual currencies, such as the dollar, euro and yen, in international trade and finance. Most nations concentrate their assets in those reserve currencies, which exaggerates the size of flows and makes financial systems overall more volatile, Mr. Zhou said.

Moving to a reserve currency that belongs to no individual nation would make it easier for all nations to manage their economies better, he argued, because it would give the reserve-currency nations more freedom to shift monetary policy and exchange rates. It could also be the basis for a more equitable way of financing the IMF, Mr. Zhou added. China is among several nations under pressure to pony up extra cash to help the IMF.

John Lipsky, the IMF's deputy managing director, said the Chinese proposal should be treated seriously. "It reflects officials' concerns about improving the stability of the financial system," he said. "It's interesting because of China's unique position, and because the governor put it in a measured and considered way."

China's proposal is likely to have significant implications, said Eswar Prasad, a professor of trade policy at Cornell University and former IMF official. "Nobody believes that this is the perfect solution, but by putting this on the table the Chinese have redefined the debate," he said. "It represents a very strong pushback by China on a number of fronts where they feel themselves being pushed around by the advanced countries," such as currency policy and funding for the IMF.

A spokeswoman for the U.S. Treasury Department declined to comment on Mr. Zhou's views. In recent weeks, senior Obama administration officials have sought to reassure Beijing that the current U.S. spending spree is a short-term effort to restart the stalled American economy, not evidence of long-term U.S. profligacy.

"The re-establishment of a new and widely accepted reserve currency with a stable valuation benchmark may take a long time," Mr. Zhou said. In remarks earlier Monday, one of his deputies, Hu Xiaolian, also said the dollar's dominant position in international trade and investment is unlikely to change soon. Ms. Hu is in charge of reserve management as the head of China's State Administration of Foreign Exchange.

Mr. Zhou's comments -- coming on the heels of Mr. Wen's musing about the safety of China's dollar holdings -- appear to be a warning to the U.S. that it can't expect China to finance its spending indefinitely.

The central banker's proposal reflects both China's desire to hold its $1.95 trillion in reserves in something other than U.S. dollars and the fact that Beijing has few alternatives. With more U.S. dollars continuing to pour into China from trade and investment, Beijing has no realistic option other than storing them in U.S. debt.

Mr. Zhou argued, without mentioning the dollar by name, that the loss of the dollar's de facto reserve status would benefit the U.S. by avoiding future crises. Because other nations continued to park their money in U.S. dollars, the argument goes, the Federal Reserve was able to pursue an irresponsible policy in recent years, keeping interest rates too low for too long and thereby helping to inflate a bubble in the housing market.

"The outbreak of the crisis and its spillover to the entire world reflected the inherent vulnerabilities and systemic risks in the existing international monetary system," Mr. Zhou said. The increasing number and intensity of financial crises suggests "the costs of such a system to the world may have exceeded its benefits."

Mr. Zhou isn't the first to make that argument. "The dollar reserve system is part of the problem," Joseph Stiglitz, the Columbia University economist, said in a speech in Shanghai last week, because it meant so much of the world's cash was funneled into the U.S. "We need a global reserve system," he said in the speech.

Mr. Zhou's idea is to expand the use of "special drawing rights," or SDRs -- a kind of synthetic currency created by the IMF in the 1960s. Its value is determined by a basket of major currencies. Originally, the SDR was intended to serve as a shared currency for international reserves, though that aspect never really got off the ground.

These days, the SDR is mainly used in the IMF's accounting for its transactions with member nations. Mr. Zhou suggested countries could increase their contributions to the IMF in exchange for greater access to a pool of reserves in SDRs.

Holding more international reserves in SDRs would increase the role and powers of the IMF. That indicates China and other developing nations aren't hostile to international financial institutions -- they just want to have more say in running them. China has resisted the U.S. push to make an immediate loan to the IMF because that wouldn't give China a bigger vote. Ms. Hu said Monday that China, which encourages the IMF to explore other fund-raising options, would consider buying into a bond issue.

The IMF has been working on a proposal to issue bonds, probably only to central banks. Bond purchases are one way for the organization to raise money and meet its goal of at least doubling its lending war chest to $500 billion from $250 billion. Japan has loaned the IMF $100 billion and the European Union has pledged another $100 billion.
Gold, the Central Banks and the IMF

Below is an article that gives a nice summary of the somewhat quiet world of gold sales and the central banks. According to the article many central banks are expected to reduce sales of gold this year. The article claims that this is being done because gold "supply and demand" or in balance. I wonder if the central banks are hedging their bets considering the condition of the economy. banks Text in bold is my emphasis. From Market Watch:

The world's major central banks, which hold more than 15% of global gold stockpiles, are expected to reduce their sales or lending of their bullion reserves this year, potentially restricting supplies and putting a floor under gold prices.

Several precious metals consultancies and the industry's main trade group anticipate total sales from major central banks such as France and Switzerland will decline again this year. One estimate projects sales could tumble to their lowest level in at least a decade.

Fewer sales mean gold supplies, which have been retreating in recent years as mining production has weakened, are likely to keep falling short of demand.

As long as investor appetite stays strong - and that's a big question mark, of course - this trend should support prices over the long term.

"Falling central bank sales have been a part of the gradual improvement in the overall balance between demand and supply in the gold market," said George Milling-Stanley, managing director of the official sector at the producer-funded World Gold Council.

"There are a whole bunch of reasons why the [gold] price has been going up, and I think that lower supply has been one of those reasons," he added. . . .

. . . . Analysts also anticipate official holders such as central banks will lend less of their reserves, keeping with a trend of recent years. Some analysts say central banks' loans of their reserves to mining companies and private banks contributed to a slump in gold prices in the second half of last year.

Another important milestone for the supply of official gold this year is the International Monetary Fund. The organization has said it plans to sell more than 400 tons of gold to diversify its revenue and strengthen its balance sheet.

Some investors are worried that the IMF sales could pressure gold prices, although the fund has said it plans to coordinate closely with central banks to minimize the impact of this large gold sale.

The IMF's plan could provide a boost in getting central banks to extend an agreement expiring in September to limit how much gold they will sell every year. That deal, called the Central Bank Gold Agreement, has helped restrain central bank gold supplies over the past decade. . . . .

. . . . Central banks sell gold to rebalance their reserves portfolio by reducing the portion of gold. By selling gold, a country can switch into assets with higher return and better liquidity.

For example, Switzerland, which had held the most gold reserves per capita in Europe in 1999, has sold more than 1,300 tons of its gold reserves. Other major sellers in the past 10 years included France, the Netherlands, and the U.K.

Countries like France, where monetary policy is now set by the European Central Bank, still maintains its own central bank. The U.S. hasn't sold gold.

In the past, abrupt selling has sometimes depressed gold prices. The Bank of England's announcement in early 1999 that it was selling part of its reserves helped gold prices slump to a 20-year low. Gold traded at just above $250 an ounce by the summer of that year.

But efforts to coordinate those sales have reduced those shocks. On Sept. 26, 1999, 15 European central banks, led by the ECB, signed the first CBGA to take concerted moves on gold sales.

The banks agreed that in a five-year period, they will cap their total gold sales at around 400 tons a year, with sales in five years not exceeding 2,000 tons. The CBGA was renewed in 2004 for another five-year period. The second CBGA raised annual ceiling to 500 tons and the five-year limit to 2,500 tons.

"There is a general consensus in the gold market that the two successive CBGAs have been a success for the whole market and for central banks in particular," said WGC's Stanley.

In the past 10 years, almost all the official gold sales have been from signatories of the CBGA. Their sales have fallen in recent years and are likely to fall further this year, analysts say.

VM Group, a precious metals consultancy based in London, estimated that selling under the CBGA will fall to 150 tons in the year ended Sept. 26. If realized, this will be the lowest number since 1999, when the first CBGA was signed.

The World Gold Council and CPM Group, a New York-based precious metals consultancy, also anticipate official gold sales will fall this year.

Central bank gold sales declined to 279 tons in the 2008 calendar year, more than 200 tons, or 42%, lower than a year ago, according to data collected by GFMS, a London-based precious metals consultancy.

The fall in official sales is a major contributor to the decline in global gold supply in 2008, GFMS data showed. Meanwhile, the portion of official sales in total gold supply also fell to 8% in 2008 from 14% a year ago.

"Central banks that wanted to reduce their gold holdings have sold most of the gold they wanted to sell by the middle of this decade," said Jeffrey Christian, managing director at CPM Group.
But further selling could come from countries that still hold a big portion of gold in their reserves, such as Germany and Italy, according to analysts at VM. Earlier this year, politicians in Germany were talking about selling gold to fund the country's stimulus package.

Aside from selling gold, some central banks also lend the metal to miners, big banks and funds. Miners borrow gold to sell forward in order to lock in their future revenue. Funds and banks sometimes sell borrowed gold to invest the proceeds in other markets.

Gold borrowed for these two purposes used to have a dramatic impact on the market because it was immediately sold in spot markets, said WGC's Stanley.

VM estimated that total outstanding balance of central bank gold lending was at 2,345 tons at the end of 2008. That's more than the year's total mining production, the major source of gold supply.

Nonetheless, this balance has shrunk consistently since the late 1990s, reducing its impact on the markets. The balance in 2008 fell almost 50% from 2004's more than 4,300 tons, according to VM.

"Gold mining companies have largely stopped selling production as a hedge, and the hedge funds have largely abandoned the practice of selling gold forward as a speculation," said Stanley.

Miners reduced forward sales by 1.54 million ounces in the fourth quarter, the smallest amount for the year, according to GFMS. Gold producers still had 15.52 million ounces left in hedging at the end of the year. . . . .

. . . . From last August, when the global credit crunch hit the financial industry, bullion banks borrowed "as much gold as was available and executed gold swaps to raise liquidity," VM analysts led by Carl Firman pointed out in a yearly report released earlier this month.

The activity had an "immediate and very marked affect" on gold by holding prices back, even in the wake of strong retail demand for physical metal, Firman wrote in a report.

Gold prices slumped nearly 30% from July's high to below $700 in November.

By lending gold, central banks can earn interest on it. Unless central banks can lend out their gold, it earns nothing, and the stockpile in fact is a cost in terms of storage and insurance, said VM's Firman in a telephone interview.

Despite some wild speculations, all evidence indicates that the U.S., the biggest gold holder, is not lending gold, said CPM's Christian.

"The people, the gold conspiracy theorists who claim evidence, twist the truth like Uri Gellar twists spoons," said Christian.

More than half of the 8,133.5 tons of gold held by the U.S. is stored in Fort Knox, Ky., according to the Treasury Department. Gold is also stored in West Point, N.Y., and Denver, Colo.

The second CBGA is expiring in September. Stanley said he expected a new agreement will be signed. William Lelieveldt, an ECB spokesman, declined to comment on the potential renewal of the agreement.

One of the beneficiaries of a third CBGA will be the IMF, which is considering coordinating with central banks to sell 403 tons of gold.

The fund, which holds more than 3,200 tons of gold, ranking the third in the world after the U.S. and Germany, is facing a widening deficit. With the majority of its income coming from interest payment of the fund's loans, the IMF has been looking for other revenue sources.

One of the plans is the creation of an endowment, with major financing for the endowment coming from the proceeds of gold sales.

The IMF acknowledged drawbacks of gold sales, but also said that the sales could "form part of a package approach" and should "subject to strong safeguards to limit their market impact," according to the plan.

The sales "need to be coordinated with the existing and possible future central bank gold agreements," the committee said in the report. By coordinating with the CBGA framework, IMF gold sales "should not add to the announced volume of sales from official sources."
The WGC's Stanley said the IMF is likely to help push through a third CBGA.

"The proposal was designed not just to plug the income gap, but also to put the IMF's finances on a more diverse, sustainable and stable footing for the longer-term, and less subject to the ups and downs of the world economy," wrote Matthew Turner, an analyst at VM, in a report.

Monday, March 23, 2009

Tough Times

A friend of mine sent me this. Unfortunately, I do not know the source.

(double click to enlarge)
A Sensible View About AIG

Below is an editorial from the NY Times that discusses the situation at AIG in a sensible and rational way, that is, what is best for the taxpayer (the primary shareholder).

Of special interest in the editorial below would be the formation of a "Pecora committee" for the current financial crisis. The original committee was formed in 1932 to understand the origins of the financial collapse in the Great Depression. A new committee would be the source of valuable information from which good policies could evolve. Besides at this time we need to dial down the rhetoric. It is time for the mob with the pitch forks to go into "time-out" for awhile.

With all that said, the taxpayer needs to believe they are: 1) being heard and 2) getting a fair shake. I think there is a high probability of a very contentious period (both in the streets and in the polls) if the taxpayer continues to be ignored except for the periodic witch hunt.

Text in bold or in color is my emphasis.

Can we all just calm down a little?

Yes, the $165 million in bonuses handed out to executives in the financial products division of AIG was infuriating. Truly, it was. As many others have noted, this is the same unit whose shenanigans came perilously close to bringing the world’s financial system to its knees. When Fed chairman, Ben Bernanke, said recently that AIG’s “irresponsible bets” had made him “more angry” than anything else about the financial crisis he could have been speaking for most Americans.

But death threats? “All the executives and their families should be executed with piano wire — my greatest hope,” wrote one person in an e-mail message to the company. Another suggested publishing a list of the “Yankee” bankers “so some good old southern boys can take care of them.”

Or how about those efforts to publicize names of individual executives who received bonuses — efforts championed by Attorney General Cuomo of New York and Barney Frank, chairman of the House Financial Services Committee. To what end?

How does outing these executives fix skewed compensation incentives, which have created that unjustified sense of entitlement that pervades Wall Street? No, it’s mostly about using subpoena power to satisfy the public’s thirst for blood. (In light of the death threats, when Mr. Cuomo received the list of AIG bonus recipients on Thursday, he promised to consider “individual security” and “privacy rights” in deciding whether to publicize the names.)

Then there was that awful Congressional hearing on Wednesday, in which AIG’s newly installed chief executive, Edward Liddy, was forced to listen to one outraged member of Congress after another rail about bonuses — and obsess about when Treasury Secretary Tim Geithner learned about them — while ignoring far more troubling problems surrounding the AIG rescue.

Oh, and let’s not forget the bill that was passed on Thursday by the House of Representatives. It would tax at a 90 percent rate bonus payments made to anyone who earned over $250,000 at any financial institution receiving significant bailout funds. Should it become law, it will affect tens of thousands of employees who had absolutely nothing to do with creating the crisis, and who are trying to help fix their companies.

Meanwhile, the real culprits — like Joseph J. Cassano, the former head of AIG’s financial products division— are counting their money in “retirement.” Nobody on Capitol Hill seems much interested in getting that money back. (And the bill does nothing about bonuses that were paid before 2009, meaning that most of those egregious Merrill Lynch bonuses, paid at the end of last year, will not be touched.)

By week’s end, I was more depressed about the financial crisis than I’ve been since last September. Back then, the issue was the disintegration of the financial system, as the Lehman bankruptcy set off a terrible chain reaction. Now I’m worried that the political response is making the crisis worse. The Obama administration appears to have lost its grip on Congress, while the Treasury Department always seems caught off guard by bad news.

And Congress, with its howls of rage, its chaotic, episodic reaction to the crisis, and its shameless playing to the crowds, is out of control. This week, the body politic ran off the rails.
There are times when anger is cathartic. There are other times when anger makes a bad situation worse. “We need to stop committing economic arson,” Bert Ely, a banking consultant, said to me this week. That is what Congress committed: economic arson.

How is the political reaction to the crisis making it worse? Let us count the ways.

IT IS DESTROYING VALUE During his testimony on Wednesday, Mr. Liddy pointed out that much of the money the government turned over to AIG was a loan, not a gift. The company’s goal, he kept saying, was to pay that money back. But how? Mr. Liddy’s plan is to sell off the healthy insurance units — or, failing that, give them to the government to sell when they can muster a good price.

In other words, it is in the taxpayers’ best interest to position AIG as a company with many profitable units, worth potentially billions, and one bad unit that needs to be unwound. Which, by the way, is the truth. But as Mr. Ely puts it, “the indiscriminate pounding that AIG is taking is destroying the value of the company.” Potential buyers are wary. Customers are going elsewhere. Employees are looking to leave. Treating all of AIG like Public Enemy No. 1 is a pretty dumb way for a majority shareholder to act when he hopes to sell the company for top dollar.

IT IS, UNFORTUNATELY, BESIDE THE POINT Even on Wall Street this week, I didn’t hear anyone condoning the AIG bonuses. They should never have been granted, and Mr. Liddy should have been tougher about renegotiating them. (A rich irony here is that any nonfinancial company in AIG’s straits would be in bankruptcy, and contracts would have to be renegotiated. The fact that the government is afraid to force AIG into bankruptcy, despite its crippled state, is the main reason Mr. Liddy felt he couldn’t try to redo the contracts.)

But there is a much bigger issue that has barely been touched upon by Congress: the way tens of billions of dollars of taxpayers’ money has been funneled to AIG’s counterparties — at 100 cents on the dollar. How can it possibly make sense that Goldman Sachs, Bank of America, Citigroup and every other company that bought credit default swaps from AIG should be made whole by the government? Why isn’t it forcing them to take a haircut?

What’s worse, some of those companies are foreign banks that used credit-default swaps to exploit a regulatory loophole. Should the United States taxpayer really be responsible for ensuring the safety of European banks that were taking advantage of European regulations?

The person who has made this point most forcefully is Eliot Spitzer, of all people. In his column for Slate.com, he wrote: “Why did Goldman have to get back 100 cents on the dollar? Didn’t we already give Goldman a $25 billion cash infusion, and aren’t they sitting on more than $100 billion in cash?” Mr. Spitzer told me that while “there is a legitimate sense of outrage over the bonuses, the larger outrage should be the use of AIG funding as a second bailout for the large investment houses.” Precisely.

IT IS DESTABILIZING How can you run a company when the rules keep changing, when you have to worry about being second-guessed by Congress? Who can do business under those circumstances?

Take, for instance, that new securitization program the government is trying to get off the ground, called the Term Asset-Backed Securities Loan Facility — or TALF. Although it is backed by large government loans, it requires people in the marketplace — Wall Street bankers! — to participate.

This program could help revive the consumer credit market. But at this point, most Wall Street bankers would rather be attacked by wild dogs than take part. They fear that they’ll do something — make money perhaps? — that will arouse Congressional ire. Or that the rules will change. “The constant flip-flopping is terrible,” said Simon Johnson, a banking expert who teaches at the MIT Sloan School of Business.

AIG offers another good example. Not all the employees who face the possibility of having their bonuses taxed out from under them work for the evil financial products division. Many of them work in insurance divisions. Very few of them pull down million-dollar bonuses, and none of them brought AIG to its knees. (And employees who bought the company’s stock are already hurting financially, having seen its value virtually wiped out.) They are the ones the company badly needs to keep if it hopes to sell those units at a healthy price. Taking away their bonuses — after they’ve already put the money in their bank accounts — hardly seems like the right way to motivate them. And demonizing them in Congressional hearings doesn’t help either.

In previous columns, I have been an advocate of nationalizing big banks like Citigroup. But after watching Congress this week, I’m having second thoughts. If this is how Congress treats AIG, what would it do if it had a bank in its paws?

What the country really needs right now from Congress is facts instead of rhetoric. Instead of these “raise your hand if you took a private jet to get here” exercises of outraged populism, we need hearings that educate and illuminate. Hearings like the old Watergate hearings. Hearings in which knowledge is accumulated over time, and a record is established. Hearings that might actually help us get out of this crisis. It’s happened before. In 1932, Congress established the Pecora committee, named for its chief counsel, Ferdinand Pecora. It was an intense, two-year inquiry, and its findings — executives shorting their own company’s stock, for instance — shocked the country. It also led to the establishment of the Securities and Exchange Commission and other investor protections. One person who has been calling for a new Pecora committee is Senator Richard Shelby of Alabama, a Republican and key member of the Senate Banking Committee.

“As we restructure our regulatory system, we need to be thorough,” he told me. “We need to understand what caused it. We shouldn’t rush it.”

Meanwhile, the House Financial Services Committee has scheduled a hearing on Tuesday featuring Mr. Bernanke and Mr. Geithner. The hearing has been called to find out only one thing: what did the two men know about the AIG bonuses, and when did they know it?

Is that Nero I hear fiddling?